1. DESCRIPTION OF BUSINESS
Cisco Systems, Inc. and its subsidiaries ("Cisco" or the "Company") is the worldwide leader in networking for the Internet. Cisco hardware, software, and service offerings are used to create Internet solutions so that individuals, companies, and countries have seamless access to information -- regardless of differences in time and place. Cisco solutions provide competitive advantage to our customers through more efficient and timely exchange of information, which in turn leads to cost savings, process efficiencies, and closer relationships with their customers, prospects, business partners, suppliers, and employees. These solutions form the networking foundation for companies, universities, utilities, and government agencies worldwide.


2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Fiscal Year The Company's fiscal year is the 52 or 53 weeks ending on the last Saturday in July. Fiscal 2000, 1999, and 1998 were 52-week, 53-week, and 52-week fiscal years, respectively.

Principles of Consolidation The Consolidated Financial Statements include the accounts of Cisco Systems, Inc. and its subsidiaries. All significant intercompany accounts and transactions have been eliminated.

Cash and Cash Equivalents The Company considers all highly liquid investments purchased with an original or remaining maturity of less than three months at the date of purchase to be cash equivalents. Substantially all cash and cash equivalents are custodied with three major financial institutions.

Investments The Company's investments comprise U.S., state, and municipal government obligations; corporate debt securities; and public corporate equity securities. Investments with maturities of less than one year are considered short-term and are carried at fair value. All investments are primarily held in the Company's name and custodied with two major financial institutions. The specific identification method is used to determine the cost of securities disposed. At July 29, 2000 and July 31, 1999, substantially all of the Company's investments were classified as available for sale. Unrealized gains and losses on these investments are included as a separate component of shareholders' equity, net of any related tax effect.

The Company also has certain other minority investments in nonpublicly traded companies. These investments are included in other assets on the Company's balance sheet and are generally carried at cost. The Company monitors these investments for impairment and makes appropriate reductions in carrying values when necessary.

Inventories Inventories are stated at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis.

Restricted Investments Restricted investments consist of U.S. government obligations with maturities of more than one year. These investments are carried at fair value and are restricted as to withdrawal. Restricted investments are held in the Company's name and custodied with two major financial institutions.

Fair Value of Financial Instruments Carrying amounts of certain of the Company's financial instruments, including cash and cash equivalents, accrued compensation, and other accrued liabilities, approximate fair value because of their short maturities. The fair values of investments are determined using quoted market prices for those securities or similar financial instruments.

Concentrations Cash and cash equivalents are primarily maintained with three major financial institutions in the United States. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and, therefore, bear minimal risk.

The Company performs ongoing credit evaluations of its customers and, with the exception of certain financing transactions, does not require collateral from its customers.

The Company receives certain of its components from sole suppliers. Additionally, the Company relies on a limited number of hardware manufacturers. The inability of any supplier or manufacturer to fulfill supply requirements of the Company could materially impact future operating results.

Revenue Recognition The Company generally recognizes product revenue when persuasive evidence of an arrangement exists, delivery has occurred, fee is fixed or determinable, and collectibility is probable. Revenue from service obligations is deferred and generally recognized ratably over the period of the obligation. The Company makes certain sales to partners in two-tier distribution channels. These partners are generally given privileges to return a portion of inventory and participate in various cooperative marketing programs. The Company recognizes revenue to two-tier distributors based on estimates which approximate the point products have been sold by the distributors and also maintains accruals and allowances for all cooperative marketing and other programs. The Company accrues for warranty costs, sales returns, and other allowances based on its experience.

Lease Receivables Cisco provides a variety of lease financing services to its customers to build, maintain, and upgrade their networks. Lease receivables represent the principal balance remaining in sales-type and direct-financing leases under these programs. These leases typically have two to three year terms and are collateralized by a security interest in the underlying assets.

Advertising Costs The Company expenses all advertising costs as incurred.

Software Development Costs Software development costs, which are required to be capitalized pursuant to Statement of Financial Accounting Standards No. 86, "Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed," have not been material to date.

Depreciation and Amortization Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization is computed using the straight-line method over the estimated useful lives of the assets. Estimated useful lives of 24 to 30 months are used on computer equipment and related software and production and engineering equipment and five years for office equipment, furniture, and fixtures. Depreciation and amortization of leasehold improvements is computed using the shorter of the remaining lease term or five years.

Goodwill and Purchased Intangible Assets Goodwill and purchased intangible assets are carried at cost less accumulated amortization. Amortization is computed using the straight-line method over the economic lives of the respective assets, generally three to five years.

Income Taxes Income tax expense is based on pre-tax financial accounting income. Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts.

Computation of Net Income per Common Share Basic net income per common share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income per common share is computed using the weighted-average number of common and dilutive common equivalent shares outstanding during the period. Dilutive common equivalent shares consist of stock options. Share and per-common share data for all periods presented reflect the two-for-one stock split effective March 2000.

Foreign Currency Translation Assets and liabilities of non-U.S. subsidiaries that operate in a local currency environment are translated to U.S. dollars at exchange rates in effect at the balance sheet date with the resulting translation adjustments recorded directly to a separate component of shareholders' equity. Income and expense accounts are translated at average exchange rates during the year. Where the U.S. dollar is the functional currency, translation adjustments are recorded in income.

Derivatives The Company enters into foreign exchange forward contracts to minimize the short-term impact of foreign currency fluctuations on assets and liabilities denominated in currencies other than the functional currency of the reporting entity. All foreign exchange forward contracts are highly inversely correlated to the hedged items and are designated as, and considered effective as, hedges of the underlying assets or liabilities. Gains and losses on the contracts are included in interest and other income, net, and offset foreign exchange gains or losses from the revaluation of intercompany balances or other current assets and liabilities denominated in currencies other than the functional currency of the reporting entity. Fair values of foreign exchange forward contracts are determined using published rates. If a derivative contract terminates prior to maturity, the investment is shown at its fair value with the resulting gain or loss reflected in interest and other income, net. The Company periodically hedges anticipated transactions with purchased currency options. The premium paid is amortized over the life of the option while any intrinsic value is recognized in income during the same period as the hedged transaction.

Minority Interest Minority interest represents the preferred stockholders' proportionate share of the equity of Cisco Systems, K.K. (Japan). At July 29, 2000, the Company owned all issued and outstanding common stock amounting to 73.2% of the voting rights. Each share of preferred stock is convertible into one share of common stock at any time at the option of the holder.

Use of Estimates The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Estimates are used for, but not limited to, the accounting for the allowance for doubtful accounts, inventory allowances, depreciation and amortization, sales returns, warranty costs, taxes, and contingencies. Actual results could differ from these estimates.

Impairment of Long-Lived Assets Long-lived assets and certain identifiable intangible assets to be held and used are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. Measurement of an impairment loss for long-lived assets and certain identifiable intangible assets that management expects to hold and use are based on the fair value of the asset. Long-lived assets and certain identifiable intangible assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell.

Recent Accounting Pronouncements In June 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 133, as amended, establishes accounting and reporting standards for derivative instruments and hedging activities. It requires an entity to recognize all derivatives as either assets or liabilities on the balance sheet and measure those instruments at fair value. Management does not expect the initial adoption of SFAS 133 to have a material effect on the Company's operations or financial position. The Company is required to adopt SFAS 133 in the first quarter of fiscal 2001.

In September 1999, the FASB issued Emerging Issues Task Force Topic No. D-83, "Accounting for Payroll Taxes Associated with Stock Option Exercises" ("EITF D-83"). EITF D-83 requires that payroll tax paid on the difference between the exercise price and the fair value of acquired stock in association with an employee's exercise of stock options be recorded as operating expenses. Payroll tax on stock option exercises of $51 million was expensed in fiscal 2000.

In December 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101"). SAB 101, as amended, summarizes certain of the SEC's views in applying generally accepted accounting principles to revenue recognition in financial statements. At this time, management does not expect the adoption of SAB 101 to have a material effect on the Company's operations or financial position; however, the SEC's final guidance for implementation has not been released to date. The Company is required to adopt SAB 101 in the fourth quarter of fiscal 2001.

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

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3. BUSINESS COMBINATIONS

Pooling of Interests Combinations
In fiscal 2000, the Company acquired StratumOne Communications, Inc. ("StratumOne"); TransMedia Communications, Inc. ("TransMedia"); Cerent Corporation ("Cerent"); WebLine Communications Corporation ("WebLine"); SightPath, Inc. ("SightPath"); InfoGear Technology Corporation ("InfoGear"); and ArrowPoint Communications, Inc. ("ArrowPoint"), which were accounted for as poolings of interests. All historical financial information has been restated to reflect these acquisitions. In addition, the historical financial information has been restated to reflect the acquisition of Fibex Systems ("Fibex"), which was completed in the fourth quarter of fiscal 1999 and accounted for as a pooling of interests. These transactions are summarized as follows (in millions):


All of these acquired companies used a calendar year end. In order for all companies to operate on the same fiscal year, operations for the one-month period ending July 31, 1999, which were not significant to the Company, have been reflected as an adjustment to retained earnings in fiscal 2000. No significant adjustments were necessary to conform accounting policies. However, the companies' historical results have been adjusted to reflect the elimination of previously provided valuation allowances on deferred tax assets. There were no intercompany transactions requiring elimination in any period presented. The following table shows the historical results for the periods prior to the mergers of these entities (in millions):


In fiscal 1999, the Company acquired GeoTel Communications Corporation, and approximately 68 million shares of common stock were exchanged and options were assumed for a fair value of $2 billion. The transaction was accounted for as a pooling of interests and all periods presented prior to fiscal 1999 were restated.

Other Pooling of Interests Combinations Completed as of July 29, 2000
The Company has also completed a number of other pooling transactions during the three years ended July 29, 2000. The historical operations of these entities were not material to the Company's consolidated operations on either an individual or aggregate basis; therefore, prior period financial statements have not been restated for these acquisitions. These transactions are summarized as follows (in millions):



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Purchase Combinations
During the three years ended July 29, 2000, the Company completed a number of purchase acquisitions. The Consolidated Financial Statements include the operating results of each business from the date of acquisition. Pro forma results of operations have not been presented because the effects of these acquisitions were not material on either an individual or an aggregate basis.

The amounts allocated to in-process research and development ("in-process R&D") were determined through established valuation techniques in the high-technology communications equipment industry and were expensed upon acquisition because technological feasibility had not been established and no future alternative uses existed. Amounts allocated to goodwill and purchased intangible assets are amortized on a straight-line basis over periods not exceeding five years. A summary of purchase transactions is outlined as follows (in millions):



Other Purchase Combinations Completed as of July 29, 2000
In fiscal 2000, the Company acquired Maxcomm Technologies, Inc.; Calista, Inc.; Tasmania Network Systems, Inc.; Internet Engineering Group, LLC; Worldwide Data Systems, Inc.; and Seagull Networks, Ltd. for a total purchase price of $228 million, paid in common stock and cash. Total in-process R&D related to these acquisitions amounted to $71 million.

Total in-process R&D expense in fiscal 2000, 1999, and 1998 was $1.37 billion, $471 million, and $594 million, respectively. The in-process R&D expense that was attributable to stock consideration for the same periods was $1.28 billion, $379 million, and $436 million, respectively.

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4. BALANCE SHEET DETAIL
The following tables provide details of selected balance sheet items (in millions):



5. LEASE RECEIVABLES
Lease receivables represent sales-type and direct-financing leases resulting from the sale of the Company's and complementary third-party products and services. These lease arrangements typically have terms from two to three years and are usually collateralized by a security interest in the underlying assets. The net lease receivables are summarized as follows (in millions):



Contractual maturities of the gross lease receivables at July 29, 2000 were $588 million in fiscal 2001, $354 million in fiscal 2002, $337 million in fiscal 2003, $29 million in fiscal 2004, and $2 million in fiscal 2005. Actual cash collections may differ from the contractual maturities due to early customer buyouts or refinancings. The current portion of lease receivables is included in prepaid expenses and other current assets.

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6. INVESTMENTS
The following tables summarize the Company's investments in securities (in millions):


Net gains realized on minority investments were $531 million in fiscal 2000. The net gains realized on minority investments that were attributable to noncash activity were $92 million in fiscal 2000. The net gains realized on minority investments were not material in fiscal 1999 and were $5 million in fiscal 1998.

The following table summarizes debt investment and mandatorily redeemable convertible preferred stock maturities (including restricted investments) at July 29, 2000 (in millions):



7. LINE OF CREDIT
At July 29, 2000, the Company had a syndicated credit agreement under the terms of which a group of banks committed a maximum of $500 million on an unsecured, revolving basis for borrowings of various maturities. The commitments made under this agreement expire on July 1, 2002. Under the terms of the agreement, borrowings bear interest at a spread over the London Interbank Offered Rate based on certain financial criteria and third-party rating assessments. As of July 29, 2000, this spread was 17.5 basis points. From this spread, a commitment fee of 5.5 basis points is assessed against any undrawn amounts. The agreement includes a single financial covenant that places a variable floor on tangible net worth, as defined, if certain leverage ratios are exceeded. There have been no borrowings under this agreement to date.

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8. COMMITMENTS AND CONTINGENCIES

Leases
The Company has entered into several agreements to lease 448 acres of land located in San Jose, California, where it has established its headquarters operations, and 759 acres of land located in Boxborough, Massachusetts; Salem, New Hampshire; Richardson, Texas; and Research Triangle Park, North Carolina, where it has expanded certain research and development and customer-support activities.

All of the leases have initial terms of five to seven years and options to renew for an additional three to five years, subject to certain conditions. At any time during the terms of these leases, the Company may purchase the land. If the Company elects not to purchase the land at the end of each of the leases, the Company has guaranteed a residual value of $624 million.

The Company has also entered into agreements to lease certain buildings standing or to be constructed on the land described above. The lessors of the buildings have committed to fund up to a maximum of $1.40 billion (subject to reductions based on certain conditions in the respective leases) for the construction of the buildings, with the portion of the committed amount actually used to be determined by the Company. Rent obligations for the buildings commenced on various dates and will expire at the same time as the land leases.

The Company has options to renew the building leases for an additional three to five years, subject to certain conditions. The Company may, at its option, purchase the buildings during or at the end of the terms of the leases at approximately the amount expended by the lessors to construct the buildings. If the Company does not exercise the purchase options by the end of the leases, the Company will guarantee a residual value of the buildings as determined at the lease inception date of each agreement (approximately $748 million at July 29, 2000).

As part of the above lease transactions, the Company restricted $1.29 billion of its investment securities as collateral for specified obligations of the lessors under the leases. These investment securities are restricted as to withdrawal and are managed by a third party subject to certain limitations under the Company's investment policy. In addition, the Company must maintain a minimum consolidated tangible net worth, as defined.

The Company also leases office space in Santa Clara, California; Chelmsford, Massachusetts; and for its various U.S. and international sales offices.

Future annual minimum lease payments under all noncancelable operating leases as of July 29, 2000 are as follows (in millions):



Rent expense totaled $229 million, $123 million, and $90 million for fiscal 2000, 1999, and 1998, respectively.

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Foreign Exchange Forward and Option Contracts
The Company conducts business on a global basis in several major currencies. As such, it is exposed to adverse movements in foreign currency exchange rates. The Company enters into foreign exchange forward contracts to reduce the impact of certain currency exposures. These contracts hedge exposures associated with nonfunctional currency assets and liabilities denominated in Australian, Canadian, Japanese, Korean, and several European currencies, primarily the euro and British pound.

The Company does not enter into foreign exchange forward contracts for trading purposes. Gains and losses on the contracts are included in interest and other income, net, and offset foreign exchange gains or losses from the revaluation of intercompany balances or other current assets and liabilities denominated in currencies other than the functional currency of the reporting entity. The Company's foreign exchange forward contracts generally range from one to three months in original maturity.

The Company periodically hedges anticipated transactions with purchased currency options. A purchased currency option's premium is amortized over the life of the option while any intrinsic value is recognized in income during the same period as the hedged transaction. The deferred premium and intrinsic value from hedging anticipated transactions were not material at July 29, 2000. In the unlikely event that the underlying transaction terminates or becomes improbable, the remaining premium or deferred intrinsic value will be recorded in the Consolidated Statements of Operations. The Company does not purchase currency options for trading purposes. Foreign exchange forward and option contracts as of July 29, 2000 are summarized as follows (in millions):



The Company's foreign exchange forward and option contracts contain credit risk to the extent that its bank counterparties may be unable to meet the terms of the agreements. The Company minimizes such risk by limiting its counterparties to major financial institutions. In addition, the potential risk of loss with any one party resulting from this type of credit risk is monitored. Management does not expect any material losses as a result of default by other parties.

Legal Proceedings
The Company is subject to legal proceedings, claims, and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, 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.

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9. SHAREHOLDERS' EQUITY

Authorized Shares
On November 10, 1999, the shareholders of the Company approved an increase to the authorized number of shares of common stock from 5.40 billion to 10 billion shares. On March 20, 2000, the Board of Directors of the Company approved an increase to the authorized number of shares of common stock from 10 billion to 20 billion shares relating to the two-for-one stock split distributed on March 22, 2000.

Stock Split
The Board of Directors authorized the splitting of the Company's common stock on a two-for-one basis for shareholders of record on February 22, 2000 and the resulting shares from the split were distributed on March 22, 2000. All references to share and per-share data for all periods presented have been adjusted to give effect to this two-for-one stock split.

Shareholders' Rights Plan
In June 1998, the Board of Directors approved a Shareholders' Rights Plan ("Rights Plan"). The Rights Plan is intended to protect shareholders' rights in the event of an unsolicited takeover attempt. It is not intended to prevent a takeover of the Company on terms that are favorable and fair to all shareholders and will not interfere with a merger approved by the Board of Directors. Each right entitles shareholders to buy a unit equal to a portion of a new share of Series A Preferred Stock of the Company. The rights will be exercisable only if a person or a group acquires or announces a tender or exchange offer to acquire 15% or more of the Company's common stock.

In the event the rights become exercisable, the Rights Plan allows for Cisco shareholders to acquire, at an exercise price of $108 per right owned, stock of the surviving corporation having a market value of $217, whether or not Cisco is the surviving corporation. The rights, which expire in June 2008, are redeemable for $0.00017 per right at the approval of the Board of Directors.

Preferred Stock
Under the terms of the Company's Articles of Incorporation, the Board of Directors may determine the rights, preferences, and terms of the Company's authorized but unissued shares of preferred stock.

Comprehensive Income
The components of comprehensive income, net of tax, are as follows (in millions):


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10. EMPLOYEE BENEFIT PLANS

Employee Stock Purchase Plan
The Company has an Employee Stock Purchase Plan (the "Purchase Plan") under which 222 million shares of common stock have been reserved for issuance. Eligible employees may purchase a limited number of shares of the Company's common stock at 85% of the market value at certain plan-defined dates. The Purchase Plan terminates on January 3, 2005. In fiscal 2000, 1999, and 1998, seven million, 10 million, and 14 million shares, respectively, were issued under the Purchase Plan. At July 29, 2000, 123 million shares were available for issuance under the Purchase Plan.

Employee Stock Option Plans
The Company has two main stock option plans: the 1987 Stock Option Plan (the "Predecessor Plan") and the 1996 Stock Incentive Plan (the "1996 Plan"). The Predecessor Plan was terminated in 1996. All outstanding options under the Predecessor Plan were transferred to the 1996 Plan. However, all outstanding options under the Predecessor Plan continue to be governed by the terms and conditions of the existing option agreements for those grants.

The maximum number of shares under the 1996 Plan was initially limited to the 620 million shares transferred from the Predecessor Plan. However, under the terms of the 1996 Plan, the share reserve increased each December for the three fiscal years beginning with fiscal 1997, by an amount equal to 4.75% of the outstanding shares on the last trading day of the immediately preceding November. In fiscal 1999, the Company's shareholders approved the extension of the automatic share increase provision of the 1996 Plan for an additional three-year period.

Although the Board of Directors has the authority to set other terms, the options are generally 20% or 25% exercisable one year from the date of grant and then ratably over the following 48 or 36 months, respectively. Options issued under the Predecessor Plan generally had terms of four years. New options granted under the 1996 Plan expire no later than nine years from the grant date. A summary of option activity follows (in millions, except per-share amounts):



The Company has, in connection with the acquisitions of various companies, assumed the stock option plans of each acquired company. During fiscal 2000, a total of approximately 31 million shares of the Company's common stock have been reserved for issuance under the assumed plans and the related options are included in the preceding table.

In 1997, the Company adopted a Supplemental Stock Incentive Plan (the "Supplemental Plan") under which options can be granted or shares can be directly issued to eligible employees. Officers and members of the Company's Board of Directors are not eligible to participate in the Supplemental Plan. Nine million shares have been reserved for issuance under the Supplemental Plan, of which 9,000 shares are subject to outstanding options and 66,600 shares have been issued in fiscal 2000.

The following table summarizes information concerning outstanding and exercisable options at July 29, 2000 (in millions, except number of years and per-share amounts):