**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 **Washington,
        D.C. 20549**
 
 **FORM
        10-Q**
 
 
 (Mark
        one)
 
 [X]
              Quarterly
                  Report pursuant to Section 13 or 15(d) of the Securities Exchange
                  Act of
                  1934 for the quarterly period ended September 30, 2006,
                  or
 
 [  
                ]
              Transition
                  Report pursuant to Section 13 or 15(d) of the Securities Exchange
                  Act of
                  1934 for the transition period from ______________ to
                  _____________.
 
 Commission
        File No. 0-23862
  **Fonix
        Corporation**
 (Exact
        name of registrant as specified in its charter)
 
 **Delaware**
              **22-2994719**(State
                  or other jurisdiction of incorporation or organization)
              (I.R.S.
                  Employer Identification No.)
 
 **9350
        South 150 East, Suite 700**
 **Sandy,
        Utah 84070**
 (Address
        of principal executive offices with zip code)
 
 **(801)
        553-6600**
 (Registrant's
        telephone number, including area code)
 
 Indicate
        by check mark whether the registrant (1) has filed all reports required to
        be
        filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
        the
        preceding 12 months (or for such shorter period that the registrant was required
        to file such reports), and (2) has been subject to such filing requirements
        for
        the past 90 days: Yes [X]  No [  ].
 
 Indicate
        by check mark whether the registrant is a large accelerated filer, an
        accelerated filer, or a non-accelerated filer. (Check One): Larger Accelerated
        Filer __ Accelerated Filer __ Non-Accelerated Filer X .
 
 Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-25 of the Exchange Act). Yes __ No X
 
 As
        of
        November 13, 2006, there were issued and outstanding 1,094,684,682 shares
        of our
        Class A common stock.
 
   
 
  1
  
 **FONIX
        CORPORATION**
 **FORM
        10-Q**
 
 
 **TABLE
        OF CONTENTS**
 
 **PART
        I - FINANCIAL INFORMATION**
 
 **Page**Item
                  1.
              Financial
                  Statements (Unaudited)Condensed
                  Consolidated Balance Sheets - As of September 30, 2006, and December
                  31,
                  2005
              3Condensed
                  Consolidated Statements of Operations and Comprehensive Loss for
                  the Three
                  and Nine Months Ended September 30, 2006 and 2005
              4Condensed
                  Consolidated Statements of Cash Flows for the Nine Months Ended
                  September
                  30, 2006 and 2005
              5Condensed
                  Combined Balance Sheets (Liquidation Basis) - As of September 30,
                  2006,
                  and December 31, 2005
              7Condensed
                  Combined Statements of Operations and Comprehensive Loss (Liquidation
                  Basis) for the Three and Nine Months Ended September 30, 2006 and
                  2005
              8Condensed
                  Combined Statements of Cash Flows (Liquidation Basis) for the Nine
                  Months
                  Ended September 30, 2006 and 2005
              9Notes
                  to Condensed Consolidated Financial Statements
              10Item
                  2.
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              20Item
                  3.
              Quantitative
                  and Qualitative Disclosures About Market Risk
              31Item
                  4.
              Controls
                  and Procedures
              31**PART
                  II - OTHER INFORMATION**Item
                  1.
              Legal
                  Proceedings
              32Item
                  1A.
              Risk
                  Factors
              32Item
                  2.
              Unregistered
                  Sales of Equity Securities and Use of Proceeds
              33Item
                  4.
              Submission
                  of Matters to a Vote of Security Holders
              33Item
                  6.
              Exhibits
              33
 
 
 
  2
 **Fonix
        Corporation and Subsidiaries**
 **CONDENSED
        CONSOLIDATED BALANCE SHEETS**
 **(Unaudited)**
 **September
                  30,**
              
              **December
                  31,****2006**
              
              **2005****ASSETS****Current
                  assets**Cash
                  and cash equivalents
              
              $
              44,000
              
              $
              28,000Accounts
                  receivable
              
              
              -
              
              
              1,000Prepaid
                  expenses and other current assets
              
              
              186,000
              
              
              139,000**Total
                  current assets**
              
              
              230,000
              
              
              168,000**Property
                  and equipment,**net of accumulated depreciation of $1,247,000 and $1,203,000,
                  respectively
              
              
              62,000
              
              
              94,000**Deposits
                  and other assets**
              
              
              119,000
              
              
              1,238,000**Goodwill**
              
              
              2,631,000
              
              
              2,631,000**Total
                  assets**
              
              $
              3,042,000
              
              $
              4,131,000**LIABILITIES
                  AND STOCKHOLDERS' DEFICIT****Current
                  liabilities**Accrued
                  liabilities
              
              $
              1,592,000
              
              $
              435,000Accounts
                  payable
              
              
              1,403,000
              
              
              955,000Investment
                  in affiliate
              
              
              9,571,000
              
              
              9,571,000Derivative
                  liability
              
              
              21,392,000
              
              
              -Accrued
                  payroll and other compensation
              
              
              214,000
              
              
              223,000Accrued
                  settlement obligation, net of unamortized discount of $35,000 and
                  $118,000, respectively
              
              
              1,511,000
              
              
              1,853,000Deferred
                  revenues
              
              
              476,000
              
              
              466,000Notes
                  payable - related parties
              
              
              706,000
              
              
              486,000Current
                  portion of notes payable
              
              
              3,503,000
              
              
              1,599,000Deposits
                  and other
              
              
              7,000
              
              
              7,000**Total
                  current liabilities**
              
              
              40,375,000
              
              
              15,595,000**Long-term
                  notes payable, net of current portion**
              
              
              3,077,000
              
              
              3,762,000**Total
                  liabilities**
              
              
              43,452,000
              
              
              19,357,000**Commitments
                  and contingencies****Stockholders'
                  deficit**Preferred
                  stock, $0.0001 par value; 50,000,000 shares authorized;Series
                  A, convertible; 166,667 shares outstanding (aggregate liquidation
                  preference of $6,055,000)
              
              
              500,000
              
              
              500,000Series
                  H, nonconvertible; 0 shares and 2,000 shares outstanding
              
              
              -
              
              
              4,000,000Series
                  I, convertible; 0 shares and 0 shares outstanding, respectively
              
              
              -
              
              
              -Series
                  J, convertible; 0 shares and 1,359 shares outstanding, respectively
              
              
              -
              
              
              1,359,000Series
                  K, convertible; 0 shares and 0 shares outstanding, respectively
              
              
              -
              
              
              -Series
                  L, convertible; 1,973 shares and 0 shares outstanding ,
                  respectively
              
              
              -
              
              
              -Common
                  stock, $0.0001 par value; 5,000,000,000 shares authorized;Class
                  A voting, 886,430,512 shares and 392,929,230 shares outstanding,
                  respectively
              
              
              88,000
              
              
              39,000Class
                  B non-voting, none outstanding
              
              
              -
              
              
              -Additional
                  paid-in capital
              
              
              235,519,000
              
              
              228,905,000Outstanding
                  warrants to purchase Class A common stock
              
              
              474,000
              
              
              474,000Cumulative
                  foreign currency translation adjustment
              
              
              10,000
              
              
              18,000Accumulated
                  deficit
              
              
              (277,001,000
              )
              
              (250,521,000
              )**Total
                  stockholders' deficit**
              
              
              (40,410,000
              )
              
              (15,226,000
              )**Total
                  liabilities and stockholders' deficit**
              
              $
              3,042,000
              
              $
              4,131,000
 
 See
        accompanying notes to condensed consolidated financial statements.
 3
  **Fonix
        Corporation and Subsidiaries**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF OPERATIONS**
 **AND
        COMPREHENSIVE LOSS**
 **(Unaudited)**
 
 **Three
                  Months Ended**
                **September
                  30,**
              
              **Nine
                  Months Ended**
                **September
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Revenues
              
              $
              386,000
              
              $
              258,000
              
              $
              1,024,000
              
              $
              978,000Cost
                  of revenues
              
              
              6,000
              
              
              21,000
              
              
              12,000
              
              
              34,000Gross
                  profit
              
              
              380,000
              
              
              237,000
              
              
              1,012,000
              
              
              944,000Expenses:Selling,
                  general and administrative
              
              
              2,024,000
              
              
              1,410,000
              
              
              4,444,000
              
              
              3,756,000Legal
                  settlement expense
              
              
              -
              
              
              2,080,000
              
              
              -
              
              
              2,080,000Product
                  development and research
              
              
              551,000
              
              
              580,000
              
              
              1,711,000
              
              
              1,628,000Total
                  expenses
              
              
              2,575,000
              
              
              4,070,000
              
              
              6,155,000
              
              
              7,464,000Other
                  income (expense):Interest
                  and other income
              
              
              -
              
              
              106,000
              
              
              -
              
              
              112,000Interest
                  expense
              
              
              (528,000
              )
              
              (283,000
              )
              
              (1,279,000
              )
              
              (931,000
              )Loss
                  on derivative liability
              
              
              (1,763,000
              )
              
              -
              
              
              (1,763,000
              )
              
              -Gain
                  on forgiveness of liabilities
              
              
              -
              
              
              78,000
              
              
              -
              
              
              95,000Other
                  expense, net
              
              
              (2,291,000
              )
              
              (99,000
              )
              
              (3,042,000
              )
              
              (724,000
              )Net
                  loss
              
              
              (4,486,000
              )
              
              (3,932,000
              )
              
              (8,185,000
              )
              
              (7,244,000
              )Preferred
                  stock dividends
              
              
              (16,192,000
              )
              
              (423,000
              )
              
              (18,295,000
              )
              
              (996,000
              )Loss
                  attributable to common stockholders
              
              $
              (20,678,000
              )
              $
              (4,355,000
              )
              $
              (26,480,000
              )
              $
              (8,240,000
              )Basic
                  and diluted loss per common share
              
              $
              (0.03
              )
              $
              (0.01
              )
              $
              (0.04
              )
              $
              (0.04
              )Net
                  loss
              
              $
              (4,486,000
              )
              $
              (3,932,000
              )
              $
              (8,185,000
              )
              $
              (7,244,000
              )Other
                  comprehensive (loss) income - foreign currency translation
              
              
              -
              
              
              (20,000
              )
              
              7,000
              
              
              2,000Comprehensive
                  loss
              
              $
              (4,486,000
              )
              $
              (3,952,000
              )
              $
              (8,178,000
              )
              $
              (7,242,000
              )
 
 See
        accompanying notes to condensed consolidated financial statements.
  4
  **Fonix
        Corporation and Subsidiaries**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF CASH FLOWS**
 **(Unaudited)**
 
 **Nine
                  Months Ended Sept 30,**
              
              **2006**
              
              **2005****Cash
                  flows from operating activities**Net
                  loss
              
              $
              (8,185,000
              )
              $
              (7,244,000
              )Adjustments
                  to reconcile net loss to net cash used in operating
                  activities:Loss
                  on derivative liability
              
              
              1,763,000
              
              
              -Accretion
                  of discount on notes payable
              
              
              603,000
              
              
              558,000Non-cash
                  expense related to the issuance of preferred stock
              
              
              -
              
              
              250,000Stock
                  issued for interest expense on long-term debt
              
              
              -
              
              
              384,000Accretion
                  of discount on legal settlement
              
              
              98,000
              
              
              -Write
                  down of intercompany receivable
              
              
              1,214,000
              
              
              -Legal
                  settlement expense
              
              
              -
              
              
              2,080,000Gain
                  on sale of preferred stock
              
              
              -
              
              
              (104,000
              )Gain
                  on forgiveness of liabilities
              
              
              -
              
              
              (95,000
              )Depreciation
              
              
              44,000
              
              
              45,000Foreign
                  exchange loss (gain)
              
              
              (8,000
              )
              
              2,000Changes
                  in assets and liabilitiesAccounts
                  receivable
              
              
              1,000
              
              
              -Prepaid
                  expenses and other current assets
              
              
              (47,000
              )
              
              (98,000
              )Intercompany
                  account
              
              
              -
              
              
              (1,078,000
              )Other
                  assets
              
              
              (95,000
              )
              
              (33,000
              )Accounts
                  payable
              
              
              448,000
              
              
              (149,000
              )Accrued
                  payroll and other compensation
              
              
              (9,000
              )
              
              (1,421,000
              )Other
                  accrued liabilities
              
              
              582,000
              
              
              131,000Deferred
                  revenues
              
              
              10,000
              
              
              24,000Net
                  cash used in operating activities
              
              
              (3,581,000
              )
              
              (6,748,000
              )**Cash
                  flows from investing activities**Purchase
                  of property and equipment
              
              
              (12,000
              )
              
              (23,000
              )Net
                  cash used in investing activities
              
              
              (12,000
              )
              
              (23,000
              )**Cash
                  flows from financing activities**Proceeds
                  from issuance of Class A common stock, net
              
              
              3,504,000
              
              
              6,521,000Proceeds
                  from related party note payable
              
              
              325,000
              
              
              140,000Proceeds
                  from debentures
              
              
              250,000
              
              
              -Proceeds
                  from credit advance
              
              
              75,000
              
              
              -Payments
                  on related party note payable
              
              
              (105,000
              )
              
              -Payments
                  of accrued settlement obligation
              
              
              (440,000
              )
              
              -Principal
                  payments on notes payable
              
              
              -
              
              
              (102,000
              )Net
                  cash provided by financing activities
              
              
              3,609,000
              
              
              6,559,000**Net
                  decrease in cash and cash equivalents**
              
              
              16,000
              
              
              (212,000
              )**Cash
                  and cash equivalents at beginning of year**
              
              
              28,000
              
              
              309,000**Cash
                  and cash equivalents at end of year**
              
              $
              44,000
              
              $
              97,000
 
 See
        accompanying notes to condensed consolidated financial statements.
  5
  **Fonix
        Corporation and Subsidiaries**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)**
 **(Unaudited)**
 
 
 **Supplemental
        schedule of noncash investing and financing activities**
 
 **For
        the Nine Months Ended September 30, 2006:**
 
 Issued
        15,028,249 shares of Class A common stock in conversion of 266 shares of
        Series
        J Convertible Preferred Stock.
 
 Issued
        109,300,000 shares of Class A common stock in conversion of 1,093 shares
        of
        Series K Convertible Preferred Stock.
 
 Issued
        2,838,412 shares of Class A common stock as payment of $65,000 of dividends
        on
        Series H Preferred Stock.
 
 Accrued
        $692,000 of dividends on Series H Preferred Stock.
 
 Issued
        2,000 shares of Series L Convertible Preferred Stock with a face value of
        $20,000,000 in exchange for 2,000 shares of Series H Preferred Stock with
        a face
        value of $20,000,000.
 
 Issued
        66,334,622 shares of Class A common stock in conversion of 27 shares of Series
        L
        Preferred Stock.
 
 **For
        the Nine Months Ended September 30, 2005:**
 
 Issued
        18,482,083 shares of Class A common stock in conversion of 1,078 shares of
        Series I Convertible Preferred Stock.
 
 Issued
        12,944,095 shares of Class A common stock as payment of $750,000 of dividends
        on
        Series H Preferred Stock.
 
 Issued
        18,894,034 shares of Class A common stock as payment of $968,000 of principal
        and interest on long-term debt.
 
 Accrued
        $250,000 of dividends on Series H Preferred Stock.
 
 Issued
        1,452 shares of Series J Preferred Stock with a value of $1,452,000 in exchange
        for 1,172 shares of Series I Preferred Stock with a value of $1,172,000,
        a
        placement fee of $250,000 and settlement expense of $30,000.
 
 Issued
        2,277,000 shares of Class A common stock for a legal settlement expense valued
        at $73,000, or $0.03 per share.
 
 
 
 
 
   
 
 See
        accompanying notes to condensed consolidated financial statements.
  6
  **LecStar
        Telecom, Fonix Telecom & LTEL Holdings**
 **CONDENSED
        COMBINED BALANCE SHEETS (Liquidation Basis)**
 **(Unaudited)**
 
 **September
                  30,**
              
              **December
                  31,****2006**
              
              **2005****ASSETS****Current
                  assets**Cash
                  and cash equivalents
              
              $
              -
              
              $
              140,000Accounts
                  receivable
              
              
              -
              
              
              1,120,000Prepaid
                  expenses and other current assets
              
              
              -
              
              
              37,000**Total
                  current assets**
              
              
              -
              
              
              1,297,000**Property
                  and equipment,**net of accumulated depreciation of $0 and $391,000,
                  respectively
              
              
              -
              
              
              853,000**Deposits
                  and other assets**
              
              
              -
              
              
              1,473,000**Intangible
                  assets**
              
              
              -
              
              
              2,658,000**Total
                  assets**
              
              $
              -
              
              $
              6,281,000**LIABILITIES
                  AND STOCKHOLDERS' DEFICIT****Current
                  liabilities**Accrued
                  liabilities
              
              $
              8,757,000
              
              $
              7,703,000Accounts
                  payable
              
              
              9,847,000
              
              
              5,815,000Intercompany
                  payable
              
              
              1,214,000
              
              
              1,119,000Deferred
                  revenues
              
              
              371,000
              
              
              457,000Current
                  portion of notes payable
              
              
              256,000
              
              
              248,000Deposits
                  and other
              
              
              216,000
              
              
              222,000**Total
                  current liabilities**
              
              
              20,661,000
              
              
              15,564,000**Long-term
                  notes payable, net of current portion**
              
              
              158,000
              
              
              288,000**Total
                  liabilities**
              
              
              20,819,000
              
              
              15,852,000**Commitments
                  and contingencies****Stockholders'
                  deficit**Additional
                  paid-in capital
              
              
              12,800,000
              
              
              12,800,000Accumulated
                  deficit
              
              
              (33,619,000
              )
              
              (22,371,000
              )**Total
                  stockholders' deficit**
              
              
              (20,819,000
              )
              
              (9,571,000
              )**Total
                  liabilities and stockholders' deficit**
              
              $
              -
              
              $
              6,281,000
   
 See
        accompanying notes to condensed consolidated financial statements.
 
  7
  **LecStar
        Telecom, Fonix Telecom & LTEL Holdings**
 **CONDENSED
        COMBINED STATEMENTS OF OPERATIONS**
 **AND
        COMPREHENSIVE LOSS (Liquidation Basis)**
 **(Unaudited)**
 
 **Three
                  Months Ended**
                **September
                  30,**
              
              **Nine
                  Months Ended**
                **September
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Revenues
              
              $
              2,622,000
              
              $
              3,699,000
              
              $
              8,424,000
              
              $
              11,526,000Cost
                  of revenues
              
              
              2,145,000
              
              
              2,388,000
              
              
              6,725,000
              
              
              7,062,000Gross
                  profit
              
              
              477,000
              
              
              1,311,000
              
              
              1,699,000
              
              
              4,464,000Expenses:Selling,
                  general and administrative
              
              
              1,923,000
              
              
              2,105,000
              
              
              5,412,000
              
              
              6,571,000Impairment
                  of assets
              
              
              4,611,000
              
              
              -
              
              
              5,623,000
              
              
              -Amortization
                  of intangible assets
              
              
              -
              
              
              1,586,000
              
              
              917,000
              
              
              4,757,000Total
                  expenses
              
              
              6,534,000
              
              
              3,691,000
              
              
              11,952,000
              
              
              11,328,000Other
                  income (expense):Interest
                  expense
              
              
              (304,000
              )
              
              -
              
              
              (995,000
              )
              
              (964,000
              )Gain
                  on sale of investments
              
              
              -
              
              
              -
              
              
              -
              
              
              147,000Other
                  expense, net
              
              
              (304,000
              )
              
              -
              
              
              (995,000
              )
              
              (817,000
              )Net
                  loss
              
              
              (6,361,000
              )
              
              (2,380,000
              )
              
              (11,248,000
              )
              
              (7,681,000
              )
                
 See
        accompanying notes to condensed consolidated financial statements.
 
  8
  **LecStar
          Telecom, Fonix Telecom & LTEL Holdings**
 **CONDENSED
        COMBINED STATEMENTS OF CASH FLOWS (Liquidation Basis)**
 **(Unaudited)**
 
 **Nine
                  Months Ended Sept 30,**
              
              **2006**
              
              **2005****Cash
                  flows from operating activities**Net
                  loss
              
              $
              (11,248,000
              )
              $
              (7,681,000
              )Adjustments
                  to reconcile net loss to net cash used in operating
                  activities:Amortization
                  of intangibles
              
              
              917,000
              
              
              4,758,000Impairment
                  of assets
              
              
              5,623,000
              
              
              -Depreciation
              
              
              276,000
              
              
              136,000Changes
                  in assets and liabilitiesAccounts
                  receivable
              
              
              (545,000
              )
              
              295,000Prepaid
                  expenses and other current assets
              
              
              (90,000
              )
              
              12,000Intercompany
                  account
              
              
              95,000
              
              
              886,000Other
                  assets
              
              
              (17,000
              )
              
              (358,000
              )Accounts
                  payable
              
              
              4,032,000
              
              
              854,000Accrued
                  payroll and other compensation
              
              
              -
              
              
              69,000Other
                  accrued liabilities
              
              
              1,049,000
              
              
              1,977,000Deferred
                  revenues
              
              
              (86,000
              )
              
              (5,000
              )Net
                  cash used in operating activities
              
              
              6,000
              
              
              943,000**Cash
                  flows from investing activities**Proceeds
                  from sale of long term investments
              
              
              -
              
              
              237,000Purchase
                  of property and equipment
              
              
              (23,000
              )
              
              (941,000
              )Net
                  cash used in investing activities
              
              
              (23,000
              )
              
              (704,000
              )**Cash
                  flows from financing activities**Principal
                  payments on notes payable
              
              
              (123,000
              )
              
              (155,000
              )Net
                  cash provided by financing activities
              
              
              (123,000
              )
              
              (155,000
              )**Net
                  decrease in cash and cash equivalents**
              
              
              (140,000
              )
              
              84,000**Cash
                  and cash equivalents at beginning of year**
              
              
              140,000
              
              
              114,000**Cash
                  and cash equivalents at end of year**
              
              $
              -
              
              $
              198,000
         
 See
        accompanying notes to condensed consolidated financial statements.
  9
  **Fonix
        Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**
 
 **1.
        SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**
 
 ***Basis
        of Presentation*** - The
        accompanying unaudited condensed consolidated financial statements
        of ** Fonix ** Corporation
        and subsidiaries (collectively, the “Company” or “Fonix”) have been prepared by
        the Company pursuant to the rules and regulations of the Securities and Exchange
        Commission (the “SEC”). Certain information and footnote disclosures normally
        included in financial statements prepared in accordance with accounting
        principles generally accepted in the United States of America have been
        condensed or omitted pursuant to such rules and regulations, although the
        Company believes that the following disclosures are adequate to make the
        information presented not misleading. The Company suggests that these condensed
        consolidated financial statements be read in conjunction with the consolidated
        financial statements and the notes thereto included in the Company’s 2005 Annual
        Report on Form 10-K.
 
 The
        Company has not consolidated the assets, liabilities or operations related
        to
        the assets shown on the liquidation basis financial statements as these assets
        are under the control of the court appointed bankruptcy trustee pursuant
        to the
        filing for protection under Chapter 7 of the Bankruptcy Code by LecStar Telecom,
        Inc., LecStar DataNet, Inc., LTEL Holdings and Fonix Telecom, Inc. on October
        2,
        2006 (See Note 9). The accompanying footnotes do not include disclosures
        related
        to the operations of the aforementioned companies and represent solely the
        operations of Fonix Speech, Inc. The Company has also included the financial
        statements for LecStar Telecom, Fonix Telecom and LTEL Holdings shown on
        a
        combined liquidation basis.
 
 These
        condensed consolidated financial statements reflect all adjustments (consisting
        only of normal recurring adjustments) that, in the opinion of management,
        are
        necessary to present fairly the financial position and results of operations
        of
        the Company for the periods presented. The Company’s business strategy is not
        without risk, and readers of these condensed consolidated financial statements
        should carefully consider the risks set forth under the heading “Certain
        Significant Risk Factors” in the Company’s 2005 Annual Report on Form
        10-K.
 
 Operating
        results for the nine months ended September 30, 2006, are not necessarily
        indicative of the results that may be expected for the year ending December
        31,
        2006.
 
 ***Nature
        of Operations*** **-** ****** Fonix
        Corporation, a technology company based in Salt Lake City, Utah, provides
        value-added speech technologies through Fonix Speech, Inc. (“Fonix Speech”).
 
 Through
        Fonix Speech, the Company delivers speech interface development tools, solutions
        and applications (the “Speech Products”) that empower people to interact
        conversationally with information systems and devices. The Speech Products
        are
        based on the Company’s speech-enabling technologies, which include
        text-to-speech (“TTS”) and proprietary neural network-based automatic speech
        recognition (“ASR”). ASR and TTS technologies are sometimes collectively
        referred to in this report as “Core Technologies.” The Company has received
        various patents for certain elements of its Core Technologies and has filed
        applications for other patents covering various aspects of its technologies.
        The
        Company’s Speech Products enhance user productivity, ease of use and efficiency
        in a broad range of market segments, including mobile and wireless devices;
        entertainment game consoles; electronic devices for assistive, language
        learning, robots and appliances; and computer telephony and server applications.
        Revenues for Fonix Speech are generated through licensing of speech-enabling
        technologies, royalty payments for the use of the Company’s technologies,
        maintenance contracts and services.
 
 On
        October 2, 2006, LecStar Telecom Inc., a Georgia corporation (“LecStar
        Telecom”), LecStar DataNet, Inc., a Georgia corporation (“LecStar DataNet”),
        LTEL Holdings Corporation (“LTEL Holdings”), a Delaware corporation, and Fonix
        Telecom Inc., a Delaware corporation (“Fonix Telecom”), each of which are direct
        or indirect subsidiaries of the Company, filed for bankruptcy protection
        in the
        United States Bankruptcy Court for the District of Delaware (the “Bankruptcy
        Court”). The case numbers are as follows: LTEL Holdings Corporation, 06-11081
        (BLS); LecStar Telecom, Inc., 06-11082 (BLS); LecStar DataNet, Inc., 06-11083
        (BLS); Fonix Telecom, Inc., 06-11084 (BLS).)
 
 LecStar
        Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom sought protection
        under Chapter 7 of title 11 of the U.S. Bankruptcy Code, 11 U.S.C ss 101
        et seq.
        (the “Bankruptcy Code”). Pursuant to Bankruptcy Code Section 701, on October 3,
        2006, Alfred Thomas Guliano was appointed the interim trustee for LecStar
        Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom.
 
  10
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Condensed Consolidated Financial Statements**
 
 ***Business
        Condition*** **** -
        For the
        three months ended September 30, 2006 and 2005, the Company generated revenues
        of $386,000 and $258,000, respectively, and incurred net losses of $4,486,000
        and $3,932,000, respectively. For the nine months ended September 30, 2006
        and
        2005, the Company generated revenues of $1,024,000 and $978,000, respectively,
        incurred net losses of $8,185,000 and $7,244,000, respectively, and had negative
        cash flows from operating activities of $3,581,000 and $6,748,000, respectively.
        As of September 30, 2006, the Company had an accumulated deficit of
        $277,001,000, negative working capital of $40,145,000, derivative liability
        of
        $21,392,000 related to the issuance of Series L Preferred Stock, a negative
        investment in affiliates of $9,571,000 related to the telecom subsidiaries
        subject to bankruptcy (LecStar, Telecom, LecStar DataNet, LTEL Holdings and
        Fonix Telecom), accrued liabilities and accrued settlement obligation of
        $3,103,000, accounts payable of $1,403,000 and current portion of notes payable
        of $4,209,000. The Company expects to continue to incur significant losses
        and
        negative cash flows from operating activities at least through December 31,
        2007, primarily due to expenditure requirements associated with continued
        marketing and development of its speech-enabling technologies.
 
 The
        Company’s cash resources, limited to collections from customers, draws on the
        Seventh Equity Line and loans, have not been sufficient to cover operating
        expenses. As a result, some payments to vendors have been delayed. The Company
        currently does not have an active registration statement with the SEC and
        cannot
        access funds under the Seventh Equity Line. The Company does not anticipate
        being able to access additional funds under the Seventh Equity
        Line.
 
 These
        factors, as well as the risk factors set forth herein and in the Company’s
        Annual Report on Form 10-K for the year ended December 31, 2005, raise
        substantial doubt about the Company’s ability to continue as a going concern.
        The accompanying financial statements do not include any adjustments that
        might
        result from the outcome of this uncertainty. Management plans to fund further
        operations of the Company through cash flows from future license and royalty
        arrangements and with proceeds from additional issuance of debt and equity
        securities. There can be no assurance that management’s plans will be
        successful.
 
 ***Net
        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. As of September 30, 2006 and
        2005,
        there were outstanding common stock equivalents to purchase 6,192,412,281
        and
        81,965,771 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.
 
 The
        following table is a reconciliation of the net loss numerator of basic and
        diluted net loss per common share for the three months and nine months ended
        September 30, 2006 and 2005:
 
 **Three
                  Months Ended September 30,****2006**
              
              **2005****Per**
              
              
              
              **Per****Share**
              
              
              
              **Share****Amount**
              
              **Amount**
              
              **Amount**
              
              **Amount**Net
                  loss
              
              $
              (4,486,000
              )
              
              
              
              $
              (3,932,000
              )Preferred
                  stock dividends
              
              
              (16,192,000
              )
              
              
              
              
              (423,000
              )Loss
                  attributable to common stockholders
              
              $
              (20,678,000
              )
              $
              (0.03
              )
              $
              (4,355,000
              )
              $
              (0.01
              )Weighted-average
                  common shares outstanding
              
              
              825,819,722
              
              
              
              
              
              294,655,483
 
  11
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Condensed Consolidated Financial Statements**
 **Nine
                  Months Ended September 30,****2006**
              
              **2005****Per**
              
              
              
              **Per****Share**
              
              
              
              **Share****Amount**
              
              **Amount**
              
              **Amount**
              
              **Amount**Net
                  loss
              
              $
              (8,185,000
              )
              
              
              
              $
              (7,244,000
              )Preferred
                  stock dividends
              
              
              (18,295,000
              )
              
              
              
              
              (996,000
              )Loss
                  attributable to common stockholders
              
              $
              (26,480,000
              )
              $
              (0.04
              )
              $
              (8,240,000
              )
              $
              (0.04
              )Weighted-average
                  common shares outstanding
              
              
              716,417,308
              
              
              
              
              
              221,598,946
 
 ***Imputed
        Interest Expense*** - ****** Interest
        is imputed on long-term debt obligations where management has determined
        that
        the contractual interest rates are below the market rate for instruments
        with
        similar risk characteristics.
 
 ***Comprehensive
        Loss*** - ****** Other
        comprehensive loss as presented in the accompanying condensed consolidated
        financial statements consists of cumulative foreign currency translation
        adjustments.
 
 ***Revenue
        Recognition*** -
        The
        Company recognizes revenue when pervasive evidence of an arrangement exists;
        services have been rendered or products have been delivered; the price to
        the
        buyer is fixed and determinable; and collectibility is reasonably assured.
        Revenues are recognized by the Company based on the various types of
        transactions generating the revenue. For software sales, the Company recognizes
        revenues in accordance with the provisions of Statement of Position No. 97-2,
        “Software Revenue Recognition,” and related interpretations *.* The
        Company generates revenues from licensing the rights to its software products
        to
        end users and from royalties.
 
 For
        Fonix
        Speech, revenue of all types is recognized when acceptance of functionality,
        rights of return and price protection are confirmed or can be reasonably
        estimated, as appropriate. Revenues from development and consulting services
        are
        recognized on a completed-contract basis when the services are completed
        and
        accepted by the customer. The completed-contract method is used because the
        Company’s contracts are typically either short-term in duration or the Company
        is unable to make reasonably dependable estimates of the costs of the contracts.
        Revenue for hardware units delivered is recognized when delivery is verified
        and
        collection assured.
 
 Revenue
        for products distributed through wholesale and retail channels and through
        resellers is recognized upon verification of final sell-through to end users,
        after consideration of rights of return and price protection. Typically,
        the
        right of return on such products has expired when the end user purchases
        the
        product from the retail outlet. Once the end user opens the package, it is
        not
        returnable unless the medium is defective.
 
 When
        arrangements to license software products do not require significant production,
        modification or customization of software, revenue from licenses and royalties
        are recognized when persuasive evidence of a licensing arrangement exists,
        delivery of the software has occurred, the fee is fixed or determinable,
        and
        collectibility is probable. Post-contract obligations, if any, generally
        consist
        of one year of support including such services as customer calls, bug fixes,
        and
        upgrades. Related revenue is recognized over the period covered by the
        agreement. Revenues from maintenance and support contracts are also recognized
        over the term of the related contracts.
 
 Revenues
        applicable to multiple-element fee arrangements are bifurcated among elements
        such as license agreements as well as support and upgrade obligations using
        vendor-specific objective evidence of fair value. Such evidence consists
        primarily of pricing of multiple elements as if sold as separate products
        or
        arrangements. These elements vary based upon factors such as the type of
        license, volume of units licensed, and other related factors.
 
 Deferred
        revenue as of September 30, 2006, and December 31, 2005, consisted of the
        following:
 **Description**
                
                **Criteria
                    for Recognition**
                
                **September
                    30, 2006**
                
                **December
                    31, 2005**Deferred
                    unit royalties and license fees
                
                Delivery
                    of
                    units to end users or expiration of contract
                
                $
                476,000
                
                $
                466,000
   12
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Condensed Consolidated Financial Statements**
 
 ***Cost
        of Revenues*** -Cost
        of
        revenues from license, royalties, and maintenance consists of costs to
        distribute the product, installation and support personnel compensation,
        amortization and impairment of capitalized speech software costs, licensed
        technology, and other related costs. Cost of service revenues consists of
        personnel compensation and other related costs.
 
 ***Software
        Technology Development and Production Costs*** **** -
        All
        costs incurred to establish the technological feasibility of speech software
        technology to be sold, leased, or otherwise marketed are charged to product
        development and research expense. Technological feasibility is established
        when
        a product design and a working model of the software product have been completed
        and confirmed by testing. Costs to produce or purchase software technology
        incurred subsequent to establishing technological feasibility are capitalized.
        Capitalization of software costs ceases when the product is available for
        general release to customers. Costs to perform consulting or development
        services are charged to cost of revenues in the period in which the
        corresponding revenues are recognized. The cost of maintenance and customer
        support is charged to expense when related revenue is recognized or when
        these
        costs are incurred, whichever occurs first.
 
 ***Stock-Based
        Employee Compensation*** -
        Effective January 1, 2006, the Company adopted Statement of Financial Accounting
        Standards No. 123(R), “Share-Based Payment” (“FAS 123(R)”), an amendment of SFAS
        No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) using the
        modified prospective transition method. Under this transition method,
        compensation costs are recognized beginning with the effective date: (a)
        based
        on the requirements of FAS 123(R) for all share-based awards granted after
        the
        effective date; and (b) based on the requirements of SFAS 123 for all awards
        granted to employees prior to the effective date of FAS 123(R) that remain
        unvested on the effective date. Accordingly, the Company did not restate
        the
        results of prior periods. The most notable change resulting from the adoption
        of
        FAS123(R) is that compensation expense associated with stock options is now
        recognized in the Company’s Statements of Operations, rather than being
        disclosed in a pro forma footnote to the Company’s financial
        statements.
 
 The
        Company recognized compensation expense related to option grants and the
        vesting
        of previously unvested options for the three months ended September 30, 2006,
        of
        $0. For the nine months ended September 30, 2006, the Company recognized
        compensation expense related to option grants and the vesting of previously
        unvested options of $0.
 
 Prior
        to
        January 1, 2006, the Company accounted for stock options granted under its
        Stock
        Option Plans under the recognition and measurement provisions of Accounting
        Principles Board Opinion No. 25, *Accounting
        for Stock Issued to Employees* )
        and
        related interpretations, as permitted by SFAS 123. Had the Company determined
        compensation cost based on the fair value at the grant date for its stock
        options under SFAS No. 123, the Company’s net loss would have been increased to
        the pro forma amounts indicated below for the three and nine months ended
        September 30, 2005:
 
 **Three
                  Months Ended September 30,**
              
              **2005**Net
                  loss, as reported
              
              $
              (3,932,000
              )Add
                  back: Total stock-based employee compensation
              
              
              -Deduct:
                  Total stock-based employee compensation determined under fair value
                  based
                  method for all awards
              
              
              (15,000
              )Pro
                  forma net loss
              
              $
              (3,947,000
              )Basic
                  and diluted net loss per common share:As
                  reported
              
              $
              (0.01
              )Pro
                  forma
              
              
              (0.01
              )
 
  13
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Condensed Consolidated Financial Statements**
 
 **Nine
                  Months Ended September 30,**
              
              **2005**Net
                  loss, as reported
              
              $
              (7,244,000
              )Add
                  back: Total stock-based employee compensation
              
              
              -Deduct:
                  Total stock-based employee compensation determined under fair value
                  based
                  method for all awards
              
              
              (37,000
              )Pro
                  forma net loss
              
              $
              (7,281,000
              )Basic
                  and diluted net loss per common share:As
                  reported
              
              $
              (0.04
              )Pro
                  forma
              
              
              (0.04
              )
 
 The
        fair
        value of the options granted during the nine months ended September 30, 2005
        was
        $76,000, or $0.11 per share, and was estimated on the dates granted using
        the
        Black Scholes option pricing model with the following weighted average
        assumptions: dividend yield of 0%, expected volatility of 142%, risk-free
        rate
        of 3.75% and expected life of 5 years .
 
 **2.
        GOODWILL**
 
 The
        carrying value of goodwill is assessed for impairment quarterly. An assessment
        was performed for the nine months ended September 30, 2006, which resulted
        in no
        impairment, and the carrying value of goodwill remained unchanged at $2,631,000
        for the nine months ended September 30, 2006.
 
 **3.
        NOTES PAYABLE**
 
 In
        connection with the acquisition of the capital stock of LTEL Holdings in
        2004,
        the Company issued a 5%, $10,000,000, secured, six-year note (the “Note”)
        payable to McCormack Avenue, Ltd. (“McCormack”). Under the terms of the Note,
        quarterly interest- only payments were required through January 15, 2005,
        with
        quarterly principal and interest payments of $319,000 beginning April 2005
        and
        continuing through January 2010. Interest on the Note is payable in cash
        or, at
        the Company’s option, in shares of the Company’s Class A common stock. The Note
        is secured by the capital stock and all of the assets of LTEL Holdings and
        its
        subsidiaries. The Note was originally valued at $4,624,000 based on an imputed
        interest rate of 25 percent per annum.
 
 The
        discount on the N ote
        is
        based on an imputed interest rate of 25%. The carrying amount of the Note
        of
        $5,312,000 at September 30, 2006, was net of unamortized discount of $3,241,000.
        As of November 13, 2006, the Company had not made any scheduled payments
        for
        2006.
 
 On
        September 8, 2006, the Company received a default notice (the “Default Notice”)
        from McCormack in respect of the Note. Under the terms of the Note, and a
        related Security Agreement between the Company and McCormack dated February
        24,
        2004 (the “Security Agreement”), McCormack may declare all liabilities,
        indebtedness, and obligations of the Company to McCormack under the Security
        Agreement and the Note immediately due and owing upon an event of default.
        The
        Note defines an event of default to include the non-payment by the Company
        of a
        scheduled payment which is not cured within 60 days .
 
 In
        the
        Default Notice, McCormack stated that it intended to exercise its rights,
        including any and all rights set forth in the Note, as amended.
 
 Also
        on
        September 8, 2006, McCormack provided to the Company a Notice of Sale, stating
        McCormack’s intention to sell at public auction all of the collateral referred
        to in the Security Agreement, consisting of the capital stock and assets
        of
        LecStar Telecom, LecStar DataNet, and LTEL Holdings. To date, no sale of
        the
        assets or capital stock of LecStar Telecom, LecStar DataNet nor LTEL Holdings
        has occurred..
 
 During
        the fourth quarter of 2005, the Company entered into two promissory notes
        with
        an unrelated third party in the aggregate amount of $650,000. These notes
        accrue
        interest at 10% annually and were due and payable during May and June of
        2006.
        As of November 13, 2006, the Company had not made the scheduled payments
        on
        these promissory notes; the holder of the notes has not declared a default
        under
        the notes.
 
 During
        the third quarter of 2006, the Company entered into a debenture agreement
        with
        an unrelated third party for $619,000. The debenture accrues interest at
        9%
        annually and was due and payable on September 30, 2006. As of November 13,
        2006,
        the Company had not made payment on the debenture; the holder of the debenture
        has not declared a default under the debenture.
 
  14
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Condensed Consolidated Financial Statements**
 
 The
        following schedule summarizes the Company’s current debt obligations and
        respective balances at September 30, 2006, and December 31, 2005:
 
 **Notes
                  Payable**
              
              **2006**
              
              **2005**5%
                  Note payable to a company, $8,733,000 and $8,733,000, respectively
                  face
                  amount, due in quarterly installments of $319,000, matures January
                  2010,
                  less unamortized discount based on interest imputed at 25% of $3,421,000
                  and $4,023,000, respectively
              
              $
              5,311,000
              
              $
              4,710,000Note
                  payable to a company, interest at 10%, matured May 2006
              
              
              350,000
              
              
              350,000Note
                  payable to a company, interest at 10%, matured June 2006
              
              
              300,000
              
              
              300,000Debenture
                  to a company, interest at 9%, matured September 2006
              
              
              619,000
              
              
              --Note
                  payable to related parties, interest at 12%, matured September
                  2006,
                  secured by intellectual property rights
              
              
              706,000
              
              
              486,000Total
                  notes payable
              
              
              7,286,000
              
              
              5,846,000Less
                  current maturities
              
              
              (4,209,000
              )
              
              (2,084,000
              )Long-Term
                  Note Payable
              
              $
              3,077,000
              
              $
              3,762,000
 
 **4.
        RELATED-PARTY NOTES PAYABLE**
 
 During
        2002, two of the Company’s executive officers (the “Lenders”) sold shares of the
        Company’s Class A common stock owned by them and advanced the resulting proceeds
        amounting to $333,000 to the Company under the terms of a revolving line
        of
        credit and related promissory note. The funds were advanced for use in the
        Company’s operations. The advances bear interest at 12 percent per annum, which
        interest is payable on a semi-annual basis. The entire principal, along with
        unpaid accrued interest and any other unpaid charges or related fees, were
        originally due and payable on June 10, 2003. Fonix and the Lenders have agreed
        to postpone the maturity date on several occasions. The note was due September
        30, 2006. As of November 13, 2006, the Company had not made payment against
        the
        outstanding balance due on the note. All or part of the outstanding balance
        and
        unpaid interest may be converted at the option of the Lenders into shares
        of
        Class A common stock of Fonix at any time. The conversion price was the average
        closing bid price of the shares at the time of the advances. To the extent
        the
        market price of the Company’s shares is below the conversion price at the time
        of conversion, the Lenders are entitled to receive additional shares equal
        to
        the gross dollar value received from the original sale of the shares. The
        Lenders may also receive additional compensation as determined appropriate
        by
        the Board of Directors.
 
 In
        October 2002, the Lenders pledged 30,866 shares of the Company's Class A
        common
        stock to the Equity Line Investor in connection with an advance of $183,000
        to
        the Company under the Third Equity Line. The Equity Line Investor subsequently
        sold the pledged shares and applied $82,000 of the proceeds as a reduction
        of
        the advance. The value of the pledged shares of $82,000 was treated as an
        additional advance from the Lenders.
 
  15
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Condensed Consolidated Financial Statements**
 
 During
        the fourth quarter of 2003, the Company made a principal payment of $26,000
        against the outstanding balance of the promissory note. During 2004, the
        Company
        entered into an agreement with the holders of the promissory note to increase
        the balance of the note payable by $300,000 in exchange for a release of
        the
        $1,443,000 of accrued liabilities related to prior indemnity agreements between
        the Company and the note holders. The Company classified the release of
        $1,143,000 as a capital contribution in the Consolidated Financial Statements
        during the fourth quarter of 2004. The Company made principal payments against
        the note of $253,000 during the year ended December 31, 2004. During the
        year
        ended December 31, 2005, the Company received an additional advance of $50,000
        under the note from the Lenders. The balance due the Lenders at December
        31,
        2005, was $486,000. During the nine months ended September 30, 2006, the
        Company
        received additional advances of $325,000 and made principal payments to the
        Lenders against the note of $105,000. The balance due at September 30, 2006,
        was
        $706,000.
 
 The
        unpaid balance of $706,000 at September 303, 2006, is secured by the Company’s
        assets, including its stock of Fonix Speech. As of September 30, 2006, the
        Lenders had not converted any of the outstanding balance or interest into
        common
        stock.
 
 **5.
        PREFERRED STOCK**
 
 The
        Company’s certificate of incorporation allows for the issuance of preferred
        stock in such series and having such terms and conditions as the Company’s board
        of directors may designate.
 
 ***Series
        A Convertible Preferred Stock*** - As of
        September 30, 2006, there were 166,667 shares of Series A convertible preferred
        stock outstanding. Holders of the Series A convertible preferred stock have
        the
        same voting rights as common stockholders, have the right to elect one person
        to
        the board of directors and are entitled to receive a one time preferential
        dividend of $2.905 per share of Series A convertible preferred stock prior
        to
        the payment of any dividend on any class or series of stock. At the option
        of
        the holders, each share of Series A convertible preferred stock is convertible
        into one share of Class A common stock and in the event that the common stock
        price has equaled or exceeded $10 per share for a 15 day period, the shares
        of
        Series A convertible preferred stock will automatically be converted into
        Class
        A common stock. In the event of liquidation, the holders are entitled to
        a
        liquidating distribution of $36.33 per share and a conversion of Series A
        convertible preferred stock at an amount equal to .0375 shares of common
        stock
        for each share of Series A convertible preferred stock.
 
 ***Series
        H Preferred Stock*** - The
        Company issued 2,000 shares of 5% Series H nonvoting, nonconvertible Preferred
        Stock on February 24, 2004 in connection with the acquisition of LTEL. Dividends
        on the $20,000,000 stated value of the outstanding Series H Preferred Stock
        were
        payable at the rate of 5% per annum as and when declared by the Board of
        Directors. The annual dividend requirement was $1,000,000. If dividends were
        declared on Fonix's common stock, as a condition of that dividend, Fonix
        was
        required to pay three percent of the aggregate amount of such dividend to
        the
        Series H Preferred Stock. Dividends on the Series H Preferred Stock were
        payable
        in cash or, at the option of Fonix, in shares of Class A common stock. The
        Company has accrued for the March 31, 2006, June 30, 2006 and the period
        from
        July 1, 2006 through September 7, 2006 dividend payments under the Series
        H
        Preferred Stock, but has not paid the dividends to the holders of the Series
        H
        Preferred Stock as of the date of this report.
 
 On
        September 7, 2006, the Company entered into an agreement to exchange the
        2,000
        shares of Series H Preferred Stock for shares of the Company’s Series L
        Preferred Stock. (See discussion below under “Series L Preferred Stock.”) As of
        September 30, 2006, no shares of Series H Preferred Stock remained
        outstanding.
 
 ***Series
        J Preferred Stock*** -
        On
        October 6, 2005, the Company entered into a Series J 5% Convertible Preferred
        Stock Exchange Agreement (the "Exchange Agreement") with Southridge Partners,
        LP
        ("Southridge"), a Delaware limited partnership. Pursuant to the Exchange
        Agreement, Southridge exchanged all of the shares of the Company’s Series I
        Preferred Stock that it acquired from The Breckenridge Fund, LLC, for 1,452
        shares of the Company's Series J 5% Convertible Preferred Stock (the "Series
        J
        Preferred Stock").
 
 Because
        the shares of Series J Preferred Stock were issued in exchange for the remaining
        outstanding shares of Series I Preferred Stock, the Company did not receive
        any
        proceeds in connection with the issuance of the Series J Preferred Stock.
        The
        Company issued 1,452 shares of Series J Preferred Stock in exchange for 1,172
        shares of Series I Preferred Stock. Of the 280 additional shares that were
        issued to Southridge, 250 were issued as a placement fee and were accounted
        for
        as selling, general and administrative expense. The remaining 30 shares were
        issued as additional litigation expense and were accounted for as legal
        settlement expense.
 
  16
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Condensed Consolidated Financial Statements**
 
 The
        Series J Preferred Stock entitled Southridge to receive dividends in an amount
        equal to 5% of the then-outstanding balance of shares of Series J Preferred
        Stock. The dividends were payable in cash or shares of the Company's Class
        A
        common stock, at the Company's option.
 
 The
        Series J Preferred Stock was convertible into common stock of the Company
        at the
        option of the holder by using a conversion price which was 90% of the average
        of
        the two (2) lowest closing bid prices for the twenty-day trading period prior
        to
        the conversion date.
 
 For
        the
        year ended December 31, 2005, the Company issued 3,795,918 shares of its
        Class A
        common stock upon conversion of 93 shares of its Series J Preferred Stock.
        For
        the nine months ended September 30, 2006, the Company issued 15,028,249 shares
        of its Class A common stock upon conversion of 266 shares of its Series J
        Preferred Stock. As of September 30, 2006, no shares of Series J Preferred
        Stock
        remained outstanding.
 
 ***Series
        K Preferred Stock*** - On
        February 3, 2006, the Company’s Board of Directors approved the designation and
        issuance of Series K 5% Convertible Preferred Stock (the “Series K Preferred
        Stock”). The Series K Preferred Stock entitled the holder to receive dividends
        in an amount equal to 5% of the stated value of the then-outstanding balance
        of
        shares of Series K Preferred Stock. The dividends were payable in cash or
        shares
        of the Company’s Class A common stock, at the Company’s option.
 
 The
        shares of Series K Preferred Stock were issued pursuant to a Series K 5%
        Convertible Preferred Stock Exchange Agreement (the “Series K Agreement”), in
        connection with which Southridge exchanged 1,093 shares of Series J Convertible
        Preferred Stock for 1,093 shares of Series K Convertible Preferred
        Stock.
 
 The
        Series K Preferred Stock were convertible into common stock of the Company
        at
        the option of the holder by using a conversion price of $0.01 per
        share.
 
 For
        the
        nine months ended September 30, 2006, the Company issued 109,300,000 shares
        of
        its Class A common stock upon conversion of all 1,093 shares of its Series
        K
        Preferred Stock. As of September 30, 2006, no shares of Series K Preferred
        Stock
        remained outstanding.
 
 ***Series
        L Preferred Stock*** - On
        September 7, 2006, the Company entered into a Series L 9% Convertible Preferred
        Stock Exchange Agreement (the "Exchange Agreement") with McCormack and Kenzie
        Financial (“Kenzie”), a British Virgin Islands company. Pursuant to the Exchange
        Agreement, McCormack and Kenzie exchanged all of the shares of Series H
        Preferred Stock that they acquired from sale of LTEL Holdings, for 1,960.8
        and
        39.2 shares, respectively, of the Company's Series L 9% Convertible Preferred
        Stock (the "Series L Preferred Stock").
 
 Because
        the shares of Series L Preferred Stock were issued in exchange for the remaining
        outstanding shares of Series H Preferred Stock, the Company did not receive
        any
        proceeds in connection with the issuance of the Series L Preferred Stock.
 
 The
        Series L Preferred Stock entitles McCormack and Kenzie to receive dividends
        in
        an amount equal to 9% of the then-outstanding balance of shares of Series
        L
        Preferred Stock. The dividends are payable in cash or shares of the Company's
        Class A common stock, at the Company's option.
 
 The
        Series L Preferred Stock is convertible into common stock of the Company
        at the
        option of the holder by using a conversion price which was 80% of the average
        of
        the two (2) lowest closing bid prices for the twenty-day trading period prior
        to
        the conversion date.
 
 Redemption
        of the Series L Preferred Stock, whether at the Company’s option or that of
        McCormack or Kenzie, requires the Company to pay, as a redemption price,
        the
        stated value of the outstanding shares of Series L Preferred Stock to be
        redeemed, together with any accrued but unissued dividends thereon, multiplied
        by one hundred ten percent (110%).
 
  17
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Condensed Consolidated Financial Statements**
 
 In
        connection with the issuance of the Series L Preferred Stock, the Company
        filed
        with the State of Delaware a Certificate of Designation and Series L 9%
        Convertible Stock Terms (the “Series L Terms”), which become a part of the
        Company’s Certificate of Incorporation, as amended.
 
 The
        Company accounted for the exchange as redemption of the outstanding Series
        H
        Preferred Stock as the Series H Preferred Stock was not convertible into
        shares
        of common stock of the Company. The Series L Preferred Stock is convertible
        into
        shares of common stock of the Company. The Company followed the accounting
        treatment in SFAS 150 “ *Accounting
        for Certain Financial Instruments with Characteristics of Both Liabilities
        and
        Equity,”* SFAS
        133
“ *Accounting
        for Derivative Instruments and Hedging Activities”* and
        EITF
        00-19 “ *Accounting
        for Derivative Financial Instruments Indexed to, and Potentially Settled
        in, a
        Company’s Own Stock.”* The
        Company recognized a derivative liability upon the redemption of $30,991,000
        due
        to the value of the conversion feature of the Series L Preferred Stock. The
        liability was calculated using the Black-Scholes valuation model with the
        following assumptions: dividend yield of 0%, expected volatility of 140%,
        risk-free rate of 3.75% and expected life of 4 years. As the value of the
        derivative liability was greater than the face value of the Series L Preferred
        Stock, no value was prescribed to the Series L Preferred Stock. Also in
        connection with the redemption, the Company recognized a preferred stock
        dividend of $16,000,000, equal to the original discount the Company had assigned
        to the Series H Preferred Stock.
 
 For
        the
        nine months ended September 30, 2006, the Company issued 66,334,622 shares
        of
        our Class A common stock in conversion of 27 shares of its Series L Preferred
        Stock. At September 30, 2006, 1,973 shares of Series L Preferred Stock remained
        outstanding. Subsequent to September 30, 2006 and through November 13, 2006,
        the
        Company issued 208,254,171 shares of our Class A common stock in conversion
        of
        59.2 shares of Series L Preferred Stock.
 
 **6.
        EQUITY LINES OF CREDIT**
 
 ***Seventh
        Equity Line of Credit*** - On May
        27, 2005, the Company entered into a seventh private equity line agreement
        (the
“Seventh Equity Line Agreement”) with Queen, LLC (the “Equity Line Investor”).
        Under the Seventh Equity Line Agreement, the Company has the right to draw
        up to
        $20,000,000 against an equity line of credit (“the Seventh Equity Line”) from
        the Equity Line Investor. The Company is entitled under the Seventh Equity
        Line
        Agreement to draw certain funds and to put to the Equity Line Investor shares
        of
        the Company’s Class A common stock in lieu of repayment of the draw. The number
        of shares to be issued is determined by dividing the amount of the draw by
        93%
        of the average of the two lowest closing bid prices of the Company’s Class A
        common stock over the ten trading days after the put notice is tendered.
        The
        Equity Line Investor is required under the Seventh Equity Line Agreement
        to
        tender the funds requested by the Company within two trading days after the
        ten-trading-day period used to determine the market price.
 
 Pursuant
        to the Seventh Equity Line Agreement, the Company granted to the Equity Line
        Investor a right of first refusal (the “Refusal Right”) with respect to
        additional financing transactions. Under the Refusal Right, for a period
        of 180
        days after the effective date of a registration statement filed to register
        resales by the Equity Line Investor, the Company may not offer or sell, with
        certain exceptions, shares of our common stock in a financing transaction
        without first offering that financing transaction to the Equity Line Investor.
        The Equity Line Investor then has the right to choose to offer financing
        to the
        Company on the same terms or to allow the Company to proceed with the financing
        transaction with other investors.
 
 In
        connection with the Seventh Equity Line Agreement, the Company entered into
        an
        agreement with the Equity Line Investor to terminate all previous equity
        lines,
        and cease further draws or issuances of shares in connection with all previous
        equity lines. As such, as of the date of this report, the only active equity
        line of credit was the Seventh Equity Line.
 
 Also
        in
        connection with the Seventh Equity Line Agreement, the Company granted
        registration rights to the Equity Line Investor and has filed three registration
        statements which cover the resales of the shares to be issued under the Seventh
        Equity Line. All of the shares registered by the first registration statement
        had been sold as of October 24, 2005. The second registration statement filed
        in
        connection with the Seventh Equity Line was declared effective by the SEC
        on
        February 10, 2006. All of the shares registered by the second registration
        statement had been sold as of July 26, 2006. The Company filed a third
        registration statement on June 26, 2006, to register additional shares under
        the
        Seventh Equity Line. However, this registration statement has not been declared
        effective the SEC and, based upon its communication with the SEC, the Company
        currently expects that the SEC will not declare the registration statement
        to be
        effective. Accordingly, the Company does not currently have an active
        registration statement filed with the SEC related to the Seventh Equity Line
        and
        is currently unable to draw on the Seventh Equity Line.
 
  18
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Condensed Consolidated Financial Statements**
 
 For
        the
        nine months ended September 30, 2006, the Company received $3,378,000 in
        funds
        drawn under the Seventh Equity Line, less commissions and fees of $114,000.
        The
        Company issued 300,000,000 shares of Class A common stock to the Equity Line
        Investor as puts under the Seventh Equity Line totaling $3,378,000.
 
 **7.
        COMMON STOCK, STOCK OPTIONS AND WARRANTS**
 
 ***Class
        A Common Stock*** - During
        the nine months ended September 30, 2006, 300,000,000 shares of Class A common
        stock were issued in connection with draws on the Seventh Equity Line,
        15,028,249 shares were issued in conversion of 266 shares of Series J Preferred
        Stock, 109,300,000 shares were issued in conversion of 1,093 shares of Series
        K
        Preferred Stock, 2,838,412 shares were issued in payment of dividends on
        Series
        H Preferred Stock and 66,334,621 shares were issued in conversion of 27 shares
        of Series L Preferred Stock.
 
 ***Stock
        Options -*** As of
        September 30, 2006, the Company had a total of 916,705 options to purchase
        Class
        A common stock outstanding. During the six months ended September 30, 2006,
        the
        Company granted options to employees to purchase 58,000 shares of Class A
        common
        stock, none of which were to employees participating in the option exchange
        program. The options have exercise prices ranging from $0.01 to $0.02 per
        share,
        which was the quoted fair market value of the stock on the dates of grant.
        The
        options granted vest over the three years following issuance. Options expire
        within ten years from the date of grant if not exercised. Using the
        Black-Scholes pricing model, the weighted average fair value of the employee
        options was $0.01 per share.
 
 ***Warrants*** - As of
        September 30, 2006, the Company had warrants to purchase a total of 15,000
        shares of Class A common stock outstanding that expire through
        2010.
 
 **8.
        LITIGATION, COMMITMENTS AND CONTINGENCIES**
 
 ***Breckenridge
        Complaint*** - On
        June 6, 2006, The Breckenridge Fund, LP (“Breckenridge”) filed a complaint
        against the Company in the Supreme Court of the State of New York, County
        of
        Nassau (Index No. 009050/06), in connection with a settlement agreement between
        the Company and Breckenridge entered into in September 2005. In the Complaint,
        Breckenridge alleges that Fonix failed to pay certain amounts due under the
        settlement agreement in the amount of $450,000. The Company has denied the
        allegations of Breckenridge’s complaint and has filed for a summary judgment
        motion. The Company intends to vigorously defend itself.
 
 **9.
        SUBSEQUENT EVENTS**
 
 Subsequent
        to September 30, 2006, and through November 13, 2006, the Company received
        conversion notices on its Series L Preferred Stock and issued 208,254,171
        shares
        of its Class A common stock in conversion of 59.2 shares of its Series L
        Preferred Stock.
 
 On
        October 2, 2006, LecStar Telecom Inc., a Georgia corporation (“LecStar
        Telecom”), LecStar DataNet, Inc., a Georgia corporation (“LecStar DataNet”),
        LTEL Holdings Corporation (“LTEL Holdings”), a Delaware corporation, and Fonix
        Telecom Inc., a Delaware corporation (“Fonix Telecom”), each of which are direct
        or indirect subsidiaries of the Company, filed for bankruptcy protection
        in the
        United States Bankruptcy Court for the District of Delaware (the “Bankruptcy
        Court”). The case numbers are as follows: LTEL Holdings Corporation, 06-11081
        (BLS); LecStar Telecom, Inc., 06-11082 (BLS); LecStar DataNet, Inc., 06-11083
        (BLS); Fonix Telecom, Inc., 06-11084 (BLS).)
 
 LecStar
        Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom sought protection
        under Chapter 7 of title 11 of the U.S. Bankruptcy Code, 11 U.S.C ss 101
        et seq.
        (the “Bankruptcy Code”). Pursuant to Bankruptcy Code Section 701, on October 3,
        2006, Alfred Thomas Guliano was appointed the interim trustee for LecStar
        Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom.
 
  19
  **ITEM
                  2.**
              **MANAGEMENT'S
                  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
                  OPERATIONS**
 
 ***This
        report on Form 10-Q contains, in addition to historical information,
        forward-looking statements that involve substantial risks and uncertainties.
        All
        forward-looking statements contained herein are deemed by Fonix to be covered
        by
        and to qualify for the safe harbor protection provided by Section 21E of
        the
        Private Securities Litigation Reform Act of 1995. Actual results could differ
        materially from the results anticipated by Fonix and discussed in the
        forward-looking statements. When used in this report, words such as “believes,”
“expects,” “intends,” “plans,” “anticipates,” “estimates,” and similar
        expressions are intended to identify forward-looking statements, although
        there
        may be certain forward-looking statements not accompanied by such expressions.
        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, 2005. The
        Company disclaims any obligation or intention to update any forward-looking
        statements.***
 
 **To
        date, we have earned only limited revenue from operations and intend to continue
        to rely primarily on financing through the sale of our equity and debt
        securities to satisfy future capital requirements.**
  **Overview**
 
 We
        are
        engaged in providing value-added speech technologies through Fonix Speech,
        Inc.
        (“Fonix Speech”). We offer speech-enabling technologies including automated
        speech recognition (“ASR”) and text-to-speech (“TTS”) through Fonix Speech. We
        offer our speech-enabling technologies to markets for wireless and mobile
        devices, computer telephony, server solutions and personal software for consumer
        applications. We have received various patents for certain elements of our
        core
        technologies and have filed applications for other patents covering various
        aspects of our technologies. We seek to develop relationships and strategic
        alliances with third-party developers and vendors in telecommunications,
        computers, electronic devices and related industries, including producers
        of
        application software, operating systems, computers and microprocessor chips.
        Revenues are generated through licensing of speech-enabling technologies,
        maintenance contracts and services.
 
 We
        previously operated a telecommunications business, the results of which were
        included in prior SEC filings. On October 2, 2006, LecStar Telecom Inc.,
        a
        Georgia corporation (“LecStar Telecom”), LecStar DataNet, Inc., a Georgia
        corporation (“LecStar DataNet”), LTEL Holdings Corporation (“LTEL Holdings”), a
        Delaware corporation, and Fonix Telecom Inc., a Delaware corporation (“Fonix
        Telecom”), each of which are direct or indirect subsidiaries of Fonix, filed for
        bankruptcy protection in the United States Bankruptcy Court for the District
        of
        Delaware (the “Bankruptcy Court”). The case numbers are as follows: LTEL
        Holdings Corporation, 06-11081 (BLS); LecStar Telecom, Inc., 06-11082 (BLS);
        LecStar DataNet, Inc., 06-11083 (BLS); Fonix Telecom, Inc., 06-11084 (BLS).)
 
 LecStar
        Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom sought protection
        under Chapter 7 of title 11 of the U.S. Bankruptcy Code, 11 U.S.C ss 101
        et seq.
        (the “Bankruptcy Code”). Pursuant to Bankruptcy Code Section 701, on October 3,
        2006, Alfred Thomas Guliano was appointed the interim trustee for LecStar
        Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom. As these subsidiary
        companies are now in Chapter 7 Bankruptcy proceedings, the results of their
        operations have not been included in this report.
 
 For
        the
        three months ended September 30, 2006 and 2005, the Company generated revenues
        of $386,000 and $258,000, respectively; and incurred net losses of $4,486,000
        and $3,932,000, respectively. For the nine months ended September 30, 2006
        and
        2005, the Company generated revenues of $1,024,000 and $978,000, respectively,
        incurred net losses of $8,185,000 and $7,244,000, respectively, and had negative
        cash flows from operating activities of $3,581,000 and $6,748,000, respectively.
        As of September 30, 2006, we had an accumulated deficit of $277,001,000,
        negative working capital of $40,145,000, derivative liability of $21,392,000
        related to the issuance of Series L Preferred Stock, a negative investment
        in
        affiliates of $9,571,000 related to the telecom subsidiaries subject to
        bankruptcy (LecStar Telecom, LecStar DataNet, LTEL Holdings and Fonix Telecom),
        accrued liabilities and accrued settlement obligation of $3,103,000, accounts
        payable of $1,403,000 and current portion of notes payable of $4,209,000.
        We
        expect to continue to incur significant losses and negative cash flows from
        operating activities at least through December 31, 2007, primarily due to
        expenditure requirements associated with continued marketing and development
        of
        its speech-enabling technologies.
 
  20
  We
        are
        continually developing new product offerings in the ASR businesses in an
        effort
        to increase our revenue stream, and we are continuing to work with our existing
        customers to increase sales. We have also experienced operating expense
        decreases through headcount reductions and overall cost reduction measures.
        Through the combination of increased recurring revenues and the overall
        operating cost reduction strategies we have implemented, we hope to achieve
        positive cash flow from operations in the next 18-24 months. However, there
        can
        be no assurance that we will be able to achieve positive cash flow from
        operations within this time frame.
 
 Our
        cash
        resources, limited to collections from customers, draws on the Seventh Equity
        Line and loans, have not been sufficient to cover operating expenses. We
        have
        not been declared in default under the terms of any material agreements.
        We
        periodically engage in discussions with various sources of financing to
        facilitate our cash requirements including buyers of both debt and equity
        securities. To date, no additional sources of funding offering terms superior
        to
        those available under equity lines have been implemented, and we rely on
        first,
        cash generated from operations, and second, cash provided through the Seventh
        Equity Line. We will need to generate approximately $6 to $8 million to continue
        operations for the next twelve months .
 
 ***Significant
        Accounting Policies***
 
 The
        discussion and analysis of our financial condition and results of operations
        are
        based upon our consolidated financial statements, which have been prepared
        in
        accordance with accounting principles generally accepted in the United States.
        The preparation of these financial statements requires management to make
        estimates and assumptions that affect the reported amounts of assets and
        liabilities and disclosure of contingent assets and liabilities at the date
        of
        the financial statements and the reported amounts of sales and expenses during
        the reporting period. Significant accounting policies and areas where
        substantial judgments are made by management include:
 
 ***Accounting
        estimates*** **-** The
        preparation of financial statements in conformity with accounting principles
        generally accepted in the United States requires management to make estimates
        and assumptions that affect the reported amounts of assets and liabilities
        and
        the disclosures of contingent assets and liabilities at the date of the
        financial statements, and the reported amounts of revenues and expenses during
        the reporting period. Actual results could differ from those
        estimates.
 
 ***Valuation
        of long-lived assets*** - The
        carrying values of our long-lived assets are reviewed for impairment whenever
        events or changes in circumstances indicate that they may not be recoverable.
        When such an event occurred, we would project undiscounted cash flows to
        be
        generated from the use of the asset and its eventual disposition over the
        remaining life of the asset. If projections were to indicate that the carrying
        value of the long-lived asset would not be recovered, the carrying value
        of the
        long-lived asset, other than software technology, would be reduced by the
        estimated excess of the carrying value over the projected discounted cash
        flows.
 
 ***Goodwill*** -
        Goodwill represents the excess of the cost over the fair value of net assets
        of
        acquired businesses. Goodwill is not amortized, but is tested for impairment
        quarterly or when a triggering event occurs. The testing for impairment requires
        the determination of the fair value of the asset or entity to which the goodwill
        relates (the reporting unit). The fair value of a reporting unit is determined
        based upon a weighting of the quoted market price of our common stock and
        present value techniques based upon estimated future cash flows of the reporting
        unit, considering future revenues, operating costs, the risk-adjusted discount
        rate and other factors. Impairment is indicated if the fair value of the
        reporting unit is allocated to the assets and liabilities of that unit, with
        the
        excess of the fair value of the reporting unit over the amounts assigned
        to its
        assets and liabilities assigned to the fair value of goodwill. The amount
        of
        impairment of goodwill is measured by the excess of the goodwill’s carrying
        value over its fair value.
 
 ***Revenue
        recognition -*** We
        recognize revenue when pervasive evidence of an arrangement exists, services
        have been rendered or products have been delivered, the price to the buyer
        is
        fixed and determinable and collectibility is reasonable assured. Revenues
        are
        recognized by us based on the various types of transactions generating the
        revenue. For software sales, we recognize revenues in accordance with the
        provisions of Statement of Position No. 97-2, “Software Revenue Recognition” and
        related interpretations *.* We
        generate revenues from licensing the rights to its software products to end
        users and from royalties.
 
  21
  For
        Fonix
        Speech, revenue of all types is recognized when acceptance of functionality,
        rights of return, and price protection are confirmed or can be reasonably
        estimated, as appropriate. Revenues from development and consulting services
        are
        recognized on a completed-contract basis when the services are completed
        and
        accepted by the customer. The completed-contract method is used because our
        contracts are typically either short-term in duration or we are unable to
        make
        reasonably dependable estimates of the costs of the contracts. Revenue for
        hardware units delivered is recognized when delivery is verified and collection
        assured.
 
 Revenue
        for products distributed through wholesale and retail channels and through
        resellers is recognized upon verification of final sell-through to end users,
        after consideration of rights of return and price protection. Typically,
        the
        right of return on such products has expired when the end user purchases
        the
        product from the retail outlet. Once the end user opens the package, it is
        not
        returnable unless the medium is defective.
 
 When
        arrangements to license software products do not require significant production,
        modification or customization of software, revenue from licenses and royalties
        are recognized when persuasive evidence of a licensing arrangement exists,
        delivery of the software has occurred, the fee is fixed or determinable,
        and
        collectibility is probable. Post-contract obligations, if any, generally
        consist
        of one year of support including such services as customer calls, bug fixes,
        and
        upgrades. Related revenue is recognized over the period covered by the
        agreement. Revenues from maintenance and support contracts are also recognized
        over the term of the related contracts.
 
 Revenues
        applicable to multiple-element fee arrangements are bifurcated among elements
        such as license agreements and support and upgrade obligations using
        vendor-specific objective evidence of fair value. Such evidence consists
        primarily of pricing of multiple elements as if sold as separate products
        or
        arrangements. These elements vary based upon factors such as the type of
        license, volume of units licensed, and other related factors.
 
 Deferred
        revenue as of September 30, 2006, and December 31, 2005, consisted of the
        following:
  **Description**
                  
                  **Criteria
                      for Recognition**
                  
                  **September
                      30, 2006**
                  
                  **December
                      31, 2005**Deferred
                      unit royalties and license fees
                  
                  Delivery
                      of
                      units to end users or expiration of contract
                  
                  $
                  476,000
                  
                  $
                  466,000
  ***Cost
          of revenues*** **-** Cost of
          revenues from license, royalties, and maintenance consists of costs to
          distribute the product, installation and support personnel compensation,
          amortization and impairment of capitalized speech software costs, licensed
          technology, and other related costs. Cost of service revenues consists
          of
          personnel compensation and other related costs.
 
 ***Software
        Technology Development and Production Costs*** **** -
        All
        costs incurred to establish the technological feasibility of speech software
        technology to be sold, leased, or otherwise marketed are charged to product
        development and research expense. Technological feasibility is established
        when
        a product design and a working model of the software product have been completed
        and confirmed by testing. Costs to produce or purchase software technology
        incurred subsequent to establishing technological feasibility are capitalized.
        Capitalization of software costs ceases when the product is available for
        general release to customers. Costs to perform consulting or development
        services are charged to cost of revenues in the period in which the
        corresponding revenues are recognized. Costs of maintenance and customer
        support
        are charged to expense when related revenue is recognized or when these costs
        are incurred, whichever occurs first.
 
 Capitalized
        software technology costs were amortized on a product-by-product basis.
        Amortization was recognized from the date the product was available for general
        release to customers as the greater of (a) the ratio that current gross revenue
        for a product bears to total current and anticipated future gross revenues
        for
        that product or (b) the straight-line method over the remaining estimated
        economic life of the products. Amortization was charged to cost of
        revenues.
 
 We
        assessed unamortized capitalized software costs for possible write down on
        a
        quarterly basis based on net realizable value of each related product. Net
        realizable value was determined based on the estimated future gross revenues
        from a product reduced by the estimated future cost of completing and disposing
        of the product, including the cost of performing maintenance and customer
        support. The amount by which the unamortized capitalized costs of a software
        product exceeded the net realizable value of that asset was written
        off.
 
  22
  ***Stock-Based
        Employee Compensation***  ***-*** Effective
        January 1, 2006, we adopted Statement of Financial Accounting Standards No.
        123(R), “Share-Based Payment” (“FAS 123(R)”), an amendment of SFAS No. 123,
“Accounting for Stock-Based Compensation,” using the modified prospective
        transition method. Under this transition method, compensation costs are
        recognized beginning with the effective date: (a) based on the requirements
        of
        FAS 123(R) for all share-based awards granted after the effective date and
        (b)
        based on the requirements of FAS 123 for all awards granted to employees
        prior
        to the effective date of FAS 123(R) that remain unvested on the effective
        date.
        Accordingly, we did not restate the results of prior periods. The most notable
        change resulting from the adoption of FAS 123(R)is that compensation expense
        associated with stock options is now recognized in our Statements of Operations,
        rather than being disclosed in a pro forma footnote to our financial statements.
        We recognized compensation expense related to option grants and the vesting
        of
        previously unvested options for the three months ended September 30, 2006,
        of
        $0. For the nine months ended September 30, 2006, we recognized compensation
        expense related to option grants and the vesting of previously unvested options
        of $0.
 
 Prior
        to
        January 1, 2006, we accounted for stock options granted under our Stock Option
        Plans under the recognition and measurement provisions of Accounting Principles
        Board Opinion No. 25, *Accounting
        for Stock Issued to Employees,* and
        related interpretations, as permitted by Statement of Financial Accounting
        Standards No. 123, *Accounting
        for Stock-Based Compensation* .
 
 ***Imputed
        Interest Expense*** -
        Interest is imputed on long-term debt obligations and notes receivable where
        management has determined that the contractual interest rates are below the
        market rate for instruments with similar risk characteristics.
 
 ***Foreign
        Currency Translation*** **-** The
        functional currency of our Korean subsidiary is the South Korean won.
        Consequently, assets and liabilities of the Korean operations are translated
        into United States dollars using current exchange rates at the end of the
        year.
        All revenue is invoiced in South Korean won and revenues and expenses are
        translated into United States dollars using weighted-average exchange rates
        for
        the year.
 
 ***Comprehensive
        Income*** *-* ****** Other
        comprehensive income presented in the accompanying consolidated financial
        statements consists of cumulative foreign currency translation adjustments.
 
 ***Results
        of Operation*** *s*
  **Three
        months ended September 30, 2006, compared with three months ended September
        30,
        2005**
  
 During
        the three months ended September 30, 2006, we recorded revenues of $386,000,
        an
        increase of $128,000 from $258,000 in 2005. The increase was primarily due
        to
        increased licensing revenues of $77,000, increased royalty revenue of $50,000
        and increased retail product sales of $31,000, partially offset by decreased
        non-recurring engineering (“NRE”) speech revenues of $28,000.
 
 Selling,
        general and administrative expenses were $2,024,000 for the three months
        ended
        September 30, 2006, an increase of $614,000 from $1,410,000 in 2005. The
        increase is primarily due to the expense related to fully reserving the
        intercompany receivable we had with our subsidiaries that filed for bankruptcy
        protection of $1,214,000, increased advertising expenses of $8,000 and increased
        occupancy expenses of $7,000, partially offset by decreased other expenses
        of
        $235,000, decreased legal and accounting fees of $159,000, decreased consulting
        expenses of $125,000, decreased travel expenses of $37,000 and decreased
        salary
        and wage expenses of $27,000
 
 We
        incurred research and product development expenses of $551,000 for the three
        months ended September 30, 2006, a decrease of $29,000 from $580,000 in 2005.
        The decrease was primarily due to an overall decrease in consulting expenses
        of
        $45,000 and decreased other expenses of $13,000, partially offset by increased
        salaries and wage-related expenses of $12,000, increased occupancy related
        expenses of $6,000 and increased travel expenses of $8,000.
 
 Net
        interest and other expense was $2,291,000 for the three months ended September
        30, 2006, an increase of $2,192,000 from $99,000 in 2005. The overall increase
        was due to the loss recognized on the redemption of the Series H Preferred
        Stock
        of $10,991,000 and an increase in interest expense of $245,000, combined
        with
        decreased interest income of $106,000 and the gain on forgiveness of liabilities
        of $78,000 recognized in the 2005 period, partially offset by a gain recognized
        on the change in the derivative liability associated with the Series L Preferred
        Stock of $9,228,000.
 
  23
  **Nine
        months ended September 30, 2006, compared with nine months ended September
        30,
        2005**
 
 During
        the nine months ended September 30, 2006, we recorded revenues of $1,024,000,
        an
        increase of $46,000 from $978,000 in 2005. The increase was primarily due
        to
        increased royalty revenues of $138,000 and increased licensing revenues of
        $74,000, partially offset by decreased NRE speech revenues of $146,000 and
        decreased retail product sales of $23,000.
 
 Selling,
        general and administrative expenses were $4,444,000 for the nine months ended
        September 30, 2006, an increase of $688,000 from $3,756,000 in 2005. The
        increase is primarily due to the expense related to fully reserving the
        intercompany receivable we had with our subsidiaries that filed for bankruptcy
        protection of $1,214,000, increased salary and wage expenses of $125,000,
        increased occupancy expenses of $33,000, increased advertising expenses of
        $25,000 and increased travel expenses of $6,000, partially offset by decreased
        legal and accounting fees of $363,000, decreased other expenses of $225,000,
        decreased investor relations related expenses of $75,000 and decreased other
        tax
        expenses of $42,000.
 
 We
        incurred research and product development expenses of $1,711,000 for the
        nine
        months ended September 30, 2006, an increase of $83,000 from $1,628,000 in
        2005.
        The increase was primarily due to an overall increase in salaries and
        wage-related expenses of $116,000, increased travel expense of $17,000 and
        increased occupancy related expenses of $14,000, partially offset by decreased
        other operating expenses of $36,000 and decreased consulting expenses of
        $27,000.
 
 Net
        interest and other expense was $3,042,000 for the nine months ended September
        30, 2006, an increase of $2,319,000 from $723,000 in 2005. The overall increase
        was due to the loss recognized on the redemption of the Series H Preferred
        Stock
        of $10,991,000 and an increase in interest expense of $349,000, combined
        with
        decreased interest income of $112,000 and the gain on forgiveness of liabilities
        of $112,000 recognized in the 2005 period, partially offset by a gain recognized
        on the change in the derivative liability associated with the Series L Preferred
        Stock of $9,228,000.
 
 ***Liquidity
        and Capital Resources***
 
 We
        must
        raise additional funds to be able to satisfy our cash requirements during
        the
        next 12 months. It
        is
        anticipated that we will need to raise approximately $6 to $8 million over
        the
        next 12 months to meet obligations and continue our product development,
        corporate operations and marketing expenses. Because
        we presently have only limited revenue from operations, we intend to continue
        to
        rely primarily on financing through the sale of our equity and debt securities
        to satisfy future capital requirements until such time as we are able to
        enter
        into additional third-party licensing, collaboration, or co-marketing
        arrangements such that we will be able to finance ongoing operations from
        license, royalty, and sales revenue. We
        are
        working with game developers and other potential licensors of our speech
        product
        offerings to develop additional revenue streams for our speech technologies. There
        can
        be no assurance that we will be able to enter into such agreements . Furthermore, the issuance of equity or debt securities which are or may become
        convertible into equity securities of Fonix in connection with such financing
        could result in substantial additional dilution to the stockholders of
        Fonix.
 
 Our
        cash
        resources are limited to collections from customers, proceeds from the issuance
        of preferred stock and loan proceeds, and are only sufficient to cover current
        operating expenses and payments of current liabilities. At September 30,
        2006, we
        had
        negative working capital of $40,145,000, derivative liability of $21,392,000
        related to the issuance of Series L Preferred Stock, a negative investment
        in
        affiliates of $9,571,000 related to the telecom assets subject to bankruptcy,
        accrued liabilities and accrued settlement obligation of $3,103,000, accounts
        payable of $1,403,000 and current portion of notes payable of
        $4,209,000.
 
 We
        had
        $1,024,000 in revenue and a loss of $8,185,000 for the nine months ended
        September 30, 2006. Net cash used in operating activities of $3,581,000 for
        the
        nine months ended September 30, 2006, resulted principally from the net loss
        incurred of $8,185,000, recognized on the derivative liability, increased
        other
        assets of $95,000, increased prepaid expenses of $47,000, and decreased accrued
        payroll of $9,000, partially offset by the loss on derivative liability of
        $1,763,000, the write-down of intercompany receivables of $1,214,000, non-cash
        accretion of the discount on notes payable of $603,000, increased other accrued
        liabilities of $582,000, increased accounts payable of $448,000, non-cash
        accretion of the discount on legal settlement obligation of $98,000,
        depreciation expense of $44,000 and increased deferred revenues of $10,000.
        Net
        cash used in investing activities of $12,000 for the nine months ended September
        30, 2006, consisted of the purchase of equipment of $12,000. Net cash provided
        by financing activities of $3,609,000 consisting primarily of the receipt
        of
        $3,504,000 in cash related to the sale of shares of Class A common stock,
        $325,000 in cash from proceeds from related party notes, proceeds from
        debentures of $250,000 and proceeds from a credit advance of $75,000, partially
        offset by payments on accrued settlement obligation of $440,000 and payments
        on
        related party notes of $105,000.
 
  24
  We
        had
        negative working capital of $40,145,000 at September 30, 2006, compared to
        negative working capital of $15,427,000 at December 31, 2005. Current assets
        increased by $62,000 to $230,000 from $168,000 from December 31, 2005, to
        September 30, 2006. Current liabilities increased by $24,780,000 to $40,375,000
        from $15,595,000 during the same period. The change in working capital from
        December 31, 2005, to September 30, 2006, reflects, in part, the derivative
        liability recognized in connection with the issuance of Series L Preferred
        Stock
        of $21,392,000, increases in current portion of notes payable, accrued
        liabilities and accounts payable, partially offset by decreases in accrued
        settlement obligation due to payments made during the nine months ended
        September 30, 2006. Total assets were $3,042,000 at September 30, 2006, compared
        to $4,131,000 at December 31, 2005.
 
 ***Notes
        Payable - Related Parties***
 
 During
        2002, two of our executive officers (the “Lenders”) sold shares of our Class A
        common stock owned by them and advanced the resulting proceeds amounting
        to
        $333,000 to us under the terms of a revolving line of credit and related
        promissory note. The funds were advanced for use in our operations. The advances
        bear interest at 12 percent per annum, which interest is payable on a
        semi-annual basis. The entire principal, along with unpaid accrued interest
        and
        any other unpaid charges or related fees, were originally due and payable
        on
        June 10, 2003. Fonix and the Lenders have agreed to postpone the maturity
        date
        on several occasions. The note was due September 30, 2006. As of November
        13,
        2006, we had not made payment against the outstanding balance due on the
        note.
        All or part of the outstanding balance and unpaid interest may be converted
        at
        the option of the Lenders into shares of Class A common stock of Fonix at
        any
        time. The conversion price was the average closing bid price of the shares
        at
        the time of the advances. To the extent the market price of our shares is
        below
        the conversion price at the time of conversion, the Lenders are entitled
        to
        receive additional shares equal to the gross dollar value received from the
        original sale of the shares. The Lenders may also receive additional
        compensation as determined appropriate by the Board of Directors.
 
 In
        October 2002, the Lenders pledged 30,866 shares of the Company's Class A
        common
        stock to the Equity Line Investor in connection with an advance of $183,000
        to
        us under the Third Equity Line. The Equity Line Investor subsequently sold
        the
        pledged shares and applied $82,000 of the proceeds as a reduction of the
        advance. The value of the pledged shares of $82,000 was treated as an additional
        advance from the Lenders.
 
 During
        the fourth quarter of 2003, we made a principal payment of $26,000 against
        the
        outstanding balance of the promissory note. During 2004, we entered into
        an
        agreement with the holders of the promissory note to increase the balance
        of the
        note payable by $300,000 in exchange for a release of the $1,443,000 of accrued
        liabilities related to prior indemnity agreements between us and the note
        holders. We classified the release of $1,143,000 as a capital contribution
        in
        the Consolidated Financial Statements during the fourth quarter of 2004.
        We made
        principal payments against the note of $253,000 during the year ended December
        31, 2004. During the year ended December 31, 2005, we received an additional
        advance of $50,000 under the note from the Lenders. The balance due the Lenders
        at December 31, 2005 was $486,000. During the nine months ended September
        30,
        2006 we received additional advances of $325,000 and made principal payments
        to
        the Lenders against the note of $105,000. The balance due at September 30,
        2006
        was $706,000.
 
 The
        unpaid balance of $706,000 at September 30, 2006, is secured by our assets,
        including our stock of Fonix Speech. As of September 30, 2006, the Lenders
        had
        not converted any of the outstanding balance or interest into common
        stock.
 
  25
  ***Notes
        Payable***
 
 In
        connection with the acquisition of the capital stock of LTEL Holdings in
        2004,
        we issued a 5%, $10,000,000, secured, six-year note (the “Note”) payable to
        McCormack Avenue, Ltd. (“McCormack”). Under the terms of the Note, quarterly
        interest only payments were required through January 15, 2005, with quarterly
        principal and interest payments beginning April 2005 and continuing through
        January 2010. Interest on the Note is payable in cash or, at our option,
        in
        shares of our Class A common stock. The Note is secured by the capital stock
        and
        all of the assets of LTEL Holdings and its subsidiaries. The Note was valued
        at
        $4,624,000 based on an imputed interest rate of 25 percent per annum.
 
 The
        discount on the Note is based on an imputed interest rate of 25%. The carrying
        amount of the Note of $5,312,000 at September 30, 2006, was net of unamortized
        discount of $3,421,000. As of November 13, 2006, we had not made any scheduled
        payments for 2006.
 
 On
        September 8, 2006, we received a default notice (the “Default Notice”) from
        McCormack in respect of the Note. Under the terms of the Note, and a related
        Security Agreement between us and McCormack dated February 24, 2004 (the
        “Security Agreement”), McCormack may declare all liabilities, indebtedness, and
        obligations of Fonix to McCormack under the Security Agreement and the Note
        immediately due and owing upon an event of default. The Note defines an event
        of
        default to include the non-payment by us of a scheduled payment which is
        not
        cured within 60 days .
 
 In
        the
        Default Notice, McCormack stated that it intended to exercise its rights,
        including any and all rights set forth in the Note as amended.
 
 Also
        on
        September 8, 2006, McCormack provided to us a Notice of Sale, stating
        McCormack’s intention to sell at public auction all of the collateral referred
        to in the Security Agreement, consisting of the capital stock and assets
        of
        LecStar Telecom, LecStar DataNet and LTEL Holdings. To date, no sale of the
        assets or capital stock of LecStar Telecom, LecStar DataNet nor LTEL Holdings
        has occurred.
 
 McCormack
        has notified us that notwithstanding the Series L Exchange Agreement between
        us
        and McCormack discussed above, McCormack has not waived any of its rights
        in
        connection with the Note, the Modification Agreement, the Security Agreement,
        or
        the Supplemental Security Agreement.
 
 During
        2005, we entered into two promissory notes with an unrelated third party
        in the
        aggregate amount of $650,000. These notes accrue interest at 10% annually
        and
        were due and payable during May and June of 2006. As of November 13, 2006,
        we
        had not made the scheduled payments on these promissory notes; the holder
        of the
        notes has not declared a default under the notes.
 
 During
        the third quarter of 2006, we entered into a debenture agreement with an
        unrelated third party for $619,000. The debenture accrues interest at 9%
        annually and was due and payable on September 30, 2006. As of November 13,
        2006,
        we had not made payment on the debenture; the holder of the debenture has
        not
        declared a default under the debenture.
 
 ***S*** ***eventh
        Equity Line of Credit***
 
 On
        May
        27, 2005, we entered into a seventh private equity line agreement (the “Seventh
        Equity Line Agreement”) with Queen, LLC (the “Equity Line Investor”). Under the
        Seventh Equity Line Agreement, we have the right to draw up to $20,000,000
        against an equity line of credit (“the Seventh Equity Line”) from the Equity
        Line Investor. We are entitled under the Seventh Equity Line Agreement to
        draw
        certain funds and to put to the Equity Line Investor shares of our Class
        A
        common stock in lieu of repayment of the draw. The number of shares to be
        issued
        is determined by dividing the amount of the draw by 93% of the average of
        the
        two lowest closing bid prices of our Class A common stock over the ten trading
        days after the put notice is tendered. The Equity Line Investor is required
        under the Seventh Equity Line Agreement to tender the funds requested by
        us
        within two trading days after the ten-trading-day period used to determine
        the
        market price.
 
  26
  Pursuant
        to the Seventh Equity Line Agreement, we granted to the Equity Line Investor
        a
        right of first refusal (the “Refusal Right”) with respect to additional
        financing transactions. Under the Refusal Right, for a period of 180 days
        after
        the effective date of a registration statement filed to register resales
        by the
        Equity Line Investor, we may not offer or sell, with certain exceptions,
        shares
        of our common stock in a financing transaction without first offering that
        financing transaction to the Equity Line Investor. The Equity Line Investor
        then
        has the right to choose to offer financing to us on the same terms or to
        allow
        us to proceed with the financing transaction with other investors.
 
 In
        connection with the Seventh Equity Line Agreement, we entered into an agreement
        with the Equity Line Investor to terminate all previous equity lines, and
        cease
        further draws or issuances of shares in connection with all previous equity
        lines. As such, as of the date of this report, the only active equity line
        of
        credit was the Seventh Equity Line.
 
 Also
        in
        connection with the Seventh Equity Line Agreement, we granted registration
        rights to the Equity Line Investor and have filed three registration statements
        which cover the resales of the shares to be issued under the Seventh Equity
        Line. All of the shares registered by the first registration statement had
        been
        sold as of October 24, 2005. The second registration statement filed in
        connection with the Seventh Equity Line was declared effective by the SEC
        on
        February 10, 2006. All of the shares registered by the second registration
        statement had been sold as of July 26, 2006. We filed a third registration
        statement on June 26, 2006, to register additional shares under the Seventh
        Equity Line. However, this registration statement has not been declared
        effective by the SEC and, based upon our communication with the SEC, we
        currently expect that the SEC will not declare the registration statement
        to be
        effective. Accordingly, we do not currently have an active registration
        statement filed with the SEC related to the Seventh Equity Line and we are
        currently unable to draw on the Seventh Equity Line.
 
 For
        the
        nine months ended September 30, 2006, we received $3,378,000 in funds drawn
        under the Seventh Equity Line, less commissions and fees of $114,000. We
        issued
        300,000,000 shares of Class A common stock to the Equity Line Investor as
        puts
        under the Seventh Equity Line totaling $3,378,000.
 
 ***Series
        H Preferred Stock***
 
 We
        issued
        2,000 shares of 5% Series H nonvoting, nonconvertible Preferred Stock on
        February 24, 2004 in connection with the acquisition of LTEL. Dividends on
        the
        $20,000,000 stated value of the outstanding Series H Preferred Stock were
        payable at the rate of 5% per annum as and when declared by the Board of
        Directors. The annual dividend requirement was $1,000,000. If dividends were
        declared on Fonix's common stock, as a condition of that dividend, Fonix
        was
        required to pay three percent of the aggregate amount of such dividend to
        the
        Series H Preferred Stock. Dividends on the Series H Preferred Stock were
        payable
        in cash or, at the option of Fonix, in shares of Class A common stock. We
        have
        accrued for the March 31, 2006, June 30, 2006 and the period from July 1,
        2006
        through September 7, 2006 dividend payments under the Series H Preferred
        Stock,
        but have not paid the dividends to the holders of the Series H Preferred
        Stock
        as of the date of this report.
 
 On
        September 7, 2006, we entered into an agreement to exchange the 2,000 shares
        of
        Series H Preferred Stock for shares of our Series L Preferred Stock. (See
        discussion below under “Series L Preferred Stock.”) As of September 30, 2006, no
        shares of Series H Preferred Stock remained outstanding.
 
 ***Series
        J Preferred Stock***
 
 On
        October 6, 2005, we entered into a Series J 5% Convertible Preferred Stock
        Exchange Agreement (the "Exchange Agreement") with Southridge Partners, LP
        ("Southridge"), a Delaware limited partnership. Pursuant to the Exchange
        Agreement, Southridge exchanged all of the shares of our Series I Preferred
        Stock that it acquired from The Breckenridge Fund, LLC, for 1,452 shares
        of our
        Series J 5% Convertible Preferred Stock (the "Series J Preferred
        Stock").
 
 Because
        the shares of Series J Preferred Stock were issued in exchange for the remaining
        outstanding shares of Series I Preferred Stock, we did not receive any proceeds
        in connection with the issuance of the Series J Preferred Stock. We issued
        1,452
        shares of Series J Preferred Stock in exchange for 1,172 shares of Series
        I
        Preferred Stock. Of the 280 additional shares that were issued to Southridge,
        250 were issued as a placement fee and were accounted for as selling, general
        and administrative expense. The remaining 30 shares were issued as additional
        litigation expense and were accounted for as legal settlement
        expense.
 
  27
  The
        Series J Preferred Stock entitled Southridge to receive dividends in an amount
        equal to 5% of the then-outstanding balance of shares of Series J Preferred
        Stock. The dividends were payable in cash or shares of the Company's Class
        A
        common stock, at our option.
 
 The
        Series J Preferred Stock was convertible into common stock of Fonix at the
        option of the holder by using a conversion price which was 90% of the average
        of
        the two (2) lowest closing bid prices for the twenty-day trading period prior
        to
        the conversion date.
 
 For
        the
        year ended December 31, 2005, the Company issued 3,795,918 shares of its
        Class A
        common stock upon conversion of 93 shares of its Series J Preferred Stock.
        For
        the nine months ended September 30, 2006, we issued 15,028,249 shares of
        its
        Class A common stock upon conversion of 266 shares of its Series J Preferred
        Stock. At September 30, 2006, no shares of Series J Preferred Stock remained
        outstanding.
 
 ***Series
        K Preferred Stock***
 
 On
        February 3, 2006, the Company’s Board of Directors approved the designation and
        issuance of Series K 5% Convertible Preferred Stock (the “Series K Preferred
        Stock”). The Series K Preferred Stock entitles the holder to receive dividends
        in an amount equal to 5% of the stated value of the then-outstanding balance
        of
        shares of Series K Preferred Stock. The dividends are payable in cash or
        shares
        of our Class A common stock, at our option.
 
 The
        shares of Series K Preferred Stock were issued pursuant to a Series K 5%
        Convertible Preferred Stock Exchange Agreement (the “Series K Agreement”), in
        connection with which Southridge exchanged 1,093 shares of Series J Convertible
        Preferred Stock for 1,093 shares of Series K Convertible Preferred
        Stock.
 
 The
        Series K Preferred Stock were convertible into shares of our Class A common
        stock at the option of the holder by using a conversion price of $0.01 per
        share.
 
 For
        the
        nine months ended September 30, 2006, we issued 109,300,000 shares of its
        Class
        A common stock upon conversion of 1,093 shares of our Series K Preferred
        Stock.
        At September 30, 2006, no shares of Series J Preferred Stock remained
        outstanding.
 
 ***Series
        L Preferred Stock***
 
 On
        September 7, 2006, we entered into a Series L 9% Convertible Preferred Stock
        Exchange Agreement (the "Exchange Agreement") with McCormack and Kenzie
        Financial (“Kenzie”), a British Virgin Islands company. Pursuant to the Exchange
        Agreement, McCormack and Kenzie exchanged all of the shares of Series H
        Preferred Stock that they acquired from sale of LTEL Holdings, for 1,960.8
        and
        39.2 shares, respectively, of our Series L 9% Convertible Preferred Stock
        (the
        "Series L Preferred Stock").
 
 Because
        the shares of Series L Preferred Stock were issued in exchange for the remaining
        outstanding shares of Series H Preferred Stock, we did not receive any proceeds
        in connection with the issuance of the Series L Preferred Stock.
 
 The
        Series J Preferred Stock entitles McCormack and Kenzie to receive dividends
        in
        an amount equal to 9% of the then-outstanding balance of shares of Series
        L
        Preferred Stock. The dividends are payable in cash or shares of our Class
        A
        common stock, at our option.
 
 The
        Series L Preferred Stock is convertible into common stock of Fonix at the
        option
        of the holder by using a conversion price which was 80% of the average of
        the
        two (2) lowest closing bid prices for the twenty-day trading period prior
        to the
        conversion date.
 
 Redemption
        of the Series L Preferred Stock, whether at the Company’s option or that of
        McCormack or Kenzie, requires us to pay, as a redemption price, the stated
        value
        of the outstanding shares of Series L Preferred Stock to be redeemed, together
        with any accrued but unissued dividends thereon, multiplied by one hundred
        ten
        percent (110%).
 
  28
  In
        connection with the issuance of the Series L Preferred Stock, we filed with
        the
        State of Delaware a Certificate of Designation and Series L 9% Convertible
        Stock
        Terms (the “Series L Terms”), which become a part of our Certificate of
        Incorporation, as amended.
 
 We
        accounted for the exchange as redemption of the outstanding Series H Preferred
        Stock as the Series H Preferred Stock was not convertible into shares of
        common
        stock of Fonix. The Series L Preferred Stock is convertible into shares of
        common stock of Fonix. We followed the accounting treatment in SFAS 150
“ *Accounting
        for Certain Financial Instruments with Characteristics of Both Liabilities
        and
        Equity,”* SFAS
        133
“ *Accounting
        for Derivative Instruments and Hedging Activities”* and
        EITF
        00-19 “ *Accounting
        for Derivative Financial Instruments Indexed to, and Potentially Settled
        in, a
        Company’s Own Stock.”* We
        recognized a derivative liability upon the redemption of $30,991,000 due
        to the
        value of the conversion feature of the Series L Preferred Stock. The liability
        was calculated using the Black-Scholes valuation model. As the value of the
        derivative liability was greater than the face value of the Series L Preferred
        Stock, no value was prescribed to the Series L Preferred Stock. Also in
        connection with the redemption, the Company recognized a preferred stock
        dividend of $16,000,000, equal to the original discount we had assigned to
        the
        Series H Preferred Stock.
 
 For
        the
        nine months ended September 30, 2006, we issued 66,334,622 shares of its
        Class A
        common stock in conversion of 27 shares of its Series L Preferred Stock.
        At
        September 30, 2006, 1,973 shares of Series L Preferred Stock remained
        outstanding. Subsequent to September 30, 2006 and through November 13, 2006,
        we
        issued 208,254,171 shares of our Class A common stock in conversion of 59.2
        shares of our Series L Preferred Stock.
 
 ***Stock
        Options and Warrants*** ****
 
 ****** During
        the nine months ended September 30, 2006, we granted options to employees
        to
        purchase 58,000 shares of Class A common stock. The options have an exercise
        prices ranging from $0.01 to $0.02 per share, which was the quoted fair market
        value of the stock on the dates of grant. The options granted vest over the
        three years following issuance. Options expire within ten years from the
        date of
        grant if not exercised. Using the Black-Scholes pricing model, the weighted
        average fair value of the employee options was $0.01 per share. As of September
        30, 2006, we had a total of 916,705 options to purchase Class A common stock
        outstanding.
 
 As
        of
        September 30, 2006, we had warrants to purchase a total of 15,000 shares
        of
        Class A common stock outstanding that expire through 2010.
 
 **Other**
 
 We
        presently have no plans to purchase new research and development or office
        facilities.
 
 **Outlook**
 
 Fonix’s focus
        on
        providing competitive and value-added solutions for customers and partners
        requires a broad set of technologies, service offerings and channel
        capabilities. Management anticipates and expects further development of
        complementary technologies, added product and application developments, access
        to market channels and additional opportunities for strategic alliances in
        other
        industry segments.
 
 We
        will
        continue to leverage our research and development of speech technologies
        to
        deliver software applications and engines to device manufacturers looking
        to
        incorporate speech interfaces into end-user products. Fonix Speech’s
        award-wining technologies provide competitive embedded speech solutions for
        mobile/wireless devices, videogames, telephony systems and products for the
        assistive market based on Fonix’s proprietary and patented TTS and ASR
        technologies.
 
 As
        we
        proceed to implement our strategy and to reach our objectives, we anticipate
        further development of complementary technologies, added product and
        applications development expertise, access to market channels and additional
        opportunities for strategic alliances in other industry segments. The strategy
        adopted by us has significant risks, and shareholders and others interested
        in
        Fonix and our Class A common stock should carefully consider the risks set
        forth
        below and under the heading “Certain Significant Risk Factors” in Item 1, Part
        I, of our Annual Report on Form 10-K for the year ended December 31,
        2005.
 
  29
  As
        noted
        above, as of September 30, 2006, we had an accumulated deficit of $277,001,000,
        negative working capital of $40,145,000 ,
        derivative liability of $21,392,000 related to the issuance of Series L
        Preferred Stock, a negative investment in affiliates of $9,571,000 related
        to
        the telecom assets (LecStar Telecom, LecStar DataNet, LTEL Holdings and Fonix
        Telecom) subject to bankruptcy, accrued liabilities and accrued settlement
        obligation of $3,103,000, accounts payable of $1,403,000 and current portion
        of
        notes payable of $4,209,000. Sales of
        products and revenue from licenses based on our technologies have not been
        sufficient to finance ongoing operations. These matters raise substantial
        doubt
        about our ability to continue as a going concern. Our continued existence
        is
        dependent upon several factors, including our success in (1) increasing speech
        license, royalty and services revenues, (2) raising sufficient additional
        funding, and (3) minimizing operating costs. Until sufficient revenues are
        generated from operating activities, we expected to continue to fund our
        operations through debt instruments. We are currently pursuing additional
        sources of liquidity in the form of traditional commercial credit, asset
        based
        lending, or additional sales of our equity securities to finance our ongoing
        operations. Additionally, we are pursuing other types of commercial and private
        financing, which could involve sales of our assets or sales of one or more
        operating divisions. Our sales and financial condition have been adversely
        affected by our reduced credit availability and lack of access to alternate
        financing because of our significant ongoing losses and increasing liabilities
        and payables. As we have noted in our annual report and other public filings,
        if
        additional financing is not obtained in the near future, we will be required
        to
        more significantly curtail our operations or seek protection under bankruptcy
        laws.
 
 **Information
        Concerning Forward-Looking Statements**
 
 Certain
        of the statements contained in this report (other than the historical financial
        data and other statements of historical fact) are forward-looking statements.
        These statements include, but are not limited to our expectations with respect
        to the development of a diversified revenue base; delivery of our VoiceDial
        application; the market volume of educational electronic dictionary devices;
        our
        ability to capitalize in markets including toys, appliances, and other devices;
        the market demand for videogames; our growth strategies and the implementation
        of our Core Technologies and potential results; our payment of dividends
        on our
        common stock; our ability to meet customer demand for speech technologies
        and
        solutions; development of complementary technologies, products, marketing,
        and
        strategic alliance opportunities; profitability of language learning tools;
        the
        status of traditional operator systems; our ability to continue operations
        in
        the event we do not receive approval to amend our articles of incorporation;
        the
        comparability of our speech-enabled Speech Products to other products; our
        intentions with respect to strategic collaborations and marketing arrangements;
        our intentions with respect to use of licenses; our plans with respect to
        development and acquisition of speech solutions; our goals with respect to
        supplying speech solutions for OEMs; our expectations with respect to continued
        financial losses; and our intentions with respect to financing our operations
        in
        the future. Additional forward-looking statements may be found in the “Certain
        Significant Risk Factors” Section of our Annual Report on Form 10-K for the year
        ended December 31, 2005, together with accompanying explanations of the
        potential risks associated with such statements.
 
 Forward-looking
        statements made in this report, are made based upon management’s good faith
        expectations and beliefs concerning future developments and their potential
        effect upon Fonix. There can be no assurance that future developments will
        be in
        accordance with such expectations, or that the effect of future developments
        on
        Fonix will be those anticipated by management. Forward-looking statements
        may be
        identified by the use of words such as “believe,” “expect,” “plans,” “strategy,”
“prospects,” “estimate,” “project,” “anticipate,” “intends” and other words of
        similar meaning in connection with a discussion of future operating or financial
        performance.
 
 You
        are
        cautioned not to place undue reliance on these forward looking statements,
        which
        are current only as of the date of this Report. We disclaim any intention
        or
        obligation to update or revise any forward-looking statements, whether as
        a
        result of new information, future events, or otherwise. Many important factors
        could cause actual results to differ materially from management’s expectations,
        including those listed in the “Certain Significant Risk Factors” Section of our
        2005 Annual Report on Form 10-K, as well as the following:
 
 •
              unpredictable
                  difficulties or delays in the development of new products and
                  technologies;
 
 •
              changes
                  in U.S. or international economic conditions, such as inflation,
                  interest
                  rate fluctuations, foreign exchange rate fluctuations or recessions
                  in
                  Fonix's markets;
 
  30
  •
              pricing
                  changes to our supplies or products or those of our competitors,
                  and other
                  competitive pressures on pricing and
                  sales;
 
 •
              difficulties
                  in obtaining or retaining the management, engineering, and other
                  human
                  resource competencies that we need to achieve our business
                  objectives;
 
 •
              the
                  impact on Fonix or a subsidiary from the loss of a significant
                  customer or
                  a significant number of customers;
 
 •
              risks
                  generally relating to our international operations, including
                  governmental, regulatory or political
                  changes;
 
 •
              transactions
                  or other events affecting the need for, timing and extent of our
                  capital
                  expenditures; and
 
 •
              the
                  extent to which we reduce outstanding
                  debt.
 
 **Item
                  3.**
              **Quantitative
                  and Qualitative Disclosures About Market
                  Risk**
 
 **Foreign
        Currency Exposure**
 
 To
        date,
        all of our revenues have been denominated in United States dollars and received
        primarily from customers in the United States. Our exposure to foreign currency
        exchange rate changes has been insignificant. We expect, however, that future
        product license and services revenue may also be derived from international
        markets and may be denominated in the currency of the applicable market.
        As a
        result, operating results may become subject to significant fluctuations
        based
        upon changes in the exchange rate of certain currencies in relation to the
        U.S.
        dollar. Furthermore, to the extent that we engage in international sales
        denominated in U.S. dollars, an increase in the value of the U.S. dollar
        relative to foreign currencies could make our products less competitive in
        international markets. Although we will continue to monitor our exposure
        to
        currency fluctuations, we cannot assure that exchange rate fluctuations will
        not
        adversely affect financial results in the future.
 
 **Item
                  4.**
              **Controls
                  and Procedures**
 
 Evaluation
        of Disclosure Controls and Procedures .
        Our
        Chief Executive Officer and our Chief Financial Officer, after evaluating
        the
        effectiveness of the Company’s “disclosure controls and procedures” (as defined
        in the Securities Exchange Act of 1934 (Exchange Act) Rules 13a-15(e) or
        15d-15(e)) as of the end of the period covered by this quarterly report,
        have
        concluded that our disclosure controls and procedures are effective based
        on
        their evaluation of these controls and procedures required by paragraph (b)
        of
        Exchange Act Rules 13a-15 or 15d-15.
 
 Changes
        in Internal Control Over Financial Reporting .
        There
        were no changes in our internal control over financial reporting identified
        in
        connection with the evaluation required by paragraph (d) of Exchange Act
        Rules
        13a-15 or 15d-15 that occurred during our last fiscal quarter that have
        materially affected, or are reasonably likely to materially affect, our internal
        control over financial reporting.
 
 Section
        404 Assessment .
        Section
        404 of the Sarbanes-Oxley Act of 2002 requires management’s annual review and
        evaluation of our internal controls, and an attestation of the effectiveness
        of
        these controls by our independent registered public accounting firm beginning
        with our Form 10-K for the fiscal year ending on December 31, 2007. We are
        dedicating significant resources, including management time and effort, and
        incurring substantial costs in connection with our ongoing Section 404
        assessment. We are currently documenting and testing our internal controls
        and
        considering whether any improvements are necessary for maintaining an effective
        control environment at our company. The evaluation of our internal controls
        is
        being conducted under the direction of our senior management. In addition,
        our
        management is regularly discussing the results of our testing and any proposed
        improvements to our control environment with our Audit Committee. We will
        continue to work to improve our controls and procedures, and to educate and
        train our employees on our existing controls and procedures in connection
        with
        our efforts to maintain an effective controls infrastructure at our
        Company.
 
  31
  Limitations
        on Effectiveness of Controls .
        A
        system of controls, however well designed and operated, can provide only
        reasonable, and not absolute, assurance that the system will meet its
        objectives. The design of a control system is based, in part, upon the benefits
        of the control system relative to its costs. Control systems can be circumvented
        by the individual acts of some persons, by collusion of two or more people,
        or
        by management override of the control. In addition, over time, controls may
        become inadequate because of changes in conditions, or the degree of compliance
        with the policies or procedures may deteriorate. In addition, the design
        of any
        control system is based in part upon assumptions about the likelihood of
        future
        events.
 
 **PART
        II - OTHER INFORMATION**
 
 **Item
                  1.**
              **Legal
                  Proceedings**
 
 ***Breckenridge
        Complaint*** - On
        June 6, 2006, The Breckenridge Fund, LP (“Breckenridge”) filed a complaint
        against the Company in the Supreme Court of the State of New York, County
        of
        Nassau (Index No. 009050/06), in connection with a settlement agreement between
        the Company and Breckenridge entered into in September 2005.  In the
        Complaint, Breckenridge alleges that Fonix failed to pay certain amounts
        due
        under the settlement agreement in the amount of $450,000. We have denied
        the
        allegations of Breckenridge’s complaint. We have filed for a motion of summary
        judgment. The Company intends to vigorously defend itself.
 
 **Item
                  1A.**
              **Risk
                  Factors**
 
 We
        attempt to identify, manage and mitigate the risks and uncertainties associated
        with our business to the extent practical. However, some level of risk and
        uncertainty will always be present. The section of our Annual Report on Form
        10-K for the fiscal year ended December 31, 2005, entitled “Certain Significant
        Risk Factors” describes some of the risks and uncertainties associated with our
        business. These risks and uncertainties have the potential to materially
        affect
        our business, financial condition, results of operations, cash flows, projected
        results and future prospects. We have revised the following risk factors
        which
        were previously disclosed in our Annual Report on Form 10-K for the fiscal
        year
        ended December 31, 2005.
 
 **Our
        substantial and continuing losses since inception, coupled with significant
        ongoing operating expenses, raise doubt about our ability to continue as
        a going
        concern.**
 
 Since
        inception, we have sustained substantial losses. Such losses continue due
        to
        ongoing operating expenses and a lack of revenues sufficient to offset operating
        expenses. We have raised capital to fund ongoing operations by private sales
        of
        our securities, some of which sales have been highly dilutive and involve
        considerable expense. In our present circumstances, there is substantial
        doubt
        about our ability to continue as a going concern absent significant sales
        of our
        products and telecommunication services, substantial revenues from new licensing
        or co-development contracts, or continuing large sales of our
        securities.
 
 We
        incurred net losses of $22,631,000, $15,148,000 and $13,543,000 for the years
        ended December 31, 2005, 2004 and 2003, respectively. We incurred a net loss
        of
        $4,486,000 for the three months ended September 30, 2006 and $8,185,000 for
        the
        nine months ended September 30, 2006. As of September 30, 2006, we had an
        accumulated deficit of $277,001,000, negative working capital of $40,145,000,
        derivative liability of $21,392,000 related to the issuance of Series L
        Preferred Stock, a negative investment in affiliates of $9,571,000 related
        to
        the telecom assets subject to bankruptcy, accrued liabilities and accrued
        settlement obligation of $3,103,000, accounts payable of $1,403,000 and current
        portion of notes payable of $4,209,000.
 
 We
        expect
        to continue to spend significant amounts to enhance our Speech Products and
        technologies and fund further Product development. As a result, we will need
        to
        generate significant additional revenue to achieve profitability. Even if
        we do
        achieve profitability, we may not be able to sustain or increase profitability
        on a quarterly or annual basis. If we do not achieve and maintain profitability,
        the market price for our common stock may further decline, perhaps
        substantially, and we may have to curtail or cease our operations.
 
 **Continuing
        debt obligations could impair our ability to continue as a going
        concern.**
 
 As
        of
        September 30, 2006, we had debt obligations of $7,286,000, accrued liabilities
        and accrued settlement obligation of $3,103,000 and vendor accounts payable
        of
        approximately $1,403,000. At present, our revenues from existing licensing
        arrangements and Speech Product sales are not sufficient to offset our ongoing
        operating expenses or to pay in full our current debt obligations.
 
  32
  There
        is
        substantial risk, therefore, that the existence and extent of the debt
        obligations described above could adversely affect our business, operations
        and
        financial condition, and we may be forced to curtail our operations, sell
        part
        or all of our assets, or seek protection under bankruptcy laws. Additionally,
        there is substantial risk that the current or former employees or our vendors
        could bring lawsuits to collect the unpaid amounts. In the event of lawsuits
        of
        this type, if we are unable to negotiate settlements or satisfy our obligations,
        we could be forced into bankruptcy.
 
 **We
        currently do not have access to the Seventh Equity Line or other equity lines
        of
        credit, which could have a material adverse effect on our ability to continue
        operations.**
 
 Since
        2000, we have relied substantially on equity lines of credit for financing
        our
        operations. Pursuant to these equity lines, we historically have drawn funds
        against the equity line and put shares of our Class A common stock to the
        equity
        line investor in repayment of the draws. Under current SEC regulations and
        interpretations by SEC staff members, it appears that we will no longer have
        access to the Seventh Equity Line of Credit or similar financing arrangements.
        Although we are seeking to negotiate additional financing sources and reviewing
        our options, there can be no guarantee that we will be able to enter into
        arrangements for financing that will be on terms that will be satisfactory
        to
        us. Any inability to enter into new financing arrangements could have a material
        adverse impact on our ability to continue our operations, and we may be required
        to seek protection under the bankruptcy laws.
 
 **Item
                  2.**
              **Unregistered
                  Sales of Equity Securities and Use of
                  Proceeds**
 
 During
        the nine months ended September 30, 2006, we issued 300,000,000 shares of
        our
        common stock under the Seventh Equity Line to the Equity Line Investor in
        connection with draws of $3,378,000. We issued 15,028,249 shares of our common
        stock in connection with conversions of our Series J Preferred Stock for
        which
        we received no proceeds. We issued 109,300,000 shares of our common stock
        in
        connection with conversions of our Series K Preferred Stock for which we
        received no proceeds. We issued 2,838,412 shares of our common stock in payment
        of $65,000 in dividends on our Series H Preferred Stock. We issued 66,334,621
        shares of our common stock in connection with conversions of our Series L
        Preferred Stock for which we received no proceeds. Subsequent to September
        30,
        2006 and through November 13, 2006, we issued 208,254,171 shares of our common
        stock in connection with conversions of our Series L Preferred Stock. The
        shares
        of common stock were issued without registration under the 1933 Act in reliance
        on Section 4(2) of the 1933 Act and the rules and regulations promulgated
        thereunder.
 
 The
        resales of the shares issued in connection with the Seventh Equity Line were
        registered under registration statements on Form S-1 and Form S-2. The proceeds
        from the Seventh Equity Line transactions were used for working capital.
        We
        received no proceeds from the issuance of shares upon conversion of our series
        of preferred stock.
 
 **Item
                  4.**
              **Submission
                  of Matters to a Vote of Security
                  Holders**
 
 None.
 
 **Item
                  6.**
              **Exhibits**
 
 a.
              Exhibits:
                  The following Exhibits are filed with this Form 10-Q pursuant to
                  Item
                  601(a) of Regulation S-K:
 
 Exhibit
                  No.
              Description
                  of Exhibit
 
 31.1
              Certification
                  of President
 31.2
              Certification
                  of Chief Financial Officer
 32.1
              Certification
                  of President Pursuant to Section 906 of the Sarbanes-Oxley Act
                  of
                  2002
 32.2
              Certification
                  of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley
                  Act of 2002.
 
  33
  **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:
                  November 20, 2006
              /s/
                  Roger D.
                  DudleyRoger
                  D. Dudley, Executive Vice President,Chief
                  Financial Officer(Principal
                  financial officer)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
   34