|UNITED STATES                                                                                                                                                                                                                                                                                                                                                          
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|SECURITIES AND EXCHANGE COMMISSION                                                                                                                                                                                                                                                                                                                                     
|Washington, D.C. 20549                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                       
|FORM 10-Q                                                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                       
|(Mark one)                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                                                                                                                                                                                                                                       
|[X]
Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended June 30, 2005, or                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                       
|[   ]
Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from ______________ to _____________.                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                                                                                       
|Commission File No. 0-23862                                                                                                                                                                                                                                                                                                                                            
|Fonix Corporation                                                                                                                                                                                                                                                                                                                                                      
|(Exact name of registrant as specified in its charter)                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                       
|Delaware  22-2994719                                                                                                                                                                                                                                                                                                                                                   
|(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.)                                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                                       
|9350 South 150 East, Suite 700                                                                                                                                                                                                                                                                                                                                         
|Sandy, Utah 84070                                                                                                                                                                                                                                                                                                                                                      
|(Address of principal executive offices with zip code)                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                       
|(801) 553-6600                                                                                                                                                                                                                                                                                                                                                         
|(Registrant's telephone number, including area code)                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                       
|Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes [X] No[ ].
|                                                                                                                                                                                                                                                                                                                                                                       
|Indicate by check mark whether the registrant is an accelerated filer (as defined in rule 12b-2 of the Exchange Act).  Yes [ ] No [X].                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                       
|As of August 10, 2005, there were issued and outstanding 271,265,451 shares of our Class A common stock.                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                       





1







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|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, 2005 and December 31, 2004
3             
|                                                                                                
|Condensed Consolidated Statements of Operations and Comprehensive Loss for the                  
|Three Months and Six Months Ended June 30, 2005 and 2004
4                                      
|                                                                                                
|Condensed Consolidated Statements of Cash Flows for the Six Months Ended                        
|June 30, 2005 and 2004
5                                                                        
|                                                                                                
|Notes to Condensed Consolidated Financial Statements
7                                          
|                                                                                                
|Item 2.
Managements Discussion and Analysis of Financial Condition and Results of Operations
22
|                                                                                                
|Item 3.
Quantitative and Qualitative Disclosures about Market Risk
36                           
|                                                                                                
|Item 4.
Evaluation of Disclosure Controls and Procedures
38                                     
|                                                                                                
|                                                                                                
|PART II - OTHER INFORMATION                                                                     
|                                                                                                
|Item 1.
Legal Proceedings
38                                                                    
|                                                                                                
|Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
40                          
|                                                                                                
|Item 6.
Exhibits
40                                                                             









2







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Fonix Corporation and Subsidiaries

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)



|                                                                                                   |                                                                    |                                                                                                      |                      | June 30,  | December 31,
|-------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------ | ---------------------------------------------------------------------------------------------------- | -------------------- | --------- | ------------
|                                                                                                   |                                                                    |                                                                                                      |                      | 2005      | 2004        
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|ASSETS                                                                                             |                                                                    |                                                                                                      |                     
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|Current assets                                                                                     |                                                                    |                                                                                                     
|                                                                                                   | Cash and cash equivalents                                          | $            393,000                                                                                 | $            423,000
|                                                                                                   | Accounts receivable                                                | 1,213,000                                                                                            | 1,541,000           
|                                                                                                   | Prepaid expenses and other current assets                          | 290,000                                                                                              | 156,000             
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|Total current assets                                                                               | 1,896,000                                                          | 2,120,000                                                                                           
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|Long-term investments                                                                              | -                                                                  | 237,000                                                                                             
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|Property and equipment, net of accumulated depreciation of $1,556,000 and $1,456,000, respectively | 992,000                                                            | 236,000                                                                                             
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|Deposit in escrow                                                                                  | 395,000                                                            | 395,000                                                                                             
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|Deposits and other assets                                                                          | 1,246,000                                                          | 1,072,000                                                                                           
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|Intangible assets,net of accumulated amortization of $7,887,000 and $5,453,000, respectively       | 9,137,000                                                          | 12,309,000                                                                                          
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|Goodwill                                                                                           |                                                                    | 2,631,000                                                                                            | 2,631,000           
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|Total assets                                                                                       | $       16,297,000                                                 | $       19,000,000                                                                                  
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|LIABILITIES AND STOCKHOLDERS' DEFICIT                                                              |                                                                    |                                                                                                     
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|Current liabilities                                                                                |                                                                    |                                                                                                     
|                                                                                                   | Accrued liabilities                                                | $         7,674,000                                                                                  | $         6,815,000 
|                                                                                                   | Accounts payable                                                   | 5,903,000                                                                                            | 5,225,000           
|                                                                                                   | Accrued payroll and other compensation                             | 501,000                                                                                              | 1,756,000           
|                                                                                                   | Deferred revenues                                                  | 1,028,000                                                                                            | 984,000             
|                                                                                                   | Notes payable - related parties                                    | 623,000                                                                                              | 513,000             
|                                                                                                   | Current portion of notes payable                                   | 1,158,000                                                                                            | 214,000             
|                                                                                                   | Deposits and other                                                 | 216,000                                                                                              | 193,000             
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|Total current liabilities                                                                          | 17,103,000                                                         | 15,700,000                                                                                          
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|Long-term notes payable, net of current portion                                                    | 4,517,000                                                          | 5,358,000                                                                                           
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|Total liabilities                                                                                  | 21,620,000                                                         | 21,058,000                                                                                          
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|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              | 500,000  
|                                                                                                   |                                                                    | Series H, nonconvertible; 2,000 shares outstanding (aggregate liquidation preference of $20,000,000) | 4,000,000            | 4,000,000
|                                                                                                   |                                                                    | Series I, convertible; 1,172 and 2,250 shares outstanding, respectively                              |                      |          
|                                                                                                   |                                                                    | (aggregate liquidation preference of $1,350,000)                                                     | 1,172,000            | 2,250,000
|                                                                                                   | Common stock, $0.0001 par value; 800,000,000 shares authorized;    |                                                                                                      |                     
|                                                                                                   |                                                                    | Class A voting, 242,547,954 and 131,200,170 shares outstanding, respectively                         | 24,000               | 13,000   
|                                                                                                   |                                                                    | Class B non-voting, none outstanding                                                                 | -                    | -        
|                                                                                                   | Additional paid-in capital                                         | 223,828,000                                                                                          | 217,061,000         
|                                                                                                   | Outstanding warrants to purchase Class A common stock              | 735,000                                                                                              | 735,000             
|                                                                                                   | Cumulative foreign currency translation adjustment                 | 30,000                                                                                               | 8,000               
|                                                                                                   | Accumulated deficit                                                | (235,612,000)                                                                                        | (226,625,000)       
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|Total stockholders' deficit                                                                        | (5,323,000)                                                        | (2,058,000)                                                                                         
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             
|Total liabilities and stockholders' deficit                                                        | $       16,297,000                                                 | $       19,000,000                                                                                  
|                                                                                                   |                                                                    |                                                                                                      |                      |           |             

See accompanying notes to condensed consolidated financial statements.



3



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Fonix Corporation and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(Unaudited)



|                                                                 |                                     |                   |           | Three Months Ended June 30, |           | Six Months Ended  June 30,
|---------------------------------------------------------------- | ----------------------------------- | ----------------- | --------- | --------------------------- | --------- | --------------------------
|                                                                 |                                     | 2005              |           | 2004                        |           | 2005                      
|                                                                 |                                     |                   |           |                             |           |                           
|                                                                 |                                     |                   |           |                             |           |                           
|Revenues                                                         |                                     | $   4,324,000     |           | $   4,242,000               |           | $   8,547,000             
|Cost of revenues                                                 |                                     | 2,499,000         |           | 2,269,000                   |           | 4,686,000                 
|                                                                 |                                     |                   |           |                             |           |                           
|Gross profit                                                     |                                     | 1,825,000         |           | 1,973,000                   |           | 3,861,000                 
|                                                                 |                                     |                   |           |                             |           |                           
|Expenses:                                                        |                                     |                   |           |                             |           |                           
|                                                                 | Selling, general and administrative |                   | 3,404,000 |                             | 3,779,000 |                           
|                                                                 | Impairment of intangible assests    |                   | -         |                             | 738,000   |                           
|                                                                 | Amortization of intangible assets   |                   | 1,586,000 |                             | 1,709,000 |                           
|                                                                 | Product development and research    |                   | 527,000   |                             | 668,000   |                           
|                                                                 |                                     |                   |           |                             |           |                           
|Total expenses                                                   |                                     | 5,517,000         |           | 6,894,000                   |           | 11,035,000                
|                                                                 |                                     |                   |           |                             |           |                           
|Other income (expense):                                          |                                     |                   |           |                             |           |                           
|                                                                 | Interest income                     |                   | 5,000     |                             | 1,000     |                           
|                                                                 | Gain on forgiveness of liabilities  |                   | 16,000    |                             | 21,000    |                           
|                                                                 | Interest expense                    |                   | (666,000) |                             | (666,000) |                           
|                                                                 | Gain on sale of investments         |                   | -         |                             | -         |                           
|                                                                 |                                     |                   |           |                             |           |                           
|Other expense, net                                               |                                     | (645,000)         |           | (644,000)                   |           | (1,240,000)               
|                                                                 |                                     |                   |           |                             |           |                           
|Net loss                                                         |                                     | (4,337,000)       |           | (5,565,000)                 |           | (8,414,000)               
|Preferred stock dividends                                        |                                     | (276,000)         |           | (315,000)                   |           | (573,000)                 
|                                                                 |                                     |                   |           |                             |           |                           
|Loss attributable to common stockholders                         |                                     | $ (4,613,000)     |           | $  (5,880,000)              |           | $ (8,987,000)             
|                                                                 |                                     |                   |           |                             |           |                           
|                                                                 |                                     |                   |           |                             |           |                           
|Basic and diluted loss per common share                          |                                     | $          (0.02) |           | $           (0.07)          |           | $          (0.05)         
|                                                                 |                                     |                   |           |                             |           |                           
|                                                                 |                                     |                   |           |                             |           |                           
|Net loss                                                         |                                     | $ (4,337,000)     |           | $  (5,565,000)              |           | $ (8,414,000)             
|Other comprehensive (loss) income - foreign currency translation | 11,000                              |                   | -         |                             | 22,000    |                           
|                                                                 |                                     |                   |           |                             |           |                           
|Comprehensive loss                                               |                                     | $ (4,326,000)     |           | $  (5,565,000)              |           | $ (8,392,000)             







See accompanying notes to condensed consolidated financial statements.



4



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Fonix Corporation and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)



|                                                                            |                                                                          |                                           |                 | Six Months Ended June 30,
|--------------------------------------------------------------------------- | ------------------------------------------------------------------------ | ----------------------------------------- | --------------- | -------------------------
|                                                                            |                                                                          |                                           |                 | 2005                     
|Cash flows from operating activities                                        |                                                                          |                                           |                
|Net loss                                                                    |                                                                          | $    (8,414,000)                          |                 | $    (7,905,000)         
|Adjustments to reconcile net loss to net cash used in operating activities: |                                                                          |                                           |                
|                                                                            | Stock issued for interest expense related to McCormack Note              | 267,000                                   |                 | -                        
|                                                                            | Accretion of discount on notes payable                                   | 375,000                                   |                 | 214,000                  
|                                                                            | Impairment losses                                                        | -                                         |                 | 737,000                  
|                                                                            | Gain on sale of long-term assets                                         | (134,000)                                 |                 | -                        
|                                                                            | Gain on forgiveness of liabilities                                       | -                                         |                 | (502,000)                
|                                                                            | Amortization of intangibles                                              | 3,172,000                                 |                 | 2,282,000                
|                                                                            | Depreciation and amortization                                            | 82,000                                    |                 | 189,000                  
|                                                                            | Foreign exchange loss (gain)                                             | 22,000                                    |                 | (13,000)                 
|                                                                            | Changes in assets and liabilities, net of effects from purchase of LTEL: |                                           |                 |                          
|                                                                            |                                                                          | Accounts receivable                       | 328,000         |                          
|                                                                            |                                                                          | Prepaid expenses and other current assets | (134,000)       |                          
|                                                                            |                                                                          | Other assets                              | (174,000)       |                          
|                                                                            |                                                                          | Accounts payable                          | 678,000         |                          
|                                                                            |                                                                          | Accrued payroll and other compensation    | (1,255,000)     |                          
|                                                                            |                                                                          | Other accrued liabilities                 | 774,000         |                          
|                                                                            |                                                                          | Deferred revenues                         | 44,000          |                          
|                                                                            |                                                                          |                                           |                 |                          
|                                                                            | Net cash used in operating activities                                    | (4,369,000)                               |                 | (8,687,000)              
|                                                                            |                                                                          |                                           |                 |                          
|Cash flows from investing activities                                        |                                                                          |                                           |                
|Cash received in connection with LTEL acquisition                           | -                                                                        |                                           | 47,000         
|Proceeds from sale of long term investment                                  | 371,000                                                                  |                                           | -              
|Payments of deposit into escrow                                             | -                                                                        |                                           | (340,000)      
|Purchase of property and equipment                                          | (838,000)                                                                |                                           | (171,000)      
|                                                                            |                                                                          |                                           |                 |                          
|                                                                            | Net cash used in investing activities                                    | (467,000)                                 |                 | (464,000)                
|                                                                            |                                                                          |                                           |                 |                          
|Cash flows from financing activities                                        |                                                                          |                                           |                
|Proceeds from issuance of Class A common stock, net                         | 4,791,000                                                                |                                           | 7,809,000      
|Proceeds from related party note payable                                    | 110,000                                                                  |                                           | -              
|Proceeds from issuance of Series I Preferred Stock                          | -                                                                        |                                           | 3,010,000      
|Payment of dividend on Series H Preferred Stock                             | -                                                                        |                                           | (350,000)      
|Principal payments on notes payable                                         | (95,000)                                                                 |                                           | (95,000)       
|Proceeds from note payable                                                  | -                                                                        |                                           | -              
|                                                                            |                                                                          |                                           |                 |                          
|                                                                            | Net cash provided by financing activities                                | 4,806,000                                 |                 | 10,374,000               
|                                                                            |                                                                          |                                           |                 |                          
|Net (decrease) increase in cash and cash equivalents                        | (30,000)                                                                 |                                           | 1,223,000      
|                                                                            |                                                                          |                                           |                 |                          
|Cash and cash equivalents at beginning of year                              | 423,000                                                                  |                                           | 50,000         
|                                                                            |                                                                          |                                           |                 |                          
|Cash and cash equivalents at end of year                                    | $        393,000                                                         |                                           | $     1,273,000
|                                                                            |                                                                          |                                           |                 |                          
|                                                                            |                                                                          |                                           |                 |                          
|Supplemental disclosure of cash flow information                            |                                                                          |                                           |                
|                                                                            | Cash paid during the period for interest                                 | $        238,000                          |                 | $        522,500         



See accompanying notes to condensed consolidated financial statements.



5



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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, 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



For the Six Months Ended June 30, 2004:



Issued 1,463,753 shares of Class A common stock in full satisfaction of $292,000 of liabilities.



In February 2004, the Company purchased all of the capital stock of LTEL Holdings Corporation for $12,800,000.  In conjunction with the acquisition, the Company acquired $22,259,000 of assets and assumed $9,459,000 liabilities of LTEL Holdings Corporation by the issuance of 7,036,801 shares of Class A common stock valued at $4,176,000, the issuance of 2,000 shares of 5% Series H nonvoting, nonconvertible preferred stock valued at $4,000,000 and the issuance of a 5% $10,000,000 promissory note valued at $4,624,000.





See accompanying notes to condensed consolidated financial statements.



6



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Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)





1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



Basis of Presentation - The accompanying unaudited condensed consolidated financial statements ofFonixCorporation and subsidiaries (collectively, the Company or Fonix) have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the SEC).  Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the following disclosures are adequate to make the information presented not misleading.  The Company suggests that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in the Companys 2004 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 2004 Annual Report on Form 10-K.



Operating results for the six months ended June 30, 2005, are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.



Nature of Operations Fonix Corporation and its subsidiaries are engaged in providing integrated telecommunications services through LTEL Holdings Corporation and Fonix Telecom, Inc., and value-added speech-enabling technologies through The Fonix Speech Group.  Through LTEL Holdings Corporation, the Company operates LecStar Telecom, Inc., a regional provider 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.)  Through Fonix Telecom, Inc., the Company offers Voice over Internet Protocol (VoIP) and Broadband Power Line (BPL) telecommunication services primarily in the Southeastern United States.



The Company offers its speech-enabling technologies including automated speech recognition (ASR) and text-to-speech (TTS) through The Fonix Speech Group.  The Company offers ASR and TTS technologies to markets for wireless and mobile devices, computer telephony, server solutions and personal software for consumer applications. 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 seeks to develop relationships and strategic alliances with third-party developers and vendors in telecommunications, computers, electronic devices and related industries, including producers of application software, operating systems, computers and microprocessor chips.  Revenues relating to the speech-enabling technologies are generated through licensing agreements, maintenance contracts and services.



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.



Fonix Telecoms VoIP telecommunication services include wireline voice, data, and long distance to primarily business customers.  Fonix Telecoms BPL telecommunication services include wireline voice, data, and long distance to primarily residential customers.   Fonix Telecom, Inc., is in the process of becoming certified by the Federal Communications Commission and in various Southeastern states as a CLEC to provide regulated local, long distance and international telecommunications services



7



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Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)





Business Condition - For the three months ended June 30, 2005 and 2004, the Company generated revenues of $4,324,000 and $4,242,000, respectively, and incurred net losses of $4,337,000 and $5,565,000, respectively.  For the six months ended June 30, 2005 and 2004, the Company generated revenues of $8,547,000 and $6,168,000, respectively, incurred net losses of $8,414,000 and $7,905,000, respectively and had negative cash flows from operating activities of $4,369,000 and $8,687,000, respectively.  As of June 30, 2005, the Company had an accumulated deficit of $235,612,000, negative working capital of $15,207,000, accrued liabilities of $7,674,000, accounts payable of $5,903,000 and accrued employee wages and other compensation of $501,000.  The Company expects to continue to incur significant losses and negative cash flows from operating activities through at least December 31, 2005, primarily due to significant expenditure requirements associated with continued marketing and development of its speech-enabling technologies and further developing its telecommunications services business.



The Companys cash resources, limited to collections from customers, draws on the Sixth and Seventh Equity Lines and loans, have not been sufficient to cover operating expenses.  As a result, payments to employees and vendors have been delayed.  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 in the Companys Annual Report on Form 10-K for the year ended December 31, 2004, 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 future operations of the Company through revenues generated from its telecommunications 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, 2005 and 2004, there were outstanding common stock equivalents to purchase 38,264,776 and 17,970,599 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, 2005 and 2004:



|                                             |                  | Three Months Ended June 30,
|-------------------------------------------- | ---------------- | ---------------------------
|                                             |                  | 2005                       
|                                             |                  |                            
|                                             |                  |                            
|                                             |                  | Amount                     
|Net loss                                     |                  | $    (4,337,000)           
|Preferred stock dividends                    | (276,000)        |                            
|Net loss attributable to common stockholders | $    (4,613,000) |                            
|Weighted-average common shares outstanding   | 216,972,730      |                            
|                                             |                  |                            
|                                             |                  | Six Months Ended June 30,  
|                                             |                  | 2005                       
|                                             |                  |                            
|                                             |                  |                            
|                                             |                  | Amount                     
|Net loss                                     |                  | $    (8,414,000)           
|Preferred stock dividends                    | (573,000)        |                            
|Net loss attributable to common stockholders | $    (8,987,000) |                            
|Weighted-average common shares outstanding   | 184,465,237      |                            



8



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Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)





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 -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, are not amortized and are tested for impairment on a quarterly basis. Impairment of these intangible asserts is recognized if their carrying amounts are not recoverable or exceed their fair values.



Revenue Recognition - The Company recognizes revenue when persuasive 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 The Fonix Speech Group, 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.  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 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 LTEL Holdings, the Companys 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.



9



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Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)





Deferred revenue as of June 30, 2005, and December 31, 2004, consisted of the following:



|Description                              | Criteria for Recognition                                 | June 30, 2005  | December 31, 2004
|---------------------------------------- | -------------------------------------------------------- | -------------- | -----------------
|Deferred unit royalties and license fees | Delivery of units to end users or expiration of contract | $      500,000 | $       458,000  
|Telecom deferred revenue                 | Service provided for customer                            | 528,000        | 526,000          
|Total deferred revenue                   |                                                          | $   1,028,000  | $      984,000   





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.  With respect to The Fonix Speech Group, 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 Compensation Plans - The Company accounts for its stock-based compensation issued to non-employees using the fair value method in accordance with SFAS No. 123, Accounting for Stock-Based Compensation. Under SFAS No. 123, stock-based compensation is determined as either the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable.  The measurement date for these issuances is the earlier of the date at which a commitment for performance by the recipient to earn the equity instruments is reached or the date at which the recipients performance is complete.



At June 30, 2005, the Company had stock-based employee compensation plans.  The Company accounts for the plans under the recognition method and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and the related Interpretations. Under APB Opinion No. 25, compensation related to stock options, if any, is recorded if an options exercise price on the measurement date is below the fair value of the Companys common stock, and amortized to expense over the vesting period.  Compensation expense for stock awards or purchases, if any, is recognized if the award or purchase price on the measurement date is below the fair value of the Companys common stock, and is recognized on the date of award or purchase.  The effect on net loss and net loss per common share if the Company had applied the fair value recognition provisions of SFAS No. 123 to employee stock-based compensation is as follows:



|Three Months Ended June 30,                             | 2005                 |        | 2004                 
|------------------------------------------------------- | -------------------- | ------ | ---------------------
|Net loss, as reported                                   | $    (4,337,000)     |        | $     (5,565,000)    
|Add back: Total stock-based employee compensation       | -                    |        | -                    
|Deduct: Total stock-based employee compensation         |                      |        |                      
|determined under fair value based method for all awards | (15,000)             |        | (10,000)             
|Pro forma net loss                                      | $    (4,352,000)     |        | $     (5,575,000)    
|Basic and diluted net loss per common share:            |                      |        |                      
|As reported                                             | $             (0.02) |        | $              (0.07)
|Pro forma                                               |                      | (0.02) |                      



10



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Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)







|Six Months Ended June 30,                               | 2005                 |        | 2004                 
|------------------------------------------------------- | -------------------- | ------ | ---------------------
|Net loss, as reported                                   | $    (8,414,000)     |        | $     (7,905,000)    
|Add back: Total stock-based employee compensation       | -                    |        | -                    
|Deduct: Total stock-based employee compensation         |                      |        |                      
|determined under fair value based method for all awards | (37,000)             |        | (59,000)             
|Pro forma net loss                                      | $    (8,451,000)     |        | $     (7,964,000)    
|Basic and diluted net loss per common share:            |                      |        |                      
|As reported                                             | $             (0.05) |        | $              (0.15)
|Pro forma                                               |                      | (0.05) |                      





Recently Enacted Accounting Standards  In June 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections,a replacement of APB Opinion No. 20, Accounting Changes,and FASB No. 3, Reporting Accounting Changes in Interim Financial Statements. Statement 154 applies to all voluntary changes in accounting principle, and changes the requirements for accounting for and reporting of a change in accounting principle. Statement 154 requires retrospective application to prior periods financial statements of a voluntary change in accounting principle unless it is impracticable. It is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Earlier application is permitted for accounting changes and corrections of errors made occurring in fiscal years beginning after June 1, 2005.  The Company expects that the adoption of SFAS 154 will not have a material impact on its financial statements.



2.  ACQUISITIONS



LecStar Acquisition-On February 24, 2004, Fonix acquired all of the capital stock of LTEL Holdings Corporation ("LTEL") and its wholly owned subsidiaries, LecStar Telecom, Inc., and LecStar DataNet, Inc. (collectively "LecStar").  The results of LecStar's operations are included in the consolidated financial statements from February 24, 2004.  LecStar is a regional provider of communications services, including wireline voice, data, long distance and Internet services, to business and residential customers in the Southeastern United States.  LecStar Telecom, Inc., is certified by the Federal Communications Commission in nine states as a competitive local exchange carrier (CLEC) to provide regulated local, long distance and international telecommunications services.  LecStar DataNet, Inc., provides non-regulated telecommunications services such as Internet access.



The following pro forma information is presented to reflect the operations of the Company and LTEL on a combined basis as if the acquisition of LTEL had been completed as of the beginning of the six-month period ended June 30, 2004:



|                                            | Six Months         
|------------------------------------------- | -------------------
|                                            | Ended June 30, 2004
|Revenues                                    | $
9,272,000        
|Net loss                                    | $
(9,405,000)      
|Basic and diluted net loss per common share | $
(0.12)           



Empire One Telecommunications, Inc Acquisition -On November 19, 2004, the Company signed a Merger Agreement (the Agreement) that set forth the principal terms on which Fonix would acquire Empire One Telecommunications, Inc., (EOT), a Brooklyn, New York-based CLEC.  EOT is a regional provider of communications services, including wireline voice, data, long distance and Internet services, to business and residential customers in 16 states and the District of Columbia.  The closing of the EOT transaction (as anticipated by the Agreement) is subject to several conditions including, among others, the completion of necessary regulatory approvals.  At the present time, EOT has not completed the necessary closing conditions, including the completion of necessary regulatory approvals.  The Company has substantial questions about whether EOT can and will complete the required conditions to closing. Accordingly, there can be no assurance that Fonix will complete this acquisition.



11



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Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)





3.  GOODWILL AND INTANGIBLE ASSETS



Goodwill -Goodwill relates solely to our speech-enabling business segment of The Fonix Speech Group.  The carrying value of goodwill is assessed for impairment quarterly.  These assessments resulted in no impairment and the carrying value of goodwill remained unchanged at $2,631,000 for the six months ended June 30, 2005.



Intangible Assets -The components of other intangible assets at June 30, 2005, which all relate to LTEL were as follows:



|                                    | Gross Carrying
Amount | Accumulated
Amortization | Net Carrying
Amount
|----------------------------------- | --------------------- | ------------------------ | -------------------
|Customer base  business            | $      8,139,000      | $  (3,289,000)           | $  4,850,000       
|Customer base  residential         | 6,291,000             | (3,647,000)              | 2,644,000          
|Contracts and agreements            | 1,484,000             | (951,000)                | 533,000            
|Total Amortizing Intangible Assets  | 15,914,000            | (7,887,000)              | 8,027,000          
|Indefinite-lived Intangible Assets: |                       |                          |                    
|Brand name                          | 1,110,000             | --                       | 1,110,000          
|                                    |                       |                          |                    
|Total Intangible Assets             | $    17,024,000       | $  (7,887,000)           | $ 9,137,000        



Customer base amortization was $1,300,000 during the three months and $2,600,000 during the six months ended June 30, 2005.  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.  At June 30, 2004, the Company recognized an impairment loss on the contracts and agreements intangible asset acquired in connection with the LecStar acquisition of $738,000 based on estimated future cash flows.  No further impairment was required at June 30, 2005.



Estimated aggregate amortization expense for the six months ending December 31, 2005, and each of the succeeding three full years is as follows:



|2005 |  | $3,134,000
|---- |  | ----------
|2006 |  | 3,743,000 
|2007 |  | 1,151,000 
|2008 |  |          



4.  NOTES PAYABLE



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 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%.  During 2004, the Company made mandatory prepayments on the note of $415,000.  During the six months ended June 30, 2005, the Company made scheduled principal payments of $178,000.



On January 15, 2005, the Company issued 655,162 shares of its Class A common stock in payment of $124,000 of interest under the terms of the note.  On April 15, 2005, the Company issued 6,384,283 shares of its Class A common stock in payment of $319,000 of interest and principal under the terms of the note.



12



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Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)





On February 28, 2003, LecStar established an asset securitization facility that 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.  The Company has recorded the $750,000 as a note payable in its consolidated financial statements.  The note bears an interest rate of 6.5% and is due on February 27, 2007, with 24 equal monthly installments that began on March 6, 2005.  The Company had made principal payments of $97,000 through June 30, 2005.



The following schedule summarizes notes payable at June 30, 2005, and December 31, 2004:



|                                                                 | June 30,      |  | December 31,   
|---------------------------------------------------------------- | ------------- |  | ---------------
|Notes Payable                                                    | 2005          |  | 2004           
|5% Note payable to a company, $9,408,000 and $9,584,000          |               |  |                
|face amount, respectively, due in quarterly installments of      |               |  |                
|$319,000, matures January 2010, less unamortized discount        |               |  |                
|based on interest imputed at 25% of $4,388,000 and               |               |  |                
|$4,762,000, respectively                                         | $   5,022,000 |  | $     4,822,000
|Note payable to a company, due in monthly installments of        |               |  |                
|$23,000, interest at 6.5%, matures February 2007, collateralized |               |  |                
|by trade accounts receivable                                     | 653,000       |  | 750,000        
|Note payable to related parties, interest at 12%, matures        |               |  |                
|September 2005                                                   | 545,000       |  | 435,000        
|Note payable to related parties, interest at 5%, matures         |               |  |                
|December 2005                                                    | 78,000        |  | 78,000         
|Total notes payable                                              | 6,298,000     |  | 6,085,000      
|Less current maturities                                          | (1,781,000)   |  | (727,000)      
|Long-Term Notes Payable                                          | $   4,517,000 |  | $     5,358,000





5.  RELATED-PARTY NOTES PAYABLE



In connection with the acquisition of certain entities in 1998, the Company issued unsecured demand notes payable to former stockholders of the acquired entities in the aggregate amount of $1,710,000.  Of the notes payable, $78,000 remained unpaid as of June 30, 2005.  During 2000, the holders of these notes made demand for payment and the Company commenced negotiating with the holders of these notes to reduce the outstanding balance.  No additional demands have been made and no payments have been made by the Company to the holders of these notes.



During 2002, two executive officers of the Company (the Lenders) sold shares of the Companys Class A common stock owned by them and advanced the resulting proceeds amounting to $333,000 to the Company under the terms of a revolving line of credit and related promissory note.  The funds were advanced for use in Company operations.  The advances bear interest at 12 percent per annum, which interest is payable on a semi-annual basis.  The entire principal, along with unpaid accrued interest and any other unpaid charges or related fees, were originally due and payable on June 10, 2003.  The Company and the Lenders agreed to postpone the maturity date on several occasions.  The note is presently due September 30, 2005.  After December 11, 2002, all or part of the outstanding balance and unpaid interest became convertible at the option of the Lenders into shares of Class A common stock of the Company.  The conversion price was the average closing bid price of the shares at the time of the advances.  To the extent the market price of the Companys shares is below the conversion price at the time of conversion, the Lenders are entitled to receive additional shares equal to the gross dollar value received from the original sale of the shares.  A beneficial conversion option of $15,000 was recorded as interest expense in connection with this transaction.  The Lenders may also receive additional compensation as determined appropriate by the Board of Directors.



13



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Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)





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 under the revolving line of credit.



During the fourth quarter of 2003, the Company made a principal payment of $26,000 against the outstanding balance of the promissory note.  At September 30, 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 $1,443,000 as a capital contribution 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 quarter ended June 30, 2005, the Company received an additional advance of $110,000 against the promissory note.  The balance due at June 30, 2005 was $545,000.



The unpaid balance of $545,000 is secured by a second priority security interest in the Companys intellectual property rights.  As of June 30, 2005, the Lenders had not converted any of the outstanding balance or interest into common stock.



6.  SERIES D CONVERTIBLE DEBENTURES



On October 11, 2002, the Company issued $1,500,000 of Series D 12% Convertible Debentures (the Debentures), due April 9, 2003, and 194,444 shares of Class A common stock to The Breckenridge Fund, LLC (Breckenridge), an unaffiliated third party, for $1,500,000 before offering costs of $118,000.  The outstanding principal amount of the Debentures was convertible at any time at the option of the holder into shares of the Companys common stock at a conversion price equal to the average of the two lowest closing bid prices of the Companys Class A common stock for the twenty trading days immediately preceding the conversion date, multiplied by 90%.



In connection with the issuance of the Debentures, the Company issued, as collateral to secure its performance under the Debenture, 2,083,333 shares of Class A common stock (the "Collateral Shares"), which were placed into an escrow pursuant to an escrow agreement.  Under the escrow agreement, the Collateral Shares were not released to Breckenridge unless the Company was delinquent with respect to payments under the Debenture.



The Debentures were originally due April 9, 2003.  However, the Company and Breckenridge agreed in January 2003 to modify the terms of the Debentures requiring principal and interest payments from January through May 2003 totaling $1,540,000.  Additionally, the Company agreed to release 237,584 of the Collateral Shares to Breckenridge as consideration (the Released Shares) for revising the terms of the purchase agreement.  The additional shares were accounted for as an additional discount to the Debentures of $285,000.



As part of the Debenture agreement, the Company was required to pay Breckenridge a placement fee in the amount of $350,000 payable in stock at the conclusion of the Debenture.  The Company satisfied the obligation through the issuance of 2,000,000 shares of the Companys Class A common stock valued at $358,000, or $0.179 per share and 377,717 shares of the Companys Class A common stock valued at $59,000, or $0.157 per share.  The Company recorded the expense as interest expense during December 2003.



In March 2004, the Company discovered that during 2003 an aggregate of 2,277,778 shares of Class A common stock (the Unauthorized Shares) were improperly transferred to the Debenture holder as a result of (i) the unauthorized release from escrow of the Collateral Shares (net of the Released Shares), and (ii) the transfer to the Debenture holder of a duplicate certificate for 194,445 shares where the original certificate was not returned to the transfer agent for cancellation.  The Unauthorized Shares were, therefore, in excess of the shares the Debenture holder was entitled to receive.  No consideration was paid to or received by the Company for the Unauthorized Shares during 2003; therefore, the Company did not recognize the Unauthorized Shares as being validly issued during 2003 nor subsequently.  Accordingly, the Company does not deem the Unauthorized Shares to be validly outstanding and the transfer of the Unauthorized Shares to the Debenture holder has not been recognized in the accompanying consolidated financial statements.



14



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Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)





Upon discovering in March 2004 that the Unauthorized Shares had been improperly transferred to the Debenture holder, the Company attempted to settle the matter with the Debenture holder but was unable to reach a settlement.  Accordingly, in October 2004, the Company asserted claims in a lawsuit against the Debenture holder, alleging the improper transfer to and subsequent sale of the Unauthorized Shares by the Debenture holder.  .  In the lawsuit the Company seeks (i) a declaratory judgment that the Company may set off the fair value of the Unauthorized Shares against the value the Company owes to the Debenture holder in connection with the Series I Preferred Stock transaction (see Note 7), (ii) judgment against the Debenture holder for the fair value of the Unauthorized Shares, and (iii) punitive damages from the Debenture holder for improper conversion of the Unauthorized Shares.



7.  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 - At June 30, 2005, 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 with a stated value of $10,000 per share on February 24, 2004.  The Series H Preferred Stock is carried at $4,000,000 or $2.00 per share.



Dividends on the 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 3% of the aggregate amount of such dividend to the holders of 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.



In the event of a voluntary or involuntary liquidation, dissolution or winding up of Fonix, the funds available for distribution, after payment to creditors and then to the holders of Fonix's Series A preferred stock of their liquidation payment, but before any liquidation payments to holders of junior preferred stock or common stock, would be payable to the holders of the Series H Preferred Stock (and any other subsequently created class of preferred stock having equal liquidation rights with the Series H Preferred Stock) in an amount equal to the stated value of the then outstanding Series H Preferred Stock plus any unpaid accumulated dividends thereon.  The closing of any transaction or series of transactions involving the sale of all or substantially all of the assets of Fonix, LTEL or a merger, reorganization or other transaction in which holders of a majority of the outstanding voting control of Fonix do not continue to own a majority of the outstanding voting shares of the surviving corporation would be deemed to be a liquidation entitling the holders of the Series H Preferred Stock, at their option, to the payments described above.



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 unpaid 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 Stock 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.



Under the terms of the Series H Preferred Stock, the consent of the holders of 66% of the outstanding Series H Preferred Stock is required in order to:

15



---

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)







$

issue securities with any rights senior to or on parity with the Series H Preferred Stock;

$

sell substantially all of Fonix's assets, grant any exclusive rights or license to Fonix's products or intangible assets (except in the ordinary course of business), or merge with or consolidate into any other entity in a transaction or series of related transactions, except during periods after the stated value of the outstanding Series H Preferred Stock is less than $5,000,000;

$

redeem any outstanding equity securities, except for previously issued options, warrants, or preferred stock, except during periods after the stated value of the outstanding Series H Preferred Stock outstanding is less than $5,000,000; or

$make any changes in the rights, preferences, or privileges of the Series H Preferred Stock or amend the certificate of incorporation or bylaws.



Series I Convertible Preferred Stock -On October 24, 2003, the Company entered into a private placement of shares of its Class A common stock with The Breckenridge Fund, LLC, a New York limited liability company ("Breckenridge").  Under the terms of the private placement, Breckenridge agreed to purchase 1,043,478 shares of Fonix Class A common stock for $240,000 (the "Private Placement Funds").



Subsequent to the Companys receiving the Private Placement Funds, but before any shares were issued in connection with the private placement, the Company agreed with Breckenridge to rescind the private placement of the shares and to restructure the transaction.  The Company retained the Private Placement Funds as an advance in connection with the restructured transaction.  The Company paid no interest or other charges to Breckenridge for use of the Private Placement Funds.



Following negotiations with Breckenridge, the Company entered into a purchase agreement (the "Purchase Agreement") with Breckenridge dated as of December 31, 2003 and on January 29, 2004, the Company issued to Breckenridge 3,250 shares of 8% Series I Convertible Preferred Stock (the "Series I Preferred Stock"), for an aggregate purchase price of $3,250,000, including the Private Placement Funds which the Company had already received.  .  The Series I Preferred Stock has a stated value of $1,000 per share.



In connection with the offering of the Series I Preferred Stock, the Company also issued to Breckenridge warrants to purchase up to 965,839 shares of the Companys Class A common stock at $0.50 per share, exercisable through December 31, 2008, and issued 2,414,596 shares of Class A common stock.



In connection with the issuance of the Series I Preferred Stock, the Company agreed to register the resale by Breckenridge of the Class A common shares issued and the Class A common shares issuable upon conversion of the Series I Preferred Stock, issuable as payment of dividends accrued on the Series I Preferred Stock and issuable upon exercise of the warrants.



Dividends on the Series I Preferred Stock are payable at the annual rate of 8% of the stated value of the shares of Series I Preferred Stock outstanding.  The dividends are payable in cash or shares of our Class A common stock, at the Companys option.  As of June 30, 2005, the Company had accrued dividends of $330,000 on its Series I Preferred Stock.



The Series I Preferred Stock is convertible into shares of our Class A common stock at the lower of (i) $0.75 per share or (ii) 87.5% of the average of the two lowest closing bid prices over the twenty trading days prior to the conversion date.



Under the terms of the purchase agreement, the Company agreed to establish an escrow account (the Escrow Account), into which it deposits funds which can be used for the Companys optional redemption of the Preferred Stock, or which may be used by Breckenridge to require the Company to redeem the Preferred Stock if the Company has defaulted under the purchase agreement.  The Company is required to deposit into the Escrow Account 25% of any amount it receives in excess of $1,000,000, calculated per put, under the terms of the Fifth Equity Line of Credit, or other similar equity line of financing arrangement.   As of June 30, 2005, the Company had deposited $395,000 into the escrow account in full compliance with the requirement.  The escrow deposit is reflected as a long-term asset in the accompanying financial statements.



In the event that there remains in the Escrow Account amounts following either (i) the conversion of all of the outstanding shares of Preferred Stock, together with any accrued and unpaid dividends thereon, or (ii) redemption of all of the outstanding shares of Preferred Stock, together with any accrued and unpaid dividends thereon, those remaining amounts shall be released from the Escrow Account to the Company.

16



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Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)





The Company has granted Breckenridge a first lien position on the Companys intellectual property assets as security under the Purchase Agreement. Breckenridge has agreed to release such lien upon the registration of the Companys Class A common stock becoming effective, which has occurred, and the Company depositing $2,000,000 in the Escrow Account.



Redemption of the Preferred Stock, whether at our option or that of Breckenridge, requires the Company to pay, as a redemption price, the stated value of the outstanding shares of Preferred Stock to be redeemed, together with any accrued but unissued dividends thereon, multiplied (i) 120% for any redemption occurring between the 151st day and the second anniversary of the closing date of the issuance or (ii) 130% for any payment of the redemption price occurring on or after the second anniversary of the closing date of the issuance.



The Company allocated the proceeds from the issuance of the Series I Preferred Stock, warrants, additional shares and fee shares as follows: $262,000 was allocated to the warrants, $730,000 was allocated to the common shares, $429,000 to the Series I Preferred Stock, and $1,830,000 to a beneficial conversion option.  The amounts allocated to the warrants, common shares and the beneficial conversion option resulted in a discount on the Series I Preferred Stock that was fully amortized at the date of issuance, resulting in the recognition of a dividend on the Series I Preferred Stock of $2,821,000 on January 29, 2004.  The Series I Preferred Stock was recorded as an item of stockholders deficit with $2,821,000 recognized as a dividend distribution related to the beneficial conversion and $429,000 as the value of the Series I Preferred Stock.



As of June 30, 2005, the Company had issued 27,066,095 shares of the Companys Class A common stock in response to conversion requests during 2004 and 2005 for 2,078 shares of Series I Preferred Stock.  As of June 30, 2005, there were 1,172 shares of Series I Preferred Stock outstanding.



The Company and Breckenridge are engaged in litigation in New York Superior Court concerning the Companys assertion that it should be allowed to offset certain claims against Breckenridge against the balance due under the Series I Preferred Stock, as more fully described in Note 10 below.



8.  EQUITY LINES OF CREDIT



Fifth Equity Line of Credit - The Company entered, as of July 1, 2003, into a fifth private equity line agreement (the Fifth Equity Line Agreement) with Queen, LLC (the Equity Line Investor).  Under the Fifth Equity Line Agreement, the Company had the right to draw up to $20,000,000 against an equity line of credit (the Fifth Equity Line) from the Equity Line Investor.  The Company was entitled under the Fifth 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 was determined by dividing the amount of the draw by 90% 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 was tendered.  The Equity Line Investor was required under the Fifth 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.



For the six months ended June 30, 2005, the Company issued 5,480,405 shares of Class A common stock to the Equity Line Investor in full satisfaction of an outstanding put of $668,000.



Sixth Equity Line of Credit  On November 15, 2004, the Company entered into a sixth private equity line agreement (the Sixth Equity Line Agreement) with the Equity Line Investor.  Under the Sixth Equity Line Agreement, the Company had the right to draw up to $20,000,000 against an equity line of credit (the Sixth Equity Line) from the Equity Line Investor.  The Company was entitled under the Sixth 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 was determined by dividing the amount of the draw by 90% 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 was tendered.  The Equity Line Investor was required under the Sixth 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.



In connection with the Sixth Equity Line Agreement, the Company granted registration rights to the Equity Line Investor and filed a registration statement on Form S-2, which covered the resales of the shares to be issued under the Sixth Equity Line.  The Company was obligated to maintain the effectiveness of the registration statement.

17



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Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)





For the six months ended June 30, 2005, the Company received $4,263,000 in funds drawn under the Sixth Equity Line, less commissions and fees of $141,000 and issued 74,396,474 shares of Class A common stock to the Equity Line Investor.  As of June 30, 2005, the Company owed 737,025 shares of Class A common stock to the Equity Line Investor relating to funds received under a put notice valued at $85,000.  This amount is reflected in the financial statements as an accrued liability.



Seventy Equity Line of Credit On May 27, 2005, the Company entered into a seventh private equity line agreement (the "Seventh Equity Line Agreement") with the Equity Line Investor, on terms substantially similar to those of the Sixth Equity Line between Queen and the Company dated November 15, 2004.



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 Company is limited as to the amount of shares we may put to the Equity Line Investor in connection with each put; the Company may not put shares which would cause the Equity Line Investor to own more than 4.99% of the Companys outstanding common stock on the date of the put notice.  The number of shares to be issued in connection with each draw 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.



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.



In connection with the Seventh Equity Line Agreement, the Company granted registration rights to the Equity Line Investor and filed a registration statement which covers the resales of the shares to be issued under the Seventh Equity Line.



9.  COMMON STOCK, STOCK OPTIONS AND WARRANTS



Class A Common Stock  During the six months ended June 30, 2005, the Company issued 5,480,405 shares of its Class A common stock under the Fifth Equity Line and 74,396,474 shares of its Class A common stock under the Sixth Equity Line (see Note 8); 18,630,223 shares were issued in conversion of 1,078 shares of Series I Preferred Stock; 3,636,042 shares were issued as payment of $500,000 of Series H Preferred dividends; and 7,039,445 shares were issued as payment of $443,000 of principal and interest on long-term debt.



Stock Options On January 19, 2005 the Company entered into an option exchange program with its employees, wherein the Company gave eligible Fonix employees the opportunity to exchange outstanding stock options for the same number of new options to be issued at least six months and one day from the expiration of the offer.  As a result of the option exchange program, the Company cancelled 414,450 options to purchase shares of the Companys Class A common stock effective February 22, 2005.  The Company issued a promise to grant options on August 23, 2005, to employees who elected to tender their options.  As of June 30, 2005, the Company had a total of 962,750 options to purchase Class A common stock outstanding.  During the six months ended June 30, 2005, the Company granted options to employees to purchase 708,100 shares of Class A common stock, none of which were to employees participating in the option exchange program.  The options have an exercise price of $0.12 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 $0.11 per share.



Warrants  As of June 30, 2005, the Company had warrants to purchase a total of 980,389 shares of Class A common stock outstanding that expire through 2010.



18



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Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)





10.  LITIGATION, COMMITMENTS AND CONTINGENCIES



U.S. Department of Labor Settlement Agreement- On March 5, 2003, the Company entered into a settlement agreement with the U.S. Department of Labor relating to back wages owed to former and current employees during 2002.  Under the agreement the Company is required to pay an aggregate of $4,755,000 to certain former and current employees in twenty-four installment payments.  The first installment payment was due May 1, 2003.  The remaining payments are due on the first day of each month, until paid in full.  On June 30 2005, the balance due under this obligation was approximately $430,000.



Grenfell Litigation - Two of the Companys subsidiaries, LecStar Telecom, Inc., and LecStar DataNet, Inc., (the Subsidiaries) are among the defendants who have been sued in the Superior Court of Fulton County, State of Georgia, by James D. Grenfell, the former CFO of LecStar.  The suit was filed in December 2003. The plaintiff in that case alleges that he has an unpaid judgment in the amount of $1,015,000 plus interest against the former parent entities of the Subsidiaries and that the transfer of such stock and business in December 2002 was in violation of the Georgia Fraudulent Transfer statute.   LecStar Telecom, Inc. has also intervened in the underlying action relating to the judgment.   To the extent that our subsidiaries or we are or should become proper parties to this action, and if the appeal and the motion to dismiss are denied, the Company will defend vigorously against these claims.



First Empire Complaint  One of the Companys subsidiaries, LTEL Holding Corporation, is among the defendants who have been sued in the Superior Court of Fulton County, State of Georgia, by First Empire Corporation and Allen B. Thomas, directly and derivatively in his capacity as shareholder of LecStar Corporation.  The lawsuit was filed in July 2004.  The plaintiffs in that case allege that certain of the defendants employed fraudulent and deceptive means to acquire the assets of LecStar Corporation, which included the capital stock of the Subsidiaries, LecStar Telecom, Inc.  and LecStar Datanet, Inc.  The plaintiffs further allege that those defendants subsequently transferred the stock of the subsidiaries to LTEL Holding Ltd., which we acquired through our subsidiary LTEL Acquisition Corporation in February 2004.  The plaintiffs argue that they are entitled to recover the value that we paid for LTEL Holding Corporation under multiple legal theories including breaches of fiduciary duty, negligence, gross negligence, conversion, fraud and violation of the Georgia Securities Act.  Three of the employees of the Subsidiaries have also been named as defendants in the litigation.



The Company has filed an answer in the litigation, but has not been involved in discovery in this litigation because the litigation is in the early states.  Nonetheless, the Company believes that the claims of the plaintiffs are without merit and management intends to vigorously defend against eh claims of the plaintiffs.



The principal Series H preferred stockholder has placed 300 shares of Series H Preferred Stock in escrow for a period of 12 months from the date of acquisition as protection with respect to breaches of representations and warranties of the LTEL 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, we have asserted a claim for breach of certain representations and warranties.  To our knowledge, the Escrow Shares have not been released.



Breckenridge Lawsuit In October 2004, the Company filed a lawsuit against The Breckenridge Fund, LLC (Breckenridge), alleging the improper transfer to and subsequent sale of shares of our common stock by Breckenridge (the Breckenridge Lawsuit).  The complaint seeks (i) a declaratory judgment that we may set off the fair value of the Unauthorized Shares against the value we owe to Breckenridge in connection with the Series I Preferred Stock transaction, (ii) judgment against Breckenridge for the fair value of the Unauthorized Shares, and (iii) punitive damages from Breckenridge for improper conversion of the Unauthorized Shares.  In March 2005, the court dismissed the Breckenridge Lawsuit without prejudice, finding that a forum selection clause required the claims to be litigated in New York.  The Company is now litigating those claims in New York (see Second Series I Complaint, below).



First Series I Complaint  On November 10, 2004, Breckenridge tendered to Fonix a conversion notice, converting 16 shares of Series I Preferred Stock into 123,971 shares of common stock.  In response, Fonix instructed its transfer agent to include on the share certificate a legend referencing the restraining order and the Breckenridge Lawsuit.   Subsequently, Breckenridge filed a complaint against us (Supreme Court of the State of New York, County of Nassau, Index No. 015822/04) (the First Series I Complaint) alleging that it was improper for us to include any legends on the shares issued in connection with conversions of the Series I Preferred Stock other than those agreed to by Breckenridge in the Series I Preferred Stock purchase agreement (the Series I Agreement).  Breckenridge also seeks liquidated damages for our failure to issue shares free of the allegedly inappropriate legend.  The Complaint seeks $4,000,000 in compensatory damages and $10,000,000 in punitive damages.  The Company has filed a motion to dismiss and intends to vigorously defend itself.

19



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Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)





Subsequent to filing the complaint, Breckenridge moved for a temporary restraining order to prevent the Company from issuing shares with any legend other than those agreed upon by Breckenridge in the Series I Agreement.  On November 18, 2004, at a hearing on Breckenridges motion, the court entered an order stating that we may not place any legend on shares issued to Breckenridge upon conversion of the Series I Preferred Stock other than those permitted under the Series I Agreement.



The Security Agreement Complaint  On November 23, 2004, Breckenridge filed a complaint against the Company (Supreme Court of the State of New York, County of Nassau, Index No. 015185/04) alleging: (1) Fonix executed a Security Agreement and a Registration Rights Agreement in connection with the Series I Agreement pursuant to which it granted to Breckenridge a security interest in certain collateral, including Fonixs intellectual property (the Collateral); (2) Fonix breached the Registration Rights Agreement and the Security Agreement; and (3) Breckenridge is entitled to damages totaling $585,000 and possession of the Collateral.  The Company has filed a motion to dismiss and intends to vigorously defend itself.



Second Series I Complaint  On March 10, 2005, Breckenridge filed a complaint against the Company (Supreme Court of the State of New York, County of Nassau, Index No. 3457/05) in connection with the Series I Preferred Stock (the Second Series I Complaint).  In the Second Series I Complaint, Breckenridge alleges that Fonix improperly failed to honor a conversion notice it tendered to us on February 25, 2005, converting 500 shares of Series I Preferred Stock into 6,180,469 shares of common stock.  Breckenridge sought a temporary restraining order and preliminary injunction requiring Fonix to honor that conversion notice, and all subsequently tendered conversion notices.  On March 14, 2005, the Court entered a temporary restraining order directing us to honor the February 25, 2005, conversion notice, and directed Breckenridge to deposit all proceeds from the sale of the converted shares to be deposited in an interest-bearing escrow account.  Breckenridge subsequently agreed that it would deposit the proceeds of all converted shares into the interest-bearing escrow account pending the outcome of this litigation.  The Company has filed a counterclaim against Breckenridge asserting the same causes of action as it alleged in the Breckenridge Lawsuit.  Discovery is proceeding and a trial is scheduled to commence on September 12, 2005.  The Company intends to vigorously defend itself against the claims of Breckenridge and to vigorously purse its counterclaims against Breckenridge .



The Company is the subject of certain legal actions.  Management does not believe that current pending litigation involving the Company will have a material adverse effect on the Companys consolidated financial position or results of operations.  This conclusion has been developed in consultation with outside counsel handling the Companys defense in the matters.  However, the litigation and other claims noted in this report are subject to inherent uncertainties and it is possible that future results of operations for any particular quarterly or annual period could be materially affected by changes in managements assumptions and the effectiveness of Fonixs strategies related to these legal actions.





11. 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:



LecStar Telecom- Telecommunications services include wireline voice, data, long distance and Internet services to business and residential customers.



Speech - 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.



Fonix Telecom  Telecommunications services including Voice over Internet Protocol (VoIP) and Broadband over Power Line (BPL) and other services including satellite television and security services to business and residential customers



20



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Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)





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



|                                    | LecStar Telecom |  | Fonix Telecom     | Speech       |  | Total        | 
|----------------------------------- | --------------- |  | ----------------- | ------------ |  | ------------ | 
|                                    |                 |  |                   |              |  |              | 
|Revenues from external customers    | $  7,798,000    |  | $          29,000 | $    720,000 |  | $  8,547,000 | 
|Selling, general and administrative | 3,372,000       |  | 1,031,000         | 2,332,000    |  | 6,735,000    | 
|Depreciation and amortization       | 3,222,000       |  | --                | 32,000       |  | 3,254,000    | 
|Interest expense                    | 761,000         |  | --                | 647,000      |  | 1,408,000    | 
|Gain on sale of investments         | 134,000         |  | --                | --           |  | 134,000      | 
|Segment loss                        | (5,714,000)     |  | (1,028,000)       | (1,672,000)  |  | (8,414,000)  | 
|Segment assets                      | 12,043,000      |  | 686,000           | 3,568,000    |  | 16,297,000   | 
|Expenditures for segment assets     | 145,000         |  | 686,000           | 7,000        |  | 838,000      | 



Revenues and assets outside the United States of America were not material.  During the three and six months ended June 30, 2005 and 2004, the Company had no customers that exceeded 10% of total revenues.



12.  SUBSEQUENT EVENTS



Subsequent to June 30, 2005 and through August 10, 2005 the Company received $5,000 in funds, drawn under the Sixth Equity Line and issued 737,025 additional shares of Class A common stock to the Equity Line Investor.



Subsequent to June 30, 2005 and through August 10, 2005, the Company received $1,000,000 in funds, less commissions and fees of $34,000 drawn under the Seventh Equity Line and issued 19,110,763 shares of Class A common stock to the Equity Line Investor.



Subsequent to June 30, 2005 and through August 10, 2005, the Company issued 3,881,988 shares as payment of Series H Preferred dividends of $250,000 and 4,987,721 shares of Class A commons tock as payment of $319,000 of principal and interest on the McCormack debt.



21



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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, 2004.



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 LTEL Holdings Corporation and Fonix Telecom, Inc., and LecStar Telecom, Inc., and value-added speech technologies through The Fonix Speech Group.  Through LTEL Holdings Corporation, we operate LecStar Telecom, Inc., a regional provider 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).  Through Fonix Telecom, Inc., we offer Voice over Internet Protocol (VoIP) and Broadband Power Line (BPL) telecommunication services primarily in the Southeastern United States.



We offer our speech-enabling technologies including automated speech recognition (ASR) and text-to-speech (TTS) through The Fonix Speech Group.  We offer our ASR and TTS 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.



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.



Fonix Telecoms VoIP telecommunication services include wireline voice, data, and long distance to primarily business customers.  Fonix Telecoms BPL telecommunication services include wireline voice, data, and long distance to primarily residential customers.   Fonix Telecom, Inc., is in the process of becoming certified by the Federal Communications Commission and in various Southeastern states as a CLEC to provide regulated local, long distance and international telecommunications services



For the three months ended June 30, 2005 and 2004, we generated revenues of $4,324,000 and $4,242,000, respectively, and incurred net losses of $4,337,000 and $5,565,000, respectively.  For the six months ended June 30, 2005 and 2004, we generated revenues of $8,547,000 and $6,168,000, respectively, incurred net losses of $8,414,000 and $7,905,000, respectively, and had negative cash flows from operating activities of $4,369,000 and $8,687,000, respectively.  As of June 30, 2005, we had an accumulated deficit of $235,613,000, negative working capital of $15,207,000, accrued liabilities of $7,674,000, accounts payable of $5,903,000 and accrued employee wages and other compensation of $501,000.  We expect to continue to incur significant losses and negative cash flows from operating activities through at least December 31, 2005, primarily due to expenditure requirements associated with continued marketing and development of our speech-enabling technologies and further developing our telecommunications services business.

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Our cash resources, limited to collections from customers, draws on the Sixth and Seventh Equity Lines and loans, have not been sufficient to cover operating expenses.  We had not been declared in default under the terms of any material agreements.



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 are not amortized, are tested for impairment on a quarterly basis and impairment is recognized if the carrying amount is not recoverable or exceeds its fair value.  During the year ended December 31, 2004, we recorded an impairment loss on the intangible asset related to the contracts and agreements acquired in connection with the LecStar acquisition (see Note 2 of the Condensed Consolidated Financial Statements) of $738,000 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.  If a triggering event occurs, the undiscounted net cash flows of the asset or entity to which the goodwill relates are evaluated.  Impairment is indicated if undiscounted cash flows are less than the carrying value of the assets.  The amount of the impairment is measured using a discounted-cash-flow model considering future revenues, operating costs, a risk-adjusted discount rate and other factors.



Revenue recognition  We recognize revenue when persuasive 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 our software products to end-users and from royalties.  For telecommunications services, revenue is recognized in the period that the service is provided.



For The Fonix Speech Group, 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.  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.

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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 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 LTEL Holdings, 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.



Deferred revenue as of June 30, 2005, and December 31, 2004, consisted of the following:



|Description                              | Criteria for Recognition                                 | June 30, 2005    | December 31, 2004
|---------------------------------------- | -------------------------------------------------------- | ---------------- | -----------------
|Deferred unit royalties and license fees | Delivery of units to end users or expiration of contract | $      500 ,000  | $       458,000  
|Telecom deferred revenue                 | Service provided for customer                            | 528,000          | 526,000          
|Total deferred revenue                   |                                                          | $      1,028,000 | $      984,000   



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.  With respect to The Fonix Speech Group, 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.



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Stock-based Compensation Plans We account for our stock-based compensation issued to non-employees using the fair value method in accordance with SFAS No. 123, Accounting for Stock-Based Compensation. Under SFAS No. 123, stock-based compensation is determined as either the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable.  The measurement date for these issuances is the earlier of the date at which a commitment for performance by the recipient to earn the equity instruments is reached or the date at which the recipients performance is complete.



At June 30, 2005, we had stock-based employee compensation plans.  We account for the plans under the recognition method and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and the related Interpretations. Under APB Opinion No. 25, compensation related to stock options, if any, is recorded if an options exercise price on the measurement date is below the fair value of our common stock, and amortized to expense over the vesting period.  Compensation expense for stock awards or purchases, if any, is recognized if the award or purchase price on the measurement date is below the fair value of our common stock, and is recognized on the date of award or purchase.



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.



Recently Enacted Accounting Standards  In June 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections,a replacement of APB Opinion No. 20, Accounting Changes,and FASB No. 3, Reporting Accounting Changes in Interim Financial Statements. Statement 154 applies to all voluntary changes in accounting principle, and changes the requirements for accounting for and reporting of a change in accounting principle. Statement 154 requires retrospective application to prior periods financial statements of a voluntary change in accounting principle unless it is impracticable. It is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Earlier application is permitted for accounting changes and corrections of errors made occurring in fiscal years beginning after June 1, 2005.  We expect that the adoption of SFAS 154 will not have a material impact on our financial statements.



In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123 (revised 2004), Share-Based Payment. SFAS No. 123(R) requires that the compensation cost relating to share-based payment transactions be recognized in financial statements.  The cost will be measured based on the fair value of the instruments issued. SFAS No. 123(R) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. SFAS No. 123(R) replaces SFAS No. 123 and supersedes APB Opinion No. 25. As originally issued in 1995, SFAS No. 123 established as preferable the fair-value-based method of accounting for share-based payment transactions with employees.  However, that Statement permitted entities the option of continuing to apply the guidance in Opinion 25, as long as the footnotes to financial statements disclosed what net income would have been had the preferable fair-value-based method been used. We will be required to apply SFAS No. 123(R) as of the first interim reporting period that begins after June 15, 2005, and we plan to adopt it using the modified-prospective method, effective July 1, 2005.  We are currently evaluating the impact SFAS No. 123(R) will have on us and, based on our preliminarily analysis, we expect that the adoption will not have a material impact on our financial statements.



In December 2004, the FASB issued SFAS Statement No. 153, Exchanges of Non-monetary Assetsan amendment of APB Opinion No.29. This Statement amends APB Opinion 29 to eliminate the exception for non-monetary exchanges of similar productive assets and replaces it with a general exception for exchanges of non-monetary assets that do not have commercial substance. A non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The statement will be effective in January 2006. We do not expect that the adoption of SFAS No. 153 will have a material impact on our consolidated financial statements.



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Results of Operations

Three months ended June 30, 2005, compared with three months ended June 30, 2004



During the three months ended June 30, 2005, we recorded revenues of $4,324,000, an increase of $82,000 from $4,242,000 for the same period in 2004.  The increase was primarily due to increased non-recurring engineering (NRE) speech revenues of $235,000, partially offset by decreased telecommunications revenues of $164,000 due to the implementation of more stringent credit policies at LecStar.



Cost of revenues was $2,499,000, an increase of $230,000 from $2,269,000, for the three months ended June 30, 2005.  The increase was primarily due increased costs associated with providing our telecommunications services through LecStar.



Selling, general and administrative expenses were $3,404,000 for the three months ended June 30, 2005, a decrease of $375,000 from $3,779,000 for the same period in 2004.  The decrease was primarily due the decreased salary and wage expenses of $131,000, decreased bad debt of $103,000, decreased depreciation expenses of $82,000, decreased travel expenses of $40,000, decreased legal and accounting fees of $19,000, decreased promotion and advertising expenses of $16,000, decreased billing costs of $13,000, decreased consulting expenses of $10,000, decreased occupancy related expenses of $8,000 and decreased investor relations expenses of $2,000, partially offset by increased taxes, licenses and permits of $26,000 and increased other operating expenses of $23,000.



We incurred research and product development expenses of $527,000 for the three months ended June 30, 2005, a decrease of $141,000 from $668,000 for the same period in 2004.  The decrease was primarily due to an overall decrease in salaries and wage-related expenses of $51,000, decreased other operating expenses of $46,000, decreased consulting expenses of $25,000, decreased travel expenses of $11,000 and decreased depreciation of $8,000 due to the overall decrease in fixed assets.



Other expense, net of other income, was $645,000 for the three months ended June 30, 2005, an increase of $1,000 from $644,000 for the same period in 2004.

Six months ended June 30, 2005, compared with six months ended June 30, 2004



During the six months ended June 30, 2005, we recorded revenues of $8,547,000, an increase of $2,379,000 from $6,168,000 for the same period in 2004.  The increase was primarily due to the acquisition of LecStar accounting for $2,272,000, increase NRE revenues of $239,000, increased retail revenue of $43,000, increased licenses revenues of $7,000 and a decrease in DECTalk royalties of $182,000.



Cost of revenues was $4,686,000 for the six months ended June 30, 2005, an increase of $1,624,000 from $3,062,000 for the same period in 2004.  The increase was primarily due increased costs associated with providing our telecommunications services through LecStar.



Selling, general and administrative expenses were $6,817,000 for the six months ended June 30, 2005, representing an increase of $687,000 from $6,130,000 for the same period in 2004.  The increase was due to increased depreciation expense and increased amortization expense related to intangible assets acquired in the LecStar acquisition of $601,000, increased investor relations related expenses of $34,000, increase other operating expense of $30,000 and increased taxes and license fees of $9,000, partially offset by decreased legal and accounting fees of $232,000, decreased salary and wage related costs of $174,000, decreased travel related expenses of $60,000, decrease consulting expenses of $26,000 decreased occupancy related costs of $21,000 and decreased promotion and advertising expenses of $8,000.



We incurred research and product development expenses of $1,046,000 for the six months ended June 30, 2005, a decrease of $420,000 from $1,466,000 for the same period in 2004.  The decrease was primarily due to an overall decrease in salaries and wage related expenses of $263,000, decreased other operating expenses of $85,000, decreased consulting expenses of $48,000 due to a decrease in the utilization of external consultants, decreased depreciation of $18,000 due to the overall decrease in fixed assets and decrease travel expenses of $20,000, partially offset by increase occupancy related costs of $14,000.

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Other expense, net of other income, was $1,240,000 for the six months ended June 30, 2005, an increase of $845,000 from $395,000 for the same period in 2004.  The overall increase is due to the increased interest expense related to debt acquired in connection with the LecStar acquisition of $327,000, the change in the gain on forgiveness of liabilities of $486,000, partially offset by the gain on the sale of investments of $134,000.



Liquidity and Capital Resources



We must raise additional funds to be able to satisfy our cash requirements during the next 12 months. Product development, corporate operations, and marketing expenses will continue to require additional capital.  Because our current revenue from operations is not sufficient to cover our operating expenses, we intend to continue to rely on financing through the sale of our equity and debt securities to satisfy future capital requirements until such time as we are able to acquire additional telecommunications customers or enter into additional third-party licensing, collaboration, or co-marketing arrangements such that we will be able to finance ongoing operations from sales, license and royalty revenue. There can be no assurance that we will be able to enter into such agreements. Furthermore, the issuance of equity or debt securities which are or may become convertible into equity securities of Fonix in connection with such financing could result in substantial additional dilution to the stockholders Fonix.



As of June 30, 2005, our cash resources were limited to collections from customers, draws on the Sixth Equity Line, proceeds from the issuance of preferred stock and loan proceeds, and were only sufficient to cover current operating expenses and payments of current liabilities.  We have entered into certain term payment plans with current and former employees and vendors.  As a result of cash flow deficiencies, payments to former employees and vendors not on a payment plan have been delayed.  At June 30, 2005, we had accrued liabilities of $7,647,000, accrued wages and other compensation payable to current and former employees amounted to approximately $501,000 and vendor accounts payable amounted to approximately $5,903,000.  We had not been declared in default under the terms of any material agreements.



We had $8,547,000 in revenue and a loss of $8,412,000 for the six months ended June 30, 2005. Net cash used in operating activities of $4,367,000 for the six months ended June 30, 2005, resulted principally from the net loss incurred of $8,412,000, decreased accrued payroll of $1,255,000, decreased prepaid expenses and other current assets of $134,000, gain recognized in connection with the sale of long-term assets of $134,000 and decreased other assets of $174,000, partially offset by amortization of intangible assets of $3,172,000, increased accrued liabilities of $774,000, increased accounts payable of $678,000, collection of LecStar accounts receivables of $328,000 and depreciation expense of $82,000.  Net cash used in investing activities of $467,000 was due to purchases of property and equipment of $838,000, partially offset by the sale of long-term investments of $371,000.  Net cash provided by financing activities of $4,806,000 consisted of the receipt of $4,791,000 in cash related to the sale of shares of Class A common stock and proceeds from related party notes payable of $110,000, partially offset by principal payments on notes payable of $95,000.



We had negative working capital of $15,207,000 at June 30, 2005, compared to negative working capital of $13,580,000 at December 31, 2004.  Current assets decreased by $224,000 to $1,896,000 from December 31, 2004, to June 30, 2005.  Current liabilities increased by $1,403,000 to $17,103,000 during the same period.  The change in working capital from December 31, 2004, to June 30, 2005, reflects, in part, increases resulting from increased accrued liabilities of $859,000, increased accounts payable of $678,000, reduced accounts receivable of $328,000, increased related party notes payable of $110,000 and the reclassification of long-term debt to current debt of $944,000, partially offset by the decreased accrued payroll balance of $1,255,000 due to scheduled payments made during the period and increased prepaid assets of $134,000.  Total assets were $16,297,000 at June 30, 2005, compared to $19,000,000 at December 31, 2004.

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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 10 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 agreed to postpone the maturity date on several occasions.  The note is presently due September 30, 2005.  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.  A beneficial conversion option of $15,000 was recorded as interest expense in connection with this transaction.  The Lenders may also receive additional compensation as determined appropriate by the Board of Directors.



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 (see Note 12 to Consolidated Financial Statements).  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 quarter ended June 30, 2005, the Company received an additional advance of $110,000 against the promissory note.  The balance due at June 30, 2005 was $545,000.



The unpaid balance of $545,000 is secured by a second priority security interest in the Companys intellectual property rights.  As of June 30, 2005, the Lenders had not converted any of the outstanding balance or interest into common stock.



Notes Payable



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 were 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%.  During 2004, we made mandatory prepayments on the note of $415,000.  During the six months ended June 30, 2005, we made scheduled principal payments of $178,000.



On January 15, 2005, we issued 655,162 shares of our Class A common stock in payment of $124,000 of interest under the terms of the note.  On April 15, 2005, we issued 6,384,283 shares of our Class A common stock in payment of $319,000 of interest and principal under the terms of the note.



On February 28, 2003, LecStar established an asset securitization facility that 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 that began on March 6, 2005.  We had made principal payments of $97,000 through June 30, 2005.

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Series D Debentures



On October 11, 2002, the Company issued $1,500,000 of Series D 12% Convertible Debentures (the Debentures), due April 9, 2003, and 194,444 shares of Class A common stock to Breckenridge Fund, LLC (Breckenridge), an unaffiliated third party, for $1,500,000 before offering costs of $118,000.  The outstanding principal amount of the Debentures was convertible at any time at the option of the holder into shares of our common stock at a conversion price equal to the average of the two lowest closing bid prices of our Class A common stock for the twenty trading days immediately preceding the conversion date, multiplied by 90%.



In connection with the issuance of the Debentures, we issued, as collateral to secure its performance under the Debenture, 2,083,333 shares of Class A common stock (the Collateral Shares), which were placed into an escrow pursuant to an escrow agreement.  Under the escrow agreement, the Collateral Shares would not be released to Breckenridge unless we were delinquent with respect to payments under the Debenture.



The Debentures were originally due April 9, 2003.  However, Fonix and Breckenridge agreed in January 2003 to modify the terms of the Debentures requiring the following principal payments plus accrued interest: $400,000 in January 2003; $350,000 in February 2003; $250,000 in March 2003; $250,000 in April 2003; and $250,000 in May 2003.  Additionally, we agreed to release 237,584 of the Collateral Shares to Breckenridge as consideration (the Released Shares) for revising the terms of the purchase agreement.  The additional shares were accounted for as an additional discount of $285,000.



As part of the Debenture agreement, we were required to pay Breckenridge a placement fee in the amount of $350,000 payable in stock at the conclusion of the Debenture.  We satisfied the obligation through the issuance of 2,000,000 shares of our Class A common stock valued at $358,000, or $0.179 per share and 377,717 shares of our Class A common stock valued at $59,000, or $0.157 per share.  We recorded the expense as interest expense in the accompanying financial statements.



In March 2004, we discovered that during 2003 an aggregate of 2,277,778 shares of Class A common stock (the Unauthorized Shares) were improperly transferred to the Debenture holder as a result of (i) the unauthorized release from escrow of the Collateral Shares (net of the Released Shares), and (ii) the transfer to the Debenture holder of a duplicate certificate for 194,445 shares where the original certificate was not returned to the transfer agent for cancellation.  The Unauthorized Shares were, therefore, in excess of the shares the Debenture holder was entitled to receive.  No consideration was paid to or received by us for the Unauthorized Shares during 2003; therefore, we did not recognize the Unauthorized Shares as being validly issued during 2003 nor subsequently.  Accordingly, we do not deem the Unauthorized Shares to be validly outstanding and the transfer of the Unauthorized Shares to the Debenture holder has not been recognized in the accompanying consolidated financial statements.



Upon discovering in March 2004 that the Unauthorized Shares had been improperly transferred to the Debenture holder, we attempted to settle the matter with the Debenture holder but was unable to reach a settlement.  Accordingly, in October 2004, we asserted claims in a lawsuit against the Debenture holder, alleging the improper transfer to and subsequent sale of the Unauthorized Shares by the Debenture holder.  In the lawsuit we seek (i) a declaratory judgment that we may set off the fair value of the Unauthorized Shares against the value we owe to the Debenture holder in connection with the Series I Preferred Stock transaction (see Note 7 to Condensed Consolidated Financial Statements), (ii) judgment against the Debenture holder for the fair value of the Unauthorized Shares, and (iii) punitive damages from the Debenture holder for improper conversion of the Unauthorized Shares.



Fifth Equity Line of Credit



We entered, as of July 1, 2003, into a Private Equity Line Agreement (the Fifth Equity Line Agreement) with Queen, LLC (the Equity Line Investor).  Under the Fifth Equity Line Agreement, we had the right to draw up to $20,000,000 against an equity line of credit (the Fifth Equity Line) from the Equity Line Investor.  We were entitled under the Fifth 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 was determined by dividing the amount of the draw by 90% 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 was tendered.  The Equity Line Investor was required under the Fifth 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.

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In connection with the Fifth Equity Line Agreement, we granted registration rights to the Equity Line Investor and filed a registration statement on Form S-2, which covered the resales of the shares to be issued under the Fifth Equity Line.



For the six months ended June 30, 2005, we issued 5,480,405 shares of Class A common stock to the Equity Line Investor in full satisfaction of an outstanding put of $668,000.



Sixth Equity Line of Credit



We entered, as of November 15, 2004, into a sixth private equity line agreement (the "Sixth Equity Line Agreement") with the Equity Line Investor, on terms substantially similar to those of the Fifth Equity Line.  Under the Fifth Equity Line Agreement, we had the right to draw up to $20,000,000 against an equity line of credit ("the Sixth Equity Line") from the Equity Line Investor.  We were entitled under the Sixth 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 was determined by dividing the amount of the draw by 90% 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 was tendered.  The Equity Line Investor was required under the Sixth 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.



In connection with the Sixth Equity Line Agreement, we granted registration rights to the Equity Line Investor and filed a registration statement on Form S-2, which covered the resales of the shares to be issued under the Sixth Equity Line.  That registration statement was declared effective on January 5, 2005.



For the six months ended June 30, 2005, we received $4,263,000 in funds drawn under the Sixth Equity Line, less commissions and fees of $141,000 and issued 74,396,474 shares of Class A common stock to the Equity Line Investor.  This amount is reflected in the financial statements as an accrued liability.  Subsequent to June 30, 2005 and through August 10, 2005, we received $5,000 in funds drawn under the Sixth Equity Line and issued 737,025 additional shares to the Equity Line Investor.



Seventh Equity Line of Credit



On May 27, 2005, we entered into a seventh private equity line agreement (the "Seventh Equity Line Agreement") with the Equity Line Investor, on terms substantially similar to those of the Sixth Equity Line between Queen and us dated November 15, 2004.



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 the Company's Class A common stock in lieu of repayment of the draw.  We are limited as to the amount of shares we may put to the Equity Line Investor in connection with each put; we may not put shares which would cause the Equity Line Investor to own more than 4.99% of our outstanding common stock on the date of the put notice.  The number of shares to be issued in connection with each draw 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.



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.



In connection with the Seventh Equity Line Agreement, we granted registration rights to the Equity Line Investor and filed a registration statement which covers the resales of the shares to be issued under the Seventh Equity Line.



Subsequent to June 30, 2005 and through August 10, 2005, we received $1,000,000 in funds, less commissions and fees of $34,000 drawn under the Seventh Equity Line and issued 19,110,763 shares of our Class A common stock to the Equity Line Investor.

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We entered into an agreement with the Equity Line Investor to terminate the first through fifth equity lines, and cease further draws or issuances of shares in connection with all previous equity lines.  We also agreed to terminate the Sixth Equity Line.  As such, as of the date of this report, the only active equity line of credit was the Seventh Equity Line.



Series I Convertible Preferred Stock



On October 24, 2003, we entered into a private placement of shares of its Class A common stock with The Breckenridge Fund, LLC, a New York limited liability company ("Breckenridge").  Under the terms of the private placement, Breckenridge agreed to purchase 1,043,478 shares of our Class A common stock for $240,000 (the "Private Placement Funds").



Subsequent to our receiving the Private Placement Funds, but before any shares were issued in connection with the private placement, we agreed with Breckenridge to rescind the private placement of the shares and to restructure the transaction.  We retained the Private Placement Funds as an advance in connection with the restructured transaction.  We paid no interest or other charges to Breckenridge for use of the Private Placement Funds.



Following negotiations with Breckenridge, we entered into a purchase agreement (the Purchase Agreement) with Breckenridge dated as of December 31, 2003 and on January 29, 2004, we issued to Breckenridge 3,250 shares of 8% Series I Convertible Preferred Stock (the "Series I Preferred Stock"), for an aggregate purchase price of $3,250,000, including the Private Placement Funds which the Company had already received.  The Series I Preferred Stock has a stated value of $1,000 per share.



In connection with the offering of the Series I Preferred Stock, we also issued to Breckenridge warrants to purchase up to 965,839 shares of the Companys Class A common stock at $0.50 per share through December 31, 2008, and issued 2,414,596 shares of our Class A common stock.



In connection with the issuance of the Series I Preferred Stock, we agreed to register the resale by Breckenridge of the Class A common shares issued and the Class A common shares issuable upon conversion of the Series I Preferred Stock, issuable as payment of dividends accrued on the Series I Preferred Stock and issuable upon exercise of the warrants.



Dividends on the Series I Preferred Stock are payable at the annual rate of 8% of the stated value of the shares of Series I Preferred Stock outstanding.  The dividends are payable in cash or shares of our Class A common stock, at the Companys option.  Aggregate annual dividend requirements for the Series I Preferred Stock are $260,000.



The Series I Preferred Stock is convertible into shares of our Class A common stock at the lower of (i) $0.75 per share or (ii) 87.5% of the average of the two lowest closing bid prices over the twenty trading days prior to the conversion date.



In connection with the sale of the Series I Preferred Stock, we agreed to establish an escrow account (the "Escrow Account"), into which it deposits funds which can be used for our optional redemption of the Series I Preferred Stock, or which may be used by Breckenridge to require us to redeem the Series I Preferred Stock if we have defaulted under the Purchase Agreement.  We are required to deposit into the Escrow Account 25% of any amount we receive in excess of $1,000,000, calculated per put, under the terms of the Fifth Equity Line of Credit, or other similar equity line of financing arrangement.  As of June 30, 2005, we had deposited $395,000 into the Escrow Account.



In the event that there remains in the Escrow Account amounts following either (i) the conversion of all of the outstanding shares of Series I Preferred Stock, together with any accrued and unpaid dividends thereon, or (ii) redemption of all of the outstanding shares of Series I Preferred Stock, together with any accrued and unpaid dividends thereon, those remaining amounts shall be released from the Escrow Account to us.



We granted Breckenridge a first lien position on our intellectual property assets as security under the Purchase Agreement.  Breckenridge has agreed to release such lien upon the registration of our Class A common stock, as outlined above, becoming effective and our depositing $2,000,000 in the Escrow Account.



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Redemption of the Series I Preferred Stock, whether at our option or that of Breckenridge, requires us to pay, as a redemption price, the stated value of the outstanding shares of Series I Preferred Stock to be redeemed, together with any accrued but unpaid dividends thereon, multiplied by (i) 110% for any redemption occurring within 90 days after the closing date of the issuance of the Series I Preferred Stock; (ii) 115% for any redemption occurring between the 91st day but before the 150th day after the closing date of the issuance; (iii) 120% for any redemption occurring between the 151st day and the second anniversary of the closing date of the issuance; and (iv) 130% for any payment of the redemption price occurring on or after the second anniversary of the closing date of the issuance.



As of June 30, 2005, we had issued 27,066,095 shares of our Companys Class A common stock in response to conversion requests for 2,078 shares of Series I Preferred Stock.  As of June 30, 2005, there were 1,172 shares of Series I Preferred Stock outstanding.



We are engaged in litigation with Breckenridge in New York Superior Court concerning our assertion that we should be allowed to offset certain claims against Breckenridge against the balance due under the Series I Preferred Stock (see Note 10 to Condensed Consolidated Financial Statements).



Stock Options and Warrants



During the six months ended June 30, 2005, we granted options to employees to purchase 708,100 shares of Class A common stock.  The options have an exercise price of $0.12 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 $0.11 per share.



On January 19, 2005 we entered into an option exchange program with our employees, wherein we gave eligible Fonix employees the opportunity to exchange outstanding stock options for the same number of new options to be issued at least six months and one day from the expiration of the offer.  As a result of the option exchange program, we cancelled 414,450 options to purchase shares of our Class A common stock effective February 22, 2005.  We issued a promise to grant options on August 23, 2005 to employees who elected to tender their options.  As of June 30, 2005, we had a total of 962,750 options to purchase Class A common stock outstanding.



As of June 30, 2005, we had warrants to purchase a total of 980,389 shares of Class A common stock outstanding that expire through 2010.



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Other



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



Outlook



Corporate Mission Statement, Strategic Goals, Financial Objectives and Growth Strategy



Mission Statement:  Provide integrated communication products and services through innovative technologies.



Strategic Goals:



§

Deliver innovated technologies such as Voice over Internet Protocol (VoIP), Broadband over Power Line (BPL) and switched telecommunication services with efficient and profitable revenue.



§

Capitalize on LecStars built-in customer base.



§

Implement a CLEC roll-up and consolidation strategy using the LecStar platform and infrastructure.



§

Integrate our speech technologies with LecStars product offerings to expand customer base and improve operating margins.



§

Provide competitive speech solutions for mobile/wireless devices, games, telephony systems and assistive markets based on text-to-speech technologies (TTS) and automated speech recognition technologies (ASR and together with our TTS, the Core Technologies).



§

Couple our award-winning Core Technology with the leading names in wireless devices, entertainment game platforms and telephony solutions.



§

Focus on clearly measured, value-added speech-based market solutions.



§

Expand awareness of our products and services by enhancing our public profile on a targeted basis.



§

Enhance our competitiveness by increasing value-added solutions, portability and ease of use.



Financial Goals:



§

Increase revenue and positive EBITDA based on the combination of LecStars revenue and our speech technology revenue.



§

Deliver predictable revenue and earnings.



§

Provide return on shareholder equity.



Growth Strategy:



We anticipate that we will deliver VoIP services on our own soft switch and expand our partner relationship with Duke Energy facilitating BPL.  We expect to employ a consolidation-driven growth strategy in the telecom industry using LecStar as the platform.  We also anticipate that strategic acquisitions of synergistic companies will deliver a stable revenue stream and expanded customer base.  We expect to transition our telecommunication customers and acquired customers to our VoIP and/or BPL solution.  Integration of support functions and overhead will create operational and financial efficiencies.  We further expect that the implementation of our Core Technologies by acquired synergistic companies will

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§

enhance operating margins;

§

improve customer service;

§

minimize customer churn; and

§

increase customer loyalty.



Most speech recognition products offered by other companies are based on technologies that are largely in the public domain and represent nothing particularly new or creative.  Many of the Fonix speech products and Core Technologies are based on proprietary technology that is protected by patents.  Management believes our speech-enabled products provide a superior competitive alternative compared to other technologies available in the marketplace.  In addition, we believe our unique market focus for our speech-enabled Products will be a substantial differentiator.  To accomplish this objective, we intend to proceed as follows:



Substantially Increase Marketing and Sales Activities.  We intend to expand our sales through partners, OEMs, VARs, direct sales, and existing sales channels, both domestically and internationally, who will focus on the wireless and mobile device markets, telephony and server phone solutions and assistive and language learning devices.  To address global opportunities, we will continue to develop and expand our sales and marketing teams in Asia, Europe, and the United States.



Expand Strategic Relationships.  We have a number of strategic collaboration and marketing arrangements with developers and VARs.  We intend to expand such relationships and add additional similar relationships, specifically in the wireless and mobile device markets, assistive and language learning devices and end-to-end solutions.  Further, when we are able to identify first mover speech-enabling applications in which we can integrate our products and Core Technologies, we intend to investigate investment opportunities so we can obtain preferred or priority collaboration rights.



Continue to Develop Standard Speech Solutions Based on the Core Technologies.  We plan to continue to invest resources in the development and acquisition of standard speech solutions and enhancements to the Core Technologies of speech-enabling technologies, developer tools, and development frameworks to maintain our competitive advantages.



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, 2004.



As noted above, as of June 30, 2005, we had an accumulated deficit of $235,612,000, negative working capital of $15,207,000, accrued liabilities of $7,674,000, accounts payable $5,903,000, and accrued employee wages and other compensation of $501,000.  Sales of products and telecommunications services and revenue from licenses based on our technologies have not been sufficient to finance ongoing operations, although we have limited capital available under an equity line of credit.  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, 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.  Over the past several months, we have reduced our workforce in our speech business unit by approximately 50%.  This reduction may adversely affect our ability to fill existing orders.  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.

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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), including, without limitation, statements as to managements expectations and beliefs, are forward-looking statements.  Forward-looking statements are made based upon managements 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 can 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.  Many important factors could cause actual results to differ materially from managements expectations, including:





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





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





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





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);





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 few 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.



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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.



Regulatory Uncertainty



Prior to 2005, the Companys telecommunications services were provided almost exclusively through the use of unbundled network elements purchased from BellSouth, our primary incumbent local exchange company, or ILEC, that were made available to us pursuant to Federal Communications Commission, or FCC, rules. It has been primarily the availability of cost-based rates for these unbundled network elements that has enabled us to price our local telecommunications services competitively.



In December 2004, the FCC issued final rules that effectively eliminated the requirement under Section 251 of the Telecom Act of 1996 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 (TELRIC).  The FCC established a 12-month transition plan for implementation:



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