<PAGE>
 
                      SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
                                        
                                  FORM 10-K/A
                               (Amendment No. 1)

(Mark one)

[X]  Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange
     Act of 1934 for the fiscal year ended December 31, 1997, or

[ ]  Transition Report pursuant to Section 13 or 15(d) of the Securities
     Exchange Act of 1934 for the transition period from ______________ to
     _____________.

Commission File No. 0-23862

                               fonix corporation
             (Exact name of registrant as specified in its charter)

          Delaware                                     87-0380088
(State or other jurisdiction of            (I.R.S. Employer Identification No.)
 incorporation or organization)       


                    60 East South Temple Street, Suite 1225
                           Salt Lake City, Utah 84111
             (Address of principal executive offices with Zip Code)

                                 (801) 328-8700
              (Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:  None

Securities registered pursuant to Section 12(g) of the Act:  Common Stock
     ($0.0001 par value per share)

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

The aggregate market value of the voting stock held by non-affiliates of the
registrant is approximately $124,541,303 calculated using a closing price of
$4.875 per share on April 8, 1998. For purposes of this calculation, the
registrant has included only the number of shares held by its officers and
directors directly of record as of April 8, 1998 (and not counting shares
beneficially owned on that date) in determining the shares held by non-
affiliates.  As of April 8, 1998, there were issued and outstanding 51,303,521
shares of the Company's Common Stock (excludes 166,667 shares issuable upon
conversion of 166,667 shares of Series A Preferred Stock outstanding as of April
8, 1998).

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [  ]
<PAGE>
 
     This Amendment No. 1 to the Annual Report on Form 10-K of Fonix Corporation
is submitted to amend the following Items, which originally were submitted as
part of the Annual Report filed with the Securities and Exchange Commission as
of April 15, 1998:
<TABLE>
<CAPTION>
 
Part I                                                                        Page
------                                                                        ----
<S>                                                                           <C>
 Item  1.    Business.......................................................     3
 Item  2.    Properties.....................................................    14
 Item  3.    Legal Proceedings..............................................    15
 
Part II
-------
 Item  7.    Management's Discussion and Analysis of Financial Condition and
             Results of Operations..........................................    16
 
Part III
--------
 Item 13.    Certain Relationships and Related Transactions.................    24
 
</TABLE>

     Pursuant to SEC Rule 12b-15, each of the foregoing Items, as amended
hereby, is set forth below in its entirety.

                                  Page 2 of 28
<PAGE>
 
                                     PART I

ITEM 1.   BUSINESS

Overview

fonix, a development stage company, is a Delaware corporation engaged in
research and development of certain proprietary automatic speech recognition,
text-to-speech (speech synthesis), compression and neural network technologies
and other human-computer interface technologies and products.  fonix licenses
its technologies to and has entered into co-development relationships and
strategic alliances with third parties that are participants in the horizontal
computer industry (including producers of application software, operating
systems, computers and microprocessor chips) or are research and development
entities, including academia and industry and commercial speech product
developers. fonix intends for the foreseeable future to continue this practice
and will seek to generate revenues from its proprietary speech recognition
technologies from licensing fees and royalties and strategic partnerships and
alliances.  To date, the Company has entered into two strategic partnerships and
one license agreement relating to its automatic speech recognition technologies.
The Company received its first revenue in February 1998.

The Company created a wholly owned subsidiary in March 1998, for the purpose of
acquiring AcuVoice, Inc., a California corporation ("AcuVoice"). AcuVoice has
developed and markets text-to-speech or speech synthesis technologies and
products directly to end-users, systems integrators and original equipment
manufacturers ("OEMs") for use in the telecommunications, multi-media, education
and assistive technology markets.  To date, 96 companies have purchased AcuVoice
text-to-speech developer kits and many now have introduced products utilizing
AcuVoice technologies.  The acquisition of AcuVoice by the Company provides an
opportunity to introduce fonix-branded products into the market for the first
time in the Company's history.

The executive offices of the Company are located at 60 East South Temple Street,
Suite 1225, Salt Lake City, Utah 84111, and its telephone number is (801) 328-
8700.  The executive offices of AcuVoice are located at 84 West Santa Clara
Street, Suite 720, San Jose, CA 95113, and its telephone number is (408) 289-
1661.  The Company also maintains offices in Lexington, Massachusetts and a
research facility in Draper, Utah.

Technology Overview

Automatic Speech Recognition

Presently available traditional voice recognition technologies have been used in
a variety of products for industrial, telecommunications, business and personal
applications.  Speech recognition algorithms in software have been developed and
refined over the past ten years.  However, the increase in processing speed and
memory capacity of personal computers has accounted for much of the improvement
in traditional speech recognition systems during that period.  This improvement
includes vocabulary size, recognition accuracy and continuous speech recognition
ability.  Currently available speech recognition systems for personal computers
include speech command systems for navigating the Windows(R) interface and
inexpensive, discrete word dictation systems offered by Dragon Systems, IBM, and
Lernout & Hauspie.  Recently, general and specific vocabulary continuous speech
dictation systems also have been introduced by Philips, IBM, Dragon Systems and
others.  In addition, telephony applications with menu choice systems and small
vocabulary dialogue systems have been demonstrated by Nuance, Nortel, and
others.

Despite the nominal advances in performance of such presently available systems,
there are significant limitations inherent in all of these systems, each of
which continues to use traditional approaches generally based on Hidden Markov
Models ("HMMs") technology.  These traditional approaches have not appreciably
advanced since the late 1980's.  Applications based on such traditional speech
recognition systems for personal computers all require close-talking microphones
in 

                                  Page 3 of 28
<PAGE>
 
relatively low noise environments and a formal speaking style to achieve
acceptable accuracy.  In so-called continuous dictation systems, significant
adaptation to user speech, speaking style, and content area also are required.
These traditional systems are generally restricted to speech recognition for a
single individual dictating in a quiet environment; presently available
telephony-based systems are even more limited in general functionality.

The present industry standard methodology, the HMMs, use a general template or
pattern matching technique based on statistical language models.  Massachusetts
Institute of Technology researcher, Dr. Victor Zue, has noted that speech-
recognition systems based on such technology

     "utilize little or no specific-speech knowledge, but rely instead primarily
     on general-purpose pattern-recognition algorithms.  While such techniques
     are adequate for a small class of well-constrained speech recognition
     problems, their extendibility to multiple speakers, large vocabularies,
     and/or continuous speech is highly questionable.  In fact, even for the
     applications that these devices are designed to serve, their performance
     typically falls far short of human performance."

HMMs' widely recognized weaknesses are many:  (i) they do not meet the needs for
many mass market implementations, (ii) they have limited input feature types,
(iii) they account for only limited context, (iv) they have limited ability to
generalize acoustic and language structure, (v) they require training data from
the end-user for acceptable performance, (vi) models become extremely large and
complex as vocabulary grows, and (vii) there is a lack of hardware parallel
processing capability.

In contrast to HMMs, fonix researchers have developed what the Company believes
to be a fundamentally new approach to the analysis of human speech sounds and
the contextual recognition of speech.  The core fonix automatic speech
recognition technologies (the "ASRT" or "Core Technologies") attempt to
approximate the techniques employed by the human auditory system and language
understanding centers in the human brain.  The ASRT use information in speech
sounds perceptible to humans but not discernible by current automatic speech
recognition systems.  They also employ neural net technologies (artificial
intelligence techniques) for identifying speech components and word sequences
contextually, similar to the way in which scientists believe information is
processed by the human brain.  As presently developed, the ASRT are comprised of
several components including a phonetic sound representation recognition engine,
audio signal processing, a feature extraction process, a phoneme estimation
process, and a linguistic process consisting of two components, one of which is
expert- or rule-based and one of which is based on proprietary neural net
technologies, that are designed to interpret human speech contextually.

fonix believes the reliable recognition of natural, spontaneous speech spoken by
one or more individuals in a variety of common environments by means of a
conveniently placed microphone, all based on its ASRT, will significantly
improve the performance, utility and convenience of applications currently based
on traditional HMMs technology such as computer interface navigation, data
input, text generation, telephony transactions, continuous dictation and other
applications.  Additionally, the Company believes that its ASRT will make
possible major new speech recognition applications such as the transcription of
business meetings and conversations, real-time speech-to-speech language
translation, natural dialogues with computers for information access and
consumer electronic devices controlled by natural language.

Thus, in the near term, the Company believes that its ASRT will initially offer
unique speech processing techniques that will be both complementary and
significantly enhancing to currently available speech recognition systems.
fonix intends to continue to license its ASRT, to continue to co-develop the
ASRT with research and development groups in government, industry, and academia
and ultimately to market a suite of fonix-branded products.  As discussed more
fully below, fonix recently entered into the Siemens Agreement to conduct joint
research and development for applications in the telecommunications industry of
certain technologies related to the ASRT.  fonix anticipates that it will enter
into additional strategic alliances and co-development agreements in other
industry segments.  In the long term, the Company 

                                  Page 4 of 28
<PAGE>
 
anticipates that automatic speech recognition systems employing the Company's
unique new ASRT will dominate the market and set the industry standard for all
automatic speech recognition applications because of its anticipated capacities
to overcome the weaknesses of HMMs. In addition, the Company expects that
certain elements of its Core Technologies will have industry-leading
applications in such non-speech recognition industries, market segments and
disciplines as artificial intelligence and data compression. Although these
plans represent management's belief and expectation based on its current
understanding of the market and its experience in the industry, there can be no
assurance that actual results will meet these expectations. See "Certain
Significant Risk Factors." In the last two fiscal years, the Company has
expended $7,066,294 and $4,758,012 on research and development activities. Since
its inception (October 1, 1993), the Company has spent $17,937,293 on research
and development of the ASRT. The Company expects that a substantial part of its
capital resources will continue to be devoted to research and development of the
ASRT and other proprietary technologies for the foreseeable future.

Text-to-Speech (Speech Synthesis)

In March 1998, a wholly owned subsidiary of the Company acquired AcuVoice in a
statutory merger.  The subsidiary changed its name to AcuVoice, Inc. immediately
following the merger and will continue the business of AcuVoice using that name.
AcuVoice began in 1986 to develop and market a new approach to synthesized
speech, a system using actual recordings of "units" of human speech (i.e., the
sound pulsation).  Since the unit of speech consists of more than one phoneme
(i.e., sound), AcuVoice's approach has been called a "large segment
concatenative speech synthesis" approach. Other companies such as DEC and AT&T
began in the early 1960s and continue until the present to use a system called
"parametric speech synthesis."  Parametric systems continue to be plagued with
problems of speech quality, because their unit is not an actual recording, but a
computer's version of what a human voice sounds like.  Poor speech quality also
occurs because the parametric unit consists, for the most part, of a single
phoneme, such as the "t" in the word "time."

Although as early as 1994 AcuVoice released versatile prototypes of its system,
it was not until early 1996 that the AcuVoice Speech Synthesizer was ready for
sale into the telecommunications, multi-media, educational and assistive
technology markets.  AcuVoice won awards as "best text-to-speech" product at the
Computer Technology Expo '97 and '98 and the best of show award at AVIOS '97.
Presently AcuVoice products are being sold to a fast-growing body of end-users,
systems integrators and OEMs.

Employees

As of March 31, 1998, the Company employed 94 persons.  Of this total, 7 persons
are employed at AcuVoice.

Recent Developments

Consistent with the objectives, vision and strategy of the Company outlined
above, fonix has entered into several key transactions in recent months.  These
are discussed briefly in the following section.

The Siemens Transaction

On November 14, 1997, the Company entered into a Master Agreement for Joint
Collaboration (the "Siemens Agreement") with Siemens Aktiengesellschaft
("Siemens") pursuant to which the Company and Siemens have agreed to pursue
through a strategic alliance, research and development of certain technologies
related to the ASRT and the commercialization of such technologies for the
telecommunications industry.  On February 11, 1998, the Company and Siemens
entered into the First Statement of Work and License Agreement contemplated by
the Siemens Agreement, pursuant to which Siemens paid the Company a non-
refundable license fee (for which the Company has no further obligation)
relating to the development and production of the fonix ASRT in integrated
circuits suitable for certain telecommunications applications.  Siemens also
purchased 1,000,000 Common Stock purchase warrants and was granted 

                                  Page 5 of 28
<PAGE>
 
an option to purchase shares of Common Stock. The Siemens Agreement provides for
the payment to the Company of additional license fees when the Company and
Siemens have entered into further agreements for the development of specific
technologies, although there can be no assurance that such additional agreements
will be entered into.

The OGI Master Technology Collaboration Agreement

On October 14, 1997, the Company entered into a Master Technology Collaboration
Agreement (the "OGI Agreement") with the Oregon Graduate Institute of Science
and Technology ("OGI"), pursuant to which the Company and OGI have agreed to
pursue research and development of certain aspects of the Company's ASRT.  Under
the terms of the first statement of work between the Company and OGI entered
into pursuant to the OGI Agreement, the parties are collaborating on advanced
ASRT applications for entry in the 1999 DARPA competition.  The Defense Advanced
Research Projects Agency, or DARPA, has been a major supporter of speech
technology research.  The OGI Agreement contemplates that the Company and OGI
will enter into additional agreements to pursue research and development of
other aspects of the ASRT.  There can be no assurance that additional agreements
will be entered into by the Company and OGI.  OGI is a major academic research
and development facility for speech technology and provides fonix with access to
leading speech researchers such as Dr. Ron Cole, the director of OGI's Center
for Spoken Language Understanding.  Dr. Cole became a consultant to the Company
following execution of the OGI Agreement.

Acquisition of AcuVoice

On March 13, 1998, the Company acquired AcuVoice.  The transaction described
below by which the Company acquired AcuVoice is referred to herein as the
"Merger."  AcuVoice was incorporated in 1984, and since that time has been
engaged in the development of a software only text-to-human-speech synthesis
technology called "concatenative speech synthesis," now recognized in the speech
technology industry as a leading method of achieving natural sounding speech
from a computer.

Concatenative speech synthesis refers to the basic methodology used to
synthesize the human voice.  Specifically, the method involves the recording and
then recombining of speech units into a new, synthesized word or pattern.  The
speech units that are recorded and then recombined for a concatenative speech
synthesis system may vary in size from single sounds, to syllables, to whole
words, and frequent phrases.  The manner in which recorded speech units are
recombined to form new utterances is essentially the same across all
concatenative systems, although the "glue," or linguistic knowledge that holds
the segments together is proprietary to each system.  The "glue" will vary in
form and content, according to the size of units on which the system is based,
the supplemental units that may be needed, and the number of time-varying
parameters that are available for manipulation.

Other differences among various concatenative speech synthesis systems include
the extent of the language inventory covered by the system and the signal
processing that is required to overlap and add the recorded segments in a
natural sounding  manner with no bubbles, pops or squeaks resulting from the
synthesis process.  Additionally, concatenative systems differ in the way they
process syntax, semantic marking, the way alphanumeric text is handled, e-mail
and in the extent to which they generate natural word stress and intonation.

The fonix concatenative text-to-speech, or TTS,  system is based on syllables.
Other commercially available concatenative TTS systems use diphones, or a hybrid
of whole words and parametric values.   Fonix believes that the distinguishing
feature of its TTS system lies in its decade-long development of a complete
syllabic database for American English, with other polysyllables added where
appropriate, special attention to the holistic pronunciation of numbers and
dates, and a sophisticated method for producing natural sentence stress and
intonation.

The Merger was effected by an exchange of restricted shares of fonix Common
Stock for the issued and outstanding Common Stock of AcuVoice and a cash
payment.  A total of 2,692,218 shares of fonix Common Stock were issued in

                                  Page 6 of 28
<PAGE>
 
exchange for AcuVoice Common Stock and a total of $8,000,232 was paid in cash
(including amounts paid in lieu of fractional shares).  The Closing was deemed
to have occurred on March 13, 1998, notwithstanding the fact that certain acts
were completed following that date.

The Merger will become effective at such time as the Certificate of Merger
required under Utah law is filed with the Utah Division of Corporations and
Commercial Code and the Secretary of State of California.

In the fall of 1997, John A. Oberteuffer, Ph.D., a leading expert in the field
of speech recognition and speech synthesis technologies, who since March 1997
has served on the fonix Board, and who presently is employed as the Company's
Vice President--Technology, introduced the Company to AcuVoice.  Dr. Oberteuffer
originally met E. David Barton, the Chairman, President and a substantial
shareholder of AcuVoice in 1992, but neither Dr. Oberteuffer nor any other
officer or director of fonix had any affiliation with or interest in AcuVoice
prior to the completion of the Merger.

AcuVoice released the first versatile prototypes of its system in 1994.  By
early 1996, the AcuVoice Speech Synthesizer was ready for sale into the
telecommunications, multi-media, educational and assistive technology markets.
Companies which have purchased developer kits from AcuVoice and are now
developing products for the market include IBM, General Motors, Kurzweil
Educational Systems, Pratt & Whitney, Octel Communications, Andersen Consulting,
NEC, Dialogic, and Bell Atlantic.  Companies which have developed products using
AcuVoice developer kits, and now are selling or using products containing
AcuVoice text-to-speech include AT&T, Motorola, Northern Telecom, Lucky Goldstar
(Korea), Aumtech Inc., Mail Call, Inc., IMG, Hurdman Communications (Better
Business Bureau), SmartDial, Signet, Concierge, Ultimate Technology, FirstCall,
XL Vision, Applied Future Technologies and Productivity Works.

To the Company's knowledge, no other company has succeeded in developing a
versatile system of large segment concatenative synthesis.  However, the
AcuVoice speech synthesis products compete with other concatenative and
parametric speech synthesis products.  AcuVoice's main competitors are Lernout
&Hauspie, Lucent Technologies, Eloquent Technologies and Apple.

AcuVoice's competitors offer a range of voices (male, female, child) and
languages.  AcuVoice is accelerating its current development of a female voice,
and is actively pursuing strategic alliances in order to develop synthesis
products for major languages other than English.

fonix believes that the AcuVoice text-to-speech technologies will be an
important and complementary addition to the suite of Core Technologies the
Company has developed to date and will develop in the future.  For example,
because both voice synthesis and voice recognition technologies are dependent
upon the analysis of human speech patterns, those technologies share many
similar challenges, and a solution in one arena often will be portable to the
other.  Additionally, the Company believes that a state-of-the-art voice
synthesis technology, coupled with the Company's Core Technologies, will
substantially increase the marketability of both technologies by broadening the
potential product applications, thereby increasing the pool of potential
licensees of the technologies.

1998 Private Placement

In March 1998, the Company completed a private placement (the "Offering") of
6,666,666 shares of its restricted Common Stock to seven separate investment
funds.  The total purchase price to be paid by the investors pursuant to the
Offering is $30,000,000.  Of that amount, $15,000,000 was provided to the
Company on March 12, 1998, in return for which the Company issued a total of
3,333,333 shares of restricted stock, pro rata to the investors in proportion to
the total amount of the purchase price paid by them.  The remainder of the
purchase price is to be paid by the investors on that date that is 60 days after
the effectiveness of a registration statement that the Company will prepare and
file with the Securities and Exchange Commission covering all of the restricted
Common Stock to be issued in connection with the Offering, provided that, as of
such date, certain conditions are satisfied.  Specifically, such conditions
include the following: (i) that 

                                  Page 7 of 28
<PAGE>
 
the registration statement covering all of the Common Stock to be issued is
effective as of such date, (ii) the representations and warranties of the
Company as set forth in the documents underlying the Offering shall be correct
in all material respects, (iii) the market price of the Company's Common Stock
shall exceed $4.50 per share, (iv) the dollar volume of trading in the Company's
Common Stock for the 10-trading-day period preceding such date shall equal or
exceed $1,000,000, (v) that there shall be at least 18 market makers for the
Company's Common Stock, and (vi) there shall be no material adverse change in
the Company's business or financial condition.

Additionally, the investors in the Offering will have certain "reset" rights
pursuant to which the investors will receive additional shares of restricted
Common Stock if the average market price of the Company's Common Stock for the
60-day periods following the initial closing date and the second funding date
does not equal or exceed $5.40 per share.  The number of additional shares that
will be issued pursuant to such reset provisions will be determined by dividing
(x) the product of (A) the amount by which such 60-day average price is less
than $5.40 and (B) the number of shares of Common Stock issued to the investor
by (y) the 60-day average price.  The investors in the offering also have
certain first rights of refusal and other rights if the Company conducts other
offerings in the near future with other investors and the terms of such other
offerings are more advantageous to such other investors than the terms of the
Offering.

The Synergetics Transaction

Prior to March 1997, the Company's scientific research and development
activities were conducted by a third party, Synergetics, Inc. ("Synergetics"),
pursuant to product development and assignment contracts (collectively, the
"Synergetics Agreement").  Under that arrangement, Synergetics provided
personnel and facilities, and the Company financed the scientific research and
development activities on an as-required basis.  There was no minimum
requirement or maximum limit with respect to the amount of funding the Company
was obligated to provide to Synergetics and the Company was obligated to use its
best efforts in raising all of the necessary funding for the development of the
ASRT. Moreover, under the Synergetics Agreement, the Company was obligated to
pay to Synergetics a royalty of 10 percent (the "Royalty") of revenues from
sales of the ASRT or products incorporating the ASRT.  Synergetics compensated
its developers and others contributing to the development effort by granting
project shares to share in royalty payments received by Synergetics ("Project
Shares").  On March 13, 1997, the Company and Synergetics reached an agreement
in principle to modify the Synergetics Agreement ( the "Modification Terms")
with regard to the development and assignment of the ASRT.  On April 6, 1998,
the Company and Synergetics entered into a Royalty Modification Agreement to
finalize the Modification Terms.  Under the terms of the Royalty Modification
Agreement, the Company agreed to offer an aggregate of 4,800,000 non-
transferable Common Stock purchase warrants to the holders of the Project Shares
in consideration for which Synergetics agreed to cancel any further obligation
on the part of the Company to pay the Royalty.  The exercise price of the
warrants is $10 per share.  The Company has agreed to register the shares of
Common Stock underlying the warrants and no warrants will be offered to the
holders of the Project Shares until such time as the registration statement
relating to such shares has been declared effective by the Securities and
Exchange Commission. After issuance, the warrants will not be exercisable until
the first to occur of (i) the date that the per share closing bid price of the
Common Stock is equal to or greater than $37.50 per share for a period of 15
consecutive trading days, or (ii) September 30, 2000.  In addition, the warrants
will become immediately exercisable in the event of a merger or similar
transaction in which the Company is not the surviving entity or the sale of
substantially all of the Company assets.

                                  Page 8 of 28
<PAGE>
 
                        Certain Significant Risk Factors

The short and long-term success of the Company is subject to certain risks, many
of which are substantial in nature and outside the control of the Company.
Shareholders and prospective shareholders in the Company should consider
carefully the following risk factors, in addition to other information contained
herein.  All forward-looking statements contained herein are deemed by the
Company to be covered by and to qualify for the safe harbor protection provided
by the private securities litigation reform act of 1995 (the "1995 Act").
Shareholders and prospective shareholders should understand that several factors
govern whether any forward-looking statement contained herein will or can be
achieved.  Any one of those factors could cause actual results to differ
materially from those projected herein. These forward-looking statements include
plans and objectives of management for future operations, including the
strategies, plans and objectives relating to the products and the future
economic performance of the Company and its subsidiaries discussed above.  In
light of the significant uncertainties inherent in the forward-looking
statements included herein, the inclusion of any such statement should not be
regarded as a representation by the Company or any other person that the
objectives or plans of the Company will be achieved.

The Company has had substantial and continuing losses which have not been offset
by the Company's limited revenues, resulting in a significant accumulated
deficit and the necessity of raising additional capital to finance ongoing
operations.

Since commencing its business of developing its ASRT and certain other
proprietary technologies, including data compression and neural network design
technologies (collectively the ASRT and such other related technologies are
referred to in this Report on Form 10-K as the "Core Technologies") until
February 1998, the Company had no revenues from operations.  In February 1998,
the Company received its first revenue under a license granted to Siemens
related to integrated circuits suitable for certain telecommunications
applications.  Since its inception, however, the Company has sustained ongoing
losses associated with its research and development costs.  The Company incurred
a net loss of $7,829,508 for the year ended December 31, 1996 and a net loss
attributable to Common Stockholders of $25,175,939 for the year ended December
31, 1997.  The auditors' reports on the Company's financial statements include
an explanatory paragraph regarding substantial doubt about the Company's ability
to continue as a going concern.  Losses of this magnitude are expected to
continue for the near term and until such time as the Company is able to
complete additional licensing or co-development arrangements with third parties
which produce revenues sufficient to offset losses associated with the Company's
ongoing operating expenses, and there can be no assurance that the Company will
achieve profitable operations or that profitable operations will be sustained if
achieved.  At December 31, 1997, the Company's accumulated deficit was
$45,017,476.  fonix anticipates incurring additional research and development
expenses for the foreseeable future, which will require substantial amounts of
additional cash on an ongoing basis.  fonix must continue to secure additional
financing to complete its research and development activities, and to seek and
engage in negotiations with potential strategic alliance partners and otherwise
market its technology to industry segments that can incorporate the Company's
technologies into their products.  fonix believes that the cash generated to
date from its financing activities and the Company's ability to raise cash in
future financing activities will be sufficient to satisfy its working capital
requirements through at least the next twelve-month period.  However, there can
be no assurance that this assumption will prove to be accurate or that events in
the future will not require the Company to obtain additional financing sooner
than presently anticipated or preclude the Company from receiving necessary
additional capital when and as needed. Furthermore, to the extent that the
Company's future financing activities involve the issuance of equity securities
or securities convertible into equity securities, additional, and possibly
substantial, dilution to the interests of the Company's stockholders will
result.  Although the Company continues to investigate several financing
alternatives, including strategic partnerships, private debt and equity
financing and other sources in relation to its ongoing and research and
development activities, there can be no assurance that the current levels of
funding or additional funding will be available when needed, or if available
will be on terms satisfactory to the Company.  Failure to obtain additional
financing could have a material adverse effect on the Company, including
possibly requiring it to significantly curtail its operations.  See "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations."

                                  Page 9 of 28
<PAGE>
 
The Company has not entered into significant revenue generating operations
because its Core Technologies are still in development, and there is a risk the
Company may not be able to engage in such operations.

While the Company generally is pleased with the progress made to date with
respect to the research and development of its Core Technologies, at December
31, 1997, there were no products incorporating the Core Technologies.  As a
development stage company, the Company continues its efforts to enter into
revenue-generating licensing and co-development arrangements or strategic
alliances with third parties.   Other than the arrangements with Siemens and OGI
described elsewhere in this Report, the Company has no licensing or co-
development agreements with any third party and other than the non-refundable
license fee paid by Siemens, the Company has received no revenue to date from
its ASRT. fonix presently anticipates that any products incorporating the
Company's Core Technologies would be manufactured and marketed by such third
party licensees and co-development and strategic alliance partners such as
Siemens and therefore has no plans to manufacture products incorporating the
ASRT for the foreseeable future.  There can be no assurance that the Company
will be able to license its Core Technologies to third parties other than
Siemens or enter into additional co-development or strategic alliance
agreements.

The Company's business plan is dependent upon licensing arrangements with third
parties, and there is a risk that the Company will not be able to create or
maintain such relationships sufficient to allow it to achieve profitable
operations.

fonix's strategy for commercialization of its Core Technologies depends, in
material part, upon the formation of strategic alliances and licensing
arrangements and, ultimately, marketing a suite of fonix-branded products.  To
date, the Company has formed only two strategic alliances, with Siemens and OGI,
and the Company's ability to generate revenue in association with those
alliances is subject to several factors, including the negotiation and execution
of and performance under additional agreements with Siemens pertaining to the
development and/or application of specific technologies and the joint
development of commercially viable technologies under the OGI Agreement and the
successful licensing of such technologies to third-parties.  fonix anticipates
that, in addition to the arrangement with Siemens, it will need to enter into
additional revenue-generating strategic alliances or co-development arrangements
with other parties to fully implement its business strategy, although the
Company has not entered into any such additional arrangements to date.  There
can be no assurance that the strategic alliances with Siemens or OGI will
generate substantial royalty or license fees or that the Company will be able to
establish additional strategic alliance or licensing arrangements, or if
established that any such additional arrangements or licenses will be on terms
favorable to the Company, or that any strategic alliances or licensing
arrangements ultimately will be successful.  Moreover, even under the Siemens or
OGI arrangements or any additional licensing or co-development arrangements, if
any are signed, the extent of revenues to the Company resulting from such
agreements will depend on factors beyond the Company's control such as the
timing and extent of manufacture of products incorporating the Company's Core
Technologies, the scope of the marketing effort related to such products, the
price of any product or products incorporating the Company's Core Technologies,
and competition from new or existing products.  Additionally, disputes may arise
with respect to the ownership of and royalty or other payments for rights to any
technology developed with strategic partners. These and other possible
disagreements between strategic partners and the Company could lead to delays in
the collaborative research, development or commercialization of certain product
candidates, or could require or result in litigation or arbitration, which could
be time consuming and expensive, and which could have a material adverse effect
on the Company's business, financial condition and results of operations.

The market for speech recognition and related technologies is not yet mature,
and there is a risk that such markets may never mature, which could adversely
affect the Company, its financial condition and its future prospects.

The market for speech recognition technologies is relatively new.  fonix's Core
Technologies are new and represent a significant departure from technologies
which have already found a degree of acceptance in the nascent voice recognition
marketplace. The financial performance of the Company will depend, in part, on
the future development, growth and ultimate size of the market for voice
recognition products generally, and products incorporating the Company's Core
Technologies specifically.  Products, if any, incorporating the Company's Core
Technologies will compete with more 

                                 Page 10 of 28
<PAGE>
 
conventional means of information processing (e.g., data entry or access by
keyboard or touch-tone phone). fonix believes that there is a substantial
potential market for products incorporating speaker-independent, natural
language, continuous speech recognition technology with vocabulary contextually
sufficient to be useful for general purpose consumer, commercial and industrial
use, and capable of operating in real time with acceptable levels of accuracy.
Nevertheless, there can be no assurance that any market for the Company's Core
Technologies or for products incorporating the Company's Core Technologies will
develop, or that the Company's technology will find general acceptance in the
marketplace, or that sales of products incorporating the Core Technologies will
be profitable. Even if the Core Technologies are licensed and products
incorporating such technologies are manufactured and marketed, the occurrence of
warranty or product liability, or retraction of market acceptance due to product
failure, excess product returns or failure of the products to meet market
expectations could prevent the Company from achieving or sustaining profitable
operations.

The Company may not be able to compete successfully with larger, better
established companies that may develop or market similar technologies and
services.

The computer hardware and software industries are highly and intensely
competitive.  In particular, the speech recognition field and the computer voice
and communications industries are characterized by rapid technological change.
Competition in the field of speech recognition is based largely on marketing
ability and resources and technological superiority. The development of new
technology or material improvements to existing technologies by the Company's
competitors may render the Company's technology obsolete.  Accordingly, the
success of the Company will depend upon its ability to continually enhance its
Core Technologies to keep pace with or ahead of technological developments and
to address the changing needs of the marketplace. Although the Company expects
to continue to devote significant resources to research and development
activities, there can be no assurance that these activities will allow the
Company's Core Technologies to successfully be incorporated into marketable
products or to keep pace with changing demands and needs of the marketplace.  In
addition, there can be no assurance that the introduction of products or
technological developments by others will not have a material adverse effect on
the Company's operations.  Although the Company believes that its Core
Technologies could beneficially be incorporated into most existing computer
speech recognition applications based on traditional HMM technology, several
companies already manufacture and market computer speech recognition products
against which products incorporating the Core Technologies would compete.  Some,
if not all, of those companies have greater experience in manufacturing and
marketing speech recognition products, and some have far greater financial and
other resources than the Company and/or its potential licensees and co-
developers, as well as broader name-recognition, more-established technology
reputations, and mature distribution channels for their products.  Multiple
computer speech recognition products are presently available that provide
continuous speech dictation capabilities.  Such products could have the effect
of desensitizing the market to new dictation products and increasing the
installed base of products incorporating traditional voice recognition
technologies.  Additionally, as the market for automatic speech recognition
expands and matures, the Company expects more entrants into this already
competitive arena.  There can be no assurance that the distinguishing
characteristics of the Core Technologies as completed and/or as may be enhanced
in the future and any products employing such technology will be sufficient to
allow the Company to successfully compete in the marketplace.

The Company's ongoing needs for operating capital will require the Company to
offer and sell more of its equity capital which will be dilutive to existing
stockholders and costly for the Company.

The development of the Company's Core Technologies has required that the Company
establish a substantial research and scientific infrastructure consisting of
teams of experts in, among others, the fields of computer programming and
design, electrical engineering and linguistics, as well as the assembly of
certain specialized equipment and developmental and diagnostic software and
hardware, some of which has been designed and built exclusively by the Company.
fonix has consumed substantial amounts of cash to date in developing this
infrastructure and in developing and refining its Core Technologies.  During the
year ended December 31, 1996, the Company incurred total research and
development expenses 

                                 Page 11 of 28
<PAGE>
 
in the amount of $4,758,012. During 1997, the Company incurred total research
and development expenses of $7,066,294. fonix anticipates that its research and
development expenditures will continue at present rates or increased rates for
the foreseeable future. fonix's actual future capital requirements, however,
will depend on many factors, including further development of its Core
Technologies, the Company's ability to enter into additional revenue-generating
strategic alliance, co-development and licensing arrangements, the progress of
the development, manufacturing and marketing efforts of the Company's strategic
partners, if any, the level of the Company's activities relating to
commercialization rights it may retain in its strategic alliance arrangements,
competing technological and market developments, and the costs involved in
enforcing patent claims and other intellectual property rights. In the event
that substantial amounts of additional financing are required, the Company does
not believe it will be able to obtain such financing from traditional commercial
lenders. Rather, the Company likely will have to conduct additional sales of its
equity and/or debt securities. There can be no assurance that such additional
financing will be available if and when, and in the amounts required, by the
Company. Moreover, even if such financing is available if and when required,
there can be no assurance that such financing will be obtained on terms that are
favorable to the Company, and substantial and immediate dilution to existing
stockholders likely would result from any sales of equity securities or other
securities convertible into equity securities. To the extent that the Company
raises additional funds through strategic alliance and licensing arrangements,
the Company may be required to relinquish rights to certain of its technologies,
or to grant licenses on terms that are not favorable to the Company, either of
which could have a material adverse effect on the Company's business, financial
condition and results of operations. In the event that adequate funds are not
available when and as needed, the Company's business would be adversely
affected.

If the Company's Common Stock is delisted from the Nasdaq Stock Market, the
liquidity of the Common Stock could be adversely affected which could, in turn,
adversely affect the market price of the Common Stock.

The Company's Common Stock presently is listed on the Nasdaq SmallCap Market
under the symbol "FONX."  In order to maintain the continued listing on such
market, the Company, like all companies listed on the Nasdaq SmallCap Market, is
subject to certain maintenance standards.  Since February 23, 1998, companies
with securities listed on the Nasdaq SmallCap market are able to satisfy
continued listing requirements by reference, among other factors, to their total
market capitalization.  If the Company fails to meet any of such requirements,
there can be no assurance that the Company's Common Stock will not be delisted
from the Nasdaq SmallCap Market.  If delisted, the Company's Common Stock would
likely continue to be traded in the over-the-counter market.  Nevertheless, in
such event, there can be no assurance that such delisting would not adversely
affect the prevailing market price of the Common Stock or the general liquidity
of an investment in the Company's Common Stock.

Fonix's operations and financial condition could be adversely affected by
Fonix's failure or inability to protect its intellectual property or if Fonix's
technologies are found to infringe the intellectual property of a third party.

On June 17, 1997, the United States Patent and Trademark Office issued U.S.
Patent No. 5,640,490 entitled "A User Independent, Real-time Speech Recognition
System and Method."  The patent has a 20-year life running from the November 4,
1994 filing date, and has been assigned to the Company.  However, there can be
no assurance that such patent will be incontestable to a user with prior rights.
fonix is unaware of any facts or circumstances suggesting that the Core
Technologies or the Company's anticipated use thereof infringes or will infringe
any third party intellectual property rights.  Regardless of the foregoing,
there can be no assurance that the Core Technologies will not infringe upon
third party intellectual property rights, nor can there be any assurance that a
third party will not assert that the Company has infringed its intellectual
property rights, in which case the Company could be involved in protracted and
costly litigation which could seriously impede the Company's development or
otherwise adversely affect its operations.  Additionally, attempts may be made
to copy or reverse engineer aspects of the Core Technologies, or to obtain, use
or exploit information or methods which the Company deems proprietary.  Policing
the use of the Core Technologies and perhaps infringing technology is difficult
and expensive. Litigation or other action may be necessary in the future to
protect the Company's proprietary rights and to determine the validity and scope
of the proprietary rights of others.  Such litigation 

                                 Page 12 of 28
<PAGE>
 
or proceedings could result in substantial costs and diversions of resources and
management's attention, and could have a material adverse impact upon the
Company's business, operating results and financial condition. In addition to
patents, the Company relies on proprietary technology that it closely guards as
trade secrets. The Company has required nondisclosure and confidentiality
agreements to be executed by its employees, potential licensees, and potential
strategic alliance and co-development partners, and the Company expects to
continue this requirement. However, there can be no assurance that such non-
disclosure and confidentiality agreements will be legally enforceable or
sufficient to maintain the secrecy of the Company's proprietary technology.
Moreover, although the Company presently is seeking patent protection for
certain additional technologies, there can be no assurance that such patents
will issue or that the Company will be able to sufficiently protect any
technologies developed by it in the future.

Some matters affecting Fonix effectively could be determined by a controlling
shareholder.

Thomas A. Murdock, a director, executive officer and founding shareholder of the
Company is the trustee of a voting trust into which is deposited a majority of
the Company's issued and outstanding Common Stock, which effectively gives Mr.
Murdock control of the Company.  fonix believes that it will be controlled by
Mr. Murdock, as the trustee of the voting trust and one of its founding
shareholders, for the foreseeable future.

Fonix is subject to the risk that certain key personnel, on whom Fonix depends,
in part, for its operations, will cease to be involved with Fonix.

fonix is dependent on the knowledge, skill and expertise of several key
scientific employees and consultants, including but not limited to John A.
Oberteuffer, Ph.D., C. Hal Hansen, Dale Lynn Shepherd, R. Brian Moncur, Tony R.
Martinez, Ph.D., Ron Cole, Ph.D., Caroline Henton, Ph.D. and E. David Barton,
and its executive officers, Messrs. Studdert, Murdock and Dudley.  The loss of
any of such personnel could materially and adversely affect the Company's future
business efforts.  Moreover, although the Company has taken reasonable steps to
protect its intellectual property rights including obtaining non-competition and
non-disclosure agreements from all of its employees, if one or more of the
Company's key scientific employees or consultants resigns from the Company to
join a competitor (to the extent not prohibited by such person's non-competition
and non-disclosure agreement), the loss of such personnel and the employment of
such personnel by a competitor could have a material adverse effect on the
Company.  In the event of loss of any of the Company's key employees or
consultants, there can be no assurance that the Company would be able to prevent
the unauthorized disclosure or use of its proprietary technology by such former
employees or consultants, although the Company's employees and consultants have
entered into confidentiality agreements with the Company. fonix does not
presently have any key man life insurance on any of its employees.

Risks associated with pending litigation could adversely affect Fonix.

The Company has been named as a defendant in two civil actions.  See Part I,
Item 3, "Legal Proceedings."   After consideration of the nature of the claims
and the facts relating to these actions, the Company believes that the
resolution of them will not have a material effect on the Company's business,
financial condition and results of operations; however, the results of these
actions, including any potential settlements, are uncertain and there can be no
assurance to that effect. At a minimum these actions will result in some
diversion of management time and effort from the operation of the business.

Absence of Dividends

fonix has never paid dividends on or in connection with its Common Stock and
does not intend to pay any dividends to common shareholders for the foreseeable
future.

                                 Page 13 of 28
<PAGE>
 
Year 2000 Risks

Since its inception, the Company has attempted to leverage technology, including
increasingly sophisticated computer hardware and software, in managing the
Company's business and operations.  Historically, the Company has implemented
computer systems for accounting and financial management, purchasing, research,
development and design, and other purposes. The computer industry recently has
recognized that many existing computer programs, many of which are large,
custom-programmed mainframe applications that have continuously been written and
amended over a long time period and by a variety of different programmers, use
only two digits to identify a year in the date field.  Such programs were
designed, developed and modified without considering the impact of the upcoming
change in the century.  If not corrected, many such computer applications could
fail or create erroneous results by or at the Year 2000 by erroneously
identifying the year "00" as 1900, rather than 2000.  Correcting a Year 2000
problem on a large mainframe or network application, however, can be difficult
and expensive.  In many cases, the original developer of the subject software is
either defunct or otherwise unable or unwilling to address the problem.
Moreover, because many individuals may have programmed different pieces of a
program, and some of them may have died or cannot be located, many companies
will be forced to review the code comprising their software on a line-by-line
basis, which can take enormous amounts of time and significant financial
resources.  The Year 2000 issue affects virtually all companies and
organizations, including the Company.  If a company does not successfully
address its Year 2000 issues, it may face material adverse consequences. The
Company is in the process of insuring that its internal computer systems are
Year 2000 compliant.  The Company's own Core Technologies are designed to be
Year 2000 compliant.  With respect to third-party providers whose services are
critical to the Company, the Company intends to monitor the efforts of such
providers as they become Year 2000 compliant.  Management is presently not aware
of any Year 2000 issues that have been encountered by any such third-party which
could materially affect the Company's operations.  Notwithstanding the
foregoing, there can be no assurance that the Company will not experience
operational difficulties as a result of Year 2000 issues, either arising out of
internal operations, or caused by third-party service providers, which
individually or collectively could have an adverse impact on business operations
or require the Company to incur unanticipated expenses to remedy any problems.

Risks Associated with the Acquisition of AcuVoice

The business of AcuVoice recently acquired by the Company is also subject to
many of the same risks and uncertainties discussed above, including, but not
limited to the risks associated with  intense competition for text-to-speech
products, technological obsolescence and the acceptance of new technologies, the
need for additional capital, and introduction of new and unproven technologies.
In addition, there are risks to the Company associated with the AcuVoice
acquisition. This is the first such acquisition completed by the Company.
Accordingly, there may be difficulties and inefficiencies encountered in the
process of integrating the business, products and personnel of AcuVoice with
those of the Company. It may be some time before any inefficiencies or
difficulties are overcome and the Company begins to benefit from economies of
scale, synergies from the combination of the business, technology and personnel,
and the addition of new products to the Company's business.  There can be no
assurance that the transition will not involve significant additional expense or
result in delays in the expected completion of on-going development products or
other business objectives of the Company.  Furthermore, as management of the
Company seeks to supervise and manage the activities of AcuVoice, which are
conducted at some distance from the primary corporate offices and research
facilities of the Company, there may be considerable increase in expense and
management time spent in administration of the combined businesses.

ITEM 2.   PROPERTIES

The Company owns no real property.  Commencing in October 1996, the Company
leased from an unaffiliated third party a 25,600 square foot facility in Draper,
Utah, at which it conducts its principal scientific research and development
activities.  The Company's lease of that facility is for a term of 8 years.
Provided that the Company is not in default under the lease, the Company has the
option to extend the lease for 5 additional years.  If the Company requires
additional space 

                                 Page 14 of 28
<PAGE>
 
in the same building and the landlord is unable to provide such additional
space, the Company has the right after 5 years to terminate the lease. The
average base monthly lease payment over the 8-year life of the lease for the
facility is $28,389.

In addition to the Draper facility, the Company sub-leases office space at
market rates for its corporate headquarters and administrative operations in
Salt Lake City, Utah, from Studdert Companies Corp., a Utah corporation ("SCC").
SCC is owned and controlled by three individuals who are executive officers and
directors of the Company and who each beneficially owns more than 10% of the
Company's Common Stock. [See "Certain Relationships and Related Transactions,"
and "Security Ownership of Certain Beneficial Owners and Management"].  The base
monthly rental for the sub-leased space during 1997 was approximately $6,500,
plus reimbursable direct expenses for the use of telephone, facsimile, photocopy
and other business equipment.  The three executive officers of the Company have
personally guaranteed this lease in favor of SCC's landlord.

AcuVoice leases 1,620 square feet of office space in San Jose, California.  The
lease on this space is on a month-to-month basis, with rents of $2,581 per
month.  The Company is presently seeking to relocate these operations to a
larger facility.

The Company also leases approximately 1,500 square feet of office space in
Lexington, Massachusetts.  The term of this lease is for one year (through
October 1998) and monthly rents are $1,500.

The Company believes that the facilities described above are adequate for its
current needs.

ITEM 3.   LEGAL PROCEEDINGS

The Polomba Action

On February 10, 1997, a shareholder derivative  action  was filed in the
Delaware Chancery Court for New Castle County by Richard J. Palomba, the owner
of approximately 15,000 shares of the Company's common stock, against the
Company, certain directors of the Company and a third party affiliated with
certain of the director-defendants.   Although the parties have reached, in
principal, a settlement agreement, as is discussed in more detail below, the
complaint in that action alleges that certain of the individual employee
director defendants wrongfully caused the Company to engage in a series of loan
transactions with K.L.S. Enviro Resources, Inc., a Nevada corporation ("KLSE"),
and thereafter appropriated to themselves certain corporate opportunities
resulting from such loan transactions.  The Complaint further alleges that the
non-employee director defendants wrongfully acquiesced in or ratified the
conduct of the employee-directors, and that all of the individual defendants
breached their fiduciary duties to the Company.  The complaint seeks to compel
an accounting for any alleged profits earned by the employee director
defendants, equitable relief in the form of an order requiring certain of the
employee director defendants to forfeit certain securities of KLSE they
allegedly acquired in breach of their fiduciary duties to the Company, monetary
damages in an unspecified amount, and costs and legal fees. After that action
was filed but before process was served, the Company commenced settlement
negotiations with the plaintiff. A settlement agreement in principal was reached
by the parties.  Limited discovery has been undertaken and documentation is
being drafted to submit to the court for approval.  Regardless of the outcome of
the settlement or the commencement of litigation proceedings if the settlement
is not consummated, the Company believes that the claims asserted against the
Company in this action are entirely without merit, and that the material facts
and circumstances surrounding the relationship between the Company and KLSE have
been fully disclosed in accordance with applicable laws and regulations.  After
consideration of the nature of the claims and the facts relating to this action,
the Company believes that the resolution of this action will not have a material
effect on the Company's business, financial condition and results of operations;
however, the results of this action, including any potential settlement, are
uncertain and there can be no assurance to that effect.  At a minimum this
action will result in some diversion of management time and effort from the
operations of the business.

                                 Page 15 of 28
<PAGE>
 
The J&L Action

On March 11, 1998 an action (the "J&L Action) was filed against the Company in
the Supreme Court of the State of New York for the County of New York by Jesup &
Lamont Securities Corporation ("J&L").  The J&L Action alleges that the Company
had agreed to pay to J&L a fee in connection with a private placement of the
Company completed in March 1998.  The claim is for a cash payment of $1,200,000
and 30,000 restricted shares of the Company's Common Stock. The matter is still
in the early stages of litigation and the Company has not yet engaged in any
discovery with respect to the allegations by J&L.  The Company believes that the
J&L Action is without merit and intends to vigorously defend the J&L Action.


                                    PART II

ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS

THIS REPORT ON FORM 10-K CONTAINS, IN ADDITION TO HISTORICAL INFORMATION,
FORWARD-LOOKING STATEMENTS THAT INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES.
THE COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE RESULTS
ANTICIPATED BY THE COMPANY AND DISCUSSED IN THE FORWARD-LOOKING STATEMENTS.
FACTORS THAT COULD CAUSE OR CONTRIBUTE TO SUCH DIFFERENCES ARE DISCUSSED BELOW
IN THE SECTION ENTITLED "FACTORS AFFECTING FUTURE OPERATING RESULTS."

Overview
--------

fonix is a development-stage company engaged in scientific research and
development of proprietary automatic speech recognition and related technologies
("ASRT") comprised of components which may be licensed in whole or in part to
third parties.  The Company has completed the Core Technologies related to the
ASRT such that they are available for third-party licensing and co-development.
In November 1997, the Company entered into the Siemens Agreement pursuant to
which the Company and Siemens have agreed to pursue research and development of
certain technologies related to the ASRT and the commercialization of such
technologies for the telecommunications industry through a strategic alliance.
Pursuant to the terms of the Siemens Agreement, the Company and Siemens entered
into the First Statement of Work and License Agreement pursuant to which Siemens
paid the Company a license fee for the development and production of fonix ASRT
in integrated circuits suitable for certain telecommunications applications. The
Siemens Agreement calls for the payment to the Company of additional license
fees when the Company and Siemens have entered into further agreements for the
development of specific technologies, although there can be no assurance that
the parties will enter into such additional agreements.  On October 14, 1997,
the Company entered into a Master Technology Collaboration Agreement (the "OGI
Agreement") with the Oregon Graduate Institute of Science and Technology ("OGI")
pursuant to which the Company and OGI have agreed to pursue research and
development of certain ASRT.  Under the terms of the first Statement of Work
between the Company and OGI entered into pursuant to the OGI Agreement, the
parties are collaborating on advanced ASR applications for entry in the 1999
DARPA competition.  The OGI Agreement contemplates that the Company and OGI will
enter into other agreements to pursue research and development of certain
technologies related to the ASRT, although there can be no assurance that such
additional agreements will be entered into by the Company and OGI.

Other than the arrangements with Siemens and OGI, the Company has no licensing
or co-development agreements with any third party and other than the non-
refundable license fee paid by Siemens, the Company has received no revenue to
date.  fonix presently anticipates that any products incorporating the Company's
Core Technologies would be manufactured and marketed by such third party
licensees and co-development and strategic alliance partners such as 

                                 Page 16 of 28
<PAGE>
 
Siemens and therefore has no plans to manufacture products incorporating the
ASRT for the foreseeable future. The Company is presently engaged in discussions
with potential licensees and co-developers. There can be no assurance that the
Company will be able to license its Core Technologies to third parties other
than Siemens or enter into additional co-development or strategic alliance
agreements.

The Company's primary development objective is to further develop, refine and
enhance the main components of its ASRT and certain supplemental technologies.
The Company's initial marketing direction is to focus on licensing its ASRT to
third parties and co-developers.  These licenses will be made broadly available
to many segments of the computer industry, including application software,
operating systems, computers and microprocessor chips, and research and
development entities worldwide, including academia, government, industry and
commercial speech product developers who may want to take advantage of the
Company's ASRT or related technologies in their existing products. The Company
anticipates that it will sell or license its ASRT or related technologies on
terms advantageous to the Company, and that run-time product license royalty
rates will vary according to applications, sales volumes, and end-user pricing
of products using the ASRT.  The Company may reserve exclusive rights in some
fields of use for the internal development of high value end-user products and
applications.

The Company acquired AcuVoice in March 1998, after the end of the year covered
by this Report.  The following discussion does not take into consideration any
of the operating results of AcuVoice.

Results of Operations
---------------------

1997 Compared to 1996

Prior to March 1997, the Company conducted its scientific research and
development activities through Synergetics, Inc. ("Synergetics"), pursuant to
product development and assignment contracts (collectively the "Synergetics
Agreement"). Synergetics provided personnel and facilities and the Company
financed scientific research and development of the ASRT on an as-required
basis.  There was no minimum requirement or maximum limit with respect to the
amount of funding the Company was obligated to provide to Synergetics under the
Synergetics Agreement, and the Company was obligated to use its best efforts in
raising all of the necessary funding for the development of the ASRT.
Synergetics submitted pre-authorized work orders and budgets, which were then
reviewed and approved by the Company.  All funds paid to Synergetics have been
accounted for by the Company as research and development expense.  Under the
Synergetics Agreement, the Company had also agreed to pay a royalty to
Synergetics equal to 10 percent of revenues from sales of the ASRT or products
incorporating the ASRT (the "Royalty").  On March 13, 1997, the Company and
Synergetics reached an agreement in principle to modify the Synergetics
Agreement with regard to the development and assignment of the Company's ASRT.
All research and development activity previously conducted by Synergetics was
moved in-house to the Company in or about March 1997 at the time the agreement
in principle was reached.  On April 6, 1998, the parties finalized their
understanding in a written agreement (the "Modification Agreement").  Under the
Modification Agreement, the Company no longer has any obligation to pay the
Royalty or any percentage of the revenues received from entering into licensing
and/or co-development agreements or otherwise from the manufacture of products
incorporating the ASRT.  Assignment to the Company of all technology relating to
the ASRT is confirmed by the Modification Agreement.

Because the Company did not license its ASRT until February 1998, the Company
did not generate any revenues during 1997 or 1996.  From inception on October 1,
1993 through December 31, 1997, the Company has invested $17,937,293 in research
and development relating to its Core Technologies.  During the year ended
December 31, 1997, the Company incurred research and development expenses of
$7,066,294, an increase of $2,308,282 over the previous year.  This increase is
due primarily to the addition of research and development personnel, equipment
and facilities.  The Company anticipates similar or increased research and
development costs as it expands and continues to develop and market its Core
Technologies.

                                 Page 17 of 28
<PAGE>
 
General and administrative expenses were $12,947,112 and $3,530,400,
respectively, for the years ended December 31, 1997 and 1996.  This increase
over the previous year was due primarily to non-cash expenses associated with
the issuance of debt and equity securities and an increase in consulting and
outside services.  Consulting and outside services were $7,134,115 and
$1,456,297 for the years ended December 31, 1997 and 1996, respectively, an
increase of $5,677,818 in 1997.  In 1997, $4,112,970 of the consulting and
outside services was a non-cash expense for the issuance of Common Stock for
services associated with potential strategic alliances.  Additionally, the
Company incurred increased expenses in salaries, rents, legal and accounting
fees, and fees paid for outside consulting services.

Due to the lack of revenues and significant research and development and general
and administrative expenses, the Company has incurred losses from operations
since inception totaling $40,183,963, of which $20,013,406 and $8,288,412 were
incurred in the years ended December 31, 1997 and 1996, respectively.   At
December 31, 1997, the Company had an accumulated deficit of $45,017,746 and
stockholders' equity of $2,372,475.  The Company anticipates that its investment
in ongoing scientific research and development of the ASRT and related
artificial intelligence and compression/decompression technologies will continue
at present or increased levels for at least the remainder of fiscal 1998.

Net other expense was $1,558,678 for the year ended December 31, 1997, an
increase in net expense of $2,017,582 over the previous year.  This increase was
due primarily to expenses associated with the issuance of convertible debentures
and warrants.  In addition, the Company has drawn on its line of credit to fund
its operations, thereby investing smaller amounts of cash reserves which
decreased interest income and increased interest expense.

The Company extinguished debentures in the amount of $2,150,000 and related
accrued interest of $28,213 by issuing 108,911 shares of Series B Preferred
Stock.  In connection with the extinguishment of the debentures and the issuance
of Series B Preferred Stock, the Company expensed unamortized prepaid financing
costs in the amount of $220,014 as a loss on extinguishment of debt.  In
connection with this extinguishment, the Company issued a warrant to purchase up
to 175,000 shares of Common Stock.  The Company recorded the fair value of the
warrant of $661,850 as an additional loss on extinguishment of debt.

1996 Compared to 1995

The Company generated no revenues during 1996 and 1995.  From October 1, 1993
(date of inception) through December 31, 1996, the Company expended $10,870,999
in research and development relating to its Core Technologies.  During the years
ended December 31, 1996 and 1995, the Company incurred research and development
expenses of $4,758,012 and $2,704,165, respectively, an increase of $2,053,847
in 1996.  This increase was due primarily to the addition of research and
development personnel, equipment and facilities.

General and administrative expenses were $3,530,400 and $3,553,665,
respectively, for the years ended December 31, 1996 and December 31, 1995.
General and administrative expenses decreased slightly during these periods
primarily due to minimal increases in office employees and related salaries
offsetting in part, larger decreases in management fees, legal and accounting
fees and consulting services.

Due to the lack of revenues and significant research and development and general
and administrative expenses, the Company incurred losses from operations from
inception through December 31, 1996 totaling $20,170,557, of which $8,288,412
and $6,257,830 were incurred in the years ended December 31, 1996 and 1995,
respectively.   At December 31, 1996, the Company had an accumulated deficit of
$19,841,807 and stockholders' equity of $6,270,189.

Net other income was $458,904 for the year ended December 31, 1996, an increase
of $546,971 over the previous year. This increase was due primarily to earnings
on the Company's increased cash reserves.  Interest income increased $988,330
from $191,929 for the year ended December 31, 1995 to $1,180,259 for the year
ended December 31, 1996.

                                 Page 18 of 28
<PAGE>
 
Liquidity and Capital Resources
-------------------------------

The Company's current assets exceeded its current liabilities by $678,823 at
December 31, 1997 compared to $4,906,520 at December 31, 1996.  The current
ratio was 1.03 at December 31, 1997, compared to 1.26 at December 31, 1996.
Current assets decreased by $2,818,912 to $21,148,689 from December 31, 1996 to
December 31, 1997.  Current liabilities increased by $1,408,785 to $20,469,866
during the same period.  The decrease in working capital from 1996 to 1997 is
primarily attributable to the Company's use of its cash reserves to fund
increased operating expenses during the year ended December 31, 1997.  Total
assets were $22,894,566 at December 31, 1997 compared to $25,331,270 at December
31, 1996.

From its inception, the Company's principal source of capital has been private
and other exempt sales of the Company's debt and equity securities.   Private
and other exempt sales of the Company's debt and equity securities resulted in
net cash proceeds of $9,058,000 and $11,888,443 for the years ended December 31,
1997 and 1996, respectively.

On June 18, 1997, the Company entered into a Convertible Debenture Purchase
Agreement (the "Agreement") whereby an unrelated investment entity agreed to
purchase up to an aggregate principal amount of $10,000,000 of the Company's
Series B Convertible Debentures.  The debentures were due June 18, 2007, bore
interest at 5 percent and were convertible into shares of the Company's Common
Stock at anytime after issuance at the holder's option.  The conversion feature
provided for a conversion rate of the lesser of $6.81 or the average of the per
share market value for the five trading days immediately preceding the
conversion date multiplied by 90 percent for any conversion on or prior to the
120/th/ day after the original issue date and 87.5 percent for any conversion
thereafter.  On June 18, 1997, the Company received $3,000,000 in proceeds
related to the issuance of Series B Convertible Debentures.  Using the
conversion terms most beneficial to the investor, the Company recorded a prepaid
financing cost of approximately $427,900 in connection with the debenture to be
amortized as additional interest expense over the 120 day period commencing June
18, 1997.  As part of the same transaction, the Company also issued to the
investor a warrant to purchase up to 250,000 shares of Common Stock at any time
prior to June 18, 2002, at the exercise price of $8.28 per share.  The Company
recorded the fair value of the warrants, totaling $897,750, as a charge to
interest expense.  On July 31, 1997 and September 26,1997, $500,000 and $350,000
of the Series B Convertible Debentures were converted into 87,498 and 58,249
shares of Common Stock, respectively.

Effective September 30, 1997, the Company and the Series B Convertible Debenture
holders agreed to modify the Agreement.  The holder extinguished all then
outstanding debentures in the amount of $2,150,000 and related accrued interest
of $28,213 for 108,911 shares of Series B Preferred Stock having essentially the
same terms as the debentures. In connection with the extinguishment of the
Series B Convertible Debentures and the issuance of Series B Preferred Stock,
the Company recorded all unamortized prepaid financing costs as a loss on
extinguishment of debt.  Also in connection with this modification, the Company
issued an additional warrant to purchase up to 175,000 shares of Common Stock at
any time prior to October 24, 2002, at the exercise price of $7.48 per share.
In connection with the issuance of that warrant, the Company recorded the fair
value of the warrant, totaling $661,850, as a loss on extinguishment of debt.

Dividends accrue on the stated value ($20 per share) of Series B Preferred Stock
at a rate of 5 percent per year, are payable quarterly in cash or Common Stock,
at the option of the Company, and are convertible into shares of the Company's
Common Stock at anytime after issuance at the holder's option.  In the event of
liquidation the holders of the Series B Preferred Stock are entitled to an
amount equal to the stated value ($20 per share) plus accrued but unpaid
dividends whether declared or not.  The holders of Series B Preferred Stock have
no voting rights.  The Series B Preferred Stock, together with dividends accrued
thereon, may be converted into shares of the Company's Common Stock at the
lesser of $6.81 or the average of the per share market value for the five
trading days immediately preceding the conversion date multiplied by 90 percent
for any conversion on or prior to the 120/th/ day after the original issue date
and 87.5 percent for any conversion thereafter.  Using the conversion terms most
beneficial to the holder, the Company recorded a dividend 

                                 Page 19 of 28
<PAGE>
 
of $219,614, which represents a discount of 10 percent, which is available to
the holder upon issuance. The additional 2.5 percent discount of $68,509 was
amortized as a dividend over the remaining days in the 120 vesting period. Prior
to the actual issuance of the Series B Preferred Stock in exchange for the
outstanding balance under the debenture, the holder converted the balance of
$2,150,000 into 431,679 shares of Common Stock.

The Company sold an additional 125,000 shares of Series B Preferred Stock for
$2,500,000 less $145,000 in related fees. Using the conversion terms most
beneficial to the holder, the Company recorded a dividend of $576,667 which
represents a discount of 10 percent, which is available to the holder on or
before 120 days subsequent to closing.  A 2.5 percent discount of $87,905 is
being amortized as a dividend over 120 days.  As a condition for issuing
convertible Preferred Stock, the holder was granted a put option by SMD, L.L.C.
("SMD"), a company controlled by three shareholders who are officers of fonix.
The put option requires SMD to purchase the Series B Preferred Stock from the
holder at the holder's option, but only in the event that the Common Stock of
the Company is removed from listing on the Nasdaq Small Cap Market or any other
national securities exchange.  There was no agreement which would have required
the Company to reimburse SMD should SMD be required to purchase the Series B
Preferred Stock from the holder. In connection with this put option, the Company
recorded an expense and a corresponding capital contribution of $125,000. As of
December 31, 1997, 97,500 of the Series B Preferred Stock and related dividends
had been converted into 355,188 shares of Common Stock.  In January 1998, the
remaining 27,500 shares of Series B Preferred Stock and related dividends were
converted into 193,582 shares of Common Stock and there are no shares of Series
B Preferred Stock outstanding.

In September 1997, the Series A Convertible Debenture was converted into 166,667
shares of Series A Preferred Stock. The holder of the Series A Preferred Stock
has the same voting rights as Common stockholders, has the right to elect one
person to the board of directors and receives a one time preferential dividend
of $2.905 per share of Series A Preferred Stock prior to the payment of any
dividend on any class or series of stock.  At the option of the holder, each
share of Series A Preferred Stock is convertible into one share of Common Stock
and in the event that the Common Stock price has equaled or exceeded $10 for a
fifteen day period, the Series A Preferred Stock shares are automatically
converted into Common Stock.  In the event of liquidation, the holder is
entitled to a liquidating distribution of $36.33 per share and a conversion of
Series A Preferred Stock at an amount equal to 1.5 shares of Common Stock for
each share of Series A Preferred Stock.

Effective September 30, 1997, the Company entered into an agreement with an
unrelated investment entity whereby that entity agreed to purchase 187,500
shares of the Company's Series C Preferred Stock for $3,750,000. The cash
purchase price was received in October 1997.  Dividends accrue on the stated
value of Series C Preferred Stock at a rate of 5 percent per year, are payable
quarterly in cash or Common Stock, at the option of the Company, and are
convertible into shares of the Company's Common Stock at anytime after issuance
at the holder's option.  In the event of liquidation the holders of the Series C
Preferred Stock are entitled to an amount equal to the stated value ($20 per
share) plus accrued but unpaid dividends whether declared or not.  The holders
of Series C Preferred Stock have no voting rights. The Series C Preferred Stock,
together with dividends accrued thereon, may be converted into shares of the
Company's Common Stock at the lesser of $5.98 or the average of the five lowest
closing bid prices for the 15 trading days preceding the date of any conversion
notice multiplied by 91 percent for any conversion on or prior to the 120/th/
day after the original issue date, 90 percent for any conversion between 121 and
180 days and 88 percent for any conversion thereafter.  Using the conversion
terms most beneficial to the holder, the Company recorded a dividend of
$1,060,718, which represents a discount of 9 percent, which is available to the
holder on or before 120 days subsequent to closing.  The additional 3 percent
discount of $164,002 is being amortized as a dividend over 180 days.  As a
condition for issuing convertible Preferred Stock, the Series C Preferred
Stockholder was granted a put option by SMD.  The put option required SMD to
purchase the Series C Preferred Stock from the holder at the holder's option,
but only in the event that the Common Stock of the Company is removed from
listing on the Nasdaq Small Cap Market or any other national securities exchange
or if the trading price of the Company's Common Stock drops below $3.00 per
share for two consecutive days.  No agreement required the Company to reimburse
SMD should SMD have been required to purchase the Preferred Stock from the
holder.   In connection with this put option, the Company recorded an expense
and a corresponding capital 

                                 Page 20 of 28
<PAGE>
 
contribution of $375,000. Associated with the issuance of the Series C Preferred
Stock, the Company issued a warrant to purchase up to 200,000 shares of Common
Stock at any time prior to October 24, 2000, at the exercise price of $7.18 per
share. The Company recorded the fair market value of the warrant of $600,000 as
determined as of October 24, 1997 using the Black-Scholes pricing model. During
the year ended December 31, 1997, the Company issued 17,198 shares of Common
Stock upon conversion of 2,500 shares of Series C Preferred Stock and related
accrued dividends. Subsequent to December 31, 1997, the balance of 185,000
shares of Series C Preferred Stock and related dividends were converted into
1,295,699 shares of the Company's Common Stock and there are presently no shares
of Series C Preferred Stock outstanding.

Although the Company has signed its first Statement of Work with Siemens and the
Company anticipates that it will enter into additional third party license or
licenses or co-development agreements for its ASRT with Siemens and other
parties during fiscal year 1998, there can be no assurance that this will occur.
Even with the current Siemens agreement in place, the Company's operating
expenses remain higher than revenues from operations.  Accordingly, the Company
expects to incur significant losses at least through the end of fiscal 1998 and
until such time as it is able to enter into substantial licensing and co-
development agreements and receive substantial revenues from such arrangements,
of which there can be no assurance.

The Company has established a relationship with a major regional federally
insured financial institution pursuant to which the Company is permitted to
borrow against its own funds on deposit with the institution.  As of December
31, 1997 and 1996, the Company had funds on deposit of $20,000,000.  As of
December 31, 1997, the Company owed $18,612,272 to the institution, compared
with $16,377,358 the previous year.  The weighted average outstanding balance
during 1997 and 1996 was $18,861,104 and $11,786,889, respectively.  The
weighted average interest rate was 5.94 percent and 5.80 percent during 1997 and
1996, respectively.  This note is due April 29, 1998 and bore an interest rate
of 6.50 percent at December 31,1997.  This revolving note is renegotiated
quarterly and the Company plans to continue renewing the note indefinitely.  The
net difference between the rate of interest paid by the institution for the
Company's funds on deposit at the institution and the interest rate paid to the
Company by the institution is approximately 1 percent.  Interest income and
expense is payable monthly and the principal amount is payable in full at
maturity.

The Company is a development stage company and generated no revenues for the
year ended December 31, 1997.  The Company reported net  losses totaling
$22,453,948 for the year ended December 31, 1997, and cumulative losses of
$42,295,755 for the period from inception to December 31, 1997.  The Company has
minimal stockholders' equity of $2,372,475 and minimal working capital of
$678,823 as of December 31, 1997.   The Company expects to continue to incur
significant losses through at least December 31, 1998, primarily due to
expenditures associated with the marketing and development of its proprietary
automatic speech recognition and related technologies.  The Company must secure
substantial funding to be able to satisfy its cash requirements during the next
12 months. Scientific research and development, corporate operations and
marketing expenses will continue to require additional capital.  Because the
Company presently has only limited revenue from operations, the Company intends
to continue to rely primarily on financing through the sale of its equity and
debt securities to satisfy future capital requirements until such time as the
Company is able to enter into additional acceptable third-party licensing or co-
development arrangements such that it will be able to finance ongoing operations
out of license, royalty and sales revenue.  The Company anticipates that it will
be able to secure adequate funding to finance its operations and acquisitions
over the next 12 months, although there can be no assurance that such financing
will be available.  If such financing is not available, the Company will
significantly reduce or suspend its operations.  Furthermore, the issuance of
equity securities or other securities which are or may become convertible to the
equity securities of the Company to secure financing will result in dilution to
the stockholders of the Company, which could be substantial.  These factors, as
well as the risk factors set out elsewhere in this document, raise substantial
doubt about the Company's ability to continue as a going concern.  The
accompanying financial statements do not include any adjustments that might
result from the outcome of this uncertainty.

                                 Page 21 of 28
<PAGE>
 
The Company's Core Technologies are designed to be Year 2000 compliant.  The
Company intends to monitor the efforts of third-party providers whose services
are critical to the Company as they become Year 2000 compliant.  Management is
presently not aware of any Year 2000 issues that have been encountered by any
such third-party which could materially affect the Company's operations.
Notwithstanding the foregoing, there can be no assurance that the Company will
not experience operational difficulties as a result of Year 2000 issues, either
arising out of internal operations, or caused by third-party service providers,
which individually or collectively could have an adverse impact on business
operations or require the Company to incur unanticipated expenses to remedy any
problems. providers as they become Year 2000 compliant.

The Company presently has no plans to purchase any new plants or office
facilities.  The Company is currently planning to lease a larger office facility
in the San Jose, California area to house a growing AcuVoice staff and
anticipates that it will incur approximately $950,000 in capital expenditures
for equipment Company-wide during 1998.

                                    Outlook

Corporate Objectives, Technology Vision and Acquisition Strategy

The Company has positioned itself as a developer of "next generation" speech
technology.  The management team of fonix has assembled leading talents in the
speech recognition and speech synthesis arenas.  The Board of Directors and
management have developed a business strategy that identifies the Company's
strengths and objectives, outlines a vision of the next major market opportunity
in the computer industry (implementation of speech technologies) and articulates
a corporate and technology strategy that includes strategic alliances,
collaborative development agreements, strategic acquisitions and, ultimately,
marketing a suit of fonix-branded products.

Management believes the strengths of fonix include:

     .    Next generation Core Technologies
     .    Strong Board of Directors and management team
     .    Inclusive, supportive corporate culture

Management believes that these strengths can be used by the Company to provide
added access to capital markets, facilitate accomplishment of the objectives of
the Company and position the Company as an attractive investment and development
partner.

The Company believes that its Core Technologies will be the platform for the
next generation of automatic speech technology and products.  Most speech
recognition products offered by other companies are based on technologies such
as HMMs, that are largely in the public domain and represent nothing
particularly "new" or creative.  The fonix Core Technologies are based on
proprietary, patented technology.  The Company will continue to seek patent
protection of the Core Technologies and will seek to add, through acquisitions,
such as the AcuVoice merger, products and technologies that are either patented
or unique in the marketplace.  Management believes this strategy will set the
Company's advanced speech products apart from the competition.

The Company is determined to become a multi-market, multi-product enterprise
offering advanced speech and human-computer interface technologies for business,
consumer and service applications.  Advance human-computer interface
technologies and multi-modal systems include:

     .    speech recognition and synthesis
     .    speaker identification
     .    pen and touch screen input

                                 Page 22 of 28
<PAGE>
 
     .    haptic (manual) input and output
     .    facial and gesture input and output

Anticipated products incorporating such advanced multi-modal human computer
interface technology include the following:

     .    PC's and cellular phones
     .    automotive and home environment speech controls
     .    automated information and transaction kiosks and telephone systems
          with natural dialogue and gesture controls

This next generation technology presents important product and service
opportunities for companies like fonix in a variety of industry segments,
including:

     .    semiconductors
     .    telecommunications
     .    computers
     .    software
     .    consumer electronics
     .    entertainment

fonix is a technology company.  Since its inception, the Company has focused on
the development of its Core Technologies and related complimentary technologies.
The Company will pursue the development and acquisition of advanced speech and
computer-interface technologies that will enhance or may be enhanced by its own
Core Technologies.  fonix will pursue this development through strategic
alliances, such as the Siemens agreement in the telecommunications industry, and
through collaborative research arrangements such as its agreement with OGI.

Acquisition targets will (i) have technologies that are complementary to the
Core Technologies, (ii) offer existing products and marketing strengths that
provide immediate revenues to the Company, (iii) open new marketing channels for
existing technologies or products of the Company, (iv) provide new product
vehicles for the Core Technologies and (v) possess vertical market applications
expertise that can be leveraged by the Company in further product development
and marketing opportunities.  The Company has observed that there are numerous
small "boutique" speech technology vendors.  An alliance with or acquisition of
such vendors by the Company can offer these small companies greater access to
human and financial resources which, it is hoped, will lead to greater market
share, improved product development and support, and creation of additional
applications.  The Company believes that the ideal candidates will be involved
in one or more of these categories:

     .    Core speech and language technology, which would include companies
          with speech products or technology involving text-to-speech, multiple
          languages, natural language processing, translation, speaker
          identification, and microphone design.

     .    Speech products and applications, such as interactive natural dialogue
          systems, telephone systems, large vocabulary medical, legal systems,
          compression, and chip-based systems.

     .    Other computer interface technologies, such as pen input and
          handwriting recognition, haptic (manual) input and output, face and
          gesture recognition, pentop and wearable computers.

As the Company proceeds to implement its strategy and to reach its objectives,
it anticipates realizing several benefits for itself and for its shareholders.
In 1998, the Company will, for the first time in its history, begin to realize
recurring 

                                 Page 23 of 28
<PAGE>
 
revenues. In addition, the Company expects further development of complementary
technologies, added product and applications development expertise, access to
market channels, leverage of strategic alliances, increased access to capital
markets, and additional opportunities for strategic alliances in other industry
segments.

The strategy described above is not without risk, and shareholders and others
interested in the Company and its Common Stock should carefully consider the
risks contained elsewhere in this Report.

               Special Note Regarding Forward-Looking Statements

Certain statements contained herein under "Business," "Management's Discussion
and Analysis of Financial Condition and Results of Operations" and "Outlook,"
including statements concerning (i) the Company's strategy, (ii) the Company's
expansion plans, (iii) the market for the Company's technology, products and
services, (iv) the effects of future government regulation of the Company's
products, (v) the development and launch of new products and the results of
research and development efforts, and (vi) the growth of the Company's business,
contain certain forward-looking statements concerning the Company's operations,
economic performance and financial condition.  Because such statements involve
risks and uncertainties, actual results may differ materially from those
expressed or implied by such forward-looking statements.  Factors that could
cause such differences include, but are not necessarily limited to, those
discussed under the heading "Certain Significant Risk Factors," elsewhere in
this Report.

                                    PART III

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Studdert Companies Corp.

SCC is a Utah corporation that provides investment and management services.  The
officers, directors and owners of SCC are Stephen M. Studdert, Thomas A. Murdock
and Roger D. Dudley, each of whom is a director and an executive officer of the
Company and each of whom beneficially owns more than ten percent of the
Company's issued and outstanding Common Stock.  Between June 1994, when the
Company commenced its present business of developing its ASRT, and April 30,
1996, the Company did not pay or award any compensation in any form directly to
the Company's executive officers.  Rather, in June 1994 the Company entered into
an Independent Consulting Agreement (the "SCC Agreement") with SCC pursuant to
which SCC, through Messrs. Studdert, Murdock and Dudley, rendered certain
management and financial services to the Company.

In 1993, SCC began to render management services to PTI, the Company's
predecessor in interest, with respect to PTI's business of developing the ASRT.
Those services included providing day-to-day administrative management services,
debt financing directly to PTI, procuring debt financing from third parties, and
commencing a search for a joint venture partner or merger candidate at monthly
charges ranging from $50,000 to $100,000.  In June 1994, PTI merged with and
into a subsidiary of the Company, after which the Company entered into the SCC
Agreement with SCC dated as of June 22, 1994.  Under the SCC Agreement, SCC
agreed that for a period of two years it would manage all aspects of the
Company's day-to-day business, have authority to engage on behalf of the Company
such employees, agents and professionals as it deemed appropriate, and be
reimbursed for its reasonable costs and expenses incurred for and on behalf of
the Company.  In return for such services, the Company agreed to compensate SCC
in the amount of $50,000 per month, which monthly amount was exclusive of (i)
fees for capital raising activities by SCC on the Company's behalf and (ii)
actual expenses incurred by SCC.

Pursuant to the SCC Agreement, the Company paid to SCC $209,300 during the year
ended December 31, 1994.  At December 31, 1994, the Company owed SCC $1,164,200
for accrued management fees and $66,805 for expenses incurred.  Between January
and July 1995, SCC continued to invoice the Company for services rendered under
the 

                                 Page 24 of 28
<PAGE>
 
Consulting Agreement.  By July 1995, the Company owed SCC approximately
$1,417,000 pursuant to the terms of the SCC Agreement.  On November 16, 1994,
the Company's Board of Directors approved the issuance of warrants to purchase
up to 3,700,000 shares of the Company's Common Stock to SCC (the "SCC
Warrants").  The authorized purchase price of the SCC Warrants was $.033 per
share, and the authorized exercise price for each share of Common Stock
underlying the SCC Warrants was $.35.  The Board of Directors' resolution
authorizing the issuance of the SCC Warrants specified that the purchase price
for the SCC Warrants and the exercise price for shares of Common Stock
underlying the SCC Warrants could be satisfied by canceling invoices for
services previously rendered to the Company under the Consulting Agreement or by
cash payment.  The November 16, 1994 Board meeting was attended by a quorum of
the Board, but only one director who was not also a principal of SCC was
present.  Subsequently, on April 11, 1995, pursuant to the unanimous consent of
all disinterested directors in lieu of a special Board meeting, all of the
Company's disinterested directors ratified the adoption of the resolution
authorizing the Company to offer the SCC Warrants.  On July 31, 1995, the
Company issued and SCC purchased the SCC Warrants.  The purchase price of the
SCC Warrants was $.033 per share of Common Stock underlying the SCC Warrants, or
an aggregate of $122,100.  On August 11, 1995, SCC exercised the SCC Warrants at
an exercise price of $.35 per share of Common Stock underlying the SCC Warrants.
Both the $122,100 purchase price and the $1,295,000 aggregate exercise price for
the SCC Warrants were satisfied by the cancellation of amounts invoiced to the
Company by SCC pursuant to the SCC Agreement during the fiscal year ended
December 31, 1994 and the period between January 1, 1995 and August 11, 1995.
Such cancellation was accomplished on a dollar-for-dollar basis.

Between August 1995 and October 1995, SCC continued to invoice the Company for
its $50,000 monthly management fee under the Consulting Agreement, portions of
which amounts continued to accrue.  On October 23, 1995, the Company entered
into an investment agreement (the "Beesmark Agreement") with Beesmark.  In
connection with the Company's execution of the Beesmark Agreement, SCC and the
Company collaterally agreed that any then accrued but unpaid balance due to SCC
for management services rendered under the SCC Agreement would be placed on
"conditional status" and deferred until the Company successfully completed
certain developmental milestones set forth in the Beesmark Agreement, at which
time such amounts would be due and payable in full.  With respect to management
services to be rendered by SCC after the closing of the Beesmark Agreement, SCC
agreed that the Company would pay only $30,000 of the monthly invoiced $50,000,
the balance to be placed on conditional status.  Thus, of the total $600,000
invoiced to the Company by SCC during the year ended December 31, 1995, the
Company paid SCC $90,000 in cash; $257,000 of accrued but unpaid amounts were
placed on conditional status under the Investment Agreement; and $253,000 was
canceled in partial payment of the exercise price of the SCC Warrants.  In
addition to the amounts invoiced by SCC for management fees during the 1995
fiscal year, the Company also reimbursed SCC for actual expenses incurred in the
amount of $337,405.  Thus, at December 31, 1995, the Company owed SCC $257,000
in management fees, all of which was on conditional status under the terms of
the Beesmark Agreement and was payable to SCC only in the event that the Company
achieved the developmental milestones set forth in the Beesmark Agreement.  At
December 31, 1995, the Company also owed SCC $3,825 for expenses incurred.
Additionally, during the year ended December 31, 1995, SCC charged a total of
$70,915 in capital raising fees to the Company.  Of that amount, $49,576 was
written off by SCC in connection with the Beesmark Agreement, and $21,339 was
paid to SCC.

Between January 1, 1996 and April 30, 1996, SCC invoiced the Company for
services under the SCC Agreement in the amount of $200,000.  Of that amount,
$80,000 was placed on conditional status pursuant to the Beesmark Agreement and
$120,000 was paid to SCC. On April 30, 1996, the disinterested members of the
Company's Board of Directors authorized the Company to enter into an agreement
with SCC modifying the SCC Agreement effective May 1, 1996.  Under the SCC
Agreement, as modified, SCC no longer invoices the Company for management
services, but continues to invoice the Company for reimbursement of actual
expenses incurred on the Company's behalf.  SCC and the Company agreed that any
amounts invoiced under the SCC Agreement but placed on conditional status
pursuant to the Beesmark Agreement would remain outstanding obligations of the
Company payable only if the Company achieved the milestones specified in the
Beesmark Agreement.  The Company further agreed to pay any then accrued but
unpaid amounts invoiced under the SCC Agreement, including amounts owed and
carried over from the year ended December 31, 1995, which amounts 

                                 Page 25 of 28
<PAGE>
 
totaled $5,862, as well as outstanding amounts for expenses incurred. In
connection with the modification of the SCC Agreement, the disinterested members
of the Company's Board of Directors approved base salaries for fiscal year 1996
for each of the Company's executive officers, effective as of April 1996, as
follows: Stephen M. Studdert, Chief Executive Officer -- $180,000; Thomas A.
Murdock, President and Chief Operating Officer -- $180,000; and Roger D. Dudley,
Executive Vice President and Chief Financial Officer -- $180,000. Effective
November 15, 1996, the disinterested members of the Company's Board of Directors
approved an increase in the base salaries of the executive officers from
$180,000 to $250,000 per annum for the remainder of fiscal 1996, with base
compensation increasing annually over the five-year term of those persons'
employment agreements. [See Item 10. Executive Compensation]. In September 1996,
Beesmark made the last of the funding payments provided for under the terms of
the Beesmark Agreement. On February 10, 1997, the Company paid to SCC the entire
balance due to SCC for accrued management fees in the amount of $337,000. Thus,
during the year ended December 31, 1996, the Company paid to SCC a total of
$120,000 for management fees and SCC was reimbursed for actual expenses incurred
on the Company's behalf in the amount of $740,052. During 1996, the Company made
no payments to SCC for capital raising activities. The Company and SCC have
agreed to extend the SCC Agreement, at least insofar as the Company has agreed
to reimburse SCC for actual expenses incurred on behalf of the Company, until
December 1998.

The Company paid no compensation in any form directly to any of its executive
officers during fiscal 1995 and until April 1, 1996.  However, as the principals
of SCC, during such periods, the Company's executive officers received a portion
of the amounts paid by the Company to SCC under the SCC Agreement. See
"Executive Compensation."

Cancellation of Debt By SCC and Thomas A. Murdock

In connection with the Beesmark Agreement, SCC and the Company entered into a
collateral agreement whereby SCC agreed that it would cancel principal debt of
$135,368 and accrued interest of $19,298 owed by the Company to SCC in
connection with a promissory note executed by PTI and assumed by the Company at
the time of the merger of PTI with and into a subsidiary of the Company.  In
another collateral agreement, the Company and Thomas A. Murdock, a director and
executive officer of the Company, agreed that the Company would cancel principal
debt of $286,493 and accrued interest of $65,715 due to Mr. Murdock under a
promissory note initially made by PTI and assumed by the Company at the time of
the merger of PTI with and into a subsidiary of the Company.

Alan C. Ashton and Beesmark Investments, L.C.

On October 23, 1995, the Company, Beesmark and Dr. Ashton entered into the
Beesmark Agreement.  Dr. Ashton is presently a director of the Company, although
he did not occupy such position when the Beesmark Agreement was negotiated and
executed.  Dr. Ashton also is a co-manager of and has an indirect pecuniary
interest in a portion of Beesmark's assets.  Pursuant to the Beesmark Agreement,
Beesmark agreed to provide a total of $6,050,000 of funding to the Company over
a period of approximately 11 months, provided that during that time the Company
was able to timely meet, to Beesmark's satisfaction, specified developmental
milestones.  In return for the funding provided to Beesmark, the Company issued
11,562,500 shares of Common Stock at a price of $.48 per share and a $500,000
Series A Convertible Subordinated Debenture.  The Debenture was subsequently
converted to 166,667 shares of Series A Preferred Stock.

Synergetics

Thomas A. Murdock, a director and the Chief Operating Officer of the Company, is
also one of seven directors of Synergetics.  In addition, Mr. Murdock, Stephen
M. Studdert and Roger D. Dudley, each of whom is an executive officer and
director of the Company, own shares of the Common Stock of Synergetics, although
such share ownership in the aggregate constitutes less than 5% of the total
shares of Synergetics common stock issued and outstanding.

                                 Page 26 of 28
<PAGE>
 
John A. Oberteuffer

Mr. Oberteuffer has been a director of the Company since March 1997 and an
executive officer of the Company since January 1998.  Mr. Oberteuffer is also
the founder and president of Voice Information Associates, Inc. ("VIA"), a
consulting group providing strategic technical, market evaluation, product
development and corporate information to the speech recognition industry.
During fiscal year 1997, the Company paid approximately $110,000 in consulting
fees to VIA for services provided to the Company.  In April 1998, the Company
entered into an agreement with Dr. Oberteuffer under which Dr. Oberteuffer
assigned certain patent and other rights to certain technology for 500,000
Common Stock purchase warrants.  The exercise price of the warrants is $5.13 per
share (the closing price of the Company's Common Stock on the date of the
agreement).  250,000 warrants are exercisable for a three-year period commencing
with the date of the agreement and the balance of the warrants become
exercisable at such time as a patent is issued relating to the technology.

SMD

From September 4, 1997, through October 15, 1997 and again on December 31, 1997,
the Company borrowed funds from SMD pursuant to a revolving, unsecured
promissory note, bearing interest at the rate of 12% per annum.  The aggregate
of all amounts loaned under the note was $2,000,000 and the highest outstanding
balance at any one time was $1,550,000. All amounts have been repaid, together
with $5,542.14 in interest.  The loan and its terms were approved  by the
independent members of the board of directors of the Company.

On March 19, 1998, the Company granted an aggregate of 450,000 stock options to
the three executive officers who also own SMD.  These options have a ten-year
life and an exercise price of $5.16 per share.

The Company believes that the related party transactions described in this Item
13 were on terms no less favorable to the Company than it could have obtained
with unaffiliated third parties.



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                                 Page 27 of 28
<PAGE>
 
                                   SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this Amendment No. 1 to the Annual
Report on Form 10-K for the year ended December 31, 1997 to be signed on its
behalf by the undersigned, thereunto duly authorized, on this _______/th/ day
of March, 1999.



                                    fonix corporation




Date:     March 12, 1999             By:   /s/ Roger D. Dudley         
      ----------------------------         ----------------------------    
                                           Roger D. Dudley,
                                           Executive Vice President

                                 Page 28 of 28