The fair value of options and shares issued pursuant to the option plans and at the grant date were estimated using the Black-Scholes model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricingOption-pricing models require the input of highly subjective assumptions including the expected stock price volatility. The Company uses projected volatility rates, which are based upon historical volatility rates trended into future years. Because employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of options.

The effects of applying pro forma disclosures of net loss and net loss per share are not likely to be representative of the pro forma effects on net loss/income and net loss/earnings per share in the future years, as the number of future shares to be issued under these plans is not known and the assumptions used to determine the fair value can vary significantly.

Prior to the Company’s initial public offering, the fair value of each stock option grant was estimated using the minimum value method. Volatility and dividend yields were not factors in the Company’s minimum value calculation. Subsequent to the offering, the fair value of each stock option grant has been estimated on the date of the grant using the Black-Scholes option pricing model. The Company has also estimated the fair value of the purchase rights issued from its employee stock purchase plan using the Black-Scholes option pricing model. The Company first issued purchase rights from the 1998 Employee Stock Purchase Plan in fiscal year 1999.

10

TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, expectexcept per share amounts)

Recent accounting pronouncements

In July 2002,April 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS 146,No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, “Accounting for Costs Associated with Exit or DisposalDerivative Instruments and Hedging Activities.” SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. SFAS 146 eliminates the definition and requirement for recognition of exit costs in EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring),” where a liability for an exit cost was recognized at the date of an entity’s commitment to an exit plan. This statement149 is effective for exitcontracts entered into or disposal activities initiatedmodified after December 31, 2002.September 30, 2003, and for hedging relationships designated after September 30, 2003. The Company does not believebelieves that the adoption of this statementstandard will not have a material impact on its results of operations, financial position or cash flows.

In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002, and have been implemented in the Company’s financial statements.

In November 2002, the EITF reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The Company is currently evaluating this Issue and its impact on the Company’s financial statements.

In December 2002,May 2003, the FASB issued SFAS No. 148,150, “Accounting for Stock-Based Compensation, TransitionCertain Financial Instruments with Characteristics of both Liabilities and Disclosure.Equity.” SFAS No. 148 provides alternative methods150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of transition forboth liabilities and equity. It requires that an issuer classify a voluntary change to the fair value based methodfinancial instrument that is within its scope as a liability (or an asset in some circumstances). Many of accounting for stock-based employee compensation.those instruments were previously classified as equity. SFAS No. 148 also requires that disclosures150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the pro formafirst interim period beginning after September 15, 2003. It is to be implemented by reporting the cumulative effect of usinga change in an accounting principle for financial instruments created before the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, SFAS No. 148 requires disclosure of the pro forma effect in interim financial statements. The transition and annual disclosure requirementsissuance date of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The interim disclosure requirements are effective for interim periods150 and still existing at the beginning after December 15, 2002. The interim disclosure requirements of SFAS No. 148 have been implemented in the Company’s financial statements.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity dointerim period of adoption. Restatement is not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003.permitted. The Company believes that the adoption of this standard will not have a material impact on its financial statements.

Reclassifications

Certain reclassifications have been made to prior yearperiod balances in order to conform to the current yearperiod presentation.

TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, except per share amounts)

NOTE 3—NET LOSS PER SHARE:

Basic and diluted net loss per share is computed using the weighted average number of common shares outstanding. Options were not included in the computation of diluted net loss per share because the effect would be antidilutive.

11

TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, except per share amounts)

The calculation of net loss per share follows:

NOTE 4—COMPREHENSIVE LOSS:

Comprehensive loss includes net loss, unrealized gains and losses on other assets,investments, and foreign currency translation adjustments that have been previously excluded from net loss and reflected instead in stockholders’ equity. The following table sets forth the calculation of comprehensive loss:

		Three Months  Ended September 30,								Nine Months  Ended September 30,
		2003				2002				2003				2002
Net loss		$	(742	)		$	(5,867	)		$	(4,998	)		$	(24,621	)
Unrealized gains (losses) on investments			—				(7	)			12				(62	)
Foreign currency translation adjustments			(12	)			(4	)			(24	)			(5	)
Net change in other comprehensive loss			(12	)			(11	)			(12	)			(67	)
Total comprehensive loss		$	(754	)		$	(5,878	)		$	(5,010	)		$	(24,688	)

12

TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, except per share amounts)

NOTE 5—BALANCE SHEET COMPONENTS:

		September 30, 2003				December 31, 2002
Inventories, net:
Finished goods		$	3,601			$	3,667
Raw materials			221				221
		$	3,822			$	3,888
Property and equipment:
Computers and software		$	1,198			$	932
Test equipment			1,960				1,501
Office equipment			46				33
			3,204				2,466
Less: accumulated depreciation			(1,625	)			(836	)
		$	1,579			$	1,630
Accrued liabilities:
Provision for loss on purchase commitments		$	—			$	3,700
Professional Services			228				612
Compensation			799				604
Restructuring accrual			98				473
Other			653				535
		$	1,778			$	5,924

13

TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, except per share amounts)

Intangibles and other assets:

The aggregate amortization expense for the three and nine months ended March 31,September 30, 2003 was $442 and $1,360, respectively. The aggregate amortization expense for the three and nine months ended September 30, 2002 was $459$300 and $300,$899, respectively.

Minimum future amortization expense at March 31,as of September 30, 2003 areis as follows:

Remainder of 2003		$	449
2004			1,586
2005			955
2006			485
2007			363
Thereafter			106
		$	3,944

NOTE 6—RESTRUCTURING COSTS:

In August 2003, the Company discontinued further development of one of its products. Accordingly, the Company implemented a restructuring program that included a workforce reduction and relocation. As a result of this restructuring program, the Company recorded restructuring costs of $292. The workforce reduction was approximately 11% of the Company’s employees, resulting in severance and fringe benefit expenses of approximately $192 along with relocation costs of $100. As of September 30, 2003, the Company had a remaining accrual of $100. The restructuring will be completed by December 31, 2003.

14

TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, except per share amounts)

NOTE 6—7—COMMITMENTS AND CONTINGENCIES:

Lease obligations

The Company leases equipment and office, manufacturingassembly and warehouse space under noncancelable operating leases that expire infrom 2003 andthrough 2005. In connection with the acquisition of VideoTele.com (“VTC”) in November 2002, the Company assumed an operating lease that expires in July 2005.

In August 2002, the Company entered into an agreement to terminate its lease for engineering facilities in Bridgewater Township, New Jersey for $257, which consisted of forfeiture of a $116 letter of credit and a cash payment of $141. As part of its November 2002 restructuring program, the Company entered into an agreement to terminate its lease for its headquarters facility in Pleasanton, California for $2,409, which consisted of forfeiture of a $1,350 letter of credit and a cash payment of $1,059. The Company also incurred $327 in legal costs and other professional fees related to this lease termination. These amounts have beenwere paid as of March 31, 2003. In December 2002, the Company entered into a lease agreement for a facility in Pleasanton, California that expires in December 2003.

Minimum future lease payments under operating leases at March 31,as of September 30, 2003 are as follows:

TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, except per share amounts)

Purchase commitments

The Company had noncancelablenoncancellable commitments to purchase finished goods inventory totaling $375$416 and $421 in aggregate at March 31,September 30, 2003 and December 31, 2002, respectively.

Contingencies

Beginning July 12, 2001, sixnine putative stockholder class action lawsuits were filed in the United States District Court for the Northern District of California against Tut Systems, Inc.the Company and certain of its current and former officers and directors. The complaints were filed on behalf of a purported class of people who purchased the Company’s stock during the period between July 20, 2000 and January 31, 2001, seeking unspecified damages. The complaints allege that the Company and certain of its current and former officers and directors made false and misleading statements about itsthe Company’s business during the putative class period. Specifically, the complaints allege violations of SectionsSection 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaints have been consolidated under the nameIn re Tut Systems, Inc. Securities Litigation, Master File No. C-01-2659-CW (the “Securities Litigation Action”). Lead plaintiffs and lead counsel for plaintiffs have been appointed. Plaintiffs filed a consolidated class action complaint on February 4, 2002. Defendants filed a Motion to Dismiss on March 29, 2002. On August 15, 2002, the courtCourt granted in part and denied in part the Motion to Dismiss. On September 23, 2002, the plaintiffs filed an amended complaint. Defendants filed a motionMotion to dismiss portionsDismiss the amended complaint, and on August 6, 2003 the Court granted in part that Motion. On September 24, 2003, Defendants answered the remaining allegations of the amended complaint. The CourtDiscovery has not ruledcommenced. Trial is scheduled to begin on that motion.March 7, 2005. The Company believes it has meritorious defenses to the allegations against it are without meritin the complaint and intends to defend the actioncase vigorously. An unfavorable resolution of this litigation could have a material adverse effect on the Company’s business, results of operations, financial condition or cashflows.and cash flows.

15

TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, except per share amounts)

On March 19, 2003, Chesky Lefkowitz, a shareholder of the Company, filed a derivative complaint entitled Lefkowitz v. D’Auria, et al., No. RG03087467, in the Superior Court of the State of California, County of Alameda, against certain of the Company’s current and former officers and directors. The complaint alleges causes of action for breach of fiduciary duty, gross negligence, breach of contract, unjust enrichment and improper insider stock trading, based on the same factual allegations contained in the Securities Litigation Action. The complaint seeks unspecified damages against the individual defendants on behalf of the Company, equitable relief, and attorneys’ fees. There has not been a responseOn May 21, 2003, the Company and the individual defendants filed separate demurrers to the complaint, discovery hascomplaint. The demurrers have not commenced,yet been heard by the Court, and no trial date has been established.

On August 3, 2001, a complaint,Arrow Electronics, Inc. v. Tut Systems, Inc., Case No. CV 800433, was filed in the Superior Court of the State of California for the County of Santa Clara against the Company. The complaint was filed by one of the Company’s suppliers and alleges causes of action for breach of contract and for money on common counts. The complaint sought damages in the amount of $10,469. The Company settled this case on December 20, 2002 and the related costs have been recorded in the consolidated financial statements

On October 30, 2001, the Company and certain of its current and former officers and directors were named as defendants inWhalen v. Tut Systems, Inc. et al., Case No. 01-CV-9563, a purported securities class action lawsuit filed in the United States District Court for the Southern District of New York. An amended complaint was filed on December 5, 2001. A consolidated amended complaint was filed on April 19, 2002. The consolidated amended complaint asserts that the prospectuses from the Company’s January 29, 1999 initial public offering and its March 23, 2000 secondary offering failed to disclose certain alleged actions by the underwriters for the offerings. The complaint alleges claims against the Company and certain of its current and former officers and directors under Section 11 of the Securities Act of 1933, as amended, (the “1933 Act”) and under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended, and alleges claims against certain of its current and former officers and directors under Sections 15 and 20(a) of the 1933 Act. The complaints also name as defendants the underwriters for the Company’s initial public offering and secondary offering. The Court has denied the Company’s motion to dismissdismiss. The Company’s Board recently approved a tentative settlement proposal from the plaintiffs. The settlement is subject to a number of conditions, including approval of the Court. If the settlement does not occur, and the case will now proceed to discovery. Thelitigation against the Company continues, the Company believes it has meritorious defenses to the allegations against it are without meritin the complaint and intends to defend the actioncase vigorously. An unfavorable resolution of this litigation could have a material adverse effect on the Company’s business, results of operations, financial condition orand cash flows.

The Company is subject to other legal proceedings, claims and litigation arising in the ordinary course of business. The Company’s management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on the Company’s consolidated financial position, results of operations, or cash flows.

16

TUT SYSTEMS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(in thousands, except per share amounts)

NOTE 7—8—SEGMENT INFORMATION:

Revenue

The Company currently targets its sales and marketing efforts to both public and private service providers and users across two related markets. TheManagement evaluates the financial performance of the Company currently operates inas a single business segment as there is only one measurement of profitability for its operations.segment. Revenues are attributed to the following countries based on the location of customers: