Cisco Systems, Inc. (the "Company") provides networking solutions that connect computing devices and computer networks, allowing people to access or transfer information without regard to differences in time, place, or type of computer system. The Company sells its products in approximately 90 countries through a combination of direct sales and reseller and distribution channels.

Fiscal Year
The Company's fiscal year is the 52 or 53 weeks ending on the last Saturday in July. The fiscal years ended July 26, 1997, July 28, 1996, and July 30, 1995 all comprised 52-week years. Prior to fiscal year 1997, the Company's fiscal year was the 52- or 53-week period ending on the last Sunday in July.

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 Equivalents
The Company considers cash and 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 of its cash and equivalents are custodied with three major financial institutions.

Short-Term Investments
The Company's short-term investments comprise U.S., state, and municipal government obligations, and foreign and corporate securities with maximum maturities of one year. These investments are carried at fair value. Nearly all short-term investments are held in the Company's name and custodied with two major financial institutions.

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.

Investments
Investments consist of U.S., state, and municipal government obligations, and foreign and corporate securities with maturities of more than one year. These investments are carried at fair value. Nearly all investments are held in the Company's name and custodied with two major financial institutions.

Restricted Investments
Restricted investments consist of U.S. governmental obligations with maturities of more than one year. These investments are carried at fair value and are restricted as to withdrawal (see Note 7). 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 equivalents, accrued payroll, 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 (see Note 5 on investments).

Concentrations
Cash and equivalents are, for the most part, maintained with several 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 generally does not require collateral from its customers.

The Company receives certain of its custom semiconductor chips for some of its products 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 impact future results. The Company continually monitors exposures in this regard.

Revenue Recognition
The Company generally recognizes product revenue upon shipment of product. Revenue from service obligations is deferred and recognized over the lives of the contracts. The Company accrues for warranty costs, sales returns, and other allowances at the time of shipment based on its experience.

Depreciation and Amortization
Property and equipment are stated at cost and depreciated on a straight-line basis over the estimated useful lives of the assets. Such lives vary from two and one-half to five years. Goodwill and other intangible assets are included in other assets and are carried at cost less accumulated amortization, which is being provided on a straight-line basis over the economic lives of the respective assets, generally three to five years.

Income Taxes
Income tax expense is based on pretax 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
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.

Foreign Currency Translation
Substantially all of the Company's international subsidiaries use their local currency as their functional currency. For those subsidiaries using the local currency as their functional currency, assets and liabilities are translated at exchange rates in effect at the balance sheet date and income and expense accounts at average exchange rates during the year. Resulting translation adjustments are recorded directly to a separate component of shareholders' equity. Where the U.S. dollar is the functional currency, translation adjustments are recorded in income.

Derivatives
The Company enters into forward exchange 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 designated as and effective as a hedge and are highly inversely correlated to the hedged item as required by generally accepted accounting principles.

Gains and losses on the contracts are included in other income 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 exchange 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/(loss) reflected in operating results.

Minority Interest
Minority interest represents the minority stockholders' proportionate share of the equity of Nihon Cisco Systems, K.K. At July 26, 1997, the Company maintained 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 in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Estimates are used for, but not limited to, the accounting for doubtful accounts, depreciation and amortization, sales returns, warranty costs, taxes, and contingencies. Actual results could differ from these estimates.

Recent Accounting Pronouncements
In February 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 128, "Earnings per Share" (EPS), which simplifies existing computational guidelines, revises disclosure requirements, and increases the comparability of earnings per share on an international basis. Management has not yet evaluated the effects of this change in computational guidelines on the Company's EPS. SFAS No. 128 is effective for periods ending after December 15, 1997 and requires restatement of all prior period EPS data presented. The Company will adopt SFAS No. 128 in its second quarter of fiscal year 1998.

In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income," which establishes standards for reporting and display of comprehensive income and its components (revenue, expenses, gains, and losses) in a full set of general-purpose financial statements. The Company will adopt SFAS No. 130 in its fiscal year 1999.

In June 1997, the FASB issued SFAS No. 131, "Disclosure about Segments of an Enterprise and Related Information," which changes the way public companies report information about operating segments. SFAS No. 131, which is based on the management approach to segment reporting, establishes requirements to report selected segment information quarterly and to report entity-wide disclosures about products and services, major customers, and the material countries in which the entity holds assets and reports revenue. Management has not yet evaluated the effects of this change on its reporting of segment information. The Company will adopt SFAS No. 131 in its fiscal year 1999.

Pooling of Interests Combinations
On July 9, 1996, the Company acquired StrataCom, Inc. ("StrataCom"). Under the terms of the agreement, one share of the Company's common stock was exchanged for each outstanding share of StrataCom. Approximately 76.4 million shares of common stock were issued to acquire StrataCom.

The Company also assumed remaining outstanding StrataCom stock options that were converted to options to purchase approximately 11.5 million shares of the Company's common stock. The transaction was accounted for as a pooling of interests in fiscal year 1996; therefore, all prior periods presented were restated.

Prior to the merger, StrataCom used a calendar year end. Restated financial statements of the Company combine the July 28, 1996, and July 30, 1995 results of the Company with the June 30, 1996, and July 1, 1995 results of StrataCom, respectively. No adjustments have been made to conform accounting policies of the entities. However, StrataCom's historical results have been adjusted to reflect an increase in income taxes because of the elimination of a previously provided valuation allowance on its deferred tax asset as of the earliest period presented. There were no significant intercompany transactions requiring elimination in any period presented. In order for both companies to operate on the same fiscal year for 1997, StrataCom's operations for the one-month period ended July 28, 1996 that are not material to the consolidated companies have been reflected as an adjustment to retained earnings in the first quarter of fiscal 1997.

The Company has also completed a number of other pooling acquisitions. The historical operations of these entities is immaterial to the Company's consolidated operations on either an individual or an aggregated basis; therefore, prior period statements have not been restated for these acquisitions. These transactions are summarized as follows (in millions of shares):

In conjunction with these poolings, the Company also assumed the outstanding options of these companies, which were converted to options to purchase approximately 3.6 million shares of the Company's common stock.

Purchase Combinations
During the three years ended July 26, 1997, the Company made the acquisitions described in the paragraphs that follow, each of which has been accounted for as a purchase. 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 purchased research and development were determined through established valuation techniques in the high-technology communications industry and were expensed upon acquisition, because technological feasibility had not been established and no future alternative uses existed. Research and development costs to bring the products from the acquired companies to technological feasibility are not expected to have a material impact on the Company's future results of operations or cash flows. Amounts allocated to goodwill and other intangibles are amortized on a straight-line basis up to a five-year period.

In January 1995, the Company acquired substantially all of the assets and assumed the liabilities of LightStream Corporation ("LightStream"), a developer of enterprise-class ATM switching technology, for $120.0 million in cash and related acquisition costs of approximately $.5 million.

The purchase price was allocated to the acquired assets and assumed liabilities based on fair values as follows (in thousands):

The remaining amounts allocated to goodwill after the $5.1 million write-off in fiscal 1996 were amortized on a straight-line basis over two years.

In October 1996, the Company acquired substantially all of the assets of Telebit Corporation ("Telebit") and its Modem ISDN Channel Aggregation (MICA™) technologies for approximately $200.0 million in cash. The Company purchased Telebit patents and MICA intellectual property, established employment contracts with MICA personnel, and assumed certain preferred stock and notes receivable related to a management buyout of the remaining assets of Telebit. As part of this transaction, the Company recorded approximately $174.6 million in purchased research and development expense in the first quarter of fiscal 1997.

In November 1996, the Company acquired Netsys Technologies ("Netsys"), a privately held innovator of network infrastructure management and performance analysis software. Under the terms of the agreement, the Company exchanged common stock worth approximately $81.1 million and assumed net liabilities of approximately $3.8 million for all outstanding shares and options of Netsys. As part of this transaction, the Company recorded approximately $43.2 million in purchased research and development expense and $41.7 million of goodwill and other intangible assets in the second quarter of fiscal 1997.

In July 1997, the Company completed the acquisition of Skystone Systems Corporation ("Skystone"), an innovator of high-speed Synchronous Optical Network/Synchronous Digital Hierarchy (SONET/SDH). Under the terms of the agreement, shares of the Company's common stock worth approximately $69.4 million, and $22.7 million in cash has been exchanged for all outstanding shares, warrants, and options of Skystone. As part of this transaction, the Company recorded approximately $89.4 million in purchased research and development expense.

In July 1997, the Company acquired Ardent Communications ("Ardent"), a designer of combined communications support for compressed voice, LAN, data, and video traffic across public and private Frame Relay and ATM networks. Under the terms of the agreement, shares of the Company's stock worth approximately $165.3 million have been exchanged for the outstanding shares and options of Ardent. As part of this transaction, the Company recorded approximately $163.6 million in purchased research and development expense.

Also in July 1997, the Company acquired Global Internet Software Group ("Global Internet"), a wholly owned subsidiary of Global Internet.Com and a pioneer in the Windows NT network security marketplace. Approximately $40.2 million in cash was exchanged for all of the outstanding shares of Global Internet. As part of this transaction, the Company recorded approximately $37.6 million in purchased research and development expense.

Business Combinations Completed Subsequent to Year-End
On July 28, 1997, the Company entered into an agreement to purchase the Dagaz xDSL business of Integrated Network Corporation ("INC"). The Company agreed to pay approximately $108.0 million in cash for the xDSL business. As part of this transaction, the Company assumed approximately .2 million shares of INC stock options, which will be converted to options to purchase the Company's common stock. This transaction was completed in August 1997.

At July 26, 1997 and July 28, 1996, substantially all of the Company's investments were classified as available for sale. The difference between the cost and fair value of those investments, net of the tax effect, is shown as a separate component of shareholders' equity.

The following tables summarize the Company's investment in securities (in thousands):

There were no material realized gains in fiscal years 1996 and 1995. Gross realized gains and losses on the sale of investments are calculated using the specific identification method.

In July 1997, the Company entered into a syndicated credit agreement under the terms of which a group of banks has committed a maximum of $500.0 million on an unsecured, revolving basis for cash borrowings of various maturities. The commitments made under this agreement expire on July 1, 2002. This agreement replaces an earlier, three-year, $100.0 million credit agreement entered into on May 22, 1995. Under the terms of the new agreement, borrowings bear interest at a spread over the London Interbank Offered Rate based on certain financial criteria and third-party rating assessments or other alternative rates. As of July 26, 1997, this spread was 20 basis points. A commitment fee of 7 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 or the previous agreement.

Leases
The Company has entered into several agreements to lease 221 acres of land located in San Jose, California, where it has established its headquarters operations, and 45 acres of land located in 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 land 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 $124.1 million.

The Company has also entered into agreements to lease certain buildings to be constructed on the land described above. The lessors of the buildings have committed to fund up to a maximum of $341.6 million (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 an option 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 ends 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 ends of the leases, the Company will guarantee a residual value of the buildings as determined at the lease inception date of each agreement (approximately $186.6 million at July 26, 1997).

As part of the above lease transactions, the Company restricted $363.2 million of its investment securities as collateral for specified obligations of the lessor 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, of $1 billion.

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 26, 1997, are as follows (in thousands):

Rent expense totaled $64.4 million, $36.8 million, and $24.0 million for 1997, 1996, and 1995, respectively.

Forward Exchange Contracts
The Company conducts business on a global basis in several major international currencies. As such, it is exposed to adverse movements in foreign currency exchange rates. The Company enters into forward foreign exchange contracts to reduce certain currency exposures. These contracts hedge exposures associated with nonfunctional currency assets and liabilities denominated in Japanese, Canadian, Australian, and several European currencies. At the present time, the Company hedges only those currency exposures associated with certain nonfunctional currency assets and liabilities and does not generally hedge anticipated foreign currency cash flows.

The Company does not enter into forward exchange contracts for trading purposes. Gains and losses on the contracts are included in other income 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 forward currency contracts generally range from one to three months in original maturity. Forward exchange contracts outstanding and their unrealized gains and (losses) as of July 26, 1997 are summarized as follows (in thousands):

The Company's forward exchange contracts contain credit risk in that its banking 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 and its subsidiaries are subject to 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.

The Company's common stock was split two for one on February 16, 1996. All applicable share and per-share data in these consolidated financial statements have been restated to give effect to this stock split.

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.

Employee Stock Purchase Plan
The Company has an Employee Stock Purchase Plan ("the Purchase Plan") under which 9.8 million shares of common stock have been reserved for issuance. Eligible employees may designate not more than 10% of their cash compensation to be deducted each pay period for the purchase of common stock under the Purchase Plan, and participants may purchase not more than $25,000 of common stock in any one calendar year. On the last business day of each calendar quarter, shares of common stock are purchased with the employees' payroll deductions over the immediately preceding six months at a price per share of 85% of the lesser of the market price of the common stock on the purchase date or the market price on the first day of the period. The Purchase Plan will terminate no later than January 3, 2000. In fiscal 1997, 1996, and 1995, 1.4 million, 1.3 million, and 1.5 million shares, respectively, were issued under the Purchase Plan. At July 26, 1997, 2.0 million shares were available for issuance under the Purchase Plan.

Stock Option Plans
In November 1996, the Company's shareholders approved the 1996 Stock Incentive Plan (the "1996 Plan"). This plan was the successor to the Company's 1987 Stock Option Plan (the "Predecessor Plan"). The 1996 Plan became effective immediately upon shareholder approval, and 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 68.8 million shares transferred from the Predecessor Plan. Under the terms of the 1996 Plan, the share reserve will increase each December for the next 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. Although the Board has the authority to set other terms, the options are generally 25% exercisable one year from the date of grant and then ratably over the following 36 months. Under the Predecessor Plan, the options generally had terms of five years. Under the 1996 Plan, options expire no later than nine years from the grant date.

A summary of option activity follows (in thousands, except per-share amounts):

At July 26, 1997 and July 28, 1996, approximately 24.8 million and 21.7 million outstanding options, respectively, were exercisable. The weighted average exercise prices for options were $20.66 and $11.42 at July 26, 1997 and July 28, 1996, respectively.

The Company has, in connection with the acquisition of various companies, assumed the stock option plans of each acquired company. A total of 4.6 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.

The following tables summarize information concerning outstanding and exercisable options at July 26, 1997 (in thousands, except per-share amounts):

The Company has adopted SFAS No. 123, "Accounting for Stock-Based Compensation," issued in October of 1995. In accordance with SFAS No. 123, the Company applies APB Opinion 25 and related Interpretations in accounting for its stock option plans, and accordingly does not record compensation costs. If the Company had elected, beginning in fiscal 1996, to recognize compensation cost based on the fair value of the options granted at grant date as prescribed by SFAS No. 123, net income and net income per common share would have been reduced to the pro forma amounts shown below (in thousands, except per-share amounts):

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions:

The Black-Scholes option valuation 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 valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's 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 the Company's options. The weighted average estimated fair values of employee stock options granted during fiscal 1997 and 1996 were $15.60 and $13.34 per share, respectively.

The above pro forma disclosures are not likely to be representative of the effects on net income and net income per common share in future years, because they do not take into consideration pro forma compensation expense related to grants made prior to the Company's fiscal year 1996.

Employee 401(k) Plan
The Company has adopted a plan known as the Cisco Systems, Inc. 401(k) Plan ("the Plan") to provide retirement and incidental benefits for its employees. As allowed under Section 401(k) of the Internal Revenue Code, the Plan provides tax-deferred salary deductions for eligible employees.

Employees may contribute from 1% to 15% of their annual compensation to the Plan, limited to a maximum annual amount as set periodically by the Internal Revenue Service. The Company matches employee contributions dollar for dollar up to a maximum of $1,500 per year per person. All matching contributions vest immediately. In addition, the Plan provides for discretionary contributions as determined by the Board of Directors. Such contributions to the Plan are allocated among eligible participants in the proportion of their salaries to the total salaries of all participants. Company matching contributions to the Plan totaled $12.6 million in 1997, $6.6 million in 1996, and $3.5 million in 1995. No discretionary contributions were made in 1997, 1996, or 1995.

The provision (benefit) for income taxes consists of (in thousands):

The Company paid income taxes of $658.7 million, $335.1 million, and $270.5 million, in fiscal 1997, 1996, and 1995, respectively.

The items accounting for the difference between income taxes computed at the federal statutory rate and the provision for income taxes follow:

The components of the deferred income tax assets (liabilities) follow (in thousands):

The noncurrent portion of the deferred income tax assets, which totaled $66.0 million at July 26, 1997 and $16.0 million at July 28, 1996, is included in other assets.

The Company's income taxes payable for federal, state, and foreign purposes have been reduced by the tax benefits of disqualifying dispositions of stock options. The benefit is the difference between the market value of the stock issued at the time of exercise and the option price tax effected.

The Company operates in a single industry segment encompassing the design, development, manufacture, marketing, and technical support of networking products and services.

In 1997, 1996, and 1995, no single customer accounted for 10% or more of the Company's net sales. International sales, primarily in Europe, the Pacific region, and Canada, were $2,803 million in 1997, $1,976 million in 1996, and $931 million in 1995. Export sales, primarily to these regions, were $1,939 million in 1997, $1,530 million in 1996, and $737 million in 1995.

Summarized financial information by geographic region for 1997, 1996, and 1995 is as follows (in thousands):