<PAGE>
 
                      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, 1997, or

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

Commission File No. 0-23862


                               FONIX CORPORATION
            (Exact name of registrant as specified in its charter)

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



                    60 EAST SOUTH TEMPLE STREET, SUITE 1225
                          SALT LAKE CITY, UTAH 84111
            (Address of principal executive offices with Zip Code)

                                (801) 328-0161
             (Registrant's telephone number, including area code)

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

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

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

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.[_]
<PAGE>
 
                               FONIX CORPORATION
                                        
                         1997 FORM 10-K ANNUAL REPORT

                               TABLE OF CONTENTS

                                    Part I

                                                                            Page
                                                                            ----

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

                                    Part II

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

                                    Part III

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

                                    Part IV

Item 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K
<PAGE>
 
                                    PART I

ITEM 1.   BUSINESS

OVERVIEW

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

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

The executive offices of the Company are located at 60 East South Temple Street,
Suite 1225, Salt Lake City, Utah 84111, and its telephone number is (801) 328-
0161.  The executive offices of AcuVoice are located at 84 West Santa Clara
Street, Suite 720, San Jose, CA 95113, and its telephone number is (408) 289-
1661.  The Company also maintains offices in Lexington, Massachusetts and a
research facility in Draper, Utah.

TECHNOLOGY OVERVIEW

Automatic Speech Recognition

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

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

                                  Page 3 of 46
<PAGE>
 
The present industry standard methodology, the HMMs, use a general template or
pattern matching technique based on statistical language models.  Massachusetts
Institute of Technology researcher, Dr. Victor Zue, has noted that speech-
recognition systems based on such technology

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

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

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

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

Thus, in the near term, the Company believes that its ASRT will initially offer
unique speech processing techniques that will be both complementary and
significantly enhancing to currently available speech recognition systems.
fonix intends to continue to license its ASRT, to continue to co-develop the
ASRT with research and development groups in government, industry, and academia
and ultimately to market a suite of fonix-branded products.  As discussed more
fully below, fonix recently entered into the Siemens Agreement to conduct joint
research and development for applications in the telecommunications industry of
certain technologies related to the ASRT.  fonix anticipates that it will enter
into additional strategic alliances and co-development agreements in other
industry segments.  In the long term, the Company anticipates that automatic
speech recognition systems employing the Company's unique new ASRT will dominate
the market and set the industry standard for all automatic speech recognition
applications because of its anticipated capacities to overcome the weaknesses of
HMMs.  In addition, the Company expects that certain elements of its Core
Technologies will have industry-leading applications in such non-speech
recognition industries, market segments and disciplines as artificial
intelligence and data compression.  Although these plans represent management's
belief and expectation based on its current understanding of the market and its
experience in the industry, there can be no assurance that actual results will
meet these expectations.  See "Certain Significant Risk Factors."  In the last
two fiscal years, the Company has expended $7,066,294 and $4,758,012 on research
and development activities.  Since its inception (October 1, 1993), the Company
has spent $17,937,293 on research and development of the ASRT.  The Company
expects that a substantial part of its capital resources will continue to be
devoted to research and development of the ASRT and other proprietary
technologies for the foreseeable future.

                                  Page 4 of 46
<PAGE>
 
Text-to-Speech (Speech Synthesis)

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

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

EMPLOYEES

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

RECENT DEVELOPMENTS

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

The Siemens Transaction

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

The OGI Master Technology Collaboration Agreement

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

                                  Page 5 of 46
<PAGE>
 
Acquisition of AcuVoice

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

The Merger was effected by an exchange of restricted shares of fonix Common
Stock for the issued and outstanding Common Stock of AcuVoice and a cash
payment.  A total of 2,692,218 shares of fonix Common Stock were issued in
exchange for AcuVoice Common Stock and a total of $8,000,232 was paid in cash
(including amounts paid in lieu of fractional shares).  The Closing was deemed
to have occurred on March 13, 1998, notwithstanding the fact that certain acts
were completed following that date.

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

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

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

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

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

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

1998 Private Placement

In March 1998, the Company completed a private placement (the "Offering") of
6,666,666 shares of its restricted Common Stock to seven separate investment
funds.  The total purchase price to be paid by the investors pursuant to the

                                  Page 6 of 46
<PAGE>
 
Offering is $30,000,000.  Of that amount, $15,000,000 was provided to the
Company on March 12, 1998, in return for which the Company issued a total of
3,333,333 shares of restricted stock, pro rata to the investors in proportion to
the total amount of the purchase price paid by them.  The remainder of the
purchase price is to be paid by the investors on that date that is 60 days after
the effectiveness of a registration statement that the Company will prepare and
file with the Securities and Exchange Commission covering all of the restricted
Common Stock to be issued in connection with the Offering, provided that, as of
such date, certain conditions are satisfied.  Specifically, such conditions
include the following: (i) that the registration statement covering all of the
Common Stock to be issued is effective as of such date, (ii) the representations
and warranties of the Company as set forth in the documents underlying the
Offering shall be correct in all material respects, (iii) the market price of
the Company's Common Stock shall exceed $4.50 per share, (iv) the dollar volume
of trading in the Company's Common Stock for the 10-trading-day period preceding
such date shall equal or exceed $1,000,000, (v) that there shall be at least 18
market makers for the Company's Common Stock, and (vi) there shall be no
material adverse change in the Company's business or financial condition.

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

The Synergetics Transaction

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

                                  Page 7 of 46
<PAGE>
 
                       CERTAIN SIGNIFICANT RISK FACTORS

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

LIMITED REVENUES; SUBSTANTIAL AND CONTINUING LOSSES; ACCUMULATED DEFICIT; FUTURE
DILUTION

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

DEVELOPMENT STAGE OF FONIX'S CORE TECHNOLOGIES

While the Company generally is pleased with the progress made to date with
respect to the research and development of its Core Technologies, at December
31, 1997, there were no products incorporating the Core Technologies.  As a
development stage company, the Company continues its efforts to enter into
revenue-generating licensing and co-development arrangements or strategic
alliances with third parties.   Other than the arrangements with Siemens and OGI
described elsewhere in this Report, the Company has no licensing or co-
development agreements with any third party and 

                                  Page 8 of 46
<PAGE>
 
other than the non-refundable license fee paid by Siemens, the Company has
received no revenue to date from its ASRT. fonix presently anticipates that any
products incorporating the Company's Core Technologies would be manufactured and
marketed by such third party licensees and co-development and strategic alliance
partners such as Siemens and therefore has no plans to manufacture products
incorporating the ASRT for the foreseeable future. There can be no assurance
that the Company will be able to license its Core Technologies to third parties
other than Siemens or enter into additional co-development or strategic alliance
agreements.

IMPLEMENTATION OF BUSINESS STRATEGY

fonix's business strategy is to achieve revenues through appropriate strategic
alliances, co-development arrangements and license agreements.  To date, the
Company has entered into one revenue-generating license and a strategic alliance
with Siemens, a strategic collaborative alliance with OGI, and the acquisition
of AcuVoice.  Although the Company will receive revenues from the sale of
AcuVoice products and technology, only the Siemens agreement has produced
revenue to date from the Company's Core Technologies.  fonix's ability to
implement its strategy fully over the long term, and the ultimate success of
this strategy, are subject to a broad range of uncertainties and contingencies,
many of which are beyond the Company's control.  fonix may not be able to
achieve the revenue growth it is seeking as a result of incompatibilities
between its Core Technologies and the needs of third-party developers and
manufacturers or an unwillingness of companies with existing voice recognition
products to integrate the Company's technologies.  In addition, there can be no
assurance that the Company will be able to enter into revenue-generating
licensing or co-development arrangements or to implement strategic
relationships, or, if entered into, that such strategic relationships will in
fact further the implementation of the Company's business strategy.

MANAGEMENT OF EXPANDED OPERATIONS

The Company may not be equipped to successfully manage any future periods of
rapid growth or expansion, which could be expected to place a significant strain
on the Company's managerial, operating, financial and other resources.  The
Company is highly dependent upon the efforts of management, and the Company's
future performance will depend, in part, upon the ability of management to
manage growth effectively (including the growth resulting from the recent
acquisition of AcuVoice), which will require the Company to implement additional
financial control systems and management information systems capabilities, to
further develop its operating, administrative, financial and accounting systems
and controls, to maintain close coordination among engineering, accounting,
finance, marketing, sales and operations, and to hire and train additional
technical and marketing personnel.  There is intense competition for management,
technical and marketing personnel in the areas of the Company's activities.  The
loss of the services of any of the Company's management or the failure to
attract and retain additional key employees could have a material adverse effect
on the Company's business, operating results and financial condition.

BUDGET AND COST OVERRUNS; PRODUCTION DELAYS

The Company budgets the cost of each project, reviews cost reports and updates
its cost projections regularly.  However, there can be no assurance that the
actual production costs for its projects will remain within budget.  Risks such
as production delays, higher talent costs, increased subcontractor costs, and
other unanticipated events may substantially increase production costs and delay
or even prevent completion of the production of any one or more of the Company's
projects now or in the future.  The failure to remain within budget and timely
complete a production may have a material adverse effect on the Company's
operations.

UNPROVEN MARKET; RISKS OF NEW TECHNOLOGY

The market for speech recognition technologies is relatively new.  fonix's Core
Technologies are new and represent a significant departure from technologies
which have already found a degree of acceptance in the nascent voice recognition
marketplace. The financial performance of the Company will depend, in part, on
the future development, growth and ultimate size of the market for voice
recognition products generally, and products incorporating the Company's Core
Technologies specifically.  Products, if any, incorporating the Company's Core
Technologies will compete with more conventional means of information processing
(e.g., data entry or access by keyboard or touch-tone phone).  fonix believes
that there is a substantial potential market for products incorporating speaker-
independent, natural language, continuous speech recognition technology with
vocabulary contextually sufficient to be useful for general purpose consumer,

                                  Page 9 of 46
<PAGE>
 
commercial and industrial use, and capable of operating in real time with
acceptable levels of accuracy.  Nevertheless, there can be no assurance that any
market for the Company's Core Technologies or for products incorporating the
Company's Core Technologies will develop, or that the Company's technology will
find general acceptance in the marketplace, or that sales of products
incorporating the Core Technologies will be profitable.  Accordingly, the
Company is subject to all of the risks inherent in developing and marketing new
products based on new technology, together with the risks associated with market
acceptance of such technology, technological obsolescence, inappropriate and/or
illegal intellectual property appropriation and inadequate funding to commence
and/or sustain operations.  Even if the Core Technologies are licensed and
products incorporating such technologies are manufactured and marketed, the
occurrence of warranty or product liability, or retraction of market acceptance
due to product failure, excess product returns or failure of the products to
meet market expectations could prevent the Company from achieving or sustaining
profitable operations.

RELIANCE ON STRATEGIC PARTNERS

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

COMPETITION AND TECHNOLOGICAL CHANGE

The computer hardware and software industries are highly and intensely
competitive.  In particular, the speech recognition field and the computer voice
and communications industries are characterized by rapid technological change.
Competition in the field of speech recognition is based largely on marketing
ability and resources and technological superiority. The development of new
technology or material improvements to existing technologies by the Company's
competitors may render the Company's technology obsolete.  Accordingly, the
success of the Company will depend upon its ability to continually enhance its
Core Technologies to keep pace with or ahead of technological developments and
to address the changing needs of the marketplace. Although the Company expects
to continue to devote significant resources to research and development
activities, there can be no assurance that these activities will allow the
Company's Core Technologies to successfully be incorporated into marketable
products or to keep pace with changing demands and needs of the marketplace.  In
addition, there can be no assurance that the introduction of products or
technological developments by others will not have a material adverse effect on
the Company's operations.  Although the Company believes that its Core
Technologies could beneficially be incorporated into most existing computer
speech recognition applications based on traditional HMM technology, several
companies already manufacture and market computer speech recognition products
against which products incorporating the Core Technologies would compete.  Some,
if not all, of those companies have greater experience in manufacturing and
marketing speech recognition products, and some have far greater financial and
other resources than the Company and/or its potential licensees and co-
developers, as well as broader name-recognition, 

                                 Page 10 of 46
<PAGE>
 
more-established technology reputations, and mature distribution channels for
their products. Multiple computer speech recognition products are presently
available that provide continuous speech dictation capabilities. Such products
could have the effect of desensitizing the market to new dictation products and
increasing the installed base of products incorporating traditional voice
recognition technologies. Additionally, as the market for automatic speech
recognition expands and matures, the Company expects more entrants into this
already competitive arena. There can be no assurance that the distinguishing
characteristics of the Core Technologies as completed and/or as may be enhanced
in the future and any products employing such technology will be sufficient to
allow the Company to successfully compete in the marketplace.

NEED FOR ADDITIONAL FINANCING

The development of the Company's Core Technologies has required that the Company
establish a substantial research and scientific infrastructure consisting of
teams of experts in, among others, the fields of computer programming and
design, electrical engineering and linguistics, as well as the assembly of
certain specialized equipment and developmental and diagnostic software and
hardware, some of which has been designed and built exclusively by the Company.
fonix has consumed substantial amounts of cash to date in developing this
infrastructure and in developing and refining its Core Technologies.  During the
year ended December 31, 1996, the Company incurred total research and
development expenses in the amount of $4,758,012.  During 1997, the Company
incurred total research and development expenses of $7,066,294.  fonix
anticipates that its research and development expenditures will continue at
present rates or increased rates for the foreseeable future.  fonix's actual
future capital requirements, however, will depend on many factors, including
further development of its Core Technologies, the Company's ability to enter
into additional revenue-generating strategic alliance, co-development and
licensing arrangements, the progress of the development, manufacturing and
marketing efforts of the Company's strategic partners, if any, the level of the
Company's activities relating to commercialization rights it may retain in its
strategic alliance arrangements, competing technological and market
developments, and the costs involved in enforcing patent claims and other
intellectual property rights.  In the event that substantial amounts of
additional financing are required, the Company does not believe it will be able
to obtain such financing from traditional commercial lenders.  Rather, the
Company likely will have to conduct additional sales of its equity and/or debt
securities.  There can be no assurance that such additional financing will be
available if and when, and in the amounts required, by the Company.  Moreover,
even if such financing is available if and when required, there can be no
assurance that such financing will be obtained on terms that are favorable to
the Company, and substantial and immediate dilution to existing stockholders
likely would result from any sales of equity securities or other securities
convertible into equity securities.  To the extent that the Company raises
additional funds through strategic alliance and licensing arrangements, the
Company may be required to relinquish rights to certain of its technologies, or
to grant licenses on terms that are not favorable to the Company, either of
which could have a material adverse effect on the Company's business, financial
condition and results of operations.  In the event that adequate funds are not
available when and as needed, the Company's business would be adversely
affected.

NASDAQ STOCK MARKET LISTING REQUIREMENTS

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

INTELLECTUAL PROPERTY PROTECTION

On June 17, 1997, the United States Patent and Trademark Office issued U.S.
Patent No. 5,640,490 entitled "A User Independent, Real-time Speech Recognition
System and Method."  The patent has a 20-year life running from the November 4,
1994 filing date, and has been assigned to the Company.  However, there can be
no assurance that such patent will be incontestable to a user with prior rights.
fonix is unaware of any facts or circumstances suggesting that the 

                                 Page 11 of 46
<PAGE>
 
Core Technologies or the Company's anticipated use thereof infringes or will
infringe any third party intellectual property rights. Regardless of the
foregoing, there can be no assurance that the Core Technologies will not
infringe upon third party intellectual property rights, nor can there be any
assurance that a third party will not assert that the Company has infringed its
intellectual property rights, in which case the Company could be involved in
protracted and costly litigation which could seriously impede the Company's
development or otherwise adversely affect its operations. Additionally, attempts
may be made to copy or reverse engineer aspects of the Core Technologies, or to
obtain, use or exploit information or methods which the Company deems
proprietary. Policing the use of the Core Technologies and perhaps infringing
technology is difficult and expensive. Litigation or other action may be
necessary in the future to protect the Company's proprietary rights and to
determine the validity and scope of the proprietary rights of others. Such
litigation or proceedings could result in substantial costs and diversions of
resources and management's attention, and could have a material adverse impact
upon the Company's business, operating results and financial condition. In
addition to patents, the Company relies on proprietary technology that it
closely guards as trade secrets. The Company has required nondisclosure and
confidentiality agreements to be executed by its employees, potential licensees,
and potential strategic alliance and co-development partners, and the Company
expects to continue this requirement. However, there can be no assurance that
such non-disclosure and confidentiality agreements will be legally enforceable
or sufficient to maintain the secrecy of the Company's proprietary technology.
Moreover, although the Company presently is seeking patent protection for
certain additional technologies, there can be no assurance that such patents
will issue or that the Company will be able to sufficiently protect any
technologies developed by it in the future.

CONTROLLING INTEREST OF RELATED PARTIES

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

DEPENDENCE ON KEY PERSONNEL

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

OTHER DEMANDS ON MANAGEMENT

In addition to occupying positions as the Company's Chief Executive Officer,
President and Chief Operating Officer, 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, including but not limited to its present performance under a management
services contract with K.L.S. Enviro Resources, Inc.("KLSE"), a Nevada
corporation with a class of securities registered under the Exchange Act.  Under
the agreement there is no specific amount of time required of the SCC principals
in connection with SCC's services to KLSE. Since SCC executed the management
services contract, there has been no material reduction in the amount of time
spent by Messrs. Studdert, Murdock and Dudley in the performance of their duties
as executive officers of the Company.  fonix estimates that, since January 1,
1997, Messrs. Studdert, Murdock and Dudley, on average, have worked more than 40
hours per week in their respective capacities as executive officers of the
Company.  Further, in addition to serving as Vice 

                                 Page 12 of 46
<PAGE>
 
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. fonix does not expect there to be in the foreseeable future any
material change in the amount of time spent by those persons in their capacities
as executive officers of the Company or in the Company's overall operations as a
result of the management services contract between SCC and KLSE, or as a result
of any other activities of SCC or VIA. However, there can be no assurance that
the outside activities of Messrs. Studdert, Murdock, Dudley or Oberteuffer, in
connection with SCC, KLSE, 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.

ASSETS CONSISTING OF INTANGIBLE INTELLECTUAL PROPERTY RIGHTS

fonix's assets include intangible assets, principally intellectual rights such
as patents, trademarks and trade secrets, the value of which will depend
significantly upon the success of the Company's development of the Core
Technologies and its ability to enter into licensing and co-development
arrangements with third parties.  In the event of default on indebtedness or
liquidation of the Company, there can be no assurance that the value of these
assets will be sufficient to satisfy its obligations.

RISKS ASSOCIATED WITH PENDING LITIGATION

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

POTENTIAL ADVERSE EFFECT OF ANTI-TAKEOVER PROVISIONS

fonix is subject to anti-takeover provisions of Section 203 of the Delaware
General Corporation Law, which prohibits the Company from engaging in a
"business combination" with an "interested shareholder" for a period of three
years after the date of the transaction in which the person first becomes an
"interested shareholder," unless the business combination is approved in a
prescribed manner. The application of Section 203 also could have the effect of
delaying or preventing changes of control or management of the Company, which
could adversely affect the market price of the Company's Common Stock.  These
provisions, and other provisions of the Company's Certificate of Incorporation,
may have the effect of deterring hostile takeovers or delaying or preventing
changes in control or management of the Company, including transactions in which
shareholders might otherwise receive a premium for their shares over then
current market prices. In addition, these provisions may limit the ability of
shareholders to approve transactions that they may deem to be in their best
interests.

POSSIBLE VOLATILITY OF STOCK PRICE

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 

                                 Page 13 of 46
<PAGE>
 
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.

ABSENCE OF DIVIDENDS

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

YEAR 2000 RISKS

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

RISKS ASSOCIATED WITH ACUVOICE

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

ITEM 2.   PROPERTIES

The Company owns no real property.  Commencing in October 1996, the Company
leased a 25,600 square foot facility in Draper, Utah, from an unaffiliated third
party at which it conducts its principal scientific research and development
activities.  The Company's lease of that facility is for a term of 8 years (with
a right to terminate after five years), and with 

                                 Page 14 of 46
<PAGE>
 
an option to renew for 5 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 at
market rates for its corporate headquarters and administrative operations in
Salt Lake City, Utah, from Studdert Companies Corp., a Utah corporation ("SCC").
SCC is owned and controlled by three individuals who are executive officers and
directors of the Company and who each beneficially owns more than 10% of the
Company's Common Stock. [See "Certain Relationships and Related Transactions,"
and "Security Ownership of Certain Beneficial Owners and Management"].  The base
monthly rental for the sub-leased space during 1997 was approximately $6,500,
plus reimbursable direct expenses for the use of telephone, facsimile, photocopy
and other business equipment.  The three executive officers of the Company have
personally guaranteed this lease in favor of SCC's landlord.

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

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

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

ITEM 3.   LEGAL PROCEEDINGS

THE POLOMBA ACTION

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

THE J&L ACTION

On March 11, 1998 an action (the "J&L Action) was filed against the Company in
the Supreme Court of the State of New York for the County of New York by Jesup &
Lamont Securities Corporation ("J&L").  The J&L Action alleges that the Company
had agreed to pay to J&L a fee in connection with a private placement of the
Company completed in March 1998.  The claim is for a cash payment of $1,200,000
and 30,000 restricted shares of the Company's Common Stock. The matter is still
in the early stages of litigation and the Company has not yet engaged in any
discovery with respect to 

                                 Page 15 of 46
<PAGE>
 
the allegations by J&L. The Company believes that the J&L Action is without
merit and intends to vigorously defend the J&L Action.

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 1997.

                                    PART II

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

fonix Common Stock has been listed on the Nasdaq SmallCap Market since July 31,
1996 (trading symbol: "FONX"). Prior to being listed on the Nasdaq SmallCap
Market, the Company's Common Stock was quoted on the NASD Electronic Bulletin
Board system.  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 1997, the third and fourth quarters of calendar 1996 and as
quoted by the Electronic Bulletin Board for the first and second quarters of
1996.  The quotations reflect inter-dealer prices, without retail mark-up, mark-
down or commissions and may not represent actual transactions.
 
                            Calendar Year 1997         Calendar Year 1996
                            ------------------         ------------------
                            High          Low          High          Low
                            ----          ----         ----          ----       
               
     First Quarter          $9.00        $7.13         $ 3.97       $2.53
     Second Quarter          8.75         6.50          12.25        3.28
     Third Quarter           7.44         6.00          10.03        7.80
     Fourth Quarter          7.00         2.88           9.13        5.00

On April 8, 1998, the high and low sales prices for the Company's Common Stock
were $5.3125 and $4.875 per share, respectively, as reported by Nasdaq.

As of April 8, 1998, there were 51,303,521 shares of fonix Common Stock
outstanding, held by 239 holders of record and approximately 5,132 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 of the Company's ASRT.  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

Consulting Agreements

During fiscal year 1997, the Company issued a total of 592,500 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) 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 $3,812,971 or an average of approximately $6.44
per share.

Southbrook International Investments, Ltd.

In June 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

                                 Page 16 of 46
<PAGE>
 
Series B 5% Convertible Debentures.  The debentures were due June 18, 2007, bore
interest at 5% and were convertible into shares of the Company's Common Stock at
anytime after issuance at the holder's option.  Under the terms of the
Agreement, the debentures were to be purchased in three installments.  The first
payment of $3,000,000 was made to the Company on June 18, 1997.  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% for any conversion
on or prior to the 120th day after the original issue date and 87.5% for any
conversion thereafter.  As part of the same transaction, the Company also issued
to the investor a warrant to purchase up to 250,000 shares of Common Stock at
any time prior to June 18, 2002, at the exercise price of $8.28 per share.
Prior to September 30, 1997, $850,000 face value of the Series B 5% Convertible
Debenture was converted into 145,747 shares of Common Stock.  Pursuant to a
memorandum of understanding between the Company and the investor dated as of
September 30, 1997 (the "MOU") the parties agreed to modify the Agreement to
convert all then outstanding debentures in the amount of $2,150,000 into 107,500
shares of Series B Preferred Stock, convertible into Common Stock under the same
terms as the debentures.  Also in connection with this modification, the Company
issued an additional warrant to purchase up to 175,000 shares of Common Stock at
any time prior to October 24, 2002, at the exercise price of $7.48 per share.
Additionally, the Company entered into an amended and restated registration
rights agreement with the investor under which the Company registered the Common
Stock issuable upon conversion of the Preferred Stock and exercise of the
warrants.  Under the MOU, the Company agreed that it would convert the remaining
$2,150,000 balance into 107,500 shares of Preferred Stock effective as of
September 30, 1997.  Prior to the actual issuance of such Preferred Stock,
however, the investor converted the balance of $2,150,000 into 431,619 shares of
Common Stock.  The Company received a second payment in the amount of $2,500,000
in exchange for 125,000 shares of Preferred Stock. All of these preferred shares
and related dividends were converted into 548,770 shares of Common Stock.

The issuance of the securities described above was, and the issuance of the
Common Stock underlying the Preferred Stock, warrants and options identified
above will be, accomplished without registration under the 1933 Act, pursuant to
exemptions or exceptions from the registration requirement of the 1933 Act
afforded by Section 4(2) of 1933 Act and the rules and regulations promulgated
thereunder and/or Regulation S under the 1933 Act.

JNC Opportunity Fund Ltd. and Diversified Strategies Fund, L.P.

The Company entered into a Memorandum of Understanding ("MOU2") dated as of
September 30, 1997, with JNC Opportunity Fund, Ltd. ("JNC") and Diversified
Strategies Fund, L.P. ("DSF") (JNC and DSF are collectively referred to in this
Report as the "Series C Investors").  The Series C Investors each are investment
entities that have no prior affiliation or relationship of any kind with the
Company or its affiliates prior to the execution of the MOU2.  Under the MOU2,
the Series C Investors agreed to subscribe for the purchase of 187,500 shares of
Series C Preferred for a purchase price of $3,750,000.  Each share of Series C
Preferred has a "stated" or principal value of $20, on which amount dividends
accrue at the rate of 5% per annum and are payable quarterly in cash or Common
Stock at the option of the Company. The Series C Preferred is convertible into
that number of shares of Common Stock as is determined by dividing the aggregate
stated value of the Series C Preferred to be converted by the lesser of $5.9813
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% for any conversion
on or prior to the 120th day after the original issue date, 90% for any
conversion between 121 and 180 days and 88% for any conversion thereafter.
Subsequent to September 30, 1997, the Company and the Series C Investors
executed definitive documents in connection with the transactions described in
the MOU2, which documents included, among others, a Preferred Stock Purchase
Agreement (the "Series C Agreement") and a Registration Rights Agreement (the
"Series C Registration Rights Agreement").  Also in connection with the issuance
of the Series C Preferred as described in the MOU2 and the Series C Agreement,
the Series C Investors received the Series C Warrants.  Under the Series C
Registration Rights Agreement, the Company registered the Common Stock issuable
upon conversion of the Series C Preferred, payment of dividends thereon and
exercise of the Series C Warrants.  The Company received the entire purchase
price of the Series C Preferred, $3,750,000, and the Series C Investors have
since converted all of the shares of Series C Preferred and related dividends
into 1,312,897 shares of Common Stock, 17,198 of which were converted during
fiscal year 1997.

The issuance of the securities described above was, and the issuance of the
Common Stock underlying the Preferred Stock, warrants and options identified
above will be, accomplished without registration under the 1933 Act, pursuant to
exemptions or exceptions from the registration requirement of the 1933 Act
afforded by Section 4(2) of the 1933 Act and the rules and regulations
promulgated thereunder and/or Regulation S under the 1933 Act.

                                 Page 17 of 46
<PAGE>
 
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 each of
the four fiscal years ended December 31, 1997, 1996, 1995 and 1994.  The
Company's inception was October 1, 1993.  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.

<TABLE>
<CAPTION>
                                                           FOR THE YEARS ENDED DECEMBER 31,
                                                ------------------------------------------------------
                                                   1997             1996          1995          1994
                                                -----------     -----------   -----------   -----------       
<S>                                             <C>             <C>           <C>           <C>
                                                       (IN THOUSANDS, EXCEPT PER SHARE DATA)

STATEMENT OF OPERATIONS DATA:

Revenues                                        $        --     $        --   $        --   $        --

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

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

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

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

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

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

Basic and diluted net loss per common share     $     (0.59)    $     (0.21)  $     (0.30)  $     (0.28)
                                                ===========    ============   ===========   =========== 
Weighted average number of common shares          
 outstanding                                     42,320,188      36,982,610    21,343,349    14,095,000
</TABLE>


                                           
<TABLE>
<CAPTION>
                                                                AS OF DECEMBER 31,
                                                ------------------------------------------------------
                                                    1997           1996           1995          1994
                                                ------------   ------------   -----------   ----------       
                                                                    (IN THOUSANDS)

BALANCE SHEET DATA:

<S>                                             <C>            <C>            <C>           <C>
Current assets                                  $21,148,689    $23,967,601    $7,912,728    $2,150,286

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

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

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

Stockholders' equity (deficit)                    2,372,475      6,270,189     1,309,734    (1,967,709)
</TABLE>

                                 Page 18 of 46
<PAGE>
 
ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS

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

OVERVIEW
--------

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

Other than the arrangements with Siemens and OGI, the Company has no licensing
or co-development agreements with any third party and other than the non-
refundable license fee paid by Siemens, the Company has received no revenue to
date.  fonix presently anticipates that any products incorporating the Company's
Core Technologies would be manufactured and marketed by such third party
licensees and co-development and strategic alliance partners such as Siemens and
therefore has no plans to manufacture products incorporating the ASRT for the
foreseeable future.  The Company is presently engaged in discussions with
potential licensees and co-developers.  There can be no assurance that the
Company will be able to license its Core Technologies to third parties other
than Siemens or enter into additional co-development or strategic alliance
agreements.

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

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

                                 Page 19 of 46
<PAGE>
 
RESULTS OF OPERATIONS
---------------------

1997 COMPARED TO 1996

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

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

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

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

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

The Company extinguished debentures in the amount of $2,150,000 and related
accrued interest of $28,213 by issuing 108,911 shares of Series B Preferred
Stock.  In connection with the extinguishment of the debentures and the issuance
of Series B Preferred Stock, the Company expensed unamortized prepaid financing
costs in the amount of $220,014 as 

                                 Page 20 of 46
<PAGE>
 
a loss on extinguishment of debt. In connection with this extinguishment, the
Company issued a warrant to purchase up to 175,000 shares of Common Stock. The
Company recorded the fair value of the warrant of $661,850 as an additional loss
on extinguishment of debt.

1996 COMPARED TO 1995

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

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

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

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

LIQUIDITY AND CAPITAL RESOURCES
-------------------------------

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

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

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

                                 Page 21 of 46
<PAGE>
 
Effective September 30, 1997, the Company and the Series B Convertible Debenture
holders agreed to modify the Agreement.  The holder extinguished all then
outstanding debentures in the amount of $2,150,000 and related accrued interest
of $28,213 for 108,911 shares of Series B Preferred Stock having essentially the
same terms as the debentures. In connection with the extinguishment of the
Series B Convertible Debentures and the issuance of Series B Preferred Stock,
the Company recorded all unamortized prepaid financing costs as a loss on
extinguishment of debt.  Also in connection with this modification, the Company
issued an additional warrant to purchase up to 175,000 shares of Common Stock at
any time prior to October 24, 2002, at the exercise price of $7.48 per share.
In connection with the issuance of that warrant, the Company recorded the fair
value of the warrant, totaling $661,850, as a loss on extinguishment of debt.

Dividends accrue on the stated value ($20 per share) of Series B Preferred Stock
at a rate of 5 percent per year, are payable quarterly in cash or Common Stock,
at the option of the Company, and are convertible into shares of the Company's
Common Stock at anytime after issuance at the holder's option.  In the event of
liquidation the holders of the Series B Preferred Stock are entitled to an
amount equal to the stated value ($20 per share) plus accrued but unpaid
dividends whether declared or not.  The holders of Series B Preferred Stock have
no voting rights.  The Series B Preferred Stock, together with dividends accrued
thereon, may be converted into shares of the Company's Common Stock at the
lesser of $6.81 or the average of the per share market value for the five
trading days immediately preceding the conversion date multiplied by 90 percent
for any conversion on or prior to the 120/th/ day after the original issue date
and 87.5 percent for any conversion thereafter.  Using the conversion terms most
beneficial to the holder, the Company recorded a dividend of $219,614, which
represents a discount of 10 percent, which is available to the holder upon
issuance.  The additional 2.5 percent discount of $68,509 was amortized as a
dividend over the remaining days in the 120 vesting period. Prior to the actual
issuance of the Series B Preferred Stock in exchange for the outstanding balance
under the debenture, the holder converted the balance of $2,150,000 into 431,679
shares of Common Stock.

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

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

Effective September 30, 1997, the Company entered into an agreement with an
unrelated investment entity whereby that entity agreed to purchase 187,500
shares of the Company's Series C Preferred Stock for $3,750,000. The cash
purchase price was received in October 1997.  Dividends accrue on the stated
value of Series C Preferred Stock at a rate of 5 percent per year, are payable
quarterly in cash or Common Stock, at the option of the Company, and are
convertible into shares of the Company's Common Stock at anytime after issuance
at the holder's option.  In the event of liquidation the holders of the Series C
Preferred Stock are entitled to an amount equal to the stated value ($20 per
share) plus accrued but unpaid dividends whether declared or not.  The holders
of Series C Preferred Stock have no voting rights. The Series 

                                 Page 22 of 46
<PAGE>
 
C Preferred Stock, together with dividends accrued thereon, may be converted
into shares of the Company's Common Stock at the lesser of $5.98 or the average
of the five lowest closing bid prices for the 15 trading days preceding the date
of any conversion notice multiplied by 91 percent for any conversion on or prior
to the 120/th/ day after the original issue date, 90 percent for any conversion
between 121 and 180 days and 88 percent for any conversion thereafter. Using the
conversion terms most beneficial to the holder, the Company recorded a dividend
of $1,060,718, which represents a discount of 9 percent, which is available to
the holder on or before 120 days subsequent to closing. The additional 3 percent
discount of $164,002 is being amortized as a dividend over 180 days. As a
condition for issuing convertible Preferred Stock, the Series C Preferred
Stockholder was granted a put option by SMD. The put option required SMD to
purchase the Series C Preferred Stock from the holder at the holder's option,
but only in the event that the Common Stock of the Company is removed from
listing on the Nasdaq Small Cap Market or any other national securities exchange
or if the trading price of the Company's Common Stock drops below $3.00 per
share for two consecutive days. No agreement required the Company to reimburse
SMD should SMD have been required to purchase the Preferred Stock from the
holder. In connection with this put option, the Company recorded an expense and
a corresponding capital contribution of $375,000. Associated with the issuance
of the Series C Preferred Stock, the Company issued a warrant to purchase up to
200,000 shares of Common Stock at any time prior to October 24, 2000, at the
exercise price of $7.18 per share. The Company recorded the fair market value of
the warrant of $600,000 as determined as of October 24, 1997 using the Black-
Scholes pricing model. During the year ended December 31, 1997, the Company
issued 17,198 shares of Common Stock upon conversion of 2,500 shares of Series C
Preferred Stock and related accrued dividends. Subsequent to December 31, 1997,
the balance of 185,000 shares of Series C Preferred Stock and related dividends
were converted into 1,295,699 shares of the Company's Common Stock and there are
presently no shares of Series C Preferred Stock outstanding.

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

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

Presently, the Company anticipates that it will need to 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 has
recently acquired AcuVoice and is actively seeking additional acquisition
opportunities.  These transactions will require additional capital resources,
even if the Company uses its securities in payment of all or part of the
purchase price of such acquisitions.  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.

                                 Page 23 of 46
<PAGE>
 
The Company's Core Technologies are designed to be Year 2000 compliant.  The
Company intends to monitor the efforts of third-party providers whose services
are critical to the Company as they become Year 2000 compliant.  Management is
presently not aware of any Year 2000 issues that have been encountered by any
such third-party which could materially affect the Company's operations.
Notwithstanding the foregoing, there can be no assurance that the Company will
not experience operational difficulties as a result of Year 2000 issues, either
arising out of internal operations, or caused by third-party service providers,
which individually or collectively could have an adverse impact on business
operations or require the Company to incur unanticipated expenses to remedy any
problems. providers as they become Year 2000 compliant.

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

                                    OUTLOOK

CORPORATE OBJECTIVES, TECHNOLOGY VISION AND ACQUISITION STRATEGY

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

Management believes the strengths of fonix include:

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

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

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

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

     .    speech recognition and synthesis
     .    speaker identification
     .    pen and touch screen input
     .    haptic (manual) input and output
     .    facial and gesture input and output

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

     .    PC's and cellular phones

                                 Page 24 of 46
<PAGE>
 
     .    automotive and home environment speech controls
     .    automated information and transaction kiosks and telephone systems
          with natural dialogue and gesture controls

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

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

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

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

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

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

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

As the Company proceeds to implement its strategy and to reach its objectives,
it anticipates realizing several benefits for itself and for its shareholders.
In 1998, the Company will, for the first time in its history, begin to realize
recurring revenues.  In addition, the Company expects further development of
complementary technologies, added product and applications development
expertise, access to market channels, leverage of strategic alliances, increased
access to capital markets, and additional opportunities for strategic alliances
in other industry segments.

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

               SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Certain statements contained herein under "Business," "Management's Discussion
and Analysis of Financial Condition and Results of Operations" and "Outlook,"
including statements concerning (i) the Company's strategy, (ii) the Company's
expansion plans, (iii) the market for the Company's technology, products and
services, (iv) the effects of future government regulation of the Company's
products, (v) the development and launch of new products and the results 

                                 Page 25 of 46
<PAGE>
 
of research and development efforts, and (vi) the growth of the Company's
business, contain certain forward-looking statements concerning the Company's
operations, economic performance and financial condition. Because such
statements involve risks and uncertainties, actual results may differ materially
from those expressed or implied by such forward-looking statements. Factors that
could cause such differences include, but are not necessarily limited to, those
discussed under the heading "Certain Significant Risk Factors," elsewhere in
this Report.

ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     Index to Financial Statements:
<TABLE>
<CAPTION>
<S>                                                                                                     <C>
      Reports of Independent Public Accountants                                                          F-2
 
      Consolidated Balance Sheets as of December 31, 1997 and 1996                                       F-5
 
      Consolidated Statements of Operations for the Years Ended December 31, 1997, 1996
           and 1995 and for the Period from October 1, 1993 (Date of Inception) to December 31, 1997     F-6
 
      Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 1997, 1996
           and 1995 and for the Period from October 1, 1993 (Date of Inception) to December 31, 1997     F-7
 
      Consolidated Statements of Cash Flows for the Years Ended December 31, 1997, 1996
           and 1995 and for the Period from October 1, 1993 (Date of Inception) to December 31, 1997    F-10
 
      Notes to Consolidated Financial Statements                                                        F-12
 
</TABLE>
ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
          FINANCIAL DISCLOSURE

Subsequent to the year ended December 31, 1997, in February 1998, the Company
appointed Arthur Andersen LLP ("Andersen") to replace Deloitte & Touche LLP
("Deloitte") as independent auditors of the Company for the fiscal year ended
December 31, 1997.  Deloitte resigned as the Company's independent auditors on
February 23, 1998.

The report of Deloitte on the Company's consolidated financial statements for
the year ended December 31, 1996 contained no adverse opinion or disclaimer of
opinion and was not qualified or modified as to uncertainty, audit scope or
accounting principle, except that Deloitte's report on the consolidated
financial statements for the year ended December 31, 1996 included an
explanatory paragraph with respect to the Company being in the development stage
and its having suffered recurring losses which raise substantial doubt about its
ability to continue as a going concern.

The decision to engage Andersen as the Company's independent auditors was
approved by the Company's board of directors.

In connection with the audit for the year ended December 31, 1996, and through
February 23, 1998, the Company has had no disagreements with Deloitte on any
matter of accounting principles or practices, financial statement disclosure, or
auditing scope or procedure, which disagreements if not resolved to the
satisfaction of Deloitte would have caused it to make reference thereto in its
report on the consolidated financial statements for such year.

During the year ended December 31, 1996, and through February 23, 1998, there
have been no reportable events (as defined in Item 304(a)(1)(v) of Regulation S-
K).

                                 Page 26 of 46
<PAGE>
 
                                    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, 1998:
<TABLE>
<CAPTION>
 
Name                          Age          Position
----                          ---          --------                                             
<S>                           <C>          <C>
 
Stephen M. Studdert            49          Chairman and CEO
Thomas A. Murdock              53          Director, President and Chief Operating Officer
Roger D. Dudley                45          Director, Executive Vice President, Corporate Finance
John A. Oberteuffer, Ph.D.     57          Director, Vice President, Technology
Douglas L. Rex                 52          Vice President, Chief Financial Officer and Treasurer
Alan C. Ashton, Ph.D.          54          Director
Joseph Verner Reed             61          Director
James B. Hayes                 58          Director
Rick D. Nydegger               49          Director
Reginald K. Brack              60          Director
</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, Chairman, Chief Executive Officer.  Mr. Studdert, 49,
     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, and has
     been the Company's Chief Executive Officer since May 1996.  He also is the
     Chairman of the Board of Directors of K.L.S. Enviro Resources, Inc.
     ("KLSE"), a company with a class of securities registered under Section
     12(g) of the Securities Exchange Act of 1934, as amended (the "Exchange
     Act").  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 who each are executive officers and
     directors of the Company.  He 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.

     THOMAS A. MURDOCK, President, Chief Operating Officer and Director.  Mr.
     Murdock, 53, is a co-founder and has served as an executive officer and
     member of the Company's Board of Directors since June 1994.  Mr. Murdock
     also has served as President of SCC since 1992 and Assistant to the
     Chairman and Director of Synergetics, Inc., a research company located in
     Utah that formerly has provided research and development services in
     connection with the Company's automatic computer voice recognition and
     related technologies.  For much of his career, Mr. Murdock has been a
     commercial banker and a senior corporate executive with significant
     international emphasis and experience.  Mr. Murdock also serves as a
     director of KLSE.

     ROGER D. DUDLEY, Executive Vice President, Corporate Finance, and Director.
     Mr. Dudley, 45, is a co-founder 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 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.  He
     also serves as an executive officer of an entity which manages a foreign
     investment fund. He is also a director of KLSE.

     JOHN A. OBERTEUFFER, Ph.D., Vice President Technology and Director.  Dr.
     Oberteuffer, 57, 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 automatic speech recognition
     industry.  In addition, VIA publishes the monthly newsletter, ASRNews.  Dr.
     Oberteuffer also is 

                                 Page 27 of 46
<PAGE>
 
     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, and he was
     a member of the research staff at Massachusetts Institute of Technology for
     five years.

     DOUGLAS L. REX has served as the Chief Financial Officer of the Company
     since May 1997.  For the past seven years Mr. Rex has been 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 (AICPA) and the Utah Association of Certified Public
     Accountants (UACPA).  Mr. Rex is also the Chief Financial Officer of KLSE.
     Mr. Rex is also a Vice President and the CFO of SCC.

     ALAN C. ASHTON, Ph.D., Director.  Dr. Ashton, 54, has served on the
     Company's Board of Directors since October 23, 1995.  He conducted research
     and taught computer science for more than 16 years before launching his own
     word-processing computer software company, WordPerfect Corporation, where
     he also served as an executive officer and director.  WordPerfect employed
     more than 4,000 employees worldwide and realized annual revenues of more
     than $700 million before being acquired by Novell, Inc. in 1994.  Dr.
     Ashton served as a director Novell from 1994 until 1996.  He presently
     serves on the board of directors of Geneva Steel and SkyMall, Inc. Novell,
     Geneva Steel and SkyMall each have a class of securities registered under
     Section 12 of the Exchange Act.  Dr. Ashton also currently serves on the
     governing board of Utah Valley State College.

     JOSEPH VERNER REED, Director.  Ambassador Reed, 61, has served as a
     director of the Company since June 1994.  He 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.  Since
     December 31, 1996, Ambassador Reed also has served as a director of KLSE, a
     company with a class of securities registered under Section 12 of the
     Exchange Act.

     JAMES B. HAYES, Director.  Mr. Hayes, 58, is the former Publisher of
     FORTUNE, one of America's most prestigious business publications, and a
     former Vice President of Time, Inc.  He joined Time, Inc. in 1959 and held
     various positions including Publisher of Discover.  In July 1995, he was
     appointed President and Chief Executive Officer of Junior Achievement,
     Inc., a position he continues to occupy.  He was one of 15 U.S. business
     executives selected for a Presidential Mission to the former Soviet Union
     to discuss business development and economic cooperation.  He presently is
     Chairman of Moorehouse School of Medicine.  Mr. Hayes has served on the
     Company's Board of Directors since June 1994.

     RICK D. NYDEGGER, Director. Mr. Nydegger, 49, is a patent and trademark
     attorney.  Mr. Nydegger was a founder and, during the past five years, has
     been a shareholder and director of the law firm Workman, Nydegger & Seeley
     in Salt Lake City, Utah, a firm specializing in patent, trademark,
     copyright, trade secret, unfair competition, licensing and intellectual
     property matters.  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.
     He also joined the Board of Directors of KLSE in December 1996.

     REGINALD K. BRACK, Director.  Mr. Brack, 60, was named to the Board of
     Directors in 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., a wholly owned subsidiary of Time Warner
     Inc., is the world's largest book and magazine publishing company and the
     fastest growing on-line media entity.

                                 Page 28 of 46
<PAGE>
 
                     SIGNIFICANT EMPLOYEES AND CONSULTANTS

In addition to the officers and directors identified above, the Company expects
the following individuals (listed in alphabetical order) to make significant
contributions to the Company's business.

     CARL HAL HANSEN.  Mr. Hansen, 47, is Senior Project Engineer for the
     Company's automatic speech recognition technologies ("ASRT"), and Chairman
     and CEO of Synergetics.  Mr. Hansen holds a degree in Electronics from the
     Utah Trade Technical Institute of Provo, Utah.  For approximately fourteen
     years, Mr. Hansen was employed by Signetics, Inc. in various capacities,
     including Test Equipment Engineer, Characterization Engineer, Product
     Engineer, and as an Electronic Specialist.  He was involved in the design,
     fabrication and release of layout design for PC boards and interfaces.  In
     1991, Mr. Hansen founded Synergetics, where he continues to have direct
     leadership with respect to new product development and engineering.  Since
     March 13, 1997, he has been a full-time consultant to the Company.

     CAROLINE HENTON, Ph.D.  Dr. Henton, 43, is 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.

     TONY R. MARTINEZ, Ph.D.  Dr. Martinez, 38, 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, 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 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, 38, 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.

     E. DAVID BARTON.  Mr. Barton was a founder of AcuVoice and continues to
     serve as its Chief Executive Officer.  Before founding AcuVoice in 1985,
     Mr. Barton was the founder and Chief Executive Officer of Bartco
     International, Inc., a Texas corporation from 1976 to 1985.  Since 1959,
     Mr. Barton has held a number of executive positions with companies doing
     business in the U.S. and abroad.  He holds a BA in Psychology and an MA in
     Psychology and Language from the Catholic University of America, an MA in
     Japanese Language, History and Culture from the Institute of Oriental
     Languages in Tokyo, Japan, and an MS (with credits in Linguistics,
     Phonology and Semantics) from the University of New York.

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

                                 Page 29 of 46
<PAGE>
 
ITEM 11.  EXECUTIVE COMPENSATION

The following table sets forth information concerning the compensation paid to
the Company's Chief Executive Officer and the Company's other executive officers
whose annual compensation exceeded $100,000 during the last fiscal year (other
than the Chief Executive Officer), collectively the "Named Executive Officers":

                           SUMMARY COMPENSATION TABLE
<TABLE> 
<CAPTION> 
  
                               ANNUAL COMPENSATION          LONG-TERM COMPENSATION
                               -------------------          ----------------------

                                                                    AWARDS
-----------------------------------------------------------------------------------

                                                                         SECURITIES
                                                              OTHER      UNDERLYING
                                                              ANNUAL     OPTIONS/
NAME AND PRINCIPAL POSITION    YEAR (1)      SALARY           BONUS      SARS(#)
---------------------------    -------      --------        ---------    ----------                                    
<S>                            <C>          <C>             <C>          <C>
Stephen M. Studdert              1995        -- /(2)/       -- /(2)/             0
CEO (4/96-Present)               1996       $ 131,539       -- /(2)/       400,000
                                 1997       $ 305,385       -- /(2)/       400,000
 
Thomas A. Murdock                1995        -- /(2)/       -- /(2)/             0
CEO (6/94 to 4/96)               1996       $ 131,539       -- /(2)/       400,000
President, COO                   1997       $ 305,385       -- /(2)/       400,000
 
Roger D. Dudley                  1995        -- /(2)/       -- /(2)/             0
Exec. VP                         1996       $ 131,539       -- /(2)/       400,000
                                 1997       $ 305,385       -- /(2)/       400,000
 
---------------------------                                 
</TABLE>

     (1)  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
          [See Director Compensation, below]. All options granted in 1997 were
          granted pursuant to the Company's 1997 Stock Option Plan.

     (2)  During fiscal 1995 and part of 1996, these executive officers were not
          compensated directly by the Company.  During those periods, any
          compensation received by the Named Executive Officers for any services
          rendered by them to the Company was paid by SCC, an entity owned and
          controlled by the Named Executive Officers. [See, "Certain
          Relationships and Related Transactions."]  Although the Company makes
          no representation about the compensation arrangements between SCC and
          its employees, including the Named Executive Officers, the total
          compensation paid by the Company to SCC during such periods is as
          follows:
<TABLE>
<CAPTION>
 
                                       Management Fee   Management Fee
                     Year                 (Cash)           (Stock) 
                     ----              --------------   --------------
                     <S>               <C>              <C>
 
                     1995                 $111,339        3,699,900 *
                     1996                 $120,000               --
</TABLE>

          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 

                                 Page 30 of 46
<PAGE>
 
          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 of
          Directors' resolution authorizing the issuance of the SCC Warrants
          specified that the purchase price for the SCC Warrants and the
          exercise price for shares of Common Stock underlying the SCC Warrants
          could be satisfied by canceling invoices for services previously
          rendered to the Company under the Consulting Agreement or by cash
          payment. 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 each of
          the Named Executive Officers. The material terms of each executive
          employment agreement with each executive officer 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. 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 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 

                                 Page 31 of 46
<PAGE>
 
          shares purchased by SCC on August 11, 1995 and on the bonus amount.
          The amounts allocated for this bonus was $2.5 million, of which
          $2,102,585 had been paid out as of December 31, 1997.
          
          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.

                       OPTION GRANTS IN FISCAL YEAR 1997
<TABLE>  
<CAPTION>
                                                                                          POTENTIAL REALIZABLE
                                                                                            VALUE AT ASSUMED
                                                                                             ANNUAL RATES OF
                              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 FISCAL YEAR    ($/SHARE)      DATE              5%  ($)         10%  ($)
<S>                    <C>           <C>               <C>          <C>                 <C>             <C>        
-------------------    ------------  ----------------  -----------  -------------       ---------       ----------
 
Stephen M. Studdert       200,000          4.2%           $6.00      10/28/2007          $60,000         $120,000
 
Thomas A. Murdock         200,000          4.2%           $6.00      10/28/2007          $60,000         $120,000
 
Roger D. Dudley           200,000          4.2%           $6.00      10/28/2007          $60,000         $120,000
 
</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, 1997.

       BOARD OF DIRECTORS MEETINGS, COMMITTEES AND DIRECTOR COMPENSATION

The Company's Board of Directors took action at 7 duly noticed meetings of the
Board during 1997.  Each director attended (in person or telephonically) at
least 75% of the meetings of the Company's Board of Directors except for Messrs.
Hayes and Reed, who attended or otherwise participated in 5 of the 7 meetings.
During 1997, 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. Hayes, Reed and Dudley, and
Compensation Committee, comprised of Messrs. Studdert, Reed, Ashton 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 Securities 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 its Chief Executive Officer, Stephen M. Studdert,
during the year ended December 31, 1997.

                                 Page 32 of 46
<PAGE>
 
Compensation Policy.  The Committee's policy with respect to executive
compensation has been designed to:

          .    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;

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

          .    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:

          .    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.

          .    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

                                 Page 33 of 46
<PAGE>
 
               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
               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.

          .    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. Studdert, Murdock and Dudley.  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
                              Alan C. Ashton
                              Rick D. Nydegger

                           COMPENSATION OF DIRECTORS

Prior to April 1996, the Company's directors received no compensation for their
service as such, although the Company historically has reimbursed its directors
for actual expenses incurred in traveling to and participating in director's
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 for
each of fiscal 1996 and 1997 which options vest after completion of at least six
months' service on the Board during those fiscal years.   Such options have
terms of 10 years. 

                                 Page 34 of 46
<PAGE>
 
Thus, under the Directors Plan, during the fiscal year ended
December 31, 1997, the Company granted stock options to members of the Board as
follows:

           STOCK OPTIONS GRANTED TO DIRECTORS DURING FISCAL YEAR 1997
<TABLE>
<CAPTION>
 
                       SHARES       DATE      EXERCISE         SHARES VESTED
NAME                   GRANTED (#)  GRANTED   PRICE PER SHARE    AT FY-END
----                   -----------  --------  ---------------  -------------
<S>                    <C>          <C>       <C>              <C>
 
Stephen M. Studdert    200,000      10/28/97  $6.00               600,000
Alan C. Ashton         200,000      10/28/97  $6.00               200,000
Joseph Verner Reed     200,000      10/28/97  $6.00               600,000
James B. Hayes         200,000      10/28/97  $6.00               600,000
Rick D. Nydegger       200,000       3/13/97  $7.13               200,000
                       200,000      10/28/97  $6.00                     0
Reginald K. Brack      200,000      10/28/97  $6.00                     0
Thomas A. Murdock      200,000      10/28/97  $6.00               600,000
Roger D. Dudley        200,000      10/28/97  $6.00               600,000
 
</TABLE>
               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 ten percent
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, 1997, the Company is aware of the following untimely filings:
the grant of the options to each director in October 1997 was reported on a Form
5 which was filed after the 45/th/ day following the fiscal year end.  However,
the Company believes that all other transactions required to be reported under
Section 16(a) of the Securities Exchange Act were reported on timely filed
reports by the affected individuals.

                                 Page 35 of 46
<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,
1997, 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, 1993 in the Company's Common
Stock and in the Common Stock of the companies in the referenced Indexes and
further assumes reinvestments of dividends.

                       [PERFORMANCE GRAPH APPEARS HERE]

<TABLE>
                   COMPARISON OF FIVE YEAR CUMULATIVE RETURN
        AMONG FONIX CORPORATION, MEDIA GENERAL INDEX AND SIC CODE INDEX

<CAPTION>
                                              Media
Measurement period                 fonix     General     SIC Code
(Fiscal Year Covered)           Corporation   Index       Index
---------------------           -----------  --------    --------
<S>                             <C>          <C>         <C>
Measurement PT -
12/1992                         $100.00      $100.00     $100.00

FYE 12/1993                     $102.67      $119.95     $124.40
FYE 12/1994                     $ 93.99      $125.94     $ 82.68
FYE 12/1995                     $222.72      $163.35     $ 75.34
FYE 12/1996                     $495.88      $202.99     $ 78.19
FYE 12/1997                     $174.00      $248.30     $104.53
</TABLE> 


                                 Page 36 of 46
<PAGE>
 
ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

The following table sets forth, as of March 31, 1998, the number of shares of
Common Stock of the Company beneficially owned by all persons known to be
holders of more than 5 percent 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
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>
     Thomas A. Murdock                                   26,947,981/(2)/          51.2%
     President, COO and Director
 
     Alan C. Ashton, Director                            12,329,167/(3)(4)/       23.7%
     c/o Beesmark Investments, L.C.
     261 East 1200 South
     Orem, Utah 84097
 
     Beesmark Investments, L.C.                          11,729,167/(4)/          22.8%
     5% Beneficial Owner
     261 East 1200 South
     Orem, Utah  84097
 
     Roger D. Dudley, Executive Vice President            8,329,596/(5)/          15.9%
     and Director
 
     Stephen M. Studdert, Chairman of the Board           8,329,296/(6)/          15.9%
     Chief Executive Officer
 
     Studdert Companies Corp.                             3,700,000/(7)/           7.2%
     5% Beneficial Owner
 
     Joseph Verner Reed, Director                         1,020,000/(8)/           2.0%
     73 Sterling Road
     Greenwich, Connecticut 06831
 
     James B. Hayes, Director                             1,020,000/(8)/           2.0%
     One Education Way
     Colorado Springs, Colorado 80906
 
     Rick D. Nydegger, Director                             400,000                1.0%
     10217 North Oak Creek Lane
     Highland, Utah 84003
 
     John A. Oberteuffer, Ph.D.                             180,000                *
     Voice Information Associates, Inc.
     14 Glen Road South
     Lexington, Massachusetts 02173
 
     Reginald K. Brack, Director                            226,500/(9)/           *
 
     Douglas L. Rex, Chief Financial Officer                205,300/(10)/          *
 
     Officers and Directors as a Group (10 persons)      33,086,587               56.4%
---------------
</TABLE>
     [Footnotes on following page.]

                                 Page 37 of 46
<PAGE>
 
     * Less than 1 percent.

     /(1)/    Percentages rounded to nearest 1/10th of one percent. Except as
              indicated in the footnotes below, each of the persons listed
              exercises sole voting and investment power over the shares of the
              Company's Common Stock listed for each such person in the table.

     /(2)/    Includes 25,657,749 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 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 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 3,465,083 shares as to which he directly owns the
              economic interest, 3,700,000 shares the economic rights as to
              which are owned by SCC, of which Mr. Murdock is a 1/3 equity owner
              and 11,400 shares the economic rights as to which are owned by a
              limited liability company of which Mr. Murdock is a 1/3 equity
              owner. Also includes 2,813 shares owned directly by Mr. Murdock,
              140,232 shares (including shares issuable upon the exercise of
              options) beneficially owned by members of Mr. Murdock's immediate
              family and 1,150,000 shares of Common Stock underlying stock
              options exercisable presently or within 60 days.

     /(3)/    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.

     /(4)/    Beesmark's beneficial ownership includes 166,667 shares of Common
              Stock presently issuable upon the conversion of shares of Series A
              Preferred Stock. All shares are deposited into the Voting Trust.
              The managers of Beesmark are Alan C. 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.

     /(5)/    Includes (i) 3,465,083 shares owned by Mr. Dudley and deposited
              into the Voting Trust, (ii) 3,700,000 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 SMD, as to which Mr. Dudley has 1/3
              indirect equity ownership and control and that are deposited into
              the Voting Trust; and (vi) 1,150,000 shares underlying stock
              options exercisable presently or within 60 days.

     /(6)/    Includes (i) 3,465,083 shares owned by Mr. Studdert and deposited
              into the Voting Trust, (ii) 3,700,000 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 SMD, as to
              which Mr. Studdert has 1/3 direct equity ownership and control and
              which are deposited in the Voting Trust; and (v) 1,150,000 shares
              underlying stock options exercisable presently or within 60 days.

                                 Page 38 of 46
<PAGE>
 
     /(7)/    All shares deposited into the Voting Trust.

     /(8)/    Includes 1,000,000 shares of Common Stock underlying presently
              exercisable stock options.

     /(9)/    Includes 26,000 shares owned directly by Mr. Brack and 500 shares
              owned by Mr. Brack's son and 200,000 shares underlying options.

     /(10)/   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 200,000 shares underlying presently
              exercisable stock options.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Studdert Companies Corp.

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

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

Pursuant to the SCC Agreement, the Company paid to SCC $209,300 during the year
ended December 31, 1994.  At December 31, 1994, the Company owed SCC $1,164,200
for accrued management fees and $66,805 for expenses incurred.  Between January
and July 1995, SCC continued to invoice the Company for services rendered under
the Consulting Agreement.  By July 1995, the Company owed SCC approximately
$1,417,000 pursuant to the terms of the SCC Agreement.  On November 16, 1994,
the Company's Board of Directors approved the issuance of warrants to purchase
up to 3,700,000 shares of the Company's Common Stock to SCC (the "SCC
Warrants").  The authorized purchase price of the SCC Warrants was $.033 per
share, and the authorized exercise price for each share of Common Stock
underlying the SCC Warrants was $.35.  The Board of Directors' resolution
authorizing the issuance of the SCC Warrants specified that the purchase price
for the SCC Warrants and the exercise price for shares of Common Stock
underlying the SCC Warrants could be satisfied by canceling invoices for
services previously rendered to the Company under the Consulting Agreement or by
cash payment.  The November 16, 1994 Board meeting was attended by a quorum of
the Board, but only one director who was not also a principal of SCC was
present.  Subsequently, on April 11, 1995, pursuant to the unanimous consent of
all disinterested directors in lieu of a special Board meeting, all of the
Company's disinterested directors ratified the adoption of the resolution
authorizing the Company to offer the SCC Warrants.  On July 31, 1995, the
Company issued and SCC purchased the SCC Warrants.  The purchase price of the
SCC Warrants was $.033 per share of Common Stock underlying the SCC Warrants, or
an aggregate of $122,100.  On August 11, 1995, SCC exercised the SCC Warrants at
an exercise price of $.35 per share of Common Stock underlying the SCC Warrants.
Both the $122,100 purchase price and the $1,295,000 aggregate exercise price for
the SCC Warrants were satisfied by the cancellation of amounts invoiced to the
Company by SCC pursuant to the SCC Agreement during 

                                 Page 39 of 46
<PAGE>
 
the fiscal year ended December 31, 1994 and the period between January 1, 1995
and August 11, 1995. Such cancellation was accomplished on a dollar-for-dollar
basis.

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

Between January 1, 1996 and April 30, 1996, SCC invoiced the Company for
services under the SCC Agreement in the amount of $200,000.  Of that amount,
$80,000 was placed on conditional status pursuant to the Beesmark Agreement and
$120,000 was paid to SCC. On April 30, 1996, the disinterested members of the
Company's Board of Directors authorized the Company to enter into an agreement
with SCC modifying the SCC Agreement effective May 1, 1996. Under the SCC
Agreement, as modified, SCC no longer invoices the Company for management
services, but continues to invoice the Company for reimbursement of actual
expenses incurred on the Company's behalf.  SCC and the Company agreed that any
amounts invoiced under the SCC Agreement but placed on conditional status
pursuant to the Beesmark Agreement would remain outstanding obligations of the
Company payable only if the Company achieved the milestones specified in the
Beesmark Agreement.  The Company further agreed to pay any then accrued but
unpaid amounts invoiced under the SCC Agreement, including amounts owed and
carried over from the year ended December 31, 1995, which amounts totaled
$5,862, as well as outstanding amounts for expenses incurred.  In connection
with the modification of the SCC Agreement, the disinterested members of the
Company's Board of Directors approved base salaries for fiscal year 1996 for
each of the Company's executive officers, effective as of April 1996, as
follows: Stephen M. Studdert, Chief Executive Officer -- $180,000; Thomas A.
Murdock, President and Chief Operating Officer -- $180,000; and Roger D. Dudley,
Executive Vice President and Chief Financial Officer -- $180,000.  Effective
November 15, 1996, the disinterested members of the Company's Board of Directors
approved an increase in the base salaries of the executive officers from
$180,000 to $250,000 per annum for the remainder of fiscal 1996, with base
compensation increasing annually over the five-year term of those persons'
employment agreements.  [See Item 10. Executive Compensation].  In September
1996, Beesmark made the last of the funding payments provided for under the
terms of the Beesmark Agreement.  On February 10, 1997, the Company paid to SCC
the entire balance due to SCC for accrued management fees in the amount of
$337,000.  Thus, during the year ended December 31, 1996, the Company paid to
SCC a total of $120,000 for management fees and SCC was reimbursed for actual
expenses incurred on the Company's behalf in the amount of $740,052.  During
1996, the Company made no payments to SCC for capital raising activities.  The
Company and SCC have agreed to extend the SCC Agreement, at least insofar as the
Company has agreed to reimburse SCC for actual expenses incurred on behalf of
the Company, until December 1998.

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

                                 Page 40 of 46
<PAGE>
 
Cancellation of Debt By SCC and Thomas A. Murdock

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

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

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

Synergetics

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

John A. Oberteuffer

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

SMD

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

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

                                 Page 41 of 46
<PAGE>
 
                                    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, 1997 and 1996

          Consolidated Statements of Operations for the Years Ended December 31,
          1997, 1996 and 1995 and for the Period October 1, 1993 (Date of
          Inception) to December 31, 1997

          Consolidated Statements of Stockholders' Equity for the Years Ended
          December 31, 1997,1996 and 1995 and for the Period October 1, 1993
          (Date of Inception) to December 31, 1997

          Consolidated Statements of Cash Flows for the Years Ended December 31,
          1997, 1996 and 1995 and for the Period October 1, 1993 (Date of
          Inception) to December 31, 1997

          Notes to Consolidated Financial Statements

     2.   Financial Statement Schedules: Financial statement schedules have
          been omitted because they are not required or are not applicable, or
          because the required information is shown in the financial statements
          or notes thereto.

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

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

     (2)            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
                    
     (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

     (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

                                 Page 42 of 46
<PAGE>
 
     (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

     (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 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

                                 Page 43 of 46
<PAGE>
 
     (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)      Convertible Debenture Purchase Agreement dated as of June
                    18, 1997 between the Company and Southbrook International
                    Investments, Ltd., incorporated by reference from Amendment
                    No. 1 to the Quarterly Report on Form 10-Q for the period
                    ended June 30, 1997

     (10)(viii)     Amended and Restated Purchase Agreement effective as of
                    September 30, 1997 and dated as of October 24, 1997 by and
                    between the Company and Southbrook International
                    Investments, Ltd., which is incorporated by reference from
                    the Company's Quarterly Report on Form 10-Q for the period
                    ended September 30, 1997

     (10)(ix)       Convertible Preferred Stock Purchase Agreement effective as
                    of September 30, 1997 and dated as of October 24, 1997 by
                    and among the Company and JNC Opportunity Fund Ltd. and
                    Diversified Strategies Fund, L.P., which is incorporated by
                    reference from the Company's Quarterly Report on Form 10-Q
                    for the period ended September 30, 1997

     (10)(x)        Restated Master Agreement for Joint Collaboration between
                    the Company and Siemens, dated November 14, 1997, filed
                    herewith

     (10)(xi)       Restated First Statement of Work and License Agreement
                    between the Company and Siemens, dated February 11, 1998, as
                    revised*

     (10)(xii)      Master Technology Collaboration Agreement between the
                    Company and OGI, dated October 14, 1997, filed herewith.

     (10)(xiii)     Common Stock Purchase Agreement among the Company and JNC
                    Opportunity Fund Ltd. and Diversified Strategies Fund, LP,
                    dated as of March 9, 1998, filed herewith

     (10)(xiv)      Common Stock Purchase Agreement between the Company and
                    Thomson Kernaghan & Co., dated as of March 9, 1998, filed
                    herewith.

     (10)(xv)       Royalty Modification Agreement among the Company and
                    Synergetics, dated as of April 6, 1998, filed herewith

     (10)(xvi)      Purchase Agreement with John Oberteuffer and the Company
                    dated April 9, 1998, filed herewith

     (10)(xvii)     Employment Agreement by and between the Company and John A.
                    Oberteuffer, filed herewith

     (10)(xviii)    First Amendment to Master Agreement for Joint Collaboration
                    between the Company and Siemens, dated February 13, 1998,
                    filed herewith.

     (10)(xix)      Second Amendment to Master Agreement for Joint Collaboration
                    between the Company and Siemens, dated March 13, 1998, filed
                    herewith.

                                 Page 44 of 46
<PAGE>
 
     (22)           Subsidiaries of Registrant, filed herewith

     (23)(i)        Consent of Arthur Andersen LLP

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

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

     (27)           Financial Data Schedule
____________________

     * This document contains confidential information. The Confidential Portion
       has been filed separately with the Commission pursuant to an application
       for confidential treatment of such information.

(B)  Reports filed on Form 8-K during the last quarter of the fiscal year ended
     December 31, 1997:

     On October 27, 1997, the Company filed a Current Report on Form 8-K to
     report modifications and additional payments under a convertible debenture
     purchase agreement with an investor and to file pro forma financial
     information that included the proceeds received in connection with such
     modifications.

                                 Page 45 of 46
<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 13th day of April,
1998.

                                        FONIX CORPORATION


Date:    13 April 1998                By:   /s/ Stephen M. Studdert
     ---------------------               ---------------------------------------
                                         Stephen M. Studdert, Chairman and
                                         Chief Executive Officer


Date:    13 April 1998                By:    /s/ Douglas L. Rex
     ---------------------               ---------------------------------------
                                         Douglas L. Rex, Chief Financial Officer
                                         (Principal Financial and Accounting 
                                         Oficer)

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/ Stephen M. Studdert
--------------------------               _______________________________________
Stephen M. Studdert, Chairman,           Alan C. Ashton, Ph.D., Director
  Principal Executive Officer


13 April 1998
--------------------------               _______________________________________
Date                                     Date


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


 13 April 1998                            13 April 1998
--------------------------               ---------------------------------------
Date                                     Date

/s/ Thomas A. Murdock
__________________________               _______________________________________
Thomas A. Murdock, Director              James B. Hayes, Director

14 April 1998
__________________________               _______________________________________
Date                                     Date


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


 13 April 1998                           14 April 1998
------------------------------           _______________________________________
Date                                     Date


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


 12 April 1998
------------------------------
Date

                                 Page 46 of 46
<PAGE>
 
                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
<S>                                                                                                     <C> 
REPORTS OF INDEPENDENT PUBLIC ACCOUNTANTS                                                               F-2
 
FINANCIAL STATEMENTS
 
Consolidated Balance Sheets as of December 31, 1997 and 1996..........................................  F-5
 
Consolidated Statements of Operations for the Years Ended December 31, 1997, 1996 and 1995
   and for the period from October 1, 1993 (Date of Inception) to December 31, 1997...................  F-6
 
Consolidated Statements of Stockholders' Equity for the years ended December 31, 1997, 1996 and 1995
   and for the period from October 1, 1993 (Date of Inception) to December 31, 1997...................  F-7
 
Consolidated Statements of Cash Flows for the Years Ended December 31, 1997,  1996 and 1995
   and for the period from October 1, 1993 (Date of Inception) to December 31, 1997...................  F-10
 
Notes to Consolidated Financial Statements............................................................  F-12
 
</TABLE>

                                      F-1
<PAGE>
 
                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To fonix/(TM)/ corporation:

We have audited the accompanying consolidated balance sheet of fonix/(TM)/
corporation (a Utah corporation in the development stage) and subsidiary as of
December 31, 1997 and the related consolidated statements of operations,
stockholders' equity and cash flows for the year then ended, and for the period
from inception (October 1, 1993) to December 31, 1997. 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 consolidated financial statements of the Company as of December
31, 1996 and for the year then ended, 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 net loss. The consolidated financial statements of the
Company for the year ended December 31, 1995 and for the period from inception
(October 1, 1993) 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 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 reports 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/(TM)/ corporation and subsidiary as of December 31, 1997 and the results
of their operations and their cash flows for the year then ended and for the
period from inception (October 1, 1993) to December 31, 1997 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 revenues
through December 31,1997 and has incurred significant recurring losses since its
inception.  The Company expects these losses to continue at least through
December 31, 1998.  As of December 31, 1997, the Company has an accumulated
deficit of $45,017,746, minimal stockholders' equity of $2,372,475 and minimal
working capital of $678,823.  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 8, 1998

                                      F-2
<PAGE>
 
INDEPENDENT AUDITORS' REPORT

To the Board of Directors
  and Shareholders of
fonix/(TM)/ corporation
Salt Lake City, Utah

We have audited the accompanying consolidated balance sheet of fonix/(TM)/
corporation and subsidiary (a development stage company) as of December 31,
1996, and the related consolidated statements of operations, stockholders'
equity and cash flows for the year then ended, 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 as of and for the year ended December 31,
1995, and 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 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 consolidated
financial position of the Company as of December 31, 1996 and the results of its
operations and its cash flows for the year then ended, 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/(TM)/ corporation
Salt Lake City, Utah


We have audited the accompanying consolidated statements of operations,
stockholders' equity and cash flows of fonix/(TM)/ 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
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/(TM)/ 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, 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 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> 

ASSETS
------
                                                                                 December 31,          December 31,     
                                                                                    1997                  1996                 
                                                                                 ------------          ------------            
<S>                                                                              <C>                   <C> 
Current assets:                                                                                                                
   Cash and cash equivalents                                                     $ 20,501,676          $ 22,805,786            
   Notes receivable                                                                   600,000             1,000,000            
   Interest and other receivables                                                      14,919               157,643            
   Prepaid assets                                                                      32,094                 4,172            
                                                                                 ------------          ------------            
      Total current assets                                                         21,148,689            23,967,601            
                                                                                                                               
Property and equipment, net of accumulated                                                                                     
  depreciation of $464,100 in 1997 and $80,232 in 1996                              1,567,279             1,279,746            
                                                                                                                               
Intangible assets, net of accumulated amortization                                                                             
  of $25,509 in 1997 and $4,168 in 1996                                               138,951                53,011            

Other assets                                                                           39,647                30,912            
                                                                                 ------------          ------------            
         Total assets                                                            $ 22,894,566          $ 25,331,270            
                                                                                 ============          ============            
                                                                                                                               
LIABILITIES AND STOCKHOLDERS' EQUITY                                                                                           
------------------------------------                                                                                           
                                                                                                                               
Current liabilities:                                                                                                           
   Revolving note payable                                                        $ 18,612,272          $ 16,377,358            
   Revolving note payable - related party                                             551,510                     -            
   Accounts payable                                                                   291,638               307,931            
   Accrued liabilities                                                                505,619               114,049            
   Accrued liabilities - related party                                                459,502             1,761,743            
   Capital lease obligation - current portion                                          49,325                     -            
   Series A convertible debenture                                                           -               500,000            
                                                                                 ------------          ------------            
      Total current liabilities                                                    20,469,866            19,061,081            
                                                                                                                               
Capital lease obligation, net of current portion                                       52,225                     -            
                                                                                 ------------          ------------            
         Total liabilities                                                         20,522,091            19,061,081            
                                                                                 ------------          ------------            
                                                                                                                               
Commitments and contingencies (Notes 1, 11 and 13)                                                                             
                                                                                                                               
Stockholders' equity:                                                                                                          
   Preferred stock, $.0001 par value;  100,000,000 shares authorized:                                                          
      Series A, convertible; 166,667 shares outstanding in                                                                     
         1997 (aggregate liquidation preference of $6,055,012)                        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                     -            
   Common stock, $.0001 par value;  100,000,000 shares authorized;                                                             
     43,583,875 and 41,626,563 shares outstanding, respectively                         4,358                 4,163            
   Additional paid-in capital                                                      38,637,059            26,107,473            
   Outstanding warrants                                                             2,936,360                   360            
   Deficit accumulated during the development stage                               (45,017,746)          (19,841,807)           
                                                                                 ------------          ------------            
         Total stockholders' equity                                                 2,372,475             6,270,189            
                                                                                 ------------          ------------            
                                                                                 $ 22,894,566          $ 25,331,270            
                                                                                 ============          ============             
</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,   
                                                1997          1996            1995              1997       
                                           ------------   ------------     -----------    -----------------
<S>                                        <C>            <C>              <C>            <C> 
Revenues                                   $          -   $          -     $         -     $             -     
                                           ------------   ------------     -----------    -----------------
Expenses:                                                                                                    
   General and administrative                12,947,112      3,530,400       3,553,665          22,246,670
   Research and development                   7,066,294      4,758,012       2,704,165          17,937,293
                                           ------------   ------------     -----------    -----------------
     Total expenses                          20,013,406      8,288,412       6,257,830          40,183,963 
                                           ------------   ------------     -----------    -----------------
                                                                                       
Loss from operations                        (20,013,406)    (8,288,412)     (6,257,830)        (40,183,963) 
                                           ------------   ------------     -----------    -----------------
                                                                                       
Other income (expense):                                                                
   Interest income                            1,199,610      1,180,259         191,929           2,592,067
   Interest expense                          (2,758,288)      (721,355)       (279,996)         (3,852,543)
                                           ------------   ------------     -----------    -----------------
                                                                                       
     Total other income (expense), net       (1,558,678)       458,904         (88,067)         (1,260,476)
                                           ------------   ------------     -----------    -----------------
                                                                                       
Loss before extraordinary items             (21,572,084)    (7,829,508)     (6,345,897)        (41,444,439)
                                                                                       
Extraordinary items:                                                                   
   Loss on extinguishment of debt              (881,864)             -               -            (881,864)
   Gain on forgiveness of debt                        -              -          30,548              30,548
                                           ------------   ------------     -----------    -----------------
                                                                                       
Net loss                                   $(22,453,948)  $ (7,829,508)    $(6,315,349)    $   (42,295,755)
                                           ============   ============     ===========    =================
                                                                                       
Basic and diluted net loss per                                                         
 common share                              $      (0.59)  $      (0.21)    $     (0.30)
                                           ============   ============     ===========    

</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       Common Stock   
                                                       ---------------    ---------------   ---------------   -------------------
                                                       Shares   Amount    Shares   Amount   Shares   Amount    Shares     Amount 
--------------------------------------------------------------------------------------------------------------------------------- 
<S>                                                    <C>      <C>       <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 Technology, 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)           -        -         -        -        -        -              -        -
</TABLE> 
<TABLE> 
<CAPTION> 
                                                                                         Deficit                      
                                                                                       Accumulated                        
                                                       Additional                      During the                         
                                                        Paid-in        Outstanding     Development                        
                                                        Capital         Warrants          Stage            Total          
------------------------------------------------------------------------------------------------------------------
<S>                                                    <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 Technology, 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         
</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       Common Stock   
                                                       ---------------    ---------------   ---------------   -------------------
                                                       Shares   Amount    Shares   Amount   Shares   Amount    Shares     Amount 
--------------------------------------------------------------------------------------------------------------------------------- 
<S>                                                    <C>      <C>       <C>      <C>      <C>      <C>       <C>        <C> 
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
                                                                                                                                  
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 
</TABLE> 
<TABLE> 
<CAPTION> 
                                                                                                Deficit                          
                                                                                              Accumulated                        
                                                            Additional                        During the                         
                                                             Paid-in         Outstanding      Development                        
                                                             Capital          Warrants           Stage             Total           
----------------------------------------------------------------------------------------------------------------------------
<S>                                                         <C>             <C>               <C>               <C> 
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                -                 -       
                                                                                                         
Net loss for the year ended December 31, 1995                         -                -        (6,315,349)       (6,315,349)      
----------------------------------------------------------------------------------------------------------------------------

Balance, December 31, 1995                                   13,318,732              360       (12,012,299)        1,309,734 
                                                                                                         
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          386,710                -                 -           386,719
                                                                                                         
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 
</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>       
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                     -           -         -            -        -           -   
                                                                                                                              
Balance, December 31, 1997                                  166,667   $ 500,000    27,500    $ 667,659  185,000 $ 4,644,785   
</TABLE> 
<TABLE> 
<CAPTION> 
                                                                                                        Deficit      
                                                                                                       Accumulated   
                                                            Common Stock      Additional                During the   
                                                          -----------------    Paid-in    Outstanding  Development   
                                                           Shares   Amount     Capital     Warrants       Stage         Total    
---------------------------------------------------------------------------------------------------------------------------------
<S>                                                        <C>     <C>      <C>           <C>         <C>            <C>         
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                                        804,065       80     4,891,180            -            -              -
                                                                                                                                 
Shares issued during the year in connection with                                                                                 
  exercise of options at $2.97 per share                   15,000        1        44,499            -            -         44,500
                                                                                                                                 
Shares issued during the year in connection with the                                                                             
  exercise of warrants at $.50 per share                  100,000       10        49,990            -            -         50,000
                                                                                                                                 
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)
---------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                  
Balance, December 31, 1997                             43,583,875  $ 4,358  $ 38,637,059  $ 2,936,360 $(45,017,746)  $  2,372,475 
=================================================================================================================================
</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, 
                                                                 1997              1996                1995               1997
                                                            -------------      -------------      -------------      --------------
<S>                                                         <C>                <C>               <C>                 <C> 
CASH FLOWS FROM OPERATING ACTIVITIES:
   Net loss                                                 $ (22,453,948)     $  (7,829,508)     $  (6,315,349)     $  (42,295,755)
   Adjustments to reconcile net loss to net cash
     used in operating activities:
     Issuance of common stock for services                      4,112,970            901,520            167,750           5,437,240
     Non-cash expense related to issuance of debentures,
       warrants, preferred and common stock                     3,967,337                  -                  -           3,967,337
     Non-cash compensation expense related to issuance
       of stock options                                                 -                  -          2,282,900           2,282,900
     Write-off of assets received in acquisition                        -                  -                  -               1,281
     Depreciation and amortization                                405,209             83,183              1,217             489,609
     Extraordinary loss on extinguishment of debt                 881,864                  -                  -             881,864
     Extraordinary gain on forgiveness of debt                          -                  -            (30,548)            (30,548
     Changes in assets and liabilities:
       Interest and other receivables                             142,724           (131,419)           (21,827)            (14,919)
       Prepaid assets                                             (27,922)            (4,172)                 -             (32,094)
       Other assets                                                (8,735)           (30,912)                 -             (39,647)
       Accounts payable                                           128,638             42,702          1,652,731           2,071,838
       Accrued liabilities - related party                         47,759          1,500,918           (970,180)            459,502
       Accrued liabilities                                       (922,367)            83,053             50,136             633,600
                                                            -------------      -------------      -------------      --------------
     Net cash used in operating activities                    (13,726,471)        (5,384,635)        (3,183,170)        (26,187,792)
                                                            -------------      -------------      -------------      --------------
                                                                                                              
CASH FLOWS FROM INVESTING ACTIVITIES:                                                                         
   Purchase of property and equipment                            (671,401)        (1,311,236)           (48,742)         (2,031,379)
   Investment in intangible assets                               (107,281)           (33,126)           (24,053)           (164,460)
   Issuance of notes receivable                                (1,483,600)          (963,106)           (36,894)         (2,483,600)
   Payments received on notes receivable                        1,883,600                  -                  -           1,883,600
                                                            -------------      -------------      -------------      --------------
     Net cash used in investing activities                       (378,682)        (2,307,468)          (109,689)         (2,795,839)
                                                            -------------      -------------      -------------      --------------

CASH FLOWS FROM FINANCING ACTIVITIES:
   Net proceeds from revolving note payable                     2,234,914         10,759,836          3,619,300          18,612,272
   Net proceeds from revolving note payable - related party       551,510                  -                  -             551,510
   Proceeds from other notes payable                                    -                  -            824,551           2,351,667
   Payments on other notes payable                                      -                  -           (977,818)         (1,779,806)
   Principal payments on capital lease obligation                 (43,381)                 -                  -             (43,381)
   Proceeds from issuance of convertible debentures, net        2,685,000                  -            500,000           3,185,000
   Proceeds from sale of warrants                                 600,000                  -                  -             600,000
   Proceeds from sale of common stock, net                        469,500         11,888,443          5,030,547          20,704,545
   Proceeds from sale of Series B and C preferred stock, net    5,303,500                  -                  -           5,303,500
                                                            -------------      -------------      -------------      --------------
     Net cash provided by financing activities                 11,801,043         22,648,279          8,996,580          49,485,307
                                                            -------------      -------------      -------------      --------------

NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS           (2,304,110)        14,956,176          5,703,721          20,501,676

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD               22,805,786          7,849,610          2,145,889                   -
                                                            -------------      -------------      -------------      --------------

CASH AND CASH EQUIVALENTS AT END OF PERIOD                  $  20,501,676      $  22,805,786      $   7,849,610      $   20,501,676
                                                            =============      =============      =============      ==============
</TABLE> 

         See accompanying notes to consolidated financial statements.

                                     F-10
<PAGE>
                               fonix corporation
                         [A Development Stage Company]

               CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)


<TABLE> 
<CAPTION> 
                                                                                                                     OCTOBER 1,    
                                                                                                                        1993
                                                                                   YEARS ENDED DECEMBER 31,        (INCEPTION) TO
                                                                         ---------------------------------------    DECEMBER 31,
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:                           1997          1996          1995            1997
                                                                         -----------   -----------   -----------   --------------   
<S>                                                                      <C>           <C>           <C>           <C> 
     Cash paid during the year for interest                              $ 1,148,553   $   638,302   $   229,039   $    2,037,019
</TABLE> 

SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:

     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 Preferred Stock.

     During July, 1994, the Company converted $150,000 of notes payable and 
       $6,905 of accrued interest payable to restricted  common stock.

     On June 17, 1994, Taris, Inc., issued 10,395,249 shares of common stock in
       exchange for all of the issued stock of Phonic Technologies, Inc.  
       Inasmuch as the 10,395,249 shares of common stock is deemed to have
       acquired Taris, Inc. 

     Taris, Inc. had the following assets and liabilities at the transaction 
       date:

     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 Preferred Stock and related dividends of 
       $13,422 were converted into 786,867 shares common stock.

     2,500 shares of Series C Preferred Stock and related dividends of $472 
       were converted into 17,198 shares 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.

     FOR THE YEAR ENDED DECEMBER 31, 1995:

     The Company was forgiven of related-party notes payable of $286,493 and 
       $135,386 with accrued interest of $65,715 and $19,298, respectively.  

     The Company was also forgiven of various accounts payable in the amount 
       of $30,548.

     The Company issued 285,000 shares of common stock to unrelated parties 
       for services rendered valued at $167,750.

     The Company issued 231,630 shares of common stock to unrelated parties to
       cancel $187,621 in accounts payable.

     The Company issued 3,700,000 shares of common stock upon conversion of 
       3,700,000 warrants to a company controlled by the majority shareholders
       of the Company in lieu of payment of management fees for services
       previously rendered of $1,417,100 included in accounts payable.

         See accompanying notes to consolidated financial statements.

                                     F-11

<PAGE>
 
                            FONIX/(TM)/ CORPORATION
                         [A DEVELOPMENT STAGE COMPANY]
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES

NATURE OF OPERATIONS - fonix/(TM)/ 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 automatic speech
recognition technologies. On June 17, 1994, fonix/(TM)/ corporation
("fonix") entered into a merger agreement with PTI whereby fonix corporation
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.

The Company's primary emphasis and focus to date have been the development of
its sound recognition engine, neural network, audio signal processor, and
command processing engine for use in its core automatic speech recognition
technologies.  The Company licenses its technologies to and has entered into co-
development relationships and strategic alliances with third parties that are
participants in the horizontal computer industry (including producers of
application software, operating systems, computers and microprocessor chips) or
are research and development entities, including academia and industry and
commercial speech product developers. The Company  intends for the foreseeable
future to continue this practice and will seek to generate revenues from its
proprietary speech recognition technologies from licensing royalties and
strategic partnerships and alliances.  To date, the Company has entered into two
strategic partnerships and one license agreement relating to its automatic
speech recognition technologies.  The Company received its first revenue from
its automatic speech recognition technologies in February 1998 under a license
agreement (see Note 13).  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.  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 revenues to pay
its operating costs and complete the development of its technologies.

DEVELOPMENT STAGE PRESENTATION - fonix is a development stage company.  The
Company generated no revenues and reported net  losses totaling  $22,453,948 for
the year ended December 31, 1997, and cumulative losses of $42,295,755 for the
period from inception to December 31, 1997.  The Company has minimal
stockholders' equity of $2,372,475 and minimal working capital of $678,823 as of
December 31, 1997.  Although the Company received its first revenue in February
1998, the Company expects to continue to incur significant  losses through at
least December 31, 1998, primarily due to expenditures associated with the
marketing and development of its proprietary automatic speech recognition and
related technologies.  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 from the
outcome of this uncertainty.  Management plans to fund the operations of the
Company through proceeds from additional sales of equity securities (see Note
13).

CONSOLIDATION - The accompanying consolidated financial statements include the
accounts of the Company and its wholly owned subsidiary, fonix systems
corporation ("fonix systems"), which is the primary operating entity in the
consolidated group.  All significant intercompany balances and transactions have
been eliminated in consolidation.

                                      F-12
<PAGE>
 
                            FONIX/(TM)/ CORPORATION
                         [A DEVELOPMENT STAGE COMPANY]
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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.

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                                 8 years

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 direct costs incurred by
the Company in applying for patents on its technologies.  Amortization is
computed on a straight-line basis over the estimated useful life of five years.

RESEARCH AND DEVELOPMENT - All expenditures for research and development are
charged to research and development expense as incurred.  The Company incurred
total research and development expenses of $7,066,294, $4,758,012 and $2,704,165
for the years ended December 31, 1997, 1996 and 1995, respectively.

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.

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.

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, 1997, 1996 and 1995 there were outstanding common stock
equivalents to purchase 8,223,623, 2,450,000 and 410,000 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.   Net loss per common share amounts and share
data have been restated for all periods presented to reflect basic and diluted
per share presentations.

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, 1997, 1996
and 1995.

                                      F-13
<PAGE>
 
                            FONIX/(TM)/ CORPORATION
                         [A DEVELOPMENT STAGE COMPANY]
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE> 
<CAPTION> 
                                                           1997                     1996                      1995
                                               ------------------------   -----------------------   -----------------------
                                                              Per Share                 Per Share                 Per Share
                                                               Amount                    Amount                    Amount 
                                                   Loss       ---------      Loss       ---------      Loss       ---------
                                               ------------               -----------               -----------   
   <S>                                         <C>            <C>         <C>           <C>         <C>           <C>  
   Loss before extraordinary items             $(21,572,084)              $(7,829,508)              $(6,345,897)
   Preferred stock dividends                     (2,721,991)                        -                         -
                                               ------------               -----------               -----------
   Loss attributable to common stockholders     
      before extraordinary items                (24,294,075)  $   (0.57)   (7,829,508)  $   (0.21)   (6,345,897)  $   (0.30)
    Extraordinary items:                                       
      Loss on extinguishment of debt               (881,864)      (0.02)            -           -             -           -   
      Gain on forgiveness of debt                         -           -             -           -        30,548       (0.00)
                                               ------------   ---------   -----------   ---------   -----------   ---------
     Net loss attributable to common           
        stockholders                           $(25,175,939)  $   (0.59)  $(7,829,508)  $   (0.21)  $(6,315,349)  $   (0.30)
                                               ============   =========   ===========   =========   ===========   =========
 
     Weighted average common shares              
         outstanding                             42,320,188                36,982,610                21,343,349
                                               ============               ===========               ===========
</TABLE>

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.

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.

RECLASSIFICATIONS - Certain reclassifications have been made to  the prior
years' financial statements to conform with the current year presentation.

2.  CERTIFICATE OF DEPOSIT

At December 31, 1997 and 1996, 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 5.50 percent and 4.75 percent at December 31,
1997 and 1996, respectively.  Interest is payable monthly.  This certificate is
pledged as collateral on a revolving note payable (see Note 5).

3.  NOTES RECEIVABLE

At December 31, 1997, the Company had a short-term unsecured, non-interest
bearing note receivable from an unrelated entity in the amount of $500,000. This
note receivable was issued in connection with the Company's intended acquisition
of that entity (see Note 13).

At December 31, 1997, the Company had a short-term unsecured, demand note
receivable from an unrelated entity in the amount of $100,000.  Interest begins
to accrue at six percent per year on the date the Company demands payment. This
note receivable was issued in connection with the Company's intended acquisition
of that entity.  This note is payable  90 days following demand by the Company
in the event both parties agree that the acquisition will not proceed.
Subsequent to December 31, 1997, the Company has advanced an additional $300,000
under similar terms.

At December 31, 1996, the Company had an unsecured note receivable from an
unrelated third party in the amount of $1,000,000 which bore interest at 12% per
annum and was due and payable thirty days after written notice from the Company.
Payment on this note was received in full during 1997.

                                      F-14
<PAGE>
 
                            FONIX/(TM)/ CORPORATION
                         [A DEVELOPMENT STAGE COMPANY]
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

4.  PROPERTY AND EQUIPMENT

Property and equipment consisted of the following at December 31:

                                                          1997          1996
                                                       ----------    ----------
    Furniture and fixtures                             $  640,992    $  602,620
    Computer equipment                                  1,321,016       687,987
    Leasehold improvements                                 69,371        69,371
                                                       ----------    ----------
 
    Less accumulated depreciation and amortization      2,031,379     1,359,978
                                                         (464,100)      (80,232)
                                                       ----------    ----------
 
       Net property and equipment                      $1,567,279    $1,279,746
                                                       ==========    ==========

5.  REVOLVING NOTES PAYABLE


At December 31, 1997 and 1996, the Company has a revolving note payable to a
bank in the amount of $18,612,272 and $16,377,358, respectively.  Borrowings
under the revolving note payable are limited to $20,000,000.  The weighted
average outstanding balance during 1997 and 1996 was $18,861,104 and
$11,786,889, respectively.  The weighted average interest rate was 5.94 percent
and 5.80 percent during 1997 and 1996, respectively.  This note is due April 29,
1998, bore an interest rate of 6.50 percent at December 31,1997, and is secured
by a certificate of deposit in the amount of $20,000,000 (see Note 2).  This
revolving note is renegotiated quarterly and interest is payable monthly.  The
Company plans to continue renewing the note indefinitely.

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, 1997, $551,510 in principal and $22,243 in accrued interest was
outstanding under this revolving note payable.  The weighted average balance
outstanding during the borrowing period was $555,407.  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 $1,550,000 in 1997.  In
connection with this revolving note, the Company accrued a loan fee of $93,000
payable to the related entity.  To date, no interest has been paid on the note.
Subsequent to December 31, 1997, the principal balance has been reduced to
$37,853.  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.

6.  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 was originally due October
23,1996 and was subsequently extended to October 23, 1997 and then to October
23, 1998.  The debenture bore an annual interest rate of 5 percent. On September
25, 1997, the debenture was converted into 166,667 shares of Series A Preferred
Stock.

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, 

                                      F-15
<PAGE>
 
                            FONIX/(TM)/ CORPORATION
                         [A DEVELOPMENT STAGE COMPANY]
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

bore interest at 5 percent and were convertible into shares of the Company's
common stock at anytime after issuance at the holder's option. The 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 120/th/ day after the original issue date and 87.5
percent for any conversion thereafter. On June 18, 1997, the Company received
$3,000,000 in proceeds related to the issuance of Series B Convertible
Debentures. Using the conversion terms most beneficial to the investor, the
Company recorded a prepaid financing cost of approximately $427,900 in
connection with the debenture to be amortized as additional interest expense
over the 120 day period commencing June 18, 1997. As part of the same
transaction, the Company also issued to the investor a warrant to purchase up to
250,000 shares of common stock at any time prior to June 18, 2002, at the
exercise price of $8.28 per share. The Company recorded the fair value of the
warrants, totaling $897,750, as a charge to interest expense. 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 5 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
then 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 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
Preferred Stock.  In connection with the extinguishment of the Series B
Convertible Debenture and the issuance of Series B Preferred Stock, the Company
recorded all unamortized prepaid financing costs as a loss on extinguishment of
debt.  Also in connection with this modification, the Company issued an
additional warrant to purchase up to 175,000 shares of common stock at any time
prior to October 24, 2002, at the exercise price of $7.48 per share.  In
connection with the issuance of that warrant, the Company recorded the fair
value of the warrant, totaling $661,850 as 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.

7.  STOCKHOLDERS' EQUITY

COMMON STOCK - 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 convertible preferred
stock and 592,500 were issued to unaffiliated individuals for services rendered
valued at $3,812,971.

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 warrants. 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.

During the year ended December 31, 1995, the Company issued a total of
11,209,168 shares of common stock.  Of this total,  6,442,538 shares were issued
to unrelated private investors pursuant to various stock purchase agreements.  A
total of 516,630 shares were issued for non-cash consideration including
cancellation of $187,621 of accounts payable and $167,750 for services rendered.
An additional 4,250,000 shares were issued upon exercise of warrants.

PREFERRED STOCK - In 1995, the Company's board of directors adopted a resolution
to amend the articles of incorporation to provide for the issuance of preferred
stock and give the board of directors authority to fix the rights, preferences
and 

                                      F-16
<PAGE>
 
                            FONIX/(TM)/ CORPORATION
                         [A DEVELOPMENT STAGE COMPANY]
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

restrictions of any series of preferred stock. At the same time, the board of
directors established a class of Series A Preferred Stock. In August 1997, a
majority of the shareholders of the Company authorized an 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. Subsequent to the approval of rights and preferences of
Series A Preferred Stock, the Company's board of directors adopted resolutions
establishing Series B Preferred Stock and Series C Preferred Stock in connection
with certain capital fund raising.

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

SERIES B PREFERRED STOCK - 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 then 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 Preferred Stock. Dividends accrue on the stated value ($20
per share) of Series B Preferred Stock at a rate of 5 percent per year, are
payable quarterly in cash or common stock, at the option of the Company, and are
convertible into shares of the Company's common stock at anytime after issuance
at the holders' option.  In the event of liquidation, the holders of the Series
B 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
Preferred Stock have no voting rights.  The Series B Preferred Stock, together
with dividends accrued thereon, may be converted into shares of the Company's
common stock at the lesser of $6.81 or the average of the per share market value
for the five trading days immediately preceding the conversion date multiplied
by 90 percent for any conversion on  or prior to the 120/th/ day after the
original issue date and 87.5 percent for any conversion thereafter.  Using the
conversion terms most beneficial to the holder, the Company recorded a dividend
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 vesting
period the Series B Convertible Debentures. Prior to the actual issuance of the
Series B Preferred Stock in exchange for the outstanding balance under the
debenture, the holder converted the balance of $2,150,000, 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
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 is being amortized as a dividend over 120 days.  As
a condition for issuing convertible preferred stock, the holder was granted a
put option by SMD, L.L.C. ("SMD"), a company which is controlled by three
shareholders who are officers of fonix.  The put option requires SMD to purchase
the Series B Preferred Stock from the holder at the holder's option but only in
the event that the common stock of 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 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 Preferred Stock and dividends earned
thereon had been converted into 355,188 shares of common stock.  In January

                                      F-17
<PAGE>
 
                            FONIX/(TM)/ CORPORATION
                         [A DEVELOPMENT STAGE COMPANY]
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1998, the remaining 27,500 shares of Series B Preferred Stock and dividends
earned thereon were converted into 193,582 shares of common stock.

SERIES C PREFERRED STOCK - Effective September 30, 1997, the Company entered
into an agreement with an unrelated investment entity whereby that entity agreed
to purchase 187,500 shares of the Company's Series C Preferred Stock for
$3,750,000. The cash purchase price was received in October 1997.  Dividends
accrue on the stated value ($20 per share) of Series C Preferred Stock at a rate
of 5 percent per year, are payable quarterly in cash or common stock, at the
option of the Company, and are convertible into shares of the Company's common
stock at anytime after issuance at the holders' option.  In the event of
liquidation, the holders of the Series C Preferred Stock are entitled to an
amount equal to the stated value ($20 per share) plus accrued but unpaid
dividends whether declared or not.  The holders of Series C Preferred Stock have
no voting rights. The Series C Preferred Stock, together with dividends accrued
thereon, may be converted into shares of the Company's common stock at the
lesser of $5.98 or the average of the five lowest closing bid prices for the 15
trading days preceding the date of any conversion notice multiplied by 91
percent for any conversion on or prior to the 120/th/ day after the original
issue date, 90 percent for any conversion between 121 and 180 days and 88
percent for any conversion thereafter.  Using the conversion terms most
beneficial to the holder, the Company recorded a dividend of $1,060,718 which
represents a discount of 9 percent, which is available to the holder on or
before 120 days subsequent to closing.  The additional 3 percent discount of
$164,002 is being amortized as a dividend over 180 days.  As a condition for
issuing convertible preferred stock, the Series C Preferred Stockholder was
granted a put option by SMD.  The put option requires SMD to purchase the Series
C Preferred Stock from the holder at the holder's option but only in the event
that the common stock of 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 of $375,000.  Associated with the issuance of
the Series C Preferred Stock, the Company issued a warrant to purchase up to
200,000 shares of common stock at any time prior to October 24, 2000, at the
exercise price of $7.18 per share. The Company recorded the fair 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 Preferred Stock and related accrued dividends.  Subsequent to December
31, 1997, the balance of 185,000 shares of Series C Preferred Stock and related
dividends were converted into 1,295,699 shares of the Company's common stock.

REGISTRATION RIGHTS AND RESERVED SHARES - During 1997, the Company entered into
an amended and restated registration rights agreement with investors under which
the Company agreed to register the common stock issuable upon the conversion of
all series of preferred stock 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 any dividends then payable in stock thereon
and the exercise of warrants. As of December 31, 1997, the Company had reserved
1,655,948 shares of common stock for this purpose.

STOCK OPTIONS - 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, 1997, the number of shares available for granting under this plan is
1,511,000.

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 

                                      F-18
<PAGE>
 
                            FONIX/(TM)/ CORPORATION
                         [A DEVELOPMENT STAGE COMPANY]
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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 options are granted. The option term is ten years from date of
grant. As of December 31, 1997, the number of shares available for granting
under this plan is 1,000,000.

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 such 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, 1997, the number of
shares available for granting under this plan is 709,000.

A summary of options granted under the Company's various stock option plans for
the years ended December 31, 1997 and 1996 is presented below (no options were
issued or outstanding during 1995):
<TABLE> 
<CAPTION> 
                                                                1997                  1996
                                                       ---------------------  -------------------
                                                                    WEIGHTED             WEIGHTED
                                                                    AVERAGE              AVERAGE
                                                         STOCK      EXERCISE    STOCK    EXERCISE
                                                        OPTIONS     PRICE      OPTIONS   PRICE
                                                       ----------   --------  ---------  --------
     <S>                                               <C>          <C>       <C>        <C> 
     Total options outstanding at beginning of year
           Granted                                      4,626,000      $4.07          -     $   -
           Exercised                                    6,009,000       6.38  4,626,000      4.07
           Forfeited                                      (15,000)      2.97          -         -
           Canceled                                       (30,000)      7.66          -         -
                                                          (25,000)      5.00          -         -
                                                       ----------             ---------  
     Total options outstanding at end of year          10,565,000       5.38  4,626,000      4.07
                                                       ==========             =========  

     Total options exercisable at end of year           5,392,675       5.05  2,000,000      4.06
                                                       ==========             =========  

     Weighted average fair value of options granted                     
       during the year                                                 $6.38                $4.07
</TABLE>

                                      F-19
<PAGE>
 
                            FONIX/(TM)/ CORPORATION
                         [A DEVELOPMENT STAGE COMPANY]
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

A summary of options outstanding and options exercisable under the Company's
various stock option plans at December 31, 1997 and 1996 is presented below (no
options were issued or outstanding during 1995):
<TABLE>
<CAPTION>
            OPTIONS OUTSTANDING                     OPTIONS EXERCISABLE
-------------------------------------------------  ---------------------
                             WEIGHTED
                             AVERAGE     WEIGHTED               WEIGHTED
  RANGE OF                   REMAINING   AVERAGE                AVERAGE
EXERCISABLE      NUMBER     CONTRACTUAL  EXERCISE    NUMBER     EXERCISE
  PRICES       OUTSTANDING     LIFE       PRICE    EXERCISABLE   PRICE
-------------  -----------  -----------  --------  -----------  --------
<S>            <C>          <C>          <C>       <C>          <C> 
 $2.97-3.66        140,000   8.3 years      $3.61       60,669     $3.55
  4.06           4,400,000   8.3 years       4.07    3,200,000      4.07
  5.00-6.50      5,715,000   9.6 years       6.33    1,828,672      6.48
  7.13-8.50        310,000   9.2 years       7.17      303,334      7.15
                ----------                           ---------
  2.97-8.50     10,565,000   9.0 years      $5.38    5,392,675     $5.05
                ==========                           =========
</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 Statement of Financial
Standards No. 123, "Accounting for Stock Based Compensation", the Company's net
loss per common share would have been increased to the pro forma amounts
indicated below for the years ended December 31, 1997, 1996 and 1995:
<TABLE>
<CAPTION> 
                                                     1997          1996          1995
                                                 -----------   -----------    ----------
<S>                                              <C>           <C>           <C>
Net loss attributable to common stockholders:    
  As reported                                    $25,175,939   $ 7,829,508    $6,315,349

  Pro forma                                       48,870,670    20,289,706     6,486,254

Basic and diluted net loss per common share:
  As reported                                    $     (0.59)  $     (0.21)   $    (0.30)

  Pro forma                                            (1.15)        (0.55)        (0.30)
</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 1997, 1996 and 1995:

Risk-free interest rate of 5.6 percent, 6.5 percent and 6.0 percent for 1997,
1996 and 1995, respectively; expected dividend yield of 0 percent for 1997, 1996
and 1995; expected exercise lives of 5 years, 10 years and 3 years for 1997,
1996 and 1995, respectively; expected volatility of 75 percent, 103 percent and
205 percent  for 1997, 1996 and 1995, 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.
The pro forma net loss attributable to common stockholders for 1996 of
$20,289,706 has been adjusted from the amount reported in the prior year to
reflect a change in the Company's assumptions used to compute the estimated fair
value of the options.

                                      F-20
<PAGE>
 
                            FONIX/(TM)/ CORPORATION
                         [A DEVELOPMENT STAGE COMPANY]
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

WARRANTS - A summary of warrants granted by the Company during the years ended
December 31, 1997,  1996 and 1995 is presented below:
<TABLE> 
<CAPTION> 
                                                        1997                  1996                 1995
                                               ---------------------  ------------------  ----------------------
                                                           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      450,000       $1.50  410,000      $0.93     155,000       $0.50
      Granted                                    975,000        6.92  100,000       3.24   4,505,000        0.51
      Exercised                                 (250,000)       1.40  (60,000)      0.50  (4,250,000)       0.47
                                               ---------              -------             ----------
                                               
     Total outstanding at end of year          1,175,000        6.39  450,000       1.63     410,000        0.93  
                                               =========              =======             ==========  
                                               
     Total exercisable at end of year          1,175,000        6.39  450,000       1.63     410,000        0.93 
                                               =========              =======             ==========
 
</TABLE>

VOTING TRUST - As of December 31, 1997, 25,657,749 shares of the Company's
outstanding common stock were deposited in a voting trust (the "Voting Trust")
as to which the President and Chief Operating 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.

8.  RELATED-PARTY  TRANSACTIONS

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 ten percent of the Company's issued and outstanding Common Stock.
Between June 1994, when the Company commenced its present business of developing
its ASRT, and April 30, 1996, the Company did not pay or award any compensation
in any form directly to the Company's executive officers.  Rather, in June 1994,
the Company entered into an Independent Consulting Agreement (the "SCC
Agreement") with SCC pursuant to which SCC 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 $.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 collaterally 

                                      F-21
<PAGE>
 
                            FONIX/(TM)/ CORPORATION
                         [A DEVELOPMENT STAGE COMPANY]
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

agreed that any then accrued but unpaid balance due to SCC for management
services rendered under the SCC Agreement would be placed on "conditional
status" and deferred until the Company successfully completed certain
developmental milestones set forth in the Beesmark Agreement, at which time such
amounts would be due and payable in full. With respect to management services to
be rendered by SCC after the closing of the Beesmark Agreement, SCC agreed that
the Company would pay only $30,000 of the monthly invoiced $50,000, the balance
to be placed on conditional status. Thus, of the total $600,000 invoiced to the
Company by SCC during the year ended December 31, 1995, the Company paid SCC
$90,000 in cash; $257,000 of accrued but unpaid amounts were placed on
conditional status under the 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 invoices the Company for management
services, but continues to invoice the Company for reimbursement of actual
expenses incurred on the Company's behalf.  SCC and the Company agreed that any
amounts invoiced under the SCC Agreement but placed on conditional status
pursuant to the Beesmark Agreement would remain outstanding obligations of the
Company payable only if the Company achieved the milestones specified in the
Beesmark Agreement.  The Company further agreed to pay any then accrued but
unpaid amounts invoiced under the SCC Agreement, including amounts owed and
carried over from the year ended December 31, 1995, which amounts 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, until December 1998.

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

Related-party transactions with SCC  not otherwise disclosed herein for the
years ended December 31, 1997, 1996 and 1995 were as follows:

                                      F-22
<PAGE>
 
                            FONIX/(TM)/ CORPORATION
                         [A DEVELOPMENT STAGE COMPANY]
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION> 
                                      1997        1996        1995
                                    --------   ----------   --------
        <S>                         <C>        <C>          <C>
        Expenses:
         Management fees            $      -   $  200,000   $600,000
         Interest                          -            -      8,881
         Rent                         77,203       52,000     24,000
 
        Liabilities:                    
         Accounts payable                  -      411,743          - 
         Accrued liabilities         459,502    1,350,000          - 
</TABLE>

The Company rents office space under a month-to-month lease from SCC and the
lease from SCC is guaranteed by the officers, owners and directors of SCC.  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 unaffiliated third party in a
similar transaction.

Cancellation of Debt By SCC and A Director and Executive Officer

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

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 $.48 per share and a $500,000 Series A Convertible
Subordinated Debenture that is convertible into either 166,667 shares of Series
A 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.

K.L.S. Enviro Resources, Inc. and SMD, L.L.C.

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% 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 

                                      F-23
<PAGE>
 
                            FONIX/(TM)/ CORPORATION
                         [A DEVELOPMENT STAGE COMPANY]
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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, L.L.C., a company owned by directors and officers of
the Company, advanced debt financing (the "SMD Loan") to KLSE in the amount of
$1,673,730.  The SMD Loan was due on demand, bore interest at the rate of 12%
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.  Such warrants have never
been exercised and no gain has been realized thereon by SMD.

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 promissory note. Thus, as of December 31, 1996, KLSE  was not
indebted to the Company in any amount nor did the Company have any beneficial
interest in KLSE.

SMD

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

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

Synergetics

A director and the chief operating officer of the Company, is also one of seven
directors of Synergetics.  In addition, three executive officers and directors
of the Company own shares of the common stock of Synergetics, although such
share ownership in the aggregate constitutes less than 5% of the total shares of
Synergetics common stock issued and outstanding (see Note 9).

VIA

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.

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. As of December 31, 1997, the Company
had paid $2,159,484 of the authorized reimbursements.  The balance of the
liability is included in accrued expenses-related party in the accompanying 1997
consolidated balance sheet.

9.  RESEARCH AND DEVELOPMENT

In October 1993, the Company entered into an agreement with Synergetics,
Inc.(the "Synergetics Agreement"), a research and development entity, whereby
Synergetics was to develop certain technologies related to the Company's

                                      F-24
<PAGE>
 
                            FONIX/(TM)/ CORPORATION
                         [A DEVELOPMENT STAGE COMPANY]
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

automated speech recognition technology ("ASRT").  The president of the Company
is one of seven members of the board of directors of Synergetics, and three
executive officers, directors and 10 percent beneficial owners of the Company
own 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 is obligated to use its best efforts in raising the
necessary funding for the engineering, development and marketing of the ASRT.
As part of the Synergetics Agreement, the Company agreed to pay Synergetics a
royalty of 10 percent of gross revenues from sales of its ASRT (the "Royalty").
As of December 31, 1997, 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 $2,819,427,
$4,758,012, and $2,704,165 in 1997, 1996 and 1995, 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.  Commencing on March 14, 1997, the Company has
been conducting research and development of the ASRT 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 the 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 are not 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 the Company of any
Project Shares the related Royalty commitment will be canceled.


10.  INCOME TAXES

At December 31, 1997 and 1996, net deferred income tax assets, before
considering the valuation allowance, totaled $15,746,597 and $7,830,697,
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 provision for
income taxes in the accompanying consolidated statements of operations.  The net
change in the valuation allowance was an increase of $7,844,007 for the year
ended December 31, 1997.

                                      F-25
<PAGE>
 
                            FONIX/(TM)/ CORPORATION         
                         [A DEVELOPMENT STAGE COMPANY]      
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 

The Company has available at December 31, 1997, unused federal net operating
loss carryforwards of approximately $ 41,227,000 and unused state net operating
loss carryforwards of approximately $41,606,000, which may be applied against
future taxable income, if any, and which expire in various years from 2008
through 2012. The Internal Revenue Code contains provisions which 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 temporary differences and carryforwards which give rise to the deferred
income tax assets (liabilities) as of December 31, 1997 and 1996 are as follows:
<TABLE> 
<CAPTION> 
                                                                         1997                 1996
                                                                         ----                 ---- 
<S>                                                                  <C>                 <C> 
DEFERRED INCOME TAX ASSETS:
     Net operating loss carryforwards                                
       Federal                                                       $ 14,030,670        $ 5,737,199
       State                                                            1,312,988            884,388
     Research and development credits                                     275,927            551,980
     Payables to cash-basis related parties                                     -            153,580
     Accrued bonus liabilities                                            127,012            503,550
                                                                     ------------        -----------  
     Total deferred income tax assets before valuation allowance       15,746,597          7,830,697

     Valuation allowance                                              (15,646,783)        (7,802,776)
                                                                     ------------        -----------  
     Net deferred income tax assets                                        99,814             27,921
                                                                     ------------        -----------   
                                                                                                   
DEFERRED INCOME TAX LIABILITIES:                                    
     Depreciation                                                         (99,514)           (27,621)
     Intangibles                                                             (300)              (300)
                                                                     ------------        -----------   
     Total deferred income tax liabilities                                (99,814)           (27,921)
                                                                     ------------        -----------   
                                                                     $          -        $         - 
                                                                     ============        ===========
</TABLE> 
A reconciliation of income taxes at the federal statutory rate to the Company's
effective rate is as follows:
<TABLE>
<CAPTION> 
                                              1997       1996       1995
                                             ------     ------     ------
     <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>

                                      F-26
<PAGE>
 
                            FONIX/(TM)/ CORPORATION         
                         [A DEVELOPMENT STAGE COMPANY]      
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 

11.  COMMITMENTS AND CONTINGENCIES

EMPLOYMENT AGREEMENTS - On November 1, 1996, the Company entered into employment
contracts with three executive officers which expire on December 31, 2001.  The
minimum salary payments required on these contracts are as follows:

        Years ending December 31,
         -------------------------
                              
                1998                    $1,024,750
                1999                     1,337,500
                2000                     1,750,000
                2001                     1,875,250
                                        ----------
                  Total                 $5,987,500
                                        ==========


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%

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.

LITIGATION - 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 (see Note 13).

                                      F-27
<PAGE>
 
                            FONIX/(TM)/ CORPORATION         
                         [A DEVELOPMENT STAGE COMPANY]      
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 

OPERATING LEASE AGREEMENT - In October 1996, the Company entered into a long-
term non-cancelable operating lease agreement for its research facility with an
unrelated party.  Future aggregate minimum obligations under this operating
lease are as follows:

        Years ending December 31,
        -------------------------
                                            
                1998                        $  340,672
                1999                           340,672
                2000                           340,672
                2001                           340,672
                2002                           340,672
              Thereafter                       617,877
                                            ----------
                        Total               $2,321,237
                                            ==========

The Company incurred rental expense of $416,798 and $103,139 during 1997 and
1996, respectively, related to this lease.

CAPITAL LEASE OBLIGATION - Future minimum lease payments for equipment held
under a capital lease arrangement as of December 31, 1997 are as follows:

        Years ending December 31,
        -------------------------

                1998                               $ 61,374       
                1999                                 56,260
                                                   --------
                                                   
 Total future minimum lease payments                117,634      
 Less amount representing interest                  (16,084)      
                                                   -------- 

 Present value of future minimum lease payments     101,550
 Less current portion                               (49,325)
                                                   --------
 
                                                   $ 52,225
                                                   ========

Total assets held under the capital lease arrangement were $150,208 with
accumulated depreciation of $29,067 as of December 31, 1997.

12.  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.

13.  SUBSEQUENT EVENTS

EMPLOYMENT AGREEMENTS - In January 1998, the Company entered into employment
contracts with two executives 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 355,000
shares of the Company's 

                                      F-28
<PAGE>
 
                            FONIX/(TM)/ CORPORATION         
                         [A DEVELOPMENT STAGE COMPANY]      
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 

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.

SIEMENS STATEMENT OF WORK - On February 11, 1998, the Company entered into its
first Statement of Work agreement with Siemens Semiconductor Group of Siemens
Aktiengesellschaft ("Siemens") pursuant to which the Company and Siemens will
jointly pursue the development of Siemens integrated circuits incorporating the
Company's technologies for use in certain telecommunications applications. The
Company has received $2,691,066 from Siemens.  Of this amount: (1) $1,291,712
was paid to the Company as a non-refundable payment to license  certain
automatic speech recognition technologies for which the Company has no further
obligation; (2) $322,928 was paid to purchase warrants to acquire 1,000,000
shares of fonix 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 shares of the Company's
restricted common stock (the "Shares") at any time prior to March 12, 1998.  The
exercise period was subsequently extended to April 30, 1998.  If Siemens elects
not to acquire all or a part of the Shares on or prior to April 30, 1998, the
$1,076,426 or any portion thereof not used to purchase all or a portion of the
Shares will be a nonrefundable royalty payment.  The purchase price of the
Shares shall be the closing price of the stock on the day preceding the day on
which Siemens notifies the Company of its election to purchase the Shares.

ISSUANCE OF STOCK - On March 11, 1998, the Company completed a private placement
(the "Offering") of 6,666,666 shares of its restricted common stock to seven
separate investment funds.  The total purchase price to be paid by the investors
pursuant to the Offering is $30,000,000.  Of that amount, $15,000,000 was
received by the Company on March 12, 1998, in return for which the Company
issued a total of 3,333,333 shares of restricted stock.  Finders' fees in the
amount of $850,000 were paid in connection with the $15,000,000 received.  The
remainder of the purchase price is to be paid by the investors 60 days after the
effectiveness of a registration statement that the Company will prepare and file
with the Securities and Exchange Commission covering all of the restricted
common stock to be issued in connection with the  Offering, provided that, as of
such date, certain conditions are satisfied.  Specifically, such conditions
include the following: (i) the registration statement covering all of the common
stock to be issued is effective as of such date, (ii) the representation and
warranties of the Company as set forth in the documents underlying the Offering
shall be correct in all material respects, (iii) the market price of the
Company's common stock shall exceed $4.50 per share, (iv) the dollar volume of
trading in the Company's common stock for the 10-trading day period preceding
such date shall equal or exceed $1,000,000, (v) there shall be at least 18
market makers for the Company's common stock, and (vi) there shall be no
material adverse change in the Company's business or financial condition.

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

LITIGATION - 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.  The J&L Action alleges that the
Company is 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 Offering.  The
Company has not yet filed an answer or other pleading in response 

                                      F-29
<PAGE>
 
                            FONIX/(TM)/ CORPORATION         
                         [A DEVELOPMENT STAGE COMPANY]      
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 

to the claims set forth in the J&L Action. Management and legal counsel of the
Company believe that the J&L Action is without merit, and the Company intends to
vigorously defend the action. There can be no assurance that the Company will
prevail in the J&L Action, or that the pendency of the lawsuit will not
adversely affect the Company's operations. As the outcome of this matter cannot
be reasonable determined, the Company has not accrued any potential losses.

ACQUISITION - The Company created a wholly owned subsidiary for the purpose of
acquiring AcuVoice, Inc., a California corporation, in March 1998, which changed
its name to AcuVoice, Inc. subsequent to the acquisition.  AcuVoice, Inc.
develops and markets text-to-speech or speech synthesis 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. On March 13, 1998, the Company acquired 100
percent of the outstanding common stock of AcuVoice, Inc. for the issuance of
2,692,218 shares the Company's restricted common stock (having a market value of
$16,995,972 on that date)and a cash payment of approximately $8,000,000.  This
acquisition will be accounted for as a purchase.

ISSUANCE OF STOCK OPTIONS -  On March 19, 1998, the Company granted an aggregate
of 450,000 stock options to 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.  These options have a ten-year life and an exercise
price of $5.16 per share.

                                      F-30