<PAGE>
 
                UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C.  20549

                                  FORM 10-Q/A
                               (Amendment No. 1)


[X]  Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange
     Act of 1934 for the quarterly period ended September 30, 1998

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

                      Commission file number    0-23862
                                              ------------

                               fonix corporation
             (Exact name of registrant as specified in its charter)

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

                    60 East South Temple Street, Suite 1225
                          Salt Lake City, Utah 84111
             -----------------------------------------------------
             (Address of principal executive offices and zip code)

                                (801) 328-8700
             ----------------------------------------------------
             (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 Section 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  or No
                                 ----      ----       

As of November 9, 1998, 62,828,552 shares of the issuer's common stock, par
value $.0001 per share, were issued and outstanding.
<PAGE>
 
                                  INTRODUCTION

     This Amendment No. 1 to the Quarterly Report on Form 10-Q for the quarterly
period ended September 30, 1998, of Fonix Corporation (the "Company") is
submitted to amend the following Items:

Part I - Financial Information
         Item 1.  Financial Statements
         Item 2.  Management's Discussion and Analysis


                         PART I - FINANCIAL INFORMATION

Item 1.  Financial Statements.

     The interim unaudited condensed consolidated financial statements required
     by Rule 10-01 of Regulation S-X follow immediately.

                                       2
<PAGE>
 
                               fonix corporation
                         (A Development Stage Company)

                     CONDENSED CONSOLIDATED BALANCE SHEETS
                                  (Unaudited)
<TABLE> 
<CAPTION> 
ASSETS
                                                                                              September 30,         December 31,
                                                                                                  1998                  1997
                                                                                         --------------------- ---------------------
<S>                                                                                       <C>                       <C> 
Current assets:
       Cash and cash equivalents                                                                 $ 20,053,030          $ 20,501,676
       Notes receivable                                                                               822,139               600,000
       Accounts receivable, net                                                                       257,186                     -
       Interest and other receivables                                                                  91,722                14,919
       Inventory                                                                                       65,523                     -
       Prepaid expense                                                                                136,775                32,094
       Stock subscription receivable                                                                2,000,000                     -
                                                                                         --------------------- ---------------------

              Total current assets                                                                 23,426,375            21,148,689

Property and equipment, net of accumulated depreciation of $955,944 and 
  $464,100, respectively                                                                            2,462,907             1,567,279

Intangible assets, net of accumulated amortization of $1,356,381 and 
  $25,509, respectively                                                                            34,726,176               138,951

Other assets                                                                                          130,302                39,647
                                                                                        --------------------- ---------------------

              Total assets                                                                       $ 60,745,760          $ 22,894,566
                                                                                        ===================== =====================

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
       Bank overdraft                                                                            $    178,757          $          -
       Revolving notes payable                                                                     20,034,536            18,612,272
       Notes payable - related party                                                                6,737,453               551,510
       Notes payable - other                                                                          100,000                     -
       Accounts payable                                                                             2,868,670               291,638
       Accrued liabilities                                                                          1,133,388               505,619
       Accrued liabilities - related party                                                            492,636               459,502
       Deferred revenues                                                                              931,816                     -
       Capital lease obligation - current portion                                                      55,227                49,325
                                                                                         --------------------- ---------------------

              Total current liabilities                                                            32,532,483            20,469,866

Capital lease obligation, net of current portion                                                       10,039                52,225
                                                                                        --------------------- ---------------------

              Total liabilities                                                                    32,542,522            20,522,091
                                                                                         --------------------- ---------------------

Commitments and contingencies (Notes 11 and 12)

Stockholders' equity:
       Preferred stock                                                                             25,697,414             5,812,444
       Common stock                                                                                     5,859                 4,358
       Additional paid-in capital                                                                  82,396,674            38,637,059
       Outstanding warrants                                                                         3,258,928             2,936,360
       Deferred consulting expense                                                                   (186,725)                    -
       Deficit accumulated during the development stage                                           (82,968,912)          (45,017,746)
                                                                                         --------------------- ---------------------

              Total stockholders' equity                                                           28,203,238             2,372,475
                                                                                         --------------------- ---------------------

              Total liabilities and stockholders' equity                                         $ 60,745,760          $ 22,894,566
                                                                                         ===================== =====================
</TABLE> 
    See accompanying notes to condensed consolidated financial statements.

                                       3


<PAGE>
 
                               fonix corporation
                         (A Development Stage Company)

                CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                                  (Unaudited)
<TABLE> 
<CAPTION> 
                                                                                                                      October 1,
                                                                                                                         1993
                                                 Three Months Ended                   Nine Months Ended             (Inception) to
                                                  September 30,                         September 30,                September 30,
                                     ----------------------------------------------------------------------------
                                          1998               1997               1998               1997                1998
                                     ------------------ ----------------- ------------------- ------------------ -------------------
<S>                                  <C>                 <C>               <C>                 <C>                 <C> 
Revenues                                      $ 199,017     $           -         $ 2,671,302     $            -         $ 2,671,302
Cost of revenues                                 33,164                 -              57,353                  -              57,353
                                     ------------------ ----------------- ------------------- ------------------ -------------------

       Gross profit                             165,853                 -           2,613,949                  -           2,613,949
                                     ------------------ ----------------- ------------------- ------------------ -------------------

Expenses:
    Purchased in-process research
     and development                          3,821,000                 -          13,136,000                  -          13,136,000
    Product development and research          4,419,400         1,650,371          10,080,895          4,715,650          28,018,188
    Selling, general and 
     administrative                           4,320,891         2,185,169           8,360,964          5,935,838          30,607,634
                                     ------------------ ----------------- ------------------- ------------------ -------------------

       Total expenses                        12,561,291         3,835,540          31,577,859         10,651,488          71,761,822
                                     ------------------ ----------------- ------------------- ------------------ -------------------

Loss from operations                       (12,395,438)       (3,835,540)        (28,963,910)       (10,651,488)        (69,147,873)
                                     ------------------ ----------------- ------------------- ------------------ -------------------

Other income (expense):
    Interest income                            292,526           279,671             856,408            882,096           3,448,475
    Interest expense                          (378,636)       (1,697,550)           (973,537)        (3,203,735)         (4,826,080)
    Cancellation of common stock
     reset provisions                       (6,111,577)                -          (6,111,577)                 -          (6,111,577)
                                     ------------------ ----------------- ------------------- ------------------ -------------------

       Total other expense, net             (6,197,687)       (1,417,879)         (6,228,706)        (2,321,639)         (7,489,182)
                                     ------------------ ----------------- ------------------- ------------------ -------------------

Loss before extraordinary items            (18,593,125)       (5,253,419)        (35,192,616)       (12,973,127)        (76,637,055)

Extraordinary items:
    Loss on extinguishment of debt                   -          (881,864)                  -           (881,864)           (881,864)
    Gain on forgiveness of debt                      -                 -                   -                  -              30,548
                                     ------------------ ----------------- ------------------- ------------------ -------------------

Net loss                                 $ (18,593,125)     $ (6,135,283)      $ (35,192,616)     $ (13,854,991)      $ (77,488,371)
                                     ================== ================= =================== ================== ===================


Basic and diluted net loss per
 common share                            $       (0.39)     $      (0.18)      $       (0.75)     $       (0.37)
                                     ================== ================= =================== ==================
</TABLE> 

    See accompanying notes to condensed consolidated financial statements.

                                       4


<PAGE>
 
                               fonix corporation
                         (A Development Stage Company)

                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                  (Unaudited)
               Increase (Decrease) in Cash and Cash Equivalents
<TABLE> 
<CAPTION> 
                                                                                                                     
                                                                                                                      October 1,   
                                                                                       Nine Months Ended                1993       
                                                                                        September 30,              (Inception) to
                                                                         ---------------------------------------    September 30, 
                                                                                1998                1997                1998
                                                                         ------------------- ------------------- -------------------
<S>                                                                      <C>                   <C>                  <C> 
Cash flows from operating activities:
       Net loss                                                               $ (35,192,616)      $ (13,854,991)      $ (77,488,371)
       Adjustments to reconcile net loss to net cash
         used in operating activities:
          Issuance of common stock for services                                           -           1,120,004           5,437,240
          Issuance of common stock for patent                                       100,807                   -             100,807
          Non-cash expense related to issuance of debentures,
            warrants, preferred stock and common stock                            6,111,577           2,489,336          10,078,914
          Non-cash compensation expense related to issuance
            of stock options                                                        133,375                   -           2,416,275
          Non-cash expense related to issuance of notes payable and
            accrued expense for services                                            857,000                   -             857,000
          Non-cash expense related to exchange of notes receivable for services     150,000                   -             150,000
          Non-cash expense related to purchased in-process research and
           development                                                           12,635,768                   -          12,635,768
          Gains (losses) on asset disposals                                             (88)                  -               1,193
          Depreciation and amortization                                           1,802,814             237,784           2,292,423
          Extraordinary loss on extinguishment of debt                                    -             881,864             881,864
          Extraordinary gain on forgiveness of debt                                       -                   -             (30,548)
          Changes in assets and liabilities, net of acquisitions:
              Accounts receivable, net                                             (183,418)                  -            (183,418)
              Interest and other receivables                                        (74,009)            157,643             (88,928)
              Inventory                                                              (8,358)                  -              (8,358)
              Prepaid expense                                                      (100,281)           (152,689)           (132,375)
              Other assets                                                          (80,212)            (18,420)           (119,859)
              Accounts payable                                                    2,381,610              40,870           4,453,448
              Accrued liabilities                                                   482,568          (1,006,905)          1,116,168
              Accrued liabilities - related party                                  (370,966)             (4,978)             88,536
              Deferred revenues                                                       2,126                   -               2,126
                                                                         ------------------- ------------------- -------------------

          Net cash used in operating activities                                 (11,352,303)        (10,110,482)        (37,540,095)
                                                                         ------------------- ------------------- -------------------

Cash flows from investing activities, net of effects of acquisitions:
       Acquisition of subsidiaries, net of cash acquired                        (14,738,495)                  -         (14,738,495)
       Purchase of property and equipment                                        (1,240,540)           (625,597)         (3,271,919)
       Proceeds from sale of equipment                                                  500                   -                 500
       Investment in intangible assets                                              (94,789)            (75,035)           (259,249)
       Issuance of notes receivable                                              (1,322,139)           (883,600)         (3,805,739)
       Payments received on notes receivable                                              -           1,633,600           1,883,600
                                                                         ------------------- ------------------- -------------------

          Net cash (used in) provided by investing activities                   (17,395,463)             49,368         (20,191,302)
                                                                         ------------------- ------------------- -------------------

Cash flows from financing activities:
       Bank overdraft                                                               178,757                   -             178,757
       Net proceeds from revolving note payable                                   1,422,264           3,352,637          20,034,536
       Net (payments) proceeds on revolving note payable - related party           (514,296)            760,000              37,214
       Proceeds from notes payable - other                                          100,000                   -           2,451,667
       Payments on notes payable - other                                            (49,250)                  -          (1,829,056)
       Principal payments on capital lease obligation                               (36,284)                  -             (79,665)
       Proceeds from issuance of convertible debentures, net                              -           2,685,000           3,185,000
       Proceeds from sale of warrants                                               322,928                   -             922,928
       Proceeds from sale of common stock, net                                   17,471,155             425,000          38,175,700
       Proceeds from sale of Series B, C and D preferred stock, net               9,403,846                   -          14,707,346
                                                                         ------------------- ------------------- -------------------

          Net cash provided by financing activities                              28,299,120           7,222,637          77,784,427
                                                                         ------------------- ------------------- -------------------

Net increase (decrease) in cash and cash equivalents                               (448,646)         (2,838,477)         20,053,030

Cash and cash equivalents at beginning of period                                 20,501,676          22,805,786                   -
                                                                         ------------------- ------------------- -------------------

Cash and cash equivalents at end of period                                     $ 20,053,030        $ 19,967,309        $ 20,053,030
                                                                         =================== =================== ===================
</TABLE> 
    See accompanying notes to condensed consolidated financial statements.

                                       5


<PAGE>
 
                               fonix corporation
                         (A Development Stage Company)

          CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
                                  (Unaudited)
<TABLE> 
<CAPTION> 
                                                                                                                  
                                                                                                                     October 1,  
                                                                                       Nine Months Ended               1993     
                                                                                         September 30,             (Inception) to
                                                                                  ----------------------------     September 30,  
Supplemental disclosure of cash flow information:                                     1998           1997               1998
                                                                                  -------------  -------------   -------------------
<S>                                                                               <C>             <C>             <C> 
       Cash paid during the period for interest                                      $ 747,629      $ 771,037           $ 2,784,648
</TABLE> 
Supplemental Schedule of Non-cash Investing and Financing Activities:

       For the Nine Months Ended September 30, 1998:

       The Company has a stock subscription receivable in the amount of
           $2,000,000 in connection with the issuance of 100,000 shares of
           Series E 4% Convertible Preferred Stock that was consummated as of
           September 30, 1998. This receivable was collected subsequent to
           period end.

       Preferred Stock Dividends of $1,553,001 were recorded related to the
           beneficial conversion features of Series D and Series E 4%
           Convertible Preferred Stock.

       The Company issued 1,390,476 shares of common stock and 608,334 shares of
           Series D 4% Convertible Preferred Stock in connection with the
           cancellation of existing reset provisions and costs associated with
           the issuance of Series D 4% Convertible Preferred Stock (see Note 8).

       Preferred Stock Dividends of $1,000,000 were recorded related to the
           issuance of 1,390,476 common shares and 608,334 shares of Series D 4%
           Convertible Preferred Stock in connection with the cancellation of
           existing reset provisions (see Note 8).

       Preferred Stock Dividends of $73,889 were accrued on Series D 4%
           Convertible Preferred Stock.

       The Company exchanged 150,000 shares of Series D 4% Convertible Preferred
           Stock for 150,000 shares of Series E 4% Convertible Preferred Stock.

       The Company issued 5,140,751 shares of common stock (having a market
           value of $8,353,720) and notes payable of $4,747,339 in connection
           with the acquisition of Articulate Systems, Inc. The Company has
           agreed to issue options to purchase 91,830 shares of common stock to
           the holders of Articulate Systems, Inc. (having a fair market value
           of approximately $130,000).

       Preferred Stock Dividends of $131,660 were recorded related to the
           beneficial conversion features of Series B and Series C Convertible
           Preferred Stock.

       A total of 27,500 shares of Series B Preferred Stock and related
           dividends of $8,531 were converted into 193,582 shares of common
           stock.

       A total of 185,000 shares of Series C Preferred Stock and related
           dividends of $123,129 were converted into 1,295,919 shares of common
           stock.

       The Company issued 2,692,216 shares of common stock (having a market
           value of $16,995,972) in connection with the acquisition of AcuVoice,
           Inc.

       For the Nine Months Ended September 30, 1997:

       A $500,000 Series A Convertible Debenture was converted into 166,667
           shares of Series A Preferred Stock.

       Series B Convertible Debentures in the amount of $850,000 and related
           accrued interest of $7,850 were converted into 145,747 shares of
           common stock.

       Series B Convertible Debentures in the amount of $2,150,000 and related
           accrued interest of $28,213 were converted into 108,911 shares of
           Series B Preferred Stock.

       Preferred Stock Dividends of $2,647,171 were recorded related to the
           beneficial conversion features and accretion of Series B and Series C
           Convertible Preferred Stock.


    See accompanying notes to condensed consolidated financial statements.

                                       6
<PAGE>
 
                               fonix corporation
                         (A Development Stage Company)
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (Unaudited)

1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation - The accompanying unaudited condensed consolidated
financial statements of  fonix corporation and subsidiaries (collectively, the
"Company") have been prepared by the Company pursuant to the rules and
regulations of the Securities and Exchange Commission. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles 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.

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 as of the balance sheet dates and for the periods
presented.

Operating results for the three and nine months ended September 30, 1998 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 1998.  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 Annual Report on Form
10-K for the year ended December 31, 1997.

Certain reclassifications have been made in the prior period consolidated
financial statements to conform with the current period presentation.

Recently Enacted Accounting Standards - Effective January 1, 1998, the Company
adopted Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
Comprehensive Income."  This Statement establishes standards for reporting and
display of comprehensive income and its components in financial statements.  The
adoption of this statement had no effect on the Company's statements of
operations presentation.

In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information."  SFAS No.
131 establishes new standards for public companies to report information about
their operating segments, products and services, geographic areas and major
customers.  This statement is effective for financial statements issued for
periods beginning after December 15, 1997.  SFAS No. 131 need not be applied to
interim financial statements in the initial year of its application.
Accordingly, the Company will adopt SFAS No. 131 beginning with its consolidated
financial statements for the year ending December 31, 1998.

In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities."  The Statement
establishes accounting and reporting standards requiring that derivative
instruments be recorded in the balance sheet as either an asset or liability
measured at its fair value and that changes in the derivative's fair value be
recognized currently in earnings unless specific hedge accounting criteria are
met.  SFAS No. 133 is effective for fiscal years beginning after June 15, 1999.
The adoption of this statement will not have a material effect on the Company's
consolidated financial statements as the Company does not currently hold any
derivative or hedging instruments.

Net Loss Per Common Share - Basic and diluted net loss per common share are
calculated by dividing net loss attributable to common stockholders by the
weighted average number of shares of common stock outstanding during the period.
At September 30, 1998 and 1997, there were outstanding common stock equivalents
to purchase 38,413,473 and 9,982,403 shares of common stock, respectively, that
were not included in the computation of diluted net loss per common share as
their effect would have been anti-dilutive, thereby decreasing the net loss per
common share.  Net loss per common share amounts have been restated for all
periods presented to reflect basic and diluted per share presentations.

                                       7
<PAGE>
 
                               fonix corporation
                         (A Development Stage Company)
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (Unaudited)

The following table is a reconciliation of the net loss numerator of basic and
diluted net loss per common share for the three and nine months ended September
30, 1998 and 1997:
<TABLE>
<CAPTION>
                                                             Three Months Ended September 30,
                                                    ---------------------------------------------------
                                                               1998                 1997
                                                    ---------------------------------------------------
                                                                   Per Share                 Per Share
                                                        Loss         Amount        Loss        Amount
                                                    -------------  ----------  ------------  ----------
<S>                                                 <C>            <C>         <C>           <C>
Loss before extraordinary items                     $(18,593,125)              $(5,253,419)

Preferred stock dividends                             (2,626,890)               (1,660,718)
                                                    ------------               -----------
Loss attributable to common stockholders
 before extraordinary items                          (21,220,015)     $(0.39)   (6,914,137)     $(0.16)
                                                    ============      ======   ===========      ======
Extraordinary loss on extinguishment of
 debt                                                          -           -      (881,864)      (0.02)
                                                    ------------      ------   -----------      ------
Net loss attributable to common
 stockholders                                       $(21,220,015)     $(0.39)  $(7,796,001)     $(0.18)
                                                    ============      ======   ===========      ======
Weighted average common shares
 outstanding                                          54,020,736                42,192,776
                                                    ============               ===========
</TABLE>

<TABLE>
<CAPTION>
                                                              Nine Months Ended September 30,
                                                    ----------------------------------------------------
                                                                1998                 1997
                                                    ----------------------------------------------------
                                                                   Per Share                  Per Share
                                                        Loss         Amount        Loss         Amount
                                                    -------------  ----------  -------------  ----------
<S>                                                 <C>            <C>         <C>            <C>
Loss before extraordinary items                     $(35,192,616)              $(12,973,127)

Preferred stock dividends                             (2,758,550)                (1,660,718)
                                                    ------------               ------------
Loss attributable to common stockholders
 before extraordinary items                          (37,951,166)     $(0.75)   (14,633,845)     $(0.35)
                                                                      
 
Extraordinary loss on extinguishment of
 debt                                                          -           -       (881,864)      (0.02)
                                                    ------------      ------   ------------      ------
Net loss attributable to common
 stockholders                                       $(37,951,166)     $(0.75)  $(15,515,709)     $(0.37)
                                                    ============      ======   ============      ======
Weighted average common shares
 outstanding                                          50,385,468                 42,053,697
                                                    ============               ============
</TABLE>

                                       8
<PAGE>
 
                               fonix corporation
                         (A Development Stage Company)
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (Unaudited)

2.  ACQUISITIONS

The Company created a wholly owned subsidiary ("fonix/Articulate") for the sole
purpose of acquiring Articulate Systems, Inc. ("ASI"), a Delaware corporation,
in September 1998.  ASI was a provider of sophisticated voice recognition
products to specialized segments of the health care industry.  Those same
products and services are now provided by the Company's HealthCare Solutions
Group.  The acquisition was closed on September 2, 1998.  The Company delivered
to the former ASI stockholders 5,140,751 shares of restricted common stock
(having a market value of $8,353,720 on that date), a cash payment of $7,787,249
and 8.5 percent demand notes in the aggregate amount of $4,747,339.
Additionally, the Company agreed to issue stock options in exchange for all of
ASI's stock options outstanding and unexercised on the date of acquisition at a
rate designed to allow the holders thereof to receive that amount of fonix stock
as they would have received had they exercised their options before the merger
closed for payment of the same exercise price (see Note 8). The fair market
value of the options to be issued to ASI option holders is approximately
$130,000 using the Black-Scholes option pricing model. Subsequent to the
acquisition, the Company agreed to pay several ASI employees incentive
compensation for continued employment in the aggregate amount of $857,000 (which
was not included in the purchase price of ASI), in connection with which the
Company issued 8.5 percent demand notes for $452,900 and recorded an accrued
liability of $404,100 for the balance. The demand notes issued to both the ASI
stockholders and the ASI employees are payable after November 1, 1998. The
$404,100 accrued liability is payable on or before January 31, 1999. The ASI
acquisition was accounted for as a purchase.

Purchase price allocations to tangible assets included $286,954 of cash, $62,835
of accounts receivable, $57,165 of inventory, $14,043 of prepaid expense and
$117,540 of fixed assets.  Purchase price allocations to liabilities assumed
included $310,008 of accounts payable and accrued expenses, $1,900,000 of notes
payable and $929,690 of deferred revenue.

The excess of the purchase price over the estimated fair market value of the
acquired assets and liabilities of ASI was $23,714,256, including direct
acquisition costs of $94,787, of which $13,945,000 was capitalized as the
purchase cost of completed technology, $5,948,256 was capitalized as goodwill
and other intangibles and $3,821,000 was expensed as purchased in-process
research and development.

The Company also created a wholly owned subsidiary for the sole purpose of
acquiring AcuVoice, Inc. ("AcuVoice"), a California corporation, in March 1998.
After the acquisition, the acquisition subsidiary changed its name to
fonix/AcuVoice, Inc. ("fonix/AcuVoice"). AcuVoice developed and marketed text-
to-speech or speech synthesis technologies and products directly to end-users,
systems integrators and original equipment manufacturers for use in the
telecommunications, multi-media, education and assistive technology markets.
Those same products and services are now provided by the Company's Interactive
Technologies Solutions Group.  The AcuVoice acquisition was closed on March 13,
1998.  The Company issued 2,692,216 shares of restricted common stock (having a
market value of $16,995,972 on that date) and paid a cash payment of
approximately $8,000,000 for all of the then outstanding common shares of
AcuVoice.  The acquisition was accounted for as a purchase.

Purchase price allocations to tangible assets included $253,881 of cash, $13,728
of accounts receivable, $9,902 of fixed assets and $800 of prepaid expense.
Purchase price allocations to liabilities assumed included $22,929 of accounts
payable and accrued expenses and $599,250 of notes payable.

The excess of the purchase price over the estimated fair market value of the
acquired tangible net assets of AcuVoice was $25,339,840, of which $11,192,000
was capitalized as the purchase cost of the completed technology, $4,832,840 was
capitalized as goodwill and $9,315,000 was expensed as purchased in-process
research and development.

The following unaudited pro forma financial statement data for the three and
nine months ended September 30, 1998 and 1997 present the results of operations
of the Company as if the acquisitions of AcuVoice and ASI had occurred at the
beginning of each three and nine-month period.  The pro forma results have been
prepared for comparative purposes only and do not purport to be indicative of
what would have occurred had the acquisitions been made at the beginning of the
applicable period or of future results.  Expenses related to purchased in-
process research and development related 

                                       9
<PAGE>
 
                               fonix corporation
                         (A Development Stage Company)
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (Unaudited)

to the acquisitions of AcuVoice and ASI of $9,315,000 and $3,821,000,
respectively, were recorded at the date of the acquisitions and are not
presented in the following pro forma financial statement data since they are 
non-recurring charges directly attributable to the acquisitions.
<TABLE>
<CAPTION>
 
                                                    Three Months Ended September 30,                 Nine Months Ended September 30,
                                                    --------------------------------                 -------------------------------

                                                            1998          1997                             1998           1997
                                                       -------------  ------------                     -------------  -------------
<S>                                                 <C>              <C>                               <C>           <C> 
 
Revenues                                               $    239,980   $   195,517                      $  3,233,621   $    755,191
 
Loss before extraordinary items                         (15,875,374)   (7,258,091)                      (26,749,586)   (19,028,576)
 
Net loss                                                (15,875,374)   (8,139,955)                      (26,749,586)   (19,910,440)
 
Basic and diluted net loss
   per common share                                           (0.28)        (0.16)                            (0.48)         (0.40)
</TABLE>

3.  CERTIFICATE OF DEPOSIT

As of September 30, 1998, the Company had a $20,000,000 short-term certificate
of deposit at a bank which amount is included in cash and cash equivalents.  The
certificate bore interest at an annual rate of 5.55 percent at September 30,
1998.  Interest is payable monthly.  This certificate is pledged as collateral
on a revolving note payable (see Note 6).

4.  NOTES RECEIVABLE

As of September 30, 1998, the Company had short-term, unsecured, demand notes
receivable from two unrelated entities in the amounts of $662,139 and $160,000
which notes were issued in connection with the Company's intended acquisition of
these entities.  Interest begins to accrue at an annual rate of six percent on
the date which is 90 days after the Company demands payment, which the Company
may do if both parties agree that the acquisition of any entity will not
proceed.

Previously, the Company had entered into short-term, unsecured, demand notes
receivable agreements with two unrelated entities in the amounts of $100,000 and
$50,000 which were issued in connection with the Company's intended acquisition
of these entities.  The Company no longer intends to pursue these acquisitions,
and has canceled these notes as consideration for product development and
research services rendered by these entities to the Company.

5.  INTANGIBLE ASSETS

Intangible assets consist of the purchase cost of completed technology, goodwill
and other intangibles in connection with the acquisitions of AcuVoice and ASI
and direct costs incurred by the Company in applying for patents covering its
technologies.  Amortization is computed on a straight-line basis over the
estimated useful lives of the completed technology, goodwill, other intangibles
and patents of five to eight years.

6.  NOTES PAYABLE

As of September 30, 1998, the Company had a revolving note payable to a bank in
the amount of $19,984,536.  Loaned amounts under the revolving note payable are
limited, in the aggregate at any time, to $20,000,000.  The weighted average
outstanding balance during the nine months ended September 30, 1998 was
$18,121,205.  This note was due October 29, 1998, bore interest at an annual
rate of 6.55 percent, and is secured by a certificate of deposit in the amount
of $20,000,000 (see Note 3).  This revolving note is renegotiated quarterly and
interest is payable monthly.  As of 

                                       10
<PAGE>
 
                               fonix corporation
                         (A Development Stage Company)
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (Unaudited)

September 30, 1998, the Company owed the bank $309,457 in past due interest.
Subsequently, all such amounts were paid to the bank and the note has been
negotiated to extend the maturity date of the note to December 4, 1998.

As of September 30, 1998, the Company had an unsecured revolving note payable to
a bank in the amount of $50,000. Loaned amounts under the revolving note payable
are limited, in the aggregate at any time, to $50,000.  The weighted average
outstanding balance during the nine months ended September 30, 1998 was $2,390.
This note is payable on demand and bears interest at an annual rate of 10.5
percent.

As of September 30, 1998, the Company had an unsecured, non-interest bearing
demand note payable in the amount of $100,000 to  Synergetics, Inc.
("Synergetics"), a  research and development entity (see Note 11).  This note is
payable on demand.

7.  RELATED-PARTY NOTES PAYABLE

As of September 30, 1998, the Company had unsecured demand notes payable to ASI
stockholders in the aggregate amount of $4,747,339, which notes were issued in
connection with the ASI acquisition on September 2, 1998 (see Note 2).  These
demand notes bear interest at an annual rate of 8.5 percent and are payable
after November 1, 1998.

As of September 30, 1998, the Company had unsecured demand notes payable to
various ASI employees in the aggregate amount of $452,900.  The Company agreed
to pay several ASI employees incentive compensation for continued employment  in
the aggregate amount of $857,000, for which the Company issued demand notes for
$452,900 and recorded an accrued liability of $404,100 for the balance (see Note
2).  The demand notes bear interest at an annual rate of 8.5 percent and are
payable after November 1, 1998.

In connection with the acquisition of certain liabilities of ASI pursuant to the
ASI merger (see Note 2), the Company executed and delivered  a $1,500,000
unsecured demand note payable to a company which is a stockholder of the
Company.  This demand note bears interest at an annual rate of 8.5 percent and
is payable after November 1, 1998.

As of September 30, 1998, the Company had a $37,214 unsecured revolving note
payable to a company owned by three individuals who are executive officers and
directors of the Company and who each beneficially own more than ten percent of
the Company's common stock.  The weighted average balance outstanding during the
nine months ended September 30, 1998 was $85,967.  This revolving note is
payable on demand and bears interest at an annual rate of 12 percent.  The
maximum amount outstanding under this revolving note was $551,510 during the
nine months ended September 30, 1998.  The Company believes the terms of the
related-party revolving note payable are at least as favorable to the Company as
the terms that could have been obtained from an unrelated third party in a
similar transaction.

8.  STOCKHOLDERS' EQUITY

Common Stock - During the nine months ended September 30, 1998, the Company
issued 15,002,758 shares of common stock.  Of such shares, 5,390,476 shares were
issued in connection with a private placement (see below), 7,832,967  shares
were issued in connection with the acquisitions of AcuVoice and ASI (see Note
2), 1,489,501 shares were issued upon the conversion of Series B and C
Convertible Preferred Stock and related dividends, 265,000 shares were issued
upon the exercise of previously granted warrants and options and 24,814 shares
were issued for the purchase of a patent.

Private Placement - On March 12, 1998, the Company completed a private placement
(the "Offering") of up to 6,666,666 shares of its restricted common stock to
seven accredited investors (the "Investors").  The total purchase price to be
paid by the Investors pursuant to the Offering was $30,000,000.  Of that amount,
$15,000,000 was received by 

                                       11
<PAGE>
 
                               fonix corporation
                         (A Development Stage Company)
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (Unaudited)

the Company on March 12, 1998, in return for which the Company issued a total of
3,333,333 shares of restricted common stock. Finders' fees of $870,000 were paid
in connection with the $15,000,000 received. The remainder of the purchase price
was to be paid by the Investors on July 27, 1998 (60 days after the
effectiveness of a registration statement that the Company filed with the
Securities and Exchange Commission covering the common stock issued and issuable
to the investors) (the "Second Funding Date"), provided that, as of such date,
certain conditions were satisfied. Certain conditions precedent to receiving the
additional funding were not met as of the Second Funding Date. In separate
transactions in June and August 1998, certain Investors paid to the Company
$3,000,000 in return for which the Company issued 666,667 additional shares
under the terms and conditions set forth in the Offering documents. Finders'
fees of $163,846 have been accrued in connection with the $3,000,000 received.
No other payment has been received by the Company pursuant to the Offering, and
the Company does not expect any further payment to be made.

The Investors acquired certain "reset rights" in connection with the Offering
pursuant to which the Investors would receive additional shares of restricted
common stock ("Reset Shares") if the average market price of the Company's
common stock for the 60-day period following the initial closing date did not
equal or exceed $5.40 per share.  On August 31, 1998, the Company and the
Investors in the Offering restructured the reset provision whereby the Company
issued 608,334 shares of Series D 4%  Convertible Preferred Stock ("Series D")
and 1,390,476 shares of common stock for (i) the relinquishment of the
Investors' contractual right to receive Reset Shares in connection with the
$15,000,000 received in March 1998, and the $3,000,000 received in June and
August 1998, and (ii) a financing cost in connection with the issuance of
500,000 shares of Series D.  In connection with the restructuring, the Company
recorded an expense of $6,111,577 for the difference between the Company's
original obligation to issue additional shares under the "reset rights"
provision in the Offering and the fair value of the shares that were actually
issued in settlement for the relinquishment of the reset provision, and recorded
a preferred stock dividend of $1,000,000 related to financing costs in
connection with the issuance of 500,000 shares of Series D (see Series D
Preferred Stock below).

Series B Preferred Stock - In January 1998, 27,500 shares of Series B
Convertible Preferred Stock and related dividends were converted into 193,582
shares of common stock.  At September 30, 1998, no shares of Series B
Convertible Preferred Stock were outstanding.

Series C Preferred Stock - During the three months ended March 31, 1998, 185,000
shares of Series C Convertible Preferred Stock and related dividends were
converted into 1,295,919 shares of the Company's common stock.  At September 30,
1998, no shares of  Series C Convertible Preferred Stock were outstanding.

Series D Preferred Stock - On August 31, 1998, the Company entered into an
agreement with the Investors whereby the Company issued 500,000 shares of the
Company's Series D for $10,000,000.  Additionally, the Company issued to certain
of the Investors a total of 608,334 shares of Series D (i) in return for their
relinquishment of their contractual right to receive Reset Shares in connection
with the Offering (see Private Placement above), and as (ii) an additional cost
of raising the $10,000,000 from the Series D placement.  Dividends accrue on the
stated value ($20 per share) of Series D at the rate of 4 percent per year, are
payable annually or upon conversion, in cash or common stock, at the option of
the Company, and are convertible into shares of the Company's common stock at
the holder's option anytime after the earlier of November 29, 1998 or the date
the registration statement which the Company has agreed to file with the
Securities and Exchange Commission covering the common stock issuable upon the
conversion of the Series D is declared effective.  Each month the holders of the
Series D may not convert more than 25 percent of the total number of shares of
Series D originally issued to such holders on a cumulative basis.  For example,
during the first month a holder may convert up to 25% of the total preferred
stock issued to the holder, and during the following month that same holder may
convert, on an aggregate to date basis, up to 50% of the total number of shares
of Series D held by the holder. Additionally, each month, the holders may
convert up to 50 percent of the total number of shares of Series D originally
issued to such holders on a cumulative basis, if both of the following
conditions are satisfied:  the average daily trading volume of the Company's
common stock is more than 500,000 shares for the 10-trading-day period before
the conversion; and the average per share closing bid price for such 10-trading-
day period has not decreased by more 

                                       12
<PAGE>
 
                               fonix corporation
                         (A Development Stage Company)
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (Unaudited)

than 5 percent during that 10-trading-day period. Any outstanding shares of
Series D as of August 31, 2001 automatically will be converted at the conversion
price described below most beneficial to the holders on such date. In the event
of liquidation, the holders of the Series D are entitled to an amount equal to
the stated value ($20 per share) plus accrued but unpaid dividends whether
declared or not. The holders of Series D have no voting rights. The Series D
shares, together with dividends accrued thereon, may be converted into shares of
the Company's common stock at the lesser of: $3.50 per share; or the lesser of
110 percent of the average per share closing bid price for the 15 trading days
immediately preceding the date of issuance of the Series D shares; or 90 percent
of the average of the three lowest per share closing bid prices during the 22
trading days immediately preceding the conversion date. In the event that the
holders convert at the $3.50 per share price, the Company is obligated to issue
warrants to purchase 0.8 shares of common stock for each share of Series D
converted to common stock. Using the conversion terms most beneficial to the
holder, the Company is amortizing a beneficial conversion feature of $2,462,964
as a dividend over a 180 day-period.

Series E Preferred Stock - Effective as of September 30, 1998, the Company
entered into an agreement with two of the Investors whereby the Company issued
100,000 shares of the Company's Series E 4% Convertible Preferred Stock ("Series
E") for $2,000,000.  Additionally, the Company issued to the purchasers of the
Series E a total of 150,000 additional shares of Series E in exchange for which
those purchasers surrendered a total of 150,000 shares of Series D. Dividends
accrue on the stated value ($20 per share) of Series E at a rate of 4 percent
per year, are payable annually or upon conversion, in cash or common stock, at
the option of the Company, and are convertible into shares of the Company's
common stock at anytime at the holder's option.  Any outstanding shares of
Series E as of September 30, 2001 are automatically converted at the conversion
price described below most beneficial to the holders on such date. In the event
of liquidation, the holders of the Series E are entitled to an amount equal to
the stated value ($20 per share) plus accrued but unpaid dividends whether
declared or not.  The holders of Series E have no voting rights. The Series E,
together with dividends accrued thereon, may be converted into shares of the
Company's common stock at the lesser of:  $3.50 per share; or the lesser of 110
percent of the average per share closing bid price for the 15 trading days
immediately preceding the date of issuance of the Series E shares; or 90 percent
of the average of the three lowest per share closing bid prices during the 22
trading days immediately preceding the conversion date.  If the Investors
convert at the $3.50 per share price, the Company is obligated to issue warrants
to purchase 0.8 shares of common stock for each share of Series E converted to
common stock.  Using the conversion terms most beneficial to the holder, the
Company recorded a preferred stock dividend of $968,047 for the beneficial
conversion feature of the Series E.  As of September 30, 1998, no shares of
Series E had been converted to common stock.  On November 4, 1998, 50,000 shares
of Series E and related dividends were converted into 1,130,805 shares of common
stock.

Common Stock Options - During the nine months ended September 30, 1998, the
Company granted options to purchase 2,734,000 shares of common stock.  Of such
options, 450,000 (having an exercise price of $5.16 per share) were granted to
three individuals who are executive officers and directors of the Company and
who each beneficially own more than ten percent of the Company's common stock;
355,000, 1,240,000, and 589,000 options were granted to various employees at
exercise prices of $3.34, $3.54, and $6.50 per share, respectively, and 100,000
options were granted to an unrelated party for services with an exercise price
of $3.75 per share.  The term of all options granted during the nine months
ended September 30, 1998 is ten years from the date of grant.  Additionally, the
Company agreed to issue stock options in exchange for ASI stock options in
connection with the acquisition of ASI (see Note 2).  These options will have
expiration dates ranging from January 1, 2001 to November 2, 2002.  As of
September 30, 1998, the Company had a total of 13,411,750 options outstanding.

On June 1, 1998, the Company's board of directors approved the 1998 Stock Option
and Incentive Plan (the "Plan") for directors, employees and other persons
acting on behalf of the Company, under which the aggregate number of shares
authorized for issuance is 10,000,000.  On July 14, 1998, the Company's
shareholders approved the Plan.  The Plan is administered by a committee
consisting of two or more directors of the Company.  The exercise price for
these 

                                       13
<PAGE>
 
                               fonix corporation
                         (A Development Stage Company)
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (Unaudited)

options is the closing market price of the stock on the date the options
are granted.  The option term is ten years from the date of grant.

9.  RELATED-PARTY TRANSACTIONS

Related-party transactions with entities owned by three individuals who are
directors and executive officers of the Company and each of whom beneficially
own more than ten percent of the Company's issued and outstanding common stock
not otherwise disclosed herein for the nine months ended September 30, 1998 and
1997 were as follows:

The Company subleases office space leased by a company owned by the three
individuals described above.  The rent and other related charges are passed
through without mark-up to the Company:

                               Nine months Ended September 30,
                               -------------------------------
                                    1998             1997
                               ---------------  --------------
Expenses:

     Base rent                         $83,788         $57,900

     Leasehold improvements             35,247               -

Liabilities:

     Accrued liabilities                44,846           5,772

During 1996, disinterested members of the Company's Board of Directors
authorized the Company to reimburse three executive officers for all taxes
payable by them in conjunction with the 1995 exercise of 3,700,000 warrants by a
company owned by them.  The total authorized reimbursement was $1,150,000 in
1997 and $1,350,000 in 1996.  As of September 30, 1998, the Company had paid the
total authorized reimbursement of $2,500,000, $340,516 of which was paid during
the nine months ended September 30, 1998.

10.  STATEMENTS OF WORK

On February 11, 1998, the Company entered into a Restated First Statement of
Work and License Agreement with Siemens Semiconductor Group of Siemens
Aktiengesellschaft ("Siemens").  The Company and Siemens are jointly pursuing
the development of Siemens' integrated circuits incorporating the Company's
technologies for use in certain telecommunications applications.  On February
20, 1998, the Company received $2,691,066 in cash from Siemens.  Of that amount:
(1) $1,291,712 was paid to the Company as a non-refundable payment to license
certain automated speech recognition technologies for which the Company has no
further obligation; (2) $322,928 was paid to purchase warrants to acquire
1,000,000 shares of the Company's restricted common stock at an average exercise
price of $20 per share with expiration dates ranging from December 31, 1998 to
December 31, 1999; and (3) $1,076,426 was paid to the Company to acquire, if
Siemens so elected, shares of the Company's restricted common stock or to become
a non-refundable license payment.  In June 1998, Siemens elected to apply the
$1,076,426 portion as a  non-refundable payment to license certain automated
speech recognition technologies for which the Company has no further obligation.
The Company recorded the $1,291,712 and $1,076,426 license payments as revenue
during the nine months ended September 30, 1998.

11.  PRODUCT DEVELOPMENT AND RESEARCH

In October 1993, the Company entered into an agreement (the "Synergetics
Agreement") with Synergetics, whereby Synergetics was to develop certain
technologies related to the Company's automated speech recognition ("ASR")

                                       14
<PAGE>
 
                               fonix corporation
                         (A Development Stage Company)
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (Unaudited)

technologies.  The Company's president is one of seven members of the board of
directors of Synergetics, and three executive officers, directors and ten
percent beneficial owners of the Company own less than five percent of the
common stock of Synergetics.  Under the terms of the Synergetics Agreement, as
subsequently modified, the Company acquired intellectual property rights,
technologies and technology rights that were developed by Synergetics and that
pertained to the ASR  technologies.  The Company agreed to provide all funding
necessary for Synergetics to develop commercially viable technologies.  There
was no minimum requirement or maximum limit with respect to the amount of the
funding to be provided by the Company.  However, under the terms of the
Synergetics Agreement, the Company was obligated to use its best efforts in
raising the necessary funding for the engineering, development and marketing of
the ASR technologies.  As part of the Synergetics Agreement, the Company agreed
to pay Synergetics a royalty of ten percent of gross revenues from sales of its
ASR technologies (the "Royalty").  Under the terms of the Synergetics Agreement,
the Company paid to Synergetics $125,995 and $1,628,433 for the three and nine
months ended September 30, 1998, respectively, for product development and
research efforts.

Until March 1997, Synergetics had compensated its engineers, employees, members
of its development team, and other financial backers (collectively, the
"Developers"), in part, with the issuance of "Project Shares" granting the
holders of such shares the right, within limits, to share pro rata in future
Royalty payments by the Company.  In addition to issuance of Project Shares,
Synergetics had made cash advances to some members of its project team (which
members are not employees of the Company)  on a non-recourse basis.  Repayment
of those advances was secured by future disbursements, if any, under the
borrower's Project Shares.

On April 6, 1998, the Company and Synergetics entered into a Royalty
Modification Agreement, under which the Company agreed, subject to its
compliance with applicable securities laws, to make an offer to exchange common
stock purchase warrants having an exercise price of $10 per share for the
Project Shares at the rate of one warrant to purchase 800 shares of the
Company's  common shares for each Project Share.  The warrants, if and when
issued, will not be exercisable until the earlier of (1) the date the Company's
common stock has traded for a period of 15 consecutive trading days at a minimum
of  $37.50 per share or (2) September 30, 2000.  The offer of warrants to
holders of Project Shares cannot be made by the Company until a registration
statement covering the total number of warrants issuable upon the  exercise of
the warrants has been declared effective by the Securities and Exchange
Commission.  Upon the tender to the Company of any Project Shares a
corresponding percentage of the Royalty will be canceled.

12.  COMMITMENTS AND CONTINGENCIES

Operating Lease Agreement - In June 1998, the Company entered into a long-term
noncancellable operating lease agreement for a facility in Cupertino,
California, which houses its Silicon Valley  operations.  Future aggregate
minimum obligations under this operating lease are as follows:
 
    Years ending December 31,
 
          1998                         $  163,883
          1999                            292,899
          2000                            308,474
          2001                            320,531
          2002                            332,589
          Thereafter                      140,672
                                       ----------
 
            Total                      $1,559,048
                                       ==========

                                       15
<PAGE>
 
                               fonix corporation
                         (A Development Stage Company)
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (Unaudited)

The Company has a noncancellable operating lease agreement for a facility in
Woburn, Massachusetts, which houses its HealthCare Solutions and Interactive
Technologies Solutions Groups.  Future aggregate minimum obligations under this
operating lease for the years ended December 31, 1998 and 1999 are $89,373 and
$245,776, respectively.

Professional Services Agreement - Effective May 7, 1998, the Company entered
into a one-year professional services agreement with a public relations firm.
The minimum monthly retainer is $15,000 per month.  In connection with this
agreement, the firm was granted options to purchase 100,000 shares of the
Company's common stock at $3.75 per share. The options have a ten-year term and
are fully vested.  In connection with this transaction, the Company recorded
$320,100 of consulting expense, of which $186,725 is deferred as of September
30, 1998, and will be recognized ratably over the life of the agreement.

Litigation - On August 28, 1998, John R. Clarke and Perpetual Growth Fund, a
company Clarke's spouse purportedly owns, commenced an action against the
Company in federal court for the Southern District of New York.  Clarke and
Perpetual Growth assert claims for breach of contract relating to certain
financing the Company received during 1998. Specifically, Clarke and Perpetual
Growth allege that they entered into a contract with the Company under which the
Company agreed to pay them a commission of 5 percent of all financing provided
to the Company by Southridge Capital Management or its affiliates.  Clarke and
Perpetual claim that they are entitled to commissions with respect to
approximately $3,000,000 of equity financing to the Company in July and August
1998, and the Company's offerings of Series D and Series E preferred stock
(totaling together $12,000,000) in August and September 1998.

The Company believes that the Clarke lawsuit is without merit and filed a motion
to dismiss based upon the court's lack of personal jurisdiction over the
Company.  The court granted the Company's motion to dismiss, subject to the
right of Clarke and Perpetual Growth to produce additional evidence which would
establish jurisdiction of the New York court over the Company.  Even if such
evidence is available, the Company intends to vigorously defend the claims
asserted in that action.  However, Clarke and Perpetual Growth could prevail in
the lawsuit, in which case the Company may be required to pay significant
amounts of monetary damages or other amounts awarded by the court.   At a
minimum, the ongoing nature of this action will result in some diversion of
management time and effort from the operation of the business.

On March 11, 1998, an action (the "J&L Action") was filed against the Company in
the Supreme Court of the State of New York for the County of New York by Jesup &
Lamont Securities Corporation ("J&L").  The J&L Action alleged that the Company
was obligated to pay a fee in excess of $1,200,000 plus 30,000 shares of the
Company's restricted common stock in connection with the Offering (see Note 8).
The J & L Action was settled upon payment of $385,000 by the Company to J&L.
The J&L Action has been dismissed with prejudice.

On July 9, 1998, the Company settled a case brought by a shareholder of the
Company against certain directors of the Company and K.L.S. Enviro Resources,
Inc. ("KLSE"), a third party affiliated with certain of the director-defendants.
Pursuant to the settlement, and at no cost to the Company, the Company  received
warrants to purchase 583,000 shares of KLSE common stock at a purchase price of
$0.40 per share.

In addition to these actions, the Company from time to time may be involved in
various lawsuits, claims  and actions arising in the ordinary course of
business.  In the opinion of management, after consultation with legal counsel,
the ultimate disposition of these matters will not materially affect the
consolidated financial position or results of operations of the Company.

                                       16
<PAGE>
 
                               fonix corporation
                         (A Development Stage Company)
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (Unaudited)

13.  SUBSEQUENT EVENTS

Note payable - Subsequent to September 30, 1998, in connection with the
employment of a person as an officer of the Company, the Company issued a
$20,000 unsecured note payable to that officer.  This note bears interest at ten
percent and is due on December 31, 1998.

Acquisitions - The Company created a wholly owned subsidiary for the purpose of
acquiring Papyrus Associates, a Pennsylvania corporation and Papyrus
Development, a Massachusetts corporation, in October 1998.  Papyrus Associates
develops, markets and supports handwriting recognition software.  Such software
is now marketed by the Company's Interactive Technologies Solutions Group.  On
October 29,1998, the Company acquired 100 percent of the outstanding common
stock of Papyrus Associates for the issuance of 1,076,926 shares of the
Company's restricted common stock (having a market value of $1,110,580 on that
date) and promissory notes to the shareholders of Papyrus Associates totaling
$360,000, due the fifth business day following the closing of the Company's next
equity funding, but no later than February 28, 1999 and notes totaling $180,000,
due April 30, 1999.  These notes bear interest at an annual rate of six percent.

Papyrus Development has developed and has expertise in embedded systems and
enhanced Internet applications.  Such activities are now conducted by the
Company's Interactive Technologies Solutions Group.  On October 29,1998, the
Company acquired 100 percent of the outstanding common stock of Papyrus
Development for the issuance of 2,034,188 shares of the Company's restricted
common stock (having a market value of $2,097,756 on that date) and promissory
notes to the shareholders of Papyrus Development totaling $490,000, due the
fifth business day following the closing of the Company's next equity funding,
but no later than February 28, 1999, notes totaling $340,000, due February 28,
1999 and notes totaling $340,000, due September 30, 1999.  These notes bear
interest at an annual rate of six percent. These acquisitions will be accounted
for as purchases.

                                       17
<PAGE>
 
ITEM 2.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS

THIS QUARTERLY REPORT ON FORM 10-Q CONTAINS, IN ADDITION TO HISTORICAL
INFORMATION, FORWARD-LOOKING STATEMENTS THAT INVOLVE SUBSTANTIAL RISKS AND
UNCERTAINTIES.  THE COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE
RESULTS ANTICIPATED BY THE COMPANY 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, 1997.

Overview
--------

fonix is a development stage company that aims to make commercially available a
comprehensive package of human-computer interaction technology products and
solutions.  The Company has developed proprietary automated computer voice
recognition technologies and related technologies such as text-to-speech, neural
network design and data compression.  These technologies, as developed to date,
employ a proprietary phonetic speech modeling engine and a linguistic and
contextual process based on a proprietary neural network system (artificial
intelligence).

In November 1997, the Company entered into an agreement (the "Siemens
Agreement") with the Siemens Semiconductor Group of Siemens Aktiengesellschaft
("Siemens") pursuant to which the Company and Siemens agreed to pursue research
and development of certain of the Company's technologies and the
commercialization of such technologies for the telecommunications industry
through a strategic alliance.  Pursuant to the terms of the Siemens Agreement,
the Company and Siemens entered into the First Statement of Work and License
Agreement (see Note 10 to the condensed consolidated financial statements)
pursuant to which Siemens paid the Company a license fee for the development and
production of certain of its technologies in integrated circuits suitable for
certain telecommunications applications. The Siemens Agreement calls for the
payment to the Company of additional license fees when the Company and Siemens
have entered into further agreements for the development of specific
technologies, although there can be no assurance that the parties will enter
into such additional agreements.

In March 1998, the Company expanded its suite of human-computer interaction
technologies by acquiring the award-winning voice synthesis technologies of
AcuVoice, Inc. ("AcuVoice").  That acquisition was accomplished through a merger
of AcuVoice into a wholly owned subsidiary of the Company now known as
fonix/AcuVoice, Inc ("fonix/AcuVoice").  The business operations previously
conducted by AcuVoice are now part of the Company's Interactive Technologies
Solutions Group.  AcuVoice was incorporated in 1984 and since that time has been
engaged in development of a software only text-to-human-speech synthesis
technology called "concatenative speech synthesis," now recognized in the speech
technology industry as a leading method of achieving natural sounding speech
from a computer.  Beginning in early 1996, AcuVoice began selling developer kits
based on its technology.  Companies that the Company believes to be developing
marketable products based on the fonix/AcuVoice technologies include IBM,
General Motors, Kurzweil Educational Systems, Pratt & Whitney, Octel
Communications, Andersen Consulting, NEC, Dialogic and Bell Atlantic.  Companies
that have developed products using fonix/AcuVoice developer kits, and now are
selling or using products containing fonix/AcuVoice text-to-speech technologies
include AT&T, Motorola, Northern Telecom, Lucky Goldstar (Korea), Smart Dial,
Signet, Concierge, Ultimate Technology, First Call, XL Vision, Applied Future
Technologies and Productivity Works.

In September 1998, the Company acquired Articulate Systems, Inc. ("ASI"), a
developer of leading voice recognition and systems software for specialized
applications in the health care industry.  That acquisition was accomplished
through a merger of ASI into a wholly owned subsidiary of the Company now known
as fonix/Articulate, Inc. ("fonix/Articulate").  The business operations
previously conducted by Articulate are now conducted by the Company's HealthCare
Solutions Group based in Woburn, Massachusetts.

In October 1998, the Company acquired Papyrus Associates, Inc. ("PAI") and
Papyrus Development Corporation ("PDC").  PAI develops and markets printing and
cursive handwriting recognition software for personal digital assistants, pen
tablets and mobile phones.  The Papyrus Recognizer is marketed under the
trademark "Allegro."  PDC is a systems integration provider with expertise and
intellectual property related to embedded systems and enhanced Internet
applications.  PDC has an ongoing partnership with e-Travel that resulted in the
first corporate travel 

                                       18
<PAGE>
 
management Web-browser client software system. The acquisition of both PDC and
PAI (collectively "Papyrus") was accomplished through a merger of PDC and PAI
into a wholly owned subsidiary of the Company, Papyrus Acquisition Corporation.
Following the acquisitions, the Company operates the business formerly operated
by Papyrus as part of its Interactive Technologies Solutions Group in Woburn,
Massachusetts.

The Company markets its previously developed technologies, together with text-
to-speech technologies and products acquired from AcuVoice, handwriting
recognition technologies and products acquired from Papyrus, and intelligent
agent technologies, through its Interactive Technologies Solutions Group.  The
present marketing direction for the Interactive Technologies Group is to form
relationships with third parties who can incorporate the Company's technologies
and the other technologies available to the Interactive Technologies Group into
their own products or product development efforts.  Such relationships may be
structured in any of a variety of ways including traditional technology
licenses, co-development relationships through joint ventures or otherwise, and
strategic alliances.  The third parties with whom the Company presently has such
relationships and with which it may have similar relationships in the future
include participants in the application software, operating systems, computer,
microprocessor chips, consumer electronics, automobile, telephony and health
care technology industries.

The Company markets its voice recognition and systems software for specialized
applications in the health care industry through its HealthCare Solutions Group.
The HealthCare Solutions Group presently markets large vocabulary voice
recognition software for the rapid capture, transcription and management of
clinical information dictated by radiologists and emergency medical physicians.
The two products now being sold by the HealthCare Solutions Group, PowerScribe
Radiology and PowerScribeEM, are marketed to major hospitals and medical centers
by The MRC Group, Inc., an unaffiliated third party distributor.  The MRC Group
also supports and services the systems within the United States.

The Company presently intends to consummate other previously announced
acquisitions involving additional complementary technologies (see Note 13 to the
condensed consolidated financial statements).  There can be no assurance that
any other acquisitions will be consummated, however, or that the AcuVoice, ASI
or Papyrus acquisitions, or any other acquisition or merger already consummated
or that may be consummated in the future, will generate substantial revenues or
result in increased opportunities for the Company to enter into profitable
licensing arrangements or that such additional technologies can be successfully
integrated with the Company's existing technologies.  To the extent the Company
finances such acquisitions by issuances of its capital stock, additional, and
possibly substantial, dilution will result to existing shareholders.

Acquisitions
------------

During the nine months ended September 30, 1998, the Company acquired AcuVoice,
and ASI, for the in-process research and development (IPR&D) of each of the
respective companies.

AcuVoice (Acquired March 13, 1998)

AcuVoice is a developer of a speech-synthesizing software system that is capable
of translating text into natural sounding speech. Its currently available
products include the AcuVoice Speech Synthesizer AV1700 Text Reader and the
AcuVoice Speech Synthesizer AV2001 Telephony/Multimedia Interface.  These
applications are able to read a variety of input text in an American English
male voice.

At the date of acquisition, AcuVoice IPR&D efforts were focused on the continued
development and evolution of the next generation of these products.
Specifically, the Company is working to expand voice capacity to include both a
male and female voice, and to expand language capacity to include Japanese,
Mandarin Chinese, French, German, and Spanish. In addition to the technological
issues resulting from these efforts, the Company also intends to enhance the
next generation applications with a stronger Text-to-Speech engine, sound bank,
SAPI 4.0, SDK, and user dictionary; and increased VOX file output,
documentation, C++ API and JSAPI.  AcuVoice is also developing an ESL product
for the Windows 95/Windows NT environments that would have a customized
dictionary and sample English sentences, and a highly scalable multi-channel
version for applications that would operate in Windows NT/Solaris environments.

The developmental projects at the time of the acquisition were not
technologically feasible and had no alternative future use. This conclusion was
attributable to the fact that AcuVoice had not completed a working model that
had been tested 

                                       19
<PAGE>
 
and proven to work at performance levels which were expected to be commercially
viable, and that the technologies constituting the projects had no alternative
use other than their intended use. The value is attributable solely to the
development efforts completed as of the acquisition date. The acquired IPR&D was
valued at approximately $9.3 million based on an analysis of forecasted income.

As of the date of acquisition, AcuVoice had invested approximately $3.5 million
in the IPR&D identified above. Development of the acquired in-process technology
into commercially viable products and services required efforts principally
related to the completion of all planning, designing, coding, prototyping,
scalability verification, and testing activities necessary to establish that the
proposed technologies would meet their design specifications, including
functional, technical, and economic performance requirements. Management
estimates that approximately $1.0 million will be required over the next 12
months to develop the aforementioned products to commercial viability.

The Company currently estimates that a redeveloped version of its AcuVoice
applications will be released within range of the development horizon in terms
of date of release and cost to complete anticipated at the date of acquisition.
Management confirms that remaining IPR&D projects are continuing to be developed
as anticipated.

ASI (Acquired September 2, 1998)

ASI focuses on developing and marketing speech recognition and integrated
speech-oriented software applications for desk-top and client server-based
computer environments. In 1993, the company focused on developing large-
vocabulary speech applications for the heath care market, with a primary focus
on medical records management. In 1995, ASI began development of PowerScribe,
which converts speech into text to create an electronic medical report. The
first PowerScribe application focused on the radiology market.

At the date of acquisition, ASI's IPR&D focused on (1) enhancing its current
PowerScribe Radiology application to meet the needs of the health care market,
and (2) develop products addressing the needs of other health care segments. The
next generation of PowerScribe Radiology, identified as Version 2.5, will differ
from Version 1.0, in that it will have an enhanced tool kit, providing a common
set of services including storage and retrieval, and improved voice recognition
technology using a different set of language models. In addition, Version 2.5
will also be developed with new version of SQL. SQL Version 7.0 is significantly
improved over Version 6.5, in that it self-administers more effectively, and
incorporates technology supporting remote access via a virtual connection. ASI
is also developing PowerScribe products for emergency, cardiology, and pathology
health care segments.

The developmental projects at the time of the acquisition were not
technologically feasible and had no alternative future use. This conclusion was
attributable to the fact that ASI had not completed a working model that had
been tested and proven to work at performance levels which were expected to be
commercially viable, and that the technologies constituting the projects had no
alternative use other than their intended use.  The value is attributable solely
to the development efforts completed as of the acquisition date.  The acquired
IPR&D was valued at approximately $3.8 million based on an analysis of
forecasted income.

As of the date of acquisition, ASI had invested approximately $3.4 million in
the IPR&D identified above. Development of the acquired in-process technology
into commercially viable products and services required efforts principally
related to the completion of all planning, designing, coding, prototyping,
scalability verification, and testing activities necessary to establish that the
proposed technologies would meet their design specifications, including
functional, technical, and economic performance requirements. Management
estimates that an additional $1.0 million will be required over the next 12
months to develop the aforementioned products to commercial viability.

Of the projects deemed IPR&D, both Radiology 2.5 and Emergency 1.0 achieving
technological feasibility and commercial viability subsequent to the acquisition
date, within range of the anticipated time of release and cost to complete.
Management confirms that remaining IPR&D projects are continuing to be developed
as anticipated.

Valuation Methodology

The valuations of the respective acquired IPR&D included, but were not limited
to, an analysis of (1) the market for AcuVoice products; (2) the completion
costs for the projects; (3) the expected cash flows attributable to the IPR&D

                                       20
<PAGE>
 
projects; and (4) the risks associated with achieving such cash flows. The
assumptions underlying the cash flow projections were derived from investment
banking reports, independent analyst reports, fonix, AcuVoice, and ASI company
records, and discussions with the management of both companies. Primary
assumptions such as revenue growth and profitability were compared to
indications of similar companies as well as to indications from industry analyst
reports, to determine the extent to which these assumptions were supportable.
The Company did not assume in its valuation any material change in its profit
margins as a result of the acquisition and did not assume any material increases
in selling, general and administrative expenses as a result of the acquisition.
The Company did not anticipate any expense reductions or other synergies as a
result of the acquisition. The basis of the acquisition was an attempt to
enhance the Company's competitive position by offering a broader product line,
including applications and functionality based upon the acquired Speech
Recognition and Text-to-Speech technology.

The Company does not break down revenues attributable specifically to AcuVoice-
and ASI-derived products. As products are offered both as a suite and as
individual applications, fonix license fees are not necessarily application
specific.  However, the Company believes that revenues generated to date concur
with the assumptions used in the valuation analysis.

Because the Company does not account for expenses by product, it is not possible
to determine the actual expenses associated with the technology acquired from
AcuVoice and ASI. The Company currently believes that expenses associated with
completing the purchased IPR&D are approximately consistent with the Company's
estimates used in the analysis and that completion dates for the development
projects discussed above concur with projections used at the time of the
acquisition. Research and development spending with respect to these offerings
is expected to continue at a rate that is consistent with the Company's overall
research and development spending. The Company does not believe that the
acquisition resulted in any material changes in its profit margins or in
selling, general and administrative expenses. The Company does not believe that
it achieved any material expense reductions or synergies as a result of the
acquisition.

The rates utilized to discount the net cash flows to their present value were
consistent with the nature of the forecast and the risks associated with the
projected growth, profitability and developmental projects. Discount rates of
50% and 60% for AcuVoice and 35% and 40% for ASI were deemed appropriate for the
business enterprises and for the acquired IPR&D, respectively. These discount
rates were consistent with the acquired companies' various stages of
development; the uncertainties in the economic estimates described above; the
inherent uncertainty at the time of the acquisition surrounding the successful
development of the purchased in-process technology; the useful life of such
technology; the profitability levels of such technology; and the inherent
uncertainties of the technological advances that were indeterminable at the time
of the acquisition.

The forecasts used in valuing the IPR&D were based upon assumptions the Company
believed to be reasonable but which were inherently uncertain and unpredictable.
For these reasons, actual results may vary from projected results. The Company
currently markets the AcuVoice and ASI acquired and subsequently-developed
products. Management intends to continue the acquired companies' development
programs until the Company is able to successfully introduce the new suite of
products.

Results of Operations
---------------------

Three months ended September 30, 1998 compared with three months ended September
30, 1997

During the three months ended September 30, 1998, the Company recorded revenues
of $199,017 from the operations of its HealthCare Solutions and Interactive
Technologies Solutions Groups.

Prior to March 1997, the Company conducted its scientific research and
development activities solely through Synergetics, Inc.("Synergetics"), a
research and development entity, pursuant to product development and assignment
contracts between the Company and Synergetics (collectively, the "Synergetics
Agreement").  Under that arrangement, Synergetics provided personnel and
facilities and the Company financed scientific research and development of the
its technologies on an as-required basis.  There was no minimum requirement or
maximum limit with respect to the amount of funding the Company was obligated to
provide to Synergetics under the Synergetics Agreement, and the Company was
obligated to use its best efforts in raising all of the necessary funding for
the development of its technologies. 

                                       21
<PAGE>
 
Synergetics submitted pre-authorized work orders and budgets, which were then
reviewed and approved by the Company. All funds paid to Synergetics have been
accounted for by the Company as research and development expense. Under the
Synergetics Agreement, the Company had also agreed to pay a royalty to
Synergetics equal to ten percent of revenues from sales of the technologies
developed by Synergetics or products incorporating such technologies (the
"Royalty"). On March 13, 1997, the Company and Synergetics reached an agreement
in principle to modify the Synergetics Agreement with regard to the development
and assignment of the technologies developed by Synergetics. Most research and
development activities previously conducted by Synergetics were moved in-house
to the Company in or about March 1997. On April 6, 1998, the Company and
Synergetics entered into a Royalty Modification Agreement, under which the
Company agreed, subject to its compliance with applicable securities laws, to
make an offer to exchange common stock purchase warrants having an exercise
price of $10 per share for the Project Shares at the rate of one warrant to
purchase 800 shares of the Company's common shares for each Project Share. The
warrants, if and when issued, will not be exercisable until the earlier of (1)
the date the Company's common stock has traded for a period of 15 consecutive
trading days at a minimum of $37.50 per share or (2) September 30, 2000. The
offer of warrants to holders of Project Shares cannot be made by the Company
until a registration statement covering the total number of warrants issuable
upon the exercise of the warrants has been declared effective by the Securities
and Exchange Commission. Upon the tender to the Company of any Project Shares a
corresponding percentage of the Royalty will be canceled. Assignment to the
Company of all technology relating to the technologies developed by Synergetics
is confirmed by the Modification Agreement.

From inception on October 1, 1993 through September 30, 1998, the Company has
invested $28,018,188 in product development and research relating to its
technologies.  During the three months ended September 30, 1998, the Company
incurred product development and research expenses of $4,419,400, an increase of
$2,769,029 over the same period in the previous year.  This increase is due
primarily to the addition of product development and research personnel,
increased use of independent contractors, equipment, facilities and the
acquisitions of AcuVoice and ASI. Approximately $423,727 of such increase is for
development costs from the operations of  fonix/AcuVoice and fonix/Articulate.
The Company anticipates similar or increased product development and research
costs as it continues to expand, develop and market its Technologies.
Additionally, the Company purchased in-process research and development totaling
$3,821,000 during the three months ended September 30, 1998, in connection with
the acquisition of fonix/Articulate.

Selling, general and administrative expenses were $4,320,981 and $2,185,169 for
the three months ended September 30, 1998 and 1997, respectively.  This increase
from the previous period was due primarily to the hiring of additional employees
and the resulting increases in salaries, wages and related costs, legal and
accounting and depreciation and amortization.  Salaries, wages and related costs
were $1,754,401 and $772,744 for the three months ended September 30, 1998 and
1997, respectively, an increase of $981,657 over the three months ended
September 30, 1997.  This increase is attributable to incentive compensation for
continue employment paid to employees of ASI of $857,000, and to increases in
personnel from recent acquisitions.  Legal and accounting expenses increased
$386,328 and depreciation and amortization increased $739,909.  The $739,909
increase in depreciation and amortization is primarily attributable to the
amortization of intangible assets acquired in connection with the acquisitions
of AcuVoice and ASI.

Due to significant product development and research and selling, general and
administrative expenses, the Company has incurred losses from operations since
inception totaling $69,147,873, of which $12,395,438 and $3,835,540 were
incurred during the three months ended September 30, 1998 and 1997,
respectively.   At September 30, 1998, the Company had an accumulated deficit of
$82,968,912 and stockholders' equity of $28,203,238.  The Company anticipates
that its investment in ongoing scientific product development and research of
its Technologies will continue at present or increased levels for at least the
remainder of fiscal 1998 assuming the availability of working capital.

Net other expense was $6,197,687 for the three months ended September 30, 1998,
an increase of $4,779,808 over the three months ended September 30, 1997.  This
increase was due primarily to a $6,111,577 expense recorded in connection with
the cancellation of a reset provision associated with a private placement of the
Company's common stock (see Liquidity and Capital Resources).

                                       22
<PAGE>
 
Nine months ended September 30, 1998 compared with nine months ended September
30, 1997

During the nine months ended September 30, 1998, the Company recorded revenues
of $2,671,302, of which $2,368,138 was a non-refundable license fee from
Siemens, for which the Company has no further obligation.  The remainder of such
revenues were from sales and licensing fees.

During the nine months ended September 30, 1998, the Company incurred product
development and research expenses of $10,080,895, an increase of $5,365,245 over
the same period in the previous year.  This increase was due primarily to the
addition of product development and research personnel, increased use of
independent contractors, equipment, facilities and the operations of AcuVoice
and ASI.  Approximately $643,575 of such increase is for development costs from
the operations of the HealthCare Solutions and Interactive Technologies
Solutions Groups.  The Company anticipates similar or increased product
development and research costs as it expands and continues to develop and market
the applications and products offered by its HealthCare Solutions and
Interactive Technologies Solutions Groups. Additionally, the Company purchased
in-process product development and research totaling $13,136,000 during the nine
months ended September 30, 1998, in connection with the acquisitions of AcuVoice
and ASI.

Selling, general and administrative expenses were $8,360,964 and $5,935,838,
respectively, for the nine months ended September 30, 1998 and 1997.  This
increase from the previous period was due primarily to the hiring of additional
employees and the resulting increases in salaries, wages and related costs,
legal and accounting and depreciation and amortization.  Salaries, wages and
related costs were $3,280,790 and $1,787,726 for the nine months ended September
30, 1998 and 1997, respectively, an increase of $1,493,064 over the nine months
ended September 30, 1997.  This increase is attributable to incentive
compensation for continued employment paid to employees of ASI of $857,000, and
to increases in personnel from recent acquisitions.  Legal and accounting
expenses increased $774,475 and depreciation and amortization increased
$1,381,996.  The $1,381,996 increase in depreciation and amortization is
primarily attributable to the amortization of intangible assets acquired in
connection with the acquisitions of AcuVoice and ASI.  Additionally, consulting
and outside services decreased by $2,303,087.

The Company incurred losses from operations of $28,963,910 and $10,651,488
during the nine months ended September 30, 1998 and 1997, respectively.  The
significant increase in losses from operations is primarily due to purchased in-
process product development and research charges of $13,136,000 associated with
the acquisitions of AcuVoice and ASI.  The Company anticipates that its
investment in ongoing scientific product development and research will continue
at present or increased levels for at least the remainder of fiscal 1998
assuming availability of working capital.

Net other expense was $6,228,706 for the nine months ended September 30, 1998,
an increase in net other expense of $3,907,067 over the nine months ended
September 30, 1997.  This increase was primarily due to a $6,111,577 expense
recorded in connection with the settlement of a reset provision associated with
a private placement of the Company's common stock (see Liquidity and Capital
Resources).  Additionally, interest expense decreased $2,230,198 from the nine
months ended September 30, 1997, primarily due to financing costs associated
with the issuance and extinguishment of debt instruments during the nine months
ended September 30, 1997.

Liquidity and Capital Resources
-------------------------------

The Company had negative working capital of $9,106,108 at September 30, 1998
compared to positive working capital of $678,823 at December 31, 1997.  The
current ratio was 0.72 at September 30, 1998, compared to 1.03 at December 31,
1997.  Current assets increased by $2,277,686 to $23,426,375 from December 31,
1997 to September 30, 1998. Current liabilities increased by $12,062,617 to
$32,532,483 during the same period.  The decrease in working capital from
December 31, 1997 to September 30, 1998, was primarily attributable to an
increase in notes payable associated with the acquisition of ASI and increases
in accounts payable and notes payable of $859,000 as incentive compensation to
ASI employees to ensure continued employment, and accrued liabilities due to a
cash shortage.  Total assets were $60,745,760 at September 30,1998 compared to
$22,894,566 at December 31, 1997.

From its inception, the Company's principal source of capital has been private
and other exempt sales of the Company's debt and equity securities.  During the
nine months ended September 30, 1998, the Company issued 15,002,758 shares of
common stock.  Of such shares, 5,390,476 shares were issued in connection with a
private placement (see below), 

                                       23
<PAGE>
 
7,832,967 shares were issued in connection with the acquisitions of AcuVoice and
ASI, 1,489,501 shares were issued upon the conversion of Series B and C
Convertible Preferred Stock and related dividends, 265,000 shares were issued
upon the exercise of previously granted warrants and options and 24,814 shares
were issued for the purchase of a patent.

On March 12, 1998, the Company completed a private placement (the "Offering") of
up to 6,666,666 shares of its restricted common stock to seven accredited
investors (the "Investors").  The total purchase price to be paid by the
Investors pursuant to the Offering was $30,000,000.  Of that amount, $15,000,000
was received by the Company on March 12, 1998, in return for which the Company
issued a total of 3,333,333 shares of restricted common stock. Finders' fees of
$870,000 were paid in connection with the $15,000,000 received.  The remainder
of the purchase price was to be paid by the Investors on July 27, 1998 (60 days
after the effectiveness of a registration statement that the Company filed with
the Securities and Exchange Commission covering the common stock issued and
issuable to the investors) (the "Second Funding Date"), provided that, as of
such date, certain conditions were satisfied.  Certain conditions precedent to
receiving the additional funding were not met as of the Second Funding Date.  In
separate transactions in June and August 1998, certain Investors paid to the
Company $3,000,000 in return for which the Company issued 666,667 additional
shares under the terms and conditions set forth in the Offering documents.
Placement  fees of $163,846 have been accrued in connection with the $3,000,000
received.  No other payment has been received by the Company pursuant to the
Offering and the Company does not expect any further payment to be made.

The Investors acquired certain "reset rights" in connection with the Offering
pursuant to which the Investors would receive additional shares of restricted
common stock ("Reset Shares") if the average market price of the Company's
common stock for the 60-day period following the initial closing date did not
equal or exceed $5.40 per share.  On August 31, 1998, the Company and the
Investors in the Offering restructured the reset provision whereby the Company
issued 608,334 shares of Series D 4%  Convertible Preferred Stock ("Series D")
and 1,390,476 shares of common stock for (i) the relinquishment of the
Investors' contractual right to receive Reset Shares in connection with the
$15,000,000 received in March 1998, and the $3,000,000 received in June and
August 1998, and (ii) a financing cost in connection with the issuance of
500,000 shares of Series D.  In connection with the restructuring, the Company
recorded an expense of $6,111,577 for the difference between the Company's
original obligation to issue additional shares under the "reset rights"
provision in the Offering and the fair value of the shares that were actually
issued in settlement for the relinquishment of the reset provision and recorded
a preferred stock dividend of $1,000,000 related to financing costs in
connection with the issuance of 500,000 shares of Series D (see Series D
Preferred Stock below).

In January 1998, 27,500 shares of Series B Convertible Preferred Stock and
related dividends were converted into 193,582 shares of common stock.  At
September 30, 1998, no shares of  Series B Convertible Preferred Stock were
outstanding.

During the three months ended March 31, 1998, 185,000 shares of Series C
Convertible Preferred Stock and related dividends were converted into 1,295,919
shares of the Company's common stock.  At September 30, 1998, no shares of
Series C Convertible Preferred Stock were outstanding.

On August 31, 1998, the Company entered into an agreement with the Investors
whereby the Company issued 500,000 shares of the Company's Series D for
$10,000,000.  Additionally, the Company issued to certain of the Investors a
total of 608,334 shares of Series D (i) in return for their relinquishment of
their contractual right to receive Reset Shares in connection with the Offering
(see Private Placement above), and as (ii) an additional cost of raising the
$10,000,000 from the Series D placement.  Dividends accrue on the stated value
($20 per share) of Series D at the rate of 4 percent per year, are payable
annually or upon conversion, in cash or common stock, at the option of the
Company, and are convertible into shares of the Company's common stock at the
holder's option anytime after the earlier of November 29, 1998 or the date the
registration statement which the Company has agreed to file with the Securities
and Exchange Commission covering the common stock issuable upon the conversion
of the Series D is declared effective.  Each month the holders of the Series D
may not convert more than 25 percent of the total number of shares of Series D
originally issued to such holders on a cumulative basis.  For example, during
the first month a holder may convert up to 25% of the total preferred stock
issued to the holder, and during the following month that same holder may
convert, on an aggregate to date basis, up to 50% of the total number of shares
of Series D held by the holder. Additionally, each month, the holders may
convert up to 50 percent of the total number of shares of Series D originally
issued to such holders on a cumulative basis, if both of the following
conditions are satisfied:  the average daily trading volume of the Company's
common stock is more than 500,000 shares for the 10-trading-day period before
the conversion; and the 

                                       24
<PAGE>
 
average per share closing bid price for such 10-trading-day period has not
decreased by more than 5 percent during that 10-trading-day period. Any
outstanding shares of Series D as of August 31, 2001 automatically will be
converted at the conversion price described below most beneficial to the holders
on such date. In the event of liquidation, the holders of the Series D are
entitled to an amount equal to the stated value ($20 per share) plus accrued but
unpaid dividends whether declared or not. The holders of Series D have no voting
rights. The Series D shares, together with dividends accrued thereon, may be
converted into shares of the Company's common stock at the lesser of: $3.50 per
share; or the lesser of 110 percent of the average per share closing bid price
for the 15 trading days immediately preceding the date of issuance of the Series
D shares; or 90 percent of the average of the three lowest per share closing bid
prices during the 22 trading days immediately preceding the conversion date. In
the event that the holders convert at the $3.50 per share price, the Company is
obligated to issue warrants to purchase 0.8 shares of common stock for each
share of Series D converted to common stock. Using the conversion terms most
beneficial to the holder, the Company is amortizing a beneficial conversion
feature of $2,462,964 as a dividend over a 180 day-period.

Effective as of September 30, 1998, the Company entered into an agreement with
two of the Investors whereby the Company issued 100,000 shares of the Company's
Series E 4% Convertible Preferred Stock ("Series E") for $2,000,000.
Additionally, the Company issued to the purchasers of the Series E a total of
150,000 additional shares of Series E in exchange for which those purchasers
surrendered a total of 150,000 shares of Series D.  Dividends accrue on the
stated value ($20 per share) of Series E at a rate of 4 percent per year, are
payable annually or upon conversion, in cash or common stock, at the option of
the Company, and are convertible into shares of the Company's common stock at
anytime at the holder's option.  Any outstanding shares of Series E as of
September 30, 2001 are automatically converted at the conversion price described
below most beneficial to the holders on such date.  In the event of liquidation,
the holders of the Series E are entitled to an amount equal to the stated value
($20 per share) plus accrued but unpaid dividends whether declared or not.  The
holders of Series E have no voting rights. The Series E, together with dividends
accrued thereon, may be converted into shares of the Company's common stock at
the lesser of:  $3.50 per share; or the lesser of 110 percent of the average per
share closing bid price for the 15 trading days immediately preceding the date
of issuance of the Series E shares; or 90 percent of the average of the three
lowest per share closing bid prices during the 22 trading days immediately
preceding the conversion date.  If the Investors convert at the $3.50 per share
price, the Company is obligated to issue warrants to purchase 0.8 shares of
common stock for each share of Series E converted to common stock.  Using the
conversion terms most beneficial to the holder, the Company recorded a preferred
stock dividend of $968,047 for the beneficial conversion feature of the Series
E.  As of September 30, 1998, no shares of Series E had been converted to common
stock.  On November 4, 1998, 50,000 shares of Series E and related dividends
were converted into 1,130,805 shares of common stock.

During the nine months ended September 30, 1998, the Company granted options to
purchase 2,734,000 shares of common stock.  Of such options, 450,000 (having an
exercise price of $5.16 per share) were granted to three individuals who are
executive officers and directors of the Company and who each beneficially own
more than ten percent of the Company's common stock; 355,000, 1,240,000, and
589,000 options were granted to various employees at exercise prices of $3.34,
$3.54, and $6.50 per share, respectively, and 100,000 options were granted to an
unrelated party for services with an exercise price of $3.75 per share.  The
term of all options granted during the nine months ended September 30, 1998 is
ten years from the date of grant.  Additionally, the Company agreed to issue
stock options in exchange for ASI stock options in connection with the
acquisition of ASI.  These options have expiration dates ranging from January 1,
2001 to November 2, 2002.  As of September 30, 1998, the Company had a total of
13,319,920 options outstanding.

Although the Company has signed its first Statement of Work with Siemens and the
Company anticipates that it will enter into additional third-party licenses or
co-development agreements for its technologies with Siemens during fiscal year
1998, there can be no assurance that this will occur.  Even with the Siemens
Agreement in place and taking into account expected revenues from the HealthCare
Solutions and Interactive Technologies Solutions Groups, the Company's ongoing
operating expenses will remain higher than revenues from operations at least
through the first half of 1999.  Accordingly, the Company expects to incur
significant losses at least through the end of fiscal year 1998 and until such
time as it is able to enter into substantial licensing and co-development
agreements and receive substantial revenues from such arrangements or from the
operations of its recently acquired subsidiaries, of which there can be no
assurance.

                                       25
<PAGE>
 
As of September 30, 1998, the Company had a revolving note payable to a bank in
the amount of $19,984,536.  Loaned amounts under the revolving note payable are
limited, in the aggregate at any time, to $20,000,000.  The weighted average
outstanding balance during the nine months ended September 30, 1998 was
$18,121,205.  This note was due October 29, 1998, bore interest at an annual
rate of 6.55 percent, and is secured by a certificate of deposit in the amount
of $20,000,000.  This revolving note is renegotiated quarterly and interest is
payable monthly.  As of September 30, 1998, the Company owed the bank $309,457
in past due interest.  Subsequently, all such amounts were paid to the bank and
the note has  been negotiated to extend the maturity date of the note to
December 4, 1998.

The Company will need to raise additional funds in the near term to satisfy its
cash requirements for operations and current liabilities. Scientific product
development and research, corporate operations and marketing expenses will
continue to require substantial additional capital. In addition, the Company
recently has acquired AcuVoice and ASI and intends to complete other previously
announced acquisitions. These and other acquisition transactions have required
and will require substantial additional capital resources, even if the Company
uses its securities in payment of all or part of the purchase price of such
acquisitions. Because the Company presently has only limited revenue from
operations, the Company intends to continue to rely primarily on financing
through sales of its equity, convertible equity and debt securities to satisfy
future capital requirements until such time as the Company is able to generate
sufficient revenues to enable it to finance ongoing operations. There can be no
assurance that the Company will be able to sell its equity and debt securities
or enter into such arrangements, such that sufficient operating capital will be
available when and in the amounts needed. If such financing is not available,
the Company will have to significantly reduce or suspend its operations.
Furthermore, the issuance of equity securities or other securities which are or
may become convertible to the equity securities of the Company in connection
with such financing (or in connection with acquisitions) will result in dilution
to the stockholders of the Company which could be substantial.

The Company presently has no plans to purchase any new plants or office
facilities.  The Company presently anticipates that it will incur approximately
$900,000 in capital expenditures for equipment Company-wide over the next twelve
months.

Year 2000 Risks

Many computer systems and software products are coded to accept only two digit
entries in the date code field. These date code fields will need to accept four
digit entries to distinguish 21st century dates from 20th century dates. As a
result, many companies' software and computer systems will need to be upgraded
or replaced in order to comply with such Year 2000 requirements.

In the ordinary course of its business, the Company tests and evaluates its
technologies and  software and hardware products. The Company  believes that all
of its technologies and products generally are Year 2000 compliant, meaning that
the use or occurrence of dates on or after January 1, 2000 will not materially
affect the performance of such technologies or products with respect to four
digit date dependent data or the ability of such products to correctly create,
store, process, and output information related to such data.  However, the
Company may learn that certain of its technologies or products do not contain
all necessary software routines and codes necessary for the accurate
calculation, display, storage, and manipulation of data involving dates. In
addition, the Company  has warranted or expects to warrant that the use or
occurrence of dates on or after January 1, 2000 will not adversely affect the
performance of its technologies or products with respect to four digit date
dependent data or the ability to create, store, process, and output information
related to such data.  If the end users of any of the Company's technologies or
products experience Year 2000 problems, those persons could assert claims for
damages.

The Company uses third party equipment and software that may not be Year 2000
compliant. The Company has implemented a review of key products provided by
outside vendors to determine if their products are Year 2000 compliant and
presently believes that all software provided by third parties that is critical
to its business is Year 2000 compliant or will be before the year 2000. The
Company  believes that all computer software and hardware acquired from third
parties  after the 2/nd/ quarter of 1997 is Year 2000 compliant. However, if
third party equipment or software does not operate properly with regard to the
Year 2000 issue, the Company  may incur unexpected expenses to remedy any
problems. Such costs may materially adversely affect the Company's business,
operating results, and financial condition.  In addition, if the Company's  key
systems, or a significant number of its systems, failed as a result of Year 2000
problems the Company could incur substantial costs and disruption of its
business. The Company may also 

                                       26
<PAGE>
 
experience delays in implementing Year 2000 compliant software products. Any of
these problems have the potential to cause a material adverse affect on the
Company's business, operating results, or financial condition by making it
difficult to bill customers timely and accurately, meet product development or
production schedules, or pay obligations and operating expenses timely.

In addition, the purchasing patterns of the Company's licensees, potential
licensees, customers and potential customers may be affected by Year 2000
issues. Many companies are expending significant resources to correct their
current software systems for Year 2000 compliance. These expenditures may result
in reduced funds available to license fonix technologies or to purchase other
Company products. This may adversely affect the Company's business, operating
results, and financial condition.

The Company expects that its Year 2000 compliance efforts will cost
approximately $70,000 per year through the year 2000.


Outlook

Corporate Objectives, Technology Vision and Acquisition Strategy

The Company has positioned itself as a developer of "next generation" speech and
human-computer interaction technologies that will provide multiple product
solutions for business, consumer and service applications. The Company's
management team has assembled leading talents in the speech recognition, speech
synthesis, handwriting recognition and other arenas related to its two primary
business units; the HealthCare Solutions and Interactive Technologies Solutions
Groups.  The Board of Directors and management have developed a business
strategy that focuses on the health care and interactive systems markets,
outlines a vision of the next major market opportunities in these industries and
articulates a corporate and technology strategy that includes marketing of a
suite of fonix-branded products, strategic alliances, collaborative development
agreements and technology licenses.

The Company is determined to become a multi-market, multi-product enterprise
offering advanced speech and human-computer interaction technologies for health
care, embedded and interactive applications.  Advanced human-computer interface
technologies and multi-modal systems include:

     .    speech recognition
     .    speech synthesis
     .    speaker identification and verification
     .    handwriting recognition
     .    pen and touch screen input
     .    intelligent agents
     .    natural language understanding

Products anticipated to incorporate such advanced multi-modal human computer
interaction technologies include, among others, the following:

     .    PCs and PDAs
     .    cellular phones
     .    automotive and home environment speech controls
     .    automated information and transaction kiosks
     .    telephone systems with natural dialogue and gesture controls
     .    medical transcription and reporting systems, including PowerScribe
          Radiology and PowerScribe EM
     .    smart consumer appliances and electronics
     .    speech and pen-based computers utilizing handwriting and cursive
          recognition
     .    interactive education and entertainment systems
     .    interactive advertising
     .    real-time translation systems

                                       27
<PAGE>
 
This next generation technology presents important product and service
opportunities for the Company in a variety of industry segments, including:

     .    semiconductors
     .    health care
     .    telecommunications
     .    computers
     .    software
     .    consumer electronics
     .    entertainment
     .    automotive

The Company has observed that there are numerous small "boutique" speech
technology vendors.  The Company has previously acquired several such vendors
including AcuVoice, ASI and Papyrus.  An alliance with other  such vendors by
the Company can offer these small companies greater access to human and other
resources which, it is hoped, will lead to greater market share, improved
product development and support, and creation of additional product
opportunities.  In turn, the Company believes that such alliances will provide
it with additional speech and human computer interaction technologies, including
haptic (manual) input and output, face and gesture recognition, pentop and
wearable computers.

The strategy described above is not without risk, and shareholders and others
interested in the Company and its common stock should carefully consider the
risks contained in the Company's Annual Report on Form 10-K for the year ended
December 31, 1997.

               Special Note Regarding Forward-Looking Statements

Certain statements contained herein under,  "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and "Outlook,"
including statements concerning (i) the Company's strategy, (ii) the Company's
expansion plans, (iii) the market for and potential applications of the
Company's technologies, (iv) the results of product development and research
efforts, and (v) the growth of the Company's business contain certain forward-
looking statements concerning the Company's operations, economic performance and
financial condition.  Because such statements involve risks and uncertainties,
actual results may differ materially from those expressed or implied by such
forward-looking statements.  Factors that could cause such differences include,
but are not necessarily limited to, those discussed in the Company's Annual
Report on Form 10-K for the year ended December 31, 1997.

                                       28
<PAGE>
 
                                  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 corporation



Date:     March 12, 1999               /s/ Douglas L. Rex
     ------------------------          -----------------------
                                       Douglas L. Rex,
                                       Chief Financial Officer

                                       29