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                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549


                                    FORM 10-K/A


(Mark one)

[X]  Annual Report  pursuant to Section 13 or 15(d) of the  Securities  Exchange
     Act of 1934 for the fiscal year ended December 31, 1998, or

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

Commission File No. 0-23862

                                Fonix Corporation
             (Exact name of registrant as specified in its charter)


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



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

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

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

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

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

The  aggregate  market value of the voting stock held by  non-affiliates  of the
registrant is approximately  $35,828,186.25  calculated using a closing price of
$0.75  per  share  on April 9,  1999.  For  purposes  of this  calculation,  the
registrant  has  included  only the number of shares  held by its  officers  and
directors  directly  of record as of April 9,  1999,  (and not  counting  shares
beneficially   owned  on  that  date)  in   determining   the  shares   held  by
non-affiliates.  As  of  April  9,  1999,  there  were  issued  and  outstanding
70,064,495 shares of the Company's common stock.

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

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           This  Amendment  No. 1 to the  Annual  Report  on Form  10-K of Fonix
Corporation is submitted to amend the following  Items,  which  originally  were
submitted as part of the Annual  Report filed with the  Securities  and Exchange
Commission as of April 15, 1999:

Part II
       Item  7.  Management's Discussion and Analysis of Financial Condition and
                 Results of Operations........................................28
       Item 8.   Financial Statements and Supplementary Data..................39

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


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

THIS  REPORT ON FORM 10-K  CONTAINS,  IN  ADDITION  TO  HISTORICAL  INFORMATION,
FORWARD-LOOKING STATEMENTS THAT INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES. THE
COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE RESULTS ANTICIPATED BY
THE COMPANY AND DISCUSSED IN THE FORWARD-LOOKING STATEMENTS.  FACTORS THAT COULD
CAUSE OR  CONTRIBUTE  TO SUCH  DIFFERENCES  ARE  DISCUSSED  BELOW IN THE SECTION
ENTITLED  "FACTORS  AFFECTING  FUTURE  OPERATING  RESULTS" AND UNDER THE HEADING
"CERTAIN SIGNIFICANT RISK FACTORS" IN ITEM 1 PART i OF THIS REPORT, ABOVE.



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Overview

Fonix  is  a  development-stage  company  engaged  in  scientific  research  and
development of proprietary automated speech recognition and related technologies
("ASRT")  comprised of  components  which may be licensed in whole or in part to
third parties.  The Company has completed the Core  Technologies  related to the
ASRT such that they are available for third-party  licensing and co-development.
In November 1997, the Company  entered into an agreement with the  semiconductor
unit of Siemens AG pursuant  to which the  Company and Siemens  agreed to pursue
research and  development  of certain  technologies  related to the ASRT and the
commercialization  of  such  technologies  for the  telecommunications  industry
through a strategic  alliance.  Pursuant to the terms of the Siemens  agreement,
the Company and Siemens  entered  into the First  Statement  of Work and License
Agreement  pursuant  to which  Siemens  paid the  Company a license  fee for the
development  and  production of Fonix ASRT in integrated  circuits  suitable for
certain  telecommunications  applications.  Under the Siemens  agreement,  Fonix
received  its first  revenue  associated  with the ASRT in 1998.  On October 14,
1997, the Company entered into a Master Technology  Collaboration Agreement (the
"OGI  Agreement")  with the Oregon Graduate  Institute of Science and Technology
("OGI") pursuant to which the Company and OGI have agreed to pursue research and
development  of certain  ASRT.  Under the terms of the first  Statement  of Work
entered into pursuant to the OGI  Agreement,  the parties are  collaborating  on
advanced automated speech  recognition  applications for entry in the 1999 DARPA
competition.  The OGI Agreement contemplates that the Company and OGI will enter
into other agreements to pursue research and development of certain technologies
related to the ASRT,  although  there can be no assurance  that such  additional
agreements  will be entered  into by the Company  and OGI. In 1998,  the Company
entered into a similar arrangement with Brigham Young University.

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

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

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

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

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

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

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

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

Details of Acquisitions and Valuation Methodologies

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

AcuVoice (Acquired March 13, 1998)

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

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

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

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



Through  December  31,  1998,  the Company has spent  approximately  $130,000 on
development of the projects. Management estimates that


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the projects are 78% complete and that a total of approximately $870,000 will be
required to complete the AcuVoice  projects.  The purchased  IPR&D  projects are
continuing  to be  developed  as  anticipated,  and there are no  changes to the
initial estimates regarding completion and cost of development.



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Articulate (Acquired September 2, 1998)

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

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

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

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


Of the projects  deemed  IPR&D,  both  Radiology  2.5 and Emergency 1.0 achieved
technological feasibility and commercial viability subsequent to the acquisition
date, as anticipated  in terms of time of release and cost to complete.  Through
December 31, 1998, the Company has spent  approximately  $280,000 on development
of all of the projects.  Management estimates that the combined projects are 82%
complete,  and  that a total  of  approximately  $720,000  will be  required  to
complete  all of the  Articulate  projects.  The  remaining  IPR&D  projects are
continuing  to be  developed  as  anticipated,  and there are no  changes to the
initial estimates regarding completion and cost of development.


Valuation Methodology

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


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

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

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

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


For each acquisition, the excess purchase price over the net tangible assets was
allocated to  in-process  research and  development,  completed  technology  and
goodwill.


Results of Operations

1998 Compared to 1997

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

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

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

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decreased by $6,740,619.

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

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

1997 Compared to 1996

Prior  to  March  1997,  the  Company  conducted  its  scientific  research  and
development activities through Synergetics,  Inc.  ("Synergetics"),  pursuant to
product  development and assignment  contracts  (collectively  the  "Synergetics
Agreement").  Synergetics  provided  personnel  and  facilities  and the Company
financed  scientific  research  and  development  of the ASRT on an  as-required
basis.  There was no minimum  requirement  or maximum  limit with respect to the
amount of funding the Company was obligated to provide to Synergetics  under the
Synergetics Agreement,  and the Company was obligated to use its best efforts in
raising  all  of  the  necessary  funding  for  the  development  of  the  ASRT.
Synergetics  submitted  pre-authorized work orders and budgets,  which were then
reviewed and approved by the Company.  All funds paid to  Synergetics  have been
accounted  for by the Company as research  and  development  expense.  Under the
Synergetics  Agreement,  the  Company  had  also  agreed  to  pay a  royalty  to
Synergetics  equal  to 10% of  revenues  from  sales  of the  ASRT  or  products
incorporating  the ASRT (the  "Royalty").  On March 13,  1997,  the  Company and
Synergetics  reached  an  agreement  in  principle  to  modify  the  Synergetics
Agreement with regard to the  development  and assignment of the Company's ASRT.
On  April  6,  1998,  the  Company  and  Synergetics   entered  into  a  Royalty
Modification  Agreement,   under  which  the  Company  agreed,  subject  to  its
compliance with applicable  securities laws, to make an offer to exchange common
stock  purchase  warrants  having  an  exercise  price of $10 per  share for the
Project  Shares  at the  rate of one  warrant  to  purchase  800  shares  of the
Company's  common  shares for each  Project  Share.  The  warrants,  if and when
issued,  will not be exercisable until the earlier of (1) the date the Company's
common stock has traded for a period of 15 consecutive trading days at a minimum
of $37.50 per share or (2) September 30, 2000.  The offer of warrants to holders
of Project Shares cannot be made by the Company until a  registration  statement
covering the total number of warrants issuable upon the exercise of the warrants
has been declared effective by the Securities and Exchange Commission.  Upon the
tender to the Company of any Project  Shares a  corresponding  percentage of the
Royalty will be canceled.

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

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


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Due to the lack of revenues and significant research and development and general
and  administrative  expenses,  the Company has incurred  losses from operations
since inception totaling  $40,183,963,  of which $20,013,406 and $8,288,412 were
incurred  in the years  ended  December  31,  1997 and 1996,  respectively.  The
Company  anticipates  that its  investment  in ongoing  scientific  research and
development   of   the   ASRT   and   related   artificial    intelligence   and
compression/decompression  technologies  will  continue at present or  increased
levels.

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

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

Liquidity and Capital Resources

The  Company  must  raise  additional  funds  to be able  to  satisfy  its  cash
requirements  during  the  next  twelve  months.  The  scientific  research  and
development,  corporate  operations  and  marketing  expenses  will  continue to
require additional  capital.  In addition,  the Company's recent acquisitions of
AcuVoice,  Articulate,  and Papyrus place further  requirements on the Company's
limited cash resources.  Because the Company  presently has only limited revenue
from operations,  the Company intends to continue to rely primarily on financing
through the sale of its equity and debt  securities  to satisfy  future  capital
requirements  until such time as the  Company  is able to enter into  additional
acceptable  third party licensing or  co-development  arrangements  such that it
will be able to finance  ongoing  operations  out of license,  royalty and sales
revenue.  There can be no assurance  that the Company will be able to enter into
such  agreements.  Furthermore,  the  issuance  of  equity  securities  or other
securities which are or may become  convertible to the equity  securities of the
Company in connection with such financing (or in connection  with  acquisitions)
would  result in dilution  to the  stockholders  of the  Company  which could be
substantial.

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

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

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

                                        9

<PAGE>



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

On March 12, 1998, the Company the March 1998 Offering of its restricted  common
stock to seven accredited investors.  $15,000,000 was received by the Company on
March 12,  1998,  in return for which the  Company  issued a total of  3,333,333
shares of  restricted  common  stock and paid  finders'  fees of  $870,000.  The
investors agreed to purchase an additional $15,000,000 on July 27, 1998 (60 days
after the effectiveness of a registration  statement that the Company filed with
the SEC covering the common  stock  issued and issuable to the  investors)  (the
"Second Funding Date"),  provided that, as of such date, certain conditions were
satisfied. Certain conditions precedent to receiving the additional funding were
not met as of the Second  Funding  Date.  In separate  transactions  in June and
August 1998,  certain  investors  paid to the Company  $3,000,000  in return for
which  the  Company  issued  666,667  additional  shares  under  the  terms  and
conditions  set forth in the March 1998 Offering  documents.  Placement  fees of
$163,846 were  recorded in connection  with the  $3,000,000  received.  No other
payment was received by the Company pursuant to the March 1998 Offering.

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

Effective as of September 30, 1998,  the Company  entered into an agreement with
two of the investors  who  participated  in the March 1998 Offering  whereby the
Company  issued  100,000 shares of Series E for  $2,000,000.  Additionally,  the
Company issued to the  purchasers of the Series E a total of 150,000  additional
shares of Series E in exchange for which those purchasers surrendered a total of
150,000 shares of Series D. Dividends accrue on the stated value ($20 per share)

                                        10

<PAGE>



of Series E at a rate of 4% per year, are payable  annually or upon  conversion,
in cash or common stock, at the option of the Company,  and are convertible into
shares of the  Company's  common  stock at anytime at the holder's  option.  Any
outstanding  shares of Series E as of September 30, 2001  automatically  will be
converted at the conversion  price most  beneficial to the holders on such date.
In the event of  liquidation,  the  holders of the Series E are  entitled  to an
amount  equal to the  stated  value  ($20 per  share)  plus  accrued  but unpaid
dividends  whether  declared  or not.  The  holders  of  Series E have no voting
rights. The Series E, together with dividends accrued thereon,  may be converted
into shares of the Company's  common stock at the lesser of: $3.50 per share; or
the lesser of 110% of the average per share closing bid price for the 15 trading
days immediately  preceding the date of issuance of the Series E shares;  or 90%
of the average of the three  lowest per share  closing bid prices  during the 22
trading days immediately preceding the conversion date. If the investors convert
at the $3.50 per share  price,  the Company is  obligated  to issue  warrants to
purchase  0.8  shares of common  stock for each share of Series E  converted  to
common stock.  Using the  conversion  terms most  beneficial to the holder,  the
Company  recorded a preferred  stock  dividend of  $968,047  for the  beneficial
conversion  feature of the Series E. As of December 31, 1998,  114,928 shares of
Series E and related  dividends  had been  converted  into  2,591,733  shares of
common stock.

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

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

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

            $1.3875  from  March 22,  1999 to and  including  April 21, 1999,
            $1.3986 from April 22, 1999 to and including May 21, 1999,
            $1.4097 from May 22, 1999 to and including  June 20, 1999,
            $1.4208 from June 21, 1999 to and including July 20, 1999,and
            $1.4319 at any time after July 20, 1999 until the
            expiration of the Repricing Rights

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

                                        11

<PAGE>



Company agreed to grant each of them common stock purchase  warrants to purchase
666,666 shares of common stock at a price of $1.59 per share.  On or about April
6, 1999, the holders of the  Debentures  notified the Company and the Guarantors
that the Guarantors were in default under the terms of the pledge,  and that the
holders  intended  to exercise  their  rights to sell some or all of the pledged
shares.  At the  present  time,  the Company  has no  knowledge  of sales of the
Guarantors' shares by the holders.  However, if the holders proceed to sell some
or all of the  Guarantors'  shares,  the  Company  may be  obligated  under  its
indemnity agreement in favor of the Guarantors to issue shares to the Guarantors
in  replacement  of all shares sold by the holders and reimburse the  Guarantors
for any income tax liability  incurred as a result of the holders'  sales of the
Guarantors' shares.

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

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

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

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

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

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

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

                                        12

<PAGE>



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

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

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

As of December 31, 1998,  the Company had a revolving  note payable to a bank in
the amount of  $19,988,193.  Loaned amounts under the revolving note payable are
limited,  in the  aggregate  at any  time,  to  $20,000,000.  In order to reduce
interest  expenses,  on January 8, 1999, the Company applied its deposit account
in the amount of  $20,024,109  against the unpaid loan  balance of  $20,046,776,
resulting in a balance of $22,667 due, which amount was subsequently paid by the
Company.

The Company's  Core  Technologies  are designed to be Year 2000  compliant.  The
Company  intends to monitor the efforts of third-party  providers whose services
are critical to the Company as they become Year 2000  compliant.  Management  is
presently  not aware of any Year 2000 issues that have been  encountered  by any
such  third-party  which  could  materially  affect  the  Company's  operations.
Notwithstanding  the foregoing,  there can be no assurance that the Company will
not experience operational  difficulties as a result of Year 2000 issues, either
arising out of internal operations,  or caused by third-party service providers,
which  individually  or  collectively  could have an adverse  impact on business
operations or require the Company to incur unanticipated  expenses to remedy any
problems.  The Company expects that its year 2000  compliance  efforts will cost
approximately $70,000 during fiscal year 1999.

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

Outlook

Corporate Objectives and Technology Vision

The Company  believes  that its Core  Technologies  will be the platform for the
next  generation  of  automated  speech  technology  and  products.  Most speech
recognition  products offered by other companies are based on technologies  such
as HMM, that are largely in the public domain and represent nothing particularly
"new" or  creative.  The  Fonix  Core  Technologies  are  based on  proprietary,
patented technology.  The Company will continue to seek patent protection of the
Core  Technologies  as well as  technologies  and  inventions  derived  from the
knowhow,  technologies  and products  obtained with the acquisition of AcuVoice,
Articulate and Papyrus. Management believes this strategy will set the Company's
advanced human computer interaction products apart from the competition.

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

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

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

                                        13

<PAGE>



following:

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

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

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

Fonix is a technology company.  Since its inception,  the Company has focused on
the   development   of  its  Core   Technologies   and   related   complementary
technologies.,  including  those  technologies  obtained in connection  with the
acquisitions  of AcuVoice,  Articulate and Papyrus.  The Company will pursue the
development of advanced  speech and  computer-interface  technologies  that will
enhance or may be enhanced by its own Core Technologies.  Fonix will pursue this
development  through strategic  alliances,  such as the Siemens agreement in the
telecommunications  industry,  and through  collaborative  research arrangements
such as its agreements with OGI and Brigham Young University.

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

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

                Special Note Regarding Forward-Looking Statements

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


                                        14

<PAGE>



ITEM 8.              FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to Financial Statements:

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

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

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

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

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

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

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

Notes to Consolidated Financial Statements                                  F-12




                                        15

<PAGE>



                               TABLE OF CONTENTS








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

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

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

FINANCIAL STATEMENTS:

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

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

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

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

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



























                                        F-1

<PAGE>








                      REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To Fonix Corporation:

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

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

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

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


/s/ Arthur Andersen LLP

ARTHUR ANDERSEN LLP

Salt Lake City, Utah
April 14, 1999


                                       F-2

<PAGE>








INDEPENDENT AUDITORS' REPORT

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

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

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

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

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


/s/ Deloitte & Touche LLP
DELOITTE & TOUCHE LLP

Salt Lake City, Utah
March 28, 1997

                                       F-3

<PAGE>





INDEPENDENT AUDITORS' REPORT




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


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

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

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

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


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

PRITCHETT, SILER & HARDY, P.C.

Salt Lake City, Utah
March 4, 1996






                                       F-4

<PAGE>

                                Fonix Corporation
                          [A Development Stage Company]

                           CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>



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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


          See accompanying notes to consolidated financial statements.

                                      F-5

<PAGE>
                                Fonix Corporation
                          [A Development Stage Company]

                      CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>

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

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

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

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


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

</TABLE>

          See accompanying notes to consolidated financial statements.

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


                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>



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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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


<TABLE>
<CAPTION>

                                                                    Series D          Series E
                                                                Preferred Stock   Preferred Stock            Common Stock
                                                                ---------------   ---------------   ------------------------------
                                                                Shares   Amount   Shares   Amount      Shares            Amount
                                                                ------   ------   ------   ------   -------------    -------------
<S>                                                             <C>      <C>      <C>      <C>      <C>              <C>
Balance, December 31, 1992                                           -   $     -       -   $    -     37,045,000     $      3,704

Reverse stock split one share for ninety shares                      -         -       -        -    (36,633,389)          (3,663)

Restatement for reverse acquisition of fonix
  corporation by Phonic Technologies, Inc.                           -         -       -        -      9,983,638              999
                                                                ------   ------   ------   ------   -------------    -------------
Balance, October 1, 1993 (date of inception)                         -         -       -        -     10,395,249            1,040

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

Balance, December 31, 1993                                           -         -       -        -     10,395,249            1,040


Acquisition of Taris, Inc.                                           -         -       -        -        411,611               41

Shares issued for services at $.14 to $.18 per share                 -         -       -        -      1,650,000              165

Shares issued for services at $.25 per share                         -         -       -        -         20,000                2

Shares issued for conversion of notes payable
  and interest payable at $.04 per share                             -         -       -        -      3,900,000              390

Shares issued for cash at $1.19 to $3.13 per
  share, less offering costs of $368,450                             -         -       -        -      1,819,293              181

Net loss for the year ended December 31, 1994                        -         -       -        -              -                -
                                                                ------   ------   ------   ------   -------------    -------------
Balance, December 31, 1994                                           -         -       -        -     18,196,153            1,819


Shares issued during the year for cash at $.45 to $2.50
  per share, less offering costs of $ 267,714                        -         -       -        -      6,442,538              645

Shares issued during the year for services
  rendered and cancellation of accounts payable
  at $.55 to $1.55 per share                                         -         -       -        -        516,630               52

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

Shares issued during the year upon conversion of
  warrants for cancellation of
  accounts payable at $.35 per share                                 -         -       -        -      3,700,000              370

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

Shares issued during the year upon conversion of
  warrants for cash at $.50 to $1.00 per share                       -         -       -        -        550,000               55

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

Net loss for the year ended December 31, 1995                        -         -       -        -              -                -
                                                                ------   ------   ------   ------   -------------    -------------
Balance, December 31, 1995                                           -         -       -        -     29,405,321            2,941

</TABLE>


<TABLE>
<CAPTION>
                                                                                                         Deficit
                                                                                           Deferred    Accumulated
                                                                Additional                 Consult-    During the
                                                                 Paid-in     Outstanding      ing      Development
                                                                 Capital       Warrants    Expense        Stage          Total
                                                              -------------  -----------   --------   -------------   -----------
<S>                                                           <C>            <C>           <C>        <C>             <C>
Balance, December 31, 1992                                    $    136,659   $        -    $     -    $    (29,495)   $  110,868

Reverse stock split one share for ninety shares                      3,663            -          -               -             -

Restatement for reverse acquisition of fonix
  corporation by Phonic Technologies, Inc.                        (141,362)           -          -          29,495      (110,868)
                                                              -------------  -----------   --------   -------------   -----------
Balance, October 1, 1993 (date of inception)                        (1,040)           -          -               -             -

Net loss for the period October 1, 1993
  (date of inception) to December 31, 1993                               -            -          -      (1,782,611)   (1,782,611)
                                                              -------------  -----------   --------   -------------   -----------

Balance, December 31, 1993                                          (1,040)           -          -      (1,782,611)   (1,782,611)

Acquisition of Taris, Inc.                                           1,240            -          -               -         1,281

Shares issued for services at $.14 to $.18 per share               249,835            -          -               -       250,000

Shares issued for services at $.25 per share                         4,998            -          -               -         5,000

Shares issued for conversion of notes payable
  and interest payable at $.04 per share                           156,515            -          -               -       156,905

Shares issued for cash at $1.19 to $3.13 per
  share, less offering costs of $368,450                         3,315,874            -          -               -     3,316,055

Net loss for the year ended December 31, 1994                            -            -          -      (3,914,339)   (3,914,339)
                                                              -------------  -----------   --------   -------------   -----------
Balance, December 31, 1994                                       3,727,422            -          -      (5,696,950)   (1,967,709)

Shares issued during the year for cash at $.45 to
  $2.50 per share, less offering costs of $267,714               4,509,542            -          -               -     4,510,187

Shares issued during the year for services
  rendered and cancellation of accounts payable
  at $.55 to $1.55 per share                                       355,319            -          -               -       355,371

Warrants issued during the year for
  cancellation of accounts payable at $.033
  per warrant (additional compensation expense
  of $2,282,900 or $.62 per share was recorded)                          -    2,405,000          -               -     2,405,000

Shares issued during the year upon conversion of
  warrants for cancellation of accounts
  payable at $.35 per share                                      3,699,630   (2,405,000)         -               -     1,295,000

Warrants issued during the year for cash at $.0033 to
  $.10 per warrant, less offering costs of$5,040                         -       45,360          -               -        45,360

Shares issued during the year upon conversion of
  warrants for cash at $.50 to $1.00 per share                     519,945      (45,000)         -               -       475,000

Forgiveness of debt with related parties                           506,874            -          -               -       506,874

Net loss for the year ended December 31, 1995                            -            -          -      (6,315,349)   (6,315,349)
                                                              -------------  -----------   --------   -------------   -----------
Balance, December 31, 1995                                      13,318,732          360          -     (12,012,291)    1,309,734

</TABLE>

          See accompanying notes to consolidated financial statements

                                      F-7

<PAGE>
                                Fonix Corporation
                          [A Development Stage Company]

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

<TABLE>
<CAPTION>

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


Shares issued during the year for finders' fees
  at $1.52 to $2.72 per share                               -   $         -             -   $         -       420,000   $        42

Shares issued during the year upon conversion
  of warrants for cash at $.50 per share                    -             -             -             -        60,000             6

Shares issued during the year for cash at $.48
  to $3.38 per share, less offering costs of
  $2,033,286                                                -             -             -             -    11,741,242         1,174

Net loss for the year ended December 31, 1996               -             -             -             -             -             -
                                                  ------------  ------------  ------------  ------------  ------------  ------------
Balance, December 31, 1996                                  -             -             -             -    41,626,563         4,163

Shares issued for services at $3.75 to $5.31
  per share                                                 -             -             -             -        87,500             9

Shares issued for services at $6.50 to
  $8.38 per share                                           -             -             -             -       505,000            50

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

Shares issued upon the exercise of warrants
  for services at $2.00 per share                           -             -             -             -       150,000            15

Shares issued during the year for cash at
  $2.50 per share                                           -             -             -             -       150,000            15

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

Shares issued upon conversion of convertible
  debenture to common shares                                -             -             -             -       145,747            15

Series B preferred shares issued for
  extinguishment of convertible debenture at
  $20 stated value per share                                -             -             -             -             -             -

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

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

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

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

Series A preferred shares issued upon
  conversion of convertible debenture at
  $3 per share                                              -             -             -             -             -             -

Conversion of Series B and Series C
  preferred shares to common shares                         -             -             -             -       804,065            80

Shares issued during the year in connection
  with exercise of options at $2.97 per share               -             -             -             -        15,000             1

Shares issued during the year in connection
  with the exercise of warrants at $.50                     -             -             -             -       100,000            10
  per share

Accretion of Series C preferred stock                       -             -             -             -             -             -

Dividends on preferred stock                                -       $     -             -       $     -             -    $        -

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

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


Shares issued during the year for finders' fees
  at $1.52 to $2.72 per share                         901,478   $         -   $         -   $         -   $   901,520

Shares issued during the year upon conversion
  of warrants for cash at $.50 per share               29,994             -             -             -        30,000

Shares issued during the year for cash at $.48
  to $3.38 per share, less offering costs of
  $2,033,286                                       11,857,269             -             -             -    11,858,443

Net loss for the year ended December 31, 1996               -             -             -    (7,829,508)   (7,829,508)
                                                  ------------  ------------  ------------  ------------  ------------
Balance, December 31, 1996                         26,107,473           360             -   (19,841,807)    6,270,189

Shares issued for services at $3.75 to $5.31
  per share                                           366,710             -             -             -       366,719

Shares issued for services at $6.50 to
  $8.38 per share                                   3,426,202             -             -             -     3,426,252

Warrants issued during the year for services                -     1,165,500             -             -     1,165,500

Shares issued upon the exercise of warrants
  for services at $2.00 per share                     689,085      (389,100)            -             -       300,000

Shares issued during the year for cash at
  $2.50 per share                                   1,256,235             -             -             -     1,256,250

Warrants issued during the year in connection
  with the issuance of a convertible debenture
  and convertible preferred stock                           -     1,559,600             -             -     1,559,600

Shares issued upon conversion of convertible
  debenture to common shares                          857,835             -             -             -       857,850

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

Sale of Series C preferred shares and
  warrants, less cash fees of $201,500                      -       600,000             -             -     3,548,500

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

Capital contribution in connection with
  put options                                         500,000             -             -             -       500,000

Beneficial conversion features of Series B
  convertible debenture                               427,850             -             -             -       427,850

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

Conversion of Series B and Series C
  preferred shares to common shares                 4,891,180             -             -             -             -

Shares issued during the year in connection
  with exercise of options at $2.97 per share          44,499             -             -             -        44,500

Shares issued during the year in connection
  with the exercise of warrants at $.50                49,900             -             -             -        50,000
  per share

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

Dividends on preferred stock                        $       -       $     -      $      -   $(2,121,991)    $       -

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

          See accompanying notes to consolidated financial statements.

                                      F-8

<PAGE>
                                Fonix Corporation
                          [A Development Stage Company]

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




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

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

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

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

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

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

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

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

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

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

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

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

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

Expiration of warrants                                      -             -             -             -             -             -

Amortization of deferred consulting
  expense                                                   -             -             -             -             -             -

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

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

</TABLE>

<TABLE>
<CAPTION>

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

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

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

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

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

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

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

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

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

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

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

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

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

Expiration of warrants                                      -             -             -             -             -             -

Amortization of deferred consulting
  expense                                                   -             -             -             -             -             -

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

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

</TABLE>

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

</TABLE>

          See accompanying notes to consolidated financial statements.

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

                      CONSOLIDATED STATEMENTS OF CASH FLOWS

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

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

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

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

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

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

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

</TABLE>

          See accompanying notes to consolidated financial statements.

                                      F-10

<PAGE>
                               Fonix Corporation
                         [A Development Stage Company]


               CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)

Supplemental disclosure of cash flow information:

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

</TABLE>

Supplemental Schedule of Non-cash Investing and Financing Activities:

     For the Year Ended December 31, 1998:

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

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

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

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

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

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

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

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

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

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

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

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


     For the Year Ended December 31, 1997:

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

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

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

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

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

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

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

     For the Year Ended December 31, 1996:

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

          See accompanying notes to consolidated financial statements.

                                      F-11

<PAGE>

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


 1.  NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES

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

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

Development  Stage  Presentation  - Fonix is a development  stage  company.  The
Company  generated  revenues of  $2,889,684  and  incurred  net losses  totaling
$43,118,782  for the year ended  December  31,  1998.  The Company has  incurred
cumulative  losses of $85,414,537  for the period from inception to December 31,
1998. The Company has an accumulated  deficit of $92,933,777,  negative  working
capital of $14,678,975,  demand and other notes currently due of $29,438,218 (of
which $1,335,030 is due upon demand or is in default) and $1,965,490 of accounts
payable over 60 days past due as of December 31, 1998. The net loss for 1998 and
the  accumulated  deficit as of December 31, 1998 include  charges of $9,315,000
and  $3,821,000  related to the  Company's  acquisition  of  in-process  product
research and development in connection with its  acquisitions of AcuVoice,  Inc.
and Articulate Systems, Inc.,  respectively.  Although the Company generated its
first  revenue in  February  1998,  the  Company  expects to  continue  to incur
significant  losses  through  at  least  December  31,  1999,  primarily  due to
significant   expenditure   requirements   associated  with  the  marketing  and
development of its proprietary ASR and related  technologies.  These factors, as
well as the risk factors set out  elsewhere in the  Company's  Annual  Report on
Form 10-K, raise substantial doubt about the Company's ability


                                       F-12

<PAGE>


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


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
sales of debt and equity  securities  and, if necessary,  the sale of certain of
its  technologies  (see Note 20).  There can be no assurance  that  management's
plans will be successful.

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

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

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

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

           Furniture and fixtures            5 years
           Computer equipment                3 to 5 years
           Leasehold improvements            18 months to 8 years

Leasehold  improvements are amortized over the shorter of the useful life of the
applicable  asset or the  remaining  lease  term.  Maintenance  and  repairs are
charged to expense as incurred and major improvements are capitalized.  Gains or
losses on sales or retirements  are included in the  consolidated  statements of
operations in the year of disposition.

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

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

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

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

Research and  Development - All  expenditures  for research and  development are
charged to  expense  as  incurred.  The  Company  incurred  total  research  and
development expenses of $13,620,748, $7,066,294 and $4,758,012 for the years

                                       F-13

<PAGE>


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


ended  December  31, 1998,  1997 and 1996,  respectively.  The Company  expensed
$13,136,000 of research and  development  costs purchased in connection with the
acquisitions of AcuVoice, Inc. and Articulate Systems, Inc. (see Note 2).

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

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

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

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

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

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


                                       F-14

<PAGE>


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

<TABLE>
<CAPTION>

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

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

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

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

2.  ACQUISITIONS

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

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


                                       F-15

<PAGE>


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


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

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

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


  The amount  attributed to purchased  in-process  research and  development was
expensed in connection  with the  acquisition  because the purchased  in-process
technology had not yet reached technological  feasibility and had no alternative
future use.


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

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

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

The excess of the  purchase  price over the  estimated  fair market value of the
acquired tangible net assets of Articulate was $23,584,256, of which $13,945,000
was capitalized as the purchase cost of completed technology, $5,818,256 was


                                       F-16

<PAGE>


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



capitalized  as goodwill and other  intangibles  and  $3,821,000 was expensed as
purchased  in-process  research  and  development.   The  amount  attributed  to
purchased  in-process  research and  development was expensed in connection with
the acquisition because the purchased in-process  technology had not yet reached
technological feasibility and had no alternative future use.

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

At the time of its acquisition by Fonix,  Articulate's  research and development
focused on developing a new PowerScribe platform design that will support as-yet
unproven  features  including an enhanced tool kit that supports  advanced voice
recognition  technology built on all-new language models, as well as new storage
and retrieval applications.  At the time of its acquisition by Fonix, AcuVoice's
research and development efforts were focused on the continued  development of a
completely   new   generation   of   proprietary    text-to-speech   technology.
Specifically,  AcuVoice  was working to expand voice  capacity to include  other
voices  (including  female  and  foreign  language  voices).  As of the  date of
acquisition,  Articulate  and AcuVoice  invested  approximately  $3,400,000  and
$3,500,000,  respectively,  in the projects identified above. Development of the
acquired  in-process  technology into commercially  viable products and services
required  efforts  principally  related  to  the  completion  of  all  planning,
designing, coding, prototyping, scalability verification, and testing activities
necessary to establish  that the proposed  technologies  would meet their design
specifications,   including  functional,  technical,  and  economic  performance
requirements.  As of the date of acquisition,  management estimated that each of
the Articulate and AcuVoice projects was approximately 75 percent complete based
on costs.  Remaining  development  efforts for these  projects  include  various
phases of design, development and testing. Funding for the projects was expected
to be obtained  from  private  offerings  of the  Company's  equity  securities.
Management  believes  that the  AcuVoice  projects  may be  finished as early as
October  1999 while the  Articulate  projects  are  expected  to be  finished no
earlier than fiscal 2000. Expenditures to complete the AcuVoice projects and the
Articulate projects are each expected to total approximately  $1,000,000.  These
estimates  are subject to change,  given the  uncertainties  of the  development
process,  and no assurance can be given that  significant  deviations from these
estimates will not occur.

The net cash flows resulting from the projects at Articulate and AcuVoice, which
were used to value the purchased in-process research and development, were based
on  management's  estimates  of  revenues,   cost  of  revenues,   research  and
development costs,  selling,  general and administrative costs, and income taxes
from such projects. These estimates are based on the following assumptions:  the
potential market size that the projects are addressing; the Company's ability to
gain  market  share  in  these  segments;  and  the  life  cycle  of  in-process
technology. Earnings before interest and taxes are estimated to be approximately
35  percent  to 60  percent  for the sales  generated  from the  Articulate  and
AcuVoice  in-process  technology.  Estimated  total  revenues from the purchased
in-process product areas peak in calendar years 2000-2001 and decline thereafter
as other new products are expected to enter the market.  In addition,  a portion
of the  anticipated  revenues has been  attributed to  enhancements  of the base
technology  under  development,  and has been  excluded  from the net cash  flow
calculations.  Existing  technology was valued at $13,945,000 for Articulate and
$11,192,000 for AcuVoice. There can be no assurances that these assumptions will
prove  accurate,  or that the Company  will realize the  anticipated  benefit of
these acquisitions.

The rates  utilized to discount  the net cash flows to their  present  value are
based on cost of capital calculations. Due to the high risk nature of the growth
and  profitability  inherent in the forecast and the risks  associated  with the
developmental projects, capital rates of return of 40 percent and 60 percent for
Articulate and AcuVoice,



                                       F-17

<PAGE>


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



respectively,  were  considered  appropriate  for the  acquired  companies.  The
discount  rates  used to derive  the net  present  value of cash flows from each
purchased  in-process  technology were commensurate with each acquired company's
i) early stage of development;  ii) history of limited revenues and losses; iii)
the  uncertainties in the economic  estimates  described above; iv) the inherent
uncertainty  surrounding the successful  development of the purchased in-process
technology; v) the useful life of such technology;  vi) the profitability levels
of the  technology;  and, vii) the  uncertainty  associated  with  technological
advances inherent in the research and development.

If these  projects  are not  successfully  developed,  the  Company's  business,
operating results,  and financial  condition may be adversely affected in future
periods.  In addition,  the value of other intangible assets acquired may become
impaired.  To date,  results have not differed  significantly  from the forecast
assumptions at each respective date of acquisition in terms of anticipated  date
of release and cost to  complete.  Management  believes  the value  allocated to
acquired  developed  technology  and  in-process  research  and  development  is
consistent with these facts and circumstances.


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

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

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

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

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

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

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


                                       F-18

<PAGE>


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


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

<TABLE>
<CAPTION>
                                                                     For the Year  Ended December 31,
                                                                    ----------------------------------
                                                                      1998                      1997
                                                                    --------                  --------
<S>                                                           <C>                       <C>
 Revenues                                                     $     3,493,460           $  2,055,419
 Loss before extraordinary items                                  (36,131,670)           (21,360,635)
 Net loss                                                         (36,131,670)           (22,242,499)
 Basic and diluted net loss per common share                            (0.64)                 (0.49)
</TABLE>

3.  CERTIFICATE OF DEPOSIT

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

4.  NOTES RECEIVABLE

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

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

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

5.  PROPERTY AND EQUIPMENT

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

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

                                      F-19

<PAGE>


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


6.  REVOLVING AND OTHER NOTES PAYABLE

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

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

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

7.  RELATED-PARTY NOTES PAYABLE

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

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

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

                                      F-20

<PAGE>


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


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

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

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

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

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

8.  CONVERTIBLE DEBENTURES

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

Series B Convertible  Debentures - On June 18, 1997, the Company  entered into a
Convertible  Debenture Purchase Agreement (the "Agreement") whereby an unrelated
investment  entity  agreed to purchase up to an  aggregate  principal  amount of
$10,000,000  of the Company's  Series B Convertible  Debentures.  The debentures
were due June 18, 2007, bore interest at five percent and were  convertible into
shares of the Company's  common stock at anytime after  issuance at the holder's
option.  The debentures  were  convertible  into shares of the Company's  common
stock at the lesser of $6.81 or the  average of the per share  market  value for
the five trading days immediately preceding the conversion date multiplied by 90
percent for any conversion on or prior to the 120th day after the original issue
date and 87.5  percent for any  conversion  thereafter.  On June 18,  1997,  the
Company  received  $3,000,000  in proceeds  related to the  issuance of Series B
Convertible  Debentures.  Using the  conversion  terms  most  beneficial  to the
investor,  the  Company  recorded  a  prepaid  financing  cost of  approximately
$427,900 to be amortized as additional  interest expense over the 120 day period
commencing  June 18,  1997.  As part of the same  transaction,  the Company also
issued to the  investor a warrant  to  purchase  up to 250,000  shares of common
stock at any time prior to June 18, 2002, at the exercise price of $8.28 per

                                      F-21

<PAGE>


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

share. The Company recorded the fair value of the warrants,  totaling  $897,750,
as a charge to interest  expense.  The fair value of the warrants was determined
as of the date of grant  using the  Black-Scholes  pricing  model  assuming  the
following:  dividend yield of 0 percent; expected volatility of 65 percent; risk
free  interest  rate of 5.9  percent  and an  expected  life to exercise of five
years.  On July 31, 1997 and  September  26,1997,  $500,000  and $350,000 of the
Series B  Convertible  Debentures  together with  interest  earned  thereon were
converted into 87,498 and 58,249 shares of common stock, respectively.

Effective September 30, 1997, the Company and the Series B Convertible Debenture
holders agreed to modify the Agreement to provide that the holders  exchange all
the  outstanding  debentures  in the amount of $2,150,000  and accrued  interest
thereon in the amount of $28,213  into  108,911  shares of Series B  Convertible
Preferred Stock that would have essentially the same terms as the debentures and
that any additional  purchases  under the Agreement would be for the purchase of
Series B Convertible  Preferred Stock. In connection with the  extinguishment of
the Series B  Convertible  Debenture  and the  issuance of Series B  Convertible
Preferred Stock, the Company recorded all unamortized prepaid financing costs as
a loss on extinguishment of debt. Also in connection with this modification, the
Company issued an additional  warrant to purchase up to 175,000 shares of common
stock at any time prior to October 24, 2002,  at an exercise  price of $7.48 per
share. In connection with the issuance of that warrant, the Company recorded the
fair  value  of  the  warrant,  totaling  $661,850  as  an  additional  loss  on
extinguishment  of debt. The fair value of the warrants was determined as of the
date of the grant using the Black-Scholes  pricing model assuming the following:
dividend  yield of 0  percent;  expected  volatility  of 65  percent;  risk free
interest rate of 5.8 percent and expected life to exercise of 5 years.

9. PREFERRED STOCK

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

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

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

                                      F-22

<PAGE>


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


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

On October 24, 1997,  the Company sold an additional  125,000 shares of Series B
Convertible  Preferred  Stock for $2,500,000  less $145,000 in related  offering
costs.  Using the conversion  terms most  beneficial to the holder,  the Company
recorded a dividend of $576,667 which represents a discount of 10 percent, which
is available to the holder on or before 120 days  subsequent  to closing.  A 2.5
percent  discount of $87,905 was  amortized  as a dividend  over 120 days.  As a
condition for issuing  preferred  stock,  the holder was granted a put option by
SMD, L.L.C. ("SMD"), a company which is controlled by three shareholders who are
officers or  directors  of Fonix.  The put option  requires  SMD to purchase the
Series B Convertible  Preferred Stock from the holder at the holder's option but
only in the event that the common  stock of Fonix is removed from listing on the
NASDAQ Small Cap Market or any other national securities exchange.  In addition,
Fonix has not entered into any type of agreement  which would  require  Fonix to
reimburse  SMD should  SMD be  required  to  purchase  the Series B  Convertible
Preferred Stock from the holder. In connection with this put option, the Company
recorded  a  financing  expense  and a  corresponding  capital  contribution  of
$125,000.  As of December 31, 1997, 97,500 of the Series B Convertible Preferred
Stock and dividends  earned  thereon had been  converted  into 355,188 shares of
common  stock.  In  January  1998,  the  remaining  27,500  shares  of  Series B
Convertible  Preferred  Stock and dividends  earned  thereon were converted into
193,582 shares of common stock.

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

                                      F-23

<PAGE>


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


of $375,000.  Associated with the issuance of the Series C Convertible Preferred
Stock,  the Company  issued a warrant to purchase up to 200,000 shares of common
stock at any time prior to October 24, 2000, at the exercise  price of $7.18 per
share.  The  Company  recorded  the fair  value of the  warrant of  $600,000  as
determined as of October 24,1997 using the Black-Scholes  pricing model assuming
the following:  dividend yield of 0 percent;  expected volatility of 65 percent;
risk free interest rate of 5.8 percent and expected life to exercise of 3 years.
During the year ended  December 31, 1997,  the Company  issued  17,198 shares of
common stock upon  conversion of 2,500 shares of Series C Convertible  Preferred
Stock and related accrued dividends.  During 1998, the balance of 185,000 shares
of Series C Convertible  Preferred  Stock and related  dividends  were converted
into 1,295,919 shares of the Company's common stock.

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

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

                                      F-24

<PAGE>


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


conversion  price most  beneficial  to the holders on such date. In the event of
liquidation,  the  holders  of the  Series E  Convertible  Preferred  Stock  are
entitled to an amount equal to the stated value ($20 per share) plus accrued but
unpaid  dividends  whether  declared or not. The holders of Series E Convertible
Preferred Stock have no voting rights. The Series E Convertible Preferred Stock,
together with  dividends  accrued  thereon,  may be converted into shares of the
Company's  common stock at the lesser of: $3.50 per share;  or the lesser of 110
percent of the  average  per share  closing  bid price for the 15  trading  days
immediately preceding the date of issuance of the Series E Convertible Preferred
shares;  or 90 percent of the average of the three lowest per share  closing bid
prices during the 22 trading days immediately  preceding the conversion date. If
the Investors  convert at the $3.50 per share price, the Company is obligated to
issue warrants to purchase 0.8 shares of common stock for each share of Series E
Convertible  Preferred  Stock  converted to common stock.  Using the  conversion
terms most  beneficial  to the holder,  the Company  recorded a preferred  stock
dividend  of  $968,047  for the  beneficial  conversion  feature of the Series E
Convertible Preferred Stock. As of December 31, 1998, 114,928 shares of Series E
Convertible  Preferred  Stock and  related  dividends  had been  converted  into
2,591,733  shares of common  stock.  Subsequent  to December 31,  1998,  122,572
shares of  Series E  Convertible  Preferred  Stock and  related  dividends  were
converted into 3,042,145 shares of common stock.

10.  COMMON STOCK AND COMMON STOCK SUBJECT TO REDEMPTION

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

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

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

                                      F-25

<PAGE>


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



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

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

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

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

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

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


                                      F-26

<PAGE>


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


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

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

11. STOCK OPTIONS AND WARRANTS

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

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

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

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

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




                                      F-27

<PAGE>


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



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

<TABLE>
<CAPTION>

                                                    1998                      1997                               1996
                                 ----------------------------    --------------------------------    ------------------------------
                                                   Weighted                           Weighted                            Weighted
                                                    Average                           Average                             Average
                                     Stock         Exercise          Stock            Exercise            Stock           Exercise
                                    Options         Price           Options            Price             Options            Price
                                --------------   -----------    ----------------    -------------    ----------------     ---------
<S>                             <C>              <C>            <C>                 <C>              <C>                  <C>
Total options outstanding
  at beginning of year             10,565,000    $    5.38            4,626,000     $    4.07                   -         $     -
    Granted                         6,414,782         2.08            6,009,000          6.38           4,626,000            4.07
    Exercised                         (35,000)        6.00              (15,000)         2.97                   -               -
    Forfeited                      (1,067,000)        4.56              (30,000)         7.66                   -               -
    Canceled                                -            -              (25,000)         5.00                   -               -
                                --------------                  ----------------                      ----------------
Total options outstanding
  at end of year                   15,877,782         4.10           10,565,000          5.38           4,626,000             4.07
                                ==============                  ================                      ================

Total options exercisable
  at end of year                    9,524,766         5.11            5,392,675          5.05           2,000,000             4.06
                                ==============                  ================                      ================
Weighted average fair
  value of options granted
    during the year                              $    1.98                          $    6.38                             $   4.07

</TABLE>

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

<TABLE>
<CAPTION>


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

 $0.08-8.50    15,877,782     8.7 years     $    4.10            9,524,766           $  5.11
</TABLE>


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

                                      F-28

<PAGE>


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


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

<TABLE>
<CAPTION>
                                                       1998            1997             1996
                                                  -------------    -------------    -------------
<S>                                               <C>              <C>              <C>
 Net loss attributable to common stockholders:
      As reported                                  $47,916,031     $  25,175,939    $  7,829,508
      Pro forma                                     56,576,232        48,870,670      20,289,706

 Basic and diluted net loss per common share:
      As reported                                  $    (0.91)     $       (0.59)   $     (0.21)
      Pro forma                                         (1.08)             (1.15)         (0.55)
</TABLE>

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

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

<TABLE>
<CAPTION>

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

Total exercisable at end of year            1,925,000     13.08      1,175,000      6.39       450,000       1.63
</TABLE>

12.  RELATED-PARTY  TRANSACTIONS

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

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

                                      F-29

<PAGE>


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


<TABLE>
<CAPTION>

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

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

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

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

Studdert   Companies  Corp.  -  Studdert  Companies  Corp.  ("SCC")  is  a  Utah
corporation  that provides  investment  and management  services.  The officers,
directors and owners of SCC are directors and executive  officers of the Company
and each of whom  beneficially owns more than 10 percent of the Company's issued
and outstanding common stock.  Between June 1994, when the Company commenced its
present  business of developing  its ASR  technologies,  and April 30, 1996, the
Company  did not pay or  award  any  compensation  in any form  directly  to the
Company's executive officers.  Rather, in June 1994, the Company entered into an
Independent  Consulting  Agreement  (the "SCC  Agreement")  with SCC pursuant to
which SCC rendered certain management and financial services to the Company.

Pursuant to the SCC Agreement,  between  January and July 1995, SCC invoiced the
Company for services rendered.  By July 1995, the Company owed SCC approximately
$1,417,000  pursuant to the terms of the SCC  Agreement.  On July 31, 1995,  the
Company  issued  warrants to purchase up to  3,700,000  shares of the  Company's
common stock to SCC.  The purchase  price of the warrants was $.033 per share of
common stock, or an aggregate of $122,100. On August 11, 1995, SCC exercised the
warrants at an exercise  price of $0.35 per share.  Both the  $122,100  purchase
price  and  the  $1,295,000  aggregate  exercise  price  for the  warrants  were
satisfied by the cancellation of amounts invoiced to the Company by SCC pursuant
to the SCC  Agreement  during the fiscal  year ended  December  31, 1994 and the
period  between  January 1, 1995 and  August 11,  1995.  Such  cancellation  was
accomplished on a dollar-for-dollar basis.

Between  August 1995 and October 1995,  SCC continued to invoice the Company for
its $50,000  monthly  management  fee. On October 23, 1995, the Company  entered
into an investment  agreement  (the  "Beesmark  Agreement")  with  Beesmark.  In
connection with the Company's execution of the Beesmark  Agreement,  SCC and the
Company  agreed  that  any  then  accrued  but  unpaid  balance  due to SCC  for
management  services  rendered  under  the SCC  Agreement  would  be  placed  on
"conditional  status"  and  deferred  until the Company  successfully  completed
certain developmental  milestones set forth in the Beesmark Agreement,  at which
time such amounts  would be due and payable in full.  With respect to management
services to be rendered by SCC after the closing of the Beesmark Agreement,  SCC
agreed that the Company would pay only $30,000 of the monthly invoiced  $50,000,
the balance to be placed on conditional status.

                                      F-30

<PAGE>


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


Thus, of the total $600,000 invoiced to the Company by SCC during the year ended
December 31, 1995, the Company paid SCC $90,000 in cash; $257,000 of accrued but
unpaid amounts were placed on conditional  status under the Beesmark  Agreement;
and $253,000 was  canceled in partial  payment of the exercise  price of the SCC
Warrants.  In addition to the amounts invoiced by SCC for management fees during
the 1995  fiscal  year,  the Company  also  reimbursed  SCC for actual  expenses
incurred in the amount of $337,405. Thus, at December 31, 1995, the Company owed
SCC $257,000 in management  fees, all of which was on  conditional  status under
the terms of the  Beesmark  Agreement  and was  payable to SCC only in the event
that the Company achieved the developmental milestones set forth in the Beesmark
Agreement.  At December 31, 1995,  the Company also owed SCC $3,825 for expenses
incurred.  Additionally,  during the year ended December 31, 1995, SCC charged a
total of $70,915 in capital raising fees to the Company. Of that amount, $49,576
was written off by SCC in connection  with the Beesmark  Agreement,  and $21,339
was paid to SCC.

Between  January  1, 1996 and April 30,  1996,  SCC  invoiced  the  Company  for
services  under the SCC  Agreement  in the amount of  $200,000.  Of that amount,
$80,000 was placed on conditional  status pursuant to the Beesmark Agreement and
$120,000 was paid to SCC. On April 30, 1996,  the  disinterested  members of the
Company's  board of directors  authorized the Company to enter into an agreement
with SCC  modifying  the SCC  Agreement  effective  May 1,  1996.  Under the SCC
Agreement,  as  modified,  SCC no longer  invoiced  the Company  for  management
services,  but  continued  to invoice the Company  for  reimbursement  of actual
expenses incurred on the Company's  behalf.  SCC and the Company agreed that any
amounts  invoiced  under the SCC  Agreement  but  placed on  conditional  status
pursuant to the Beesmark Agreement would remain  outstanding  obligations of the
Company  payable only if the Company  achieved the  milestones  specified in the
Beesmark  Agreement.  The  Company  further  agreed to pay any then  accrued but
unpaid  amounts  invoiced under the SCC  Agreement,  including  amounts owed and
carried  over from the year ended  December  31,  1995,  which  amounts  totaled
$5,862, as well as outstanding amounts for expenses incurred. In September 1996,
Beesmark made the last of the funding  payments  provided for under the terms of
the Beesmark Agreement. On February 10, 1997, the Company paid to SCC the entire
balance due to SCC for accrued management fees in the amount of $337,000.  Thus,
during the year ended  December  31,  1996,  the Company  paid to SCC a total of
$120,000 for management fees and SCC was reimbursed for actual expenses incurred
on the Company's behalf in the amount of $740,052. During 1996, the Company made
no  payments  to SCC for capital  raising  activities.  The Company and SCC have
agreed to extend the SCC  Agreement,  at least insofar as the Company has agreed
to reimburse SCC for actual  expenses  incurred on behalf of the Company through
December 1998.

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

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


                                1998              1997            1996
                              -------------   -------------  ---------------

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

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

                                      F-31

<PAGE>


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


unaffiliated third party in a similar transaction.

Beesmark  Investments,  L.C. - On October 23, 1995, the Company,  Beesmark and a
director entered into the Beesmark  Agreement.  The director did not occupy such
position when the Beesmark  Agreement was negotiated and executed.  The director
also is a co-manager of and has an indirect  pecuniary  interest in a portion of
Beesmark's  assets.  Pursuant  to the  Beesmark  Agreement,  Beesmark  agreed to
provide  a total of  $6,050,000  of  funding  to the  Company  over a period  of
approximately 11 months,  provided that during that time the Company was able to
timely meet, to Beesmark's satisfaction,  specified developmental milestones. In
return  for the  funding  provided  to  Beesmark,  the  Company  agreed to issue
11,562,500  shares of common  stock at a price of $0.48 per share and a $500,000
Series A Convertible  Subordinated  Debenture  that is  convertible  into either
166,667 shares of Series A Convertible  Preferred Stock or 166,667 shares of the
Company's common stock.  During the year ended December 31, 1996,  Beesmark paid
all  installments  payable by Beesmark  under the  Beesmark  Agreement,  and the
Company issued, in the increments  specified,  all of the securities issuable to
Beesmark under the Beesmark Agreement.

SMD,  L.L.C.  - From  September 4, 1997,  through  October 15, 1997 and again on
December 31, 1997, the Company, borrowed funds from SMD, L.L.C., a company owned
by  three  directors  and  executive  officers  of the  Company  (each  of  whom
beneficially  owns more than 10 percent of the Company's  issued and outstanding
common  stock)  pursuant to a  revolving,  unsecured  promissory  note,  bearing
interest  at the rate of 12 percent  per annum.  The  aggregate  of all  amounts
loaned under the note was $2,000,000 and the highest  outstanding balance at any
one time was  $1,550,000.  All  amounts  were  repaid,  together  with $5,542 in
interest  in 1998.  The loan and its  terms  were  approved  by the  independent
members of the board of directors of the Company.

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

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

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

                                      F-32

<PAGE>


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


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

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

Voice  Information  Associates,  Inc. - A director and executive  officer of the
Company is also the founder and president of Voice Information Associates,  Inc.
("VIA"), a consulting group providing  strategic  technical,  market evaluation,
product  development  and  corporate   information  to  the  speech  recognition
industry.  During 1997,  the Company paid  approximately  $110,000 in consulting
fees to VIA for services  provided to the Company.  No payments were made by the
Company to VIA in 1998.

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

13. STATEMENT OF WORK

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

14.  PRODUCT DEVELOPMENT AND RESEARCH

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

                                      F-33

<PAGE>


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


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

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

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

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

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

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

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

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

                                      F-34

<PAGE>


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


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

15.  INCOME TAXES

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

The Company has  available at December 31, 1998,  unused  federal net  operating
loss  carryforwards of approximately  $62,916,000 and unused state net operating
loss  carryforwards  of approximately  $63,295,000  which may be applied against
future  taxable  income,  if any,  and which  expire in various  years from 2008
through 2018. The Internal  Revenue Code contains  provisions which likely could
reduce or limit the  availability  and  utilization  of these net operating loss
carryforwards.  For example,  limitations  are imposed on the utilization of net
operating loss  carryforwards if certain  ownership  changes have taken place or
will take place. The Company has not performed an analysis to determine  whether
any such limitations have occurred.

The  temporary  differences  and  carryforwards  which give rise to the deferred
income tax assets (liabilities) as of December 31, 1998 and 1997 are as follows:

<TABLE>
<CAPTION>
                                                          1998               1997
                                                   ---------------     -----------------
<S>                                                <C>                 <C>
Deferred income tax assets:
      Net operating loss carryforwards:
         Federal                                   $   21,391,555      $    14,030,670
         State                                          2,088,746            1,312,988
       Research and development credits                   694,239              275,927
       Accrued bonus liabilities                          150,729              127,012
                                                   ---------------     -----------------
      Total deferred income tax assets before
         valuation allowance                           24,325,269           15,746,597

       Valuation allowance                            (24,176,653)         (15,646,783)
                                                   ---------------     -----------------
       Net deferred income tax assets                     148,616               99,814
                                                   ---------------     -----------------

Deferred income tax liabilities:
       Depreciation                                      (148,316)             (99,514)
       Intangibles                                           (300)                (300)
                                                   ---------------     -----------------
       Total deferred income tax liabilities             (148,616)             (99,814)

                                                    $           -      $             -
                                                   ===============     =================
</TABLE>



                                      F-35

<PAGE>


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

A reconciliation  of income taxes at the federal statutory rate to the Company's
effective rate is as follows:

<TABLE>
<CAPTION>
                                                               Year Ended December 31,
                                                               -----------------------
                                                       1998               1997           1996
                                                       ----               ----           ----
         <S>                                         <C>                 <C>            <C>


         Federal statutory income tax rate            34.0 %              34.0 %         34.0 %
         State and local income tax rate,
            net of federal benefit                     3.3                 3.3            3.3
         Valuation allowance                         (37.3)              (37.3)         (37.3)

         Effective income tax rate                       -  %                - %            -  %
</TABLE>

16.  COMMITMENTS AND CONTINGENCIES

Employment  Agreements - In January 1998,  the Company  entered into  employment
contracts  with two employees  which expire in January 2001.  The minimum annual
salary payments  required by these contracts total $405,000.  In connection with
these  agreements,  these  individuals  were granted options to purchase 360,000
shares of the  Company's  common stock at $3.34 per share.  These options have a
ten-year  life and are subject to a  three-year  vesting  schedule,  pursuant to
which  one-third  of the total number of options  granted may be exercised  each
year.  One-third  of the options  are vested on the date of grant.  In the event
that, during the contract term, both a change of control occurs,  and within six
months  after such  change in control  occurs,  the  executive's  employment  is
terminated by the Company for any reason other than cause,  death or retirement,
the  executive  shall be entitled to receive an amount in cash equal to all base
salary then and thereafter payable within thirty days of termination. In January
1999,  the Company  announced a major cost  reduction  program for the Company's
1999 operating year wherein the compensation of two employees  referred to above
was reduced 30 percent effective February 1999.

Executive Employment  Agreements - On November 1, 1996, the Company entered into
employment  contracts with three executive officers (one of whom is no longer an
executive  officer)  which expire on December  31, 2001.  The annual base salary
compensation  for each executive  officer for the years ended December 31, 1999,
2000 and 2001 is $425,000, $550,000 and $750,000, respectively.

Additionally,  each  executive  officer is entitled to annual  performance-based
incentive  compensation  payable on or before  December 31 of each calendar year
during the contract term. During the first three years of the contract term, the
performance-based incentive compensation is determined in relation to the market
price of the Company's common stock, adjusted for stock dividends and splits. If
the price of the Company's  common stock  maintains an average price equal to or
greater  than the level set forth  below over a period of any three  consecutive
months during the calendar year, the  performance-based  incentive  compensation
will be paid in the  corresponding  percentage  amount of annual base salary for
each year as follows:

   Quarterly Average Stock Price            Percentage Bonus
   -----------------------------           ------------------
               $10.00                             30%
               $12.50                             35%
               $15.00                             40%
               $20.00                             45%
               $25.00+                            50%

The annual  base salary and  performance-based  incentive  compensation  for the
final two  contract  years will be subject to review by the  Company's  board of
directors.

                                      F-36

<PAGE>


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

In the event that,  during the contract term,  both a change of control  occurs,
and within  six months  after such  change in control  occurs,  the  executive's
employment is terminated by the Company for any reason other than cause,  death,
or  retirement,  the  executive  shall be  entitled to receive an amount in cash
equal to all base  salary  then and  thereafter  payable  within  thirty days of
termination.

In January 1999, the Company  announced a major cost  reduction  program for the
Company's  1999  operating  year wherein the  compensation  of the two remaining
officers will be reduced to $297,500 commencing February 1999. At the same time,
Stephen M.  Studdert  resigned  as the  Company's  Chief  Executive  Officer and
entered into a separation  agreement pursuant to which Mr. Studdert will be paid
$250,000  per year  through  January  31, 2001 and  $100,000  for the year ended
January 31, 2002. Additionally, his employment contract was canceled.

Professional  Services  Agreement - Effective May 7, 1998,  the Company  entered
into a one-year  professional  services  agreement with a public relations firm.
The  minimum  monthly  retainer is $15,000 per month.  In  connection  with this
agreement,  the firm was  granted  options  to  purchase  100,000  shares of the
Company's  common stock at $3.75 per share. The options have a ten-year term and
are fully vested.  In connection  with this  transaction,  the Company  recorded
$320,100 of consulting expense, of which $106,700 is deferred as of December 31,
1998, to be recognized ratably over the life of the agreement.

Operating Lease Agreements - The Company leases certain facilities and equipment
used in its operations.  The amount of commitments for noncancellable  operating
leases in effect at December 31, 1998, were as follows:

   Years ending December 31,
   -------------------------
            1999                    $1,043,342
            2000                       677,073
            2001                       685,275
            2002                       696,162
            2003                       507,308
         Thereafter                    293,664
                                    ----------
                Total               $3,902,824
                                    ==========

The Company  incurred  rental expense of $868,110,  $416,798 and $103,139 during
1998, 1997 and 1996, respectively, related to these leases.

In March 1999,  the Company  entered into an  agreement  to lease  approximately
3,780 square feet of office space in Cleveland,  Ohio for sales and installation
personnel.  The lease is for  three  years at a  monthly  rate of $4,260  and is
effective May 1, 1999.

Capital  Lease  Obligation  - Future  minimum  lease  payments  of  $56,260  for
equipment held under a capital lease arrangement as of December 31, 1998 are due
in 1999.  The present value of these future  minimum lease  payments is $52,225.
Total  assets  held under the  capital  lease  arrangement  were  $150,208  with
accumulated depreciation of $48,737 as of December 31, 1998.

AcuVoice - In connection with the AcuVoice acquisition, AcuVoice and its founder
made  certain  representations  and  warranties  to the  Company.  One of  those
representations  focused on the scope of a license agreement  previously entered
into by  AcuVoice  and  General  Magic for use by  General  Magic of  AcuVoice's
text-to-speech software in General Magic's Serengeti product. After the AcuVoice
acquisition  closed,  the Company  determined  that AcuVoice and its founder had
breached the  representation  concerning  the General Magic  license  agreement.
Under the terms of the

                                      F-37

<PAGE>


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


AcuVoice acquisition agreement, on March 12, 1999, the Company submitted a claim
for  the  80,000  shares  deposited  into  the  escrow  account  by  the  former
stockholders of AcuVoice.  The founder,  as agent for the former stockholders of
AcuVoice,  denied the claim. The Company is presently  preparing,  a response to
the founder's  denial of the claim.  If the founder  continues to deny the claim
after review of the Company's  response,  the Company will seek to arb its claim
pursuant  to the terms of the  AcuVoice  acquisition  agreement.  The Company is
presently  considering other possible remedies against the founder and the other
former directors of AcuVoice.

General  Magic,  Inc. - On September 23, 1997,  AcuVoice  entered into a license
agreement with General Magic,  Inc.  ("General  Magic") wherein AcuVoice granted
General Magic a perpetual, irrevocable, worldwide license in a specific field of
use to use, reproduce,  publicly display and distribute  AcuVoice's TTS software
in connection with General Magic's voice accessed  integrated  network  service,
also known as the  Serengeti  product.  The license is  exclusive  for the first
three  years  and  non-exclusive  thereafter.  Under  the  terms of the  license
agreement,  the  Company is  entitled  to royalty  payments  based upon  monthly
subscriber revenue from the use of the integrated network service. Additionally,
the Company  granted an option to General Magic to purchase the then current TTS
source code and all source code  documentation  for a cash payment of $2,500,000
and $2,500,000 in General Magic common stock.

 17. LITIGATION

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

Fonix  believes  that the Clarke  lawsuit is without merit and filed a motion to
dismiss  based upon the court's lack of personal  jurisdiction  over Fonix.  The
court granted Fonix's motion to dismiss, on a conditional basis,  subject to the
right of Clarke and Perpetual Growth to produce additional  evidence which would
establish  jurisdiction  of the New York court over Fonix.  Clarke and Perpetual
Growth filed a motion with the New York court that sought to establish a factual
and legal basis for the New York court's  exercise of  jurisdiction  over Fonix.
However,  the court  denied  that  motion.  In the  interim,  Fonix filed a suit
against Clarke and Perpetual Growth in federal court for the Central District of
Utah seeking a declaratory judgment that it does not owe any money to Clarke and
Perpetual  Growth.  Now that the  action in New York has been  dismissed,  Fonix
intends to  vigorously  pursue the Utah action.  However,  Clarke and  Perpetual
Growth could prevail in the lawsuit,  in which case Fonix may be required to pay
significant amounts of money damages or other amounts awarded by the court. At a
minimum,  the ongoing  nature of this action  will result in some  diversion  of
management time and effort from the operation of the business.

Papyrus - After the Papyrus acquisition closed, the Company investigated some of
the  representations  and  warranties  made by Papyrus to induce the  Company to
acquire Papyrus. The Company determined that certain of the representations made
by Papyrus and their executive  officers were false. At about the same time, the
Company began negotiations with the former executive officers of Papyrus,  which
negotiations,  among other things,  included discussions regarding rescission of
the Papyrus  acquisition.  On February  26,  1999,  the Company  filed an action
against  Papyrus in the United States  District  Court for the District of Utah,
Central  Division (the "Utah Action").  In the Utah Action,  the Company alleged
claims for misrepresentation,  negligent misrepresentation,  breach of contract,
breach of the implied covenant of good faith and fair dealing and rescission. On
March 11,  1999,  three of the former  shareholders  of Papyrus  filed an action
against  the Company in the United  States  District  Court for the  District of
Massachusetts (the "Massachusetts  Action"),  alleging a default under the terms
of  the  promissory  notes  issued  to  them  in  connection  with  the  Papyrus
Acquisition.  On April 2, 1999, the three former Papyrus  shareholders  filed an
amended complaint against the Company

                                      F-38

<PAGE>


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


seeking  additional  remedies  including  violation of Massachusetts  unfair and
deceptive acts and practices  statutes and copyright  infringement.  On April 8,
1999, a fourth former  Papyrus  shareholder  filed an action against the Company
alleging  a default  under the terms of the  promissory  notes  issued to him in
connection  with  the  Papyrus   acquisition  and  seeking  additional  remedies
including  violation of  Massachusetts  unfair and deceptive  acts and practices
statutes and copyright infringement.  Subsequently, the Company has entered into
agreements  with the four  former  Papyrus  shareholders  for  dismissal  of the
actions and  cancellation  of the  promissory  notes upon  payment to the former
shareholders  of  $1,122,209  (the  "Settlement  Payment")  an  amount  equal to
approximately  73 percent of the balance due them under the notes issued to them
in the  Papyrus  acquisition,  and return  for  cancellation  by the  Company of
970,586  shares  of  restricted  common  stock  issued  to them  in the  Papyrus
acquisition. The Company must pay the Settlement Payment before May 16, 1999. If
it does not, the Company and the four former  Papyrus  shareholders  are free to
pursue their respective claims.

Apple Computer,  Inc. - In February 1993, Articulate received a patent (the "303
patent")  for a product  which  would  allow the user of an Apple  Macintosh  to
create spoken  commands which the computer would  recognize and respond to. Soon
after the 303 patent was issued, Articulate put Apple Computer, Inc ("Apple") on
notice that Apple's  "PlainTalk"  product  infringed the 303 patent.  When Apple
ignored Articulate's notices, Articulate sued Apple. Apple responded to the suit
by suing  Articulate  and Dragon  Systems,  Inc.,  which  suit was  subsequently
dismissed.  The  Company  acquired  Articulate's  claims  against  Apple  in the
Articulate  acquisition (see Note 2). The Company has completed discovery in the
action pending against Apple and is awaiting the scheduling of a trial.

In addition to the above,  the Company is involved in various  lawsuits,  claims
and  actions  arising in the  ordinary  course of  business.  In the  opinion of
management,  after consultation with legal counsel,  the ultimate disposition of
these matters will not materially affect the consolidated  financial position or
results of operations of the Company.

18.  EMPLOYEE PROFIT SHARING PLAN

The Company has a 401(k)  profit  sharing plan covering  essentially  all of its
full-time  employees.  Under the plan,  employees may reduce their salaries,  in
amounts allowed by law, and contribute the salary  reduction  amount to the plan
on a pretax basis.  The plan also allows the Company to make matching and profit
sharing  contributions  as  determined  by the board of  directors.  To date, no
matching or profit sharing contributions have been made by the Company.

19.  REPORTABLE SEGMENTS

The Company is  organized  into two  business  segments  based  primarily on the
nature of the  Company's  products and  customers.  Each  segment is  separately
managed  because  its  customers  require  different  technology  solutions  and
marketing strategies.

The  Company's  HealthCare  Solutions  Group  (HSG)  includes  the  development,
manufacture,  sale and  maintenance  of its  voice  recognition  product  to the
healthcare industry marketed under the PowerScribe(R)  trademark.  The Company's
Interactive  Technologies  Solutions  Group (ITSG)  includes the  development of
relationships  with third parties who can incorporate  Fonix  technologies  into
their own products or product development efforts. These products include speech
recognition   technology   licensing   including    speech-to-text   (STT)   and
text-to-speech (TTS) applications.

The accounting  policies of the segments are the same as those  described in the
summary  of  significant  accounting  policies.  These  operating  segments  are
components for which separate  information is available that is evaluated by the
Company's chief operating  decision maker in deciding how to allocate  resources
and in assessing performance.





                                      F-39

<PAGE>


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

The following  table reflects  certain  financial  information  relating to each
reportable segment for each of the years ended December 31, 1998, 1997 and 1996:

<TABLE>
<CAPTION>


                                                              1998                1997               1996
                                                         ----------------    --------------     --------------
<S>                                                      <C>                 <C>                <C>
Revenues:
   HSG - PowerScribe                                     $      284,960      $          -       $          -
   ITSG - STT and TTS                                         2,604,724                 -                  -
                                                         ----------------    --------------     --------------
Total revenues                                           $    2,889,684      $          -       $          -
                                                         ================    ==============     ==============

Gross margin:
   HSG - PowerScribe                                     $      244,056      $          -       $          -
   ITSG - STT and TTS                                         2,569,284                 -                  -
                                                         ----------------    --------------     --------------
Total gross margin                                       $    2,813,340      $          -       $          -
                                                         ================    ==============     ==============

Research and development expenses:
   HSG - PowerScribe                                     $    4,360,619      $          -       $          -
   ITSG - STT and TTS                                        21,896,365         6,816,798          4,758,012
                                                         ----------------    --------------     --------------
Total research and development expenses                  $   26,256,984      $  6,816,798       $  4,758,012
                                                         ================    ==============     ==============

Depreciation and amortization:
   HSG - PowerScribe                                     $      856,253      $          -       $          -
   ITSG - STT and TTS                                         2,429,180           405,209             83,183
                                                         ----------------    --------------     --------------
Total depreciation and amortization                      $    3,285,433      $    405,209       $     83,183
                                                         ================    ==============     ==============

Other operating expenses:
   HSG - PowerScribe                                     $    1,246,377      $          -       $          -
   ITSG - STT and TTS                                         8,579,969        12,791,399          3,447,217
                                                         ----------------    --------------     --------------
Total other operating expenses                           $    9,826,346      $ 12,791,399       $  3,447,217
                                                         ================    ==============     ==============

Loss from operations:
   HSG - PowerScribe                                     $    6,219,193      $          -       $          -
   ITSG - STT and TTS                                        30,336,230        20,013,406          8,288,412
                                                         ----------------    --------------     --------------
Total loss from operations                               $   36,555,423      $ 20,013,406       $  8,288,412

                                                         ================    ==============     ==============
Long-lived assets:
   HSG - PowerScribe                                     $   19,561,867      $          -       $          -
   ITSG - STT and TTS                                        21,582,566         1,706,230          1,332,757
                                                         -----------------   --------------     --------------
Total long-lived assets                                  $   41,144,433      $  1,706,230       $   1,332,757
                                                         =================   ==============     ==============
</TABLE>


All of the Company's  revenues for 1998 were sourced from the United States.  Of
the $2,889,684 in revenues for 1998, $2,368,138 was from one customer,  Siemens,
in connection with non-refundable license payments under a Statement of Work and
License  Agreement.  The remaining amount of revenue was primarily from hospital
and medical centers in the eastern United States in connection with sales of the
Company's PowerScribe(R) suite of products.




                                      F-40

<PAGE>


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

20.  SUBSEQUENT EVENTS

Related  Party Notes  Payable - Subsequent  to December  31,  1998,  the Company
issued unsecured notes payable to an executive  officer in the amount of $68,691
for cash used as working capital by the Company. These notes bear interest at 10
percent and are due on July 31, 1999.

Recent  Financing  Activities - On January 29, 1999, the Company  entered into a
Securities  Purchase Agreement with four investors pursuant to which the Company
sold its Series C 5% Convertible Debentures in the aggregate principal amount of
$4,000,000. The outstanding principal amount of the debentures is convertible at
any time at the option of the holder into shares of the  Company's  common stock
at a conversion  price equal to the lesser of $1.25 or 80 percent of the average
of the closing bid price of the Company's common stock for the five trading days
immediately  preceding  the  conversion  date.  The Company also issued  400,000
warrants  in  connection  with this  financing.  On March 3, 1999,  the  Company
executed a supplemental  agreement  pursuant to which the Company agreed to sell
another $2,500,000 principal amount of Series C 5% Convertible Debentures on the
same  terms  and  conditions  as the  January  29,  1999  agreement,  except  no
additional warrants were issued. The obligations of the Company for repayment of
the  debentures, as  well as its  obligation  to  register  the  common  stock
underlying  the potential  conversion of the  debentures and the exercise of the
warrants  issued  in  these  transactions,  are  personally  guaranteed  by  the
Guarantors.  These  personal  guarantees  are  secured by a pledge of  6,000,000
shares of Fonix common stock beneficially owned by them. The Company has entered
into an  indemnity  agreement  with the  Guarantors  relating  to this and other
guarantees  and pledges (see Note 12). In connection  with second  funding,  the
Company agreed to pledge, as collateral for repayment of the debentures,  a lien
on the patent covering the Company's ASR technologies.

Subsequent to the second  funding,  the holders of the  debentures  notified the
Company and the Guarantors  that the Guarantors  were in default under the terms
of the pledge and that the holders  intended to  exercise  their  rights to sell
some or all of the pledged  shares of the  Guarantors.  At the present time, the
Company has no  knowledge  of sales of the  Guarantors'  shares by the  holders.
However,  if the holders proceed to sell some or all of the Guarantors'  shares,
the  Company  may  be  obligated,   under  its  indemnity  agreement,  to  issue
replacement  shares to the  Guarantors  for all shares  sold by the  holders and
reimburse Guarantors for any costs incurred as a result of the holders' sales of
Guarantors' shares.

One of several  events  described  in the  Securities  Purchase  Agreement  as a
"Triggering  Event" is the suspension from listing or delisting of the Company's
common stock from the Nasdaq SmallCap Market for a period of three trading days.
In March 1999,  trading in the Company's common stock was temporarily halted for
more than three days.  Trading resumed within five trading days, and the Company
has not been notified that the holders of the Series C 5% Convertible Debentures
desire to exercise any rights they may have under the agreement.

Issuance  of Stock  Options - On  February  15,  1999,  the  Company  granted an
aggregate of 762,500  stock options to various  employees of the Company.  These
options have a ten-year life, an exercise price of $1.53 per share and vested on
the grant date.



                                      F-41

                                    SIGNATURES

Pursuant to the  requirements of Section 13 or 15(d) of the Securities  Exchange
Act of 1934,  the  registrant has duly caused this Amendment No. 1 to the Annual
Report on Form 10-K for the year ended  December 31,  1998,  to be signed on its
behalf  by  the  undersigned,  thereunto  duly  authorized,  on this 11th day of
August, 1999.

                                                     Fonix Corporation



Date: August 11, 1999                                /s/ Roger D. Dudley
     ----------------------------                    ---------------------------
                                                     Roger D. Dudley
                                                     Executive Vice President