UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q





(Mark
one)





[X]
            Quarterly
      Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934 for the quarterly period ended September 30, 2009,
  or





[   ]
            Transition
      Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934 for the transition period from ______________ to
      _____________.





Commission
File No. 0-23862




Fonix
Corporation


(Exact
name of registrant as specified in its charter)





Delaware
            22-2994719(State
      or other jurisdiction of incorporation or organization)
            (I.R.S.
      Employer Identification No.)





387
South 520 West, Suite 110


Lindon,
Utah 84042


(Address
of principal executive offices with zip code)





(801)
553-6600


(Registrant's
telephone number, including area code)





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 whether the registrant has submitted electronically and posted on
its Web site, if any, every Interactive Data File required to be submitted and
posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or
for such shorter period that the registrant was required to submit and post such
files). Yes  ___   No ___





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer, or a smaller reporting
company.  (Check one):


Large
accelerated filer [  ]  Accelerated filer
[  ]  Non-accelerated filer
[  ]  Smaller reporting company [X]





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-25 of the Exchange Act).  Yes __ No X





As of
November 12, 2009, there were issued and outstanding 64,815,229 shares of our
Class A common stock.


1





FONIX
CORPORATION


FORM
10-Q








TABLE
OF CONTENTS





PART
I - FINANCIAL INFORMATION





PageItem
      1.
            Financial
      Statements (Unaudited)Condensed
      Consolidated Balance Sheets – As of September 30, 2009, and December 31,
      2008
            3Condensed
      Consolidated Statements of Operations and Comprehensive Income (Loss) for
      theThree
      and Nine Months Ended September 30, 2009 and 2008
            4Condensed
      Consolidated Statements of Cash Flows for the Nine Months
      EndedSeptember
      30, 2009 and 2008
            5Notes
      to Condensed Consolidated Financial Statements
      (Unaudited)
            8Item
      2.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            22Item
      3.
            Quantitative
      and Qualitative Disclosures About Market Risk
            35Item
      4.
            Controls
      and Procedures
            35PART
      II - OTHER INFORMATIONItem
      1.
            Legal
      Proceedings
            37Item
      2.
            Unregistered
      Sales of Equity Securities and Use of Proceeds
            37Item
      3.
            Defaults
      Upon Senior Securities
            37Item
      4.
            Submission
      of Matters to a Vote of Security Holders
            37Item
      5.
            Other
      Information
            37Item
      6.
            Exhibits
            38




2


Fonix
Corporation and Subsidiaries


CONDENSED
CONSOLIDATED BALANCE SHEETS


(Unaudited)


September
      30,
              
              
              December
      31,2009
              
              
              2008ASSETSCurrent
      assetsCash
      and cash equivalents
              
              $
              1,011,000
              
              
              $
              2,000Accounts
      receivable, net of allowance of doubtful accounts of $4,000 and $0,
      respectively
              
              
              2,000,000
              
              
              
              -Bills
      receivable
              
              
              396,000
              
              
              
              -Total
      current assets
              
              
              3,407,000
              
              
              
              2,000Property and
      equipment, net of accumulated depreciation of $1,314,000 and
      $1,303,000, respectively
              
              
              56,000
              
              
              
              26,000Goodwill
              
              
              658,000
              
              
              
              -Deposits
      and other assets
              
              
              12,000
              
              
              
              12,000Total
      assets
              
              $
              4,133,000
              
              
              $
              40,000LIABILITIES
      AND STOCKHOLDERS' DEFICITCurrent
      liabilitiesAccrued
      liabilities
              
              $
              8,942,000
              
              
              $
              6,510,000Accounts
      payable
              
              
              2,215,000
              
              
              
              1,715,000Related
      party accounts payable
              
              
              107,000
              
              
              
              86,000Tax
      payable
              
              
              29,000
              
              
              
              -Derivative
      liability
              
              
              36,460,000
              
              
              
              34,582,000Accrued
      payroll and other compensation
              
              
              902,000
              
              
              
              211,000Deferred
      revenues
              
              
              465,000
              
              
              
              445,000Notes
      payable - related parties
              
              
              777,000
              
              
              
              917,000Deferred
      tax liabilities, net
              
              
              228,000
              
              
              
              -Deposits
      and other
              
              
              7,000
              
              
              
              7,000Total
      current liabilities
              
              
              50,132,000
              
              
              
              44,473,000Total
      liabilities
              
              
              50,132,000
              
              
              
              44,473,000Commitments
      and contingenciesStockholders'
      deficitPreferred
      stock, $0.0001 par value;  50,000,000 shares
      authorized;Series A, convertible; 166,667 shares outstanding (aggregate liquidation
      preference of $6,055,000)
              
              
              500,000
              
              
              
              500,000Series L, convertible; 1,467 shares and 1,498 shares outstanding ,
      respectively
              
              
              -
              
              
              
              -Common
      stock, $0.0001 par value; 20,000,000,000 shares
authorized;Class A voting, 45,706,715 shares and 3,447,501 shares outstanding,
      respectively
              
              
              5,000
              
              
              
              1,000Class B non-voting, none outstanding
              
              
              -
              
              
              
              -Additional
      paid-in capital
              
              
              241,958,000
              
              
              
              240,949,000Outstanding
      warrants to purchase Class A common stock
              
              
              474,000
              
              
              
              474,000Cumulative
      foreign currency translation adjustment
              
              
              (97,000
              )
              
              
              10,000Accumulated
      deficit
              
              
              (288,839,000
              )
              
              
              (286,367,000
              )Total
      stockholders' deficit
              
              
              (45,999,000
              )
              
              
              (44,433,000
              )Total
      liabilities and stockholders' deficit
              
              $
              4,133,000
              
              
              $
              40,000




See
accompanying notes to condensed consolidated financial statements.


3


Fonix
Corporation and Subsidiaries


CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS


(Unaudited)




Three
      Months Ended September 30,
            
            
            Nine
      Months Ended September 30,2009
            
            
            2008
            
            
            2009
            
            
            2008RevenuesOperating
      revenues
            
            $
            335,000
            
            
            $
            223,000
            
            
            $
            1,301,000
            
            
            $
            1,069,000Total
      Revenue
            
            
            335,000
            
            
            
            223,000
            
            
            
            1,301,000
            
            
            
            1,069,000Cost
      of revenuesCost
      of goods sold
            
            
            65,000
            
            
            
            3,000
            
            
            
            313,000
            
            
            
            53,000Main
      operating taxes and surcharges
            
            
            8,000
            
            
            
            -
            
            
            
            17,000
            
            
            
            -Total
      cost of revenues
            
            
            73,000
            
            
            
            3,000
            
            
            
            330,000
            
            
            
            53,000Gross
      profit
            
            
            262,000
            
            
            
            220,000
            
            
            
            971,000
            
            
            
            1,016,000Operating
      expenses:Selling,
      general and administrative
            
            
            597,000
            
            
            
            343,000
            
            
            
            1,704,000
            
            
            
            1,431,000Product
      development and research
            
            
            155,000
            
            
            
            300,000
            
            
            
            620,000
            
            
            
            992,000Total
      operating expenses
            
            
            752,000
            
            
            
            643,000
            
            
            
            2,324,000
            
            
            
            2,423,000Other
      income (expense):Other
      income
            
            
            235,000
            
            
            
            -
            
            
            
            235,000
            
            
            
            -Interest
      income
            
            
            57,000
            
            
            
            -
            
            
            
            97,000
            
            
            
            -Interest
      expense
            
            
            (28,000
            )
            
            
            (1,686,000
            )
            
            
            (76,000
            )
            
            
            (2,723,000
            )Gain
      on forgiveness of liabilities
            
            
            56,000
            
            
            
            -
            
            
            
            56,000
            
            
            
            -Gain
      (loss) on derivative liability
            
            
            431,000
            
            
            
            408,000
            
            
            
            1,022,000
            
            
            
            95,000Other
      income (expense), net
            
            
            751,000
            
            
            
            (1,278,000
            )
            
            
            1,334,000
            
            
            
            (2,628,000
            )Income
      (loss) from continuing operations
            
            
            261,000
            
            
            
            (1,701,000
            )
            
            
            (19,000
            )
            
            
            (4,035,000
            )Provision
      for foreign income taxes
            
            
            (31,000
            )
            
            
            -
            
            
            
            (31,000
            )
            
            
            -Net
      income (loss)
            
            
            230,000
            
            
            
            (1,701,000
            )
            
            
            (50,000
            )
            
            
            (4,035,000
            )Preferred
      stock dividends
            
            
            (536,000
            )
            
            
            (466,000
            )
            
            
            (2,416,000
            )
            
            
            (1,491,000
            )Income
      (loss) attributable to common stockholders
            
            $
            (306,000
            )
            
            $
            (2,167,000
            )
            
            $
            (2,466,000
            )
            
            $
            (5,526,000
            )Basic
      and diluted loss per common share from continuing
    operations
            
            $
            (0.01
            )
            
            $
            (0.85
            )
            
            $
            (0.16
            )
            
            $
            (3.44
            )Net
      income (loss)
            
            
            230,000
            
            
            
            (1,701,000
            )
            
            
            (50,000
            )
            
            
            (4,035,000
            )Other
      comprehensive income - foreign currency translation
            
            $
            (7,000
            )
            
            $
            -
            
            
            $
            (107,000
            )
            
            $
            -Comprehensive
      income (loss)
            
            $
            223,000
            
            
            $
            (1,701,000
            )
            
            $
            (157,000
            )
            
            $
            (4,035,000
            )




See
accompanying notes to condensed consolidated financial
statements.





4




Fonix
Corporation and Subsidiaries


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS


(Unaudited)




Nine
      Months Ended September 30,
              
              2009
              
              
              2008Cash
      flows from operating activitiesNet
      loss
              
              $
              (50,000
              )
              
              $
              (4,035,000
              )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Gain
      on derivative liability
              
              
              (1,022,000
              )
              
              
              (95,000
              )Gain
      on forgiveness of liabilities
              
              
              (56,000
              )
              
              
              -Accretion
      of discount on notes payable
              
              
              -
              
              
              
              2,124,000Deferred
      income taxes
              
              
              (9,000
              )
              
              
              -Issuance
      of shares for employee grants
              
              
              -
              
              
              
              709,000Depreciation
              
              
              11,000
              
              
              
              8,000Foreign
      exchange gain
              
              
              (107,000
              )
              
              
              -Changes
      in assets and liabilitiesAccounts
      receivable
              
              
              615,000
              
              
              
              -Bills
      receivable
              
              
              (396,000
              )
              
              
              -Prepaid
      expenses and other current assets
              
              
              -
              
              
              
              134,000Inventory
              
              
              2,000
              
              
              
              -Other
      assets
              
              
              -
              
              
              
              96,000Accounts
      payable
              
              
              189,000
              
              
              
              242,000Related
      party accounts payable
              
              
              21,000
              
              
              
              32,000Tax
      payable
              
              
              (4,000
              )
              
              
              -Accrued
      payroll and other compensation
              
              
              747,000
              
              
              
              -Deferred
      revenues
              
              
              20,000
              
              
              
              -Other
      accrued liabilities
              
              
              124,000
              
              
              
              576,000Net
      cash provided (used) in operating activities
              
              
              85,000
              
              
              
              (209,000
              )Cash
      flows from investing activitiesPurchase
      of property and equipment
              
              
              -
              
              
              
              (20,000
              )Net
      cash acquired in acquistion
              
              
              796,000
              
              
              
              -Net
      cash used in investing activities
              
              
              796,000
              
              
              
              (20,000
              )Cash
      flows from financing activitiesProceeds
      from related party note payable
              
              
              50,000
              
              
              
              59,000Proceeds
      from issuance of Series O Preferred Stock
              
              
              -
              
              
              
              609,000Proceeds
      from issuance of Series P Preferred Stock
              
              
              78,000
              
              
              
              -Payments
      on accrued settlement obligation
              
              
              -
              
              
              
              (455,000
              )Net
      cash provided by financing activities
              
              
              128,000
              
              
              
              213,000Net
      increase in cash and cash equivalents
              
              
              1,009,000
              
              
              
              (16,000
              )Cash
      and cash equivalents at beginning of period
              
              
              2,000
              
              
              
              26,000Cash
      and cash equivalents at end of period
              
              $
              1,011,000
              
              
              $
              10,000




See
accompanying notes to condensed consolidated financial statements.


5


Fonix
Corporation and Subsidiaries


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)


(Unaudited)








Supplemental
schedule of noncash investing and financing activities





For
the Nine Months Ended September 30, 2009:





Issued
351 shares of Series P Preferred stock for the acquisition of G-Soft
Limited.





Issued
320,702 shares of Class A common stock for unpaid legal fees.





Issued
6,950,000 shares of Class A common stock for consulting services.





Issued
6,088,466 shares of Class A common stock upon conversion of 10 shares of Series
P Convertible Preferred Stock.





Issued
22,323,333 shares of Class A common stock upon conversion of 31 shares of Series
L Convertible Preferred Stock including accrued interest converted of
$71,000.





Issued
6,095,331 shares of Class A common stock upon conversion of $197,000 in notes
payable.





Issued
480,969 shares of Class A common stock upon conversion of $15,000 in accrued
interest on notes payable.





Accrued
$1,007,000 of dividends on Series L Preferred Stock.





Accrued
$102,000 of dividends on Series M Preferred Stock.





Accrued
$120,000 of dividends on Series N Preferred Stock.





Accrued
$50,000 of dividends on Series O Preferred Stock.





Accrued
$1,052,000 of dividends on Series P Preferred Stock.





Accrued
$85,000 of dividends on Fonix Speech Series B Preferred Stock.





The
Company acquired the following balance sheet items as a result of the
acquisition of G-Soft Limited:


·
            Cash
      - $796,000


·
            Accounts
      receivable - $2,600,000


·
            Other
      receivables - $15,000


·
            Inventory
      - $2,000


·
            Property,
      plant and equipment - $41,000


·
            Goodwill
      - $658,000


·
            Accounts
      payable - $319,000


·
            Accrued
      liabilities - $13,000


·
            Taxes
      payable - $33,000


·
            Deferred
      tax liabilities, assumed - $237,000


See
accompanying notes to condensed consolidated financial
statements.


6





Fonix
Corporation and Subsidiaries


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)


(Unaudited)








For
the Nine Months Ended September 30, 2008:





Issued
645,696 shares of Class A common stock upon conversion of 34 shares of Series L
Convertible Preferred Stock.





Issued
896,788 shares of Class A common stock for employee stock grants.





Issued
124,941 shares of Class A common stock for unpaid legal fees.





Issued
145,225 shares of Class A common stock for consulting services.





Issued
267,949 shares of Class A common stock upon conversion of $162,000 in accrued
interest.





Issued
41,985 shares of Class A common stock upon conversion of $21,000 in notes
payable – related parties.





Accrued
$1,040,000 of dividends on Series L Preferred Stock.





Accrued
$103,000 of dividends on Series M Preferred Stock.





Accrued
$105,000 of dividends on Series N Preferred Stock.





Accrued
$23,000 of dividends on Series O Preferred Stock.





Accrued
$86,000 of dividends on Fonix Speech Series B Preferred Stock.




See
accompanying notes to condensed consolidated financial
statements.


7


Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)


1.  SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES





Basis of
Presentation – The accompanying unaudited condensed consolidated
financial statements ofFonixCorporation and
subsidiaries (collectively, the “Company” or “Fonix”) have been prepared by the
Company pursuant to the rules and regulations of the Securities and Exchange
Commission (the “SEC”).  Certain information and footnote disclosures
normally included in financial statements prepared in accordance with accounting
principles generally accepted in the United States of America have been
condensed or omitted pursuant to such rules and regulations, although the
Company believes that the following disclosures are adequate to make the
information presented not misleading.  The Company suggests that these
condensed consolidated financial statements be read in conjunction with the
consolidated financial statements and the notes thereto included in the
Company’s 2008 Annual Report on Form 10-K.





These
condensed consolidated financial statements reflect all adjustments (consisting
only of normal recurring adjustments) that, in the opinion of management, are
necessary to present fairly the financial position and results of operations of
the Company for the periods presented.  The Company’s business
strategy is not without risk, and readers of these condensed consolidated
financial statements should carefully consider the risks set forth under the
heading “Certain Significant Risk Factors” in the Company’s 2008 Annual Report
on Form 10-K.





On July
1, 2009, the Company adopted the FASB Accounting Standards Codification (“ASC”).
The ASC does not alter current U.S. GAAP, but rather integrated existing
accounting standards with other authoritative guidance. The ASC provides a
single source of authoritative U.S. GAAP for nongovernmental entities and
supersedes all other previously issued non-SEC accounting and reporting
guidance. The adoption of the ASC did not have any effect
on the results of operations or financial position of the company. All
prior references to U.S. GAAP have been revised to conform to the ASC. Updates
to the ASC are issued in the form of Accounting Standards Updates
(“ASU”).





Operating
results for the nine months ended September 30, 2009, are not necessarily
indicative of the results that may be expected for the year ending December 31,
2009.





Nature of
Operations–Fonix
Corporation (the “Company,” or “Fonix,”) was incorporated in Delaware in 1985,
and, pursuant to a merger transaction in 1994, the Company’s name was changed to
Fonix Corporation. The Company’s operations are managed through two wholly owned
subsidiaries, Fonix Speech, Inc. (“Fonix Speech”) and Fonix GS Acquisition Co.,
Inc. (“Fonix GS”).





Fonix
Speech





Fonix
Speech provides value-added speech-enabling technologies, speech interface
development tools, and speech solutions and applications, including automated
speech recognition (“ASR”) and text-to-speech (“TTS,” together with ASR, the
“Core Technologies”) that empower users to interact conversationally with
information systems and devices.  Fonix Speech offers speech-enabling
technologies to markets for personal software for consumer applications
including video games, e.Dictionaries and mobile navigation devices with GPS,
wireless and mobile devices, computer telephony, and server solutions. Fonix
Speech’s products enhance user productivity, ease of use and efficiency in a
broad range of market segments, including mobile and wireless devices; videogame
consoles; electronic devices for the assistive and language learning markets,
robots, appliances; automotive telematics, computer telephony and server
applications.





Fonix
Speech has received various patents for certain elements of the Core
Technologies and has filed applications for patents covering other aspects of
the Core Technologies. Fonix Speech seeks to develop relationships and strategic
alliances with third-party developers and vendors in telecommunications,
computers, electronic devices and related industries, including producers of
application software, operating systems, computers and microprocessor chips.
Revenues are generated through licensing of speech-enabling technologies, unit
royalties, maintenance contracts and services.





Prior to
2002, Fonix Speech focused on research and development (“R&D”) projects for
customized applications.  R&D and prototype development used the
Core Technologies to develop applications and engines marketed for multiple
operating systems and hardware platforms.  Today, Fonix Speech serves
markets that are adopting speech-enabled interfaces, solutions and
applications.  As memory requirements, noise robustness, speech
recognition accuracy and efficiency of speech interface solutions become
increasingly critical, Fonix Speech anticipates that its Core Technologies and
related solutions will meet customer demand for simple, convenient user
interfaces.


8





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




Fonix GS





Fonix GS
was formed on June 27, 2008, to facilitate the acquisition of Shanghai Gaozhi
Software Systems Limited (“GaozhiSoft”).  The acquisition was
completed in early 2009.  GaozhiSoft is a Chinese software developer
and solutions provider in 2G (second-generation) and 3G (third-generation)
telecommunication operation support systems in China and throughout the
Asian-Pacific region.  Gaozhisoft is qualified by the appropriate
Chinese governmental entities as a competitor for telecommunication operation
support systems.  GaozhiSoft’s products are designed to increase data
transferring speed, reduce telecommunications data loss, and provide network
management, billing accuracy and improved implementation techniques to telecom
carriers.





GaozhiSoft’s
software products are divided into two main categories: (1) MOSS series and (2)
MDtrac series. MOSS products provide service providers with integrated
electronic management platforms for peer-to-peer business operation and
automatic management.  MDtrac products provide data collection
solutions.  GaozhiSoft has received various copyrights and patents for
certain of its products and has filed applications for other copyrights and
patents covering other aspects of its products.





Business
Condition-For
the three months ended September 30, 2009 and 2008, the Company generated
revenues of $335,000 and $223,000, respectively, and incurred net income of
$230,000 and a net loss of $1,701,000, respectively.  For the nine
months ended September 30, 2009 and 2008, the Company generated revenues of
$1,301,000 and $1,069,000, respectively, incurred net losses attributable to
common stockholders of $2,466,000 and $5,526,000, respectively, and had cash
flows from operating activities of $85,000 and negative cash flows from
operating activities of $209,000, respectively.  As of September 30,
2009, the Company had an accumulated deficit of $288,839,000; negative working
capital of $46,725,000; derivative liabilities of $36,460,000 related to the
issuance of Series P Preferred Stock, Series L Preferred Stock, Series M
Preferred Stock, Series N Preferred Stock, Series O Preferred Stock and Series E
Convertible Debentures and Series B Preferred Stock of its subsidiary, Fonix
Speech; accrued liabilities of $8,942,000; accrued payroll and other
compensation of $902,000; accounts payable of $2,215,000; related party accounts
payable of $107,000; tax payable of $29,000; deferred tax liabilities of
$228,000; related party notes payable of $777,000; and deferred revenues of
$465,000.  The Company expects to continue to incur significant losses
and negative cash flows from operating activities at least through December 31,
2009, primarily due to expenditure requirements associated with continued
marketing and development of our speech-enabling technologies.





The
Company’s cash resources, limited to collections from customers, sales of our
equity and debt securities and loans, have not been sufficient to cover
operating expenses.  As a result, some payments to vendors and service
providers have been delayed.





These
factors, as well as the risk factors set out in the Company’s Annual Report on
Form 10-K for the year ended December 31, 2008,  raise substantial
doubt about the Company’s ability to continue as a going concern.  The
accompanying financial statements do not include any adjustments that might
result from the outcome of this uncertainty.  Management plans to fund
further operations of the Company from cash flows from future license and
royalty arrangements and with proceeds from additional issuance of debt and
equity securities.  There can be no assurance that management’s plans
will be successful.





Net Income/Loss
Per Common Share –Basic and diluted net
income/loss per common share are calculated by dividing net income/loss
attributable to common stockholders by the weighted average number of shares of
common stock outstanding during the period.  As of September 30, 2009
and 2008, there were outstanding common stock equivalents to purchase or receive
2,282,671,661and 8,568,133
shares of common stock, respectively.  All common stock equivalents at
September 30, 2009 and 2008, were excluded in the computation of diluted net
income/loss per common share as their effect would have been anti-dilutive,
thereby decreasing the net loss per common share.


9


Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)


The
following table is a reconciliation of the net income/loss numerator of basic
and diluted net loss per common share for the three and nine months ended
September 30, 2009 and 2008:








Three
      Months Ended September 30,2009
            
            
            2008Per
            
            
            
            
            
            PerShare
            
            
            
            
            
            ShareAmount
            
            
            Amount
            
            
            Amount
            
            
            AmountNet
      income (loss)
            
            $
            230,000
            
            
            
            
            
            $
            (1,701,000
            )Preferred
      stock dividends
            
            
            (536,000
            )
            
            
            
            
            
            (466,000Loss
      attributable to common stockholders
            
            $
            (306,000
            )
            
            $
            (
      0.01
            )
            
            $
            (2,167,000
            )
            
            $
            (0.85
            )Weighted-average
      common shares outstanding
            
            
            30,796,779
            
            
            
            
            
            
            
            2,546,643








Nine
      Months Ended September 30,2009
            
            
            2008Per
            
            
            
            
            
            PerShare
            
            
            
            
            
            ShareAmount
            
            
            Amount
            
            
            Amount
            
            
            AmountNet
      income (loss)
            
            $
            (50,000
            )
            
            
            
            
            $
            (4,035,000
            )Preferred
      stock dividends
            
            
            (2,416,000
            )
            
            
            
            
            
            (1,491,000
            )Loss
      attributable to common stockholders
            
            $
            (2,466,000
            )
            
            $
            (0.16
            )
            
            $
            (5,526,000
            )
            
            $
            (3.44
            )Weighted-average
      common shares outstanding
            
            
            15,624,184
            
            
            
            
            
            
            
            1,605,706





Imputed Interest
Expense–Interest
is imputed on long-term debt obligations where management has determined that
the contractual interest rates are below the market rate for instruments with
similar risk characteristics.





Comprehensive
Loss–Other
comprehensive loss as presented in the accompanying condensed consolidated
financial statements consists of cumulative foreign currency translation
adjustments.





Revenue
Recognition– The Company recognizes revenue when pervasive evidence of
an arrangement exists; services have been rendered or products have been
delivered; the price to the buyer is fixed and determinable; and collectability
is reasonably assured.  Revenues are recognized by the Company based
on the various types of transactions generating the revenue.  The
Company generates revenues from licensing the rights to its software products to
end users and from royalties.





For Fonix
Speech, revenue of all types is recognized when acceptance of functionality,
rights of return, and price protection are confirmed or can be reasonably
estimated, as appropriate.  Revenues from development and consulting
services are recognized on a completed-contract basis when the services are
completed and accepted by the customer.  The completed-contract method
is used because the Company’s contracts are typically either short-term in
duration or the Company is unable to make reasonably dependable estimates of the
costs of the contracts.  Revenue for hardware units delivered is
recognized when delivery is verified and collection assured.


10


Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




Revenue
for products distributed through wholesale and retail channels and through
resellers is recognized upon verification of final sell-through to end users,
after consideration of rights of return and price
protection.  Typically, the right of return on such products has
expired when the end user purchases the product from the retail
outlet.  Once the end user opens the package, it is not returnable
unless the medium is defective.





When
arrangements to license software products do not require significant production,
modification or customization of software, revenue from licenses and royalties
are recognized when persuasive evidence of a licensing arrangement exists,
delivery of the software has occurred, the fee is fixed or determinable, and
collectability is probable.  Post-contract obligations, if any,
generally consist of one year of support including such services as customer
calls, bug fixes, and upgrades.  Related revenue is recognized over
the period covered by the agreement.  Revenues from maintenance and
support contracts are also recognized over the term of the related
contracts.





Revenues
applicable to multiple-element fee arrangements are bifurcated among the
elements such as license agreements and support and upgrade obligations using
vendor-specific objective evidence of fair value.  Such evidence
consists primarily of pricing of multiple elements as if sold as separate
products or arrangements.  These elements vary based upon factors such
as the type of license, volume of units licensed, and other related
factors.





Deferred
revenue as of September 30, 2009, and December 31, 2008, consisted of the
following:





Description
            Criteria
      for Recognition
            
            September
      30, 2009
            
            
            December
      31, 2008Deferred
      unit royalties and license fees
            Delivery
      of units to end users or expiration of contract
            
            $
            465,000
            
            
            $
            445,000





Cost of Revenues– Cost of revenues from license, royalties, and maintenance consists of
costs to distribute the product, installation and support personnel
compensation, amortization and impairment of capitalized speech software costs,
licensed technology, and other related costs.  Cost of service
revenues consists of personnel compensation and other related
costs.





Software
Technology Development and Production Costs– All costs incurred to
establish the technological feasibility of speech software technology to be
sold, leased, or otherwise marketed are charged to product development and
research expense.  Technological feasibility is established when a
product design and a working model of the software product have been completed
and confirmed by testing.  Costs to produce or purchase software
technology incurred subsequent to establishing technological feasibility are
capitalized.  Capitalization of software costs ceases when the product
is available for general release to customers.  Costs to perform
consulting or development services are charged to cost of revenues in the period
in which the corresponding revenues are recognized.  The cost of
maintenance and customer support is charged to expense when related revenue is
recognized or when these costs are incurred, whichever occurs
first.





Goodwill -The Company tests its recorded goodwill for impairment on an annual basis
during the fourth quarter, or more often if indicators of potential impairment
exist, by determining if the carrying value of each reporting unit exceeds its
estimated fair value. Factors that could trigger impairment include, but are not
limited to, underperformance relative to historical or projected future
operating results, significant changes in the manner of use of the acquired
assets or the Company’s overall business and significant negative industry or
economic trends. Future impairment reviews may require write-downs in the
Company’s goodwill and could have a material adverse impact on the Company’s
operating results for the periods in which such write-downs occur.





Bills
Receivable - Bills receivable in China are undertaken by the banks to
honor the payments at maturity, and the customers are required to place deposits
with the banks equivalent to a certain percentage of the bills amount as
collateral. These bills receivable can be sold to any third party at a discount
before maturity. The Company does not maintain allowance for bills receivable in
the absence of bad debt experience, and the payments are undertaken by the
banks. The financial guarantees issued to third parties are located in the
PRC.


11





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)


Concentration of
Credit Risk and Major Customer - During the nine months ended September
30, 2009, sales to two customers represented 22% and 11%, respectively, of
revenues.  At September 30, 2009, these customers made up 50% and 0%,
respectively, of accounts receivable.





Fair
Value of Financial Instruments - The carrying amount of cash and cash
equivalents, receivables, accounts payable and accrued expenses approximates
fair value because of their short maturity.  The carrying value of the
goodwill approximates its fair value.





Reclassification-Certain amounts in the 2008
financial statements have been reclassified to conform to the 2009
presentation.





2.  NOTES
PAYABLE





In
connection with the acquisition of the capital stock of LTEL Holdings in 2004,
the Company issued a 5%, $10,000,000, secured, six-year note (the “Note”)
payable to McCormack Avenue, Ltd. (“McCormack”).  Under the terms of
the Note, quarterly interest-only payments were required through January 15,
2005, with quarterly principal and interest payments of $319,000 beginning April
2005 and continuing through January 2010.  Interest on the Note is
payable in cash or, at the Company’s option, in shares of the Company’s Class A
common stock.  The Note was secured by the capital stock and all of
the assets of LTEL Holdings and its subsidiaries.  The Note was
originally valued at $4,624,000 based on an imputed interest rate of 25 percent
per annum.





On
September 8, 2006, the Company received a default notice (the “Default Notice”)
from McCormack in respect of the Note  In the Default Notice,
McCormack stated that it intended to exercise its rights, including any and all
rights set forth in the Note, as amended.  McCormack has taken no
action to collect amounts due under the Note.





During
the fourth quarter of 2006, the Company entered into two promissory notes with
McCormack Avenue, Ltd., in the aggregate amount of $330,000. These notes accrue
interest at 10% annually and were due and payable during the second quarter of
2007.  These promissory notes were exchanged for shares of the
Company’s Series P Preferred Stock.  See table below.





During
the quarter ended March 31, 2007, the Company entered into five promissory notes
with McCormack Avenue, Ltd. and Sovereign Partners LP., in the aggregate amount
of $450,000.  These notes accrue interest at 10% annually and were due
and payable during the third quarter of 2007.  These promissory notes
were exchanged for shares of the Company’s Series P Preferred
Stock.  See table below.





On
September 30, 2008, the Company entered into a Series P 9% Convertible Preferred
Stock Exchange Agreement (the “Exchange Agreement”) with McCormack and Sovereign
Partners, LP (“Sovereign”), whereby McCormack exchanged the Note, along with
other promissory notes and the Series E debenture (discussed in Note 5), and
Sovereign exchanged two promissory notes, for shares of the Company’s Series P
9% Convertible Preferred Stock (the Series P Preferred Stock”).  The
obligations exchanged and the number of shares of Series P Preferred Stock
issued is as follows:








Purchaser
            Nature
      of Obligation Exchanged
            Amount
      of Obligation Exchanged
            Number
      of Series P Preferred Shares IssuedSovereign
      Partners LP
            Promissory
      Note, dated February 22, 2007, in the principal amount of $100,000, and
      interest of $16,278
            $116,278
            11.6278Sovereign
      Partners LP
            Promissory
      Note, dated March 13, 2007, in the principal amount of $100,000, and
      interest of $15,750
            $115,750
            11.575McCormack
      Avenue, Ltd.
            Promissory
      Note, dated January 11, 2007, in the principal amount of $50,000, and
      interest of $8,722
            $58,722
            5.8722McCormack
      Avenue, Ltd.
            Promissory
      Note, dated January 19, 2007, in the principal amount of $100,000, and
      interest of $17,222
            $117,222
            11.7222McCormack
      Avenue, Ltd.
            Promissory
      Note, dated January 26, 2007, in the principal amount of $100,000, and
      interest of $17,028
            $117,028
            11.7028McCormack
      Avenue, Ltd.
            Promissory
      Note, dated December 28, 2006, in the principal amount of $95,000, and
      $16,942
            $111,942
            11.1942McCormack
      Avenue, Ltd.
            Promissory
      Note, dated December 15, 2006, in the principal amount of $235,000, and
      interest of $42,701
            $277,701
            27.7701McCormack
      Avenue, Ltd.
            Note
      Payable, dated February, 2004, in the principal amount of $8,732,620, and
      interest of $1,311,105
            $10,043,725
            1,004.3725McCormack
      Avenue, Ltd.
            Series
      E Debenture, dated December 7, 2007, in the principal amount of
      $1,754,464, and interest of $291,763
            $2,046,227
            204.6227





12





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)




3.  RELATED-PARTY
NOTES PAYABLE AND ACCOUNTS PAYABLE





During
2002, two executive officers of the Company (the “Lenders”) sold shares of the
Company’s Class A common stock owned by them and advanced the resulting proceeds
amounting to $333,000 to the Company under the terms of a revolving line of
credit and related promissory note.  The funds were advanced for use
in Company operations.  The advances bear interest at 12 percent per
annum, payable on a semi-annual basis.  The entire principal, along
with unpaid accrued interest and any other unpaid charges or related fees, was
originally due and payable on June 10, 2003.  The Company and the
Lenders have agreed to postpone the maturity date on several
occasions.  The note was due September 30, 2006.  As of June
30, 2008, the Company had not made payment against the outstanding balance due
on the note.  All or part of the outstanding balance and unpaid
interest may be converted at the option of the Lenders into shares of Class A
common stock of the Company at any time.  The conversion price was the
average closing bid price of the shares at the time of the
advances.  To the extent the market price of the Company’s shares is
below the conversion price at the time of conversion, the Lenders are entitled
to receive additional shares equal to the gross dollar value received from the
original sale of the shares.  A beneficial conversion option of
$15,000 was recorded as interest expense in connection with this
transaction.  The Lenders may also receive additional compensation as
determined appropriate by the Board of Directors.





During
the year ended December 31, 2005, the Company received an additional advance of
$50,000 from the Lenders.  The balance due at December 31, 2005 was
$486,000.  During the year ended December 31, 2006, the Company
received additional advances and other consideration from the Lenders in the
aggregate amount of $419,000 and made principal payments to the Lenders against
the note of $105,000.  During the year ended December 31, 2007, the
Company received additional advances of $102,000.  During the nine
months ended September 30, 2009, the Company received additional advances of
$49,500.  The balance due at September 30, 2009, was
$777,000.





The
balance due of $777,000 is secured by the Company’s intellectual property rights
and common stock of Fonix Speech.  For the nine months ended September
30, 2009, one of the Lenders, Thomas A. Murdock, a former officer and director
of the Company, converted $190,000 of the principal balance into 6,095,331
shares common stock, and also converted $22,000 of accrued interest into 480,969
shares of common stock.





The
Company currently owes an officer and former officer $107,000 for travel related
expenses.





13





4.  PREFERRED
STOCK





The
Company’s certificate of incorporation allows for the issuance of preferred
stock in such series and having such terms and conditions as the Company’s board
of directors may designate.





Series A
Convertible Preferred Stock – As of September 30, 2009, there were
166,667 shares of Series A convertible preferred stock
outstanding.  Holders of the Series A convertible preferred stock have
the same voting rights as common stockholders, have the right to elect one
person to the board of directors and are entitled to receive a one time
preferential dividend of $2.905 per share of Series A convertible preferred
stock prior to the payment of any dividend on any class or series of
stock.  At the option of the holders, each share of Series A
convertible preferred stock is convertible into one share of Class A common
stock and in the event that the common stock price has equaled or exceeded $15
per share for a 15 day period, the shares of Series A convertible preferred
stock will automatically be converted into Class A common stock.  In
the event of liquidation, the holders are entitled to a liquidating distribution
of $36.33 per share and a conversion of Series A convertible preferred stock at
an amount equal to .0000075 shares of common stock for each share of Series A
convertible preferred stock.





Series L
Preferred Stock – On September 7, 2006, the Company entered into a Series
L 9% Convertible Preferred Stock Exchange Agreement (the "Exchange Agreement")
with McCormack and Kenzie Financial (“Kenzie”), a British Virgin Islands
company.  Pursuant to the Exchange Agreement, McCormack and Kenzie
exchanged all 2,000 shares of Series H Preferred Stock that they acquired from
the sale of LTEL Holdings, for 1,960.8 and 39.2 shares,
respectively,  of the Company's Series L 9% Convertible Preferred
Stock (the "Series L Preferred Stock").




Because
the shares of Series L Preferred Stock were issued in exchange for the remaining
outstanding shares of Series H Preferred Stock, the Company did not receive any
proceeds in connection with the issuance of the Series L Preferred
Stock.





The
Series L Preferred Stock entitles McCormack and Kenzie to receive dividends in
an amount equal to 9% of the then-outstanding balance of shares of Series L
Preferred Stock.  The dividends are payable in cash or shares of the
Company's Class A common stock, at the Company's option.





The
Series L Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price which was 80% of the average of
the two (2) lowest closing bid prices for the twenty-day trading period prior to
the conversion date.





Redemption
of the Series L Preferred Stock, whether at the Company’s option or that of
McCormack or Kenzie, requires the Company to pay, as a redemption price, the
stated value of the outstanding shares of Series L Preferred Stock to be
redeemed, together with any accrued but unissued dividends thereon, multiplied
by one hundred ten percent (110%).





The
Company accounted for the exchange as redemption of the outstanding Series H
Preferred Stock as the Series H Preferred Stock was not convertible into shares
of common stock of the Company.  The Series L Preferred Stock is
convertible into shares of common stock of the Company.  The Company
recognized a derivative liability upon the redemption of $30,991,000 due to the
value of the conversion feature of the Series L Preferred Stock.  The
liability was calculated using the Black-Scholes valuation model with the
following assumptions: dividend yield of 0%, expected volatility of 140%,
risk-free rate of 3.75% and expected life of 4 years.  As the value of
the derivative liability was greater than the face value of the Series L
Preferred Stock, no value was prescribed to the Series L Preferred
Stock.  Also in connection with the redemption, the Company recognized
a preferred stock dividend of $16,000,000, equal to the original discount the
Company had assigned to the Series H Preferred Stock.  At September
30, 2009, the fair value of the Series L Preferred Stock derivative liability
was $14,697,000.





14




Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)


For the
nine months ended September 30, 2009, the Company issued 22,323,333 shares of
its Class A common stock in conversion of 31 shares of its Series L Preferred
Stock including total interest converted of $71,000.  At September 30,
2009, 1,467 shares of Series L Preferred Stock remained
outstanding.  (See Note 11 for discussion of conversions subsequent to
September 30, 2009.)





Series M
Preferred Stock– On April 4, 2007, the Company entered into a Series M
9% Convertible Preferred Stock Exchange Agreement with Sovereign Partners, LP
(“Sovereign”).  Pursuant to the exchange agreement, Sovereign
exchanged 150 shares of the Company’s Series L Preferred Stock for 150 shares of
the Company’s Series M 9% Convertible Preferred Stock (the “Series M Preferred
Stock”).





The
Series M Preferred Stock entitles Sovereign or its assignees to receive
dividends in an amount equal to 9% of the then-outstanding balance of shares of
Series M Preferred Stock.  The dividends are payable in cash or shares
of the Company’s Class A common stock, at the Company’s option.





The
Series M Preferred Stock may be converted into common stock of the Company at
the option of the holder by using a conversion price which shall be the lower of
(i) 80% of the average of the two lowest closing bid prices for the twenty-day
trading period prior to the conversion date, or (ii) $0.004.





Redemption
of the Series M Preferred Stock, whether at the Company’s option or that of
Sovereign, requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series M Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).





Because
the shares of Series M were issued in exchange for the outstanding shares of
Series L Preferred Stock, the Company did not receive any proceeds in connection
with the issuance of the Series M Preferred Stock.





The
Company recognized a derivative liability upon the redemption of $1,603,000 due
to the value of the conversion feature of the Series M Preferred Stock, which
was previously recorded as part of the Series L Preferred Stock derivative
liability.  The liability was calculated using the Black-Scholes
valuation model with the following assumptions: dividend yield of 0%, expected
volatility of 134%, risk-free rate of 5% and expected life of 4
years.  As the value of the derivative liability was greater than the
face value of the Series M Preferred Stock, no value was prescribed to the
Series M Preferred Stock.  At September 30, 2009, the fair value of
the Series M Preferred Stock derivative liability was $1,502,000.




As of
September 30, 2009, there were 150 shares of Series M Preferred Stock
convertible preferred stock outstanding.





Series N
Convertible Preferred Stock – On August 24, 2007, the Company entered
into a Securities Purchase Agreement with Trillium Partners, LP and other
unnamed future investors relating to the issuance and sale of the Company’s
Series N 9% Convertible Preferred Stock.





Pursuant
to the agreement, the Company agreed to issue up to 2,400 shares of its Series N
9% Convertible Preferred Stock (the “Series N Preferred Stock”) at a per share
price of $1,000 to Trillium Partners, LP and other unnamed future investors, for
gross proceeds of up to $2,400,000.  As of the date of this report,
the Company had issued 1,755 shares of the Series N Preferred Stock, for cash
proceeds of $1,350,000.





The
Series N Preferred Stock entitles the Purchasers to receive dividends in an
amount equal to 9% of the then-outstanding balance of shares of Series N
Preferred Stock.  The dividends are payable in cash or shares of the
Company's Class A common stock, at the Company's option.





The
Series N Preferred Stock is convertible into Class A common stock of the Company
at the option of the holder by using a conversion price equal to 80% of the
average of the two lowest closing bid prices for the twenty-day trading period
prior to the conversion date.




15




Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)


Redemption
of the Series N Preferred Stock, whether at the Company’s option or that of the
Purchasers requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series N Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).





The
Company recognized a derivative liability upon the redemption of $957,000 due to
the value of the conversion feature of the Series N Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 128%, risk-free rate of 5.0% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
N Preferred Stock, no value was prescribed to the Series N Preferred
Stock.  At September 30, 2009, the fair value of the Series N
Preferred Stock derivative liability was $1,757,000.





As of
September 30, 2009, there were 1,755 shares of Series N Preferred Stock
convertible preferred stock outstanding.





Series O
Convertible Preferred Stock – Between January 25, 2008, and September 30,
2008, the Company received advances from three entities in connection with the
purchase agreements related to the Company’s Series O 9% Convertible Preferred
Stock (“Series O Preferred Stock”). On May 20, 2008, the Company entered into
Securities Purchase Agreements with Southridge Partners LP, Southshore Capital
Fund LTD, Sovereign Partners LP (collectively, the “Series O Purchasers”) for
the sale of an aggregate of 730 shares of Series O Preferred Stock for gross
proceeds of $730,000.  The material terms of the purchase agreements
had been agreed upon prior to receipt of the advances.  Therefore, the
Series O Preferred Stock was accounted for as discussed below on the dates cash
proceeds were received by the Company.  The Company also began
accruing dividends upon receiving the advances.





The
Series O Preferred Stock entitles the Purchasers to receive dividends in an
amount equal to 9% of the then-outstanding balance of shares of Series O
Preferred Stock. The dividends are payable in cash or shares of the Company's
Class A common stock, at the Company's option.





The
Series O Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price, equal to 80% of the average of
the two lowest closing bid prices for the twenty-day trading period prior to the
conversion date.





Redemption
of the Series O Preferred Stock, whether at the Company’s option or that of the
Purchasers requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series O Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).





The
Company recognized a derivative liability upon the redemption of $290,000 due to
the value of the conversion feature of the Series O Preferred Stock. The
liability was calculated using the Black-Scholes valuation model with the
following assumptions: dividend yield of 0%, expected volatility of 128%,
risk-free rate of 5.0% and expected life of 4 years. As the value of the
derivative liability was greater than the face value of the Series O Preferred
Stock, no value was prescribed to the Series O Preferred Stock. At September 30,
2009, the fair value of the Series O Preferred Stock derivative liability was
$731,000.





As of
September 30, 2009, there were 730 shares of Series O Preferred Stock
convertible preferred stock outstanding.





Series P
Convertible Preferred Stock – On September 30, 2008, the Company entered
into a Series P 9% Convertible Preferred Stock Exchange Agreement (the “Exchange
Agreement”) with Sovereign Partners, LP (“Sovereign”), and McCormack Avenue Ltd.
(“McCormack”).  Pursuant to the Exchange Agreement, Sovereign and
McCormack exchanged certain debt obligations, discussed more fully below, for
shares of the Company’s Series P 9% Convertible Preferred Stock (the “Series P
Preferred Stock”).




16


Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)


The
Series P Preferred Stock entitles the holders to receive dividends in an amount
equal to 9% of the then-outstanding balance of shares of Series P Preferred
Stock.  The dividends are payable in cash or shares of the Company’s
Class A common stock, at the Company’s option.





The
Series P Preferred Stock may be converted into common stock of the Company at
the option of the holder by using a conversion price which shall be 80% of the
average of the two (2) lowest closing bid prices for the twenty-day trading
period prior to the conversion date.





Redemption
of the Series P Preferred Stock, whether at our option or that of the holder,
requires us to pay, as a redemption price, the stated value of the outstanding
shares of Series P Preferred Stock to be redeemed, together with any accrued but
unissued dividends thereon, multiplied by one hundred ten percent
(110%).




Because
the shares of Series P were issued in exchange for certain outstanding debt
obligations, the Company, we did not receive any proceeds in connection with the
issuance of the Series P Preferred Stock to McCormack and
Sovereign.





In
connection with the issuance of the Series P Preferred Stock, on September 26,
2008, the Company filed with the State of Delaware a Certificate of Designation
and Series P 9% Convertible Stock Terms (the “Series P Terms”), which become a
part of its Certificate of Incorporation, as amended.





The
Company recognized a derivative liability upon the redemption of $13,000 due to
the value of the conversion feature of the Series P Preferred Stock. The
liability was calculated using the Black-Scholes valuation model with the
following assumptions: dividend yield of 0%, expected volatility of 128%,
risk-free rate of 5.0% and expected life of 4 years. As the value of the
derivative liability was greater than the face value of the Series P Preferred
Stock, no value was prescribed to the Series P Preferred Stock. At September 30,
2009, the fair value of the Series P Preferred Stock derivative liability was
$16,517,000.




For the
nine months ended September 30, 2009, the Company issued 6,088,466 shares of its
Class A common stock in conversion of 10 shares of its Series P Preferred
Stock.  At September 30, 2009, 1,649 shares of Series P Preferred
Stock remained outstanding.   On May 1, 2009 the Company issued 5
shares of Series P Preferred Stock for proceeds of $42,500.  On July
7, 2009 the Company issued 3.5 shares of Series P Preferred Stock for proceeds
of $35,000.  (See Note 11 for discussion of conversions subsequent to
September 30, 2009.) Also, during the year ending September 30, 2009, the
Company issued the following shares of Series P Preferred Stock for the purchase
of G-Soft Limited, a Hong Kong corporation:





Issuance
of Series P 9% Convertible Preferred Stock in G-Soft Transaction





On March
27, 2009, the Company issued an aggregate of one hundred and twenty shares of
the Company’s Series P Preferred Stock to G-Soft, which is the ultimate parent
of GaozhiSoft, and the shareholders of G-Soft (collectively, the
“Sellers”).  The Shares of Series P Preferred Stock were issued
pursuant to an exchange agreement (the “Exchange Agreement”), with Southridge
LLC, a Connecticut limited liability company (“Southridge”), and the
Sellers.  Additionally, subject to the terms of the amended agreement
with the Sellers, the Sellers are entitled to annual earn-out payments equal to
fifty percent (50%) of the prior year’s net income of GaozhiSoft, to be paid in
the form of Series P Preferred Stock (the “Earn-Out Payments”).  The
aggregate of the Earn-Out Payments is limited to three hundred and eighty shares
of Series P Preferred, which were issued into an escrow account.





Under the
G-Soft Agreement and the Series P Terms, the holders of the Series P Preferred
Stock may convert shares of Series P Preferred Stock into shares of the
Company’s common stock.





Issuance
of Shares of Series P 9% Convertible Preferred Stock to Acquire Remaining 20% of
G-Soft





In
connection with the G-Soft transaction described above, on March 27, 2009, the
Company entered into a Series P Convertible Preferred Stock Purchase Agreement
(the “Preferred Stock Purchase Agreement”), with Southridge.  Pursuant
to the Preferred Stock Purchase Agreement, the Company issued 189 shares of
Series P Preferred Stock in exchange for the 20% of G-Soft shares which
Southridge had purchased in the G-Soft Transaction described above.





The
Series P Preferred Stock issued to Southridge has the same terms as described
above.





Under the
Preferred Stock Purchase Agreement and the Series P Terms, Southridge may
convert shares of Series P Preferred Stock into shares of the Company’s common
stock.





Issuance
of Shares of Series P 9% Convertible Preferred Stock In Payment of
Notes





In
connection with the G-Soft transaction described above, Southridge and
Southshore Capital Fund (“Southshore”) made a bridge loan to G-Soft in the
amount of $400,000.  Upon the acquisition of G-Soft by Fonix GS, Fonix
Corporation agreed to repay the bridge loan through the issuance of shares of
Series P Preferred Stock.




17





Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)


In an
agreement dated March 31, 2009, the Company issued an aggregate of 42 shares of
Series P Preferred Stock to Southridge and Southshore as repayment of the bridge
loans described above.





The
Series P Preferred Stock issued to Southridge and Southshore has the same terms
as described above.





Under the
Preferred Stock Purchase Agreement and the Series P Terms, Southridge and
Southshore may convert shares of Series P Preferred Stock into shares of the
Company’s common stock.





Fonix Speech,
Inc., Series B Convertible Preferred Stock – On April 4, 2007, the
Company entered into a Securities Purchase Agreement by and among the Company,
Fonix Speech, Inc. (“FSI”), and Sovereign Partners, LP.  FSI is a
wholly owned subsidiary of the Company.





Pursuant
to the FSI purchase agreement, FSI sold 125 shares of its Series B 9%
Convertible Preferred Stock (the “Series B Preferred Stock”) at a per share
price of $10,000 to Sovereign, for gross proceeds of $1,250,000.





The
shares of Series B Preferred Stock are convertible into shares of the Company’s
Class A common stock.  The Series B Preferred Stock may be converted
into common stock of the Company at the option of the holder by using a
conversion price which shall be the lower of (i) 80% of the average of the two
lowest closing bid prices for the twenty-day trading period prior to the
conversion date, or (ii) $0.004.




The
Series B Preferred Stock entitles Sovereign or its assignees to receive
dividends in an amount equal to 9% of the then-outstanding balance of shares of
Series B Preferred Stock.  The dividends are payable in cash or shares
of the Company's Class A common stock, at the Company's option
 
 The
Company recognized a derivative liability upon the issuance of $1,336,207 due to
the value of the conversion feature of the Series B Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 134%, risk-free rate of 5% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
B Preferred Stock, no value was prescribed to the Series B Preferred
Stock.  At September 30, 2009, the fair value of the Series B
Preferred Stock derivative liability was $1,252,000.
 
 As of
September 30, 2009, there were 125 shares of Series B Preferred Stock
convertible preferred stock outstanding.


18





Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)


5.  CONVERTIBLE
DEBENTURES





On
December 7, 2006, the Company entered into a Securities Purchase Agreement,
dated as of December 1, 2006 (the “Agreement”), with Southridge Partners, LP
(“Southridge”) relating to the purchase and sale of a Series E 9% Secured
Subordinated Convertible Debenture (the “Debenture”) in the principal amount of
$850,000.





Pursuant
to the Agreement, Southridge paid the purchase price by tendering a prior
debenture in the aggregate amount (including principal and interest) of
$641,000, and agreed that an advance to the Company in the amount of $75,000
made in November 2006 would also constitute part of the purchase
price.  Southridge agreed to fund the remaining $134,000 upon the
effectiveness of a registration statement, to be filed by the Company, to
register the resales of shares issuable to Southridge upon conversion of the
Debenture.  The Company received no new capital in connection with the
issuance and sale of the Debenture.





This
Debenture was exchanged for shares of the Company’s Series P Preferred
Stock.  See Note 2.





In
addition to the Debenture issued to Southridge described above, on December 7,
2006, the Company entered into a Securities Purchase Agreement, dated as of
December 1, 2006 (the “McCormack Agreement”), with McCormack, relating to the
purchase and sale of a Series E 9% Secured Subordinated Convertible Debenture
(the “McCormack Debenture”) in the principal amount of $1,039,000.





Pursuant
to the McCormack Agreement, McCormack paid the purchase price by tendering
outstanding promissory notes in the amounts of $300,000 and $350,000, together
with combined interest thereon of $64,000, and agreed that advances to the
Company in the amount of $325,000, made in September, October, and November
2006, would also constitute part of the purchase price.





This
Debenture was also exchanged for shares of the Company’s Series P Preferred
Stock.  See Note 2.





6.  COMMON
STOCK, STOCK OPTIONS AND WARRANTS





Class A Common
Stock – In December 2008, the Company implemented a 1-for-5,000 share
reverse stock split.  The share numbers in these notes have been
adjusted to reflect the reverse stock split.  During the nine months
ended September 30, 2009, 22,323,333 shares of Class A common stock were issued
in conversion of 31 shares of Series L Preferred Stock including total interest
converted of $71,000, 6,088,466 shares of Class A common stock were issued in
conversion of 10 shares of Series P Preferred stock, 6,095,331 shares were
issued in conversion of the outstanding balance on the related party note and
480,969 shares were issued in conversion of accrued interest on the related
party note.





Stock Options
– As of September 30, 2009, the Company had a total of 40 options to
purchase Class A common stock outstanding.  During the nine months
ended September 30, 2009 no options were granted.





Warrants –
As of September 30, 2009, the Company had warrants to purchase a total of 3
shares of Class A common stock outstanding that expire through
2010.




7.  LITIGATION,
COMMITMENTS AND CONTINGENCIES
 
 Hite Development Corporation v. Fonix
Corporation,Third District Court, Salt Lake County (Civil No.
070900883).  In January 2007, Hite Development Corporation (“Hite”)
brought a lawsuit against the Company claiming breach of contract and breach of
the covenant of good faith and fair dealing, alleging that the Company failed to
make certain payments under a settlement agreement with Hite dating from March
2005.  The complaint seeks approximately $33,000 plus
interest.  The Company filed its answer in May
2007.   On May 8, 2008, Hite filed a motion for summary judgment,
which the Court granted.  Judgment was entered against the Company on
March 31, 2009.
 
 RR Donnelley Receivables Inc. v.
Fonix Corporation,Third District Court, Salt Lake County (Civil No.
070412088).  In July 2007, RR Donnelley Receivables Inc. (“Donnelly”)
brought a lawsuit against the Company for alleged failure to pay for services
provided.  The complaint seeks approximately $21,000 plus
interest.  The Company filed its answer in August 2007, and filed a
motion to dismiss the action in December 2007.  That motion is
currently pending before the court.  If the Company’s motion to
dismiss is denied, the Company intends to defend against
the claims in the complaint.


19




Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)


Perpetual Storage, Inc. vs. Fonix
Corporation, Third District Court, Salt Lake County (Civil No.
080907080).  Perpetual Storage, Inc. (“PSI”), brought suit, claiming
breach of contract and unjust enrichment, and seeking damages of approximately
$12,300 plus attorneys’ fees and costs.  The Company filed its answer
in July 2008.  In December 2008, PSI moved for summary judgment, which
the Company opposed.  The Court denied the motion at a hearing in
April 2009.  As of the date of this report, the parties have settled
this matter and were working to finalize the terms of the
settlement.





8.  FAIR
VALUE





Fair
value is defined as the exchange price that would be received for an asset or
paid to transfer a liability (an exit price) in the principal or most
advantageous market for the asset or liability in an orderly transaction between
market participants on the measurement date. The company utilizes a fair value
hierarchy, which maximizes the use of observable inputs and minimizes the use of
unobservable inputs when measuring fair value. The fair value hierarchy has
three levels of inputs that may be used to measure fair value:





·
            Level
      1: Quoted prices (unadjusted) for identical assets or liabilities in
      active markets that the entity has the ability to access as of the
      measurement date.





·
            Level
      2: Level 1 inputs for assets or liabilities that are not actively traded.
      Also consists of an observable market price for a similar asset or
      liability. This includes the use of “matrix pricing” used to value debt
      securities absent the exclusive use of quoted
  prices.





·
            Level
      3: Consists of unobservable inputs that are used to measure fair value
      when observable market inputs are not available. This could include the
      use of internally developed models, financial forecasting,
      etc.





Fair
value is defined as the price that would be received to sell an asset or paid to
transfer a liability between market participants at the balance sheet date. When
possible, the Company looks to active and observable markets to price identical
assets or liabilities. When identical assets and liabilities are not traded in
active markets, the Company looks to observable market data for similar assets
and liabilities.  However, when certain assets and liabilities are not
traded in observable markets the Company must use other valuation methods to
develop a fair value.





The
following table presents financial assets and liabilities measured on a
nonrecurring basis:





Fair
      Value Measurements at Reporting Date UsingDescription
            
            Balance
      at
              September
      30, 2009
            
            
            Quoted
      Prices in Active Markets
              for
      Identical Assets
              (Level
      1)
            
            
            Significant
      Other
              ObservableInputs
              (Level
      2)
            
            
            Significant/Unobservable
              Inputs
              (Level
      3)Goodwill
            
            $
            658,000
            
            
            
            —
            
            
            
            —
            
            
            $
            658,000


9.  OTHER
INCOME
 
 In July
2009 the Company discovered that a former employee, who was not a director or
executive officer of the Company, had misappropriated as much as $355,000 during
the term of his employment which ended in May 2009.  The Company
asserted claims against the former employee for the misappropriation, and
considered certain defenses and offsets asserted by the former employee, which
led to a settlement in which the former employee agreed to pay the Company
$235,000 on or before September 30, 2009.  The former employee paid
the Company $235,000 on September 30, 2009.
 
 10.  PROFORMA
INFORMATION
 
 As
further discussed in Note 4, on March 27, 2009, the Company issued shares of its
Series P Convertible Preferred Stock for the purchase of G-Soft Limited, a Hong
Kong corporation (“G-Soft”), which is the ultimate parent of Shanghai Gaozhi
Software Systems Limited.


20




Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)


The
following unaudited information is presented to reflect the operations of the
Company as if the acquisition of G-Soft had been completed on January 1,
2008:





For
      the Nine Months Ended September 30,
            
            2009
            
            
            2008Total
      Revenues
            
            $
            1,866,000
            
            
            $
            2,308,000Net
      Income (Loss) attributable to common stockholders
            
            
            170,000
            
            
            
            (3,698,000
            )Basic
      and diluted income (loss) per common sharefrom
      continuing operations
            
            $
            0.01
            
            
            $
            (3.23
            )





11.  SUBSEQUENT
EVENTS





Subsequent
to September 30, 2009, the Company has issued 7,409,618 shares of its Class A
common stock in conversion of 8 shares of Series L Preferred Stock.





Subsequent
to September 30, 2009, the Company has issued 738,184 shares of its Class A
common stock in payment of interest on the Series L Preferred
Stock.





Subsequent
to September 30, 2009, the Company has issued 1,794,046 shares of its Class A
common stock in conversion of 2 shares of Series P Preferred Stock.





Subsequent
to September 30, 2009, the Company has issued 3,500,000 shares of its Class A
common stock in payment of principal and interest on related party notes
payable.





Subsequent
to September 30, 2009, the Company has issued 5,666,667 shares of its Class A
common stock for settlement of litigation.




21


ITEM
      2.
            MANAGEMENT'S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS





This
report on Form 10-Q contains, in addition to historical information,
forward-looking statements that involve substantial risks and
uncertainties.  All forward-looking statements contained herein are
deemed by Fonix to be covered by and to qualify for the safe harbor protection
provided by Section 21E of the Private Securities Litigation Reform Act of
1995.  When used in this report, words such as “believes,” “expects,”
“intends,” “plans,” “anticipates,” “estimates,” and similar expressions are
intended to identify forward-looking statements, although there may be certain
forward-looking statements not accompanied by such
expressions.  Statements relating to the future performance, business
strategies and implementation, availability of outside financing, financial
performance, market acceptance of our products, and similar statements may also
include forward looking statements.  Actual results could differ
materially from the results anticipated by Fonix and discussed in the
forward-looking statements.    Factors that could cause or
contribute to such differences are discussed in the Company’s Annual Report on
Form 10-K for the year ended December 31, 2008.  The Company disclaims
any obligation or intention to update any forward-looking
statements.





To
date, we have earned only limited revenue from operations and intend to continue
to rely primarily on financing through the sale of our equity and debt
securities to satisfy future capital requirements.





The
following Management’s Discussion and Analysis of Financial Condition and
Results of Operations (“MD&A”) is intended to help the reader understand
Fonix Corporation, our operations and our present business
environment.  MD&A is provided as a supplement to, and should be
read in conjunction with, our condensed consolidated financial statements and
the accompanying notes thereto.  This overview summarizes MD&A,
which includes the following sections:





·
            Overview
      – a general description of our business and the markets in which we
      operate; our objective; our areas of focus; and challenges and risks of
      our business.





·
            Significant
      Accounting Policies– a discussion of
      accounting policies that require critical judgments and
      estimates.





·
            Results of
      Operations– an analysis of
      our Company’s consolidated results of operations for the three years
      presented in our consolidated financial statements.  Except to
      the extent that differences among our operating segments are material to
      an understanding of our business as a whole, we present the discussion in
      the MD&A on a consolidated
basis.





·
            Liquidity
      and Capital Resources– an analysis of
      cash flows; off-balance sheet arrangements and aggregate contractual
      obligations; the impact of foregoing exchange; an overview of financial
      position; and the impact of inflation and changing
  prices.





We intend
for this discussion to provide the reader with information that will assist in
understanding our financial statements, the changes in certain key items in
those financial statements from year to year, and the primary factors that
accounted for those changes, as well as how certain accounting principles affect
our financial statements.  The discussion also provides information
about the financial results of the various segments of our business to provide a
better understanding of how those segments and their results affect the
financial condition and results of operations of the Company as a
whole.  This discussion should be read in conjunction with our
financial statements as of December 31, 2008, and the year then ended and the
notes accompanying those financial statements.





Overview





We are
engaged in providing value-added speech technologies through Fonix Speech, Inc.
(“Fonix Speech”).  We offer speech-enabling technologies including
automated speech recognition (“ASR”) and text-to-speech (“TTS”) through Fonix
Speech.  We offer our speech-enabling technologies to markets for
wireless and mobile devices, computer telephony, server solutions and personal
software for consumer applications.  We have received various patents
for certain elements of our core technologies and have filed applications for
other patents covering various aspects of our technologies.  We seek
to develop relationships and strategic alliances with third-party developers and
vendors in telecommunications, computers, electronic devices and related
industries, including producers of application software, operating systems,
computers and microprocessor chips.  Revenues are generated through
licensing of speech-enabling technologies, maintenance contracts and
services.


22




For the
three months ended September 30, 2009 and 2008, we generated revenues of
$335,000 and $223,000, respectively, and incurred net income of $230,000 and a
net loss of $1,701,000, respectively.  For the nine months ended
September 30, 2009 and 2008, we generated revenues of $1,301,000 and $1,069,000,
respectively, incurred net losses attributable to common stockholders of
$2,466,000 and $5,526,000, respectively, and had cash flows from operating
activities of $85,000 and negative cash flows from operating activities of
$209,000, respectively.  As of September 30, 2009, we had an
accumulated deficit of $288,839,000; negative working capital of $46,725,000;
derivative liabilities of $36,460,000 related to the issuance of Series P
Preferred Stock, Series L Preferred Stock, Series M Preferred stock, Series N
Preferred Stock, Series O Preferred Stock, Series E Convertible Debentures and
Series B Preferred Stock of our subsidiary Fonix Speech; accrued liabilities of
$8,942,000; accrued payroll and other compensation of $902,000; accounts payable
of $2,215,000; related party accounts payable of $21,000 tax payable of $29,000;
deferred tax liabilities of $228,000; related party notes payable of $777,000;
and deferred revenues of $465,000.  We expect to continue to incur
significant losses and negative cash flows from operating activities at least
through December 31, 2009, primarily due to expenditure requirements associated
with continued marketing and development of our speech-enabling
technologies.





We are
continually developing new product offerings in the ASR businesses in an effort
to increase our revenue stream, and we are continuing to work with our existing
customers to increase sales.  We have also experienced operating
expense decreases through headcount reductions and overall cost reduction
measures.  Through the combination of increased recurring revenues and
the overall operating cost reduction strategies we have implemented, we hope to
achieve positive cash flow from operations in the next 18-24
months.  However, there can be no assurance that we will be able to
achieve positive cash flow from operations within this time frame.





Fonix GS
was formed on June 27, 2008, to facilitate the acquisition of Shanghai Gaozhi
Software Systems Limited (“GaozhiSoft”), which was completed in early
2009.  GaozhiSoft is a leading Chinese software developer and
solutions provider in 2G (second-generation) and 3G (third-generation)
telecommunication operation support systems in China and throughout the Asian
Pacific region.  Gaozhisoft is a qualified competitor for
telecommunication operation supports systems.





GaozhiSoft’s
products are designed to increase data transferring speed, reduce
telecommunications data loss and provide network management, billing accuracy
and improved implementation techniques to telecom carriers.





GaozhiSoft’s
software products are divided into two main categories: (1) MOSS series and (2)
MDtrac series. MOSS products provide service providers with integrated
electronic management platforms for peer-to-peer business operation and
automatic management.  MDtrac products provide data collection
solutions.  GaozhiSoft has received various copyrights and patents for
certain of its products and has filed applications for other copyrights and
patents covering various aspects of its products.





Gaozhisoft
has an outstanding management team with extensive industrial knowledge and
experience with system developing, marketing and sales.  Since
completion of the acquisition of GaozhiSoft, Fonix GS, through its wholly owned
foreign entities, has been working with the management team to transition the
business with a focus on creating synergies among the Company’s existing
technologies and GoazhiSoft’s products.  Upon completion of the
transition, we expect GaozhiSoft to continue its rapid growth and market
penetration based on the implementation of the 3G mobile network service with
these professional partners.





Historically,
our cash resources, limited to collections from customers, draws on equity lines
of credit and loans, have not been sufficient to cover operating
expenses.  We periodically engage in discussions with various sources
of financing to facilitate our cash requirements including buyers of both debt
and equity securities.  To date, no additional sources of funding
offering terms superior to those available under equity lines have been
implemented, and we rely on first, cash generated from operations, and second,
cash provided through convertible debt financing arrangements.  We
will need to generate approximately $2 to $3 million to continue operations for
the next twelve months.  There can be no assurance that we will be
able to obtain such financing or that, if we can obtain such financing, it will
be on terms favorable to us.




23


Significant
Accounting Policies





The
discussion and analysis of our financial condition and results of operations are
based upon our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United
States.  The preparation of these financial statements 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 sales and
expenses during the reporting period.  Significant accounting policies
and areas where substantial judgments are made by management
include:





Accounting
estimates-The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
the disclosures of contingent assets and liabilities at the date of the
financial statements, and the reported amounts of revenues and expenses during
the reporting period.  Actual results could differ from those
estimates.





Valuation of
long-lived assets - The carrying values of our long-lived assets are
reviewed for impairment whenever events or changes in circumstances indicate
that they may not be recoverable.  When such an event occurs, we
project undiscounted cash flows to be generated from the use of the asset and
its eventual disposition over the remaining life of the asset.  If
projections indicate that the carrying value of the long-lived asset will not be
recovered, the carrying value of the long-lived asset, other than software
technology, is reduced by the estimated excess of the carrying value over the
projected discounted cash flows.





Goodwill
–
Goodwill represents the excess of the cost over the fair value of net assets of
acquired businesses. Goodwill is not amortized, but is tested for impairment
quarterly or when a triggering event occurs.  The testing for
impairment requires the determination of the fair value of the asset or entity
to which the goodwill relates (the reporting unit).  The fair value of
a reporting  unit is determined based upon a weighting of the quoted
market price of our common stock and present value techniques based upon
estimated future cash flows of the reporting unit, considering future revenues,
operating costs, the risk-adjusted discount rate and other
factors.  Impairment is indicated if the fair value of the reporting
unit is allocated to the assets and liabilities of that unit, with the excess of
the fair value of the reporting unit over the amounts assigned to its assets and
liabilities assigned to the fair value of goodwill.  The amount of
impairment of goodwill is measured by the excess of the goodwill’s carrying
value over its fair value.





Revenue
recognition – We recognize revenue when pervasive evidence of an
arrangement exists, services have been rendered or products have been delivered,
the price to the buyer is fixed and determinable and collectability is
reasonable assured.  Revenues are recognized by us based on the
various types of transactions generating the revenue.  We generate
revenues from licensing the rights to its software products to end users and
from royalties.





For Fonix
Speech, revenue of all types is recognized when acceptance of functionality,
rights of return, and price protection are confirmed or can be reasonably
estimated, as appropriate.  Revenues from development and consulting
services are recognized on a completed-contract basis when the services are
completed and accepted by the customer.  The completed-contract method
is used because our contracts are typically either short-term in duration or we
are unable to make reasonably dependable estimates of the costs of the
contracts.  Revenue for hardware units delivered is recognized when
delivery is verified and collection assured.





Revenue
for products distributed through wholesale and retail channels and through
resellers is recognized upon verification of final sell-through to end users,
after consideration of rights of return and price
protection.  Typically, the right of return on such products has
expired when the end user purchases the product from the retail
outlet.  Once the end user opens the package, it is not returnable
unless the medium is defective.





When
arrangements to license software products do not require significant production,
modification or customization of software, revenue from licenses and royalties
are recognized when persuasive evidence of a licensing arrangement exists,
delivery of the software has occurred, the fee is fixed or determinable, and
collectability is probable.  Post-contract obligations, if any,
generally consist of one year of support including such services as customer
calls, bug fixes, and upgrades.  Related revenue is recognized over
the period covered by the agreement.  Revenues from maintenance and
support contracts are also recognized over the term of the related
contracts.




24


Revenues
applicable to multiple-element fee arrangements are bifurcated among the
elements such as license agreements and support and upgrade obligations using
vendor-specific objective evidence of fair value.  Such evidence
consists primarily of pricing of multiple elements as if sold as separate
products or arrangements.  These elements vary based upon factors such
as the type of license, volume of units licensed, and other related
factors.





Deferred revenue as of September 30,
2009, and December 31, 2008, consisted of the following:




Description
            Criteria
      for Recognition
            
            September
      30, 2009
            
            
            December
      31, 2008Deferred
      unit royalties and license fees
            Delivery
      of units to end users or expiration of contract
            
            $
            465,000
            
            
            $
            445,000





Cost of
revenues-  Cost of revenues from license, royalties, and maintenance
consists of costs to distribute the product, installation and support personnel
compensation, amortization and impairment of capitalized speech software costs,
licensed technology, and other related costs.  Cost of service
revenues consists of personnel compensation and other related
costs.





Software
Technology Development and Production Costs- All costs incurred to
establish the technological feasibility of speech software technology to be
sold, leased, or otherwise marketed are charged to product development and
research expense.  Technological feasibility is established when a
product design and a working model of the software product have been completed
and confirmed by testing.  Costs to produce or purchase software
technology incurred subsequent to establishing technological feasibility are
capitalized.  Capitalization of software costs ceases when the product
is available for general release to customers.  Costs to perform
consulting or development services are charged to cost of revenues in the period
in which the corresponding revenues are recognized.  Costs of
maintenance and customer support are charged to expense when related revenue is
recognized or when these costs are incurred, whichever occurs
first.





Capitalized
software technology costs were amortized on a product-by-product
basis.  Amortization was recognized from the date the product was
available for general release to customers as the greater of (a) the ratio that
current gross revenue for a product bears to total current and anticipated
future gross revenues for that product or (b) the straight-line method over the
remaining estimated economic life of the products.  Amortization was
charged to cost of revenues.





We
assessed unamortized capitalized software costs for possible write down on a
quarterly basis based on net realizable value of each related
product.  Net realizable value was determined based on the estimated
future gross revenues from a product reduced by the estimated future cost of
completing and disposing of the product, including the cost of performing
maintenance and customer support.  The amount by which the unamortized
capitalized costs of a software product exceeded the net realizable value of
that asset was written off.





Imputed Interest
Expense and Income - Interest is imputed on long-term debt obligations
and notes receivable where management has determined that the contractual
interest rates are below the market rate for instruments with similar risk
characteristics.





Foreign Currency
Translation-The
functional currency of our Korean subsidiary is the South Korean
won.  Consequently, assets and liabilities of the Korean operations
are translated into United States dollars using current exchange rates at the
end of the year.  All revenue is invoiced in South Korean won and
revenues and expenses are translated into United States dollars using
weighted-average exchange rates for the year.





The
functional currency of our operating subsidiaries in the PRC is
RMB.  Consequently, assets and liabilities of the PRC operations are
translated into United States dollars using current exchange rates at the end of
the period.  All revenue is invoiced in RMB and revenues and expenses
are translated into United States dollars using weighted-average exchange rates
for the period.





Comprehensive
Income-Other
comprehensive income presented in the accompanying consolidated financial
statements consists of cumulative foreign currency translation
adjustments.


25





Recent
Accounting Pronouncements





In
October 2009, the FASB issued ASU No. 2009-13, Revenue Recognition (“ASC Topic
605”) - Multiple-Deliverable Revenue Arrangements, a consensus of the FASB
Emerging Issues Task Force.  This guidance modifies the fair value
requirements of ASC subtopic 605-25, “Revenue Recognition-Multiple Element
Arrangements” by allowing the use of the “best estimate of selling price” in
addition to vendor-specific objective evidence (“VSOE”) (now referred to as
“TPE” standing for third-party evidence) for determining the selling price of a
deliverable. A vendor is now required to use its best estimate of the selling
price when VSOE or TPE of the selling price cannot be determined. In addition,
the residual method of allocating arrangement consideration is no longer
permitted.





In
October 2009, the FASB issued ASU No. 2009-14, Software (“ASC Topic 985”) -
Certain Revenue Arrangements That Include Software Elements, a consensus of the
FASB Emerging Issues Task Force. This guidance modifies the scope of ASC
subtopic 965-605, “Software-Revenue Recognition” to exclude from its
requirements (a) non-software components of tangible products and (b) software
components of tangible products that are sold, licensed, or leased with tangible
products when the software components and non-software components of the
tangible product function together to deliver the tangible product’s essential
functionality.





ASC Topic
605 and 985 require expanded qualitative and quantitative disclosures and are
effective for fiscal years beginning on or after June 15, 2010. However,
companies may elect to adopt as early as interim periods ended September 30,
2009. These updates may be applied either prospectively from the beginning of
the fiscal year for new or materially modified arrangements or retrospectively.
We are currently evaluating the impact of adopting these updates on our
consolidated financial statements.





Results
of Operations





Three
months ended September 30, 2009, compared with three months ended September 30,
2008





During
the three months ended September 30, 2009, we recorded revenues of $335,000, an
increase of $112,000 from $223,000 for the same period in 2008. The
increase was primarily due to increased revenues from the addition of G-Soft of
$30,000 and an increase of revenue from software development kits sold of
$82,000.





Selling,
general and administrative expenses were $597,000 for the three months ended
September 30, 2009, an increase of $254,000 from $343,000 for the same
period in 2008.  The increase is primarily due to an increase of
expenses in the quarter of $59,000 related to the acquisition of
G-Soft.  The remainder of the change is primarily due to decreased
salary and wage related expenses of $122,000, increased other expenses of
$32,000, decreased occupancy related expenses of $93,000, decreased depreciation
expenses of $2,000, decreased investor relations related expenses of $1,000,
increased consulting expenses $76,000, decreased travel expenses of $25,000, an
increase in other operating expenses of $89,000, a decrease in marketing
material of $14,000 and increased legal and accounting fees of
$255,000.





We
incurred research and product development expenses of $155,000 for the three
months ended September 30, 2009, a decrease of $145,000 from $300,000 for the
same period in 2008. The decrease was primarily due to an overall decrease
in wage related expenses of $122,000, decrease occupancy expenses of $12,000 and
decreased travel expenses of $11,000.





Net
interest and other expense was a gain of $751,000 for the three months ended
September 30, 2009, a decrease of $2,029,000 from net other expense of a loss of
$1,278,000 for the same period in 2008.  The overall decrease was
due to a decrease in interest expense of $1,658,000, an increase in interest
income of $57,000, an increase in a gain on the forgiveness of liabilities of
$56,000, an increase in other income of $235,000 and a decrease in the loss
recognized on the derivative liability of $23,000.





Nine
months ended September 30, 2009, compared with nine months ended September 30,
2008





During
the nine months ended September 30, 2009, we recorded revenues of $1,301,000, an
increase of $232,000 from $1,069,000 for the same period in
2008.  The increase was primarily due to an increase of revenue of
$595,000 from the acquisition of G-Soft, an increase of $35,000 from software
development kit sale and voice related application sales, offset primarily by
decreased licensing revenue of $352,000 and decreased support fees of
$46,000.


26




Selling,
general and administrative expenses were $1,704,000 for the nine months ended
September 30, 2009, an increase of $273,000 from $1,431,000 for the same
period in 2008. The increase is primarily due to an increase in expenses
from the acquisition of G-Soft of $298,000.  The other changes related
to decreased salary and wage related expenses of $74,000, increased other
expenses of $38,000, decreased taxes, licenses and permits of $3,000, decreased
consulting expenses of $52,000, increased legal and accounting fees of $290,000,
decreased occupancy related expenses of $183,000, increased investor relations
related expenses of $9,000, decreased travel expenses of $33,000, decreased
advertising expenses of $15,000 and decreased depreciation expenses of
$2,000.





We
incurred research and product development expenses of $620,000 for the nine
months ended September 30, 2009, a decrease of $372,000 from $992,000 for the
same period in 2008. The decrease was primarily due to an overall decrease
in wage related expenses of $311,000, decreased travel expenses of $4,000,
decreased occupancy expenses of $36,000, decreased depreciation expenses of
$2,000, and a decrease in other operating expenses of $19,000.




Liquidity
and Capital Resources





We must
raise additional funds to be able to satisfy our cash requirements during the
next 12 months.  It is anticipated that we will need to raise
approximately $2.5 to $3 million over the next 12 months to meet obligations and
continue our product development, corporate operations and marketing
expenses.  Because we presently have only limited revenue from
operations, we intend to continue to rely primarily on financing through the
sale of our equity and debt securities to satisfy future capital requirements
until such time as we are able to enter into additional third-party licensing,
collaboration, or co-marketing arrangements such that we will be able to finance
ongoing operations from license, royalty, and sales revenue.  We are
working with game developers and other potential licensors of our speech product
offerings to develop additional revenue streams for our speech
technologies.  There can be no assurance that we will be able to enter
into such agreements.  Furthermore, the issuance of equity or debt
securities which are or may become convertible into equity securities of Fonix
in connection with such financing could result in substantial additional
dilution to the stockholders of Fonix.





Our cash
resources are limited to collections from customers, proceeds from the issuance
of preferred stock, and loan proceeds, and are not sufficient to cover current
operating expenses and payments of current liabilities.  At September
30, 2009, we had negative working capital of $46,725,000; derivative liabilities
of $36,460,000 related to the issuance of Series L Preferred
Stock,  Series M Preferred Stock, Series N Preferred Stock, Series O
Preferred Stock,  Series P Preferred Stock and Series B Preferred
Stock of our subsidiary, Fonix Speech; accrued liabilities of $8,942,000;
accounts payable of $2,215,000; related party accounts payable of
$107,000;  notes payable to related parties of $777,000; accrued
payroll and other compensation of $902,000; deferred tax liabilities of
$228,000; and deferred revenues of $465,000.  In July 2009 the Company
discovered that a former employee, who was not a director or executive officer
of the Company, had misappropriated funds during the term of his employment
which ended in May 2009.  The Company asserted claims against the
former employee for the misappropriation which lead to a settlement in which the
former employee agreed to pay the Company $235,000 on or before September 30,
2009.  The former employee paid the Company $235,000 on September 30,
2009.





We had
$1,301,000 in revenue and a loss of $50,000 for the nine months ended September
30, 2009.  Net cash provided in operating activities of $85,000 for
the nine months ended September 30, 2009, resulted principally from the net loss
incurred of $50,000, offset by increased accrued liabilities of
$290,000,  non-cash gain recognized on the derivative liability of
$1,236,000, decrease in accounts receivable of $615,000, decreased accounts
payable of $9,000, decreased related party accounts payable of $11,000 and
depreciation expense of $11,000.  Net cash obtained in investing
activities of $796,000, for the nine months ended September 30, 2009, consisted
of the cash acquired in the acquisition of $796,000.  Net cash
provided by financing activities was $128,000 obtained from the proceeds from
the related party note of $50,000 and the issuance of Series P preferred stock
of $78,000.





We had
negative working capital of $46,725,000 at September 30, 2009, compared to
negative working capital of $44,471,000 at December 31, 2008.  Current
assets increased by $3,405,000 to $3,407,000 from $2,000 from December 31, 2008,
to September 30, 2009.  Current liabilities increased by $5,659,000 to
$50,132,000 from $44,473,000 during the same period.  The change in
working capital from December 31, 2008, to September 30, 2009, reflects, in
part, increased accrued liabilities of $2,432,000, increased accounts payable of
$500,000, increased related party accounts payable of $21,000 increased
derivative liability of $1,878,000, increased accrued payroll and other
compensation of $691,000, increased tax payable of $29,000, and an increase in
deferred tax liabilities of $228,000.  Total assets were $4,133,000 at
September 30, 2009, compared to $40,000 at December 31, 2008.


27




As of
September 30, 2009, we had $396,000 in bills receivable, which we received from
our customers in the form of bankers' acceptance drafts.  In China,
bankers' acceptance drafts are used to settle trade debts between companies. A
banker's acceptance draft is issued by a depositor who maintains an account at
an acceptance bank. The acceptance bank ensures unconditional payment to the
draft holder on the designated maturity date specified on the draft. Typically,
our customers pay us with bankers' acceptance drafts with maturity dates ranging
from 60 to 90 days. We reasonably expect that all of our bankers' acceptance
drafts will be paid upon maturity. In addition, we can endorse and transfer
those bankers' acceptance drafts to pay our suppliers. Overall, we believe that
our cash flow from operating activities should be adequate to sustain our
operations at our current levels through the rest of the 2009 year.





Notes
Payable and Accounts Payable - Related Parties





During
2002, two executive officers of the Company (the “Lenders”) sold shares of the
Company’s Class A common stock owned by them and advanced the resulting proceeds
amounting to $333,000 to the Company under the terms of a revolving line of
credit and related promissory note.  The funds were advanced for use
in Company operations.  The advances bear interest at 12 percent per
annum, which interest is payable on a semi-annual basis.  The entire
principal, along with unpaid accrued interest and any other unpaid charges or
related fees, was originally due and payable on June 10, 2003.  The
Company and the Lenders have agreed to postpone the maturity date on several
occasions.  The note was due September 30, 2006.  As of
September 30, 2009, the Company had not made payment against the outstanding
balance due on the note.  All or part of the outstanding balance and
unpaid interest may be converted at the option of the Lenders into shares of
Class A common stock of the Company at any time.  The conversion price
was the average closing bid price of the shares at the time of the
advances.  To the extent the market price of the Company’s shares is
below the conversion price at the time of conversion, the Lenders are entitled
to receive additional shares equal to the gross dollar value received from the
original sale of the shares.  A beneficial conversion option of
$15,000 was recorded as interest expense in connection with this
transaction.  The Lenders may also receive additional compensation as
determined appropriate by the Board of Directors.





During
the year ended December 31, 2005, the Company received an additional advance of
$50,000 against the promissory note.  The balance due at December 31,
2005 was $486,000.  During the year ended December 31, 2006, the
Company received additional advances and other consideration from the Lenders in
the aggregate amount of $419,000 and made principal payments to the Lenders
against the note of $105,000.  During the year ended December 31,
2007, the Company received additional advances of $102,000.  During
the nine months ended September 30, 2009, the Company received additional
advances of $49,500.  The balance due at September 30, 2009, was
$777,000.





The
balance due of $777,000 is secured by the Company’s intellectual property rights
and common stock of Fonix Speech.  For the nine months ended September
30, 2009, one of the Lenders, Thomas A. Murdock, a former officer and director
of the Company, converted $190,000 of the principal balance into 6,095,331
shares common stock, and also converted $22,000 of accrued interest into 480,969
shares of common stock.





The
Company currently owes an officer and former officer $107,000 for travel related
expenses.





Notes
Payable





In
connection with the acquisition of the capital stock of LTEL Holdings in 2004,
the Company issued a 5%, $10,000,000, secured, six-year note (the “Note”)
payable to McCormack Avenue, Ltd. (“McCormack”).  Under the terms of
the Note, quarterly interest-only payments were required through January 15,
2005, with quarterly principal and interest payments of $319,000 beginning April
2005 and continuing through January 2010.  Interest on the Note was
payable in cash or, at the Company’s option, in shares of the Company’s Class A
common stock.  The Note was secured by the capital stock and all of
the assets of LTEL Holdings and its subsidiaries.  The Note was
originally valued at $4,624,000 based on an imputed interest rate of 25 percent
per annum.





On
September 8, 2006, the Company received a default notice (the “Default Notice”)
from McCormack in respect of the Note.   In the Default Notice,
McCormack stated that it intended to exercise its rights, including any and all
rights set forth in the Note, as amended.  McCormack took no action to
collect amounts due under the Note.




28


During
the fourth quarter of 2006, the Company entered into two promissory notes (the
“Additional Notes”) with McCormack Avenue, Ltd., in the aggregate amount of
$330,000. These Additional Notes accrue interest at 10% annually and were due
and payable during the second quarter of 2007.  The Additional Notes
were exchanged for shares of the Company’s Series P Preferred
Stock.  See below.





During
the quarter ended March 31, 2007, the Company entered into five promissory notes
with McCormack Avenue, Ltd. and Sovereign Partners LP., in the aggregate amount
of $450,000.  These notes accrue interest at 10% annually and were due
and payable during the third quarter of 2007.  These promissory notes
were exchanged for shares of the Company’s Series P Preferred
Stock.  See below.





On
September 30, 2008, the Company entered into a Series P 9% Convertible Preferred
Stock Exchange Agreement (the “Exchange Agreement”) with McCormack and Sovereign
Partners, LP (“Sovereign”), whereby McCormack exchanged the Note, along with the
Additional Notes and the Series E debenture (discussed in Note 5), and Sovereign
exchanged two promissory notes, for shares of the Company’s Series P 9%
Convertible Preferred Stock (the Series P Preferred Stock”).  A table
listing the obligations exchanged and the number of shares of Series P Preferred
Stock issued.





Series A
Convertible Preferred Stock – As of September 30, 2009, there were
166,667 shares of Series A convertible preferred stock
outstanding.  Holders of the Series A convertible preferred stock have
the same voting rights as common stockholders, have the right to elect one
person to the board of directors and are entitled to receive a one time
preferential dividend of $2.905 per share of Series A convertible preferred
stock prior to the payment of any dividend on any class or series of
stock.  At the option of the holders, each share of Series A
convertible preferred stock is convertible into one share of Class A common
stock and in the event that the common stock price has equaled or exceeded $15
per share for a 15 day period, the shares of Series A convertible preferred
stock will automatically be converted into Class A common stock.  In
the event of liquidation, the holders are entitled to a liquidating distribution
of $36.33 per share and a conversion of Series A convertible preferred stock at
an amount equal to .0000075 shares of common stock for each share of Series A
convertible preferred stock.





Series L
Preferred Stock – On September 7, 2006, the Company entered into a Series
L 9% Convertible Preferred Stock Exchange Agreement (the "Exchange Agreement")
with McCormack and Kenzie Financial (“Kenzie”), a British Virgin Islands
company.  Pursuant to the Exchange Agreement, McCormack and Kenzie
exchanged all 2,000 shares of Series H Preferred Stock that they acquired from
the sale of LTEL Holdings, for 1,960.8 and 39.2 shares,
respectively,  of the Company's Series L 9% Convertible Preferred
Stock (the "Series L Preferred Stock").





Because
the shares of Series L Preferred Stock were issued in exchange for the remaining
outstanding shares of Series H Preferred Stock, the Company did not receive any
proceeds in connection with the issuance of the Series L Preferred
Stock.





The
Series L Preferred Stock entitles McCormack and Kenzie to receive dividends in
an amount equal to 9% of the then-outstanding balance of shares of Series L
Preferred Stock.  The dividends are payable in cash or shares of the
Company's Class A common stock, at the Company's option.





The
Series L Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price which was 80% of the average of
the two (2) lowest closing bid prices for the twenty-day trading period prior to
the conversion date.





Redemption
of the Series L Preferred Stock, whether at the Company’s option or that of
McCormack or Kenzie, requires the Company to pay, as a redemption price, the
stated value of the outstanding shares of Series L Preferred Stock to be
redeemed, together with any accrued but unissued dividends thereon, multiplied
by one hundred ten percent (110%).





29




The
Company accounted for the exchange as redemption of the outstanding Series H
Preferred Stock as the Series H Preferred Stock was not convertible into shares
of common stock of the Company.  The Series L Preferred Stock is
convertible into shares of common stock of the Company.  The Company
recognized a derivative liability upon the redemption of $30,991,000 due to the
value of the conversion feature of the Series L Preferred Stock.  The
liability was calculated using the Black-Scholes valuation model with the
following assumptions: dividend yield of 0%, expected volatility of 140%,
risk-free rate of 3.75% and expected life of 4 years.  As the value of
the derivative liability was greater than the face value of the Series L
Preferred Stock, no value was prescribed to the Series L Preferred
Stock.  Also in connection with the redemption, the Company recognized
a preferred stock dividend of $16,000,000, equal to the original discount the
Company had assigned to the Series H Preferred Stock.  At September
30, 2009, the fair value of the Series L Preferred Stock derivative liability
was $14,697,000.


For the
nine months ended September 30, 2009, the Company issued 22,323,333 shares of
its Class A common stock in conversion of 31 shares of its Series L Preferred
Stock including total interest converted of $71,000.  At September 30,
2009, 1,467 shares of Series L Preferred Stock remained
outstanding.  (See Note 11 to the condensed consolidated financial
statements above for discussion of conversions subsequent to September 30,
2009.)





Series M
Preferred Stock– On April 4, 2007, the Company entered into a Series M
9% Convertible Preferred Stock Exchange Agreement with Sovereign Partners, LP
(“Sovereign”).  Pursuant to the exchange agreement, Sovereign
exchanged 150 shares of the Company’s Series L Preferred Stock for 150 shares of
the Company’s Series M 9% Convertible Preferred Stock (the “Series M Preferred
Stock”).





The
Series M Preferred Stock entitles Sovereign or its assignees to receive
dividends in an amount equal to 9% of the then-outstanding balance of shares of
Series M Preferred Stock.  The dividends are payable in cash or shares
of the Company’s Class A common stock, at the Company’s option.





The
Series M Preferred Stock may be converted into common stock of the Company at
the option of the holder by using a conversion price which shall be the lower of
(i) 80% of the average of the two lowest closing bid prices for the twenty-day
trading period prior to the conversion date, or (ii) $0.004.





Redemption
of the Series M Preferred Stock, whether at the Company’s option or that of
Sovereign, requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series M Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).





Because
the shares of Series M were issued in exchange for the outstanding shares of
Series L Preferred Stock, the Company did not receive any proceeds in connection
with the issuance of the Series M Preferred Stock.





The
Company recognized a derivative liability upon the redemption of $1,603,000 due
to the value of the conversion feature of the Series M Preferred Stock, which
was previously recorded as part of the Series L Preferred Stock derivative
liability.  The liability was calculated using the Black-Scholes
valuation model with the following assumptions: dividend yield of 0%, expected
volatility of 134%, risk-free rate of 5% and expected life of 4
years.  As the value of the derivative liability was greater than the
face value of the Series M Preferred Stock, no value was prescribed to the
Series M Preferred Stock.  At September 30, 2009, the fair value of
the Series M Preferred Stock derivative liability was $1,502,000.





As of
September 30, 2009, there were 150 shares of Series M Preferred Stock
convertible preferred stock outstanding.





Series N
Convertible Preferred Stock – On August 24, 2007, the Company entered
into a Securities Purchase Agreement with Trillium Partners, LP and other
unnamed future investors relating to the issuance and sale of the Company’s
Series N 9% Convertible Preferred Stock.





Pursuant
to the agreement, the Company agreed to issue up to 2,400 shares of its Series N
9% Convertible Preferred Stock (the “Series N Preferred Stock”) at a per share
price of $1,000 to Trillium Partners, LP and other unnamed future investors, for
gross proceeds of up to $2,400,000.  As of the date of this report,
the Company had issued 1,755 shares of the Series N Preferred Stock, for cash
proceeds of $1,350,000.





30




The
Series N Preferred Stock entitles the Purchasers to receive dividends in an
amount equal to 9% of the then-outstanding balance of shares of Series N
Preferred Stock.  The dividends are payable in cash or shares of the
Company's Class A common stock, at the Company's option.
 
 The
Series N Preferred Stock is convertible into Class A common stock of the Company
at the option of the holder by using a conversion price equal to 80% of the
average of the two lowest closing bid prices for the twenty-day trading period
prior to the conversion date.


Redemption
of the Series N Preferred Stock, whether at the Company’s option or that of the
Purchasers requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series N Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).





The
Company recognized a derivative liability upon the redemption of $957,000 due to
the value of the conversion feature of the Series N Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 128%, risk-free rate of 5.0% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
N Preferred Stock, no value was prescribed to the Series N Preferred
Stock.  At September 30, 2009, the fair value of the Series N
Preferred Stock derivative liability was $1,757,000.





As of
September 30, 2009, there were 1,755 shares of Series N Preferred Stock
convertible preferred stock outstanding.





Series O
Convertible Preferred Stock – Between January 25, 2008, and September 30,
2008, the Company received advances from three entities in connection with the
purchase agreements related to the Company’s Series O 9% Convertible Preferred
Stock (“Series O Preferred Stock”). On May 20, 2008, the Company entered into
Securities Purchase Agreements with Southridge Partners LP, Southshore Capital
Fund LTD, Sovereign Partners LP (collectively, the “Series O Purchasers”) for
the sale of an aggregate of 730 shares of Series O Preferred Stock for gross
proceeds of $730,000.  The material terms of the purchase agreements
had been agreed upon prior to receipt of the advances.  Therefore, the
Series O Preferred Stock was accounted for as discussed below on the dates cash
proceeds were received by the Company.  The Company also began
accruing dividends upon receiving the advances.





The
Series O Preferred Stock entitles the Purchasers to receive dividends in an
amount equal to 9% of the then-outstanding balance of shares of Series O
Preferred Stock. The dividends are payable in cash or shares of the Company's
Class A common stock, at the Company's option.





The
Series O Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price, equal to 80% of the average of
the two lowest closing bid prices for the twenty-day trading period prior to the
conversion date.





Redemption
of the Series O Preferred Stock, whether at the Company’s option or that of the
Purchasers requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series O Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).





The
Company recognized a derivative liability upon the redemption of $290,000 due to
the value of the conversion feature of the Series O Preferred Stock. The
liability was calculated using the Black-Scholes valuation model with the
following assumptions: dividend yield of 0%, expected volatility of 128%,
risk-free rate of 5.0% and expected life of 4 years. As the value of the
derivative liability was greater than the face value of the Series O Preferred
Stock, no value was prescribed to the Series O Preferred Stock. At September 30,
2009, the fair value of the Series O Preferred Stock derivative liability was
$731,000.





As of
September 30, 2009, there were 730 shares of Series O Preferred Stock
convertible preferred stock outstanding.





Series P
Convertible Preferred Stock – On September 30, 2008, the Company entered
into a Series P 9% Convertible Preferred Stock Exchange Agreement (the “Exchange
Agreement”) with Sovereign Partners, LP (“Sovereign”), and McCormack Avenue Ltd.
(“McCormack”).  Pursuant to the Exchange Agreement, Sovereign and
McCormack exchanged certain debt obligations, discussed more fully below, for
shares of the Company’s Series P 9% Convertible Preferred Stock (the “Series P
Preferred Stock”).




31




The
Series P Preferred Stock entitles the holders to receive dividends in an amount
equal to 9% of the then-outstanding balance of shares of Series P Preferred
Stock.  The dividends are payable in cash or shares of the Company’s
Class A common stock, at the Company’s option.


The
Series P Preferred Stock may be converted into common stock of the Company at
the option of the holder by using a conversion price which shall be 80% of the
average of the two (2) lowest closing bid prices for the twenty-day trading
period prior to the conversion date.





Redemption
of the Series P Preferred Stock, whether at our option or that of the holder,
requires us to pay, as a redemption price, the stated value of the outstanding
shares of Series P Preferred Stock to be redeemed, together with any accrued but
unissued dividends thereon, multiplied by one hundred ten percent
(110%).




Because
the shares of Series P were issued in exchange for certain outstanding debt
obligations, the Company, we did not receive any proceeds in connection with the
issuance of the Series P Preferred Stock to McCormack and
Sovereign.





In
connection with the issuance of the Series P Preferred Stock, on September 26,
2008, the Company filed with the State of Delaware a Certificate of Designation
and Series P 9% Convertible Stock Terms (the “Series P Terms”), which become a
part of its Certificate of Incorporation, as amended.





The
Company recognized a derivative liability upon the redemption of $13,000 due to
the value of the conversion feature of the Series P Preferred Stock. The
liability was calculated using the Black-Scholes valuation model with the
following assumptions: dividend yield of 0%, expected volatility of 128%,
risk-free rate of 5.0% and expected life of 4 years. As the value of the
derivative liability was greater than the face value of the Series P Preferred
Stock, no value was prescribed to the Series P Preferred Stock. At September 30,
2009, the fair value of the Series P Preferred Stock derivative liability was
$16,517,000.




For the
nine months ended September 30, 2009, the Company issued 6,088,468 shares of its
Class A common stock in conversion of 10 shares of its Series P Preferred
Stock.  At September 30, 2009, 1,649 shares of Series P Preferred
Stock remained outstanding.   On May 1, 2009 the Company issued 5
shares of Series P Preferred Stock for proceeds of $42,500.  On July
7, 2009 the Company issued 3.5 shares of Series P Preferred Stock for proceeds
of $35,000.  (See Note 11 to the condensed consolidated financial
statements above for discussion of conversions subsequent to September 30,
2009.) Also, during the year ending September 30, 2009, the Company issued the
following shares of Series P Preferred Stock for the purchase of G-Soft Limited,
a Hong Kong corporation:





Issuance
of Series P 9% Convertible Preferred Stock in G-Soft Transaction





On March
27, 2009, the Company issued an aggregate of one hundred and twenty shares of
the Company’s Series P Preferred Stock to G-Soft, which is the ultimate parent
of GaozhiSoft, and the shareholders of G-Soft (collectively, the
“Sellers”).  The Shares of Series P Preferred Stock were issued
pursuant to an exchange agreement (the “Exchange Agreement”), with Southridge
LLC, a Connecticut limited liability company (“Southridge”), and the
Sellers.  Additionally, subject to the terms of the amended agreement
with the Sellers, the Sellers are entitled to annual earn-out payments equal to
fifty percent (50%) of the prior year’s net income of GaozhiSoft, to be paid in
the form of Series P Preferred Stock (the “Earn-Out Payments”).  The
aggregate of the Earn-Out Payments is limited to three hundred and eighty shares
of Series P Preferred, which were issued into an escrow account.





Under the
G-Soft Agreement and the Series P Terms, the holders of the Series P Preferred
Stock may convert shares of Series P Preferred Stock into shares of the
Company’s common stock.





Issuance
of Shares of Series P 9% Convertible Preferred Stock to Acquire Remaining 20% of
G-Soft





In
connection with the G-Soft transaction described above, on March 27, 2009, the
Company entered into a Series P Convertible Preferred Stock Purchase Agreement
(the “Preferred Stock Purchase Agreement”), with Southridge.  Pursuant
to the Preferred Stock Purchase Agreement, the Company issued 189 shares of
Series P Preferred Stock in exchange for the 20% of G-Soft shares which
Southridge had purchased in the G-Soft Transaction described above.




32




The
Series P Preferred Stock issued to Southridge has the same terms as described
above.
 
 Under the
Preferred Stock Purchase Agreement and the Series P Terms, Southridge may
convert shares of Series P Preferred Stock into shares of the Company’s common
stock.


Issuance
of Shares of Series P 9% Convertible Preferred Stock In Payment of
Notes





In
connection with the G-Soft transaction described above, Southridge and
Southshore Capital Fund (“Southshore”) made a bridge loan to G-Soft in the
amount of $400,000.  Upon the acquisition of G-Soft by Fonix GS, Fonix
Corporation agreed to repay the bridge loan through the issuance of shares of
Series P Preferred Stock.





In an
agreement dated March 31, 2009, the Company issued an aggregate of 42 shares of
Series P Preferred Stock to Southridge and Southshore as repayment of the bridge
loans described above.





The
Series P Preferred Stock issued to Southridge and Southshore has the same terms
as described above.





Under the
Preferred Stock Purchase Agreement and the Series P Terms, Southridge and
Southshore may convert shares of Series P Preferred Stock into shares of the
Company’s common stock.





Fonix Speech,
Inc., Series B Convertible Preferred Stock – On April 4, 2007, the
Company entered into a Securities Purchase Agreement by and among the Company,
Fonix Speech, Inc. (“FSI”), and Sovereign Partners, LP.  FSI is a
wholly owned subsidiary of the Company.





Pursuant
to the FSI purchase agreement, FSI sold 125 shares of its Series B 9%
Convertible Preferred Stock (the “Series B Preferred Stock”) at a per share
price of $10,000 to Sovereign, for gross proceeds of $1,250,000.





The
shares of Series B Preferred Stock are convertible into shares of the Company’s
Class A common stock.  The Series B Preferred Stock may be converted
into common stock of the Company at the option of the holder by using a
conversion price which shall be the lower of (i) 80% of the average of the two
lowest closing bid prices for the twenty-day trading period prior to the
conversion date, or (ii) $0.004.





The
Series B Preferred Stock entitles Sovereign or its assignees to receive
dividends in an amount equal to 9% of the then-outstanding balance of shares of
Series B Preferred Stock.  The dividends are payable in cash or shares
of the Company's Class A common stock, at the Company's option





The
Company recognized a derivative liability upon the issuance of $1,336,207 due to
the value of the conversion feature of the Series B Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 134%, risk-free rate of 5% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
B Preferred Stock, no value was prescribed to the Series B Preferred
Stock.  At September 30, 2009, the fair value of the Series B
Preferred Stock derivative liability was $1,252,000.





As of
September 30, 2009, there were 125 shares of Series B Preferred Stock
convertible preferred stock outstanding.





Stock Options and
Warrants





During
the nine months ended September 30, 2009, we did not grant any stock
options.  As of September 30, 2009, we had a total of 40 options to
purchase Class A common stock outstanding.





As of
September 30, 2009, we had warrants to purchase a total of 3 shares of Class A
common stock outstanding that expire through 2010.




Other


We
presently have no plans to purchase new research and
development.


33




Corporate
Outlook





Company
management intends to focus on the following strategies:


(i)
            provide
      competitive and value-added speech interface solutions for customers and
      partners through Fonix Speech Inc.
and;





(ii)
            expand
      organic revenue growth through GS in China,
and;


utilize
      the GS platform for additional China-based
  acquisitions.


As we
proceed to implement our strategy and to reach our objectives, we anticipate
further development of complementary technologies, added product and
applications development expertise, access to market channels and additional
opportunities for strategic alliances in other industry segments.  The
strategy adopted by us has significant risks, and shareholders and others
interested in Fonix and our Class A common stock should carefully consider the
risks set forth below and under the heading “Certain Significant Risk Factors”
in Item 1, Part I, of our annual report on Form 10-K for the year ended December
31, 2008.





As noted
above, as of  September 30, 2009, we had an accumulated deficit of
$288,839,000; negative working capital of $46,725,000; derivative liabilities of
$36,460,000 related to the issuance of Series L Preferred
Stock,  Series M Preferred Stock, Series N Preferred Stock, Series O
Preferred Stock , Series P Preferred Stock and Series B Preferred Stock of our
subsidiary Fonix Speech; accrued liabilities of $8,942,000; accounts payable of
$2,215,000; related party accounts payable of $107,000; taxes payable of
$29,000; notes payable to related parties of $777,000; accrued payroll and other
compensation of $902,000; and deferred revenues of $465,000.  Sales of
products and revenue from licenses based on our technologies have not been
sufficient to finance ongoing operations.  These matters raise
substantial doubt about our ability to continue as a going
concern.  Our continued existence is dependent upon several factors,
including our success in (1) increasing speech license, royalty and services
revenues, (2) raising sufficient additional funding, and (3) minimizing
operating costs.  Until sufficient revenues are generated from
operating activities, we expected to continue to fund our operations through
debt instruments.  We are currently pursuing additional sources of
liquidity in the form of traditional commercial credit, asset based lending, or
additional sales of our equity securities to finance our ongoing
operations.  Additionally, we are pursuing other types of commercial
and private financing, which could involve sales of our assets or sales of one
or more operating divisions.  Our sales and financial condition have
been adversely affected by our reduced credit availability and lack of access to
alternate financing because of our significant ongoing losses and increasing
liabilities and payables.  As we have noted in our previous annual
reports and other public filings, if additional financing is not obtained in the
near future, we will be required to more significantly curtail our operations or
seek protection under bankruptcy laws.





Information
Concerning Forward-Looking Statements





Certain
of the statements contained in this report (other than the historical financial
data and other statements of historical fact) are forward-looking
statements.  These statements include, but are not limited to our
expectations with respect to the development of a diversified revenue base;
delivery of our iSpeak application for the Apple iPhone; the market volume of
educational electronic dictionary devices; our ability to capitalize in markets
including toys, appliances, and other devices; the market demand for videogames;
our growth strategies and the implementation of our Core Technologies and
potential results; our China business growth  opportunities through
existing customers and potential acquisitions; our payment of dividends on our
common stock; our ability to meet customer demand for speech technologies and
solutions; development of complementary technologies, products, marketing, and
strategic alliance opportunities; profitability of language learning tools; the
status of  traditional operator systems; our ability to continue
operations in the event we do not receive approval to amend our articles of
incorporation; the comparability of our speech-enabled Speech Products to other
products; our intentions with respect to strategic collaborations and marketing
arrangements; our intentions with respect to use of licenses; our plans with
respect to development and acquisition of speech solutions; our goals with
respect to supplying speech solutions for OEMs; our expectations with respect to
continued financial losses; and our intentions with respect to financing our
operations in the future.  Additional forward-looking statements may
be found in the “Certain Significant Risk Factors” Section of our 10-K for the
year ended December 31, 2008, together with accompanying explanations of the
potential risks associated with such statements.




34




Forward-looking
statements made in this report, are made based upon management’s good faith
expectations and beliefs concerning future developments and their potential
effect upon Fonix.  There can be no assurance that future developments
will be in accordance with such expectations, or that the effect of future
developments on Fonix will be those anticipated by
management.  Forward-looking statements may be identified by the use
of words such as “believe,” “expect,” “plans,” “strategy,” “prospects,”
“estimate,” “project,” “anticipate,” “intends” and other words of similar
meaning in connection with a discussion of future operating or financial
performance.


You are
cautioned not to place undue reliance on these forward looking statements, which
are current only as of the date of this Report.  We disclaim any
intention or obligation to update or revise any forward-looking statements,
whether as a result of new information, future events, or
otherwise.  Many important factors could cause actual results to
differ materially from management’s expectations, including those listed in the
“Certain Significant Risk Factors” Section of our 10-K for the year ended
December 31, 2008, as well as the following:





•          
unpredictable difficulties or delays in the development of new products and
technologies;





• changes
in U.S. or international economic conditions, such as inflation, interest rate
fluctuations, foreign exchange rate fluctuations or recessions in Fonix's
markets;





• pricing
changes to our supplies or products or those of our competitors, and other
competitive pressures on pricing and sales;





• difficulties
in obtaining or retaining the management, engineering, and other human resource
competencies that we need to achieve our business objectives;





• the
impact on Fonix or a subsidiary from the loss of a significant customer or a
significant number of customers;





• risks
generally relating to our international operations, including governmental,
regulatory or political changes;





• transactions
or other events affecting the need for, timing and extent of our capital
expenditures; and





•          
the extent to which we reduce outstanding debt.





Item
3.              Quantitative
and Qualitative Disclosures About Market Risk





Foreign Currency
Exposure





Our
functional currency is the U.S. Dollar (USD).  The functional currency
of our operating subsidiaries in the PRC is RMB and the functional currency of
our operating subsidiary in Korea is the South Korean won.  However,
the accompanying financial statements have been expressed in USD, which is our
functional currency.  The accompanying consolidated balance sheets
have been translated into USD at the exchange rates prevailing at each balance
sheet date.





Fluctuations
in exchange rates may affect our financial results reported in USD terms without
giving effect to any underlying change in our business or results of
operations.








ITEM
4T - CONTROLS AND PROCEDURES





(a)
Evaluation of disclosure controls and procedures.





Our Chief
Executive Officer/ Chief Financial Officer evaluated the effectiveness of our
disclosure controls and procedures pursuant to Rule 13a-15 under the Securities
Exchange Act of 1934 (Exchange Act) as of September 30, 2009.  In
designing and evaluating the disclosure controls and procedures, management
recognizes that any controls and procedures, no matter how well designed and
operated, can provide only reasonable assurance of achieving the desired control
objectives. In addition, the design of disclosure controls and procedures must
reflect the fact that there are resource constraints and that management is
required to apply its judgment in evaluating the benefits of possible controls
and procedures relative to their costs.





35




Based
on our evaluation, our Chief Executive Officer/Chief Financial Officer
concluded that, as a result of the material weakness described below which was
identified in the second quarter of 2009, our disclosure controls and procedures
were not designed at a reasonable assurance level and were ineffective to
provide reasonable assurance that information we are required to disclose in
reports that we file or submit under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in Securities and
Exchange Commission rules and forms, and that such information is not
accumulated nor communicated to our management, including our Chief Executive
Officer/Chief Financial Officer to allow timely decisions regarding required
disclosure.


A
“material weakness” is a deficiency, or a combination of deficiencies, in
internal control, such that there is a reasonable possibility that a material
misstatement of the financial statements will not be prevented, or detected and
corrected on a timely basis.





The
material weakness, which relates to internal control over financial reporting
and specifically to internal accounting and disbursements, that was identified
was not having sufficient personnel in our accounting and financial reporting
functions.  As a result, we were not able to achieve adequate
segregation of incompatible duties. This control deficiency results in a
reasonable possibility that material misstatements of the financial statements
will not be prevented, or detected and corrected on a timely basis.





Remediation





Throughout
the third quarter of 2009, we have taken and will continue to take steps to
remediate this material weakness until management determines that our controls
and procedures are effective.  As of the filing of this Report, we
had:




-
              revised internal accounting procedures,
  including:


-
            segregation
      of the duties for expense approval from the preparation and signing of the
      checks;


-
            discontinued
      use of paper payroll checks;


-
            employee
      expense reimbursement checks, vendor checks and payroll checks
      require advance written approval ;
and


-
            weekly
      cash flow reports reviewed by the Chief Financial Officer and the
      Accounting Manager;





-
            hired
      the Accounting Manager to manage daily transactions, including maintaining
      the general ledger, processing payroll, and processing cash disbursements;
      and





-
            established
      more formal policies for segregation of incompatible duties and
      responsibilities between the Company’s Chief Financial Officer, Accounting
      Manager, and a third-party
consultant.





Management
believes that when the Company is able to do so, hiring additional knowledgeable
personnel with technical accounting expertise will further remediate the
material weakness. Due to the fact that our accounting staff presently consists
of the Chief Financial Officer and the Accounting Manager, additional personnel
will also ensure the proper segregationofincompatible duties and provide more
checks and balances within the department.  As an additional step to
enhance accurate and timely financial reporting, we have engaged a third-party
consultant to take a significant role in the processing of our financial
information and to assist with the preparation of our periodic
reports.  We believe this increases the effectiveness of our internal
control. To compensate for the limited number of personnel in our accounting and
financial reporting department, we expect to engage consultants to assist us
with the proper accounting treatment for complex transactions.




36




Management
will continue to monitor and evaluate the effectiveness of our disclosure
controls and procedures and our internal controls over financial reporting, and
we are committed to taking further action and implementing additional
enhancements or improvements, as necessary and as resources allow. As part of
this commitment, we will continue to assess our current personnel resources and
technical accounting expertise within the accounting function. As our level of
operations increases, we will look to increase our personnel resources to improve the segregationofincompatible duties and to provide in-house expertise for
accounting for non-routine or complex transactions.


PART
II - OTHER INFORMATION





Item
1.                      Legal
Proceedings





Hite Development Corporation v. Fonix
Corporation,Third District Court, Salt Lake County (Civil No.
070900883).  In January 2007, Hite Development Corporation (“Hite”)
brought a lawsuit against the Company claiming breach of contract and breach of
the covenant of good faith and fair dealing, alleging that the Company failed to
make certain payments under a settlement agreement with Hite dating from March
2005.  The complaint seeks approximately $33,000 plus
interest.  The Company filed its answer in May
2007.   On May 8, 2008, Hite filed a motion for summary judgment,
which the Court granted.  Judgment was entered against the Company on
March 31, 2009.





RR Donnelley Receivables Inc. v.
Fonix Corporation,Third District Court, Salt Lake County (Civil No.
070412088).  In July 2007, RR Donnelley Receivables Inc. (“Donnelly”)
brought a lawsuit against the Company for alleged failure to pay for services
provided.  The complaint seeks approximately $21,000 plus
interest.  The Company filed its answer in August 2007, and filed a
motion to dismiss the action in December 2007.  That motion is
currently pending before the court.  If the Company’s motion to
dismiss is denied, the Company intends to defend against
the claims in the complaint.





Perpetual Storage, Inc. vs. Fonix
Corporation, Third District Court, Salt Lake County (Civil No.
080907080).  Perpetual Storage, Inc. (“PSI”), brought suit, claiming
breach of contract and unjust enrichment, and seeking damages of approximately
$12,300 plus attorneys’ fees and costs.  The Company filed its answer
in July 2008.  In December 2008, PSI moved for summary judgment, which
the Company opposed.  The Court denied the motion at a hearing in
April 2009.  As of the date of this report, the parties have settled
this matter and were working to finalize the terms of the
settlement.





Item
2.                      Unregistered
Sales of Equity Securities and Use of Proceeds





During
the nine months ended September 30, 2009, we issued 22,323,333 shares of our
common stock in connection with conversions of 31 shares of our Series L
Preferred Stock including total interest converted of $71,000 for which we
received no proceeds and we issued 6,088,468 shares of our common stock in
connection with conversions of 10 shares of our Series P Preferred Stock for
which we also received no proceeds.    The shares of common
stock were issued without registration under the 1933 Act in reliance on Section
4(2) of the 1933 Act and the rules and regulations promulgated
thereunder.





We
received no proceeds from the issuance of shares upon conversion of our series
of preferred stock.





Item
3.                      Defaults
Upon Senior Securities





None.





Item
4.                      Submission
of Matters to a Vote of Security Holders





None.





Item
5.                      Other
Information





None.




37


Item
6.                      Exhibits





a.
            Exhibits:
      The following Exhibits are filed with this Form 10-Q pursuant to Item
      601(a) of Regulation S-K:





Exhibit
      No.
            Description of
      Exhibit





3
            
            Amendment
      to Certificate of Incorporation (previously filed as an exhibit to a
      Current Report filed on December 24, 2008, and incorporated herein by
      reference).4
            
            Certificate
      of Designation of Rights and Preferences for Series P 9% Convertible
      Preferred Stock (previously filed as an exhibit to a Quarterly Report
      filed on November 19, 2008, and incorporated herein by
      reference).10.1
            
            Exchange
      Agreement, dated as of September 30, 2008 (previously filed as an exhibit
      to a Quarterly Report filed on November 19, 2008, and incorporated herein
      by reference).10.2
            
            Form
      of First Amendment to the Exchange Agreement, dated as of December 12,
      2008 (previously filed as an exhibit to a Current Report filed on December
      19, 2008, and incorporated herein by reference).10.3
            
            Escrow
      Agreement dated of December 12, 2008 (previously filed as an exhibit to a
      Current Report filed on December 19, 2008, and incorporated herein by
      reference).10.4
            
            Side
      Letter Agreement dated as of February 18, 2009 (previously filed as an
      exhibit to a Current Report filed on March 27, 2009, and incorporated
      herein by reference).Other
      Contracts31
            
            Certification
      of President and Chief Financial Officer32
            
            Certification
      of President and Chief Financial Officer Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002








SIGNATURES





In
accordance with the requirements of the Exchange Act, the registrant caused this
report to be signed on its behalf by the undersigned, thereunto duly
authorized.








Fonix
      CorporationDate:
      November 16, 2009,
            /s/  Roger
      D.  DudleyRoger
      D.  Dudley, Chief Executive Officer,
  President,Chief
      Financial Officer, and Director(Principal
      Executive Officer, Principal Financial
Officer)







38