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                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    FORM 10-K

(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, 1998, 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           (I.R.S. Employer Identification No.)
of incorporation or organization) 



                        60 East South Temple, 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  $35,828,186.25  calculated using a closing price of
$0.75  per  share  on April 9,  1999.  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 9,  1999,  (and not  counting  shares
beneficially   owned  on  that  date)  in   determining   the  shares   held  by
non-affiliates.  As  of  April  9,  1999,  there  were  issued  and  outstanding
70,064,495 shares of the Company's common stock.

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. [ ]

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                                Fonix Corporation

                          1998 FORM 10-K ANNUAL REPORT

                                TABLE OF CONTENTS

                                     Part I

                                                                            

Item  1. Business..............................................................3
Item  2. Properties...........................................................22
Item  3. Legal Proceedings....................................................23
Item  4. Submission of Matters to a Vote of Security Holders..................24

                                     Part II

Item  5. Market for Registrant's Common Equity and Related 
         Stockholder Matters..................................................24
Item  6. Selected Financial Data..............................................27
Item  7. Management's Discussion and Analysis of Financial Condition and
         Results of Operations................................................28
Item  8. Financial Statements and Supplementary Data..........................39
Item  9. Changes in and Disagreements with Accountants on Accounting and
         Financial Disclosure.................................................40

                                    Part III

Item 10. Directors and Executive Officers of the Registrant...................40
Item 11. Executive Compensation...............................................42
Item 12. Security Ownership of Certain Beneficial Owners and Management.......50
Item 13. Certain Relationships and Related Transactions.......................52

                                     Part IV

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K......54

                                  Page 2 of 60

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                                     PART I

ITEM 1.  BUSINESS

Overview

Fonix Corporation ("Fonix" or the "Company") is a development-stage company that
aims to make  commercially  available a  comprehensive  package of products  and
technologies  that allow humans to interact with  computer and other  electronic
products in a more efficient, intuitive and natural way than traditional methods
such as the keyboard.  Specifically,  Fonix has developed  proprietary automated
speech  recognition  and related  technologies  such as  text-to-speech  (speech
synthesis),  handwriting recognition and speech compression. These technologies,
as developed to date, use speech recognition  techniques that include the use of
a proprietary neural network method. Neural networks are computer-based  methods
which simulate the way the human brain processes information. Fonix licenses its
technologies to and has entered into co-development  relationships and strategic
alliances  with third  parties  including  producers  of  application  software,
operating systems, computers and microprocessor chips.

In March 1998, the Company acquired AcuVoice, Inc., a California corporation and
award winning developer of text-to-speech  technologies  ("AcuVoice").  AcuVoice
had developed and marketed its  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.  The  acquisition of AcuVoice by the Company
resulted in the  introduction  of  Fonix-branded  products to the market for the
first time in the Company's  history.  The  transaction  by which Fonix acquired
AcuVoice is referred to in this report as the AcuVoice Acquisition.

In September 1998, the Company  acquired  Articulate  Systems,  Inc., a Delaware
corporation and leading developer of specialized speech recognition applications
used in the health care industry ("Articulate"). This transaction is referred to
in this report as the Articulate  Acquisition.  Articulate's market focus, prior
to  and  following  the  acquisition,  is  providing  solutions  for  healthcare
organizations for cost effective and rapid capture, transcription and management
of dictated  clinical  information  across a network.  Specifically,  Articulate
develops, markets and supports an integrated  dictation/transcription  solutions
process called  PowerScribe(R) to healthcare  organizations  utilizing  advanced
continuous  speech  recognition  technology to  significantly  automate  medical
reporting.  The PowerScribe system is intended to be user friendly to physicians
and other medical professionals, to significantly reduce transcription costs and
report  turnaround time, and to provide other key benefits  without  sacrificing
dictation  accuracy or physician  acceptance.  Articulate entered into its first
sales  contracts  for its first  product,  PowerScribeRAD,  a  product  designed
specifically for radiologists, in January 1998. Articulate's first contracts for
its second  product,  PowerScribe  EM for emergency  medicine  physicians,  were
signed in January 1999.  Fonix is in the process of developing a suite of speech
recognition solutions for the healthcare and other markets.

In October 1998, the Company acquired Papyrus  Associates,  Inc., a Pennsylvania
corporation  ("PAI"),  and  Papyrus  Development  Corporation,  a  Massachusetts
corporation ("PDC" and together with PAI, "Papyrus"). The acquisition of PDC and
PAI by Fonix is  referred  to in this  report as the  Papyrus  Acquisition.  PAI
develops and markets printing and cursive handwriting  recognition  software for
personal  digital  assistants  ("PDAs"),  pen  tablets  and mobile  phones.  Its
customers include Philips,  Hitachi,  Olivetti/Oracle  Research Lab, NuovoMedia,
ARM, Amstrad,  Purple Software and Digital Equipment.  The Papyrus technology is
marketed under the trademark  Allegro(TM).  PAI's software and technology are an
integral  part of the Psion  PDA.  PDC is a systems  integration  provider  with
expertise and intellectual  property in embedded  systems and enhanced  Internet
applications.  PDC had a partnership  with e-Travel  which resulted in the first
corporate travel management  Web-browser client software system. This product is
now shipped by e-Travel to customers such as Fidelity  Investments,  ADP, Travel
One, Coca Cola, Time Inc., and Unisys.

The Company markets speech recognition  technologies it has developed,  together
with  text-to-speech  technologies  and  products  acquired  from  AcuVoice  and
handwriting recognition products and applications acquired from Papyrus, through
its Interactive  Technologies  Solutions Group. The present marketing  direction
for the Interactive  Technologies  Solutions Group is to form relationships with
third  parties who can  incorporate  the Company's  technologies  into their own
products or product development efforts. Such relationships may be structured in
any  of  a  variety  of  ways   including   traditional   technology   licenses,
co-development  relationships through joint ventures or otherwise, and strategic
alliances.   The  third  parties  with  whom  the  Company  presently  has  such
relationships and with which it may have similar relationships in the

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future include  participants in the  application  software,  operating  systems,
computer, microprocessor chips, consumer electronics,  automobile, telephony and
health care technology industries.  The Company received its first revenues from
its internally developed speech recognition technologies in 1998.

The Company markets its voice  recognition and systems  software for specialized
applications in the health care industry through its HealthCare Solutions Group.
The  HealthCare   Solutions  Group  presently  markets  large  vocabulary  voice
recognition  software  to major  hospitals  and  medical  centers  for the rapid
capture,  transcription  and  management  of  clinical  information  dictated by
radiologists and emergency medical  physicians.  The HealthCare  Solutions Group
also  supports and services the systems  within the United  States.  In December
1998,  the Company  acquired the assets used in the marketing of the  HealthCare
Solutions Group's products from The MRC Group, Inc. ("MRC").

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 principal executive offices of the HealthCare Solutions Group are
located at 600 West Cummings Park, Suite 4500, Woburn,  Massachusetts 01801. The
executive offices of the Interactive Technologies Solutions Group are located at
180 West  Election  Drive,  Draper,  Utah 84020.  The Company  also  maintains a
facility in Cupertino, California.

Technology and Product Overview

Automated 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 several 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,
Lernout  &  Hauspie  and  others.  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  ("HMM")  technology.  These  traditional  approaches  have not  advanced
appreciably since the late 1980s.  Applications based on such traditional speech
recognition systems for personal computers all require close-talking microphones
in 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 HMM, uses 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."

HMM's widely recognized  weaknesses are many: (i) it does not meet the needs for
many mass market implementations, (ii) it has limited input feature types, (iii)
it accounts for only limited context,  (iv) it has limited ability to generalize
acoustic and language structure, (v) it requires training data from the end-user
for acceptable performance, (vi) models

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become  extremely  large and complex as vocabulary  grows,  and (vii) there is a
lack of hardware parallel processing capability.

In contrast to HMM, 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  automated  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  automated  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 HMM 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,  the  Company  believes  that its ASRT  offers  unique  speech  processing
techniques that will complement and significantly  enhance  currently  available
speech  recognition  systems.  Through its  Interactive  Technologies  Solutions
Group,  Fonix intends to continue to license its ASRT, to continue to co-develop
the ASRT with  research  and  development  groups in industry  and  academia and
ultimately to market a suite of Fonix-branded  technologies and products. In the
long term, the Company  anticipates  that automated speech  recognition  systems
employing  the  Company's  unique ASRT will set the  industry  standard  for all
automated speech recognition  applications because of its anticipated capacities
to overcome the weaknesses of HMM. In addition, the Company expects that certain
elements of its Core  Technologies  will have  industry-leading  applications in
non-speech  recognition  industries,  market  segments and  disciplines  such as
artificial  intelligence  and data  compression.  Although these plans represent
management's beliefs and expectations 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  $13,620,748 and $7,066,294
on research and development  activities.  Since its inception (October 1, 1993),
the Company has spent  $31,558,041on  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.

HealthCare Solutions Group Products

The three PowerScribe  products now being sold by the HealthCare Solutions Group
are  PowerScribeRAD,  PowerScribeRAD  Software  Development  Kit ("SDK")TM,  and
PowerScribeEM.  PowerScribe  products use  state-of-the-  art continuous  speech
recognition engines licensed from Dragon Systems,  Inc., which enables a user to
dictate  naturally  and  continuously  without  having to pause  between  words.
PowerScribe   incorporates  customized  medical  language  models  gleaned  from
millions of words  sampled  from  medical  specialty  departments  across  North
America.

PowerScribe  products have been  designed as  mission-critical  applications  to
operate as an open and scalable continuous speech reporting and charting system.
PowerScribe  products utilize core  technologies from Microsoft's Back Office(R)
applications  development  suite  and  rely  on  Windows  NT(R),  Open  Database
Connectivity (ODBC) and SQL Server(R) as the foundation operational elements.


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         PowerScribeRAD for Radiology Reporting

PowerScribeRAD  enables the full automation of the radiology  reporting  process
and   replaces   existing   digital   dictation   and   transcription   systems.
PowerScribeRAD  permits the dictation of radiology  reports  directly into text,
with edit, approve, and sign functions  accomplished within a matter of minutes;
thereby significantly  reducing  transcription costs and report turnaround time.
Once reports are  dictated,  they may be  automatically  stored in the Radiology
Information  System  ("RIS"),   the  Hospital   Information  System  ("HIS")  or
PowerScribeRAD's own report repository.

         PowerScribeEM for Emergency Medicine Reporting

PowerScribeEM  is a  completely  integrated  emergency  medicine  dictation  and
transcription system which allows emergency department  professionals to dictate
their reports  directly into text in the first total  solution for capturing and
documenting  emergency  medicine clinical  encounters.  PowerScribeEM  minimizes
training and the need for healthcare  professionals to modify their work styles.
PowerScribe includes post-processing of the text for organization into a typical
structured  emergency  medicine  report.  PowerScribeEM  seamlessly  handles the
overall workflow of an emergency department.  Once reports are dictated, reports
are  either  automatically  stored  in the HIS or in  PowerScribe's  own  report
repository for further analysis at a later date.

         PowerScribe Radiology SDK for User Development Applications

The PowerScribe  Radiology SDK allows users to integrate the full  functionality
of the  PowerScribeRAD  system into the user's own radiology  applications.  For
radiology  environments such as a RIS or Picture Archival  Communication  System
("PACS") the  PowerScribe  SDK allows  users to develop a completely  integrated
dictation and  transcription  system utilizing  continuous  speech  recognition.
Using this SDK, the PowerScribeRAD client functionality can be embedded into the
user's application while also customizing the user interface and report workflow
to meet specific  application  needs. The  PowerScribeRAD  SDK supports multiple
development  environments  including  Microsoft(R)  Visual  Basic,  C++  and the
Microsoft(R)  Internet  Explorer  environment.  The  SDK  includes  an  Active-X
composite control along with sample code and developer documentation.

Interactive Solutions Group Products

The Interactive  Technologies  Solutions Group offers products and  technologies
which include  automated  speech  recognition,  text-to-speech,  and handwriting
recognition  for a variety of hardware and  software  platforms.  The  marketing
direction  for  the  Interactive   Technologies   Solutions  Group  is  to  form
relationships  with third parties who can incorporate  Fonix  technologies  into
their own products or product  development  efforts.  Such  relationships may be
structured  in  any  of a  variety  of  ways  including  traditional  technology
licenses,  co-development relationships through joint ventures or otherwise, and
strategic  alliances.  The third  parties  with whom  Fonix  presently  has such
relationships  and with which it may have  similar  relationships  in the future
include participants in the application software,  operating systems,  computer,
microprocessor  chips, consumer  electronics,  automobile,  telephony and health
care technology market sectors.  Interactive Technologies Group products include
AcuVoice  AV 1700,  AV 2001  text-to-speech  systems,  and  Allegro  handwriting
recognition.

         Embedded Technologies

Fonix  has  developed  an  application  development  tool,  the  Fonix  Advanced
Application  Speech  Toolkit  (FAAST(TM))  which allows  developers to simulate,
prototype and create code for embedded  applications using Fonix' human computer
interaction   technologies.   This  system   currently   supports  Fonix  speech
recognition   for   command  and  control   applications   and  Fonix   AcuVoice
text-to-speech  engines for both very high quality  limited  vocabulary and high
quality unlimited vocabulary  applications.  The system is designed to support a
number  of  popular   microprocessors   and   operating   systems  for  embedded
applications.  Currently,  FAAST supports the Siemens TriCore  micro-controller.
The beta version of the FAAST system will be available  for  developers  in June
1999. An alpha version of the system is currently being used internally at Fonix
to  support  the  development  of  embedded  systems  applications  for  several
companies including consumer electronic, automotive, and cell phone devices.


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         Core Speech Recognition Technologies

Since 1994 Fonix has pursued the  development  of a "3rd  Generation"  automated
speech recognition technology to overcome the limitations of currently available
commercial  speech   recognition   systems.   This  development  has  yielded  a
proprietary  ASR system  utilizing a unique  front-end  analysis of the acoustic
speech signal,  a neural net based phoneme  identifier,  and a completely  novel
neural net architecture for back-end language modeling.  The latter component is
the MULTCONS or multi-level constraint  satisfaction network. These developments
have been the  subject of two issued  patents.  In  addition,  the  Company  has
acquired a related patent covering portions of this technology. Portions of this
technology are currently being employed in Fonix embedded systems applications.


         Text-to-Speech (Speech Synthesis)

In 1986  AcuVoice  began 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
(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  are  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 sold to end-users, systems integrators and OEMs.

Fonix  text-to-speech  products  include  those  developed by AcuVoice and those
developed  by Fonix.  All are sold under the AcuVoice  brand name.  The products
include the AcuVoice AV 1700 TTS system for end-user  desktop and laptop  system
use. The AcuVoice AV 2001 SDK is a software  development  kit for  developers of
telephony  applications.  Run-time software licenses for the AV 2001 are offered
for  applications  developed  with  the SDK.  The SDK  supports  major  computer
telephony platforms.

         Handwriting Recognition

Prior to the  Papyrus  Acquisition  in October  1998,  PAI  developed  and began
selling  handwriting  recognition  software  including  the Allegro  handwriting
recognition software.  The Allegro handwriting  recognition software is a single
letter  recognition  system like the popular  Graffiti  handwriting  recognition
software for the PalmPilot PDA.  However,  Allegro's  alphabet is all natural in
appearance  as lower  case  letters.  Because  the  letters  are  written in the
standard  way in almost all  instances,  the  Allegro  system is easy to use and
requires practically no learning.  Allegro is sold by Purple Software in England
for the Psion Series 5 hand-held  PC. This  software  has also been  licensed to
Philips for its popular smart cell phone. Allegro is also the subject of a sales
agreement  with Lucent  Technologies  for use in its Inferno  operating  system.
Papyrus  has also  developed  cursive  handwriting  recognition  software  which
recognizes  naturally-written  whole  words.  This  cursive  technology  is only
available  as a licensed  product to OEM  customers.  Both the  Allegro  and the
cursive  handwriting  recognition  software are user  independent and require no
training of the software.

Employees

As of March 31,  1999,  the Company  employed  129  persons.  Of this total,  74
persons are employed in the  Interactive  Technologies  Solutions  Group, 34 are
employed in the HealthCare  Solutions Group and 21 are employed on the executive
and administrative staff.


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Recent Developments

Consistent  with the  objectives,  vision and  strategy of the Company  outlined
above, Fonix entered into several key transactions in 1998 and the first quarter
of 1999. These are discussed briefly in the following section.

Acquisition of AcuVoice

The AcuVoice  Acquisition  was effected by an exchange of  restricted  shares of
Fonix  common  stock and cash for the issued  and  outstanding  common  stock of
AcuVoice.  A total of 2,692,216  shares of Fonix  common stock  (having a market
value of  $16,995,772)  were issued in exchange for AcuVoice  common stock and a
total  of  $8,000,232  was  paid  in  cash  (including  amounts  paid in lieu of
fractional shares). Of the 2,692,216 shares of Fonix stock issued, 80,000 shares
were placed in an escrow  against which any claims for breach of warranty by the
Company  against  AcuVoice  could be  asserted.  The  closing was deemed to have
occurred  on March  13,  1998,  although  certain  acts such as the  payment  of
consideration to some AcuVoice stockholders and the filing of articles of merger
occurred  after  that  date.   After  the  AcuVoice   Acquisition,   the  former
shareholders of AcuVoice,  consisting of 52 persons, beneficially owned 5.25% of
the  total  of  51,303,739   shares  of  Fonix  common  stock  then  issued  and
outstanding.

Before the acquisition,  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 that 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  that 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 Computer.

AcuVoice's  competitors  offer a range  of  voices  (male,  female,  child)  and
languages.  AcuVoice  presently  offers only a male voice which speaks  American
English.  However,  AcuVoice is  developing  a female  voice,  and is working to
expand language capacity to major languages other than English.

Fonix believes that the AcuVoice  text-to-speech  technologies  are an important
and  complementary  addition to the ASRT 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
ASRT, will  substantially  increase the  marketability  of both  technologies by
broadening the potential product  applications,  thereby  increasing the pool of
potential licensees of the technologies.

In connection  with the AcuVoice  Acquisition,  AcuVoice and its founder,  David
Barton, made certain representations and warranties to the Company. One of those
representations  focused on the scope of a license agreement  previously entered
into between AcuVoice and General Magic for the use of AcuVoice's text-to-speech
software in General Magic's Serengeti  product.  After the AcuVoice  Acquisition
closed,  the  Company  determined  that  AcuVoice  and Barton had  breached  the
representation  concerning  the scope of the General  Magic  license  agreement.
Under the terms of the AcuVoice  Acquisition  agreement,  on March 12, 1999, the
Company  submitted  a claim for the  80,000  shares  deposited  into the  escrow
account by the former stockholders of AcuVoice.  Barton, as agent for the former
stockholders of AcuVoice, denied the claim. The Company is presently preparing a
response to Barton's denial of the claim. If Barton  continues to deny the claim
after review of the Company's  response,  the Company will seek to arbitrate its
claim pursuant to the terms of the AcuVoice Acquisition  agreement.  The Company
is presently  considering  other possible  remedies against Barton and the other
former directors of AcuVoice.

                                    Page 8 of 60

<PAGE>

Acquisition of Articulate and Certain Assets of  MRC

The Articulate  Acquisition  was effected  through a merger of Articulate into a
wholly owned  subsidiary  of the Company  that closed on  September 2, 1998.  As
consideration for the Company's acquisition by merger of Articulate, the Company
tendered to the  stockholders  of Articulate,  in the  aggregate,  (i) 5,140,751
shares of the  Company's  restricted  common  stock  (having  a market  value of
$8,353,720) and (ii) a cash payment of $12,534,588 (the "Cash Payment").  Of the
5,140,751  shares  of stock  issued,  315,575  shares  were  placed in an escrow
against  which claims by the Company for breach of warranty  against  Articulate
could be asserted and  1,985,000  shares were placed in a separate  escrow to be
converted  to a  new  class  of  non-voting  common  stock  to  be  issued  upon
authorization  by the  shareholders  of the  Company.  The balance of  2,840,176
shares of restricted  common stock was issued to the shareholders of Articulate.
At closing, 13 of the Articulate  stockholders agreed to accept a portion of the
Cash Payment payable to them in the form of demand notes bearing interest at the
rate of 8.5% per  annum,  payable  at any  time  after  November  1,  1998.  The
aggregate principal amount of such notes is $4,747,339. The Company made partial
payments  of several of these  notes and has agreed  with all of the  holders to
extend the due dates to between  March 15, 1999 and April 30, 1999.  The balance
due and owing the  holders  of these  notes was  $4,708,980  at March 31,  1999.
Additionally,  the Company agreed to pay seven Articulate employees cash bonuses
in the aggregate amount of $857,000.  At Closing,  the Company  delivered demand
notes  representing  $452,900 of that aggregate  bonus amount.  These notes bear
interest at 8.5% per annum.  The  balance  was payable on or before  January 31,
1999.  None of the  holders of these  notes have made  demand for payment of the
balance  due and they have  verbally  agreed to extend the due date to April 30,
1999. After the merger, the former  shareholders of Articulate,  constituting 62
persons,  beneficially owned 8.8% of the total 58,586,633 shares of Fonix common
stock then issued and outstanding.

At  the  time  the  Company  acquired  Articulate,   MRC  marketed  Articulate's
PowerScribeRAD and PowerScribeEM  products to hospitals and medical centers. The
Company intended to continue to use MRC to market its PowerScribe products after
the acquisition. However, shortly after the acquisition the Company learned that
MRC had agreed to be acquired by Medquist,  Inc.,  which, the Company  believes,
had little or no interest in marketing the PowerScribe products. Thereafter, the
Company  commenced  negotiations  to acquire  certain  assets of MRC relating to
MRC's sales,  marketing and service of the PowerScribe products. On December 31,
1998, the Company entered into an Asset Acquisition  Agreement with MRC pursuant
to which it acquired  certain fixed  assets,  license  agreements,  intellectual
property,  advertising  materials and other property used by MRC to market, sell
and service the PowerScribe  products.  In consideration of the assets described
above, the Company agreed to pay MRC at closing $219,833, less amounts then owed
to the Company, plus $133,333 per month for each of the three months immediately
following the closing,  less certain  credits.  The unpaid balance due and owing
MRC was $190,144 as of March 31, 1999. In addition to acquiring  certain  assets
of MRC relating to  PowerScribe  products,  the Company hired  approximately  20
former  employees  of MRC who had  been  engaged  in the  marketing,  sales  and
servicing of PowerScribe products.

Acquisition of Papyrus

The Papyrus  Acquisition  which  closed  October 29,  1998,  was  effected by an
exchange of restricted  shares of the  Company's  common stock and the Company's
promissory  notes for all of the issued and outstanding  common stock of PAI and
PDC as follows:

     PAI

     The Company issued 1,076,926 shares of its restricted  common stock (having
     a market value of  $1,110,580  on the closing  date) and  promissory  notes
     aggregating  $540,000 to the stockholders of PAI in exchange for all of the
     outstanding  shares of PAI common stock.  The promissory notes were payable
     as follows:  $360,000 of notes were  payable  not later than  February  28,
     1999;  and $180,000 of notes are payable on April 30, 1999.  The notes bear
     interest at the rate of 6% per annum after they become payable. The Company
     has entered into  agreements  with four of the holders of these  promissory
     notes to pay  approximately  88% of the balances  due under the  promissory
     notes on or before May 15, 1999 in consideration for which the holders will
     surrender  to the Company  30%, or  approximately  276,630  shares,  of the
     common stock issued to the note holders in the PAI Acquisition. The Company
     is in default with respect to the remaining five promissory  notes totaling
     $51,750.  However,  the Company  anticipates  paying the  balances of these
     notes on or before May 15, 1999.


                                    Page 9 of 60

<PAGE>

     PDC

     The Company issued 2,034,188 shares of its restricted  common stock (having
     a market value of  $2,097,756  on the closing  date) and  promissory  notes
     aggregating  $1,170,000 to the  stockholders  of PDC in exchange for all of
     the  outstanding  shares of PDC  common  stock.  The  promissory  notes are
     payable as follows:  $490,000 of notes were payable not later than February
     28, 1999; $340,000 of notes were payable on February 28, 1999; and $340,000
     of the notes are due and  payable on  September  30,  1999.  The notes bear
     interest at the rate of 6% per annum after they become payable. The Company
     has entered into an agreement  with all of the holders of these  promissory
     notes to pay  approximately  70% of the  balances due under the notes on or
     before May 15, 1999, in consideration  for which the holders will surrender
     to the Company 30%, or  approximately  610,256 shares,  of the common stock
     issued to the note holders in the PDC Acquisition.

After  the  Papyrus  Acquisition,  the  former  shareholders  of  PAI  and  PDC,
constituting 10 persons, beneficially owned less than 1% of the total 61,697,747
shares of the  Company's  common  stock  then  issued  and  outstanding.  Of the
3,111,114 shares of the stock issued in the Papyrus Acquisition,  311,106 shares
were placed in an escrow  against  which any claims by the Company for breach of
warranty  against  Papyrus  could be  asserted.  After the  Papyrus  Acquisition
closed, the Company investigated some of the representations and warranties made
by Papyrus to induce the Company to acquire Papyrus. The Company determined that
certain of the  representations  made by Papyrus and the  executive  officers of
Papyrus  were  not  accurate.   At  about  the  same  time,  the  Company  began
negotiations  with the former  executive  officers of Papyrus.  On February  26,
1998, the Company filed an action against  Papyrus in the United States District
Court for the District of Utah,  Central  Division (the "Utah  Action").  In the
Utah  Action,  the  Company  alleged  claims  for  misrepresentation,  negligent
misrepresentation,  breach of contract,  breach of the implied  covenant of good
faith and fair dealing and  rescission.  On March 11, 1999,  three of the former
shareholders of Papyrus filed an action against the Company in the United States
District  Court for the  District of  Massachusetts  (the  "First  Massachusetts
Action"),  alleging a default under the terms of the promissory  notes issued to
them in  connection  with the Papyrus  Acquisition.  On April 8, 1999,  a fourth
former  Papyrus  shareholder  filed an action  against the Company in the United
States   District  Court  for  the  District  of   Massachusetts   (the  "Second
Massachusetts  Action")  alleging  a default  under the terms of the  promissory
notes  issued to him in  connection  with the  Papyrus  Acquisition  and seeking
additional  remedies including  violation of Massachusetts  unfair and deceptive
acts and practices statutes and copyright infringement.  The Company has entered
into agreements with the four former Papyrus  shareholders  for dismissal of the
First and Second  Massachusetts  Actions and the Utah Action upon payment to the
former shareholders of $1,122,209 (the "Settlement  Payment") an amount equal to
approximately  73% of the balance due them under the notes issued to them in the
Papyrus  Acquisition,  and return  for  cancellation  by the  Company of 970,586
shares of  restricted  common  stock  issued in the  Papyrus  Acquisition.  This
represents  approximately  30% of the total  number  of shares of the  Company's
common stock originally issued to these shareholders in the Papyrus Acquisition.
The Company must pay the Settlement Payment before May 16, 1999. If it does not,
the Company and the four former  Papyrus  shareholders  are free to pursue their
respective  claims in the Utah  Action  and the First and  Second  Massachusetts
Actions.

Status of Acquisition Activities

In addition to the transactions  involving  AcuVoice,  Articulate and Papyrus in
1998,  the Company  also was in  negotiations  to acquire  several  other speech
technology   companies  in  1998.  The  Company  has  now  terminated  all  such
acquisition discussions. The Company advanced money during 1998 to some of those
acquisition  candidates in  anticipation  of the  completion  of an  acquisition
transaction.  The Company  presently is pursuing the return of such loaned funds
which amount, in the aggregate, is $245,000.

Financing Activities

         Series D and Series E Preferred Stock

In March  1998,  the  Company  completed  a private  placement  (the "March 1998
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 March 1998 Offering was $30,000,000. Of that amount, $15,000,000 was paid
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.  Finders'  fees of
$870,000 were paid in connection with

                                   Page 10 of 60

<PAGE>

the  $15,000,000  received.  The proceeds of that offering were used to fund the
AcuVoice  Acquisition and for operating  capital.  The remainder of the purchase
price  was to be paid by the  investors  on July 27,  1998 (60  days  after  the
effectiveness  of a  registration  statement  that the  Company  filed  with the
Securities and Exchange Commission covering the common stock issued and issuable
to the investors (the "Second Funding  Date")),  provided that, as of such date,
certain conditions were satisfied. Additionally, the investors in the March 1998
Offering  acquired  certain "reset" rights pursuant to which the investors would
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 did not equal or  exceed  $5.40 per
share.  On August 31,  1998,  the  Company and the  investors  in the March 1998
Offering  restructured  the reset  provision  whereby the Company issued 608,334
shares of Series D 4%  Convertible  Preferred  Stock  ("Series D") and 1,390,476
shares of common stock for (i) the relinquishment of the investors'  contractual
right to receive reset shares in  connection  with the  $15,000,000  received in
March 1998,  and an additional  $3,000,000  received in June and August 1998. On
that same date,  the Company  issued  500,000  additional  shares of Series D in
consideration  for the  investment of  $10,000,000  of  additional  funds by the
investors.  These  proceeds  were  used  primarily  to  finance  the  Articulate
Acquisition.

Effective  September 30, 1998, the Company entered into an agreement with two of
the  investors in the March 1998  Offering  whereby the Company  issued  100,000
shares of the Company's Series E 4% Convertible Preferred Stock ("Series E") for
$2,000,000. Additionally, the Company issued to the purchasers of the Series E a
total of  150,000  additional  shares of Series E in  exchange  for which  those
purchasers surrendered a total of 150,000 shares of Series D.

Subsequently, on November 13, 1998, the Company sold 50,000 additional shares of
Series D on the same terms and conditions as the August 31, 1998 agreement.

Each share of Series D and Series E is convertible into that number of shares of
common stock as determined by dividing $20 by the lesser of any of the following
(at the option of the converting holder):

     1.   $3.50, or

     2.   the lesser of

          *    $2.3375  (for the Series D) or  $1.4369  (for the Series E) which
               amounts  constitute  110% of the  average  per share  closing bid
               prices for the 15 trading days immediately preceding the dates of
               the Series D and Series E Agreements, respectively; or

          *    90% of the  average  of the three  lowest per share  closing  bid
               prices  during  the 22 trading  days  immediately  preceding  the
               conversion date.

If the converting  holder elects  conversion option 1, in addition to the shares
of common stock issued upon the conversion, the converting holder will receive a
warrant to purchase  0.8 shares of common  stock.  Those  warrants  will have an
exercise  price  that  will be 120% of the per  share  closing  bid price of the
common  stock on the date the  warrants  are issued  and will have a  three-year
term.  Any shares of Series D or Series E not  converted  as of August 31,  2001
will  automatically  be converted to common stock  according to whichever of the
conversion  formulas  described  above yields the  greatest  number of shares of
common stock.

As part of the Series D and Series E  transactions,  the Company  agreed that it
would register the shares of common stock issuable upon conversion of the Series
D and Series E or the exercise of any warrants issued upon conversion for public
resales by the  converting  or  exercising  holder.  On November 19,  1998,  the
Company  filed  a  registration  statement  with  the  Securities  and  Exchange
Commission  on Form S-3 to register  the sale by the holders of the Series D and
Series E of up to  58,623,442  shares of the  Company's  common  stock (File No.
333-67573).  The shares covered by the registration  statement are the shares of
common stock issued or issuable by the Company upon the conversion of the Series
D or Series E, or the exercise of the warrants, if any warrants are issued. That
registration statement has not yet been declared effective.

When the registration statement is declared effective,  the selling stockholders
will be able to sell the Company's shares issued upon conversion of the Series D
and Series E preferred stock in public transactions or otherwise, on the Nasdaq

                                   Page 11 of 60

<PAGE>

SmallCap Market or in privately negotiated transactions. Those resales may be at
the then-prevailing  market price or at any other price the selling stockholders
may negotiate.

         December 1998 Private Placement of Common Stock

On December 22,  1998,  the Company  completed a private  placement of 1,801,802
shares of common stock. Additionally, for each share of common stock issued, the
Company issued one "Repricing Right" that entitles the holder thereof to receive
upon exercise  additional shares of the Company's common stock for no additional
consideration  according  to a formula  that is related  to the  then-prevailing
market price of the  Company's  common  stock.  The Company also issued  200,000
common stock purchase warrants in connection with this  transaction.  The number
of  additional  shares of common stock  issuable  upon exercise of the Repricing
Rights is determined by multiplying the number of Repricing  Rights exercised by
the following fraction:

                        (Repricing Price - Market Price)
                        --------------------------------
                                  Market Price

"Market Price" means the lowest closing bid price of common stock,  as quoted on
the Nasdaq Small Cap Market,  during the 15 consecutive trading days immediately
preceding the exercise date. "Repricing Price" means:

     $1.3875 from March 22, 1999 to and including April 21, 1999,

     $1.3986 from April 22, 1999 to and including May 21, 1999,

     $1.4097 from May 22, 1999 to and including June 20, 1999,

     $1.4208 from June 21, 1999 to and including July 20, 1999, and

     $1.4319 at any time  after  July  20,  1999  until  the  expiration  of the
          Repricing Rights.

The  investor  that  purchased  the common  stock in the  December  1998 private
placement  has the  right,  upon  the  occurrence  of a "Major  Transaction"  or
"Triggering  Event" as those terms are defined in the  transaction  documents to
require  the  Company to  repurchase  all or a portion of such  holder's  common
shares or Repricing Rights at a price equal to (i) for each common share with an
associated  Repricing  Right,  the greater of (A) 125% of the purchase price and
(B) the sum of (I) the purchase  price and (II) the product of (x) the Repricing
Rate of the Repricing Right on the date of such holder's delivery of a notice of
repurchase  and (y) the last reported sale price of the common stock on the date
of such holder's  delivery of a notice of  repurchase,  (ii) for each  Repricing
Right  without  the  associated  share of common  stock,  the product of (x) the
Repricing  Rate of the Repricing  Right on the date such holder's  delivery of a
notice of repurchase and (y) the last reported sale price of the common stock on
the date of such holder's  delivery of a notice of repurchase and (iii) for each
common share without an associated  Repricing Right, 125% of the purchase price.
One  of  the  several  events  described  in  the  transaction  documents  as  a
"Triggering  Event"is  the  suspension  from  listing or delisting of the common
stock from The Nasdaq  SmallCap  Market for a period of three  trading  days. In
March 1999,  trading in the Company's  common stock was  temporarily  halted for
more than three days.  Trading resumed within five trading days, and the Company
has not been notified that the holders of the common stock and Repricing  Rights
desire to exercise any repurchase rights they may have.

         Series C 5% Convertible Debentures

On January 29, 1999, the Company  entered into a Securities  Purchase  Agreement
with  four  investors  pursuant  to  which  the  Company  sold  its  Series C 5%
Convertible  Debentures (the "Debentures") in the aggregate  principal amount of
$4,000,000. The outstanding principal amount of the Debentures is convertible at
any time at the option of the holder into shares of the  Company's  common stock
at a conversion  price equal to the lesser of $1.25 or 80% of the average of the
closing  bid  price  of the  Company  common  stock  for the five  trading  days
immediately  preceding  the  conversion  date.  The Company also issued  400,000
warrants in connection with this financing.  Each warrant entitles the holder to
purchase up to 400,00 shares of the Company common stock at an exercise price of
$1.1625  per  share.  On March 3, 1999,  the  Company  executed  a  Supplemental
Agreement pursuant to which the Company agreed to sell an additional  $2,500,000
principal  amount of the  Debentures  on the same  terms and  conditions  as the
January 29, 1999  agreement,  except no additional  warrants were issued.  Gross
proceeds  to the  Company  from  these two  transactions  were  $6,500,000.  The
obligations  of the  Company for  repayment  of the  Debentures,  as well as its
obligation to register the common stock  underlying the potential  conversion of
the  Debentures and the exercise of the warrants  issued in these  transactions,
were

                                  Page 12 of 60

<PAGE>

personally  guaranteed by Thomas A.  Murdock,  Roger D. Dudley (each of whom are
executive  officers  and  directors  of the  Company)  and  Stephen M.  Studdert
(Chairman of the Board of Directors of the Company).  The personal guarantees of
these three  directors  were  secured by a pledge of  6,000,000  shares of Fonix
common  stock  beneficially  owned by them and  held in the  name of  Thomas  A.
Murdock,  Trustee.  In connection with the Supplemental  Agreement,  the Company
agreed to pledge as collateral  for repayment of the  Debentures,  a lien on the
patent  covering  the ASRT.  At the present  time the Company has not executed a
security  agreement  in  favor  of  the  investors  describing  the  patent.  In
connection  with the  guaranty and the pledge for that  guaranty  given by these
directors,  the Company  agreed to indemnify and hold them harmless in the event
of a default by the Company  that  results in any payment or other  liability or
damage incurred by any of them. In consideration  for the guaranty and pledge by
these directors,  the Company agreed to grant each of them common stock purchase
warrants  to  purchase  666,666  shares of common  stock at a price of $1.59 per
share.  On or about April 6, 1999,  the holders of the  Debentures  notified the
Company and the Guarantors  that the Guarantors  were in default under the terms
of the pledge,  and that the holders  intended to exercise  their rights to sell
some or all of the  pledged  shares.  At the  present  time,  the Company has no
knowledge of sales of the  Guarantors'  shares by the holders.  However,  if the
holders proceed to sell some or all of the Guarantors'  shares,  the Company may
be obligated  under its indemnity  agreement in favor of the Guarantors to issue
shares to the  Guarantors in  replacement  of all shares sold by the holders and
reimburse the  Guarantors  for any income tax liability  incurred as a result of
the holders' sales of the Guarantors' shares.

Grants Of Stock Options

During the year ended December 31, 1998, the Company granted options to purchase
6,414,782  shares of common stock. Of such options,  450,000 (having an exercise
price of $5.16 per share) and 1,200,000  (having an exercise  price of $1.18 per
share)  were  granted  to  three  individuals  who are  executive  officers  and
directors  of the  Company;  1,600,000  (having an  exercise  price of $1.18 per
share) were granted to directors and 400,000  (having an exercise price of $1.18
per share) were granted to two officers of the Company, 360,000,  1,595,000, and
617,950  options were  granted to a director  and various  employees at exercise
prices of $3.34, $1.00, and $6.50 per share,  respectively,  and 100,000 options
were granted to an unrelated  party for services with an exercise price of $3.75
per share.  The term of all of these stock options is ten years from the date of
grant.  Additionally,  the Company  agreed to issue  options to purchase  91,832
shares of common stock in exchange for stock options  granted in connection with
the  acquisition of Articulate.  Of these options,  58,678 are  exercisable at a
price of $0.83 per share and have expiration  dates ranging from June 1, 2000 to
November  2, 2002.  During the year ended  December  31,  1998,  35,000  options
previously   outstanding  were  exercised,   and  1,067,000  options  previously
outstanding were forfeited.  As of December 31, 1998, the Company had a total of
15,877,782 options outstanding, of which 9,524,766 were exercisable on or before
December 31, 1998.

The Synergetics Transaction

Prior  to  March  1997,  the  Company's   scientific  research  and  development
activities  were  conducted   solely  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% (the "Royalty") of net revenues
from sales of products incorporating  Synergetics' "VoiceBox" technology as well
as technologies derivatives thereof.  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. 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

                                   Page 13 of 60

<PAGE>

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.

Termination of Financing Relationship

For several  years,  the  Company has  maintained  a  relationship  with a major
regional federally insured financial  institution  pursuant to which the Company
borrowed against its own funds on deposit with the institution. Borrowings under
this arrangement  accrued  interest at a rate  approximately 1% greater than the
rate of  interest  earned  by the  Company  on its  funds  on  deposit  with the
institution.  In order to reduce  interest  expenses,  on January  8, 1999,  the
Company  applied its deposit  account in the amount of  $20,024,109  against the
unpaid loan  balance of  $20,046,776,  resulting  in an unpaid  loan  balance of
$22,667, which amount subsequently was paid by the Company.

Resignation of Stephen M. Studdert as Chief Executive Officer

On January  26,  1999,  Stephen M.  Studdert  resigned  as the  Company's  Chief
Executive Officer.  Mr. Studdert continues as the non-executive  Chairman of the
Board of Directors of the  Company.  In  connection  with his  resignation,  the
Company entered into a separation  agreement with Mr. Studdert pursuant to which
Mr.  Studdert  released  the Company from all claims and  obligations  under his
employment agreement, and the Company agreed to pay Mr. Studdert $250,000 during
1999, $250,000 in 2000 and $100,000 in 2001.

Cost Reduction Plan

On January 28,  1999,  the Company  announced a plan to reduce  overall  monthly
operating expenses by approximately  $8,000,000 for all of 1999. The Company has
taken steps to implement  these  reductions by  terminating  certain  consulting
relationships,   reducing  personnel,   realizing  cost  efficiencies  from  the
integration  of  acquired  business  units  and the  reduction  of salary of all
officers and certain  employees of the Company.  The Company  believes such cost
reductions  were  necessary  and  appropriate  in  light  of  ongoing  operating
requirements and limited  revenues to date to offset such expenses.  The Company
is not able to predict  whether such present cost  reductions will be sufficient
to achieve its goal of $8,000,000 of overall reductions for 1999. Similarly, the
Company cannot give any assurance  that its  operations and financial  condition
will not be adversely affected by these measures.

                        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.
You 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").  You 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.

FONIX'S  SUBSTANTIAL  AND  CONTINUING  LOSSES  SINCE  INCEPTION,   COUPLED  WITH
SIGNIFICANT  ONGOING  OPERATING  COSTS,  RAISE  DOUBT ABOUT  FONIX'S  ABILITY TO
CONTINUE AS A GOING CONCERN.

Since its  inception,  Fonix has  sustained  ongoing  losses.  Such  losses  are
presently continuing at an accelerated rate due to recent acquisitions,  ongoing
operating  expenses and a lack of revenues  sufficient  to offset the  increased
operating expenses. Because past and current expenses exceed revenues, Fonix has
negative  working  capital and has been forced to raise  capital to fund ongoing
operations by private sales of its securities,  the terms of which  transactions
have been highly  dilutive and involve  considerable  expense.  Furthermore,  in
recent months, the financial condition of the Company

                                   Page 14 of 60

<PAGE>



has required the Company to negotiate  with its creditors to extend the due date
of certain  obligations and has resulted in the Company's failure to make timely
payment of certain of its obligations.  In its present  circumstances,  there is
substantial  doubt about Fonix's  ability to continue as a going concern  absent
immediate and significant sales of its existing products,  substantial  revenues
from new licensing contracts or a relatively large sale of its securities in the
near term.

Fonix  incurred a net loss of  $43,118,782  for the year ended December 31, 1998
and a net loss of $22,453,948 for the year ended December 31, 1997. For the year
ended December 31, 1998, Fonix recorded revenues from the operations of AcuVoice
and Articulate businesses in the aggregate amount of $521,546.  Other than these
revenues,  Fonix's only revenues to date  resulted from one-time  non-refundable
license fees totaling $2,368,138 paid by Siemens  Aktiengesellschaft for the use
of  technologies  in  integrated   circuits   suitable  for   telecommunications
applications.

Fonix expects continuing losses fro operating activities until such time as:

         o        Fonix   is   able  to   complete   additional   licensing   or
                  co-development  arrangements  with third  parties that produce
                  revenues   sufficient  to  offset  Fonix's  ongoing  operating
                  expenses; or

         o        revenues from Fonix's  HealthCare  Solutions  and  Interactive
                  Technologies Solutions Groups increase to levels sufficient to
                  exceed Fonix's aggregate operating expenses.

RECENTLY INCURRED DEBT OBLIGATIONS COULD IMPAIR FONIX'S ABILITY TO CONTINUE AS A
GOING CONCERN.

During the last half of 1998, Fonix incurred  substantial amounts of debt which,
coupled with Fonix's ongoing operating expenses, could hamper Fonix's ability to
continue  as a going  concern  unless  Fonix  is  immediately  able to  generate
significant  revenues  or to raise a  substantial  amount of capital to pay that
debt. Presently,  Fonix is in default on notes in the aggregate principal amount
of  $3,116,000.  Much of  Fonix's  debt is  payable  on  demand.  Fonix does not
presently  have  sufficient  operating  capital or  revenues  to allow  Fonix to
satisfy notes  presently in default or additional  demand  obligations if demand
for  payment  is made and  Fonix  cannot  renegotiate  the  terms of the debt or
otherwise  persuade  its  creditors  to withdraw  their  demand.  In such event,
Fonix's  financial  condition and operations  could be adversely  affected.  The
following discussion  summarizes the extent and nature of such recently incurred
debt.

In connection with Fonix's  acquisition of Articulate in September  1998,  Fonix
incurred new debt  obligations  to 13 former  shareholders  of Articulate in the
aggregate amount of $4,747,339. These debt obligations are in the form of demand
notes  payable at any time after  November  1, 1998,  and bear  interest  at the
annual  rate of  8.5%.  The due  dates of these  obligations  subsequently  were
extended to dates ranging from April 1999 to October  1999,  and, in some cases,
Fonix has agreed to pay  interest at rates  exceeding  8.5% per annum.  Fonix is
presently in default on $2,943,206 of these notes. After the acquisition,  Fonix
agreed to pay several Articulate employees incentive  compensation for continued
employment in the aggregate  amount of $857,000,  in connection with which Fonix
issued 8.5% demand  notes for  $452,900  and  recorded an accrued  liability  of
$404,100  for the  balance.  The notes issued to the  Articulate  employees  are
presently payable on demand, but, as of the date hereof,  Fonix has not received
any demand for  payment of the notes by the  former  Articulate  employees.  The
$404,100 accrued liability was payable on or before January 31, 1999. The payees
with  respect to this  obligation  have  orally  agreed to an  extension  of the
payment date to June 30, 1999. In connection with Fonix's acquisition of Papyrus
in  October  1998,  Fonix  also  incurred  new debt  obligations  to the  former
shareholders  of  Papyrus  in the  aggregate  amount of  $1,710,000.  These debt
obligations  are in the form of  promissory  notes  which bear  interest  at the
annual  rate of 6.0%  after  they  become  due and were  originally  payable  as
follows:

           Amount              Due Date
           ------              --------

           $ 1,190,000         Presently payable

           $   180,000         April 30, 1999

           $   340,000         September 30, 1999


                                   Page 15 of 60

<PAGE>

With  respect to the debt listed  immediately  above that is  presently  due and
payable,  holders of $1,632,375 of the notes, including substantially all of the
debt which is  presently  due and  payable,  have agreed to accept an  aggregate
payment of $1,632,375 in full  satisfaction of the notes, if paid before May 15,
1999.

On  December 2, 1998,  Fonix  borrowed  $560,000  from an  unaffiliated  private
lender.  The loan accrues  interest at the rate of 18% per annum,  is secured by
certain accounts  receivable and was due January 2, 1999. Fonix has subsequently
extended  the due date of this loan from month to month by paying the lender the
accrued  interest  plus a fee of $5,600.  The loan  balance is due May 28, 1999.
However,  Fonix anticipates that it will request and pay for an extension of the
due date for one or more additional months beyond that date.

In addition to these notes, Fonix presently owes trade payables in the aggregate
amount  of  approximately  $2,700,000,  some of  which  are  more  than 120 days
overdue.

All of these debt  obligations  are in addition to Fonix's  regularly  recurring
operating  expenses.  At  present,  Fonix's  revenues  from  existing  licensing
arrangements and products are not sufficient to offset Fonix's ongoing operating
expenses or to pay substantial  amounts of Fonix's  presently due debt. There is
substantial  risk,  therefore,  that  the  existence  and  extent  of  the  debt
obligations  described  above could adversely  affect Fonix,  its operations and
financial condition.

IF FONIX DOES NOT  RECEIVE  ADDITIONAL  CAPITAL  WHEN AND IN THE AMOUNTS IT WILL
NEED IN THE NEAR  FUTURE,  ITS ABILITY TO CONTINUE  AS A GOING  CONCERN  WILL BE
DOUBTFUL.

Fonix anticipates  incurring  substantial  product  development and research and
general  operating  expenses  for the  foreseeable  future  which  will  require
substantial  amounts of additional cash on an ongoing basis. These capital needs
are in addition to the amounts required to repay the debt discussed above. Fonix
most  likely  will  have to  obtain  such  capital  from  sales  of its  equity,
convertible equity and debt securities. Obtaining future financing may be costly
and will be dilutive to  existing  stockholders.  If Fonix is not able to obtain
financing  when and in the amounts  needed,  and on terms that are acceptable to
it, Fonix's  operations,  financial  condition and prospects could be materially
and adversely  affected,  and Fonix could be forced to curtail its operations or
sell part or all of its assets, including its technology.

HOLDERS  OF  FONIX  COMMON  STOCK  ARE  SUBJECT  TO THE RISK OF  ADDITIONAL  AND
SUBSTANTIAL  DILUTION  TO THEIR  INTERESTS  AS A  RESULT  OF THE  CONVERSION  OF
PRESENTLY ISSUED  PREFERRED STOCK AND OTHER  SECURITIES  CONVERTIBLE INTO COMMON
STOCK.

Introduction

Fonix's present outstanding Series D and Series E are convertible into shares of
Fonix common stock.  The Series D and Series E are convertible into Fonix common
stock according to one of three separate  conversion  formulas,  one of which is
based,  in part,  on the market  price of Fonix  common stock during the several
week period  leading up to the conversion  date.  Such  conversion  formulas are
described above under the heading  "Recent  Developments - Series D and Series E
Preferred  Stock."  In  addition  to the  Series D and Series E, Fonix has other
contractual  obligations to issue additional shares of its common stock that are
dependent on the  prevailing  market price of Fonix common stock,  including the
Repricing Rights issued in December 1998 and the $6,500,000  principal amount of
Debentures  issued in  January  and March  1999.  The  market  price  conversion
features of the Repricing  Rights and the Debentures  are described  above under
the headings "Recent Developments - December 1998 Private Placement" and "Recent
Developments - Series C 5% Convertible Debentures."

The  following  table  identifies  the total  number of shares of all  series of
preferred stock with floating  conversion  rates,  the total number of Repricing
Rights outstanding and the total principal amount of the Debentures outstanding,
and  the  total  number  of  shares  of  common  stock  issuable   assuming  the
hypothetical  conversion  or exercise  of all such  preferred  stock,  Repricing
Rights or Debentures as of February 25, 1999, and the percentage of common stock
that would be issued to the holders of such convertible securities assuming such
conversions or exercises. For purposes of this table, Fonix has assumed that the
holders of the Series D and Series E, Repricing Rights and Debentures would have
elected that conversion  price that would yield the greatest number of shares of
common stock upon conversion. All calculations exclude the issuance of shares of
common  stock as payment of  dividends  accrued on the Series D and Series E and
the Debentures at the date of conversion.

                                   Page 16 of 60

<PAGE>

<TABLE>
<CAPTION>


                                 Number of Convertible                                     Percent of Common
                                 Securities Outstanding/      Shares of Common             Stock Owned By
                                 Principal Amount of          Stock Issuable Upon          Holders After
Convertible Security             Debentures                   Conversion or Exercise       Conversion
-----------------------------  ---------------------------  ---------------------------  -----------------------
<S>                            <C>                          <C>                          <C> 
Series D Preferred Stock                       990,834                   24,465,037               26.5%

Series E Preferred Stock                        90,000                    2,222,222               3.2%

Repricing Rights                             1,801,802                            0               0.0%

Debentures                                  $6,500,000                    5,200,000               7.1%
                                                                    -------------------
                      Total                                              31,887,259               32.0%
                                                                    ===================
</TABLE>


The following table describes the number of shares of common stock that would be
issuable assuming all of the presently issued and outstanding shares of Series D
and Series E were  converted,  the Repricing  Rights were exercised on the terms
most beneficial to the holder,  and the Debentures  were converted,  and further
assuming that the applicable  conversion or exercise  prices at the time of such
conversion or exercise were the following  amounts (the table excludes effect of
the  issuance of shares of common stock upon  payment of accrued  dividends  and
also  excludes   differences  among  the  various  methods  of  calculating  the
applicable conversion or exercise price):

<TABLE>
<CAPTION>

                                Shares of Common Stock Issuable Upon Conversion or Exercise of
-------------------   -----------------------------------------------------------------------------------   --------------------

Hypothetical            Series D              Series E
Conversion/             Preferred             Preferred            Repricing                                   Total Common
Exercise  Price         Stock                 Stock                Rights                Debentures            Stock Issuable
-------------------   -------------------   ------------------   -------------------   ---------------------  --------------------
<S>                   <C>                   <C>                  <C>                   <C>                    <C>
             $0.75         26,422,240            2,400,000              1,531,531           8,666,667             39,020,438

             $1.50         13,211,120            1,200,000                      0           4,333,333             18,744,453

             $2.25          8,807,413              800,000                      0           2,888,889             12,496,302

             $3.00          6,605,560              600,000                      0           2,166,667              9,372,227

</TABLE>

Given the structure of the  conversion  formulas  applicable to the Series D and
Series  E,  and  the  other  convertible   securities   described  above,  there
effectively  is no limitation on the number of shares of Fonix common stock into
which such convertible  securities may be converted or exercised.  As the market
price of the Fonix common stock decreases,  the number of shares of Fonix common
stock underlying the Series D and Series E and such other convertible securities
continues to increase.  Following  are  specific  risk factors  relative to this
dilution.

Overall Dilution to Market Price and Relative Voting Power of Previously  Issued
Common Stock

The  conversion  of the Series D and  Series E, the  exercise  of the  Repricing
Rights and the conversion of the  Debentures may result in substantial  dilution
to the equity  interests of other holders of Fonix common  stock.  Specifically,
the  issuance of a  significant  amount of  additional  Fonix common stock would
result in a decrease of the relative voting control of Fonix common stock issued
and  outstanding  prior to the  conversion  of the  Series D and  Series  E, the
exercise  of  the  Repricing  Rights  and  the  conversion  of  the  Debentures.
Furthermore,  public  resales of Fonix common stock  following the conversion of
the  Series  D and  Series  E,  the  exercise  of the  Repricing  Rights  or the
conversion of the Debentures likely would depress the prevailing market price of
Fonix common stock. Even prior to the time of actual conversions,  exercises and
public  resales,  the market  "overhang"  resulting  from the mere  existence of
Fonix's  obligation  to honor such  conversions  or exercises  could depress the
market price of Fonix common stock.

Increased Dilution With Decreases in Market Price of Common Stock

The outstanding  shares of Series D and Series E are convertible,  the Repricing
Rights are  exercisable  and the  Debentures may be  convertible,  at a floating
price that may and likely will be below the market  price of Fonix  common stock
prevailing  at the time of conversion  or exercise.  As a result,  the lower the
market price of Fonix common stock at and

                                   Page 17 of 60

<PAGE>


around the time the  holder  converts  or  exercises,  the more  shares of Fonix
common stock the holder of such convertible securities receives. Any increase in
the number of shares of Fonix common stock issued upon conversion or exercise of
these  securities as a result of decreases in the prevailing  market price would
compound the risks of dilution described in the preceding paragraph of this risk
factor.

Increased Potential for Short Sales

Downward  pressure on the market  price of Fonix  common stock that likely would
result from sales of Fonix common stock issued on conversion of the Series D and
Series  E,  the  exercise  of the  Repricing  Rights  or the  conversion  of the
Debentures  could  encourage  short sales of common  stock by the holders of the
Series D and Series E, the Repricing Rights, the Debentures or others.  Material
amounts of such short  selling  could  place  further  downward  pressure on the
market price of Fonix common stock.

Limited Effect of Restrictions on Extent of Conversions

The  holders  of the  Series  D and  Series  E,  the  Repricing  Rights  and the
Debentures are prohibited  from  converting  their preferred stock or exercising
their  Repricing  Rights  into more than  4.999% of the then  outstanding  Fonix
common  stock.  This  restriction,  however,  does not prevent such holders from
either  waiving such  limitation or converting or exercising and selling some of
their convertible security position and thereafter  converting or exercising the
rest or another  significant  portion of their holding.  In this way, individual
holders of Series D and Series E, the Repricing Rights, and the Debentures could
sell more than 4.999% of the  outstanding  Fonix  common  stock in a  relatively
short time frame while never holding more than 4.999% at a time.

IF FONIX HAS DIFFICULTY INTEGRATING INTO ITS BUSINESS AND CAPITALIZING ON RECENT
ACQUISITIONS,   ITS  OPERATIONS  AND  FINANCIAL  PROSPECTS  COULD  BE  ADVERSELY
AFFECTED.

Fonix recently completed the acquisitions of AcuVoice,  Articulate,  Papyrus and
MRC.  Fonix's  acquisitions of AcuVoice,  Articulate,  Papyrus and MRC,  present
risks including at least the following:

     o    Fonix may have difficulty financing ongoing operations of the acquired
          businesses to the extent such  businesses are not generating  positive
          cash flows;

     o    Fonix may have  difficulty  combining or integrating  the  technology,
          operations,  management or work force of the acquired  businesses with
          Fonix's existing operations;

     o    Fonix may have difficulty  retaining the key personnel of the acquired
          businesses;

     o    Fonix may have difficulty  expanding  Fonix's financial and management
          controls  and  reporting   systems  and  procedures  to  the  acquired
          businesses;

     o    Fonix may have difficulty  maintaining  uniform  standards,  controls,
          procedures, and policies across its entire organization, including the
          acquired businesses;

     o    There may be impairment of relationships  with employees,  vendors and
          customers  as a  result  of  the  integration  of new  businesses  and
          management personnel; and

     o    There may be diversion of management  attention during the pendency of
          transactions,  and increased  commitment  of management  resources and
          related  expenses  resulting  from  efforts  to  integrate  and manage
          acquired  businesses  located at a  distance  from  Fonix's  principal
          executive offices and research facilities.

FONIX HAS ONLY A LIMITED PRODUCT  OFFERING AND MANY OF ITS KEY  TECHNOLOGIES ARE
STILL IN THE DEVELOPMENT STAGE.

There presently are only a limited number of commercially available applications
or  products  incorporating  the  Fonix  technologies.  Through  its  HealthCare
Solutions Group, Fonix offers  PowerScribeRAD  and PowerScribeEM,  sophisticated
voice  recognition  products for  radiologists  and emergency  medical  doctors.
Through its Interactive Technologies

                                   Page 18 of 60

<PAGE>



Solutions Group,  Fonix markets  text-to-speech  products acquired from AcuVoice
and the Allegro handwriting  recognition  software acquired from Papyrus.  Fonix
has also licensed  certain  elements of its speech  recognition  technologies to
Siemens for incorporation into  telecommunications  equipment to be manufactured
by  Siemens.  Those  products  are not yet  being  manufactured.  These  product
offerings  are  still  relatively   limited  and  have  not  generated  to  date
significant  revenues.  An additional element of Fonix's business strategy is to
achieve  revenues  through  appropriate   strategic  alliances,   co-development
arrangements  and  license  agreements  with  third  parties.   Other  than  the
arrangement with Siemens, a collaborative  scientific  agreement with the Oregon
Graduate  Institute of Science and Technology,  a similar agreement with Brigham
Young  University  and  a  license  of  its  Allegro   handwriting   recognition
technology,  Fonix presently has no licensing or co-development  agreements with
any third party for the technologies which it has developed to date.

THE MARKET FOR MANY OF FONIX'S  TECHNOLOGIES  IS LARGELY  UNPROVEN AND MAY NEVER
DEVELOP  SUFFICIENTLY  TO  ALLOW  FONIX  TO  CAPITALIZE  ON ITS  TECHNOLOGY  AND
PRODUCTS.

The market for  human-computer  interaction  technologies,  including  automated
speech recognition technologies, is relatively new. Fonix's technologies are new
and, in many  instances,  represent a significant  departure  from  technologies
which  already  have  found  a  degree  of  acceptance  in  the   human-computer
interaction  marketplace.  The financial  performance  of Fonix will depend,  in
part,  on the future  development,  growth and  ultimate  size of the market for
human-  computer   interaction   applications   and  products   generally,   and
applications   and  products   incorporating   Fonix's   technologies   and  the
applications   and  products  of  its  HealthCare   Solutions  and   Interactive
Technologies   Solutions   Groups   specifically.   Applications   and  products
incorporating  Fonix's technologies will compete with more conventional means of
information  processing  such as data entry,  access by  keyboard or  touch-tone
phone  or  professional  dictation  services.  Fonix  believes  that  there is a
substantial  potential  market  for  applications  and  products   incorporating
advanced human- computer interface  technologies  including speech  recognition,
speech synthesis,  speech compression,  speaker identification and verification,
handwriting  recognition,  pen and  touch  screen  input  and  natural  language
understanding.  Nevertheless,  such a market  for  Fonix's  technologies  or for
products  incorporating Fonix's technologies may never develop to the point that
profitable operations can be achieved or sustained.

COMPETITION  FROM OTHER INDUSTRY  PARTICIPANTS  AND RAPID  TECHNOLOGICAL  CHANGE
COULD IMPEDE FONIX'S ABILITY TO ACHIEVE PROFITABLE OPERATIONS.

The  computer  hardware  and  software   industries  are  highly  and  intensely
competitive.  In particular,  the human computer  interaction  market sector and
specifically  the  speech   recognition,   computer  voice  and   communications
industries are characterized by rapid technological  change.  Competition in the
market  sector of  human-computer  interaction  technology  is based  largely on
marketing ability and resources,  distribution channels,  technology and product
superiority and product  service and support.  The development of new technology
or material  improvements to existing  technologies  by Fonix's  competitors may
render Fonix's technologies less attractive or even obsolete.  Accordingly,  the
success  of Fonix  will  depend  upon its  ability to  continually  enhance  its
technologies and interactive and health care solutions and products to keep pace
with or ahead of technological developments and to address the changing needs of
the  marketplace.  Some  of  Fonix's  competitors  have  greater  experience  in
developing,  manufacturing and marketing human computer interface  technologies,
applications  and  products,  and some  have far  greater  financial  and  other
resources than Fonix, or its potential  licensees and co-developers,  as well as
broader name-recognition,  more-established  technology reputations,  and mature
distribution channels for their products and technologies.  Barriers to entry in
the  software  industry are low,  and as the market for various  human  computer
interaction products expands and matures,  Fonix expects more entrants into this
already competitive arena.

FONIX'S INDEPENDENT PUBLIC ACCOUNTANTS HAVE INCLUDED A "GOING CONCERN" PARAGRAPH
IN THEIR AUDIT REPORTS FOR 1998, 1997 AND 1996.

The auditors'  reports for Fonix's  financial  statements for fiscal years 1998,
1997 and 1996 include an explanatory paragraph regarding substantial doubt about
Fonix's ability to continue as a going concern.  This may have an adverse effect
on the Company's ability to obtain financing.

THE  COMPANY'S  SHARE PRICE AND  FINANCIAL  CONDITION MAY RESULT IN A FAILURE TO
CONTINUE TO MEET THE NASDAQ STOCK MARKET LISTING REQUIREMENTS.

                                  Page 19 of 60

<PAGE>

To maintain its stock listing on the Nasdaq SmallCap Market, Fonix is subject to
certain  maintenance  standards.  One such  maintenance  standard  is that Fonix
common stock must have a minimum bid price of $1 per share. Fonix will be deemed
to be in  violation  of this  particular  requirement  if the bid price of Fonix
common  stock is less  than $1 for a period  of 30  consecutive  business  days.
Thereafter,  upon receipt of a notice from the Nasdaq SmallCap Market  regarding
such failure, Fonix would have a period of 90 calendar days from receipt of such
notification to achieve compliance with the listing requirement.  Fonix would be
deemed  to be in  compliance  with the  standard  if the bid  price of the Fonix
common stock was $1 or more for a minimum of 10 consecutive business days during
such 90 day period.  Fonix has not  received  any  notification  from the Nasdaq
SmallCap  Market that the Fonix  common  stock will be delisted  from the Nasdaq
SmallCap  Market.  During the last half of 1998,  and  continuing to the present
date, Fonix common stock has traded at levels that have  periodically  been less
than $1 per share. If the Fonix common stock were to be delisted from the Nasdaq
SmallCap Market,  it would likely continue to be traded in the  over-the-counter
market.  Nevertheless,  such  delisting  could  adversely  affect the prevailing
market price of the common stock or the general  liquidity of an  investment  in
Fonix common  stock.  A delisting  would be deemed an event of default under the
rights and preferences of its outstanding  series of preferred  stock, the terms
and  conditions of the Debentures and the terms of its agreement for the sale of
common stock entered into in December 1998.

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.

Dependence on proprietary technology

Fonix's success is heavily  dependent upon proprietary  technology.  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 Fonix. This patent covers certain elements of the
Fonix ASRT.  Fonix has acquired  other patents and has filed  additional  patent
applications.  In addition to its  patents,  Fonix  relies on a  combination  of
copyright and trademark  laws,  trade  secrets,  confidentiality  procedures and
contractual  provisions  to  protect  its  proprietary  rights.  Such  means  of
protecting  Fonix's  proprietary  rights may not be adequate  because  such laws
provide only limited protection. Despite precautions that Fonix takes, it may be
possible  for  unauthorized  third  parties  to  duplicate  aspects of the Fonix
technologies  or the current or future  products or technologies of its business
units or to obtain  and use  information  that  Fonix  regards  as  proprietary.
Additionally,  Fonix's competitors may independently develop similar or superior
technology.  Policing  unauthorized use of proprietary rights is difficult,  and
some  non-U.S.  laws do not  protect  proprietary  rights to the same  extent as
United States laws. Litigation  periodically may be necessary to enforce Fonix's
intellectual  property rights,  to protect its trade secrets or to determine the
validity  and scope of the  proprietary  rights of others.  Fonix  presently  is
prosecuting an infringement action brought by Articulate against Apple Computer,
which  action is now  pending in federal  court in Boston,  Massachusetts.  Such
litigation  often  results in  substantial  costs and  diversion  of  management
resources and could  materially  adversely  affect Fonix's  business,  operating
results,  and  financial  condition.  The  Company has agreed to pledge the ASRT
patent as additional  security for the  repayment of the  Company's  Debentures.
While the Company has not executed a pledge agreement in favor of the holders of
the  Debentures,  it may be  required  to do so in the  future.  A breach of the
Company's  obligations  under  such  Debentures  could  result  in a loss of the
Company's control of or rights under the patent.

Risks of infringement

Fonix is not aware and does not believe that any of its technologies or products
infringe the proprietary  rights of third parties.  Nevertheless,  third parties
may claim  infringement  with respect to its current or future  technologies  or
products  or  products   manufactured  by  others  and   incorporating   Fonix's
technologies. Fonix expects that participants in the human- computer interaction
industry  increasingly  will be subject to infringement  claims as the number of
products and competitors in the industry grows and the functionality of products
in different industry segments overlaps. Any such claims, with or without merit,
could be time consuming, result in costly litigation,  cause development delays,
or require  Fonix to enter  into  royalty or  licensing  agreements.  Royalty or
license  agreements  may not be  available on  acceptable  

                                   Page 20 of  60

<PAGE>


terms or at all. As a result,  infringement claims could have a material adverse
affect on Fonix's business, operating results, and financial condition.

SOME MATTERS  AFFECTING FONIX  EFFECTIVELY  COULD BE DETERMINED BY A CONTROLLING
SHAREHOLDER.

Thomas A.  Murdock,  a  director,  the Chief  Executive  Officer  and a founding
shareholder  of Fonix,  is the trustee of a voting trust into which is deposited
approximately  33% of  Fonix's  common  stock,  based on the  number  of  shares
outstanding as of April 9, 1999. This  concentration of voting power in a single
individual  could allow Mr. Murdock to control  certain  matters as to which the
Fonix shareholders are asked to vote. Such concentrated share ownership also may
prevent or  discourage  potential  bids to acquire Fonix unless the terms of the
acquisition are approved by Mr. Murdock.

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 independent contractors, including John A. Oberteuffer,
Ph.D.,  Dale Lynn  Shepherd,  Ivan Mimica,  R. Brian Moncur,  Tony R.  Martinez,
Ph.D., and Caroline Henton, Ph.D., and its executive officers, Thomas A. Murdock
and Roger D.  Dudley.  The loss of any of the key  personnel  listed above could
materially and adversely affect Fonix's future business efforts. Fonix has taken
reasonable steps to protect its intellectual property rights including obtaining
non-competition  and  non-disclosure  agreements  from all of its  employees and
independent  contractors.  However,  if one or more of Fonix's key scientific or
executive  employees  or  independent  contractors  resigns from Fonix 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 Fonix.  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 is party to certain  litigation as described  more  particularly  in
Part I, Item 3 of this Report. An adverse ruling or judgment against the Company
in any of such  actions  may have a  material  adverse  effect on the  Company's
business, results of operations or financial condition.

YEAR 2000 PROBLEMS COULD ADVERSELY AFFECT FONIX.

Many computer  systems and software  products are coded to accept only two digit
entries in the date code field.  These date code fields will need to accept four
digit entries to distinguish  21st century dates from 20th century  dates.  As a
result,  many companies'  software and computer systems will need to be upgraded
or  replaced  in order to comply  with such  Year  2000  requirements.  Fonix is
subject to the risk that problems  encountered with Year 2000 issues,  either in
its internal  systems,  technologies and products,  or in external systems could
adversely affect its operations and financial condition.

In  the  ordinary  course  of  its  business,  Fonix  tests  and  evaluates  its
technologies  and  software  and  hardware  products.  Fonix  believes  that its
technologies  and products  generally are Year 2000 compliant,  meaning that the
use or  occurrence  of dates on or after  January  1, 2000  will not  materially
affect the  performance  of such  technologies  or products with respect to four
digit date dependent  data or the ability of such products to correctly  create,
store, process, and output information related to such data. However,  Fonix may
learn that certain of its  technologies or products do not contain all necessary
software  routines and codes  necessary for the accurate  calculation,  display,
storage,  and  manipulation  of data  involving  dates.  In addition,  Fonix has
warranted or expects to warrant that the use or  occurrence of dates on or after
January 1, 2000 will not adversely affect the performance of its technologies or
products  with  respect  to four  digit date  dependent  data or the  ability to
create,  store, process, and output information related to such data. If the end
users of any of Fonix's  technologies or products experience Year 2000 problems,
those persons could assert claims for damages.

Fonix  uses  third-party  equipment  and  software  that  may not be  Year  2000
compliant.  Fonix is presently  conducting a review of key products  provided by
outside vendors to determine if their products are Year 2000 compliant. Although
that process is not yet completed,  Fonix  presently  believes that all software
provided  by  third  parties  that is  critical  to its  business  is Year  2000
compliant. Fonix expects to complete its review of all internal systems for Year
2000 compliance by June 30, 1999. If this third-party equipment or software does
not  operate  properly  with  regard  to the Year  2000  issue,  

                                   Page 21 of 60

<PAGE>

Fonix may incur  unexpected  expenses  to remedy  any  problems.  Such costs may
materially  adversely affect Fonix's business,  operating results, and financial
condition.  In addition,  if Fonix's key systems, or a significant number of its
systems,  fail as a result of Year 2000 problems  Fonix could incur  substantial
costs  and  disruption  of its  business.  Fonix may also  experience  delays in
implementing Year 2000 compliant  software  products.  Any of these problems may
materially  adversely affect Fonix's  business,  operating  results or financial
condition.

In addition, the purchasing patterns of Fonix's licensees,  potential licensees,
customers  and  potential  customers  may be affected by Year 2000 issues.  Many
companies are expending  significant resources to correct their current software
systems for Year 2000 compliance. These expenditures may result in reduced funds
available to license Fonix  technologies  or to purchase  other Fonix  products.
This may adversely affect Fonix's  business,  operating  results,  and financial
condition.

OTHER DEMANDS ON MANAGEMENT COULD ADVERSELY AFFECT FONIX.

In addition to  occupying  positions as the  Company's  Chairman of the Board of
Directors,  Chief Executive Officer and President, and Executive Vice President,
respectively, Messrs. Stephen M. Studdert, Thomas A. Murdock and Roger D. Dudley
are  executive  officers  and owners of Studdert  Companies  Corp.  ("SCC"),  an
international  investment,  finance and management firm based in Salt Lake City,
Utah.  SCC  engages  in a variety  of  commercial  activities  unrelated  to the
Company. Mr. Studdert recently resigned his position as Chief Executive Officer,
and Mr. Murdock replaced Mr. Studdert as Chief Executive Officer of the Company.
Further,  in addition to serving as Vice President,  Technology for the Company,
Dr.  John  A.  Oberteuffer  is the  sole  shareholder  and  President  of  Voice
Information  Associates,  Inc. ("VIA"), a company which publishes  ASRNews,  and
provides marketing consulting and other related services to other ASR companies,
groups and associations. Under the terms of his employment agreement with Fonix,
executed in February 1998, Dr. Oberteuffer is not required to devote more than 4
days per week to the business of Fonix.  Although the Company  anticipates  that
Dr.  Oberteuffer can fully discharge all of his duties and  responsibilities  to
the  Company by working 4 days per week,  the Company  has no  comparable  prior
experience with such an arrangement.  There can be no assurance that the outside
activities of Messrs.  Murdock,  Dudley or Oberteuffer,  in connection with SCC,
VIA or  otherwise,  will not  materially  impede  their  ability  to  perform as
executive  officers of the Company,  in which case the Company's  operations and
financial condition could be adversely affected.

THE MARKET PRICE OF FONIX'S COMMON STOCK IS EXTREMELY VOLATILE.

The trading price of the Company's  common stock has been  characterized by wide
fluctuations  and the common stock must be considered a speculative  investment.
Persons  should  not  invest  in Fonix  common  stock  unless  they can bear the
economic  risks  thereof,  including  the  possibility  of losing  their  entire
investment.  Fonix believes that factors such as  announcements  of developments
related to the Company's business, announcements by competitors, the issuance of
patents,  financings,  and other  factors have caused the price of the Company's
stock and its trading  volume to  fluctuate,  in some cases  substantially,  and
could  continue  to do so in the  future.  In  addition,  the stock  market  has
experienced  extreme  price  and  volume  fluctuations  that  have  particularly
affected the market price for many technology companies and that have often been
unrelated to the operating  performance of these  companies.  These broad market
fluctuations  may  adversely  affect the market  price of the  Company's  common
stock.  The trading prices of many technology  companies'  stocks are at or near
their historical highs, and reflect  price/earnings  ratios  substantially above
historical  norms. In the Company's case the absence of revenues from operations
before  February 1998  indicates  that the market price of the Company's  common
stock fluctuates as a result of highly  speculative  factors.  In addition,  the
Company has issued debt and equity  securities  convertible to common stock. The
conversion  features of these  securities are adjusted based on the market price
of the  Company's  common stock and  conversion is likely to occur at times when
the price for the common  stock is low,  resulting  in the issuance of a greater
number of shares of common stock and increasing,  sometimes  significantly,  the
dilution  experienced by the Company's  shareholders.  Such conversions,  or the
possibility of the  significant  dilution that may be experienced as a result of
such conversions,  is also a factor contributing to the volatility of the market
price of the Company's common stock.

ITEM 2.   PROPERTIES

The Company  owns no real  property.  Commencing  in October  1996,  the Company
leased a 25,600 square foot facility in Draper, Utah, from an unaffiliated third
party at which it conducts its  principal  scientific  research and  development

                                   Page 22 of 60

<PAGE>

activities  and operates  its  Interactive  Technologies  Solutions  Group.  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.  The average base monthly  lease payment over
the 8-year life of the lease for that facility is $28,389.

In addition to the Draper  facility,  the Company  sub-leases  office space on a
month-to-month  basis  at  market  rates  for  its  corporate  headquarters  and
administrative  operations in Salt Lake City,  Utah,  from SCC. SCC is owned and
controlled by three individuals who are executive  officers and directors of the
Company.  [See "Certain  Relationships and Related  Transactions," and "Security
Ownership of Certain  Beneficial  Owners and  Management"].  The three executive
officers of the Company have personally  guaranteed this lease in favor of SCC's
landlord.  The base  monthly  rental for the  sub-leased  space  during 1998 was
approximately  $10,369,  plus  reimbursable  direct  expenses  for  the  use  of
telephone,  facsimile,  photocopy  and other  business  equipment.  The  Company
anticipates  continuing the month-to-month  sublease agreement with SCC for 1999
whereby  the  Company  will pay the actual  monthly  rental and common area fees
incurred by SCC.

The Company  also leases  approximately  10,000  square feet of office  space in
Cupertino,  California.  The lease on this space is for 5 additional years, with
rent of $24,412 per month.  The Company is presently  seeking to sublease all or
part of this space.  In the event the Company can sublease all of the space,  it
will seek to relocate its operations in California to a smaller facility.

The Company leases  approximately  16,810 square feet of office space in Woburn,
Massachusetts,  at which it conducts the operations of its Health Care Solutions
Group.  This lease extends through November 1999, and monthly rents are $22,343.
The Company  intends to  negotiate an extension of the term of this lease for at
least one year or locate comparable space in the greater Boston area.

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


ITEM 3.   LEGAL PROCEEDINGS

The Polomba Action

On July 9, 1998,  the Company  settled a case  brought by a  shareholder  of the
Company against certain  directors of the Company and K.L.S.  Enviro  Resources,
Inc. ("KLSE"), a third party affiliated with certain of the director-defendants.
Pursuant  to the  settlement,  the  Company  has  received  warrants to purchase
583,000 shares of KLSE common stock at a purchase price of $0.40 per share.

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 alleged that the Company
was  obligated to pay a fee in excess of  $1,200,000  plus 30,000  shares of the
Company's restricted common stock in connection with the March 1998 Offering. In
September  1998,  the J & L Action was settled and dismissed with prejudice upon
payment of $385,000 by the Company to J&L.

The Clarke Action

On August  28,  1998,  John R.  Clarke  ("Clarke")  and  Perpetual  Growth  Fund
("Perpetual  Growth"),  a company Clarke's spouse purportedly owns, commenced an
action  against the Company in federal  court for the  Southern  District of New
York.  Clarke and Perpetual Growth assert claims for breach of contract relating
to certain financing the Company received during 1998. Specifically,  Clarke and
Perpetual Growth allege that they entered into a contract with the Company under
which  the  Company  agreed  to pay  them a  commission  of 5% of all  financing
provided to the Company by  Southridge  Capital  Management  or its  affiliates.
Clarke and  Perpetual  Growth claim that they are entitled to  commissions  with
respect to  approximately  $3,000,000 of equity financing to the Company in July
and August 1998, and the Company's  offerings of Series D and Series E (totaling
together $12,000,000) in August and September 1998.



                                   Page 23 of 60

<PAGE>

The Company believes that the Clarke lawsuit is without merit. The Company filed
a motion to dismiss  based upon the court's lack of personal  jurisdiction  over
the Company.  The court granted the Company's motion to dismiss,  but Clarke and
Perpetual have appealed the New York court's decision that it lacks jurisdiction
over the Company. On November 9, 1998, the Company filed an action in the United
States  District  Court for the  Central  District of Utah,  against  Clarke and
Perpetual  seeking a  declaratory  judgment that the Company is not obligated to
Clarke or  Perpetual.  Clarke  and  Perpetual  have  sought to have this  action
dismissed, but the Utah court has not yet ruled on their motion. However, Clarke
and Perpetual Growth could prevail in the lawsuit, in which case the Company may
be required to pay significant amounts of money damages or other amounts awarded
by the court.  At a minimum,  the  ongoing  nature of this action will result in
some diversion of management time and effort from the operation of the business,
as well as additional legal fees and related costs and expenses.

The Papyrus Actions

On February 26, 1998, the Company filed an action against  Papyrus in the United
States  District  Court for the District of Utah,  Central  Division  (the "Utah
Action"). In the Utah Action, the Company alleged claims for  misrepresentation,
negligent misrepresentation,  breach of contract, breach of the implied covenant
of good faith and fair dealing and rescission.  On March 11, 1999,  three of the
former shareholders of Papyrus filed an action against the Company in the United
States   District   Court  for  the  District  of   Massachusetts   (the  "First
Massachusetts  Action"),  alleging a default  under the terms of the  promissory
notes issued to them in  connection  with the Papyrus  Acquisition.  On April 8,
1999, a fourth former Papyrus shareholder filed an action against the Company in
the United States District Court for the District of Massachusetts  (the "Second
Massachusetts  Action")  alleging  a default  under the terms of the  promissory
notes  issued to him in  connection  with the  Papyrus  Acquisition  and seeking
additional  remedies including  violation of Massachusetts  unfair and deceptive
acts and practices statutes and copyright infringement.  The Company has entered
into agreements with the four former Papyrus  shareholders  for dismissal of the
First and Second  Massachusetts  Actions and the Utah Action upon payment to the
former shareholders of $1,122,209 (the "Settlement  Payment") an amount equal to
approximately  73% of the balance due them under the notes issued to them in the
Papyrus  Acquisition,  and return  for  cancellation  by the  Company of 970,586
shares of  restricted  common stock  issued to them in the Papyrus  Acquisition.
This represents  approximately  30% of the total number of the Company's  common
stock originally issued to these  shareholders in the Papyrus  Acquisition.  The
Company must pay the Settlement Payment before May 16, 1999. If it does not, the
Company  and the four  former  Papyrus  shareholders  are free to  pursue  their
respective  claims in the Utah  Action  and the First and  Second  Massachusetts
Actions.

The Apple Litigation

In February 1995,  Articulate received a patent (the "303 Patent") for a product
that would allow users of Apple  Macintosh  computers to use voice  commands for
certain computer control commands. Soon after the 303 Patent issued,  Articulate
notified Apple that its "PlainTalk" product infringed the 303 Patent. When Apple
ignored Articulate's notice, Articulate sued Apple in the United States District
Court for the District of  Massachusetts.  Apple  responded to the suit by suing
Articulate and Dragon Systems,  Inc. in California.  The California suit against
Articulate  and Dragon  Systems has now been  dismissed.  The  Company  acquired
Articulate's claims against Apple in the Articulate acquisition. The Company has
completed  discovery in the action pending in Massachusetts  and is awaiting the
scheduling of trial.


ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters  submitted  to a vote of the security  holders  during the
fourth quarter of fiscal 1998.

                                     PART II

ITEM 5.    MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Fonix  common  stock is listed on the Nasdaq  SmallCap  Market under the trading
symbol  FONX.  The  following  table shows the range of high and low sales price
information  for the  Company's  common  stock as quoted on Nasdaq  for the four
quarters of calendar 1998 and 1997. The quotations reflect  inter-dealer prices,
without retail mark-up,  mark-down or commissions  and may not represent  actual
transactions.

     

                                   Page 24 of 60

<PAGE>
                         Calendar Year 1998                 Calendar Year 1997  
                         ------------------                 ------------------  
                       High              Low              High              Low 
                       ----              ---              ----              --- 

     First Quarter    $ 6.50            $ 3.50            $ 9.00           $7.13
     Second Quarter   $ 6.34            $ 3.00            $ 8.75           $6.50
     Third Quarter    $ 4.00            $ 1.12            $ 7.44           $6.50
     Fourth Quarter   $ 2.63            $ 0.94            $ 7.00           $2.88


As of  April 9,  1999,  there  were  7,064,495  shares  of  Fonix  common  stock
outstanding,  held by 239 holders of record and  approximately  5,100 beneficial
holders.  This number of beneficial holders represents an estimate of the number
of actual holders of the Company's stock,  including beneficial owners of shares
held in "nominee" or "street"  name.  The actual number of beneficial  owners is
not known to the Company.

The Company  has never  declared  any  dividends  on its common  stock and it is
expected that  earnings,  if any, in future  periods will be retained to further
the   development   and  sale  of  the  Company's   human-computer   interaction
technologies  and products.  No dividends can be paid on the common stock of the
Company  until such time as all accrued and unpaid  dividends  on the  Company's
preferred stock have been paid.

                 Recent Sales of Unregistered Equity Securities

During fiscal year 1998, the Company issued a total of 59,814  restricted shares
of common stock to various third parties in payment for services  rendered under
consulting  and other  agreements.  The shares  were  issued  pursuant to and in
reliance on exemptions  from  registration  under the Securities Act of 1933, as
amended (the "1933 Act"),  particularly pursuant to Section 4(2) of the 1933 Act
and the rules and regulations  promulgated  thereunder.  The value of the shares
issued in these  transactions,  based on the fair market  value of the shares on
the  several  dates of  issuance  was  approximately  $151,119  or an average of
approximately  $2.53 per share.  More detail  concerning  these  transactions is
included below.

On February 24, 1998,  the Company  issued  24,814  shares of common stock to an
unaffiliated entity as payment for certain  intellectual  property.  The Company
issued  such  shares  without  registration  under the 1933 Act in  reliance  on
Section 4(2).  Such shares of common stock were issued as restricted  securities
and the  certificates  representing  such shares were stamped with a restrictive
legend to prevent any resale without registration under the 1933 Act or pursuant
to an exemption.

On  March  5,  1998,  the  Company  issued  80,000  shares  of  common  stock to
unaffiliated  individuals  upon the exercise of warrants at a per share price of
$2.00. The Company issued such shares without registration under the 1933 Act in
reliance  on Section  4(2) or  Regulation  D. Such  shares of common  stock were
issued as restricted  securities and the certificates  representing  such shares
were  stamped  with  a  restrictive   legend  to  prevent  any  resale   without
registration under the 1933 Act or pursuant to an exemption.

On March 12, 1998, the Company issued  3,333,333 shares of common stock to seven
institutional  investors  under  the  terms  of the  March  1998  Offering.  The
consideration  received by the Company for these shares was  $15,000,000  ($4.50
per share). In connection with the sale of those shares,  the investors acquired
"reset"  rights  obligating  the Company to issue to them  additional  shares of
common stock (the "Reset Shares") for no additional consideration if the average
market price of the Company's  common stock for the 60 day period preceding July
27,  1998,  did not equal or exceed  $5.40 per share.  The  Company  issued such
shares  without  registration  under the 1933 Act in reliance on Section 4(2) or
Regulation D. Such shares of common stock were issued as  restricted  securities
and the  certificates  representing  such shares were stamped with a restrictive
legend to prevent any resale without registration under the 1933 Act or pursuant
to an exemption.

On March 13,  1998,  the  Company  issued  100,000  shares  of  common  stock to
unaffiliated  individuals upon the exercise of warrants.  The exercise price was
$0.50 per share. The Company issued such shares without  registration  under the
1933 Act in  reliance  on Section  4(2) or  Regulation  D. Such shares of common
stock were issued as restricted  securities  and 


                                   Page 25 of 60

<PAGE>

the certificates representing such shares were stamped with a restrictive legend
to prevent any resale without  registration under the 1933 Act or pursuant to an
exemption.

On March 13,  1998,  the  Company  issued  2,692,216  shares of common  stock to
various shareholders of AcuVoice.  as part of the consideration for the AcuVoice
Acquisition.  The common stock was valued at $6.31 per share. The Company issued
such shares without  registration under the 1933 Act in reliance on Section 4(2)
or  Regulation  D. Such  shares  of  common  stock  were  issued  as  restricted
securities  and the  certificates  representing  such shares were stamped with a
restrictive legend to prevent any resale without registration under the 1933 Act
or pursuant to an exemption.

On April 16,  1998,  the  Company  issued  10,000  shares  of common  stock to a
non-employee  director  upon the  exercise  of  warrants  at a price of $.50 per
share. The Company issued such shares without registration under the 1933 Act in
reliance on Section 4(2).  Such shares of common stock were issued as restricted
securities  and the  certificates  representing  such shares were stamped with a
restrictive legend to prevent any resale without registration under the 1933 Act
or pursuant to an exemption.

On May 7, 1998,  the Company  issued 40,000 shares of common stock at a price of
$2.00 per share to an  unaffiliated  entity upon the exercise of  warrants.  The
Company issued such shares without  registration  under the 1933 Act in reliance
on Section  4(2) or  Regulation  D. Such  shares of common  stock were issued as
restricted securities and the certificates representing such shares were stamped
with a restrictive  legend to prevent any resale without  registration under the
1933 Act or pursuant to an exemption.

On June 12,  1998,  the Company  issued  options to purchase  100,000  shares of
common stock at an exercise price of $3.75 per share to an  unaffiliated  entity
as partial payment for professional  services to be rendered by such entity. The
Company issued such shares without  registration  under the 1933 Act in reliance
on Section  4(2) or  Regulation  D. Such  shares of common  stock were issued as
restricted securities and the certificates representing such shares were stamped
with a restrictive  legend to prevent any resale without  registration under the
1933 Act or pursuant to an exemption.

On June 23, 1998,  the Company issued 35,000 shares of common stock at $6.00 per
share to an unaffiliated person upon the exercise of options. The Company issued
such shares without  registration under the 1933 Act in reliance on Section 4(2)
or  Regulation  D. Such  shares  of  common  stock  were  issued  as  restricted
securities  and the  certificates  representing  such shares were stamped with a
restrictive legend to prevent any resale without registration under the 1933 Act
or pursuant to an exemption.

On June 29, 1998,  the Company  issued 444,444 shares of common stock as part of
the March 1998  Offering  upon the payment by some of the investors in the March
1998 Offering of $2,000,000. The Company issued such shares without registration
under the 1933 Act in reliance on Section 4(2) or  Regulation  D. Such shares of
common stock were issued as restricted  stock, but were covered,  as of the date
of  their  issuance  for  public  resales  by  the  investors,  by an  effective
registration  statement  filed  with  the  Securities  and  Exchange  Commission
("SEC").

On August 7, 1998,  the Company issued 222,222 shares of common stock as part of
the March 1998  Offering  upon the payment by some of the investors in the March
1998 Offering of $1,000,000. The Company issued such shares without registration
under the 1933 Act in reliance on Section 4(2) or  Regulation  D. Such shares of
common stock were issued as restricted  stock, but were covered,  as of the date
of  their  issuance  for  public  resales  by  the  investors,  by an  effective
registration statement filed with the SEC.

On August, 31, 1998, the Company issued 1,390,476 shares of common stock for (i)
the  relinquishment of the rights of the investors in the March 1998 Offering to
receive Reset Shares in connection with  $3,000,000  received in June and August
1998,  and (ii) a  financing  cost in  connection  with the  issuance of 500,000
shares of Series D  preferred  stock.  The Company  issued  such shares  without
registration  under the 1933 Act in reliance on Section  4(2) or  Regulation  D.
Such shares of common stock were issued as restricted  stock,  but were covered,
as of the date of their  issuance  for public  resales by the  investors,  by an
effective registration statement filed with the SEC.

Also on August 31, 1998, the Company issued an aggregate of 1,108,334  shares of
Series D to various  unaffiliated  institutional  investors  for the  payment of
$10,000,000 and the  relinquishment  of investors'  contractual right to receive
Reset  Shares  in   connection   with   $15,000,000   received  in  March  1998.
Subsequently,  on November 13, 1998, the 

                                   Page 26 of 60

<PAGE>

Company  issued  50,000  additional  shares  of  Series  D  preferred  stock  in
considerations  of $1,000,000 of additional  investment.  The Company issued the
Series D shares without  registration  under the 1933 Act in reliance on Section
4(2) or Regulation  D. The Series D shares were issued as restricted  securities
and the certificates representing such shares were

stamped with a  restrictive  legend to prevent any resale  without  registration
under the 1933 Act or pursuant to an exemption.

On September 2, 1998,  the Company  issued  5,140,751  shares of common stock to
various  shareholders  of  Articulate  as  part  of the  consideration  for  the
Articulate  acquisition.  The common  stock was  valued at $1.63 per share.  The
Company issued such shares without  registration  under the 1933 Act in reliance
on Section  4(2) or  Regulation  D. Such  shares of common  stock were issued as
restricted securities and the certificates representing such shares were stamped
with a restrictive  legend to prevent any resale without  registration under the
1933 Act or pursuant to an exemption.

On September  30,  1998,  the Company  issued an aggregate of 250,000  shares of
Series E to various  unaffiliated  institutional  investors  in exchange for the
payment of $2,000,000  which was received in October 1998 and 150,000  shares of
Series D that were  tendered  in exchange  for  150,000  shares of Series E. The
Company  issued the Series E shares without  registration  under the 1933 Act in
reliance  on Section  4(2) or  Regulation  D. The Series E shares were issued as
restricted securities and the certificates representing such shares were stamped
with a restrictive  legend to prevent any resale without  registration under the
1933 Act or pursuant to an exemption.

On October 29, 1998,  the Company  issued a total of 3,111,114  shares of common
stock to the Papyrus  shareholders as part of the  consideration for the Papyrus
Acquisition.  The common stock was valued at $1.17 per share. The Company issued
such shares without  registration under the 1933 Act in reliance on Section 4(2)
or  Regulation  D. Such  shares  of  common  stock  were  issued  as  restricted
securities  and the  certificates  representing  such shares were stamped with a
restrictive legend to prevent any resale without registration under the 1933 Act
or pursuant to an exemption.

On November 13, 1998, the Company sold 50,000  additional  shares of Series D to
the investors who had purchased under the August 31, 1998 agreement, on the same
terms and conditions as the August 31, 1998 agreement.

On December 22,  1998,  the Company  issued  1,801,802  shares of common  stock,
together  with a  corresponding  number of Repricing  Rights,  which entitle the
holder  thereof  to  receive  additional  shares of common  stock at the time of
exercise of the Repricing Rights,  depending upon the prevailing market price of
the common stock.  The Company issued the common stock and the Repricing  Rights
without  registration  under  the  1933  Act in  reliance  on  Section  4(2)  or
Regulation  D. The common  stock was  issued as  restricted  securities  and the
certificates  representing such shares were stamped with a restrictive legend to
prevent  any resale  without  registration  under the 1933 Act or pursuant to an
exemption.

On January 29, 1999,  the Company sold  Debentures  in the  aggregate  principal
amount of $4,000,000 to four investors.  The outstanding principal amount of the
Debentures is convertible at any time at the option of the holder into shares of
Fonix common stock at a conversion  price equal to the lesser of $1.25 or 80% of
the  average of the  closing  bid price of the Fonix  common  stock for the five
trading days immediately  preceding the conversion date. The Company also issued
warrants to purchase  400,000  shares of common  stock in  connection  with this
financing. The warrants are exercisable at a price of $1.25 per share and have a
three year term. On March 3, 1999, the Company executed a Supplemental Agreement
with the same  four  investors,  pursuant  to which  the  Company  sold  another
$2,500,000  principal  amount of the Debentures on the same terms and conditions
as the January 29, 1999  agreement,  except no additional  warrants were issued.
The Company issued all of the Debentures without registration under the 1933 Act
in reliance  on Section  4(2) or  Regulation  D. The  Debentures  were issued as
restricted  securities and the Debentures were stamped with a restrictive legend
to prevent any resale without  registration under the 1933 Act or pursuant to an
exemption.

ITEM 6.    SELECTED FINANCIAL DATA

The  selected  consolidated  financial  data set forth below is derived from the
Company's  consolidated  statements  of  operations  and balance  sheets for the
fiscal years ended December 31, 1998,  1997,  1996,  1995 and 1994. The data set
forth below should be read in  conjunction  with  "Management's  Discussion  and
Analysis of Financial  Condition and Results of Operations" and the consolidated
financial statements and related notes thereto included in this Report.




                                   Page 27 of 60

<PAGE>
<TABLE>
<CAPTION>



                                                                           For the Year Ended December 31,
                                            ---------------------------------------------------------------------------------------
                                                     1998              1997             1996             1995             1994
                                            ---------------------------------------------------------------------------------------
                                                                     (in thousands, except per share data)
<S>                                           <C>                   <C>               <C>             <C>              <C>    
Statement of Operations Data:

Revenues                                      $    2,889,684        $        --       $      --       $       --       $       --

General and administrative expenses               12,612,015         12,947,112       3,530,400        3,553,665        1,339,987

Research and development expenses                 13,620,748          7,066,294       4,758,012        2,704,165        2,522,090

Purchase of in-process research and 
  development                                     13,136,000                 --              --               --               --

Loss from operations                            (36,555,423)       (20,013,406)     (8,288,412)      (6,257,830)      (3,862,077)

Other income (expense)                           (6,563,359)        (1,558,678)         458,904         (88,067)         (52,262)

Gain (loss) on extraordinary item                         --          (881,864)              --           30,548               --

Net loss                                        (43,118,782)       (22,453,948)     (7,829,508)      (6,315,349)      (3,914,339)

Basic and diluted net loss per common share            (.91)   $          (0.59)  $         (0.21)$          (0.30)$          (0.28)

Weighted average number of common shares          52,511,185         42,320,188      36,982,610       21,343,349       14,095,000
outstanding
</TABLE>

<TABLE>
<CAPTION>
                                                                             As of December 31,
                                    -------------------------------------------------------------------------------------

                                          1998             1997             1996             1995             1994
                                    -------------------------------------------------------------------------------------
                                                                       (in thousands)
<S>                                  <C>               <C>              <C>                <C>             <C>   
Balance Sheet Data:

Current assets                       $20,715,206       $ 21,148,689     $ 23,967,601       $ 7,912,728     $ 2,150,286

Total assets                          61,989,927          22,894,566       25,331,270         7,984,306       2,150,286

Current liabilities                   35,394,181          20,469,866       19,061,081         6,674,572       4,117,995

Long-term debt, net of current 
  portion                                     --              52,225               --                --              --

Stockholders' equity (deficit)        24,765,746           2,372,475        6,270,189         1,309,734      (1,967,709)

</TABLE>

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" AND UNDER THE HEADING
"CERTAIN SIGNIFICANT RISK FACTORS" IN ITEM 1 PART i OF THIS REPORT, ABOVE.



                                   Page 28 of 60

<PAGE>

Overview

Fonix  is  a  development-stage  company  engaged  in  scientific  research  and
development of proprietary automated 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 an agreement with the  semiconductor
unit of Siemens AG pursuant  to which the  Company and Siemens  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.  Under the Siemens  agreement,  Fonix
received  its first  revenue  associated  with the ASRT in 1998.  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
entered into pursuant to the OGI  Agreement,  the parties are  collaborating  on
advanced automated speech  recognition  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. In 1998,  the Company
entered into a similar arrangement with Brigham Young University.

Other than the arrangements with Siemens, OGI, and Brigham Young University, the
Company has no licensing or co- development  agreements with any third party for
its ASRT. Other than the non-refundable license fee paid by Siemens, the Company
has  received  no revenue  to date with  respect  to the 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 or enter into additional  co-development or strategic alliance
agreements.

In March 1998,  the Company  expanded  its suite of  human-computer  interaction
technologies  by acquiring the  award-winning  voice  synthesis  technologies of
AcuVoice.  The business operations previously conducted by AcuVoice are now part
of the Company's Interactive  Technologies  Solutions Group, which also includes
the Company's  previously  developed  Core  Technologies.  During the year ended
December 31, 1998, the Company  received in the  aggregate,  $236,586 in revenue
from licensing or sale of the AcuVoice technologies.

In September 1998, the Company acquired Articulate, a developer of leading voice
recognition and systems software for specialized applications in the health care
industry.  The business  operations  previously  conducted by Articulate are now
conducted  by  the  Company's   HealthCare  Solutions  Group  based  in  Woburn,
Massachusetts. During the year ended December 31, 1998, the Company received, in
the aggregate,  $284,960 from sales of the  PowerScribe  products  acquired from
Articulate.

In October 1998,  the Company  acquired  Papyrus.  Papyrus  develops and markets
printing and cursive handwriting  recognition software for PDAs, pen tablets and
mobile phones. The Company operates the business formerly operated by Papyrus as
part of its Interactive  Technologies Solutions Group in Woburn,  Massachusetts.
During the year ended December 31, 1998, the Company received, in the aggregate,
$0 from licensing of technologies acquired from Papyrus.

The  Company  markets  its  previously  developed  technologies,  together  with
text-to-speech  technologies  and products  acquired from AcuVoice,  handwriting
recognition  technologies  and products  acquired from Papyrus,  and intelligent
agent technologies,  through its Interactive  Technologies  Solutions Group. The
present marketing direction for the Interactive  Technologies Solutions Group is
to form  relationships  with third  parties who can  incorporate  the  Company's
technologies   and  the  other   technologies   available  to  the   Interactive
Technologies  Solutions  Group into their own  products  or product  development
efforts.  Such  relationships  may be  structured  in any of a  variety  of ways
including traditional technology licenses,  co-development relationships through
joint  ventures or otherwise,  and strategic  alliances.  The third parties with
whom the Company  presently  has such  relationships  and with which it may have
similar relationships in the future include

                                   Page 29 of 60

<PAGE>

participants  in  the  application   software,   operating  systems,   computer,
microprocessor  chips, consumer  electronics,  automobile,  telephony and health
care technology industries.

The Company markets its voice  recognition and systems  software for specialized
applications in the health care industry through its HealthCare Solutions Group.
The  HealthCare   Solutions  Group  presently  markets  large  vocabulary  voice
recognition  software for the rapid  capture,  transcription  and  management of
clinical  information dictated by radiologists and emergency medical physicians.
The  products  now  being  sold by the  HealthCare  Solutions  Group,  including
PowerScribeRAD  and  PowerScribeEM,  are marketed to major hospitals and medical
centers.

In addition to the transactions  involving  AcuVoice,  Articulate and Papyrus in
1998,  the Company  also was in  negotiations  to acquire  several  other speech
technology  companies.  The  Company  has now  terminated  all such  acquisition
discussions.  The Company advanced money to some of those acquisition candidates
in  anticipation  of the completion of an acquisition  transaction.  The Company
presently  is  pursuing  the  return of such  funds in the  aggregate  amount of
$245,000.

Details of Acquisitions and Valuation Methodologies

During fiscal year 1998, the Company acquired AcuVoice and Articulate. A portion
of the  consideration  paid in each acquisition was for in-process  research and
development ("IPR&D").

AcuVoice (Acquired March 13, 1998)

At the date of  acquisition,  AcuVoice was a developer of a  speech-synthesizing
software  system  that is  capable of  translating  text into  natural  sounding
speech. Its currently available products include the AcuVoice Speech Synthesizer
AV1700   Text   Reader   and   the   AcuVoice    Speech    Synthesizer    AV2001
Telephony/Multimedia Interface. These applications are able to read a variety of
input text in an American English male voice.

At the  date of  acquisition,  AcuVoice's  IPR&D  efforts  were  focused  on the
continued  development  and evolution of the next  generation of these products.
The Company now is working to expand  voice  capacity to include both a male and
female voice,  and to expand  language  capacity to include  Japanese,  Mandarin
Chinese,  French,  German, and Spanish. In addition to the technological  issues
resulting  from these  efforts,  the  Company  also  intends to enhance the next
generation  applications with a stronger text-to-speech engine, sound bank, SAPI
4.0, SDK, and user dictionary; and increased VOX file output, documentation, C++
API and JSAPI.  The  Company is also  developing  an ESL product for the Windows
95/Windows NT  environments  that would have a customized  dictionary and sample
English sentences,  and a highly scalable multi-channel version for applications
that would operate in Windows NT/Solaris environments.

The   developmental   projects  at  the  time  of  the   acquisition   were  not
technologically  feasible and had no alternative future use. This conclusion was
attributable  to the fact that  AcuVoice had not  completed a working model that
had been tested and proven to work at performance  levels which were expected to
be commercially viable, and that the technologies  constituting the projects had
no  alternative  use other than their  intended  use. The value is  attributable
solely to the  development  efforts  completed as of the  acquisition  date. The
acquired  IPR&D was valued at $9.3  million  based on an analysis of  forecasted
income.

As of the date of  acquisition,  AcuVoice had invested $3.5 million in the IPR&D
identified  above.  Development  of  the  acquired  in-process  technology  into
commercially  viable products and services required efforts  principally related
to the completion of all planning,  designing, coding, prototyping,  scalability
verification,  and testing  activities  necessary to establish that the proposed
technologies  would  meet their  design  specifications,  including  functional,
technical,  and economic  performance  requirements.  Management  estimates that
approximately  $1.0 million will be required  over the next 12 months to develop
the aforementioned products to commercial viability.

The Company  currently  estimates  that a  redeveloped  version of its  AcuVoice
applications  will be released within range of the development  horizon in terms
of date of release and cost to complete  anticipated at the date of acquisition.
The remaining IPR&D projects are continuing to be developed as anticipated.


                                   Page 30 of 60

<PAGE>

Articulate (Acquired September 2, 1998)

Articulate focused on developing and marketing speech recognition and integrated
speech-oriented  software  applications  for  desk-top  and client  server-based
computer    environments.    In   1993,   Articulate   focused   on   developing
large-vocabulary  speech  applications for the heath care market, with a primary
focus on medical records  management.  In 1995,  Articulate began development of
PowerScribe,  which  converts  speech into text to create an electronic  medical
report. The first PowerScribe application focused on the radiology market.

At the date of  acquisition,  Articulate's  IPR&D  focused on (1)  enhancing its
current PowerScribeRAD  application to meet the needs of the health care market,
and (2) developing  products addressing the needs of other health care segments.
The next  generation of  PowerScribeRAD,  identified as Version 2.5, will differ
from Version 1.0 in that it will have an enhanced  tool kit,  providing a common
set of services including storage and retrieval,  and improved voice recognition
technology  using a different set of language models.  In addition,  Version 2.5
will  also  be  developed  with  a new  version  of  SQL.  SQL  Version  7.0  is
significantly  improved  over  Version  6.5 in  that  it  self-administers  more
effectively and incorporates  technology  supporting remote access via a virtual
connection.  Articulate is also developing  PowerScribe  products for emergency,
cardiology, and pathology health care segments.

The   developmental   projects  at  the  time  of  the   acquisition   were  not
technologically  feasible and had no alternative future use. This conclusion was
attributable  to the fact that Articulate had not completed a working model that
had been tested and proven to work at performance  levels which were expected to
be commercially viable, and that the technologies  constituting the projects had
no  alternative  use other than their  intended  use. The value is  attributable
solely to the  development  efforts  completed as of the  acquisition  date. The
acquired  IPR&D was valued at $3.8  million  based on an analysis of  forecasted
income.

As of the date of acquisition, Articulate had invested $3.4 million in the IPR&D
identified  above.  Development  of  the  acquired  in-process  technology  into
commercially  viable products and services required efforts  principally related
to the completion of all planning,  designing, coding, prototyping,  scalability
verification,  and testing  activities  necessary to establish that the proposed
technologies  would  meet their  design  specifications,  including  functional,
technical, and economic performance  requirements.  Management estimates that an
additional  $1.0 million will be required over the next 12 months to develop the
aforementioned products to commercial viability.

Of the projects  deemed  IPR&D,  both  Radiology  2.5 and Emergency 1.0 achieved
technological feasibility and commercial viability subsequent to the acquisition
date, within range of the anticipated time of release and cost to complete.  The
remaining IPR&D projects are continuing to be developed as anticipated.

Valuation Methodology

The valuations of the respective  acquired IPR&D included,  but were not limited
to, an analysis  of (1) the market for  AcuVoice  and  Articulate  products  and
technologies;  (2) the completion costs for the projects;  (3) the expected cash
flows  attributable  to the IPR&D  projects;  and (4) the risks  associated with
achieving such cash flows. The assumptions  underlying the cash flow projections
were derived from  investment  banking  reports,  independent  analyst  reports,
Fonix,  AcuVoice,  and Articulate  company  records,  and  discussions  with the
management of all  companies.  Primary  assumptions  such as revenue  growth and
profitability  were compared to indications  of similar  companies as well as to
indications  from  industry  analyst  reports,  to determine the extent to which
these assumptions were supportable.  The Company did not assume in its valuation
any material  change in its profit margins as a result of the  acquisitions  and
did not assume any  material  increases in selling,  general and  administrative
expenses as a result of the  acquisitions.  The Company did not  anticipate  any
expense reductions or other synergies as a result of the acquisitions. The basis
of the acquisitions was an attempt to enhance the Company's competitive position
by offering a broader product line,  including  applications  and  functionality
based upon the acquired speech recognition and text-to-speech technologies.

The Company does not break down revenues attributable  specifically to AcuVoice-
and Articulate-derived  products. As products are offered both as a suite and as
individual  applications,  Fonix  license fees are not  necessarily  application
specific.  However,  the Company believes that revenues generated to date concur
with the assumptions used in the valuation analysis.


                                   Page 31 of 60

<PAGE>

Because the Company does not account for expenses by product, it is not possible
to determine the actual expenses associated with the technologies  acquired from
AcuVoice and Articulate. The Company currently believes that expenses associated
with completing the purchased IPR&D and  integrating the  technologies  with the
Company's  existing  products are  approximately  consistent  with the Company's
estimates  used in the analysis and that  completion  dates for the  development
projects  discussed  above  concur  with  projections  used  at the  time of the
acquisition.  Research and development  spending with respect to these offerings
is expected to continue at a rate that is consistent with the Company's  overall
research  and  development  spending.  The  Company  does not  believe  that the
acquisitions  resulted  in any  material  changes  in its  profit  margins or in
selling,  general and administrative expenses. The Company does not believe that
it achieved  any  material  expense  reductions  or synergies as a result of the
acquisitions.

The rates  utilized to discount the net cash flows to their  present  value were
consistent  with the nature of the  forecast and the risks  associated  with the
projected growth,  profitability and developmental  projects.  Discount rates of
50% and 60% for AcuVoice and 35% and 40% for Articulate were deemed  appropriate
for the business  enterprises  and for the acquired IPR&D,  respectively.  These
discount rates were  consistent with the acquired  companies'  various stages of
development;  the uncertainties in the economic  estimates  described above; the
inherent  uncertainty at the time of the acquisition  surrounding the successful
development  of the  purchased  in-process  technology;  the useful life of such
technology;  the  profitability  levels  of such  technology;  and the  inherent
uncertainties of the technological advances that were indeterminable at the time
of the acquisition.

The forecasts used in valuing the IPR&D were based upon  assumptions the Company
believed to be reasonable but which were inherently uncertain and unpredictable.
For these reasons,  actual results may vary from projected results.  The Company
currently    markets    the    AcuVoice    and    Articulate     acquired    and
subsequently-developed products.

Results of Operations

1998 Compared to 1997

During fiscal year 1998, the Company recorded  revenues of $2,889,684,  of which
$2,368,138 was a  non-refundable  license fee from Siemens for which the Company
has no further  obligation.  The  remainder of such revenues were from sales and
licensing fees related to the  PowerScribe  dictation and  text-to-speech  voice
synthesis technologies.

During fiscal year 1998, the Company incurred  product  development and research
expenses of $13,620,748,  an increase of $6,554,454 over the $7,066,294 incurred
in 1997. This increase was due primarily to the addition of product  development
and research  personnel,  increased use of independent  contractors,  equipment,
facilities  and  the  operations  of  AcuVoice  and   Articulate.   The  Company
anticipates  similar or increased  product  development and research costs as it
expands  and  continues  to develop  and market the  applications  and  products
offered by its  HealthCare  Solutions  and  Interactive  Technologies  Solutions
Groups.  Additionally,   the  Company  purchased  IPR&D  totaling  approximately
$13,136,000  during  fiscal year 1998, in connection  with the  acquisitions  of
AcuVoice and Articulate.

Selling,  general  and  administrative  expenses  remained  relatively  flat  at
$12,612,015  and  $12,947,112  respectively,  for  fiscal  years  1998 and 1997.
Salaries,  wages and related costs were  $4,163,943  and  $2,216,400  for fiscal
years 1998 and 1997, respectively,  an increase of $1,947,543.  This increase is
attributable  to  incentive   compensation  for  continued  employment  paid  to
employees of Articulate of $857,000,  and to increases in personnel  from recent
acquisitions.   Legal  and   accounting   expenses   increased   $1,234,178  and
depreciation and amortization  increased $2,629,956.  The $2,629,956 increase in
depreciation and  amortization is primarily  attributable to the amortization of
intangible  assets acquired in connection with the  acquisitions of AcuVoice and
Articulate.   Additionally,   consulting  and  outside  services   decreased  by
$6,740,619.

The Company  incurred  losses from  operations of  $36,555,423  and  $20,013,406
during fiscal years 1998 and 1997,  respectively.  The  significant  increase in
losses  from   operations  is  primarily  due  to  purchased  IPR&D  charges  of
$13,136,000  associated with the  acquisitions  of AcuVoice and Articulate.  The
Company   anticipates  that  its  investment  in  ongoing   scientific   product
development  and research  will  continue at present or increased  levels for at
least  the  remainder  of fiscal  year 1999  assuming  availability  of  working
capital.


                                   Page 32 of 60

<PAGE>

Net other  expense was  $6,563,359  for the year ended  December  31,  1998,  an
increase of $5,004,681  over the previous year.  This increase was primarily due
to a $6,111,577  expense  recorded in connection  with the settlement of a reset
provision associated with a private placement of the Company's common stock (see
Liquidity  and  Capital  Resources).  This  increase  was  offset  in  part by a
reduction in interest  expense of $1,231,182  from the previous year,  primarily
due to extinguishment of certain debt instruments during the year ended December
31, 1998.

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% 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.
On  April  6,  1998,  the  Company  and  Synergetics   entered  into  a  Royalty
Modification  Agreement,   under  which  the  Company  agreed,  subject  to  its
compliance with applicable  securities laws, to make an offer to exchange common
stock  purchase  warrants  having  an  exercise  price of $10 per  share for the
Project  Shares  at the  rate of one  warrant  to  purchase  800  shares  of the
Company's  common  shares for each  Project  Share.  The  warrants,  if and when
issued,  will not be exercisable until the earlier of (1) the date the Company's
common stock has traded for a period of 15 consecutive trading days at a minimum
of $37.50 per share or (2) September 30, 2000.  The offer of warrants to holders
of Project Shares cannot be made by the Company until a  registration  statement
covering the total number of warrants issuable upon the exercise of the warrants
has been declared effective by the Securities and Exchange Commission.  Upon the
tender to the Company of any Project  Shares a  corresponding  percentage of the
Royalty will be canceled.

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 was
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.

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.  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.

Net other  expense was  $1,558,678  for the year ended  December  31,  1997,  an
increase 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  drew down its line of credit to fund its  operations,
thereby  investing  smaller  amounts of cash reserves which  decreased  interest
income and increased interest expense.

                                   Page 33 of 60

<PAGE>


The Company converted 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.

Liquidity and Capital Resources

The  Company  must  raise  additional  funds  to be able  to  satisfy  its  cash
requirements  during  the  next  twelve  months.  The  scientific  research  and
development,  corporate  operations  and  marketing  expenses  will  continue to
require additional  capital.  In addition,  the Company's recent acquisitions of
AcuVoice,  Articulate,  and Papyrus place further  requirements on the Company's
limited cash resources.  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.  There can be no assurance  that the Company will be able to enter into
such  agreements.  Furthermore,  the  issuance  of  equity  securities  or other
securities which are or may become  convertible to the equity  securities of the
Company in connection with such financing (or in connection  with  acquisitions)
would  result in dilution  to the  stockholders  of the  Company  which could be
substantial.

The Company had negative  working  capital of  $14,678,975 at December 31, 1998,
compared to positive  working  capital of $678,823  at December  31,  1997.  The
current  ratio was 0.59 at December 31,  1998,  compared to 1.03 at December 31,
1997. Current assets increased by $433,483 to $20,715,206 from December 31, 1997
to  December  31,  1998.  Current   liabilities   increased  by  $14,924,315  to
$35,394,181  during  the same  period.  The  decrease  in working  capital  from
December  31,  1997,  to December 31, 1998,  was  primarily  attributable  to an
increase in notes payable  associated  with the  acquisition  of Articulate  and
increases  in  accounts   payable,   notes  payable  of  $857,000  as  incentive
compensation to Articulate employees to ensure continued employment, and accrued
liabilities  due to minimal  available  cash.  Total assets were  $61,989,927 at
December 31, 1998, compared to $22,894,566 at December 31, 1997.

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.  During the
year ended  December 31, 1998, the Company  issued  22,542,407  shares of common
stock.  Of such shares,  7,192,078  shares were issued in connection  with three
private placements (see below), 10,944,081 shares were issued in connection with
the  acquisitions  of AcuVoice,  Articulate and Papyrus,  4,081,234  shares were
issued upon the  conversion of preferred  stock and related  dividends,  265,000
shares were issued upon the exercise of previously granted warrants and options,
35,000  shares were issued for loan  structuring  advice and 24,814  shares were
issued for the purchase of a patent.  For the years ended  December 31, 1998 and
1997,  respectively,  private and other exempt sales of the  Company's  debt and
equity securities resulted in net cash proceeds of $33,693,981 and $11,844,424.

In January  1998,  27,500  shares of Series B  Convertible  Preferred  Stock and
related  dividends  were  converted  into  193,582  shares of common  stock.  At
December  31,  1998,  no shares of Series B  Convertible  Preferred  Stock  were
outstanding.

During  the first  quarter  of 1998,  185,000  shares  of  Series C  Convertible
Preferred  Stock and related  dividends were converted into 1,295,919  shares of
the  Company's  common  stock.  At  December  31,  1998,  no  shares of Series C
Convertible Preferred Stock were outstanding.

On March 12, 1998, the Company the March 1998 Offering of its restricted  common
stock to seven accredited investors.  $15,000,000 was received by the Company on
March 12,  1998,  in return for which the  Company  issued a total of  3,333,333
shares of  restricted  common  stock and paid  finders'  fees of  $870,000.  The
investors agreed to purchase an additional $15,000,000 on July 27, 1998 (60 days
after the effectiveness of a registration  statement that the Company filed with
the SEC covering the common  stock  issued and issuable to the  investors)  (the
"Second Funding Date"),  provided that, as of such date, certain conditions were
satisfied. Certain conditions precedent to receiving the additional funding were
not met as of the Second  Funding  Date.  In separate  transactions  in June and
August 1998,  certain  investors  paid to the Company  $3,000,000  in return for
which the Company issued 666,667 additional shares under the terms and

                                   Page 34 of 60

<PAGE>

conditions  set forth in the March 1998 Offering  documents.  Placement  fees of
$163,846 were  recorded in connection  with the  $3,000,000  received.  No other
payment was received by the Company pursuant to the March 1998 Offering.

The  investors  in the March  1998  Offering  acquired  certain  "reset  rights"
pursuant to which they would  receive  additional  shares of  restricted  common
stock ("Reset Shares") if the average market price of the Company's common stock
for the 60-day period following the  effectiveness  date and Second Funding Date
did not equal or exceed $5.40 per share. On August 31, 1998, the Company and the
investors  restructured  the reset provision  whereby the Company issued 608,334
Series D shares and 1,390,476 shares of common stock for (i) the  relinquishment
of the investors'  contractual  right to receive Reset Shares in connection with
the $15,000,000  received in March 1998 and the $3,000,000  received in June and
August 1998.  In  connection  with the  restructuring,  the Company  recorded an
expense  of  $6,111,577  for  the  difference  between  the  Company's  original
obligation  to issue Reset  Shares and the fair value of the shares of preferred
and common stock that were actually issued in settlement for the  relinquishment
of the reset  provision.  The Company also issued 500,000 shares of Series D for
$10,000,000.  The Company  recorded a  preferred  stock  dividend of  $1,000,000
related to  financing  costs in  connection  with the issuance of these Series D
shares.  Dividends accrue on the stated value ($20 per share) of Series D at the
rate of 4% per year, are payable annually or upon conversion,  in cash or common
stock, at the option of the Company,  and are presently  convertible into shares
of the Company's  common stock at the holder's  option Each month the holders of
the  Series D may not  convert  more than 25% of the  total  number of shares of
Series D originally  issued to such holders on a cumulative  basis. For example,
during  the first  month a holder may  convert up to 25% of the total  preferred
stock issued to the holder,  and during the following month that same holder may
convert,  on an aggregate to date basis, up to 50% of the total number of shares
of Series D held by the  holder.  Additionally,  each  month,  the  holders  may
convert up to 50% of the total number of shares of Series D originally issued to
such holders on a cumulative  basis,  if both of the  following  conditions  are
satisfied: (1) the average daily trading volume of the Company's common stock is
more than 500,000 shares for the  10-trading-day  period before the  conversion;
and (2) the average per share closing bid price for such  10-trading-day  period
has not  decreased  by more  than 5%  during  that  10-trading-day  period.  Any
outstanding  shares of  Series D as of August  31,  2001  automatically  will be
converted at the conversion  price most  beneficial to the holders on such date.
In the event of  liquidation,  the  holders of the Series D 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 D have no voting
rights.  The Series D shares,  together with dividends  accrued thereon,  may be
converted into shares of the Company's  common stock at the lesser of: $3.50 per
share;  or the lesser of 110% of the average per share closing bid price for the
15 trading  days  immediately  preceding  the date of  issuance  of the Series D
shares;  or 90% of the average of the three lowest per share  closing bid prices
during the 22 trading days  immediately  preceding the  conversion  date. In the
event that the  holders  convert at the $3.50 per share  price,  the  Company is
obligated  to issue  warrants  to purchase  0.8 shares of common  stock for each
share of Series D converted to common  stock.  Using the  conversion  terms most
beneficial  to the holder,  the Company is  amortizing a  beneficial  conversion
feature of $2,462,964 as a dividend  over a 180  day-period.  As of December 31,
1998, no shares of Series D had been converted into common stock.

Effective as of September 30, 1998,  the Company  entered into an agreement with
two of the investors  who  participated  in the March 1998 Offering  whereby the
Company  issued  100,000 shares of Series E for  $2,000,000.  Additionally,  the
Company issued to the  purchasers of the Series E a total of 150,000  additional
shares of Series E in exchange for which those purchasers surrendered a total of
150,000 shares of Series D. Dividends accrue on the stated value ($20 per share)
of Series E at a rate of 4% per year, are payable  annually or upon  conversion,
in cash or common stock, at the option of the Company,  and are convertible into
shares of the  Company's  common  stock at anytime at the holder's  option.  Any
outstanding  shares of Series E as of September 30, 2001  automatically  will be
converted at the conversion  price most  beneficial to the holders on such date.
In the event of  liquidation,  the  holders of the Series E 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 E have no voting
rights. The Series E, together with dividends accrued thereon,  may be converted
into shares of the Company's  common stock at the lesser of: $3.50 per share; or
the lesser of 110% of the average per share closing bid price for the 15 trading
days immediately  preceding the date of issuance of the Series E shares;  or 90%
of the average of the three  lowest per share  closing bid prices  during the 22
trading days immediately preceding the conversion date. If the investors convert
at the $3.50 per share  price,  the Company is  obligated  to issue  warrants to
purchase  0.8  shares of common  stock for each share of Series E  converted  to
common stock.  Using the  conversion  terms most  beneficial to the holder,  the
Company  recorded a preferred  stock  dividend of  $968,047  for the  beneficial
conversion  feature of the Series E. As of December 31, 1998,  114,928 shares of
Series E and related  dividends  had been  converted  into  2,591,733  shares of
common stock.


                                   Page 35 of 60

<PAGE>

On December 22,  1998,  the Company  completed a private  placement of 1,801,802
shares of common stock. The investor that  participated in that transaction also
acquired  "Repricing  Rights"  that  entitle the holder  thereof to receive upon
exercise  that number of  additional  shares of common  stock for no  additional
consideration  as shall be  determined  by  multiplying  the number of Repricing
Rights exercised by the following fraction:

                        (Repricing Price - Market Price)
                        --------------------------------
                                  Market Price

The  investor  acquired  one  Repricing  Right for each  share of  common  stock
purchased. "Market Price" means the lowest closing bid price of common stock, as
quoted on the Nasdaq  SmallCap  Market,  during the 15 consecutive  trading days
immediately preceding the exercise date. "Repricing Price" means:

     $1.3875 from March 22, 1999 to and including April 21, 1999,

     $1.3986 from April 22, 1999 to and including May 21, 1999,

     $1.4097 from May 22, 1999 to and including June 20, 1999,

     $1.4208 from June 21, 1999 to and including July 20, 1999,and

     $1.4319 at any time  after  July  20,  1999  until  the  expiration  of the
          Repricing Rights

On January 29, 1999, the Company  entered into a Securities  Purchase  Agreement
with  four  investors  pursuant  to  which  the  Company  sold  its  Series C 5%
Convertible  Debentures (the "Debentures") in the aggregate  principal amount of
$4,000,000. The outstanding principal amount of the Debentures is convertible at
any time at the option of the holder into shares of the  Company's  common stock
at a conversion  price equal to the lesser of $1.25 or 80% of the average of the
closing  bid  price  of the  Company  common  stock  for the five  trading  days
immediately  preceding  the  conversion  date.  The Company also issued  400,000
warrants in connection with this financing.  Each warrant entitles the holder to
purchase up to 400,00 shares of the Company common stock at an exercise price of
$1.1625  per  share.  On March 3, 1999,  the  Company  executed  a  Supplemental
Agreement pursuant to which the Company agreed to sell an additional  $2,500,000
principal  amount of the  Debentures  on the same  terms and  conditions  as the
January 29, 1999  agreement,  except no additional  warrants were issued.  Gross
proceeds  to the  Company  from  these two  transactions  were  $6,500,000.  The
obligations  of the  Company for  repayment  of the  Debentures,  as well as its
obligation to register the common stock  underlying the potential  conversion of
the  Debentures and the exercise of the warrants  issued in these  transactions,
were personally  guaranteed by Thomas A. Murdock,  Roger D. Dudley (each of whom
are  executive  officers and  directors of the Company) and Stephen M.  Studdert
(Chairman of the Board of Directors of the Company).  The personal guarantees of
these three  directors  were  secured by a pledge of  6,000,000  shares of Fonix
common  stock  beneficially  owned by them and  held in the  name of  Thomas  A.
Murdock,  Trustee.  In connection with the Supplemental  Agreement,  the Company
agreed to pledge as collateral  for repayment of the  Debentures,  a lien on the
patent  covering  the ASRT.  At the present  time the Company has not executed a
security  agreement  in  favor  of  the  investors  describing  the  patent.  In
connection  with the  guaranty and the pledge for that  guaranty  given by these
directors,  the Company  agreed to indemnify and hold them harmless in the event
of a default by the Company  that  results in any payment or other  liability or
damage incurred by any of them. In consideration  for the guaranty and pledge by
these directors,  the Company agreed to grant each of them common stock purchase
warrants  to  purchase  666,666  shares of common  stock at a price of $1.59 per
share.  On or about April 6, 1999,  the holders of the  Debentures  notified the
Company and the Guarantors  that the Guarantors  were in default under the terms
of the pledge,  and that the holders  intended to exercise  their rights to sell
some or all of the  pledged  shares.  At the  present  time,  the Company has no
knowledge of sales of the  Guarantors'  shares by the holders.  However,  if the
holders proceed to sell some or all of the Guarantors'  shares,  the Company may
be obligated  under its indemnity  agreement in favor of the Guarantors to issue
shares to the  Guarantors in  replacement  of all shares sold by the holders and
reimburse the  Guarantors  for any income tax liability  incurred as a result of
the holders' sales of the Guarantors' shares.

At December  31, 1998 and 1997,  the Company had a revolving  note  payable to a
bank in the amount of  $19,988,193  and  $18,612,272,  respectively.  Borrowings
under the  revolving  note  payable were  limited to  $20,000,000.  The weighted
average   outstanding   balance  during  1998  and  1997  was   $18,590,642  and
$18,861,104,  respectively.  The weighted average interest rate was 6.40 percent
and 5.94 percent during 1998 and 1997,  respectively.  This note was due January
8, 1999,  bore an interest  rate of 6.00  percent at December  31,1998,  and was
secured by a certificate of deposit in the amount of $20,000,000. This revolving
note has been renegotiated quarterly and interest was payable monthly. The

                                   Page 36 of 60

<PAGE>

Company paid this revolving note in full, including accrued interest, on January
8, 1999 with  proceeds  from the related  certificate  of deposit and $22,667 in
cash.

At December 31, 1998,  the Company has an unsecured  revolving note payable to a
bank in the amount of $50,000.  Loaned  amounts under the revolving note payable
are limited to $50,000. The weighted average outstanding balance during the year
ended December 31, 1998 was $14,384.  The weighted average interest rate was 9.4
percent  during  1998.  This note is payable on demand,  matures  April 1, 2007,
bears  interest at an annual rate of the banks prime rate plus 2.0 percent (9.75
percent at December 31, 1998) and interest is payable monthly.

At December 31, 1998, the Company has an unsecured,  non-interest bearing demand
note payable in the amount of $100,000 to Synergetics,  Inc. ("Synergetics"),  a
research and development entity. This note is payable on demand.

At December 31,  1998,  the Company has a note payable to a lender in the amount
of $560,000 which bears  interest at 18 percent,  was due January 2, 1999 and is
secured by certain accounts  receivable.  The Company has subsequently  extended
the due date from month to month by paying the lender  accrued  interest  plus a
fee of $5,600.  The loan  balance is  currently  due May 1,  1999.  The  Company
anticipates that it will request additional extensions of the due date. Interest
is payable  monthly on the first day of the following  month. In connection with
the issuance of the note  payable,  the Company  issued  35,000 shares of common
stock  (having a fair value of $50,314 on the date of  issuance)  as a loan fee.
This amount is included in  interest  expense in the  accompanying  consolidated
statement of operations.  The note is guaranteed by three officers and directors
of the Company.  The Company has entered into an  indemnity  agreement  with the
three officers and directors relating to this and other guarantees and pledges.

At December 31, 1998, the Company has unsecured 8.5 percent demand notes payable
outstanding  to  former  Articulate  stockholders  in the  aggregate  amount  of
$4,708,980,  issued in connection with the Articulate  acquisition (see Note 2).
These notes bear  interest at an annual rate of 9.0 percent to 10.0  percent and
were  payable on demand  after  November 1, 1998.  The Company has made  partial
payment of several of these  notes and has agreed  with all the holders of these
notes to extend the due dates of these  notes to between  March 15 and April 30,
1999.

At December 31, 1998, the Company has unsecured 8.5 percent demand notes payable
outstanding to various Articulate employees in the aggregate amount of $452,900.
Subsequent  to the  Articulate  acquisition,  the Company  agreed to pay several
Articulate  employees  incentive  compensation  for continued  employment in the
aggregate  amount of  $857,000,  for which the Company  issued  demand notes for
$452,900  and recorded an accrued  liability  of $404,100  for the balance.  The
demand notes bear  interest  currently at an annual rate of 9.0 percent and were
payable upon demand after  November 1, 1998.  None of the holders of these notes
have made demand for payment and they all have agreed to extend the due dates of
these  notes to April 30 1999.  The  Company  has not yet paid  $404,100  of the
accrued liability due on or before January 31, 1999.

In connection with the acquisition of certain liabilities of Articulate pursuant
to the  Articulate  merger (see Note 2), the Company  executed  and  delivered a
$1,500,000  unsecured demand note payable to a company which is a stockholder of
the Company. This demand note bore interest at an annual rate of ten percent and
was  payable  upon  demand  after  November  1, 1998.  The  Company  obtained an
extension  of the due date from the holder of the note and on  February 2, 1999,
this note, including all accrued interest, was paid in full.

At December 31, 1998, the Company has an unsecured note payable to an officer of
the Company in the amount of $20,000,  which bears interest at an annual rate of
ten percent and was due December 31, 1998. The holder of this note has agreed to
extend the due date to June 30, 1999.

Even taking into account  expected  revenues from the  HealthCare  Solutions and
Interactive  Technologies  Solutions  Groups,  the Company's  ongoing  operating
expenses will remain  higher than revenues from  operations at least through the
first half of 1999. Accordingly, the Company expects to incur significant losses
until  such  time  as it  is  able  to  enter  into  substantial  licensing  and
co-development   agreements   and  receive   substantial   revenues   from  such
arrangements or from the operations of its recently  acquired  subsidiaries,  of
which there can be no assurance.

As of December 31, 1998,  the Company had a revolving  note payable to a bank in
the amount of  $19,988,193.  Loaned amounts under the revolving note payable are
limited, in the aggregate at any time, to $20,000,000. In order to reduce

                                   Page 37 of 60

<PAGE>

interest  expenses,  on January 8, 1999, the Company applied its deposit account
in the amount of  $20,024,109  against the unpaid loan  balance of  $20,046,776,
resulting in a balance of $22,667 due, which amount was subsequently paid by the
Company.

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.  The Company expects that its year 2000  compliance  efforts will cost
approximately $70,000 during fiscal year 1999.

The Company  presently has no plans to purchase any new research and development
or office facilities.

                                     Outlook

Corporate Objectives and Technology Vision

The Company  believes  that its Core  Technologies  will be the platform for the
next  generation  of  automated  speech  technology  and  products.  Most speech
recognition  products offered by other companies are based on technologies  such
as HMM, 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  as well as  technologies  and  inventions  derived  from the
knowhow,  technologies  and products  obtained with the acquisition of AcuVoice,
Articulate and Papyrus. Management believes this strategy will set the Company's
advanced human computer interaction 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.  Advanced human-computer interface
technologies and multi-modal systems include:

     o     speech recognition and synthesis
     o     speaker identification and verification
     o     handwriting recognition
     o     pen and touch screen input
     o     natural language understanding

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

     o     PCs and PDAs
     o     cellular phones
     o     automotive and home environment speech controls
     o     automated information and transaction kiosks
     o     telephone systems with natural dialogue and gesture controls
     o     medical transcription and reporting systems, including PowerScribeRAD
     o     PowerScribeEM
     o     smart consumer appliances and electronics
     o     speech and pen-based computers utilizing handwriting and cursive 
           recognition
     o     interactive education and entertainment systems
     o     redesigned appliances
     o     toys and games

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

                                   Page 38 of 60

<PAGE>

     o     semiconductors
     o     health care
     o     telecommunications
     o     computers
     o     software
     o     consumer electronics
     o     entertainment
     o     automotive

Fonix is a technology company.  Since its inception,  the Company has focused on
the   development   of  its  Core   Technologies   and   related   complementary
technologies.,  including  those  technologies  obtained in connection  with the
acquisitions  of AcuVoice,  Articulate and Papyrus.  The Company will pursue the
development 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 agreements with OGI and Brigham Young University.

As the Company  proceeds to implement its strategy and to reach its  objectives,
it anticipates  that it will continue to realize several benefits for itself and
for its shareholders.  In addition,  the Company expects further  development of
complementary   technologies,   added  product  and   applications   development
expertise,  access to market channels and additional opportunities for strategic
alliances in other industry segments.

The strategy  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," in Item I, Part
I, above.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to Financial Statements:

     Report of Independent Public Accountants (Arthur Andersen LLP)......... F-2

     Report of Independent Public Accountants Deloitte & Touche LLP)........ F-3

     Report of Independent Public Accountants  (Pritchett,  
          Siler & Hardy, P.C.)...............................................F-4

     Consolidated Balance Sheets as of December 31, 1998 and 1997............F-5

     Consolidated Statements of Operations for the Years Ended 
          December 31, 1998,  1997 and 1996 and for the Period from  October 
          1, 1993 (Date of Inception) to December 31, 1998...................F-6

     Consolidated  Statements  of  Stockholders'  Equity  for  the  
          Years  Ended December  31,  1998,  1997 and 1996 and for 
          the Period from October 1, 1993 (Date of Inception) to 
          December 31, 1998..................................................F-7

     Consolidated  Statements  of Cash Flows for the Years  Ended  
          December  31, 1998, 1997 and 1996 and  for the Period from  
          October 1, 1993 (Date of  Inception)  to December
          31, 1998..........................................................F-10


                                   Page 39 of 60

<PAGE>

    
     Notes to Consolidated Financial Statements.............................F-12

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE


During the years ended December 31, 1998, and December 31, 1997, there have been
no reportable events (as defined in Item 304(a)(1)(v) of Regulation S-K).

                                    PART III

ITEM 10.   DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY

The following  table sets forth  certain  information  concerning  the executive
officers and directors of the Company as of April 8, 1999:

<TABLE>
<CAPTION>


Name                                Age              Position
----                                ---              --------
<S>                                 <C>              <C>
Stephen M. Studdert                 50               Chairman
Thomas A. Murdock                   55               Director, President and Chief Executive Officer
Roger D. Dudley                     46               Director, Executive Vice President, Corporate Finance
John A. Oberteuffer, Ph.D.          58               Director, Vice President, Technology
Joseph Verner Reed                  62               Director
Rick D. Nydegger                    50               Director
Reginald K. Brack                   61               Director
Douglas L. Rex                      53               Vice President, Chief Financial Officer and Treasurer

</TABLE>

All directors hold office until the next annual meeting of the  stockholders  of
the Company or until their  successors  have been  elected  and  qualified.  The
officers of the Company are elected  annually  and serve at the  pleasure of the
Board of Directors.

     STEPHEN M.  STUDDERT is a co-founder  of the Company and has been  Chairman
     since the merger of Phonic  Technologies,  Inc.  ("PTI") and the Company in
     June 1994. He served as the Company's Chief Executive Officer from May 1996
     to January  1999.  Since 1992,  Mr.  Studdert has been Chairman of Studdert
     Companies Corp.  ("SCC"),  an international  investment  management company
     that is owned and  controlled by three  individuals,  two of whom,  Messrs.
     Murdock and Dudley,  are  executive  officers and directors of the Company.
     Mr.  Studdert  served as a White  House  advisor to U.S.  Presidents  Bush,
     Reagan and Ford.  Mr.  Studdert  has served as a member of the  President's
     Export Council and the Foreign Trade  Practices  Subcommittee,  and he is a
     director  and former  chairman  of the  Federal  Home Loan Bank of Seattle.
     During the year ended December 31, 1998,  Mr.  Studdert was Chairman of the
     Board of K.L.S. Enviro Resources,  Inc. ("KLSE"), a company with a class of
     securities  registered  under Section 12 of the Securities  Exchange Act of
     1934 ("1934 Act"). In February 1999, Mr.  Studdert  resigned from the Board
     of  Directors  of  KLSE.  Mr.  Studdert  resigned  as the  Company's  Chief
     Executive Officer in January 1999.

     THOMAS A.  MURDOCK  is a  co-founder  of the  Company  and has served as an
     executive officer and member of the Company's Board of Directors since June
     1994. He has been the Company's Chief  Executive  Officer since January 26,
     1999.  Mr. Murdock also has served as President of SCC since 1992. For much
     of his career,  Mr. Murdock was a commercial  banker and a senior corporate
     executive  with  significant  international  emphasis and  experience.  Mr.
     Murdock also serves as a director of KLSE and of Advocast, Inc. an Internet
     research and development company.

     ROGER D.  DUDLEY  is a  co-founder  of the  Company  and has  served  as an
     executive officer and member of the Company's Board of Directors since June
     1994. Mr. Dudley is also executive vice president of SCC, a

                                   Page 40 of 60

<PAGE>



     position he has held since 1993.  After  several  years at IBM in marketing
     and  sales,  he began  his  career  in the  investment  banking  and  asset
     management  industry.  He has  extensive  experience  in real estate  asset
     management  and in  project  development.  Mr.  Dudley  also  serves  as an
     executive officer of an entity which manages a foreign investment fund, and
     is a director of KLSE.

     JOHN A.  OBERTEUFFER,  Ph.D. has been a Director of the Company since March
     1997 and Vice  President  Technology  since  January  1998.  He is also the
     founder and president of Voice Information Associates, Inc. ("VIA"). VIA is
     a  consulting  group  providing  strategic  technical,  market  evaluation,
     product  development  and corporate  information  to the  automated  speech
     recognition  industry.  In addition,  VIA publishes the monthly newsletter,
     ASRNews.  Dr.  Oberteuffer also is executive director of the American Voice
     Input/Output  Society ("AVIOS").  He was formerly vice president,  personal
     computer systems,  of Voice Processing Corp. (now merged with Voice Control
     Systems,  Inc.),  and also was founder and CEO of Iris Graphics,  which was
     acquired by Seitex  Corp.  Dr.  Oberteuffer  received  his  bachelor's  and
     master's  degrees  from  Williams  College,  and his Ph.D.  in Physics from
     Northwestern  University.  He  was  a  member  of  the  research  staff  at
     Massachusetts Institute of Technology for five years.

     JOSEPH VERNER REED has served as a director of the Company since June 1994.
     Ambassador  Reed is President of the  Secretariat  and was Under  Secretary
     General of the United  Nations in New York.  Following a career as a senior
     advisor  to the  Chairman  of the Chase  Manhattan  Bank,  Ambassador  Reed
     received several Presidential  appointments in the United States diplomatic
     service,  including  that of United States  Ambassador  to Morocco,  United
     States  Ambassador  to the United  Nations,  and Chief of  Protocol  of the
     United  States.  He has extensive  corporate  experience and holds honorary
     doctorates from several universities.

     RICK D. NYDEGGER is a patent and  trademark  attorney.  Mr.  Nydegger was a
     founder and is a shareholder and director of the law firm Workman, Nydegger
     & Seeley in Salt Lake City, Utah. Mr. Nydegger received his law degree from
     the J. Reuben  Clark Law School (cum laude,  1974) in Provo,  Utah.  He has
     published  numerous  articles  in trade  journals  and law  reviews  on the
     subject  of  computer  law  and  intellectual  property.  Mr.  Nydegger  is
     registered to practice before the U.S. Patent and Trademark  Office and has
     been admitted to practice  before the U.S.  Court of Appeals in the Federal
     Circuit  and the  Fifth  and Tenth  Circuits,  as well as the U.S.  Supreme
     Court.  Mr.  Nydegger has been a member of the Company's Board of Directors
     since  December  1996.  During the year ended  December 31, 1998, and until
     March 1999, Mr. Nydegger was a director of KLSE.

     REGINALD  K. BRACK has been a member of the  Company's  Board of  Directors
     since September 1997. He is the chairman emeritus of Time Inc.,  serving as
     the CEO of Time Inc.  from 1986  until  1994 and as  chairman  of the board
     until 1997. Time Inc. is a wholly owned subsidiary of Time Warner Inc.

     DOUGLAS L. REX has  served as the Chief  Financial  Officer of the  Company
     since May 1997.  From 1989 to 1996,  Mr. Rex was President of Tebbs & Smith
     P.C., a business  consulting,  tax planning,  accounting and auditing firm.
     Mr.  Rex  is a  member  of  the  American  Institute  of  Certified  Public
     Accountants and the Utah Association of Certified Public Accountants.

                      Significant Employees and Consultants

In addition to the officers and directors  identified above, the Company expects
the following  individuals to make  significant  contributions  to the Company's
business during 1999.

     CAROLINE  HENTON,  Ph.D.  Dr.  Henton,  44,  has been  Vice  President  and
     Strategic Technology Adviser of the Company since February 1998. Dr. Henton
     received  a masters  degree  in  General  Linguistics  and a  Doctorate  in
     Acoustic Phonetics from the University of Oxford.  After an academic career
     in the UK and California,  she joined Apple  Computer,  Inc. to produce the
     high quality  synthetic speech  available on all Apple  platforms.  For the
     past five years,  Dr. Henton has been Director of Language  Development for
     Voice  Processing  Corp.   (Cambridge,   MA)  and  Director  of  Linguistic
     Development  for  the  DECtalk  speech  synthesizer   produced  by  Digital
     Equipment  Corp.  She has also acted as a consultant  in speech  synthesis,
     linguistics,  localization,  speech  interface design and as a voice talent
     for Sun  Microsystems,  Inc.,  Claris Corp.,  Digital Sound Corp.,  Lexicon
     Naming Inc.,  Interval Research Inc., Apple Computer,  General Magic, Inc.,
     and Digital Equipment Corp.

                                   Page 41 of 60

<PAGE>


     TONY R. MARTINEZ,  Ph.D. Dr. Martinez,  39, is senior consulting  scientist
     for the  Company's  neural  network  development.  He received his Ph.D. in
     computer science at UCLA in 1986. He is an associate  professor of Computer
     Science at  Brigham  Young  University  and  currently  heads up the Neural
     Network and Machine Learning  Laboratory in the BYU Ph.D./MS  program.  His
     main research is in neural networks, machine learning, ASOCS, connectionist
     systems,  massively  parallel  algorithms  and  architectures,  and non-von
     Neuman  computing  methods.  He is  associate  editor  of  the  Journal  of
     Artificial Neural Networks.

     R. BRIAN MONCUR.  Mr. Moncur,  40, was employed by Synergetics from 1992 to
     March 13,  1997,  when he became a full-time  employee of the  Company.  He
     graduated from Brigham Young  University  with a Bachelor of Science degree
     in chemical engineering. Before his employment with Synergetics, Mr. Moncur
     was employed by Signetics,  Inc. and Mentorgraphics,  where he was a Senior
     Process Engineer and Software Development Engineer.

     DALE LYNN SHEPHERD. Mr. Shepherd, 39, was employed by Synergetics from 1992
     to March 13, 1997, when he became a full-time  employee of the Company.  He
     graduated from Brigham Young  University  with a Bachelor of Science Degree
     in  Electrical  Engineering.   He  also  received  a  Masters  of  Business
     Administration  from B.Y.U.  Before his employment  with  Synergetics,  Mr.
     Shepherd  was  employed  with  Mentorgraphics  where he acted as a software
     systems architect in automatic semiconductor design. Before Mentorgraphics,
     Mr. Shepherd worked on a contract basis with Signetics, Inc.

None of the  executive  officers or  directors  of the Company is related to any
other officer or director of the Company.

ITEM 11. EXECUTIVE COMPENSATION

The following table sets forth  information  concerning the compensation paid to
all persons serving as the Company's  Chief Executive  Officer and the Company's
four most highly  compensated  executive officers other than its Chief Executive
Officer who were serving as executive  officers at December 31, 1998,  and whose
annual compensation  exceeded $100,000 during such year (collectively the "Named
Executive Officers"):
<TABLE>
<CAPTION>
                                                Summary Compensation Table

                                               Annual Compensation                     Long-Term Compensation
                                               -------------------                     ----------------------
-------------------------------------------------------------------------------------------------------------
                                                                                            Securities
                                                                             Other          Underlying
                                                                            Annual           Options/
Name and Principal Position         Year (1)           Salary                Bonus            SARs(2)  
---------------------------        ----------      -------------          -----------       -----------
<S>                                <C>              <C>                    <C>              <C>  


Stephen M. Studdert                 1996             $131,539                    -           400,000/0
CEO (4/96-1/26/99)                  1997             $305,385                    -           400,000/0
                                    1998             $425,000                    -           550,000/0


Thomas A. Murdock                   1996             $131,539                    -           400,000/0
CEO (6/94 to 4/96 and               1997             $305,385                    -           400,000/0
1/26/99 - present) and              1998             $425,000                    -           550,000/0
President              
                       

Roger D. Dudley                     1996             $131,539                    -           400,000/0
Executive Vice President            1997             $305,385                    -           400,000/0
                                    1998             $425,000                    -           550,000/0


Douglas L. Rex                      1998             $157,685                    -           200,000/0
Chief Financial Officer


John A. Oberteuffer                 1998             $203,941                    -           580,000/0
Vice President Technology
</TABLE>

                                   Page 42 of 60

<PAGE>

(1)  During fiscal year 1995 and part of 1996, these executive officers were not
     compensated directly by the Company. During those periods, any compensation
     received by Messrs. Studdert,  Murdock and Dudley for any services rendered
     by them to the Company was paid by SCC, an entity owned and  controlled  by
     those individuals.  [See "Certain Relationships and Related Transactions."]
     Although  the  Company  makes  no  representation  about  the  compensation
     arrangements  between SCC and its employees,  including  Messrs.  Studdert,
     Murdock  and  Dudley,  the total  compensation  paid by the  Company to SCC
     during such periods is as follows:

                               Management Fee                 Management Fee
           Year                   (Cash)                          (Stock)      
           ----                   ------                          -------      
           1995                  $111,339                        3,699,900
           1996                  $120,000                            --

     The management  services contract between the Company and SCC obligated the
     Company to pay SCC a monthly management fee of $50,000,  which amounts were
     invoiced  monthly by SCC but often accrued due to the  Company's  cash flow
     constraints. By July 1995, the Company owed SCC approximately $1,417,000 of
     accrued but unpaid  management  fees.  On November 16, 1994,  the Company's
     Board of Directors  approved the issuance of warrants (the "SCC  Warrants")
     to purchase up to 3,700,000  shares of the  Company's  common stock to SCC.
     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 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.  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.  The total dollar value of the
     transaction  subsequently  was adjusted upward and expensed as compensation
     paid  by  the  Company  in  the  amount  of   $3,699,900.   [See   "Certain
     Relationships and Related Transactions."]

     The Company  presently has  executive  employment  agreements  with Messrs.
     Murdock  and  Dudley.  The  material  terms  of each  executive  employment
     agreement with Messrs. Murdock and Dudley are identical and are as follows:
     The term of each  employment  contract  is from  November  1, 1996  through
     December 31, 2001.  Annual base  compensation  for each  executive  for the
     first three years of such term is $250,000  from  November 1, 1996  through
     December 31, 1996; $325,000 from January 1, 1997 through December 31, 1997;
     and $425,000  from January 1, 1998  through  December 31, 1999.  The annual
     base  compensation  for the final two years of the employment  agreement is
     $550,000 from January 1, 2000 through  December 31, 2000; and $750,000 from
     January 1, 2001 through  December 31,  2001.  However,  for these final two
     contract  years,   annual  base  compensation  and  the   performance-based
     incentive  compensation will be subject to review by the Company's Board of
     Directors  based upon either or both of the market  price of the  Company's
     common stock and profits  derived by the Company from annual  revenues from
     operations.  Notwithstanding  the  foregoing,  Messrs.  Murdock  and Dudley
     voluntarily  reduced their  compensation to $297,500  commencing January 1,
     1999 as part of the  Company's  overall  efforts  to  reduce  expenses.  In
     addition,  each executive  officer is entitled to annual  performance-based
     incentive  compensation  payable on or before  December 31 of each calendar
     year during the contract term. During the first three years of the contract
     term, the performance-based incentive compensation is determined with

                                   Page 43 of 60

<PAGE>


     relation to the market price of the Company's  common  stock,  adjusted for
     stock  dividends  and splits.  If the price of the  Company's  common stock
     maintains  an average  price  equal to or greater  than the level set forth
     below over a period of any three  consecutive  months  during the  calendar
     year,  the  performance-based  incentive  compensation  will be paid in the
     corresponding  percentage  amount of annual  base  salary  for each year as
     follows:

                  Quarterly Average Stock Price      Percentage Bonus

                           $10.00                          30%
                           $12.50                          35%
                           $15.00                          40%
                           $20.00                          45%
                           $25.00+                         50%

     Each  such  executive  officer  also is  entitled  to  customary  insurance
     benefits,  office  and  support  staff  and  the use of an  automobile.  In
     addition,  if any executive is terminated without cause during the contract
     term then all salary then and  thereafter due and owing under the executive
     employment  agreement shall, at the executive's option, be immediately paid
     in a lump sum  payment  to the  executive  officer  and all stock  options,
     warrants and other similar rights granted by the Company and then vested or
     earned  shall be  immediately  granted  to the  executive  officer  without
     restriction  or  limitation  of any kind.  Further,  the Board of Directors
     authorized  the payment of a cash bonus to SCC in an amount  sufficient  to
     pay all personal  state and federal  income taxes on the 3.7 million shares
     purchased  by SCC on August 11,  1995 and on the bonus  amount.  The amount
     allocated for this bonus was approximately  $2.5 million,  all of which had
     been paid out as of December 31, 1998.

     Each   executive    employment   agreement   contains   a   non-disclosure,
     confidentiality,  non-solicitation  and non-competition  clause.  Under the
     terms of the  non-competition  clause, each executive has agreed that for a
     period of one year after the termination of his employment with the Company
     that the executive not engage in any capacity in a business  which competes
     with or may compete with the Company.

     During  the  entirety  of the year  ended  December  31,  1998,  Stephen M.
     Studdert had an  employment  agreement  identical in material  terms to the
     agreements of Messrs.  Murdock and Dudley described above. In January 1999,
     in  conjunction  with his  resignation  as the  Company's  Chief  Executive
     Officer, Mr. Studdert entered into a Separation Agreement with the Company.
     Under that Separation  Agreement,  Mr. Studdert's  employment agreement was
     terminated. The Company agreed to pay Mr. Studdert severance pay consisting
     of  $250,000  for the last 11  months  of 1999,  $250,000  during  2000 and
     $100,000 during 2001.  Additionally,  the Company agreed to continue to pay
     for Mr. Studdert's health insurance  coverage until such time as he obtains
     coverage  from  another  employer  and to pay  for an  automobile  for  Mr.
     Studdert until June 30, 1999.

     All options  granted to named  executive  officers  during fiscal 1996 were
     granted  under  the  Company's  1996   Director's   Stock  Option  Plan  as
     compensation  for their  service on the Company's  Board of Directors.  All
     options  granted in 1997 were granted  pursuant to the Company's 1997 Stock
     Option  Plan.  All  options  granted in 1998 were  granted  pursuant to the
     Company's 1998 Stock Option Plan.



                                   Page 44 of 60

<PAGE>
<TABLE>
<CAPTION>


                                              Option Grants in Fiscal Year 1998
                                                                                           Potential Realizable
                                                                                             Value at Assumed
                                                                                              Annual Rates of
                                                                                               Stock Price
                                    Individual Grants                                   Appreciation for Option Term
---------------------------------------------------------------------------------     -------------------------------
     (a)                       (b)           (c)        (d)             (e)                (f)           (g)
                            Number of
                           Securities     % of Total
                          Underlying       Options     Exercise   
                             Options      Granted to   or Base    
                             Granted      Employees     Price         Expiration
 Name                         (#)           in FY      ($/Share)         Date               5%($)         10%($)
----------------------     ----------      --------   ---------      ------------       ---------     ------------
<S>                        <C>             <C>        <C>            <C>                <C>           <C>

Stephen M. Studdert         150,000           2%       $ 5.16          3/18/2008         $38,700        $77,400
                            400,000           6%       $ 1.18         11/30/2008         $23,600        $47,200

Thomas A. Murdock           150,000           2%       $ 5.16          3/18/2008         $38,700        $77,400
                            400,000           6%       $ 1.18         11/30/2008         $23,600        $47,200
 
Roger D. Dudley             150,000           2%       $ 5.16          3/18/2008         $38,700        $77,400
                            400,000           6%       $ 1.18         11/30/2008         $23,600        $47,200

Douglas L. Rex              200,000           2%       $ 1.18         11/30/2008         $11,800        $23,600

John A. Oberteuffer         400,000           6%       $ 1.18          12/1/2008         $23,600        $47,200
                            180,000           2%       $ 5.16          3/19/2008         $46,440        $92,880
</TABLE>

No options were exercised by the Named Executive Officers during the fiscal year
and no options held by them were in the money as of December 31, 1998.

        Board of Directors Meetings, Committees and Director Compensation

The Company's  Board of Directors took action at seven duly noticed  meetings of
the Board during 1998. Each director attended (in person or  telephonically)  at
least 75% of the meetings of the Company's Board of Directors.  During 1998, the
Company's Board of Directors had the following committees: 1996 Directors' Stock
Option Plan  Committee,  comprised of Messrs.  Ashton,  Reed and Studdert;  1997
Stock and Incentive Plan Committee, comprised of Messrs Nydegger and Reed; Audit
Committee,  comprised  of  Messrs.  Brack , Reed and  Dudley;  and  Compensation
Committee,  comprised of Messrs.  Studdert,  Reed and Nydegger.  These  standing
committees  conducted meetings in conjunction with meetings of the full Board of
Directors.

             Compensation Committee Report on Executive Compensation

Preliminary Note:  Notwithstanding  anything to the contrary set forth in any of
the previous filings made by the Company under the 1933 Act or the 1934 Act that
might  incorporate  future filings,  including,  but not limited to, this Annual
Report on Form 10-K, in whole or in part, the following  Executive  Compensation
Report and the  performance  graph  appearing  herein  shall not be deemed to be
incorporated by reference into any such future filings.

This   Executive   Compensation   Report   discusses  the  Company's   executive
compensation  policies  and the  basis  for the  compensation  paid to the Named
Executive Officers, including the persons serving as its Chief Executive Officer
during the year ended December 31, 1998.

Compensation   Policy.   The  Committee's   policy  with  respect  to  executive
compensation has been designed to:

     o    Adequately  and fairly  compensate  executive  officers in relation to
          their responsibilities,  capabilities and contributions to the Company
          and in a  manner  that  is  commensurate  with  compensation  paid  by
          companies of comparable size or within the Company's industry;

                                   Page 45 of60

<PAGE>


     o    Reward executive officers for the achievement of short-term  operating
          goals and for the  enhancement of the long-term  value of the Company;
          and

     o    Align  the  interests  of the  executive  officers  with  those of the
          Company's  shareholders with respect to short-term operating goals and
          long-term increases in the price of the Company's common stock.

The components of compensation  paid to executive  officers consist of: (a) base
salary,  (b)  incentive  compensation  in the form of annual bonus  payments and
stock options  awarded by the Company under the Company's  Stock Incentive Plans
and (c) certain other benefits provided to the Company's executive officers. The
Company's Compensation Committee is responsible for reviewing and approving cash
compensation  paid by the Company to its  executive  officers and members of the
Company's  senior  management  team,  including annual bonuses and stock options
awarded under the Company's Stock Incentive Plans, selecting the individuals who
will be awarded bonuses and stock options under the Stock Incentive  Plans,  and
for  determining  the timing,  pricing and amount of all stock  options  granted
thereunder, each within the terms of the Company's Stock Incentive Plans.

The Company's executive compensation program historically has emphasized the use
of incentive-based  compensation to reward the Company's  executive officers and
members of senior  management for the  achievement  of goals  established by the
Board of Directors. The Company uses stock options to provide an incentive for a
substantial number of its officers and employees,  including selected members of
management,  and to reward such officers and employees for achieving  goals that
have been  established  for the  Company.  The Company  believes  its  incentive
compensation plan rewards  management when the Company and its shareholders have
benefitted  from  achieving  the  Company's  goals  and  targeted  research  and
development  objectives,  all of which the  Compensation  Committee  feels  will
dictate, in large part, the Company's future operating results. The Compensation
Committee  believes that its policy of compensating  officers and employees with
incentive-based compensation fairly and adequately compensates those individuals
in relation to their  responsibilities,  capabilities  and  contribution  to the
Company,  and in a  manner  that  is  commensurate  with  compensation  paid  by
companies of comparable size or within the Company's industry.

Components of Compensation.  The primary  components of compensation paid by the
Company to its  executive  officers  and senior  management  personnel,  and the
relationship of such  components of  compensation to the Company's  performance,
are discussed below:

     o    Base  Salary.  The  Compensation  Committee  periodically  reviews and
          approves the base salary paid by the Company to its executive officers
          and  members  of the  senior  management  team.  Adjustments  to  base
          salaries are determined based upon a number of factors,  including the
          Company's  performance  (to the extent such  performance can fairly be
          attributed or related to each executive's performance), as well as the
          nature  of  each   executive's   responsibilities,   capabilities  and
          contributions.  In addition,  the Compensation  Committee periodically
          reviews the base  salaries of its senior  management  personnel  in an
          attempt  to  ascertain  whether  those  salaries  fairly  reflect  job
          responsibilities  and prevailing  market  conditions and rates of pay.
          The  Compensation  Committee  believes  that  base  salaries  for  the
          Company's  executive  officers have  historically  been  reasonable in
          relation to the Company's size and  performance in comparison with the
          compensation paid by similarly sized companies or companies within the
          Company's industry.

     o    Incentive  Compensation.  As discussed above, a substantial portion of
          each  executive  officer's  compensation  package  is in the  form  of
          incentive   compensation   designed  to  reward  the   achievement  of
          short-term  operating  goals and  long-term  increases in  shareholder
          value.  The  Company's  Stock  Incentive  Plans  allow  the  Board  of
          Directors  or the  Compensation  Committee  to grant stock  options to
          executive  officers  and  employees  for the purchase of shares of the
          Company's common stock.  Under the terms of the Stock Incentive Plans,
          the Board of Directors and the Compensation  Committee have authority,
          within the terms of the Stock Incentive Plans, to select the executive
          officers  and  employees  who will be  granted  stock  options  and to
          determine the timing, pricing and number of stock options to be

                                   Page 46 of 60

<PAGE>

          awarded.  The Compensation  Committee  believes that the stock options
          granted under the Stock Incentive Plans reward executive officers only
          to the extent that  shareholders have benefitted from increases in the
          value of the Company's common stock.

     o    Other  Benefits.   The  Company  maintains  certain  other  plans  and
          arrangements for the benefit of its executive  officers and members of
          senior management.  The Company believes these benefits are reasonable
          in relation to the executive compensation practices of other similarly
          sized companies or companies within the Company's industry.

Compensation  of the Chief  Executive  Officer.  As described  elsewhere in this
Report,  the Company has  entered  into  executive  employment  agreements  with
Messrs.  Murdock and Dudley and a Separation  Agreement with Mr.  Studdert.  The
material  terms of each  executive  employment  agreement  with  each  executive
officer are  identical  and are  described  above.  The  Compensation  Committee
believes  that the monthly  compensation  under such  contracts  adequately  and
fairly  compensates  these  executive  officers in relation to their  respective
responsibilities,  capabilities, contributions and dedication to the Company and
secures  for the  Company  the  benefit  of  their  leadership,  management  and
financial skills and capabilities. Moreover, the Compensation Committee believes
that  the  salary  and  other   benefits  are  reasonable  in  relation  to  the
responsibilities, capabilities, contributions and dedication of these men to the
Company and are warranted to keep them in line with the  compensation  earned by
chief executive  officers employed by companies of comparable size or within the
Company's industry.

Conclusion.  The  Compensation  Committee  believes that the concepts  discussed
above  further  the  shareholders'  interests  because  a  significant  part  of
executive  compensation  is based upon the Company  achieving  its  research and
development goals and other specific goals set by the Board of Directors. At the
same time,  the  Compensation  Committee  believes  that the program  encourages
responsible  management  of the  Company  in the  short-term.  The  Compensation
Committee  regularly  considers  plan  design  so that the total  program  is as
effective as possible in furthering shareholder interests.

The  Compensation  Committee  bases  its  review  on the  experience  of its own
members, on information requested from management personnel,  and on discussions
with and information compiled by various independent consultants retained by the
Company.

                                 Respectfully submitted,

                                 Compensation Committee:

                                 Stephen M. Studdert
                                 Joseph Verner Reed
                                 Rick D. Nydegger

                            Compensation of Directors

Prior to April 1996, the Company's  directors received no compensation for their
service.  The Company  historically  has  reimbursed  its  directors  for actual
expenses incurred in traveling to and participating in directors' meetings,  and
the Company intends to continue that policy for the foreseeable future. On April
30,  1996,  the  Company's  board  of  directors  adopted,   and  the  Company's
shareholders  subsequently  approved, the Company's 1996 Directors' Stock Option
Plan (the "Directors  Plan").  Under the Directors Plan, members of the Board as
constituted on the date of adoption  received options to purchase 200,000 shares
of the Company's  common stock for each year (or any portion thereof  consisting
of at least six months)  during  which such  persons had served on the board for
each of fiscal years 1994 and 1995 and were granted  200,000  shares for each of
fiscal years 1996 through 1999,  which options vest after completion of at least
six months'  service on the Board during those fiscal years.  These options have
terms of 10 years.  Similar  grants  have been made to the  Company's  directors
under the Company's 1998 Stock Option Plan.  Thus,  under the Directors Plan and
the 1998 Stock Option Plan,  during 1998,  the Company  granted stock options to
members of the Board as follows:


                                   Page 47 of 60

<PAGE>

           Stock Options Granted to Directors During Fiscal Year 1998
           ----------------------------------------------------------

                         Shares      Date      Exercise          Shares Vested
Name(1)                  Granted    Granted    Price Per Share   at FY-End  
-------                  -------    -------    ---------------   ---------   
Joseph Verner Reed       400,000    12/1/98    $1.18             800,000

Rick D. Nydegger         400,000    12/1/98    $1.18             400,000

Reginald K. Brack        400,000    12/1/98    $1.18             200,000


     (1)  Directors who are also Named Executive  Officers also received options
          as set forth in the table above.

                Compliance With Section 16(a) of the Exchange Act

Section  16(a) of the  Securities  Exchange Act of 1934  requires the  Company's
officers  and  directors,  and persons who  beneficially  own more than 10% of a
registered  class  of the  Company's  equity  securities,  to  file  reports  of
ownership and changes in ownership with the Securities and Exchange  Commission.
Officers,  directors and greater than ten- percent  shareholders are required by
regulation of the Securities and Exchange Commission to furnish the Company with
copies of all Section 16(a) forms which they file. Based solely on its review of
the copies of such forms  furnished to the Company  during the fiscal year ended
December 31, 1998, the Company is aware of the following untimely filings:

Roger D. Dudley,  Stephen M.  Studdert,  and Joseph V. Reed each filed  year-end
Forms 5 as required by Section 16(a). The Forms 5 were filed on April 15, 1998.

James B. Hayes, Rick D. Nydegger,  Thomas A. Murdock, and Reginald K. Brack each
filed year-end  Forms 5 as required by Section 16(a).  The Forms 5 were filed on
April 17, 1998.

Alan C. Ashton filed a year-end Form 5 as required by Section 16(a).  The Form 5
was filed on May 11, 1998.

John A. Oberteuffer  acquired options to purchase up to 180,000 shares of common
stock of the  Company  on  January  23,  1998.  Mr.  Oberteuffer  filed a Form 4
reporting the transaction on May 8, 1998.

Thomas A. Murdock,  Roger D. Dudley,  Stephen M. Studdert, and SCC filed amended
Forms 4 for the month of October
1998 on December 9, 1998.

All such untimely filings  reflected  transactions  based on grants of converted
stock options.  The Company believes that all other transactions  required to be
reported under Section 16(a) of the  Securities  Exchange Act were reported in a
timely manner on reports filed by the affected individuals.



                                   Page 48 of

<PAGE>

                             Stock Performance Graph

The  following  graph  compares  the yearly  cumulative  total  returns from the
Company's  common stock  during the five fiscal year period  ended  December 31,
1998,  with the  cumulative  total  return  on the Media  General  Index and the
Standard  Industrial  Classification  (SIC) Code Index for that same period. The
comparison assumes $100 was invested on January 1, 1994, in the Company's common
stock and in the common  stock of the  companies in the  referenced  Indexes and
further assumes reinvestments of dividends. [GRAPHIC OMITTED]


                           1993      1994     1995     1996     1997      1998
                           ----      ----     ----     ----     ----      ----
   FONIX CORPORATION      100.00    91.54    216.92   482.97   169.47    72.67
   SIC CODE INDEX         100.00    66.46     60.56    62.86    84.03    79.56
   NASDAQ MARKET INDEX    100.00   104.99    136.18   169.23   207.00    291.96

Assumes $100 invested on Jan. 01, 1994


                                   Page 49 of 60

<PAGE>

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

The following  table sets forth,  as of March 31, 1999,  the number of shares of
common  stock  of the  Company  beneficially  owned by all  persons  known to be
holders  of more than 5% of the  Company's  common  stock  and by the  executive
officers  and  directors  of the  Company  individually  and as a group.  Unless
indicated  otherwise,  the address of the shareholder is the Company's principal
executive offices, 60 East South Temple Street, Suite 1225, Salt Lake City, Utah
84111.
<TABLE>
<CAPTION>


                                                                   Number of
                                                                    Shares
           Name and Address of 5% Beneficial Owners,             Beneficially                 Percent of
               Executive Officers and Directors                      Owned                     Class(1)     
               --------------------------------                      -----                     --------     
          <S>                                                  <C>                             <C>

          Alan C. Ashton, Ph.D.                                12,329,167(2)(3)                  17.4%
          c/o Beesmark Investments, L.C.
          5% Beneficial Owner
          261 East 1200 South
          Orem, Utah 84097

          Beesmark Investments, L.C.                             11,729,167(3)                   16.7%
          5% Beneficial Owner
          261 East 1200 South
          Orem, Utah  84097

          Thomas A. Murdock, Director                            23,605,854(4)                   33.1%
          Chief Executive Officer, and president

          Roger D. Dudley, Director and                          5,185,389(5)                     7.3%
          Executive Vice President

          Stephen M. Studdert, Director                          5,185,089(6)                     7.3%
          10252 Oak Creek Lane
          Highland, Utah 84003

          Joseph Verner Reed, Director                           1,220,000(7)                     1.7%
          73 Sterling Road
          Greenwich, Connecticut 06831

          Rick D. Nydegger, Director                                600,000                       *
          10217 North Oak Creek Lane
          Highland, Utah 84003

          John A. Oberteuffer, Ph.D., Director and                  580,000                       *
          Vice President
          600 West Cummings Park, Suite 4650
          Woburn, MA  01801

          Reginald K. Brack, Director                             426,500(8)                      *
          1271 Avenue of the Americas, 43rd Floor
          New York, New York 10020

          Douglas L. Rex, Chief Financial Officer                  405,300(9)                     *

          Officers and Directors as a Group (8 persons)          29,330,180                      38.0%

</TABLE>

     *    Less than 1%.


                                   Page 50 of 60

<PAGE>

     (1)  Percentages  rounded to nearest  1/10th of 1%.  Except as indicated in
          the footnotes below,  each of the persons listed exercises sole voting
          and  investment  power over all shares of common stock listed for each
          such person in the table.

     (2)  Includes all common stock beneficially owned by Beesmark  Investments,
          L.C.  ("Beesmark"),  but only to the extent that Dr.  Ashton is one of
          two managers of Beesmark,  and, as such, is deemed to share investment
          power with  respect to shares  beneficially  owned by  Beesmark.  Also
          includes  600,000  shares of common  stock  underlying  stock  options
          exercisable by Dr. Ashton presently or within 60 days.

     (3)  Beesmark's  beneficial  ownership  includes  166,667  shares of common
          stock  presently  issuable upon the  conversion  of 166,667  shares of
          Series A preferred stock. All shares of common stock owned by Beesmark
          are deposited into the Voting Trust.  The managers of Beesmark are Dr.
          Ashton and Karen Ashton. As managers of Beesmark, they each are deemed
          to share voting  control over shares  beneficially  owned by Beesmark.
          Mrs. Ashton beneficially owns no shares other those deemed to be owned
          by  her  as  a  control  person  of  Beesmark,  and  consequently  her
          beneficial ownership is not separately reported.

     (4)  Includes 22,213,542 shares of common stock deposited in a voting trust
          (the  "Voting  Trust") as to which Mr.  Murdock  is the sole  trustee.
          Persons  who have  deposited  their  shares of common  stock  into the
          Voting Trust have dividend and liquidation rights ("Economic  Rights")
          in  proportion  to the  number of shares  of  common  stock  they have
          deposited in the Voting Trust,  but have no voting rights with respect
          to such shares. All voting rights associated with the shares deposited
          into the Voting Trust are  exercisable  solely and  exclusively by the
          Trustee of the Voting Trust. The Voting Trust expires, unless extended
          according to its terms, on the earlier of September 30, 1999 or any of
          the  following  events:  (i)  the  Trustee  terminates  it;  (ii)  the
          participating  shareholders  unanimously  terminate  it;  or (iii) the
          Company is  dissolved or  liquidated.  Although as the sole trustee of
          the Voting Trust Mr. Murdock exercises the voting rights of all of the
          shares deposited into the Voting Trust, and accordingly has listed all
          shares in the table above, he has no economic or pecuniary interest in
          any of the shares deposited into the Voting Trust except for 3,415,083
          shares as to which he  directly  owns  Economic  Rights,  and  405,793
          shares the Economic Rights as to which are owned by SCC, a corporation
          of which Mr. Murdock is a 1/3 equity owner. Also includes 2,813 shares
          owned  directly  by Mr.  Murdock,  11,400  shares  owned by a  limited
          liability  company of which Mr. Murdock is a 1/3 equity owner,  28,099
          shares (including  20,000shares issuable upon the exercise of options)
          beneficially  owned  by  members  of Mr.  Murdock's  immediate  family
          residing in the same  household and  1,350,000  shares of common stock
          underlying   stock  options  owned  by  Mr.  Murdock  and  exercisable
          presently or within 60 days.

     (5)  Includes (i) 3,415,083  shares owned by Mr. Dudley and deposited  into
          the Voting  Trust,  (ii)  405,793  shares owned by SCC as to which Mr.
          Dudley shares investment power because of his management position with
          and 1/3  ownership of SCC,  which  shares are  deposited in the Voting
          Trust;  (iii) 2,813  shares  owned  directly by Mr.  Dudley;  (iv) 300
          shares owned by Mr. Dudley's minor  children;  (v) 11,400 shares owned
          by a limited  liability  company  of which Mr.  Dudley is a 1/3 equity
          owner; and (vi) 1,350,000 shares underlying stock options  exercisable
          presently or within 60 days.

     (6)  Includes (i) 3,415,083 shares owned by Mr. Studdert and deposited into
          the Voting  Trust,  (ii)  405,793  shares owned by SCC as to which Mr.
          Studdert shares  investment  power because of his management  position
          with and 1/3  ownership  of SCC,  which  shares are  deposited  in the
          Voting Trust; (iii) 2,813 shares owned directly by Mr. Studdert;  (iv)
          11,400  shares  owned by a  limited  liability  company  of which  Mr.
          Studdert is a 1/3 equity owner and controls;  and (v) 1,350,000 shares
          underlying stock options exercisable presently or within 60 days.

     (7)  Includes  1,200,000  shares  of  common  stock  underlying   presently
          exercisable stock options.


                                   Page 51 of 60

<PAGE>

     (8)  Includes  26,000  shares  owned  directly by Mr.  Brack and 500 shares
          owned by Mr.  Brack's  son and  400,000  shares  underlying  presently
          exercisable stock options.

     (9)  Includes 2,400 shares owned directly by Mr. Rex, 2,400 shares owned by
          his spouse, 500 shares owned by an entity owned and controlled by him,
          and 400,000 shares underlying presently exercisable stock options.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Studdert Companies Corp. (SCC)

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 of the  Company.  Additionally,
Messrs.  Murdock and Dudley are executive officers of the Company.  Between June
1994 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.

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.  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.

On July 31,  1995,  the Company  issued and SCC  purchased  warrants to purchase
3,700,000  shares of common  stock for $.35 per share (the "SCC  Warrants").  On
August 11, 1995,  SCC  exercised 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.

In 1997, the Company's Board of Directors authorized the payment of a cash bonus
to SCC in an amount  sufficient  to pay all  personal  state and federal  income
taxes on the 3,700,000 shares of common stock issued to SCC upon exercise of the
SCC Warrants,  and on the bonus amount.  Pursuant to that authorization $340,516
and  $2,159,484  were paid to SCC in the years ended December 31, 1998 and 1997,
respectively.

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  invoiced the Company for management  services,  but continued to invoice
the Company  for  reimbursement  of actual  expenses  incurred on the  Company's
behalf.  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.  During  1998,  the
Company  paid  to SCC a  total  of  $590,390  under  the  SCC  Agreement,  which
terminated in December 1998.

The Company entered subleases from SCC its corporate  headquarters located at 60
East  South  Temple  Street,   Salt  Lake  City,  Utah.  The  sublease  is  from
month-to-month  pursuant  to which the  Company  has  agreed  to pay the  actual
monthly  rental of $10,369 and all common area charges  payable  under the lease
with SCC's landlord.

The Company has an unsecured revolving note payable to SCC. At December 31, 1998
and 1997,  $0 and  $551,510  in  principal  and  $2,482  and  $22,243in  accrued
interest,  respectively, were outstanding under this revolving note payable. The
weighted average balance  outstanding during the borrowing period was $73,811 in
1998 and $555,407 in 1997.  This  revolving  note is payable on demand and bears
interest at an annual rate of 12 percent.  The maximum amount  outstanding under
this  revolving  note was $551,510 in 1998 and $1,550,000 in 1997. In connection
with this revolving  note, the Company paid a loan fee of $93,000 to the related
entity.  The Company  believes  the terms of the  related-party  revolving  note
payable  are at least as  favorable  as the terms that could have been  obtained
from an unrelated third party in a similar transaction.


                                   Page 52 of 60

<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 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.

SMD

From September 4, 1997, through October 15, 1997 and again on December 31, 1997,
the Company borrowed funds from SMD, an entity owned by three individuals two of
whom are  officers and all of whom are  directors of the Company,  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 were
repaid,  together with $5,542 in interest.  The loan and its terms were approved
by the independent members of the board of directors of the Company.


Indemnity Agreement Related to Debenture Offering

In  connection  with the  Company's  January  and  March  1999  offering  of its
Debentures,  Stephen M. Studdert,  Thomas A. Murdock and Roger D. Dudley entered
into Stock Pledge Agreements, whereby each personally guaranteed the performance
and  obligations  of the Company  under the  Debentures,  and pledged  6,000,000
shares  of  common  stock of the  Company  owned by them as  security  for their
obligations under the guaranty.  The Company entered into an Indemnity Agreement
under which it agreed that,  in the event of a default by the Company  under the
terms of the Debenture offering and any or all of Messrs. Studdert,  Murdock, or
Dudley were  required to pay money or forfeit any of their pledged  shares,  the
Company  would  reimburse  and repay the  obligation  and  liability  of each of
Messrs.  Studdert,  Murdock,  and Dudley by transferring shares of the Company's
common  stock on a  one-for-one  basis and paying  cash in amounts  equal to the
out-of-pocket  expenses of Messrs.  Studdert,  Murdock,  and  Dudley,  including
without  limitation  any  income  tax  liability  they  incur  as  a  result  of
foreclosure sales of the pledged shares. Additionally, the disinterested members
of the Company's Board of Directors agreed that, in consideration of the pledge,
the Company would issue to each of Messrs. Studdert, Murdock and Dudley warrants
to purchase  666,666  shares of common  stock at an exercise  price of $1.59 per
share. The warrants have a 10-year term.

Messrs.  Studdert,  Murdock,  and Dudley also entered into  agreements  with the
purchasers of the  Debentures  whereby  Messrs.  Studdert,  Murdock,  and Dudley
agreed to  deliver  the  pledged  shares of stock for the use or  benefit of the
investors.  In the event that the shares are not  returned to Messrs.  Studdert,
Murdock,  or Dudley,  the Company's  obligation under the associated  Debentures
would be reduced accordingly.

Loans to the Company

During 1998,  Messrs.  Murdock and Dudley advanced funds in the aggregate amount
of $89,073 and $74,181,  respectively,  to pay certain operating expenses of the
Company.  In addition,  Mr.  Dudley has advanced  funds in 1999 in the aggregate
amount of $68,691 to pay  Company  expenses.  The  Company  has  recorded  these
advances as loans from shareholders.  Certain additional  advances resulted from
margin account pledges of Company common stock,  the cash proceeds of which were
used to pay Company  expenses.  Upon the subsequent  foreclosure of such pledged
shares, the Company incurred the obligation to repay Messrs.  Studdert,  Murdock
and Dudley for the value of the shares  forfeited by them upon  foreclosure,  in
the aggregate amount of $234,316.

Stock Pledges for Payment of Legal Fees

The Company and Messrs.  Murdock and Dudley  entered into an agreement  with the
law firm of Davis  Weber & Edwards,  P.C.,  regarding  payment of the  Company's
legal  fees owed to that  firm.  Under the  agreement,  Thomas  A.  Murdock,  as
Trustee,  entered into a Stock Pledge  Agreement  pledging 100,000 shares of the
Company's common stock  beneficially  owned by Messrs.  Murdock and Dudley,  and
Messrs. Murdock and Dudley guaranteed the full payment

                                   Page 53 of 60

<PAGE>

of the Company's  legal fees to Davis Weber & Edwards,  P.C.,  together with any
other  indebtedness  of the Company to Davis  Weber & Edwards,  P.C. At the time
Messrs.  Murdock and Dudley  agreed to guarantee  the payment,  the Company owed
fees in the approximate amount of $142,875 to Davis Weber & Edwards, P.C.


                                     PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(A) Documents filed as part of this Form 10-K:

     1.   Consolidated Financial Statements (included in Part II, Item 8)

          Consolidated Balance Sheets as of December 31, 1998 and 1997

          Consolidated Statements of Operations for the Years Ended December 31,
          1998,  1997 and 1996  and for the  Period  October  1,  1993  (Date of
          Inception) to December 31, 1998

          Consolidated  Statements of  Stockholders'  Equity for the Years Ended
          December  31, 1998,  1997 and 1996 and for the Period  October 1, 1993
          (Date of Inception) to December 31, 1998

          Consolidated Statements of Cash Flows for the Years Ended December 31,
          1998,  1997 and 1996  and for the  Period  October  1,  1993  (Date of
          Inception) to December 31, 1998

          Notes to Consolidated Financial Statements

     2.   Financial Statement Schedules: None

     3.   Exhibits:  The  following  Exhibits  are  filed  with  this  Form 10-K
          pursuant to Item 601(a) of Regulation S-K:

     Exhibit No. and Description of Exhibit
     --------------------------------------

     (2)(i)  Agreement  and Plan of  Reorganization  among  the  Company,  Fonix
          Acquisition  Corporation  and  AcuVoice  dated as of January 13, 1998,
          incorporated  by reference  from the Company's  Current Report on Form
          8-K, filed March 20, 1998

     (2)(ii) Agreement  and Plan of Merger among Fonix,  Articulate  Acquisition
          Corporation,  and Articulate,  dated as of July 31, 1998, incorporated
          by reference  from the  Company's  Current  Report on Form 8-K,  filed
          September 17, 1998

     (2)(iii)  Agreement  and Plan of Merger  among Fonix,  Papyrus  Acquisition
          Corporation,  and Papyrus Associates,  Inc., dated as of September 10,
          1998,  incorporated by reference from the Company's  Current Report on
          Form 8-K, filed November 13, 1998

     (3)(i) Articles of  Incorporation  of the Company which are incorporated by
          reference from the Company's Registration Statement on Form S-18 dated
          as of September 12, 1989

     (3)(ii) Certificate of Amendment of Certificate of  Incorporation  dated as
          of  March  21,  1994,  which is  incorporated  by  reference  from the
          Company's Annual Report for the Fiscal Year Ended December 31, 1994 on
          Form 10-KSB

     (3)(iii) Certificate of Amendment of Certificate of Incorporation  dated as
          of May 13, 1994, which is incorporated by reference from the Company's
          Annual  Report for the Fiscal  Year Ended  December  31,  1994 on Form
          10-KSB

                                   Page 54 of 60

<PAGE>




     (3)(iv) Certificate of Amendment of Certificate of  Incorporation  dated as
          of September 24, 1997,  which is  incorporated  by reference  from the
          Company's Quarterly Report on Form 10-Q for the period ended September
          30, 1997

     (3)(v)  The  Company's  Bylaws,  as  amended,  which  are  incorporated  by
          reference  from the Company's  Annual Report for the Fiscal Year Ended
          December 31, 1994 on Form 10-KSB

     (4)(i) Description of the Company's  common stock and other  securities and
          specimen   certificates   representing   such  securities   which  are
          incorporated by reference from the Company's Registration Statement on
          Form S-18 dated as of September 12, 1989, as amended

     (4)(ii) Certificate  of  Designation of Rights and  Preferences of Series A
          Preferred  Stock,  filed with the  Secretary  of State of  Delaware on
          September  24,  1997,  which is  incorporated  by  reference  from the
          Company's Quarterly Report on Form 10-Q for the period ended September
          30, 1997

     (4)(iii)  Certificate of Designation of Rights and  Preferences of Series B
          Convertible  Preferred  Stock,  filed with the  Secretary  of State of
          Delaware on October 27, 1997,  which is incorporated by reference from
          the  Company's  Quarterly  Report  on Form 10-Q for the  period  ended
          September 30, 1997

     (4)(iv) Certificate of Designation of Rights and Preferences of 5% Series C
          Convertible  Preferred  Stock,  filed with the  Secretary  of State of
          Delaware on October 24, 1997,  which is incorporated by reference from
          the  Company's  Quarterly  Report  on Form 10-Q for the  period  ended
          September 30, 1997

     (4)(v) Certificate of Designation of Rights and  Preferences of Series D 4%
          Convertible  Preferred  Stock,  filed with the  secretary  of State of
          Delaware on August 27, 1998,  which is  incorporated by reference from
          the  Company's  Quarterly  Report  on Form 10-Q for the  period  ended
          September 30, 1998

     (4)(vi) Certificate of Designation of Rights and Preferences of Series E 4%
          Convertible  Preferred  Stock,  filed with the  secretary  of State of
          Delaware on October 15, 1998,  which is incorporated by reference from
          the  Company's  Quarterly  Report  on Form 10-Q for the  period  ended
          September 30, 1998

     (9)(i) Voting  Trust  Agreement  dated as of December 10, 1993 by and among
          Phonic Technologies,  Inc., Stephen M. Studdert, Thomas A. Murdock and
          Roger D. Dudley, which is incorporated by reference from the Company's
          Current Report on Form 8-K dated as of June 17, 1994

     (9)(ii)  Amendment  of Voting  Trust  Agreement  by and among the  Company,
          Stephen M.  Studdert,  Thomas A.  Murdock,  Roger D. Dudley,  Beesmark
          Investments,  L.C.,  Studdert  Companies  Corporation,  and  Thomas A.
          Murdock as Trustee,  dated as of October  23,  1995,  incorporated  by
          reference  from the Company's  Current  Report on Form 8-K dated as of
          October 23, 1995

     (9)(iii)  Second  Amendment  of  Voting  Trust  Agreement  by and among the
          Company,  Stephen M.  Studdert,  Thomas A.  Murdock,  Roger D. Dudley,
          Beesmark Investments, L.C., Studdert Companies Corporation, and Thomas
          A.  Murdock  as  Trustee,  dated as of July 2, 1996,  incorporated  by
          reference  from the Annual  Report on Form  10-KSB for the fiscal year
          ended December 31, 1996

     (9)(iv) Third Amendment of Voting Trust Agreement by and among the Company,
          Stephen M.  Studdert,  Thomas A.  Murdock,  Roger D. Dudley,  Beesmark
          Investments, L.C., Studdert

                                   Page 55 of 60

<PAGE>

          Companies  Corporation,  and Thomas A. Murdock as Trustee, dated as of
          September 20, 1996,  incorporated  by reference from the Annual Report
          on Form 10-KSB for the fiscal year ended December 31, 1996

     (9)(v) Fourth Amendment of Voting Trust Agreement by and among the Company,
          Stephen M.  Studdert,  Thomas A.  Murdock,  Roger D. Dudley,  Beesmark
          Investments,  L.C.,  Studdert  Companies  Corporation,  and  Thomas A.
          Murdock as Trustee,  dated as of September 20, 1996,  incorporated  by
          reference  from the Annual  Report on Form  10-KSB for the fiscal year
          ended December 31, 1996

     (10)(i) Product  Development  and Assignment  Agreement dated as of October
          16, 1993 between  Phonic  Technologies,  Inc. and  Synergetics,  Inc.,
          which is incorporated  by reference from the Company's  Current Report
          on Form 8-K dated as of June 17, 1994

     (10)(ii) Re-Stated Product Development and Assignment Agreement dated as of
          March 30, 1995, between Fonix Corporation and Synergetics, Inc., which
          is incorporated by reference from the Company's  Annual Report for the
          Fiscal Year Ended December 31, 1994 on Form 10-KSB

     (10)(iii)  Memorandum of  Understanding  dated as of March 13, 1997, by and
          among the  Company,  Synergetics,  Inc.  and C. Hal  Hansen,  which is
          incorporated  by reference  from the  Company's  Annual Report on Form
          10-KSB for the fiscal year ended December 31, 1996

     (10)(iv)  Employment  Agreement  by and  between the Company and Stephen M.
          Studdert, which is incorporated by reference from the Company's Annual
          Report on Form 10-KSB for the fiscal year ended December 31, 1996

     (10)(v)  Employment  Agreement  by and  between  the  Company and Thomas A.
          Murdock,  which is incorporated by reference from the Company's Annual
          Report on Form 10-KSB for the fiscal year ended December 31, 1996

     (10)(vi)  Employment  Agreement  by and  between  the  Company and Roger D.
          Dudley,  which is incorporated by reference from the Company's  Annual
          Report on Form 10-KSB for the fiscal year ended December 31, 1996

     (10)(vii)Restated  Master  Agreement  for Joint  Collaboration  between the
          Company and Siemens,  dated  November 14, 1997,  as revised,  which is
          incorporated  by reference  from the  Company's  Annual Report on Form
          10-K for the year ended December 31, 1997

     (10)(viii) Restated First Statement of Work and License Agreement between 
          the Company and Siemens,  dated  February 11, 1998,  as revised,  
          which is incorporated  by reference  from the  Company's  Annual 
          Report on Form 10-K for the year ended December 31, 1997

     (10)(ix) Master Technology  Collaboration Agreement between the Company and
          OGI, dated October 14, 1997,  which is  incorporated by reference from
          the Company's  Annual Report on Form 10-K for the year ended  December
          31, 1997

     (10)(x)  Common  stock  Purchase   Agreement  among  the  Company  and  JNC
          Opportunity Fund Ltd. and Diversified Strategies Fund, LP, dated as of
          March 9, 1998,  which is  incorporated by reference from the Company's
          Annual Report on Form 10-K for the year ended December 31, 1997

     (10)(xi) Common stock  Purchase  Agreement  between the Company and Thomson
          Kernaghan & Co., dated as of March 9, 1998,  which is  incorporated by
          reference  from the Company's  Annual Report on Form 10-K for the year
          ended December 31, 1997

                                   Page 56 of

<PAGE>

     (10)(xii) Royalty Modification Agreement among the Company and Synergetics,
          dated as of April 6, 1998, which is incorporated by reference from the
          Company's  Annual Report on Form 10-K for the year ended  December 31,
          1997

     (10)(xiii) Purchase  Agreement with John  Oberteuffer and the Company dated
          April 9, 1998,  which is  incorporated by reference from the Company's
          Annual Report on Form 10-K for the year ended December 31, 1997

     (10)(xiv)Employment  Agreement  by and  between  the  Company  and  John A.
          Oberteuffer,  which is  incorporated  by reference  from the Company's
          Annual Report on Form 10-K for the year ended December 31, 1997

     (10)(xv) First  Amendment  to  Master  Agreement  for  Joint  Collaboration
          between the Company and Siemens,  dated  February  13, 1998,  which is
          incorporated  by reference  from the  Company's  Annual Report on Form
          10-K for the year ended December 31, 1997

     (10)(xvi)Second  Amendment  to Master  Agreement  for  Joint  Collaboration
          between the  Company  and  Siemens,  dated  March 13,  1998,  which is
          incorporated  by reference  from the  Company's  Annual Report on Form
          10-K for the year ended December 31, 1997

     (10)(vii) Series D Convertible  Preferred  Stock Purchase  Agreement  Among
          Fonix corporation,  JNC Opportunity Fund, Ltd., Diversified Strategies
          Fund,  L.P.,  Dominion  Capital Fund, Ltd.,  Sovereign  Partners,  LP,
          Canadian Advantage Limited Partnership and Thomson Kernaghan & Co. (as
          agent) dated as of August 31, 1998, incorporated by reference from the
          Company's Quarterly Report on Form 10-Q for the period ended September
          30, 1998

          (10)(xviiSeries E Convertible  Preferred  Stock  Exchange and Purchase
               Agreement among Fonix  corporation,  Sovereign  Partners,  LP and
               Dominion  Capital  Fund,  Ltd.,  dated as of September  30, 1998,
               incorporated by reference from the Company's  Quarterly Report on
               Form 10-Q for the period ended September 30, 1998

          (10)(xix)Securities Purchase Agreement among Fonix Corporation and JNC
               Strategic Fund,  dated December 21, 1998 for 1,801,802  shares of
               common stock and Repricing Rights, incorporated by reference from
               Amendment No. 1 to  Registration  Statement on Form S-3 (File No.
               333-67573)

          (10)(xx) Securities Purchase Agreement among Fonix Corporation and the
               investors   identified   therein   dated  January  29,  1999,  as
               supplemented  on March 3, 1999,  concerning  sales of  $6,500,000
               principal   amount  of  Series  C  5%   Convertible   Debentures,
               incorporated  by reference from  Amendment No. 1 to  Registration
               Statement on Form S-3 (File No. 333-67573)

          (22) Subsidiaries of Registrant

          (23)(i) Consent of Arthur Andersen LLP

          (23)(ii) Consent of Deloitte & Touche LLP

          (23)(iii) Consent of Pritchett Siler & Hardy, P.C.

          (27) Financial Data Schedule

(B)  Reports  filed on Form 8-K during the last quarter of the fiscal year ended
     December 31, 1998:


                                   Page 57 of 60

<PAGE>



     On November 13,  1998,  the Company  filed a Current  Report on Form 8-K to
     report the  acquisition  of Papyrus and to file the Agreements and Plans of
     Merger with the two acquired companies.

     On November 16,  1998,  the Company  filed a Current  Report on Form 8-K to
     file  financial  information  relating  to  the  Company's  acquisition  of
     Articulate,  previously reported by the Company in a Current Report on Form
     8-K filed on September 17, 1998.




                                   Page 58 of 60

<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 report to be signed on its
behalf by the undersigned,  thereunto duly authorized, on this 14th day of April
1999.

                                         Fonix Corporation


Date:   April 14, 1999                   By:   /s/ Thomas A. Murdock
     ------------------                    -----------------------------
                                          Thomas A. Murdock, President and
                                            Chief Executive Officer


Date:   April 14, 1999                   By:    /s/ Douglas L. Rex
     ------------------                    -----------------------------
                                          Douglas L. Rex, Chief Financial 
                                            Officer (Principal Financial and 
                                            Accounting Officer)

In  accordance  with the Exchange  Act, this report has been signed below by the
following  persons on behalf of the  registrant and in the capacities and on the
dates indicated:


  /s/ Thomas A. Murdock                    /s/ Stephen M. Studdert
--------------------------------        --------------------------------
Thomas A. Murdock, President and        Stephen M. Studdert, Director
       Chief Executive Officer

April 12, 1999                          April 8, 1999                         
--------------------------------        -------------------------------
Date                                    Date


  /s/ Roger D. Dudley                     /s/ Joseph Verner Reed
--------------------------------        --------------------------------
Roger D. Dudley, Director               Ambassador Joseph Verner Reed, Director

April 9, 1999                           April 8, 1999                         
--------------------------------        -------------------------------
Date                                    Date


/s/ Reginald K. Brack             
--------------------------------     
Reginald K. Brack, Director

April 9, 1999 
--------------------------------         
Date


 /s/ John A. Oberteuffer                 /s/ Rick D. Nydegger
--------------------------------        --------------------------------
John A. Oberteuffer, Ph.D.              Rick D. Nydegger, Director

 April 12, 1999                         April 12, 1999                      
--------------------------------        -------------------------------
Date                                    Date





                                   Page 59 of 60

<PAGE>

                                   EXHIBIT 22

                           SUBSIDIARIES OF REGISTRANT

     Fonix Systems Corporation, a Utah corporation, wholly owned by the Company

     Fonix/AcuVoice, Inc., a Utah corporation, wholly owned by the Company

     Fonix/Articulate, Inc., a Utah corporation, wholly owned by the Company

     Fonix/Papyrus Inc., a Utah corporation, wholly owned by the Company

                                   Page 60 of 60

<PAGE>
                                TABLE OF CONTENTS








REPORT   OF   INDEPENDENT    PUBLIC    ACCOUNTANTS    
    (ARTHUR    ANDERSEN   LLP)...............................................F-2

INDEPENDENT AUDITORS' REPORT (DELOITTE & TOUCHE LLP).........................F-3

INDEPENDENT AUDITORS' REPORT (PRITCHETT, SILER & HARDY, P.C.)................F-4

FINANCIAL STATEMENTS:

Consolidated Balance Sheets as of December 31, 1998 and 1997.................F-5

Consolidated Statements of Operations for the Years Ended December 
  31, 1998, 1997 and 1996 and for the Period from October 1, 1993 
  (Date of Inception) to December 31, 1998...................................F-6

Consolidated Statements of Stockholders' Equity for the Years 
  ended December 31, 1998, 1997 and 1996 and for the Period 
  from October 1, 1993 (Date of Inception) to December 31, 1998..............F-7

Consolidated Statements of Cash Flows for the Years Ended December
  31, 1998,  1997 and 1996 and for the Period from October 1, 1993
  (Date of Inception) to December 31, 1998..................................F-10

Notes to Consolidated Financial Statements .................................F-12












                                       F-1

<PAGE>


                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To Fonix Corporation:

We  have  audited  the  accompanying   consolidated   balance  sheets  of  Fonix
Corporation (a Delaware  corporation in the development  stage) and subsidiaries
as of  December  31, 1998 and 1997 and the related  consolidated  statements  of
operations, stockholders' equity and cash flows for the years then ended and for
the  period  from  inception  (October  1, 1993) to  December  31,  1998.  These
financial  statements are the  responsibility of the Company's  management.  Our
responsibility  is to express an opinion on these financial  statements based on
our audits.  The consolidated  financial  statements of the Company for the year
ended December 31, 1996 and for the period from  inception  (October 1, 1993) to
December 31, 1996,  were audited by other  auditors whose report dated March 28,
1997,  expressed  an  unqualified  opinion on those  statements  and included an
explanatory  paragraph  regarding the  Company's  ability to continue as a going
concern.  The  consolidated  financial  statements for the period from inception
(October 1, 1993) to December 31, 1996 reflect a net loss of  $19,841,807 of the
total inception to date net loss of $85,414,537.  The other auditors' report has
been  furnished  to us, and our  opinion,  insofar as it relates to the  amounts
included  for such prior  periods,  is based  solely on the report of such other
auditors.

We  conducted  our  audits  in  accordance  with  generally   accepted  auditing
standards.  Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the  accounting  principles  used and  significant  estimates  made by
management,  as well as evaluating the overall financial statement presentation.
We believe that our audits and the report of other auditors provide a reasonable
basis for our opinion.

In our  opinion,  based on our audits and the report of other  auditors  for the
cumulative  information  for the  period  from  inception  (October  1, 1993) to
December 31,  1996,  the  consolidated  financial  statements  referred to above
present fairly, in all material respects, the consolidated financial position of
Fonix  Corporation  and  subsidiaries  as of December  31, 1998 and 1997 and the
results  of their  operations  and their cash flows for the years then ended and
for the  period  from  inception  (October  1,  1993) to  December  31,  1998 in
conformity with generally accepted accounting principles.

The accompanying  consolidated  financial statements have been prepared assuming
that the Company will continue as a going concern. As discussed in Note 1 to the
consolidated  financial  statements,  the Company has  generated no  significant
recurring  revenues  through  December  31,1998  and  has  incurred  significant
recurring  losses  since its  inception.  The Company  expects  these  losses to
continue at least  through  December  31, 1999.  As of December  31,  1998,  the
Company has an accumulated  deficit of $92,933,777,  negative working capital of
$14,678,975,  demand and other notes currently due of $29,438,218 (some of which
are in default) and $1,965,490 of accounts  payable over 60 days past due. These
matters raise  substantial  doubt about the  Company's  ability to continue as a
going  concern.  Management's  plans  with  respect  to these  matters  are also
described in Note 1. The accompanying  consolidated  financial statements do not
include any adjustments that might result from the outcome of this uncertainty.


/s/ Arthur Andersen LLP

ARTHUR ANDERSEN LLP

Salt Lake City, Utah
April 14, 1999

                                       F-2

<PAGE>


INDEPENDENT AUDITORS' REPORT

To the Board of Directors
   and Shareholders of
Fonix Corporation
Salt Lake City, Utah

We  have  audited  the  accompanying   consolidated  statements  of  operations,
stockholders'  equity  and cash flows of Fonix  Corporation  and  subsidiary  (a
development  stage  company) (the Company) for the year ended December 31, 1996,
and for the period from  October 1, 1993 (date of  inception)  to  December  31,
1996.  These  financial  statements  are  the  responsibility  of the  Company's
management.  Our  responsibility  is to express  an  opinion on these  financial
statements based on our audit. The Company's  consolidated  financial statements
for the period from  October 1, 1993 (date of  inception)  to December  31, 1995
were audited by other auditors whose report,  dated March 4, 1996,  expressed an
unqualified  opinion on those  statements and included an explanatory  paragraph
regarding the Company's  ability to continue as a going  concern.  The financial
statements for the period October 1, 1993 (date of inception)  through  December
31, 1995 reflect a net loss of  $12,012,299  of the total  inception to date net
loss.  The other  auditors'  report has been  furnished  to us, and our opinion,
insofar as it relates to the amounts  included for such prior periods,  is based
solely on the report of such other auditors.

We conducted our audit in accordance with generally accepted auditing standards.
Those standards  require that we plan and perform the audit to obtain reasonable
assurance   about  whether  the  financial   statements  are  free  of  material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the  accounting  principles  used and  significant  estimates  made by
management,  as well as evaluating the overall financial statement presentation.
We believe that our audit and the report of other auditors  provide a reasonable
basis for our opinion.

In our  opinion,  based on our audit  and the  report  of other  auditors,  such
financial  statements present fairly, in all material  respects,  the results of
the  Company's  operations  and its cash flows for the year ended  December  31,
1996,  and for the period from October 1, 1993 (date of  inception)  to December
31, 1996, in conformity with generally accepted accounting principles.

The accompanying  consolidated  financial statements have been prepared assuming
that the Company will continue as a going concern.  The Company is a development
stage   enterprise   engaged  in   developing   automated   speech   recognition
technologies.  As discussed in Note 1 to the consolidated  financial statements,
the Company's operating losses since inception raise substantial doubt about the
Company's ability to continue as a going concern.  Management's  plans in regard
to these  matters  are also  described  in Note 1.  The  consolidated  financial
statements do not include any adjustments  that might result from the outcome of
this uncertainty.


/s/ Deloitte & Touche LLP
DELOITTE & TOUCHE LLP

Salt Lake City, Utah
March 28, 1997

                                       F-3

<PAGE>


INDEPENDENT AUDITORS' REPORT


To the Board of Directors
Fonix Corporation
Salt Lake City, Utah


We have audited the consolidated statements of operations,  stockholders' equity
and cash flows of Fonix Corporation and subsidiary [a development stage company]
for the year ended  December 31,  1995,  and for the period from October 1, 1993
(date of inception)  to December 31, 1995 (these  financial  statements  are not
presented  separately herein).  These consolidated  financial statements are the
responsibility of the Company's management.  Our responsibility is to express an
opinion on these financial statements based on our audit.

We conducted our audit in accordance with generally accepted auditing standards.
Those standards  require that we plan and perform the audit to obtain reasonable
assurance   about  whether  the  financial   statements  are  free  of  material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the  accounting  principles  used and  significant  estimates  made by
management,  as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.

In our opinion,  the financial  statements  referred to above present fairly, in
all material respects,  the consolidated results of operations and cash flows of
Fonix  Corporation  and subsidiary (a development  stage company) for the period
from October 1, 1993 (date of inception) to December 31, 1995 in conformity with
generally accepted accounting principles.

The  consolidated  financial  statements  referred  to above have been  prepared
assuming that the Company will continue as a going concern. As discussed in Note
1 to  the  consolidated  financial  statements,  the  Company  is  still  in the
development  stage and has suffered  recurring  losses  which raise  substantial
doubt about its ability to continue as a going  concern.  Management's  plans in
regard to these matters are also described in Note 1. The consolidated financial
statements do not include any adjustments  that might result from the outcome of
this uncertainty.


/s/ PRITCHETT, SILER & HARDY, P.C.

PRITCHETT, SILER & HARDY, P.C.

Salt Lake City, Utah
March 4, 1996





                                       F-4

<PAGE>

                                Fonix Corporation
                          [A Development Stage Company]

                           CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>



                                                                                           December 31,   December 31,  
                                                                                              1998           1997
                                                                                         --------------- --------------
<S>                                                                                      <C>             <C>
ASSETS
------
Current assets:                                                                        
      Cash and cash equivalents                                                            $ 20,045,539   $ 20,501,676
      Notes receivable                                                                          245,000        600,000
      Accounts receivable, net of allowance for doubtful accounts of $8,115                     219,908              -
      Employee advances                                                                          67,231              -
      Interest and other receivables                                                              8,276         14,919
      Inventory                                                                                  77,386              -
      Prepaid expenses                                                                           51,866         32,094
                                                                                         --------------- --------------

          Total current assets                                                               20,715,206     21,148,689

Property and equipment, net of accumulated depreciation of 
   $1,195,390 and $464,100, respectively                                                      2,328,012      1,567,279

Intangible assets, net of accumulated amortization of $2,599,554 
   and $25,509, respectively                                                                 38,816,421        138,951

Other assets                                                                                    130,288         39,647
                                                                                         --------------- --------------

          Total assets                                                                     $ 61,989,927   $ 22,894,566
                                                                                         =============== ==============

LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------

Current liabilities:
      Bank overdraft                                                                       $    138,034   $          -
      Revolving notes payable                                                                20,038,193     18,612,272
      Notes payable - related parties                                                         8,491,880        551,510
      Notes payable - other                                                                     560,000              -
      Accounts payable                                                                        3,536,074        291,638
      Accrued liabilities                                                                       981,774        505,619
      Accrued liabilities - related parties                                                     900,004        459,502
      Deferred revenues                                                                         695,997              -
      Capital lease obligation - current portion                                                 52,225         49,325
                                                                                         --------------- --------------

          Total current liabilities                                                          35,394,181     20,469,866

Capital lease obligation, net of current portion                                                      -         52,225
                                                                                         --------------- --------------

          Total liabilities                                                                  35,394,181     20,522,091
                                                                                         --------------- --------------

Common stock and related repricing rights subject to redemption; 1,801,802 
   shares and repricing rights outstanding in 1998 (aggregate redemption 
   value of $2,500,000                                                                        1,830,000              -
                                                                                         --------------- --------------

Commitments and contingencies (Notes 1, 7, 12, 14, 16, 17 and 20)                      

Stockholders' equity:                                                                  
      Preferred stock, $.0001 par value;  100,000,000 shares authorized;               
          Series A, convertible; 166,667 shares outstanding                            
               (aggregate liquidation preference of $6,055,012)                                 500,000        500,000
          Series B, 5% cumulative convertible; 27,500 shares outstanding in 1997
               (aggregate liquidation preference of $555,197)                                         -        667,659
          Series C, 5% cumulative convertible; 185,000 shares outstanding in 1997
               (aggregate liquidation preference of $3,734,550)                                       -      4,644,785
          Series D, 4% cumulative convertible; 1,008,334 shares outstanding
               in 1998 (aggregate liquidation preference of $20,441,828)                     22,200,936              -
          Series E, 4% cumulative convertible; 135,072 shares outstanding in 1998
               (aggregate liquidation preference of $2,739,403)                               3,257,886              -
      Common stock, $.0001 par value; 100,000,000 shares authorized;                   
          64,324,480 and 43,583,875 shares outstanding, respectively                              6,432          4,358
      Additional paid-in capital                                                             88,517,711     38,637,059
      Outstanding warrants                                                                    3,323,258      2,936,360
      Deferred consulting expense                                                              (106,700)             -
      Deficit accumulated during the development stage                                      (92,933,777)   (45,017,746)
                                                                                         --------------- --------------

          Total stockholders' equity                                                         24,765,746      2,372,475
                                                                                         --------------- --------------

          Total liabilities and stockholders' equity                                       $ 61,989,927   $ 22,894,566
                                                                                         =============== ==============
</TABLE>


          See accompanying notes to consolidated financial statements.

                                      F-5

<PAGE>
                                Fonix Corporation
                          [A Development Stage Company]

                      CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
                                                                                                     
                                                                                                      October 1,    
                                                                                                         1993     
                                                                  Years Ended December 31,           (Inception) to
                                                      -------------------------------------------     December 31,  
                                                          1998            1997            1996           1998
                                                      ------------    ------------    -----------    ------------
<S>                                                   <C>             <C>             <C>            <C>
Revenues                                              $  2,889,684    $       --      $      --      $  2,889,684
Cost of revenues                                            76,344            --             --            76,344
                                                      ------------    ------------    -----------    ------------
      Gross margin                                       2,813,340            --             --         2,813,340
                                                      ------------    ------------    -----------    ------------

Expenses:
      Product development and research                  13,620,748       7,066,294      4,758,012      31,558,041
      Purchased in-process research and development     13,136,000            --             --        13,136,000
      Selling, general and administrative               12,612,015      12,947,112      3,530,400      34,858,685
                                                      ------------    ------------    -----------    ------------
           Total expenses                               39,368,763      20,013,406      8,288,412      79,552,726
                                                      ------------    ------------    -----------    ------------
Loss from operations                                   (36,555,423)    (20,013,406)    (8,288,412)    (76,739,386)
                                                      ------------    ------------    -----------    ------------

Other income (expense):
      Interest income                                    1,075,324       1,199,610      1,180,259       3,667,391
      Interest expense                                  (1,527,106)     (2,758,288)      (721,355)     (5,379,649)
      Cancellation of common stock reset provision      (6,111,577)           --             --        (6,111,577)
                                                      ------------    ------------    -----------    ------------
           Total other income (expense), net            (6,563,359)     (1,558,678)       458,904      (7,823,835)
                                                      ------------    ------------    -----------    ------------
Loss before extraordinary items                        (43,118,782)    (21,572,084)    (7,829,508)    (84,563,221)

Extraordinary items:
      Loss on extinguishment of debt                          --          (881,864)          --          (881,864)
      Gain on forgiveness of debt                             --              --             --            30,548
                                                      ------------    ------------    -----------    ------------
Net loss                                              $(43,118,782)   $(22,453,948)   $(7,829,508)   $(85,414,537)
                                                      ============    ============    ===========    ============


Basic and diluted net loss per common share           $      (0.91)   $     (0.59)   $      (0.21)
                                                      ============    ===========    ============

</TABLE>

          See accompanying notes to consolidated financial statements.

                                      F-6
<PAGE>
                                Fonix Corporation
                          [A Development Stage Company]


                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>



                                                                    Series A                Series B                 Series C     
                                                                 Preferred Stock         Preferred Stock         Preferred Stock 
                                                                 ---------------         ---------------         --------------- 
                                                                Shares      Amount      Shares      Amount      Shares      Amount  
                                                                ------      ------      ------      ------      ------      ------  
<S>                                                             <C>         <C>         <C>         <C>         <C>         <C>

Balance, December 31, 1992                                           -      $    -           -      $    -           -      $    -

Reverse stock split one share for ninety shares                      -           -           -           -           -           -

Restatement for reverse acquisition of fonix
  corporation by Phonic Technologies, Inc.                           -           -           -           -           -           -
                                                                ------      ------      ------      ------      ------      ------  
Balance, October 1, 1993 (date of inception)                         -           -           -           -           -           -

Net loss for the period October 1, 1993
  (date of inception) to December 31, 1993                           -           -           -           -           -           -
                                                                ------      ------      ------      ------      ------      ------  
Balance, December 31, 1993                                           -           -           -           -           -           -


Acquisition of Taris, Inc.                                           -           -           -           -           -           -

Shares issued for services at $.14 to $.18 per share                 -           -           -           -           -           -

Shares issued for services at $.25 per share                         -           -           -           -           -           -

Shares issued for conversion of notes payable
  and interest payable at $.04 per share                             -           -           -           -           -           -

Shares issued for cash at $1.19 to $3.13 per
  share, less offering costs of $368,450                             -           -           -           -           -           - 

Net loss for the year ended December 31, 1994                        -           -           -           -           -           -
                                                                ------      ------      ------      ------      ------      ------  
Balance, December 31, 1994                                           -           -           -           -           -           - 

Shares issued during the year for cash at $.45 to
  $2.50 per share, less offering costs of $ 267,714                  -           -           -           -           -           -

Shares issued during the year for services
  rendered and cancellation of accounts payable
  at $.55 to $1.55 per share                                         -           -           -           -           -           -

Warrants issued during the year for  cancellation  
  of accounts  payable at $.033
  per warrant (additional compensation expense
  of $2,282,900 or $.62 per share was recorded)                      -           -           -           -           -           -

Shares issued during the year upon conversion of
  warrants for cancellation of accounts
  payable at $.35 per share                                          -           -           -           -           -           - 

Warrants issued during the year for cash at $.0033 to
  $.10 per warrant, less offering costs of$5,040                     -           -           -           -           -           -

Shares issued during the year upon conversion of
  warrants for cash at $.50 to $1.00 per share                       -           -           -           -           -           -

Forgiveness of debt with related parties                             -           -           -           -           -           -

Net loss for the year ended December 31, 1995                        -           -           -           -           -           - 
                                                                ------      ------      ------      ------      ------      ------  
Balance, December 31, 1995                                           -           -           -           -           -           -
</TABLE>


<TABLE>
<CAPTION>

                                                                    Series D          Series E                         
                                                                Preferred Stock   Preferred Stock            Common Stock   
                                                                ---------------   ---------------   ------------------------------
                                                                Shares   Amount   Shares   Amount      Shares            Amount
                                                                ------   ------   ------   ------   -------------    -------------
<S>                                                             <C>      <C>      <C>      <C>      <C>              <C>
Balance, December 31, 1992                                           -   $     -       -   $    -     37,045,000     $      3,704
                                                                                                                                    
Reverse stock split one share for ninety shares                      -         -       -        -    (36,633,389)          (3,663)
                                                                                                                                    
Restatement for reverse acquisition of fonix                                                                                        
  corporation by Phonic Technologies, Inc.                           -         -       -        -      9,983,638              999   
                                                                ------   ------   ------   ------   -------------    -------------
Balance, October 1, 1993 (date of inception)                         -         -       -        -     10,395,249            1,040   
                                                                                                                                    
Net loss for the period October 1, 1993                                                                                 
  (date of inception) to December 31, 1993                           -         -       -        -              -                -
                                                                ------   ------   ------   ------   -------------    -------------
                                                                                                                                    
Balance, December 31, 1993                                           -         -       -        -     10,395,249            1,040   
                                                                                                                                    
                                                                                                                                    
Acquisition of Taris, Inc.                                           -         -       -        -        411,611               41
                                                                                                                                    
Shares issued for services at $.14 to $.18 per share                 -         -       -        -      1,650,000              165   
                                                                                                                                    
Shares issued for services at $.25 per share                         -         -       -        -         20,000                2   
                                                                                                                                    
Shares issued for conversion of notes payable                                                                                       
  and interest payable at $.04 per share                             -         -       -        -      3,900,000              390   
                                                                                                                                    
Shares issued for cash at $1.19 to $3.13 per                                                                                        
  share, less offering costs of $368,450                             -         -       -        -      1,819,293              181 
                                                                                                                                    
Net loss for the year ended December 31, 1994                        -         -       -        -              -                -
                                                                ------   ------   ------   ------   -------------    -------------
Balance, December 31, 1994                                           -         -       -        -     18,196,153            1,819   
                                                                                                                                    
                                                                                                                                    
Shares issued during the year for cash at $.45 to $2.50                                                                             
  per share, less offering costs of $ 267,714                        -         -       -        -      6,442,538              645   
                                                                                                                                    
Shares issued during the year for services                                                                                          
  rendered and cancellation of accounts payable                                                                                     
  at $.55 to $1.55 per share                                         -         -       -        -        516,630               52   
                                                                                                                                    
Warrants issued during the year for                                                                                                 
  cancellation of accounts payable at $.033                                                                                         
  per warrant (additional compensation expense                                                                                      
  of $2,282,900 or $.62 per share was recorded)                      -         -       -        -              -                - 
                                                                                                                                    
Shares issued during the year upon conversion of                                                                                    
  warrants for cancellation of                                                                                                      
  accounts payable at $.35 per share                                 -         -       -        -      3,700,000              370   
                                                                                                                                    
Warrants issued during the year for cash at $.0033 to                                                                               
  $.10 per warrant, less offering costs of$5,040                     -         -       -        -              -                -
                                                                                                                                    
Shares issued during the year upon conversion of                                                                                    
  warrants for cash at $.50 to $1.00 per share                       -         -       -        -        550,000               55   
                                                                                                                                    
Forgiveness of debt with related parties                             -         -       -        -              -                -   
                                                                                                                                    
Net loss for the year ended December 31, 1995                        -         -       -        -              -                -  
                                                                ------   ------   ------   ------   -------------    -------------
Balance, December 31, 1995                                           -         -       -        -     29,405,321            2,941

</TABLE>


<TABLE>
<CAPTION>
                                                                                                         Deficit        
                                                                                           Deferred    Accumulated 
                                                                Additional                 Consult-    During the       
                                                                 Paid-in     Outstanding      ing      Development   
                                                                 Capital       Warrants    Expense        Stage          Total
                                                              -------------  -----------   --------   -------------   -----------
<S>                                                           <C>            <C>           <C>        <C>             <C> 
Balance, December 31, 1992                                    $    136,659   $        -    $     -    $    (29,495)   $  110,868
                                                                                                                  
Reverse stock split one share for ninety shares                      3,663            -          -               -             -
                                                                                                                         
Restatement for reverse acquisition of fonix                                                                                     
  corporation by Phonic Technologies, Inc.                        (141,362)           -          -          29,495      (110,868)
                                                              -------------  -----------   --------   -------------   -----------
Balance, October 1, 1993 (date of inception)                        (1,040)           -          -               -             -
                                                                                                                                 
Net loss for the period October 1, 1993                                                                                          
  (date of inception) to December 31, 1993                               -            -          -      (1,782,611)   (1,782,611)
                                                              -------------  -----------   --------   -------------   -----------
                                                                                                                            
Balance, December 31, 1993                                          (1,040)           -          -      (1,782,611)   (1,782,611)
                                                                                                                               
Acquisition of Taris, Inc.                                           1,240            -          -               -         1,281
                                                                                                                               
Shares issued for services at $.14 to $.18 per share               249,835            -          -               -       250,000
                                                                                                                                 
Shares issued for services at $.25 per share                         4,998            -          -               -         5,000
                                                                                                                            
Shares issued for conversion of notes payable                                                                                  
  and interest payable at $.04 per share                           156,515            -          -               -       156,905
                                                                                                                            
Shares issued for cash at $1.19 to $3.13 per                                                                                    
  share, less offering costs of $368,450                         3,315,874            -          -               -     3,316,055
                                                                                                                              
Net loss for the year ended December 31, 1994                            -            -          -      (3,914,339)   (3,914,339)
                                                              -------------  -----------   --------   -------------   -----------
Balance, December 31, 1994                                       3,727,422            -          -      (5,696,950)   (1,967,709)
                                                                                                                              
Shares issued during the year for cash at $.45 to                                                                            
  $2.50 per share, less offering costs of $267,714               4,509,542            -          -               -     4,510,187
                                                                                                                            
Shares issued during the year for services                                                                                      
  rendered and cancellation of accounts payable                                                                                   
  at $.55 to $1.55 per share                                       355,319            -          -               -       355,371
                                                                                                                               
Warrants issued during the year for                                                                                             
  cancellation of accounts payable at $.033                                                                                  
  per warrant (additional compensation expense                                                                             
  of $2,282,900 or $.62 per share was recorded)                          -    2,405,000          -               -     2,405,000
                                                                                                                                  
Shares issued during the year upon conversion of                                                                                
  warrants for cancellation of accounts                                                                                    
  payable at $.35 per share                                      3,699,630   (2,405,000)         -               -     1,295,000
                                                                                                                               
Warrants issued during the year for cash at $.0033 to                                                                         
  $.10 per warrant, less offering costs of$5,040                         -       45,360          -               -        45,360
                                                                                                                                  
Shares issued during the year upon conversion of                                                                             
  warrants for cash at $.50 to $1.00 per share                     519,945      (45,000)         -               -       475,000
                                                                                                                                
Forgiveness of debt with related parties                           506,874            -          -               -       506,874
                                                                                                                                
Net loss for the year ended December 31, 1995                            -            -          -      (6,315,349)   (6,315,349)
                                                              -------------  -----------   --------   -------------   -----------
Balance, December 31, 1995                                      13,318,732          360          -     (12,012,291)    1,309,734

</TABLE>

          See accompanying notes to consolidated financial statements

                                      F-7

<PAGE>
                                Fonix Corporation
                          [A Development Stage Company]

                   CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
                                                           Series A                   Series B                   Series C
                                                       Preferred Stock            Preferred Stock             Preferred Stock
                                                       ---------------            ---------------             ---------------
                                                     Shares       Amount        Shares        Amount        Shares        Amount
                                                  ------------  ------------  ------------  ------------  ------------  -----------
<S>                                               <C>           <C>           <C>           <C>           <C>           <C>


Shares issued during the year for finders' fees
  at $1.52 to $2.72 per share                               -  $          -             -   $         -             -   $         -

Shares issued during the year upon conversion
  of warrants for cash at $.50 per share                    -             -             -             -             -             -

Shares issued during the year for cash at $.48 
  to $3.38 per share, less offering costs of 
  $2,033,286                                                -             -             -             -             -             -

Net loss for the year ended December 31, 1996               -             -             -             -             -             -
                                                  ------------  ------------  ------------  ------------  ------------  -----------
Balance, December 31, 1996                                  -             -             -             -             -             -

Shares issued for services at $3.75 to $5.31 
  per share                                                 -             -             -             -             -             -

Shares issued for services at $6.50 to 
  $8.38 per share                                           -             -             -             -             -             -

Warrants issued during the year for services                -             -             -             -             -             -

Shares issued upon the exercise of warrants
  for services at $2.00 per share                           -             -             -             -             -             -

Shares issued during the year for cash at 
  $2.50 per share                                           -             -             -             -             -             -

Warrants issued during the year in connection
  with the issuance of a convertible debenture
  and convertible preferred stock                           -             -             -             -             -             -

Shares issued upon conversion of convertible
  debenture to common shares                                -             -             -             -             -             -

Series B preferred shares issued for 
  extinguishment of convertible debenture at 
  $20 stated value per share                                -             -       108,911     2,178,213             -             -

Sale of Series C preferred shares and 
  warrants, less cash fees of $201,500                      -             -             -             -       187,500     2,948,500

Sale of Series B preferred shares for cash, 
  less cash fees of $145,000                                -             -       125,000     2,355,000             -             -

Capital contribution in connection with 
  put options                                               -             -             -             -             -             -

Beneficial conversion features of Series B 
  convertible debenture                                     -             -             -             -             -             -

Series A preferred shares issued upon 
  conversion of convertible debenture at 
  $3 per share                                        166,667       500,000             -             -             -             -

Conversion of Series B and Series C 
  preferred shares to common shares                         -             -      (206,411)   (4,828,488)       (2,500)      (62,772)

Shares issued during the year in connection 
  with exercise of options at $2.97 per share               -             -             -             -             -             -

Shares issued during the year in connection 
  with the exercise of warrants at $.50 
  per share                                                 -             -             -             -             -             -

Accretion of Series C preferred stock                       -             -             -             -             -       600,000

Dividends on preferred stock                                -       $     -             -     $ 962,934             -   $ 1,159,057

Net loss for the year ended December 31, 1997               -             -             -             -             -             - 
                                                  ------------  ------------  ------------  ------------  ------------  ------------
</TABLE>

<TABLE>
<CAPTION>

                                                             Series D                   Series E                         
                                                         Preferred Stock           Preferred Stock               Common Stock   
                                                         ---------------           ---------------         -----------------------
                                                     Shares        Amount        Shares         Amount       Shares        Amount
                                                  ------------  ------------  ------------  ------------  ------------  ------------
<S>                                               <C>           <C>           <C>           <C>           <C>           <C>


Shares issued during the year for finders' fees
  at $1.52 to $2.72 per share                               -   $         -             -   $         -       420,000   $        42
                                                                                                             
Shares issued during the year upon conversion             
  of warrants for cash at $.50 per share                    -             -             -             -        60,000             6
                                                         
Shares issued during the year for cash at $.48          
  to $3.38 per share, less offering costs of             
  $2,033,286                                                -             -             -             -    11,741,242         1,174
                                                         
Net loss for the year ended December 31, 1996               -             -             -             -             -             - 
                                                  ------------  ------------  ------------  ------------  ------------  ------------
Balance, December 31, 1996                                  -             -             -             -    41,626,563         4,163
                                                         
Shares issued for services at $3.75 to $5.31
  per share                                                 -             -             -             -        87,500             9
                                                        
Shares issued for services at $6.50 to                                                                         
  $8.38 per share                                           -             -             -             -       505,000            50
                                                                                                               
Warrants issued during the year for services                -             -             -             -             -             -
                                                                                                               
Shares issued upon the exercise of warrants               
  for services at $2.00 per share                           -             -             -             -       150,000            15
                                                         
Shares issued during the year for cash at                                                                      
  $2.50 per share                                           -             -             -             -       150,000            15
                                                                                                               
Warrants issued during the year in connection               
  with the issuance of a convertible debenture              
  and convertible preferred stock                           -             -             -             -             -             -
                                                            
Shares issued upon conversion of convertible                
  debenture to common shares                                -             -             -             -       145,747            15
                                                            
Series B preferred shares issued for                        
  extinguishment of convertible debenture at                
  $20 stated value per share                                -             -             -             -             -             -
                                                                  
Sale of Series C preferred shares and                                                                          
  warrants, less cash fees of $201,500                      -             -             -             -             -             -
                                                                                                               
Sale of Series B preferred shares for cash,               
  less cash fees of $145,000                                -             -             -             -             -             -
                                                                  
Capital contribution in connection with                                                                        
  put options                                               -             -             -             -             -             - 
                                                                                                               
Beneficial conversion features of Series B                      
  convertible debenture                                     -             -             -             -             -             -

Series A preferred shares issued upon                                                                          
  conversion of convertible debenture at                       
  $3 per share                                              -             -             -             -             -             -
                                                               
Conversion of Series B and Series C                            
  preferred shares to common shares                         -             -             -             -       804,065            80
                                                               
Shares issued during the year in connection                    
  with exercise of options at $2.97 per share               -             -             -             -        15,000             1
                                                               
Shares issued during the year in connection                
  with the exercise of warrants at $.50                     -             -             -             -       100,000            10
  per share                                               
                                                                                                               
Accretion of Series C preferred stock                       -             -             -             -             -             -
                                                                                                                                  
Dividends on preferred stock                                -       $     -             -       $     -             -    $        -

Net loss for the year ended December 31, 1997               -             -             -             -             -             -
                                                  ------------  ------------  ------------  ------------  ------------  ------------
</TABLE>

<TABLE>
<CAPTION>
                                                                                             Deficit        
                                                                               Deferred     Accumulated 
                                                    Additional                  Consult-     During the       
                                                      Paid-in   Outstanding       ing       Development   
                                                      Capital     Warrants      Expense        Stage          Total
                                                  ------------  ------------  ------------  ------------  ------------ 
<S>                                               <C>           <C>           <C>           <C>           <C>         


Shares issued during the year for finders' fees
  at $1.52 to $2.72 per share                         901,478   $         -   $         -   $         -   $   901,520
                                                                                                             
Shares issued during the year upon conversion             
  of warrants for cash at $.50 per share               29,994             -             -             -        30,000 
                                                         
Shares issued during the year for cash at $.48          
  to $3.38 per share, less offering costs of             
  $2,033,286                                       11,857,269             -             -             -    11,858,443 
                                                         
Net loss for the year ended December 31, 1996               -             -             -    (7,829,508)   (7,829,508)
                                                  ------------  ------------  ------------  ------------  ------------       
Balance, December 31, 1996                         26,107,473           360             -   (19,841,807)    6,270,189 
                                                         
Shares issued for services at $3.75 to $5.31
  per share                                           366,710             -             -             -       366,719 
                                                        
Shares issued for services at $6.50 to                                                                         
  $8.38 per share                                   3,426,202             -             -             -     3,426,252
                                                                                                               
Warrants issued during the year for services                -     1,165,500             -             -     1,165,500 
                                                                                                               
Shares issued upon the exercise of warrants               
  for services at $2.00 per share                     689,085      (389,100)            -             -       300,000 
                                                         
Shares issued during the year for cash at                                                                      
  $2.50 per share                                   1,256,235             -             -             -     1,256,250 
                                                                                                               
Warrants issued during the year in connection               
  with the issuance of a convertible debenture              
  and convertible preferred stock                           -     1,559,600             -             -     1,559,600 
                                                            
Shares issued upon conversion of convertible                
  debenture to common shares                          857,835             -             -             -       857,850 
                                                            
Series B preferred shares issued for                        
  extinguishment of convertible debenture at                
  $20 stated value per share                                -             -             -             -     2,178,213  
                                                                  
Sale of Series C preferred shares and                                                                          
  warrants, less cash fees of $201,500                      -       600,000             -             -     3,548,500
                                                                                                               
Sale of Series B preferred shares for cash,               
  less cash fees of $145,000                                -             -             -             -     2,355,000 
                                                                  
Capital contribution in connection with                                                                        
  put options                                         500,000             -             -             -       500,000 
                                                                                                               
Beneficial conversion features of Series B                      
  convertible debenture                               427,850             -             -             -       427,850 

Series A preferred shares issued upon                                                                          
  conversion of convertible debenture at                       
  $3 per share                                              -             -             -             -       500,000 
                                                               
Conversion of Series B and Series C                            
  preferred shares to common shares                 4,891,180             -             -             -             - 
                                                               
Shares issued during the year in connection                    
  with exercise of options at $2.97 per share          44,499             -             -             -        44,500 
                                                               
Shares issued during the year in connection                
  with the exercise of warrants at $.50                49,900             -             -             -        50,000 
  per share                                               
                                                                                                               
Accretion of Series C preferred stock                       -             -             -      (600,000)            - 
                                                                                                                      
Dividends on preferred stock                        $       -       $     -      $      -   $(2,121,991)    $       -

Net loss for the year ended December 31, 1997               -             -             -   (22,453,948)  (22,453,948)
                                                  ------------  ------------  ------------  ------------  ------------
</TABLE>

          See accompanying notes to consolidated financial statements.

                                      F-8

<PAGE>
                                Fonix Corporation
                          [A Development Stage Company]

                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>




                                                           Series A                   Series B                   Series C
                                                       Preferred Stock            Preferred Stock             Preferred Stock
                                                       ---------------            ---------------             ---------------
                                                     Shares       Amount        Shares        Amount        Shares        Amount
                                                  ------------  ------------  ------------  ------------  ------------  ------------
<S>                                               <C>           <C>           <C>           <C>           <C>           <C>
Balance, December 31, 1997                            166,667       500,000        27,500       667,659       185,000     4,644,785

Shares issued for debt costs at $1.44 per share             -             -             -             -             -             -

Options issued during the year for services                 -             -             -             -             -             -

Shares issued during the year for patent                    -             -             -             -             -             -

Warrants issued during the year for cash                    -             -             -             -             -             -

Shares issued upon the exercise of options
  and warrants                                              -             -             -             -             -             -

Shares issued during the year for cash at $4.50
  per share, less issuance costs of $1,033,846              -             -             -             -             -             -

Shares issued during the year in connection 
  with the acquisitions of AcuVoice, Articulate
  and Papyrus                                               -             -             -             -             -             -

Sale of Series D preferred shares, less 
  issuance costs of $546,154                                -             -             -             -             -             -

Sale of Series E preferred shares, less 
  issuance costs of $50,000                                 -             -             -             -             -             -

Exchange of Series D for Series E preferred
  stock                                                     -             -             -             -             -             -

Conversions of preferred stock to common 
  stock                                                     -             -       (27,500)     (676,190)     (185,000)   (4,767,913)

Shares issued in connection with the 
  relinquishment of a reset provision                       -             -             -             -             -             -

Expiration of warrants                                      -             -             -             -             -             -

Amortization of deferred consulting 
  expense                                                   -             -             -             -             -             -

Dividends on preferred stock                                -             -             -         8,531             -       123,128

Net loss for the year ended December 
  31, 1998                                                  -             -             -             -             -             -
                                                  ------------  ------------  ------------  ------------  ------------  ------------
Balance, December 31, 1998                            166,667     $ 500,000             -     $       -             -     $       -
                                                  ============  ============  ============  ============  ============  ============

</TABLE>

<TABLE>
<CAPTION>

                                                             Series D                   Series E                         
                                                         Preferred Stock           Preferred Stock               Common Stock   
                                                         ---------------           ---------------         -----------------------
                                                     Shares        Amount        Shares         Amount       Shares        Amount
                                                  ------------  ------------  ------------  ------------  ------------  ------------
<S>                                               <C>           <C>           <C>           <C>           <C>           <C>
Balance, December 31, 1997                                  -             -             -             -    43,583,875         4,358

Shares issued for debt costs at $1.44 per share             -             -             -             -        35,000             4

Options issued during the year for services                 -             -             -             -             -             -

Shares issued during the year for patent                    -             -             -             -        24,814             3

Warrants issued during the year for cash                    -             -             -             -             -             -

Shares issued upon the exercise of options
  and warrants                                              -             -             -             -       265,000            27

Shares issued during the year for cash at $4.50
  per share, less issuance costs of $1,033,846              -             -             -             -     4,000,000           400

Shares issued during the year in connection 
  with the acquisitions of AcuVoice, Articulate
  and Papyrus                                               -             -             -             -    10,944,081         1,094

Sale of Series D preferred shares, less
  issuance costs of $546,154                          500,000    10,453,846             -             -             -             -

Sale of Series E preferred shares, less 
  issuance costs of $50,000                                 -             -       100,000     1,950,000             -             -

Exchange of Series D for Series E preferred
  stock                                              (150,000)   (3,079,167)      150,000     3,079,167             -             -

Conversions of preferred stock to common 
  stock                                                     -             -      (114,928)   (2,777,292)    4,081,234           407)

Shares issued in connection with the 
  relinquishment of a reset provision                 608,334    11,166,668             -             -     1,390,476           139

Expiration of warrants                                      -             -             -             -             -             -

Amortization of deferred consulting 
  expense                                                   -             -             -             -             -             -

Dividends on preferred stock                                -     3,659,579             -     1,006,011             -             -

Net loss for the year ended December 
  31, 1998                                                  -             -             -             -             -             -
                                                  ------------  ------------  ------------  ------------  ------------  ------------
Balance, December 31, 1998                          1,008,334   $22,200,936       135,072    $3,257,886   $64,324,480     $   6,432
                                                  ============  ============  ============  ============  ============  ============

</TABLE>

<TABLE>
<CAPTION>
                                                                                             Deficit        
                                                                               Deferred     Accumulated 
                                                    Additional                  Consult-     During the       
                                                      Paid-in   Outstanding       ing       Development   
                                                      Capital     Warrants      Expense        Stage          Total
                                                  ------------  ------------  ------------  ------------  ------------ 
<S>                                               <C>           <C>           <C>           <C>           <C>         

Balance, December 31, 1997                         38,637,059     2,936,360             -   (45,017,746)    2,372,475

Shares issued for debt costs at $1.44 per share        50,310             -             -             -        50,314

Options issued during the year for services           320,100             -      (320,100)            -             -

Shares issued during the year for patent              100,804             -             -             -       100,807

Warrants issued during the year for cash                    -       472,928             -             -       472,928

Shares issued upon the exercise of options 
  and warrabnts                                       505,333           360)            -             -       505,000

Shares issued during the year for cash at $4.50
  per share, less issuance costs of $1,033,846     16,965,754             -             -             -    16,966,154

Shares issued during the year in connection with
  the acquisitions of AcuVoice, Articulate
  and Papyrus                                      28,686,933             -             -             -    28,688,027

Sale of Series D preferred shares, less 
  issuance costs of $546,154                                -             -             -             -    10,453,846

Sale of Series E preferred shares, less 
  issuance costs of $50,000                                 -             -             -             -     1,950,000

Exchange of Series D for Series E 
  preferred stock                                           -             -             -             -             -

Conversions of preferred stock to common stock      8,220,988             -             -             -             -

Shares issued in connection with the 
  relinquishment of a reset provision              (5,055,240)            -             -             -     6,111,577

Expiration of warrants                                 85,670       (85,670)            -             -             -

Amortization of deferred consulting expense                 -             -       213,400             -       213,400

Dividends on preferred stock                                -             -             -    (4,797,249)            -

Net loss for the year ended December 31, 1998               -             -             -   (43,118,782)  (43,118,782)
                                                  ------------  ------------  ------------  ------------  ------------ 
Balance, December 31, 1998                        $88,517,711    $3,323,258     $(106,700) $(92,933,777) $ 24,765,746
                                                  ============  ============  ============  ============ ============= 

</TABLE>

          See accompanying notes to consolidated financial statements.

                                      F-9
<PAGE>
                                Fonix Corporation
                          [A Development Stage Company]

                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                Increase (Decrease) in Cash and Cash Equivalents
<TABLE>
<CAPTION>

                                                                                                                       October 1, 
                                                                                                                         1993     
                                                                                Years Ended December 31,             (Inception) to
                                                                   ----------------------------------------------      December 31,
                                                                        1998              1997            1996           1998
                                                                   ---------------   -------------   -------------   --------------
<S>                                                                <C>               <C>             <C>             <C>   
Cash flows from operating activities:                     
     Net loss                                                      $  (43,118,782)   $(22,453,948)   $ (7,829,508)   $ (85,414,537)
     Adjustments to reconcile net loss to net cash
       used in operating activities:
        Issuance of common stock for services                              50,314       4,112,970         901,520        5,487,554
        Issuance of common stock for patent                               100,807              --              --          100,807
        Non-cash expense related to issuance of debentures,
          warrants, preferred and common stock                          6,111,577       3,967,337              --       10,078,914
        Non-cash compensation expense related to issuance
          of stock options                                                213,400              --              --        2,496,300
        Non-cash expense related to issuance of notes payable
           and accrued expense for services                               857,000              --              --          857,000
        Non-cash exchange of notes receivable for services                150,000              --              --          150,000
        Non-cash portion of purchased in-process research and 
          development                                                  13,136,000              --              --       13,136,000
        Write-off of assets received in acquisition                            --              --              --            1,281
        Depreciation and amortization                                   3,285,845         405,209          83,183        3,775,454
        Extraordinary loss on extinguishment of debt                           --         881,864              --          881,864
        Extraordinary gain on forgiveness of debt                              --              --              --          (30,548)
        Changes in assets and liabilities, net of effects 
         of acquisitions:
          Accounts receivable                                            (148,498)             --              --         (148,498)
          Employee advances                                               (67,231)             --              --          (67,231)
          Interest and other receivables                                    9,436         142,724        (131,419)          (5,483)
          Inventory                                                       (20,221)             --              --          (20,221)
          Prepaid assets                                                  (15,372)        (27,922)         (4,172)         (47,466)
          Other assets                                                    (80,198)         (8,735)        (30,912)        (119,845)
          Accounts payable                                              2,941,898         128,638          42,702        5,013,736
          Accrued liabilities                                               8,189        (922,367)         83,053          641,789
          Accrued liabilities - related party                            (311,743)         47,759       1,500,918          147,759
          Deferred revenues                                                81,266              --              --           81,266
                                                                   ---------------   -------------   -------------   --------------
        Net cash used in operating activities                         (16,816,313)    (13,726,471)     (5,384,635)     (43,004,105)
                                                                   ---------------   -------------   -------------   --------------

Cash flows from investing activities, net of effects of 
  acquisitions:
     Acquisition of subsidiaries, net of cash acquired                (15,323,173)             --              --      (15,323,173)
     Purchase of property and equipment                                (1,305,091)       (671,401)     (1,311,236)      (3,336,470)
     Investment in intangible assets                                           --        (107,281)        (33,126)        (164,460)
     Issuance of notes receivable                                        (745,000)     (1,483,600)       (963,106)      (3,228,600)
     Payments received on notes receivable                                     --       1,883,600              --        1,883,600
                                                                   ---------------   -------------   -------------   --------------
        Net cash used in investing activities                         (17,373,264)       (378,682)     (2,307,468)     (20,169,103)
                                                                   ---------------   -------------   -------------   --------------

Cash flows from financing activities:
     Bank overdraft                                                       138,034              --              --          138,034
     Net proceeds from revolving note payable                           1,376,671       2,234,914      10,759,836       19,988,943
     Net proceeds (payments) from revolving note 
       payable - related parties                                         (469,869)        551,510              --           81,641
     Proceeds from other notes payable                                    560,000              --              --        2,911,667
     Payments on other notes payable                                           --              --              --       (1,779,806)
     Principal payments on capital lease obligation                       (49,325)        (43,381)             --          (92,706)
     Proceeds from issuance of convertible debentures, net                     --       2,685,000              --        3,185,000
     Proceeds from sale of warrants                                       472,928         600,000              --        1,072,928
     Proceeds from sale of common stock, net                           17,471,155         469,500      11,888,443       38,175,700
     Proceeds from sale of preferred stock, net                        12,403,846       5,303,500              --       17,707,346
     Proceeds from sale of common stock and related 
       repricing rights subject to redemption, net                      1,830,000              --              --        1,830,000
                                                                   ---------------   -------------   -------------   --------------
        Net cash provided by financing activities                      33,733,440      11,801,043      22,648,279       83,218,747
                                                                   ---------------   -------------   -------------   --------------

Net (decrease) increase in cash and cash equivalents                     (456,137)     (2,304,110)     14,956,176       20,045,539

Cash and cash equivalents at beginning of period                       20,501,676      22,805,786       7,849,610               --
                                                                   ---------------   -------------   -------------   --------------

Cash and cash equivalents at end of period                         $   20,045,539    $ 20,501,676    $ 22,805,786    $  20,045,539
                                                                   ==============    =============   =============   ==============

</TABLE>

          See accompanying notes to consolidated financial statements.

                                      F-10

<PAGE>
                               Fonix Corporation
                         [A Development Stage Company]


               CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)

Supplemental disclosure of cash flow information:

<TABLE>
<CAPTION>
                                                                                                    October 1, 
                                                                                                       1993      
                                                              Years Ended December 31,             (Inception) to
                                                 -----------------------------------------------    December 31, 
                                                      1998            1997             1996           1998
                                                 -------------    -------------    -------------   --------------
<S>                                              <C>              <C>              <C>             <C>
   Cash paid during the period for interest      $  1,392,987     $  1,148,553     $    638,302    $   3,430,006

</TABLE>

Supplemental Schedule of Non-cash Investing and Financing Activities:

     For the Year Ended December 31, 1998:

     Preferred  stock  dividends  of  $3,461,543  were  recorded  related to the
     beneficial conversion features of convertible preferred stock.

     Preferred stock dividends of $335,706 were accrued on convertible preferred
     stock.

     A total of  27,500  shares  of  Series B  convertible  preferred  stock and
     related  dividends of $8,531 were  converted  into 193,582 shares of common
     stock.

     A total of  185,000  shares of  Series C  convertible  preferred  stock and
     related  dividends of $123,129  were  converted  into  1,295,919  shares of
     common stock.

     TheCompany  issued  1,390,476  shares of common stock and 608,334 shares of
     Series D 4% convertible preferred stock in connection with the cancellation
     of an existing reset  provision and costs  associated  with the issuance of
     Series D 4% convertible preferred stock.

     Preferred  stock  dividends  of  $1,000,000  were  recorded  related to the
     issuance  of  1,390,476  common  shares and  608,334  shares of Series D 4%
     convertible  preferred  stock in  connection  with the  cancellation  of an
     existing reset provision.

     The Company exchanged  150,000 shares of Series D 4% convertible  preferred
     stock for 150,000 shares of Series E 4% convertible preferred stock.

     A total of  114,928  shares of  Series E  convertible  preferred  stock and
     related dividends of $15,969 were converted into 2,591,733 shares of common
     stock.

     The Company issued  2,692,216 shares of common stock (having a market value
     of $16,995,972) in connection with the acquisition of AcuVoice, Inc.

     The Company issued  5,140,751 shares of common stock (having a market value
     of  $8,353,720)  and notes payable of  $4,747,339  in  connection  with the
     acquisition of Articulate Systems, Inc.

     The Company issued  3,111,114 shares of common stock (having a market value
     of  $3,208,336)  and notes payable of  $1,710,000  in  connection  with the
     acquisition of Papyrus.

     The  Company  issued  notes  payable of  $348,145  in  connection  with the
     acquisition of certain assets of The MRC Group, Inc.


     For the Year Ended December 31, 1997:

     A $500,000 Series A convertible debenture was converted into 166,667 shares
     of Series A preferred stock.

     Series B  convertible  debentures  in the amount of  $850,000  and  related
     accrued  interest of $7,850 were  converted  into 145,747  shares of common
     stock.

     Series B convertible  debentures  in the amount of  $2,150,000  and related
     accrued  interest of $28,213 were converted into 108,911 shares of Series B
     convertible preferred stock.

     Dividends of $2,721,991 were recorded related to the beneficial  conversion
     features  and  accretion  of Series B and  Series C  convertible  preferred
     stock.

     206,411  shares  of  Series  B  convertible  preferred  stock  and  related
     dividends of $13,422 were converted into 786,867 shares of common stock.

     2,500 shares of Series C convertible  preferred stock and related dividends
     of $472 were converted into 17,198 shares of common stock.

     Accounts  payable of $144,931 was converted into a capital lease obligation
     of the same amount.

     For the Year Ended December 31, 1996:

     The Company issued 420,000 shares of common stock to unrelated  parties for
     finders' fees of $901,520.

          See accompanying notes to consolidated financial statements.

                                      F-11

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1.  NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES

Nature  of  Operations  -The  Company's  primary  focus  to date  has  been  the
development  of its  human  computer  interface  technologies  including:  sound
recognition  engine,  neural  network,  audio  signal  processor,   and  command
processing  engine  for use in its core  automated  speech  recognition  ("ASR")
technologies  and the development of its  text-to-speech  ("TTS")  technologies,
handwriting   recognition   technologies,   and  speech   embedded   and  speech
verification   technologies.   The   Company   is  also   developing   pen-voice
technologies,  a combination of handwriting  and ASR. The Company has received a
patent  and  continues  to seek  additional  United  States and  foreign  patent
protection  for  various  aspects  of its  technologies  through  the  filing of
domestic and  international  applications.  The U.S. Patent and Trademark Office
issued the initial patent to the Company  describing 36 claims on June 17, 1997.
Additionally,  Fonix has acquired other patents and has filed additional  patent
applications.  The Company  licenses  its  technologies  to and has entered into
co-development relationships and strategic alliances with third parties that are
participants  in  the  computer  and  electronic  devices  industry   (including
producers  of   application   software,   operating   systems,   computers   and
microprocessor  chips)  or are  research  and  development  entities,  including
academia and industrial and commercial  speech product  developers.  The Company
intends for the  foreseeable  future to continue  this practice and will seek to
generate  revenues  from  its  proprietary   technologies  from  product  sales,
licensing  royalties and strategic  partnerships  and  alliances.  To date,  the
Company  has  entered  into a strategic  partnership  and one license  agreement
relating to its ASR  technologies.  The Company generated its first revenue from
its ASR  technologies in February 1998 under a license  agreement (see Note 13).
Additionally,  in 1998, the Company  recorded minimal revenues from sales of its
TTS  technologies  and  PowerScribe  medical  speech  recognition  and dictation
products.  Although the Company has completed  development of the key components
of its core  technologies,  there can be no assurance that Fonix will be able to
sell,  license or otherwise market its technologies to third parties in order to
generate  sufficient  recurring revenues to pay its operating costs and complete
the development of its technologies.

Fonix  Corporation  (known as Taris,  Inc.  prior to its  acquisition  of Phonic
Technologies,  Inc., as described below) (the "Company") was organized under the
laws of the state of Delaware on September  12, 1985.  Taris,  Inc. was a public
company with no  operations.  Prior to June 17,  1994,  Taris,  Inc.  effected a
reverse stock split of one share for ninety  shares.  The  financial  statements
have been adjusted to reflect the stock split as though it had happened  January
1, 1993. Phonic Technologies, Inc. ("PTI"), a Utah corporation and the Company's
predecessor  in interest with respect to some of the Company's  technology,  was
organized on October 1, 1993 (the  Company's  date of inception) for the purpose
of developing proprietary ASR technologies.  On June 17, 1994, Fonix Corporation
("Fonix")  entered  into a  merger  agreement  with  PTI  whereby  Fonix  issued
10,395,249  shares of its common  stock for all of the  issued  and  outstanding
common shares of PTI. Upon completion of the merger,  PTI stockholders  owned in
excess of 90 percent of the outstanding  common stock of Fonix.  The transaction
was accounted for as a reverse  acquisition  as though PTI acquired  Fonix.  The
financial  statements,  therefore,  reflect  the  operations  of Fonix since the
acquisition on June 17, 1994 and PTI since October 1, 1993.

Development  Stage  Presentation  - Fonix is a development  stage  company.  The
Company  generated  revenues of  $2,889,684  and  incurred  net losses  totaling
$43,118,782  for the year ended  December  31,  1998.  The Company has  incurred
cumulative  losses of $85,414,537  for the period from inception to December 31,
1998. The Company has an accumulated  deficit of $92,933,777,  negative  working
capital of $14,678,975,  demand and other notes currently due of $29,438,218 (of
which $1,335,030 is due upon demand or is in default) and $1,965,490 of accounts
payable over 60 days past due as of December 31, 1998. The net loss for 1998 and
the  accumulated  deficit as of December 31, 1998 include  charges of $9,315,000
and  $3,821,000  related to the  Company's  acquisition  of  in-process  product
research and development in connection with its  acquisitions of AcuVoice,  Inc.
and Articulate Systems, Inc.,  respectively.  Although the Company generated its
first  revenue in  February  1998,  the  Company  expects to  continue  to incur
significant  losses  through  at  least  December  31,  1999,  primarily  due to
significant   expenditure   requirements   associated  with  the  marketing  and
development of its proprietary ASR and related  technologies.  These factors, as
well as the risk factors set out  elsewhere in the  Company's  Annual  Report on
Form 10-K, raise  substantial doubt about the Company's ability to continue as a
going  concern.  The  accompanying  financial  statements  do  not  include  any
adjustments that might result

                                      F-12

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


from the outcome of this uncertainty. Management plans to fund the operations of
the Company  through  proceeds from sales of debt and equity  securities and, if
necessary,  the sale of certain of its technologies  (see Note 20). There can be
no assurance that management's plans will be successful.

Consolidation - The accompanying  consolidated  financial statements include the
accounts  of the  Company  and its  wholly  owned  subsidiaries,  Fonix  Systems
Corporation,  Fonix/AcuVoice,  Inc.,  Fonix/Articulate,  Inc. and Fonix/Papyrus,
Inc. All significant intercompany balances and transactions have been eliminated
in consolidation.

Cash and Cash Equivalents - The Company  considers all highly liquid  short-term
investments with a maturity of three months or less to be cash equivalents.

Inventory  -  Inventory,   consisting   primarily  of  microphones  and  related
accessories,  is stated at the lower of cost  (first-in,  first -out  method) or
market value.

Property and Equipment - Property and equipment are stated at cost. Depreciation
is computed for financial  statement purposes on a straight-line  basis over the
estimated useful lives of the assets as follows:

         Furniture and fixtures         5 years             
         Computer equipment             3 to 5 years        
         Leasehold improvements         18 months to 8 years
                                        
Leasehold  improvements are amortized over the shorter of the useful life of the
applicable  asset or the  remaining  lease  term.  Maintenance  and  repairs are
charged to expense as incurred and major improvements are capitalized.  Gains or
losses on sales or retirements  are included in the  consolidated  statements of
operations in the year of disposition.

Intangible  Assets - Intangible assets consist of the purchase cost of completed
technology and goodwill in connection with the  acquisitions of AcuVoice,  Inc.,
Articulate Systems, Inc., Papyrus Development  Corporation,  Papyrus Associates,
Inc.  and certain  assets of The MRC Group,  Inc.  (see Note 2) and direct costs
incurred by the  Company in applying  for  patents  covering  its  technologies.
Amortization  is computed on a  straight-line  basis over the  estimated  useful
lives of the  completed  technology,  goodwill and patents  ranging from five to
eight years.  The patent covering the Company's core  technologies is pledged as
collateral  for repayment of the Company's  Series C 5 % Convertible  Debentures
that were issued subsequent to December 31, 1998 (see Note 20).

Revenue  Recognition - The Company  recognizes  revenues in accordance  with the
provisions of Statement of Position No. 97-2,  "Software  Revenue  Recognition".
The  Company  generates  revenues  from  licensing  the  rights to its  software
products to end users and from  royalties.  The Company also  generates  service
revenues from the sale of consulting and development services.

Revenues from software  license  agreements are recognized  upon shipment of the
software if there are no significant post delivery obligations. If post delivery
obligations exist,  revenues are recognized upon customer  acceptance.  Revenues
from   development   and  consulting   services  are  recognized  upon  customer
acceptance.

Cost of revenues consists of costs to distribute the product (including the cost
of the  media on which it is  delivered),  installation  and  support  personnel
salaries and licensed technology and related costs.

Research and  Development - All  expenditures  for research and  development are
charged to  expense  as  incurred.  The  Company  incurred  total  research  and
development  expenses of  $13,620,748,  $7,066,294  and $4,758,012 for the years
ended  December  31, 1998,  1997 and 1996,  respectively.  The Company  expensed
$13,136,000 of research and

                                      F-13

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


development  costs  purchased in connection  with the  acquisitions of AcuVoice,
Inc. and Articulate Systems, Inc. (see Note 2).

Income Taxes - The Company recognizes  deferred income tax assets or liabilities
for the expected future tax  consequences of events that have been recognized in
the financial statements or tax returns. Under this method,  deferred income tax
assets or  liabilities  are  determined  based upon the  difference  between the
financial and income tax bases of assets and liabilities using enacted tax rates
expected to apply when differences are expected to be settled or realized.

Concentration  of Credit Risks - The  Company's  cash and cash  equivalents  are
maintained in bank deposit accounts which exceed federally  insured limits.  The
Company  has not  experienced  any losses  with  respect to these  deposits  and
believes  it is not  exposed  to any  significant  credit  risk on cash and cash
equivalents. In the normal course of business, the Company provides credit terms
to its customers.  Accordingly, the Company performs on-going credit evaluations
of its  customers  and  maintains  allowances  for possible  losses,  which when
realized, have been within the range of management's expectations.

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

Fair Value of Financial  Instruments - The book value of the Company's financial
instruments  approximates  fair  value.  The  estimated  fair  values  have been
determined using appropriate market information and valuation methodologies.

Net Loss Per Common  Share - Basic and  diluted  net loss per  common  share are
calculated  by dividing  net loss  attributable  to common  stockholders  by the
weighted average number of shares of common stock  outstanding  during the year.
At  December  31,  1998,  1997 and 1996,  there were  outstanding  common  stock
equivalents to purchase  38,319,638,  13,395,948 and 2,450,000  shares of common
stock,  respectively,  that were not included in the  computation of diluted net
loss per common  share as their effect  would have been  anti-dilutive,  thereby
decreasing the net loss per common share.



The following table is a  reconciliation  of the net loss numerator of basic and
diluted net loss per common share for the years ended  December  31, 1998,  1997
and 1996.

                                      F-14

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>

                                                       1998                           1997                         1996            
                                           ----------------------------    ----------------------------   ------------------------
                                                             Loss                            Loss                         Loss
                                                Loss         Per Share           Loss       Per Share        Loss       Per Share
                                           --------------    ---------     --------------   ---------     ------------  ---------
<S>                                         <C>              <C>            <C>             <C>           <C>           <C>
Loss before extraordinary item             $ (43,118,782)                   $(21,572,084)                 $(7,829,508)
Preferred stock dividends                     (4,797,249)                     (2,721,991)                        -        
                                           --------------                  --------------                 ------------
Loss attributable to common                                                                                            
    stockholders before extraordinary                                                                                  
    items                                    (47,916,031)     $(0.91)        (24,294,075)   $(0.57)        (7,829,508)   $(0.21) 
Extraordinary items:                                                                                                               
    Loss on extinguishment of debt                     -           -            (881,864)    (0.02)                 -         -    
                                           --------------    ----------    --------------   ----------    ------------   ---------
Net loss attributable to common                                                                                                    
        stockholders                        $(47,916,031)     $(0.91)       $(25,175,939)   $(0.59)       $(7,829,508)   $(0.21) 
                                           ==============    ==========    ==============   ==========    ============   =========
Weighted average common shares                                                                                         
         outstanding                           52,511,185                    42,320,188                    36,982,610 
                                           ==============                  ==============                 ============            
</TABLE>

Recently Enacted  Accounting  Standards - Effective January 1, 1998, the Company
adopted Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
Comprehensive  Income." This statement  established  standards for reporting and
display of comprehensive income and its components in financial statements.  The
adoption of this statement had no effect on the Company's consolidated financial
statement presentation.

In June 1997,  the  Financial  Accounting  Standards  Board issued SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related  Information." SFAS No.
131 established new standards for public companies to report  information  about
their  operating  segments,  products and services,  geographic  areas and major
customers.  The Company has adopted SFAS No. 131  beginning  with the year ended
December 31, 1998 (see Note 19).

In June 1998,  the  Financial  Accounting  Standards  Board issued SFAS No. 133,
"Accounting for Derivative  Instruments and Hedging  Activities." This statement
establishes   accounting  and  reporting  standards  requiring  that  derivative
instruments  be recorded in the  balance  sheet as either an asset or  liability
measured at its fair value and that  changes in the  derivative's  fair value be
recognized  currently in earnings unless specific hedge accounting  criteria are
met. SFAS No. 133 is effective for fiscal years  beginning  after June 15, 1999.
The adoption of this statement in not expected to have a material  effect on the
Company's  consolidated  financial  statements as the Company does not currently
hold any derivative or hedging instruments.

2.  ACQUISITIONS

AcuVoice,  Inc. - In March 1998, the Company  created a wholly owned  subsidiary
(Fonix/AcuVoice,  Inc.) that  acquired  AcuVoice,  Inc.  ("AcuVoice").  AcuVoice
developed  and marketed TTS  technologies  and products  directly to  end-users,
systems  integrators  and  original  equipment  manufacturers  for  use  in  the
telecommunications,  multi-media,  education and assistive  technology  markets.
These same products and services are now provided by the  Company's  Interactive
Technologies  Solutions Group. The Company issued 2,692,216 shares of restricted
common stock (having a market value of  $16,995,972  on that date) and paid cash
of  approximately  $8,000,000 for all of the then  outstanding  common shares of
AcuVoice. The acquisition was accounted for as a purchase.

Of the  2,692,216  shares of stock  issued,  80,000 shares were placed in escrow
against which any claims for breach of warranty against the former  shareholders
of AcuVoice  could be asserted by the Company.  On March 12,  1999,  the Company
submitted a claim for the shares  deposited into the escrow account based on the
Company's assertion of

                                      F-15

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


misrepresentations  made to the Company (see Note 16). The shares held in escrow
have been excluded from the  calculation  of basic net loss per common share for
the year ended December 31,1998.

The purchase price  allocations to tangible  assets  included  $253,881 of cash,
$13,728  of  accounts  receivable,  $9,902 of fixed  assets  and $800 of prepaid
expenses. The purchase price allocations to liabilities assumed included $22,929
of accounts payable and accrued expenses and $599,250 of notes payable.

The excess of the  purchase  price over the  estimated  fair market value of the
acquired  tangible net assets of AcuVoice was $25,339,840,  of which $11,192,000
was capitalized as the purchase cost of the completed technology, $4,832,840 was
capitalized  as goodwill and  $9,315,000  was  expensed as purchased  in-process
research and development.

The valuation of the acquired in-process research and development included,  but
was not  limited to, an analysis  of (1) the market for  AcuVoice  products  and
technologies;  (2) the completion costs for the projects;  (3) the expected cash
flows  attributed to the projects;  and (4) the risks  associated with achieving
such cash flows.  The  assumptions  used in valuing the in-process  research and
development  were based upon  assumptions the Company  believed to be reasonable
but which are inherently uncertain and unpredictable.  For these reasons, actual
results may vary from projected results.

Articulate  Systems,  Inc.  - In  1998,  the  Company  created  a  wholly  owned
subsidiary   ("Fonix/Articulate")   that  acquired  Articulate   Systems,   Inc.
("Articulate")  in September  1998.  Articulate was a provider of  sophisticated
voice recognition  products to specialized segments of the health care industry.
These same  products and services are now provided by the  Company's  HealthCare
Solutions Group.  The Company  delivered  5,140,751 shares of restricted  common
stock  (having a market  value of  $8,353,720  on that date),  a cash payment of
$7,787,249  and 8.5 percent  demand notes in the aggregate  amount of $4,747,339
for all the then  outstanding  common shares of  Articulate.  Additionally,  the
Company issued 98,132 stock options in exchange for all Articulate stock options
outstanding on the date of acquisition at an exchange rate based on the relative
fair value of the  companies'  stocks.  The estimated  fair value of the options
issued was $130,000 using the  Black-Scholes  option pricing model with weighted
average  assumptions  of a risk-free  rate of 5.1 percent,  expected life of 2.5
years,  expected  volatility of 85 percent and an expected  dividend  yield of 0
percent.  Subsequent  to the  acquisition,  the  Company  agreed to pay  several
Articulate  employees  incentive  compensation  for continued  employment in the
aggregate  amount of $857,000.  The Company  issued 8.5 percent demand notes for
$452,900 and  recorded an accrued  liability of $404,100 for the balance of this
obligation.  The demand notes issued to both the Articulate stockholders and the
Articulate  employees  were  payable  after  November  1, 1998 (see Note 7). The
$404,100  accrued  liability  is  payable on or before  January  31,  1999.  The
Articulate acquisition was accounted for as a purchase.

Of the 5,140,751  shares of common stock issued,  315,575  shares were placed in
escrow  against  which any  claims  for breach of  warranty  against  the former
shareholders of Articulate could be asserted by the Company and 1,985,000 shares
were placed in escrow to be converted to a new class of non-voting  common stock
upon approval of the  establishment of such a class of stock by the shareholders
of the  Company.  The  shares  held  in  escrow  have  been  excluded  from  the
calculation  of basic  net loss per  common  share for the year  ended  December
31,1998.

The purchase price  allocations to tangible  assets  included  $286,954 of cash,
$62,835  of  accounts  receivable,  $57,165  of  inventory,  $14,043  of prepaid
expenses  and  $117,540 of fixed  assets.  The  purchase  price  allocations  to
liabilities  assumed included $310,008 of accounts payable and accrued expenses,
$1,900,000 of notes payable and $929,690 of deferred revenue.

The excess of the  purchase  price over the  estimated  fair market value of the
acquired tangible net assets of Articulate was $23,584,256, of which $13,945,000
was  capitalized  as the purchase cost of completed  technology,  $5,818,256 was
capitalized  as goodwill and other  intangibles  and  $3,821,000 was expensed as
purchased in-process research and development.


                                      F-16

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


The valuation of the acquired in-process research and development included,  but
was not limited to, an analysis of (1) the market for  Articulate  products  and
technologies;  (2) the completion costs for the projects;  (3) the expected cash
flows  attributed to the projects;  and (4) the risks  associated with achieving
such cash flows.  The  assumptions  used in valuing the in-process  research and
development  were based upon  assumptions the Company  believed to be reasonable
but which are inherently uncertain and unpredictable.  For these reasons, actual
results may vary from projected results.

Papyrus Associates,  Inc. and Papyrus Development Corporation - In October 1998,
the  Company  created  a wholly  owned  subsidiary  (Fonix/Papyrus,  Inc.)  that
acquired Papyrus Associates,  Inc. ("PAI"), and Papyrus Development  Corporation
("PDC")  (together with PAI, "Papyrus").  PAI developed,  marketed and supported
printing and cursive  handwriting  recognition  software for  "personal  digital
assistants", pen tablets and mobile phones under the trademark, Allegro(TM). PDC
was a systems integration  provider with expertise and intellectual  property in
imbedded  systems and enhanced  Internet  applications.  These same products and
services are now provided by the Company's  Interactive  Technologies  Solutions
Group. The Company issued 3,111,114 shares of restricted  common stock (having a
market  value of  $3,208,336  on that  date) and  promissory  notes  aggregating
$1,710,000  with due dates from  February 28, 1999 to September 30, 1999 for all
of the then outstanding common shares of PAI and PDC.

Of the 3,111,114  shares of common stock issued,  311,106  shares were placed in
escrow  against  which any  claims  for breach of  warranty  against  the former
shareholders  of Papyrus  could be asserted by the  Company.  The shares held in
escrow  have been  excluded  from the  calculation  of basic net loss per common
share for the year ended December 31, 1998. The acquisition was accounted for as
a purchase.

The purchase price  allocation to tangible assets  included  $10,342 of cash and
$7,629 of accounts  receivable.  The purchase  price  allocation to liabilities
assumed  included  $118,293 of accounts  payable  and accrued  liabilities.  The
excess  of the  purchase  price  over the  estimated  fair  market  value of the
acquired  tangible net assets of Papyrus was $5,018,658  and was  capitalized as
goodwill.

The Company  incurred  $821,197 in research and development  expenses related to
services performed by Papyrus prior to the date of the acquisition.

The MRC Group,  Inc. - On December 31, 1998, the Company acquired certain assets
of The MRC  Group,  Inc.  ("MRC")  relating  to  MRC's  selling,  marketing  and
servicing of the PowerScribe(R)  products.  In consideration for the assets, the
Company  agreed  to pay MRC  $219,833  less  certain  amounts  then  owed to the
Company,  plus  $133,333  per  month for each of the  three  months  immediately
following the closing,  less certain  credits.  Subsequent to December 31, 1998,
the remaining amounts owing related to this acquisition are $216,666.

The purchase price  allocations to tangible assets included $142,852 of accounts
receivable  and $40,000 of fixed  assets.  The  purchase  price  allocations  to
liabilities  assumed  included  $311,588  of accrued  expenses  and  $849,742 of
deferred revenue. Additionally,  $152,839 of accounts receivable and $987,531 of
deferred revenue from Articulate were eliminated in purchase accounting.

The excess of the  purchase  price over the  estimated  fair market value of the
acquired  tangible  net  assets of MRC was  $314,761  which was  capitalized  as
goodwill.

Proforma Financial  Statement Data - The following unaudited pro forma financial
statement  data for the years  ended  December  31,  1998 and 1997  present  the
results  of  operations  of the  Company  as if the  acquisitions  of  AcuVoice,
Articulate and Papyrus had occurred at the beginning of each year. The pro forma
results have been prepared for  comparative  purposes only and do not purport to
be indicative of future results or what would have occurred had the acquisitions
been made at the beginning of the applicable year. Purchased in-process research
and development  expenses related to the acquisitions of AcuVoice and Articulate
of $9,315,000  and  $3,821,000,  respectively,  were recorded at the date of the
acquisitions  and  are  not  presented  in the  following  unaudited  pro  forma
financial statement data since they

                                      F-17

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


are non-recurring charges directly attributable to the acquisitions. The results
of  operations  of MRC are not  included in the  unaudited  pro forma  financial
statement data as the acquisition did not constitute the purchase of a business.


                                            For the Year  Ended December 31,
                                            ---------------------------------
                                                 1998              1997      
                                            --------------    ---------------

   Revenues                                 $   3,493,460     $    2,055,419

   Loss before extraordinary items            (36,131,670)       (21,360,635)

   Net loss                                   (36,131,670)       (22,242,499)

   Basic and diluted net loss per 
      common share                                  (0.64)             (0.49)

3.  CERTIFICATE OF DEPOSIT

At December 31, 1998 and 1997, the Company  maintained a $20,000,000  short-term
certificate of deposit at a bank which is included in cash and cash equivalents.
The  certificate  bore  interest at 4.0 percent and 5.5 percent at December  31,
1998 and 1997, respectively.  Interest was payable monthly. This certificate was
pledged as  collateral  on a revolving  note payable (see Note 6). On January 8,
1999, this certificate of deposit matured and was not renewed. Proceeds from the
certificate were applied to reduce the related revolving note payable balance.

4.  NOTES RECEIVABLE

At December  31,  1998,  the Company had a note  receivable  from a research and
development  entity in the amount of  $20,000  which was  repaid  subsequent  to
December 31, 1998.

As of December 31, 1998,  the Company had a six percent  short-term,  unsecured,
demand note receivable from an unrelated entity in the amount of $225,000, which
note was issued in connection  with the Company's  intended  acquisition  of the
entity.  Because the  acquisition  was not pursued,  subsequent  to December 31,
1998, the Company demanded and received payment of the $225,000 note.

At December  31, 1997,  the Company had a  short-term,  unsecured,  non-interest
bearing note receivable  from AcuVoice in the amount of $500,000.  When AcuVoice
was acquired  effective  March 13, 1998,  this note receivable was eliminated in
connection with the acquisition. Additionally, at December 31, 1997, the Company
had a short-term,  unsecured, demand note receivable from an unrelated entity in
the amount of  $100,000.  During  1998,  the  Company  determined  this note was
uncollectible and expensed the related amount.

5.  PROPERTY AND EQUIPMENT

Property and equipment consisted of the following at December 31, 1998 and 1997:

                                             1998           1997
                                         ------------    ------------
    Computer equipment                    $2,463,208      $1,321,016    
    Furniture and fixtures                   854,050         640,992 
    Leasehold improvements                   206,144          69,371  
                                         ------------    ------------
    Less accumulated depreciation          3,523,402       2,031,379 
       and amortization                   (1,195,390)       (464,100) 
                                         ------------    ------------
    Net property and equipment            $2,328,012      $1,567,279  
                                         ============    ============

                                      F-18

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                                      
6.  REVOLVING AND OTHER NOTES PAYABLE

At December  31, 1998 and 1997,  the Company had a revolving  note  payable to a
bank in the amount of  $19,988,193  and  $18,612,272,  respectively.  Borrowings
under the  revolving  note  payable were  limited to  $20,000,000.  The weighted
average   outstanding   balance  during  1998  and  1997  was   $18,590,642  and
$18,861,104,  respectively.  The weighted average interest rate was 6.40 percent
and 5.94 percent during 1998 and 1997,  respectively.  This note was due January
8, 1999,  bore an interest  rate of 6.00  percent at December  31,1998,  and was
secured by a certificate of deposit in the amount of  $20,000,000  (see Note 3).
This revolving note was renegotiated quarterly and interest was payable monthly.
The Company paid this revolving note in full,  including  accrued  interest,  on
January 8, 1999 with proceeds from the  certificate  of deposit that secured the
note and $22,667 in cash.

At December 31, 1998,  the Company has an unsecured  revolving note payable to a
bank in the amount of $50,000.  Loaned  amounts under the revolving note payable
are limited to $50,000. The weighted average outstanding balance during the year
ended December 31, 1998 was $14,384.  The weighted average interest rate was 9.4
percent  during  1998.  This note is payable on demand,  matures  April 1, 2007,
bears interest at a bank's prime rate plus 2.0 percent (9.75 percent at December
31, 1998) and requires interest to be paid monthly.

At December 31,  1998,  the Company has a note payable to a lender in the amount
of $560,000  which  bears  interest  at 18  percent,  which  interest is payable
monthly.  The note  payable  was due  January  2, 1999 and is secured by certain
accounts  receivable.  The Company has  subsequently  extended the due date from
month to month by paying the lender accrued  interest plus a fee of $5,600.  The
loan balance is currently due May 28, 1999. The Company anticipates that it will
request  additional  extensions of the due date. In connection with the issuance
of the note payable,  the Company issued 35,000 shares of common stock (having a
fair value of $50,314 on the date of issuance) in payment for a loan origination
fee.  This  amount  is  included  in  interest   expense  in  the   accompanying
consolidated  statement of operations.  The note is personally guaranteed by two
officers  and  directors  and the  chairman  of the  board of  directors  of the
Company.  The Company has entered  into an  indemnity  agreement  with the three
directors relating to this and other guarantees and pledges (see Note 12).

7.  RELATED-PARTY NOTES PAYABLE

At December 31, 1998, the Company has unsecured demand notes payable outstanding
to the former  Articulate  stockholders  in the aggregate  amount of $4,708,980.
These notes were issued in connection with the Articulate  acquisition (see Note
2).  These  notes were  payable on demand any time after  November  1, 1998.  In
December 1998, the holder of $ 407,971 of notes demanded payment.  In connection
with this demand,  the Company paid the holder  $50,000  representing  a partial
payment and the holder  agreed to extend the date to March 15, 1999 and increase
the interest rate to 11 percent per annum.  No additional  demand has been given
for this note.  Additionally  in 1998,  the  Company  negotiated  extensions  on
$3,521,726  of the notes  which  adjusted  the  interest  rate to 10 percent and
extended  the due  dates to May 30,  1999.  No  demand  has been  given  for the
remaining balance of notes.

Subsequent  to the  Articulate  acquisition,  the Company  agreed to pay several
Articulate  employees  incentive  compensation  for continued  employment in the
aggregate  amount of $857,000.  The Company issued demand notes for $452,900 and
recorded an accrued  liability  of $404,100  for the balance of this  obligation
(see Note 2). The demand  notes bear  interest  at an annual rate of 8.5 percent
and were  payable  upon demand  after  November 1, 1998.  None of the holders of
these notes has demanded payment and they have verbally agreed to extend the due
dates of these notes to April 30, 1999, and the Company has also verbally agreed
to pay  interest at nine  percent per annum after the November 1, 1998 due date.
The Company has not paid the $404,100 of accrued  liability  which was due on or
before January 31, 1999.

In connection  with the  acquisition of certain  liabilities of Articulate  (see
Note 2), the Company  executed and delivered a $1,500,000  unsecured demand note
payable to a company which is a stockholder of the Company. This demand note

                                      F-19

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


bore  interest at an annual rate of 10 percent and was payable upon demand after
November 1, 1998.  The Company  obtained an  extension  of the due date from the
holder of the note and on February 2, 1999, this note and related  interest were
paid in full.

At December 31, 1998,  the Company has unsecured  demand notes payable to former
Papyrus  stockholders  in the aggregate  amount of $1,710,000,  which notes were
issued in  connection  with the  Papyrus  acquisition.  The notes are payable as
follows: $1,190,000 due by February 28, 1999, $180,000 due on April 30, 1999 and
$340,000 due on September  30, 1999,  and bear interest at six percent per annum
after their due date.  The Company has not made any  payments on these notes and
is negotiating with the former  shareholders of Papyrus to resolve issues raised
in a legal action filed by the Company  against  certain former  shareholders of
Papyrus (see Note 17).

The Company has an unsecured  revolving note payable to a company owned by three
individuals who are executive officers and directors of the Company and who each
beneficially own more than 10 percent of the Company's common stock. At December
31,  1998 and 1997,  $0 and  $551,510  in  principal  and $2,482 and  $22,243 in
accrued   interest  were   outstanding   under  this   revolving  note  payable,
respectively.  The weighted  average  balance  outstanding  during the borrowing
period was $73,811 in 1998 and $555,407 in 1997.  This revolving note is payable
on demand and bears interest at an annual rate of 12 percent. The maximum amount
outstanding  under this  revolving  note was $551,510 in 1998 and  $1,550,000 in
1997.  In  connection  with  this  revolving  note,  the  Company  paid  a  loan
origination  fee of  $93,000  in 1997.  The  Company  believes  the terms of the
related-party revolving note payable are at least as favorable as the terms that
could have been obtained from an unrelated third party in a similar transaction.

At December 31, 1998, the Company has an unsecured,  non-interest bearing demand
note payable in the amount of $100,000 to Synergetics,  Inc. ("Synergetics"),  a
research and development entity (see Note 12). This note is payable on demand.

At December 31, 1998, the Company has an unsecured note payable to an officer of
the Company in the amount of $20,000,  which bears interest at an annual rate of
10 percent and was due December 31, 1998.  Subsequent to December 31, 1998,  the
holder of this note agreed to extend the due date to June 30, 1999.

8.  CONVERTIBLE DEBENTURES

Series A Convertible Debenture - On October 23, 1995, the Company entered into a
Securities  Purchase  Agreement  (the  "Securities   Purchase  Agreement")  with
Beesmark  Investments,  L.C., a Utah limited liability company  controlled by an
individual  who  assumed a  position  on the  Company's  board of  directors  in
connection with the execution of the Securities  Purchase  Agreement.  Under the
Securities  Purchase  Agreement,  the  Company  issued a  Series  A  Convertible
Debenture in the amount of $500,000. The debenture bore interest at five percent
and was originally due October 23, 1996. The debenture was ultimately  converted
into 166,667 shares of Series A Preferred Stock on September 25, 1997.

Series B Convertible  Debentures - 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 five percent and were  convertible into
shares of the Company's  common stock at anytime after  issuance at the holder's
option.  The debentures  were  convertible  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 120th 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 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

                                      F-20

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

share. The Company recorded the fair value of the warrants,  totaling  $897,750,
as a charge to interest  expense.  The fair value of the warrants was determined
as of the date of grant  using the  Black-Scholes  pricing  model  assuming  the
following:  dividend yield of 0 percent; expected volatility of 65 percent; risk
free  interest  rate of 5.9  percent  and an  expected  life to exercise of five
years.  On July 31, 1997 and  September  26,1997,  $500,000  and $350,000 of the
Series B  Convertible  Debentures  together with  interest  earned  thereon 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 to provide that the holders  exchange all
the  outstanding  debentures  in the amount of $2,150,000  and accrued  interest
thereon in the amount of $28,213  into  108,911  shares of Series B  Convertible
Preferred Stock that would have essentially the same terms as the debentures and
that any additional  purchases  under the Agreement would be for the purchase of
Series B Convertible  Preferred Stock. In connection with the  extinguishment of
the Series B  Convertible  Debenture  and the  issuance of Series B  Convertible
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 an 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  an  additional  loss  on
extinguishment  of debt. The fair value of the warrants was determined as of the
date of the grant using the Black-Scholes  pricing model assuming the following:
dividend  yield of 0  percent;  expected  volatility  of 65  percent;  risk free
interest rate of 5.8 percent and expected life to exercise of 5 years.

9. PREFERRED STOCK

In 1995,  the  Company's  board of directors  adopted a resolution  to amend the
certificate of  incorporation to provide for the issuance of preferred stock and
give  the  board of  directors  authority  to fix the  rights,  preferences  and
restrictions  of any series of preferred  stock.  At the same time, the board of
directors authorized,  subject to approval by the Company's  shareholders of the
amendment to the certificate of  incorporation,  a class of Series A Convertible
Preferred Stock. The Series A Convertible Preferred Stock authorized in 1995 was
issued shortly thereafter. In August 1997, a majority of the shareholders of the
Company  approved the amendment to the Company's  certificate  of  incorporation
authorizing  and  approving  the issuance of preferred  stock in such series and
having  such  terms and  conditions  as the  Company's  board of  directors  may
designate.  The amendment became effective September 24, 1997.  Thereafter,  the
Company's  board  of  directors  adopted   resolutions   establishing  Series  B
Convertible  Preferred Stock,  Series C Convertible  Preferred  Stock,  Series D
Convertible  Preferred  Stock  and  Series  E  Convertible  Preferred  Stock  in
connection  with certain  capital  fund-raising  in 1997 and 1998,  as described
below.

Series  A  Convertible  Preferred  Stock  - In  September  1997,  the  Series  A
Convertible  Debenture was converted into 166,667 shares of Series A Convertible
Preferred Stock. The holder of the Series A Convertible  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  Convertible  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 Convertible  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 Convertible  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  Convertible  Preferred  Stock at an amount
equal to 1.5  shares of  common  stock  for each  share of Series A  Convertible
Preferred Stock.

Series B Convertible Preferred Stock - Effective September 30, 1997, the Company
and the Series B  Convertible  Debenture  holders  agreed to  exchange  all then
outstanding  Series B  debentures  in the  aggregate  amount of  $2,150,000  and
accrued  interest thereon in the amount of $28,213 into 108,911 shares of Series
B Convertible  Preferred  Stock.  Dividends  accrue on the stated value ($20 per
share) of Series B Convertible Preferred Stock at a rate of five percent

                                      F-21

<PAGE>


                               Fonix Corporation
                         [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


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 any
time after issuance at the holders'  option.  In the event of  liquidation,  the
holders of the Series B  Convertible  Preferred  Stock are entitled to an amount
equal to the stated value plus accrued but unpaid dividends  whether declared or
not. The holders of Series B Convertible  Preferred Stock have no voting rights.
The Series B  Convertible  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 120th 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 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 original 120 day vesting  period of the
Series B Convertible  Debentures.  Prior to the actual  issuance of the Series B
Convertible  Preferred Stock in exchange for the  outstanding  balance under the
debenture,  the  holder  converted  the  balance  of  $2,150,000,   and  related
dividends, into 431,679 shares of common stock.

On October 24, 1997,  the Company sold an additional  125,000 shares of Series B
Convertible  Preferred  Stock for $2,500,000  less $145,000 in related  offering
costs.  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 was  amortized  as a dividend  over 120 days.  As a
condition for issuing  preferred  stock,  the holder was granted a put option by
SMD, L.L.C. ("SMD"), a company which is controlled by three shareholders who are
officers or  directors  of Fonix.  The put option  requires  SMD to purchase the
Series B Convertible  Preferred Stock from the holder at the holder's option but
only in the event that the common  stock of Fonix is removed from listing on the
NASDAQ Small Cap Market or any other national securities exchange.  In addition,
Fonix has not entered into any type of agreement  which would  require  Fonix to
reimburse  SMD should  SMD be  required  to  purchase  the Series B  Convertible
Preferred Stock from the holder. In connection with this put option, the Company
recorded  a  financing  expense  and a  corresponding  capital  contribution  of
$125,000.  As of December 31, 1997, 97,500 of the Series B Convertible Preferred
Stock and dividends  earned  thereon had been  converted  into 355,188 shares of
common  stock.  In  January  1998,  the  remaining  27,500  shares  of  Series B
Convertible  Preferred  Stock and dividends  earned  thereon were converted into
193,582 shares of common stock.

Series C Convertible 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 Convertible
Preferred Stock for $3,750,000.  The cash purchase price was received in October
1997.  Dividends  accrue  on the  stated  value  ($20  per  share)  of  Series C
Convertible  Preferred  Stock at a rate of five  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 holders' option. In the event of liquidation, the holders of the Series C
Convertible  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  Convertible  Preferred  Stock have no voting  rights.  The
Series C Convertible  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 120th 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
nine percent,  which is available to the holder on or before 120 days subsequent
to closing. The additional three percent discount of $164,002 was amortized as a
dividend over 180 days. As a condition for issuing preferred stock, the Series C
Convertible  Preferred  Stockholder  was  granted a put  option by SMD.  The put
option  requires SMD to purchase the Series C Convertible  Preferred  Stock from
the holder at the holder's option but only in the event that the common stock of
Fonix is  removed  from  listing  on the  NASDAQ  Small Cap  Market or any other
national securities exchange.  In addition,  Fonix has not entered into any type
of agreement  which would  require Fonix to reimburse SMD should SMD be required
to purchase the preferred  stock from the holder.  In  connection  with this put
option,  the Company  recorded a financing  expense and a corresponding  capital
contribution

                                      F-22

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


of $375,000.  Associated with the issuance of the Series C Convertible 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  value of the  warrant of  $600,000  as
determined as of October 24,1997 using the Black-Scholes  pricing model assuming
the following:  dividend yield of 0 percent;  expected volatility of 65 percent;
risk free interest rate of 5.8 percent and expected life to exercise of 3 years.
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 Convertible  Preferred
Stock and related accrued dividends.  During 1998, the balance of 185,000 shares
of Series C Convertible  Preferred  Stock and related  dividends  were converted
into 1,295,919 shares of the Company's common stock.

Series D Convertible  Preferred  Stock - On August 31, 1998, the Company entered
into an agreement  with  investors  whereby the Company issued 500,000 shares of
the  Company's   Series  D   Convertible   Preferred   Stock  for   $10,000,000.
Additionally,  the Company issued to certain investors a total of 608,334 shares
of Series D Convertible  Preferred Stock (i) in return for their  relinquishment
of their  contractual right to receive Reset Shares in connection with the March
1998  offering  (see Note 10),  and as (ii) an  additional  cost of raising  the
$10,000,000 from the Series D Convertible  Preferred Stock placement.  Dividends
accrue on the stated  value ($20 per  share) of Series D  Convertible  Preferred
Stock at the  rate of four  percent  per  year,  are  payable  annually  or upon
conversion,  in cash or common  stock,  at the  option of the  Company,  and are
convertible into shares of the Company's common stock at the holder's option any
time. Each month the holders of the Series D Convertible Preferred Stock may not
convert  more  than 25  percent  of the  total  number  of  shares  of  Series D
Convertible  Preferred Stock  originally  issued to such holders on a cumulative
basis. For example, during the first month a holder may convert up to 25 percent
of the total Series D  Convertible  Preferred  Stock  issued to the holder,  and
during the following month that same holder may convert, on an aggregate to date
basis,  up to 50 percent of the total  number of shares of Series D  Convertible
Preferred Stock held by the holder.  Additionally,  each month,  the holders may
convert up to 50 percent of the total  number of shares of Series D  Convertible
Preferred Stock originally issued to such holders on a cumulative basis, if both
of the following  conditions are satisfied:  the average daily trading volume of
the Company's  common stock is more than 500,000  shares for the  10-trading-day
period  before the  conversion;  and the average per share closing bid price for
such  10-trading-day  period has not decreased by more than five percent  during
that  10-trading-day  period.  Any  outstanding  shares of Series D  Convertible
Preferred  Stock as of August 31, 2001  automatically  will be  converted at the
conversion  price most  beneficial  to the holders on such date. In the event of
liquidation,  the  holders  of the  Series D  Convertible  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 D Convertible
Preferred Stock have no voting rights. The Series D Convertible Preferred Stock,
together with  dividends  accrued  thereon,  may be converted into shares of the
Company's  common stock at the lesser of: $3.50 per share;  or the lesser of 110
percent of the average per share closing bid price for the fifteen  trading days
immediately preceding the date of issuance of the Series D Convertible Preferred
shares;  or 90 percent of the average of the three lowest per share  closing bid
prices during the 22 trading days immediately  preceding the conversion date. In
the event that the holders convert at the $3.50 per share price,  the Company is
obligated  to issue  warrants  to purchase  0.8 shares of common  stock for each
share of Series D Convertible  Preferred Stock converted to common stock.  Using
the conversion terms most beneficial to the holder,  the Company is amortizing a
beneficial conversion feature of $3,638,147 as a dividend over a 180 day-period.
Subsequent to December 31, 1998, 45,000 shares of Series D Convertible Preferred
Stock and related dividends were converted into 741,749 shares of common stock.

Series E Convertible  Preferred  Stock - Effective as of September 30, 1998, the
Company  entered into an agreement  with two of the  investors who purchased the
Series D Convertible  Preferred  Stock whereby the Company issued 100,000 shares
of  the  Company's   Series  E  Convertible   Preferred  Stock  for  $2,000,000.
Additionally,  the Company  issued to the purchasers of the Series E Convertible
Preferred  Stock a total of 150,000  additional  shares of Series E  Convertible
Preferred  Stock in exchange for which those  purchasers  surrendered a total of
150,000 shares of Series D Convertible Preferred Stock.  Dividends accrue on the
stated value ($20 per share) of Series E Convertible  Preferred  Stock at a rate
of four percent per year, are payable  annually or upon  conversion,  in cash or
common stock, at the option of the Company,  and are convertible  into shares of
the Company's common stock at any time at the holder's  option.  Any outstanding
shares of Series E  Convertible  Preferred  Stock as of  September  30, 2001 are
automatically converted at the

                                      F-23

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


conversion  price most  beneficial  to the holders on such date. In the event of
liquidation,  the  holders  of the  Series E  Convertible  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 E Convertible
Preferred Stock have no voting rights. The Series E Convertible Preferred Stock,
together with  dividends  accrued  thereon,  may be converted into shares of the
Company's  common stock at the lesser of: $3.50 per share;  or the lesser of 110
percent of the  average  per share  closing  bid price for the 15  trading  days
immediately preceding the date of issuance of the Series E Convertible Preferred
shares;  or 90 percent of the average of the three lowest per share  closing bid
prices during the 22 trading days immediately  preceding the conversion date. If
the Investors  convert at the $3.50 per share price, the Company is obligated to
issue warrants to purchase 0.8 shares of common stock for each share of Series E
Convertible  Preferred  Stock  converted to common stock.  Using the  conversion
terms most  beneficial  to the holder,  the Company  recorded a preferred  stock
dividend  of  $968,047  for the  beneficial  conversion  feature of the Series E
Convertible Preferred Stock. As of December 31, 1998, 114,928 shares of Series E
Convertible  Preferred  Stock and  related  dividends  had been  converted  into
2,591,733  shares of common  stock.  Subsequent  to December 31,  1998,  122,572
shares of  Series E  Convertible  Preferred  Stock and  related  dividends  were
converted into 3,042,145 shares of common stock.

10.  COMMON STOCK AND COMMON STOCK SUBJECT TO REDEMPTION

Common  Stock - During the year ended  December  31,  1998,  the Company  issued
20,740,605 shares of common stock. Of such shares,  4,000,000 shares were issued
in  connection  with a private  placement  transaction,  10,944,081  shares were
issued in connection with the  acquisitions of AcuVoice,  Articulate and Papyrus
(see Note 2) (of which 2,691,681  shares are held in escrow),  4,081,234  shares
were issued  upon the  conversion  of  preferred  stock and  related  dividends,
1,390,476  shares  were issued in  connection  with the  restructuring  of reset
rights,  265,000  shares  were issued upon the  exercise of  previously  granted
warrants and options, 35,000 shares were issued in payment of a loan origination
fee (see Note 6) and 24,814 shares were issued for the purchase of a patent.

On March 12, 1998, the Company completed a private  placement  offering of up to
6,666,666 shares of its restricted  common stock. The total purchase price to be
paid by the investors pursuant to the offering was $30,000,000.  Of that amount,
$15,000,000  was received by the Company on March 12, 1998,  in return for which
the Company  issued a total of  3,333,333  shares of  restricted  common  stock.
Finders' fees of $870,000 were paid in connection with the $15,000,000 received.
The remainder of the purchase  price was to be paid by the investors on July 27,
1998 (60 days  after the  effectiveness  of a  registration  statement  that the
Company filed with the  Securities and Exchange  Commission  covering the common
stock issued and issuable to the  investors)  provided  that certain  conditions
were  satisfied.  As of the July 27, 1998, the certain  conditions  precedent to
receiving the additional funding were not met. In separate  transactions in June
and August 1998,  certain investors paid to the Company a total of $3,000,000 in
return for which the Company  issued 666,667  additional  shares under the terms
and  conditions  set  forth in the  offering.  Finders'  fees of  $163,846  were
incurred in connection with the $3,000,000  received.  No other payment has been
received  by the  Company  pursuant to the  offering,  and the Company  does not
expect any further payment to be made.

The investors  acquired  certain "reset rights" in connection  with the offering
pursuant to which the investors  would receive  additional  shares of restricted
common stock  ("Reset  Shares") for no additional  consideration  if the average
market price of the Company's  common stock for the 60-day period  following the
effective date of the related registration  statement or the second funding date
did not equal or exceed $5.40 per share. On August 31, 1998, the Company and the
investors in the offering  restructured the reset provision  whereby the Company
issued  608,334  shares of Series D  Convertible  Preferred  Stock and 1,390,476
shares of common stock for (i) the relinquishment of the investors'  contractual
right to receive Reset Shares in  connection  with the  $15,000,000  received in
March 1998,  and the  $3,000,000  received in June and August  1998,  and (ii) a
financing  cost in  connection  with the issuance of 500,000  shares of Series D
Convertible  Preferred  Stock. The Company recorded an expense of $6,111,577 for
the difference between the Company's  original  obligation to issue reset shares
and the fair value of the shares that were actually issued in settlement for the
relinquishment of the reset provision and recorded a preferred stock dividend of
$1,000,000 related to financing costs in connection with the issuance of 500,000
shares of Series D Convertible Preferred Stock.

                                      F-24

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Registration  Rights  and  Reserved  Shares - During  1997,  1998 and 1999,  the
Company entered into  registration  rights agreements with investors under which
the Company  agreed to register the common stock issuable upon the conversion of
all series of preferred  stock and debentures and the exercise of warrants.  The
Company  covenanted  to reserve out of its  authorized  and  unissued  shares of
common stock no less than that number of shares that would be issuable  upon the
conversion of all series of preferred stock and debentures and any dividends and
interest  then  payable in stock  thereon and the  exercise of  warrants.  As of
December 31, 1998,  the Company has reserved  31,887,259  shares of common stock
for this purpose.  Nevertheless,  the Company does not presently have sufficient
authorized  capital  to enable it to issue all of the  common  stock it would be
required  to issue  if all the  presently  issued  and  outstanding  convertible
preferred stock debentures,  options, warrants, and other convertible securities
were  converted or  exercised.  The Company is in the process of  attempting  to
obtain  shareholder  approval of an amendment to the  Company's  certificate  of
incorporation that would sufficiently increase the Company's authorized capital,
including common stock.

Voting  Trust - As of December  31,  1998,  25,657,749  shares of the  Company's
outstanding  common stock were held in a voting trust (the "Voting Trust") as to
which the  President  and Chief  Executive  Officer  of the  Company is the sole
trustee.  Persons who have deposited their shares of the Company's  common stock
into the Voting Trust have dividend and liquidation  rights in proportion to the
number of shares of the Company's common stock they have deposited in the Voting
Trust, but have no voting rights with respect to such shares.  All voting rights
associated  with the  shares  deposited  into the Voting  Trust are  exercisable
solely and  exclusively  by the trustee of the Voting  Trust.  The Voting  Trust
expires, unless extended according to its terms, on the earlier of September 30,
1999 or any of the following  events:  (i) the trustee  terminates  it; (ii) the
participating  stockholders  unanimously  terminate  it; or (iii) the Company is
dissolved or liquidated.

Common Stock Subject to Redemption - On December 21, 1998,  the Company  entered
into a private placement securities  agreement.  Pursuant to the agreement,  the
Company received  $1,980,000 in net proceeds in exchange for 1,801,802 shares of
redeemable  common stock, an equal number of "Repricing  Rights" and warrants to
purchase  200,000  shares of common stock.  Each  Repricing  Right  entitles the
holder  to  receive  a number  of  additional  shares  of  common  stock  for no
additional  consideration  according to a formula ("Repricing  Rights") based on
the lowest  closing bid price of the Company's  common  stock,  as quoted by the
NASDAQ  Stock  Market,  during  the  15  consecutive  trading  days  immediately
preceding  the exercise  date and a repricing  price,  as defined,  ranging from
$1.3875 to $1.4319 depending upon the date of the exercise. The repricing rights
became exercisable on March 21, 1999.

Each holder of redeemable common stock has the right ("Repurchase Right"), based
on certain conditions,  to require the Company to repurchase all or a portion of
the holder's common shares or repricing  rights.  The Repurchase Rights may only
be exercised  simultaneously with or after the occurrence of a major transaction
or  triggering  event as  defined  in the  private  placement  agreement.  Major
transactions   and  triggering   events   consist  of,  among  others,   certain
consolidations,  mergers or other business combinations, the sale or transfer of
all or substantially  all the Company's  assets, a purchase,  tender or exchange
offering of more than 40 percent of the Company's  outstanding common stock made
and  accepted,  the failure to have a related  registration  statement  declared
effective  prior to 180 days after the closing date or a suspension from listing
or delisting of the Company's common stock for a period of three days.

The repurchase  price for the common stock is $ 1.3875 per share. The repurchase
price for the Repricing  Rights is based on a formula  using the Repricing  Rate
and the last reported  sale price of the  Company's  common stock on the date of
the exercise of the repurchase right.

 The  warrants  have an  exercise  price of $1.67  per share and a term of three
years.  The  Company  assigned  a fair  value of  $150,000  to the  warrants  as
determined on December 21, 1998 using the Black-Scholes pricing model assuming a
dividend  yield of 0 percent,  expected  volatility  of 85 percent,  a risk free
interest rate of 4.5 percent and an expected life of 3 years.


                                      F-25

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


During the year ended December 31, 1997, the Company issued 1,957,312 shares of
common  stock.  Of such  shares,  150,000  were issued to an  unrelated  private
investor,  265,000 were issued upon the exercise of previously  granted warrants
and options,  145,747 were issued upon  conversion  of  convertible  debentures,
804,065  were issued upon the  conversion  of  preferred  stock and 592,500 were
issued to unaffiliated  individuals  for services  rendered valued at $3,812,971
based on the fair market value of the shares at the time of issuance.

During the year ended December 31,1996,  the Company issued 11,741,242 shares of
common stock to unrelated private  investors  pursuant to various stock purchase
agreements  and 60,000  shares  were issued  upon the  exercise  of warrant.  In
connection  with these stock  issuances,  the Company  issued  420,000 shares of
common stock valued at $901,520 as payment of finders'  fees to unrelated  third
parties.

11. STOCK OPTIONS AND WARRANTS

Common  Stock  Options  - On June 1,  1998,  the  Company's  board of  directors
approved the 1998 Stock Option and Incentive Plan for  directors,  employees and
other persons acting on behalf of the Company,  under which the aggregate number
of shares  authorized  for issuance is  10,000,000.  The Company's  shareholders
approved  the plan on July 14,  1998.  The plan is  administered  by a committee
consisting  of two or more  directors  of the Company.  The  exercise  price for
options  granted under the plan is the closing  market price of the common stock
on the date the options are granted.  The option term is ten years from the date
of grant.  As of December 31, 1998,  the number of shares  available  for grants
under this plan is 3,585,218.

On March 10, 1997,  the  Company's  board of  directors  approved the 1997 Stock
Option and Incentive Plan for  directors,  employees and other persons acting on
behalf of the Company, under which the aggregate number of shares authorized for
issuance is 7,500,000. The plan is administered by a committee consisting of two
or more  directors  of the Company.  The  exercise  price of such options is the
closing  market  price of the stock on the date the  options  are  granted.  The
option term is ten years from the date of grant.  As of December 31,  1998,  the
number of shares available for grants under this plan is 1,812,000.

In April 1996,  the Company's  board of directors  approved the 1996  Directors'
Stock Option Plan,  under which the aggregate  number of shares  authorized  for
issuance is  5,400,000.  The  shareholders  of the Company  approved the plan at
their  annual  meeting in July 1996.  The plan is  administered  by a  committee
consisting of two or more directors of the Company.  The plan provides that each
director  shall receive  options to purchase  200,000 shares of common stock for
services rendered as a director during each entire calendar year or portion of a
calendar year in excess of six months. The exercise price of such options is the
closing  market  price of the stock on the date the  options  are  granted.  The
option term is ten years from date of grant. As of December 31, 1998, the number
of shares available for granting under this plan is 1,800,000.

In December 1998, the Company  granted options to purchase  2,800,000  shares of
common  stock to members of the board of  directors.  Of the  2,800,000  shares,
1,400,000 were for services performed in 1998 and 1,400,000 were for services to
be performed in 1999 providing the directors serve six months in 1999.

In April 1996,  the  Company's  board of  directors  approved a Long-Term  Stock
Investment  and  Incentive  Plan for  officers,  key employees and other persons
acting on behalf  of the  Company  under  which the  aggregate  number of shares
authorized for issuance is 900,000  shares.  The exercise price of these options
is the closing  market  price of the stock on the date the options are  granted.
The term of the plan is ten  years  and  options  are  subject  to a  three-year
vesting  schedule,  pursuant to which  one-third  of the total number of options
granted may be  exercised  each year.  As of December  31,  1998,  the number of
shares available for grant under this plan is 725,000.




                                      F-26

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



A summary of options granted under the Company's  various stock option plans for
the years ended December 31, 1998, 1997 and 1996 is presented below:

<TABLE>
<CAPTION>

                                                    1998                      1997                               1996           
                                 ----------------------------    --------------------------------    ------------------------------
                                                   Weighted                           Weighted                            Weighted 
                                                    Average                           Average                             Average 
                                     Stock         Exercise          Stock            Exercise            Stock           Exercise 
                                    Options         Price           Options            Price             Options            Price  
                                --------------   -----------    ----------------    -------------    ----------------     ---------
<S>                             <C>              <C>            <C>                 <C>              <C>                  <C>
Total options outstanding                                                              
  at beginning of year             10,565,000    $    5.38            4,626,000     $    4.07                   -         $     -  
    Granted                         6,414,782         2.08            6,009,000          6.38           4,626,000            4.07  
    Exercised                         (35,000)        6.00              (15,000)         2.97                   -               -  
    Forfeited                      (1,067,000)        4.56              (30,000)         7.66                   -               -  
    Canceled                                -            -              (25,000)         5.00                   -               -  
                                --------------                  ----------------                      ----------------    
Total options outstanding                                                                                                         
  at end of year                   15,877,782         4.10           10,565,000          5.38           4,626,000             4.07  
                                ==============                  ================                      ================          
                                                                                                                            
Total options exercisable                                                                                                          
  at end of year                    9,524,766         5.11            5,392,675          5.05           2,000,000             4.06  
                                ==============                  ================                      ================          
Weighted average fair                                                                                                             
  value of options granted                                                                                                        
    during the year                              $    1.98                          $    6.38                             $   4.07  

</TABLE>

A summary of options  outstanding  and options  exercisable  under the Company's
various stock option plans at December 31, 1998 is presented below:

<TABLE>
<CAPTION>


                      Options Outstanding                            Options Exercisable 
-----------------------------------------------------------    -----------------------------------
                              Weighted  
                              Average         Weighted                               Weighted  
 Range of                    Remaining         Average                                Average   
 Exercise        Number      Contractual       Exercise            Number            Exercise  
  Prices      Outstanding       Life            Price            Exercisable           Price    
------------  --------------  ----------   ----------------    ---------------    ----------------
<S>           <C>             <C>          <C>                 <C>                <C>
 $0.08-1.18     4,886,832     9.9 years     $    1.11              425,422           $  1.13                        
  2.97-4.06     4,199,000     7.5 years          3.98            3,917,669              4.02                        
  5.00-6.50     6,471,950     8.7 years          6.28            4,865,008              6.21                        
  7.13-8.50       320,000     8.2 years          7.17              316,667              7.16  
                                                                                                                    
 $0.08-8.50    15,877,782     8.7 years     $    4.10            9,524,766           $  5.11  
</TABLE>


The Company  accounts for its stock option plans as they relate to employees and
directors under Accounting  Principles  Board Opinion No. 25, and therefore,  no
compensation  expense  has  been  recognized  in the  accompanying  consolidated
statements  of  operations.  Had  compensation  expense for these  options  been
determined in accordance with the method prescribed by SFAS No. 123, "Accounting
for Stock Based Compensation", the Company's net loss per common share

                                      F-27

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


would have been increased to the pro forma amounts indicated below for the years
ended December 31, 1998, 1997 and 1996:

<TABLE>
<CAPTION>
                                                       1998            1997             1996
                                                  -------------    -------------    -------------
<S>                                               <C>              <C>              <C>  
 Net loss attributable to common stockholders:
      As reported                                  $47,916,031     $  25,175,939    $  7,829,508
      Pro forma                                     56,576,232        48,870,670      20,289,706
                                                                                                 
 Basic and diluted net loss per common share:                                                    
      As reported                                  $    (0.91)     $       (0.59)   $     (0.21)
      Pro forma                                         (1.08)             (1.15)         (0.55)
</TABLE>

The fair value of options and warrants is  estimated  on the date granted  using
the Black-Scholes pricing model with the following weighted-average  assumptions
used for grants  during  1998,  1997 and 1996:  Risk-free  interest  rate of 4.8
percent,  5.6 percent and 6.5  percent  for 1998,  1997 and 1996,  respectively;
expected dividend yield of 0 percent for 1998, 1997 and 1996;  expected exercise
lives of 5 years,  5 years and 10 years for 1998,  1997 and 1996,  respectively;
expected volatility of 85 percent, 75 percent and 103 percent for 1998, 1997 and
1996,  respectively.  The estimated fair value of options  granted is subject to
the assumptions  made, and if the assumptions  were to change the estimated fair
value amounts could be significantly different.

Warrants - A summary of warrants  granted by the Company  during the years ended
December  31,  1998,  1997  and  1996  is  presented   below: 

<TABLE>
<CAPTION>

                                                    1998                      1997                     1996
                                            ---------------------    ---------------------    ---------------------
                                                         Weighted                Weighted                 Weighted  
                                                          Average                 Average                  Average  
                                                         Exercise                Exercise                 Exercise  
                                             Shares       Price         Shares     Price        Shares      Price   
                                            ----------  ----------   ----------  ----------   ---------- ----------
<S>                                         <C>         <C>          <C>         <C>          <C>        <C>
Total outstanding at beginning of year      1,175,000   $  6.39        450,000    $ 1.63       410,000     $ 0.93 
    Granted                                 1,200,000     16.94        975,000      6.92       100,000       3.24 
    Exercised                                (230,000)     1.28       (250,000)     1.40       (60,000)      0.50 
    Forfeited                                (220,000)     9.14              -                                  -
Total outstanding at end of year            1,925,000     13.08      1,175,000      6.39       450,000       1.63 
                                                                                                                   
Total exercisable at end of year            1,925,000     13.08      1,175,000      6.39       450,000       1.63 
</TABLE>
                                                                               
12.  RELATED-PARTY  TRANSACTIONS

Employee  Advances  - The  Company  advanced  funds to  certain  executives  and
employees  totaling  $67,231 as of December 31, 1998.  Subsequent  to that date,
certain  executives of the Company have advanced  funds  totaling  approximately
$306,000  to the  Company.  These  advances  have been  used to  reduce  current
obligations  of the  Company.  

Guarantee of Company  Obligations  and Related  Indemnity  Agreement -Two of the
executive  officers and  directors and the chairman of the board of directors of
the Company  (the  "Guarantors")  have  guaranteed  certain  obligations  of the
Company.  As  security  for some of the  guarantees,  the  Guarantors  have also
pledged shares of Fonix common stock  beneficially owned by them. The guaranteed
obligations and the related pledged Fonix shares are summarized as follows:

                                      F-28

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


<TABLE>
<CAPTION>

                                                                   Amount           Shares
                                                                 Guaranteed         Pledged   
                                                                -------------    --------------
<S>                                                             <C>              <C>  
 As of December 31, 1998:
    Revolving bank note in excess of the                        $  222,380         3,500,000
      pledged certificate of deposit,
      credit cards payable, and accrued interest
    Note payable                                                   560,000                 -

 Guarantees issued after December 31, 1998:
    Series C 5% Convertible Debentures                           6,500,000         6,000,000
    Accounts payable - legal fees                                  147,000           100,000
</TABLE>

In  consideration  for the pledge of Fonix common shares as  collateral  for the
Series C 5%  Convertible  Debentures,  the  board of  directors  authorized  the
issuance, to the guarantors of one common stock purchase warrant for every three
shares pledged.  The common stock purchase  warrants have a term of 10 years and
an  exercise  price of 125  percent of the  closing  bid price of the  Company's
common stock on January 29, 1999,  the date of issuance of the  debentures.  The
warrants are not exercisable for at least six months after the date of issuance.
In addition,  the Company has agreed to  indemnify  the  Guarantors  if they are
required to pay any sums for the benefit of the Company under their  guaranty of
the Series C 5% Convertible  Debentures.  The indemnity  agreement provides that
the Company will issue shares of the Company's  common stock of sufficient value
to reimburse the guarantors in full, plus interest at 10 percent per annum,  for
all costs associated with meeting the guarantee commitment, including any income
taxes resulting therefrom.

Subsequent to December 31, 1998,  143,230 of the pledged shares were sold by the
bank and the proceeds were used to pay the  outstanding  balance  related to the
credit cards.

Studdert   Companies  Corp.  -  Studdert  Companies  Corp.  ("SCC")  is  a  Utah
corporation  that provides  investment  and management  services.  The officers,
directors and owners of SCC are directors and executive  officers of the Company
and each of whom  beneficially owns more than 10 percent of the Company's issued
and outstanding common stock.  Between June 1994, when the Company commenced its
present  business of developing  its ASR  technologies,  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 rendered certain management and financial services to the Company.

Pursuant to the SCC Agreement,  between  January and July 1995, SCC invoiced the
Company for services rendered.  By July 1995, the Company owed SCC approximately
$1,417,000  pursuant to the terms of the SCC  Agreement.  On July 31, 1995,  the
Company  issued  warrants to purchase up to  3,700,000  shares of the  Company's
common stock to SCC.  The purchase  price of the warrants was $.033 per share of
common stock, or an aggregate of $122,100. On August 11, 1995, SCC exercised the
warrants at an exercise  price of $0.35 per share.  Both the  $122,100  purchase
price  and  the  $1,295,000  aggregate  exercise  price  for the  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. 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  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.

                                      F-29

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


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 Beesmark  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  invoiced  the Company  for  management
services,  but  continued  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  totaled
$5,862, as well as outstanding amounts for expenses incurred. 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 through
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.

Related-party transactions with SCC not otherwise disclosed herein as of and for
the years ended December 31, 1998, 1997 and 1996 were as follows:


                                1998              1997            1996
                              -------------   -------------  ---------------
 
   Expenses:
      Management fees          $       -      $        -     $    200,000
      Rent                       117,228          77,203           52,000
   Liabilities:                                                      
      Accounts payable                 -               -          411,743
      Accrued liabilities              -         459,502        1,350,000

The Company  rents  office space under a  month-to-month  lease from SCC and the
lease from SCC is guaranteed by the three officers, owners and directors of SCC.
The lease requires monthly  payments of $10,368.  The Company believes the terms
of the  related-party  lease are at least as  favorable  as the terms that could
have been obtained from an

                                      F-30

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


unaffiliated third party in a similar transaction.

Beesmark  Investments,  L.C. - On October 23, 1995, the Company,  Beesmark and a
director entered into the Beesmark  Agreement.  The director did not occupy such
position when the Beesmark  Agreement was negotiated and executed.  The director
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  agreed to issue
11,562,500  shares of common  stock at a price of $0.48 per share and a $500,000
Series A Convertible  Subordinated  Debenture  that is  convertible  into either
166,667 shares of Series A Convertible  Preferred Stock or 166,667 shares of the
Company's common stock.  During the year ended December 31, 1996,  Beesmark paid
all  installments  payable by Beesmark  under the  Beesmark  Agreement,  and the
Company issued, in the increments  specified,  all of the securities issuable to
Beesmark under the Beesmark Agreement.

SMD,  L.L.C.  - From  September 4, 1997,  through  October 15, 1997 and again on
December 31, 1997, the Company, borrowed funds from SMD, L.L.C., a company owned
by  three  directors  and  executive  officers  of the  Company  (each  of  whom
beneficially  owns more than 10 percent of the Company's  issued and outstanding
common  stock)  pursuant to a  revolving,  unsecured  promissory  note,  bearing
interest  at the rate of 12 percent  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  were  repaid,  together  with $5,542 in
interest  in 1998.  The loan and its  terms  were  approved  by the  independent
members of the board of directors of the Company.

K.L.S. Enviro Resources, Inc. - Between May 1996 and August 1996, as part of the
Company's  short-term cash management  policy, the Company entered into a series
of loan  transactions  with KLSE, an entity which then was unaffiliated with the
Company.  The Company was introduced to KLSE by an unaffiliated  third party. As
of August 12, 1996, the Company had loaned to KLSE a total of $1,900,000,  which
loans were due upon demand,  bore  interest at the rate of 12 percent per annum,
required  the payment of certain  loan  origination  fees,  and were  secured by
substantially all of the assets of KLSE, except its real property.  The first of
the loans from the  Company in the amount of  $710,000  was made on May 16, 1996
and the last advance  prior to August 12, 1996,  in the amount of $590,000,  was
made on July 16, 1996. Pursuant to the terms of the promissory note representing
the  $710,000  advanced by the  Company to KLSE in May 1996,  all or part of the
balance due under that note was  convertible  at the option of the holder of the
note to 2,366,667  shares of the restricted  common stock of KLSE at the rate of
$.30  per  share.  Similarly,  the  remaining  $1,190,000  owed to the  Company,
represented by four separate  promissory  notes, was convertible into a total of
2,975,000 shares of KLSE restricted  common stock at the rate of $.40 per share.
KLSE also entered into a  registration  rights  agreement  with the Company.  In
connection  with that course of financing,  a director and executive  officer of
the Company assumed a position on KLSE's board of directors,  effective July 10,
1996.

On September 30, 1996, SMD advanced debt financing (the "SMD Loan") to KLSE (see
below)  in the  amount  of  $1,673,730.  The SMD  Loan was due on  demand,  bore
interest  at the rate of 12 percent  per annum and was  secured by the assets of
KLSE, except its real property. The proceeds of the SMD Loan enabled KLSE to pay
the Company $1,673,700 in satisfaction of all then-outstanding  balances due the
Company  except a balance of $272,156  due and owing under the first  promissory
note from KLSE to the  Company  in the  amount of  $710,000.  In return  for the
provision of the SMD Loan to KLSE, SMD acquired  warrants to purchase  6,600,000
shares of KLSE restricted  Common Stock at the exercise price of $.40 per share.
These warrants have never been exercised.

Based upon certain  changed  circumstances  at KLSE,  on October 29,  1996,  the
Company made an additional loan of $200,000 to KLSE. That additional advance was
repaid in full, with accrued  interest,  by KLSE on December 24, 1996.  Also, on
December 31, 1996 the Company sold for cash and assigned $270,000 of the balance
due under the $710,000  promissory note to Ballard  Investment  Company,  a Utah
limited partnership  unaffiliated with the Company.  Also, on December 31, 1996,
KLSE paid the Company the balance of  approximately  $10,500 due and owing under
the $710,000

                                      F-31

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


promissory  note.  Since  December 31, 1996,  KLSE has not been  indebted to the
Company in any amount nor has the Company had any beneficial interest in KLSE.

Synergetics - Through December 1998, a director and the chief executive  officer
of the Company was also one of seven directors of Synergetics, Inc. In addition,
three executive officers and directors of the Company owned shares of the common
stock of Synergetics, although such share ownership in the aggregate constituted
less than 5 percent of the total shares of  Synergetics  common stock issued and
outstanding.  Effective  December  31,1998,  the  chief  executive  officer  and
director of the Company  resigned  from the board of  Synergetics  and the three
executive  officers and  directors  relinquished  all  ownership of  Synergetics
shares.  The Company engages  Synergetics to provide  assistance to Fonix in the
development of its ASR technologies (see Note 14).

Voice  Information  Associates,  Inc. - A director and executive  officer of the
Company 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 1997,  the Company paid  approximately  $110,000 in consulting
fees to VIA for services  provided to the Company.  No payments were made by the
Company to VIA in 1998.

Other Transactions - During 1996,  disinterested  members of the Company's board
of directors  authorized the Company to reimburse certain officers for all taxes
payable by the  officers in  conjunction  with the 1995  exercise  of  3,700,000
warrants by a company owned by the officers.  The total amount  authorized to be
reimbursed was $1,150,000 in 1997 and $1,350,000 in 1996. During the years ended
December  31,  1998  and  1997,  the  Company  paid  $340,516  and   $2,159,484,
respectively, of the authorized reimbursements.

13. STATEMENT OF WORK

On February 11,  1998,  the Company  entered into a First  Statement of Work and
License Agreement with Siemens Semiconductor Group of Siemens Aktiengesellschaft
("Siemens")  under  which the Company  and  Siemens  are  jointly  pursuing  the
development of Siemens' integrated circuits  incorporating ASR and other related
technologies for use in certain telecommunications applications. On February 20,
1998, the Company received  $2,691,066 in cash from Siemens. Of that amount: (1)
$1,291,712  was paid to the  Company  as a  non-refundable  payment  to  license
certain ASR  technologies for which the Company has no further  obligation;  (2)
$322,928 was paid to purchase warrants to acquire 1,000,000 shares of restricted
common stock at an average exercise price of $20 per share with expiration dates
ranging from December 31, 1998 to December 31, 1999; and (3) $1,076,426 was paid
to the  Company  to  acquire,  if Siemens so  elected,  shares of the  Company's
restricted common stock or to become a non-refundable  license payment.  In June
1998,  Siemens  elected  to apply the  $1,076,426  portion  as a  non-refundable
payment to license certain ASR technologies for which the Company has no further
obligation.  The Company  recorded the  $2,368,138  license  payments as revenue
during the year ended December 31, 1998.

14.  PRODUCT DEVELOPMENT AND RESEARCH

Synergetics  - In October  1993,  the Company  entered  into an  agreement  with
Synergetics (the "Synergetics  Agreement"),  a research and development  entity,
whereby Synergetics was to develop certain technologies related to the Company's
ASR  technologies.  The Chief Executive  Officer of the Company was one of seven
members of the board of directors of Synergetics,  and three executive  officers
and  directors and 10 percent  beneficial  owners of the Company owned less than
five  percent  of the  common  stock  of  Synergetics.  Under  the  terms of the
Synergetics   Agreement,   as  subsequently   modified,   the  Company  acquired
intellectual  property  rights,  technologies  and  technology  rights that were
developed by  Synergetics.  The Company agreed to provide all funding  necessary
for  Synergetics  to  develop  commercially  viable  technologies.  There was no
minimum  requirement  or maximum limit with respect to the amount of the funding
to be  provided  by the  Company.  However,  under the terms of the  Synergetics
Agreement, the Company was obligated to use

                                      F-32

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


its  best  efforts  in  raising  the  necessary  funding  for  the  engineering,
development  and marketing of the ASR  technologies.  As part of the Synergetics
Agreement,  the Company agreed to pay Synergetics a royalty of 10 percent of net
revenues  from  sales  of  the  Company's  products  incorporating  Synergetics'
"VoiceBox"  speech  recognition  technologies or technologies  derived therefrom
(the  "Royalty").  As of December 31, 1998,  the Company had not yet licensed or
sold its  technologies,  and  consequently,  had not made any royalty  payments.
Under the terms of the  Synergetics  Agreement,  the Company paid to Synergetics
$1,128,433, $2,819,427, and $4,758,012 in 1998, 1997 and 1996, respectively, for
research and development efforts.

Until March 1997, Synergetics had compensated its engineers,  employees, members
of  its  development  team,  and  other  financial  backers  (collectively,  the
"Developers"),  in part,  with the  issuance of "Project  Shares"  granting  the
holders of such  shares the right,  within  limits,  to share pro rata in future
royalty  payments.  In addition to issuance of Project  Shares,  Synergetics had
made  advances to some  members of its  project  team on a  non-recourse  basis.
Repayment of the advances was secured by future  disbursements under the Project
Shares.

On  March  13,  1997,  the  Company  and  Synergetics  signed  a  Memorandum  of
Understanding (the "MOU") which manifested their agreement in principle that the
Royalty  should be canceled in exchange  for the  offering  and  issuance by the
Company of warrants to purchase up to 4,800,000  shares of the Company's  common
stock.  Certain of the employees  and  independent  contractors  then engaged by
Synergetics  became  full-time  employees  or  independent  contractors  of  the
Company.  The  majority  shareholder  and  president  of  Synergetics  became  a
full-time consultant to the Company.  Since March 14, 1997, the Company has been
conducting the majority of the research and development of the ASR  technologies
at its own  research  facility  staffed  by its own  employees,  including  some
Developers who have been employees of the Company since March 14, 1997.

On  April  6,  1998,  the  Company  and  Synergetics   entered  into  a  Royalty
Modification  Agreement,  which  provides  for the  Company  to make an offer of
exchange of the Company's warrants to purchase common stock with a $10 per share
exercise  price for the project  shares at a rate of one warrant to purchase 800
common  shares for each project  share.  The warrants  would not be  exercisable
until the earlier of (1) the date the  Company's  common  stock is trading for a
period of 15  consecutive  trading  days at a minimum of $37.50 per share or (2)
September  30,  2000.  The offer of the  warrants  cannot be made by the Company
until a registration  statement  covering the total number of warrants  issuable
upon the  exercise  of the  warrants  has been  declared  effective  by the U.S.
Securities  and  Exchange  Commission.  Upon the  tender to  Synergetics  of any
Project  Shares  the  related  Royalty  commitment  will  be  canceled.  Pending
completion  of the  registration  statement  and  issuance of the  warrant,  the
Company will not pay any royalties to Synergetics.

IMC-2  - In  March  1998,  the  Company  entered  into a  professional  services
agreement with IMC-2, a research and development  entity, to provide  assistance
to Fonix  in the  continuing  development  of  specific  ASR  technologies.  The
president of IMC-2 is also the president of Synergetics and Adiva. The agreement
is for a term of 36 months and requires the Company to make monthly  payments of
$22,000.  Future  noncancellable  payments  under this  agreement  are $264,000,
$264,000 and $44,000 for the years ended December 31, 1999, 2000 and 2001. Under
the terms of the  agreement,  Fonix  expended  $220,000 in 1998 for research and
development efforts.

Adiva- During 1998, the Company  utilized the research and development  services
of Adiva. The president of Adiva is also the president of Synergetics and IMC-2.
During 1998, the Company expended $600,174 for services provided.

Advocast - In July 1997, the Company entered into an arrangement  with Advocast,
Inc. ("Advocast") an Internet research and development entity,  whereby Advocast
assisted Fonix in development of  technologies  to create and locate  searchable
data  bases on the  Internet  through  the use of  interactive  video  and voice
technologies.  Under  the  terms of the  arrangement  Fonix  paid  $816,750  and
$705,005 in 1998 and 1997, respectively, for research and development efforts.

On November 25, 1998, in consideration for the research and development payments
received from Fonix through that date, Advocast issued 60,200 shares of Advocast
Series A 6% Convertible Preferred Stock. The Advocast shares, if

                                      F-33

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


converted,  represent  less than 20 percent of the total  outstanding  shares of
Advocast  voting  common  stock.  Advocast is a  development  stage company with
minimal  operations and there is substantial  uncertainty as to the value of the
Advocast  shares.  The  Company  has  therefore  determined  that  there  is not
sufficient  marketability  in Advocast  shares to determine  their  value.  As a
result,  the Company  has not  recorded a value for the  Advocast  shares in the
accompanying consolidated financial statements.

15.  INCOME TAXES

At  December  31,  1998  and  1997,  net  deferred  income  tax  assets,  before
considering  the  valuation  allowance,  totaled  $24,325,269  and  $15,746,597,
respectively.  The amount of and ultimate  realization  of the benefits from the
deferred  income tax assets is dependent,  in part, upon the tax laws in effect,
the Company's  future  earnings,  and other future events,  the effects of which
cannot be determined.  The Company has established a valuation allowance for all
deferred  income tax assets not offset by deferred income tax liabilities due to
the  uncertainty  of their  realization.  Accordingly,  there is no benefit  for
income taxes in the accompanying consolidated statements of operations.  The net
change in the valuation  allowance  was an increase of  $8,529,870  for the year
ended December 31, 1998.

The Company has  available at December 31, 1998,  unused  federal net  operating
loss  carryforwards of approximately  $62,916,000 and unused state net operating
loss  carryforwards  of approximately  $63,295,000  which may be applied against
future  taxable  income,  if any,  and which  expire in various  years from 2008
through 2018. The Internal  Revenue Code contains  provisions which likely could
reduce or limit the  availability  and  utilization  of these net operating loss
carryforwards.  For example,  limitations  are imposed on the utilization of net
operating loss  carryforwards if certain  ownership  changes have taken place or
will take place. The Company has not performed an analysis to determine  whether
any such limitations have occurred.

The  temporary  differences  and  carryforwards  which give rise to the deferred
income tax assets (liabilities) as of December 31, 1998 and 1997 are as follows:

<TABLE>
<CAPTION>
                                                          1998               1997
                                                   ---------------     -----------------
<S>                                                <C>                 <C>   
Deferred income tax assets:                  
      Net operating loss carryforwards:
         Federal                                   $   21,391,555      $    14,030,670 
         State                                          2,088,746            1,312,988 
       Research and development credits                   694,239              275,927 
       Accrued bonus liabilities                          150,729              127,012  
                                                   ---------------     -----------------
      Total deferred income tax assets before
         valuation allowance                           24,325,269           15,746,597 
                                                                                       
       Valuation allowance                            (24,176,653)         (15,646,783) 
                                                   ---------------     -----------------
       Net deferred income tax assets                     148,616               99,814  
                                                   ---------------     -----------------
                                                                                       
Deferred income tax liabilities:                                                       
       Depreciation                                      (148,316)             (99,514) 
       Intangibles                                           (300)                (300) 
                                                   ---------------     -----------------
       Total deferred income tax liabilities             (148,616)             (99,814)
                                                                                       
                                                    $           -      $             -   
                                                   ===============     ================= 
</TABLE>
                                                                               


                                      F-34

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

A reconciliation  of income taxes at the federal statutory rate to the Company's
effective rate is as follows:

<TABLE>
<CAPTION>
                                                               Year Ended December 31,      
                                                               -----------------------      
                                                       1998               1997           1996
                                                       ----               ----           ----
         <S>                                         <C>                 <C>            <C>


         Federal statutory income tax rate            34.0 %              34.0 %         34.0 %
         State and local income tax rate,                                                  
            net of federal benefit                     3.3                 3.3            3.3
         Valuation allowance                         (37.3)              (37.3)         (37.3)
                                                                                               
         Effective income tax rate                       -  %                - %            -  %
</TABLE>

16.  COMMITMENTS AND CONTINGENCIES

Employment  Agreements - In January 1998,  the Company  entered into  employment
contracts  with two employees  which expire in January 2001.  The minimum annual
salary payments  required by these contracts total $405,000.  In connection with
these  agreements,  these  individuals  were granted options to purchase 360,000
shares of the  Company's  common stock at $3.34 per share.  These options have a
ten-year  life and are subject to a  three-year  vesting  schedule,  pursuant to
which  one-third  of the total number of options  granted may be exercised  each
year.  One-third  of the options  are vested on the date of grant.  In the event
that, during the contract term, both a change of control occurs,  and within six
months  after such  change in control  occurs,  the  executive's  employment  is
terminated by the Company for any reason other than cause,  death or retirement,
the  executive  shall be entitled to receive an amount in cash equal to all base
salary then and thereafter payable within thirty days of termination. In January
1999,  the Company  announced a major cost  reduction  program for the Company's
1999 operating year wherein the compensation of two employees  referred to above
was reduced 30 percent effective February 1999.

Executive Employment  Agreements - On November 1, 1996, the Company entered into
employment  contracts with three executive officers (one of whom is no longer an
executive  officer)  which expire on December  31, 2001.  The annual base salary
compensation  for each executive  officer for the years ended December 31, 1999,
2000 and 2001 is $425,000, $550,000 and $750,000, respectively.

Additionally,  each  executive  officer is entitled to annual  performance-based
incentive  compensation  payable on or before  December 31 of each calendar year
during the contract term. During the first three years of the contract term, the
performance-based incentive compensation is determined in relation to the market
price of the Company's common stock, adjusted for stock dividends and splits. If
the price of the Company's  common stock  maintains an average price equal to or
greater  than the level set forth  below over a period of any three  consecutive
months during the calendar year, the  performance-based  incentive  compensation
will be paid in the  corresponding  percentage  amount of annual base salary for
each year as follows:

   Quarterly Average Stock Price            Percentage Bonus 
   -----------------------------           ------------------                  
               $10.00                             30%        
               $12.50                             35%        
               $15.00                             40%        
               $20.00                             45%        
               $25.00+                            50%        
                                               
The annual  base salary and  performance-based  incentive  compensation  for the
final two  contract  years will be subject to review by the  Company's  board of
directors.

                                      F-35

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In the event that,  during the contract term,  both a change of control  occurs,
and within  six months  after such  change in control  occurs,  the  executive's
employment is terminated by the Company for any reason other than cause,  death,
or  retirement,  the  executive  shall be  entitled to receive an amount in cash
equal to all base  salary  then and  thereafter  payable  within  thirty days of
termination.

In January 1999, the Company  announced a major cost  reduction  program for the
Company's  1999  operating  year wherein the  compensation  of the two remaining
officers will be reduced to $297,500 commencing February 1999. At the same time,
Stephen M.  Studdert  resigned  as the  Company's  Chief  Executive  Officer and
entered into a separation  agreement pursuant to which Mr. Studdert will be paid
$250,000  per year  through  January  31, 2001 and  $100,000  for the year ended
January 31, 2002. Additionally, his employment contract was canceled.

Professional  Services  Agreement - Effective May 7, 1998,  the Company  entered
into a one-year  professional  services  agreement with a public relations firm.
The  minimum  monthly  retainer is $15,000 per month.  In  connection  with this
agreement,  the firm was  granted  options  to  purchase  100,000  shares of the
Company's  common stock at $3.75 per share. The options have a ten-year term and
are fully vested.  In connection  with this  transaction,  the Company  recorded
$320,100 of consulting expense, of which $106,700 is deferred as of December 31,
1998, to be recognized ratably over the life of the agreement.

Operating Lease Agreements - The Company leases certain facilities and equipment
used in its operations.  The amount of commitments for noncancellable  operating
leases in effect at December 31, 1998, were as follows:

   Years ending December 31,
   -------------------------
            1999                    $1,043,342 
            2000                       677,073 
            2001                       685,275 
            2002                       696,162 
            2003                       507,308 
         Thereafter                    293,664 
                                    ---------- 
                Total               $3,902,824 
                                    ==========

The Company  incurred  rental expense of $868,110,  $416,798 and $103,139 during
1998, 1997 and 1996, respectively, related to these leases.

In March 1999,  the Company  entered into an  agreement  to lease  approximately
3,780 square feet of office space in Cleveland,  Ohio for sales and installation
personnel.  The lease is for  three  years at a  monthly  rate of $4,260  and is
effective May 1, 1999.

Capital  Lease  Obligation  - Future  minimum  lease  payments  of  $56,260  for
equipment held under a capital lease arrangement as of December 31, 1998 are due
in 1999.  The present value of these future  minimum lease  payments is $52,225.
Total  assets  held under the  capital  lease  arrangement  were  $150,208  with
accumulated depreciation of $48,737 as of December 31, 1998.

AcuVoice - In connection with the AcuVoice acquisition, AcuVoice and its founder
made  certain  representations  and  warranties  to the  Company.  One of  those
representations  focused on the scope of a license agreement  previously entered
into by  AcuVoice  and  General  Magic for use by  General  Magic of  AcuVoice's
text-to-speech software in General Magic's Serengeti product. After the AcuVoice
acquisition  closed,  the Company  determined  that AcuVoice and its founder had
breached the  representation  concerning  the General Magic  license  agreement.
Under the terms of the

                                      F-36

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


AcuVoice acquisition agreement, on March 12, 1999, the Company submitted a claim
for  the  80,000  shares  deposited  into  the  escrow  account  by  the  former
stockholders of AcuVoice.  The founder,  as agent for the former stockholders of
AcuVoice,  denied the claim. The Company is presently  preparing,  a response to
the founder's  denial of the claim.  If the founder  continues to deny the claim
after review of the Company's  response,  the Company will seek to arb its claim
pursuant  to the terms of the  AcuVoice  acquisition  agreement.  The Company is
presently  considering other possible remedies against the founder and the other
former directors of AcuVoice.

General  Magic,  Inc. - On September 23, 1997,  AcuVoice  entered into a license
agreement with General Magic,  Inc.  ("General  Magic") wherein AcuVoice granted
General Magic a perpetual, irrevocable, worldwide license in a specific field of
use to use, reproduce,  publicly display and distribute  AcuVoice's TTS software
in connection with General Magic's voice accessed  integrated  network  service,
also known as the  Serengeti  product.  The license is  exclusive  for the first
three  years  and  non-exclusive  thereafter.  Under  the  terms of the  license
agreement,  the  Company is  entitled  to royalty  payments  based upon  monthly
subscriber revenue from the use of the integrated network service. Additionally,
the Company  granted an option to General Magic to purchase the then current TTS
source code and all source code  documentation  for a cash payment of $2,500,000
and $2,500,000 in General Magic common stock.

 17. LITIGATION

Clarke - On August 28, 1998, John R. Clarke and Perpetual Growth Fund, a company
Clarke's spouse  purportedly owns,  commenced an action against Fonix in federal
court for the Southern  District of New York. Clarke and Perpetual Growth assert
claims for breach of  contract  relating  to certain  financing  Fonix  received
during 1998. Specifically,  Clarke and Perpetual Growth allege that they entered
into a contract  with Fonix under which Fonix agreed to pay them a commission of
five percent of all financing provided to Fonix by Southridge Capital Management
or its  affiliates.  Clarke  and  Perpetual  claim  that  they are  entitled  to
commissions  with respect to  approximately  $3,000,000  of equity  financing to
Fonix in July and August  1998,  and Fonix's  offerings of Series D and Series E
preferred stock, totaling together $12,000,000, in August and September 1998.

Fonix  believes  that the Clarke  lawsuit is without merit and filed a motion to
dismiss  based upon the court's lack of personal  jurisdiction  over Fonix.  The
court granted Fonix's motion to dismiss, on a conditional basis,  subject to the
right of Clarke and Perpetual Growth to produce additional  evidence which would
establish  jurisdiction  of the New York court over Fonix.  Clarke and Perpetual
Growth filed a motion with the New York court that sought to establish a factual
and legal basis for the New York court's  exercise of  jurisdiction  over Fonix.
However,  the court  denied  that  motion.  In the  interim,  Fonix filed a suit
against Clarke and Perpetual Growth in federal court for the Central District of
Utah seeking a declaratory judgment that it does not owe any money to Clarke and
Perpetual  Growth.  Now that the  action in New York has been  dismissed,  Fonix
intends to  vigorously  pursue the Utah action.  However,  Clarke and  Perpetual
Growth could prevail in the lawsuit,  in which case Fonix may be required to pay
significant amounts of money damages or other amounts awarded by the court. At a
minimum,  the ongoing  nature of this action  will result in some  diversion  of
management time and effort from the operation of the business.

Papyrus - After the Papyrus acquisition closed, the Company investigated some of
the  representations  and  warranties  made by Papyrus to induce the  Company to
acquire Papyrus. The Company determined that certain of the representations made
by Papyrus and their executive  officers were false. At about the same time, the
Company began negotiations with the former executive officers of Papyrus,  which
negotiations,  among other things,  included discussions regarding rescission of
the Papyrus  acquisition.  On February  26,  1999,  the Company  filed an action
against  Papyrus in the United States  District  Court for the District of Utah,
Central  Division (the "Utah Action").  In the Utah Action,  the Company alleged
claims for misrepresentation,  negligent misrepresentation,  breach of contract,
breach of the implied covenant of good faith and fair dealing and rescission. On
March 11,  1999,  three of the former  shareholders  of Papyrus  filed an action
against  the Company in the United  States  District  Court for the  District of
Massachusetts (the "Massachusetts  Action"),  alleging a default under the terms
of  the  promissory  notes  issued  to  them  in  connection  with  the  Papyrus
Acquisition.  On April 2, 1999, the three former Papyrus  shareholders  filed an
amended complaint against the Company

                                      F-37

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


seeking  additional  remedies  including  violation of Massachusetts  unfair and
deceptive acts and practices  statutes and copyright  infringement.  On April 8,
1999, a fourth former  Papyrus  shareholder  filed an action against the Company
alleging  a default  under the terms of the  promissory  notes  issued to him in
connection  with  the  Papyrus   acquisition  and  seeking  additional  remedies
including  violation of  Massachusetts  unfair and deceptive  acts and practices
statutes and copyright infringement.  Subsequently, the Company has entered into
agreements  with the four  former  Papyrus  shareholders  for  dismissal  of the
actions and  cancellation  of the  promissory  notes upon  payment to the former
shareholders  of  $1,122,209  (the  "Settlement  Payment")  an  amount  equal to
approximately  73 percent of the balance due them under the notes issued to them
in the  Papyrus  acquisition,  and return  for  cancellation  by the  Company of
970,586  shares  of  restricted  common  stock  issued  to them  in the  Papyrus
acquisition. The Company must pay the Settlement Payment before May 16, 1999. If
it does not, the Company and the four former  Papyrus  shareholders  are free to
pursue their respective claims.

Apple Computer,  Inc. - In February 1993, Articulate received a patent (the "303
patent")  for a product  which  would  allow the user of an Apple  Macintosh  to
create spoken  commands which the computer would  recognize and respond to. Soon
after the 303 patent was issued, Articulate put Apple Computer, Inc ("Apple") on
notice that Apple's  "PlainTalk"  product  infringed the 303 patent.  When Apple
ignored Articulate's notices, Articulate sued Apple. Apple responded to the suit
by suing  Articulate  and Dragon  Systems,  Inc.,  which  suit was  subsequently
dismissed.  The  Company  acquired  Articulate's  claims  against  Apple  in the
Articulate  acquisition (see Note 2). The Company has completed discovery in the
action pending against Apple and is awaiting the scheduling of a trial.

In addition to the above,  the Company is involved in various  lawsuits,  claims
and  actions  arising in the  ordinary  course of  business.  In the  opinion of
management,  after consultation with legal counsel,  the ultimate disposition of
these matters will not materially affect the consolidated  financial position or
results of operations of the Company.

18.  EMPLOYEE PROFIT SHARING PLAN

The Company has a 401(k)  profit  sharing plan covering  essentially  all of its
full-time  employees.  Under the plan,  employees may reduce their salaries,  in
amounts allowed by law, and contribute the salary  reduction  amount to the plan
on a pretax basis.  The plan also allows the Company to make matching and profit
sharing  contributions  as  determined  by the board of  directors.  To date, no
matching or profit sharing contributions have been made by the Company.

19.  REPORTABLE SEGMENTS

The Company is  organized  into two  business  segments  based  primarily on the
nature of the  Company's  products and  customers.  Each  segment is  separately
managed  because  its  customers  require  different  technology  solutions  and
marketing strategies.

The  Company's  HealthCare  Solutions  Group  (HSG)  includes  the  development,
manufacture,  sale and  maintenance  of its  voice  recognition  product  to the
healthcare industry marketed under the PowerScribe(R)  trademark.  The Company's
Interactive  Technologies  Solutions  Group (ITSG)  includes the  development of
relationships  with third parties who can incorporate  Fonix  technologies  into
their own products or product development efforts. These products include speech
recognition   technology   licensing   including    speech-to-text   (STT)   and
text-to-speech (TTS) applications.

The accounting  policies of the segments are the same as those  described in the
summary  of  significant  accounting  policies.  These  operating  segments  are
components for which separate  information is available that is evaluated by the
Company's chief operating  decision maker in deciding how to allocate  resources
and in assessing performance.





                                      F-38

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

The following  table reflects  certain  financial  information  relating to each
reportable segment for each of the years ended December 31, 1998, 1997 and 1996:

<TABLE>
<CAPTION>


                                                              1998                1997               1996
                                                         ----------------    --------------     --------------
<S>                                                      <C>                 <C>                <C>            
Revenues:
   HSG - PowerScribe                                     $      284,960      $          -       $          -
   ITSG - STT and TTS                                         2,604,724                 -                  -
                                                         ----------------    --------------     --------------
Total revenues                                           $    2,889,684      $          -       $          -
                                                         ================    ==============     ==============

Gross margin:
   HSG - PowerScribe                                     $      244,056      $          -       $          -
   ITSG - STT and TTS                                         2,569,284                 -                  -
                                                         ----------------    --------------     --------------
Total gross margin                                       $    2,813,340      $          -       $          -
                                                         ================    ==============     ==============

Research and development expenses:
   HSG - PowerScribe                                     $    4,360,619      $          -       $          -
   ITSG - STT and TTS                                        21,896,365         6,816,798          4,758,012
                                                         ----------------    --------------     --------------
Total research and development expenses                  $   26,256,984      $  6,816,798       $  4,758,012
                                                         ================    ==============     ==============

Depreciation and amortization:
   HSG - PowerScribe                                     $      856,253      $          -       $          -
   ITSG - STT and TTS                                         2,429,180           405,209             83,183
                                                         ----------------    --------------     --------------
Total depreciation and amortization                      $    3,285,433      $    405,209       $     83,183
                                                         ================    ==============     ==============

Other operating expenses:
   HSG - PowerScribe                                     $    1,246,377      $          -       $          -
   ITSG - STT and TTS                                         8,579,969        12,791,399          3,447,217
                                                         ----------------    --------------     --------------
Total other operating expenses                           $    9,826,346      $ 12,791,399       $  3,447,217
                                                         ================    ==============     ==============

Loss from operations:
   HSG - PowerScribe                                     $    6,219,193      $          -       $          -
   ITSG - STT and TTS                                        30,336,230        20,013,406          8,288,412
                                                         ----------------    --------------     --------------
Total loss from operations                               $   36,555,423      $ 20,013,406       $  8,288,412

                                                         ================    ==============     ==============
Long-lived assets:
   HSG - PowerScribe                                     $   19,561,867      $          -       $          -
   ITSG - STT and TTS                                        21,582,566         1,706,230          1,332,757
                                                         -----------------   --------------     --------------
Total long-lived assets                                  $   41,144,433      $  1,706,230       $   1,332,757
                                                         =================   ==============     ==============
</TABLE>


All of the Company's  revenues for 1998 were sourced from the United States.  Of
the $2,889,684 in revenues for 1998, $2,368,138 was from one customer,  Siemens,
in connection with non-refundable license payments under a Statement of Work and
License  Agreement.  The remaining amount of revenue was primarily from hospital
and medical centers in the eastern United States in connection with sales of the
Company's PowerScribe(R) suite of products.




                                      F-39

<PAGE>


                                Fonix Corporation
                          [A Development Stage Company]
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

20.  SUBSEQUENT EVENTS

Related  Party Notes  Payable - Subsequent  to December  31,  1998,  the Company
issued unsecured notes payable to an executive  officer in the amount of $68,691
for cash used as working capital by the Company. These notes bear interest at 10
percent and are due on July 31, 1999.

Recent  Financing  Activities - On January 29, 1999, the Company  entered into a
Securities  Purchase Agreement with four investors pursuant to which the Company
sold its Series C 5% Convertible Debentures in the aggregate principal amount of
$4,000,000. The outstanding principal amount of the debentures is convertible at
any time at the option of the holder into shares of the  Company's  common stock
at a conversion  price equal to the lesser of $1.25 or 80 percent of the average
of the closing bid price of the Company's common stock for the five trading days
immediately  preceding  the  conversion  date.  The Company also issued  400,000
warrants  in  connection  with this  financing.  On March 3, 1999,  the  Company
executed a supplemental  agreement  pursuant to which the Company agreed to sell
another $2,500,000 principal amount of Series C 5% Convertible Debentures on the
same  terms  and  conditions  as the  January  29,  1999  agreement,  except  no
additional warrants were issued. The obligations of the Company for repayment of
the  debentures, as  well as its  obligation  to  register  the  common  stock
underlying  the potential  conversion of the  debentures and the exercise of the
warrants  issued  in  these  transactions,  are  personally  guaranteed  by  the
Guarantors.  These  personal  guarantees  are  secured by a pledge of  6,000,000
shares of Fonix common stock beneficially owned by them. The Company has entered
into an  indemnity  agreement  with the  Guarantors  relating  to this and other
guarantees  and pledges (see Note 12). In connection  with second  funding,  the
Company agreed to pledge, as collateral for repayment of the debentures,  a lien
on the patent covering the Company's ASR technologies.

Subsequent to the second  funding,  the holders of the  debentures  notified the
Company and the Guarantors  that the Guarantors  were in default under the terms
of the pledge and that the holders  intended to  exercise  their  rights to sell
some or all of the pledged  shares of the  Guarantors.  At the present time, the
Company has no  knowledge  of sales of the  Guarantors'  shares by the  holders.
However,  if the holders proceed to sell some or all of the Guarantors'  shares,
the  Company  may  be  obligated,   under  its  indemnity  agreement,  to  issue
replacement  shares to the  Guarantors  for all shares  sold by the  holders and
reimburse Guarantors for any costs incurred as a result of the holders' sales of
Guarantors' shares.

One of several  events  described  in the  Securities  Purchase  Agreement  as a
"Triggering  Event" is the suspension from listing or delisting of the Company's
common stock from the Nasdaq SmallCap Market for a period of three trading days.
In March 1999,  trading in the Company's common stock was temporarily halted for
more than three days.  Trading resumed within five trading days, and the Company
has not been notified that the holders of the Series C 5% Convertible Debentures
desire to exercise any rights they may have under the agreement.

Issuance  of Stock  Options - On  February  15,  1999,  the  Company  granted an
aggregate of 762,500  stock options to various  employees of the Company.  These
options have a ten-year life, an exercise price of $1.53 per share and vested on
the grant date.



                                      F-40