UNITED
STATES SECURITIES AND EXCHANGE COMMISSION


WASHINGTON,
D.C.  20549




FORM
10-Q




(Mark
One)




(X)
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the
quarterly period ended September 30, 2008




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 number 1-4324









ANDREA
ELECTRONICS CORPORATION


(Exact
name of registrant as specified in its charter)




New
      York
            
            11-0482020(State
      or other jurisdiction of incorporation or organization)
            
            (I.R.S.
      employer identification no.)65
      Orville Drive, Bohemia, New York
            
            11716(Address
      of principal executive offices)
            
            (Zip
      Code)Registrant’s
      telephone number (including area code):
            
            631-719-1800




Indicate
by checkmark whether the registrant (1) has filed all reports required to by
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.  Yes _X_
No ___




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See definition of “large accelerated filer,” “accelerated
filer” and “smaller reporting company” in Rule 12b-2 of the Exchange
Act.  (Check one)




Large
      Accelerated Filer  ̈
            
            Accelerated
      Filer                    ̈Non-Accelerated
      Filer    ̈
            
            Smaller
      Reporting Company x


(Do not
check if a smaller reporting company)




Indicate
by checkmark whether the registrant is a shell company (as defined in Rule 12b-2
of the Exchange Act). Yes ___ No _X_




Indicate
the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date:  As of November 10, 2008,
there are 60,406,945 common shares outstanding.









PART
I.                           FINANCIAL
INFORMATION
  ITEM
1.                           FINANCIAL
STATEMENTS
  ANDREA
ELECTRONICS CORPORATION AND SUBSIDIARIES
 CONDENSED
CONSOLIDATED BALANCE SHEETS
 
 September
      30,
              
              
              December
      31,2008
              
              
              2007(unaudited)ASSETSCurrent
      assets:Cash
      and cash equivalents
              
              $
              1,156,518
              
              
              $
              811,403Accounts
      receivable, net of allowance for doubtful accounts of $7,815 and $21,705,
      respectively
              
              
              727,067
              
              
              
              994,446Inventories,
      net
              
              
              1,008,445
              
              
              
              714,864Prepaid
      expenses and other current assets
              
              
              77,737
              
              
              
              64,005Total
      current assets
              
              
              2,969,767
              
              
              
              2,584,718Property
      and equipment, net
              
              
              70,016
              
              
              
              57,751Intangible
      assets, net
              
              
              2,655,947
              
              
              
              2,977,673Other
      assets
              
              
              12,864
              
              
              
              12,864Total
      assets
              
              $
              5,708,594
              
              
              $
              5,633,006LIABILITIESANDSHAREHOLDERS’
      EQUITYCurrent
      liabilities:Trade
      accounts payable
              
              $
              639,728
              
              
              $
              474,346Accrued
      Series C Preferred Stock Dividends
              
              
              151,583
              
              
              
              151,583Other
      current liabilities
              
              
              185,340
              
              
              
              121,268Total
      current liabilities
              
              
              976,651
              
              
              
              747,197Series
      B Redeemable Convertible Preferred Stock, $.01 par value; authorized:
      1,000 shares; issued and outstanding: 0 shares
              
              
              -
              
              
              
              -Commitments
      and contingenciesShareholders’
      equity:Preferred
      stock, $.01 par value; authorized: 2,497,500 shares; none issued and
      outstanding
              
              
              -
              
              
              
              -Series
      C Convertible Preferred Stock, net, $.01 par value; authorized: 1,500
      shares; issued and outstanding: 90.7 shares; liquidation value:
      $907,015
              
              
              1
              
              
              
              1Series
      D Convertible Preferred Stock, net, $.01 par value; authorized: 2,500,000
      shares; issued and outstanding:  1,192,858 shares; liquidation
      value:  $1,192,858
              
              
              11,929
              
              
              
              11,929Common
      stock, $.01 par value; authorized:  200,000,000 shares; issued
      and outstanding: 60,361,193 and 59,861,193 shares on September 30, 2008
      and December 31, 2007, respectively
              
              
              603,612
              
              
              
              598,612Additional
      paid-in capital
              
              
              76,754,833
              
              
              
              76,568,825Accumulated
      deficit
              
              
              (72,638,432
              )
              
              
              (72,293,558
              )Total
      shareholders’ equity
              
              
              4,731,943
              
              
              
              4,885,809Total
      liabilities and shareholders’ equity
              
              $
              5,708,594
              
              
              $
              5,633,006
 
 
 
 
 
 
 
 
 
 See Notes
to Condensed Consolidated Financial Statements.
  2




ANDREA
ELECTRONICS CORPORATION AND SUBSIDIARIES
 CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS
 (UNAUDITED)
 
 For
      the Three Months Ended
              
              
              For
      the Nine Months EndedSeptember
      30,
                  2008
              
              
              September
      30,
                  2007
              
              
              September
      30,
                  2008
              
              
              September
      30,
                  2007RevenuesNet
      product revenues
              
              $
              946,575
              
              
              $
              959,963
              
              
              $
              2,560,133
              
              
              $
              3,127,078License
      revenues
              
              
              337,382
              
              
              
              89,952
              
              
              
              857,715
              
              
              
              497,853Revenues
              
              
              1,283,957
              
              
              
              1,049,915
              
              
              
              3,417,848
              
              
              
              3,624,931Cost
      of revenues
              
              
              526,311
              
              
              
              565,167
              
              
              
              1,486,028
              
              
              
              1,822,086Gross
      margin
              
              
              757,646
              
              
              
              484,748
              
              
              
              1,931,820
              
              
              
              1,802,845Research
      and development expenses
              
              
              179,062
              
              
              
              173,895
              
              
              
              557,807
              
              
              
              502,755General,
      administrative and selling expenses
              
              
              555,326
              
              
              
              507,503
              
              
              
              1,721,773
              
              
              
              1,587,335Income
      (loss) from operations
              
              
              23,258
              
              
              
              (196,650
              )
              
              
              (347,760
              )
              
              
              (287,245
              )Interest
      income, net
              
              
              2,031
              
              
              
              3,967
              
              
              
              6,602
              
              
              
              4,371Income
      (loss) before provision for income taxes
              
              
              25,289
              
              
              
              (192,683
              )
              
              
              (341,158
              )
              
              
              (282,874
              )Provision
      for income taxes
              
              
              -
              
              
              
              1,886
              
              
              
              3,716
              
              
              
              30,340Net
      income (loss)
              
              $
              25,289
              
              
              $
              (194,569
              )
              
              $
              (344,874
              )
              
              $
              (313,214
              )Basic
      weighted average shares
              
              
              60,149,236
              
              
              
              59,714,946
              
              
              
              59,957,908
              
              
              
              59,457,994Diluted
      weighted average shares
              
              
              69,426,298
              
              
              
              59,714,946
              
              
              
              59,957,908
              
              
              
              59,457,994Basic
      and diluted net income (loss) per share
              
              $
              .00
              
              
              $
              (.00
              )
              
              $
              (.01
              )
              
              $
              (.01
              )
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 See Notes
to Condensed Consolidated Financial Statements.
  3




ANDREA
ELECTRONICS CORPORATION AND SUBSIDIARIES
 
 CONDENSED
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
 FOR THE
NINE MONTHS ENDED SEPTEMBER 30, 2008
 (UNAUDITED)
 
 
 Series
      C Convertible Preferred Stock Outstanding
              
              
              Series
      C Convertible Preferred Stock
              
              
              Series
      D Convertible Preferred Stock Outstanding
              
              
              Series
      D Convertible Preferred Stock
              
              
              Common
                  Stock
                  Shares
                  Outstanding
              
              
              Common
                  Stock
              
              
              Additional
                  Paid-In
                  Capital
              
              
              Accumulated
                  Deficit
              
              
              Total
                  Shareholders’
                  EquityBalance,
      January 1, 2008
              90.701477
              
              
              $
              1
              
              
              
              1,192,858
              
              
              $
              11,929
              
              
              
              59,861,193
              
              
              $
              598,612
              
              
              $
              76,568,825
              
              
              $
              (72,293,558
              )
              
              $
              4,885,809Stock-based
      Compensation Expense related to Stock Grants to Outside
      Directors
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              500,000
              
              
              
              5,000
              
              
              
              12,500
              
              
              
              -
              
              
              
              17,500Stock-based
      Compensation Expense related to Stock Option Grants
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              173,508
              
              
              
              -
              
              
              
              173,508Net
      loss
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (344,874
              )
              
              
              (344,874
              )Balance,
      September 30, 2008
              
              90.701477
              
              
              $
              1
              
              
              
              1,192,858
              
              
              $
              11,929
              
              
              
              60,361,193
              
              
              $
              603,612
              
              
              $
              76,754,833
              
              
              $
              (72,638,432
              )
              
              $
              4,731,943
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  See Notes
to Condensed Consolidated Financial Statements.
  4




ANDREA
ELECTRONICS CORPORATION AND SUBSIDIARIES
 CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS
 (UNAUDITED)
 
 
 For
      the Nine Months EndedSeptember
      30, 2008
              
              
              September
      30, 2007Cash
      flows from operating activities:Net loss
              
              $
              (344,874
              )
              
              $
              (313,214
              )Adjustments to reconcile net loss
      to net cash provided by operating activities:Depreciation and
      amortization
              
              
              380,225
              
              
              
              365,500Stock -based compensation
      expense
              
              
              191,008
              
              
              
              143,653Inventory reserve
              
              
              26,522
              
              
              
              222Change in:Accounts
    receivable
              
              
              267,379
              
              
              
              157,924Inventories
              
              
              (320,103
              )
              
              
              352,671Prepaid expenses and other
      current assets
              
              
              (13,732
              )
              
              
              266,460Trade accounts
      payable
              
              
              165,382
              
              
              
              (286,317
              )Other current
      liabilities
              
              
              64,072
              
              
              
              (124,527
              )Net cash provided by operating
      activities
              
              
              415,879
              
              
              
              562,372Cash
      flows from investing activities:Purchases of property and
      equipment
              
              
              (35,512
              )
              
              
              -Purchases of patents and
      trademarks
              
              
              (35,252
              )
              
              
              (7,730
              )Net cash used in investing
      activities
              
              
              (70,764
              )
              
              
              (7,730
              )Cash
      flows from financing activities:Payments under capital
      lease
              
              
              -
              
              
              
              (4,305
              )Net cash used in financing
      activities
              
              
              -
              
              
              
              (4,305
              )Net
      increase in cash and cash equivalents
              
              
              345,115
              
              
              
              550,337Cash
      and cash equivalents, beginning of period
              
              
              811,403
              
              
              
              303,678Cash
      and cash equivalents, end of period
              
              $
              1,156,518
              
              
              $
              854,015Non-cash investing and financing
      activities:Conversion of Series C
      Convertible Preferred Stock into common stock
              
              $
              -
              
              
              $
              16,712Supplemental
      disclosures of cash flow information:Cash
      paid for:Interest
              
              $
              -
              
              
              $
              2,038Income Taxes
              
              $
              14,211
              
              
              $
              76,420
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 See Notes
to Condensed Consolidated Financial Statements.
  5




ANDREA
ELECTRONICS CORPORATION AND SUBSIDIARIES
 NOTES TO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (UNAUDITED)




Note
1.                 Basis
of Presentation and Management’s Liquidity Plans
 
 Basis of Presentation
- The accompanying unaudited condensed consolidated interim financial statements
include the accounts of Andrea Electronics Corporation and its subsidiaries
("Andrea" or the “Company”). All intercompany balances and transactions have
been eliminated in consolidation.
 
 These
unaudited, condensed consolidated interim financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States of America for interim financial information and with the
instructions to Form 10-Q. Accordingly, they do not include all of the
information and footnotes required by accounting principles generally accepted
in the United States of America (“GAAP”) for complete financial
statements.  In addition, the December 31, 2007 balance sheet data was
derived from the audited consolidated financial statements, but does not include
all disclosures required by GAAP.  In the opinion of management, all
adjustments (consisting of normal recurring accruals) considered necessary for a
fair presentation have been included. The results of operations of any interim
period are not necessarily indicative of the results of operations to be
expected for any other interim period or for the fiscal year.
 
 These
unaudited condensed consolidated interim financial statements should be read in
conjunction with the audited consolidated financial statements and notes thereto
for the year ended December 31, 2007 included in the Company's Form 10-KSB for
the fiscal year ended December 31, 2007, filed on March 31, 2008.  The
accounting policies used in preparing these unaudited condensed consolidated
interim financial statements are consistent with those described in the December
31, 2007 audited consolidated financial statements.
 
 Management's Liquidity
Plans - As of September 30, 2008, Andrea had working capital of
$1,993,116 and cash on hand of $1,156,518.  Andrea’s income from
operations was $23,258 for the three months ended September 30,
2008.  Andrea incurred a loss from operations of $347,760 for the nine
months ended September 30, 2008.  Andrea plans to continue to improve
its cash flows during the remainder of 2008 and in 2009 by aggressively pursuing
additional licensing opportunities related to Andrea DSP Audio Software and
increasing its Andrea Anti-Noise Headset Products sales through the introduction
of refreshed product line which was introduced in September 2008 as well as the
increased efforts the Company is dedicating to its sales and marketing
efforts.  However, there can be no assurance that Andrea will be able
to successfully execute the aforementioned plans.
 
 As of
November 10, 2008, Andrea has approximately $1,200,000 of cash. Management
projects that Andrea has sufficient liquidity available to operate through at
least September 2009.  While Andrea explores opportunities to increase
revenues in new business areas, the Company also continues to examine additional
opportunities for cost reduction and further diversification of its
business.  Since the third quarter of 2006, Andrea has had generated
cash from operations.  Although these steps are encouraging, if Andrea
fails to develop additional revenues from sales of its products and licensing of
its technology or to generate adequate funding from operations, or if Andrea
fails to obtain additional financing through a capital transaction or other type
of financing, Andrea will be required to continue to significantly reduce its
operating expenses and/or operations or Andrea may have to relinquish its
products, technologies or markets which could have a materially adverse effect
on revenue and operations. Andrea has no commitment for additional financing and
may experience difficulty in obtaining additional financing on favorable terms,
if at all.
 
 Note
2.                 Summary
of Significant Accounting Policies
 
 Earnings (loss) Per
Share - Basic earnings (loss) per share is computed by dividing the net
income (loss) by the weighted average number of common shares outstanding during
the period.  Diluted earnings (loss) per share adjusts basic earnings
(loss) per share for the effects of convertible securities, stock options and
other potentially dilutive financial instruments, only in the periods in which
such effect is dilutive.  Securities that could potentially dilute
basic earnings (loss) per share (“EPS”) in the future that were not included in
the computation of the diluted EPS because to do so would have been
anti-dilutive for the periods presented, consist of the following:
 
 For
      the Three Months Ended
              
              
              For
      the Nine Months EndedSeptember
      30, 2008
              
              
              September
      30, 2007
              
              
              September
      30, 2008
              
              
              September
      30, 2007Total
      potential common shares as of:Options
      to purchase common stock (Note 7)
              
              
              12,336,820
              
              
              
              9,686,820
              
              
              
              14,676,820
              
              
              
              9,686,820Series
      C Convertible Preferred Stock and related accrued dividends (Note
      3)
              
              
              -
              
              
              
              4,149,736
              
              
              
              4,149,736
              
              
              
              4,149,736Series
      D Convertible Preferred Stock and related warrants (Note
4)
              
              
              5,158,344
              
              
              
              9,929,776
              
              
              
              9,929,776
              
              
              
              9,929,776Total
      potential common shares
              
              
              17,495,164
              
              
              
              23,766,332
              
              
              
              28,756,332
              
              
              
              23,766,332




6




ANDREA
ELECTRONICS CORPORATION AND SUBSIDIARIES
 NOTES TO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (UNAUDITED)




The
following table sets forth the components used in the computation of basic and
diluted earnings (loss) per share:
  For
      the Three Months Ended
                  
                  
                  For
      the Nine Months EndedSeptember
      30,
                    2008
                  
                  
                  September
      30,
                    2007
                  
                  
                  September
      30,
                    2008
                  
                  
                  September
      30,
                    2007Numerator:Net
      income (loss)
                  
                  $
                  25,289
                  
                  
                  $
                  (194,569
                  )
                  
                  $
                  (344,874
                  )
                  
                  $
                  (313,214
                  )Denominator:Weighted
      average shares
                  
                  
                  60,149,236
                  
                  
                  
                  59,714,946
                  
                  
                  
                  59,957,908
                  
                  
                  
                  59,457,994Effect
      of dilutive securities:Series
      C Convertible Preferred Stock
                  
                  
                  4,149,736
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Series
      D Convertible Preferred Stock
                  
                  
                  4,771,432
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Employee
      stock options
                  
                  
                  355,894
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Denominator
      for diluted income (loss) pershare-adjusted
      weighted average sharesafter
      assumed conversions
                  
                  
                  69,426,298
                  
                  
                  
                  59,714,946
                  
                  
                  
                  59,957,908
                  
                  
                  
                  59,457,994
  Cash and Cash
Equivalents - Cash and cash equivalents include cash and highly liquid
investments with original maturities of three months or less.  The
Company has cash deposits in excess of the maximum amounts insured by the
Federal Deposit Insurance Corporation at September 30, 2008 and December 31,
2007.  The Company mitigates its risk by investing in or through major
financial institutions.
 
 Concentration of Credit
Risk - The following customers accounted for 10% or more of Andrea’s
consolidated net revenues during at least one of the periods presented
below:
 For
      the Three Months Ended
              
              
              For
      the Nine Months EndedSeptember
      30,
                  2008
              
              
              September
      30,
                  2007
              
              
              September
      30,
                  2008
              
              
              September
      30,
                  2007Customer
      A
              
              
              16
              %
              
              
              13
              %
              
              
              16
              %
              
              
              12
              %Customer
      B
              
              
              15
              %
              
              
              *
              
              
              
              *
              
              
              
              *Customer
      C
              
              
              *
              
              
              
              34
              %
              
              
              *
              
              
              
              20
              %Customer
      D
              
              
              15
              %
              
              
              *
              
              
              
              14
              %
              
              
              *
 _________________
  * Amounts
are less than 10%
 
 As of
September 30, 2008, two customers accounted for approximately 10% and 13% of
accounts receivable and as of December 31, 2007, two customers account for
approximately 20% and 15% of accounts receivable.
 
 The
following suppliers accounted for 10% or more of Andrea’s purchases during at
least one of the periods presented below:
 
 For
      the Three Months Ended
              
              
              For
      the Nine Months EndedSeptember
      30,
                  2008
              
              
              September
      30,
                  2007
              
              
              September
      30,
                  2008
              
              
              September
      30,
                  2007Supplier
      A
              
              
              *
              
              
              
              43
              %
              
              
              43
              %
              
              
              66
              %Supplier
      B
              
              
              82
              %
              
              
              48
              %
              
              
              41
              %
              
              
              22
              %
 _________________
  * Amounts
are less than 10%
 
 At
September 30, 2008 and December 31, 2007, one supplier accounted for
approximately 73% and 22%, respectively of accounts payable.  The
significant amount of purchases from one supplier during the three months ended
September 30, 2008 relates to purchases of inventory relating to our refreshed
product line.  Although these products were primarily purchased from
one vendor, this source is a replaceable source.
  Allowance for Doubtful
Accounts - The Company performs on-going credit evaluations of its
customers and adjusts credit limits based upon payment history and the
customer’s current credit worthiness, as determined by the review of their
current credit information.  Collections and payments from customers
are continuously monitored.  The Company maintains an allowance for
doubtful accounts, which is based upon historical experience as well as specific
customer collection issues that have been identified.  While such bad
debt expenses have historically been within expectations and allowances
established, the Company cannot guarantee that it will continue to experience
the same credit loss rates that it has in the past.  If the financial
condition of customers were to deteriorate, resulting in an impairment of their
ability to make payments, additional allowances may be required.
 7


ANDREA
ELECTRONICS CORPORATION AND SUBSIDIARIES


NOTES TO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (UNAUDITED)




Inventories -
Inventories are stated at the lower of cost (on a first-in, first-out) or market
basis.  The cost elements of inventories include materials, labor and
overhead.  Andrea reviews its inventory reserve for obsolescence on a
quarterly basis and establishes reserves on inventories when the cost of the
inventory is not expected to be recovered.  Andrea’s policy is to
reserve for inventory that shows slow movement over the preceding six
consecutive quarters.  Andrea records charges in inventory reserves as
part of cost of revenues.
  September
      30, 2008
              
              
              December
      31, 2007Raw
      materials
              
              $
              31,441
              
              
              $
              62,834Work
      in Progress
              
              
              50,687
              
              
              
              -Finished
      goods
              
              
              1,519,780
              
              
              
              1,218,9711,601,908
              
              
              
              1,281,805Less:
      reserve for slow moving and obsolescence
              
              
              (593,463
              )
              
              
              (566,941
              )$
              1,008,445
              
              
              $
              714,864
 
 Intangible and Long-Lived
Assets - Andrea accounts for its long-lived assets in accordance with
Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for
the Impairment or Disposal of Long-Lived Assets” for purposes of determining and
measuring impairment of its long-lived assets (primarily intangible assets)
other than goodwill. Andrea’s policy is to periodically review the value
assigned to its long-lived assets to determine if they have been permanently
impaired by adverse conditions which may affect Andrea. If Andrea identifies a
permanent impairment such that the carrying amount of Andrea’s long lived assets
are not recoverable using the sum of an undiscounted cash flow projection (gross
margin dollars from product revenues), a new cost basis for the impaired asset
will be established. If required, an impairment charge is recorded based on an
estimate of future discounted cash flows.  This new cost basis will be
net of any recorded impairment.
 
 Because
the Andrea DSP Microphone and Audio Software Products business segment was
operating at a loss for the nine months ended September 30, 2008 and because the
revenues from the Andrea DSP Microphone and Audio Software Products business
segment were lower than expected and this business segment was operating at a
loss for the nine months ended September 30, 2007, management compared the sum
of Andrea’s undiscounted cash flow projections (gross margin dollars from
product sales) of the Andrea DSP Microphone and Audio Software core technology
to the carrying value of that technology.  The results of this test
indicated that there was not an impairment.  This process utilized
probability weighted undiscounted cash flow projections which include a
significant amount of management’s judgment and estimates as to future
revenue.  If these probability weighted projections do not come to
fruition, the Company could be required to record an impairment charge in the
near term and such impairment could be material.
 
 Andrea
amortizes its core technology, patents and trademarks on a straight-line basis
over the estimated useful lives of its intangible assets that range from 15 to
17 years.  For the three-month periods ended September 30, 2008 and
2007, amortization expense was $119,487 and $118,130,
respectively.  For the nine-month periods ended September 30, 2008 and
2007, amortization expense was $356,978 and $354,127, respectively.
 
 Revenue Recognition –
Non-software related revenue, which is generally comprised of microphones and
microphone connectivity product revenues, is recognized when title and risk of
loss pass to the customer, which is generally upon shipment.  With
respect to licensing revenues, Andrea recognizes revenue in accordance with
Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended,
and Staff Accounting Bulletin Topic 13 “Revenue Recognition in Financial
Statements.”  License revenue is recognized based on the terms and
conditions of individual contracts (see Note 5).  In addition, fee
based services, which are short-term in nature, are generally performed on a
time-and-material basis under separate service arrangements and the
corresponding revenue is generally recognized as the services are
performed.
  8




ANDREA
ELECTRONICS CORPORATION AND SUBSIDIARIES
 NOTES TO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (UNAUDITED)
  Income Taxes - The
provision for income taxes is a result of certain licensing revenues that are
subject to withholding of income tax as mandated by the foreign jurisdiction in
which the revenues are earned.  For all other income taxes, Andrea
accounts for income taxes in accordance with SFAS No. 109, “Accounting for
Income Taxes” and Financial Accounting Standards Board (“FASB”) Interpretation
No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB
Statement No. 109” (“FIN 48”).  SFAS No. 109 requires an asset and
liability approach for financial accounting and reporting for income
taxes.  FIN 48 establishes for all entities a minimum threshold for
financial statement recognition of the benefit of tax positions, and requires
certain expanded disclosures.  Using the guidelines set forth in both
of these statements, the provision for income taxes is based upon income or loss
after adjustment for those permanent items that are not considered in the
determination of taxable income. Deferred income taxes represent the tax effects
of differences between the financial reporting and tax bases of the Company’s
assets and liabilities at the enacted tax rates in effect for the years in which
the differences are expected to reverse.  The Company evaluates the
recoverability of deferred tax assets and establishes a valuation allowance when
it is more likely than not that some portion or all of the deferred tax assets
will not be realized.  Since cumulative losses weigh heavily in the
overall assessment, Andrea provides a full valuation allowance on future tax
benefits until it can sustain a level of profitability that demonstrates its
ability to utilize the assets, or other significant positive evidence arises
that suggests Andrea’s ability to utilize such assets.  If it becomes
more likely than not that a tax asset will be used, the related valuation
allowance on such assets would be reversed.  Management makes
judgments as to the interpretation of the tax laws that might be challenged upon
an audit and cause changes to previous estimates of tax liability.  In
management’s opinion, adequate provisions for income taxes have been made for
all years.  If actual taxable income by tax jurisdiction varies from
estimates, additional allowances or reversals of reserves may be
necessary.  Income tax expense consists of the tax payable for the
period and the change during the period in deferred tax assets and
liabilities.  The Company has identified its federal tax return and
its state tax return in New York as "major" tax jurisdictions, as defined in FIN
48.  Based on the Company's evaluation, it has concluded that there
are no significant uncertain tax positions requiring recognition in the
Company's financial statements.  The Company's evaluation was
performed for tax years ended 2003 through 2007.  The Company believes
that its income tax positions and deductions will be sustained on audit and does
not anticipate any adjustments that will result in a material change to its
financial position.
 
 Stock-Based
Compensation - At September 30, 2008, Andrea had three stock-based
employee compensation plans, which are described more fully in Note
7.  Andrea accounts for stock based compensation in accordance with
SFAS No. 123R, “Share-Based Payment.”  SFAS No. 123R establishes
accounting for stock-based awards exchanged for employee
services.  Under the provisions of SFAS No. 123R, share-based
compensation cost is measured at the grant date, based on the fair value of the
award, and is recognized as expense over the employee’s requisite service period
(generally the vesting period of the equity grant).  The fair value of
the Company’s common stock options are estimated using the Black Scholes
option-pricing model with the following assumptions:  expected
volatility, dividend rate, risk free interest rate and the expected
life.  The Company expenses stock-based compensation by using the
straight-line method.  In accordance with SFAS No. 123R, excess tax
benefits realized from the exercise of stock-based awards are classified in cash
flows from financing activities.  The future realization of the
reserved deferred tax assets related to these tax benefits associated with the
exercise of stock option will result in a credit to additional paid in capital
if the related tax deduction reduces taxes payable.  The Company has
elected the “with and without approach” regarding ordering of windfall tax
benefits to determine whether the windfall tax benefit did reduce taxes payable
in the current year.   Under this approach the windfall tax
benefit would be recognized in additional paid-in-capital only if an incremental
tax benefit is realized after considering all other benefits presently
available.
 
 Recently Issued Accounting
Pronouncements
 
 In
December 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS
141R”), which replaces SFAS No. 141, “Business Combinations.” SFAS 141R
establishes principles and requirements for determining how an enterprise
recognizes and measures the fair value of certain assets and liabilities
acquired in a business combination, including noncontrolling interests,
contingent consideration, and certain acquired contingencies. SFAS 141R also
requires acquisition-related transaction expenses and restructuring costs be
expensed as incurred rather than capitalized as a component of the business
combination. SFAS 141R will be applicable to the Company for fiscal 2009. SFAS
141R would have an impact on accounting for any businesses acquired after the
effective date of this pronouncement.
 
 In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements – An Amendment of ARB No. 51” (“SFAS 160”).
SFAS 160 establishes accounting and reporting standards for the noncontrolling
interest in a subsidiary (previously referred to as minority interests). SFAS
160 also requires that a retained noncontrolling interest upon the
deconsolidation of a subsidiary be initially measured at its fair value. Upon
adoption of SFAS 160, the Company would be required to report any noncontrolling
interests as a separate component of stockholders’ equity.  The
Company would also be required to present any net income allocable to
noncontrolling interests and net income attributable to the stockholders of the
Company separately in its consolidated statements of operations. SFAS 160 is
effective for fiscal years, and interim periods within those fiscal years,
beginning on or after December 15, 2008. SFAS 160 requires retroactive adoption
of the presentation and disclosure requirements for existing minority interests.
All other requirements of SFAS 160 shall be applied prospectively. SFAS 160
would have an impact on the presentation and disclosure of the noncontrolling
interests of any non wholly-owned businesses acquired in the
future.
  9




ANDREA
ELECTRONICS CORPORATION AND SUBSIDIARIES
 NOTES TO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (UNAUDITED)




On
February 12, 2008, the FASB issued FASB Staff Position (FSP) No. SFAS 157-2,
“Effective Date of FASB Statement No. 157” (FSP SFAS 157-2). FSP SFAS 157-2
amends SFAS No. 157, to delay the effective date of SFAS 157 for nonfinancial
assets and nonfinancial liabilities, except for the items that are recognized or
disclosed at fair value in the financial statements on a recurring basis. For
items within its scope, FSP SFAS 157-2 defers the effective date of SFAS 157 to
fiscal years beginning after November 15, 2008, and interim periods within those
fiscal years. The Company is currently evaluating the impact of adopting SFAS
157 and FSP SFAS 157-2 on its consolidated financial statements.
 
 In March
2008, the FASB issued SFAS 161, “Disclosures about Derivative Instruments and
Hedging Activities an amendment of FASB Statement No. 133”, which amends and
expands the disclosure requirements of SFAS 133 to require qualitative
disclosure about objectives and strategies for using derivatives, quantitative
disclosures about fair value amounts of and gains and losses on derivative
instruments, and disclosures about credit-risk-related contingent features in
derivative agreements. This statement will be effective for the Company
beginning on January 1, 2009. The adoption of this statement will change the
disclosures related to derivative instruments that might be held by the
Company.
 
 Reclassifications -
Certain prior year amounts have been reclassified to conform to the current year
presentation.
 
 Use of Estimates -
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America, requires management to make
estimates and assumptions that affect the reported amounts of assets,
liabilities and 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.
 
 Management
bases its estimates on historical experience and on various assumptions that are
believed to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying value of assets and liabilities
that are not readily apparent from other sources.  The most
significant estimates, among other things, are used in accounting for allowances
for bad debts, inventory valuation and obsolescence, product warranty,
depreciation, deferred income taxes, expected realizable values for assets
(primarily intangible assets), contingencies, revenue recognition as well as the
recording and presentation of the Company’s convertible preferred stock.
Estimates and assumptions are periodically reviewed and the effects of any
material revisions are reflected in the condensed consolidated financial
statements in the period that they are determined to be necessary. Actual
results could differ from those estimates and assumptions.
 
 Note
3.                 Series
C Redeemable Convertible Preferred Stock
 
 On October
10, 2000, Andrea issued and sold in a private placement $7,500,000 of Series C
Redeemable Convertible Preferred Stock (the “Series C Preferred
Stock”).  Each of these shares of Series C Preferred Stock had a
stated value of $10,000 plus $671.23 increase in the stated value, which sum is
convertible into Common Stock at a conversion price of $0.2551.  On
February 17, 2004, Andrea announced that it had entered into an Exchange and
Termination Agreement and an Acknowledgment and Waiver Agreement, which
eliminated the dividend of 5% per annum on the stated value.  The
additional amount of $671.23 represents the 5% per annum from October 10, 2000
through February 17, 2004.
 
 On April
11, 2007, 10 shares of Series C Preferred Stock, together with related accrued
dividends of $16,712, were converted into 457,516 shares of Common Stock at a
conversion price of $0.2551.
 
 As of
September 30, 2008, there were 90.701477 shares of Series C Preferred Stock
outstanding, which were convertible into 4,149,736 shares of Common Stock and
remaining accrued dividends of $151,583.
 
 On
November 10, 2008, 1 share of Series C Preferred Stock, together with related
accrued dividends, was converted into 45,752 shares of Common Stock at a
conversion price of $0.2551.
 
 Note
4.                 Series
D Redeemable Convertible Preferred Stock
 
 On
February 17, 2004, Andrea entered into a Securities Purchase Agreement
(including a Registration Rights Agreement) with certain holders of the Series C
Preferred Stock and other investors (collectively, the “Buyers”) pursuant to
which the Buyers agreed to invest a total of $2,500,000.  In
connection with this agreement, on February 23, 2004, the Buyers purchased, for
a purchase price of $1,250,000, an aggregate of 1,250,000 shares of a new class
of preferred stock, the Series D Preferred Stock, convertible into 5,000,000
shares of Common Stock (an effective conversion price of $0.25 per share) and
Common Stock warrants exercisable for an aggregate of 2,500,000 shares of Common
Stock.  The warrants are exercisable at any time after August 17, 2004
and before February 23, 2009 at an exercise price of $0.38 per
share.
  10




ANDREA
ELECTRONICS CORPORATION AND SUBSIDIARIES
 NOTES TO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (UNAUDITED)




In
addition, on June 4, 2004, the Buyers purchased for an additional $1,250,000, an
additional 1,250,000 shares of Series D Preferred Stock convertible into
5,000,000 shares of Common Stock (an effective conversion price of $0.25 per
share) and Common Stock warrants exercisable for an aggregate of 2,500,000
shares of Common Stock.  The warrants are exercisable at any time
after December 4, 2004 and before June 4, 2009 at an exercise price of $0.17 per
share.
 
 Knightsbridge
Capital served as a financial advisor to Andrea in connection with the
aforementioned transactions and the initial issuance of the Series D Preferred
Stock and related warrants.  In connection with these transactions,
Andrea agreed to pay Knightsbridge Capital $350,000 in cash and to issue
warrants exercisable for an aggregate of 439,594 shares of Common Stock. 377,094
of the warrants are exercisable at any time after August 17, 2004 and before
February 23, 2009 at an exercise price of $0.38 per share and 62,500 of the
warrants at any time after December 4, 2004 and before June 4, 2009 at an
exercise price of $0.17 per share.  Through September 30, 2008,
281,250 shares of common stock have been issued as a result of exercises of the
Series D Preferred Stock Warrants.
 
 The
Company is required to maintain an effective registration statement from the
time of issuance through June 4, 2010.  In the event that the holder
of the Series D Preferred Stock and related warrants is unable to convert these
securities into Andrea Common stock the Company shall pay to each such holder of
such registrable securities a Registration Delay Payment.  This
payment is to be paid in cash and is equal to the product of (i) the stated
value of such Preferred Shares multiplied by (ii) the product of (1) .0005
multiplied by (2) the number of days that sales cannot be made pursuant to the
Registration Statement (excluding any days during that may be considered grace
periods as defined by the Registration Rights Agreement).
 
 During
2007, 50,000 shares of Series D Preferred Stock were converted into 200,000
shares of Common Stock at a conversion price of $0.25. There were no Series D
Preferred Stock Warrant exercises during the nine months ended September 30,
2008 or the year ended December 31, 2007.
 
 As of
September 30, 2008, there are 1,192,858 shares of Series D Preferred Stock and
5,158,344 related warrants outstanding, which are convertible and exercisable
into 9,929,776 shares of Common Stock.
 
 Note
5.                 Licensing
Agreements
 
 The
Company has entered into various licensing, production and distribution
agreements with manufacturers of personal computers (“PC”) and related
components.  These agreements provide for revenues based on the terms
of each individual agreement.  The Company's three largest licensing
customers accounted for $186,459, $128,664 and $22,040 of revenues for the three
months ended September 30, 2008 and $64,436, $13,327 and $6,712 of
revenues for the three months ended September 30, 2007.  The
Company's three largest licensing customers accounted for $472,133, $322,661 and
$34,833 of revenues for the nine months ended September 30, 2008 and $251,956,
$196,379 and $34,203 of revenues for the nine months ended September 30,
2007.
 
 Note
6.                 Commitments
And Contingencies
 
 Leases
 
 In March
2005, Andrea entered into a lease for its corporate headquarters located in
Bohemia, New York, where Andrea leases space for warehousing, sales and
executive offices from an unrelated party.  The lease is for
approximately 11,000 square feet and expires in April 2010.  Rent
expense under this operating lease was $21,083 and $62,634 for the three and
nine-month periods ended September 30, 2008, respectively.  Rent
expense under this operating lease was $22,958 and $63,473 for the three and
nine-month periods ended September 30, 2007, respectively.
 
 As of
September 30, 2008, the future minimum annual lease payments under this lease
and all non-cancelable operating leases are as follows:
 
 2008
      (October 1 to December 31)
              
              $
              25,7352009
              
              
              93,5412010
              
              
              29,171Total
              
              $
              148,447
 
 Employment
Agreements
 
 In
November 2008, the Company entered into an employment agreement with the
Chairman of the Board, Douglas J Andrea.  The effective date of the
employment agreement is August 1, 2008 and expires July 31, 2010 and is subject
to renewal as approved by the Compensation Committee of the Board of
Directors.  Pursuant to his employment agreement, Mr. Andrea will
receive an annual base salary of $312,500 through July 31, 2009 and for the
period of August 1, 2009 through July 31, 2010 Mr. Andrea’s will receive an
annual base salary of $325,000.  The employment agreement provides for
quarterly bonuses equal to 25% of the Company’s pre-bonus net after tax
quarterly earnings in excess of $25,000 for a total quarterly bonus amount not
to exceed $12,500; and annual bonuses equal to 10% of the Company’s annual
pre-bonus net after tax earnings in excess of $300,000.  All bonuses
shall be payable as soon as the Company's cash flow permits.  All
bonus determinations or any additional bonus in excess of the above will be made
in the sole discretion of the Compensation Committee. On August 8, 2008, the
Board granted Mr. Andrea 2,000,000 stock options and 1,000,000 stock options
with an aggregate fair value of $120,000 (fair value was estimated using the
Black-Scholes option-pricing model).  The 2,000,000 grant vests in
three equal annual installments over a three year period commencing August 1,
2009.  The 1,000,000 grant vests in three equal annual installments
over a three year period commencing August 1, 2010.  All stock options
granted have an exercise price of $0.04 per share, which was fair market value
at the date of grant, and a term of 10 years.  Pursuant to the
employment agreement and subject to the approval of the Board, the Compensation
Committee will recommend a second grant of 1,000,000 stock options as soon as
practical after August 1, 2009, with an exercise price equal to the per share
fair market value of the Company’s common stock on the date of
grant.  Mr. Andrea is also entitled to a change in control payment
equal to two times his salary with continuation of health and medical benefits
for two years in the event of a change in control.. At September 30, 2008, the
future minimum cash commitments under this agreement aggregate
$585,417.
  11




ANDREA
ELECTRONICS CORPORATION AND SUBSIDIARIES
 NOTES TO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (UNAUDITED)




Legal
Proceedings
 
 Andrea is
involved in routine litigation incidental to the normal course of business.
While it is not feasible to predict or determine the final outcome of claims,
Andrea believes the resolution of these matters will not have a material adverse
effect on Andrea’s financial position, results of operations or
liquidity.
 
 Note
7.                 Stock
Plans and Stock Based Compensation
 
 In 1991,
the Board of Directors of Andrea (the “Board”) adopted the 1991 Performance
Equity Plan (“1991 Plan”), which was approved by the shareholders. The 1991
Plan, as amended, authorizes the granting of awards, the exercise of which would
allow up to an aggregate of 4,000,000 shares of Andrea’s Common Stock to be
acquired by the holders of those awards.  Stock options granted to
employees and directors under the 1991 Plan were granted for terms of up to 10
years at an exercise price equal to the market value at the date of
grant.  No further awards will be granted under the 1991
Plan.
 
 In 1998,
the Board adopted the 1998 Stock Option Plan (“1998 Plan”), which was
subsequently approved by the shareholders. The 1998 Plan, as amended, authorizes
the granting of awards, the exercise of which would allow up to an aggregate of
6,375,000 shares of Andrea’s Common Stock to be acquired by the holders of those
awards.  The awards can take the form of stock options, stock
appreciation rights, restricted stock, deferred stock, stock reload options or
other stock-based awards. Awards may be granted to key employees, officers,
directors and consultants.  No further awards will be granted under
the 1998 Plan..
 
 In October
2006, the Board adopted the Andrea Electronics Corporation 2006 Equity
Compensation Plan (“2006 Plan”), which was subsequently approved by the
shareholders.  The 2006 Plan authorizes the granting of awards, the
exercise of which would allow up to an aggregate of 10,000,000 shares of
Andrea’s Common Stock to be acquired by the holders of those
awards.  The awards can take the form of stock options, stock
appreciation rights, restricted stock or other stock-based awards. Awards may be
granted to key employees, officers, directors and consultants.  At
September 30, 2008, there were 101,345 shares available for further issuance
under the 2006 Plan.
 
 The stock
option awards granted under these plans have been granted with an exercise price
equal to the market price of the Company’s stock at the date of grant; with
vesting periods of up to four years and 10-year contractual terms.
 
 The fair
values of each stock option grant is estimated on the date of grant using the
Black-Scholes option-pricing model that uses the weighted-average assumptions
noted in the following table.  Expected volatilities are based on
implied volatilities from historical volatility of the Company’s
stock.  The expected term of options granted represents the period of
time that options granted are expected to be outstanding.  The
risk-free rate for periods within the contractual life of the option is based on
the U.S. Treasury yield curve in effect at the time of grant.
 
 The fair
values of the stock options granted for the three and nine-month periods ended
September 30, 2008 were estimated on the date of grant using the Black-Scholes
option-pricing model using the following weighted-average
assumptions:
 
 Three
      months ended September 30, 2008
              
              
              Nine
      months ended
                  September
      30, 2008Expected
      life in years
              
              
              6
              
              
              
              6Risk-free
      interest rates
              
              
              3.35
              %
              
              
              3.38
              %Volatility
              
              
              146.91
              %
              
              
              146.59
              %Dividend
      yield
              
              
              0
              %
              
              
              0
              %




12




ANDREA
ELECTRONICS CORPORATION AND SUBSIDIARIES
 NOTES TO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (UNAUDITED)




The fair
values of the stock options granted for the three and nine-month periods ended
September 30, 2007 were estimated on the date of grant using the Black-Scholes
option-pricing model using the following weighted-average
assumptions:
 
 Three
      months ended September 30, 2007
              
              
              Nine
      months ended
                  September
      30, 2007Expected
      life in years
              
              
              6
              
              
              
              6Risk-free
      interest rates
              
              
              4.17
              %
              
              
              4.17
              %Volatility
              
              
              100.63
              %
              
              
              100.63
              %Dividend
      yield
              
              
              0
              %
              
              
              0
              %
 
 Option
activity during 2008 and 2007 is summarized as follows:
 
 Options
      Outstanding
              
              Options
      ExercisableOptions
                Outstanding
              
              
              Weighted
                Average
                Exercise
                Price
              
              
              Weighted
                Average
                Fair
                Value
              
              Weighted
                Average
      Remaining Contractual
                Life
              
              Options
                Exercisable
              
              
              Weighted
                Average
                Exercise
                Price
              
              
              Weighted
                Average
                Fair
                Value
              
              Weighted
      Average Remaining Contractual
                LifeAt
      January 1, 2007
              
              
              7,590,001
              
              
              $
              1.05
              
              
              $
              0.81
              
              8.01
      years
              
              
              4,397,500
              
              
              $
              1.72
              
              
              $
              1.33
              
              6.26
      yearsGranted
              
              
              2,251,819
              
              
              $
              0.11
              
              
              $
              0.09Cancelled
              
              
              (155,000
              )
              
              $
              5.20
              
              
              $
              3.98At
      December 31, 2007
              
              
              9,686,820
              
              
              $
              0.76
              
              
              $
              0.59
              
              7.79
      years
              
              
              5,355,590
              
              
              $
              1.29
              
              
              $
              1.00
              
              6.57
      yearsGranted
              
              
              5,185,000
              
              
              $
              0.04
              
              
              $
              0.04Cancelled
              
              
              (195,000
              )
              
              $
              14.28
              
              
              $
              11.65At
      September 30, 2008
              
              
              14,676,820
              
              
              $
              0.33
              
              
              $
              0.25
              
              8.14
      years
              
              
              6,628,745
              
              
              $
              0.65
              
              
              $
              0.48
              
              6.61
      years
 
 During the
three months ended September 30, 2008, 1,415,857 options vested with a weighted
average exercise price of $0.11 and a weighted average fair value of $0.10 per
option.  During the nine months ended September 30, 2008, 1,468,155
options vested with a weighted average exercise price of $0.11 and a weighted
average fair value of $0.10 per option.
 
 Based on
the September 30, 2008, fair market value of the company’s common stock of
$0.09, the aggregate intrinsic value for the 14,676,820 options outstanding and
6,628,745 shares exercisable is $354,100 and $96,850, respectively.
 
 Total
compensation expense recognized related to stock option awards was $66,871 and
$42,624 for the three months ended September 30, 2008 and 2007,
respectively.  In the accompanying consolidated statement of
operations for the three months ending September 30, 2008, $52,061 of expense is
included in general, administrative and selling expenses, $14,408 is included in
research and development expenses and $402 is included in cost of
revenues.  In the accompanying consolidated statement of operations
for the three months ending September 30, 2007, $32,953 of expense is included
in general, administrative and selling expenses, $9,616 is included in research
and development expenses and $415 is included in cost of
revenues.  Total compensation expense recognized related to stock
option awards was $173,508 and $127,819 for the nine months ended September 30,
2008 and 2007, respectively.  In the accompanying consolidated
statement of operations for the nine months ending September 30, 2008, $134,836
of expense is included in general, administrative and selling expenses, $37,508
is included in research and development expenses and $1,164 is included in cost
of revenues.  In the accompanying consolidated statement of operations
for the nine months ending September 30, 2007, $101,839 of expense is included
in general, administrative and selling expenses, $24,940 is included in research
and development expenses and $1,040 is included in cost of
revenues.
 
 As of
September 30, 2008, there was $294,100 of total unrecognized compensation cost
related to nonvested share-based compensation arrangements granted under the
1998 and 2006 Plans.  This unrecognized compensation cost is expected
to be recognized over the next 3 years ($57,486 in 2008, $166,637 in 2009,
$57,056 in 2010 and $12,921 in 2011).
 
 Pursuant
to Andrea’s compensation policy for outside directors, Andrea granted 400,000
shares of Common Stock with a fair market value of $0.05 per share in 2007 and
500,000 shares of Common Stock with a fair market value of $0.04 per share in
2008.  These stock grants were fully vested on the date of
grant.  Compensation expense related to these awards was $7,498 and
$5,834 for the three months ended September 30, 2008 and 2007,
respectively.  Compensation expense related to these awards was
$17,500 and $15,834 for the nine months ended September 30, 2008 and 2007,
respectively.
  13




ANDREA
ELECTRONICS CORPORATION AND SUBSIDIARIES
 NOTES TO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (UNAUDITED)




Note
8.                 Segment
Information
 
 Andrea
follows the provisions of SFAS No. 131, “Disclosures about Segments of an
Enterprise and Related Information.” Reportable operating segments are
determined based on Andrea’s management approach. The management approach, as
defined by SFAS No. 131, is based on the way that the chief operating
decision-maker organizes the segments within an enterprise for making operating
decisions and assessing performance. While Andrea’s results of operations are
primarily reviewed on a consolidated basis, the chief operating decision-maker
also manages the enterprise in two segments: (i) Andrea DSP Microphone and Audio
Software Products and (ii) Andrea Anti-Noise Products.  Andrea DSP
Microphone and Audio Software Products primarily include products based on the
use of some, or all, of the following technologies: Andrea Digital Super
Directional Array microphone technology (DSDA), Andrea Direction Finding and
Tracking Array microphone technology (DFTA), Andrea PureAudio noise filtering
technology, and Andrea EchoStop, an advanced acoustic echo cancellation
technology.  Andrea Anti-Noise Products include noise cancellation and
active noise cancellation computer headset products and related computer
peripheral products.
 
 The
following represents selected condensed consolidated financial information for
Andrea’s segments for the three-month periods ended September 30, 2008 and
2007:
 
 2008
      Three Month Segment Data
              
              Andrea
      DSP
                  Microphone
      and
                  Audio
      Software
                  Products
              
              
              Andrea
      Anti-
                  Noise
      Products
              
              
              Total
      2008 Three
                  Month
      Segment
                  DataNet
      revenues from external customers
              
              $
              158,045
              
              
              $
              788,530
              
              
              $
              946,575License
      Revenues
              
              
              337,382
              
              
              
              -
              
              
              
              337,382Income
      (loss) from operations
              
              
              30,428
              
              
              
              (7,170
              )
              
              
              23,258Depreciation
      and amortization
              
              
              117,803
              
              
              
              10,767
              
              
              
              128,570Purchases
      of property and equipments
              
              
              2,620
              
              
              
              13,850
              
              
              
              16,470Purchases
      of patents and trademarks
              
              
              -
              
              
              
              538
              
              
              
              538Assets
              
              
              3,765,725
              
              
              
              1,942,869
              
              
              
              5,708,594Total
      long lived assets
              
              
              2,509,052
              
              
              
              229,775
              
              
              
              2,738,8272007
      Three Month Segment Data
              
              Andrea
      DSP
                  Microphone
      and
                  Audio
      Software
                  Products
              
              
              Andrea
      Anti-
                  Noise
      Products
              
              
              Total
      2007 Three
                  Month
      Segment
                  DataNet
      revenues from external customers
              
              $
              531,621
              
              
              $
              428,342
              
              
              $
              959,963License
      Revenues
              
              
              89,952
              
              
              
              -
              
              
              
              89,952Loss
      from operations
              
              
              134,811
              
              
              
              61,839
              
              
              
              196,650Depreciation
      and amortization
              
              
              117,082
              
              
              
              4,718
              
              
              
              121,800Purchases
      of patents and trademarks
              
              
              110
              
              
              
              1,350
              
              
              
              1,460
 
 
 The
following represents selected condensed consolidated financial information for
Andrea’s segments for the nine-month periods ended September 30, 2008 and
2007:
 
 2008
      Nine Month Segment Data
              
              Andrea
      DSP
                  Microphone
      and
                  Audio
      Software
                  Products
              
              
              Andrea
      Anti-
                  Noise
      Products
              
              
              Total
      2008 Nine
                  Month
      Segment
                  DataNet
      revenues from external customers
              
              $
              620,254
              
              
              $
              1,939,879
              
              
              $
              2,560,133License
      Revenues
              
              
              857,715
              
              
              
              -
              
              
              
              857,715Loss
      from operations
              
              
              (162,028
              )
              
              
              (185,732
              )
              
              
              (347,760
              )Depreciation
      and amortization
              
              
              352,691
              
              
              
              27,534
              
              
              
              380,225Purchases
      of property and equipments
              
              
              8,616
              
              
              
              26,896
              
              
              
              35,512Purchases
      of patents and trademarks
              
              
              6,155
              
              
              
              29,097
              
              
              
              35,2522007
      Nine Month Segment Data
              
              Andrea
      DSP
                  Microphone
      and
                  Audio
      Software
                  Products
              
              
              Andrea
      Anti-
                  Noise
      Products
              
              
              Total
      2007 Nine
                  Month
      Segment
                  DataNet
      revenues from external customers
              
              $
              1,327,706
              
              
              $
              1,799,372
              
              
              $
              3,127,078License
      Revenues
              
              
              497,853
              
              
              
              -
              
              
              
              497,853Loss
      from operations
              
              
              245,115
              
              
              
              42,130
              
              
              
              287,245Depreciation
      and amortization
              
              
              351,407
              
              
              
              14,093
              
              
              
              365,500Purchases
      of patents and trademarks
              
              
              620
              
              
              
              7,110
              
              
              
              7,730




14




ANDREA
ELECTRONICS CORPORATION AND SUBSIDIARIES
 NOTES TO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (UNAUDITED)




The
following represents selected condensed consolidated financial information for
Andrea’s segments as of December 31, 2007.
 
 2007
      Year End Segment Data
              
              Andrea
      DSP
                  Microphone
      and
                  Audio
      Software
                  Products
              
              
              Andrea
      Anti-
                  Noise
      Products
              
              
              Total
      2007Assets
              
              
              4,021,688
              
              
              
              1,611,318
              
              
              
              5,633,006Total
      long lived assets
              
              
              2,858,713
              
              
              
              189,575
              
              
              
              3,048,288
 
 Management
assesses non-operating income statement data on a consolidated basis
only.  International revenues are based on the country in which the
end-user is located.  For the three-month periods ended September 30,
2008 and 2007, and as of each respective period-end, net revenues and accounts
receivable by geographic area are as follows:
 
 Geographic
      Data
              
              September
      30,
                  2008
              
              
              September
      30,
                  2007Net
      revenues:United States
              
              $
              1,208,992
              
              
              $
              596,271Foreign(1)
              
              
              74,965
              
              
              
              453,644$
              1,283,957
              
              
              $
              1,049,915
  (1)
              Net
      revenues to any one foreign country did not exceed 10% of total net
      revenues for the three months ended September 30, 2008.  Net
      revenue to the People’s Republic of China and Singapore represented 17%
      and 4%, respectively of total net revenues for three months ended
      September 30, 2007.
  For the
nine-month periods ended September 30, 2008 and 2007, by geographic area, net
revenues are as follows:
 
 Geographic
      Data
              
              September
      30,
                  2008
              
              
              September
      30,
                  2007Net
      revenues:United States
              
              $
              2,967,763
              
              
              $
              2,434,017Foreign(2)
              
              
              450,085
              
              
              
              1,190,914$
              3,417,848
              
              
              $
              3,624,931
  (2)
              Net
      revenues to any one foreign country did not exceed 10% of total net
      revenues for the nine months ended September 30, 2008.  Net
      revenue to the People’s Republic of China and Singapore represented 15%
      and 9%, respectively of total net revenues for nine months ended September
      30, 2007.
  As of
September 30, 2008 and December 31, 2007, accounts receivable by geographic area
is as follows:
 
 Geographic
      Data
              
              September
      30,
                  2008
              
              
              December
      31,
                  2007Accounts
      receivable:United States
              
              $
              712,771
              
              
              $
              736,122Foreign
              
              
              14,296
              
              
              
              258,324$
              727,067
              
              
              $
              994,446
 
 15




ITEM
      2.
              MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDIDTION AND RESULTS OF
      OPERATIONS




Overview
 
 Our
mission is to provide the emerging “voice interface” markets with
state-of-the-art communications products that facilitate natural language,
human/machine interfaces.
 
 Examples
of the applications and interfaces for which Andrea DSP Microphone and Audio
Software Products and Andrea Anti-Noise Products provide benefit include:
Internet and other computer-based speech; telephony communications; multi-point
conferencing; speech recognition; multimedia; multi-player Internet and CD ROM
interactive games; and other applications and interfaces that incorporate
natural language processing. We believe that end users of these applications and
interfaces will require high quality microphone and earphone products that
enhance voice transmission, particularly in noisy environments, for use with
personal computers, mobile personal computing devises, cellular and other
wireless communication devices and automotive communication systems. Our Andrea
DSP Microphone and Audio Software Products use “far-field” digital signal
processing technology to provide high quality transmission of voice where the
user is at a distance from the microphone. High quality audio communication
technologies will be required for emerging far-field voice applications, ranging
from continuous speech dictation, to Internet telephony and multiparty video
teleconferencing and collaboration, to natural language-driven interfaces for
automobiles, home and office automation and other machines and devices into
which voice-controlled microprocessors are expected to be introduced during the
next several years.
 
 We
outsource to Asia high volume assembly for most of our products from purchased
components.  We assemble some low volume Andrea DSP Microphone and
Audio Software Products from purchased components. As sales of any particular
Andrea DSP Microphone and Audio Software Product increases, assembly operations
are transferred to a subcontractor in Asia.
 
 Our
Critical Accounting Policies
 
 Our
unaudited condensed consolidated financial statements and the notes to our
unaudited condensed consolidated financial statements contain information that
is pertinent to management's discussion and analysis.  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
disclosures of contingent assets and liabilities.  Management bases
its estimates on historical experience and on various other assumptions that are
believed to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources.  On a continual
basis, management reviews its estimates utilizing currently available
information, changes in facts and circumstances, historical experience and
reasonable assumptions.  After such reviews, and if deemed
appropriate, those estimates are adjusted accordingly.  Actual results
may vary from these estimates and assumptions under different and/or future
circumstances.  Our significant accounting policies are described in
Note 2 of the Notes to Consolidated Financial Statements included in our Annual
Report on Form 10-KSB for the year ended December 31, 2007.  A
discussion of our critical accounting policies and estimates are included in
Management’s Discussion and Analysis or Plan of Operation in our Annual Report
on Form 10-KSB for the year ended December 31, 2007. Management has discussed
the development and selection of these policies with the Audit Committee of the
Company’s Board of Directors, and the Audit Committee of the Board of Directors
has reviewed the Company’s disclosures of these policies.  There have
been no material changes to the critical accounting policies or estimates
reported in the Management’s Discussion and Analysis section of the 10-KSB for
the year ended December 31, 2007 as filed with the Securities and Exchange
Commission.
 
 Cautionary
Statement Regarding Forward-Looking Statements
 
 This
report contains forward-looking statements that are based on assumptions and may
describe future plans, strategies and expectations of the
Company.  These forward-looking statements are generally identified by
use of the words “believe”, “expect”, “intend”, “anticipate”, “estimate”,
“project” or similar expressions.  The Company’s ability to predict
results or the actual effect of future plans or strategies is inherently
uncertain. Factors which could have a material adverse effect on the operations
of the Company and its subsidiaries include, but are not limited to, changes in
economic, competitive, governmental, technological and other factors that may
affect our business and prospects.  Additional factors are discussed
below under “Risk Factors” and in Part II, “Item 6. Management’s Discussion and
Analysis or Plan of Operation—Risk Factors” in the Company’s Annual
Report on Form 10-KSB for the year ended December 31, 2007.  These
risks and uncertainties should be considered in evaluating forward-looking
statements and undue reliance should not be placed on such
statements.  Except as required by applicable law or regulation, the
Company does not undertake, and specifically disclaims any obligation, to
release publicly the result of any revisions that may be made to any
forward-looking statements to reflect events or circumstances after the date of
the statements or to reflect the occurrence of anticipated or unanticipated
events.
 
 16
  Risk
Factors
 
 Our
operating results are subject to significant fluctuation, period-to-period
comparisons of our operating results may not necessarily be meaningful and you
should not rely on them as indications of our future performance.
 
 Our
results of operations have historically been and are subject to continued
substantial annual and quarterly fluctuations. The causes of these fluctuations
include, among other things:
 
 –
              the
      volume of sales of our products under our collaborative marketing
      arrangements;
  –
              the
      cost of development of our
products;
  –
              the
      mix of products we sell;
  –
              the
      mix of distribution channels we
use;
  –
              the
      timing of our new product releases and those of our
      competitors;
  –
              fluctuations
      in the computer and communications hardware and software
      marketplace;
  –
              general
      economic conditions.
 
 We cannot
assure that the level of revenues and gross profit, if any, that we achieve in
any particular fiscal period will not be significantly lower than in other
fiscal periods.  Our net revenues for the three months ended September
30, 2008 were $1,283,957 versus $1,049,915 for the three months ended September
30, 2007.  Net income for the three months ended September 30, 2008
was $25,289, or $0.00 income per share on a basic and diluted basis, versus net
loss of $194,569, or $0.00 loss per share on a basic and diluted basis for the
three months ended September 30, 2008. Our revenues for the nine months ended
September 30, 2008 were $3,417,848 versus $3,624,931 for the nine months ended
September 30, 2007.  Net loss for the nine months ended September 30,
2008 was $344,874 or $.01 loss per share on a basic and diluted basis, versus
net loss of $313,214, or $.01 loss per share on a basic and diluted basis for
the nine months ended September 30, 2007. We continue to explore opportunities
to grow sales in other business areas; we are also examining additional
opportunities for cost reduction, production efficiencies and further
diversification of our business.  Although we have improved cash flows
by reducing overall expenses, if our revenues decline we may not continue to
generate positive cash flows and our operating results may be
affected.
 
 If
we fail to obtain additional capital or maintain access to funds sufficient to
meet our operating needs, we may be required to significantly reduce, sell, or
refocus our operations and our business, results of operations and financial
condition could be materially and adversely effected.
 
 In order
to be a viable entity we need to maintain and increase profitable
operations.  To achieve profitable operations we need to
maintain/increase current net revenues and continue to look for ways to control
expenses.  We might also need to sell additional assets or raise
capital as a means of funding continued operations.  We may have to
raise capital from external sources.  These sources may include
private or public financings through the issuance of debt, convertible debt or
equity, or collaborative arrangements.  Such additional capital and
funding may not be available on favorable terms, if at
all.  Additionally, we may only be able to obtain additional capital
or funds through arrangements that require us to relinquish rights to our
products, technologies or potential markets, in whole or in part, or result in
our sale.  As a result of past few years of performance, we believe
that we have sufficient liquidity to continue our operations at least through
September 2009, provided our net revenues do not continue to decline and our
operating expenses do not continue to increase.  Although we have
revised our business strategies to reduce our expenses and capital expenditures,
we cannot assure you that we will be successful in generating positive cash
flows or obtaining access to additional sources of funding in amounts necessary
to continue our operations.  Failure to maintain sufficient access to
funding may also result in our inability to continue operations.
 
 Shares
Eligible For Future Sale May Have An Adverse Effect On Market Price and Andrea
Shareholders May Experience Substantial Dilution.
 
 Sales of a
substantial number of shares of our common stock in the public market could have
the effect of depressing the prevailing market price of our common
stock.  Of the 200,000,000 shares of common stock presently
authorized, 60,406,945 were outstanding as of November 10, 2008. The number of
shares outstanding does not include an aggregate of 28,811,925 shares of common
stock that are issuable.  This number of issuable common shares is
equal to approximately 48% of the 60,406,945 outstanding
shares.  These issuable common shares are comprised
of:  a)14,676,820 shares of our common stock reserved for issuance
upon exercise of outstanding awards granted under our 1991 Performance Equity
Plan, 1998 Stock Plan and 2006 Stock Plan; b) 101,345 shares reserved for future
grants under our 2006 Stock Plan; c) 4,103,984 shares of common stock that are
issuable upon conversion of the Series C Preferred Stock; d) 4,771,432 shares of
common stock issuable upon conversion of the Series D Preferred Stock; and e)
5,158,344 of common stock issuable upon exercise of warrants relating to the
Series D Preferred stock.
 
 17
  Changes
in economic and political conditions outside the United States could adversely
affect our business, results of operations and financial condition.
 
 We
generate revenues to regions outside the United States, particularly in Asia.
For the three months ended September 30, 2008 and 2007, net revenues to
customers outside the United States accounted for approximately 6% and 43%,
respectively, of our net revenues. For the nine months ended September 30, 2008
and 2007, net revenues to customers outside the United States accounted for
approximately 13% and 33%, respectively, of our net sales. International sales
and operations are subject to a number of risks, including:
  •           trade
restrictions in the form of license requirements;
  •           restrictions
on exports and imports and other government controls;
  •           changes
in tariffs and taxes;
  •           difficulties
in staffing and managing international operations;
  •           problems
in establishing and managing distributor relationships;
  •           general
economic conditions; and
  •           political
and economic instability or conflict.
  To date,
we have invoiced our international revenues in U.S. dollars, and have not
engaged in any foreign exchange or hedging transactions. We may not be able to
continue to invoice all of our revenues in U.S. dollars in order to avoid
engaging in foreign exchange or hedging transactions. If we are required to
invoice any material amount of international revenues in non-U.S. currencies,
fluctuations in the value of non-U.S. currencies relative to the U.S. dollar may
adversely affect our business, results of operations and financial condition or
require us to incur hedging costs to counter such fluctuations.
  In
addition to the risk factors set forth above and the other information set forth
in this report, you should carefully consider the factors discussed in Part II,
“Item 6. Management’s
Discussion and Analysis or Plan of Operation—Risk Factors” in the
Company’s Annual Report on Form 10-KSB for the year ended December 31, 2007,
which could materially affect our business, financial condition or future
results. The risks described in this report and in our Annual Report on Form
10-KSB are not the only risks that we face. Additional risks and uncertainties
not currently known to us or that we currently deem to be immaterial also may
materially adversely affect our business, financial condition and/or operating
results.
 
 Results
Of Operations
 
 Quarter
ended September 30, 2008 compared to Quarter ended September 30,
2007
 
 Net
Revenues
  For
      the Three Months
                  Ended
      September 30
                
                
                %
                
                
                For
      the Nine Months
                  Ended
      September 30
                
                
                %2008
                
                
                
                2007
                
                
                
                Change
                
                
                
                2008
                
                
                
                2007
                
                
                
                ChangeAndrea
      Anti-Noise Products net product revenuesSales
      of products to an OEM customer for use with speech recognition
      software
                
                $
                190,143
                
                
                $
                -
                
                
                
                100
                
                
                $
                313,243
                
                
                $
                139,821
                
                
                
                124
                
                (a)Sales
      of gaming headset products to an OEM customer
                
                $
                -
                
                
                $
                -
                
                
                
                -
                
                
                $
                -
                
                
                $
                183,261
                
                
                
                (100
                )
                (a)All
      other Andrea Anti-Noise net product revenues
                
                
                598,387
                
                
                
                428,342
                
                
                
                40
                
                
                
                1,626,636
                
                
                
                1,476,290
                
                
                
                10
                
                (b)Total
      Andrea Anti-Noise Products net product revenues
                
                $
                788,530
                
                
                $
                428,342
                
                
                
                84
                
                
                $
                1,939,879
                
                
                $
                1,799,372
                
                
                
                8Andrea
      DSP Microphone and Audio Software Products revenuesSales
      of array microphone products to an OEM customer
                
                
                -
                
                
                
                359,357
                
                
                
                (100
                )
                
                
                107,800
                
                
                
                731,467
                
                
                
                (85
                )
                (c)All
      other Andrea DSP Microphone and Audio product revenues
                
                
                158,045
                
                
                
                172,264
                
                
                
                (8
                )
                
                
                512,454
                
                
                
                596,239
                
                
                
                (14
                )
                (d)License
      revenues
                
                
                337,382
                
                
                
                89,952
                
                
                
                275
                
                
                
                857,715
                
                
                
                497,853
                
                
                
                72
                
                (e)Total
      Andrea DSP Microphone and Audio Software Products revenues
                
                
                495,427
                
                
                
                621,573
                
                
                
                (20
                )
                
                
                1,477,969
                
                
                
                1,825,559
                
                
                
                (19
                )Total
      Revenues
                
                $
                1,283,957
                
                
                $
                1,049,915
                
                
                
                22
                
                
                $
                3,417,848
                
                
                $
                3,624,931
                
                
                
                (6
                )
 18
  (a)
              The
      significant increase of revenues of Andrea Anti-Noise Products is directly
      related to an Original Equipment Manufacturer (“OEM”) customer for use
      with speech recognition software and was a result of the OEM’s increased
      demand for our products associated with the timing of the launch of the
      OEMs updated software during the three and nine months ended September 30,
      2008 as compared to the same periods in 2007.  We believe that
      our annual revenues for 2008 and 2009 associated with this customer will
      be approximately $313,000 and $250,000,
  respectively.
  (b)
              The
      40% and 10% increases for the nine months and three months ended September
      30, 2008, respectively, of all other Andrea Anti-Noise net product
      revenues is associated with increased sales of products to educational
      customers for use with their distance learning
      products.
  (c)
              The
      significant decreases of revenues of microphone array products to an
      OEM customer for the three month and nine month periods ending September
      30, 2008, relates to the decreased demand from the OEM
      customer.  We believe that this decrease is result of the OEM
      deciding not to continue including a microphone array with all applicable
      product models.  The revenues in 2007 were a result of the OEM’s
      introduction of the OEM’s product and the OEM customers’ need to supply
      all of its customers for the initial launch.
  (d)
              The
      8% and 14% decrease in all other Andrea DSP Microphone and Audio product
      revenues for the three and nine month periods ended September 30, 2008,
      respectively, are a result of a decreased demand for our in-vehicle auto
      array.  We believe the decline is resulting to the decline of
      government funding for these types of
  products.
  (e)
              The
      majority of the increase in licensing revenues for the three and nine
      month periods ended September 30, 2008 is a result of licensing revenue
      from two customer in the PC Audio market.  The increase for the
      three month period was a result of these customers launch of PC’s
      utilizing Intel’s new platform.  The increase for the nine-month
      period is a result of one licensing customer’s initial implementation of
      our technology.  We expect our licensing revenues for 2008 and
      2009 to be approximately
$1,100,000.
  
 Cost of
Revenues
 
 Cost of
revenues as a percentage of net revenues for the three months ended September
30, 2008 decreased to 41% from 54% for the three months ended September 30,
2007.  The cost of revenues as a percentage of net revenues for the
three months ended September 30, 2008 for Andrea Anti-Noise Products is 61%
compared to 54% for the three months ended September 30, 2007.  The
cost of revenues as a percentage of net revenues for the three months ended
September 30, 2008 for Andrea DSP Microphone and Audio Software Products is 10%
compared to 54% for the three months ended September 30, 2007. Cost of
revenues as a percentage of net revenues for the nine months ended September 30,
2008 decreased to 44% from 50% for the nine months ended September 30,
2007.  The cost of revenues as a percentage of net revenues for the
nine months ended September 30, 2008 for Andrea Anti-Noise Products is 62%
compared to 58% for the nine months ended September 30, 2007.  The
cost of revenues as a percentage of net revenues for the nine months ended
September 30, 2008 for Andrea DSP Microphone and Audio Software Products is 19%
compared to 43% for the nine months ended September 30, 2007. The changes are
primarily the result of the changes in revenue as described under “Net Revenues”
above.  Specifically the increase in cost of revenues as a percentage
of revenues for the Andrea Anti-Noise Products is a result of high volume low
margin sales to an OEM customer.  The decrease in cost of revenues as
a percentage of revenues for the Andrea DSP Microphone and Audio Software is the
result of the increase in license revenues partially offset by the decrease in
the revenues of high volume low margin microphone array products to an OEM
customer.
 
 Research and
Development
 
 Research
and development expenses for the three months ended September 30, 2008 increased
3% to $179,062 from $173,895 for the three months ended September 30,
2007.  This small increase primarily relates to increases in
employee related benefit costs.  For the three months ended September
30, 2008, the increase in research and development expenses reflects a 6%
decrease in our Andrea DSP Microphone and Audio Software Technology efforts to
$117,670, or 66% of total research and development expenses and a 25% increase
in our Andrea Anti-Noise Headset Product efforts to $61,392, or 34% of total
research and development expenses. Research and development expenses for
the nine months ended September 30, 2008 increased 11% to $557,807 from $502,755
for the nine months ended September 30, 2007.  This increase primarily
relates to increases in employee compensation and related benefit
costs.  For the nine months ended September 30, 2008, the increase in
research and development expenses reflects a 4% increase in our Andrea DSP
Microphone and Audio Software Technology efforts to $376,240, or 67% of total
research and development expenses and a 29% increase in our Andrea Anti-Noise
Headset Product efforts to $181,567, or 33% of total research and development
expenses.  With respect to DSP Microphone and Audio Software
technologies, research efforts are primarily focused on the pursuit of
commercializing a natural language-driven human/machine interface by developing
optimal far-field microphone solutions for various voice-driven interfaces,
incorporating Andrea’s digital super directional array microphone technology,
and certain other related technologies such as noise suppression and stereo
acoustic echo cancellation.  We believe that continued research and
development spending should provide Andrea with a competitive
advantage.
 
 General, Administrative and
Selling Expenses
 
 General,
administrative and selling expenses increased approximately 9% to $555,326 for
the three months ended September 30, 2008 from $507,503 for the three
months ended September 30, 2007.  For the three months ended September
30, 2008, the increase reflects a less than 1% increase in our Andrea DSP
Microphone and Audio Software Technology efforts to $298,964, or 54% of total
general, administrative and selling expenses and a 23% increase in our Andrea
Anti-Noise Headset Product efforts to $256,362, or 46% of total general,
administrative and selling expenses. General, administrative and selling
expenses increased approximately 8% to $1,721,773 for the nine months ended
September 30, 2008 from $1,587,335 for the nine months ended September 30,
2007.  For the nine months ended September 30, 2008, the increase
reflects an 6% increase in our Andrea DSP Microphone and Audio Software
Technology efforts to $980,414, or 57% of total general, administrative and
selling expenses and a 12% increase in our Andrea Anti-Noise Headset Product
efforts to $741,359, or 43% of total general, administrative and selling
expenses. These increases relate to increases in sales and marketing
efforts as well as to increases in employee compensation and related benefit
costs.
 
 19
  Interest income,
net
 
 Interest
income, net for the three months ended September 30, 2008 was $2,031 compared to
$3,967 for the three months ended September 30, 2007. Interest income, net for
the nine months ended September 30, 2008 was $6,602 compared to $4,371 for the
nine months ended September 30, 2007.
 
 Provision for Income
Taxes
 
 The
provision for income taxes is a result of certain licensing revenues that are
subject to withholding of income tax as mandated by the foreign jurisdiction in
which the revenues are earned.  Amounts are based on net revenues and
are therefore subject to change.
 
 Net income
(loss)
 
 Net income
for the three months ended September 30, 2008 was $25,289 compared to a net loss
of $194,569 for the three months ended September 30, 2007. Net loss for the
nine months ended September 30, 2008 was $344,874 compared to a net loss of
$313,214 for the nine months ended September 30, 2007.  The net income
(loss) for the three and nine month periods ended September 30, 2008 and the net
loss for the three months and nine months ended September 30, 2007 principally
reflects the factors described above.
 
 Off-Balance Sheet
Arrangements
 
 The
Company has no off-balance sheet arrangements that have or are reasonably likely
to have a current or future effect on its financial condition, changes in
financial condition, revenues or expenses, results of operations, liquidity,
capital expenditures or capital resources that are material to
investors.
 
 Liquidity
And Capital Resources
 
 Andrea’s
principal sources of funds are and are expected to continue to be gross cash
flows from operations.  At September 30, 2008, we had cash and cash
equivalents of $1,156,518 compared with $811,403 at December 31,
2007.  The balance of cash and cash equivalents at September 30, 2008
is primarily a result of our cash provided from operations during the nine
months ended September 30, 2008.
 
 Working
capital balance at September 30, 2008 was $1,993,116 compared to a working
capital balance of $1,837,521 at December 31, 2007.  The increase in
working capital reflects an increase in total current assets of $385,049 coupled
with an increase in total current liabilities of $229,454. The increase in total
current assets reflects an increase in cash and cash equivalents of $345,115, a
decrease in accounts receivable of $267,379, an increase in inventory of
$293,581, and an increase in prepaid expenses and other current assets of
$13,372.  The increase in total current liabilities reflects an
increase in trade accounts payable of $165,382, and an increase of $64,072 in
other current liabilities. The increase in cash and cash equivalents of $345,115
reflects $415,879 of net cash provided by operating activities, and $70,764 of
net cash used in investing activities.
 
 The cash
provided by operating activities of $415,879, excluding non-cash charges for the
quarter ended September 30, 2008, is attributable to a $267,379 decrease in
accounts receivable, a $320,103 increase in inventory, a $13,732 increase in
prepaid expenses and other current assets, a $165,382 increase in accounts
payable, and a $64,072 increase in other current liabilities.  The
changes in receivables, inventory and accounts payable primarily reflect
differences in the timing related to both the payments for and the acquisition
of inventory as well as for other services in connection with ongoing efforts
related to Andrea’s various product lines.
 
 The cash
used by investing activities of $70,764 reflects an increase in property and
equipment of $35,512 and an increase in patents and trademarks of
$35,252.  The increase in property and equipment reflects capital
expenditures associated with computer purchases and tooling for some of new
products.  The increase in patents and trademarks reflects capital
expenditures associated with our intellectual property.
 
 We plan to
continue to improve our cash flows during 2008 by aggressively pursuing
additional licensing opportunities related to our Andrea DSP Audio Software and
increasing our Andrea Anti-Noise Headset Products through the introduction of
refreshed product line scheduled to be introduced in the second half of 2008 as
well as the increased efforts we are putting into our sales and marketing
efforts.  However, there can be no assurance that we will be able to
successfully execute the aforementioned plans.  As of November 10,
2008, Andrea has approximately $1,200,000 of cash and cash
equivalents.  We believe that we have sufficient liquidity available
to continue in operation through at least September 2009.  To the
extent that we do not generate sufficient cash flows from our operations in the
next twelve months, additional financing might be required.  Although
we have improved cash flows by reducing overall expenses, if our revenues
decline, these reductions may impede our ability to be cash flow positive and
our net income or loss may be disproportionately affected.  We have no
commitment for additional financing and may experience difficulty in obtaining
additional financing on favorable terms, if at all.  Any financing we
obtain may contain covenants that restrict our freedom to operate our business
or may have rights, preferences or privileges senior to our common stock and may
dilute our current shareholders’ ownership interest in Andrea. We cannot assure
that demand will continue for any of our products, including future products
related to our Andrea DSP Microphone and Audio Software technologies, or, that
if such demand does exist, that we will be able to obtain the necessary working
capital to increase production and provide marketing resources to meet such
demand on favorable terms, or at all.
  20
  Recently Issued Accounting
Pronouncements
 
 For a
discussion of the impact of recent accounting pronouncements, see Note 2 of the
accompanying condensed consolidated financial statements.
 
 ITEM
3.                      QUANTITATIVE
AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
  Not
Applicable.
 
 ITEM
4.                      CONTROLS
AND PROCEDURES
  Andrea’s
management, including its principal executive officer and principal financial
officer, have evaluated the effectiveness of the Company’s “disclosure controls
and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the
Securities Exchange Act of 1934, as amended, (the “Exchange Act”). Based upon
their evaluation, the principal executive officer and principal financial
officer concluded that, as of the end of the period covered by this report,
Andrea’s disclosure controls and procedures were effective for the purpose of
ensuring that the information required to be disclosed in the reports that it
files or submits under the Exchange Act with the Securities and Exchange
Commission (the “SEC”) (1) is recorded, processed, summarized and reported
within the time periods specified in the SEC’s rules and forms, and (2) is
accumulated and communicated to Andrea’s management, including its principal
executive and principal financial officers, as appropriate to allow timely
decisions regarding required disclosure.
  Limitations on the
Effectiveness of Controls
  A control
system, no matter how well conceived and operated, can provide only reasonable,
not absolute, assurance that all control issues and instance of fraud, if any,
within a company have been detected.  Andrea’s disclosure controls and
procedures are designed to provide reasonable assurance of achieving its
objectives.
  There have
been no changes in the Company’s internal controls over financial reporting
during the period covered by this Quarterly Report that have materially
affected, or are reasonable likely to materially affect the Company’s internal
controls over financial reporting.
  PART
II                      OTHER
INFORMATION
  ITEM
1.                      LEGAL
PROCEEDINGS
  None.
  ITEM
1A.                           RISK
FACTORS
  Not
Applicable.
  ITEM
2.                      UNREGISTERED
SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
  None.
  ITEM
3.                      DEFAULTS
UPON SENIOR SECURITIES
  None.
  ITEM
4.                      SUBMISSION
OF MATTERS TO A VOTE OF SECURITIES HOLDERS
  None
  ITEM
5.                      OTHER
INFORMATION
  On
November 11, 2008, the Company entered into an employment agreement with the
Chairman of the Board, President, Chief Executive Officer and Corporate
Secretary of the Company, Douglas J Andrea.  The effective date of the
employment agreement is August 1, 2008 and expires July 31, 2010 and is subject
to renewal as approved by the Compensation Committee of the Board of
Directors.  Pursuant to his employment agreement, Mr. Andrea will
receive an annual base salary of $312,500 through July 31, 2009 and for the
period of August 1, 2009 through July 31, 2010, Mr. Andrea’s will receive an
annual base salary of $325,000.  The employment agreement provides for
quarterly bonuses equal to 25% of the Company’s pre-bonus net after tax
quarterly earnings in excess of $25,000 for a total quarterly bonus amount not
to exceed $12,500; and annual bonuses equal to 10% of the Company’s annual
pre-bonus net after tax earnings in excess of $300,000.  All bonuses
shall be payable as soon as the Company's cash flow permits.  All
bonus determinations or any additional bonus in excess of the above will be made
in the sole discretion of the Compensation Committee. On August 8, 2008, the
Board granted Mr. Andrea 2,000,000 stock options and 1,000,000 stock options
with an aggregate fair value of $120,000 (fair value was estimated using the
Black-Scholes option-pricing model).  The 2,000,000 grant vests in
three equal annual installments over a three year period commencing August 1,
2009.  The 1,000,000 grant vests in three equal annual installments
over a three year period commencing August 1, 2010.  All stock options
granted have an exercise price of $0.04 per share, which was fair market value
at the date of grant, and a term of 10 years.  Pursuant to the
employment agreement and subject to the approval of the Board, the Compensation
Committee will recommend a second grant of 1,000,000 stock options as soon as
practical after August 1, 2009, with an exercise price equal to the per share
fair market value of the Company’s common stock on the date of
grant.  Mr. Andrea is also entitled to a change in control payment
equal to two times his salary with continuation of health and medical benefits
for two years in the event of a change in control.
  21
  On
November 11, 2008, the Company entered into an amended and restated change in
control agreement with Corisa Guiffre, Vice President, Chief Financial Officer
and Assistant Corporate Secretary of the Company. The change in control
agreement provides Ms. Guiffre with a severance benefit upon termination in
connection with a change in control (as defined in the agreement).  If
Ms. Guiffre is terminated following a change in control, the Company will pay
Ms. Guiffre a sum equal to three times Ms. Guiffre’s average annual compensation
for the five preceding taxable years.  All restrictions on any
restricted stock will lapse immediately and incentive stock options and stock
appreciation rights, if any, will become immediately exercisable in the event of
a change in control. Upon the occurrence of a change in control followed by Ms.
Guiffre’s termination of employment, the Company will cause to be continued
life, medical, dental and disability coverage. Such coverage and payments shall
cease upon the expiration of 36 full calendar months following the date of
termination..
  ITEM
6.                      EXHIBITS
  a)
              Exhibits
  Exhibit
      10.1 –
                Employment
      Agreement, dated as of November 11, 2008, by and between Andrea
      Electronics Corporation and Douglas J. Andrea*Exhibit
      10.2 –
                Change
      in Control Agreement, dated as of November 11, 2008, by and between Andrea
      Electronics Corporation and Corisa L. Guiffre*Exhibit
      31   –
                Rule
      13a-14(a)/15d-14(a) Certifications*Exhibit
      32   –
                Section
      1350 Certifications**
      Filed herewith
   SIGNATURES
  Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
  ANDREA
      ELECTRONICS CORPORATIONBy:
              /s/    DOUGLAS
      J. ANDREAName:Douglas J.
      AndreaTitle:Chairman of the Board,
      President, Chief
                Executive Officer and Corporate
      Secretary
 
   Date:
      November 14, 2008/s/    DOUGLAS
      J. ANDREA
              Chairman
      of the Board, President, Chief
              November
      14, 2008Douglas
      J. Andrea
              Executive
      Officer and Corporate Secretary/s/    CORISA
      L. GUIFFRE
              Vice
      President, Chief Financial Officer and
              November
      14, 2008Corisa
      L. Guiffre
              Assistant
      Corporate Secretary




22