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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-QSB



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(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, 2004



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



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ANDREA ELECTRONICS CORPORATION

(Exact name of small business issuer as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|New York                                                       |  | 11-0482020                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. employer identification no.)
|                                                               | 
|45 Melville Park Road, Melville, New York                      |  | 11747                               
|(Address of principal executive offices)                       |  | (Zip Code)                          



Issuers
telephone number, including area code: 631-719-1800



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Check whether the issuer (1) filed all reports required to by filed by Section 13 or 15(d) of the Exchange Act during the past 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 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, 2004, there are 54,268,149 common shares outstanding.



Transitional Small Business Disclosure format (check one)    Yes ̈No  x



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PART I. FINANCIAL INFORMATION



ITEM 1. FINANCIAL STATEMENTS



ANDREA ELECTRONICS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS



|                                                                                                                                                                                                                              |  |                                |             |   |                            |   |             |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------ | ----------- | - | -------------------------- | - | ----------- | -
|                                                                                                                                                                                                                              |  | September 30, 2004 (unaudited) |             |   | December 31,2003 (audited) |  
|ASSETS                                                                                                                                                                                                                        |  |                                |             |   |                            |   |             |  
|Current Assets                                                                                                                                                                                                                |  |                                |             |   |                            |   |             |  
|Cash and cash equivalents                                                                                                                                                                                                     |  | $                              | 761,326     |   |                            | $ | 1,725,041   |  
|Short-term investments                                                                                                                                                                                                        |  |                                | 600,000     |   |                            |   |            |  
|Accounts receivable, net of allowance for doubtful accounts of $23,706 and $56,697, respectively                                                                                                                              |  |                                | 445,650     |   |                            |   | 611,422     |  
|Note receivable                                                                                                                                                                                                               |  |                                |            |   |                            |   | 354,986     |  
|Inventories, net                                                                                                                                                                                                              |  |                                | 1,167,611   |   |                            |   | 1,301,791   |  
|Prepaid expenses and other current assets                                                                                                                                                                                     |  |                                | 532,575     |   |                            |   | 181,018     |  
|                                                                                                                                                                                                                              |  |                                |             |   |                            |   |             |  
|Total current assets                                                                                                                                                                                                          |  |                                | 3,507,162   |   |                            |   | 4,174,258   |  
|                                                                                                                                                                                                                              |  |                               
|Property and equipment, net                                                                                                                                                                                                   |  |                                | 139,335     |   |                            |   | 219,182     |  
|Intangible assets, net                                                                                                                                                                                                        |  |                                | 4,461,832   |   |                            |   | 4,805,630   |  
|Other assets, net                                                                                                                                                                                                             |  |                                | 258,678     |   |                            |   | 268,090     |  
|                                                                                                                                                                                                                              |  |                                |             |   |                            |   |             |  
|Total assets                                                                                                                                                                                                                  |  | $                              | 8,367,007   |   |                            | $ | 9,467,160   |  
|                                                                                                                                                                                                                              |  |                                |             |   |                            |   |             |  
|LIABILITIES AND SHAREHOLDERS EQUITY (DEFICIENCY)                                                                                                                                                                             |  |                                |             |   |                            |   |             |  
|Current Liabilities:                                                                                                                                                                                                          |  |                                |             |   |                            |   |             |  
|Trade accounts payable                                                                                                                                                                                                        |  | $                              | 395,649     |   |                            | $ | 731,092     |  
|Current portion of long-term debt                                                                                                                                                                                             |  |                                | 1,161       |   |                            |   | 16,527      |  
|Accrued restructuring charges                                                                                                                                                                                                 |  |                                |            |   |                            |   | 238,391     |  
|Deferred revenue                                                                                                                                                                                                              |  |                                | 1,154,954   |   |                            |   | 1,666,680   |  
|Other current liabilities                                                                                                                                                                                                     |  |                                | 780,785     |   |                            |   | 1,714,439   |  
|                                                                                                                                                                                                                              |  |                                |             |   |                            |   |             |  
|Total current liabilities                                                                                                                                                                                                     |  |                                | 2,332,549   |   |                            |   | 4,367,129   |  
|                                                                                                                                                                                                                              |  |                               
|Deferred revenue                                                                                                                                                                                                              |  |                                |            |   |                            |   | 713,284     |  
|Other liabilities                                                                                                                                                                                                             |  |                                | 230,361     |   |                            |   | 238,671     |  
|                                                                                                                                                                                                                              |  |                                |             |   |                            |   |             |  
|Total liabilities                                                                                                                                                                                                             |  |                                | 2,562,910   |   |                            |   | 5,319,084   |  
|                                                                                                                                                                                                                              |  |                                |             |   |                            |   |             |  
|Series B Redeemable Convertible Preferred Stock, net, $.01 par value; authorized: 1,000 shares; issued and outstanding: 0
shares                                                                                              |  |                                |            |   |                            |   |            |  
|Series C Redeemable Convertible Preferred Stock, net, $.01 par value; authorized: 1,500 shares; issued and outstanding: 677 shares;
liquidation value: $6,771,876 at December 31, 2003                                        |  |                                |            |   |                            |   | 6,692,603   |  
|                                                                                                                                                                                                                              |  |                                |             |   |                            |   |             |  
|Commitments and contingencies                                                                                                                                                                                                 |  |                                |             |   |                            |   |             |  
|                                                                                                                                                                                                                              |  |                               
|Shareholders equity (deficiency):                                                                                                                                                                                            |  |                                |             |   |                            |   |             |  
|Preferred stock, $.01 par value; authorized: 2,497,500 and 4,997,500 shares, respectively; none issued and outstanding                                                                                                        |  |                                |            |   |                            |   |            |  
|Series C Convertible Preferred Stock, net, $.01 par value; authorized: 1,500 shares; issued and outstanding: 145 shares; liquidation value:
$1,454,791 at September 30, 2004                                                  |  |                                | 1           |   |                            |   |            |  
|Series D Convertible Preferred Stock, net, $.01 par value; authorized: 2,500,000 and 0 shares, respectively; issued and outstanding: 1,707,143
and 0 shares, respectively; liquidation value: $1,707,143 and $0, respectively |  |                                | 17,071      |   |                            |   |            |  
|Common stock, $.01 par value; authorized: 200,000,000 shares; issued and outstanding: 54,268,149 and 27,245,932 shares,
respectively                                                                                          |  |                                | 542,681     |   |                            |   | 272,459     |  
|Additional paid-in capital                                                                                                                                                                                                    |  |                                | 76,159,616  |   |                            |   | 65,578,653  |  
|Deferred stock compensation                                                                                                                                                                                                   |  |                                | (17,500     | ) |                            |   | (2,673      | )
|Accumulated deficit                                                                                                                                                                                                           |  |                                | (70,897,772 | ) |                            |   | (68,392,966 | )
|                                                                                                                                                                                                                              |  |                                |             |   |                            |   |             |  
|Total shareholders equity (deficiency)                                                                                                                                                                                       |  |                                | 5,804,097   |   |                            |   | (2,544,527  | )
|                                                                                                                                                                                                                              |  |                                |             |   |                            |   |             |  
|Total liabilities and shareholders equity (deficiency)                                                                                                                                                                       |  | $                              | 8,367,007   |   |                            | $ | 9,467,160   |  
|                                                                                                                                                                                                                              |  |                                |             |   |                            |   |             |  



See Notes to Condensed
Consolidated Financial Statements



2



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ANDREA ELECTRONICS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)



|                                                                                                |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|----------------------------------------------------------------------------------------------- |  | -------------------------- | ---------- | - | ------------------------- | - | ---------- | ------------------ |  | - | ------------------ | - |  | - | ---------- | -
|                                                                                                |  | For the Three Months Ended |            |   | For the Nine Months Ended |  
|                                                                                                |  | September 30, 2004         |            |   | September 30, 2003        |   |            | September 30, 2004 |  |   | September 30, 2003 |  
|Revenues                                                                                        |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Product revenues                                                                                |  | $                          | 886,991    |   |                           | $ | 749,888    |                    |  | $ | 2,687,210          |   |  | $ | 2,440,802  |  
|License revenues                                                                                |  |                            | 416,670    |   |                           |   | 416,670    |                    |  |   | 1,250,010          |   |  |   | 1,250,010  |  
|                                                                                                |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Revenues                                                                                        |  |                            | 1,303,661  |   |                           |   | 1,166,558  |                    |  |   | 3,937,220          |   |  |   | 3,690,812  |  
|                                                                                                |  |                            |            |  
|Sales returns recovery  restructuring                                                          |  |                            |           |   |                           |   |           |                    |  |   | 215,325            |   |  |   |           |  
|                                                                                                |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Net revenues                                                                                    |  |                            | 1,303,661  |   |                           |   | 1,166,558  |                    |  |   | 4,152,545          |   |  |   | 3,690,812  |  
|                                                                                                |  |                            |            |  
|Cost of revenues                                                                                |  |                            | 554,090    |   |                           |   | 653,251    |                    |  |   | 1,832,677          |   |  |   | 1,941,979  |  
|                                                                                                |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Gross margin                                                                                    |  |                            | 749,571    |   |                           |   | 513,307    |                    |  |   | 2,319,868          |   |  |   | 1,748,833  |  
|                                                                                                |  |                            |            |  
|Research and development expenses                                                               |  |                            | 321,083    |   |                           |   | 667,207    |                    |  |   | 1,085,853          |   |  |   | 2,177,978  |  
|                                                                                                |  |                            |            |  
|General, administrative and selling expenses                                                    |  |                            | 756,780    |   |                           |   | 949,938    |                    |  |   | 2,624,732          |   |  |   | 2,959,623  |  
|                                                                                                |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Loss from operations                                                                            |  |                            | (328,292   | ) |                           |   | (1,103,838 | )                  |  |   | (1,390,717         | ) |  |   | (3,388,768 | )
|                                                                                                |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Other income (expense)                                                                          |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Interest (expense) income, net                                                                  |  |                            | (2,527     | ) |                           |   | 508        |                    |  |   | (39                | ) |  |   | 41,039     |  
|Rent and miscellaneous income (expense)                                                         |  |                            | (2,536     | ) |                           |   | 30,873     |                    |  |   | 108,427            |   |  |   | 108,511    |  
|                                                                                                |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Other income (expense)                                                                          |  |                            | (5,063     | ) |                           |   | 31,381     |                    |  |   | 108,388            |   |  |   | 149,550    |  
|                                                                                                |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Loss from continuing operations                                                                 |  |                            | (333,355   | ) |                           |   | (1,072,457 | )                  |  |   | (1,282,329         | ) |  |   | (3,239,218 | )
|                                                                                                |  |                            |            |  
|Income from discontinued operations, net of $0 tax                                              |  |                            |           |   |                           |   |           |                    |  |   |                   |   |  |   | 2,534,824  |  
|                                                                                                |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Net loss                                                                                        |  | $                          | (333,355   | ) |                           | $ | (1,072,457 | )                  |  | $ | (1,282,329         | ) |  | $ | (704,394   | )
|                                                                                                |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Basic and diluted loss per share:                                                               |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|                                                                                                |  |                            |            |  
|Numerator for loss per share:                                                                   |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Loss from continuing operations                                                                 |  | $                          | (333,355   | ) |                           | $ | (1,072,457 | )                  |  | $ | (1,282,329         | ) |  | $ | (3,239,218 | )
|Series C Redeemable Convertible Preferred Stock dividends                                       |  |                            |           |   |                           |   | 113,892    |                    |  |   | 45,518             |   |  |   | 334,182    |  
|Series C Convertible Preferred Stock deemed dividend                                            |  |                            |           |   |                           |   |           |                    |  |   | 469,465            |   |  |   |           |  
|Series D Convertible Preferred Stock beneficial conversion feature                              |  |                            |           |   |                           |   |           |                    |  |   | 753,012            |   |  |   |           |  
|                                                                                                |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Loss from continuing operations attributable to common shareholders  basic and diluted         |  |                            | (333,355   | ) |                           |   | (1,186,349 | )                  |  |   | (2,550,324         | ) |  |   | (3,573,400 | )
|Income from discontinued operations, net of $0 tax                                              |  |                            |           |   |                           |   |           |                    |  |   |                   |   |  |   | 2,534,824  |  
|                                                                                                |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Net loss attributable to common shareholders  basic and diluted                                |  | $                          | (333,355   | ) |                           | $ | (1,186,349 | )                  |  | $ | (2,550,324         | ) |  | $ | (1,038,576 | )
|                                                                                                |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Denominator for loss per share:                                                                 |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Basic and diluted weighted average shares                                                       |  |                            | 52,231,554 |   |                           |   | 24,310,003 |                    |  |   | 45,107,212         |   |  |   | 22,785,111 |  
|                                                                                                |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Basic and diluted loss from continuing operations attributable to common shareholders per share |  | $                          | (.01       | ) |                           | $ | (.05       | )                  |  | $ | (.06               | ) |  | $ | (.16       | )
|Basic and diluted income from discontinued operations per share                                 |  |                            |           |   |                           |   |           |                    |  |   |                   |   |  |   | .11        |  
|                                                                                                |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  
|Basic and diluted net loss attributable to common shareholders per share                        |  | $                          | (.01       | ) |                           | $ | (.05       | )                  |  | $ | (.06               | ) |  | $ | (.05       | )
|                                                                                                |  |                            |            |   |                           |   |            |                    |  |   |                    |   |  |   |            |  



See Notes to Condensed
Consolidated Financial Statements



3



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ANDREA ELECTRONICS CORPORATION AND SUBSIDIARIES



CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY (DEFICIENCY)

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004

(UNAUDITED)



|                                                                                                           |  |                                              |   |  |                                   |    |   |                                              |           |   |                                   |   |        |                                 |  |              |  |                            |         |  |                            |            |   |                     |   |         |                                        |  |   |             |   |  |   |            |  
|---------------------------------------------------------------------------------------------------------- |  | -------------------------------------------- | - |  | --------------------------------- | -- | - | -------------------------------------------- | --------- | - | --------------------------------- | - | ------ | ------------------------------- |  | ------------ |  | -------------------------- | ------- |  | -------------------------- | ---------- | - | ------------------- | - | ------- | -------------------------------------- |  | - | ----------- | - |  | - | ---------- | -
|                                                                                                           |  | Series CConvertiblePreferredStockOutstanding |   |  | Series CConvertiblePreferredStock |    |   | Series DConvertiblePreferredStockOutstanding |           |   | Series DConvertiblePreferredStock |   |        | Common Stock Shares Outstanding |  | Common Stock |  | Additional Paid-In Capital |         |  | DeferredStock Compensation |            |   | Accumulated Deficit |   |         | Total Shareholders Equity(Deficiency) | 
|Balance, January 1, 2004                                                                                   |  |                                             |   |  | $                                 |   |   |                                              |          |   |                                   | $ |       |                                 |  | 27,245,932   |  | $                          | 272,459 |  | $                          | 65,578,653 |   |                     | $ | (2,673  | )                                      |  | $ | (68,392,966 | ) |  | $ | (2,544,527 | )
|                                                                                                           |  |                                              |   |  |                                   |    |   |                                              |           |  
|Conversions of Series C Redeemable Convertible Preferred Stock by previous holders                         |  |                                             |   |  |                                   |   |   |                                              |          |   |                                   |   |       |                                 |  | 1,862,086    |  |                            | 18,621  |  |                            | 540,005    |   |                     |   |        |                                        |  |   |            |   |  |   | 558,626    |  
|Conversion of Series C Convertible Preferred Stock from temporary equity to permanent equity               |  | 629.187593                                   |   |  |                                   | 6  |   |                                              |          |   |                                   |   |       |                                 |  |             |  |                            |        |  |                            | 6,219,639  |   |                     |   |        |                                        |  |   |            |   |  |   | 6,219,645  |  
|Exchange of Series C Redeemable Convertible Preferred Stock                                                |  | (46.300000                                   | ) |  |                                   | (1 | ) |                                              |          |   |                                   |   |       |                                 |  | 1,800,000    |  |                            | 18,000  |  |                            | 59,379     |   |                     |   |        |                                        |  |   |            |   |  |   | 77,378     |  
|Conversions of Series C Convertible Preferred Stock after the change in ownership                          |  | (437.408451                                  | ) |  |                                   | (4 | ) |                                              |          |   |                                   |   |       |                                 |  | 20,012,131   |  |                            | 200,121 |  |                            | 530,894    |   |                     |   |        |                                        |  |   |            |   |  |   | 731,011    |  
|Issuance of Series D Convertible Preferred Stock                                                           |  |                                             |   |  |                                   |   |   |                                              | 2,500,000 |   |                                   |   | 25,000 |                                 |  |             |  |                            |        |  |                            | 2,475,000  |   |                     |   |        |                                        |  |   |            |   |  |   | 2,500,000  |  
|Transaction costs in connection with the issuance of Series D Convertible Preferred Stock                  |  |                                             |   |  |                                   |   |   |                                              |          |   |                                   |   |       |                                 |  |             |  |                            |        |  |                            | (487,608   | ) |                     |   |        |                                        |  |   |            |   |  |   | (487,608   | )
|Conversions of Series D Convertible Preferred Stock                                                        |  |                                             |   |  |                                   |   |   |                                              | (792,857  | ) |                                   |   | (7,929 | )                               |  | 3,171,428    |  |                            | 31,714  |  |                            | (23,785    | ) |                     |   |        |                                        |  |   |            |   |  |   |           |  
|Common Stock Warrants issued in connection with the conversion of the Series C Convertible Preferred Stock |  |                                             |   |  |                                   |   |   |                                              |          |   |                                   |   |       |                                 |  |             |  |                            |        |  |                            | 62,221     |   |                     |   |        |                                        |  |   |            |   |  |   | 62,221     |  
|Stock Grant to Outside Directors                                                                           |  |                                             |   |  |                                   |   |   |                                              |          |   |                                   |   |       |                                 |  | 176,472      |  |                            | 1,765   |  |                            | 28,235     |   |                     |   | (30,000 | )                                      |  |   |            |   |  |   |           |  
|Amortization of Deferred Stock compensation                                                                |  |                                             |   |  |                                   |   |   |                                              |          |   |                                   |   |       |                                 |  |             |  |                            |        |  |                            |           |   |                     |   | 15,173  |                                        |  |   |            |   |  |   | 15,173     |  
|Series C Redeemable Convertible Preferred Stock dividends                                                  |  |                                             |   |  |                                   |   |   |                                              |          |   |                                   |   |       |                                 |  |             |  |                            |        |  |                            | (45,518    | ) |                     |   |        |                                        |  |   |            |   |  |   | (45,518    | )
|Non-cash Series C Convertible Preferred Stock deemed dividend                                              |  |                                             |   |  |                                   |   |   |                                              |          |   |                                   |   |       |                                 |  |             |  |                            |        |  |                            | 469,465    |   |                     |   |        |                                        |  |   | (469,465    | ) |  |   |           |  
|Non-cash charge attributable to Series D Convertible Preferred Stock beneficial conversion                 |  |                                             |   |  |                                   |   |   |                                              |          |   |                                   |   |       |                                 |  |             |  |                            |        |  |                            | 753,012    |   |                     |   |        |                                        |  |   | (753,012    | ) |  |   |           |  
|Issuance of Common Stock                                                                                   |  |                                             |   |  |                                   |   |   |                                              |          |   |                                   |   |       |                                 |  | 100          |  |                            | 1       |  |                            | 24         |   |                     |   |        |                                        |  |   |            |   |  |   | 25         |  
|Net loss                                                                                                   |  |                                             |   |  |                                   |   |   |                                              |          |   |                                   |   |       |                                 |  |             |  |                            |        |  |                            |           |   |                     |   |        |                                        |  |   | (1,282,329  | ) |  |   | (1,282,329 | )
|                                                                                                           |  |                                              |   |  |                                   |    |   |                                              |           |   |                                   |   |        |                                 |  |              |  |                            |         |  |                            |            |   |                     |   |         |                                        |  |   |             |   |  |   |            |  
|Balance, September 30, 2004                                                                                |  | 145.479142                                   |   |  | $                                 | 1  |   |                                              | 1,707,143 |   |                                   | $ | 17,071 |                                 |  | 54,268,149   |  | $                          | 542,681 |  | $                          | 76,159,616 |   |                     | $ | (17,500 | )                                      |  | $ | (70,897,772 | ) |  | $ | 5,804,097  |  
|                                                                                                           |  |                                              |   |  |                                   |    |   |                                              |           |   |                                   |   |        |                                 |  |              |  |                            |         |  |                            |            |   |                     |   |         |                                        |  |   |             |   |  |   |            |  



See Notes to Condensed
Consolidated Financial Statements



4



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ANDREA ELECTRONICS CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)



|                                                                                                      |  |                           |            |   |                   |   |            |  
|----------------------------------------------------------------------------------------------------- |  | ------------------------- | ---------- | - | ----------------- | - | ---------- | -
|                                                                                                      |  | For the Nine Months Ended |           
|                                                                                                      |  | September 30,2004         |            |   | September 30,2003 |  
|Cash flows from operating activities:                                                                 |  |                           |            |   |                   |   |            |  
|Loss from continuing operations                                                                       |  | $                         | (1,282,329 | ) |                   | $ | (3,239,218 | )
|Adjustments to reconcile net loss to net cash used in continuing operations:                          |  |                           |            |   |                   |   |            |  
|Depreciation and amortization                                                                         |  |                           | 442,794    |   |                   |   | 855,096    |  
|Non-cash stock compensation expense                                                                   |  |                           | 15,173     |   |                   |   | 17,399     |  
|Provision for bad debt                                                                                |  |                           | (32,991    | ) |                   |   | 11,366     |  
|Inventory reserve                                                                                     |  |                           | 20,576     |   |                   |   | 71,906     |  
|Loss on disposal of fixed assets                                                                      |  |                           | 2,226      |   |                   |   | 47,560     |  
|Expense related to Common Stock Warrant issued in connection with the Series C Preferred Stock        |  |                           | 62,221     |   |                   |   |           |  
|                                                                                                      |  |                          
|Change in:                                                                                            |  |                           |            |   |                   |   |            |  
|Accounts receivable                                                                                   |  |                           | 198,763    |   |                   |   | (64,488    | )
|Inventories                                                                                           |  |                           | 113,604    |   |                   |   | 644,915    |  
|Prepaid expenses and other current assets                                                             |  |                           | (351,557   | ) |                   |   | 136,070    |  
|Other assets, net                                                                                     |  |                           | 9,412      |   |                   |   | 11,264     |  
|Trade accounts payable                                                                                |  |                           | (335,443   | ) |                   |   | (414,157   | )
|Accrued restructuring charges                                                                         |  |                           | (238,391   | ) |                   |   | (4,012     | )
|Deferred revenue                                                                                      |  |                           | (1,225,010 | ) |                   |   | (1,250,010 | )
|Other current and long term liabilities                                                               |  |                           | (93,425    | ) |                   |   | (803,801   | )
|                                                                                                      |  |                           |            |   |                   |   |            |  
|Net cash used in continuing operations                                                                |  |                           | (2,694,377 | ) |                   |   | (3,980,110 | )
|                                                                                                      |  |                           |            |   |                   |   |            |  
|Income from discontinued operations                                                                   |  |                           |           |   |                   |   | 2,534,824  |  
|Gain on Sale of discontinued operations                                                               |  |                           |           |   |                   |   | (2,242,573 | )
|Change in:                                                                                            |  |                           |            |   |                   |   |            |  
|Assets from discontinued operations                                                                   |  |                           |           |   |                   |   | (188,192   | )
|Liabilities from discontinued operations                                                              |  |                           |           |   |                   |   | (6,265     | )
|                                                                                                      |  |                           |            |   |                   |   |            |  
|Net cash provided by discontinued operations                                                          |  |                           |           |   |                   |   | 97,794     |  
|                                                                                                      |  |                           |            |   |                   |   |            |  
|Net cash used in operating activities                                                                 |  |                           | (2,694,377 | ) |                   |   | (3,882,316 | )
|                                                                                                      |  |                           |            |   |                   |   |            |  
|Cash flows from investing activities:                                                                 |  |                           |            |   |                   |   |            |  
|Purchase of short-term investments                                                                    |  |                           | (600,000   | ) |                   |   |           |  
|Proceeds from the sale of Aircraft Communications Products Division                                   |  |                           |           |   |                   |   | 2,500,000  |  
|Principal payments received on note receivable from sale of Aircraft Communications Products Division |  |                           | 354,986    |   |                   |   | 591,640    |  
|Purchases of property and equipment                                                                   |  |                           | (13,040    | ) |                   |   | (52,156    | )
|Patents and trademarks                                                                                |  |                           | (8,335     | ) |                   |   | (96,094    | )
|                                                                                                      |  |                           |            |   |                   |   |            |  
|Net cash (used in) provided by investing activities                                                   |  |                           | (266,389   | ) |                   |   | 2,943,390  |  
|                                                                                                      |  |                           |            |   |                   |   |            |  
|Cash flows from financing activities:                                                                 |  |                           |            |   |                   |   |            |  
|Issuance of Common Stock                                                                              |  |                           | 25         |   |                   |   |           |  
|Net proceeds from the issuance of the Series D Convertible Preferred Stock                            |  |                           | 2,012,392  |   |                   |   |           |  
|Payment of debt obligations                                                                           |  |                           | (15,366    | ) |                   |   | (15,979    | )
|                                                                                                      |  |                           |            |   |                   |   |            |  
|Net cash provided by (used in) financing activities                                                   |  |                           | 1,997,051  |   |                   |   | (15,979    | )
|                                                                                                      |  |                           |            |   |                   |   |            |  
|Net decrease in cash and cash equivalents                                                             |  |                           | (963,715   | ) |                   |   | (954,905   | )
|                                                                                                      |  |                          
|Cash and cash equivalents, beginning of period                                                        |  |                           | 1,725,041  |   |                   |   | 3,307,437  |  
|                                                                                                      |  |                           |            |   |                   |   |            |  
|Cash and cash equivalents, end of period                                                              |  | $                         | 761,326    |   |                   | $ | 2,352,532  |  
|                                                                                                      |  |                           |            |   |                   |   |            |  
|Supplemental disclosures of cash flow information:                                                    |  |                           |            |   |                   |   |            |  
|Non-cash investing and financing activities:                                                          |  |                           |            |   |                   |   |            |  
|Deemed dividend attributable to Series C Convertible Preferred Stock                                  |  | $                         | 469,465    |   |                   | $ |           |  
|                                                                                                      |  |                           |            |   |                   |   |            |  
|Beneficial conversion charge attributable to Series D Convertible Preferred Stock                     |  | $                         | 753,012    |   |                   | $ |           |  
|                                                                                                      |  |                           |            |   |                   |   |            |  
|Conversion of Series B Redeemable Convertible Preferred Stock into common stock                       |  | $                         |           |   |                   | $ | 763,515    |  
|                                                                                                      |  |                           |            |   |                   |   |            |  
|Conversion of Series C Redeemable Convertible Preferred Stock into common stock                       |  | $                         | 636,004    |   |                   | $ | 217,952    |  
|                                                                                                      |  |                           |            |   |                   |   |            |  
|Conversion of Series C Convertible Preferred Stock into common stock                                  |  | $                         | 731,011    |   |                   | $ |           |  
|                                                                                                      |  |                           |            |   |                   |   |            |  



See Notes to Condensed
Consolidated Financial Statements



5



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ANDREA ELECTRONICS CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



Note 1. Basis of Presentation and Management Liquidity
Plans



Basis of Presentation - The accompanying condensed
consolidated 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 financial statements have been
prepared in accordance with accounting principles generally accepting in the United States of America for interim financial information and with the instructions to Form 10-QSB. Accordingly, they do not include all of the information and footnotes
required by accounting principles generally accepted in the United States of America for complete financial statements. 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 the fiscal year. For further information, refer to the consolidated financial statements
and accompanying footnotes included in Andreas annual report on Form 10-KSB for the year ended December 31, 2003.



Managements Liquidity Plans - As of September 30, 2004, Andrea had working capital of $1,174,613 and cash and cash equivalents and short-term investments of
$1,361,326. Andrea incurred a loss from continuing operations of $333,355 and $1,282,329 for the quarter and nine months ended September 30, 2004, respectively. On February 17, 2004, Andrea entered into a Securities Purchase Agreement with third
party investors (Buyers) pursuant to which the Buyers agreed to invest a total of $2.5 million in the Company for 2,500,000 shares of Series D Convertible Preferred Stock (Series D Preferred Stock). Pursuant to the terms of
the Securities Purchase Agreement, Andrea received the first tranche of financing, $1.25 million on February 23, 2004, and an additional $1.25 million in a second tranche of financing on June 4, 2004 (Note 4).



In addition to the proceeds from the Securities Purchase Agreement, Andrea plans to continue
to narrow its cash outflows during 2004 by continuing to implement reductions of administrative overhead expenses where necessary and feasible even while continuing to emphasize its sales and marketing efforts.



As of November 10, 2004, Andrea has approximately $1.1 million of cash and cash equivalents
and short term investments. Although Andrea has implemented several measures in an effort to reduce its expenses and to help preserve cash and it continues to pursue additional financial as well as strategic sources of capital, there can be no
assurance that Andrea will be successful in its attempts to raise sufficient capital essential to its survival. To the extent Andrea fails to develop additional revenues from sales of its products to generate adequate funding from operations, or if
Andrea fails to obtain additional financing through a capital transaction or other type of funding, 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 and will not be able to develop and implement a business plan. Additionally, even if Andrea does raise sufficient operating capital, there can be no assurance that the net proceeds will be sufficient to enable it to develop
its business to a level where it will generate profits and cash flows from operations. Andrea has no commitment for additional financing, and may experience difficulty in obtaining additional financing on favorable terms, if at all. These matters
raise substantial doubt about Andreas ability to continue as a going concern. As such, the third quarter condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and
satisfaction of liabilities in the normal course of business. The financial statements do not include any adjustments relating to the recoverability of the recorded assets or the classification of the liabilities that might be necessary should
Andrea be unable to continue as a going concern.



In May 2003, Andrea received
a non-compliance notice from the American Stock Exchange (AMEX or the Exchange) indicating that it is below certain of the Exchanges continued listing standards. In accordance with Section 1009 of the AMEX Company
Guide, Andrea was afforded the opportunity to submit a plan of compliance to the Exchange. The plan is to outline what action the Company will take, or has taken to bring the Company into compliance with the continued listed standards within an
18-month period. On June 25, 2003, Andrea presented its plan to the Exchange. On August 13, 2003 the Exchange notified Andrea that it has accepted the Companys plan of compliance and granted an extension of time to November 23, 2004 to regain
compliance with the continued listing standards. Andrea will be subject to periodic review by the Exchange staff during the extension period. Failure to make progress consistent with the plan or to regain compliance with the continued listing
standards by the end of the extension period could result in the Company being delisted from the Exchange. There can be no assurance that the Companys plan will be successful. Additionally, it is not possible to predict the impact that
delisting from the Exchange would have on Andrea.



Note 2. Summary of
Significant Accounting Policies



Management 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
disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. All adjustments (consisting of normal recurring accruals) considered necessary for
a fair presentation have been included.



6



---

Among other things, estimates are used in accounting for allowances for bad debts, inventory obsolescence, restructuring
reserves, product warranty, depreciation, deferred income taxes, expected realizable values for assets (primarily goodwill and intangible assets), contingencies, revenue recognition as well as the recording and presentation of our 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.



Reclassifications -
Certain prior period amounts have been reclassified to conform to the current year presentation.



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 Statement. License revenue is recognized based on the terms and conditions of individual contracts. 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.



Net Loss Per Share - Basic loss per share is computed by dividing the net loss applicable to common shares by the weighted average number of common shares
outstanding during the period. Diluted loss attributable to common shares adjusts basic 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. The shares issuable upon the exercise of stock options, warrants and convertible preferred stock are excluded from the calculation of net loss per share as their effect would be antidilutive.



Such potentially anti-dilutive securities consist of the following:





|                                                                   |  |           
|------------------------------------------------------------------ |  | ----------
|Total potential common shares as of September 30, 2004:            |  |           
|                                                                   | 
|Options to purchase common stock                                   |  | 3,242,500 
|Series C Convertible Preferred Stock and related accrued dividends |  | 6,655,902 
|Series D Convertible Preferred Stock and related Warrants (Note 4) |  | 12,268,166
|                                                                   |  |           
|Total potential common shares as of September 30, 2004             |  | 22,166,568
|                                                                   |  |           



Stock-Based Compensation - At
September 30, 2004, Andrea had two stock-based employee compensation plans. In accordance with Statement of Financial Accounting Standards (SFAS) No. 148, Accounting for Stock-Based CompensationTransition and
Disclosure, which amended SFAS No. 123, Accounting for Stock-Based Compensation, Andrea elected to continue to follow the intrinsic value method in accounting for its stock-based employee compensation arrangements as defined by APB
Opinion No. 25, Accounting for Stock Issued to Employees, and Financial Accounting Standards Board Interpretation No. (FIN) 44, Accounting for Certain Transactions Involving Stock Compensation. No compensation
expense has been recognized for options granted to employees, as all options granted under those plans have an exercise price equal to the market value of the underlying common stock on the date of grant.



The following table illustrates the effect on net loss and net loss per share as if Andrea
had applied the fair value recognition provisions of SFAS No. 123 to options granted to employees.



|                                                                                                 |  |                            |          |   |                           |   |            |                   |  |   |                   |   |  |   |            |  
|------------------------------------------------------------------------------------------------ |  | -------------------------- | -------- | - | ------------------------- | - | ---------- | ----------------- |  | - | ----------------- | - |  | - | ---------- | -
|                                                                                                 |  | For the Three Months Ended |          |   | For the Nine Months Ended |  
|                                                                                                 |  | September 30,2004          |          |   | September 30,2003         |   |            | September 30,2004 |  |   | September 30,2003 |  
|Net loss attributable to common shareholders as reported                                         |  | $                          | (333,355 | ) |                           | $ | (1,186,349 | )                 |  | $ | (2,550,324        | ) |  | $ | (1,038,576 | )
|Deduct: Total stock-based employee compensation expense determined under fair value-based method |  |                            | 76,184   |   |                           |   | 15,010     |                   |  |   | 139,770           |   |  |   | 495,100    |  
|                                                                                                 |  |                            |          |   |                           |   |            |                   |  |   |                   |   |  |   |            |  
|Pro forma net loss attributable to common shareholders                                           |  | $                          | (409,539 | ) |                           | $ | (1,201,359 | )                 |  | $ | (2,690,094        | ) |  | $ | (1,533,676 | )
|                                                                                                 |  |                            |          |   |                           |   |            |                   |  |   |                   |   |  |   |            |  
|Basic and diluted net loss attributable to common shareholders per share as reported             |  | $                          | (.01     | ) |                           | $ | (.05       | )                 |  | $ | (.06              | ) |  | $ | (.05       | )
|                                                                                                 |  |                            |          |   |                           |   |            |                   |  |   |                   |   |  |   |            |  
|Basic and diluted pro forma net loss attributable to common shareholders per share               |  | $                          | (.01     | ) |                           | $ | (.05       | )                 |  | $ | (.06              | ) |  | $ | (.07       | )
|                                                                                                 |  |                            |          |   |                           |   |            |                   |  |   |                   |   |  |   |            |  



7



---

The fair values of the stock options granted were estimated on the date of grant using the Black-Scholes option-pricing
model with the following weighted-average assumptions for the periods ended September 30, 2004 and September 30, 2003:



|                         |  |                   |   |  |                   |  
|------------------------ |  | ----------------- | - |  | ----------------- | -
|                         |  | September 30,2004 |   |  | September 30,2003 |  
|Expected life in years   |  | 4                 |   |  | 4                 |  
|Risk-free interest rates |  | 3.53              | % |  | 2.67              | %
|Volatility               |  | 224               | % |  | 200               | %
|Dividend yield           |  | 0                 | % |  | 0                 | %



Cash and Cash Equivalents -
Cash and cash equivalents include cash and highly liquid investments with original maturities of three months or less. Andrea has cash deposits in excess of the maximum amounts insured by FDIC at September 30, 2004 and 2003.



Short-term investments  Short-term investments include commercial paper with
original maturities of greater than three months and less than one year. These investments are classified as held to maturity and are reported at amortized cost.



Concentration of Credit Risk - Andrea is a manufacturer of audio communications equipment for several industries. Revenues related to
the recognition of deferred revenue as well as other service related revenues to one customer were approximately 38% and 44% of the total net revenues for the three months ended September 30, 2004 and 2003, respectively and accounted for 16% of
total accounts receivable at September 30, 2003. Revenues related to the recognition of deferred revenue as well as other service related revenues to one customer were approximately 36% and 40% of the total net revenues for the nine months ended
September 30, 2004 and 2003, respectively.



Andrea purchased a substantial
portion of its finished goods from one supplier. Purchases from this supplier amounted to 69% and 56% of total purchases for the three months ended September 30, 2004 and 2003, respectively. During the nine months ended September 30, 2004 and 2003,
purchases from this supplier amounted to 66% and 58%, respectively, of total purchases. At September 30, 2004 and 2003, the amounts due to this supplier included in accounts payable were $65,154 and $93,311, respectively.



Allowance for Doubtful Accounts - The allowance for doubtful accounts reflects
managements best estimate of probable losses inherent in the account receivable balance. Management determines the allowance based on known troubled accounts, historical experience and other currently available evidence.



Inventories - Inventories are stated at the lower of cost (on a first-in, first-out)
or market basis.



|                               |  |                    |           |   |                  |   |           |  
|------------------------------ |  | ------------------ | --------- | - | ---------------- | - | --------- | -
|                               |  | September 30, 2004 |           |   | December 31,2003 |  
|Raw materials                  |  | $                  | 537,998   |   |                  | $ | 668,929   |  
|Work-in-process                |  |                    | 61,645    |   |                  |   | 19,621    |  
|Finished goods                 |  |                    | 1,328,829 |   |                  |   | 1,353,526 |  
|                               |  |                    |           |   |                  |   |           |  
|                               |  |                    | 1,928,472 |   |                  |   | 2,042,076 |  
|                               |  |                   
|Less: reserve for obsolescence |  |                    | (760,861  | ) |                  |   | (740,285  | )
|                               |  |                    |           |   |                  |   |           |  
|                               |  | $                  | 1,167,611 |   |                  | $ | 1,301,791 |  
|                               |  |                    |           |   |                  |   |           |  



Intangible Assets



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, 2004 and 2003, amortization expense was $117,441 and $195,144,
respectively. For the nine-month periods ended September 30, 2004 and 2003, amortization expense was $352,133 and $584,367, respectively.



Long-Lived Assets



Andrea accounts for its long-lived assets in accordance with 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 undiscounted cash flows (gross margin dollars
from product sales), a new cost basis for the impaired asset(s) will be established, net of any recorded impairment. Management



8



---

recorded an impairment charge of $2,444,161 related to its core technology during the quarter ended December 31, 2003.
Additionally, management recorded an impairment charge of $289,069 relating to its trademarks and patents during the quarter ended December 31, 2003.



Recently Issued Accounting Pronouncements



In March 2004, The Emerging Issues Task Force (EITF) reached a consensus on recognition and measurement guidance previously discussed under EITF 03-01,
The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The consensus clarifies the meaning of other-than-temporary impairment and its application to investments classified as either available-for-sale
or held-to-maturity under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and investments accounted for under the cost method or the equity method. The EITF 03-01 includes new disclosure requirements for
investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however the disclosure requirements remain effective for annual periods ending after June 15, 2004. The application
of this consensus did not have a material effect on Andreas financial position or results of operations.



In April 2004, the EITF issued Statement No. 03-06 Participating Securities and the Two-Class Method Under FASB Statement No. 128, Earnings Per Share  (EITF 03-06). EITF 03-06 addresses a
number of questions regarding the computation of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company when, and if, it
declares dividends on its common stock. The issue also provides further guidance in applying the two-class method of calculating earnings per share, clarifying what constitutes a participating security and how to apply the two-class method of
computing earnings per share once it is determined that a security is participating, including how to allocate undistributed earnings to such a security. EITF 03-06 is effective for fiscal periods beginning after March 31, 2004. The adoption of this
statement did not have any effect on Andreas calculation of EPS.



In
September 2004, the EITF issued statement EITF Issue No. 04-08, The Effect of Contingently Convertible Debt on Diluted Earnings per Share (EITF 04-08). Contingently convertible debt instruments are generally convertible into
common shares of an issuer after the common stock price has exceeded a predetermined threshold for a specified period of time (the market price contingency). EITF 04-08 requires that shares issuable upon conversion of contingently
convertible debt be included in diluted earnings per share computations regardless of whether the market price contingency contained in the debt instrument has been met. EITF 04-08 is effective for reporting periods ending after December 15, 2004
and requires restatement of prior periods to the extent applicable. The adoption of this statement is not expected to have an effect on Andreas calculation of EPS.



Note 3. Series C 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). As of December 31, 2003, there were 677.187593 shares of Series C Preferred Stock outstanding, which was recorded net of the unaccreted present value of the transaction costs of $79,273. Each of these shares of
Series C Preferred Stock had a stated value of $10,000 plus a 5% per annum increase in the stated value, which sum was convertible into Common Stock at a conversion price of $0.30. This conversion price was subject to change based on various events,
including the announcement of a major transaction or upon certain triggering events. In addition, upon announcement of a major transaction or upon certain triggering events, as defined, the investors had the right to require Andrea to redeem all or
a portion of the investors Series C Preferred Stock at a defined redemption price. If Andrea were unable to effect such redemption, the Company would be subject to additional penalties. Due to these redemption features, the Series C Preferred
Stock was presented outside of shareholders equity (deficiency) in the accompanying condensed consolidated balance sheets for the period ending December 31, 2003.



In 2002, Andrea announced that a triggering event had occurred and that as a result of the trigger, the investor had the right to require
Andrea to redeem all of the Series C Preferred Stock. The investor agreed, in a Waiver Agreement, to waive its right to receive the aggregate Triggering Event Redemption Price (as defined in the Certificate of Amendment) (together with any interest
and related cash payments or penalties thereon) the investor was otherwise entitled to as a result of the existing triggering event until April 7, 2007. In addition, the investor agreed to waive, until April 7, 2007, its right to receive the
aggregate Triggering Event Redemption Price, as defined, (together with any interest and related cash payments or penalties thereon) with respect to (1) any future triggering event relating to additional registration failures, provided that the
existing registration statements remain effective and available to the investor for the number of shares covered by such registration statements as of the date of the waiver (less any future sales made pursuant to such registration statements), and
(2) any future triggering event relating to the delisting of Andreas Common Stock, provided that the Common Stock is thereafter authorized for trading on the OTC Bulletin Board. In addition, the investor agreed to waive, until April 7, 2007,
Andreas obligation to register any additional shares and Andreas obligation to make certain cash payments, if any, for its failure to register any additional shares. Finally, the investor acknowledged that no Maturity Date Redemption
Price (as defined) was due on October 10, 2002. The investors waivers described above shall be null and void immediately, however, upon the earlier of April 7, 2007, if such Triggering Event Redemption Price is not paid on April 7, 2007, the
first date on which Andrea fails to comply in any material respect with the terms of the Waiver Agreement and related agreements entered into between Andrea and the investor or the first date on which Andrea is insolvent.



9



---

As consideration for the Waiver Agreement, Andrea agreed to grant the investor a security interest in all of
Andreas assets; however, the investor agreed to have its lien on Andreas assets subordinated to (1) any lien granted in the future to a non-affiliated third party in connection with a strategic transaction with a financing component,
provided that such third-party lien relates only to the amount of the financing component of such transactions, and (2) any lien granted in the future to a bank or other similar institution pursuant to any asset-based financing transaction. In
addition, the investor agreed to release its lien in connection with any sale of any assets subject to the investors lien, provided the investor receives a lien on the proceeds of the sale. The investor acknowledged that its lien in any
portion of Andreas intellectual property is effectively subordinate to the interest of any current or future licensee of such intellectual property, as any interest the investor may have in such intellectual property cannot be greater than
Andreas interest therein.



On February 17, 2004, Andrea announced that it
had entered into an Exchange and Termination Agreement and an Acknowledgment and Waiver Agreement and that certain third party investors (the Series C Investors) had purchased 582.887593 shares of the Series C Preferred Stock from the
holder of such Series C Preferred Stock (the Existing C Holder). Pursuant to the Exchange and Termination Agreement, the Existing C Holder would exchange 46.3 shares of the Series C Preferred Stock in exchange for 1.8 million shares of
Common Stock and cease to own any of the Series C Preferred Stock. In the Acknowledgment and Waiver Agreement between Andrea and the Series C Investors, the terms of the Series C Preferred Stock would effectively be revised, which among other things
would: (i) eliminate the holders security interest in Andreas assets; (ii) eliminate any right of holders of the Series C Preferred Stock to require a redemption of the Series C Preferred Stock, with two limited exceptions which are
within Andreas control; (iii) eliminate the future increases, based on a rate of 5% per year of the Stated Value of the unconverted balance of the Series C Preferred Stock, of the shares of Common Stock issuable upon conversion of Series C
Preferred Stock; and (iv) eliminate an existing election by a holder of Series C Preferred Stock to utilize a lower market price as the conversion price and reset the conversion price of the Series C Preferred Stock to $0.2551 per share of Common
Stock from the existing $0.30 per share.



As a result of the Acknowledgement
and Waiver Agreement, the Series C Preferred Stock was presented as part of shareholders equity (deficiency) in the accompanying condensed consolidated balance sheet for the period ended September 30, 2004. Additionally, unaccreted Series C
Preferred Stock transaction costs of $72,231 were charged as a reduction to additional paid-in capital. In addition, during the three-month period ended March 31, 2004, Andrea recorded a non-cash deemed dividend of $469,465, which represents a
pro-rata portion of the consideration resulting from the reduction of the conversion price of Series C Preferred Stock.



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 the transactions related to the Series C Preferred Stock and the initial issuance of the Series D Preferred Stock, Andrea agreed to pay Knightsbridge Capital $300,000 in cash and to issue warrants exercisable
for an aggregate of 377,094 shares of Common Stock. The warrants are exercisable at any time after six months and before February 23, 2009 at an exercise price of $0.38 per share. Andrea allocated fifty percent of these transactions costs to each of
the Series C Preferred Stock and the Series D Preferred Stock. As such, $150,000 of the $300,000 payment to Knightsbridge Capital and $62,221 of the $124,442 expense related to the issuance of the warrants and other legal and transaction costs of
$101,903 were included in general, administrative and selling expenses for the period ended September 30, 2004.



Prior to the change of ownership, the following shares of Series C Preferred Stock, together with related accrued dividends, were converted in 2004:



|                                                                                  |  |                                             |  |                 |        |                       |          
|--------------------------------------------------------------------------------- |  | ------------------------------------------- |  | --------------- | ------ | --------------------- | ---------
|Date of Conversion                                                                |  | Number of SeriesC Preferred Stock Converted |  | ConversionPrice |        | Number ofCommonShares
|January 13, 2004                                                                  |  | 33.000000                                   |  | $               | 0.3000 |                       | 1,279,315
|January 27, 2004                                                                  |  | 6.000000                                    |  | $               | 0.3000 |                       | 232,986  
|February 3, 2004                                                                  |  | 5.000000                                    |  | $               | 0.3000 |                       | 194,315  
|February 4, 2004                                                                  |  | 4.000000                                    |  | $               | 0.3000 |                       | 155,470  
|February 18, 2004                                                                 |  | 46.300000                                   |  | $               | 0.3000 |                       | 1,800,000
|                                                                                  |  |                                             |  |                 |        |                       |          
|Total conversions/exchanges for prior holder of Series C Preferred Stock for 2004 |  | 94.300000                                   |  |                 |        |                       | 3,662,086
|                                                                                  |  |                                             |  |                 |        |                       |          



10



---

From the change of ownership through September 30, 2004, the following shares of Series C Preferred Stock, together with
related accrued dividends, were converted:



|                                                                                                                           |  |                                             |  |                 |        |                       |           
|-------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------------- |  | --------------- | ------ | --------------------- | ----------
|Date of Conversion                                                                                                         |  | Number of SeriesC Preferred Stock Converted |  | ConversionPrice |        | Number ofCommonShares
|February 17, 2004                                                                                                          |  | 7.000000                                    |  | $               | 0.2551 |                       | 320,261   
|February 18, 2004                                                                                                          |  | 150.261029                                  |  | $               | 0.2551 |                       | 6,874,683 
|February 24, 2004                                                                                                          |  | 11.657700                                   |  | $               | 0.2551 |                       | 533,358   
|February 25, 2004                                                                                                          |  | 46.363079                                   |  | $               | 0.2551 |                       | 2,121,184 
|February 26, 2004                                                                                                          |  | 15.000000                                   |  | $               | 0.2551 |                       | 686,274   
|March 2, 2004                                                                                                              |  | 8.326899                                    |  | $               | 0.2551 |                       | 380,969   
|March 4, 2004                                                                                                              |  | 8.000000                                    |  | $               | 0.2551 |                       | 366,013   
|March 9, 2004                                                                                                              |  | 20.000000                                   |  | $               | 0.2551 |                       | 915,032   
|March 12, 2004                                                                                                             |  | 11.657700                                   |  | $               | 0.2551 |                       | 533,358   
|March 19, 2004                                                                                                             |  | 30.947780                                   |  | $               | 0.2551 |                       | 1,415,909 
|March 22, 2004                                                                                                             |  | 20.730311                                   |  | $               | 0.2551 |                       | 948,445   
|March 30, 2004                                                                                                             |  | 5.817481                                    |  | $               | 0.2551 |                       | 266,159   
|April 15, 2004                                                                                                             |  | 33.365283                                   |  | $               | 0.2551 |                       | 1,526,514 
|April 28, 2004                                                                                                             |  | 2.914425                                    |  | $               | 0.2551 |                       | 133,339   
|July 15, 2004                                                                                                              |  | 15.405020                                   |  | $               | 0.2551 |                       | 704,804   
|July 28, 2004                                                                                                              |  | 41.634845                                   |  | $               | 0.2551 |                       | 1,904,860 
|September 22, 2004                                                                                                         |  | 8.326899                                    |  | $               | 0.2551 |                       | 380,969   
|                                                                                                                           |  |                                             |  |                 |        |                       |           
|Total conversions of Series C Preferred Stock by the new investors from the change in ownership through September 30, 2004 |  | 437.408451                                  |  |                 |        |                       | 20,012,131
|                                                                                                                           |  |                                             |  |                 |        |                       |           



As of September 30, 2004, there are
145.479142 shares of Series C Preferred Stock outstanding, which are convertible into 6,655,902 shares of Common Stock.



Note 4. Series D Convertible Preferred Stock



On February 17, 2004, Andrea entered into a Securities Purchase Agreement with the Series C Investors 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 six months and before February 23, 2009 at an exercise price of $0.38 per share.



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 six months 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 initial issuance of the Series D Preferred Stock and the transaction related to the Series C Preferred Stock. In connection with the transactions related to the Series C Preferred Stock and the initial issuance of the Series D Preferred
Stock and related Warrants, Andrea agreed to pay Knightsbridge Capital $300,000 in cash and to issue warrants exercisable for an aggregate of 377,094 shares of Common Stock. The warrants are exercisable at any time after six months and before
February 23, 2009 at an exercise price of $0.38 per share. Andrea allocated fifty percent of these transactions costs to each of the Series C Preferred Stock and the Series D Preferred Stock. As such, $150,000 of the $300,000 payment to
Knightsbridge Capital, and $62,221 of the $124,442 expense related to the issuance of the warrants offset net Series D Preferred Stock proceeds and were recorded as a decrease in additional paid-in capital for the period ended March 31, 2004. In
addition, in connection with the second tranche sale of the Series D Preferred Stock and related Warrants, Andrea paid Knightsbridge Capital an additional $50,000 and issued warrants exercisable for an aggregate of 62,500 shares of Common Stock. The
Warrants are exercisable at any time after six months and before June 4, 2009 at an exercise price of $0.17 per share.



In accordance with Emerging Issues Task Force (EITF) Issue 00-27, Application of EITF Issue No. 98-5 to Certain Convertible Instruments, Andrea
recorded a non-cash charge of $753,012 to accumulated deficit in the first quarter of 2004, related to the first tranche of the Series D Preferred Stock. The non-cash charge measures the difference between the relative fair value of the Series D
Preferred Stock and the fair market value of the shares of Andreas common stock issuable pursuant to the conversion terms on the date of issuance. This charge represents the maximum charge under this standard for this issuance.



Including the expenses related to Knightsbridge Capital allocated to the Series D Preferred
Stock, the total transaction costs associated with the issuance of the Series D Preferred Stock were $487,608. These charges are included in the accompanying condensed consolidated financial statements as a reduction of additional paid-in capital.



11



---

During the period ending September 30, 2004, the following shares of Series D Preferred Stock were converted:



|                                                                                      |  |                                             |  |                 |      |                       |          
|------------------------------------------------------------------------------------- |  | ------------------------------------------- |  | --------------- | ---- | --------------------- | ---------
|Date of Conversion                                                                    |  | Number of SeriesD Preferred Stock Converted |  | ConversionPrice |      | Number ofCommonShares
|June 7, 2004                                                                          |  | 50,000                                      |  | $               | 0.25 |                       | 200,000  
|June 11, 2004                                                                         |  | 35,714                                      |  | $               | 0.25 |                       | 142,856  
|June 16, 2004                                                                         |  | 250,000                                     |  | $               | 0.25 |                       | 1,000,000
|July 22, 2004                                                                         |  | 250,000                                     |  | $               | 0.25 |                       | 1,000,000
|September 21, 2004                                                                    |  | 35,714                                      |  | $               | 0.25 |                       | 142,856  
|September 22, 2004                                                                    |  | 171,429                                     |  | $               | 0.25 |                       | 685,716  
|                                                                                      |  |                                             |  |                 |      |                       |          
|Total conversions of Series D Preferred Stock in the period ending September 30, 2004 |  | 792,857                                     |  |                 |      |                       | 3,171,428
|                                                                                      |  |                                             |  |                 |      |                       |          



As of September 30, 2004, there are
1,707,143 shares of Series D Preferred Stock and 5,439,594 related warrants outstanding, which are convertible into 12,268,166 shares of Common Stock.



Note 5. Restructuring Accrual



During the fourth quarter of 2001, Andrea recorded restructuring charges in connection with exiting a PC headset channel, or customer-type, within the Anti-Noise Product
segment. The restructuring charge was recorded as accrued restructuring charges or as a reduction of assets, as applicable. During the three months ended March 31, 2004, Andrea reversed the restructuring accrual by $238,391, which reduced the
restructuring liability to zero. $215,325 of the reversal was recorded as sales returns recovery  restructuring and $23,066 of the reversal was recorded as a reduction in operating expenses, which was where the charges were initially recorded.
During the three and nine months ended September 30, 2003, Andrea made payments of $0 and $4,102, which reduced the restructuring liability.



Note 6. Licensing Agreements



In December 2001 and March 2002, Andrea entered into two agreements with Analog Devices. These license agreements relate to Andreas high performance noise canceling
technologies that enable clear voice communications and high-performance audio in small home-office and regular office environments. Under these agreements, Analog Devices paid Andrea a total of $5 million in license fees during 2002. The
unamortized portion of the license agreements, as amended, is recorded as current deferred revenue in the accompanying condensed consolidated balance sheets. All license revenues are being recognized on a straight-line basis over three-years, $3
million of which started to be recognized during the first quarter of 2002, and $2 million, which started to be recognized in the third quarter of 2002. During the three months ended September 30, 2004 and September 30, 2003, $416,670 of license
revenues were recognized in the accompanying condensed consolidated statement of operations. During the nine months ended September 30, 2004 and 2003, $1,250,010 of license revenues was recognized in the accompanying condensed consolidated statement
of operations.



Note 7. Commitments And Contingencies



Leases



Andreas corporate headquarters are located in Melville, New York, where Andrea leases space for warehousing, sales and executive
offices from an unrelated party. The lease is for approximately 40,000 square feet and expires in October 2008. Rent expense under this operating lease was $153,420 and $460,260 for each of the three and nine month periods ended September 30, 2004
and 2003. In January 2004, Andrea entered into an amended operating lease to defer a portion of the rent payments due in 2004 to later periods in the lease. The net lease amount remains the same. As of September 30, 2004, the future annual minimum
lease commitments, under this lease and all other noncancellable operating leases, are as follows:



|                              |  |   |          
|----------------------------- |  | - | ---------
|2004 (October to December 31) |  | $ | 232,770  
|2005                          |  |   | 847,392  
|2006                          |  |   | 842,225  
|2007                          |  |   | 816,577  
|2008                          |  |   | 609,494  
|                              |  |   |          
|Total                         |  | $ | 3,348,458
|                              |  |   |          



Employment Agreements



In August 2003, Paul E. Donofrio joined the Company as its President and
Chief Executive Officer. Pursuant to his employment agreement, Mr. Donofrio receives an annual base salary of $200,000, a minimum annual prorated bonus of $50,000 and received a stock grant of 300,000 options. Mr. Donofrio is also entitled to a
change in control payment equal to one times his base salary with



12



---

continuation of health and medical benefits for one year in the event of a change in control and subsequent termination
of employment other than for cause. The term of this agreement can be extended for one additional year. If the agreement is extended in August 2005, Mr. Donofrios base salary would be $225,000 with an additional 300,000 grant of stock options.
At September 30, 2004, the future minimum cash commitments under this agreement aggregate $245,833.



In June 2004, the Company entered into a one year employment contract with the Chairman of the Board, Douglas J. Andrea, which expires June 2005 with a provision to extend for two additional one year terms. Pursuant
to his employment agreement, Mr. Andrea will receive an initial annual base salary of $175,000 from June 14, 2004 through August 3, 2004, an initial stock grant of 400,000 options with immediate vesting on June 14, 2004 and a minimum annual prorated
bonus of $50,000 on a calendar year basis from the period beginning August 4, 2003. His annual base salary will be increased to $200,000 on August 4, 2004. Mr. Andrea would also be entitled to a change in control payment equal to one times his base
salary with continuation of health and medical benefits for one year in the event of a change in control and subsequent termination of employment other than for cause. If the agreement is extended in June 2005, Mr. Andreas annual base salary
would be $200,000 per annum through August 3, 2005 and $225,000 per annum thereafter, with additional grants of stock options each year. At September 30, 2004, the future minimum cash commitments under this agreement aggregate $216,667.



Legal Proceedings



On August 6, 2003, Christopher P. Sauvigne, director and former President and Chief Executive Officer of Andrea filed a lawsuit in the
Supreme Court of the State of New York, County of Nassau, against the Company titled Christopher P. Sauvigne v. Andrea Electronics Corporation, Index No. 03-012098 (the Action). The Action alleges that Mr. Sauvigne and Andrea were
parties to an employment contract and that Andrea breached the contract in connection with the termination of Mr. Sauvigne as President and Chief Executive Officer of Andrea on August 1, 2003. The Action seeks (i) a sum of not less than $131,250,
plus interest, (ii) a mandate that Andrea grant options for 400,000 shares of common stock to Mr. Sauvigne and (iii) reasonable counsel fees and costs. On September 25, 2003, Andrea filed a response to the Action with the Court denying these claims.
In addition, Andrea filed a counterclaim against Mr. Sauvigne alleging that (i) Mr. Sauvigne misused his corporate credit card and (ii) breached his fiduciary duty to Andrea by omitting material facts concerning his involvement with the group of
private investors that purchased the Andrea Aircraft Communications Products division and/or failing to disclose to Andrea that the private investor group included various members of Mr. Sauvignes family. The counterclaim seeks (i)
reimbursement of any compensation paid to Mr. Sauvigne for any personal and/or undocumented expenses incurred by him (ii) forfeiture and repayment to Andrea of all salary, bonuses, and benefits that Mr. Sauvigne received from Andrea after the breach
of his fiduciary duty in an amount to be determined at trial and (iii) attorneys fees and costs. On December 8, 2003, Mr. Sauvigne filed an application for an allowance of litigation expenses in advance of and during the pendency of the Action
with the Supreme Court of the State of New York, County of Nassau. On January 8, 2004, Andrea filed opposition papers in response to Mr. Sauvignes application for advance fees and expenses. On March 2, 2004, the Judge ordered that Andrea place
in escrow an amount equal to its own legal fees incurred in prosecution of its counter claims against Mr. Sauvigne pending final outcome of the action. On May 19, 2004, Mr. Sauvigne filed an appeal of the Judges March 2, 2004 order. A
Preliminary Conference was held on September 14, 2004. The parties are engaged in pre-trial discovery. An additional conference was scheduled for November 12, 2004. Additionally, a compliance conference is to take place on February 23, 2005 and a
trial date of July 11, 2005 has been scheduled. Andrea intends to defend the Action vigorously.



On November 7, 2003, Andrea filed a lawsuit in the Supreme Court of the State of New York, County of Nassau, against Radha Soami Society Beas-America, current owner of the Companys former building in Long Island
City, seeking release of funds held in a post Closing Escrow and Indemnification Agreement of approximately $200,000, which is included in other assets, net, related to the sale of such premises. The defendant has filed opposing documents against
the escrowed amount. The two parties are attempting to settle the suit outside of court.



Additionally, 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 the 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 8. Option Grants to Directors, Chairman of the Board and President and Chief Executive Officer



In May 2004, the Board of Directors granted 50,000 stock options to one of the Directors for his service as the chairperson on the
Nominating and Compensation Committees. The grant provides for a six month vesting period, an exercise price of $0.17, which was fair market value at the date of grant, and a term of 10 years.



In May 2004, the Board of Directors granted 25,000 stock options to one of the Directors for
his service as the chairperson on the Audit Committee. The grant provides for a six month vesting period, an exercise price of $0.17, which was fair market value at the date of grant, and a term of 10 years.



On June 14, 2004, in accordance with his employment agreement, the Chairman of the Board was
granted 400,000 stock options. This grant provides for immediate vesting, an exercise price of $0.13, which was fair market value at the date of grant, and a term of 10 years.



13



---

On August 4, 2004, in accordance with their respective employment agreements, the Chairman of the Board and the President
and Chief Executive Officer were granted 250,000 and 300,000 stock options, respectively. These grants provide for a six month vesting period, an exercise price of $0.10, which was fair market value at the date of grant, and a term of 10 years.



Note 9. 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, 2004 and 2003:



|                                     |  |                                                |          |   |                             |   |          |            |  |   |            |  
|------------------------------------ |  | ---------------------------------------------- | -------- | - | --------------------------- | - | -------- | ---------- |  | - | ---------- | -
|Segment Data                         |  | Andrea DSPMicrophone andAudio SoftwareProducts |          |   | Andrea Anti- Noise Products |   |          | Total 2004 | 
|Net revenues from external customers |  | $                                              | 696,133  |   |                             | $ | 607,528  |            |  | $ | 1,303,661  |  
|Loss from operations                 |  |                                                | (110,619 | ) |                             |   | (217,673 | )          |  |   | (328,292   | )
|Depreciation and amortization        |  |                                                | 129,620  |   |                             |   | 15,171   |            |  |   | 144,791    |  
|                                     |  |                                                |         
|                                     |  | Andrea DSPMicrophone andAudio SoftwareProducts |          |   | Andrea Anti- Noise Products |   |          | Total 2003 | 
|Net revenues from external customers |  | $                                              | 585,646  |   |                             | $ | 580,912  |            |  | $ | 1,166,558  |  
|Loss from operations                 |  |                                                | (712,027 | ) |                             |   | (391,811 | )          |  |   | (1,103,838 | )
|Depreciation and amortization        |  |                                                | 242,326  |   |                             |   | 48,559   |            |  |   | 290,885    |  



The following represents selected
condensed consolidated financial information for Andreas segments for the nine-month periods ended September 30, 2004 and 2003:



|                                     |  |                                                |            |   |                             |   |           |            |  |   |            |  
|------------------------------------ |  | ---------------------------------------------- | ---------- | - | --------------------------- | - | --------- | ---------- |  | - | ---------- | -
|Segment Data                         |  | Andrea DSPMicrophone andAudio SoftwareProducts |            |   | Andrea Anti- Noise Products |   |           | Total 2004 | 
|Net revenues from external customers |  | $                                              | 2,094,059  |   |                             | $ | 2,058,486 |            |  | $ | 4,152,545  |  
|Loss from operations                 |  |                                                | (765,480   | ) |                             |   | (625,237  | )          |  |   | (1,390,717 | )
|Depreciation and amortization        |  |                                                | 394,434    |   |                             |   | 48,360    |            |  |   | 442,794    |  
|                                     |  |                                                |           
|                                     |  | Andrea DSPMicrophone andAudio SoftwareProducts |            |   | Andrea Anti- Noise Products |   |           | Total 2003 | 
|Net revenues from external customers |  | $                                              | 1,783,661  |   |                             | $ | 1,907,151 |            |  | $ | 3,690,812  |  
|Loss from operations                 |  |                                                | (2,714,619 | ) |                             |   | (674,149  | )          |  |   | (3,388,768 | )
|Depreciation and amortization        |  |                                                | 721,004    |   |                             |   | 134,092   |            |  |   | 855,096    |  



14



---

Management of Andrea assesses assets and 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, 2004 and 2003, and as of each respective period-end, net revenues and accounts receivable by geographic area are as follows:



|                     |  |                   |           |                   |   |          
|-------------------- |  | ----------------- | --------- | ----------------- | - | ---------
|Geographic Data      |  | September 30,2004 |           | September 30,2003
|Net revenues:        |  |                   |           |                   |   |          
|United States        |  | $                 | 1,203,331 |                   | $ | 1,095,601
|Foreign              |  |                   | 100,330   |                   |   | 70,957   
|                     |  |                   |           |                   |   |          
|                     |  | $                 | 1,303,661 |                   | $ | 1,166,558
|                     |  |                   |           |                   |   |          
|Accounts receivable: |  |                   |           |                   |   |          
|United States        |  | $                 | 424,846   |                   | $ | 408,909  
|Foreign              |  |                   | 20,804    |                   |   | 57,062   
|                     |  |                   |           |                   |   |          
|                     |  | $                 | 445,650   |                   | $ | 465,971  
|                     |  |                   |           |                   |   |          



For the nine-month periods ended
September 30, 2004 and 2003, by geographic area are as follows:



|                |  |                   |           |                   |   |          
|--------------- |  | ----------------- | --------- | ----------------- | - | ---------
|Geographic Data |  | September 30,2004 |           | September 30,2003
|Net revenues:   |  |                   |           |                   |   |          
|United States   |  | $                 | 3,700,512 |                   | $ | 3,387,395
|Foreign         |  |                   | 452,033   |                   |   | 303,417  
|                |  |                   |           |                   |   |          
|                |  | $                 | 4,152,545 |                   | $ | 3,690,812
|                |  |                   |           |                   |   |          



Note 10. Discontinued Operations



Sale of Aircraft Communication Products Division



On April 11, 2003, Andrea completed the sale of substantially all of the assets and
liabilities of the Andrea Aircraft Communications Products division for approximately $3.8 million. Andrea received $2.5 million in cash, and approximately $1.3 million in notes which were payable in equal installments over the succeeding eleven
month period. As of June 30, 2004, the note has been paid in full. The sale resulted in a gain, recorded in the quarter ended June 30, 2003, of approximately $2.24 million which reflected the difference between the purchase price of $3.8 million and
the net assets sold (accounts receivable of $693,861, net inventories of $981,813, and accounts payable and accrued liabilities of $124,064). The Aircraft Communications Products division is engaged in the manufacture and sale of intercommunications
systems and amplifiers primarily used on legacy military aircraft. The consideration for the sale was determined through arms-length negotiations between Andrea and Andrea Systems, LLC. Andrea Systems, LLC is a new entity that was established by a
group of private investors. As part of the sale, Andrea entered into a transition services agreement with Andrea Systems, LLC pursuant to which the Company received approximately $347,000 during the transition service period which ended May 31,
2004.



During the quarter ended March 31, 2003, Andrea committed to a plan to
sell its Aircraft Communications Products division. Accordingly, the results of operations and the assets and liabilities of this division are presented as discontinued operations for the period. The following table reflects the results of the
discontinued operations of the Aircraft Communication Products business segment for the three and nine month periods ended September 30, 2003:



|                                              |  |                                              |   |                                             |   |          
|--------------------------------------------- |  | -------------------------------------------- | - | ------------------------------------------- | - | ---------
|                                              |  | For the ThreeMonths Ended September 30, 2003 |   | For the NineMonths Ended September 30, 2003
|Net sales                                     |  | $                                            |  |                                             | $ | 1,068,976
|Cost of sales                                 |  |                                              |  |                                             |   | 569,128  
|                                              |  |                                              |   |                                             |   |          
|Gross margin                                  |  |                                              |  |                                             |   | 499,848  
|Research and development expenses             |  |                                              |  |                                             |   | 119,871  
|General, administrative and selling expenses  |  |                                              |  |                                             |   | 87,726   
|                                              |  |                                              |   |                                             |   |          
|Operating Income from Discontinued Operations |  |                                              |  |                                             |   | 292,251  
|Gain of Sale of Discontinued Operations       |  |                                              |  |                                             |   | 2,242,573
|                                              |  |                                              |   |                                             |   |          
|Income from Discontinued Operations           |  |                                              |  |                                             | $ | 2,534,824
|                                              |  |                                              |   |                                             |   |          



Sales to the federal government and
related subcontractors aggregated $0 and $525,068 for the three and nine months ended September 30, 2003, respectively.



15



---

ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION



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 devices, 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 in Asia high volume assembly of most of our Andrea Anti-Noise Products from purchased components, and we are assembling low
volume Andrea DSP Microphone and Audio Software Products from purchased components primarily at our Israeli facility. 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 condensed consolidated financial statements and the notes to our 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 of America require
management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities. We believe that the following are some of the more critical judgment areas in the
application of our accounting policies that affect our financial condition and results of operations. We have discussed the application of these critical accounting policies with our Audit Committee.



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. License revenue is recognized based on the terms and conditions of individual contracts
(see Note 6 of our condensed consolidated financial statements, for example). 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.



Accounts Receivable  We are required to estimate the collectibility of our trade receivables. Judgment is required in assessing the realization of these receivables, including the current creditworthiness of each customer and related
aging of the past due balances. We evaluate specific accounts when we become aware of a situation where a customer may not be able to meet its financial obligations due to deterioration of its financial viability, credit ratings or bankruptcy. The
reserve requirements are based on the best facts available to us and reevaluated and adjusted as additional information is received. Our reserves also are determined by using percentages applied to certain aged receivable categories. At September
30, 2004 and December 31, 2003, our allowance for doubtful accounts was $23,706 and $56,697, respectively.



Inventories  We are required to state our inventories at the lower of cost or market. In assessing the ultimate realization of inventories, we are required to make considerable judgments as to future demand
requirements and compare that with our current inventory levels. Our reserve requirements generally increase as our projected demand requirements decrease due to market conditions, technological and product life cycle changes as well as longer than
previously expected usage periods. Inventories of approximately $1.2 million and $1.3 million at September 30, 2004 and December 31, 2003 are net of reserves of approximately $0.8 million and $0.7 million, respectively. It is possible that
additional charges to inventory may occur in the future if there is further declines in market conditions, or if additional restructuring actions are taken.



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 other intangible assets. 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. In order to test for recoverability, during the quarter ended December 31, 2003, Andrea compared the sum of an undiscounted cash flow projection (gross margin dollars from product



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sales) of the Andrea DSP Microphone and Audio Software core technology to the carrying value of that technology. Since
the results of this test indicated that there was an impairment, Andrea utilized the fair value method to measure the amount of the impairment. The difference between the fair value and the carrying value resulted in an impairment charge of
$2,444,161. At December 31, 2003 the net book value of Andreas core technology was $4,414,211, which Andrea will continue to amortize over the remaining life of the asset. Additionally, during the quarter ended December 31, 2003, Andrea
committed to a plan to abandon certain trademarks and patents before the end of their previously estimated useful lives which resulted in an impairment charge of $289,069. The net value of Andreas core technology and patents and trademarks at
September 30, 2004 is $4,083,145 and $378,687, respectively.



Deferred Tax
Assets  We currently have significant deferred tax assets. SFAS No. 109, Accounting for Income Taxes (FAS 109), requires that a valuation allowance be established when it is more likely than not that all or a portion of
the deferred tax assets will not be realized. Furthermore, FAS 109 provides that it is difficult to conclude that a valuation allowance is not needed when there is negative evidence such as cumulative losses in recent years. Therefore, cumulative
losses weigh heavily in the overall valuation assessment. Accordingly, we expect to provide a full valuation allowance on future tax benefits until we can sustain a level of profitability that demonstrates our ability to utilize the assets, or other
significant positive evidence arises that suggests our ability to utilize such assets. The future realization of a portion of our reserved deferred tax assets related to tax benefits associated with the exercise of stock options, if and when
realized, will not result in a tax benefit in the consolidated statement of operations, but rather will result in an increase in additional paid in capital. We will continue to re-assess our reserves on deferred income tax assets in future periods
on a quarterly basis.



We are subject to proceedings, lawsuits and other
claims, including proceedings under laws and government regulations related to securities, environmental, labor, product and other matters. We are required to assess the likelihood of any adverse judgments or outcomes to these matters, as well as
potential ranges of probable losses. A determination of the amount of reserves required, if any, for these contingencies is based on an analysis of each individual issue with the assistance of legal counsel. The amount of any reserves may change in
the future due to new developments in each matter.



The impact of changes in
the estimates and judgments pertaining to revenue recognition, receivables and inventories is directly reflected in our segments loss from operations. Although any charges related to our deferred tax assets are not reflected in our segment
results, the long-term forecasts supporting the realization of those assets and changes in them are significantly affected by the actual and expected results of each segment.



Cautionary Statement Regarding Forward-Looking Statements



Certain information contained in this Managements Discussion and Analysis of Financial Condition and Results of Operations for the
three months ended September 30, 2004 (the 2004 Third Quarter) compared to the three months ended September 30, 2003 (the 2003 Third Quarter) and for the nine months ended September 30, 2004 (the 2004 First Nine
Months) compared to the nine months ended September 30, 2003 (the 2003 First Nine Months) are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. The words anticipates, believes, estimates, expects, intends, plans, seeks, variations of such words, and similar expressions are
intended to identify forward-looking statements. We have based these forward-looking statements on our current expectations, estimates and projections about our business and industry, our beliefs and certain assumptions made by our management.
Investors are cautioned that matters subject to forward-looking statements involve risks and uncertainties including economic, competitive, governmental, technological and other factors that may affect our business and prospects. These statements
are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. In order to obtain the benefits of these safe harbor provisions for any such forward-looking
statements, we wish to caution investors and prospective investors about the following significant factors, which, among others, have in some cases affected our actual results and are in the future likely to affect our actual results and could cause
them to differ materially from those expressed in any such forward-looking statements. These factors include the following:



Our operating results are subject to significant fluctuation, period-to-period comparisons of our operating results may not 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;
| | - | --------------------------------------------------------------------



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| |  | fluctuations in the computer and communications hardware and software marketplace; and
| | - | --------------------------------------------------------------------------------------



| |  | 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 revenues for the 2004 Third
Quarter were approximately $1.3 million versus $1.2 million for the 2003 Third Quarter. Net loss applicable to common shareholders for the 2004 Third Quarter was approximately $0.3 million, or $0.01 per share on a basic and diluted basis, versus net
loss applicable to common shareholders of approximately $1.2 million, or $0.05 per share on a basic and diluted basis for the 2003 Third Quarter. Our revenues for the 2004 First Nine Months were approximately $4.2 million versus $3.7 million for the
2003 First Nine Months. Net loss applicable to common shareholders for the 2004 First Nine Months was approximately $2.6 million, or $0.06 per share on a basic and diluted basis, versus net loss applicable to common shareholders of approximately
$1.0 million, or $0.05 per share on a basic and diluted basis for the 2003 First Nine Months. During 2003 and 2004, we continued to experience cash flow constraints and, in response, on February 17, 2004, we entered into a Securities Purchase
Agreement with third party investors (Buyers) pursuant to which the Buyers agreed to invest a total of $2.5 million in the Company. Pursuant to the terms of the Securities Purchase Agreement, Andrea received $1.25 million on February 23,
2004 and another $1.25 million on June 4, 2004. While 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 intend to continue improving cash flows by reducing overall expenses, we may not be able to easily and quickly implement such initiatives and, if our revenues continue to decline or remain flat, our net income or loss
may be disproportionately affected. Furthermore, our acquisition in 1998 of Lamar Signal Processing, Ltd. (Lamar) resulted in a substantial amount of goodwill and other intangible assets. The amortization of these intangible assets has
had, and will continue to have, a negative, non-cash impact on our results of operations. At December 31, 2003, we recorded an impairment charge of approximately $2.4 million to our Core Technology associated with the Lamar acquisition. In addition,
during the first quarter of 2004, we recorded a non-cash deemed dividend of approximately $0.5 million representing a pro rata portion of the consideration given in connection with the Series C Preferred Stocks Acknowledge and Waiver Agreement
and a non-cash charge of approximately $0.8 million relating to the intrinsic value of the realization of a contingent beneficial conversion feature related to the Companys initial issuance of the Series D Convertible Preferred Stock. As a
result of all the above factors, we expect to continue to accumulate losses and the market price of our common stock could decline and/or continue to fluctuate.



If we fail to maintain access to funds sufficient to meet our operating needs, we may be required to significantly reduce, sell or refocus, our operations, our
business, results of operations and financial condition could be materially and adversely effected, our common stock could be delisted on the American Stock Exchange and/or we could be unable to continue operations.



In order to be a viable entity we need to achieve profitable operations. To accomplish that
we need to increase revenues and/or decrease expenses significantly. We might also need to sell additional assets or raise capital as a means of funding continued operations. In recent years, we have sustained significant operating losses. Since
1997, we have been unable to generate sufficient cash flow from operations to meet our operating needs and, correspondingly, from time to time during the past several years, we have raised additional capital from external sources. We may have to
continue to raise additional capital from external sources. These financial as well as strategic 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. On February 17, 2004, we entered into a Securities Purchase Agreement pursuant to which the Buyers agreed to invest a total of $2.5 million in the Company, of which we received $1.25
million on February 23, 2004 and $1.25 million on June 4, 2004. As a result, we believe that we now have sufficient liquidity to continue our operations at least through July 2005. We have revised our business strategies to reduce our expenses and
capital expenditures, but we still do not generate sufficient positive cash flow from operations to meet our operating needs and 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 delisting from the American Stock Exchange (see Note 1 of our Condensed Consolidated Financial Statements)
and our inability to continue operations.



If we fail to develop additional
revenues from sales of our products to generate adequate funding from operations, or fail to obtain additional financing through a capital transaction or other type of funding, we may be unable to continue as a going concern.



As of November 10, 2004, Andrea has approximately $1.1 million of cash and cash equivalents
and short term investments. Although Andrea has implemented several measures in an effort to reduce its expenses and to help preserve cash and it continues to pursue additional financial as well as strategic sources of capital, there can be no
assurance that Andrea will be successful in its attempts to raise sufficient capital essential to its survival. To the extent Andrea fails to develop additional revenues from sales of its products to generate adequate funding from operations, or if
Andrea fails to obtain additional financing through a capital transaction or other type of funding, 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 and will not be able to develop and implement a business plan. Additionally, even if



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Andrea does raise sufficient operating capital, there can be no assurance that the net proceeds will be sufficient to
enable it to develop its business to a level where it will generate profits and cash flows from operations. Andrea has no commitment for additional financing, and may experience difficulty in obtaining additional financing on favorable terms, if at
all. These matters raise substantial doubt about Andreas ability to continue as a going concern. As such, the third quarter condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the
realization of assets and satisfaction of liabilities in the normal course of business. The financial statements do not include any adjustments relating to the recoverability of the recorded assets or the classification of the liabilities that might
be necessary should Andrea be unable to continue as a going concern.



Shares
Eligible For Future Sale May Have An Adverse Effect On Market Price and You 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, 54,268,149 were outstanding as of November 10, 2004. The number of shares outstanding does not include an aggregate of 24,210,721 shares of common stock that are issuable. This number of
issuable common shares is equal to 45% of the 54,268,149 outstanding shares. These issuable common shares are comprised of: a) 3,242,500 shares of our common stock reserved for issuance upon exercise of outstanding option awards granted under our
1991 Performance Equity Plan and 1998 Stock Plan; b) 2,044,153 shares reserved for future grants under our 1998 Stock Plan; c) 6,655,902 shares of common stock that are issuable upon conversion of the Series C Preferred Stock; d) 6,828,572 shares of
common stock issuable upon conversion of the Series D Preferred Stock; and e) 5,439,594 of common stock issuable upon exercise of warrants relating to the Series D Preferred stock.



Conversions of our Series C Preferred Stock, Series D Preferred Stock and related Warrants may result in substantial dilution to other
holders of our common stock.



As of November 10, 2004, we had 145.479142
shares of Series C Preferred Stock, 1,707,143 shares of Series D Preferred Stock and 5,439,594 Common Stock Warrants outstanding. The issuance of shares of common stock upon conversion of the Series C Preferred Stock is limited to that amount which,
after given effect to the conversion, would cause the holder not to beneficially own an excess of 4.99% or, together with other shares beneficially own during the 60 day period prior to such conversion, not to beneficially own an excess of 9.99% of
the outstanding shares of common stock. The issuance of common stock upon conversion of the Series D Preferred Stock and the related warrants also are limited to that amount which, after given effect to the conversion, would cause the holder not to
beneficially own an excess of 4.99% of then outstanding shares of our common stock, except that each holder has a right to terminate such limitation upon 61 days notice to us. Beneficial ownership for purposes of calculation of such percentage
limitations does not include shares whose acquisition is subject to similar limitations. If all shares of the Series C and Series D Preferred Stock and warrants, which are outstanding to be issued, are assumed to be converted into or exercised for
shares of common stock, the number of new shares of common stock required to be issued as a result would aggregate 18,924,068 shares, which would represent 35% of the then outstanding shares of common stock.



Short sales of our common stock may be attracted by or accompany conversions of Series C
Preferred Stock and Series D Preferred Stock, which sales may cause downward pressure upon the price of our common stock.



Short sales of our common stock may be attracted by or accompany the sale of converted common stock, which in the aggregate could cause downward pressure upon the price
of the common stock, regardless of our operating results, thereby attracting additional short sales of the common stock.



If we fail to commercialize and fully market our Andrea DSP Microphone and Audio Software products, or continue to develop Andrea Anti-Noise Headset products, our
revenues may not increase at a high enough rate to improve our results of operations or may not increase at all.



Our business, results of operations and financial condition depend on the successful commercialization of our Andrea DSP Microphone and Audio Software products and
technologies. We introduced our first Andrea DSP Microphone products in 1998 and we continued to introduce complementary products and technologies over the last several years. We are primarily targeting these products at the desktop computer market,
the audio and video conferencing markets and the market for in-vehicle computing, among others. The success of these products is subject to the risks frequently encountered by companies in an early stage of product commercialization, particularly
companies in the computing and communications industries. Since we began sales of our initial Andrea Anti-Noise Headset products in 1995, we have developed and introduced new products in this line.



If we are unable to obtain market acceptance of Andrea DSP Microphone and Audio Software
products and technologies or if market acceptance of these products and technologies occurs at a slow rate, then our business, results of operations and financial condition will be materially and adversely affected.



We, and our competitors, are focused on developing and commercializing products and
technologies that enhance the use of voice, particularly in noisy environments, for a broad range of computer and communications applications. These products and technologies



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have been rapidly evolving and the number of our competitors has grown, but the markets for these products and
technologies are subject to a high level of uncertainty and have been developing slowly. We, alone or together with our industry, may be unsuccessful in obtaining market acceptance of these products and technologies.



If we fail to develop and successfully introduce new products and technologies in response
to competition and evolving technology, we may not be able to attract new customers or retain current customers.



The markets in which we sell our Andrea DSP Microphone and Audio Software and Andrea Anti-Noise Headset products are highly competitive. We may not compete successfully
with any of our competitors. Most of our current and potential competitors have significantly greater financial, technology development, marketing, technical support and other resources than we do. Consequently, these competitors may be able to
respond more quickly to new or emerging technologies and changes in customer requirements, or devote greater resources to the development, marketing, and sale of their products than we can. One or more of these competitors may independently develop
technologies that are substantially equivalent or superior to our technology. The introduction of products incorporating new technologies could render our products obsolete and unmarketable and could exert price pressures on existing products.



We are currently engaged in the development of digital signal processing
products and technologies for the voice, speech and natural language interface markets. We may not succeed in developing these new digital signal processing products and technologies, and any of these new digital signal processing products or
technologies may not gain market acceptance.



Further, the markets for our
products and technologies are characterized by evolving industry and government standards and specifications that may require us to devote substantial time and expense to adapt our products and technologies. For example, certain of our Andrea DSP
Microphone and Audio Software and Andrea Anti-Noise Headset products are subject to the Federal Communications Commission requirements. We may not successfully anticipate and adapt our products and technologies in a cost effective and timely manner
to changes in technology and industry standards or to introductions of new products and technologies by others that render our then existing products and technologies obsolete.



If our marketing collaborators do not effectively market those of their products with which our products are included or incorporated,
our sales growth will be adversely affected.



We have entered into
collaborative and distribution arrangements with software publishers and computer hardware manufacturers relating to the marketing and sale of Andrea DSP Microphone and Audio Software products through inclusion or incorporation with the products of
our collaborators. Our success will therefore be dependent to a substantial degree on the efforts of these collaborators to market their products with which our products are included or incorporated. Our collaborators may not successfully market
these products. In addition, our collaborators generally are not contractually obligated to any minimum level of sales of our products or technologies, and we have no control over their marketing efforts. Furthermore, our collaborators may develop
their own microphone, earphone or headset products that may replace our products or technologies or to which they may give higher priority.



Shortages of, or interruptions in, the supply of more specialized components for our products could have a material adverse effect on our sales of these products.



We conduct low volume assembly operations of our DSP Microphone and Audio
Software Products at our facility in Israel. As sales of any particular product increases, assembly operations are transferred to subcontractors (primarily in the Far East) using purchased components. Some specialized components for the Andrea DSP
Microphone and Audio Software products and Andrea Anti-Noise products, such as microphones and digital signal processing boards, are available from a limited number of suppliers (in some cases foreign) and subject to long lead times. We may not be
able to continue to obtain sufficient supplies of these more specialized components, particularly if the sales of our products increase substantially or market demand for these components otherwise increases. If our subcontractors fail to meet our
production and shipment schedules, our business, results of operations and financial condition would be materially and adversely affected.



Our ability to compete may be limited by our failure to adequately protect our intellectual property or by patents granted to third parties.



We rely on a combination of patents, patent applications, trade secrets, copyrights,
trademarks, nondisclosure agreements with our employees, licenses and potential licenses, limited access to and dissemination of our proprietary information, and other measures to protect our intellectual property and proprietary rights. However,
the steps that we have taken to protect our intellectual property may not prevent its misappropriation or circumvention. In addition, numerous patents have been granted to other parties in the fields of noise cancellation, noise reduction, computer
voice recognition, digital signal processing and related subject matter. We expect that products in these fields will increasingly be subject to claims under these patents as the numbers of products and competitors in these fields grow and the
functionality of products overlap. Claims of this type could have an adverse effect on our ability to manufacture and market our products or to develop new products and technologies, because the parties holding these patents may refuse to grant
licenses or only grant licenses with onerous royalty requirements. Moreover, the laws of other countries do not protect our proprietary rights to our technologies to the same extent as the laws of the United States.



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An unfavorable ruling in any current litigation proceeding or future proceeding may adversely affect our business,
results of operations and financial condition.



From time to time we are
subject to litigation incidental to our business. For example, we are subject to the risk of adverse claims, interference proceedings before the U.S. Patent and Trademark Office, oppositions to patent applications outside the United States, and
litigation alleging infringement of the proprietary rights of others. Litigation to establish the validity of patents, to assert infringement claims against others, and to defend against patent infringement claims can be expensive and
time-consuming, even if the outcome is in our favor.



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 Europe and areas in the Americas and Asia. For the three-month periods ended September 30,
2004, and 2003, net revenues to customers outside the United States accounted for approximately 8% and 6%, respectively, of our net revenues from continuing operations. For the nine-month periods ended September 30, 2004, and 2003, net revenues to
customers outside the United States accounted for approximately 11% and 8%, respectively, of our net revenues from continuing operations. International revenues 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.



We face risk from operating in Israel.



One of our engineering and customer support facilities is located in the State of Israel
and, as a result, certain key engineering personnel are located there as well. Although substantially all of our revenues currently are being earned from customers outside of Israel, we are nonetheless directly influenced by the political, economic
and military conditions affecting Israel. Since the establishment of the State of Israel in 1948, a state of hostility has existed, varying in degree and intensity, between Israel and Arab countries. Although Israel has entered into various
agreements with certain Arab countries and the Palestinian Authority, and various declarations have been signed in connection with efforts to resolve some of the economic and political problems in the Middle East, we cannot predict whether or in
what manner these problems will be resolved.



If we are unable to attract
and retain the necessary managerial, technical and other personnel necessary for our business, then our business, results of operations and financial condition will be harmed.



Our performance is substantially dependent on the performance of our executive officers and key employees. The loss of the services of any
of these executive officers or key employees could have a material adverse effect on our business, results of operations and financial condition. Our future success depends on our continuing ability to attract and retain highly qualified managers
and technical personnel. Competition for qualified personnel is intense and we may not be able to attract, assimilate or retain qualified personnel in the future.



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Results Of Operations



Quarter ended September 30, 2004 compared to Quarter ended September 30, 2003 and Nine Months Ended September 30, 2004 compared to the Nine Months Ended September
30, 2003.



Net Revenues



Net Revenues for the 2004 Third Quarter were $1,303,661, an increase of 12% from sales of
$1,166,558 for the 2003 Third Quarter. Net Revenues for the 2004 First Nine Months were $4,152,545, an increase of 13% from the 2003 First Nine Months net revenues of $3,690,812. Included in the 2004 First Nine Months net revenues was
$215,325 in Sales returns recovery - restructuring, representing a reversal of a restructuring accrual. The increase in net revenues for the 2004 Third Quarter reflects an increase of 5% in net revenues of Andrea Anti-Noise Products, to $607,528, or
47% of net revenues and an increase of 19% in net revenues of Andrea DSP Microphone and Software Products to $696,133, or 53% of total net revenues. The increase in net revenues for the 2004 First Nine Months reflects an increase of 8% in net
revenues of Andrea DSP Microphone and Software Products to $2,058,486, or 50% of net revenues and a 17% increase in net revenues of Andrea Anti-Noise Products to $2,094,059, or 50% of net revenues. The Third Quarter and First Nine Months increase in
net revenues of Andrea DSP Microphone and Audio Software Products is primarily due to increased product shipments to several of our OEM customers. Included in our Andrea DSP Microphone and Audio Software Products net revenues for the 2004 and 2003
Third Quarter and 2004 and 2003 First Nine Months are $416,670 and $1,250,010, respectively, of licensing revenue recognized related to our agreements with Analog Devices. The unamortized portion of the same license agreements is recorded as current
deferred revenue of $1,129,954 as of September 30, 2004. All license revenues are being recognized on a straight-line basis over three-years, $3 million of which started to be recognized during the first quarter of 2002, and $2 million of which
started in the third quarter of 2002. The quarter to quarter increase in net revenues of Andrea Anti-Noise Headset Products is due to an increasing number of businesses utilizing distance learning and on-line collaboration software who, in turn,
procure our noise canceling headset products. The year to date increase in net revenues of Andrea Anti-Noise Headset Products is due to the $215,325 reversal of a restructuring accrual included in Sales returns recovery  restructuring
partially offset by decreased product shipments to several of our OEM customers.



Cost of Revenues



Cost of revenues as a percentage of sales
for the 2004 Third Quarter decreased to 43% from 56% for the 2003 Third Quarter. Cost of revenues as a percentage of sales for the 2004 First Nine Months decreased to 44% from 53% for the 2003 First Nine Months. The quarter to quarter reduction
represents a decrease in reserves and write-offs involving slow moving and obsolete inventory in the 2004 Third Quarter as compared to the 2003 Third Quarter. The decrease in the 2004 First Nine Months cost of revenues as a percentage of sales
is primarily a result of the reversal of a restructuring accrual described under Net Revenues above as well as a decrease in reserves and write-offs involving slow moving and obsolete inventory as compared to the 2003 First Nine Months.



Research and Development



Research and development expenses for the 2004 Third Quarter decreased 52% to $321,083 from
$667,207 for the 2003 Third Quarter. Research and development expenses for the 2004 First Nine Months were $1,085,853, a decrease of 50% from the 2003 First Nine Months research and development expenses of $2,177,978. These decreases are
primarily due to cost reduction efforts related to employee compensation and related benefit costs, legal and patent expenses as well as the Companys strategic focus being redirected towards sales and marketing efforts. Notwithstanding this
decline, the substantial level of research and development is a reflection of our efforts to develop and commercialize DSP Microphone and Audio Software technologies, coupled with, to a lesser extent, Andrea Anti-Noise headset products. For the 2004
Third Quarter, the Andrea DSP Microphone and Audio Software Technology efforts were $234,878, or 73% of total research and development expenses and Andrea Anti-Noise Headset Product efforts were $86,205, or 27% of total research and development
expenses. For the 2004 First Nine Months, the Andrea DSP Microphone and Audio Software Technology efforts were $844,822, or 78% of total research and development expenses and Andrea Anti-Noise Headset Product efforts were $241,031, or 22% 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, however, as part of our overall effort to conserve cash, we intend to continue to reduce, where possible, the relatively
high levels of such expenses during the remainder of fiscal 2004.



General,
Administrative and Selling Expenses



General, administrative and selling
expenses decreased approximately 20% to $756,780 for the 2004 Third Quarter from $949,938 for the 2003 Third Quarter. General, administrative and selling expenses for the 2004 First Nine Months were $2,624,732, a decrease of 11% from the 2003 First
Nine Months general, administrative and selling expenses of $2,959,623. These decreases are predominantly due to cost reduction efforts primarily related to employee compensation and related benefit costs, legal expenses, promotional costs and
depreciation expenses. General, administrative and selling expenses for the 2004 First Nine Months include transaction costs associated with restructuring the Series C Preferred Stock of approximately $314,124. As part of our overall effort to
conserve cash, we intend to continue to reduce, where possible, the relatively high levels of general, administrative and selling expenses during the remainder of fiscal 2004.



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Other Income (Expense)



Other expense for the 2004 Third Quarter was $5,063 as compared to other income of $31,381 for the 2003 Third Quarter. Other income for the 2004 First Nine Months was
$108,388 as compared to other income of $149,550 for the 2003 First Nine Months. These decreases in other income are primarily the result of the termination of the transition agreement involved with the discontinued operations and decrease of the
related rental income.



Provision for Income Taxes



We provide a full valuation allowance on future tax benefits until we can sustain a level of
profitability that demonstrates our ability to utilize the assets, or other significant positive evidence arises that suggests our ability to utilize such assets. The future realization of a portion of our reserved deferred tax assets related to tax
benefits associated with the exercise of stock options, if and when realized, will not result in a tax benefit in the condensed consolidated statement of operations, but rather will result in an increase in additional paid-in capital. We will
continue to re-assess our reserves on deferred income tax assets in future periods on a quarterly basis.



Discontinued Operations



We sold our
Aircraft Communications Products division on April 11, 2003. The purchase price was comprised of $2.5 million in cash, and approximately $1.3 million in notes payable in equal installments over the succeeding 11-month period. The gain on the sale,
recorded in the 2003 First Nine Months, was approximately $2.2 million. The results of the Aircraft Communication Products division for the 2003 First Nine Months have been classified as discontinued operations in the accompanying condensed
consolidated financial statements. Operating income from discontinued operations was approximately $0.3 million for the 2003 First Nine Months. Aircraft Communications Products revenues, included within the discontinued operations line item, during
the 2003 First Nine Months were $1.1 million.



Net Loss



Net loss for 2004 Third Quarter was $333,355 as compared to net loss of $1,072,457 for the
2003 Third Quarter. Net loss for the 2004 First Nine Months was $1,282,329 as compared to net loss of $704,394 for the 2003 First Nine Months. The net loss for 2004 Third Quarter and 2004 First Nine Months principally reflects the factors described
above.



Liquidity And Capital Resources



Andreas principal sources of funds have historically been, and are expected to
continue to be, gross cash flows from operations and proceeds from the sale of convertible notes, preferred stock or other securities to certain financial institutions, investors and potential industry partners. At September 30, 2004, we had cash
and cash equivalents and short-term investments of $1,361,326 compared with $1,725,041 at December 31, 2003. The balance of cash and cash equivalents and short-term investments at September 30, 2004 is primarily a result of gross cash outflows from
operations, partially offset by Andreas issuance and sale of $2,500,000 of its Series D Preferred Stock and Warrants.



Working capital balance at September 30, 2004 was $1,174,613 compared to a working capital deficit of $192,871 at December 31, 2003. The increase in working capital
reflects a decrease in total current assets of $667,096 and a decrease in total current liabilities of $2,034,580. The decrease in total current assets reflects a decrease in cash and cash equivalents of $963,715, an increase in short-term
investments of $600,000, a decrease in accounts receivable of $165,772, a decrease in notes receivable of $354,986, a decrease in inventories of $134,180 and an increase in prepaid expenses and other current assets of $351,557. The decline in total
current liabilities reflects a decrease in trade accounts payable of $335,443, a decrease in current portion of long-term debt of $15,366, a decrease of $238,391 in accrued restructuring charges, a decrease of $511,726 in short-term deferred revenue
and a decrease of $933,654 in other current liabilities. The significant decrease in other current liabilities is primarily a result of the decrease in accrued dividends associated with the substantial Series C Preferred Stock conversions during the
2004 First Nine Months.



The decrease in cash and cash equivalents of $963,715
reflects $2,694,377 of net cash used in operating activities, $266,389 of net cash used in investing activities and $1,997,051 of net cash provided by financing activities.



The cash used in operating activities of $2,694,377, excluding non-cash charges, is primarily attributable to the $1,282,329 net loss from
operations for the nine month period ended September 30, 2004, a $198,763 decrease in accounts receivable, a $113,604 decrease in inventories, a $351,557 increase in prepaid expenses and other current assets, a $9,412 decrease in other assets, a
$335,443 decrease in accounts payable, a $93,425 decrease in other current and long-term liabilities, a $238,391 decrease in accrued restructuring charges and a $1,225,010 decrease in deferred revenue. The change in deferred revenue reflects
licensing revenue that was recognized during 2004 as a result of our license agreements with Analog Devices, Inc. The changes in inventories, accounts payable and other current and long term liabilities primarily reflect differences in the timing
related to both the payments for and the acquisition of inventories as well as for other services in connection with ongoing efforts related to Andreas various product lines.



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The cash used in investing activities of $266,389 reflects a $600,000 purchase of commercial paper with a six-month
maturity, principal payments received on the note receivable of $354,986 associated with the sale of the Aircraft Communications Products Division partially offset by an increase in property and equipment of $13,040 and an increase in patents and
trademarks of $8,335. The slight increases in property and equipment and patents and trademarks reflects modest capital expenditures associated with dies for our Andrea Anti Noise Headset business line and intellectual property related to our Andrea
DSP Microphone and Audio Software products, respectively.



The net cash
provided by financing activities of $1,997,051 reflects net proceeds of $2,012,392 received from the issuance of the Series D Preferred Stock and Warrants, a small payment received related to the issuance of Common Stock, partially offset by
payments related to the debt we assumed in connection with the acquisition of Lamar.



We believe that it will be necessary to continue to raise additional working capital to support operations. In recent years, we have sustained significant operating losses and we have been unable to generate sufficient cash flow from
operations to meet our operating needs. Correspondingly, from time to time during the past several years, we have raised capital from external sources. In October 2000, Andrea raised $7.5 million through the issuance and sale of Series C Preferred
Stock. In April 2003, we sold our Aircraft Communications Products division for approximately $3.8 million. On February 17, 2004, Andrea entered into a Securities Purchase Agreement with third party investors (Buyers) pursuant to which
the Buyers agreed to invest a total of $2.5 million in the Company. Pursuant to the terms of the Securities Purchase Agreement, Andrea received $1.25 million on February 23, 2004, and an additional $1.25 million on June 4, 2004.



We plan to continue to improve our cash flows during 2004 by continuing to implement
reductions of administrative overhead expenses where necessary and feasible as well as aggressively pursuing 1) existing opportunities in our Andrea Anti-Noise Headset Products market, 2) existing and prospective opportunities to sell licenses as
well as our Superbeam Array Microphone generated through our co-marketing efforts with Analog Devices in the personal computing market, 3) opportunities in the video and audio conferencing market and 4) the automotive (in-vehicle computing) market.
However, there can be no assurance that we will be able to successfully execute the aforementioned plans. As of November 10, 2004, Andrea has approximately $1.1 million (unaudited) of cash and cash equivalents and short term investments. During
2003, we utilized approximately $5.0 million in cash. We expect our cash utilization rate to decrease as a result of planned reductions of certain administrative, overhead and research and development expenses. Although we have implemented several
measures in an effort to reduce our expenses to help preserve cash and we continue to pursue additional financial as well as strategic sources of capital, there can be no assurance that we will be successful in our attempts to raise sufficient
capital essential to our survival. To the extent that we fail to develop additional revenues from sales of our products to generate adequate funding from operations, or if we fail to obtain additional financing through a capital transaction or other
type of funding, we will be required to significantly reduce our operating expenses and/or operations or we may have to relinquish our products, technologies or markets and will not be able to develop and implement a business plan. Additionally,
even if we do raise sufficient operating capital, there can be no assurance that the net proceeds will be sufficient to enable us to develop our business to a level where it will generate profits and cash flows from operations. 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. These matters raise substantial doubt about our ability to continue as a going concern. As such, the third quarter condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization
of assets and satisfaction of liabilities in the normal course of business. The financial statements do not include any adjustments relating to the recoverability of the recorded assets or the classification of the liabilities that might be
necessary should we be unable to continue as a going concern.



ITEM 3.
CONTROLS AND PROCEDURES



Andreas management, including its principal
executive officer and principal financial officer, have evaluated the effectiveness of the Andrea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.



There has
been no change in Andreas internal control over financial reporting identified in connection with the evaluation required by Rule13a-15 that occurred during Andreas last fiscal quarter that has materially affected or is reasonably likely
to materially affect, Andreas internal control over financial reporting.



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PART II OTHER INFORMATION



ITEM 1. LEGAL PROCEEDINGS



On August 6, 2003, Christopher P. Sauvigne, former director, President and Chief Executive Officer of Andrea filed a lawsuit in the Supreme Court of the State of New
York, County of Nassau, against the Company titled Christopher P. Sauvigne v. Andrea Electronics Corporation, Index No. 03-012098 (the Action). The Action alleges that Mr. Sauvigne and Andrea were parties to an employment contract and
that Andrea breached the contract in connection with the termination of Mr. Sauvigne as President and Chief Executive Officer of Andrea on August 1, 2003. The Action seeks (i) a sum of not less than $131,250, plus interest, (ii) a mandate that
Andrea grant options for 400,000 shares of common stock to Mr. Sauvigne and (iii) reasonable counsel fees and costs. On September 25, 2003, Andrea filed a response to the Action with the Court denying these claims. In addition, Andrea filed a
counterclaim against Mr. Sauvigne alleging that (i) Mr. Sauvigne misused his corporate credit card and (ii) breached his fiduciary duty to Andrea by omitting material facts concerning his involvement with the group of private investors that
purchased the Andrea Aircraft Communications Products division and/or failing to disclose to Andrea that the private investor group included various members of Mr. Sauvignes family. The counterclaim seeks (i) reimbursement of any compensation
paid to Mr. Sauvigne for any personal and/or undocumented expenses incurred by him (ii) forfeiture and repayment to Andrea of all salary, bonuses, and benefits that Mr. Sauvigne received from Andrea after the breach of his fiduciary duty in an
amount to be determined at trial and (iii) attorneys fees and costs. On December 8, 2003, Mr. Sauvigne filed an application for an allowance of litigation expenses in advance of and during the pendency of the Action with the Supreme Court of
the State of New York, County of Nassau. On January 8, 2004, Andrea filed opposition papers in response to Mr. Sauvignes application for advance fees and expenses. On March 2, 2004, the Judge ordered that Andrea place in escrow an amount equal
to its own legal fees incurred in prosecution of its counter claims against Mr. Sauvigne pending final outcome of the action. On May 19, 2004, Mr. Sauvigne filed an appeal of the Judges March 2, 2004 order. A Preliminary Conference was held on
September 14, 2004. The parties are engaged in pre-trial discovery. An additional conference was scheduled for November 12, 2004. Additionally, a compliance conference is to take place on February 23, 2005 and a trial date of July 11, 2005 has been
scheduled. Andrea intends to defend the Action vigorously. While the outcome of the Action cannot be predicted with certainty, Andrea believes the Action is without merit.



On November 7, 2003, Andrea filed a lawsuit in the Supreme Court of the State of New York, County of Nassau, against Radha Soami Society
Beas-America, current owner of the Companys former building in Long Island City, seeking release of funds held in a post Closing Escrow and Indemnification Agreement of approximately $200,000 related to the sale of such premises. The defendant
has filed opposing documents against the escrowed amount. The two parties are attempting to settle the suit outside of court.



Additionally, Andrea is involved in routine litigation incidental through the normal course of business. While it is not feasible to predict or determine the final
outcome of the 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.



See Item 2. Managements Discussion and Analysis of Financial Condition and Results of OperationsCautionary Statement
Regarding Forward-Looking StatementsAn unfavorable ruling in any current litigation proceeding or future proceeding may adversely affect our business, results of operations and financial condition and Note 7 to the unaudited condensed
consolidated financial statements in this quarterly report for a discussion of the legal proceedings of Andrea.



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



None.



ITEM 6. EXHIBITS



| | a) | Exhibits
| | -- | --------



Exhibit 31.1  Rule 13a-14(a)/15d-14(a) Certification



Exhibit 31.2  Rule 13a-14(a)/15d-14(a) Certification



Exhibit 32  Section 1350 Certifications



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SIGNATURES



In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.



ANDREA ELECTRONICS CORPORATIONBy:

/s/ PAUL E. DONOFRIOName:

Paul E. DonofrioTitle:

President and Chief Executive Officer


Date: November 12, 2004



|                      |  |                                                                           |  |                  
|--------------------- |  | ------------------------------------------------------------------------- |  | -----------------
|/s/ PAUL E. DONOFRIO  |  | President, Chief Executive Officer and Director                           |  | November 12, 2004
|Paul E. Donofrio      |  |                                                                           |  |                  
|                      |  |                                                                          
|/s/ CORISA L.
GUIFFRE |  | Vice President, Chief Financial Officer and Assistant
Corporate Secretary |  | November 12, 2004
|Corisa L. Guiffre     |  |                                                                           |  |                  



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