UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q





(Mark
one)





[X]
            Quarterly
      Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934 for the quarterly period ended June 30, 2009,
  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.)





387
South 520 West, Suite 110


Lindon,
Utah 84042


(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 has submitted electronically and posted on
its Web site, if any, every Interactive Data File required to be submitted and
posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or
for such shorter period that the registrant was required to submit and post such
files). Yes  ___   No ___





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer, or a smaller reporting
company.  (Check one):


Large
accelerated filer [  ]  Accelerated filer
[  ]  Non-accelerated filer
[  ]  Smaller reporting company [X]





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-25 of the Exchange Act).  Yes __


No X





As of
August 12, 2009, there were issued and outstanding 29,358,054 shares of our
Class A common stock.








FONIX
CORPORATION


FORM
10-Q








TABLE
OF CONTENTS





PART
      I - FINANCIAL INFORMATIONPageItem
      1.
                                                  Financial
      Statements (Unaudited)Condensed
      Consolidated Balance Sheets – As of June 30, 2009, and December 31,
      2008
                                                  3Condensed
      Consolidated Statements of Operations and Comprehensive Loss for
      theThree
      and Six Months Ended June 30, 2009 and 2008
                                                  4Condensed
      Consolidated Statements of Cash Flows for the Six Months
    EndedJune
      30, 2009 and 2008
                                                  5Notes
      to Condensed Consolidated Financial Statements
(Unaudited)Item
      2.
                                                  Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                                                  21Item
      3.
                                                  Quantitative
      and Qualitative Disclosures About Market Risk
                                                  36Item
      4.
                                                  Controls
      and Procedures
                                                  37PART
      II - OTHER INFORMATIONItem
      1.
                                                  Legal
      Proceedings
                                                  38Item
      2.
                                                  Unregistered
      Sales of Equity Securities and Use of Proceeds
                                                  38Item
      3.
                                                  Defaults
      Upon Senior Securities
                                                  38Item
      4.
                                                  Submission
      of Matters to a Vote of Security Holders
                                                  38Item
      5.
                                                  Other
      Information
                                                  39Item
      6.
                                                  Exhibits
                                                  40





2


Fonix
Corporation and Subsidiaries


CONDENSED
CONSOLIDATED BALANCE SHEETS


(Unaudited)





June
      30,
                                    
                                    
                                    December
      31,2009
                                    
                                    
                                    2008ASSETSCurrent
      assetsCash and cash equivalents
                                    
                                    $
                                    328,000
                                    
                                    
                                    $
                                    2,000Accounts receivable, net of allowance of doubtful accounts of $4,000 and
      $0, respectively
                                    
                                    
                                    2,935,000
                                    
                                    
                                    
                                    -Inventory
                                    
                                    
                                    1,000
                                    
                                    
                                    
                                    -Total
      current assets
                                    
                                    
                                    3,264,000
                                    
                                    
                                    
                                    2,000Property and equipment,
      net of accumulated depreciation of $1,310,000 and $1,303,000,
      respectively
                                    
                                    
                                    60,000
                                    
                                    
                                    
                                    26,000Goodwill
                                    
                                    
                                    658,000
                                    
                                    
                                    
                                    -Deposits
      and other assets
                                    
                                    
                                    12,000
                                    
                                    
                                    
                                    12,000Total
      assets
                                    
                                    $
                                    3,994,000
                                    
                                    
                                    $
                                    40,000LIABILITIES
      AND STOCKHOLDERS' DEFICITCurrent
      liabilitiesAccrued liabilities
                                    
                                    $
                                    8,458,000
                                    
                                    
                                    $
                                    6,510,000Accounts payable
                                    
                                    
                                    2,315,000
                                    
                                    
                                    
                                    1,801,000Tax payable
                                    
                                    
                                    27,000
                                    
                                    
                                    
                                    -Derivative liability
                                    
                                    
                                    37,404,000
                                    
                                    
                                    
                                    34,582,000Accrued payroll and other compensation
                                    
                                    
                                    731,000
                                    
                                    
                                    
                                    211,000Deferred revenues
                                    
                                    
                                    445,000
                                    
                                    
                                    
                                    445,000Notes payable - related parties
                                    
                                    
                                    843,000
                                    
                                    
                                    
                                    917,000Deferred tax liabilities, net
                                    
                                    
                                    250,000
                                    
                                    
                                    
                                    -Deposits and other
                                    
                                    
                                    7,000
                                    
                                    
                                    
                                    7,000Total
      current liabilities
                                    
                                    
                                    50,480,000
                                    
                                    
                                    
                                    44,473,000Long-term
      notes payable, net of current portion
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Total
      liabilities
                                    
                                    
                                    50,480,000
                                    
                                    
                                    
                                    44,473,000Commitments
      and contingenciesStockholders'
      deficitPreferred 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; 1,484 shares and 1,498 shares outstanding ,
      respectively
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Common stock, $0.0001 par value; 20,000,000,000 shares
      authorized;Class A voting, 13,838,561 shares and 3,447,501 shares outstanding,
      respectively
                                    
                                    
                                    1,000
                                    
                                    
                                    
                                    1,000Class B non-voting, none outstanding
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Additional paid-in capital
                                    
                                    
                                    241,273,000
                                    
                                    
                                    
                                    240,949,000Outstanding warrants to purchase Class A common stock
                                    
                                    
                                    474,000
                                    
                                    
                                    
                                    474,000Cumulative foreign currency translation adjustment
                                    
                                    
                                    (90,000
                                    )
                                    
                                    
                                    10,000Accumulated deficit
                                    
                                    
                                    (288,644,000
                                    )
                                    
                                    
                                    (286,367,000
                                    )Total
      stockholders' deficit
                                    
                                    
                                    (46,486,000
                                    )
                                    
                                    
                                    (44,433,000
                                    )Total
      liabilities and stockholders' deficit
                                    
                                    $
                                    3,994,000
                                    
                                    
                                    $
                                    40,000




See
accompanying notes to condensed consolidated financial
statements.
  3




Fonix
Corporation and Subsidiaries


CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS


(Unaudited)


Three
      Months Ended June 30,
                                                                          
                                                                          
                                                                          Six
      Months Ended June 30,2009
                                                                          
                                                                          
                                                                          2008
                                                                          
                                                                          
                                                                          2009
                                                                          
                                                                          
                                                                          2008RevenuesOperating revenues
                                                                          
                                                                          $
                                                                          750,000
                                                                          
                                                                          
                                                                          $
                                                                          560,000
                                                                          
                                                                          
                                                                          $
                                                                          891,000
                                                                          
                                                                          
                                                                          $
                                                                          846,000Total
      Revenue
                                                                          
                                                                          
                                                                          750,000
                                                                          
                                                                          
                                                                          
                                                                          560,000
                                                                          
                                                                          
                                                                          
                                                                          891,000
                                                                          
                                                                          
                                                                          
                                                                          846,000Cost
      of revenuesCost
      of goods sold
                                                                          
                                                                          
                                                                          229,000
                                                                          
                                                                          
                                                                          
                                                                          25,000
                                                                          
                                                                          
                                                                          
                                                                          248,000
                                                                          
                                                                          
                                                                          
                                                                          50,000Main operating taxes and surcharges
                                                                          
                                                                          
                                                                          9,000
                                                                          
                                                                          
                                                                          
                                                                          -
                                                                          
                                                                          
                                                                          
                                                                          9,000
                                                                          
                                                                          
                                                                          
                                                                          -Total
      cost of revenues
                                                                          
                                                                          
                                                                          238,000
                                                                          
                                                                          
                                                                          
                                                                          25,000
                                                                          
                                                                          
                                                                          
                                                                          257,000
                                                                          
                                                                          
                                                                          
                                                                          50,000Gross
      profit
                                                                          
                                                                          
                                                                          512,000
                                                                          
                                                                          
                                                                          
                                                                          535,000
                                                                          
                                                                          
                                                                          
                                                                          634,000
                                                                          
                                                                          
                                                                          
                                                                          796,000Operating
      expenses:Selling, general and administrative
                                                                          
                                                                          
                                                                          792,000
                                                                          
                                                                          
                                                                          
                                                                          588,000
                                                                          
                                                                          
                                                                          
                                                                          1,100,000
                                                                          
                                                                          
                                                                          
                                                                          1,087,000Product development and research
                                                                          
                                                                          
                                                                          216,000
                                                                          
                                                                          
                                                                          
                                                                          477,000
                                                                          
                                                                          
                                                                          
                                                                          461,000
                                                                          
                                                                          
                                                                          
                                                                          693,000Total
      operating expenses
                                                                          
                                                                          
                                                                          1,008,000
                                                                          
                                                                          
                                                                          
                                                                          1,065,000
                                                                          
                                                                          
                                                                          
                                                                          1,561,000
                                                                          
                                                                          
                                                                          
                                                                          1,780,000Other
      income (expense):Interest income
                                                                          
                                                                          
                                                                          40,000
                                                                          
                                                                          
                                                                          
                                                                          -
                                                                          
                                                                          
                                                                          
                                                                          40,000
                                                                          
                                                                          
                                                                          
                                                                          -Interest expense
                                                                          
                                                                          
                                                                          (21,000
                                                                          )
                                                                          
                                                                          
                                                                          (529,000
                                                                          )
                                                                          
                                                                          
                                                                          (48,000
                                                                          )
                                                                          
                                                                          
                                                                          (1,037,000
                                                                          )Gain (loss) on derivative liability
                                                                          
                                                                          
                                                                          875,000
                                                                          
                                                                          
                                                                          
                                                                          (234,000
                                                                          )
                                                                          
                                                                          
                                                                          591,000
                                                                          
                                                                          
                                                                          
                                                                          (313,000
                                                                          )Other
      income (expense), net
                                                                          
                                                                          
                                                                          894,000
                                                                          
                                                                          
                                                                          
                                                                          (763,000
                                                                          )
                                                                          
                                                                          
                                                                          583,000
                                                                          
                                                                          
                                                                          
                                                                          (1,350,000
                                                                          )Income
      (loss) from continuing operations
                                                                          
                                                                          
                                                                          398,000
                                                                          
                                                                          
                                                                          
                                                                          (1,293,000
                                                                          )
                                                                          
                                                                          
                                                                          (344,000
                                                                          )
                                                                          
                                                                          
                                                                          (2,334,000
                                                                          )Provision
      for foreign income taxes
                                                                          
                                                                          
                                                                          (31,000
                                                                          )
                                                                          
                                                                          
                                                                          -
                                                                          
                                                                          
                                                                          
                                                                          (31,000
                                                                          )
                                                                          
                                                                          
                                                                          -Income
      (loss) attributable to common stockholders
                                                                          
                                                                          $
                                                                          367,000
                                                                          
                                                                          
                                                                          $
                                                                          (1,293,000
                                                                          )
                                                                          
                                                                          $
                                                                          (375,000
                                                                          )
                                                                          
                                                                          $
                                                                          (2,334,000
                                                                          )Basic
      and diluted loss per common share from continuing
    operations
                                                                          
                                                                          $
                                                                          0.03
                                                                          
                                                                          
                                                                          $
                                                                          (1.00
                                                                          )
                                                                          
                                                                          $
                                                                          (0.05
                                                                          )
                                                                          
                                                                          $
                                                                          (2.07
                                                                          )Preferred
      stock dividends
                                                                          
                                                                          
                                                                          (1,123,000
                                                                          )
                                                                          
                                                                          
                                                                          (447,000
                                                                          )
                                                                          
                                                                          
                                                                          (1,872,000
                                                                          )
                                                                          
                                                                          
                                                                          (1,025,000
                                                                          )Comprehensive
      loss
                                                                          
                                                                          $
                                                                          (756,000
                                                                          )
                                                                          
                                                                          $
                                                                          (1,740,000
                                                                          )
                                                                          
                                                                          $
                                                                          (2,247,000
                                                                          )
                                                                          
                                                                          $
                                                                          (3,359,000
                                                                          )




See
accompanying notes to condensed consolidated financial statements.


4


Fonix
Corporation and Subsidiaries


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS


(Unaudited)




Six
      Months Ended June 30,
                                                            2009
                                                            2008Cash
      flows from operating activitiesNet
      loss
                                                            
                                                            
                                                            $      
      (375,000)
                                                            $     (2,334,000)Adjustments
      to reconcile net loss to net cash used in operating
      activities:Gain (loss) on derivative liability
                                                            (591,000)
                                                            313,000Accretion of discount on notes payable
                                                            -
                                                            640,000Deferred income taxes
                                                            13,000
                                                            -Issuance of shares for employee grants
                                                            -
                                                            522,000Depreciation
                                                            7,000
                                                            5,000Foreign exchange gain
                                                            (100,000)
                                                            -Changes in assets and liabilitiesAccounts
      receivable
                                                            (320,000)
                                                            -Prepaid
      expenses and other current assets
                                                            -
                                                            61,000Inventory
                                                            1,000
                                                            -Other
      assets
                                                            -
                                                            96,000Accounts
      payable
                                                            204,000
                                                            230,000Tax
      payable
                                                            (6,000)
                                                            -Accrued
      payroll and other compensation
                                                            520,000
                                                            -Other
      accrued liabilities
                                                            84,000
                                                            371,000Net cash used in operating activities
                                                            (563,000)
                                                            (96,000)Cash
      flows from investing activitiesPurchase
      of property and equipment
                                                            -
                                                            (20,000)Net
      cash acquired in acquistion
                                                            796,000
                                                            -Net cash provided by (used in) investing activities
                                                            796,000
                                                            (20,000)Cash
      flows from financing activitiesProceeds
      from related party note payable
                                                            50,000
                                                            59,000Proceeds
      from issuance of Series O Preferred Stock
                                                            -
                                                            431,000Proceeds
      from issuance of Series P Preferred Stock
                                                            43,000
                                                            -Payments
      on accrued settlement obligation
                                                            -
                                                            (327,000)Net cash provided by financing activities
                                                            93,000
                                                            163,000Net
      increase in cash and cash equivalents
                                                            326,000
                                                            47,000Cash
      and cash equivalents at beginning of period
                                                            2,000
                                                            26,000Cash
      and cash equivalents at end of period
                                                            $          328,000
                                                            $            73,000







5


Fonix
Corporation and Subsidiaries


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)


(Unaudited)




Supplemental
schedule of noncash investing and financing activities





For
the Six Months Ended June 30, 2009:





Issued
351 shares of Series P Preferred stock for the acquisition of G-Soft
Limited.





Issued
231,202 shares of Class A common stock for unpaid legal fees.





Issued
450,000 shares of Class A common stock for consulting services.





Issued
416,667 shares of Class A common stock upon conversion of 1 share of Series P
Convertible Preferred Stock.





Issued
5,159,779 shares of Class A common stock upon conversion of 14 shares of Series
L Convertible Preferred Stock.





Issued
2,613,696 shares of Class A common stock upon conversion of $143,000 in notes
payable.





Accrued
$675,000 of dividends on Series L Preferred Stock.





Accrued
$68,000 of dividends on Series M Preferred Stock.





Accrued
$79,000 of dividends on Series N Preferred Stock.





Accrued
$33,000 of dividends on Series O Preferred Stock.





Accrued
$976,000 of dividends on Series P Preferred Stock.





Accrued
$57,000 of dividends on Fonix Speech Series B Preferred Stock.





The
Company acquired the following balance sheet items as a result of the
acquisition of G-Soft Limited:


·
            Cash
      - $796,000


·
            Accounts
      receivable - $2,600,000


·
            Other
      receivables - $15,000


·
            Inventory
      - $2,000


·
            Property,
      plant and equipment - $41,000


·
            Goodwill
      - $658,000


·
            Accounts
      payable - $319,000


·
            Accrued
      liabilities - $13,000


·
            Taxes
      payable - $33,000


·
            Deferred
      tax liabilities, assumed - $237,000





6





Fonix
Corporation and Subsidiaries


CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)


(Unaudited)








For
the Six Months Ended June 30, 2008:





Issued
400,850 shares of Class A common stock upon conversion of 21 shares of Series L
Convertible Preferred Stock.





Issued
522,013 shares of Class A common stock for employee stock grants.





Issued
124,941 shares of Class A common stock for unpaid legal fees.





Issued
120,000 shares of Class A common stock for consulting services.





Issued
112,693 shares of Class A common stock upon conversion of $58,000 in accrued
interest.





Accrued
$693,000 of dividends on Series L Preferred Stock.





Accrued
$68,000 of dividends on Series M Preferred Stock.





Accrued
$62,000 of dividends on Series N Preferred Stock.





Accrued
$11,000 of dividends on Series O Preferred Stock.





Accrued
$57,000 of dividends on Fonix Speech Series B Preferred Stock.


7


Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)


1.  SUMMARY
OF SIGNIFICANT ACCOUNTING POLICIES





Basis of
Presentation – The accompanying unaudited condensed consolidated
financial statements ofFonixCorporation and
subsidiaries (collectively, the “Company” or “Fonix”) have been prepared by the
Company pursuant to the rules and regulations of the Securities and Exchange
Commission (the “SEC”).  Certain information and footnote disclosures
normally included in financial statements prepared in accordance with accounting
principles generally accepted in the United States of America have been
condensed or omitted pursuant to such rules and regulations, although the
Company believes that the following disclosures are adequate to make the
information presented not misleading.  The Company suggests that these
condensed consolidated financial statements be read in conjunction with the
consolidated financial statements and the notes thereto included in the
Company’s 2008 Annual Report on Form 10-K.





These
condensed consolidated financial statements reflect all adjustments (consisting
only of normal recurring adjustments) that, in the opinion of management, are
necessary to present fairly the financial position and results of operations of
the Company for the periods presented.  The Company’s business
strategy is not without risk, and readers of these condensed consolidated
financial statements should carefully consider the risks set forth under the
heading “Certain Significant Risk Factors” in the Company’s 2008 Annual Report
on Form 10-K.





Operating
results for the six months ended June 30, 2009, are not necessarily indicative
of the results that may be expected for the year ending December 31,
2009.





Nature of
Operations–Fonix
Corporation (the “Company,” or “Fonix,”) was incorporated in Delaware in 1985,
and, pursuant to a merger transaction in 1994, the Company’s name was changed to
Fonix Corporation. The Company’s operations are managed through two wholly owned
subsidiaries, Fonix Speech, Inc. (“Fonix Speech”) and Fonix GS Acquisition Co.,
Inc. (“Fonix GS”).





Fonix
Speech





Fonix
Speech provides value-added speech-enabling technologies, speech interface
development tools, and speech solutions and applications, including automated
speech recognition (“ASR”) and text-to-speech (“TTS,” together with ASR, the
“Core Technologies”) that empower consumers to interact conversationally with
information systems and devices.  Fonix Speech offers our
speech-enabling technologies to markets for personal software for consumer
applications including video games, e.Dictionaries and mobile navigation devices
with GPS, wireless and mobile devices, computer telephony, and server
solutions. Fonix Speech’s Products enhance user productivity, ease of use
and efficiency in a broad range of market segments, including mobile and
wireless devices; videogame consoles; electronic devices for the assistive and
language learning markets, robots, appliances; automotive telematics, computer
telephony and server applications.





Fonix
Speech has received various patents for certain elements of our Core
Technologies and have filed applications for other patents covering various
aspects of our technologies. Fonix Speech 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, unit royalties, maintenance contracts and
services.





Prior to
2002, Fonix Speech focused on research and development (“R&D”) projects for
customized applications.  R&D and prototype development used the
Core Technologies to develop applications and engines marketed for multiple
operating systems and hardware platforms.  Today, Fonix Speech serves
markets that are adopting speech-enabled interfaces, solutions and
applications.  As memory requirements, noise robustness, speech
recognition accuracy and efficiency of speech interface solutions become
increasingly critical, Fonix Speech anticipates that its Core Technologies and
solutions will meet customer demand for simple, convenient user
interfaces.




8




Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)


Fonix GS





Fonix GS
was formed on June 27, 2008, to facilitate the acquisition of Shanghai Gaozhi
Software Systems Limited (“GaozhiSoft”).  The acquisition was
completed in early 2009.  GaozhiSoft is a Chinese software developer
and solutions provider in 2G (second-generation) and 3G (third-generation)
telecommunication operation support systems in China and throughout the
Asian-Pacific region. Gaozhisoft is a qualified competitor for
telecommunication operation supports systems.  GaozhiSoft’s products
are designed to increase data transferring speed, reduce telecommunications data
loss, and provide network management, billing accuracy and improved
implementation techniques to telecom carriers.





GaozhiSoft’s
software products are divided into two main categories: (1) MOSS series and (2)
MDtrac series. MOSS products provide service providers with integrated
electronic management platforms for peer-to-peer business operation and
automatic management.  MDtrac products provide data collection
solutions.  GaozhiSoft has received various copyrights and patents for
certain of its products and has filed applications for other copyrights and
patents covering various aspects of its products.





Business
Condition-For
the three months ended June 30, 2009 and 2008, the Company generated revenues of
$750,000 and $560,000, respectively, and incurred net income of $367,000 and a
net loss of $1,293,000, respectively.  For the six months ended June
30, 2009 and 2008, the Company generated revenues of $891,000 and $846,000,
respectively, incurred net losses attributable to common stockholders of
$375,000 and $2,334,000, respectively, and had negative cash flows from
operating activities of $563,000 and $82,000, respectively.  As of
June 30, 2009, the Company had an accumulated deficit of $288,644,000; negative
working capital of $47,216,000; derivative liabilities of $37,404,000 related to
the issuance of Series P Preferred Stock, Series L Preferred Stock, Series M
Preferred stock, Series N Preferred Stock, Series O Preferred Stock, Series E
Convertible Debentures and Series B Preferred Stock of its subsidiary; accrued
liabilities of $8,435,000; accounts payable of $2,315,000; tax payable of
$27,000; deferred tax liabilities of $250,000; related party notes payable of
$843,000; and deferred revenues of $445,000.  The Company expects to
continue to incur significant losses and negative cash flows from operating
activities at least through December 31, 2009, 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 in the Company’s Annual Report on
Form 10-K for the year ended December 31, 2008,  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 Income/Loss
Per Common Share –Basic and diluted net
income/loss per common share are calculated by dividing net income/loss
attributable to common stockholders by the weighted average number of shares of
common stock outstanding during the period.  As of June 30, 2009 and
2008, there were outstanding common stock equivalents to purchase or receive
1,397,544,787and
30,758,759 shares of common stock, respectively.  All common stock
equivalents at June 30, 2009 and 2008, were excluded in the computation of
diluted net income/loss per common share as their effect would have been
anti-dilutive, thereby decreasing the net loss per common
share.


9




Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)
  The
following table is a reconciliation of the net income/loss numerator of basic
and diluted net loss per common share for the three and six months ended June
30, 2009 and 2008:





Three
      Months Ended June 30,2009
                      
                      
                      2008Per
                      
                      
                      
                      
                      
                      PerShare
                      
                      
                      
                      
                      
                      ShareAmount
                      
                      
                      Amount
                      
                      
                      Amount
                      
                      
                      AmountIncome
      (Loss) attributable to common stockholders
                      
                      $
                      367,000
                      
                      
                      $
                      0.03
                      
                      
                      $
                      (1,293,000
                      )
                      
                      $
                      (1.00
                      )Weighted-average
      common shares outstanding
                      
                      
                      10,905,081
                      
                      
                      
                      
                      
                      
                      
                      1,290,969








Six
      Months Ended June 30,2009
                      
                      
                      2008Per
                      
                      
                      
                      
                      
                      PerShare
                      
                      
                      
                      
                      
                      ShareAmount
                      
                      
                      Amount
                      
                      
                      Amount
                      
                      
                      AmountLoss
      attributable to common stockholders
                      
                      $
                      (375,000
                      )
                      
                      $
                      (0.05
                      )
                      
                      $
                      (2,334,000
                      )
                      
                      $
                      (2.07
                      )Weighted-average
      common shares outstanding
                      
                      
                      7,912,148
                      
                      
                      
                      
                      
                      
                      
                      1,130,068





Imputed Interest
Expense–Interest
is imputed on long-term debt obligations where management has determined that
the contractual interest rates are below the market rate for instruments with
similar risk characteristics.





Comprehensive
Loss–Other
comprehensive loss as presented in the accompanying condensed consolidated
financial statements consists of cumulative foreign currency translation
adjustments.





Revenue
Recognition– The Company recognizes revenue when pervasive evidence of
an arrangement exists; services have been rendered or products have been
delivered; the price to the buyer is fixed and determinable; and collectability
is reasonably assured.  Revenues are recognized by the Company based
on the various types of transactions generating the revenue.  For
software sales, the Company recognizes revenues in accordance with the
provisions of Statement of Position No. 97-2, “Software Revenue Recognition,”
and related interpretations.The Company
generates revenues from licensing the rights to its software products to end
users and from royalties.





For Fonix
Speech, revenue of all types is recognized when acceptance of functionality,
rights of return, and price protection are confirmed or can be reasonably
estimated, as appropriate.  Revenues from development and consulting
services are recognized on a completed-contract basis when the services are
completed and accepted by the customer.  The completed-contract method
is used because the Company’s contracts are typically either short-term in
duration or the Company is unable to make reasonably dependable estimates of the
costs of the contracts.  Revenue for hardware units delivered is
recognized when delivery is verified and collection assured.





Revenue
for products distributed through wholesale and retail channels and through
resellers is recognized upon verification of final sell-through to end users,
after consideration of rights of return and price
protection.  Typically, the right of return on such products has
expired when the end user purchases the product from the retail
outlet.  Once the end user opens the package, it is not returnable
unless the medium is defective.


10




Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)


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
collectability 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 June 30, 2009, and December 31, 2008, consisted of the
following:





Description
                            Criteria
      for Recognition
                            
                            June
      30, 2009
                            
                            
                            December
      31, 2008Deferred
      unit royalties and license fees
                            Delivery
      of units to end users or expiration of contract
                            
                            $
                            445,000
                            
                            
                            $
                            445,000





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.





Goodwill -In accordance with the provisions of Statements of Financial Accounting
Standard (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” the
Company tests its recorded goodwill for impairment on an annual basis during the
fourth quarter, or more often if indicators of potential impairment exist, by
determining if the carrying value of each reporting unit exceeds its estimated
fair value. Factors that could trigger impairment include, but are not limited
to, underperformance relative to historical or projected future operating
results, significant changes in the manner of use of the acquired assets or the
Company’s overall business and significant negative industry or economic trends.
Future impairment reviews may require write-downs in the Company’s goodwill and
could have a material adverse impact on the Company’s operating results for the
periods in which such write-downs occur.





Fair
Value of Financial Instruments - The carrying amount of cash and cash
equivalents, receivables, accounts payable and accrued expenses approximates
fair value because of their short maturity.  The carrying value of the
goodwill approximates its fair value.





2.  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 was 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.


11


Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)





On
September 8, 2006, the Company received a default notice (the “Default Notice”)
from McCormack in respect of the Note  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.  McCormack has taken no
action to collect amounts due under the Note.





During
the fourth quarter of 2006, the Company entered into two promissory notes with
McCormack Avenue, Ltd., in the aggregate amount of $330,000. These notes accrue
interest at 10% annually and were due and payable during the second quarter of
2007.  These promissory notes were exchanged for shares of the
Company’s Series P Preferred Stock.  See table below.





During
the quarter ended March 31, 2007, the Company entered into five promissory notes
with McCormack Avenue, Ltd. and Sovereign Partners LP., in the aggregate amount
of $450,000.  These notes accrue interest at 10% annually and were due
and payable during the third quarter of 2007.  These promissory notes
were exchanged for shares of the Company’s Series P Preferred
Stock.  See table below.





On
September 30, 2008, the Company entered into a Series P 9% Convertible Preferred
Stock Exchange Agreement (the “Exchange Agreement”) with McCormack and Sovereign
Partners, LP (“Sovereign”), whereby McCormack exchanged the Note, along with
other promissory notes and the Series E debenture (discussed in Note 5), and
Sovereign exchanged two promissory notes, for shares of the Company’s Series P
9% Convertible Preferred Stock (the Series P Preferred Stock”).  The
obligations exchanged and the number of shares of Series P Preferred Stock
issued is as follows:








Purchaser
                          Nature
      of Obligation Exchanged
                          
                          Amount
      of Obligation
                            Exchanged
                          
                          
                          Number
      of Series P
                            Preferred
      Shares IssuedSovereign
      Partners LP
                          Promissory
      Note, dated February 22, 2007, in the principal amount of $100,000, and
      interest of $16,278
                          
                          $
                          116,278
                          
                          
                          
                          11.6278Sovereign
      Partners LP
                          Promissory
      Note, dated March 13, 2007, in the principal amount of $100,000, and
      interest of $15,750
                          
                          $
                          115,750
                          
                          
                          
                          11.575McCormack
      Avenue, Ltd.
                          Promissory
      Note, dated January 11, 2007, in the principal amount of $50,000, and
      interest of $8,722
                          
                          $
                          58,722
                          
                          
                          
                          5.8722McCormack
      Avenue, Ltd.
                          Promissory
      Note, dated January 19, 2007, in the principal amount of $100,000, and
      interest of $17,222
                          
                          $
                          117,222
                          
                          
                          
                          11.7222McCormack
      Avenue, Ltd.
                          Promissory
      Note, dated January 26, 2007, in the principal amount of $100,000, and
      interest of $17,028
                          
                          $
                          117,028
                          
                          
                          
                          11.7028McCormack
      Avenue, Ltd.
                          Promissory
      Note, dated December 28, 2006, in the principal amount of $95,000, and
      $16,942
                          
                          $
                          111,942
                          
                          
                          
                          11.1942McCormack
      Avenue, Ltd.
                          Promissory
      Note, dated December 15, 2006, in the principal amount of $235,000, and
      interest of $42,701
                          
                          $
                          277,701
                          
                          
                          
                          27.7701McCormack
      Avenue, Ltd.
                          Note
      Payable, dated February, 2004, in the principal amount of $8,732,620, and
      interest of $1,311,105
                          
                          $
                          10,043,725
                          
                          
                          
                          1,004.3725McCormack
      Avenue, Ltd.
                          Series
      E Debenture, dated December 7, 2007, in the principal amount of
      $1,754,464, and interest of $291,763
                          
                          $
                          2,046,227
                          
                          
                          
                          204.6227





12




Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)
  3.  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, was 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 June
30, 2008, 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.





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 and other consideration from the Lenders in
the aggregate amount of $419,000 and made principal payments to the Lenders
against the note of $105,000.  During the year ended December 31,
2007, the Company received additional advances of $102,000.  During
the six months ended June 30, 2009, the Company received additional advances of
$49,500.  The balance due at June 30, 2009, was $843,000.





The
balance due of $843,000 is secured by the Company’s intellectual property rights
and common stock of Fonix Speech.  For the six months ended June 30,
2009, the Lenders converted $124,000 of the principal balance into 2,613,696
shares common stock, and also converted $19,000 of accrued interest into 313,014
shares of common stock for the benefit of one of the Lenders, Thomas A. Murdock,
a former officer and director of the Company.





4.  PREFERRED
STOCK





The
Company’s certificate of incorporation allows for the issuance of preferred
stock in such series and having such terms and conditions as the Company’s board
of directors may designate.





Series A
Convertible Preferred Stock – As of June 30, 2009, 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 $15 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 .0000075 shares of common
stock for each share of Series A convertible preferred stock.


13




Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)


Series L
Preferred Stock – On September 7, 2006, the Company entered into a Series
L 9% Convertible Preferred Stock Exchange Agreement (the "Exchange Agreement")
with McCormack and Kenzie Financial (“Kenzie”), a British Virgin Islands
company.  Pursuant to the Exchange Agreement, McCormack and Kenzie
exchanged all 2,000 shares of Series H Preferred Stock that they acquired from
the sale of LTEL Holdings, for 1,960.8 and 39.2 shares,
respectively,  of the Company's Series L 9% Convertible Preferred
Stock (the "Series L Preferred Stock").





Because
the shares of Series L Preferred Stock were issued in exchange for the remaining
outstanding shares of Series H Preferred Stock, the Company did not receive any
proceeds in connection with the issuance of the Series L Preferred
Stock.





The
Series L Preferred Stock entitles McCormack and Kenzie to receive dividends in
an amount equal to 9% of the then-outstanding balance of shares of Series L
Preferred Stock.  The dividends are payable in cash or shares of the
Company's Class A common stock, at the Company's option.





The
Series L Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price which was 80% of the average of
the two (2) lowest closing bid prices for the twenty-day trading period prior to
the conversion date.





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





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.  At June 30,
2009, the fair value of the Series L Preferred Stock derivative liability was
$15,161,000.





For the
six months ended June 30, 2009, the Company issued 5,159,779 shares of its Class
A common stock in conversion of 14 shares of its Series L Preferred
Stock.  At June 30, 2009, 1,484 shares of Series L Preferred Stock
remained outstanding.  (See Note 10 for discussion of conversions
subsequent to June 30, 2009.)





Series M
Preferred Stock– On April 4, 2007, the Company entered into a Series M
9% Convertible Preferred Stock Exchange Agreement with Sovereign Partners, LP
(“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.


14




Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)


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.





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
$1,603,000 due to the value of the conversion feature of the Series M Preferred
Stock, which was previously recorded as part of the Series L Preferred Stock
derivative liability.  The liability was calculated using the
Black-Scholes valuation model with the following assumptions: dividend yield of
0%, expected volatility of 134%, risk-free rate of 5% and expected life of 4
years.  As the value of the derivative liability was greater than the
face value of the Series M Preferred Stock, no value was prescribed to the
Series M Preferred Stock.  At June 30, 2009, the fair value of the
Series M Preferred Stock derivative liability was $1,533,000.





As of
June 30, 2009, there were 150 shares of Series M Preferred Stock convertible
preferred stock outstanding.





Series N
Convertible Preferred Stock – On August 24, 2007, the Company entered
into a Securities Purchase Agreement with Trillium Partners, LP and other
unnamed future investors relating to the issuance and sale of the Company’s
Series N 9% Convertible Preferred Stock.





Pursuant
to the agreement, the Company agreed to issue up to 2,400 shares of its Series N
9% Convertible Preferred Stock (the “Series N Preferred Stock”) at a per share
price of $1,000 to Trillium Partners, LP and other unnamed future investors, for
gross proceeds of up to $2,400,000.  As of the date of this report,
the Company had issued 1,755 shares of the Series N Preferred Stock, for cash
proceeds of $1,350,000.





The
Series N Preferred Stock entitles the Purchasers to receive dividends in an
amount equal to 9% of the then-outstanding balance of shares of Series N
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 N Preferred Stock is convertible into Class A common stock of the Company
at the option of the holder by using a conversion price equal to 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 N Preferred Stock, whether at the Company’s option or that of the
Purchasers requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series N Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).





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
$957,000 due to the value of the conversion feature of the Series N Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 128%, risk-free rate of 5.0% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
N Preferred Stock, no value was prescribed to the Series N Preferred
Stock.  At June 30, 2009, the fair value of the Series N Preferred
Stock derivative liability was $1,792,000.





As of
June 30, 2009, there were 1,755 shares of Series N Preferred Stock convertible
preferred stock outstanding.





Series O
Convertible Preferred Stock – Between January 25, 2008, and September 30,
2008, the Company received advances from three entities in connection with the
purchase agreements related to the Company’s Series O 9%


Convertible
Preferred Stock (“Series O Preferred Stock”). On May 20, 2008, the Company
entered into Securities Purchase Agreements with Southridge Partners LP,
Southshore Capital Fund LTD, Sovereign Partners LP (collectively, the “Series O
Purchasers”) for the sale of an aggregate of 730 shares of Series O Preferred
Stock for gross proceeds of $730,000.  The material terms of the
purchase agreements had been agreed upon prior to receipt of the
advances.  Therefore, the Series O Preferred Stock was accounted for
as discussed below on the dates cash proceeds were received by the
Company.  The Company also began accruing dividends upon receiving the
advances.


15


Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)


The
Series O Preferred Stock entitles the Purchasers to receive dividends in an
amount equal to 9% of the then-outstanding balance of shares of Series O
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 O Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price, equal to 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 O Preferred Stock, whether at the Company’s option or that of the
Purchasers requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series O Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).





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 $290,000 due to the value of the
conversion feature of the Series O Preferred Stock. The liability was calculated
using the Black-Scholes valuation model with the following assumptions: dividend
yield of 0%, expected volatility of 128%, risk-free rate of 5.0% and expected
life of 4 years. As the value of the derivative liability was greater than the
face value of the Series O Preferred Stock, no value was prescribed to the
Series O Preferred Stock. At June 30, 2009, the fair value of the Series O
Preferred Stock derivative liability was $745,000.





As of
June 30, 2009, there were 730 shares of Series O Preferred Stock convertible
preferred stock outstanding.





Series P
Convertible Preferred Stock – On September 30, 2008, the Company entered
into a Series P 9% Convertible Preferred Stock Exchange Agreement (the “Exchange
Agreement”) with Sovereign Partners, LP (“Sovereign”), and McCormack Avenue Ltd.
(“McCormack”).  Pursuant to the Exchange Agreement, Sovereign and
McCormack exchanged certain debt obligations, discussed more fully below, for
shares of the Company’s Series P 9% Convertible Preferred Stock (the “Series P
Preferred Stock”).





The
Series P Preferred Stock entitles the holders to receive dividends in an amount
equal to 9% of the then-outstanding balance of shares of Series P 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 P 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 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 P Preferred Stock, whether at our option or that of the holder,
requires us to pay, as a redemption price, the stated value of the outstanding
shares of Series P 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 P were issued in exchange for certain outstanding debt
obligations, the Company, we did not receive any proceeds in connection with the
issuance of the Series P Preferred Stock to McCormack and
Sovereign.


16


Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)


In
connection with the issuance of the Series P Preferred Stock, on September 26,
2008, the Company filed with the State of Delaware a Certificate of Designation
and Series P 9% Convertible Stock Terms (the “Series P Terms”), which become a
part of its Certificate of Incorporation, as amended.





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 $13,000 due to the value of the
conversion feature of the Series P Preferred Stock. The liability was calculated
using the Black-Scholes valuation model with the following assumptions: dividend
yield of 0%, expected volatility of 128%, risk-free rate of 5.0% and expected
life of 4 years. As the value of the derivative liability was greater than the
face value of the Series P Preferred Stock, no value was prescribed to the
Series P Preferred Stock. At June 30, 2009, the fair value of the Series P
Preferred Stock derivative liability was $16,898,000.





For the
six months ended June 30, 2009, the Company issued 416,667 shares of its Class A
common stock in conversion of 1 share of its Series P Preferred
Stock.  At June 30, 2009, 1,655 shares of Series P Preferred Stock
remained outstanding.   On May 1, 2009 the Company issued 5
shares of Series P Preferred Stock for proceeds of $42,500.  (See Note
10 for discussion of conversions subsequent to June 30, 2009.) Also, during the
year ending June 30, 2009, the Company issued the following shares of Series P
Preferred Stock for the purchase of G-Soft Limited, a Hong Kong
corporation:





Issuance
of Series P 9% Convertible Preferred Stock in G-Soft Transaction





On March
27, 2009, the Company issued an aggregate of one hundred and twenty shares of
the Company’s Series P Preferred Stock to G-Soft, which is the ultimate parent
of GaozhiSoft, and the shareholders of G-Soft (collectively, the
“Sellers”).  The Shares of Series P Preferred Stock were issued
pursuant to an exchange agreement (the “Exchange Agreement”), with Southridge
LLC, a Connecticut limited liability company (“Southridge”), and the
Sellers.  Additionally, subject to the terms of the amended agreement
with the Sellers, the Sellers are entitled to annual earn-out payments equal to
fifty percent (50%) of the prior year’s net income of GaozhiSoft, to be paid in
the form of Series P Preferred Stock (the “Earn-Out Payments”).  The
aggregate of the Earn-Out Payments is limited to three hundred and eighty shares
of Series P Preferred, which were issued into an escrow account.





Under the
G-Soft Agreement and the Series P Terms, the holders of the Series P Preferred
Stock may convert shares of Series P Preferred Stock into shares of the
Company’s common stock.





Issuance
of Shares of Series P 9% Convertible Preferred Stock to Acquire Remaining 20% of
G-Soft





In
connection with the G-Soft transaction described above, on March 27, 2009, the
Company entered into a Series P Convertible Preferred Stock Purchase Agreement
(the “Preferred Stock Purchase Agreement”), with Southridge.  Pursuant
to the Preferred Stock Purchase Agreement, the Company issued 189 shares of
Series P Preferred Stock in exchange for the 20% of G-Soft shares which
Southridge had purchased in the G-Soft Transaction described above.





The
Series P Preferred Stock issued to Southridge has the same terms as described
above.





Under the
Preferred Stock Purchase Agreement and the Series P Terms, Southridge may
convert shares of Series P Preferred Stock into shares of the Company’s common
stock.


17


Fonix
Corporation and Subsidiaries


Notes
to Condensed Consolidated Financial Statements


(Unaudited)









In
connection with the G-Soft transaction described above, Southridge and
Southshore Capital Fund (“Southshore”) made a bridge loan to G-Soft in the
amount of $400,000.  Upon the acquisition of G-Soft by Fonix GS, Fonix
Corporation agreed to repay the bridge loan through the issuance of shares of
Series P Preferred Stock.





In an
agreement dated March 31, 2009, the Company issued an aggregate of 42 shares of
Series P Preferred Stock to Southridge and Southshore as repayment of the bridge
loans described above.





The
Series P Preferred Stock issued to Southridge and Southshore has the same terms
as described above.





Under the
Preferred Stock Purchase Agreement and the Series P Terms, Southridge and
Southshore may convert shares of Series P Preferred Stock into shares of the
Company’s common 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.  FSI is a
wholly owned subsidiary of the Company.





Pursuant
to the FSI purchase agreement, FSI sold 125 shares of its Series B 9%
Convertible Preferred Stock (the “Series B Preferred Stock”) at a per share
price of $10,000 to Sovereign, for gross proceeds of $1,250,000.





The
shares of Series B Preferred Stock are convertible into shares of the Company’s
Class A common stock.  The Series B 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.





The
Series B 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 B Preferred Stock.  The dividends are payable in cash or shares
of the Company's Class A common stock, at the Company's option





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 issuance of
$1,336,207 due to the value of the conversion feature of the Series B Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 134%, risk-free rate of 5% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
B Preferred Stock, no value was prescribed to the Series B Preferred
Stock.  At June 30, 2009, the fair value of the Series B Preferred
Stock derivative liability was $1,276,000.





As of
June 30, 2009, there were 125 shares of Series B Preferred Stock convertible
preferred stock outstanding.





5.  CONVERTIBLE
DEBENTURES





On
December 7, 2006, the Company entered into a Securities Purchase Agreement,
dated as of December 1, 2006 (the “Agreement”), with Southridge Partners, LP
(“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.  The Company received no new capital in connection with the
issuance and sale of the Debenture.


18


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 Class A common stock issuable upon conversion of the
Debenture.   As of the date of this Report, no registration
statement has been filed.





This
debenture was exchanged for shares of the Company’s Series P Preferred
Stock.  See Note 2.





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.





This
debenture was exchanged for shares of the Company’s Series P Preferred
Stock.  See Note 2.





6.  COMMON
STOCK, STOCK OPTIONS AND WARRANTS





Class A Common
Stock – In December 2008, the Company implemented a 1-for-5,000 share
reverse stock split.  The share numbers in these notes have been
adjusted to reflect the reverse stock split.  During the six months
ended June 30, 2009, 5,159,779 shares of Class A common stock were issued in
conversion of 14 shares of Series L Preferred Stock, 416,667 shares of Class A
common stock were issued in conversion of 1 shares of Series P Preferred stock,
2,613,696 shares were issued in conversion of the outstanding balance on the
related party note and 313,014 shares were issued in conversion of accrued
interest on the related party note.





Stock Options
– As of June 30, 2009, the Company had a total of 40 options to purchase
Class A common stock outstanding.  During the six months ended June
30, 2009 no options were granted.





Warrants –
As of June 30, 2009, the Company had warrants to purchase a total of 3 shares of
Class A common stock outstanding that expire through 2010.





7.  LITIGATION,
COMMITMENTS AND CONTINGENCIES





Hite Development Corporation v. Fonix
Corporation,Third District Court, Salt Lake County (Civil No.
070900883).  In January 2007, Hite Development Corporation (“Hite”)
brought a lawsuit against the Company claiming breach of contract and breach of
the covenant of good faith and fair dealing, alleging that the Company failed to
make certain payments under a settlement agreement with Hite dating from March
2005.  The complaint seeks approximately $33,000 plus
interest.  The Company filed its answer in May
2007.   On May 8, 2008, Hite filed a motion for summary judgment,
which the Court granted.  Judgment was entered against the Company on
March 31, 2009.





RR Donnelley Receivables Inc. v.
Fonix Corporation,Third District Court, Salt Lake County (Civil No.
070412088).  In July 2007, RR Donnelley Receivables Inc. (“Donnelly”)
brought a lawsuit against the Company for alleged failure to pay for services
provided.  The complaint seeks approximately $21,000 plus
interest.  The Company filed its answer in August 2007, and filed a
motion to dismiss the action in December 2007.  That motion is
currently pending before the court.  If the Company’s motion to
dismiss is denied, the Company intends to defend against the claims in the
complaint.


19


Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)


Perpetual Storage, Inc. vs. Fonix
Corporation, Third District Court, Salt Lake County (Civil No.
080907080).  Perpetual Storage, Inc. (“PSI”), brought suit, claiming
breach of contract and unjust enrichment, and seeking damages of approximately
$12,300 plus attorneys’ fees and costs.  The Company filed its answer
in July 2008.  In December 2008, PSI moved for summary judgment, which
the Company opposed.  The Court denied the motion at a hearing in
April 2009.  As of the date of this report, the case was in the
discovery phase.





8.  FAIR
VALUE





SFAS No.
157 establishes a fair value hierarchy which requires an entity to maximize the
use of observable inputs and minimize the use of unobservable inputs when
measuring fair value. SFAS No. 157 describes three levels of inputs that the
Company uses to measure fair value:





·
            Level
      1: Quoted prices (unadjusted) for identical assets or liabilities in
      active markets that the entity has the ability to access as of the
      measurement date.





·
            Level
      2: Level 1 inputs for assets or liabilities that are not actively traded.
      Also consists of an observable market price for a similar asset or
      liability. This includes the use of “matrix pricing” used to value debt
      securities absent the exclusive use of quoted
  prices.





·
            Level
      3: Consists of unobservable inputs that are used to measure fair value
      when observable market inputs are not available. This could include the
      use of internally developed models, financial forecasting,
      etc.





Fair
value is defined as the price that would be received to sell an asset or paid to
transfer a liability between market participants at the balance sheet date. When
possible, the Company looks to active and observable markets to price identical
assets or liabilities. When identical assets and liabilities are not traded in
active markets, the Company looks to observable market data for similar assets
and liabilities. However, when certain assets and liabilities are not traded in
observable markets the Company must use other valuation methods to develop a
fair value.





The
following table presents financial assets and liabilities measured on a
nonrecurring basis:





Fair
      Value Measurements at Reporting Date UsingDescription
                      Balance
      at
                        June
      30, 2009
                      Quoted
      Prices in Active Markets for Identical Assets
                        (Level
      1)
                      Significant
      Other Observable
                        Inputs
                        (Level
      2)
                      Significant/Unobservable
                        Inputs
                        (Level
      3)Goodwill
                      $   658,000
                      —
                      —
                      $    658,000





9.  PROFORMA
INFORMATION





As
further discussed in Note 4, on March 27, 2009, the Company issued Series P
Convertible Preferred Stock for the purchase of G-Soft Limited, a Hong Kong
corporation (“G-Soft”), which is the ultimate parent of Shanghai Gaozhi Software
Systems Limited.





The
following unaudited information is presented to reflect the operations of the
Company as if the acquisition of G-Soft had been completed on January 1,
2008:




For
      the Six Months Ended June 30,
                        
                        2009
                        
                        
                        2008Total
      Revenues
                        
                        $
                        1,531,000
                        
                        
                        $
                        1,633,000Net
      Income (Loss) attributable to common stockholders
                        
                        
                        801,000
                        
                        
                        
                        (2,112,000
                        )Basic
      and diluted loss per common share from continuing
    operations
                        
                        $
                        0.07
                        
                        
                        $
                        1.87






20


Fonix
Corporation and Subsidiaries
 Notes
to Condensed Consolidated Financial Statements
 (Unaudited)


10.  SUBSEQUENT
EVENTS





Subsequent
to June 30, 2009, the Company has issued 4,810,053 shares of its Class A common
stock in conversion of 7 shares of Series L Preferred Stock.





Subsequent
to June 30, 2009, the Company has issued 1,346,647 shares of its Class A common
stock in payment of interest on the Series L Preferred Stock.





Subsequent
to June 30, 2009, the Company has issued 3,662,793 shares of its Class A common
stock in conversion of 7 shares of Series P Preferred Stock.





Subsequent
to June 30, 2009, the Company has issued 700,000 shares of its Class A common
stock in payment of principal and interest on related party notes
payable.





Subsequent
to June 30, 2009, the Company has issued 5,000,000 shares of its Class A common
stock for services performed.




21


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, 2008.  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, 2008, 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.


22





For the
three months ended June 30, 2009 and 2008, we generated revenues of $750,000 and
$560,000, respectively, and incurred net income of $367,000 and a net loss of
$1,293,000, respectively.  For the six months ended June 30, 2009 and
2008, we generated revenues of $891,000 and $846,000, respectively, incurred net
losses attributable to common stockholders of $375,000 and $2,334,000,
respectively, and had negative cash flows from operating activities of $563,000
and $82,000, respectively.  As of June 30, 2009, we had an accumulated
deficit of $288,644,000; negative working capital of $47,216,000; derivative
liabilities of $37,404,000 related to the issuance of Series P Preferred Stock,
Series L Preferred Stock, Series M Preferred stock, Series N Preferred Stock,
Series O Preferred Stock, Series E Convertible Debentures and Series B Preferred
Stock of our subsidiary Fonix Speech; accrued liabilities of $8,435,000;
accounts payable of $2,315,000; tax payable of $27,000; deferred tax liabilities
of $250,000; related party notes payable of $843,000; and deferred revenues of
$445,000.  We expect to continue to incur significant losses and
negative cash flows from operating activities at least through December 31,
2009, 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.





Fonix GS
was formed on June 27, 2008, to facilitate the acquisition of Shanghai Gaozhi
Software Systems Limited (“GaozhiSoft”), which was completed in early
2009.  GaozhiSoft is a leading Chinese software developer and
solutions provider in 2G (second-generation) and 3G (third-generation)
telecommunication operation support systems in China and throughout the Asian
Pacific region.  Gaozhisoft is a qualified competitor for
telecommunication operation supports systems.





GaozhiSoft’s
products are designed to increase data transferring speed, reduce
telecommunications data loss and provide network management, billing accuracy
and improved implementation techniques to telecom carriers.





GaozhiSoft’s
software products are divided into two main categories: (1) MOSS series and (2)
MDtrac series. MOSS products provide service providers with integrated
electronic management platforms for peer-to-peer business operation and
automatic management.  MDtrac products provide data collection
solutions.  GaozhiSoft has received various copyrights and patents for
certain of its products and has filed applications for other copyrights and
patents covering various aspects of its products.





Gaozhisoft
has an outstanding management team with extensive industrial knowledge and
experience with system developing, marketing and sales.  Since
completion of the acquisition of GaozhiSoft, Fonix GS, through its wholly owned
foreign entities, has been working with the management team to transition the
business with a focus on creating synergies among the Company’s existing
technologies and GoazhiSoft’s products.  Upon completion of the
transition, we expect GaozhiSoft to continue its rapid growth and market
penetration based on the implementation of the 3G mobile network service with
these professional partners.





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.  To date, no additional sources of funding
offering terms superior to those available under equity lines have been
implemented, and we rely on first, cash generated from operations, and second,
cash provided through convertible debt financing arrangements.  We
will need to generate approximately $2 to $3 million to continue operations for
the next twelve months.  There can be no assurance that we will be
able to obtain such financing or that, if we can obtain such financing, it will
be on terms favorable to us.


23


Significant
Accounting Policies





The
discussion and analysis of our financial condition and results of operations are
based upon our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United
States.  The preparation of these financial statements requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of sales and
expenses during the reporting period.  Significant accounting policies
and areas where substantial judgments are made by management
include:





Accounting
estimates-The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
the disclosures of contingent assets and liabilities at the date of the
financial statements, and the reported amounts of revenues and expenses during
the reporting period.  Actual results could differ from those
estimates.





Valuation of
long-lived assets - The carrying values of our long-lived assets are
reviewed for impairment whenever events or changes in circumstances indicate
that they may not be recoverable.  When such an event 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 collectability 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 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
collectability 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.


24




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 June 30, 2009,
and December 31, 2008, consisted of the following:




Description
                                      
                                      Criteria
      for Recognition
                                      
                                      
                                      June
      30, 2009
                                      
                                      
                                      December
      31, 2008Deferred
      unit royalties and license fees
                                      
                                      Delivery
      of units to end usersor
      expiration of contract
                                      
                                      
                                      $
                                      445,000
                                      
                                      
                                      $
                                      445,000





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.





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.





The
functional currency of our operating subsidiaries in the PRC is
RMB.  Consequently, assets and liabilities of the PRC operations are
translated into United States dollars using current exchange rates at the end of
the period.  All revenue is invoiced in RMB and revenues and expenses
are translated into United States dollars using weighted-average exchange rates
for the period.


25





Comprehensive
Income-Other
comprehensive income presented in the accompanying consolidated financial
statements consists of cumulative foreign currency translation
adjustments.




Recently
Adopted Accounting Pronouncements




In
March 2008, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards (“SFAS”) No. 161 (SFAS 161),
“Disclosures about Derivative Instruments and Hedging Activities, an Amendment
of FASB Statement No. 133.” SFAS 161 amends and expands the disclosure
requirements of Statement 133 with the intent to provide users of financial
statements with an enhanced understanding of how and why an entity uses
derivative instruments, how derivative instruments and related hedged items are
accounted for under Statement 133 and its related interpretations, and how
derivative instruments and related hedged items affect an entity’s financial
position, financial performance, and cash flows.  SFAS 161 was effective
beginning in the first quarter of fiscal 2009. The adoption of this accounting
pronouncement had no effect on the Company’s consolidated financial position or
results of operations.





In
December 2007, the FASB issued SFAS No. 141 (revised 2007)
(“SFAS 141R”), “Business Combinations”, and SFAS No. 160
(SFAS 160), “Noncontrolling Interests in Consolidated Financial Statements,
an amendment of Accounting Research Bulletin No. 51.” SFAS 141R
changes how business acquisitions are accounted for and impacts financial
statements both on the acquisition date and in subsequent periods. SFAS 160
changes the accounting and reporting for minority interests, which is
recharacterized as noncontrolling interests and classified as a component of
equity. SFAS 141R and SFAS 160 were effective for us beginning in the
first quarter of fiscal 2009. The adoption of SFAS 141R and SFAS 160
had no effect on the Company’s consolidated financial position or results of
operations.





In April
2009, the FASB issued three FASB Staff Positions, or FSPs, to address concerns
about (1) measuring the fair value of financial instruments when the
markets become inactive and quoted prices may reflect distressed transactions
and (2) recording impairment charges on investments in debt securities. The
FASB also issued a third FSP to require disclosures of fair values of certain
financial instruments in interim financial statements.





FSP No.
FAS 157-4, “Determining Fair Value When the Volume and Level of Activity for the
Asset or Liability Have Significantly Decreased and Identifying Transactions
That Are Not Orderly,” provides additional guidance to highlight and expand on
the factors that should be considered in estimating fair value when there has
been a significant decrease in market activity for a financial asset. This FSP
also requires new disclosures relating to fair value measurement inputs and
valuation techniques (including changes in inputs and valuation
techniques).





FSP No.
FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary
Impairments,” will change (1) the trigger for determining whether an
other-than-temporary impairment exists and (2) the amount of an impairment
charge to be recorded in earnings. To determine whether an other-than-temporary
impairment exists, an entity will be required to assess the likelihood of
selling a security prior to recovering its cost basis. This is a change from the
current requirement for an entity to assess whether it has the intent and
ability to hold a security to recovery or maturity. This FSP also expands and
increases the frequency of existing disclosure about other-than-temporary
impairments and requires new disclosures of the significant inputs used in
determining a credit loss, as well as a rollforward of that amount each
period.





FSP No.
FAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial
Instruments,” increases the frequency of fair value disclosures from annual to
quarterly to provide financial statement users with more timely information
about the effects of current market conditions on their financial
instruments.





The
provisions of these three FSPs were effective for the Company beginning the
second quarter of 2009. The adoption of these three FSPs did not have a material
effect on the Company’s consolidated financial position or results of
operations.





In
May 2009, the FASB issued Statement of Financial Accounting Standards
No. 165 (“SFAS 165”), “Subsequent Events,” which provides guidance to
establish general standards of accounting for and disclosures of events that
occur after the balance sheet date but before financial statements are issued or
are available to be issued. SFAS 165 also requires entities to disclose the date
through which subsequent events were evaluated as well as the rationale for why
that date was selected. SFAS 165 is effective for interim and annual periods
ending after June 15, 2009, and


accordingly,
the Company adopted this Standard during the second quarter of 2009. SFAS 165
requires that public entities evaluate subsequent events through the date that
the financial statements are issued. The Company has evaluated subsequent events
through the time of filing these financial statements with the SEC on
August [xx], 2009.


26




Recent
Accounting Pronouncements Not Yet Adopted





In
June 2009, the FASB issued Statement of Financial Accounting Standards
No. 166 (“SFAS 166”), “Accounting for Transfers of Financial Assets — an
amendment of FASB Statement No. 140,” which requires entities to provide
more information regarding sales of securitized financial assets and similar
transactions, particularly if the entity has continuing exposure to the risks
related to transferred financial assets. SFAS 166 eliminates the concept of a
“qualifying special-purpose entity,” changes the requirements for derecognizing
financial assets and requires additional disclosures. SFAS 166 is effective for
fiscal years beginning after November 15, 2009. The Company believes that
the future requirements of SFAS 166 will not have a material effect on its
consolidated financial statements.





In
June 2009, the FASB issued SFAS No. 167 (“SFAS 167”), “Amendments to
FASB Interpretation No. 46(R),” which modifies how a company determines
when an entity that is insufficiently capitalized or is not controlled through
voting (or similar rights) should be consolidated. SFAS 167 clarifies that the
determination of whether a company is required to consolidate an entity is based
on, among other things, an entity’s purpose and design and a company’s ability
to direct the activities of the entity that most significantly impact the
entity’s economic performance. SFAS 167 requires an ongoing reassessment of
whether a company is the primary beneficiary of a variable interest entity. SFAS
167 also requires additional disclosures about a company’s involvement in
variable interest entities and any significant changes in risk exposure due to
that involvement. SFAS 167 is effective for fiscal years beginning after
November 15, 2009. The Company believes that the future requirements of
SFAS 167 will not have a material effect on its consolidated financial
statements.





In June
2009, the FASB issued SFAS No. 168 (“SFAS 168”), “The FASB Accounting
Standards CodificationTM and the Hierarchy of Generally Accepted Accounting
Principles a Replacement of FASB Statement No. 162.” This Standard
establishes the FASB Accounting Standards CodificationTM (the “Codification”) as
the source of authoritative accounting principles recognized by the FASB to be
applied by nongovernmental entities in the preparation of financial statements
in conformity with U.S. GAAP. The Codification does not change current U.S.
GAAP, but is intended to simplify user access to all authoritative U.S. GAAP by
providing all the authoritative literature related to a particular topic in one
place. The Codification is effective for interim and annual periods ending after
September 15, 2009, and as of the effective date, all existing accounting
standard documents will be superseded. The Codification is effective for the
Company in the third quarter of 2009. The Company believes that the future
requirements of SFAS 168 will not have a material effect on its consolidated
financial statements.





Results
of Operations




Three
months ended June 30, 2009, compared with three months ended June 30,
2008




During
the three months ended June 30, 2009, we recorded revenues of $750,000, an
increase of $190,000 from $560,000 for the same period in 2008. The
increase was primarily due to increased revenues from the addition of G-Soft of
$460,000, offset by primarily a decrease in royalty revenue of
$270,000.





Selling,
general and administrative expenses were $792,000 for the three months ended
June 30, 2009, an increase of $204,000 from $588,000 for the same period in
2008.   The increase is primarily due to an increase of expenses
in the quarter of $124,000 related to the acquisition of G-Soft.  The
remainder of the change is primarily due to decreased salary and wage related
expenses of $98,000, increased other expenses of $28,000, decreased occupancy
related expenses of $80,000, decreased depreciation expenses of $1,000 and
decreased investor relations related expenses of $1,000, increased consulting
expenses $13,000, decreased travel expenses of $37,000, an increase in other
operating expenses of $53,000, a decrease in marketing material of $15,000 and
increased legal and accounting fees of $209,000.





We
incurred research and product development expenses of $216,000 for the three
months ended June 30, 2009, a decrease of $261,000 from $477,000 for the same
period in 2008. The decrease was primarily due to an overall


decrease
in wage related expenses of $242,000, decrease occupancy expenses of $8,000 and
decreased travel expenses of $11,000.


27




Net
interest and other expense was a gain of $894,000 for the three months ended
June 30, 2009, a decrease of $1,657,000 from net other expense of a loss of
$763,000 for the same period in 2008.  The overall decrease was
due to a decrease in interest expense of $508,000, an increase in interest
income of $40,000 and a decrease in the loss recognized on the derivative
liability of $1,109,000.




Six
months ended June 30, 2009, compared with six months ended June 30,
2008




During
the six months ended June 30, 2009, we recorded revenues of $891,000, a decrease
of $45,000 from $846,000 for the same period in 2008.  The
increase was primarily due to an increase of revenue of $460,000, offset
primarily by decreased licensing revenue of $415,000.





Selling,
general and administrative expenses were $1,100,000 for the six months ended
June 30, 2009, an increase of $13,000 from $1,087,000 for the same
period in 2008. The increase is primarily due to an increase in expenses
from the acquisition of G-Soft of $124,000.  The other changes related
to decreased salary and wage related expenses of $98,000, increased other
expenses of $27,000, decreased taxes, licenses and permits of $3,000, increased
consulting expenses of $13,000, increased legal and accounting fees of $222,000,
decreased occupancy related expenses of $169,000, decreased investor relations
related expenses of $48,000, decreased travel expenses of $39,000 and decreased
advertising expenses of $16,000.





We
incurred research and product development expenses of $461,000 for the six
months ended June 30, 2009, a decrease of $232,000 from $693,000 for the same
period in 2008. The decrease was primarily due to an overall decrease in
wage related expenses of $168,000, decreased travel expenses of $4,000,
decreased occupancy expenses of $38,000, decreased depreciation expenses of
1,000, and a decrease in other operating expenses of $21,000.





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 $3 million over the next 12 months to meet obligations and
continue our product development, corporate operations and marketing
expenses.  Because we presently have only limited revenue from
operations, we intend to continue to rely primarily on financing through the
sale of our equity and debt securities to satisfy future capital requirements
until such time as we are able to enter into additional third-party licensing,
collaboration, or co-marketing arrangements such that we will be able to finance
ongoing operations from license, royalty, and sales revenue.  We are
working with game developers and other potential licensors of our speech product
offerings to develop additional revenue streams for our speech
technologies.  There can be no assurance that we will be able to enter
into such agreements.  Furthermore, the issuance of equity or debt
securities which are or may become convertible into equity securities of Fonix
in connection with such financing could result in substantial additional
dilution to the stockholders of Fonix.





Our cash
resources are limited to collections from customers, proceeds from the issuance
of preferred stock, and loan proceeds, and are not sufficient to cover current
operating expenses and payments of current liabilities.  At June 30,
2009, we had negative working capital of $47,193,000; derivative liabilities of
$37,404,000 related to the issuance of Series L Preferred
Stock,  Series M Preferred Stock, Series N Preferred Stock, Series O
Preferred Stock,  Series P Preferred Stock and Series B Preferred
Stock of our subsidiary, Fonix Speech; accrued liabilities of $8,435,000;
accounts payable of $2,315,000;  notes payable to related parties of
$843,000; accrued payroll and other compensation of $731,000; deferred tax
liabilities of $250,000; and deferred revenues of $445,000.





We had
$891,000 in revenue and a loss of $375,000 for the six months ended June 30,
2009.  Net cash used in operating activities of $563,000 for the six
months ended June 30, 2009, resulted principally from the net loss incurred of
$531,000, increased accrued liabilities of $290,000,  non-cash gain
recognized on the derivative liability of $591,000, increased accounts payable
of $82,000, and depreciation expense of $2,000.  Net cash obtained in
investing activities of $796,000, for the six months ended June 30, 2009,
consisted of the cash acquired in the acquisition of $796,000.  Net
cash provided by financing activities was $93,000 obtained from the proceeds
from the related party note of $58,000 and the issuance of Series P preferred
stock of $43,000.


28


We had
negative working capital of $47,193,000 at June 30, 2009, compared to negative
working capital of $44,471,000 at December 31, 2008.  Current assets
increased by $3,262,000 to $3,264,000 from $2,000 from December 31, 2008, to
June 30, 2009.  Current liabilities increased by $5,987,000 to
$50,457,000 from $44,473,000 during the same period.  The change in
working capital from December 31, 2008, to June 30, 2009, reflects, in part,
increased accrued liabilities of $1,925,000, increased accounts payable of
$514,000, increased derivative liability of $2,822,000, increased accrued
payroll and other compensation of $520,000, increased tax payable of $27,000,
and an increase in deferred tax liabilities of $250,000.  Total assets
were $3,994,000 at June 30, 2009, compared to $40,000 at December 31,
2008.





Notes
Payable - Related Parties





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, was 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
March 31, 2009, 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.





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 and other consideration from the Lenders in
the aggregate amount of $419,000 and made principal payments to the Lenders
against the note of $105,000.  During the year ended December 31,
2007, the Company received additional advances of $102,000.  During
the six months ended June 30, 2009, the Company received additional advances of
$49,500.  The balance due at June 30, 2009, was $843,000.





The
balance due of $843,000 is secured by the Company’s intellectual property rights
and common stock of Fonix Speech.  For the six months ended June 30,
2009, the Lenders converted $124,000 of the principal balance into 2,613,696
shares common stock, and also converted $19,000 of accrued interest into 313,014
shares of common stock for the benefit of one of the Lenders, Thomas A. Murdock,
a former officer and director of the Company.





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 was
payable in cash or, at the Company’s option, in shares of the Company’s Class A
common stock.  The Note was 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.





On
September 8, 2006, the Company received a default notice (the “Default Notice”)
from McCormack in respect of the Note.   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.  McCormack took no action to
collect amounts due under the Note.





During
the fourth quarter of 2006, the Company entered into two promissory notes (the
“Additional Notes”) with McCormack Avenue, Ltd., in the aggregate amount of
$330,000. These Additional Notes accrue interest at 10% annually and were due
and payable during the second quarter of 2007.  The Additional Notes
were exchanged for shares of the Company’s Series P Preferred
Stock.  See below.


29


During
the quarter ended March 31, 2007, the Company entered into five promissory notes
with McCormack Avenue, Ltd. and Sovereign Partners LP., in the aggregate amount
of $450,000.  These notes accrue interest at 10% annually and were due
and payable during the third quarter of 2007.  These promissory notes
were exchanged for shares of the Company’s Series P Preferred
Stock.  See below.





On
September 30, 2008, the Company entered into a Series P 9% Convertible Preferred
Stock Exchange Agreement (the “Exchange Agreement”) with McCormack and Sovereign
Partners, LP (“Sovereign”), whereby McCormack exchanged the Note, along with the
Additional Notes and the Series E debenture (discussed in Note 5), and Sovereign
exchanged two promissory notes, for shares of the Company’s Series P 9%
Convertible Preferred Stock (the Series P Preferred Stock”).  A table
listing the obligations exchanged and the number of shares of Series P Preferred
Stock issued.





Series A
Convertible Preferred Stock – As of June 30, 2009, 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 $15 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 .0000075 shares of common
stock for each share of Series A convertible preferred stock.





Series L
Preferred Stock – On September 7, 2006, the Company entered into a Series
L 9% Convertible Preferred Stock Exchange Agreement (the "Exchange Agreement")
with McCormack and Kenzie Financial (“Kenzie”), a British Virgin Islands
company.  Pursuant to the Exchange Agreement, McCormack and Kenzie
exchanged all 2,000 shares of Series H Preferred Stock that they acquired from
the sale of LTEL Holdings, for 1,960.8 and 39.2 shares,
respectively,  of the Company's Series L 9% Convertible Preferred
Stock (the "Series L Preferred Stock").





Because
the shares of Series L Preferred Stock were issued in exchange for the remaining
outstanding shares of Series H Preferred Stock, the Company did not receive any
proceeds in connection with the issuance of the Series L Preferred
Stock.





The
Series L Preferred Stock entitles McCormack and Kenzie to receive dividends in
an amount equal to 9% of the then-outstanding balance of shares of Series L
Preferred Stock.  The dividends are payable in cash or shares of the
Company's Class A common stock, at the Company's option.





The
Series L Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price which was 80% of the average of
the two (2) lowest closing bid prices for the twenty-day trading period prior to
the conversion date.





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





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.  At June 30,
2009, the fair value of the Series L Preferred Stock derivative liability was
$15,161,000.


30




For the
six months ended June 30, 2009, the Company issued 5,159,779 shares of its Class
A common stock in conversion of 14 shares of its Series L Preferred
Stock.  At June 30, 2009, 1,484 shares of Series L Preferred Stock
remained outstanding.





Series M
Preferred Stock– On April 4, 2007, the Company entered into a Series M
9% Convertible Preferred Stock Exchange Agreement with Sovereign Partners, LP
(“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.





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
$1,603,000 due to the value of the conversion feature of the Series M Preferred
Stock, which was previously recorded as part of the Series L Preferred Stock
derivative liability.  The liability was calculated using the
Black-Scholes valuation model with the following assumptions: dividend yield of
0%, expected volatility of 134%, risk-free rate of 5% and expected life of 4
years.  As the value of the derivative liability was greater than the
face value of the Series M Preferred Stock, no value was prescribed to the
Series M Preferred Stock.  At June 30, 2009, the fair value of the
Series M Preferred Stock derivative liability was $1,533,000.





As of
June 30, 2009, there were 150 shares of Series M Preferred Stock convertible
preferred stock outstanding.





Series N
Convertible Preferred Stock – On August 24, 2007, the Company entered
into a Securities Purchase Agreement with Trillium Partners, LP and other
unnamed future investors relating to the issuance and sale of the Company’s
Series N 9% Convertible Preferred Stock.





Pursuant
to the agreement, the Company agreed to issue up to 2,400 shares of its Series N
9% Convertible Preferred Stock (the “Series N Preferred Stock”) at a per share
price of $1,000 to Trillium Partners, LP and other unnamed future investors, for
gross proceeds of up to $2,400,000.  As of the date of this report,
the Company had issued 1,755 shares of the Series N Preferred Stock, for cash
proceeds of $1,350,000.





The
Series N Preferred Stock entitles the Purchasers to receive dividends in an
amount equal to 9% of the then-outstanding balance of shares of Series N
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 N Preferred Stock is convertible into Class A common stock of the Company
at the option of the holder by using a conversion price equal to 80% of the
average of the two lowest closing bid prices for the twenty-day trading period
prior to the conversion date.


31





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





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
$957,000 due to the value of the conversion feature of the Series N Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 128%, risk-free rate of 5.0% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
N Preferred Stock, no value was prescribed to the Series N Preferred
Stock.  At June 31, 2009, the fair value of the Series N Preferred
Stock derivative liability was $1,792,000.





As of
June 30, 2009, there were 1,755 shares of Series N Preferred Stock convertible
preferred stock outstanding.





Series O
Convertible Preferred Stock – Between January 25, 2008, and September 30,
2008, the Company received advances from three entities in connection with the
purchase agreements related to the Company’s Series O 9% Convertible Preferred
Stock (“Series O Preferred Stock”). On May 20, 2008, the Company entered into
Securities Purchase Agreements with Southridge Partners LP, Southshore Capital
Fund LTD, Sovereign Partners LP (collectively, the “Series O Purchasers”) for
the sale of an aggregate of 730 shares of Series O Preferred Stock for gross
proceeds of $730,000.  The material terms of the purchase agreements
had been agreed upon prior to receipt of the advances.  Therefore, the
Series O Preferred Stock was accounted for as discussed below on the dates cash
proceeds were received by the Company.  The Company also began
accruing dividends upon receiving the advances.





The
Series O Preferred Stock entitles the Purchasers to receive dividends in an
amount equal to 9% of the then-outstanding balance of shares of Series O
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 O Preferred Stock is convertible into common stock of the Company at the
option of the holder by using a conversion price, equal to 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 O Preferred Stock, whether at the Company’s option or that of the
Purchasers requires the Company to pay, as a redemption price, the stated value
of the outstanding shares of Series O Preferred Stock to be redeemed, together
with any accrued but unissued dividends thereon, multiplied by one hundred ten
percent (110%).





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 $290,000 due to the value of the
conversion feature of the Series O Preferred Stock. The liability was calculated
using the Black-Scholes valuation model with the following assumptions: dividend
yield of 0%, expected volatility of 128%, risk-free rate of 5.0% and expected
life of 4 years. As the value of the derivative liability was greater than the
face value of the Series O Preferred Stock, no value was prescribed to the
Series O Preferred Stock. At June 30, 2009, the fair value of the Series O
Preferred Stock derivative liability was $745,000.





As of
June 30, 2009, there were 730 shares of Series O Preferred Stock convertible
preferred stock outstanding.





Series P
Convertible Preferred Stock – On September 30, 2008, the Company entered
into a Series P 9% Convertible Preferred Stock Exchange Agreement (the “Exchange
Agreement”) with Sovereign Partners, LP (“Sovereign”), and McCormack Avenue Ltd.
(“McCormack”).  Pursuant to the Exchange Agreement, Sovereign and
McCormack exchanged certain debt obligations, discussed more fully below, for
shares of the Company’s Series P 9% Convertible Preferred Stock (the “Series P
Preferred Stock”).





32


The
Series P Preferred Stock entitles the holders to receive dividends in an amount
equal to 9% of the then-outstanding balance of shares of Series P 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 P 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 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 P Preferred Stock, whether at our option or that of the holder,
requires us to pay, as a redemption price, the stated value of the outstanding
shares of Series P 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 P were issued in exchange for certain outstanding debt
obligations, the Company, we did not receive any proceeds in connection with the
issuance of the Series P Preferred Stock to McCormack and
Sovereign.





In
connection with the issuance of the Series P Preferred Stock, on September 26,
2008, the Company filed with the State of Delaware a Certificate of Designation
and Series P 9% Convertible Stock Terms (the “Series P Terms”), which become a
part of its Certificate of Incorporation, as amended.





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 $13,000 due to the value of the
conversion feature of the Series P Preferred Stock. The liability was calculated
using the Black-Scholes valuation model with the following assumptions: dividend
yield of 0%, expected volatility of 128%, risk-free rate of 5.0% and expected
life of 4 years. As the value of the derivative liability was greater than the
face value of the Series P Preferred Stock, no value was prescribed to the
Series P Preferred Stock. At June 30, 2009, the fair value of the Series P
Preferred Stock derivative liability was $16,898,000.





For the
six months ended June 30, 2009, the Company issued 416,667 shares of its Class A
common stock in conversion of 1 share of its Series P Preferred
Stock.  At June 30, 2009, 1,655 shares of Series P Preferred Stock
remained outstanding.   On May 1, 2009 the Company issued 5
shares of Series P Preferred Stock for proceeds of $42,500.  Also,
during the year ending June 30, 2009, the Company issued the following shares of
Series P Preferred Stock for the purchase of G-Soft Limited, a Hong Kong
corporation:





Issuance
of Series P 9% Convertible Preferred Stock in G-Soft Transaction





On March
27, 2009, the Company issued an aggregate of one hundred and twenty shares of
the Company’s Series P Preferred Stock to G-Soft, which is the ultimate parent
of GaozhiSoft, and the shareholders of G-Soft (collectively, the
“Sellers”).  The Shares of Series P Preferred Stock were issued
pursuant to an exchange agreement (the “Exchange Agreement”), with Southridge
LLC, a Connecticut limited liability company (“Southridge”), and the
Sellers.  Additionally, subject to the terms of the amended agreement
with the Sellers, the Sellers are entitled to annual earn-out payments equal to
fifty percent (50%) of the prior year’s net income of GaozhiSoft, to be paid in
the form of Series P Preferred Stock (the “Earn-Out Payments”).  The
aggregate of the Earn-Out Payments is limited to three hundred and eighty shares
of Series P Preferred, which were issued into an escrow account.





Under the
G-Soft Agreement and the Series P Terms, the holders of the Series P Preferred
Stock may convert shares of Series P Preferred Stock into shares of the
Company’s common stock.





Issuance
of Shares of Series P 9% Convertible Preferred Stock to Acquire Remaining 20% of
G-Soft





In
connection with the G-Soft transaction described above, on March 27, 2009, the
Company entered into a Series P Convertible Preferred Stock Purchase Agreement
(the “Preferred Stock Purchase Agreement”), with Southridge.  Pursuant
to the Preferred Stock Purchase Agreement, the Company issued 189 shares of
Series P Preferred Stock in exchange for the 20% of G-Soft shares which
Southridge had purchased in the G-Soft Transaction described
above.


33





The
Series P Preferred Stock issued to Southridge has the same terms as described
above.





Under the
Preferred Stock Purchase Agreement and the Series P Terms, Southridge may
convert shares of Series P Preferred Stock into shares of the Company’s common
stock.





Issuance
of Shares of Series P 9% Convertible Preferred Stock In Payment of
Notes





In
connection with the G-Soft transaction described above, Southridge and
Southshore Capital Fund (“Southshore”) made a bridge loan to G-Soft in the
amount of $400,000.  Upon the acquisition of G-Soft by Fonix GS, Fonix
Corporation agreed to repay the bridge loan through the issuance of shares of
Series P Preferred Stock.





In an
agreement dated March 31, 2009, the Company issued an aggregate of 42 shares of
Series P Preferred Stock to Southridge and Southshore as repayment of the bridge
loans described above.





The
Series P Preferred Stock issued to Southridge and Southshore has the same terms
as described above.





Under the
Preferred Stock Purchase Agreement and the Series P Terms, Southridge and
Southshore may convert shares of Series P Preferred Stock into shares of the
Company’s common 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 purchase agreement, FSI sold 125 shares of its Series B 9%
Convertible Preferred Stock (the “Series B Preferred Stock”) at a per share
price of $10,000 to Sovereign, for gross proceeds of $1,250,000.





The
shares of Series B Preferred Stock are convertible into shares of the Company’s
Class A common stock.  The Series B 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.





The
Series B 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 B Preferred Stock.  The dividends are payable in cash or shares
of the Company's Class A common stock, at the Company's option





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 issuance of
$1,336,207 due to the value of the conversion feature of the Series B Preferred
Stock.  The liability was calculated using the Black-Scholes valuation
model with the following assumptions: dividend yield of 0%, expected volatility
of 134%, risk-free rate of 5% and expected life of 4 years.  As the
value of the derivative liability was greater than the face value of the Series
B Preferred Stock, no value was prescribed to the Series B Preferred
Stock.  At June 30, 2009, the fair value of the Series B Preferred
Stock derivative liability was $1,276,000.





As of
June 30, 2009, there were 125 shares of Series B Preferred Stock convertible
preferred stock outstanding.





Stock Options and
Warrants





During
the six months ended June 30, 2009, we did not grant any stock
options.  As of June 30, 2009, we had a total of 40 options to
purchase Class A common stock outstanding.





As of
June 30, 2009, we had warrants to purchase a total of 3 shares of Class A common
stock outstanding that expire through 2010.


34


Other




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





Corporate
Outlook





Company
management intends to focus on the following strategies:





(i)
            provide
      competitive and value-added speech interface solutions for customers and
      partners through Fonix Speech Inc.
and;





(ii)
              expand
      organic revenue growth through GS in China, and;utilize
      the GS platform for additional China-based
  acquisitions.





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, 2008.





As noted
above, as of  June 30, 2009, we had an accumulated deficit of
$288,644,000; negative working capital of $47,216,000; derivative liabilities of
$37,404,000 related to the issuance of Series L Preferred
Stock,  Series M Preferred Stock, Series N Preferred Stock, Series O
Preferred Stock , Series P Preferred Stock and Series B Preferred Stock of our
subsidiary Fonix Speech; accrued liabilities of $8,458,000; accounts payable of
$2,315,000; taxes payable of $27,000; notes payable to related parties of
$843,000; accrued payroll and other compensation of $731,000; and deferred
revenues of $445,000.  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.





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 iSpeak application for the Apple iPhone; 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 China business growth  opportunities through
existing customers and potential acquisitions; 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, 2008, together
with accompanying explanations of the potential risks associated with such
statements.


35




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, 2008, 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.





Item
3.             Quantitative
and Qualitative Disclosures About Market Risk





Foreign Currency
Exposure





Our
functional currency is the U.S. Dollar (USD).  The functional currency
of our operating subsidiaries in the PRC is RMB and the functional currency of
our operating subsidiary in Korea is the South Korean won.  However,
the accompanying financial statements have been expressed in USD, which is our
functional currency.  The accompanying consolidated balance sheets
have been translated into USD at the exchange rates prevailing at each balance
sheet date.





Fluctuations
in exchange rates may affect our financial results reported in USD terms without
giving effect to any underlying change in our business or results of
operations.


36




ITEM
4T - CONTROLS AND PROCEDURES





(a)
Evaluation of disclosure controls and procedures.





Our Chief
Executive Officer/ Chief Financial Officer evaluated the effectiveness of our
disclosure controls and procedures pursuant to Rule 13a-15 under the Securities
Exchange Act of 1934 (Exchange Act) as of June 30, 2009.  In designing
and evaluating the disclosure controls and procedures, management recognizes
that any controls and procedures, no matter how well designed and operated, can
provide only reasonable assurance of achieving the desired control objectives.
In addition, the design of disclosure controls and procedures must reflect the
fact that there are resource constraints and that management is required to
apply its judgment in evaluating the benefits of possible controls and
procedures relative to their costs.





Based
on our evaluation, our Chief Executive Officer/Chief Financial Officer
concluded that, as a result of the material weakness described below, our
disclosure controls and procedures are not designed at a reasonable assurance
level and are ineffective to provide reasonable assurance that information we
are required to disclose in reports that we file or submit under the Exchange
Act is recorded, processed, summarized and reported within the time periods
specified in Securities and Exchange Commission rules and forms, and that such
information is not accumulated nor communicated to our management, including our
Chief Executive Officer/Chief Financial Officer to allow timely decisions
regarding required disclosure.





A
“material weakness” is a deficiency, or a combination of deficiencies, in
internal control, such that there is a reasonable possibility that a material
misstatement of the financial statements will not be prevented, or detected and
corrected on a timely basis.





The
material weakness, which relates to internal control over financial reporting
and specifically to internal accounting and disbursements, that was identified
was not having sufficient personnel in our accounting and financial reporting
functions.  As a result, we were not able to achieve adequate
segregation of incompatible duties. This control deficiency results in a
reasonable possibility that material misstatements of the financial statements
will not be prevented, or detected and corrected on a timely basis.





Remediation





We have
taken and will continue to take steps to remediate this material weakness until
management determines that our controls and procedures are
effective.  As of the filing of this Report, we had:





-
            revised
      internal accounting procedures,
including:


-
            segregation
      of the duties for expense approval from the preparation and signing of the
      checks;


-
            discontinued
      use of paper payroll checks;


-
            employee
      expense reimbursement checks, vendor checks and payroll checks require
      advance written approval ; and


-
            weekly
      cash flow reports reviewed by the Chief Financial Officer and the
      Accounting Manager;


-
            hired
      the Accounting Manager to manage daily transactions, including maintaining
      the general ledger, processing payroll, and processing cash disbursements;
      and


-
            established
      more formal policies for segregation of incompatible duties and
      responsibilities between the Company’s Chief Financial Officer, Accounting
      Manager, and a third-party
consultant.





Management
believes that when the Company is able to do so, hiring additional knowledgeable
personnel with technical accounting expertise will further remediate the
material weakness. Due to the fact that our accounting staff presently consists
of the Chief Financial Officer and the Accounting Manager, additional personnel
will also ensure the proper segregationofincompatible duties and provide more
checks and balances within the department.  As an additional step to
enhance accurate and timely financial reporting, we have engaged a third-party
consultant to take a significant
role in the processing of our financial information and to assist with the
preparation of our periodic reports.  We believe this increases the
effectiveness of our internal control. To compensate for the limited number of
personnel in our accounting and financial reporting department, we expect to
engage consultants to assist us with the proper accounting treatment for complex
transactions.


37




Management
will continue to monitor and evaluate the effectiveness of our disclosure
controls and procedures and our internal controls over financial reporting, and
we are committed to taking further action and implementing additional
enhancements or improvements, as necessary and as resources allow. As part of
this commitment, we will continue to assess our current personnel resources and
technical accounting expertise within the accounting function. As our level of
operations increases, we will look to increase our personnel resources to improve the segregationofincompatible duties and to provide in-house expertise for
accounting for non-routine or complex transactions.





PART
II - OTHER INFORMATION





Item
1.            Legal
Proceedings





Hite Development Corporation v. Fonix
Corporation,Third District Court, Salt Lake County (Civil No.
070900883).  In January 2007, Hite Development Corporation (“Hite”)
brought a lawsuit against the Company claiming breach of contract and breach of
the covenant of good faith and fair dealing, alleging that the Company failed to
make certain payments under a settlement agreement with Hite dating from March
2005.  The complaint seeks approximately $33,000 plus
interest.  The Company filed its answer in May
2007.   On May 8, 2008, Hite filed a motion for summary judgment,
which the Court granted.  Judgment was entered against the Company on
March 31, 2009.





RR Donnelley Receivables Inc. v.
Fonix Corporation,Third District Court, Salt Lake County (Civil No.
070412088).  In July 2007, RR Donnelley Receivables Inc. (“Donnelly”)
brought a lawsuit against the Company for alleged failure to pay for services
provided.  The complaint seeks approximately $21,000 plus
interest.  The Company filed its answer in August 2007, and filed a
motion to dismiss the action in December 2007.  That motion is
currently pending before the court.  If the Company’s motion to
dismiss is denied, the Company intends to defend


against
the claims in the complaint.





Perpetual Storage, Inc. vs. Fonix
Corporation, Third District Court, Salt Lake County (Civil No.
080907080).  Perpetual Storage, Inc. (“PSI”), brought suit, claiming
breach of contract and unjust enrichment, and seeking damages of approximately
$12,300 plus attorneys’ fees and costs.  The Company filed its answer
in July 2008.  In December 2008, PSI moved for summary judgment, which
the Company opposed.  The Court denied the motion at a hearing in
April 2009.  As of the date of this report, the case was in the
discovery phase.





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





During
the six months ended June 30, 2009, we issued 5,159,779 shares of our common
stock in connection with conversions of 14 shares of our Series L Preferred
Stock for which we received no proceeds and we issued 416,667 shares of our
common stock in connection with conversions of 1 share of our Series P Preferred
Stock for which we also 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
3.            Defaults
Upon Senior Securities





None.





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





None.




38





Item
5.            Other
Information




Appointment of New
Directors
 
 Effective
July 27, 2009, Fonix Corporation (the “Company”) announced the addition of four
new members to the Company’s Board of Directors.  The four, Steven G.
Jones, Barry G. Jordan, Gilbert R. Steedley, and Von H, Whitby, offer
professional experience in financial and M&A arenas, which management
believes will assist the Company in developing the Company’s acquisition
strategy, operating consolidation, and competitive position in the embedded
speech and voice recognition markets.
 
 Biographical
Information
 
 Steven G.
Jones – Mr. Jones will serve as Corporate Development Director for Fonix
Corporation with primary focus on mergers and acquisitions. Experienced in
M&A work, Mr. Jones served as CEO of Auction Trust Network, an online
auction company, and Solera Networks. He has also held a number of business
development and sales/marketing posts.  Prior to joining the Company,
Mr. Jones served as Vice President, Business Development of Alianza, Inc., from
2008 through March 2009.  Before that, he provided executive services
to various companies, including as a Board Member of Visual Share and
Soundcrank, worked in Corporate Development (M&A) at Omniture,
Inc.  From 2006 through 2007, he served as CEO for the Auction Trust
Network in Salt Lake City, Utah, and from 2005 through 2006, he served as CEO of
Solera Networks in Salt Lake City, Utah.  Prior to that, he served as
Sr. Vice President, Products & Business Development for Vykor, Inc., in
Bellevue, Washington.  Mr. Jones Received a Bachelors of Science
degree from Brigham Young University in 1991, and a Masters of Business
Administration degree from the University of Utah in 1992.
 
 In June
2008, prior to his appointment to the Company’s Board of Directors, Mr. Jones
and the Company entered into a consulting agreement, pursuant to which he agreed
to provide consulting services to the Company and the Board concerning matters
pertaining to the organization of the administrative staff, the fiscal policies
of the Company, the relationship of the Company with its employees or with any
organization representing its employees, and, in general, the important issues
in the business affairs of the Company, in exchange for shares of the Company’s
common stock.  On June 25, 2009, the Company filed a registration
statement on Form S-8 which included 600,000,000 (pre-reverse-split) shares to
be issued to Mr. Jones in connection with the consulting
agreement.  In July 2009, the Company and Mr. Jones entered into an
addendum agreement, pursuant to which Mr. Jones agreed to continue to provide
consulting services, in return for an additional 1,000,000 shares of the
Company’s common stock.  On July 28, 2009, the Company filed a
registration statement on Form S-8 which included 1,000,000 shares to be issued
to Mr. Jones in connection with the addendum agreement.
 
 Barry G.
Jordan — Mr. Jordan is Chairman of Prism Strategic Services Group, LLC, a
strategic consulting company specializing in construction management guidance.
Prior to founding Prism, Mr. Jordan was a management consultant for Booz·Allen
& Hamilton, where he performed strategic and operational consulting
engagements with the company’s Engineering and Manufacturing Group.
 
 Gilbert
R. Steedley — Mr. Steedley is senior vice president of Able Global Partners, a
New York City-based merchant bank. He is past director of equities business
development for the American Stock Exchange and specializes in equity and debt
transactions.
 
 Von H.
Whitby — Mr. Whitby is managing partner of Whitby, Santarlasci & Company, a
privately held investment banking firm. He is co-founder of Investestate, a
publicly-held real estate development and management company, and served as the
chairman and CEO of Hydro Flame Corporation


39




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





3
                            
                            Amendment
      to Certificate of Incorporation (previously filed as an exhibit to a
      Current Report filed on December 24, 2008, and incorporated herein by
      reference).4
                            
                            Certificate
      of Designation of Rights and Preferences for Series P 9% Convertible
      Preferred Stock (previously filed as an exhibit to a Quarterly Report
      filed on November 19, 2008, and incorporated herein by
      reference).10.1
                            
                            Exchange
      Agreement, dated as of September 30, 2008 (previously filed as an exhibit
      to a Quarterly Report filed on November 19, 2008, and incorporated herein
      by reference).10.2
                            
                            Form
      of First Amendment to the Exchange Agreement, dated as of December 12,
      2008 (previously filed as an exhibit to a Current Report filed on December
      19, 2008, and incorporated herein by reference).10.3
                            
                            Escrow
      Agreement dated of December 12, 2008 (previously filed as an exhibit to a
      Current Report filed on December 19, 2008, and incorporated herein by
      reference).10.4
                            
                            Side
      Letter Agreement dated as of February 18, 2009 (previously filed as an
      exhibit to a Current Report filed on March 27, 2009, and incorporated
      herein by reference).Other
      Contracts31
                            
                            Certification
      of President and Chief Financial Officer32
                            
                            Certification
      of President and Chief Financial Officer Pursuant to Section 906 of the
      Sarbanes-Oxley Act of
2002








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
      CorporationDate:
      August 14, 2009
                /s/  Roger
      D.  DudleyRoger
      D.  Dudley, Chief Executive Officer,
  President,Chief
      Financial Officer, and Director(Principal
      Executive Officer, Principal Financial
Officer)






40


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