**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 quarterlyperiod
                ended June 30, 2006, or





[ 
              ]
            Transition
                Report pursuant to Section 13 or 15(d) of the Securities Exchange
                Act of
                1934 for the transitionperiod
                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
      August 8, 2006, there were issued and outstanding 820,095,891 shares of our
      Class A common stock.




















**FONIX
      CORPORATION**


**FORM
      10-Q**








**TABLE
      OF CONTENTS**





**PART
      I - FINANCIAL INFORMATION**





**Page**Item
                1.
            Financial
                Statements (Unaudited)Condensed
                Consolidated Balance Sheets - As of June 30, 2006, and December 31,
                2005
            3Condensed
                Consolidated Statements of Operations and Comprehensive Loss for
                the Three
                and Six Months Ended June 30, 2006 and 2005
            4Condensed
                Consolidated Statements of Cash Flows for the Six Months Ended June
                30,
                2006 and 2005Notes
                to Condensed Consolidated Financial Statements
            7Item
                2.
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations
            19Item
                3.
            Quantitative
                and Qualitative Disclosures About Market Risk
            29Item
                4.
            Controls
                and Procedures
            30**PART
                II - OTHER INFORMATION**Item
                1.
            Legal
                Proceedings
            30Item
                1A.
            Risk
                Factors
            31Item
                2.
            Unregistered
                Sales of Equity Securities and Use of Proceeds
            35Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            36Item
                6.
            Exhibits
            35
















2


**Fonix
      Corporation and Subsidiaries**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**


**(Unaudited)**





**June
                30,**
            
            **December
                31,****2006**
            
            **2005****ASSETS****Current
                assets**Cash
                and cash equivalents
            
            $
            30,000
            
            $
            168,000Accounts
                receivable, net of an allowance for doubtful accounts of $138,000
                and
                $137,000, respectively
            
            
            1,000,000
            
            
            1,121,000Prepaid
                expenses and other current assets
            
            
            295,000
            
            
            176,000**Total
                current assets**
            
            
            1,325,000
            
            
            1,465,000**Property
                and equipment,**net of accumulated depreciation of $1,807,000 and $1,594,000,
                respectively
            
            
            769,000
            
            
            947,000**Deposits
                and other assets**
            
            
            1,587,000
            
            
            1,592,000**Intangible
                assets,**net
                of accumulated amortization of $0 and $0, respectively
            
            
            729,000
            
            
            2,658,000**Goodwill**
            
            
            2,631,000
            
            
            2,631,000**Total
                assets**
            
            $
            7,041,000
            
            $
            9,293,000**LIABILITIES
                AND STOCKHOLDERS' DEFICIT****Current
                liabilities**Accrued
                liabilities
            
            $
            10,349,000
            
            $
            8,138,000Accounts
                payable
            
            
            8,269,000
            
            
            6,770,000Accrued
                payroll and other compensation
            
            
            346,000
            
            
            223,000Accrued
                settlement obligation, net of unamortized discount of $35,000 and
                $118,000, respectively
            
            
            1,495,000
            
            
            1,853,000Deferred
                revenues
            
            
            873,000
            
            
            923,000Notes
                payable - related parties
            
            
            436,000
            
            
            486,000Current
                portion of notes payable
            
            
            2,816,000
            
            
            1,847,000Deposits
                and other
            
            
            227,000
            
            
            229,000**Total
                current liabilities**
            
            
            24,811,000
            
            
            20,469,000**Long-term
                notes payable, net of current portion**
            
            
            3,325,000
            
            
            4,050,000**Total
                liabilities**
            
            
            28,136,000
            
            
            24,519,000**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; 2,000 shares outstanding (aggregate liquidation
                preference of $20,000,000)
            
            
            4,000,000
            
            
            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
            
            
            -
            
            
            -Common
                stock, $0.0001 par value; 800,000,000 shares authorized;Class
                A voting, 797,311,609 shares and 392,929,230 shares outstanding,
                respectively
            
            
            80,000
            
            
            39,000Class
                B non-voting, none outstanding
            
            
            -
            
            
            -Additional
                paid-in capital
            
            
            235,046,000
            
            
            228,905,000Outstanding
                warrants to purchase Class A common stock
            
            
            474,000
            
            
            474,000Cumulative
                foreign currency translation adjustment
            
            
            11,000
            
            
            18,000Accumulated
                deficit
            
            
            (261,206,000
            )
            
            (250,521,000
            )**Total
                stockholders' deficit**
            
            
            (21,095,000
            )
            
            (15,226,000
            )**Total
                liabilities and stockholders' deficit**
            
            $
            7,041,000
            
            $
            9,293,000




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 June 30,**
            
            **Six
                Months Ended June 30,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Revenues
            
            $
            3,259,000
            
            $
            4,324,000
            
            $
            6,441,000
            
            $
            8,547,000Cost
                of revenues
            
            
            2,254,000
            
            
            2,499,000
            
            
            4,586,000
            
            
            4,686,000Gross
                profit
            
            
            1,005,000
            
            
            1,825,000
            
            
            1,855,000
            
            
            3,861,000Expenses:Selling,
                general and administrative
            
            
            2,771,000
            
            
            3,404,000
            
            
            5,906,000
            
            
            6,817,000Impairment
                of intangible assets
            
            
            1,011,000
            
            
            -
            
            
            1,011,000
            
            
            -Amortization
                of intangible assets
            
            
            459,000
            
            
            1,586,000
            
            
            918,000
            
            
            3,172,000Product
                development and research
            
            
            590,000
            
            
            527,000
            
            
            1,160,000
            
            
            1,046,000Total
                expenses
            
            
            4,831,000
            
            
            5,517,000
            
            
            8,995,000
            
            
            11,035,000Other
                income (expense):Interest
                income
            
            
            -
            
            
            5,000
            
            
            -
            
            
            18,000Interest
                expense
            
            
            (680,000
            )
            
            (666,000
            )
            
            (1,442,000
            )
            
            (1,408,000
            )Gain
                on sale of investments
            
            
            -
            
            
            -
            
            
            -
            
            
            134,000Gain
                on forgiveness of liabilities
            
            
            -
            
            
            16,000
            
            
            -
            
            
            16,000Other
                expense, net
            
            
            (680,000
            )
            
            (645,000
            )
            
            (1,442,000
            )
            
            (1,240,000
            )Net
                loss
            
            
            (4,506,000
            )
            
            (4,337,000
            )
            
            (8,582,000
            )
            
            (8,414,000
            )Preferred
                stock dividends
            
            
            (254,000
            )
            
            (276,000
            )
            
            (2,103,000
            )
            
            (573,000
            )Loss
                attributable to common stockholders
            
            $
            (4,760,000
            )
            $
            (4,613,000
            )
            $
            (10,685,000
            )
            $
            (8,987,000
            )Basic
                and diluted loss per common share
            
            $
            (0.01
            )
            $
            (0.02
            )
            $
            (0.02
            )
            $
            (0.05
            )Net
                loss
            
            $
            (4,506,000
            )
            $
            (4,337,000
            )
            $
            (8,582,000
            )
            $
            (8,414,000
            )Other
                comprehensive (loss) income - foreign currency translation
            
            
            -
            
            
            11,000
            
            
            7,000
            
            
            22,000Comprehensive
                loss
            
            $
            (4,506,000
            )
            $
            (4,326,000
            )
            $
            (8,575,000
            )
            $
            (8,392,000
            )







See
      accompanying notes to condensed consolidated financial statements.




4







**Fonix
      Corporation and Subsidiaries**


**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(Unaudited)**


**Six
                  Months Ended June 30,**
              
              **2006**
              
              **2005****Cash
                  flows from operating activities**Net
                  loss
              
              $
              (8,582,000
              )
              $
              (8,414,000
              )Adjustments
                  to reconcile net loss to net cash used in operating
                  activities:Stock
                  issued for interest expense on long-term debt
              
              
              -
              
              
              267,000Accretion
                  of discount on notes payable
              
              
              368,000
              
              
              375,000Accretion
                  of discount on legal settlement
              
              
              82,000
              
              
              -Impairment
                  losses
              
              
              1,011,000
              
              
              -Gain
                  on sale of long-term assets
              
              
              -
              
              
              (134,000
              )Amortization
                  of intangibles
              
              
              918,000
              
              
              3,172,000Depreciation
              
              
              213,000
              
              
              82,000Foreign
                  exchange loss (gain)
              
              
              (7,000
              )
              
              22,000Changes
                  in assets and liabilitiesAccounts
                  receivable
              
              
              121,000
              
              
              328,000Prepaid
                  expenses and other current assets
              
              
              (119,000
              )
              
              (134,000
              )Other
                  assets
              
              
              5,000
              
              
              (174,000
              )Accounts
                  payable
              
              
              1,499,000
              
              
              678,000Accrued
                  payroll and other compensation
              
              
              123,000
              
              
              (1,255,000
              )Other
                  accrued liabilities
              
              
              1,761,000
              
              
              774,000Deferred
                  revenues
              
              
              (50,000
              )
              
              44,000Net
                  cash used in operating activities
              
              
              (2,657,000
              )
              
              (4,369,000
              )**Cash
                  flows from investing activities**Proceeds
                  from sale of long term investments
              
              
              -
              
              
              371,000Purchase
                  of property and equipment
              
              
              (35,000
              )
              
              (838,000
              )Net
                  cash used in investing activities
              
              
              (35,000
              )
              
              (467,000
              )**Cash
                  flows from financing activities**Proceeds
                  from issuance of Class A common stock, net
              
              
              3,168,000
              
              
              4,791,000Proceeds
                  from other notes payable
              
              
              55,000
              
              
              110,000Payments
                  on related party note payable
              
              
              (105,000
              )
              
              -Payments
                  of accrued settlement obligation
              
              
              (440,000
              )
              
              -Principal
                  payments on notes payable
              
              
              (124,000
              )
              
              (95,000
              )Net
                  cash provided by financing activities
              
              
              2,554,000
              
              
              4,806,000**Net
                  decrease in cash and cash equivalents**
              
              
              (138,000
              )
              
              (30,000
              )**Cash
                  and cash equivalents at beginning of year**
              
              
              168,000
              
              
              423,000**Cash
                  and cash equivalents at end of year**
              
              $
              30,000
              
              $
              393,000


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 Six Months Ended June 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
      $500,000 of dividends on Series H Preferred Stock.





**For
      the Six Months Ended June 30, 2005:**





Issued
      18,630,223 shares of Class A common stock in conversion of 1,078 shares of
      Series I Convertible Preferred Stock.





Issued
      5,801,237 shares of Class A common stock as payment of $500,000 of dividends
      on
      Series H Preferred Stock.





Issued
      7,093,445 shares of Class A common stock as payment of $443,000 of principal
      and
      interest on long-term debt.





Accrued
      $73,000 of dividends on Series I Preferred Stock.





Accrued
      $250,000 of dividends on Series H Preferred Stock













































See
      accompanying notes to condensed consolidated financial statements.







6





**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.





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 six months ended June 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 communications and technology company based in Salt Lake City,
      Utah, provides integrated telecommunications services through Fonix Telecom,
      Inc. (“Fonix Telecom”) and LecStar Telecom, Inc., and value-added speech
      technologies through Fonix Speech, Inc. (“Fonix Speech”). On February 24, 2004,
      the Company completed its acquisition of all of the capital stock of LTEL
      Holdings Corporation (“LTEL”) and its wholly owned subsidiaries, LecStar
      Telecom, Inc., and LecStar DataNet, Inc. (collectively “LecStar”).





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.





Through
      Fonix Telecom, the Company offers next-generation telecommunications products
      and services, including Voice over Internet Protocol (“VoIP”) and Broadband over
      Power Lines (“BPL”) through partner channels and product groups. Fonix Telecom
      also provides resale telecommunication services and products through its
      interconnection agreements with major incumbent carriers. Fonix Telecom is
      currently licensed to re-sell traditional telecommunication services and
      products in Georgia, Florida, North Carolina and South Carolina. Revenues for
      Fonix Telecom are generated through providing telecommunications
      services.





Through
      LecStar, the Company provides a full array of wireline voice, data, long
      distance and Internet telephone services utilizing traditional lines. LecStar
      Telecom, Inc., is certified by the Federal Communications Commission in nine
      states—Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi, North
      Carolina, South Carolina and Tennessee—as a competitive local exchange carrier
      (“CLEC”) to provide regulated local, long distance and international
      telecommunications services. LecStar
      serves small- to medium-sized businesses and residential customers with a
      balanced focus on high-density metropolitan areas and under-served smaller
      communities. Services are offered at moderate discounts off BellSouth prices
      and
      are delivered through the use of LecStar’s network facilities, Unbundled Network
      Elements (“UNEs”), and/or resold via services acquired through wholesale
      agreements with BellSouth and other carriers. LecStar’s provisioning systems are
      electronically interfaced with BellSouth, enabling the efficient ordering of
      services in real time.








7






**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**


***Business
      Condition*** **** -
      For the
      three months ended June 30, 2006 and 2005, the Company generated revenues of
      $3,259,000 and $4,324,000, respectively; incurred net losses of $4,506,000
      and
      $4,337,000, respectively. For the six months ended June 30, 2006 and 2005,
      the
      Company generated revenues of $6,441,000 and $8,547,000, respectively, incurred
      net losses of $8,582,000 and $8,414,000, respectively, and had negative cash
      flows from operating activities of $2,657,000 and $4,369,000, respectively.
      As
      of June 30, 2006, the Company had an accumulated deficit of $261,206,000,
      negative working capital of $23,486,000, accrued liabilities and accrued
      settlement obligation of $12,190,000, accounts payable of $8,269,000 and current
      portion of notes payable of $3,252,000. 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,
      further developing its telecommunications services business and from recent
      negative changes in federal regulations that may discontinue the Company’s
      ability to provide unbundled network elements (the “UNE-P platform”) to its
      telecommunications customers.





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. As of the
      date of this report, the Company had not been declared in default under the
      terms of any material agreements.





These
      factors, as well as the risk factors set out elsewhere 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 revenues generated from its telecommunication
      operations, from cash flows from future license and royalty arrangements and
      with proceeds from additional issuance of debt and equity securities. There
      can
      be no assurance that management’s plans will be successful.





***Net
      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 June 30, 2006 and 2005, there
      were outstanding common stock equivalents to purchase 49,919,168 and 38,264,776
      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 six months ended
      June
      30, 2006 and 2005:


**Three
                Months Ended June 30,**
            
            **2006**
            
            **2005****Per**
            
            
            
            **Per****Share**
            
            
            
            **Share****Amount**
            
            **Amount**
            
            **Amount**
            
            **Amount**Net
                loss
            
            $
            (4,506,000
            )
            
            
            
            $
            (4,337,000
            )Preferred
                stock dividends
            
            
            (254,000
            )
            
            
            
            
            (276,000
            )Loss
                attributable to common stockholders
            
            $
            (4,760,000
            )
            $
            (0.01
            )
            $
            (4,613,000
            )
            $
            (0.02
            )Weighted-average
                common shares outstanding
            
            
            705,796,055
            
            
            
            
            
            216,972,730








8






**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**


**Six
                Months Ended June 30,**
            
            **2006**
            
            **2005****Per**
            
            
            
            **Per****Share**
            
            
            
            **Share****Amount**
            
            **Amount**
            
            **Amount**
            
            **Amount**Net
                loss
            
            $
            (8,582,000
            )
            
            
            
            $
            (8,414,000
            )Preferred
                stock dividends
            
            
            (2,103,000
            )
            
            
            
            
            (573,000
            )Loss
                attributable to common stockholders
            
            $
            (10,685,000
            )
            $
            (0.02
            )
            $
            (8,987,000
            )
            $
            (0.05
            )Weighted-average
                common shares outstanding
            
            
            686,768,855
            
            
            
            
            
            184,465,237





***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.





***Intangible
      Assets*** - ****** The
      customer base, contracts and agreements and brand names are amortized over
      their
      estimated useful lives unless they are deemed to have indefinite useful lives.
      For intangible assets subject to amortization, an impairment charge is
      recognized if the carrying amount is not recoverable and the carrying amount
      exceeds the fair value of the intangible asset.





***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 telecommunications services, revenue is
      recognized in the period that the service is provided.





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.





9






**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**


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





For
      Fonix
      Telecom and LecStar, telecommunications revenue is comprised of two main
      components: (1) fees paid by business and residential subscribers of voice
      and
      data services; and (2) carrier access fees. Subscriber revenues include monthly
      recurring charges, usage charges and non-recurring charges. Monthly recurring
      charges are flat monthly fees for local phone and data services. Usage charges,
      which primarily include long distance fees, are generally billed on a per-minute
      or per-call basis. Non-recurring charges are generally one-time charges for
      installation or changes to the subscriber’s service. Carrier access fees are
      paid to the Company by other telecommunications carriers as compensation for
      originating and terminating the carriers’ long distance traffic. Revenue from
      monthly recurring charges is recognized ratably over the period the local phone
      and data services are provided. Revenue from usage charges non-recurring charges
      and carrier access fees is recognized on the date the services are
      provided.





Deferred
      revenue as of June 30, 2006, and December 31, 2005, consisted of the
      following:




**Description**
                  **Criteria
                      for Recognition**
                  **March
                      31, 2006**
                  **December
                      31, 2005**Deferred
                      unit royalties and license fees
                  Delivery
                      of units to end users or expiration of contract
                  $       491,000
                  $      
                      466,000Telecom
                      deferred revenue
                  Service
                      provided for customer
                  382,000
                  457,000Total
                      deferred revenue
                  
                  $      
                      873,000
                  $      
                      923,000


***Cost
      of Revenues*** - ****** Cost
      of
      revenues from telecommunications services consists mainly of billings from
      the
      incumbent local exchange carriers (“ILECs”) for access to the ILEC’s network.
      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 SFAS 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, 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 June 30, 2006, of
      $1,000. For the six months ended June 30, 2006, the Company recognized
      compensation expense related to option grants and the vesting of previously
      unvested options of $7,000.





10






**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**





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 Statement of Financial Accounting
      Standards No. 123, *Accounting
      for Stock-Based Compensation* (“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 six months ended June 30, 2005:





**Three
                Months Ended June 30,**
            
            **2005**Net
                loss, as reported
            
            $
            (4,337,000
            )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
            
            $
            (4,352,000
            )Basic
                and diluted net loss per common share:As
                reported
            
            $
            (0.02
            )Pro
                forma
            
            
            (0.02
            )








**Six
                Months Ended June 30,**
            
            **2005**Net
                loss, as reported
            
            $
            (8,414,000
            )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
            
            $
            (8,451,000
            )Basic
                and diluted net loss per common share:As
                reported
            
            $
            (0.05
            )Pro
                forma
            
            
            (0.05
            )





The
      fair
      value of the options granted during the six months ended June 30, 2005 was
      $76,160, 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 AND INTANGIBLE ASSETS**





***Goodwill*** - ****** Goodwill
      relates solely to Fonix Speech. The carrying value of goodwill is assessed
      for
      impairment quarterly. An assessment was performed for the quarter ended June
      30,
      2006, which resulted in no impairment, and the carrying value of goodwill
      remained unchanged at $2,631,000 for the six months ended June 30, 2006.





***Intangible
      Assets*** -
      The
      components of intangible assets at June 30, 2006, were as follows:





Gross
                Carrying
              Amount
            
            Accumulated
                Amortization
            
            Net
                Carrying AmountLecStar
                Customer base - business
            
            $
            729,000
            
            
            --
            
            $
            729,000





Customer
      base amortization was $459,000 and $1,300,000 for the three months ended June
      30, 2006 and 2005, respectively. Customer base amortization was $918,000 and
      $2,600,000 for the six months ended June 30, 2006 and 2005, respectively.
      Amortization related to contracts and agreements was $285,000 during the three
      months ended and $570,000 during the six months ended June 30, 2005. All
      amortization expense is charged to selling, general and administrative expense.





11






**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**


At
      June
      30, 2006, the Company recognized an impairment charge related to the LecStar
      business customer base of $1,011,000 which is reflected in the accompanying
      financial statements. The impairment was recognized based on decreased future
      projected cash flows projected to be produced from the LecStar business customer
      base due primarily to the increasing cost of providing these
      services.





**3.
      NOTES PAYABLE**





On
      February 24, 2004, LecStar had an asset securitization facility of $750,000.
      Assets securitized under this facility consist of executory future cash flows
      from LecStar customers in the states of Georgia, Tennessee, Florida, and
      Louisiana. LecStar has pledged to the lender its interest in the special purpose
      securitization facility, LecStar Telecom Ventures LLC, a wholly owned subsidiary
      of LTEL, and customer accounts receivable. The note bears an interest rate
      of
      6.5% and is due on February 27, 2007, with 24 equal monthly installments which
      began on March 6, 2005. During 2005, the Company made principal payments of
      $213,000. During the six months ended June 30, 2006, the Company made principal
      payments of $124,000. The balance of the note at June 30, 2006 was
      $413,000.





In
      connection with the acquisition of the capital stock of LTEL in 2004, the
      Company issued a 5%, $10,000,000, secured, six-year note payable to McCormack
      Avenue, Ltd. Under the terms of the note payable, 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 promissory 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 and its subsidiaries.
      The note was originally valued at $4,624,000 based on an imputed interest rate
      of 25 percent per annum. The note has a mandatory prepayment clause wherein
      the
      Company is required to make prepayments in any given month where the Company
      receives net proceeds in excess of $900,000 from the Fifth Equity Line (or
      replacements thereof with the Equity Line Investor). The required prepayment
      is
      calculated by multiplying the net proceeds received over $900,000 by 33%. For
      the year ended December 31, 2004, the Company made mandatory prepayments on
      the
      note of $415,000. During 2005, the Company made mandatory prepayments of
      $102,000. The Company did not make any mandatory prepayments during the six
      months ended June 30, 2006.





The
      discount on the note is based on an imputed interest rate of 25%. The carrying
      amount of the note of $5,078,000 at June 30, 2006, was net of unamortized
      discount of $3,655,000. As of June 30, 2006, the Company had not made the
      scheduled payments for January 15, 2006 or April 15, 2006. As of August 8,
      2006,
      the Company had not made the scheduled July 15, 2006 payment. On May 12, 2006,
      McCormack and the Company entered into an agreement, pursuant to which payments
      were extended by the lender to June 16, 2006. As consideration for the
      extension, LecStar Telecom and LecStar DataNet granted to McCormack a security
      interest in all of the assets of LecStar Telecom and LecStar DataNet. As of
      August 8, 2006, the Company had not made any scheduled payments for
      2006.





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 August 8, 2006, the Company had not made the scheduled payments on these
      promissory notes.








12






**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**
  The
        following schedule summarizes the Company’s current debt obligations and
        respective balances at June 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 $3,655,000
                and $4,023,000, respectively
            
            $
            5,078,000
            
            $
            4,710,000Note
                payable to a company, interest at 10%, matures May 2006
            
            
            350,000
            
            
            350,000Note
                payable to a company, interest at 10%, matures June 2006
            
            
            300,000
            
            
            300,000Note
                payable to a company, due in monthly installments of $23,000, interest
                at
                6.5%, matures January 2008, collateralized by trade accounts
                receivable
            
            
            413,000
            
            
            537,000Note
                payable to related parties, interest at 12%, matures September 2006,
                secured by intellectual property rights
            
            
            436,000
            
            
            486,000Total
                notes payable
            
            
            6,577,000
            
            
            6,383,000Less
                current maturities
            
            
            (3,252,000
            )
            
            (2,333,000
            )Long-Term
                Note Payable
            
            $
            3,325,000
            
            $
            4,050,000





**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 is presently due
      September 30, 2006. 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.





13






**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
      against the promissory note. The balance due at December 31, 2005 was $486,000.
      During the six months ended June 30, 2006 the Company an additional advance
      of
      $55,000 and made principal payments against the promissory note of $105,000.
      The
      balance due at June 30, 2006 was $436,000.





The
      unpaid balance of $436,000 is secured by the Company’s intellectual property
      rights. As of June 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
      June 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 $10,000,000 stated value of the outstanding Series H Preferred Stock
      are
      payable at the rate of 5% per annum as and when declared by the Board of
      Directors. The annual dividend requirement is $1,000,000. If dividends are
      declared on Fonix's common stock, as a condition of that dividend, Fonix is
      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 are 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 and June 30, 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.





Fonix
      has
      the option, but not the obligation, exercisable at any time, to redeem all
      or
      any portion of the outstanding Series H Preferred Stock. The redemption price
      is
      equal to any accumulated dividends on the redeemed shares plus a percentage
      of
      the $10,000 per share stated value of the redeemed shares, based on the date
      the
      redemption occurs in relation to the original issuance date as follows: before
      the second anniversary - 102%; thereafter but before the third anniversary
      -
      104%; thereafter but before the fourth anniversary - 106% and thereafter -
      108%.
      If shares of Series H Preferred Stock are redeemed, additional Series H
      preferred dividends will be recognized on the date of redemption in an amount
      equal to the difference between the amount paid to redeem the shares and their
      original fair value at the date of issuance of $2,000 per share.





***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 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").






14






**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**


Because
      the shares of Series J 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.





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.





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





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 six months ended June 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.





***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.





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





In
      connection with the issuance of the Series K Preferred Stock, the Company filed
      with the State of Delaware a Certificate of Designation and Series K 5%
      Convertible Stock Terms (the “Series K Terms”), which become a part of the
      Company’s Certificate of Incorporation, as amended.





Subsequent
      to filing, but prior to the issuance of any shares of Series K Preferred Stock,
      the Company agreed with Southridge to amend the Series K Terms to put a
      conversion cap of 1.0%, in lieu of a 4.99% conversion cap. The Company and
      Southridge entered into an Amended and Restated Series K 5% Convertible
      Preferred Stock Exchange Agreement, with the only change being the change in
      the
      conversion cap.





For
      the
      six months ended June 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.








15






**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**
  **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. The third registration statement was filed June 23, 2006,
      and
      as of August 8, 2006, had not been declared effective by the SEC.





For
      the
      six months ended June 30, 2006, the Company received $3,267,000 in funds drawn
      under the Seventh Equity Line, less commissions and fees of $112,000. The
      Company issued 277,215,718 shares of Class A common stock to the Equity Line
      Investor as puts under the Seventh Equity Line totaling $3,267,000.





**7.
      COMMON STOCK, STOCK OPTIONS AND WARRANTS**





***Class
      A Common Stock*** - During
      the six months ended June 30, 2006, 277,215,718 shares of Class A common stock
      were issued in connection with draws on the equity line (see Note 6), 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 and 2,838,412 shares were issued in payment of dividends on
      Series H Preferred Stock.





***Stock
      Options -*** As of
      June 30, 2006, the Company had a total of 1,310,705 options to purchase Class
      A
      common stock outstanding. During the six months ended June 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
      June 30, 2006, the Company had warrants to purchase a total of 15,000 shares
      of
      Class A common stock outstanding that expire through 2010.





16






**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**
  **8.
        LITIGATION, COMMITMENTS AND CONTINGENCIES**





**Grenfell
      Litigation** - Two of
      the Company’s subsidiaries, LecStar Telecom and LecStar DataNet (collectively
“LecStar”), are among the defendants who were sued in the Superior Court of
      Fulton County, State of Georgia, by James D. Grenfell, the former CFO of the
      former parent of LecStar. The suit was filed in December 2003. The plaintiff
      in
      that case alleged that he had an unpaid judgment in the amount of $1,015,000
      plus interest against the former parent entities of LecStar and that the purpose
      of a transfer of the stock and business of LecStar in December 2002 was to
      avoid
      paying the judgment. In September 2005, the plaintiff dismissed the action
      in
      Fulton County. In December 2005, the plaintiff reasserted his claim in the
      Superior Court of Cobb County, State of Georgia, and, in addition to LecStar,
      the plaintiff named Fonix and LTEL Holdings as defendants in the new lawsuit.
      Fonix is the sole shareholder of LTEL Acquisition Corporation which is the
      sole
      shareholder of LTEL Holdings. Among other things, the plaintiff is seeking
      an
      attachment of stock and assets of LecStar, to unwind the previous transfer
      of
      the stock and business of LecStar in December 2002, and for money damages.





The
      Company and LecStar are aggressively defending against these claims. No
      assessment currently can be made of the likelihood of an unfavorable outcome.





**First
      Empire** - Claims
      similar to the claims brought in the Grenfell Litigation were also asserted
      by
      other plaintiffs in First Empire Corporation, et al., v. LecStar Corporation,
      et
      al., filed in the Superior Court of Fulton County, State of Georgia. In the
      third amended complaint filed in October 2005, the plaintiffs named W. Dale
      Smith, Chad Smith, Michael Britt, and LTEL Holdings Corporation as defendants.
      Messrs Smith and Britt are former officers and directors of the former parent
      of
      LecStar. LTEL Holdings was the sole shareholder of LecStar when acquired by
      the
      Company in February 2004. In the third amended complaint, the plaintiffs allege
      that Dale Smith breached his fiduciary duty to the former parent of LecStar
      by
      participating in the transaction in which the parent lost control of LecStar,
      that LTEL Holdings procured that alleged wrongful conduct from Smith, that
      the
      transaction in which the former parent lost control of LecStar was a fraudulent
      conveyance, and that a constructive trust should be imposed on LecStar for
      the
      benefits of the plaintiffs.





Messrs.
      Smith and Britt and LTEL Holdings have filed an answer in the litigation, but
      have not been involved in discovery in this litigation because the litigation
      is
      in the early stages. Nonetheless, the Company believes that the claims of the
      plaintiffs are without merit, and management intends to vigorously defend
      against the claims of the plaintiffs.





The
      principal Series H preferred stockholder has placed 300 shares of Series H
      Preferred Stock in escrow (the “Escrow Shares”) for a period of 12 months from
      the date of acquisition as protection with respect to breaches of
      representations and warranties of the LTEL Holdings selling stockholders,
      including any liability or payment that may arise from the above mentioned
      legal
      action. As a result of the filing of the First Empire Litigation, the Company
      has asserted a claim for breach of certain representations and warranties.
      To
      the Company’s knowledge, the Escrow Shares have not been released.





**Greenwich
      Insurance Action** - The
      Greenwich litigation is an action filed in the United States District Court
      for
      the Northern District of Georgia, in which Greenwich Insurance Company is
      seeking a declaratory judgment against the directors and officers of the former
      parent entity of LecStar and others. Greenwich seeks an order that it is not
      liable for coverage under its directors and officers’ liability policy for
      claims asserted in the First Empire litigation against several individuals
      who
      were officers and directors of LecStar, including W. Dale Smith, Michael Britt
      and Chad Smith. Greenwich also seeks recovery of fees advanced to law firms
      on
      behalf of these individuals for defense costs associated with the First Empire
      litigation, which Greenwich claims are in excess of $100,000. LecStar Telecom
      has agreed to assume defense costs incurred on behalf of Messrs. Smith and
      Britt
      in the Greenwich litigation. Messrs. Smith and Britt have filed answers denying
      the allegations of Greenwich. While it is the intent of Messrs. Smith and Britt
      to aggressively defend against the plaintiff’s claims, Messrs. Smith and Britt
      may experience exposure to the loss of insurance coverage presently afforded
      under the policy of insurance provided by Greenwich. In that case, LecStar
      Telecom may have exposure for any liability associated with indemnity claims
      from the officers and directors arising from previously advanced and future
      defense costs, as well as the costs of defending the Greenwich claim
      itself.





***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. No answer to the
      complaint has been filed. The Company intends to vigorously defend itself.







17






**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**





**9.
      BUSINESS SEGMENTS**





Information
      related to Fonix’s reportable operating business segments is shown below.
      Fonix’s reportable segments are reported in a manner consistent with the way
      management evaluates the businesses. The Company identifies its reportable
      business segments based on differences in products and services. The accounting
      policies of the business segments are the same as those described in the summary
      of significant accounting policies. The products and services of each business
      segment are further described in Note 1. The Company has identified the
      following business segments (the Company had previously identified three
      operating segments, the LecStar Telecom operating segment and the Fonix Telecom
      operating segment have been combined as the Telecom Operations segment for
      2005
      and 2006 below):





***Telecom
      Operations*** *-* Telecommunications
      services include VoIP, BPL and wireline voice, data, long distance and Internet
      services to business and residential customers.





***Speech
      Operations*** - The
      Company’s speech-enabling technologies include automated speech recognition and
      text-to-speech for wireless and mobile devices, computer telephony and server
      solutions, and personal software for consumer applications.





The
      following presents certain segment information as of and for the six months
      ended June 30, 2006:





**Telecom
                Operations**
            
            **Speech
                Operations**
            
            **Total**Revenues
                from external customers
            
            $
            5,802,000
            
            $
            639,000
            
            $
            6,441,000Selling,
                general and administrative
            
            
            3,297,000
            
            
            2,406,000
            
            
            5,703,000Impairment
                charge
            
            
            1,011,000
            
            
            --
            
            
            1,011,000Depreciation
                and amortization
            
            
            1,108,000
            
            
            29,000
            
            
            1,137,000Product
                development and research
            
            
            --
            
            
            1,144,000
            
            
            1,144,000Interest
                expense
            
            
            751,000
            
            
            691,000
            
            
            1,442,000Segment
                loss
            
            
            (3,697,000
            )
            
            (4,885,000
            )
            
            (8,582,000
            )Segment
                assets
            
            
            3,054,000
            
            
            3,987,000
            
            
            7,041,000Expenditures
                for segment assets
            
            
            23,000
            
            
            12,000
            
            
            35,000





The
      following presents certain segment information as of and for the six months
      ended June 30, 2005:





**Telecom
                Operations**
            
            **Speech
                Operations**
            
            **Total**Revenues
                from external customers
            
            $
            7,827,000
            
            $
            720,000
            
            $
            8,547,000Selling,
                general and administrative
            
            
            4,403,000
            
            
            2,332,000
            
            
            6,735,000Depreciation
                and amortization
            
            
            3,222,000
            
            
            32,000
            
            
            3,254,000Product
                development and research
            
            
            --
            
            
            1,046,000
            
            
            1,046,000Gain
                on sale of investments
            
            
            134,000
            
            
            --
            
            
            134,000Interest
                expense
            
            
            761,000
            
            
            647,000
            
            
            1,408,000Segment
                loss
            
            
            (6,742,000
            )
            
            (1,672,000
            )
            
            (8,414,000
            )Segment
                assets
            
            
            12,729,000
            
            
            3,568,000
            
            
            16,297,000Expenditures
                for segment assets
            
            
            831,000
            
            
            7,000
            
            
            838,000





Revenues
      and assets outside the United States of America were not material. During the
      six months ended June 30, 2006 and 2005, the Company had no customers that
      exceeded 10% of total revenues.








18






**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**


**10.
      SUBSEQUENT EVENTS**





Subsequent
      to June 30, 2006, and through August 8, 2006, the Company received $111,000
      in
      funds, less commissions and fees of $2,000 drawn under the Seventy Equity Line
      and issued 22,784,282 additional shares of Class A common stock to the Equity
      Line Investor.






















































































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 integrated telecommunications services through Fonix
      Telecom, Inc., and LecStar Telecom, Inc., and value-added speech technologies
      through Fonix Speech, Inc. (“Fonix Speech”). We operate Fonix Telecom, Inc., and
      LecStar Telecom, Inc., regional providers of telecommunications services in
      the
      Southeastern United States and LecStar DataNet, Inc., a provider of Internet
      services. (LecStar Telecom, Inc., and LecStar DataNet are collectively referred
      to in this report as “LecStar”).





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 providing telecommunication services, licensing of speech-enabling
      technologies, maintenance contracts and services.





Fonix
      Telecom's non-regulated telecommunication services include Voice over Internet
      Protocol (“VoIP”), Broadband over Power Lines (“BPL”) and wireless broadband
      access. These services are initially available in the southeastern United States
      and we anticipate will eventually be available throughout the United
      States.





LecStar's
      telecommunication services include wireline voice, data, long distance and
      Internet services to business and residential customers. LecStar Telecom, Inc.,
      is certified by the Federal Communications Commission in nine states-Alabama,
      Florida, Georgia, Kentucky, Louisiana, Mississippi, North Carolina, South
      Carolina and Tennessee-as a competitive local exchange carrier (“CLEC”) to
      provide regulated local, long distance and international telecommunications
      services. LecStar DataNet, Inc., provides non-regulated telecommunication
      services including Internet access. LecStar has been generating positive
      earnings before interest, depreciation, taxes and amortization since September
      2005.





For
      the
      three months ended June 30, 2006 and 2005, we generated revenues of $3,259,000
      and $4,327,000, respectively and incurred net losses of $4,506,000 and
      $4,337,000, respectively. For the six months ended June 30, 2006 and 2005,
      we
      generated revenues of $6,441,000 and $8,547,000, respectively; incurred net
      losses of $8,582,000 and $8,414,000, respectively; and had negative cash flows
      from operating activities of $2,657,000 and $4,369,000, respectively. As of
      June
      30, 2006, we had an accumulated deficit of $261,206,000, negative working
      capital of $23,486,000, accrued liabilities and accrued settlement obligation
      of
      $12,190,000 and accounts payable of $8,269,000. 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 our speech-enabling technologies
      and
      further developing our telecommunications services business.






20








We
      are
      continually developing new product offerings in both the ASR and
      telecommunications 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 $10,000,000 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.





***Intangible
      assets*** -
      Customer base, contracts and agreements and brand names are amortized over
      their
      estimated useful lives unless they are deemed to have indefinite useful lives.
      For intangible assets subject to amortization, an impairment charge is
      recognized if the carrying amount is not recoverable and the carrying amount
      exceeds the fair value of the intangible asset. Intangible assets deemed to
      have
      indefinite useful lives, primarily the LecStar brand name were not amortized,
      were tested for impairment on a quarterly basis and impairment was recognized
      if
      the carrying amount was not recoverable or exceeded its fair value. At June
      30,
      2006, the Company tested the intangible assets for impairment and recorded
      an
      impairment charge of $1,011,000 related to the LecStar business customer list
      based on estimated future 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.






21








***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. For telecommunications services, revenue is recognized
      in the period that the service is provided.





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.





For
      Fonix
      Telecom, our telecommunications revenue is comprised of two main components:
      (1)
      fees paid by business and residential subscribers of voice and data services;
      and (2) carrier access fees. Subscriber revenues include monthly recurring
      charges, usage charges and non-recurring charges. Monthly recurring charges
      are
      flat monthly fees for local phone and data services. Usage charges, which
      primarily include long distance fees, are generally billed on a per-minute
      or
      per-call basis. Non-recurring charges are generally one-time charges for
      installation or changes to the subscriber’s service. Carrier access fees are
      paid to us by other telecommunications carriers as compensation for originating
      and terminating the carriers’ long distance traffic. Revenue from monthly
      recurring charges is recognized ratably over the period the local phone ad
      data
      services are provided. Revenue from usage charges, non-recurring charges and
      carrier access fees is recognized on the date





Deferred
      revenue as of June 30, 2006, and December 31, 2005, consisted of the
      following:


**Description**
                    **Criteria
                        for Recognition**
                    **March
                        31, 2006**
                    **December
                        31, 2005**Deferred
                        unit royalties and license fees
                    Delivery
                        of units to end users or expiration of contract
                    $       491,000
                    $      
                        466,000Telecom
                        deferred revenue
                    Service
                        provided for customer
                    382,000
                    457,000Total
                        deferred revenue
                    
                    $      
                        873,000
                    $      
                        923,000





22






***Cost
      of revenues*** **-** Cost
      of
      revenues from telecommunications services consists mainly of billings from
      the
      incumbent local exchange carriers (“ILECs”) for access to the ILECs network.
      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.





***Stock-Based
      Employee Compensation***  ***-*** Effective
      January 1, 2006, we adopted SFAS 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 June 30, 2006, of $1,000. For the six months ended
      June 30, 2006, we recognized compensation expense related to option grants
      and
      the vesting of previously unvested options of $7,000.





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.








23






***Results
      of Operation*** *s*




**Three
      months ended June 30, 2006, compared with three months ended June 30,
      2005**







During
      the three months ended June 30, 2006, we recorded revenues of $3,259,000, a
      decrease of $1,065,000 from $4,324,000 in 2005. The decrease was primarily
      due
      to decreased monthly recurring telecommunications revenues of $497,000,
      decreased telecommunications usage revenues of $273,000, decreased
      telecommunications subscriber line charge revenues of $206,000, decreased
      non-recurring engineering (“NRE”) speech revenues of $74,000, decreased
      telecommunications activation and service revenues of $24,000, decreased speech
      retail revenues of $24,000, decreased voice mail revenues of $11,000 and
      decreased telecommunications regulatory cost recovery fees of $10,000, partially
      offset by increased speech royalties of $54,000.





Cost
      of
      revenue was $2,254,000 for the three months ended June 30, 2006, a decrease
      of
      $245,000 from $2,499,000 in 2005. The overall decrease in cost of revenue is
      due
      to the overall decrease in revenues as described above partially offset by
      increased costs of providing telecommunication services, primarily due to the
      loss of the UNE-P platform. These costs represent expenses associated with
      providing LecStar’s services through the leasing of network components from
      BellSouth and long distance services purchased from inter-exchange carriers.





Selling,
      general and administrative expenses were $2,771,000 for the three months ended
      June 30, 2006, a decrease of $633,000 from $3,404,000 in 2005. The decrease
      is
      primarily due to the decreased salary and wage expenses of $352,000, decreased
      bad debt expense of $170,000 decreased legal and accounting fees of $151,000,
      decreased telecommunication billing expense of $71,000, decreased taxes,
      licenses and permits of $57,000, decreased other operating expense of $25,000
      and, decreased promotions of $10,000 partially offset by increased consulting
      expenses of $103,000, increased depreciation expenses of $62,000, increased
      travel expenses of $28,000 and increased occupancy related expenses of $10,000.





We
      incurred research and product development expenses of $590,000 for the three
      months ended June 30, 2006, an increase of $63,000 from $527,000 in 2005. The
      increase was primarily due to an overall increase in salaries and wage-related
      expenses of $71,000, increased occupancy related expenses of $5,000 and
      increased consulting expenses of $3,000, partially offset by decreased other
      operating expenses of $16,000.





Net
      interest and other expense was $680,000 for the three months ended June 30,
      2006, an increase of $35,000 from $645,000 in 2005. The overall increase was
      due
      to an increase in interest expense of $14,000, combined with decreased interest
      income of $5,000 and decreased gain on forgiveness of liabilities of
      $16,000.





**Six
      months ended June 30, 2006, compared with six months ended June 30,
      2005**





During
      the six months ended June 30, 2006, we recorded revenues of $6,441,000, a
      decrease of $2,106,000 from $8,547,000 in 2005. The decrease was primarily
      due
      to decreased monthly recurring telecommunications revenues of $956,000,
      decreased telecommunications usage revenues of $661,000, decreased
      telecommunications subscriber line charge revenues of $414,000, decreased NRE
      speech revenues of $119,000, decreased telecommunications activation and service
      revenues of $73,000, decreased speech retail revenues of $54,000, decreased
      voice mail revenues of $17,000, partially offset by increased telecommunications
      regulatory cost recovery fees of $96,000 and increased speech royalties of
      $92,000.





Cost
      of
      revenue was $4,586,000 for the six months ended June 30, 2006, a decrease of
      $100,000 from $4,686,000 in 2005. The overall decrease in cost of revenue is
      due
      to the overall decrease in revenues as described above, partially offset by
      increased costs of providing telecommunication services, primarily due to the
      loss of the UNE-P platform. These costs represent expenses associated with
      providing LecStar’s services through the leasing of network components from
      BellSouth and long distance services purchased from inter-exchange carriers.





Selling,
      general and administrative expenses were $5,906,000 for the three months ended
      June 30, 2006, a decrease of $911,000 from $6,817,000 in 2005. The decrease
      is
      primarily due to the decreased salary and wage expenses of $602,000, decreased
      legal and accounting fees of $261,000, decreased bad debt expense of $119,000,
      decreased telecommunication billing expense of $115,000, decreased taxes,
      licenses and permits of $51,000, decreased other operating expense of $48,000
      decreased investor relations expenses of $42,000, and decreased occupancy
      related expenses of $1,000, partially offset by increased depreciation expenses
      of $138,000, increased consulting expenses of $134,000, increased travel
      expenses of $49,000 and increased promotions of $7,000.





24








We
      incurred research and product development expenses of $1,160,000 for the three
      months ended June 30, 2006, an increase of $114,000 from $1,046,000 in 2005.
      The
      increase was primarily due to an overall increase in salaries and wage-related
      expenses of $104,000, increased consulting expenses of $18,000, increased travel
      expense of $8,000 and increased occupancy related expenses of $8,000, partially
      offset by decreased other operating expenses of $23,000 and decreased
      depreciation of $1,000.





Net
      interest and other expense was $1,442,000 for the three months ended June 30,
      2006, an increase of $202,000 from $1,240,000 in 2005. The overall increase
      was
      due to the $134,000 gain on sale of investments, $18,000 in interest income
      and
      $16,000 gain on forgiveness of liabilities recorded in 2005, combined with
      an
      increase in interest expense of $34,000.





***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.
      We
      are also continuing to market our VoIP service through Fonix Telecom and
      anticipate opening additional markets in the Southeastern United States that
      will provide us with potential customers that we have not been able to service
      to date.  There
      can
      be no assurance that we will be able to enter into such agreements or
      that
      we will be successful in our VoIP expansion into different markets. 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, draws on the Seventh Equity
      Line and 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 June 30, 2006, we had accrued liabilities and accrued settlement
      obligation of $12,190,000 and accounts payable of $8,269,000. We have not been
      declared in default under the terms of any material agreements.





We
      had
      $6,441,000 in revenue and a loss of $8,582,000 for the six months ended June
      30,
      2006. Net cash used in operating activities of $2,657,000 for the six months
      ended June 30, 2006, resulted principally from the net loss incurred of
      $8,582,000, increased prepaid expenses of $119,000, decreased deferred revenues
      of $50,000 and foreign exchange gain of $7,000, partially offset by increased
      other accrued liabilities of $1,761,000, increased accounts payable of
      $1,499,000, impairment charges of $1,011,000, amortization of intangible assets
      of $918,000, non-cash accretion of the discount on notes payable of $368,000,
      depreciation expense of $213,000, increased accrued payroll of $123,000,
      collection of accounts receivable of $121,000 and non-cash accretion of discount
      on legal settlement obligation of $82,000. Net cash used in investing activities
      of $35,000 for the six months ended June 30, 2006, consisted of the purchase
      of
      equipment of $35,000. Net cash provided by financing activities of $2,554,000
      consisting primarily of the receipt of $3,168,000 in cash related to the sale
      of
      shares of Class A common stock and $50,000 in cash from proceeds from related
      party notes, partially offset by payments on accrued settlement obligation
      of
      $440,000, payments on related party notes of $105,000 and principal payments
      on
      notes payable of $124,000.





We
      had
      negative working capital of $23,486,000 at June 30, 2006, compared to negative
      working capital of $19,004,000 at December 31, 2005. Current assets decreased
      by
      $140,000 to $1,325,000 from $1,465,000 from December 31, 2005, to June 30,
      2006.
      Current liabilities increased by $4,342,000 to $24,811,000 from $20,469,000
      during the same period. The change in working capital from December 31, 2005,
      to
      June 30, 2006, reflects, in part, the 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 six months
      ended June 30, 2006. Total assets were $7,041,000 at June 30, 2006, compared
      to
      $9,293,000 at December 31, 2005.








25






**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 is presently due September 30, 2006. 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 against the promissory note. The balance due at December
      31,
      2005 was $486,000. During the six months ended June 30, 2006 we received an
      additional advance of $55,000 and made principal payments against the promissory
      note of $105,000. The balance due at June 30, 2006 was $436,000.





The
      unpaid balance of $436,000 is secured by our intellectual property rights.
      As of
      June 30, 2006, the Lenders had not converted any of the outstanding balance
      or
      interest into common stock.





***Notes
      Payable***





On
      February 28, 2004, LecStar had an asset securitization facility which provided
      LecStar with $750,000. Assets securitized under this facility consist of
      executory future cash flows from LecStar customers in the states of Georgia,
      Tennessee, Florida, and Louisiana. LecStar has pledged its interest in the
      special purpose securitization facility, LecStar Telecom Ventures LLC, and
      customer accounts receivable to the lender. We have recorded the $750,000 as
      a
      note payable in our consolidated financial statements. The note bears an
      interest rate of 6.5% and is due on February 27, 2007, with 24 equal monthly
      installments which began on March 6, 2005. During 2005, we made principal
      payments of $215,000. During the six months ended June 30, 2006, we made
      principal payments of $124,000. The balance of the note at June 30, 2006 was
      $413,000.





In
      connection with the acquisition of the capital stock of LTEL in 2004, we issued
      a 5%, $10,000,000, secured, six-year note payable to McCormack Avenue, Ltd.
      Under the terms of the note payable, quarterly interest only payments are
      required through January 15, 2005, with quarterly principal and interest
      payments beginning April 2005 and continuing through January 2010. Interest
      on
      the promissory 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 and its subsidiaries. The note was valued at $4,624,000 based on an
      imputed interest rate of 25 percent per annum. The note has a mandatory
      prepayment clause wherein we are required to make prepayments in any given
      month
      where we receive net proceeds in excess of $900,000 from the Fifth Equity Line
      (or replacements thereof with the Equity Line Investor). The required prepayment
      is calculated by multiplying the net proceeds received over $900,000 by 33%.
      For
      the year ended December 31, 2004, we made mandatory prepayments on the note
      of
      $415,000. During 2005, we made mandatory prepayments of $102,000. We have not
      made any mandatory prepayments during 2006.








26






The
      discount on the note is based on an imputed interest rate of 25%. The carrying
      amount of the note of $5,078,000 at June 30, 2006, was net of unamortized
      discount of $3,655,000. As of June 30, 2006, we had not made the scheduled
      payment for January 15, 2006 or April 15, 2006. As of August 8, 2006, we also
      had not made the scheduled July 15, 2006 payment. On May 12, 2006, McCormack
      and
      Fonix entered into an agreement, pursuant to which payments have been extended
      by the lender to June 16, 2006. As consideration for the extension, LecStar
      Telecom and LecStar DataNet granted to McCormack a security interest in all
      of
      the assets of LecStar Telecom and LecStar DataNet. As of August 8, 2006, we
      had
      not made any scheduled payments for 2006.





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 August 8, 2006, we
      had
      not made the scheduled payments on these promissory notes.





***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.





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. The third registration statement was filed June 23, 2006,
      and
      as of August 8, 2006, had note been declared effective by the SEC.





For
      the
      six months ended June 30, 2006, we received $3,267,000 in funds drawn under
      the
      Seventh Equity Line, less commissions and fees of $112,000. We issued
      277,215,715 shares of Class A common stock to the Equity Line Investor as puts
      under the Seventh Equity Line totaling $3,267,000. Subsequent to June 30, 2006
      and through August 8, 2006, we received $111,000 in funds, less commissions
      and
      fees of $2,000 and issued 22,784,282 shares of Class A common stock to the
      Equity Line Investor.








27






***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 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 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.





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.





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





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 six months ended June 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.





***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.





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





In
      connection with the issuance of the Series K Preferred Stock, the Company filed
      with the State of Delaware a Certificate of Designation and Series K 5%
      Convertible Stock Terms (the “Series K Terms”), which become a part of our
      Certificate of Incorporation, as amended.





Subsequent
      to filing, but prior to the issuance of any shares of Series K Preferred Stock,
      we agreed with Southridge to amend the Series K Terms to put a conversion cap
      of
      1.0%, in lieu of a 4.99% conversion cap. Fonix and Southridge entered into
      an
      Amended and Restated Series K 5% Convertible Preferred Stock Exchange Agreement,
      with the only change being the change in the conversion cap.






28








For
      the
      six months ended June 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.





***Stock
      Options and Warrants*** ****





During
      the six months ended June 30, 2006, we granted options to employees to purchase
      58,000 shares of Class A common stock. The options have a 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 June 30, 2006, we
      had a
      total of 1,310,705 options to purchase Class A common stock
      outstanding.





As
      of
      June 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
      offers businesses and consumers competitive technologies for integrated
      communication needs such as Voice over Internet Protocol (“VoIP”), Broadband
      over Power Line (“BPL”), switched telecommunication services and value-added
      embedded speech interface solutions. Fonix delivers its telecommunications
      and
      speech products and services through three incorporated subsidiaries: Fonix
      Telecom, Inc., LecStar Telecom, Inc. and Fonix Speech, Inc. Integration
      of company support functions and overhead will create organization-wide
      operational and financial efficiencies.





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
      expect
      to employ a consolidation-driven growth strategy in the telecommunication
      industry using Fonix Telecom as the platform. Fonix Telecom provides
      facilities-based local telephone service and interconnection services in
      Georgia, North Carolina, South Carolina, and Florida. Fonix Telecom also
      delivers VoIP services and has expanded its partner relationship with Duke
      Energy, a major utilities company serving customers in the Southern states,
      to
      deliver BPL services to business and residential customers. We anticipate
      strategic acquisitions of synergistic companies that will result in a stable
      revenue stream and an expanded customer base.




LecStar
      Telecom will continue to deliver an array of wireline voice, data and
      carrier-grade local and long distance telephone services utilizing traditional
      lines in the Southeast. LecStar’s customer base is limited as a consequence of increased
      regulatory flexibility resulting in material and retail and wholesale price
      increases.





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
      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 June 30, 2006, we had an accumulated deficit of $261,206,000,
      negative working capital of $23,486,000, accrued liabilities and accrued
      settlement obligation of $12,190,000 and accounts payable $8,269,000. Sales
      of
      products and telecommunications services and revenue from licenses based on
      our
      technologies have not been sufficient to finance ongoing operations. We have
      limited capital available under the Seventh Equity Line. 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 telecommunications services, and 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 the sale
      of
      our equity securities, primarily in connection with the Seventh Equity Line.
      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; the availability of telecommunications services; development of
      complementary technologies, products, marketing, and strategic alliance
      opportunities; the impacts on legacy CLECs of recent regulatory changes; the
      cost-efficiency of LecStar’s business strategy; the impact of legislative
      initiatives on local exchange competition; 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; our expectations with respect to revenues from
      our
      telecommunication activities; 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;








30






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





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





•
            integration
                of acquired businesses, especially integration of
                LecStar;





•
            changes
                in laws or different interpretations of laws including particularly
                potential revisions to the 1996 Telecommunications Act, which could
                have a
                material impact on our telecommunications business and
                operations;





•
            recent
                FCC rules relating to independent local exchange carrier obligations
                to
                provide access to unbundled network elements, unbundled local switching,
                and unbundled loops and transport;





•
            increases
                by the FCC in Total Element Long Run Incremental Cost, or TELRIC,
                rates
                and inter-carrier compensation;





•
            the
                outcome of BellSouth’s appeal of the Georgia Public Service Commission
                order requiring BellSouth to pursue the change of law clause in its
                interconnection agreements (as discussed in more detail in the Risk
                Factors section below);





•
            potential
                IRS rules relating to taxation of communications services, including
                Voice
                over Internet Protocol and other IP-based services, applications,
                and
                technologies;





•
            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.






31








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.





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**





**Grenfell
      Litigation** - Two of
      the Company’s subsidiaries, LecStar Telecom and LecStar DataNet (collectively
“LecStar”), are among the defendants who were sued in the Superior Court of
      Fulton County, State of Georgia, by James D. Grenfell, the former CFO of the
      former parent of LecStar. The suit was filed in December 2003. The plaintiff
      in
      that case alleged that he had an unpaid judgment in the amount of $1,015,000
      plus interest against the former parent entities of LecStar and that the purpose
      of a transfer of the stock and business of LecStar in December 2002 was to
      avoid
      paying the judgment. In September 2005, the plaintiff dismissed the action
      in
      Fulton County. In December 2005, the plaintiff reasserted his claim in the
      Superior Court of Cobb County, State of Georgia, and, in addition to LecStar,
      the plaintiff named Fonix and LTEL Holdings as defendants in the new lawsuit.
      Fonix is the sole shareholder of LTEL Acquisition Corporation which is the
      sole
      shareholder of LTEL Holdings. Among other things, the plaintiff is seeking
      an
      attachment of stock and assets of LecStar, to unwind the previous transfer
      of
      the stock and business of LecStar in December 2002, and for money damages.





The
      Company and LecStar are aggressively defending against these claims. No
      assessment currently can be made of the likelihood of an unfavorable outcome.





**First
      Empire** - Claims
      similar to the claims brought in the Grenfell Litigation were also asserted
      by
      other plaintiffs in First Empire Corporation, et al., v. LecStar Corporation,
      et
      al., filed in the Superior Court of Fulton County, State of Georgia. In the
      third amended complaint filed in October 2005, the plaintiffs named W. Dale
      Smith, Chad Smith, Michael Britt, and LTEL Holdings Corporation as defendants.
      Messrs Smith and Britt are former officers and directors of the former parent
      of
      LecStar. LTEL Holdings was the sole shareholder of LecStar when acquired by
      the
      Company in February 2004. In the third amended complaint, the plaintiffs allege
      that Dale Smith breached his fiduciary duty to the former parent of LecStar
      by
      participating in the transaction in which the parent lost control of LecStar,
      that LTEL Holdings procured that alleged wrongful conduct from Smith, that
      the
      transaction in which the former parent lost control of LecStar was a fraudulent
      conveyance, and that a constructive trust should be imposed on LecStar for
      the
      benefits of the plaintiffs.








32





Messrs.
      Smith and Britt and LTEL Holdings have filed an answer in the litigation, but
      have not been involved in discovery in this litigation because the litigation
      is
      in the early stages. Nonetheless, the Company believes that the claims of the
      plaintiffs are without merit, and management intends to vigorously defend
      against the claims of the plaintiffs.





The
      principal Series H preferred stockholder has placed 300 shares of Series H
      Preferred Stock in escrow (the “Escrow Shares”) for a period of 12 months from
      the date of acquisition as protection with respect to breaches of
      representations and warranties of the LTEL Holdings selling stockholders,
      including any liability or payment that may arise from the above mentioned
      legal
      action. As a result of the filing of the First Empire Litigation, the Company
      has asserted a claim for breach of certain representations and warranties.
      To
      the Company’s knowledge, the Escrow Shares have not been released.





**Greenwich
      Insurance Action** - The
      Greenwich litigation is an action filed in the United States District Court
      for
      the Northern District of Georgia, in which Greenwich Insurance Company is
      seeking a declaratory judgment against the directors and officers of the former
      parent entity of LecStar and others. Greenwich seeks an order that it is not
      liable for coverage under its directors and officers’ liability policy for
      claims asserted in the First Empire litigation against several individuals
      who
      were officers and directors of LecStar, including W. Dale Smith, Michael Britt
      and Chad Smith. Greenwich also seeks recovery of fees advanced to law firms
      on
      behalf of these individuals for defense costs associated with the First Empire
      litigation, which Greenwich claims are in excess of $100,000. LecStar Telecom
      has agreed to assume defense costs incurred on behalf of Messrs. Smith and
      Britt
      in the Greenwich litigation. Messrs. Smith and Britt have filed answers denying
      the allegations of Greenwich. While it is the intent of Messrs. Smith and Britt
      to aggressively defend against the plaintiff’s claims, Messrs. Smith and Britt
      may experience exposure to the loss of insurance coverage presently afforded
      under the policy of insurance provided by Greenwich. In that case, LecStar
      Telecom may have exposure for any liability associated with indemnity claims
      from the officers and directors arising from previously advanced and future
      defense costs, as well as the costs of defending the Greenwich claim
      itself.





***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. No answer to the
      complaint has been filed. 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.








33






**Holders
      of Fonix Class A common stock are subject to the risk of additional and
      substantial dilution to their interests as a result of the issuances of Class
      A
      common stock in connection with the Seventh Equity Line.**





The
      following table describes the number of shares of Class A common stock that
      would be issuable, assuming that the full remaining amount available under
      the
      Seventh Equity Line as of August 8, 2006, namely $13,495,000, had been put
      to
      the Equity Line Investor (irrespective of the contractual limitations and
      availability of registered shares), and further assuming that the applicable
      conversion price at the time of such put were the following amounts:




Hypothetical
                Conversion Price
            Shares
                issuable upon
              puts
                aggregating $13,495,000$0.005
            2,699,000,000$0.01
            1,349,500,000$0.02
            674,750,000$0.05
            269,900,000$0.10
            134,950,000$0.15
            89,966,667$0.17
            79,382,353




Given
      the
      formulas for calculating the shares to be issued in connection with puts under
      the Seventh Equity Line, there effectively is no limitation on the number of
      shares of Class A common stock which may be issued in connection with a put
      under the Seventh Equity Line, except for the number of shares registered under
      the prospectus and the registration statement covering the resale of shares
      issued in connection with the Seventh Equity Line. As such, shareholders are
      subject to the risk of substantial dilution to their interests as a result
      of
      our issuance of shares under the Seventh Equity Line.





For
      example, if the Company were to draw down $8,000,000, at August 8, 2006, under
      the Seventh Equity Line, the number of shares issuable would be approximately
      1,433,692,000. As of August 8, 2006, we had 820,095,891 shares of our Class
      A
      common stock issued and outstanding. An issuance of 1,433,692,000 would
      constitute an increase of approximately 175%. By way of information, during
      2005
      and through August 8, 2006, our stock price ranged from $0.005 to $0.17 per
      share





**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
      $4,506,000 for the three months ended June 30, 2006 and $8,582,000 for the
      six
      months ended June 30, 2006. As of June 30, 2006, we had an accumulated deficit
      of $261,206,000, accrued liabilities and accrued settlement obligation of
      $12,190,000 and owed trade payables of $8,269,000.





We
      expect
      to continue to spend significant amounts to expand our telecommunications
      services, 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.






34








**LecStar's
      current operations may not provide sufficient cash flow to sustain operations,
      and we may be required to divert proceeds from our Seventh Equity Line towards
      offsetting cash flow shortfalls at LecStar for an indefinite time period. If
      we
      do not receive additional capital when and in the amounts needed in the near
      future, our ability to continue as a going concern is in substantial
      doubt.**





We
      previously established six equity lines of credit with an unaffiliated third
      party (the “Equity Line Investor”) upon which we drew to pay operating expenses.
      We have entered into a Seventh Equity Line agreement wherein we have previously
      registered the sale of up to 400,000,000 shares of Class A common stock and
      have
      registered the sale of up to another 800,000,000 shares of Class A common stock.
      As of August 8, 2006, $13,495,000 remained available under the Seventh Equity
      Line.





LecStar’s
      operations did not generate sufficient operating revenue to pay all operating
      expenses in 2005 and required us to fund some of its operations and liabilities
      through our otherwise available financing sources, including the Seventh Equity
      Line. There can be no assurance that LecStar will become self-sufficient during
      2006 or at all, or that if LecStar becomes self-sufficient whether it will
      be
      able to maintain such level of operations. If we are required to provide
      significant operating capital to LecStar for extended periods, our business
      and
      financial condition could be adversely and materially affected. Accordingly,
      if
      we are not able to obtain adequate financing under the existing or additional
      equity line agreements or from other financing sources when and in the amounts
      needed, and on terms that are acceptable, our operations, financial condition
      and prospects could be materially and adversely affected, and we could be forced
      to curtail our operations or sell part or all of our assets, including our
      Core
      Technologies, LTEL or LecStar, or seek protection under bankruptcy laws.





**Continuing
      debt obligations could impair our ability to continue as a going
      concern.**





As
      of
      June 30, 2006, 2005, we had debt obligations of $6,577,000, accrued liabilities
      and accrued settlement obligation of $12,190,000 and vendor accounts payable
      of
      approximately $8,269,000. At present, our revenues from existing licensing
      arrangements, Speech Product sales and telecommunication services are not
      sufficient to offset our ongoing operating expenses or to pay in full our
      current debt obligations.





In
      connection with the acquisition of the capital stock of LTEL, we issued a 5%
      $10,000,000 secured, six-year note payable to McCormack Avenue, Ltd. Under
      the
      terms of the note payable, quarterly interest only payments were required
      through January 15, 2005 with quarterly principal and interest payments which
      began April 2005 through the final payment due January 2010.





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, including the Core Technologies, LTEL or LecStar, 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.





**Additional
      Risk Factors Associated with the Acquisition of LTEL Holdings
      Corporation**





**Regulatory
      Uncertainty**





Prior
      to
      2005, the Company’s telecommunications services were provided almost exclusively
      through the use of unbundled network elements purchased from BellSouth,
      LecStar’s primary incumbent local exchange company (“ILEC”), that were made
      available to us pursuant to 1996 Telecommunications Act (the “1996 Act”) and the
      Federal Communications Commission (“FCC”) rules. The availability of cost-based
      rates for these unbundled network elements has enabled LecStar to price its
      local telecommunications services competitively.





In
      December 2004, the FCC issued final rules that effectively eliminated the
      requirement under the 1996 Act that incumbent local exchange companies provide
      competitive local exchange companies (“CLECs”), including the Company’s
      telecommunications operations, wholesale services using the unbundled network
      element platform (“UNE-P”) on a cost based rate known as Total Element Long Run
      Incremental Cost. The FCC established a 12-month transition plan for
      implementation:






35








·
            Effective
                on March 11, 2005, LecStar was no longer able to use UNE-P to provide
                service to new customers, but continued to do so for our then-existing
                customers until March 10, 2006. As a result, LecStar was unable to
                add new
                customers in any area where LecStar did not have access to a wholesale
                alternative to BellSouth.





·
            From
                March 11, 2005 to March 10, 2006, the wholesale rates that LecStar
                was
                charged for the unbundled network elements purchased from the ILECs
                were
                increased by $1 per line per month. Since March 11, 2006, LecStar
                has not
                been able to use UNE-P to provide service to any of our customers,
                including pre-existing customers. As a result, LecStar has serviced
                its
                customers that are not served by another wholesale network through
                resale
                or other wholesale agreements with BellSouth which has resulted in
                significantly higher costs as compared to servicing customers using
                the
                previously available UNE-P
                platform.





In
      December 2004, the FCC also adopted new rules affecting our access to the local
      loops facilities and the dedicated transport facilities that we purchase from
      BellSouth and that are necessary for the operation of our own network
      facilities. These new rules apply only to the customer base as it existed on
      March 11, 2005, and do not permit LecStar to add new dedicated transport
      unbundled network elements in the absence of impairment.





The
      loss
      of access to cost-based UNE-P substantially impaired our plans to deploy our
      own
      network facilities. Our cost of service has risen dramatically and our plans
      for
      a service rollout using our own network facilities could be delayed
      substantially or curtailed entirely. These regulatory changes have had a
      material adverse effect on our business, prospects, operating margins, results
      of operations, cash flows and financial condition.





In
      June
      2003, the Georgia Public Service Commission (“GPSC”) reduced rates for wholesale
      access to unbundled elements in Georgia, as part of a comprehensive cost case.
      The result of that ruling was appealed by BellSouth. During the intervening
      period LecStar Telecom has been purchasing UNE-P lines at the rates established
      by the GPSC in June 2003. The U.S. District Court for the Northern District
      of
      Georgia ruled in April 2004 that the June 2003 GPSC order was unlawful. The
      Court remanded the case back to the GPSC with a requirement to “make whole”
BellSouth for the difference in rates. Other CLECs appealed the ruling to the
      U.S. Court of Appeals for the Eleventh Circuit. On appeal, the District Court’s
      ruling was affirmed in February 2005. The GPSC then established a new higher
      rate for UNE-P in Georgia in February 2006 and established a period of time
      through which LecStar Telecom would have to pay the difference in rates to
      BellSouth. A roll back to pre June 2003 UNE-P rates has an impact of roughly
      $2.00 per line per month. On May 1, 2006 BellSouth sent a letter to LecStar
      accompanied by a breakdown of the proposed true up of rates in the amount of
      $1,564,000. LecStar Telecom has begun reviewing the backup materials provided
      by
      BellSouth and has identified significant errors in the calculations. LecStar
      Telecom has been actively seeking to correct these errors. While the exact
      amount of the true up payments are not currently known, the extent to which
      these charges can be back billed based upon interconnection agreement will
      need
      to be addressed in negotiations with BellSouth and, potentially, before the
      GPSC.





***Potential
      Impacts***





We
      are
      subject to federal, state, and local laws, regulations, and orders affecting
      the
      rates, billing, terms, and conditions of certain of our service offerings,
      our
      costs and other aspects of our operations, including our relations with other
      service providers. Regulation varies in each jurisdiction and may change in
      response to judicial proceedings, legislative and administrative proposals,
      government policies, competition and technological developments. We cannot
      predict what impact, if any, such changes or proceedings may have on our
      business or results of operations, and we cannot guarantee that regulatory
      authorities will not raise material issues regarding our compliance with
      applicable regulations. There are several regulatory factors that could cause
      our network and line costs as a percentage of revenue to increase in the future,
      including without limitation:








36








·
            As
                a result of significant changes to the FCC rules that required the
                incumbent local exchange companies, such as the Regional Bell Operating
                Companies that are our principal suppliers, to provide us the unbundled
                network elements of their operating platforms on a wholesale basis,
                the
                wholesale operating platforms of the incumbent local exchange companies
                is
                effectively not available at cost based rates. This determination
                and
                others by the FCC, courts, or state commissions that make unbundled
                local
                switching and/or combinations of unbundled network elements effectively
                unavailable to us in some or all of our geographic service areas,
                has
                required us to provide services in these areas through other means,
                including total service resale agreements, purchase of special access
                services or network elements from the Regional Bell Operating Companies
                or
                wholesale services from other CLECs. Access to unbundled network
                elements
                at "just and reasonable" rates under Section 271 of the Act is another
                alternative platform; however, to our knowledge, no public service
                commission in the Southeast had established 271 rates for local switching
                as of the date of the report. Regardless of the platform used to
                serve
                customers, in all cases we have experienced and are likely to experience
                significantly increased costs of
                service.





·
            Another
                factor that could cause our costs to increase is the potential adverse
                changes to the current pricing methodology, TELRIC, mandated by the
                FCC
                for use in establishing the prices charged to us by incumbent local
                exchange companies for the use of their unbundled network elements
                for as
                long as we are permitted to continue to use them, and for the use
                of
                transport and other services in connection with our local network.
                The
                FCC’s 2003 Triennial Review Order, which was reversed in part and remanded
                to the FCC with instructions to revise the Order in material ways
                clarified several aspects of these pricing principles related to
                depreciation, fill factors (i.e. network utilization) and cost of
                capital,
                which could enable ILECs to increase the prices for unbundled network
                elements. In addition, the FCC released a Notice of Proposed Rulemaking
                on
                December 15, 2003, which initiated a proceeding to consider making
                additional changes to its unbundled network element pricing methodology,
                including reforms that would base prices more on the actual network
                costs
                incurred by incumbent local exchange companies than on the hypothetical
                network costs that would be incurred when the most efficient technology
                is
                used. The TELRIC methodology still governs our pricing for loops
                purchased
                from the incumbent local exchange companies in connection with our
                local
                network. We cannot predict if the FCC will order new TELRIC pricing
                or if
                Congress will amend the 1996 Act, affecting such pricing or availability.
                These changes could result in material increases in prices charged
                to us
                for unbundled network elements, including those used in our own local
                network.





As
      a
      result of such current uncertainty in the regulatory environment, any or all
      of
      a variety of variables such as the pending Federal and related state regulatory
      and court decisions, on-going proceedings in these jurisdictions and commercial
      negotiations underway, could potentially result in retroactively applied
      liabilities, future increases in monthly recurring costs of services, or
      both.





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





During
      the six months ended June 30, 2006, we issued 277,215,718 shares of our common
      stock under the Seventh Equity Line to the Equity Line Investor in connection
      with draws of $3,267,000. 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. Subsequent to June
      30,
      2006 and through August 8, 2006, we issued 22,784,282 shares of our common
      stock
      under the Seventh Equity Line. 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 a registration statement on Form S-1 and Form S-2. The proceeds
      from the Seventh Equity Line transactions were used for working
      capital.





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





***2006
      Annual Meeting of Shareholders***





On
      June
      23, 2006, we held our Annual Meeting of Shareholders in Salt Lake City, Utah.
      The record date for the meeting was May 5, 2006, on which date there were
      725,556,921 shares of our class A common stock outstanding.





The
      first
      matter voted upon at the meeting was the election of directors. The following
      directors were elected:






37








**DIRECTOR**
            
            **SHARES**
              **VOTED
                IN FAVOR**
            
            **SHARES**
              **VOTED
                AGAINST**Thomas
                A. Murdock
            
            509,110,346
            
            60,974,771Roger
                D. Dudley
            
            509,210,311
            
            60,874,806William
                A. Maasberg, Jr.
            
            512,869,900
            
            57,215,217





The
      second matter voted upon at the meeting was the approval of the Board of
      Directors’ selection of Hansen, Barnett & Maxwell as our independent
      registered public accounting firm for the fiscal year ending December 31, 2005
      and 2006. The results of the voting were 525,290,918 shares in favor, 42,205,569
      shares against and 2,588,630 shares abstaining.





The
      third
      matter voted upon at the meeting was the approval of an amendment to our
      Certificate of Incorporation to increase our authorized capital from 800,000,000
      shares of common stock to 5,000,000,000 shares of common stock. The results
      of
      the voting were 486,959,479 shares in favor, 81,945,287 shares against and
      1,180,351 shares abstaining.





The
      fourth matter voted upon at the meeting was a shareholder proposal relating
      to
      our adopting corporate governance guidelines and setting a company policy
      relating to an independent board of directors. The results of the voting were
      68,861,283 shares in favor, 31,045,652 shares against, 1,484,923 shares
      abstaining and 468,693,259 shares were not voted.





**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 Exhibit31.1
            Certification
                of President31.2
            Certification
                of Chief Financial Officer32.1
            Certification
                of President Pursuant to Section 906 of the Sarbanes-Oxley Act of
                200232.2
            Certification
                of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley
                Act of 2002.
































38






**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:
                August 10, 2006
            /s/
                Roger D. DudleyRoger
                D. Dudley, Executve Vice President,Chief
                Financial Officer(Principal
                financial officer)