**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 March 31, 2007,
                  or
 
 [  
                  ]
              Transition
                  Report pursuant to Section 13 or 15(d) of the Securities Exchange
                  Act of
                  1934 for the transition period from ______________ to
                  _____________.
 
 Commission
        File No. 0-23862
  **Fonix
        Corporation**
 (Exact
        name of registrant as specified in its charter)
 
 **Delaware**
              **22-2994719**(State
                  or other jurisdiction of incorporation or organization)
              (I.R.S.
                  Employer Identification No.)
 
 **9350
        South 150 East, Suite 700**
 **Sandy,
        Utah 84070**
 (Address
        of principal executive offices with zip code)
 
 **(801)
        553-6600**
 (Registrant's
        telephone number, including area code)
 
 Indicate
        by check mark whether the registrant (1) has filed all reports required to
        be
        filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
        the
        preceding 12 months (or for such shorter period that the registrant was required
        to file such reports), and (2) has been subject to such filing requirements
        for
        the past 90 days: Yes [X]  No[  ].
 
 Indicate
        by check mark whether the registrant is a large accelerated filer, an
        accelerated filer, or a non-accelerated filer. (Check One):
 Larger
        Accelerated Filer __ Accelerated Filer __ Non-Accelerated Filer X .
 
 Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-25 of the Exchange Act). Yes __ No X
 
 As
        of May
        10, 2007, there were issued and outstanding 1,707,139,820 shares of our Class
        A
        common stock.
 
 
 
 
 
 
 
 
 
  1
  
 **FONIX
        CORPORATION**
 **FORM
        10-Q**
 
 
 **TABLE
        OF CONTENTS**
 
 **PART
        I - FINANCIAL INFORMATION**
 
 **Page**Item
                  1.
              Financial
                  Statements (Unaudited)Condensed
                  Consolidated Balance Sheets - As of March 31, 2007, and December
                  31,
                  2006
              3Condensed
                  Consolidated Statements of Operations and Comprehensive Loss for
                  the Three
                  Months Ended March 31, 2007 and 2006
              4Condensed
                  Consolidated Statements of Cash Flows for the Three Months Ended
                  March 31,
                  2007 and 2006
              5Notes
                  to Condensed Consolidated Financial Statements (Unaudited)
              7Item
                  2.
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              17Item
                  3.
              Quantitative
                  and Qualitative Disclosures About Market Risk
              28Item
                  4.
              Controls
                  and Procedures
              28**PART
                  II - OTHER INFORMATION**Item
                  1.
              Legal
                  Proceedings
              28Item
                  1A.
              Risk
                  Factors
              29Item
                  2.
              Unregistered
                  Sales of Equity Securities and Use of Proceeds
              30Item
                  6.
              Exhibits
              30
 
 
 
 
 
  2
 **Fonix
        Corporation and Subsidiaries**
 **CONDENSED
        CONSOLIDATED BALANCE SHEETS**
 **(Unaudited)**
 
 **March
                  31,**
              
              **December
                  31,****2007**
              
              **2006****ASSETS****Current
                  assets**Cash
                  and cash equivalents
              
              $
              397,000
              
              $
              5,000Accounts
                  receivable, net of an allowance for doubtful accounts of $0 and
                  $137,000,
                  respectively
              
              
              -
              
              
              -Prepaid
                  expenses and other current assets
              
              
              7,000
              
              
              4,000**Total
                  current assets**
              
              
              404,000
              
              
              9,000**Property
                  and equipment,**net of accumulated depreciation of $1,275,000 and $1,261,000,
                  respectively
              
              
              34,000
              
              
              48,000**Deposits
                  and other assets**
              
              
              117,000
              
              
              117,000**Goodwill**
              
              
              2,631,000
              
              
              2,631,000**Total
                  assets**
              
              $
              3,186,000
              
              $
              2,805,000**LIABILITIES
                  AND STOCKHOLDERS' DEFICIT****Current
                  liabilities**Accrued
                  liabilities
              
              $
              2,677,000
              
              $
              2,054,000Accounts
                  payable
              
              
              1,048,000
              
              
              1,504,000Net
                  liabilities of discontinued subsidiaries
              
              
              20,819,000
              
              
              20,819,000Derivative
                  liability
              
              
              19,591,000
              
              
              20,941,000Accrued
                  payroll and other compensation
              
              
              214,000
              
              
              214,000Accrued
                  settlement obligation, net of unamortized discount of $0 and $118,000,
                  respectively
              
              
              1,530,000
              
              
              1,530,000Deferred
                  revenues
              
              
              447,000
              
              
              460,000Notes
                  payable - related parties
              
              
              902,000
              
              
              800,000Series
                  E debentures
              
              
              1,754,000
              
              
              1,754,000Advance
                  on Series B Preferred Stock
              
              
              1,250,000
              
              
              -Current
                  portion of notes payable
              
              
              3,652,000
              
              
              2,883,000Deposits
                  and other
              
              
              7,000
              
              
              7,000**Total
                  current liabilities**
              
              
              53,891,000
              
              
              52,966,000**Long-term
                  notes payable, net of current portion**
              
              
              2,908,000
              
              
              2,988,000**Total
                  liabilities**
              
              
              56,799,000
              
              
              55,954,000**Commitments
                  and contingencies****Stockholders'
                  deficit**Preferred
                  stock, $0.0001 par value; 50,000,000 shares authorized;Series
                  A, convertible; 166,667 shares outstanding (aggregate liquidation
                  preference of $6,055,000)
              
              
              500,000
              
              
              500,000Series
                  L, convertible; 1,794 shares and 1,858 shares outstanding ,
                  respectively
              
              
              -
              
              
              -Common
                  stock, $0.0001 par value; 5,000,000,000 shares authorized;Class
                  A voting, 1,707,139,820 shares and 1,309,965,981 shares outstanding,
                  respectively
              
              
              170,000
              
              
              131,000Class
                  B non-voting, none outstanding
              
              
              -
              
              
              -Additional
                  paid-in capital
              
              
              237,630,000
              
              
              236,936,000Outstanding
                  warrants to purchase Class A common stock
              
              
              474,000
              
              
              474,000Cumulative
                  foreign currency translation adjustment
              
              
              10,000
              
              
              10,000Accumulated
                  deficit
              
              
              (292,397,000
              )
              
              (291,200,000
              )**Total
                  stockholders' deficit**
              
              
              (53,613,000
              )
              
              (53,149,000
              )**Total
                  liabilities and stockholders' deficit**
              
              $
              3,186,000
              
              $
              2,805,000
  See
        accompanying notes to condensed consolidated financial statements.
 3
  **Fonix
          Corporation and Subsidiaries**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE
        LOSS**
 **(Unaudited)**
 
 **Three
                  Months Ended March 31,**
              
              **2007**
              
              **2006**Revenues
              
              $
              360,000
              
              $
              272,000Cost
                  of revenues
              
              
              7,000
              
              
              5,000Gross
                  profit
              
              
              353,000
              
              
              267,000Expenses:Selling,
                  general and administrative
              
              
              807,000
              
              
              1,173,000Product
                  development and research
              
              
              487,000
              
              
              571,000Total
                  expenses
              
              
              1,294,000
              
              
              1,744,000Other
                  income (expense):Interest
                  expense
              
              
              (463,000
              )
              
              (374,000
              )Gain
                  on derivative liability
              
              
              617,000
              
              
              -Other
                  income (expense), net
              
              
              154,000
              
              
              (374,000
              )Net
                  loss from continuing operations
              
              
              (787,000
              )
              
              (1,851,000
              )Net
                  loss from discontinued operations
              
              
              -
              
              
              (2,230,000
              )Net
                  loss
              
              
              (787,000
              )
              
              (4,081,000
              )Preferred
                  stock dividends
              
              
              (410,000
              )
              
              (1,849,000
              )Loss
                  attributable to common stockholders
              
              $
              (1,197,000
              )
              $
              (5,930,000
              )Basic
                  and diluted loss per common share from continuing
                  operations
              
              $
              (0.00
              )
              $
              (0.01
              )Basic
                  and diluted loss per common share from discontinued
                  operations
              
              $
              (0.00
              )
              $
              (0.01
              )Net
                  loss
              
              $
              (787,000
              )
              $
              (4,081,000
              )Other
                  comprehensive (loss) income - foreign currency translation
              
              
              -
              
              
              7,000Comprehensive
                  loss
              
              $
              (787,000
              )
              $
              (4,074,000
              )
 
   See
        accompanying notes to condensed consolidated financial
        statements.
  4
  **Fonix
          Corporation and Subsidiaries**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF CASH FLOWS**
 **(Unaudited)**
 
 **Three
                  Months Ended March 31,**
              
              **2007**
              
              **2006****Cash
                  flows from operating activities**Net
                  loss
              
              $
              (787,000
              )
              $
              (4,081,000
              )Adjustments
                  to reconcile net loss to net cash used in operating
                  activities:Discontinued
                  operations
              
              
              -
              
              
              2,230,000Gain
                  on derivative liability
              
              
              (617,000
              )
              
              -Accretion
                  of discount on notes payable
              
              
              239,000
              
              
              187,000Accretion
                  of discount on legal settlement
              
              
              -
              
              
              46,000Depreciation
              
              
              14,000
              
              
              14,000Foreign
                  exchange loss (gain)
              
              
              -
              
              
              (7,000
              )Changes
                  in assets and liabilitiesPrepaid
                  expenses and other current assets
              
              
              (3,000
              )
              
              14,000Intercompany
                  account
              
              
              -
              
              
              238,000Accounts
                  payable
              
              
              (456,000
              )
              
              134,000Accrued
                  payroll and other compensation
              
              
              -
              
              
              77,000Other
                  accrued liabilities
              
              
              213,000
              
              
              136,000Deferred
                  revenues
              
              
              (13,000
              )
              
              42,000Net
                  cash used in operating activities
              
              
              (1,410,000
              )
              
              (970,000
              )**Cash
                  flows from investing activities**Purchase
                  of property and equipment
              
              
              -
              
              
              (2,000
              )Net
                  cash used in investing activities
              
              
              -
              
              
              (2,000
              )**Cash
                  flows from financing activities**Proceeds
                  from issuance of Class A common stock, net
              
              
              -
              
              
              1,220,000Proceeds
                  from related party note payable
              
              
              102,000
              
              
              -Advance
                  on Series B Preferred Stock
              
              
              1,250,000
              
              
              -Proceeds
                  from notes payable
              
              
              450,000
              
              
              200,000Payments
                  on related party note payable
              
              
              -
              
              
              (50,000
              )Payments
                  of accrued settlement obligation
              
              
              -
              
              
              (260,000
              )Principal
                  payments on notes payable
              
              
              -
              
              
              (99,000
              )Net
                  cash provided by financing activities
              
              
              1,802,000
              
              
              1,011,000**Net
                  increase in cash and cash equivalents**
              
              
              392,000
              
              
              39,000**Cash
                  and cash equivalents at beginning of period**
              
              
              5,000
              
              
              28,000**Cash
                  and cash equivalents at end of period**
              
              $
              397,000
              
              $
              67,000
 
    See
        accompanying notes to condensed consolidated financial
        statements.
  5
  **Fonix
          Corporation and Subsidiaries**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)**
 **(Unaudited)**
 
 
 **Supplemental
        schedule of noncash investing and financing activities**
 
 **For
        the Three Months Ended March 31, 2007:**
 
 Issued
        397,173,839 shares of Class A common stock in conversion of 64 shares of
        Series
        L Convertible Preferred Stock.
 
 Accrued
        $370,000 of dividends on Series L Preferred Stock.
 
 **For
        the Three Months Ended March 31, 2006:**
 
 Issued
        15,028,249 shares of Class A common stock in conversion of 266 shares of
        Series
        J Convertible Preferred Stock.
 
 Issued
        27,200,000 shares of Class A common stock in conversion of 272 shares of
        Series
        K Convertible Preferred Stock.
 
 Issued
        2,838,412 shares of Class A common stock as payment of $65,000 of dividends
        on
        Series H Preferred Stock.
 
 Accrued
        $250,000 of dividends on Series H Preferred Stock.
 
 Accrued
        $7,000 of dividends on Series K Preferred Stock.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
   See
        accompanying notes to condensed consolidated financial
        statements.
  6
  **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
        of ** Fonix ** Corporation
        and subsidiaries (collectively, the “Company” or “Fonix”) have been prepared by
        the Company pursuant to the rules and regulations of the Securities and Exchange
        Commission (the “SEC”). Certain information and footnote disclosures normally
        included in financial statements prepared in accordance with accounting
        principles generally accepted in the United States of America have been
        condensed or omitted pursuant to such rules and regulations, although the
        Company believes that the following disclosures are adequate to make the
        information presented not misleading. The Company suggests that these condensed
        consolidated financial statements be read in conjunction with the consolidated
        financial statements and the notes thereto included in the Company’s 2006 Annual
        Report on Form 10-K.
 
 The
        Company has not consolidated the assets, liabilities or operations related
        to
        its former telecom operations at March 31, 2007 as these assets are under
        the
        control of the court appointed bankruptcy trustee pursuant to the filing
        for
        protection under Chapter 7 of the Bankruptcy Code by LecStar Telecom, Inc.,
        LecStar DataNet, Inc., LTEL Holdings and Fonix Telecom, Inc. on October 2,
        2006.
        The accompanying footnotes do not include disclosures related to the operations
        of the aforementioned companies and represent solely the operations of Fonix
        Speech, Inc.
 
 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 2006 Annual Report on Form
        10-K.
 
 Operating
        results for the three months ended March 31, 2007, are not necessarily
        indicative of the results that may be expected for the year ending December
        31,
        2007.
 
 ***Nature
        of Operations*** **-** ****** Fonix
        Corporation (“the Company”) provides value-added speech technologies through its
        subsidiary, Fonix Speech, Inc. (“Fonix Speech”). The Company offers
        speech-enabling technologies including automated speech recognition (“ASR”) and
        text-to-speech (“TTS”) through Fonix Speech 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
        our core technologies and have 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 are generated through licensing of
        speech-enabling technologies, maintenance contracts and services.
 
 The
        Company previously operated a telecommunications business, the results of
        which
        were included in prior SEC filings. On October 2, 2006, LecStar Telecom Inc.,
        a
        Georgia corporation (“LecStar Telecom”), LecStar DataNet, Inc., a Georgia
        corporation (“LecStar DataNet”), LTEL Holdings Corporation (“LTEL Holdings”), a
        Delaware corporation, and Fonix Telecom Inc., a Delaware corporation (“Fonix
        Telecom”), each of which are direct or indirect subsidiaries of Fonix, filed for
        bankruptcy protection in the United States Bankruptcy Court for the District
        of
        Delaware (the “Bankruptcy Court”). The case numbers are as follows: LTEL
        Holdings Corporation, 06-11081 (BLS); LecStar Telecom, Inc., 06-11082 (BLS);
        LecStar DataNet, Inc., 06-11083 (BLS); Fonix Telecom, Inc., 06-11084 (BLS).)
 
 LecStar
        Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom sought protection
        under Chapter 7 of title 11 of the U.S. Bankruptcy Code, 11 U.S.C ss 101
        et seq.
        (the “Bankruptcy Code”). Pursuant to Bankruptcy Code Section 701, on October 3,
        2006, Alfred Thomas Guliano was appointed the interim trustee for LecStar
        Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom. As these subsidiary
        companies were in Chapter 7 Bankruptcy proceedings as of the date of this
        Report, the results of their operations have been treated as discontinued
        operations.
 
  7
  **Fonix
          Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**
 **(Unaudited)**
 
 
 ***Business
        Condition*** **-** For
        the
        quarters ended March 31, 2007 and 2006, we generated revenues of $360,000
        and
        $272,000, respectively; incurred net losses of $787,000 and $4,081,000,
        respectively, and had negative cash flows from operating activities of
        $1,410,000 and $970,000, respectively. As of March 31, 2007, we had an
        accumulated deficit of $292,397,000, negative working capital of $53,487,000,
        accrued liabilities and accrued settlement liability of $4,207,000, derivative
        liabilities of $19,591,000 related to the issuance of Series L Preferred
        Stock
        and Series E Convertible Debentures, net liabilities of discontinued
        subsidiaries of $20,819,000 related to the telecom subsidiaries subject to
        bankruptcy (LecStar Telecom, LecStar DataNet, LTEL Holdings and Fonix Telecom),
        accounts payable of $1,048,000 and current portion of notes payable of
        $4,554,000. We expect to continue to incur significant losses and negative
        cash
        flows from operating activities at least through December 31, 2007, primarily
        due to expenditure requirements associated with continued marketing and
        development of our speech-enabling technologies.
 
 The
        Company’s cash resources, limited to collections from customers, sales of our
        equity and debt securities and loans, have not been sufficient to cover
        operating expenses. As a result, some payments to vendors have been delayed.
 
 These
        factors, as well as the risk factors set out elsewhere in the Annual Report
        on
        Form 10-K, raise substantial doubt about the Company’s ability to continue as a
        going concern. The accompanying financial statements do not include any
        adjustments that might result from the outcome of this uncertainty. Management
        plans to fund further operations of the Company from cash flows from future
        license and royalty arrangements and with proceeds from additional issuance
        of
        debt and equity securities. There can be no assurance that management’s plans
        will be successful.
 
 ***Net
        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 March 31, 2007 and 2006,
        there
        were outstanding common stock equivalents to purchase 12,395,755,010 and
        112,437,512 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 ended March 31, 2007
        and
        2006:
 
 **Three
                  Months Ended March 31,****2007**
              
              **2006****Per**
              
              
              
              **Per****Share**
              
              
              
              **Share****Amount**
              
              **Amount**
              
              **Amount**
              
              **Amount**Net
                  loss from continuing operations
              
              $
              (787,000
              )
              
              
              
              $
              (1,851,000
              )Net
                  loss from discontinued operations
              
              
              --
              
              
              --
              
              
              (2,230,000
              )
              $
              (0.01
              )Net
                  loss
              
              $
              (787,000
              )
              
              
              
              $
              (4,081,000
              )Preferred
                  stock dividends
              
              
              (410,000
              )
              
              
              
              
              (1,849,000
              )Loss
                  attributable to common stockholders
              
              $
              (1,197,000
              )
              $
              (0.00
              )
              $
              (5,930,000
              )
              $
              (0.01
              )Weighted-average
                  common shares outstanding
              
              
              1,522,953,187
              
              
              
              
              
              441,531,721
 
 ***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.
  8
  **Fonix
          Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**
 **(Unaudited)**
 
 
 ***Revenue
        Recognition*** -
        The
        Company recognizes revenue when pervasive evidence of an arrangement exists;
        services have been rendered or products have been delivered; the price to
        the
        buyer is fixed and determinable; and collectibility is reasonably assured.
        Revenues are recognized by the Company based on the various types of
        transactions generating the revenue. For software sales, the Company recognizes
        revenues in accordance with the provisions of Statement of Position No. 97-2,
        “Software Revenue Recognition,” and related interpretations *.* The
        Company generates revenues from licensing the rights to its software products
        to
        end users and from royalties. For telecommunications services, revenue is
        recognized in the period that the service is provided.
 
 For
        Fonix
        Speech, revenue of all types is recognized when acceptance of functionality,
        rights of return, and price protection are confirmed or can be reasonably
        estimated, as appropriate. Revenues from development and consulting services
        are
        recognized on a completed-contract basis when the services are completed
        and
        accepted by the customer. The completed-contract method is used because the
        Company’s contracts are typically either short-term in duration or the Company
        is unable to make reasonably dependable estimates of the costs of the contracts.
        Revenue for hardware units delivered is recognized when delivery is verified
        and
        collection assured.
 
 Revenue
        for products distributed through wholesale and retail channels and through
        resellers is recognized upon verification of final sell-through to end users,
        after consideration of rights of return and price protection. Typically,
        the
        right of return on such products has expired when the end user purchases
        the
        product from the retail outlet. Once the end user opens the package, it is
        not
        returnable unless the medium is defective.
 
 When
        arrangements to license software products do not require significant production,
        modification or customization of software, revenue from licenses and royalties
        are recognized when persuasive evidence of a licensing arrangement exists,
        delivery of the software has occurred, the fee is fixed or determinable,
        and
        collectibility is probable. Post-contract obligations, if any, generally
        consist
        of one year of support including such services as customer calls, bug fixes,
        and
        upgrades. Related revenue is recognized over the period covered by the
        agreement. Revenues from maintenance and support contracts are also recognized
        over the term of the related contracts.
 
 Revenues
        applicable to multiple-element fee arrangements are bifurcated among the
        elements such as license agreements and support and upgrade obligations using
        vendor-specific objective evidence of fair value. Such evidence consists
        primarily of pricing of multiple elements as if sold as separate products
        or
        arrangements. These elements vary based upon factors such as the type of
        license, volume of units licensed, and other related factors.
 
 Deferred
        revenue as of March 31, 2007, and December 31, 2006, consisted of the
        following:
 
 **Description**
              **Criteria
                  for Recognition**
              ****
              **Mar
                  31, 2007**
              ****
              **Dec
                  31, 2006**Deferred
                  unit royalties and license fees
              Delivery
                  of units to end users or expiration of contract
              
              $
              447,000
              
              $
              460,000
  ***Cost
        of Revenues*** -
        Cost of
        revenues from license, royalties, and maintenance consists of costs to
        distribute the product, installation and support personnel compensation,
        amortization and impairment of capitalized speech software costs, licensed
        technology, and other related costs. Cost of service revenues consists of
        personnel compensation and other related costs.
 
 ***Software
        Technology Development and Production Costs*** **** -
        All
        costs incurred to establish the technological feasibility of speech software
        technology to be sold, leased, or otherwise marketed are charged to product
        development and research expense. Technological feasibility is established
        when
        a product design and a working model of the software product have been completed
        and confirmed by testing. Costs to produce or purchase software technology
        incurred subsequent to establishing technological feasibility are capitalized.
        Capitalization of software costs ceases when the product is available for
        general release to customers. Costs to perform consulting or development
        services are charged to cost of revenues in the period in which the
        corresponding revenues are recognized. The cost of maintenance and customer
        support is charged to expense when related revenue is recognized or when
        these
        costs are incurred, whichever occurs first.
 
  9
  **Fonix
          Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**
 **(Unaudited)**
 
 
 ***Stock-Based
        Employee Compensation*** -
        Effective January 1, 2006, the Company adopted Statement of Financial Accounting
        Standards No. 123(R), “Share-Based Payment” (“FAS 123(R)”), an amendment of SFAS
        No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) using the
        modified prospective transition method. Under this transition method,
        compensation costs are recognized beginning with the effective date: (a)
        based
        on the requirements of FAS 123(R) for all share-based awards granted after
        the
        effective date; and (b) based on the requirements of SFAS 123 for all awards
        granted to employees prior to the effective date of FAS 123(R) that remain
        unvested on the effective date. Accordingly, the Company did not restate
        the
        results of prior periods. The most notable change resulting from the adoption
        of
        FAS123(R) is that compensation expense associated with stock options is now
        recognized in the Company’s Statements of Operations, rather than being
        disclosed in a pro forma footnote to the Company’s financial
        statements.
 
 The
        Company recognized compensation expense related to option grants and the
        vesting
        of previously unvested options for the three months ended March 31, 2007,
        of
        $0.
 
 There
        were no option grants during the three months ended March 31, 2007 .
 
 **2.
        GOODWILL**
 
 The
        carrying value of goodwill is assessed for impairment quarterly. An assessment
        was performed for the quarter ended March 31, 2007, which resulted in no
        impairment, and the carrying value of goodwill remained unchanged at $2,631,000
        for the quarter ended March 31, 2007.
 
 **3.
        NOTES PAYABLE**
 
 In
        connection with the acquisition of the capital stock of LTEL Holdings in
        2004,
        the Company issued a 5%, $10,000,000, secured, six-year note (the “Note”)
        payable to McCormack Avenue, Ltd. (“McCormack”). Under the terms of the Note,
        quarterly interest-only payments were required through January 15, 2005,
        with
        quarterly principal and interest payments of $319,000 beginning April 2005
        and
        continuing through January 2010. Interest on the Note is payable in cash
        or, at
        the Company’s option, in shares of the Company’s Class A common stock. The Note
        is secured by the capital stock and all of the assets of LTEL Holdings and
        its
        subsidiaries. The Note was originally valued at $4,624,000 based on an imputed
        interest rate of 25 percent per annum.
 
 The
        discount on the N ote
        is
        based on an imputed interest rate of 25%. The carrying amount of the Note
        of
        $5,781,000 at March 31, 2007, was net of unamortized discount of $2,952,000.
        As
        of the date of this report, the Company had not made any scheduled payments
        for
        2006 or 2007.
 
 On
        September 8, 2006, the Company received a default notice (the “Default Notice”)
        from McCormack in respect of the Note. Under the terms of the Note, and a
        related Security Agreement between the Company and McCormack dated February
        24,
        2004 (the “Security Agreement”), McCormack was entitled to declare all
        liabilities, indebtedness, and obligations of the Company to McCormack under
        the
        Security Agreement and the Note immediately due and owing upon an event of
        default. The Note defines an event of default to include the non-payment
        by the
        Company of a scheduled payment which is not cured within 60 days .
 
 In
        the
        Default Notice, McCormack stated that it intended to exercise its rights,
        including any and all rights set forth in the Note, as amended.
 
 Also
        on
        September 8, 2006, McCormack provided to the Company a Notice of Sale, stating
        McCormack’s intention to sell at public auction all of the collateral referred
        to in the Security Agreement, consisting of the capital stock and assets
        of
        LecStar Telecom, LecStar DataNet, and LTEL Holdings. As of the date of this
        report, no sale of the assets or capital stock of LecStar Telecom, LecStar
        DataNet nor LTEL Holdings had occurred.
 
 During
        the fourth quarter of 2005, the Company entered into two promissory notes
        with
        an unrelated third party in the aggregate amount of $650,000. These notes
        accrue
        interest at 10% annually and were due and payable during May and June of
        2006.
        As of the date of this report, the Company had not made the scheduled payments
        on these promissory notes; the holder of the notes has not declared a default
        under the notes.
 
  10
  **Fonix
          Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**
 **(Unaudited)**
 
 
 During
        the fourth quarter of 2006, the Company entered into two promissory notes
        with
        an unrelated third party in the aggregate amount of $330,000. These notes
        accrue
        interest at 10% annually and are due and payable during the second quarter
        of
        2007.
 
 During
        the quarter ended March 31, 2007, the Company entered into five promissory
        notes
        with an unrelated third party in the aggregate amount of $450,000. These
        notes
        accrue interest at 10% annually and are due and payable during the third
        quarter
        of 2007.
 
 The
        following schedule summarizes the Company’s current debt obligations and
        respective balances at March 31, 2007, and December 31, 2006:
 
 **Notes
                  Payable**
              
              **Mar
                  31, 2007**
              
              **Dec
                  31, 2006**5%
                  Note payable to a company, $8,733,000 and $8,733,000 face amount,
                  respectively, due in quarterly installments of $319,000, matures
                  January
                  2010, less unamortized discount based on interest imputed at 25%
                  of $
                  2,952,000 and $3,191,000, respectively
              
              $
              5,780,000
              
              $
              5,543,000Note
                  payable to a company, interest at 10%, matures June 2006
              
              
              --
              
              
              --Note
                  payable to a company, interest at 10%, matures June 2007
              
              
              235,000
              
              
              235,000Note
                  payable to a company, interest at 10%, matures June 2007
              
              
              95,000
              
              
              95,000Note
                  payable to a company, interest at 10%, matures July 2007
              
              
              450,000
              
              
              --Note
                  payable to related parties, interest at 12%, matured September
                  2006,
                  secured by intellectual property rights
              
              
              902,000
              
              
              800,000Total
                  notes payable
              
              
              7,462,000
              
              
              6,671,000Less
                  current maturities
              
              
              (4,554,000
              )
              
              (3,683,000
              )Long-Term
                  Note Payable
              
              $
              2,908,000
              
              $
              2,988,000
 
 **4.
        RELATED-PARTY NOTES PAYABLE**
 
 During
        2002, two executive officers of the Company (the “Lenders”) sold shares of the
        Company’s Class A common stock owned by them and advanced the resulting proceeds
        amounting to $333,000 to the Company under the terms of a revolving line
        of
        credit and related promissory note. The funds were advanced for use in Company
        operations. The advances bear interest at 12 percent per annum, 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 have agreed
        to
        postpone the maturity date on several occasions. The note was due September
        30,
        2006. As of the date of this report, the Company had not made payment against
        the outstanding balance due on the note. All or part of the outstanding balance
        and unpaid interest may be converted at the option of the Lenders into shares
        of
        Class A common stock of the Company at any time. The conversion price was
        the
        average closing bid price of the shares at the time of the advances. To the
        extent the market price of the Company’s shares is below the conversion price at
        the time of conversion, the Lenders are entitled to receive additional shares
        equal to the gross dollar value received from the original sale of the shares.
        A
        beneficial conversion option of $15,000 was recorded as interest expense
        in
        connection with this transaction. The Lenders may also receive additional
        compensation as determined appropriate by the Board of Directors.
 
  11
  **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 Queen, LLC (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.
 
 During
        the fourth quarter of 2003, the Company made a principal payment of $26,000
        against the outstanding balance of the promissory note. During 2004, the
        Company
        entered into an agreement with the holders of the promissory note to increase
        the balance of the note payable by $300,000 in exchange for a release of
        the
        $1,443,000 of accrued liabilities related to prior indemnity agreements between
        the Company and the note holders. The Company classified the release of
        $1,143,000 as a capital contribution in the Consolidated Financial Statements
        during the fourth quarter of 2004. The Company made principal payments against
        the note of $254,000 during the year ended December 31, 2004. During the
        year
        ended December 31, 2005, the Company received an additional advance of $50,000
        against the promissory note. The balance due at December 31, 2005 was $486,000.
        During the year ended December 31, 2006, the Company received additional
        advances of $419,000 and made principal payments to the Lenders against the
        note
        of $105,000. During the quarter ended March 31, 2007, the Company received
        additional advances of $102,000. The balance due at March 31, 2007 was
        $902,000.
 
 The
        aggregate advances of $902,000 are secured by the Company’s intellectual
        property rights. As of March 31, 2007, the Lenders had not converted any
        of the
        outstanding balance or interest into common stock.
 
 **5.
        PREFERRED STOCK**
 
 The
        Company’s certificate of incorporation allows for the issuance of preferred
        stock in such series and having such terms and conditions as the Company’s board
        of directors may designate.
 
 ***Series
        A Convertible Preferred Stock*** - As of
        March 31, 2007, 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.
 
 ***Fonix
        Speech, Inc,. Series B Convertible Preferred Stock*** - On
        April 4, 2007, the Company entered into a Securities Purchase Agreement by
        and
        among the Company, Fonix Speech, Inc. (“FSI”), and Sovereign Partners, LP
        (“Sovereign”). FSI is a wholly owned subsidiary of the Company.
 
 Pursuant
        to the FSI agreement, FSI sold 125 shares of its Series B 9% Convertible
        Preferred Stock (the “FSI Preferred Stock”) at a per share price of $10,000 to
        Sovereign. In anticipation of the transaction, Sovereign advanced the gross
        proceeds of $1,250,000 to the Company on March 30, 2007. The advance has
        been
        accounted for as a liability in the accompanying financial
        statements.
 
 The
        shares of FSI Preferred Stock are convertible into shares of the Company’s Class
        A common stock. The FSI Preferred Stock may be converted into common stock
        of
        the Company at the option of the holder by using a conversion price which
        shall
        be the lower of (i) 80% of the average of the two lowest closing bid prices
        for
        the twenty-day trading period prior to the conversion date, or (ii)
        $0.004.
 
  12
  **Fonix
          Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**
 **(Unaudited)**
 
 
 ***Series
        L Convertible Preferred Stock*** - On
        September 7, 2006, the Company entered into a Series L 9% Convertible Preferred
        Stock Exchange Agreement (the "Exchange Agreement") with McCormack and Kenzie
        Financial (“Kenzie”), a British Virgin Islands company. Pursuant to the Exchange
        Agreement, McCormack and Kenzie exchanged all of the shares of Series H
        Preferred Stock that they acquired from sale of LTEL Holdings, for 1,960.8
        and
        39.2 shares, respectively, of the Company's Series L 9% Convertible Preferred
        Stock (the "Series L Preferred Stock").
 
 Because
        the shares of Series L Preferred Stock were issued in exchange for the remaining
        outstanding shares of Series H Preferred Stock, the Company did not receive
        any
        proceeds in connection with the issuance of the Series L Preferred Stock.
 
 The
        Series L Preferred Stock entitles McCormack and Kenzie to receive dividends
        in
        an amount equal to 9% of the then-outstanding balance of shares of Series
        L
        Preferred Stock. The dividends are payable in cash or shares of the Company's
        Class A common stock, at the Company's option.
 
 The
        Series L Preferred Stock is convertible into common stock of the Company
        at the
        option of the holder by using a conversion price which was 80% of the average
        of
        the two lowest closing bid prices for the twenty-day trading period prior
        to the
        conversion date.
 
 Redemption
        of the Series L Preferred Stock, whether at the Company’s option or that of
        McCormack or Kenzie, requires the Company to pay, as a redemption price,
        the
        stated value of the outstanding shares of Series L Preferred Stock to be
        redeemed, together with any accrued but unissued dividends thereon, multiplied
        by one hundred ten percent (110%).
 
 The
        Company accounted for the exchange as redemption of the outstanding Series
        H
        Preferred Stock as the Series H Preferred Stock was not convertible into
        shares
        of common stock of the Company. The Series L Preferred Stock is convertible
        into
        shares of common stock of the Company. The Company followed the accounting
        treatment in SFAS 150 “ *Accounting
        for Certain Financial Instruments with Characteristics of Both Liabilities
        and
        Equity,”* SFAS
        133
“ *Accounting
        for Derivative Instruments and Hedging Activities”* and
        EITF
        00-19 “ *Accounting
        for Derivative Financial Instruments Indexed to, and Potentially Settled
        in, a
        Company’s Own Stock.”* The
        Company recognized a derivative liability upon the redemption of $30,991,000
        due
        to the value of the conversion feature of the Series L Preferred Stock. The
        liability was calculated using the Black-Scholes valuation model with the
        following assumptions: dividend yield of 0%, expected volatility of 140%,
        risk-free rate of 3.75% and expected life of 4 years. As the value of the
        derivative liability was greater than the face value of the Series L Preferred
        Stock, no value was prescribed to the Series L Preferred Stock. Also in
        connection with the redemption, the Company recognized a preferred stock
        dividend of $16,000,000, equal to the original discount the Company had assigned
        to the Series H Preferred Stock.
 
 For
        the
        quarter ended March 31, 2007, the Company issued 397,173,840 shares of its
        Class
        A common stock in conversion of 64 shares of its Series L Preferred Stock.
        At
        March 31, 2007, 1,794 shares of Series L Preferred Stock remained outstanding.
 
 **6.
        CONVERTIBLE DEBENTURES**
 
 On
        December 7, 2006, the Company entered into a Securities Purchase Agreement,
        dated as of December 1, 2006 (the “Agreement”), with Southridge relating to the
        purchase and sale of a Series E 9% Secured Subordinated Convertible Debenture
        (the “Debenture”) in the principal amount of $850,000.
 
 Pursuant
        to the Agreement, Southridge paid the purchase price by tendering a prior
        debenture in the aggregate amount (including principal and interest) of
        $641,000, and agreed that an advance to the Company in the amount of $75,000
        made in November 2006 would also constitute part of the purchase price.
        Southridge agreed to fund the remaining $134,000 upon the effectiveness of
        a
        registration statement, to be filed by the Company, to register the resales
        of
        shares issuable to Southridge upon conversion of the Debenture.
 
  13
  **Fonix
          Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**
 **(Unaudited)**
 
 
 The
        Debenture is convertible into shares of our Class A common stock. The number
        of
        shares issuable is determined by dividing the amount of the Debenture being
        converted by the conversion price, which is the average of the two lowest
        per
        share market values for the twenty trading days immediately preceding the
        conversion date multiplied by seventy percent. The conversion price is subject
        to adjustment as set forth in the Debenture. Southridge has agreed not to
        convert the Debenture to the extent that such conversion would cause Southridge
        to beneficially own in excess of 4.999% of the then-outstanding shares of
        Class
        A common stock of the Company except in the case of a merger by the Company
        or
        other organic change.
 
 The
        Company also entered into a Registration Rights Agreement (the “Registration
        Agreement”) with Southridge pursuant to which the Company agreed to file a
        registration statement to register the resale by Southridge of shares of
        the
        Company’s common stock issuable upon conversion of the Debenture. Under the
        Registration Agreement, the Company agreed to file a registration statement
        to
        register the resale by Southridge of up to 300,000,000 shares of Fonix Class
        A
        common stock
 
 In
        addition to the Debenture issued to Southridge described above, on December
        7,
        2006, the Company entered into a Securities Purchase Agreement, dated as
        of
        December 1, 2006 (the “McCormack Agreement”), with McCormack, relating to the
        purchase and sale of a Series E 9% Secured Subordinated Convertible Debenture
        (the “McCormack Debenture”) in the principal amount of $1,039,000.
 
 Pursuant
        to the McCormack Agreement, McCormack paid the purchase price by tendering
        outstanding promissory notes in the amounts of $300,000 and $350,000, together
        with combined interest thereon of $64,000, and agreed that advances to the
        Company in the amount of $325,000, made in September, October, and November
        2006, would also constitute part of the purchase price.
 
 The
        McCormack Debenture is convertible into shares of the Registrant’s Class A
        common stock. The number of shares issuable is determined by dividing the
        amount
        of the Debenture being converted by the conversion price, which is the average
        of the two lowest per share market values for the twenty trading days
        immediately preceding the conversion date multiplied by seventy percent.
        The
        conversion price is subject to adjustment as set forth in the Debenture.
        McCormack agreed not to convert the Debenture to the extent that such conversion
        would cause McCormack to beneficially own in excess of 4.999% of the
        then-outstanding shares of Class A common stock of the Company except in
        the
        case of a merger by the Company or other organic change.
 
 The
        Company also entered into a Registration Rights Agreement (the “McCormack
        Registration Agreement”) with McCormack pursuant to which the Company agreed to
        file a registration statement to register the resale by McCormack of shares
        of
        the Company’s common stock issuable upon conversion of the Debenture.
 
 The
        Company received no new capital in connection with the issuance and sale
        of the
        Debenture.
 
 **7.
        EQUITY LINES OF CREDIT**
 
 ***Seventh
        Equity Line of Credit*** - On May
        27, 2005, the Company entered into a seventh private equity line agreement
        (the
        "Seventh Equity Line Agreement") with 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 had 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 was 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
        was limited as to the amount of shares it may put to the Equity Line Investor
        in
        connection with each put; the Company could not put shares which would cause
        the
        Equity Line Investor to own more than 4.99% of its outstanding common stock
        on
        the date of the put notice. The number of shares to be issued in connection
        with
        each draw was 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
        was 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.
 
  14
  **Fonix
          Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**
 **(Unaudited)**
 
 
 The
        Company granted registration rights to the Equity Line Investor and filed
        three
        registration statements which cover the resales of the shares to be issued
        under
        the Seventh Equity Line. All of the shares registered by the first registration
        statement had been sold as of October 24, 2005. The second registration
        statement filed in connection with the Seventh Equity Line was declared
        effective by the SEC on February 10, 2006. All of the shares registered by
        the
        second registration statement had been sold as of July 26, 2006. The Company
        filed a third registration statement on June 26, 2006, to register additional
        shares under the Seventh Equity Line. However, that registration statement
        was
        not declared effective, and no shares were sold under that registration
        statement.
 
 In
        January, 2007, the Company terminated the Seventh Equity Line, and the Company
        has withdrawn the third registration statement related to the Seventh Equity
        Line. As such, as of the date of this Report, the Company did not have an
        equity
        line of credit financing available to it.
 
 **8.
        COMMON STOCK, STOCK OPTIONS AND WARRANTS**
 
 ***Class
        A Common Stock*** - During
        the three months ended March 31, 2007, 397,173,839 shares of Class A common
        stock were issued in conversion of 64 shares of Series L Preferred
        Stock.
 
 ***Stock
        Options -*** As of
        March 31, 2007, the Company had a total of 890,642 options to purchase Class
        A
        common stock outstanding. During the three months ended March 31, 2007 no
        options were granted.
 
 ***Warrants*** - As of
        March 31, 2007, the Company had warrants to purchase a total of 15,000 shares
        of
        Class A common stock outstanding that expire through 2010.
 
 **9.
        LITIGATION, COMMITMENTS AND CONTINGENCIES**
 
 ***Breckenridge
        Complaint*** - On
        June 6, 2006, Breckenridge filed a complaint against the Company in the Supreme
        Court of the State of New York, County of Nassau (the “Court”), in connection
        with a settlement agreement between the Company and Breckenridge entered
        into in
        September 2005. In the Complaint, Breckenridge alleged that the Company failed
        to pay certain amounts due under the settlement agreement in the amount of
        $450,000. The Company denied the allegations of Breckenridge’s complaint and has
        filed a motion for summary judgment. Breckenridge also filed for summary
        judgment on its complaint.
 
 On
        February 2, 2007, the Court granted Breckenridge’s summary judgment motion,
        denied the Company’s summary judgment motion, and directed that a hearing be
        held to determine the amount owed by the Company to Breckenridge. The Company
        and Breckenridge entered into a stipulation that the Company owed Breckenridge
        $1,530,000 plus interest at a rate of 9% from September 15, 2006 to the date
        of
        entry of judgment.
 
 The
        Court’s order, dated as of March 15, 2007, adjudged that the Company owes an
        aggregate of $1,602,000 to Breckenridge.
 
 On
        April
        26, 2007, Breckenridge filed a complaint in the United States District Court
        for
        the District of Utah, entitled “ The
        Breckenridge Fund, LLC v. Fonix Corporation, Fonix Speech, Inc., Thomas A.
        Murdock, and Roger D. Dudley .”
In
        the
        complaint Breckenridge asserts statutory claims under the Uniform Fraudulent
        Transfers Act and a related equitable claim based on the conveyance of
        intellectual property and other assets made by the Company to Fonix Speech
        in
        February 2006 in connection with the incorporation of Fonix Speech as a wholly
        owned subsidiary of the Company.  The complaint seeks a judgment against
        all of the defendants in the amount of $1,601,735.  The complaint also
        seeks to set aside alleged transfers between the Company and Dudley or Murdock,
        and for subordination of any security interest held by Dudley or Murdock.
  Concurrent
        with the filing of its complaint, Breckenridge brought a Motion for Prejudgment
        Writ of Attachment seeking to attach certain of the assets of Fonix Speech,
        including its intellectual property and cash, as necessary to satisfy the
        judgment of $1,602,000 that Breckenridge obtained in New York.  On May 11,
        2007, the United States District Court heard testimony and entered an order
        granting Breckenridge’s motion as to the cash of Fonix Speech. 
Specifically, the court ordered that Fonix Speech’s remaining $94,000 of
        operating capital be frozen immediately.  The court ordered Breckenridge to
        post a bond of $90,000.  Fonix Speech has taken steps to comply with the
        court’s order.
 
  15
  **Fonix
          Corporation and Subsidiaries**
 **Notes
        to Condensed Consolidated Financial Statements**
 **(Unaudited)**
 
 
 **10.
        SUBSEQUENT EVENTS**
 
 ***Series
        B Convertible Preferred Stock*** -
        On
        April 4, 2007, the Company entered into a Securities Purchase Agreement by
        and
        among the Company, Fonix Speech, Inc. (“FSI”), and Sovereign. FSI is a wholly
        owned subsidiary of the Company.
 
 Pursuant
        to the FSI agreement, FSI sold 125 shares of its Series B 9% Convertible
        Preferred Stock (the “FSI Preferred Stock”) at a per share price of $10,000 to
        Sovereign. In anticipation of the transaction, Sovereign advanced the gross
        proceeds of $1,250,000 to the Company on March 30, 2007. The advance has
        been
        accounted for as a liability in the accompanying financial
        statements.
 
 The
        shares of FSI Preferred Stock are convertible into shares of the Company’s Class
        A common stock. The FSI Preferred Stock may be converted into common stock
        of
        the Company at the option of the holder by using a conversion price which
        shall
        be the lower of (i) 80% of the average of the two lowest closing bid prices
        for
        the twenty-day trading period prior to the conversion date, or (ii)
        $0.004.
 
 ***Series
        M Preferred Stock*** -
        On
        April 4, 2007, the Company entered into a Series M 9% Convertible Preferred
        Stock Exchange Agreement with Sovereign. Pursuant to the exchange agreement,
        Sovereign exchanged 150 shares of the Company’s Series L Preferred Stock for 150
        shares of the Company’s Series M 9% Convertible Preferred Stock (the “Series M
        Preferred Stock”).
 
 The
        Series M Preferred Stock entitles Sovereign or its assignees to receive
        dividends in an amount equal to 9% of the then-outstanding balance of shares
        of
        Series M Preferred Stock. The dividends are payable in cash or shares of
        the
        Company’s Class A common stock, at the Company’s option.
 
 The
        Series M Preferred Stock may be converted into common stock of the Company
        at
        the option of the holder by using a conversion price which shall be the lower
        of
        (i) 80% of the average of the two lowest closing bid prices for the twenty-day
        trading period prior to the conversion date, or (ii) $0.004.
 
 Redemption
        of the Series M Preferred Stock, whether at the Company’s option or that of
        Sovereign, requires the Company to pay, as a redemption price, the stated
        value
        of the outstanding shares of Series M Preferred Stock to be redeemed, together
        with any accrued but unissued dividends thereon, multiplied by one hundred
        ten
        percent (110%).
 
 Because
        the shares of Series M were issued in exchange for the outstanding shares
        of
        Series L Preferred Stock, the Company did not receive any proceeds in connection
        with the issuance of the Series M Preferred Stock.
 
 
 
 
 
 
 
 
 
  16
  **ITEM
                  2.**
              **MANAGEMENT'S
                  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
                  OPERATIONS**
 
 ***This
        report on Form 10-Q contains, in addition to historical information,
        forward-looking statements that involve substantial risks and uncertainties.
        All
        forward-looking statements contained herein are deemed by Fonix to be covered
        by
        and to qualify for the safe harbor protection provided by Section 21E of
        the
        Private Securities Litigation Reform Act of 1995. When used in this report,
        words such as “believes,” “expects,” “intends,” “plans,” “anticipates,”
“estimates,” and similar expressions are intended to identify forward-looking
        statements, although there may be certain forward-looking statements not
        accompanied by such expressions. Statements relating to the future performance,
        business strategies and implementation, availability of outside financing,
        financial performance, market acceptance of our products, and similar statements
        may also include forward looking statements. Actual results could differ
        materially from the results anticipated by Fonix and discussed in the
        forward-looking statements. Factors that could cause or contribute to such
        differences are discussed in the Company’s Annual Report on Form 10-K for the
        year ended December 31, 2006. The Company disclaims any obligation or intention
        to update any forward-looking statements.***
 
 **To
        date, we have earned only limited revenue from operations and intend to continue
        to rely primarily on financing through the sale of our equity and debt
        securities to satisfy future capital requirements.**
 
 The
        following Management’s Discussion and Analysis of Financial Condition and
        Results of Operations (“MD&A”) is intended to help the reader understand
        Fonix Corporation, our operations and our present business environment. MD&A
        is provided as a supplement to, and should be read in conjunction with, our
        condensed consolidated financial statements and the accompanying notes thereto.
        This overview summarizes MD&A, which includes the following
        sections:
 
 ·
              ***Overview***-
                  a general description of our business and the markets in which
                  we operate;
                  our objective; our areas of focus; and challenges and risks of
                  our
                  business.
 
 ·
              ***Significant
                  Accounting Policies*****-
                  a
                  discussion of accounting policies that require critical judgments
                  and
                  estimates.
 
 ·
              ***Results
                  of Operations*****-
                  an analysis of our Company’s consolidated results of operations for the
                  three years presented in our consolidated financial statements.
                  Except to
                  the extent that differences among our operating segments are material
                  to
                  an understanding of our business as a whole, we present the discussion
                  in
                  the MD&A on a consolidated
                  basis.
 
 ·
              ***Liquidity
                  and Capital Resources*****-
                  an analysis of cash flows; off-balance sheet arrangements and aggregate
                  contractual obligations; the impact of foregoing exchange; an overview
                  of
                  financial position; and the impact of inflation and changing
                  prices.
 
 We
        intend
        for this discussion to provide the reader with information that will assist
        in
        understanding our financial statements, the changes in certain key items
        in
        those financial statements from year to year, and the primary factors that
        accounted for those changes, as well as how certain accounting principles
        affect
        our financial statements. The discussion also provides information about
        the
        financial results of the various segments of our business to provide a better
        understanding of how those segments and their results affect the financial
        condition and results of operations of the Company as a whole. This discussion
        should be read in conjunction with our financial statements as of December
        31,
        2006, and the year then ended and the notes accompanying those financial
        statements.
 
 ***Overview***
 
 We
        are
        engaged in providing value-added speech technologies through Fonix Speech,
        Inc.
        (“Fonix Speech”). We offer speech-enabling technologies including automated
        speech recognition (“ASR”) and text-to-speech (“TTS”) through Fonix Speech. We
        offer our speech-enabling technologies to markets for wireless and mobile
        devices, computer telephony, server solutions and personal software for consumer
        applications. We have received various patents for certain elements of our
        core
        technologies and have filed applications for other patents covering various
        aspects of our technologies. We seek to develop relationships and strategic
        alliances with third-party developers and vendors in telecommunications,
        computers, electronic devices and related industries, including producers
        of
        application software, operating systems, computers and microprocessor chips.
        Revenues are generated through licensing of speech-enabling technologies,
        maintenance contracts and services.
 
  17
  We
        previously operated a telecommunications business, the results of which were
        included in prior SEC filings. On October 2, 2006, LecStar Telecom Inc.,
        a
        Georgia corporation (“LecStar Telecom”), LecStar DataNet, Inc., a Georgia
        corporation (“LecStar DataNet”), LTEL Holdings Corporation (“LTEL Holdings”), a
        Delaware corporation, and Fonix Telecom Inc., a Delaware corporation (“Fonix
        Telecom”), each of which are direct or indirect subsidiaries of Fonix, filed for
        bankruptcy protection in the United States Bankruptcy Court for the District
        of
        Delaware (the “Bankruptcy Court”). The case numbers are as follows: LTEL
        Holdings Corporation, 06-11081 (BLS); LecStar Telecom, Inc., 06-11082 (BLS);
        LecStar DataNet, Inc., 06-11083 (BLS); Fonix Telecom, Inc., 06-11084 (BLS).)
 
 LecStar
        Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom sought protection
        under Chapter 7 of title 11 of the U.S. Bankruptcy Code, 11 U.S.C ss 101
        et seq.
        (the “Bankruptcy Code”). Pursuant to Bankruptcy Code Section 701, on October 3,
        2006, Alfred Thomas Guliano was appointed the interim trustee for LecStar
        Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom. As these subsidiary
        companies were in Chapter 7 Bankruptcy proceedings, as of the date of this
        Report, the results of their operations have not been included.
 
 For
        the
        quarters ended March 31, 2007 and 2006, we generated revenues of $360,000
        and
        $272,000, respectively; incurred net losses of $787.000 and $1,851,000,
        respectively, and had negative cash flows from operating activities of
        $1,410,000 and $970,000, respectively. As of March 31, 2007, we had an
        accumulated deficit of $292,397,000, negative working capital of $53,487,000,
        accrued liabilities and accrued settlement liability of $4,207,000, derivative
        liabilities of $19,591,000 related to the issuance of Series L Preferred
        Stock
        and Series E Convertible Debentures, net liabilities of discontinued
        subsidiaries of $20,819,000 related to the telecom subsidiaries subject to
        bankruptcy (LecStar Telecom, LecStar DataNet, LTEL Holdings and Fonix Telecom),
        accounts payable of $1,048,000 and current portion of notes payable of
        $4,554,000. We expect to continue to incur significant losses and negative
        cash
        flows from operating activities at least through December 31, 2007, primarily
        due to expenditure requirements associated with continued marketing and
        development of our speech-enabling technologies.
 
 We
        are
        continually developing new product offerings in the ASR businesses in an
        effort
        to increase our revenue stream, and we are continuing to work with our existing
        customers to increase sales. We have also experienced operating expense
        decreases through headcount reductions and overall cost reduction measures.
        Through the combination of increased recurring revenues and the overall
        operating cost reduction strategies we have implemented, we hope to achieve
        positive cash flow from operations in the next 18-24 months. However, there
        can
        be no assurance that we will be able to achieve positive cash flow from
        operations within this time frame.
 
 Historically,
        our cash resources, limited to collections from customers, draws on equity
        lines
        of credit and loans, have not been sufficient to cover operating expenses.
        We
        periodically engage in discussions with various sources of financing to
        facilitate our cash requirements including buyers of both debt and equity
        securities. We rely on first, cash generated from operations, and second,
        cash
        provided through convertible debt financing arrangements. We will need to
        generate approximately $2.5 to $5 million to continue operations for the
        next
        twelve months.
 
 ***Significant
        Accounting Policies***
 
 The
        discussion and analysis of our financial condition and results of operations
        are
        based upon our consolidated financial statements, which have been prepared
        in
        accordance with accounting principles generally accepted in the United States.
        The preparation of these financial statements requires management to make
        estimates and assumptions that affect the reported amounts of assets and
        liabilities and disclosure of contingent assets and liabilities at the date
        of
        the financial statements and the reported amounts of sales and expenses during
        the reporting period. Significant accounting policies and areas where
        substantial judgments are made by management include:
 
 ***Accounting
        estimates*** **-** The
        preparation of financial statements in conformity with accounting principles
        generally accepted in the United States requires management to make estimates
        and assumptions that affect the reported amounts of assets and liabilities
        and
        the disclosures of contingent assets and liabilities at the date of the
        financial statements, and the reported amounts of revenues and expenses during
        the reporting period. Actual results could differ from those
        estimates.
 
  18
  ***Valuation
        of long-lived assets*** - The
        carrying values of our long-lived assets are reviewed for impairment whenever
        events or changes in circumstances indicate that they may not be recoverable.
        When such an event occurs, we project undiscounted cash flows to be generated
        from the use of the asset and its eventual disposition over the remaining
        life
        of the asset. If projections indicate that the carrying value of the long-lived
        asset will not be recovered, the carrying value of the long-lived asset,
        other
        than software technology, is reduced by the estimated excess of the carrying
        value over the projected discounted cash flows.
 
 ***Goodwill***  ***-*** Goodwill
        represents the excess of the cost over the fair value of net assets of acquired
        businesses. Goodwill is not amortized, but is tested for impairment quarterly
        or
        when a triggering event occurs. The testing for impairment requires the
        determination of the fair value of the asset or entity to which the goodwill
        relates (the reporting unit). The fair value of a reporting unit is determined
        based upon a weighting of the quoted market price of our common stock and
        present value techniques based upon estimated future cash flows of the reporting
        unit, considering future revenues, operating costs, the risk-adjusted discount
        rate and other factors. Impairment is indicated if the fair value of the
        reporting unit is allocated to the assets and liabilities of that unit, with
        the
        excess of the fair value of the reporting unit over the amounts assigned
        to its
        assets and liabilities assigned to the fair value of goodwill. The amount
        of
        impairment of goodwill is measured by the excess of the goodwill’s carrying
        value over its fair value.
 
 ***Revenue
        recognition -*** We
        recognize revenue when pervasive evidence of an arrangement exists, services
        have been rendered or products have been delivered, the price to the buyer
        is
        fixed and determinable and collectibility is reasonable assured. Revenues
        are
        recognized by us based on the various types of transactions generating the
        revenue. For software sales, we recognize revenues in accordance with the
        provisions of Statement of Position No. 97-2, “Software Revenue Recognition” and
        related interpretations *.* We
        generate revenues from licensing the rights to its software products to end
        users and from royalties. For telecommunications services, revenue is recognized
        in the period that the service is provided.
 
 For
        Fonix
        Speech, revenue of all types is recognized when acceptance of functionality,
        rights of return, and price protection are confirmed or can be reasonably
        estimated, as appropriate. Revenues from development and consulting services
        are
        recognized on a completed-contract basis when the services are completed
        and
        accepted by the customer. The completed-contract method is used because our
        contracts are typically either short-term in duration or we are unable to
        make
        reasonably dependable estimates of the costs of the contracts. Revenue for
        hardware units delivered is recognized when delivery is verified and collection
        assured.
 
 Revenue
        for products distributed through wholesale and retail channels and through
        resellers is recognized upon verification of final sell-through to end users,
        after consideration of rights of return and price protection. Typically,
        the
        right of return on such products has expired when the end user purchases
        the
        product from the retail outlet. Once the end user opens the package, it is
        not
        returnable unless the medium is defective.
 
 When
        arrangements to license software products do not require significant production,
        modification or customization of software, revenue from licenses and royalties
        are recognized when persuasive evidence of a licensing arrangement exists,
        delivery of the software has occurred, the fee is fixed or determinable,
        and
        collectibility is probable. Post-contract obligations, if any, generally
        consist
        of one year of support including such services as customer calls, bug fixes,
        and
        upgrades. Related revenue is recognized over the period covered by the
        agreement. Revenues from maintenance and support contracts are also recognized
        over the term of the related contracts.
 
 Revenues
        applicable to multiple-element fee arrangements are bifurcated among 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.
 
  19
  Deferred
        revenue as of March 31, 2007, and December 31, 2006, consisted of the
        following:
 **Description**
                **Criteria
                    for Recognition**
                ****
                **Mar
                    31, 2007**
                ****
                **Dec
                    31, 2006**Deferred
                    unit royalties and license fees
                Delivery
                    of units to end users or expiration of contract
                
                $
                447,000
                
                $
                460,000
 ***Cost
        of revenues*** **-** Cost of
        revenues from license, royalties, and maintenance consists of costs to
        distribute the product, installation and support personnel compensation,
        amortization and impairment of capitalized speech software costs, licensed
        technology, and other related costs. Cost of service revenues consists of
        personnel compensation and other related costs.
 
 ***Software
        Technology Development and Production Costs*** **** -
        All
        costs incurred to establish the technological feasibility of speech software
        technology to be sold, leased, or otherwise marketed are charged to product
        development and research expense. Technological feasibility is established
        when
        a product design and a working model of the software product have been completed
        and confirmed by testing. Costs to produce or purchase software technology
        incurred subsequent to establishing technological feasibility are capitalized.
        Capitalization of software costs ceases when the product is available for
        general release to customers. Costs to perform consulting or development
        services are charged to cost of revenues in the period in which the
        corresponding revenues are recognized. Costs of maintenance and customer
        support
        are charged to expense when related revenue is recognized or when these costs
        are incurred, whichever occurs first.
 
 Capitalized
        software technology costs were amortized on a product-by-product basis.
        Amortization was recognized from the date the product was available for general
        release to customers as the greater of (a) the ratio that current gross revenue
        for a product bears to total current and anticipated future gross revenues
        for
        that product or (b) the straight-line method over the remaining estimated
        economic life of the products. Amortization was charged to cost of
        revenues.
 
 We
        assessed unamortized capitalized software costs for possible write down on
        a
        quarterly basis based on net realizable value of each related product. Net
        realizable value was determined based on the estimated future gross revenues
        from a product reduced by the estimated future cost of completing and disposing
        of the product, including the cost of performing maintenance and customer
        support. The amount by which the unamortized capitalized costs of a software
        product exceeded the net realizable value of that asset was written
        off.
 
 ***Stock-Based
        Employee Compensation***  ***-*** Effective
        January 1, 2006, we adopted Statement of Financial Accounting Standards No.
        123(R), “Share-Based Payment” (“FAS 123(R)”), an amendment of SFAS No. 123,
“Accounting for Stock-Based Compensation,” using the modified prospective
        transition method. Under this transition method, compensation costs are
        recognized beginning with the effective date: (a) based on the requirements
        of
        FAS 123(R) for all share-based awards granted after the effective date and
        (b)
        based on the requirements of FAS 123 for all awards granted to employees
        prior
        to the effective date of FAS 123(R) that remain unvested on the effective
        date.
        Accordingly, we did not restate the results of prior periods. The most notable
        change resulting from the adoption of FAS 123(R) is that compensation expense
        associated with stock options is now recognized in our Statements of Operations,
        rather than being disclosed in a pro forma footnote to our financial statements.
 
 ***Imputed
        Interest Expense and Income*** -
        Interest is imputed on long-term debt obligations and notes receivable where
        management has determined that the contractual interest rates are below the
        market rate for instruments with similar risk characteristics.
 
 ***Foreign
        Currency Translation*** **-** The
        functional currency of our Korean subsidiary is the South Korean won.
        Consequently, assets and liabilities of the Korean operations are translated
        into United States dollars using current exchange rates at the end of the
        year.
        All revenue is invoiced in South Korean won and revenues and expenses are
        translated into United States dollars using weighted-average exchange rates
        for
        the year.
 
 ***Comprehensive
        Income*** *-* ****** Other
        comprehensive income presented in the accompanying consolidated financial
        statements consists of cumulative foreign currency translation adjustments.
 
  20
  ***Recently
        Enacted Accounting Standards*** In June
        2006, the Financial Accounting Standards Board (“FASB”) issued FASB
        Interpretation No. 48, “ *Accounting
        for Uncertainty in Income Taxes, an interpretation of FASB Statement
        No.*  *109* ”
        (FIN 48). FIN 48 clarifies the accounting for uncertainty in income
        taxes recognized in a company’s financial statements and prescribes a
        recognition threshold and measurement attribute for financial statement
        recognition and measurement of a tax position taken or expected to be taken
        in a
        tax return. This Interpretation also provides related guidance on derecognition,
        classification, interest and penalties, accounting in interim periods and
        disclosure. FIN 48 is effective for the Company beginning January 1,
        2007. The Company adopted FIN 48 at the beginning of fiscal year 2007 with
        no
        material impact to the financial condition, results of operations, or cash
        flows.
  In
        February 2007, the FASB issued SFAS No. 159, “ *The
        Fair Value Option for Financial Assets and Financial
        Liabilities* ”
(“SFAS
        159”). This Statement provides companies with an option to report selected
        financial assets and liabilities at fair value. Generally accepted accounting
        principles have required different measurement attributes for different assets
        and liabilities that can create artificial volatility in earnings. The
        Statement’s objective is to reduce both complexity in accounting for financial
        instruments and the volatility in earnings caused by measuring related assets
        and liabilities differently. SFAS 159 is effective for the Company beginning
        January 1, 2008. The Company is currently evaluating the impact of this
        standard.
  The
        Company has reviewed all other recently issued, but not yet adopted, accounting
        standards in order to determine their effects, if any, on its consolidated
        results of operation, financial position or cash flows. Based on that review,
        the Company believes that none of these pronouncements will have a significant
        effect on its current or future earnings or operations.
  ***Results
        of Operations (Continuing operations only)***
  **Three
        months ended March 31, 2007, compared with three months ended March 31,
        2006**
  
 During
        the three months ended March 31, 2007, we recorded revenues of $360,000,
        an
        increase of $88,000 from $272,000 in 2006. The increase was primarily due
        to
        increased royalty revenues of $91,000, increased licensing revenue of $21,000
        and increased retail product sales of $46,000, partially offset by decreased
        non-recurring engineering (“NRE”) speech revenues of $66,000.
 
 Selling,
        general and administrative expenses were $807,000 for the three months ended
        March 31, 2007, a decrease of $366,000 from $1,173,000 in 2006. The decrease
        is
        primarily due to decreased legal and accounting fees of $87,000, decreased
        other
        expenses of $103,000, decreased salary and wage related expenses of $64,000,
        decreased travel expenses of $66,000, decreased investor relations related
        expenses of $31,000 and decreased advertising expenses of $21,000.
 
 We
        incurred research and product development expenses of $487,000 for the three
        months ended March 31, 2007, a decrease of $84,000 from $571,000 in 2006.
        The
        decrease was primarily due to an overall decrease in wage related expenses
        of
        $67,000, reduced travel expenses of $11,000 and reduced occupancy expenses
        of
        $5,000.
 
 Net
        other
        income was $154,000 for the three months ended March 31, 2007, an increase
        of
        $528,000 from net other expense of $374,000 in 2006. The overall increase
        was
        due to the gain recognized on the derivative liability of $617,000, partially
        offset by interest expense of $463,000.
 
 ***Liquidity
        and Capital Resources***
 
 We
        must
        raise additional funds to be able to satisfy our cash requirements during
        the
        next 12 months. It
        is
        anticipated that we will need to raise approximately $2.5 to $5 million over
        the
        next 12 months to meet obligations and continue our product development,
        corporate operations and marketing expenses. Because
        we presently have only limited revenue from operations, we intend to continue
        to
        rely primarily on financing through the sale of our equity and debt securities
        to satisfy future capital requirements until such time as we are able to
        enter
        into additional third-party licensing, collaboration, or co-marketing
        arrangements such that we will be able to finance ongoing operations from
        license, royalty, and sales revenue. We
        are
        working with game developers and other potential licensors of our speech
        product
        offerings to develop additional revenue streams for our speech technologies. There
        can
        be no assurance that we will be able to enter into such agreements . Furthermore, the issuance of equity or debt securities which are or may become
        convertible into equity securities of Fonix in connection with such financing
        could result in substantial additional dilution to the stockholders of
        Fonix.
 
  21
  Our
        cash
        resources are limited to collections from customers, proceeds from the issuance
        of preferred stock, and loan proceeds, and are only sufficient to cover current
        operating expenses and payments of current liabilities. At March 31, 2007, we
        had
        negative working capital of $53,487,000, derivative liabilities of $19,591,000
        related to the issuance of Series L Preferred Stock and Series E Convertible
        Debentures, net liabilities of discontinued subsidiaries of $20,819,000 related
        to the telecom assets subject to bankruptcy, accrued liabilities and accrued
        settlement obligation of $4,207,000, accounts payable of $1,048,000 and current
        portion of notes payable of $4,554,000.
 
 We
        had
        $360,000 in revenue and a loss of $787,000 for the quarter ended March 31,
        2007.
        Net cash used in operating activities of $1,410,000 for the quarter ended
        March
        31, 2007, resulted principally from the net loss incurred of $787,000, non-cash
        loss recognized on the derivative liability of $617,000, decreased accounts
        payable of $456,000, decreased deferred revenues of $13,000 and increased
        prepaid expenses and other current assets of $3,000, partially offset by
        non-cash accretion of discount on notes payable of $239,000, increased accrued
        liabilities of $213,000 and depreciation expense of $14,000. We did not use
        any
        cash in investing activities for the quarter ended March 31, 2007. Net cash
        provided by financing activities of $1,802,000 consisting primarily of the
        advance on the Series B Preferred Stock of $1,250,000, proceeds from notes
        payable of $450,000 and proceeds from the related party note of
        $102,000.
 
 We
        had
        negative working capital of $53,487,000 at March 31, 2007, compared to negative
        working capital of $52,957,000 at December 31, 2006. Current assets increased
        by
        $395,000 to $404,000 from $9,000 from December 31, 2006, to March 31, 2007.
        Current liabilities increased by $925,000 to $ 53,891,000 from $52,966,000
        during the same period. The change in working capital from December 31, 2006,
        to
        March 31, 2007, reflects, in part, increased current portion of notes payable
        of
        $769,000, increased accrued liabilities of $623,000 and, increased notes
        payable
        to related parties of $102,000, partially offset by decreased derivative
        liability of $1,350,000, decreased accounts payable of $456,000 and increased
        cash of $392,000. Total assets were $3,186,000 at March 31, 2007, compared
        to
        $2,805,000 at December 31, 2006.
 
 ***Notes
        Payable - Related Parties***
 
 During
        2002, two of our executive officers (the “Lenders”) sold shares of our Class A
        common stock owned by them and advanced the resulting proceeds amounting
        to
        $333,000 to us under the terms of a revolving line of credit and related
        promissory note. The funds were advanced for use in our operations. The advances
        bear interest at 12 percent per annum, which interest is payable on a
        semi-annual basis. The entire principal, along with unpaid accrued interest
        and
        any other unpaid charges or related fees, were originally due and payable
        on
        June 10, 2003. Fonix and the Lenders have agreed to postpone the maturity
        date
        on several occasions. The note was due September 30, 2006. As of March 19,
        2007,
        we had not made payment against the outstanding balance due on the note.
        All or
        part of the outstanding balance and unpaid interest may be converted at the
        option of the Lenders into shares of Class A common stock of Fonix at any
        time.
        The conversion price was the average closing bid price of the shares at the
        time
        of the advances. To the extent the market price of our shares is below the
        conversion price at the time of conversion, the Lenders are entitled to receive
        additional shares equal to the gross dollar value received from the original
        sale of the shares. The Lenders may also receive additional compensation
        as
        determined appropriate by the Board of Directors.
 
 In
        October 2002, the Lenders pledged 30,866 shares of our Class A common stock
        to
        Queen, LLC ( the “Equity Line Investor”), in connection with an advance of
        $183,000 to us under the Third Equity Line. The Equity Line Investor
        subsequently sold the pledged shares and applied $82,000 of the proceeds
        as a
        reduction of the advance. The value of the pledged shares of $82,000 was
        treated
        as an additional advance from the Lenders.
 
 During
        the fourth quarter of 2003, we made a principal payment of $26,000 against
        the
        outstanding balance of the promissory note. During 2004, we entered into
        an
        agreement with the holders of the promissory note to increase the balance
        of the
        note payable by $300,000 in exchange for a release of the $1,443,000 of accrued
        liabilities related to prior indemnity agreements between us and the note
        holders. We classified the release of $1,143,000 as a capital contribution
        in
        the Consolidated Financial Statements during the fourth quarter of 2004.
        We made
        principal payments against the note of $253,000 during the year ended December
        31, 2004. During the year ended December 31, 2005, we received an additional
        advance of $50,000 under the note from the Lenders. The balance due the Lenders
        at December 31, 2005, was $486,000. For the year ended December 31, 2006,
        we
        received additional advances of $419,000 and made principal payments to the
        Lenders against the note of $105,000. For the quarter ended March 31, 2006,
        we
        received additional advances of $102,000. The balance due at March 31, 2007
        was
        $902,000.
 
  22
  The
        unpaid balance of $902,000 at March 31, 2007, is secured by our assets,
        including our stock of Fonix Speech. As of March 31, 2007, 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 Holdings in
        2004,
        we issued a 5%, $10,000,000, secured, six-year note (the “Note”) payable to
        McCormack Avenue, Ltd. (“McCormack”). Under the terms of the Note, quarterly
        interest-only payments were required through January 15, 2005, with quarterly
        principal and interest payments beginning April 2005 and continuing through
        January 2010. Interest on the Note is payable in cash or, at our option,
        in
        shares of our Class A common stock. The Note is secured by the capital stock
        and
        all of the assets of LTEL Holdings and its subsidiaries. The Note was valued
        at
        $4,624,000 based on an imputed interest rate of 25 percent per annum.
 
 The
        discount on the Note is based on an imputed interest rate of 25%. The carrying
        amount of the Note of $5,542,000 at December 31, 2006, was net of unamortized
        discount of $3,191,000. As of the date of this Report, we had not made any
        scheduled payments for 2006 or 2007.
 
 On
        September 8, 2006, we received a default notice (the “Default Notice”) from
        McCormack in respect of the Note. Under the terms of the Note, and a related
        Security Agreement between us and McCormack dated February 24, 2004 (the
        “Security Agreement”), McCormack was entitled to declare all liabilities,
        indebtedness, and obligations of Fonix to McCormack under the Security Agreement
        and the Note immediately due and owing upon an event of default. The Note
        defines an event of default to include the non-payment by us of a scheduled
        payment which is not cured within 60 days.
 
 In
        the
        Default Notice, McCormack stated that it intended to exercise its rights,
        including any and all rights set forth in the Note as amended.
 
 Also
        on
        September 8, 2006, McCormack provided to us a Notice of Sale, stating
        McCormack’s intention to sell at public auction all of the collateral referred
        to in the Security Agreement, consisting of the capital stock and assets
        of
        LecStar Telecom, LecStar DataNet and LTEL Holdings. As of the date of this
        report, no sale of the assets or capital stock of LecStar Telecom, LecStar
        DataNet nor LTEL Holdings had occurred.
 
 McCormack
        notified us that notwithstanding the Series L Exchange Agreement between
        us and
        McCormack discussed above, McCormack had not waived any of its rights in
        connection with the Note, the Modification Agreement, the Security Agreement,
        or
        the Supplemental Security Agreement.
 
 During
        the fourth quarter of 2006, we entered into two promissory notes with an
        unrelated third party in the aggregate amount of $330,000. These notes accrue
        interest at 10% annually and are due and payable during the second quarter
        of
        2007.
 
 During
        the quarter ended March 31, 2007, we entered into five promissory notes with
        an
        unrelated third party in the aggregate amount of $450,000. These notes accrue
        interest at 10% annually and are due and payable during the third quarter
        of
        2007.
 
 ***S*** ***eventh
        Equity Line of Credit***
 
 On
        May
        27, 2005, we entered into a seventh private equity line agreement (the "Seventh
        Equity Line Agreement") with the Equity Line Investor, on terms substantially
        similar to those of the Sixth Equity Line between Queen and us dated November
        15, 2004.
 
  23
  Under
        the
        Seventh Equity Line Agreement, we had 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 were 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 were limited as
        to the
        amount of shares we may put to the Equity Line Investor in connection with
        each
        put; we could 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 was 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 was 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
        granted registration rights to the Equity Line Investor and filed three
        registration statements which cover the resales of the shares to be issued
        under
        the Seventh Equity Line. All of the shares registered by the first registration
        statement had been sold as of October 24, 2005. The second registration
        statement filed in connection with the Seventh Equity Line was declared
        effective by the SEC on February 10, 2006. All of the shares registered by
        the
        second registration statement had been sold as of July 26, 2006. We filed
        a
        third registration statement on June 26, 2006, to register additional shares
        under the Seventh Equity Line. However, that registration statement was not
        declared effective, and no shares were sold under that registration
        statement.
 
 In
        January 2007, we terminated the Seventh Equity Line, and we have withdrawn
        the
        third registration statement related to the Seventh Equity Line. As such,
        as of
        the date of this report, we did not have an equity line of credit financing
        available to us.
 
 ***Series
        A Convertible Preferred Stock***
 
 At
        March
        31, 2007, 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.
 
 ***Fonix
        Speech, Inc., Series B Convertible Preferred Stock***
 
 On
        April
        4, 2007, the Company entered into a Securities Purchase Agreement by and
        among
        Fonix, Fonix Speech, Inc. (“FSI”), and Sovereign Partners, LP (“Sovereign”). FSI
        is a wholly owned subsidiary of Fonix.
 
 Pursuant
        to the FSI agreement, FSI sold 125 shares of its Series B 9% Convertible
        Preferred Stock (the “FSI Preferred Stock”), at a per share price of $10,000 to
        Sovereign. In anticipation of the transaction Sovereign advanced the gross
        proceeds of $1,250,000 to us on March 30, 2007. The advance has been accounted
        for as a liability in the accompanying financial statements.
 
 The
        shares of FSI Preferred Stock are convertible into shares of our Class A
        common
        stock. The FSI Preferred Stock may be converted into common stock of Fonix
        at
        the option of the holder by using a conversion price which shall be the lower
        of
        (i) 80% of the average of the two lowest closing bid prices for the twenty-day
        trading period prior to the conversion date, or (ii) $0.004.
 
 ***Series
        L Convertible Preferred Stock***
 
 On
        September 7, 2006, we entered into a Series L 9% Convertible Preferred Stock
        Exchange Agreement (the "Exchange Agreement") with McCormack and Kenzie
        Financial (“Kenzie”), a British Virgin Islands company. Pursuant to the Exchange
        Agreement, McCormack and Kenzie exchanged all of the shares of Series H
        Preferred Stock that they acquired from sale of LTEL Holdings, for 1,960.8
        and
        39.2 shares, respectively, of our Series L 9% Convertible Preferred Stock
        (the
        "Series L Preferred Stock").
 
  24
  Because
        the shares of Series L Preferred Stock were issued in exchange for the remaining
        outstanding shares of Series H Preferred Stock, we did not receive any proceeds
        in connection with the issuance of the Series L Preferred Stock.
 
 The
        Series J Preferred Stock entitles McCormack and Kenzie to receive dividends
        in
        an amount equal to 9% of the then-outstanding balance of shares of Series
        L
        Preferred Stock. The dividends are payable in cash or shares of our Class
        A
        common stock, at our option.
 
 The
        Series L Preferred Stock is convertible into common stock of Fonix at the
        option
        of the holder by using a conversion price which was 80% of the average of
        the
        two (2) lowest closing bid prices for the twenty-day trading period prior
        to the
        conversion date.
 
 Redemption
        of the Series L Preferred Stock, whether at the Company’s option or that of
        McCormack or Kenzie, requires us to pay, as a redemption price, the stated
        value
        of the outstanding shares of Series L Preferred Stock to be redeemed, together
        with any accrued but unissued dividends thereon, multiplied by one hundred
        ten
        percent (110%).
 
 In
        connection with the issuance of the Series L Preferred Stock, we filed with
        the
        State of Delaware a Certificate of Designation and Series L 9% Convertible
        Stock
        Terms (the “Series L Terms”), which become a part of our Certificate of
        Incorporation, as amended.
 
 We
        accounted for the exchange as redemption of the outstanding Series H Preferred
        Stock as the Series H Preferred Stock was not convertible into shares of
        common
        stock of Fonix. The Series L Preferred Stock is convertible into shares of
        common stock of Fonix. We followed the accounting treatment in SFAS 150
“ *Accounting
        for Certain Financial Instruments with Characteristics of Both Liabilities
        and
        Equity,”* SFAS
        133
“ *Accounting
        for Derivative Instruments and Hedging Activities”* and
        EITF
        00-19 “ *Accounting
        for Derivative Financial Instruments Indexed to, and Potentially Settled
        in, a
        Company’s Own Stock.”* We
        recognized a derivative liability upon the redemption of $30,991,000 due
        to the
        value of the conversion feature of the Series L Preferred Stock. The liability
        was calculated using the Black-Scholes valuation model. As the value of the
        derivative liability was greater than the face value of the Series L Preferred
        Stock, no value was prescribed to the Series L Preferred Stock. Also in
        connection with the redemption, the Company recognized a preferred stock
        dividend of $16,000,000, equal to the original discount we had assigned to
        the
        Series H Preferred Stock.
 
 For
        the
        nine months ended September 30, 2006, we issued 66,334,622 shares of its
        Class A
        common stock in conversion of 27 shares of its Series L Preferred Stock.
        At
        September 30, 2006, 1,973 shares of Series L Preferred Stock remained
        outstanding. Subsequent to September 30, 2006 and through December 29, 2006,
        we
        issued 423,535,449 shares of our Class A common stock in conversion of 114.6
        shares of our Series L Preferred Stock.
 
 ***Series
        M Preferred Stock***
 
 On
        April
        4, 2007, we entered into a Series M 9% Convertible Preferred Stock Exchange
        Agreement with Sovereign. Pursuant to the exchange agreement, Sovereign
        exchanged 150 shares of our Series L Preferred Stock for 150 shares of our
        Series M 9% Convertible Preferred Stock (the “Series M Preferred
        Stock”).
 
 The
        Series M Preferred Stock entitles Sovereign or its assignees to receive
        dividends in an amount equal to 9% of the then-outstanding balance of shares
        of
        Series M Preferred Stock. The dividends are payable in cash or shares of
        our
        Class A common stock, at our option.
 
 The
        Series M Preferred Stock may be converted into our common stock at the option
        of
        the holder by using a conversion price which shall be the lower of (i) 80%
        of
        the average of the two lowest closing bid prices for the twenty-day trading
        period prior to the conversion date, or (ii) $0.004.
 
  25
  Redemption
        of the Series M Preferred Stock, whether at our option or that of Sovereign,
        requires us to pay, as a redemption price, the stated value of the outstanding
        shares of Series M Preferred Stock to be redeemed, together with any accrued
        but
        unissued dividends thereon, multiplied by one hundred ten percent
        (110%).
 
 Because
        the shares of Series M were issued in exchange for the outstanding shares
        of
        Series L Preferred Stock, we did not receive any proceeds in connection with
        the
        issuance of the Series M Preferred Stock.
 
 ***Stock
        Options and Warrants*** ****
 
 During
        the three months ended March 31, 2007, we did not grant any stock options.
        As of
        March 31, 2007, we had a total of 890,642 options to purchase Class A common
        stock outstanding.
 
 As
        of
        March 31, 2007, we had warrants to purchase a total of 15,000 shares of Class
        A
        common stock outstanding that expire through 2010.
 
 **Other**
 
 We
        presently have no plans to purchase new research and development or office
        facilities.
 
 **Corporate
        Outlook**
 
 Fonix’s focus
        on
        providing competitive and value-added solutions for customers and partners
        requires a broad set of technologies, service offerings and channel
        capabilities. Management anticipates and expects further development of
        complementary technologies, added product and application developments, access
        to market channels and additional opportunities for strategic alliances in
        other
        industry segments.
 
 We
        will
        continue to leverage our research and development of speech technologies
        to
        deliver software applications and engines to device manufacturers looking
        to
        incorporate speech interfaces into end-user products. Fonix Speech’s
        award-wining technologies provide competitive embedded speech solutions for
        mobile/wireless devices, videogames, telephony systems and products for the
        assistive market based on Fonix’s proprietary and patented TTS and ASR
        technologies.
 
 As
        we
        proceed to implement our strategy and to reach our objectives, we anticipate
        further development of complementary technologies, added product and
        applications development expertise, access to market channels and additional
        opportunities for strategic alliances in other industry segments. The strategy
        adopted by us has significant risks, and shareholders and others interested
        in
        Fonix and our Class A common stock should carefully consider the risks set
        forth
        below and under the heading “Certain Significant Risk Factors” in Item 1, Part
        I, of our annual report on Form 10-K for the year ended December 31,
        2006.
 
 As
        noted
        above, as of March 31, 2007, we had an accumulated deficit of $292,397,000
        negative working capital of $53,487,000 ,
        derivative liability of $19,591,000 related to the issuance of Series L
        Preferred Stock and Series E Convertible Debentures, net liabilities of
        discontinued subsidiaries of $20,819,000 related to the telecom assets (LecStar
        Telecom, LecStar DataNet, LTEL Holdings and Fonix Telecom) subject to
        bankruptcy, accrued liabilities and accrued settlement obligation of $4,207,000,
        accounts payable of $1,048,000 and current portion of notes payable of
        $4,554,000. Sales of
        products and revenue from licenses based on our technologies have not been
        sufficient to finance ongoing operations. These matters raise substantial
        doubt
        about our ability to continue as a going concern. Our continued existence
        is
        dependent upon several factors, including our success in (1) increasing speech
        license, royalty and services revenues, (2) raising sufficient additional
        funding, and (3) minimizing operating costs. Until sufficient revenues are
        generated from operating activities, we expected to continue to fund our
        operations through debt instruments. We are currently pursuing additional
        sources of liquidity in the form of traditional commercial credit, asset
        based
        lending, or additional sales of our equity securities to finance our ongoing
        operations. Additionally, we are pursuing other types of commercial and private
        financing, which could involve sales of our assets or sales of one or more
        operating divisions. Our sales and financial condition have been adversely
        affected by our reduced credit availability and lack of access to alternate
        financing because of our significant ongoing losses and increasing liabilities
        and payables. As we have noted in our previous annual reports and other public
        filings, if additional financing is not obtained in the near future, we will
        be
        required to more significantly curtail our operations or seek protection
        under
        bankruptcy laws.
 
  26
  **Information
        Concerning Forward-Looking Statements**
 
 Certain
        of the statements contained in this report (other than the historical financial
        data and other statements of historical fact) are forward-looking statements.
        These statements include, but are not limited to our expectations with respect
        to the development of a diversified revenue base; delivery of our VoiceDial
        application; the market volume of educational electronic dictionary devices;
        our
        ability to capitalize in markets including toys, appliances, and other devices;
        the market demand for videogames; our growth strategies and the implementation
        of our Core Technologies and potential results; our payment of dividends
        on our
        common stock; our ability to meet customer demand for speech technologies
        and
        solutions; development of complementary technologies, products, marketing,
        and
        strategic alliance opportunities; profitability of language learning tools;
        the
        status of traditional operator systems; our ability to continue operations
        in
        the event we do not receive approval to amend our articles of incorporation;
        the
        comparability of our speech-enabled Speech Products to other products; our
        intentions with respect to strategic collaborations and marketing arrangements;
        our intentions with respect to use of licenses; our plans with respect to
        development and acquisition of speech solutions; our goals with respect to
        supplying speech solutions for OEMs; our expectations with respect to continued
        financial losses; and our intentions with respect to financing our operations
        in
        the future. Additional forward-looking statements may be found in the “Certain
        Significant Risk Factors” Section of our 10-K for the year ended December 31,
        2006, together with accompanying explanations of the potential risks associated
        with such statements.
 
 Forward-looking
        statements made in this report, are made based upon management’s good faith
        expectations and beliefs concerning future developments and their potential
        effect upon Fonix. There can be no assurance that future developments will
        be in
        accordance with such expectations, or that the effect of future developments
        on
        Fonix will be those anticipated by management. Forward-looking statements
        may be
        identified by the use of words such as “believe,” “expect,” “plans,” “strategy,”
“prospects,” “estimate,” “project,” “anticipate,” “intends” and other words of
        similar meaning in connection with a discussion of future operating or financial
        performance.
 
 You
        are
        cautioned not to place undue reliance on these forward looking statements,
        which
        are current only as of the date of this Report. We disclaim any intention
        or
        obligation to update or revise any forward-looking statements, whether as
        a
        result of new information, future events, or otherwise. Many important factors
        could cause actual results to differ materially from management’s expectations,
        including those listed in the “Certain Significant Risk Factors” Section of our
        10-K for the year ended December 31, 2006, as well as the
        following:
 
 •
              unpredictable
                  difficulties or delays in the development of new products and
                  technologies;
 
 •
              changes
                  in U.S. or international economic conditions, such as inflation,
                  interest
                  rate fluctuations, foreign exchange rate fluctuations or recessions
                  in
                  Fonix's markets;
 
 •
              pricing
                  changes to our supplies or products or those of our competitors,
                  and other
                  competitive pressures on pricing and
                  sales;
 
 •
              difficulties
                  in obtaining or retaining the management, engineering, and other
                  human
                  resource competencies that we need to achieve our business
                  objectives;
 
 •
              the
                  impact on Fonix or a subsidiary from the loss of a significant
                  customer or
                  a significant number of customers;
 
 •
              risks
                  generally relating to our international operations, including
                  governmental, regulatory or political
                  changes;
 
 •
              transactions
                  or other events affecting the need for, timing and extent of our
                  capital
                  expenditures; and
 
 •
              the
                  extent to which we reduce outstanding
                  debt.
 
  27
  **Item
                  3.**
              **Quantitative
                  and Qualitative Disclosures About Market
                  Risk**
 
 **Foreign
        Currency Exposure**
 
 To
        date,
        all of our revenues have been denominated in United States dollars and received
        primarily from customers in the United States. Our exposure to foreign currency
        exchange rate changes has been insignificant. We expect, however, that future
        product license and services revenue may also be derived from international
        markets and may be denominated in the currency of the applicable market.
        As a
        result, operating results may become subject to significant fluctuations
        based
        upon changes in the exchange rate of certain currencies in relation to the
        U.S.
        dollar. Furthermore, to the extent that we engage in international sales
        denominated in U.S. dollars, an increase in the value of the U.S. dollar
        relative to foreign currencies could make our products less competitive in
        international markets. Although we will continue to monitor our exposure
        to
        currency fluctuations, we cannot assure that exchange rate fluctuations will
        not
        adversely affect financial results in the future.
 
 **Item
                  4.**
              **Controls
                  and Procedures**
 
 Evaluation
        of Disclosure Controls and Procedures .
        Our
        Chief Executive Officer and our Chief Financial Officer, after evaluating
        the
        effectiveness of the Company’s “disclosure controls and procedures” (as defined
        in the Securities Exchange Act of 1934 (Exchange Act) Rules 13a-15(e) or
        15d-15(e)) as of the end of the period covered by this quarterly report,
        have
        concluded that our disclosure controls and procedures are effective based
        on
        their evaluation of these controls and procedures required by paragraph (b)
        of
        Exchange Act Rules 13a-15 or 15d-15.
 
 Changes
        in Internal Control Over Financial Reporting .
        There
        were no changes in our internal control over financial reporting identified
        in
        connection with the evaluation required by paragraph (d) of Exchange Act
        Rules
        13a-15 or 15d-15 that occurred during our last fiscal quarter that have
        materially affected, or are reasonably likely to materially affect, our internal
        control over financial reporting.
 
 Section
        404 Assessment .
        Section
        404 of the Sarbanes-Oxley Act of 2002 requires management’s annual review and
        evaluation of our internal controls beginning with our Form 10-K for the
        fiscal
        year ending December 31, 2007, and an attestation of the effectiveness of
        these
        controls by our independent registered public accounting firm beginning with
        our
        Form 10-K for the fiscal year ending on December 31, 2008. We are dedicating
        significant resources, including management time and effort, and incurring
        substantial costs in connection with our ongoing Section 404 assessment.
        We are
        currently documenting and testing our internal controls and considering whether
        any improvements are necessary for maintaining an effective control environment
        at our company. The evaluation of our internal controls is being conducted
        under
        the direction of our senior management. In addition, our management is regularly
        discussing the results of our testing and any proposed improvements to our
        control environment with our Audit Committee. We will continue to work to
        improve our controls and procedures, and to educate and train our employees
        on
        our existing controls and procedures in connection with our efforts to maintain
        an effective controls infrastructure at our Company.
 
 Limitations
        on Effectiveness of Controls .
        A
        system of controls, however well designed and operated, can provide only
        reasonable, and not absolute, assurance that the system will meet its
        objectives. The design of a control system is based, in part, upon the benefits
        of the control system relative to its costs. Control systems can be circumvented
        by the individual acts of some persons, by collusion of two or more people,
        or
        by management override of the control. In addition, over time, controls may
        become inadequate because of changes in conditions, or the degree of compliance
        with the policies or procedures may deteriorate. In addition, the design
        of any
        control system is based in part upon assumptions about the likelihood of
        future
        events.
 
 **PART
        II - OTHER INFORMATION**
 
 **Item
                  1.**
              **Legal
                  Proceedings**
 
 ***Breckenridge
        Complaint*** - On
        June 6, 2006, Breckenridge filed a complaint against the Company in the Supreme
        Court of the State of New York, County of Nassau (the “Court”), in connection
        with a settlement agreement between the Company and Breckenridge entered
        into in
        September 2005. In the Complaint, Breckenridge alleged that the Company failed
        to pay certain amounts due under the settlement agreement in the amount of
        $450,000. The Company denied the allegations of Breckenridge’s complaint and has
        filed a motion for summary judgment. Breckenridge also filed for summary
        judgment on its complaint.
 
  28
  On
        February 2, 2007, the Court granted Breckenridge’s summary judgment motion,
        denied the Company’s summary judgment motion, and directed that a hearing be
        held to determine the amount owed by the Company to Breckenridge. The Company
        and Breckenridge entered into a stipulation that the Company owed Breckenridge
        $1,530,000 plus interest at a rate of 9% from September 15, 2006 to the date
        of
        entry of judgment.
 
 The
        Court’s order, dated as of March 15, 2007, adjudged that the Company owes an
        aggregate of $1,602,000 to Breckenridge.
 
 On
        April
        26, 2007, Breckenridge filed a complaint in the United States District Court
        for
        the District of Utah, entitled “ The
        Breckenridge Fund, LLC v. Fonix Corporation, Fonix Speech, Inc., Thomas A.
        Murdock, and Roger D. Dudley . "  
        In the complaint Breckenridge asserts statutory claims under the Uniform
        Fraudulent Transfers Act and a related equitable claim based on the conveyance
        of intellectual property and other assets made by the Company to Fonix Speech
        in
        February 2006 in connection with the incorporation of Fonix Speech as a wholly
        owned subsidiary of the Company.  The complaint seeks a judgment against
        all of the defendants in the amount of $1,601,735.  The complaint also
        seeks to set aside alleged transfers between the Company and Dudley or Murdock,
        and for subordination of any security interest held by Dudley or Murdock.
  Concurrent
        with the filing of its complaint, Breckenridge brought a Motion for Prejudgment
        Writ of Attachment seeking to attach certain of the assets of Fonix Speech,
        including its intellectual property and cash, as necessary to satisfy the
        judgment of $1,602,000 that Breckenridge obtained in New York.  On May 11,
        2007, the United States District Court heard testimony and entered an order
        granting Breckenridge’s motion as to the cash of Fonix Speech. 
Specifically, the court ordered that Fonix Speech’s remaining $94,000 of
        operating capital be frozen immediately.  The court ordered Breckenridge to
        post a bond of $90,000.  Fonix Speech has taken steps to comply with the
        court’s order.
 
 **Item
                  1A.**
              **Risk
                  Factors**
 
 We
        attempt to identify, manage and mitigate the risks and uncertainties associated
        with our business to the extent practical. However, some level of risk and
        uncertainty will always be present. The section of our Annual Report on Form
        10-K for the fiscal year ended December 31, 2006, entitled “Certain Significant
        Risk Factors” describes some of the risks and uncertainties associated with our
        business. These risks and uncertainties have the potential to materially
        affect
        our business, financial condition, results of operations, cash flows, projected
        results and future prospects. We have revised the following risk factors
        which
        were previously disclosed in our Annual Report on Form 10-K for the fiscal
        year
        ended December 31, 2006.
 
 **Our
        substantial and continuing losses since inception, coupled with significant
        ongoing operating expenses, raise doubt about our ability to continue as
        a going
        concern.**
 
 Since
        inception, we have sustained substantial losses. Such losses continue due
        to
        ongoing operating expenses and a lack of revenues sufficient to offset operating
        expenses. We have raised capital to fund ongoing operations by private sales
        of
        our securities, some of which sales have been highly dilutive and involve
        considerable expense. In our present circumstances, there is substantial
        doubt
        about our ability to continue as a going concern absent significant sales
        of our
        products and telecommunication services, substantial revenues from new licensing
        or co-development contracts, or continuing large sales of our
        securities.
 
 We
        incurred net losses of $21,943,000, $22,631,000 and $15,148,000 for the years
        ended December 31, 2006, 2005 and 2004, respectively. We incurred a net loss
        of
        $787,000 for the three months ended March 31, 2007. As of March 31, 2007,
        we had
        an accumulated deficit of $292,397,000, negative working capital of $53,487,000,
        derivative liability of $19,591,000 related to the issuance of Series L
        Preferred Stock and the Series E Debentures, net liabilities of unconsolidated
        subsidiaries of $20,819,000 related to the telecom assets subject to bankruptcy,
        accrued liabilities and accrued settlement obligation of $4,207,000 accounts
        payable of $1,048,000 and current portion of notes payable of $4,554,000.
   29
  We
        expect
        to continue to spend significant amounts to enhance our Speech Products and
        technologies and fund further Product development. As a result, we will need
        to
        generate significant additional revenue to achieve profitability. Even if
        we do
        achieve profitability, we may not be able to sustain or increase profitability
        on a quarterly or annual basis. If we do not achieve and maintain profitability,
        the market price for our common stock may further decline, perhaps
        substantially, and we may have to curtail or cease our operations.
 
 **Continuing
        debt obligations could impair our ability to continue as a going
        concern.**
 
 As
        of
        March 31, 2007, we had debt obligations of $7,463,000, accrued liabilities
        and
        accrued settlement obligation of $4,207,000 and vendor accounts payable of
        approximately $1,048,000. At present, our revenues from existing licensing
        arrangements and Speech Product sales are not sufficient to offset our ongoing
        operating expenses or to pay in full our current debt obligations.
 
 There
        is
        substantial risk, therefore, that the existence and extent of the debt
        obligations described above could adversely affect our business, operations
        and
        financial condition, and we may be forced to curtail our operations, sell
        part
        or all of our assets, or seek protection under bankruptcy laws. Additionally,
        there is substantial risk that the current or former employees or our vendors
        could bring lawsuits to collect the unpaid amounts. In the event of lawsuits
        of
        this type, if we are unable to negotiate settlements or satisfy our obligations,
        we could be forced into bankruptcy.
 
 **We
        currently do not have access to the Seventh Equity Line or other equity lines
        of
        credit, which could have a material adverse effect on our ability to continue
        operations.**
 
 Since
        2000, we have relied substantially on equity lines of credit for financing
        our
        operations. Pursuant to these equity lines, we historically have drawn funds
        against the equity line and put shares of our Class A common stock to the
        equity
        line investor in repayment of the draws. In light of current SEC regulations
        and
        interpretations by the SEC, we terminated the Seventh Equity Line and as
        of the
        date of the Report, we did not have access to an equity line of credit or
        similar financing arrangements. Although we are seeking to negotiate additional
        financing sources and reviewing our options, there can be no guarantee that
        we
        will be able to enter into arrangements for financing that will be on terms
        that
        will be satisfactory to us. Any inability to enter into new financing
        arrangements could have a material adverse impact on our ability to continue
        our
        operations, and we may be required to seek protection under the bankruptcy
        laws.
 
 **Item
                  2.**
              **Unregistered
                  Sales of Equity Securities and Use of
                  Proceeds**
 
 During
        the three months ended March 31, 2007, we issued 397,173,839 shares of our
        common stock in connection with conversions of 64 shares of our Series L
        Preferred Stock for which we received no proceeds. The shares of common stock
        were issued without registration under the 1933 Act in reliance on Section
        4(2)
        of the 1933 Act and the rules and regulations promulgated thereunder.
 
 We
        received no proceeds from the issuance of shares upon conversion of our series
        of preferred stock.
 
 **Item
                  6.**
              **Exhibits**
 
 a.
              Exhibits:
                  The following Exhibits are filed with this Form 10-Q pursuant to
                  Item
                  601(a) of Regulation S-K:
 
 Exhibit
                  No.
              Description
                  of Exhibit
 
 31.1
              Certification
                  of President
 31.2
              Certification
                  of Chief Financial Officer
 32.1
              Certification
                  of President Pursuant to Section 906 of the Sarbanes-Oxley Act
                  of
                  2002
 32.2
              Certification
                  of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley
                  Act of 2002.
 
 
 
 
  30
  **SIGNATURES**
 
 In
        accordance with the requirements of the Exchange Act, the registrant caused
        this
        report to be signed on its behalf by the undersigned, thereunto duly
        authorized.
 
 
 **Fonix
                  Corporation**Date:
                  May 15, 2007
              **/s/
                  Roger D.
                  Dudley**Roger
                  D. Dudley, Executive Vice President,Chief
                  Financial Officer(Principal
                  financial officer)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 31