**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-K**





(Mark
      one)





[X]
            Annual
                Report pursuant to Section 13 or 15(d) of the Securities Exchange
                Act of
                1934 for the fiscal year ended December 31, 2005,
                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**
              (State
                or other jurisdiction of incorporation or organization)
            **22-2994719**
              (I.R.S.
                Employer Identification No.)





**9350
      South 150 East, Suite 700**


**Sandy,
      Utah 84070**


(Address
      of principal executive offices with zip code)





**(801)
      553-6600**


(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: Class
      A
      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 as of June 30, 2005 is approximately $15,766,000, calculated using
      a
      closing price of $0.065 per share on June 30, 2005. For purposes of this
      calculation, the registrant has included only the number of shares directly
      held
      by its officers and directors as of (and not counting shares beneficially owned
      on that date), in determining the shares held by non-affiliates.





As
      of
      March 10, 2006, there were issued and outstanding 481,309,900 shares of our
      Class A 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. [ ]





Indicate
      by check mark whether the registrant is an accelerated filer (as defined in
      Rule
      12b-2 of the Exchange Act). Yes [  ] No [X].





Indicate
      by check mark whether the registrant is a shell company (as defined in rule
      12b-2 of the Exchange Act). Yes [  ] No [X].













**Fonix
      Corporation**





2005
      FORM
      10-K ANNUAL REPORT











TABLE
      OF
      CONTENTS





Part
                IPageItem
                1.
            Business
            3Item
                1a.
            Risk
                Factors
            14Item
                1b.
            Unresolved
                Staff Comments
            31Item
                2.
            Properties
            31Item
                3.
            Legal
                Proceedings
            32Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            34Part
                IIItem
                5.
            Market
                for Registrant's Common Equity and Related Stockholder
                Matters
            35Item
                6.
            Selected
                Financial Data
            39Item
                7.
            Management's
                Discussion and Analysis of Financial Condition and Results of
                Operations
            40Item
                8.
            Financial
                Statements and Supplementary Data
            59Item
                9.
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosure
            59Item
                9a.
            Controls
                and Procedures
            59Item
                9b.
            Other
                Information
            60Part
                IIIItem
                10.
            Directors
                and Executive Officers of the Registrant
            60Item
                11.
            Executive
                Compensation
            62Item
                12.
            Security
                Ownership of Certain Beneficial Owners and Management
            66Item
                13.
            Certain
                Relationships and Related Transactions
            67Item
                14.
            Principal
                Accountant Fees and Services
            68Part
                IVItem
                15.
            Exhibits
                and Financial Statement Schedules
            70











2







**PART
      I**





**ITEM
                1.**
            **BUSINESS**





**THIS
      ANNUAL REPORT ON FORM 10-K CONTAINS, IN ADDITION TO HISTORICAL INFORMATION,
      FORWARD-LOOKING STATEMENTS THAT INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES.
      OUR
      ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THE RESULTS ANTICIPATED BY FONIX
      AND
      DISCUSSED IN THE FORWARD-LOOKING STATEMENTS. FACTORS THAT COULD CAUSE OR
      CONTRIBUTE TO SUCH DIFFERENCES ARE DISCUSSED BELOW IN THE SECTION ENTITLED
      “FORWARD-LOOKING STATEMENTS” AND ELSEWHERE IN THIS ANNUAL REPORT.**  **WE
      DISCLAIM ANY INTENTION OR OBLIGATION TO UPDATE OR REVISE ANY FORWARD-LOOKING
      STATMEMNT, WHETHER AS A RESULTOF NEW INFORMATION, FUTURE EVENTS, OR OTHERWISE.
      THE FOLLOWING DISCUSSION SHOULD BE READ TOGETHER WITH OUR FINANCIAL STATEMENTS
      AND RELATED NOTES THERETO INCLUDED ELSEWHERE IN THIS
      DOCUMENT.**





**About
      Fonix**





Fonix
      Corporation (the “Company,” “Fonix” or “us”), a communications and technology
      company based in Salt Lake City, Utah, operates three wholly owned subsidiaries:
      (i) Fonix Telecom, Inc. (“Fonix Telecom”), which provides integrated
      network-based telecommunication service and is a re-seller of telecommunication
      products; (ii) LecStar Telecom, Inc. (“LecStar Telecom”), a re-seller of non
      network-based telecommunication services; and, (iii) Fonix Speech, Inc. (“Fonix
      Speech”), which provides value-added speech technologies. These interactive
      speech technologies, applications and solutions embedded on chips, devices
      and
      systems provide cost-effective solutions to access information and data.





With
      its
      acquisition of LecStar Telecom in February 2004 and the formation of Fonix
      Telecom in January 2005, the Company’s primary revenue source shifted to
      telecommunications services. Due to recent regulatory changes negatively
      effecting LecStar’s ability to sustain historical revenue and to manage expense,
      Fonix Telecom, through an Administrative Agreement manages the business
      operations of LecStar. For the foreseeable future, Fonix Telecom will generate
      the telecommunication revenue. The Company will continue its diversified revenue
      base between Fonix Speech and Fonix Telecom and expects Fonix Telecom will
      be
      the major source of revenue during the next 12 to 18 months,





Company
      Internet addresses are as follows:


Fonix
      Corporation - www.fonix.com


Fonix
      Speech, Inc. - www.fonixspeech.com


Fonix
      Telecom, Inc. - www.fonixtelecom.com


LecStar
      Telecom, Inc. - www.lecstar.com








**History
      and Development of the Company**





The
      Company was incorporated in Delaware in 1985, and, pursuant to a merger
      transaction in 1994, the Company’s name was changed to Fonix Corporation.
      Through Fonix Speech, the Company delivers speech interface development tools,
      solutions and applications (the “Speech Products”) that empower people to
      interact conversationally with information systems and devices. The Speech
      Products are based on the Company’s speech-enabling technologies, which include
      text-to-speech (“TTS”) and proprietary neural network-based automatic speech
      recognition (“ASR”). ASR and TTS technologies are sometimes collectively
      referred to in this report as “Core Technologies.” The Company’s Speech Products
      enhance user productivity, ease of use and efficiency in a broad range of market
      segments, including mobile and wireless devices; videogame consoles; electronic
      devices for the assistive and language learning markets, robots and appliances;
      automotive telematics, computer telephony and server applications.




Prior
      to
      2002, the Company focused on research and development (“R&D”) projects for
      customized applications. R&D and prototype development used the Core
      Technologies to develop applications and engines marketed for multiple operating
      systems and hardware platforms.





3






Today,
      Fonix Speech serves markets that are adopting speech-enabled interfaces,
      solutions and applications. As memory requirements, noise robustness, speech
      recognition accuracy and efficiency of speech interface solutions become
      increasingly critical, Fonix Speech anticipates that its Core technologies
      and
      solutions will meet customer demand for simple, convenient user
      interfaces.





On
      February 24, 2004, the Company completed its acquisition of all of the capital
      stock of LTEL Holdings Corporation (“LTEL”) and its wholly owned subsidiaries,
      LecStar Telecom, Inc. and LecStar DataNet, Inc. (collectively “LecStar”).
      LecStar, an Atlanta-based competitive local exchange carrier (“CLEC”), offers
      wire line voice, data, long distance and Internet services to business and
      residential customers throughout BellSouth’s Southeastern United States
      operating territory. The acquisition of LecStar significantly accelerated the
      Company’s growth strategy by providing a recurring revenue stream, built-in
      customer base and new marketing channels.





**TELECOMMUNICATIONS**





**Fonix
      Telecom, Inc.**





On
      January 13, 2005, Fonix announced the official formation of Fonix Telecom,
      Inc.
      (“Fonix Telec om”),
      a
      wholly owned subsidiary. Fonix Telecom, a facilities-based network provider,
      offers next-generation telecommunications products and services, including
      Voice
      over Internet Protocol (“VoIP”) and Broadband over Power Lines (“BPL”) through
      partner channels and product groups. During 2005, Fonix Telecom completed the
      purchase and installation of a softswitch manufactured by Lucent. The switch
      has
      been in service since August of 2005, providing on-net telecommunications
      services. Fonix Telecom also provides resalable telecommunication services
      and
      products through its interconnection agreements with major incumbent carriers,
      such as BellSouth. Fonix Telecom is currently licensed to re-sell traditional
      telecommunication services and products in Georgia, Florida, North Carolina
      and
      South Carolina.





Fonix
      Telecom launched VoIP services for small- to medium-sized business customers
      in
      the Southeastern United States. Fonix VoIP service provides customers with
      an
      economical alternative to private branch exchange (“PBX”) or central office
      exchange services with the flexibility and durability of Internet
      Protocol.





The
      Fonix
      IP Phone Service, known as Fonix Fone sm ,
      offers
      VoIP to business customers. It is a feature-rich service package that provides
      all Class 5 switching features, conference calling, unified messaging, “find me
      - follow me” (virtual call forwarding) and a user portal. The service works over
      the customer’s existing broadband connection. Fonix IP Phone Service is a
      cost-effective solution, combining all the features and functionalities of
      a
      virtual private network at a lower price than traditional voice service
      platforms.





On
      August
      17, 2004, Fonix Telecom field-tested delivery of BPL and VoIP with Duke Power,
      a
      business unit of Duke Energy and one of the nation’s largest electric utilities
      providing electricity and value-added products and services to more than two
      million customers in North Carolina and South Carolina. Duke Power expects
      to
      expand its BPL commercial trial service area in 2006 to approximately 15,000
      customers in North Carolina. Fonix Telecom’s BPL service allows users to turn
      any electrical outlet in their home into a gateway to the Internet, simply
      by
      plugging in their computer and BPL modem.





Effective
      January 1, 2006, Fonix Telecom and LecStar Telecom entered into an
      Administrative Service Agreement. Under
      the
      agreement, Fonix Telecom agreed to provide all operating services for LecStar’s
      accounts; including, but not limited to: billing, customer relationship
      management systems and telecommunications services under the terms of LecStar’s
      current commercial agreements with BellSouth and other wholesale
      telecommunicationsproviders. Fonix Telecom will receive fees from LecStar for
      these services and LecStar will reimburse Fonix Telecom for its costs.





**Distribution
      Strategy**





With
      its
      network-based softswitch, Fonix Telecom will sell VoIP through direct sales
      agents, channel partners and independent agents. Fonix Telecom will provide
      all
      installation, provisioning, billing and other customer services. Fonix Telecom
      VoIP services and products are provides through connection agreements with
      Level
      3, Broadwing, XO Communications and Global Crossing. Fonix Telecom expects
      to
      provide telecommunications products such as VoIP local and long distance,
      internet services through BPL.  In
      addition, Fonix Telecom has entered into interconnection agreements with
      BellSouth, Qwest, USLec, Sprint, Tier II and Global Crossing throughout the
      Southeastern United States allowing Fonix Telecom to collocate network
      facilities with these carriers, lease network elements and re-sell their
      services.







4








*Fonix
      Telecom Competition and Industry Position*





Fonix
      Telecom operates in a highly competitive market. Several key competitors have
      greater financial resources, established brand names and reputations, larger
      customer bases and diverse strategic plans and technologies. Often,
      telecommunication services companies will compete for consumers based on price.
      The dominant providers conduct extensive advertising campaigns to capture market
      share. Competitors with greater financial resources may also be able to provide
      more attractive incentive packages to independent sales agents to encourage
      them
      to offer products that compete with Fonix Telecom products and services.
      Competitors may also be better situated to negotiate more favorable contracts
      with independent sales agents and have the capital to rapidly deploy or leverage
      new or existing communications equipment and broadband networks.





In
      the
      provisioning of local access services, long distance services and data and
      integrated services, Fonix Telecom faces competition from incumbent local
      exchange carriers (“ILECs”) such as BellSouth and Sprint, other CLECs, such as
      US LEC, ITC Deltacom, Cbeyond, and Talk America, and other integrated
      communications providers and inter-exchange carriers who may have a more
      substantial marketing presence or possess their own network facilities and
      may
      offer services similar to those of Fonix Telecom at more favorable prices.
      Fonix
      Telecom purchases its services either through relationships governed by a
      Commercial Agreement with BellSouth, interconnection agreements or wholesale
      agreements for access to Internet service or BPL with Duke Power in North
      Carolina.





Fonix
      Telecom is seeking to establish relationships with independent agents to market
      and sell services to their respective customer bases. Competitors may offer
      agents exclusive agreements, greater commissions, better terms or other
      incentives that hinder Fonix Telecom’s ability to attract and/or retain these
      agents.





Existing
      competitors are likely to continue to expand their service offerings to appeal
      to agents and consumers and new competitors are likely to enter the
      telecommunications market and attempt to market services similar to Fonix
      Telecom’s, which will result in greater competition. If competitors devote
      significant additional resources to the provision of VoIP and Internet services
      to their customer base, such actions could have a material adverse effect on
      Fonix Telecom’s business, financial condition and results of operations, and
      Fonix Telecom can make no assurance that it will be able to compete successfully
      against such existing or new competitors.





In
      addition to VoIP and Internet Service Providers competitors,  Fonix
      Telecom also
      faces strong competition from competing telecommunications technologies. Other
      technologies exist with characteristics superior to Fonix Telecom’s methods of
      transmission and provisioning of services, which may be used instead of Fonix
      Telecom’s services. The development of new technologies, or the significant
      penetration of alternative technologies into Fonix Telecom’s target markets, may
      reduce the demand for Fonix Telecom’s services and harm its business. Existing
      alternative technologies include:





§
            *Digital
                Subscriber Line (DSL) Technology*-
                DSL technology was developed to produce higher data transfer rates
                over
                the existing copper-based telephone network.


§
            *Cable
                Modems*-
                Cable modems can allow users to send and receive data and VoIP
                communications using cable television distribution systems.


§
            *Wireless
                Technologies*-
                Wireless technologies such as Wi-Fi, Wi-Max, satellite and microwave
                communications systems can provide high-speed data and VoIP
                communications.


§
            *Broadband
                over Power Line (BPL)*-
                BPL is still a promising technology and, while Fonix Telecom is well
                positioned in this space, selection of a competitor such as Current
                Communications Group by a utility would foreclose competition on
                that
                utility’s network.





**LecStar
      Telecom, Inc.**





LecStar
      Telecom, Inc., a wholly owned subsidiary of Fonix, provides a full array of
      wireline voice, data, long distance and Internet telephone services utilizing
      traditional lines. LecStar serves small- to medium-sized businesses and
      residential customers with a balanced focus on high-density metropolitan areas
      and under-served smaller communities. Services are offered at moderate discounts
      off BellSouth prices and are delivered through the cost-effective use of
      LecStar’s network facilities, Unbundled Network Elements (“UNEs”) acquired from
      BellSouth, and/or resold via services acquired through wholesale agreements
      with
      BellSouth and other carriers. LecStar’s provisioning systems are electronically
      bonded with BellSouth, enabling the efficient ordering of services in real-time.







5








Due
      to
      recently regulatory changes that have severely impacted the legacy CLECs,
      LecStar believes the traditional CLEC model is unsustainable in the current
      regulatory environment .
      Recent
      regulatory changes have benefited the Regional Bell operating company (“RBOC”),
      allowing them to only offer to LecStar and other CLECs resale contracts with
      substantially smaller margins.





*Distribution
      Strategy*





LecStar
      has entered into interconnection agreements with major incumbent carriers
      throughout the Southeastern United States, allowing LecStar to collocate network
      facilities with these carriers, sell VoIP, lease network elements, re-sell
      their
      services and utilize the carriers’ provisioning, installation and maintenance
      services at favorable costs. Interconnection and resale agreements have been
      signed with BellSouth, Qwest, USLec, Level 3, Sprint, Tier II and Global
      Crossing for access to network and wholesale access services, so LecStar can
      market a full suite of communications solutions on par with other major
      carriers. Due to recent regulatory changes, LecStar can only service legacy
      UNE
      customers at decreasing margins and cannot offer telecommunication services
      and
      products to new customers under the existing interconnection agreement with
      BellSouth. LecStar is able to offer services to some customers through other
      wholesale relationships and/or the re-sale of BellSouth services. In addition,
      we expect that Georgia, LecStar’s largest state of operations, and perhaps other
      states, will establish new wholesale rates under Section 271 (“271”) of the
      Telecommunications Act of 1996. While these 271 UNE rates are likely to be
      higher than existing rates, the 271 rates are expected to be at or below the
      commercial agreement rates from BellSouth. For LecStar, an interconnection
      agreement is preferable to a commercial agreement because it does not sacrifice
      LecStar’s regulatory and legal rights and it permits LecStar to maintain its
      flexibility to move customers off of the BellSouth platform as future and more
      desirable technologies such as BPL and wireless access services
      emerge.





*Utility
      Partnerships*





LecStar
      has entered into strategic partnerships with local electric utilities in several
      parts of the Southeastern United States to market co-branded voice and data
      services to residential and business customers. In addition, LecStar has
      developed marketing partnerships with interconnect companies and value-added
      agents that market more complex telecommunication services to medium- and
      large-sized businesses.





*LecStar
      Competition and Industry Position*





LecStar
      Telecom operates in a highly competitive market. Several key competitors have
      greater financial resources, established brand names and reputations, larger
      customer bases and diverse strategic plans and technologies. Often,
      telecommunication services companies will compete for consumers based on price.
      The dominant providers ,
      principally the RBOCs, conduct extensive advertising campaigns to capture market
      share. Competitors with greater financial resources may also be able to provide
      more attractive incentive packages to independent sales agents to encourage
      them
      to offer products that compete with LecStar Telecom products and services.
      Competitors may also be better situated to negotiate more favorable contracts
      with independent sales agents and have the capital to rapidly deploy or leverage
      new or existing communications equipment and broadband networks.





In
      the
      provisioning of traditional local access services and long distance services,
      LecStar Telecom faces competition from RBOCs,
      incumbent local exchange carriers (“ILECs”) such as Sprint, other CLECs such as
      ITC Deltacom, Supra Telecom, and Talk America, and inter-exchange carriers
      who
      may have a more substantial marketing presence or possess their own network
      facilities and may offer services similar to those of LecStar Telecom at more
      favorable prices. In addition, LecStar Telecom has elected not to sign a
      commercial agreement with BellSouth in anticipation of the potentially favorable
      pricing through the regulatory process. The outcome of certain regulatory and
      legal proceedings are an important element in determining LecStar’s potential
      opportunities to add new customers at competitive rates. On March 8, 2006,
      Georgia, the largest state of operations for LecStar, ruled in favor of
      establishing a UNE rate below the commercial agreement rate offered to other
      carriers. BellSouth is likely to appeal this decision and the outcome of the
      appeal cannot be determined at this time. Several other states have ruled that
      they did not have the authority to set such a rate, while several states such
      as
      Tennessee, Kentucky and Mississippi have not yet decided the issue.







6








LecStar
      and its competitors substantially rely on independent agents to market and
      sell
      services to their respective customer bases. Competitors may offer agents
      greater commissions, better terms or other incentives that hinder LecStar
      Telecom’s use of these agents. In addition, these agents may enter into
      exclusive arrangements with competitors, which could hinder LecStar Telecom’s
      ability to attract and retain these agents.





Recent
      decisions by the Federal Communications Commission (“FCC”) and state regulatory
      bodies have created new hurdles for LecStar Telecom. Legislators and regulators
      are likely to provide ILECs such as BellSouth with increased regulatory
      flexibility and retail and wholesale pricing freedoms as competition increases.
      If ILECs are permitted to lower their retail rates substantially, and
      simultaneously implement wholesale price increases, to CLEC customers such
      as
      LecStar Telecom, with volume or term discount pricing practices for their
      largest customers, the net income or cash flow of small- to medium-sized
      integrated communications providers and CLECs such as LecStar Telecom could
      be
      materially adversely affected. Furthermore, several large, long distance
      providers have entered traditional local exchange services markets, and new
      VoIP
      technology is capturing more of the market for traditional wireline service.
      LecStar Telecom cannot predict the number of competitors that will emerge as
      a
      result of currently existing or potential federal and state regulatory or
      legislative actions. Competition from ILECs and non-traditional providers with
      respect to inter-exchange and local voice and data services could have a
      materially adverse effect on LecStar Telecom’s business.





Existing
      competitors are likely to continue to expand their service offerings to appeal
      to agents and consumers, and new competitors are likely to enter the
      telecommunications market and attempt to market services similar to LecStar
      Telecom’s, which will result in greater competition. If competitors devote
      significant additional resources to the provision of international or national
      long distance telecommunications services to their customer base, such actions
      could have a material adverse effect on LecStar Telecom’s business, financial
      condition and results of operations, and LecStar Telecom can make no assurance
      that it will be able to compete successfully against such existing or new
      competitors.





In
      addition to traditional wireline competitors,  LecStar
      Telecom also
      faces strong competition from competing telecommunication technologies. Other
      technologies exist that provide greater bandwidth than LecStar Telecom’s methods
      of transmission, which may be used instead of LecStar Telecom’s services. The
      development of new technologies, or the significant penetration of alternative
      technologies into LecStar Telecom’s target markets, may reduce the demand for
      LecStar Telecom’s services and harm its business. Existing alternative
      technologies include:





§
            *Digital
                Subscriber Line (DSL) Technology*-
                DSL technology was developed to produce higher data transfer rates
                over
                the existing copper-based telephone network.


§
            *Cable
                Modems*-
                Cable modems can allow users to send and receive data and VoIP
                communications using cable television distribution systems.


§
            *Wireless
                Technologies*-
                Wireless technologies, such as Wi-Fi, Wi-Max, satellite and microwave
                communications systems, can provide high-speed data and VoIP
                communications.


§
            *Broadband
                over Powerline*-BPL
                is still a promising technology, and, depending upon the strategy
                of the
                utility that builds out such a network, will determine whether it
                represents a wholesale alternative or a threat to LecStar.





**VALUE-ADDED
      SPEECH TECHNOLOGIES**





**Fonix
      Speech, Inc.**





On
      January 1, 2006, Fonix Speech, Inc. was incorporated and now operates as a
      wholly owned subsidiary of Fonix Corporation. Fonix Speech provides value-added
      embedded speech technology development tools, applications and solutions for
      multiple market
      segments including mobile and wireless devices; videogame consoles; electronic
      devices for the assistive and language learning markets, robots and appliances;
      automotive telematics, computer telephony and server applications.







7








Original
      Equipment Manufacturers (“OEMs”) of consumer electronics devices and products,
      software developers, wireless operators, telephony distributors, system
      integrators and value-added resellers (“VARs”) can simplify the use and increase
      the functionality of their electronic products and services by integrating
      Fonix
      speech interfaces, resulting in broader market opportunities and significant
      competitive advantages. Fonix Speech development tools and solutions support
      multiple hardware and software platforms, are environment and speaker
      independent, optimize cost and power efficiencies, are easily integrated with
      relatively small memory requirements for embedded applications, and enhance
      scalability for high channel capacity for computer telephony and server-based
      systems.





*Fonix
      Speech Market Focus*





Fonix
      Speech delivers speech solutions in the following markets:





§
            **Mobile
                / Wireless**


Fonix
      Speech provides embedded speech interface solutions for mobile phones,
      Smartphones, PDAs and wireless communication devices. The award-winning Fonix VoiceDialTM is a
      totally interactive, hands-free software application that enables users to
      place
      calls and navigate device menus and applications simply by speaking. Fonix
      VoiceCentralTM is a hands-free software application for Pocket PC that allows
      users to access Personal Information Management (“PIM”) tools, navigate
      through the device software, and access song and movie lists simply by
      speaking.





Fonix
      Mobile/Wireless Solutions:





o
            **Fonix
                VoiceDial**


Fonix
      VoiceDial TM is
      a
      totally interactive, hands-free software application for Windows Mobile Pocket
      PC, Smartphone and Symbian devices that enables users to access mobile phone
      contacts simply by speaking. VoiceDial is speaker independent, so no voice
      training is involved, including both contact names and digit dialing. The speech
      recognition is highly accurate, even in noisy environments like cars or
      airports. VoiceDial offers several prompting voices; users choose which voices
      to download to their device. All TTS voices are highly intelligible and will
      handle an unlimited vocabulary, even with difficult contact names. VoiceDial
      is
      available in multiple languages — English,
      French, German and Spanish. Current phones supported by Fonix VoiceDial include:
      Cingular 12125, T-Mobile SDA, SDA II, Audiovox SMT 5600, i-mate SP3, i-mate
      SP3i, i-mate SP5, Motorola i930, Motorola MPx220, SPV C500, SPV C600, TSM 520,
      T-Mobile MDA, Cingular 8125, PPC 6700, Audiovox PPC 6600, i-mate PDA2k, i-mate
      JASJAR, i-mate K-JAM, MDA Pro, SPV M5000, and Qtek 9100.





o
            **Fonix
                VoiceCentral**


Fonix
      VoiceCentralTM is a totally interactive, hands-free software application for
      Windows Mobile Pocket PC and Smartphone devices that enables users to access
      PIM
      tools, navigate through the device software and access song and movie lists
      simply by speaking. VoiceCentral incorporates the award-winning Fonix VoiceDial
      software, while adding several other significant capabilities. VoiceCentral
      allows users to manage email (listen to email, then choose to delete, reply
      with
      a .wav file or save), access calendar and tasks, launch or close any application
      simply by speaking, dial names directly from the contact list (users do not
      have
      to navigate multiple menu trees; they just say the name of the person they
      want
      to call), and dial a number directly using a continuous string of
      numbers.







Fonix
      Mobile / Wireless Market Opportunities:





Fonix
      Speech’s partners, original equipment manufacturers (“OEMs”) and original device
      manufacturers (“ODMs”) provide significant potential to reach users in many
      market areas. Fonix Speech has already seen significant market response to
      VoiceDial and expects to deliver in the following channels:





o
            **OEMs
                & ODMs**:
                The first Fonix VoiceDial contract delivered the solution on the
                Hewlett
                Packard (HP) Journada ® 928 WDA. To date, VoiceDial has shipped with these
                additional devices: Hitachi G1000, i-mate PDA2k, T-Mobile MDA III
                and the
                O2 XDA IIs. Fonix also has partnerships with Microsoft, Intel, Texas
                Instruments, Hitachi, O2 and HTC and is aggressively pursuing additional
                OEM opportunities with Nokia, Motorola, Sony-Ericsson, Siemens, Palm
                and
                Samsung.







8








o
            **Mobile
                Operators**:
                Fonix markets VoiceDial and VoiceCentral through mobile operators
                such as
                AT&T Wireless, T-Mobile, Orange, Vodafone and Verizon. VoiceDial can
                be delivered several ways, including loading software directly on
                the
                device or over-the-air activation.





o
            **Bundled
                Solutions**:
                Other complementary solutions are also channels for distribution
                for the
                Speech Products. Companies like ALK have integrated Fonix Speech’s
                solutions into their applications. Fonix Speech foresees partners
                shipping
                the full VoiceDial and VoiceCentral functionality as a complement
                to their
                applications and devices.





Fonix
      Speech has several competitors offering a variety of speech technologies and
      products. Companies like Nuance, Voice Signal and Neuvoice all deliver
      speaker-dependent and speaker-independent solutions. Other speech companies
      like
      IBM may introduce competitive products.





§
            **Electronic
                Devices**


Fonix
      speech solutions make everyday life easier for people who are blind or have
      visual, vocal or mobility impairments, and for non-English speakers who are
      learning the English language. Fonix DECtalk®, the best
      known and most respected name in the assistive market, transforms ordinary text into highly intelligible speech. Fonix VoiceInTM is
      Fonix Speech’s proprietary neural network-based automatic speech recognition. Fonix
      Speech has taken its intuitive Core Technologies and applied them to everyday
      speech solutions for
      PCs
      and other consumer devices such as cordless phones, electronic dictionaries,
      MP3s and toys.





Fonix
      Speech Solutions for Electronic Devices





Fonix
      Speech offers a variety of speech solutions for the assistive and language
      learning markets.





o
            **The
                Assistive Market**


Fonix
      speech solutions make everyday life easier for people who are blind, have
      visual, vocal or mobility impairments or have learning disabilities. Fonix
      DECtalk® is the assistive industry’s premier text-to-speech engine, offering
      nine highly intelligible TTS voices and six languages. Many users rely on Fonix
      DECtalk to read their email, the daily news or other documents, or to function
      as their voice to the outside world. In addition, Fonix has expanded its
      solutions for the assistive market to incorporate the full line of Fonix TTS
      offerings; including high-quality concatenated TTS and high-recognition-rate
      ASR, which is marketed as Fonix VoiceIn Standard Edition. Current OEM partners
      in the assistive market include Dynavox, GW Micro, Prentke-Romich, Kurzweil
      Education Systems and Toby Churchill.





o
            **PDA,
                PC and Electronic Devices**


Fonix
      solutions apply speech interfaces to tasks that users perform everyday. Many
      of
      these solutions are appropriate for multiple markets — assistive, mobile and
      wireless, and business and home users. The Speech Products enable users to
      listen to documents, have email read aloud, access programs and launch
      applications with speech commands. Current OEM partners include Microsoft,
      Intel, Texas Instruments, Hitachi, O2, Code
      Factory and HTC.





o
            **The
                Language Learning Market**


Fonix
      speech solutions are particularly useful for non-English speakers who are
      learning the language. In the speech-enabled language learning market, Fonix
      has
      capitalized on Fonix DECtalk’s small memory footprint and high intelligibility
      and Fonix VoiceIn’s high-recognition-rate capabilities. Speech-enabled language
      learning is an emerging market, especially in Asia. Casio currently sells
      handheld electronic dictionaries in Japan and Korea that allow individuals
      to
      type a word in their native language (like Japanese) and have the word read
      back
      to them in English. Non-English speakers can look up words in an English
      dictionary and have the device speak the word correctly in English. Educational
      electronic dictionary devices are growing in popularity in Japan and are
      expected to exceed a market volume of more than 500,000 units per quarter.
      Fonix
      Speech’s goal is to become the primary supplier of speech solutions for OEMs
      providing language learning devices and systems. Fonix Speech has partnered
      with
      Epson and other chip manufacturers to provide an integrated chip with Fonix
      speech technology to various OEMs, including Casio, manufacturing language
      learning devices.







9








o
            **Robots
                and Appliances**


Speech
      solutions are becoming increasingly popular for day-to-day use. Fonix Speech
      offers speech command and control solutions for cordless phones, toys, home
      audio and MP3 Players. Fonix has partnered with Epson to provide an integrated
      chip with Fonix speech technology to various OEMs manufacturing robots and
      appliances.





Fonix
      Market Opportunities for Electronic Devices





Revenue
      potential for speech interface applications in the assistive, language learning
      and electronic device markets is significant. In the assistive market, more
      governments are recognizing the benefits of providing accessibility to disabled
      citizens. Fonix expects significant market expansion as governments enact new
      regulations supporting and funding the use of speech-based solutions. Fonix
      Speech has partnered with various government contractors to enact government
      speech-based solutions.





With
      an
      increasingly global economy, more people are endeavoring to learn foreign
      languages. Fonix believes that language-learning tools, including translators
      and electronic dictionaries, will be a profitable market. Current OEM partners
      in the language learning market include Casio, Dico, Dream C&C, E-Star
      Laboratories, Eintech, Kodensha, Top Grade and NEC Custom Technica.





Speech
      applications are also becoming increasingly popular for day-to-day use. Fonix
      Speech is working with OEM partners to capitalize on market opportunities for
      toys, appliances and other devices where speech applications may be applicable.
      Fonix Speech has partnered with Epson to provide an integrated chip with Fonix
      speech technology to various OEMs manufacturing toys and
      appliances.




Fonix
      Speech’s primary competitors in the electronic device markets include Nuance,
      IBM, NextUp Technologies, Voice Signal and Premier Assistive
      Technology.





§
            **Videogame
                Consoles**


Fonix
      VoiceIn® Game Edition is Fonix Speech’s award-winning
      software solution for voice command and control in Xbox®, Xbox® 360,
      PlayStation®2 and PC videogames. Fonix VoiceIn is the industry’s most
      memory-efficient voice interface. Game developers worldwide can now build games
      that utilize a common version across Xbox®, Xbox® 360, PlayStation®2 and PC
      platforms. Fonix VoiceIn is optimized for game development where memory and
      processing power are at a premium.





Fonix
      Speech Videogame Solutions:





o
            **Game
                Consoles**


Fonix
      Speech’s voice command software is available for cross-platform game developers
      who wish to employ speech interfaces in videogames. In March 2004, Fonix Speech
      made Fonix VoiceIn® Game Edition commercially available to developers that
      produce videogames on multiple gaming platforms. Fonix voice command technology
      has been available in the Microsoft Xbox® developer’s kit (XDK) since February
      2003. In May 2005, Fonix announced a continuation of its agreement with
      Microsoft to deliver Fonix VoiceIn in the new Microsoft Xbox® 360 developer’s
      kit. Cross-platform game developers can use the same voice command software
      for
      PlayStation®2 and PC games. Game developers worldwide can now build games that
      utilize a common application program interface across PlayStation®2, Xbox®,
      Xbox® 360 and PC platforms. Fonix VoiceIn voice command software is available to
      game developers in multiple languages, including English and UK English, German,
      French, Spanish, Japanese and Italian. As of December 31, 2005, Fonix VoiceIn
      is
      included on 13 videogame titles on retail shelves.





Electronic
      Arts, the world’s largest game developer, has also licensed the Fonix Speech
      voice platform for its game developers worldwide. Electronic Arts signed a
      multiple-year license agreement with Fonix for PlayStation®2 entertainment
      consoles and has an option to license Fonix speech solutions for additional
      game
      platforms.







10








Fonix
      Speech Videogame Market Opportunities





In
      the
      videogames market, Fonix VoiceIn® Game Edition is a compelling feature for
      today’s game developers. Gamers seek enhancements that add excitement,
      interaction and realism. Fonix VoiceIn allows developers to take voice command
      and control to a new level. The product gives players new access to games
      features, command and control functions and menu navigation. Fonix expects
      this
      exciting new interface to expand market demand for videogames.





Fonix
      Speech’s competitors are primarily other embedded speech software vendors like
      IBM, Nuance and Voice Signal. Fonix Speech’s partners also have competitors. For
      example, Intel competes with IBM and Epson. However, Fonix Speech is not
      precluded from working with its partners’ competitors.





§
            **Customer
                Self-Service Solutions for Computer Telephony**


Fonix
      ConnectMeTM is an innovative solution for computer telephony integration and
      server systems. Fonix ConnectMe is a voice-automated telephone operator that
      provides an **** efficient,
      professional means of routing incoming, outgoing and internal calls. Fonix
      also
      offers a voice interface solution for 511 system integrators. 511 is the
      designated three-digit phone number for national travel information within
      the
      United States. Fonix ASR and TTS products are designed to give developers
      easy-to-use tools with which to build call center speech enabled solutions
      that
      lower costs and increase customer satisfaction.





Fonix
      Speech Customer Self-Service Solutions





Fonix
      Speech provides telephony and server-based solutions for automated phone
      directory and database information systems. Fonix Speech believes that
      traditional operator systems and other means of accessing information are
      becoming antiquated. Significant time is lost trying to access information
      through keypad directories or because calls are blocked after hours. Also,
      information stored or transferred through servers, PBXs or databases may not
      easily be accessed through non-integrated platforms. Voice-automated systems
      are
      capable of integrating these platforms and meeting customer expectations of
      competitive costs, easy installation with minimal change to their existing
      infrastructure and a simple user interface.





o
            **Fonix
                ConnectMeTM**


Fonix
      ConnectMeTM is a unique, voice-automated telephone operator that provides an
      efficient, professional means of routing incoming, outgoing and internal calls.
      Customers and employees dial one number, speak the name of a person or a
      department and are quickly connected to the person or department they want
      to
      reach. Whether during peak business hours or late at night, ConnectMe’s 24-hour
      high-tech customer service capabilities ensure that all calls reach their
      intended destinations. ConnectMe handles all incoming calls simultaneously,
      so
      callers are never put on hold. Employees can create, maintain and access their
      own phone lists and can customize the delivery of calls. To Fonix Speech’s
      knowledge, no other company in this niche has emerged with a competitive product
      with ConnectMe’s unique features, functionality and price point.





o
            **511
                Traffic Information System**


In
      July
      2000, the Federal Communications Commission (“FCC”) assigned “511” as the number
      for nationwide access to traveler information. 511 was designated as a free
      service and when fully implemented will cover the majority of roads in the
      U.S.,
      helping travelers avoid congested routes and safety hazards. By dialing 5-1-1,
      callers can access information about route-specific weather and road conditions.
      Fonix and partner Meridian Environmental Technology, Inc. provide a 511 system
      in North Dakota, South Dakota, Nebraska, Kansas and Montana. Other states are
      scheduled to deploy the system in the near future. Competition in the 511 market
      includes TellMe and IBM’s WebSphere .





Fonix
      Speech Customer Self-Service Market Opportunities





Fonix
      Speech is well positioned to be a primary competitor in telephony products
      with
      ConnectMe. Benefits of ConnectMe include increased customer satisfaction,
      immediate ROI, user convenience, easy installation and maintenance, and its
      ability to bring a professional “voice” to companies’ telephone operator
      systems. Fonix Speech’s market strategy is to sell ConnectMe through VARs and
      distributors, as well as to customers of Fonix Telecom and LecStar. Potential
      competitors in the telephony/server market include Nuance and
      Avaya.










11







**Fonix
      Speech Platforms, Ports, and Processors**





Fonix
      Speech supports multiple microprocessors ("Chips"); including Win32, WinCE,
      QNX,
      Linuz, Solaris Palm, Apple OS 10+, Symbian Nokia Series 60. Supported operating
      systems (“OSs”) include: Analog Devices’ Blackfin, ARM 7, ARM 9, Epson S1C33
      Family, Renasas, Intel, MIPS, Motorola, NeoMagic, MiMagic3, MiMagic5, TI
      OMAP1510, Sun Sparc, Freescale iMXL, Samsung S3C, FreeScale mCore and Power
      PC.




**Types
                  of Microprocessors**
              **Types
                  of Operating Systems**Win32
              WinCE
              QNX
              Linux
              Solaris
              Palm
              Apple
                  OS 10+
              Symbian
                  Nokia Series 60
              No
                  OS Support RequiredAnalog
                  Devices
                Blackfin
                  ADSP-21535
              
              
              
              
              
              
              
              
              XARM
                  7
                ARM
                  9
              
              X
                X
              
              X
              
              X
              
              X
              XEpson
                S1C33
                  Family
              
              
              
              
              
              
              
              
              XRenasas
                SH-3
                SH-4
              
              X
                X
              X
              
              
              
              
              
              XIntel
                SA-1110
                XScale
                X86
              X
              X
                X
              X
                X
              X
                XMIPS
                MIPS
                  R4XXX
              
              XMotorola
                PPC
                  5100/5200
              
              
              X
              XNeoMagic
                MiMagic3
                  (NMS7210)
                MiMagic5
              
              XTI
                  OMAP1510 (ARM core)
              
              XSun
                  Sparc
              
              
              
              
              XFreescale
                  iMXL (ARM)
              
              X
              
              
              
              XSamsung
                  S3C ARM
              
              X
              
              
              
              XFreeScale
                  mCore
              
              
              
              
              
              
              
              
              XPower
                  PC
              
              
              
              
              
              
              X







**Fonix
      Speech Marketing and Sales Activities**




Fonix
      Speech expects to expand sales through partners, OEMs, VARs, direct sales and
      existing sales channels, both domestically and internationally. Fonix Speech
      will focus on wireless and mobile devices, telephony and server phone solutions,
      assistive and language learning devices, the videogame market, robots and
      appliances.







12








To
      address global opportunities, Fonix Speech plans to develop and expand sales
      and
      marketing teams in Asia, Europe and the United States. Fonix has partnered
      with
      companies like A.I. Corporation, a high-tech Japanese product
      distributor and engineering company specializing in embedded system software,
      to
      capitalize on sales and marketing efforts outside the United States.





**Fonix
      Speech Strategic Relationships**





Fonix
      Speech currently has a number of strategic collaboration, distribution and
      marketing arrangements with OEMs, software developers and VARs. Fonix Speech
      intends to expand such relationships and add similar relationships, specifically
      in markets related to wireless and mobile devices, assistive and language
      learning devices and customer self-service solutions. When Fonix Speech
      identifies “first mover” speech-enabling applications that can integrate Fonix Speech
      Products and Core Technologies, Fonix Speech intends to investigate investment
      opportunities to obtain preferred or priority collaboration rights.





**Fonix
      Speech Continued Development**





Fonix
      Speech plans to continue to invest resources in the development and acquisition
      of standard speech solutions and enhancements to its Core Technologies,
      developer tools and development frameworks to maintain competitive
      advantages.





**RECENT
      DEVELOPMENTS**





***Series
      K Preferred Stock -*** On
      February 6, 2006, the Company entered into a Series K 5% Convertible Preferred
      Stock Exchange Agreement (the “Exchange Agreement”) with Southridge Partners, LP
      (“Southridge”), a Delaware limited partnership. Pursuant to the Exchange
      Agreement, Southridge exchanged 1,093 shares of Series J 5% Convertible
      Preferred Stock for 1,093 shares of the Company’s Series K 5% Convertible
      Preferred Stock (the “Series K Preferred Stock”).





The
      Series K Preferred Stock entitles Southridge to receive dividends in an amount
      equal to 5% of the then-outstanding balance of shares of Series K Preferred
      Stock. The dividends are payable in cash or shares of the Company’s Class A
      common stock, at the Company’s option.





The
      Series K Preferred Stock may be converted into common stock of the Company
      at
      the option of the holder by using a conversion price of $0.01 per
      share.





Redemption
      of the Series K Preferred Stock, whether at the option of Fonix, or that of
      Southridge, requires the Company to pay, as a redemption price, the stated
      value
      of the outstanding shares of Series K Preferred Stock to be redeemed, together
      with any accrued but unissued dividends thereon, multiplied by one hundred
      ten
      percent (110%).





Because
      the shares of Series K were issued in exchange for the remaining outstanding
      shares of Series J Preferred Stock, Fonix did not receive any proceeds in
      connection with the issuance of the Series K Preferred Stock.





In
      connection with the issuance of the Series K Preferred Stock, the Company filed
      with the State of Delaware a Certificate of Designation and Series K 5%
      Convertible Stock Terms (the “Series K Terms”), which become a part of the
      Company’s Certificate of Incorporation, as amended.





Under
      the
      Exchange Agreement and the Series K Terms, Southridge may convert shares of
      Series K Preferred Stock into shares of the Company’s common stock. The
      Company’s issuances of shares of common stock upon any conversion of the Series
      K Preferred Stock will be made without registration under the securities Act
      of
      1933 (the “1933 Act”) in reliance on Section 4(2) of the 1933 Act and the rules
      and regulations promulgated thereunder.




Subsequent
        to filing, but prior to the issuance of any shares of Series K Preferred
        Stock,
        the Company agreed with Southridge to amend the Series K Terms to put a
        conversion cap of 1.0%, in lieu of a 4.99% conversion cap. The Company and
        Southridge entered into an Amended and Restated Series K 5% Convertible
        Preferred Stock Exchange Agreement, with the only change being the change
        in the
        conversion cap. The Company filed the amended Series K Terms with the Delaware
        Secretary of State.
  Through
        March 10, 2006, the Company had issued 23,100,000 of its Class A common stock
        in
        connection with the conversion of 231 shares of Series K Preferred
        Stock.






13







**ITEM
              1a.**
            **RISK
                FACTORS**





***The
      short- and long-term success of Fonix is subject to certain risks, many of
      which
      are substantial in nature and outside the control of Fonix. You should consider
      carefully the following risk factors, in addition to other information contained
      herein. All forward-looking statements contained herein are deemed by Fonix
      to
      be covered by and to qualify for the safe harbor protection provided by Section
      21E of the Private Securities Litigation Reform Act of 1995. When used in this
      Report, words such as “believes,” “expects,” “intends,” “plans,” “anticipates,”
“estimates,” and similar expressions are intended to identify forward-looking
      statements, although there may be certain forward-looking statements not
      accompanied by such expressions. You should understand that several factors
      govern whether any forward-looking statement contained herein will or can be
      achieved. Any one of those factors could cause actual results to differ
      materially from those projected herein. These forward-looking statements include
      plans and objectives of management for future operations, including the
      strategies, plans and objectives relating to the products and the future
      economic performance of Fonix and its subsidiaries discussed above. In light
      of
      the significant uncertainties inherent in the forward-looking statements
      included herein, the inclusion of any such statement should not be regarded
      as a
      representation by Fonix or any other person that the objectives or plans of
      Fonix will be achieved.***





**Risk
      Factors Associated with All of our Operations**





**Our
      substantial and continuing losses since inception, coupled with significant
      ongoing operating expenses, raise doubt about our ability to continue as a
      going
      concern.**





Since
      inception, we have sustained substantial losses. Such losses continue due to
      ongoing operating expenses and a lack of revenues sufficient to offset operating
      expenses. We have raised capital to fund ongoing operations by private sales
      of
      our securities, some of which sales have been highly dilutive and involve
      considerable expense. In our present circumstances, there is substantial doubt
      about our ability to continue as a going concern absent significant sales of
      our
      products and telecommunication services, substantial revenues from new licensing
      or co-development contracts, or continuing large sales of our
      securities.





We
      incurred net losses of $22,631,000, $15,148,000 and $13,543,000 for the years
      ended December 31, 2005, 2004 and 2003. As of December 31, 2005, we had an
      accumulated deficit of $250,521,000, accrued liabilities and accrued legal
      settlement of $10,214,000 and owed trade payables of $6,770,000.





We
      expect
      to continue to spend significant amounts to expand our telecommunications
      services, enhance our Speech Products and technologies and fund further Product
      development. As a result, we will need to generate significant additional
      revenue to achieve profitability. Even if we do achieve profitability, we may
      not be able to sustain or increase profitability on a quarterly or annual basis.
      If we do not achieve and maintain profitability, the market price for our common
      stock may further decline, perhaps substantially, and we may have to curtail
      or
      cease our operations.





**The
      “going concern” paragraph in the reports of our independent registered public
      accounting firm for the years ended December 31, 2005, 2004 and 2003 raises
      doubts about our ability to continue as a going concern.**





The
      independent registered public accounting firm’s reports for our financial
      statements for the years ended December 31, 2005, 2004 and 2003 include an
      explanatory paragraph regarding substantial doubt about our ability to continue
      as a going concern. This may have an adverse effect on our ability to obtain
      financing for operations and to further develop and market Speech
      Products.





**LecStar's
      current operations may not provide sufficient cash flow to sustain operations,
      and we may be required to divert proceeds from our Seventh Equity Line towards
      offsetting cash flow shortfalls at LecStar for an indefinite time period. If
      we
      do not receive additional capital when and in the amounts needed in the near
      future, our ability to continue as a going concern is in substantial
      doubt.**





We
      previously established six equity lines of credit with an unaffiliated third
      party (the “Equity Line Investor”) upon which we drew to pay operating expenses.
      We have entered into a Seventh Equity Line agreement wherein we have previously
      registered the sale of up to 100,000,000 shares of Class A common stock and
      have
      registered the sale of up to another 300,000,000 shares of Class A common stock.
      As of March 10, 2006, $15,573,000 remained available under the Seventh Equity
      Line.









14








LecStar’s
      operations did not generate sufficient operating revenue to pay all operating
      expenses in 2005 and required us to fund some of its operations and liabilities
      through our otherwise available financing sources, including the Seventh Equity
      Line. There can be no assurance that LecStar will become self-sufficient during
      2006 or at all, or that if LecStar becomes self-sufficient whether it will
      be
      able to maintain such level of operations. If we are required to provide
      significant operating capital to LecStar for extended periods, our business
      and
      financial condition could be adversely and materially affected. Accordingly,
      if
      we are not able to obtain adequate financing under the existing or additional
      equity line agreements or from other financing sources when and in the amounts
      needed, and on terms that are acceptable, our operations, financial condition
      and prospects could be materially and adversely affected, and we could be forced
      to curtail our operations or sell part or all of our assets, including our
      Core
      Technologies, LTEL or LecStar, or seek protection under bankruptcy laws.





**Continuing
      debt obligations could impair our ability to continue as a going
      concern.**





As
      of
      December 31, 2005, we had debt obligations of $6,383,000, accrued liabilities
      and accrued legal settlement of $10,214,000 and vendor accounts payable of
      approximately $6,770,000. At present, our revenues from existing licensing
      arrangements, Speech Product sales and telecommunication services are not
      sufficient to offset our ongoing operating expenses or to pay in full our
      current debt obligations.





In
      connection with the acquisition of the capital stock of LTEL, we issued a 5%
      $10,000,000 secured, six-year note payable to McCormack Avenue, Ltd. Under
      the
      terms of the note payable, quarterly interest only payments were required
      through January 15, 2005 with quarterly principal and interest payments which
      began April 2005 through the final payment due January 2010.





There
      is
      substantial risk, therefore, that the existence and extent of the debt
      obligations described above could adversely affect our business, operations
      and
      financial condition, and we may be forced to curtail our operations, sell part
      or all of our assets, including the Core Technologies, LTEL or LecStar, or
      seek
      protection under bankruptcy laws. Additionally, there is substantial risk that
      the current or former employees or our vendors could bring lawsuits to collect
      the unpaid amounts. In the event of lawsuits of this type, if we are unable
      to
      negotiate settlements or satisfy our obligations, we could be forced into
      bankruptcy.





**There
      can be no guarantee that the proceeds available to us under the Seventh Equity
      Line will be sufficient for us to achieve profitable operations or to pay our
      current liabilities, which could have a material adverse impact on our ability
      to continue operations.**





There
      is
      no assurance that the funds which are available to us under the Seventh Equity
      Line will be sufficient to allow us to continue our marketing and sales efforts
      to the point we achieve profitable operations. Additionally, the payment of
      our
      current outstanding liabilities may require significant portions of the funds
      available to us under the Seventh Equity Line, and the amounts remaining may
      not
      be sufficient for us to use as working capital in our operations, which could
      have a material adverse effect on our ability to continue our
      operations.



















15







**Holders
      of Fonix Class A common stock are subject to the risk of additional and
      substantial dilution to their interests as a result of the issuances of Class
      A
      common stock in connection with the Seventh Equity Line.**





The
      following table describes the number of shares of Class A common stock that
      would be issuable, assuming that the full remaining amount available under
      the
      Seventh Equity Line as of March 10, 2006, namely $15,573,000, had been put
      to
      the Equity Line Investor (irrespective of the availability of registered
      shares), and further assuming that the applicable conversion price at the time
      of such put were the following amounts:





Hypothetical
                Conversion Price
            Shares
                issuable upon
              puts
                aggregating $15,573,000$0.03
            519,100,000$0.05
            311,460,000$0.10
            155,730,000$0.15
            103,820,000$0.25
            62,292,000$0.30
            51,910,000






Given
      the
      formulas for calculating the shares to be issued in connection with puts under
      the Seventh Equity Line, there effectively is no limitation on the number of
      shares of Class A common stock which may be issued in connection with a put
      under the Seventh Equity Line, except for the number of shares registered under
      the prospectus and the registration statement covering the resale of shares
      issued in connection with the Seventh Equity Line. As such, shareholders are
      subject to the risk of substantial dilution to their interests as a result
      of
      our issuance of shares under the Seventh Equity Line.





For
      example, if the Company were to draw down $3,000,000, at March 10, 2006, under
      the Seventh Equity Line, the number of shares issuable would be approximately
      167,000,000. As of March 10, 2006, we had 481,309,900 shares of our Class A
      common stock issued and outstanding. An issuance of 167,000,000 would constitute
      an increase of approximately 35%. By way of information, during 2005 and through
      March 10, 2006, our stock price ranged from $0.02 to $0.19 per
      share.





**Holders
      of Fonix Class A common stock are subject to the risk of additional and
      substantial dilution to their interests as a result of the issuances of Class
      A
      common stock in connection with conversions of shares of the Series K Preferred
      Stock.**





As
      noted
      above, on February 6, 2006, we entered into an exchange agreement with
      Southridge Partners, LP (“Southridge”), whereby Southridge exchanged all of the
      shares of Series J 5% Convertible Preferred Stock that it owned for 1,093 shares
      of the Company’s Series K 5% Convertible Preferred Stock (the “Series K
      Preferred Stock”). The Series K Preferred Stock has a stated value of $1,000 per
      share. The conversion price of the Series K Preferred Stock is $0.01 per share.
      As such, upon conversion of the full amount of Series K Preferred Stock,
      Southridge will receive 109,300,000 shares of our common stock, resulting in
      additional dilution to the interests of holders of our common
      stock.





**Our
      issuances of shares in connection with the conversions of the Series K Preferred
      Stock and in connection with the Seventh Equity Line likely will result in
      overall dilution to market value and relative voting power of previously issued
      common stock, which could result in substantial dilution to the value of shares
      held by shareholders.**





Historically,
      the issuance of Class A common stock to the Equity Line Investor under the
      first
      six equity lines resulted in substantial dilution to the equity interests of
      all
      holders of Class A common stock, except the Equity Line Investor. The issuance
      of Class A common stock in connection with conversions of the Series K Preferred
      Stock and with draws under the Seventh Equity Line may result in substantial
      dilution to the equity interests of holders of Fonix Class A common stock other
      than Southridge and the Equity Line Investor. Specifically, the issuance of
      a
      significant amount of additional Class A common stock will result in a decrease
      of the relative voting control of the Class A common stock issued and
      outstanding prior to the issuance of Class A common stock in connection with
      conversions of the Series K Preferred Stock or with puts under the Seventh
      Equity Line. Furthermore, public resales of Class A common stock by Southridge
      or by the Equity Line Investor following the issuance of Class A common stock
      in
      connection with conversions of the Series K Preferred Stock or with puts under
      the Seventh Equity Line likely will depress the prevailing market price of
      the
      Class A common stock. Even prior to the time of actual conversions, exercises,
      and public resales, the market “overhang” resulting from the mere existence of
      our obligation to honor such conversions or exercises could depress the market
      price of our Class A common stock.









16








**Existing
      shareholders likely will experience increased dilution with decreases in market
      value of Class A common stock in relation to our issuances of shares upon
      conversion of the Series K Preferred Stock or in connection with puts made
      under
      the Seventh Equity Line, which could have a material adverse impact on the
      value
      of their shares.**





The
      formula for determining the number of shares of Class A common stock to be
      issued in connection with puts made under the Seventh Equity Line is based,
      in
      part, on the market price of the Class A common stock and includes a discount
      from the market price equal to 93% of the average of the two lowest closing
      bid
      prices of the Class A common stock for puts under the Seventh Equity Line,
      over
      a specified trading period. The conversion price of the Series K Preferred
      Stock
      is $0.01 per share. As a result, the lower the market price of our Class A
      common stock at and around the time we put shares under the Seventh Equity
      Line,
      the more shares of Class A common stock the Equity Line Investor would receive.
      Any increase in the number of shares of Class A common stock issued upon puts
      of
      shares as a result of decreases in the prevailing market price would compound
      the risks of dilution described in the preceding paragraph.





**There
      is an increased potential for short sales of the Class A common stock due to
      the
      sales of shares put to the Equity Line Investor in connection with the Seventh
      Equity Line, which could materially affect the market price of the
      stock.**





Downward
      pressure on the market price of the Class A common stock that likely will result
      from sales of the Class A common stock by the Equity Line Investor issued in
      connection with a put under the Seventh Equity Line could encourage short sales
      of Class A common stock by market participants other than the Equity Line
      Investor. Generally, short selling means selling a security, contract or
      commodity not owned by the seller. The seller is committed to eventually
      purchase the financial instrument previously sold. Short sales are used to
      capitalize on an expected decline in the security's price. As we draw on the
      Seventh Equity Line, we put shares to the Equity Line Investor, which the Equity
      Line Investor then sells into the market. Such sales could have a tendency
      to
      depress the price of the stock, which could increase the potential for short
      sales.





Under
      applicable rules and regulations under the Exchange Act, any person engaged
      in
      the distribution of the resale shares may not simultaneously engage in market
      making activities with respect to the Common Stock for the applicable restricted
      period, as defined in Regulation M, prior to the commencement of the
      distribution. In addition, the Equity Line Investor will be subject to
      applicable provisions of the Exchange Act and the rules and regulations
      thereunder, including Regulation M, which may limit the timing of purchases
      and
      sales of shares of the Common Stock by the Equity Line Investor or any other
      person. We will make copies of this prospectus available to the Equity Line
      Investor and have informed it of the need to deliver a copy of this prospectus
      to each purchaser at or prior to the time of the sale.





Nevertheless,
      significant amounts of such short selling by market participants other than
      the
      Equity Line Investor could place further downward pressure on the market price
      of our Class A common stock, which would, in turn, result in additional shares
      being issued in connection with draws on the Seventh Equity Line.





**Certain
      restrictions on the extent of puts may have little, if any, effect on the
      adverse impact of our issuance of shares under the Seventh Equity Line, and
      as
      such, the Equity Line Investor may sell a large number of shares, resulting
      in
      substantial dilution to the value of shares held by existing
      shareholders.**





We
      are
      prohibited from putting shares to the Equity Line Investor under the Seventh
      Equity Line if such put would result in that investor holding more than 4.999%
      of the then-outstanding shares of Class A common stock. These restrictions,
      however, do not prevent the Equity Line Investor from selling shares of Class
      A
      common stock received in connection with a put, and then receiving additional
      shares of Class A common stock in connection with a subsequent put. In this
      way,
      the Equity Line Investor could sell more than 4.999% of the outstanding Class
      A
      common stock in a relatively short time frame while never holding more than
      4.999% at one time.









17








**We
      may not be able to make draws under the Seventh Equity Line if the Equity Line
      Investor is deemed to beneficially own more than 4.999% of our common stock,
      which could have a material adverse impact on our
      operations.**





Pursuant
      to the Seventh Equity Line Agreement, in the event that the Equity Line Investor
      is deemed to own more than 4.999% of our then-outstanding common stock, we
      will
      be unable to draw down on the Seventh Equity Line Agreement. The Equity Line
      Investor has a contractual advisory relationship with the General Partner of
      Southridge, the holder of our Series K Preferred Stock. The shares of our Series
      K Preferred Stock are presently convertible into shares of our Class A common
      stock, although Southridge is prohibited by the terms of the Series K Preferred
      Stock Exchange Agreement from converting shares that would result in its owning
      more than 1.0% of our outstanding shares of common stock at any time. Although
      the Equity Line Investor and Southridge each disclaim beneficial ownership
      of
      the shares held by the other entity, if their holdings are aggregated, such
      aggregation could result in the Equity Line Investor being deemed to
      beneficially own the shares which Southridge is deemed to beneficially own.
      To
      the extent that the Equity Line Investor is deemed to beneficially own 4.999%
      or
      more of our common stock through this aggregation of beneficial ownership with
      Southridge, we would be unable to draw on the Seventh Equity Line Agreement
      until such time as that ownership percentage was reduced. In that event, if
      we
      are unable to obtain additional external funding or generate revenue from
      operations, we could be forced to curtail or cease our operations.





**Certain
      restrictions on the number of shares of Series K Preferred Stock Southridge
      may
      convert at any time may have little, if any, effect on the adverse impact of
      our
      issuance of shares upon conversion of the Series K Preferred Stock, and as
      such,
      Southridge may sell a large number of shares, resulting in substantial dilution
      to the value of shares held by existing shareholders.**





Southridge
      is prohibited by the Series K Preferred Stock exchange agreement from converting
      shares of Series K Preferred Stock to the extent that the number of shares
      we
      issue upon conversion would result in Southridge’s holding more than 1.0% of the
      then-outstanding shares of Class A common stock. These restrictions, however,
      do
      not prevent Southridge from converting certain shares of Series K Preferred
      Stock, selling the shares received in connection with the conversion, and then
      converting additional shares of Series K Preferred Stock in a subsequent
      conversion. In this way, Southridge could sell more than 1.0% of the outstanding
      Class A common stock in a relatively short time frame while never holding more
      than 1.0% at one time.





**We
      have registered under registration statements the resale of shares approximately
      equal to approximately seventy percent of the number of shares currently issued
      and outstanding, which may result in substantial dilution to current
      shareholders if the selling shareholders under the other registration statements
      sell all of the shares under those registration
      statements.**





We
      have
      filed, in connection with the Seventh Equity Line and the LTEL acquisition,
      registration statements which register, in the aggregate, the resale by the
      selling shareholders named in those registration statements of up to
      approximately 350,000,000 shares of our Class A common stock. As of March 10,
      2006, we had 481,309,900 shares of our Class A common stock issued and
      outstanding. If all of the shares registered in those two registration
      statements were issued, such issuances would result in an increase of our
      outstanding shares of approximately seventy percent. Accordingly, the sale
      by
      the selling shareholders in those registration statements of all of the shares
      registered will result in substantial dilution to current holders of our Class
      A
      common stock.





**We
      have no dividend history and have no intention to pay dividends in the
      foreseeable future.**





We
      have
      never paid dividends on or in connection with any class of our common stock
      and
      do not intend to pay any dividends to common stockholders for the foreseeable
      future.





**Competition
      from other industry participants and rapid technological change could impede
      our
      ability to achieve profitable operations. Additionally, our current and
      potential competitors, some of whom have greater resources and experience than
      we do, may develop products and technologies that may cause a decline in demand
      for, and the prices of, our Speech Products and our telecommunications
      services.**










18








The
      speech-enabled technologies market sector and telecommunications industry are
      characterized by rapid technological change. Competition in the speech-enabled
      technologies market is based largely on marketing ability and resources,
      distribution channels, technology and product superiority and product service
      and support. A number of companies have developed, or are expected to develop,
      products that compete with our Speech Products and Core Technologies.
      Competitors in the speech technology software market include IBM, SpeechWorks
      International, Nuance, and ScanSoft. We expect additional competition from
      other
      companies, including Microsoft. Furthermore, our competitors may combine with
      each other, and other companies may enter our markets by acquiring or entering
      into strategic relationships with our competitors. Current and potential
      competitors have established, or may establish, cooperative relationships among
      themselves or with third parties to increase the abilities of their speech
      and
      language technology products to address the needs of our prospective
      customers.





Similarly,
      the market for telecommunications services is highly competitive. We compete,
      and expect to continue to compete, with current and potential market entrants,
      including: long-distance carriers; ILECs; other CLECs; competitive access
      providers (“CAPs”); cable television companies; electric utilities; microwave
      carriers; wireless telephone system operators; and private networks built by
      large end-users. In addition, the possibility of combinations and strategic
      alliances in the telecommunications industry could give rise to significant
      new
      competitors. We also expect increased competition from wireless service or
      voice
      VoIP providers as wireless and VoIP technologies improve.





Many
      of
      our current and potential competitors have competitive advantages over us,
      including substantially greater financial, technical, personnel and other
      resources, including brand name recognition and long-standing relationships
      with
      customers. These resources may place us at competitive disadvantage in our
      existing speech and telecommunications markets and may impair our ability to
      expand into new markets, which could adversely affect our business. If we fail
      to grow rapidly or obtain additional capital we may not be able to compete
      with
      larger, more well established companies. There can be no assurance that we
      will
      be able to successfully compete in our existing markets or in new
      markets.





**We
      may incur a variety of costs to engage in future acquisitions of companies,
      products or technologies to grow our customer base, to expand into new markets,
      or to provide new services. As such, the anticipated benefits of those
      acquisitions may never be realized.**





We
      may
      acquire other businesses to grow our customer base, to expand into new markets,
      or to provide new services. We may make acquisitions of, or significant
      investments in, complementary companies, products or technologies, such as
      the
      recent acquisition of the capital stock of LTEL Holdings Corporation, discussed
      elsewhere herein, although no additional material acquisitions or investments
      are currently pending. Acquisitions may be accompanied by risks such
      as:





•
            difficulties
                in assimilating the operations and employees of acquired
                companies;





•
            diversion
                of our management's attention from ongoing business
                concerns;





•
            our
                potential inability to maximize our financial and strategic position
                through the successful incorporation of acquired technology and rights
                into our products and services;





•
            additional
                expense associated with amortization of acquired
                assets;





•
            additional
                expense associated with understanding and development of acquired
                business;





•
            maintenance
                and implementation of uniform standards, controls, procedures and
                policies; and





•
            impairment
                of existing relationships with employees, suppliers and customers
                as a
                result of the integration of new management
                employees.





**We
      must attract and retain skilled personnel. If we are unable to hire and retain
      technical, sales and marketing and operational employees, our business could
      be
      harmed.**








19





Our
      ability to manage our growth will be particularly dependent on our ability
      to
      develop and retain an effective sales force and qualified technical and
      managerial personnel. We intend to hire additional employees, including software
      engineers, sales and marketing employees and operational employees. The
      competition for qualified sales, technical, and managerial personnel in the
      communications industry, as well as the speech technology industry, is intense,
      and we may not be able to hire and retain sufficient qualified personnel. In
      addition, we may not be able to maintain the quality of our operations, control
      our costs, maintain compliance with all applicable regulations, and expand
      our
      internal management, technical, information and accounting systems in order
      to
      support our desired growth, which could have an adverse impact on our
      operations.





**We
      are subject to the risk that certain key personnel, including key scientific
      employees named below, on whom we depend, in part, for our operations, will
      cease to be involved with us.**





We
      are
      dependent on the knowledge, skill and expertise of several key scientific and
      business development employees, including Dale Lynn Shepherd, R. Brian Moncur,
      Edward A. Bruckert, W. Dale Smith, Matthew C. Sines and Walt Nawrocki; and
      executive officers, including Thomas A. Murdock, Roger D. Dudley and William
      A.
      Maasberg, Jr. The loss of any of the key personnel listed above could materially
      and adversely affect our future business efforts. Although we have taken
      reasonable steps to protect our intellectual property rights including obtaining
      non-competition and non-disclosure agreements from all of our employees and
      independent contractors, if one or more of our key scientific employees,
      executive employees or independent contractors resigns from Fonix to join a
      competitor, to the extent not prohibited by such person's non-competition and
      non-disclosure agreement, the loss of such personnel and the employment of
      such
      personnel by a competitor could have a material adverse effect on us. We do
      not
      presently have any key man life insurance on any of our employees.





**Our
      present intention to integrate our Core Technologies into the services currently
      provided by LecStar may not proceed as planned, may take longer than
      anticipated, and may not become profitable.**





We
      intend
      to integrate the development and distribution of Speech Products into and
      through the telephone services and technologies made available to us through
      the
      LecStar acquisition. Such integration may require significant additional capital
      investment and may not be fully financially or technologically feasible.
      Further, there can be no guarantee that our plans to integrate our Speech
      Products which utilize our Core Technologies into such telephone services will
      proceed as anticipated and we may determine subsequently that the integration
      will not be profitable or have the desired effect for our operations. Any of
      these outcomes could have a materially adverse impact on our operations and
      profitability.





**Our
      primary source of funding recently has been through the Seventh Equity Line
      with
      an entity that may be an affiliate of the holder of our Series H Preferred
      Stock
      and a $10 Million promissory note, which may give rise to conflicting interests
      with respect to the future operation of the Seventh Equity
      Line.**





As
      noted
      and discussed above, our primary source of funding recently has been the Seventh
      Equity Line. Under the Seventh Equity Line Agreement, we have the right to
      draw
      up to $20,000,000 from the Equity Line Investor. We are entitled under the
      Seventh Equity Line Agreement to draw certain funds and to put to the Equity
      Line Investor shares of our Class A common stock in lieu of repayment of the
      draw. We anticipate that the Seventh Equity Line and perhaps other similar
      equity line arrangements with the Equity Line Investor or its affiliates will
      be
      the primary source of Fonix's funding in 2006.





In
      connection with the acquisition of the capital stock of LTEL, we issued to
      McCormack Avenue, Ltd., a British Virgin Island corporation (“McCormack”), a
      $10,000,000 secured promissory note (the “Note”) as well as 1,960.8 shares of
      our Series H Preferred Stock, for certain shares of LTEL held by McCormack.
      McCormack may be deemed an affiliate, as defined in rules promulgated under
      the
      Securities Act, of the Equity Line Investor. Specifically, McCormack is
      controlled by a corporate director, the president of which also has voting
      and
      investment control over Queen LLC, the Equity Line Investor.





As
      the
      holder of the Note and a large number of the Series H Preferred Shares,
      McCormack may receive and, in fact, Fonix is obligated to pay to McCormack
      amounts as principal and interest on the Note and dividends on the Preferred
      Shares. To the extent such payments are made out of draws we make under the
      Seventh Equity Line (or replacements thereof with the Equity Line Investor),
      it
      is possible that conflicts of interest could develop in how we draw against,
      and
      how the Equity Line Investor participates in, the Seventh Equity Line (or
      replacements thereof).







20








Additionally,
      to the extent that we use funds drawn from the Seventh Equity Line to make
      payments on the McCormack Note, we will have fewer proceeds available to us
      to
      use for other corporate purposes, which could have a material adverse impact
      on
      our business.





**An
      inability to market and develop additional services may adversely affect our
      ability to retain existing customers or attract new customers.**





Through
      LecStar, we currently offer local, long distance, data, and Internet
      telecommunications services. Through Fonix Speech, we offer speech technology
      solutions and products. In order to address the future needs of our customers,
      we will be required to market and develop additional products and services.
      We
      may not be able to continue to provide the range of speech products or
      telecommunication services that our customers need or desire. We may lose some
      of our customers or be unable to attract new customers if we cannot offer the
      products and services our customers need or desire.





**Our
      common stock is considered a penny stock. Penny stocks are subject to special
      regulations, which may make them more difficult to trade on the open
      market.**





Securities
      in the OTC market are generally more difficult to trade than those on the NASDAQ
      National Market, the NASDAQ SmallCap Market or the major stock exchanges. In
      addition, accurate price quotations are also more difficult to obtain. The
      trading market for our common stock is subject to special regulations governing
      the sale of penny stock.





A
“penny
      stock” is defined by regulations of the Securities and Exchange Commission as an
      equity security with a market price of less than $5.00 per share. The market
      price of our Class A common stock has been less than $5.00 for several
      years.





If
      you
      buy or sell a penny stock, these regulations require that you receive, prior
      to
      the transaction, a disclosure explaining the penny stock market and associated
      risks. Furthermore, trading in our common stock would be subject to Rule 15g-9
      of the Exchange Act, which relates to non-NASDAQ and non-exchange listed
      securities. Under this rule, broker-dealers who recommend our securities to
      persons other than established customers and accredited investors must make
      a
      special written suitability determination for the purchaser and receive the
      purchaser's written agreement to a transaction prior to sale. Securities are
      exempt from this rule if their market price is at least $5.00 per
      share.





Penny
      stock regulations will tend to reduce market liquidity of our common stock,
      because they limit the broker-dealers' ability to trade, and a purchaser's
      ability to sell the stock in the secondary market. The low price of our common
      stock will have a negative effect on the amount and percentage of transaction
      costs paid by individual shareholders. The low price of our common stock may
      also limit our ability to raise additional capital by issuing additional shares.
      There are several reasons for these effects. First, the internal policies of
      many institutional investors prohibit the purchase of low-priced stocks. Second,
      many brokerage houses do not permit low-priced stocks to be used as collateral
      for margin accounts or to be purchased on margin. Third, some brokerage house
      policies and practices tend to discourage individual brokers from dealing in
      low-priced stocks. Finally, broker's commissions on low-priced stocks usually
      represent a higher percentage of the stock price than commissions on higher
      priced stocks. As a result, our shareholders will pay transaction costs that
      are
      a higher percentage of their total share value than if our share price were
      substantially higher.





**Risk
      Factors Associated with Our Core Technologies, Speech Products and Speech
      Business**





**We
      have a limited Speech Product offering and many of our key technologies are
      still in the product development stage.**





Presently,
      there are a limited number of commercially available Speech Products
      incorporating our Core Technologies. For Fonix to be ultimately successful,
      sales from these Speech Products must be substantially greater. An additional
      element of our business strategy is to achieve revenues through strategic
      alliances, co-development arrangements, and license arrangements with third
      parties. For example, we have entered into licensing and joint-marketing
      agreements with Sony, Electronic Arts, Intel, Microsoft, HP, Panasonic, Epson,
      and others. These agreements provide for joint marketing and application
      development for end-users or customers. To date, these agreements have not
      produced significant revenues. There can be no assurance that these
      collaboration agreements will produce license or other agreements which will
      generate significant revenues for us.









21








**The
      market for many of our Core Technologies and Speech Products is largely unproven
      and may never develop sufficiently to allow us to capitalize on our Core
      Technology and Speech Products.**





The
      market for speech-enabled Speech Products is rapidly evolving. Additionally,
      our
      Speech Products are new and, in many instances, represent a significant
      departure from technologies which already have found a degree of acceptance
      in
      the speech-enabled technologies marketplace. Our financial performance will
      depend, in part, on the future development, growth and ultimate size of the
      market for speech-enabled applications and Speech Products generally, and
      applications and products incorporating our Speech Products. If the potential
      users of speech-enabled software in general and our products in particular
      do
      not perceive appropriate benefits, or if speech-enabled software platforms
      do
      not achieve commercial acceptance, our business could be harmed or even
      fail.





The
      Speech Products which incorporate our Core Technologies will be competing with
      more conventional means of information processing such as data entry, access
      by
      keyboard, mouse or touch-tone telephone. We believe that there is a substantial
      potential market for applications and products incorporating advanced
      speech-enabled technologies. Nevertheless, such a market for our Speech Products
      may never develop to the point that profitable operations can be achieved or
      sustained.





**Our
      Speech Products may not achieve widespread acceptance by businesses or
      telecommunications carriers, which could limit our ability to grow our
      business.**





Our
      ability to increase revenue in the future depends on the acceptance of
      speech-enabling products and applications by both our customers and end users.
      The adoption and integration of speech-enabling products and applications could
      be hindered by the perceived costs of these new products and applications,
      as
      well as the reluctance of enterprises that have invested substantial resources
      in existing applications to replace their current systems with these new
      products and applications. Accordingly, in order to achieve commercial
      acceptance, we will have to educate prospective customers, including large,
      established companies, about the uses and benefits of speech-enabling products
      and applications in general and our Speech Products in particular. If these
      efforts fail, or if speech-enabling products and technology platforms do not
      achieve commercial acceptance, our business will not develop or may subsequently
      fail.





Continued
      development of the market for our Speech Products also will depend upon the
      following factors over which we have little or no control:





•
            widespread
                deployment of speech-enabling applications by third parties, which
                is
                driven by consumer demand for services having a voice user
                interface;





•
            demand
                for new uses and applications of speech-enabling technology, including
                adoption of speech-enabled interfaces by companies that operate web
                sites;





•
            adoption
                of industry standards for speech-enabling and related technologies;
                and





•
            continuing
                improvements in hardware technology that may reduce the costs of
                speech-enabling technology
                solutions.





**In
      many cases, the delivery of our Speech Products to end users is dependent upon
      third-party integration and may be subject to delays and cancellations that
      are
      beyond our control.**





Generally,
      we are pursuing third-party integration of our Speech Products into mass market,
      general business, personal electronics products, and computing solutions. Thus,
      lead time to revenue recognition will be longer than software products directly
      released into consumer channels. Purchase of our Speech Products often requires
      a significant expenditure by a customer. Accordingly, the decision to purchase
      our Speech Products typically requires significant pre-purchase evaluation.
      We
      spend significant time educating and providing information to prospective
      customers regarding the use and benefits of our Speech Products. During this
      evaluation period, we may expend substantial sales, marketing and management
      resources.







22








Further,
      our Speech Products sold and integrated into customer applications and products
      are subject to both customer production schedules and customer success in
      marketing their own products and generating product sales. Our revenues are
      thus
      subject to delays and possible cancellation resulting from customer integration
      risks and delays.





In
      cases
      where our contract with our customers specifies milestones or acceptance
      criteria, we may not be able to recognize license or services revenue until
      these conditions are met. We have in the past and may in the future experience
      unexpected delays in recognizing revenue. Consequently, the length of our sales
      and implementation cycles and the varying order amounts for our Speech Products
      make it difficult to predict the quarter in which revenue recognition may occur
      and may cause license and services revenue and operating results to vary
      significantly from period to period. These factors could cause our stock price
      to be volatile or to decline.





**Our
      Speech Products can have a long sales cycle and, as a result, our quarterly
      operating results and our stock price may fluctuate.**





The
      sales
      cycles for our Speech Products are generally six to twelve months but may be
      shorter or longer depending on the size and complexity of the order, the amount
      of services to be provided and whether the sale is made directly by us or
      indirectly through an OEM, VAR, or systems integrator. The length of the sales
      cycles could adversely impact our operating results.





**Our
      failure to respond to rapid change in the speech-enabled technologies market
      could cause us to lose revenue and harm our business.**





Our
      success will depend substantially upon our ability to enhance our existing
      Speech Products and to develop and introduce, on a timely and cost-effective
      basis, new technologies, Speech Products and features that meet changing
      end-user requirements and incorporate technological advancements. If we are
      unable to develop new Speech Products and enhanced functionalities or
      technologies to adapt to these changes, or if we cannot offset a decline in
      revenue from existing Speech Products with sales of new Speech Products, our
      business will suffer.





Commercial
      acceptance of our Speech Products will depend, among other things,
      on:





•
            the
                ability of our Speech Products to meet and adapt to the needs of
                our
                target markets;





•
            the
                performance and price of our Speech Products and our competitors'
                products; and





•
            our
                ability to deliver customer services directly and through our resellers,
                VARs and OEM partners.





**In
      order to increase our international sales, we must increase the foreign language
      capacities of our Speech Products. If we are unable to do so, we may be unable
      to grow our revenue and execute our business strategy.**





We
      intend
      to expand our international sales, which requires a significant investment
      to
      create and refine different language models for each particular language or
      dialect. These language models are required to create versions of products
      that
      allow end users to speak the local language or dialect and be understood. If
      we
      fail to develop additional foreign language capacity of our Speech Products,
      our
      ability to benefit from international market opportunities and to grow our
      business will be limited.










23






**Our
      operations and financial condition could be adversely affected by our failure
      or
      inability to protect our intellectual property or if our technologies are found
      to infringe the intellectual property of a third party.**





*Dependence
      on proprietary technology*





Our
      success is heavily dependent upon our proprietary technology. Certain elements
      of our Core Technologies are the subject of seven patents issued and allowed
      by
      the United States Patent and Trademark Office and 10 other patent applications
      which are pending. In addition to our patents, we rely on a combination of
      copyright and trademark laws, trade secrets, confidentiality procedures and
      contractual provisions to protect our proprietary rights. Such means of
      protecting our proprietary rights may not be adequate because such laws provide
      only limited protection. Despite precautions that we take, it may be possible
      for unauthorized third parties to duplicate aspects of our technologies or
      the
      current or future products or technologies of our business units or to obtain
      and use information that we regard as proprietary. Additionally, our competitors
      may independently develop similar or superior technology. Policing unauthorized
      use of proprietary rights is difficult, and some international laws do not
      protect proprietary rights to the same extent as United States laws. Litigation
      periodically may be necessary to enforce our intellectual property rights,
      to
      protect our trade secrets or to determine the validity and scope of the
      proprietary rights of others.




*Risks
      of our infringement upon the technology of unrelated parties or
      entities*





We
      are
      not aware and do not believe that any of our technologies or products infringe
      the proprietary rights of third parties. Nevertheless, third parties may claim
      infringement with respect to our current or future technologies or products
      or
      products manufactured by others and incorporating our technologies. We expect
      that developers of speech-enabled technologies increasingly will be subject
      to
      infringement claims as the number of products and competitors in the industry
      grows and the functionality of products in different industry segments overlaps.
      Responding to any such claims, whether or not they are found to have merit,
      could be time consuming, result in costly litigation, cause development delays,
      or require us to enter into royalty or license agreements. Royalty or license
      agreements may not be available on acceptable terms or at all. As a result,
      infringement claims could have a material adverse affect on our business,
      operating results, and financial condition.





**Additional
      Risk Factors Associated with the Acquisition of LTEL Holdings
      Corporation**





On
      February 24, 2004, we acquired all of the capital stock of LTEL Holdings
      Corporation, a privately held Delaware corporation ("LTEL"). LTEL has two wholly
      owned operating subsidiaries, LecStar Telecom, Inc., an Atlanta-based CLEC,
      and
      LecStar DataNet, Inc., a provider of internet services to business and
      residential customers (collectively, "LecStar"). More information about the
      purchase of LecStar can be found in the "Business" Section. There are certain
      risks associated with the acquisition of LecStar which include, but are not
      limited to, the following risks.





**TELECOMMUNICATIONS
      REGULATION**





The
      following summary of regulatory developments and legislation does not purport
      to
      describe all present and proposed federal, state and local regulations and
      legislation affecting the telecommunications industry or the Company. Other
      existing federal and state legislation and regulations are currently the subject
      of judicial proceedings, legislative hearings and administrative proposals,
      which could change, in varying degrees, the manner in which this industry
      operates. Neither the outcome of these proceedings, nor their impact upon the
      telecommunications industry or the Company, can be predicted at this
      time





**Overview**





Our
      telecommunications operations are subject to federal, state, local and foreign
      laws, regulations, and orders affecting the rates, terms, and conditions of
      certain of our service offerings, our costs and other aspects of our operations,
      including our relations with other service providers. Regulation varies in
      each
      jurisdiction and may change in response to judicial proceedings, legislative
      and
      administrative proposals, government policies, competition and technological
      developments. We cannot predict what impact, if any, such changes or proceedings
      may have on our business or results of operations, and we cannot guarantee
      that
      regulatory authorities will not raise material issues regarding our compliance
      with applicable regulations.







24








**Congressional
      leaders have advanced draft versions of bills to modify, and partially replace
      the 1996 Telecommunications Act, which could have a material adverse impact
      on
      our telecommunications business and operations.**





The
      United Stated House of Representatives has drafted proposed legislation known
      as
      the Broadband Internet Transmission Services bill. This bill, which would
      substantially limit LecStar’s access to broadband services for resale to its
      customers, would have a material adverse effect on our business and operations.
      The likelihood of passage of this bill or similar legislation cannot be
      determined.





**The
      FCC decision to substantially limit ILEC obligations to provide access to
      unbundled network elements (UNEs) at cost-based rates has had a material effect
      on the way we conduct our business and operations and may have a material
      adverse effect on our profitability. Access to wholesale network elements will
      be at prices that are above cost-based rates and will have a material adverse
      effect on our profitability.**





The
      1996
      Telecommunications Act (the “1996 Act”)and FCC regulations adopted under the
      1996 Act impose additional duties on incumbent local exchange carriers
      (“ILECs”), including the duty to provide access on an unbundled basis to
      individual network elements on non-discriminatory terms and cost-based rates;
      to
      allow competitors to interconnect with their networks in a nondiscriminatory
      manner at any technically feasible point on their networks; to permit
      collocation of competitors' equipment at the ILECs premises; and to offer retail
      services at wholesale rates to competitive local exchange carriers (“CLECs”) for
      resale.





Access
      to
      ILECs' unbundled network elements at cost-based rates is critical to LecStar's
      business. Historically, LecStar’s local telecommunications services
      predominantly have been provided through the use of combinations of unbundled
      network elements, and it is the availability of cost-based rates for these
      elements that has enabled LecStar to price its local telecommunications services
      competitively. However, effective March 11, 2006, the ILECs may provide the
      unbundled network elements upon which LecStar has relied at significantly
      higher, non-cost-based rates for new services.





*Local
      Switching* :
      The FCC
      eliminated an ILEC’s obligation to provide local switching, and the unbundled
      network element platform ”UNE-P” in particular, upon which we have historically
      relied at favorable, cost-based rates. The FCC adopted a twelve-month transition
      plan for CLECs to transition away from the unbundled network element platform,
      which ended on March 10, 2006. The state Public Service Commissions in the
      states in which LecStar operates have considered this transition period, and
      Georgia has ruled that BellSouth has the obligation to continue to provide
      unbundled network elements under Section 271 of the 1996 Act (“271 UNEs”). These
      271 UNEs are expected to be available to LecStar at above cost-based rates,
      but
      below the commercial agreement rates offered to other carriers.





LecStar
      is serving its existing and new customers by using a combination of BellSouth
      Total Service Resale (a discount off of BellSouth retail rates for existing
      products which in most instances represents a substantially higher wholesale
      cost), BellSouth 271 UNEs, other wholesale switched access service providers,
      or
      by providing its own switched access services. There can be no guarantee that
      LecStar will be able to continue to obtain access to wholesale network elements,
      and any failure to obtain such access could result in a material adverse impact
      on LecStar’s operations and profitability.





*Local
      Loops and Transport* :
      The FCC
      also made impairment findings and placed certain limitations with respect to
      local loops and dedicated interoffice transport. The FCC established 10 DS1s
      and
      12 DS3s as the maximum transport a carrier can purchase from the ILEC per route.
      Furthermore, for local loops, the FCC concluded that CLECs are impaired without
      access to (1) DS1-capacity loops except in any building within the service
      area
      of a wire center containing 60,000 or more business lines and four or more
      fiber-based collocators; and (2) DS3-capacity loops except in any building
      within the service area of a wire center containing 38,000 or more business
      lines and four or more fiber-based collocations. The FCC determined that CLECs
      are not impaired without access to dark fiber loops in any instance. For
      dedicated transport, the FCC found that CLECs are impaired without access to
      (1)
      DS1 transport except on routes connecting a pair of wire centers where both
      wire
      centers contain at least four fiber-based collocators or at least 38,000
      business lines; and (2) DS3 or dark fiber transport except on routes connecting
      a pair of wire centers where both wire centers contain at least three
      fiber-based collocators or at least 24,000 business lines. The FCC concluded
      that CLECs are not impaired without access to entrance facilities connecting
      an
      ILEC's network with a CLEC's network in any instance. For both local loops
      and
      dedicated transport, the FCC adopted a twelve-month transition plan for CLECs
      to
      transition away from the use of DS1 and DS3 loops and dedicated transport where
      there is no impairment, and an eighteen-month transition plan to transition
      away
      from dark fiber.









25








In
      light
      of the FCC’s findings and limitations, LecStar will be required to serve its new
      loops and meet its transport requirements by using BellSouth Special Access
      circuits (at substantially higher wholesale rates) or other wholesale transport
      providers, to the extent that any acceptable alternatives are available. There
      can be no guarantee that LecStar will be able to profitably serve its customers
      using the BellSouth circuits or to locate alternate transport providers, which
      could result in a material adverse impact on LecStar’s operations and
      profitability. Additionally, because transport is a critical component required
      for offering local switching, the inability to locate alternative transport
      providers could have a material adverse impact on LecStar’s alternative option
      of providing switched access services.





**State
      actions to modify underlying TELRIC or cost based rates could have a material
      adverse impact on LecStar’s planned business.**





On
      February 21, 2006, the Georgia Public Service Commission (“GPSC”) voted on
      remand from the United States Circuit Court of Appeals of a BellSouth appeal
      related to the reduction of wholesale UNE rates for all carriers operating
      in
      the state. The GPSC was ordered to develop new rates based on a higher cost
      of
      capital in wholesale rates for the elements that CLECs purchase from ILECs.
      The
      court also ordered the GPSC to “make BellSouth whole” as far back as June 2003.
      The GPSC ordered that after the Georgia re-rate differences are calculated
      and
      back-billed to LecStar, the parties may petition the PSC for review of the
      interconnection agreement terms and conditions to ensure that such back-billing
      is permitted in the agreement. If permitted, this would represent a substantial
      new obligation of LecStar to BellSouth. The total potential obligation to
      BellSouth cannot accurately be predicted at this time.





On
      January 1, 2003, LecStar adopted the billing agreement **** of
      Momentum Communications which included very favorable North Carolina rates.
      LecStar utilized these rates to enter North Carolina and compete in residential
      markets not traditionally served by other carriers. On October 28, 2005, LecStar
      received a bill from BellSouth, back- billing LecStar at a higher rate based
      upon the September 2002 amendment to the contract signed by Momentum
      Communications for the period from the execution of its interconnection
      agreement to the present. While LecStar continues to dispute these charges,
      they
      represent a new unanticipated obligation of approximately $299,000 as of
      December 2005 to BellSouth if LecStar is unsuccessful in its efforts to disputes
      these charges.





**The
      unavailability of dedicated transport and other facilities at cost based rates
      could have a material adverse impact on our planned business
      operations.**





As
      we
      rely on competitive wholesale networks to the extent we are able to move off
      of
      the BellSouth infrastructure, the lack of availability of these dedicated
      transport facilities, dark fiber and entrance facilities under the FCC's rules
      at cost-based rates may adversely impact us if our wholesale providers seek
      to
      pass along the higher costs associated with buying tariffed offerings from
      BellSouth. We could be forced to use other means to effect this deployment,
      including the use of facilities purchased from the ILECs at higher tariffed
      special access rates. As a result, our cost of service could rise dramatically
      and our future plans for a service rollout for use of our own network facilities
      could be delayed substantially or derailed entirely.





**The
      reduced availability of high capacity loops and transport at cost based rates
      coupled with service disruptions and one-time charges associated with
      conversions of customers to competitive facilities could have a material adverse
      impact on our business.**





In
      anticipation of the recent developments regarding the FCC's unbundling rules,
      we
      installed a soft-switch and related collocation equipment in Georgia and North
      Carolina, using a combination of our own switching capacity and unbundled loop
      and dedicated interoffice transport facilities purchased from BellSouth and
      other providers. Reviews of the economic viability of this strategy resulted
      in
      a decision to delay our deployment of UNE-L services and to seek the use of
      competitive network facilities integrated with our switch for provision of
      VoIP
      through Fonix Telecom. We have established six collocations and will review
      establishing additional collocations as conditions warrant.









26








We
      believe the loss of the availability of high capacity circuits such as DS1
      and
      DS3 loops and transport at cost-based rates will result in materially higher
      prices on loops that we must purchase from either the ILECs or a competitive
      access provider. In April 2005, BellSouth issued its list of wire centers that
      are removed from the available list for transport and high capacity loops.
      The
      status of these wire centers will remain the focus of review by state regulators
      and is likely to be revised during the change of law cases underway before
      all
      state PSCs. We are currently evaluating the number of loops that will become
      unavailable at cost-based rates or the effect upon our alternative access plans,
      as well as our plans to mitigate these impacts.





**Our
      inability to negotiate new interconnection agreements, or extensions or
      replacements of existing interconnection agreements, on acceptable terms and
      conditions could adversely affect our results of operations.**





We
      have
      agreements for the interconnection of our networks with the networks of
      BellSouth and Sprint and are in negotiations with AllTel covering each market
      in
      which we serve customers. Our BellSouth interconnection agreement is the most
      significant agreement of this type. The term of the BellSouth agreement will
      expire on March 20, 2006. Upon expiration, the language in our current agreement
      states that LecStar will operate on BellSouth’s Standard Agreement. We may not
      be able to successfully negotiate amendments to existing agreements, negotiate
      new interconnection agreements, renew our existing interconnection agreements,
      opt into new agreements, or successfully arbitrate replacement agreements for
      interconnection on terms and conditions acceptable to us prior to the expiration
      of our current agreement. Our inability to do so could adversely affect our
      existing operations and opportunities to grow LecStar’s business in existing and
      new markets. If a new agreement cannot be reached in negotiations, LecStar
      can
      file an arbitration proceeding against BellSouth. Neither the outcome of such
      arbitrations nor their impact on LecStar can be predicted at this time.





**There
      can be no assurances that a negotiated commercial agreement or a similar
      agreement between BellSouth and LecStar regarding the use of ILEC switching
      can
      be reached.**





The
      FCC
      has encouraged ILECs and CLECs to engage in commercial negotiations to provide
      access to ILEC facilities that may no longer be available as unbundled network
      elements as a result of the withdrawal of unbundling obligations, including
      the
      unbundled network element platform. While we have engaged in general discussions
      with BellSouth, and have reviewed the agreements between BellSouth and certain
      other CLECs filed to date, we have been unable to reach any agreement, and
      there
      can be no assurances that we will be able to reach any agreement in the
      future.





**Fonix
      Telecom has signed an interconnection agreement and a commercial agreement
      to
      provide access to ILEC switching for new customers, but the market viability
      of
      products created on this new platform has not been proven.**





On
      September 15, 2005, Fonix Telecom, a new CLEC certified to offer local and
      long
      distance services in Georgia, South Carolina, North Carolina and Florida, signed
      a new interconnection agreement and commercial agreement with BellSouth for
      these states. The rates for services under the new commercial agreement are
      substantially higher for both monthly recurring and usage wholesale components
      than the UNE-P platform. The market viability of products created on this
      platform has not been proven and may result in marketing to more targeted market
      segments in the future. If the market does accept these new products, they
      are
      likely to generate a lower gross margin than the same or similar products
      delivered over the UNE-P platform, which would have an adverse impact on
      LecStar’s business.





**There
      can be no assurances that the recent Georgia public Service Commission decision
      establishing 271 Unbundled Network Element rates in Georgia will be sustained
      under appeal.**





On
      March
      8, 2006 the Georgia PSC issued an order that established rates for certain
      unbundled network elements. These unbundled network elements include local
      switching at rates above cost-based rates, but below the commercial agreement
      rates offered to most other carriers. To the extend that LecStar has a
      competitive advantage due to its access to 271 rates in Georgia, these rates
      are
      subject to a petition for reconsideration filed by BellSouth. The loss of these
      rates would have a material adverse impact on LecStar’s profitability. The
      outcome of the petition for reconsideration cannot reasonably be predicted
      at
      this time.









27








**FCC
      inter-carrier compensation rule changes could have a material adverse impact
      on
      our access revenues.**





As
      a
      local exchange provider, we bill long distance providers' access charges for
      the
      origination and termination of long distance providers' long distance calls.
      Our
      local exchange business benefits from the receipt of intrastate and interstate
      long distance traffic. As an entity that collects access charges, we must
      properly track and record the jurisdiction of our communications traffic and
      collect access charges accordingly. The result of any changes to the existing
      regulatory scheme for access charges or a determination that we have been
      improperly collecting access revenues could have a material adverse effect
      on
      Lecstar’s and Fonix Telecom’s business.





The
      FCC
      has indicated that its existing carrier compensation rules constitute
      transitional regimes that are not permanent and that they will be replaced
      in
      the near future with a new interstate, inter-carrier compensation regime based
      on bill-and-keep or another alternative. We cannot predict the impact that
      any
      such changes may have on LecStar’s and Fonix Telecom’s business.





**If
      our collection procedures prove to be insufficient or if a taxing or regulatory
      authority determines that our remittances are inadequate, we could be required
      to make additional payments, which could have a material adverse effect on
      our
      business.**





LecStar
      and Fonix Telecom are subject to numerous local, state and federal taxes and
      regulatory fees, including but not limited to a 3% federal excise tax on
      communications service, FCC regulatory fees and public utility commission
      regulatory fees. LecStar and Fonix Telecom have procedures in place to ensure
      that they properly collect taxes and fees from their customers. If LecStar’s and
      Fonix Telecom’s collection procedures prove to be insufficient or if a taxing or
      regulatory authority determines that their remittances were inadequate, they
      could be required to make additional payments, which could have a material
      adverse effect on their business.




LecStar
      and Fonix Telecom have routinely collected excise taxes pursuant to various
      state and federal laws and regulations. In some instances, they have not fully
      remitted these taxes to the relevant taxing authority and may be subject to
      their claims for penalties and interest. They have accrued these amounts and
      their estimate of penalties and interest is set forth in our consolidated
      financial statements.





On
      July
      2, 2004, the Internal Revenue Service issued an advance notice of proposed
      rulemaking asking for public comment on expanding the current 3% excise tax
      to
      new communications services, such as VoIP and other IP-based services,
      applications, and technologies, to reflect changes in technology. The comment
      cycle ended September 30, 2004. We cannot predict the outcome of this proceeding
      on LecStar’s and Fonix Telecom’s business.





**Should
      BellSouth prevail in its state PSC cases focused on the change of law clause
      of
      its interconnection agreements, that outcome could result in a materially
      adverse impact to LecStar.**





The
      Telecommunications Act of 1934 maintains the authority of individual states
      to
      impose their own regulation of rates, terms and conditions of intrastate
      services, so long as such regulation is not inconsistent with the requirements
      of federal law. Because LecStar provides communications services that originate
      and terminate within individual states, including both local service and
      in-state long distance toll calls, LecStar is subject to the jurisdiction of
      PSCs and other regulators in nine states: Alabama, Florida, Georgia, Kentucky,
      Louisiana, Mississippi, North Carolina, South Carolina and Tennessee. Some
      states are considering enactment of legislation that would deregulate ILECs
      broadband facilities and services. If such legislation became law, it could
      prevent state regulators from requiring that ILECs allow competitive carriers
      to
      interconnect with critical facilities used to provide broadband services on
      reasonable terms.









28








Following
      the issuance of the FCC’s ruling in February 2005, LecStar and other CLECs
      sought or supported motions for emergency relief in each of the nine states
      in
      which LecStar does business. On March 1, 2005, the Georgia PSC issued an order
      that requires BellSouth to pursue the change of law clause in the
      interconnection agreements with its competitors, including LecStar. This order
      and others like it in other states permit LecStar to continue to order unbundled
      network elements until LecStar’s interconnection agreement is modified. On March
      11, 2005, BellSouth challenged the Georgia PSC in an action before the United
      States District Court for the Northern District of Georgia. The District Court
      ruled in favor of BellSouth. LecStar and other CLECs appealed this ruling to
      United Stated Circuit Court of Appeals. The Circuit Court of Appeals affirmed
      the lower court’s ruling. No further action is anticipated. On March 14, 2005,
      BellSouth sent, via email, a change of law notification to LecStar requesting
      that the 90-day change of law negotiation period begin. These negotiations
      are
      pending the resolution of the generic change of law cases before each state
      PSC,
      assisting the parties with interpretation of the issues between LecStar and
      the
      ILEC related to implementation of the FCC’s order in the context of state and
      federal law. These hearings are important because they establish a number of
      critical issues with material impacts on LecStar including whether or not the
      PSCs have authority to establish rates for unbundled elements under Section
      271
      of the 1996 Act. On
      March
      8, 2006, Georgia, the largest state of operations for LecStar, ruled in favor
      of
      establishing a rate for access to unbundled network elements at a rate below
      the
      commercial agreement rate offered to other carriers. BellSouth is likely to
      appeal this decision and the outcome of the appeal cannot be determined at
      this
      time. Several other states have ruled that they did not have the authority
      to
      set such a rate, while several states such as Tennessee, Kentucky and
      Mississippi have not yet decided the issue. The
      ultimate outcome and impacts on operations and profitability of LecStar as
      a
      result of the various state rulings and any associated appeals cannot currently
      be predicted.





**Failure
      to reach a negotiated settlement with BellSouth on disputed payables over the
      past three years could result in a materially adverse impact on our
      business.**





BellSouth
      and LecStar have been engaged in settlement discussions that would create a
      global settlement to all disputed payables and establish a credit to the company
      as well as a payment schedule for unpaid balances. Failure to reach this
      agreement could result in a materially adverse impact on our business and would
      require lengthy and expensive arbitration in nine states with no certainty
      of
      the outcome of any of these proceedings, or the terms under which each state
      might offer BellSouth for repayment of the arbitrated settlement.





**Change
      of control of BellSouth in its proposed merger with AT&T and the resulting
      consolidation of operational and regulatory staff and systems to AT&T could
      have a material adverse impact on our business.**





The
      proposed AT&T acquisition of BellSouth puts all significant negotiations
      with BellSouth in doubt of proceeding rapidly or being halted entirely during
      the acquisition process. Once the acquisition is complete, if not earlier,
      the
      new AT&T may be more difficult to negotiate with and the new management team
      could reverse terms and conditions that BellSouth may have agreed to previously.
      In addition, consolidation of systems and personnel may require both LecStar
      and
      Fonix Telecom to re-engineer its processes to interface with new electronic
      ordering systems and procedures, requiring new investment and training of
      personnel.





**LecStar
      and Fonix Telecom’s continued success depends on their ability to manage and
      expand operations effectively.**





LecStar
      and Fonix Telecom’s ability to manage and expand their
      telecommunicationsoperations effectively will depend on a variety of factors,
      including their ability to: offer high-quality, reliable services to their
      customers at reasonable costs; install and operate telecommunications equipment;
      acquire necessary equipment, software and facilities; scale operations; evaluate
      markets; monitor operations; control costs; maintain effective quality controls;
      hire, train and retain qualified personnel; enhance operating and accounting
      systems; address operating challenges; adapt to market and regulatory
      developments; and obtain and maintain required governmental authorizations.
      For
      them to succeed, they must achieve these objectives in a timely manner and
      on a
      cost-effective basis. If they do not achieve these objectives, they may not
      be
      able to compete in our existing markets or expand into new markets. A failure
      to
      achieve one or more of these objectives could have a material adverse effect
      on
      LecStar and Fonix Telecom’s telecommunicationsoperations and business.





In
      addition, LecStar has grown rapidly since its inception and we expect it to
      continue to grow by expanding its product offerings. We expect LecStar’s growth
      to place a strain on operational, human and financial resources, particularly
      if
      LecStar and/or Fonix Telecom grow through acquisitions. Their ability to manage
      operations and expansion effectively depends on the continued development of
      plans, systems and controls for their operational, financial and management
      needs. There can be no assurance that LecStar and/or Fonix Telecom will be
      able
      to satisfy these requirements or otherwise manage their operations and growth
      effectively. A failure to satisfy these requirements could have a material
      adverse effect on their financial condition and ability to fully implement
      their
      growth and operating plans.









29








**A
      failure to effectively manage processes and systems for ordering, provisioning
      and billing, or the failure of third parties to deliver these services on a
      timely and accurate basis, could have a material adverse effect on the ability
      of LecStar and Fonix Telecom to retain their existing customers or to attract
      and retain new customers.**





LecStar
      and Fonix Telecom have processes and procedures and are working with external
      vendors, including the ILECs, to implement customer orders for services, the
      provisioning, installation and delivery of services, and monthly billing for
      those services. LecStar and Fonix Telecom’s inability to effectively manage
      processes and systems for these service elements or the failure of the vendors
      serving ILECs to deliver ordering, provisioning and billing services on a timely
      and accurate basis could have a material adverse effect on their ability to
      retain our existing customers or attract and retain new customers.





**System
      disruptions could cause delays or interruptions of service, which could cause
      LecStar and Fonix Telecom to lose customers.**





LecStar
      and Fonix Telecom’s success depends on providing reliable service. Although
      LecStar and Fonix Telecom have designed customer service system to minimize
      the
      possibility of service disruptions or other outages, their service may be
      disrupted by problems on their system, such as malfunctions in their software
      or
      other facilities, and by problems with a competitor's system, such as physical
      damage to telephone lines or power surges and outages. Any disruption in
      networks could cause LecStar and Fonix Telecom to lose customers and incur
      additional expenses.





**LecStar
      and Fonix Telecom are dependent on third parties for acquiring customers and
      providing access to their networks for providing service to our
      customers.**




LecStar
      and Fonix Telecom have arrangements with numerous independent parties to market
      their services to potential customers. LecStar and Fonix Telecom are highly
      dependent on these relationships for their success. LecStar and Fonix Telecom’s
      agreements with utility companies provide us the exclusive right to provide
      services to their customers; however, these agreements do contain termination
      provisions. If any of these relations were to terminate, it could result in
      a
      material adverse effect on their business, financial condition, and results
      of
      operations. LecStar and Fonix Telecom’s agreements with other independent third
      parties for the acquisition of customers are non-exclusive. These entities
      are
      not under any obligation to continue to acquire customers for LecStar and Fonix
      Telecom.





LecStar
      and Fonix Telecom are dependent on local exchange carriers for co-location
      of
      equipment space, which may not be available on reasonable terms and in a timely
      manner. As explained in detail above, they are dependent on unbundled network
      elements from local exchange carriers and additional services from other
      telecommunication providers. They are also dependent on the efficient and smooth
      interface between their information systems and those of the local exchange
      carriers for certain processing functions and customer support. If their access
      to these systems or network elements were to be disrupted, it could cause a
      material adverse impact on their business.





**We
      may not be able to retain customers.**





A
      significant portion of LecStar and Fonix Telecom’s customers, especially
      residential customers, are not subject to any contractual obligations to
      continue to use LecStar and Fonix Telecom’s telecommunication services. These
      customers may switch telecommunication service providers at will. Furthermore,
      customers who have executed a contract with LecStar and Fonix Telecom may
      terminate if LecStar and Fonix Telecom are not able to provide acceptable
      quality of telecommunication service. The loss of any significant number of
      customers would adversely affect their results of operations and financial
      condition. Adverse regulatory rulings may also result in increased retail prices
      for both new and existing customers and increased customer churn
      rates.





**LecStar’s
      existing method of providing service is susceptible to development of new
      technologies by competitors.**









30








There
      exist other technologies that provide greater bandwidth than LecStar’s methods
      of transmission and may be used instead of LecStar’s services. Significant
      penetration of these alternative technologies into LecStar’s target market may
      reduce the demand for LecStar’s services and harm its business. Existing
      alternative technologies include:





• Digital
      Subscriber Line Technology. Digital subscriber line technology was developed
      to
      produce higher data transfer rates over the existing copper-based telephone
      network. The data transfer rates for digital subscriber lines are reported
      to
      range between 144,000 bits of data per second and six million bits of data
      per
      second.





• Cable
      Modems. Cable modems can allow users to send and receive data using cable
      television distribution systems. According to industry sources, cable modem
      users typically experience download speeds of 1.5 million bits of data per
      second.





• Wireless
      Technologies. Wireless technologies, such as satellite and microwave
      communications systems can provide high-speed data communications. Not only
      are
      wireless technologies commercially deployed, there are significant tests
      underway to increase the bandwidth and availability of wireless
      technologies.





• Integrated
      Serviced Digital Networks. Integrated services digital networks have been
      offered by the incumbent local telephone companies over the existing
      copper-based telephone network for some time. These services offer data transfer
      speeds of 128,000 bits of data per second.





• Voice
      Over Internet Protocol. Voice over internet protocol usually permits broadband
      users to place and receive local and long distance calls using the Internet.
      When compared to traditional wireline services, VOIP is usually less
      expensive.





• Power
      Line Carrier. Providing telecommunication service using electrical utilities'
      infrastructure has been successfully deployed in Europe for a number of years;
      however, in the United States this technology has experienced limited commercial
      deployment to date. Several entities are researching this technology and have
      announced plans to launch testing its commercial viability.





**There
      may be additional unknown risks, which could have a negative effect on our
      business.**





The
      risks
      and uncertainties described in this section are not the only ones facing us.
      Additional risks and uncertainties not presently known to us or that we
      currently deem immaterial may also impair our business operations. If any of
      the
      foregoing risks actually occur, our business, financial condition, or results
      of
      operations could be materially adversely affected.





**ITEM
              1b.**
            **UNRESOLVED
                STAFF COMMENTS**





None.




**ITEM
              2.**
            **PROPERTIES**





We
      own no
      real property. We
      lease
      approximately 14,200 square feet of office space in Sandy, Utah, where Fonix
      Speech conducts its principal scientific research, product development and
      sales
      and marketing activities. Our lease of that facility expires August 31, 2010.
      The average base monthly lease payment over the five-year life of the lease
      is
      $26,000 .





We
      lease
      approximately 3,160 square feet of office space in Maynard, Massachusetts,
      where
      Fonix Speech conducts sales and marketing activities and development for certain
      Core Technologies. This lease expires December 31, 2007. The average base
      monthly lease payment over the two-year life of the lease is
      $2,900.





LecStar
      leased 16,511 square feet of space in Atlanta, Georgia for Fonix Telecom and
      LecStar’s operations. The base monthly lease payment for the lease was $26,000.
      This lease expired on February 28, 2005. Commencing in February 2005, LecStar
      entered into a sub-lease for 10,895 square feet of space in Atlanta, Georgia
      for
      Fonix Telecom and LecStar’s operations. This lease expires on July 31, 2008. The
      base
      monthly lease payment for the lease is $15,000. LecStar also leases 7,029 square
      feet of space in Atlanta, Georgia, for Fonix Telecom and LecStar’s call center
      operations. This lease expires on July 31, 2008. The base monthly lease payment
      for the lease is $9,000. LecStar also leases telecommunications property in
      its
      operating territories that include







31








§
            switches;


§
            high
                capacity digital lines that interconnect LecStar’s network with incumbent
                local exchange carrier networks;


§
            high
                capacity digital lines that connect LecStar’s switching equipment to its
                transmission equipment located in incumbent local exchange carrier
                central
                offices;


§
            local
                loop lines which connect LecStar’s customers to its network;
                and


§
            leasing
                space in incumbent local exchange carrier central offices for collocating
                LecStar’s transmission equipment





We
      believe that the facilities and equipment described above are generally in
      good
      condition, are well maintained, and are generally suitable and adequate for
      our
      current and projected operating needs.







**ITEM 3.**
            **LEGAL
                PROCEEDINGS**





**Grenfell
      Litigation** - Two of
      our subsidiaries, LecStar Telecom and LecStar DataNet (collectively “LecStar”),
      are among the defendants who were sued in the Superior Court of Fulton County,
      State of Georgia, by James D. Grenfell, the former CFO of the former parent
      of
      LecStar. The suit was filed in December 2003. The plaintiff in that case alleged
      that he had an unpaid judgment in the amount of $1,015,000 plus interest against
      the former parent entities of LecStar and that the purpose of a transfer of
      the
      stock and business of LecStar in December 2002 was to avoid paying the judgment.
      The plaintiff sought a preliminary injunction prior to our acquisition of
      LecStar in February 2004. The Georgia state trial court denied the plaintiff's
      motion for injunctive relief. The plaintiff did not appeal. In September 2005,
      the plaintiff dismissed the action in Fulton County. In December 2005, the
      plaintiff reasserted his claim in the Superior Court of Cobb County, State
      of
      Georgia, and, in addition to LecStar, the plaintiff named Fonix and LTEL
      Holdings as defendants in the new lawsuit. Fonix is the sole shareholder of
      LTEL
      Acquisition Corporation which is the sole shareholder of LTEL Holdings. Among
      other things, the plaintiff is seeking an attachment of stock and assets of
      LecStar, to unwind the previous transfer of the stock and business of LecStar
      in
      December 2002, and for money damages.





Fonix
      and
      LecStar have only recently been served with the summons and complaint in the
      new
      lawsuit. As yet no answers or other responsive pleadings have been filed. Fonix
      and LecStar intend to aggressively defend against these claims. No assessment
      currently can be made of the likelihood of an unfavorable outcome.





**First
      Empire** - Claims
      similar to the claims brought in the Grenfell litigation were also asserted
      by
      other plaintiffs in First Empire Corporation, et al., v. LecStar Corporation,
      et
      al., filed in the Superior Court of Fulton County, State of Georgia. In the
      third amended complaint filed in October 2005, the plaintiffs named W. Dale
      Smith, Chad Smith, Michael Britt, and LTEL Holdings Corporation as defendants.
      Messrs Smith and Britt are former officers and directors of the former parent
      of
      LecStar, and are presently employees of LecStar. LTEL Holdings was the sole
      shareholder of LecStar when acquired by us in February 2003. In the third
      amended complaint, the plaintiffs allege that Dale Smith breached his fiduciary
      duty to the former parent of LecStar by participating in the transaction in
      which the parent lost control of LecStar, that LTEL procured that alleged
      wrongful conduct from Smith, that the transaction in which the former parent
      lost control of LecStar was a fraudulent conveyance, and that a constructive
      trust should be imposed on LecStar for the benefits of the
      plaintiffs.





Messrs.
      Smith and Britt and LTEL have filed an answer in the litigation. Messrs. Smith
      and Britt and LTEL have not been involved in discovery in this litigation
      because the litigation is in the early stages. Nonetheless, management believes
      that the claims of the plaintiffs are without merit, and management intends
      to
      vigorously defend against the claims of the plaintiffs.





The
      principal Series H preferred stockholder has placed 300 shares of Series H
      Preferred Stock in escrow (the “Escrow Shares”) for a period of 12 months from
      the date of acquisition as protection with respect to breaches of
      representations and warranties of the LTEL selling stockholders, including
      any
      liability or payment that may arise from the above mentioned legal action.
      As a
      result of the filing of the First Empire Litigation, we have asserted a claim
      for breach of certain representations and warranties. To our knowledge, the
      Escrow Shares have not been released.







32








**Greenwich
      Insurance Action** - The
      Greenwich litigation is an action filed in the United States District Court
      for
      the Northern District of Georgia, in which Greenwich Insurance Company is
      seeking a declaratory judgment against the directors and officers of the former
      parent entity of LecStar and others. Greenwich seeks an order that it is not
      liable for coverage under its directors and officers’ liability policy for
      claims asserted in the First Empire litigation against several individuals
      who
      were officers and directors of LecStar, including W. Dale Smith, Michael Britt
      and Chad Smith, all of whom are currently employed by LecStar. Greenwich also
      seeks recovery of fees advanced to law firms on behalf of these individuals
      for
      defense costs associated with the First Empire litigation, which Greenwich
      claims are in excess of $100,000. LecStar Telecom has agreed to assume defense
      costs incurred on behalf of Messrs. Smith and Britt in the Greenwich litigation.
      No answers or other responsive pleadings have been filed. It is our intent
      to
      aggressively defend against the plaintiff’s claims. However, Messrs. Smith and
      Britt may experience exposure to the loss of insurance coverage presently
      afforded under the policy of insurance provided by Greenwich. In that case,
      LecStar may have exposure for any liability associated with indemnity claims
      from the officers and directors arising from previously advanced and future
      defense costs, as well as the costs of defending the Greenwich claim
      itself.





**Settlement
      of Breckenridge Lawsuits** - On
      September 27, 2005, we agreed with The Breckenridge Fund, LLC (“Breckenridge”)
      to settle and discontinue the three pending legal actions between us and
      Breckenridge. The three actions pending in the Supreme Court of New York, Nassau
      County, involved (i) the Company’s claims against Breckenridge for the improper
      transfer to and subsequent sale of shares of the Company’s common stock by
      Breckenridge; (ii) Breckenridge’s claims against the Company for failure to
      honor conversion notices or properly issue shares upon conversion of the
      Company’s Series I 8% Convertible Preferred Stock (the “Series I Preferred”) by
      Breckenridge; and (iii) Breckenridge’s claims that the Company breached
      agreements in connection with the Series I Preferred, and that pursuant to
      a
      security agreement, Breckenridge was entitled to damages and possession of
      the
      pledged collateral (collectively, the “Breckenridge Lawsuits”).





Pursuant
      to the Settlement of the Breckenridge Lawsuits, we entered into a Mutual Release
      of Claims Agreement (the “Mutual Release”), pursuant to which we and
      Breckenridge agreed to settle and dismiss the Breckenridge Lawsuits, and to
      release any and all claims against each other relating to any prior transactions
      between us and Breckenridge. Pursuant to the Mutual Release, Breckenridge agreed
      to assign the remaining shares of Series I Preferred to Southridge Partners,
      LP,
      to release its security interest in the Company’s intellectual property, and to
      stipulate to the discontinuance with prejudice of the Breckenridge Lawsuits.
      We
      agreed to pay to Breckenridge installment payments (the “Periodic Payments”)
      consisting of monthly payments of $130,000 from November 2005 through April
      2006, and monthly payments of $165,000 from May 2006 through December 2006,
      as
      well as approximately $397,000 which we had previously paid into an escrow
      account in connection with the Breckenridge Lawsuits.





We
      also
      entered into an agreement (the “Assignment Agreement”) with Breckenridge and
      Southridge Partners, LP (“Southridge”) whereby Breckenridge agreed to assign to
      Southridge all remaining shares of the Company’s Series I Preferred, consisting
      of 1,172 shares, together with all of Breckenridge’s rights, interests, duties,
      and obligations which Breckenridge received in connection with the purchase
      from
      the Company of the Series I Preferred. Southridge paid $1,203,000 for
      Breckenridge’s rights to the Series I Preferred Stock and accepted the
      assignment of the shares of Series I Preferred and all assigned rights,
      interests, duties, and obligations, and we consented to the
      assignment.





The
      effect of the Assignment Agreement was to terminate our rights, duties, and
      obligations relating to the Series I Preferred with respect to Breckenridge,
      and
      to enter into a new agreement relating to such rights, duties, and obligations
      with Southridge.









33








Additionally,
      we entered into a Security Agreement with Breckenridge relating to certain
      of
      our obligations in connection with the agreement with Breckenridge to
      discontinue the Breckenridge Lawsuits. Pursuant to the settlement agreement
      between the parties, we are required to make the Periodic Payments to
      Breckenridge. To secure those payments, we granted to Breckenridge a security
      interest in the proceeds that we receive in connection with draws on the Seventh
      Equity Line of Credit and any subsequent equity line-type financings in the
      event that we do not make a Periodic Payment when due. Specifically, we granted
      to Breckenridge the right to receive proceeds from our draws on the Seventh
      Equity Line and any subsequent equity line-type financings to the extent that
      we
      do not make a payment as required and after the applicable grace period or
      cure
      period has run. With respect to future equity line-type financings, we agreed
      to
      include in the documentation of such financings provisions granting to
      Breckenridge the right to make draws and to receive funds directly from the
      equity line provider in the event that we fail to make a payment as required,
      and then only to the extent of the amount of the payment. Our payment
      obligations which are secured under the Security Agreement consist of the
      monthly payments of $130,000 from November 2005 through April 2006, and the
      monthly payments of $165,000 from May 2006 through December 2006.





We
      are
      involved in other 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 other matters will not materially affect our
      consolidated financial position, liquidity, or results of
      operations.





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





As
      of the
      date of this report, the Company had not yet held its 2005 annual meeting.
      The
      Company anticipates holding the 2005 annual meeting in conjunction with the
      2006
      annual meeting to be held in May 2006.

























































34







**PART
      II**





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





***Market
      information***





Our
      Class
      A common stock is listed on the OTC Bulletin Board under the trading symbol
      FNIX. The following table shows the range of high and low sales price
      information for our Class A common stock as quoted on the OTC Bulletin Board
      for
      the calendar years 2004 and 2005 and for the first quarter of 2006, through
      March 10, 2006. The quotations reflect inter-dealer prices, without retail
      mark-up, mark-down or commissions and may not represent actual transactions.
      The
      quotations also do not reflect price adjustments related to the Reverse Stock
      Split (see "Reverse Stock Split" below).





**Calendar
                Year**2006
            
            2005
            
            2004High
            
            Low
            
            High
            
            Low
            
            High
            
            LowFirst
                Quarter*
            
            $
            0.03
            
            $
            0.02
            
            $
            0.19
            
            $
            0.04
            
            $
            0.66
            
            $
            0.28Second
                Quarter
            
            
            
            
            
            
            
            $
            0.11
            
            $
            0.02
            
            $
            0.32
            
            $
            0.22Third
                Quarter
            
            
            
            
            
            
            
            $
            0.07
            
            $
            0.03
            
            $
            0.28
            
            $
            0.13Fourth
                Quarter
            
            
            
            
            
            
            
            $
            0.03
            
            $
            0.02
            
            $
            0.28
            
            $
            0.14*Through
                March 10, 2006





The
      high
      and low sales prices for our Class A common stock on March 10, 2006, were $0.02
      and $0.02, respectively. As of March 10, 2006, there were 481,309,000 shares
      of
      Fonix Class A common stock outstanding, held by approximately 1,411 holders
      of
      record and approximately 37,000 beneficial holders. This number of beneficial
      holders represents an estimate of the number of actual holders of our stock,
      including beneficial owners of shares held in "nominee" or "street" name. The
      actual number of beneficial owners is not known to us.





We
      have
      never declared any dividends on our Class A common stock and it is expected
      that
      earnings, if any, in future periods will be retained to further the development
      and sale of our Core Technologies and products. No dividends can be paid on
      our
      common stock until such time as all accrued and unpaid dividends on our
      preferred stock have been paid.





**Recent
      Sales of Unregistered Equity Securities**





***Equity
      Lines of Credit*** *-* For the
      year ended December 31, 2003, we received $7,382,000 in funds and a subscription
      receivable of $245,000 drawn under the fifth equity line, less commissions
      and
      fees of $291,000, and issued 25,494,145 shares of Class A common stock to the
      Equity Line Investor. The shares were issued without registration under the
      1933
      Act in reliance on Section 4(2) of the 1933 Act and the rules and regulations
      promulgated thereunder. The resales of the shares were subsequently registered
      under a registration statement on Form S-2.





For
      the
      year ended December 31, 2004, we received $12,618,000 in funds drawn under
      the
      Fifth Equity Line, less commissions and fees of $413,000, and issued 54,768,198
      shares of Class A common stock to the Equity Line Investor. The shares were
      issued without registration under the 1933 Act in reliance on Section 4(2)
      of
      the 1933 Act and the rules and regulations promulgated thereunder. The resales
      of the shares were subsequently registered under a registration statement on
      Form S-2.





** For
      the
      year ended December 31, 2005, we issued 5,480,405 shares of Class A common
      stock
      to the Equity Line Investor in full satisfaction of an outstanding put under
      the
      Fifth Equity Line of $668,000. The shares were issued without registration
      under
      the 1933 Act in reliance on Section 4(2) of the 1933 Act and the rules and
      regulations promulgated thereunder. The resales of the shares were subsequently
      registered under a registration statement on Form S-2.










35








For
      the
      year ended December 31, 2005, we received $4,263,000 in funds drawn under the
      Sixth Equity Line, less commissions and fees of $141,000 and issued 75,000,000
      shares of Class A common stock to the Equity Line Investor. The shares were
      issued without registration under the 1933 Act in reliance on Section 4(2)
      of
      the 1933 Act and the rules and regulations promulgated thereunder. The resales
      of the shares were subsequently registered under a registration statement on
      Form S-1.





For
      the
      year ended December 31, 2005, we received $3,127,000 in funds drawn under the
      Seventh Equity Line, less commissions and fees of $106,000 and issued
      100,000,000 shares of Class A common stock to the Equity Line Investor. The
      shares were issued without registration under the 1933 Act in reliance on
      Section 4(2) of the 1933 Act and the rules and regulations promulgated
      thereunder. The resales of the shares were subsequently registered under a
      registration statement on Form S-1.





Subsequent
      to December 31, 2005 and through March 10, 2006, we received $1,000,000 in
      funds
      drawn under the Seventh Equity Line, less commissions and fees of $34,000 and
      issued 50,252,421 shares of class A common stock to the Equity Line Investor.
      The shares were issued without registration under the 1933 Act in reliance
      on
      Section 4(2) of the 1933 Act and the rules and regulations promulgated
      thereunder. The resales of the shares were subsequently registered under a
      registration statement on Form S-1.





***Stock
      Issued for Services*** *-* On
      February 11, 2004, we issued 900,000 shares of Class A common stock to our
      legal
      counsel in payment of services rendered. We also issued 813,423 shares to
      consultants as payment for services rendered.





***Series
      I Preferred*** **Stock** - On
      October 24, 2003, we entered into a private placement of shares of our Class
      A
      common stock with The Breckenridge Fund, LLC, a New York limited liability
      company (“Breckenridge”). Under the terms of the private placement, we agreed to
      sell 1,043,478 shares of our Class A common stock for $240,000 (the “Private
      Placement Funds”). The shares were issued without registration under the 1933
      Act in reliance on Section 4(2) of the Securities Act of 1933, as amended (the
      “1933 Act”), and the rules and regulations promulgated thereunder.





Subsequent
      to our receiving the Private Placement Funds, but before any shares were issued
      in connection with the private placement, we agreed with Breckenridge to rescind
      the private placement of the shares and to restructure the transaction. We
      retained the Private Placement Funds as an advance in connection with the
      restructured transaction. We paid no interest or other charges to Breckenridge
      for use of the Private Placement Funds.





Following
      negotiations with Breckenridge, we agreed to sell to Breckenridge 3,250 shares
      of our Series I 8% Convertible Preferred Stock (the “Preferred Stock”), for an
      aggregate purchase price of $3,250,000, net of the Private Placement Funds
      which
      we had already received. The sale of the Preferred Stock to Breckenridge closed
      on January 30, 2004.





In
      connection with the offering of the Preferred Stock, we also issued to
      Breckenridge (i) warrants (the “Warrants”) to purchase up to 965,839 additional
      shares of our Class A common stock; (ii) 1,931,677 shares of our Class A common
      stock (the “Additional Shares”); and (iii) 482,919 shares of our Class A common
      stock (the “Fee Shares”). The shares of Series I Preferred Stock, the Warrants,
      the Additional Shares, and the Fee Shares were issued without registration
      under
      the 1933 Act in reliance on Section 4(2) of the 1933 Act and the rules and
      regulations promulgated thereunder. We filed a registration statement on Form
      S-2 to register the resales of the shares underlying the Warrants and the Series
      I Preferred Stock, as well as the Additional Shares and the Fee Shares on March
      5, 2004.





For
      the
      year ended December 31, 2004, we issued 8,435,869 shares of our Class A common
      stock upon conversion of 1,000 shares of our Series I Preferred
      Stock.





For
      the
      year ended December 31, 2005, we issued 18,482,083 shares of our Class A common
      stock upon conversion of 1,078 shares of our Series I Preferred Stock.













36






***Series
      J Preferred Stock*** *-* Effective
      September 30, 2005, the Company entered into a 5% Series J Convertible Preferred
      Stock Exchange Agreement (the "Exchange Agreement") with Southridge Partners,
      LP
      ("Southridge"), a Delaware limited partnership. Pursuant to the Exchange
      Agreement, Southridge exchanged all of the shares of 8% Series I Convertible
      Preferred Stock that it acquired from Breckenridge for 1,452 shares of the
      Company's 5% Series J Convertible Preferred Stock (the "Series J Preferred
      Stock"). The Series J Preferred Stock has a stated value of $1,000 per
      share.





For
      the
      year ended December 31, 2005, we issued 3,795,918 shares of our Class A common
      stock upon conversion of 93 shares of our Series J Preferred Stock.





Subsequent
      to December 31, 2005 and through March 10, 2006, we issued 23,100,000 shares
      of
      our Class A common stock upon conversion of 231 shares of our Series K Preferred
      Stock.





***LecStar
      Acquisition*** *-* On
      February 24, 2004, we acquired all of the capital stock of LTEL Holdings
      Corporation (“LTEL”) and its wholly-owned subsidiaries, LecStar Telecom, Inc.,
      and LecStar DataNet, Inc. (collectively “LecStar”). The results of LecStar's
      operations are included in the consolidated financial statements from February
      24, 2004. We acquired LecStar to provide us with a recurring revenue stream,
      a
      growing customer base, new marketing channels for our Core Technologies and
      Speech Products, and to reduce the cost of capital.





In
      accordance with FAS No. 141, “Business Combinations,” the aggregate purchase
      price was $12,800,000 and consisted of the issuance of 7,036,802 shares of
      Class
      A common stock valued at $4,176,000 or $0.59 per share, 2,000 shares of 5%
      Series H nonvoting, nonconvertible preferred stock (the “Series H Preferred
      Stock”) with a stated value of $10,000 per share valued at $4,000,000, and a 5%
      $10,000,000 secured, six-year promissory note (the “Note”) valued at $4,624,000.
      The number of shares of Class A common stock issued under the terms of the
      purchase agreement was determined by dividing $3,000,000 by 90 percent of the
      average closing bid price of our common stock for the first 30 of the 33
      consecutive trading days immediately preceding the date certain regulatory
      approvals were deemed effective. Under the terms of the acquisition agreement,
      the number of Class A common shares was determinable on February 19, 2004.
      Accordingly, the value of the shares of Class A common stock was established,
      in
      accordance with SFAS No. 141, as the average market price of the Fonix common
      stock over the three-day period through February 19, 2004. The values of the
      Series H Preferred Stock and the Note were determined based on the estimated
      risk-adjusted cost of capital to Fonix at the date of the acquisition. The
      fair
      value of the Series H Preferred Stock was based on an imputed yield rate of
      25
      percent per annum, and the discount on the Note of $5,376,000 was based on
      an
      imputed interest rate of 25 percent per annum.





The
      purchase price was allocated to the assets acquired and liabilities assumed
      based on their estimated fair values. Negative goodwill was not recognized
      in
      connection with the acquisition of LecStar. Instead, the excess of the fair
      value of the net assets over the purchase price was allocated as a pro rata
      reduction of the amounts that otherwise would have been assigned to the
      long-term assets. At February 24, 2004, the purchase price was allocated to
      the
      assets acquired and the liabilities assumed as follows:





Current
                Assets
            
            $
            2,390,000Investments
            
            
            237,000Property
                and equipment
            
            
            148,000Deposits
                and other assets
            
            
            984,000Intangible
                assets
            
            
            18,500,000Total
                assets acquired
            
            
            22,259,000Current
                liabilities
            
            
            (8,923,000
            )Long-term
                portion of notes payable
            
            
            (536,000
            )Total
                liabilities assumed
            
            
            (9,459,000
            )Net
                Assets Acquired
            
            $
            12,800,000





Of
      the
      $18,500,000 of acquired intangible assets, $1,110,000 was assigned to LecStar's
      brand name, which has an indefinite life and therefore is not subject to
      amortization; $14,430,000 was assigned to the local telephone exchange customer
      base, with a 2.9-year weighted-average useful life; and $2,960,000 was assigned
      to established marketing contracts and agreements with utility companies, with
      a
      1.8-year estimated useful life. Total intangible assets subject to amortization
      have a weighted-average useful life of approximately 2.7 years.







37








Dividends
      on the stated value of the outstanding Series H Preferred Stock are payable
      at
      the rate of 5% per annum as and when declared by the Board of Directors. The
      annual dividend requirement is $1,000,000. If dividends are declared on our
      common stock, as a condition of that dividend, we are required to pay three
      percent of the aggregate amount of such dividend to the holders of the Series
      H
      Preferred Stock. Dividends on the Series H Preferred Stock and interest on
      the
      Note are payable in cash or, at our option, in shares of Class A common stock.
      We have registered the Class A common stock issued in the acquisition and
      12,000,000 additional shares of Class A common stock issuable as payment of
      interest on the Note and as dividends on the Series H Preferred Stock. The
      Note
      is secured by the assets and capital stock of our subsidiary and the capital
      stock of LTEL and LecStar.





We
      have
      the option, but not the obligation, exercisable at any time, to redeem all
      or
      any portion of the outstanding Series H Preferred Stock. The redemption price
      is
      equal to any accumulated dividends on the redeemed shares plus a percentage
      of
      the $10,000 per share stated value of the redeemed shares, based on the date
      the
      redemption occurs in relation to the original issuance date as follows: before
      the second anniversary - 102%; thereafter but before the third anniversary
      -
      104%; thereafter but before the fourth anniversary - 106% and thereafter -
      108%.
      If shares of Series H Preferred Stock are redeemed, additional Series H
      preferred dividends will be recognized on the date of redemption in an amount
      equal to the difference between the amount paid to redeem the shares and their
      original fair value at the date of issuance of $2,000 per share.





The
      principal Series H preferred stockholder has placed 300 shares of Series H
      Preferred Stock in escrow (the “Escrow Shares”) for a period of 12 months from
      the date of acquisition as protection with respect to breaches of
      representations and warranties of the LTEL selling stockholders, including
      any
      liability or payment that may arise from the above mentioned legal action.
      As a
      result of the filing of the First Empire Litigation, we have asserted a claim
      for increase of certain representations and warranties. To our knowledge, the
      Escrow Shares have not been released from escrow.





For
      the
      year ended December 31, 2004, we issued 833,334 shares of our Class A common
      stock as payment on the Note and 1,666,667 shares of our Class A common stock
      as
      dividend payments on our Series H Preferred Stock.





For
      the
      year ended December 31, 2005, we issued 29,417,578 shares of our Class A common
      stock as payment of principal and interest on long-term debt of $1,248,000
      and
      27,275,299 shares of our Class A common stock as payment of $1,113,000 of
      dividends on Series H Preferred Stock.





There
      have been no repurchases of equity securities by Fonix during the years ended
      December 31, 2005, 2004 or 2003.
























38







**ITEM
              6.**
            **SELECTED
                FINANCIAL DATA**





The
      selected consolidated financial information set forth below is derived from
      our
      consolidated balance sheets and statements of operations as of and for the
      years
      ended December 31, 2005, 2004, 2003, 2002 and 2001. The data set forth below
      should be read in conjunction with “Management’s Discussion and Analysis of
      Financial Condition and Results of Operations” and the consolidated financial
      statements and related notes thereto included in this Report.





**For
                the Year Ended December 31,****2005**
            
            **2004**
            
            **2003**
            
            **2002**
            
            **2001****Statement
                of Operations Data:**Revenues
            
            $
            16,191,000
            
            $
            14,902,000
            
            $
            2,384,000
            
            $
            3,065,000
            
            $
            582,000Cost
                of Revenues
            
            
            9,419,000
            
            
            6,169,000
            
            
            1,029,000
            
            
            657,000
            
            
            9,899,000Selling,
                general and administrative expenses
            
            
            13,290,000
            
            
            13,356,000
            
            
            7,004,000
            
            
            11,929,000
            
            
            11,646,000Legal
                settlement expense
            
            
            2,080,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -Product
                development and research
            
            
            2,196,000
            
            
            2,559,000
            
            
            5,141,000
            
            
            8,193,000
            
            
            8,123,000Amortization
                of intangible assets
            
            
            6,305,000
            
            
            5,453,000
            
            
            -
            
            
            31,000
            
            
            604,000Impairment
                loss on investment in affiliate
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            823,000Impairment
                loss on convertible note receivable
            
            
            -
            
            
            -
            
            
            -
            
            
            1,114,000
            
            
            -Impairment
                loss on intangible assets
            
            
            3,346,000
            
            
            738,000
            
            
            302,000
            
            
            -
            
            
            -Other
                expense, net
            
            
            (2,186,00
            )
            
            (1,775,000
            )
            
            (2,451,000
            )
            
            (1,039,000
            )
            
            (173,000
            )Loss
                from continuing operations, before equity in net loss of
                affiliate
            
            
            (22,631,000
            )
            
            (15,148,000
            )
            
            (13,183,000
            )
            
            (19,441,000
            )
            
            (30,687,000
            )Equity
                in loss of affiliate
            
            
            -
            
            
            -
            
            
            (360,000
            )
            
            (457,000
            )
            
            (373,000
            )Net
                loss
            
            
            (22,631,000
            )
            
            (15,148,000
            )
            
            (13,543,000
            )
            
            (19,898,000
            )
            
            (31,060,000
            )Preferred
                stock dividends
            
            
            (1,265,000
            )
            
            (3,927,000
            )
            
            -
            
            
            -
            
            
            -Net
                loss attributable to common stockholders
            
            
            (23,896,000
            )
            
            (19,075,000
            )
            
            (13,543,000
            )
            
            (19,898,000
            )
            
            (31,060,000
            )Basic
                and diluted net loss per common share
            
            $
            (0.09
            )
            $
            (0.21
            )
            $
            (0.50
            )
            $
            (1.73
            )
            $
            (5.20
            )Basic
                and diluted weighted average number of common shares
                outstanding
            
            
            261,894,849
            
            
            89,795,728
            
            
            26,894,005
            
            
            11,471,564
            
            
            5,978,281








**As
                of December 31,****2005**
            
            **2004**
            
            **2003**
            
            **2002**
            
            **2001****Balance
                Sheet Data:**Current
                assets
            
            $
            1,465,000
            
            $
            2,120,000
            
            $
            342,000
            
            $
            691,000
            
            $
            1,269,000Total
                assets
            
            
            9,293,000
            
            
            19,000,000
            
            
            3,173,000
            
            
            6,523,000
            
            
            8,599,000Current
                liabilities
            
            
            20,469,000
            
            
            15,700,000
            
            
            13,530,000
            
            
            15,120,000
            
            
            7,370,000Long-term
                debt, net of current portion
            
            
            4,050,000
            
            
            5,358,000
            
            
            40,000
            
            
            3,000
            
            
            --Stockholders’
                (deficit) equity
            
            
            (15,239,000
            )
            
            (2,058,000
            )
            
            (10,397,000
            )
            
            (8,599,000
            )
            
            1,229,000
















39







**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.
      ALL
      FORWARD-LOOKING STATEMENTS CONTAINED HEREIN ARE DEEMED BY FONIX TO BE COVERED
      BY
      AND TO QUALIFY FOR THE SAFE HARBOR PROTECTION PROVIDED BY SECTION 21E OF THE
      PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. ACTUAL RESULTS COULD DIFFER
      MATERIALLY FROM THE RESULTS ANTICIPATED BY FONIX AND DISCUSSED IN THE
      FORWARD-LOOKING STATEMENTS. WHEN USED IN THIS REPORT, WORDS SUCH AS “BELIEVES,”
“EXPECTS,” “INTENDS,” “PLANS,” “ANTICIPATES,” “ESTIMATES,” AND SIMILAR
      EXPRESSIONS ARE INTENDED TO IDENTIFY FORWARD-LOOKING STATEMENTS, ALTHOUGH THERE
      MAY BE CERTAIN FORWARD-LOOKING STATEMENTS NOT ACCOMPANIED BY SUCH EXPRESSIONS.
      WE DISCLAIM ANY INTENTION OR OBLIGATION TO UPDATE OR REVISE ANY FORWARD-LOOKING
      STATEMENTS, WHETHER AS A RESULT OF NEW INFORMATION, FUTURE EVENTS, OR OTHERWISE.
      FACTORS THAT COULD CAUSE OR CONTRIBUTE TO SUCH DIFFERENCES ARE DISCUSSED BELOW
      IN THE SECTION ENTITLED “INFORMATION CONCERNING FORWARD-LOOKING STATEMENTS” AND
      UNDER THE HEADING “CERTAIN SIGNIFICANT RISK FACTORS” IN ITEM 1 PART I OF THIS
      REPORT, ABOVE.**





The
      following discussion of the results of operations and financial condition should
      be read in conjunction with the consolidated financial statements and notes
      thereto included elsewhere in this report.





***Overview***





We
      are
      engaged in providing integrated telecommunications services through Fonix
      Telecom, Inc., and LecStar Telecom, Inc., and value-added speech technologies
      through Fonix Speech, Inc. (“Fonix Speech”). We operate Fonix Telecom, Inc., and
      LecStar Telecom, Inc., regional providers of telecommunications services in
      the
      Southeastern United States and LecStar DataNet, Inc., a provider of Internet
      services. (LecStar Telecom, Inc. and LecStar DataNet are collectively referred
      to in this report as “LecStar”).





We
      offer
      speech-enabling technologies including automated speech recognition (“ASR”) and
      text-to-speech ("TTS") through Fonix Speech. We offer our speech-enabling
      technologies to markets for wireless and mobile devices, computer telephony,
      server solutions and personal software for consumer applications. We have
      received various patents for certain elements of our core technologies and
      have
      filed applications for other patents covering various aspects of our
      technologies. We seek to develop relationships and strategic alliances with
      third-party developers and vendors in telecommunications, computers, electronic
      devices and related industries, including producers of application software,
      operating systems, computers and microprocessor chips. Revenues are generated
      through providing telecommunication services, licensing of speech-enabling
      technologies, maintenance contracts and services.





Fonix
      Telecom's non-regulated telecommunication services include VoIP, BPL and
      wireless broadband access. These services are initially available in the
      southeastern United States and we anticipate will eventually be available
      throughout the United States.





LecStar's
      telecommunication services include wireline voice, data, long distance and
      Internet services to business and residential customers. LecStar Telecom, Inc.,
      is certified by the Federal Communications Commission in nine states-Alabama,
      Florida, Georgia, Kentucky, Louisiana, Mississippi, North Carolina, South
      Carolina and Tennessee-as a competitive local exchange carrier (“CLEC”) to
      provide regulated local, long distance and international telecommunications
      services. LecStar DataNet, Inc., provides non-regulated telecommunication
      services including Internet access. LecStar has been generating positive
      earnings before interest, depreciation, taxes and amortization since September
      2005.









40








For
      the
      years ended December 31, 2005, 2004 and 2003, we generated revenues of
      $16,191,000, $14,902,000 and $2,384,000, respectively; incurred net losses
      of
      $22,631,000, $15,148,000 and $13,543,000, respectively, and had negative cash
      flows from operating activities of $7,829,000, $13,051,000 and $9,243,000,
      respectively. As of December 31, 2005, we had an accumulated deficit of
      $250,521,000, negative working capital of $19,004,000, accrued liabilities
      of
      $10,214,000 and accounts payable of $6,770,000. We expect to continue to incur
      significant losses and negative cash flows from operating activities through
      December 31, 2007, primarily due to expenditure requirements associated with
      continued marketing and development of our speech-enabling technologies and
      further developing our telecommunications services business.





We
      are
      continually developing new product offerings in both the ASR and
      telecommunications businesses in an effort to increase our revenue stream,
      and
      we are continuing to work with our existing customers to increase sales. We
      have
      also experienced operating expense decreases through headcount reductions and
      overall cost reduction measures. Through the combination of increased recurring
      revenues and the overall operating cost reduction strategies we have
      implemented, we hope to achieve positive cash flow from operations in the next
      18-24 months. However, there can be no assurance that we will be able to achieve
      positive cash flow from operations within this time frame.





Our
      cash
      resources, limited to collections from customers, draws on the Sixth and Seventh
      Equity Lines and loans, have not been sufficient to cover operating expenses.
      We
      have not been declared in default under the terms of any material agreements.
      We
      periodically engage in discussions with various sources of financing to
      facilitate our cash requirements including buyers of both debt and equity
      securities. To date, no additional sources of funding offering terms superior
      to
      those available under equity lines have been implemented, and we rely on first,
      cash generated from operations, and second, cash provided through the Seventh
      Equity Line. We will need to generate approximately $10,000,000 to continue
      operations for the next twelve months .





***Significant
      Accounting Policies***





**** The
      discussion and analysis of our financial condition and results of operations
      are
      based upon our consolidated financial statements, which have been prepared
      in
      accordance with accounting principles generally accepted in the United States.
      The preparation of these financial statements requires management to make
      estimates and assumptions that affect the reported amounts of assets and
      liabilities and disclosure of contingent assets and liabilities at the date
      of
      the financial statements and the reported amounts of sales and expenses during
      the reporting period. Significant accounting policies and areas where
      substantial judgments are made by management include:





***Accounting
      estimates*** **-** The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States 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.





***Valuation
      of long-lived assets*** - The
      carrying values of our long-lived assets are reviewed for impairment whenever
      events or changes in circumstances indicate that they may not be recoverable.
      When such an event occurs, we project undiscounted cash flows to be generated
      from the use of the asset and its eventual disposition over the remaining life
      of the asset. If projections indicate that the carrying value of the long-lived
      asset will not be recovered, the carrying value of the long-lived asset, other
      than software technology, is reduced by the estimated excess of the carrying
      value over the projected discounted cash flows.





***Intangible
      assets*** -
      Customer base, contracts and agreements and brand names are amortized over
      their
      estimated useful lives unless they are deemed to have indefinite useful lives.
      For intangible assets subject to amortization, an impairment charge is
      recognized if the carrying amount is not recoverable and the carrying amount
      exceeds the fair value of the intangible asset. Intangible assets deemed to
      have
      indefinite useful lives, primarily the LecStar brand name were not amortized,
      were tested for impairment on a quarterly basis and impairment was recognized
      if
      the carrying amount was not recoverable or exceeded its fair value. We recorded
      a charge of $1,124,000 during the year ended December 31, 2003, to fully impair
      the carrying value of its speech related intangible assets. During the year
      ended December 31, 2004, we recorded an impairment loss on the intangible asset
      related to the contracts and agreements acquired in connection with the LecStar
      acquisition of $738,000 based on estimated future cash flows. During the year
      ended December 31, 2005, we recorded a charge of $1,110,000 to fully impair
      the
      carrying value of the LecStar brand name based on the estimated cash flows
      provided by the LecStar brand name. During December 2005, we also determined
      that the intangible asset related to the LecStar customer base had become
      impaired due to decreased estimated future cash flows due to the overall cost
      increases as the we no longer had the UNE-P platform to offer to our customers.
      We recorded an impairment charge of $2,236,000 in the Consolidated Financial
      Statements







41








***Goodwill***  ***-*** Goodwill
      represents the excess of the cost over the fair value of net assets of acquired
      businesses. Goodwill is not amortized, but is tested for impairment quarterly
      or
      when a triggering event occurs. The testing for impairment requires the
      determination of the fair value of the asset or entity to which the goodwill
      relates (the reporting unit). The fair value of a reporting unit is determined
      based upon a weighting of the quoted market price of our common stock and
      present value techniques based upon estimated future cash flows of the reporting
      unit, considering future revenues, operating costs, the risk-adjusted discount
      rate and other factors. Impairment is indicated if the fair value of the
      reporting unit is allocated to the assets and liabilities of that unit, with
      the
      excess of the fair value of the reporting unit over the amounts assigned to
      its
      assets and liabilities assigned to the fair value of goodwill. The amount of
      impairment of goodwill is measured by the excess of the goodwill’s carrying
      value over its fair value.





***Revenue
      recognition -*** We
      recognize revenue when pervasive evidence of an arrangement exists, services
      have been rendered or products have been delivered, the price to the buyer
      is
      fixed and determinable and collectibility is reasonable assured. Revenues are
      recognized by us based on the various types of transactions generating the
      revenue. For software sales, we recognize revenues in accordance with the
      provisions of Statement of Position No. 97-2, “Software Revenue Recognition” and
      related interpretations *.* We
      generate revenues from licensing the rights to its software products to end
      users and from royalties. For telecommunications services, revenue is recognized
      in the period that the service is provided.





For
      Fonix
      Speech, revenue of all types is recognized when acceptance of functionality,
      rights of return, and price protection are confirmed or can be reasonably
      estimated, as appropriate. Revenues from development and consulting services
      are
      recognized on a completed-contract basis when the services are completed and
      accepted by the customer. The completed-contract method is used because our
      contracts are typically either short-term in duration or we are unable to make
      reasonably dependable estimates of the costs of the contracts. Revenue for
      hardware units delivered is recognized when delivery is verified and collection
      assured.





Revenue
      for products distributed through wholesale and retail channels and through
      resellers is recognized upon verification of final sell-through to end users,
      after consideration of rights of return and price protection. Typically, the
      right of return on such products has expired when the end user purchases the
      product from the retail outlet. Once the end user opens the package, it is
      not
      returnable unless the medium is defective.





When
      arrangements to license software products do not require significant production,
      modification or customization of software, revenue from licenses and royalties
      are recognized when persuasive evidence of a licensing arrangement exists,
      delivery of the software has occurred, the fee is fixed or determinable, and
      collectibility is probable. Post-contract obligations, if any, generally consist
      of one year of support including such services as customer calls, bug fixes,
      and
      upgrades. Related revenue is recognized over the period covered by the
      agreement. Revenues from maintenance and support contracts are also recognized
      over the term of the related contracts.





Revenues
      applicable to multiple-element fee arrangements are bifurcated among the
      elements such as license agreements and support and upgrade obligations using
      vendor-specific objective evidence of fair value. Such evidence consists
      primarily of pricing of multiple elements as if sold as separate products or
      arrangements. These elements vary based upon factors such as the type of
      license, volume of units licensed, and other related factors.





For
      Fonix
      Telecom, our telecommunications revenue is comprised of two main components:
      (1)
      fees paid by business and residential subscribers of voice and data services
      and
      (2) carrier access fees. Subscriber revenues include monthly recurring charges,
      usage charges and non-recurring charges. Monthly recurring charges are flat
      monthly fees for local phone and data services. Usage charges, which primarily
      include long distance fees, are generally billed on a per-minute or per-call
      basis. Non-recurring charges are generally one-time charges for installation
      or
      changes to the subscriber’s service. Carrier access fees are paid to us by other
      telecommunications carriers as compensation for originating and terminating
      the
      carriers’ long distance traffic. Revenue from monthly recurring charges is
      recognized ratably over the period the local phone ad data services are
      provided. Revenue from usage charges, non-recurring charges and carrier access
      fees is recognized on the date the services are provided.







42








Deferred
      revenue as of December 31, 2005, consisted of the following:


**Description**
              **Criteria
                  for Recognition**
              **Amount**Deferred
                  unit royalties and license fees
              Delivery
                  of units to end users or expiration of contract
              $         
                  466,000Telecom
                  deferred revenue
              Service
                  provided for customer
              457,000Total
                  deferred revenue
              
              $         
                  923,000





***Cost
      of revenues*** **-** Cost
      of
      revenues from telecommunications services consists mainly of billings from
      the
      incumbent local exchange carriers (“ILECs”) for access to the ILECs network.
      Cost of revenues from license, royalties, and maintenance consists of costs
      to
      distribute the product, installation and support personnel compensation,
      amortization and impairment of capitalized speech software costs, licensed
      technology, and other related costs. Cost of service revenues consists of
      personnel compensation and other related costs.





***Software
      Technology Development and Production Costs*** **** -
      All
      costs incurred to establish the technological feasibility of speech software
      technology to be sold, leased, or otherwise marketed are charged to product
      development and research expense. Technological feasibility is established
      when
      a product design and a working model of the software product have been completed
      and confirmed by testing. Costs to produce or purchase software technology
      incurred subsequent to establishing technological feasibility are capitalized.
      Capitalization of software costs ceases when the product is available for
      general release to customers. Costs to perform consulting or development
      services are charged to cost of revenues in the period in which the
      corresponding revenues are recognized. Costs of maintenance and customer support
      are charged to expense when related revenue is recognized or when these costs
      are incurred, whichever occurs first.





Capitalized
      software technology costs were amortized on a product-by-product basis.
      Amortization was recognized from the date the product was available for general
      release to customers as the greater of (a) the ratio that current gross revenue
      for a product bears to total current and anticipated future gross revenues
      for
      that product or (b) the straight-line method over the remaining estimated
      economic life of the products. Amortization was charged to cost of
      revenues.





We
      assessed unamortized capitalized software costs for possible write down on
      a
      quarterly basis based on net realizable value of each related product. Net
      realizable value was determined based on the estimated future gross revenues
      from a product reduced by the estimated future cost of completing and disposing
      of the product, including the cost of performing maintenance and customer
      support. The amount by which the unamortized capitalized costs of a software
      product exceeded the net realizable value of that asset was written
      off.





During
      2003, we modified our estimate of future cash flows to be provided by its
      software technology and determined that the carrying amount of the technology
      was in excess of future cash flows provided by the technology. Accordingly,
      we
      recorded a charge of $1,124,000 during the year ended December 31, 2003, to
      fully impair the carrying value of the speech software technology. $823,000
      of
      the operating impairment was charged to cost of revenues and $302,000 was
      charged to operating expenses, based on the use of the software.





***Stock-based
      Compensation Plans*** -We
      account for our stock-based compensation issued to non-employees using the
      fair
      value method in accordance with SFAS No. 123, “Accounting for Stock-Based
      Compensation.” Under SFAS No. 123, stock-based compensation is determined as
      either the fair value of the consideration received or the fair value of the
      equity instruments issued, whichever is more reliably measurable. The
      measurement date for these issuances is the earlier of the date at which a
      commitment for performance by the recipient to earn the equity instruments
      is
      reached or the date at which the recipient’s performance is
      complete.





At
      December 31, 2005, we had stock-based employee compensation plans, which are
      described more fully in Note 13 to the Consolidated Financial Statements. We
      account for the plans under the recognition method and measurement principles
      of
      APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and the related
      Interpretations. Under APB Opinion No. 25, compensation related to stock
      options, if any, by the amount that the option’s exercise price on the
      measurement date is below the fair value of our common stock, and amortized
      to
      expense over the vesting period. Compensation expense for stock awards or
      purchases, if any, is recognized by the amount that the award or purchase price
      on the measurement date is below the fair value of our common stock, and is
      recognized on the date of award or purchase. These accounting policies resulted
      in our not recognizing any stock-based employee compensation cost during the
      years ended December 31, 2005 2004, or 2003.







43








***Imputed
      Interest Expense and Income*** -
      Interest is imputed on long-term debt obligations and notes receivable where
      management has determined that the contractual interest rates are below the
      market rate for instruments with similar risk characteristics.





***Foreign
      Currency Translation*** **-** The
      functional currency of our Korean subsidiary is the South Korean won.
      Consequently, assets and liabilities of the Korean operations are translated
      into United States dollars using current exchange rates at the end of the year.
      All revenue is invoiced in South Korean won and revenues and expenses are
      translated into United States dollars using weighted-average exchange rates
      for
      the year.





***Comprehensive
      Income*** *-* ****** Other
      comprehensive income presented in the accompanying consolidated financial
      statements consists of cumulative foreign currency translation adjustments.





***Recently
      Enacted Accounting Standards***





***Inventory
      Costs -*** In
      November 2004, the FASB issued SFAS No. 151, *Inventory
      Costs,* which
      is
      an amendment of ARB No. 43. SFAS No. 151 requires idle facility expenses,
      freight, handling costs and wasted material (spoilage) costs to be recognized
      as
      current-period charges. It also requires that allocation of fixed production
      facilities. SFAS No. 151 will be effective for us beginning January 1, 2006
      and
      resulting adjustments will be made on prospective basis. The Company does not
      anticipate that the adoption of this standard will have a significant impact
      on
      our business, results of operations or financial position.





***Share
      Based Payment -*** In
      December 2004, the FASB issued SFAS No. 123R, *Share-Based
      Payment,* which
      is
      a revision to SFAS No. 123. SFAS No. 123R established standards for the
      accounting for transactions in which an entity exchanges its equity instruments
      for goods or services. Primarily, SFAS No. 123R focuses on accounting for
      transactions in which an entity obtains employee services in share-based payment
      transactions. It also addresses transactions in which an entity incurs
      liabilities in exchange for goods or services that are based on the fair value
      of the entity’s equity instruments or that may be settled by the issuance of
      those equity instruments.





SFAS
      No.
      123R requires us to measure the cost of employee services received in exchange
      for an award of equity instruments based on the grant-date fair value of the
      award. That cost will be recognized over the period during which an employee
      is
      required to provide service in exchange for the award, which is usually the
      vesting period. No compensation cost is recognized for equity instruments for
      which employees do not render the requisite service.





In
      accordance with the Securities and Exchange Commission’s Staff Accounting
      Bulleting 107, SFAS No. 123R is effective as of the beginning of the annual
      reporting period that begins after December 15, 2005. Under these guidelines,
      the company will adopt SFAS 123R as of January 1, 2006. We do not expect that
      the adoption of this standard will have a material impact on our future results
      of operations.





***Accounting
      Changes and Error Corrections -*** In
      May
      2005, the FASB issued SFAS No. 154, *Accounting
      Changes and Error Corrections* ,
      which
      is a replacement of APB Opinion No. 20, *Accounting
      Changes,* and
      SFAS
      No. 3, *Reporting
      Accounting Changes in Interim Financial Statements.* SFAS
      No.
      154 changes the requirements for the accounting for and reporting a change
      in an
      accounting principle. Previously, most voluntary changes in accounting principle
      required recognition of a cumulative effect adjustment in the results of
      operations of the period of change. SFAS No. 154 requires retrospective
      application to prior periods unless it is impracticable to determine either
      the
      period-specific effects or the cumulative effect of the change. SFAS No. 154
      is
      effective for accounting changes and corrections of errors made in years
      beginning after December 15, 2005; however, it does not change the transition
      provisions of any existing accounting pronouncements, such as SFAS No. 123R.
      We
      do not believe the adoption of SFAS No. 154 will have a material effect on
      our
      business, results of operations, or financial position.







44








***Results
      of Operations***





***Fiscal
      Year 2005 Compared to 2004***





During
      2005, we recorded revenues of $16,191,000, an increase of $1,289,000 from
      $14,902,000 in 2004. The increase was primarily due to an increased monthly
      recurring telecommunicationsrevenues of $997,000, increased telecommunications
      regulatory cost recovery fees of $344,000, increased non-recurring engineering
      speech revenues of $244,000, increased telecommunications subscriber line charge
      revenues of $92,000, increased speech retail revenues of $79,000, increased
      telecommunications activation and service revenues of $43,000 and increased
      voice mail revenues of $10,000, partially offset by decreased telecommunications
      call termination revenues of $239,000, decreased DECtalk royalties of $193,000
      and decreased telecommunications usage revenues of $88,000.





Cost
      of
      revenues was $9,419,000, an increase of $3,250,000 from $6,169,000 in 2004.
      The
      increase is primarily due to the increased costs of providing telecommunication
      services of $3,214,000, primarily due to the loss of the UNE-P platform. These
      costs represent expenses associated with providing LecStar’s services through
      the leasing of network components from BellSouth and long distance services
      purchased from inter-exchange carriers.





Selling,
      general and administrative expenses were $13,290,000 in 2005, a decrease of
      $66,000 from $13,356,000 in 2004. The decrease is primarily due to the decreased
      bad debt expense of $547,000, decreased legal
      and accounting fees of $307,000, decreased
      investor relations expenses of $114,000, decreased travel expenses of
      $87,000, decreased promotions of $41,000 and decreased depreciation expenses of $17,000, partially offset by increased salary
      and wage expenses of $435,000, increased other operating expense of $ 428,000,
      increased occupancy related expenses of $120,000, increased consulting expenses
      of $45,000 and increased taxes, licenses and permits of $19,000.





During
      the year ended 2005, we recorded a legal settlement expense of $2,080,000 in
      settlement of the ongoing litigation between us and Breckenridge related to
      the
      Series D Debentures and the Series I Preferred Stock (see further description
      in
      Legal Proceedings section of this report).





During
      the year ended December 31, 2005, we recorded $3,346,000 in impairment charges
      related to the intangible assets acquired in connection with the LecStar
      acquisition. We recorded a charge of $2,236,000 related to the impairment of
      the
      customer lists intangible. We reviewed the carrying amount of the intangible
      based on estimated future cash flows, and determined that the carrying amount
      was in excess of the future cash flows. The cash flows were diminished due
      to
      the loss of the UNE-P platform and the projected increased cost of providing
      service based on the alternative service platforms available to us. We also
      recorded a charge of $1,110,000 to fully impair the LecStar brand name
      intangible. We determined that the estimated future cash flows attributable
      to
      the LecStar brand name were not sufficient to substantiate the carrying amount
      of the intangible.





We
      incurred research and product development expenses of $2,196,000 in 2005, a
      decrease of $363,000 from $2,559,000 in 2004. The decrease was primarily due
      to
      an overall decrease in salaries and wage-related expenses of
      $248,000 ,
      decreased other operating expenses of $107,000 ,
      decreased depreciation of $32,000 due to the overall decrease in fixed assets
      and decreased travel expense of $14,000, partially offset by increased
      consulting expenses of $24,000 and increased occupancy related expenses of
      $14,000.





Net
      interest and other expense was $2,186,000 for 2005, an increase of $411,000
      from
      $1,775,000 for 2004. The overall increase was due to the increase in interest
      expense of $287,000 and decreased gain on forgiveness of liabilities of
      $376,000, partially offset by gains recognized on disposal of investments of
      $251,000 and increased interest income of $8,000.





***Fiscal
      Year 2004 Compared to 2003***





During
      2004, we recorded revenues of $14,902,000, an increase of $12,518,000 from
      $2,384,000 in 2003. The increase was primarily due to the acquisition of
      LecStar, accounting for $13,673,000 of the increase, partially offset by
      decreased NRE revenues of $362,000, decreased licenses revenues of $330,000
      decreased DECtalk royalties of $319,000, decrease support revenues of $53,000,
      decreased retail revenues of $39,000 and decreased hardware sales of
      $30,000.







45








Cost
      of
      revenues was $6,169,000, an increase of $5,140,000 from $1,029,000 in 2003.
      The
      increase is primarily due to the acquisition of LecStar contributing $6,136,000
      to the increase. These costs represent expenses associated with providing
      LecStar’s services through the leasing of network components from BellSouth and
      long distance services purchased from inter-exchange carriers. This increase
      was
      partially offset by decreased expenses related to NRE projects due to the
      overall decrease in NRE contracts during the year and the lack of any impairment
      charges to capitalized software technology during 2004.





Selling,
      general and administrative expenses were $13,356,000 in 2004, a increase of
      $6,352,000 from $7,004,000 in 2003 The increase is primarily due to the
      acquisition of LecStar, which contributed $8,650,000 to the increase, and
      increased legal and accounting fees of $523,000, increased
      travel expenses of $137,000, increased investor relations expenses of
      $110,000, partially offset by decreased salary and wage expenses of $1,420,000, decreased
      consulting expenses of $497,000, a reduction in accrued vacation of $344,000,
      a
      reduction in accrued payroll of $519,000, decreased occupancy related expenses
      of $163,000 and decreased depreciation expenses of $83,000, and decreased
      promotions of $42,000.





We
      incurred research and product development expenses of $2,559,000 in 2004, a
      decrease of $2,582,000 from $5,141,000 in 2003. The decrease is primarily due
      to
      an overall decrease in salaries and wage-related expenses of
      $1,884,000, a
      reduction in accrued vacation of $200,000, decreased occupancy related costs of $164,000, decreased consulting expenses
      of
      $315,000 due to a decrease in the utilization of external consultants and
      decreased depreciation of $83,000 due to the overall decrease in fixed assets,
      partially offset by increased other operating expenses of $48,000 and increased
      travel expense of $16,000.





Net
      interest and other expense was $1,775,00 for 2004, a decrease of $676,000 from
      $2,451,000 for 2003. The overall decrease is due to the gain on forgiveness
      of
      liabilities of $518,000 partially offset by increased interest expense related
      to the note payable issued in connection with the acquisition of LecStar and
      the
      LecStar credit facility.





***Selected
      Quarterly Operations Data***





The
      following tables set forth selected unaudited statement of operations data
      for
      each of the quarters in the years ended December 31, 2005 and 2004. This data
      has been derived from our unaudited financial statements that have been prepared
      on the same basis as the audited financial statements and, in the opinion of
      management, include all adjustments, consisting of normal recurring adjustments,
      necessary for a fair presentation of the information when read in connection
      with the financial statements and the related notes. Our quarterly operating
      results have varied substantially in the past and may vary substantially in
      the
      future. Conclusions about our future results for any period should not be drawn
      from the selected unaudited statement of operations data, either for any
      particular quarter or taken as a whole.


**For
                  the Quarter Ended****Mar
                  31, 2005**
              
              **Jun
                  30, 2005**
              
              **Sep
                  30, 2005**
              
              **Dec
                  31, 2005**(Unaudited)Net
                  sales
              
              $
              4,233,000
              
              $
              4,324,000
              
              $
              3,957,000
              
              $
              3,677,000Gross
                  profit
              
              
              2,036,000
              
              
              1,825,000
              
              
              1,548,000
              
              
              1,363,000Net
                  loss
              
              
              (4,080,000
              )
              
              (4,337,000
              )
              
              (6,515,000
              )
              
              (7,699,000
              )Preferred
                  stock dividends
              
              
              (297,000
              )
              
              (276,000
              )
              
              (423,000
              )
              
              (269,000
              )Net
                  loss attributable to common stockholders
              
              
              (4,377,000
              )
              
              (4,613,000
              )
              
              (6,938,000
              )
              
              (7,928,000
              )Basic
                  and diluted loss per common share
              
              $
              (0.03
              )
              $
              (0.02
              )
              $
              (0.02
              )
              $
              (0.02
              )





46




**For
                  the Quarter Ended****Mar
                  31, 2004**
              
              **Jun
                  30, 2004**
              
              **Sep
                  30, 2004**
              
              **Dec
                  31, 2004**(Unaudited)Net
                  sales
              
              $
              1,925,000
              
              $
              4,242,000
              
              $
              4,426,000
              
              $
              5,101,000Gross
                  profit
              
              
              1,133,000
              
              
              1,973,000
              
              
              2,199,000
              
              
              3,428,000Net
                  loss
              
              
              (2,342,000
              )
              
              (5,565,000
              )
              
              (3,321,000
              )
              
              (3,920,000
              )Preferred
                  stock dividends
              
              
              (2,986,000
              )
              
              (315,000
              )
              
              (315,000
              )
              
              (311,000
              )Net
                  loss attributable to common stockholders
              
              
              (5,328,000
              )
              
              (5,880,000
              )
              
              (3,636,000
              )
              
              (4,231,000
              )Basic
                  and diluted loss per common share
              
              $
              (0.08
              )
              $
              (0.07
              )
              $
              (0.04
              )
              $
              (0.13
              )





***Liquidity
      and Capital Resources***





We
      must
      raise additional funds to be able to satisfy our cash requirements during the
      next 12 months. Product development, corporate operations, and marketing
      expenses will continue to require additional capital. Because we presently
      have
      only limited revenue from operations, we intend to continue to rely primarily
      on
      financing through the sale of our equity and debt securities to satisfy future
      capital requirements until such time as we are able to enter into additional
      third-party licensing, collaboration, or co-marketing arrangements such that
      we
      will be able to finance ongoing operations from license, royalty, and sales
      revenue. There can be no assurance that we will be able to enter into such
      agreements. Furthermore, the issuance of equity or debt securities which are
      or
      may become convertible into equity securities of Fonix in connection with such
      financing could result in substantial additional dilution to the stockholders
      of
      Fonix.





Our
      cash
      resources are limited to collections from customers, draws on the Seventh Equity
      Line and proceeds from the issuance of preferred stock and loan proceeds, and
      are only sufficient to cover current operating expenses and payments of current
      liabilities. At December 31, 2005, we had accrued liabilities and accrued
      settlement obligations of $10,214,000 and accounts payable of $6,770,000. We
      have not been declared in default under the terms of any material
      agreements.





We
      had
      $16,191,000 in revenue and a loss of $22,631,000 for the year ended December
      31,
      2005. Net cash used in operating activities of $7,829,000 for the year ended
      December 31, 2005, resulted principally from the net loss incurred of
      $22,631,000 decreased accrued payroll of $1,533,000, decreased prepaids and
      other assets of $540,000, non-cash gain on sale of long-term assets of $251,000,
      non-cash gain on forgiveness of liabilities of $95,000, and decreased deferred
      revenues of $175,000 partially offset by amortization of intangible assets
      of
      $6,305,000, non-cash impairment charges recognized in connection with intangible
      assets of $3,346,000, legal settlement expense recognized of $2,080,000,
      increased accrued liabilities of $1,721,000, increased accounts payable of
      $1,563,000, non-cash accretion of the discount on notes payable, stock issued
      for interest on long-term debt of $500,000, collection of LecStar accounts
      receivables of $420,000, depreciation of $285,000, non-cash expense related
      to
      the issuance of preferred stock of $250,000, non-cash accretion of the discount
      on legal settlement of $61,000 and the foreign exchange gain of $10,000. Net
      cash used in investing activities of $508,000 for the year ended December 31,
      2005, consisted of the purchase of equipment of $996,000, partially offset
      by
      proceeds received from the sale of long-term investments of $488,000. Net cash
      provided by financing activities of $8,082,000 consisting primarily of the
      receipt of $7,827,000 in cash related to the sale of shares of Class A common
      stock, proceeds from other notes receivable of $650,000 and proceeds from
      related party notes payable of $50,000, partially offset by payments on notes
      payable of $315,000 and payments of accrued legal expense of
      $130,000.





We
      had
      negative working capital of $19,004,000 at December 31, 2005, compared to
      negative working capital of $13,580,000 at December 31, 2004. Current assets
      decreased by $655,000 to $1,465,000 from $2,120,000 from December 31, 2004,
      to
      December 31, 2005. Current liabilities increased by $4,769,000 to $20,469,000
      from $15,700,000 during the same period. The change in working capital from
      December 31, 2005, to December 31, 2005, reflects, in part, the increases in
      accrued liabilities, accounts payable and notes payable, partially offset by
      decreases in accrued payroll and related party notes payable due to payments
      made during 2005. Total assets were $9,293,000 at December 31, 2005, compared
      to
      $19,000,000 at December 31, 2004.







47








***Investment
      In Audium Corporation***





In
      February 2001, the Company entered into a collaboration agreement with Audium
      Corporation (“Audium”) to provide an integrated platform for generating Voice
      XML solutions for Internet and telephony systems. Audium is a mobile application
      service provider that builds and operates mobile applications that allow access
      to Internet information and to complete online transactions using any telephone.
      The collaboration includes integration of the Company’s technologies with
      Audium’s mobile applications development capability.





***Note
      Receivable*** - In
      connection with the collaboration agreement with Audium, in February and May
      2001, the Company advanced an aggregate of $400,000 to Audium as a bridge loan
      (the “Audium Note”). The loan bore interest at a rate of 5 percent per year, had
      a term of four years, and was convertible into shares of Audium Series A
      Convertible Preferred Stock (“Audium Preferred Stock”). The Audium Note was
      convertible into shares of Audium Preferred Stock at a price of $1.46 per share
      upon the occurrence of certain events. The Audium Note was secured by Audium's
      intellectual property. Further, at the closing, Audium granted the Company
      a
      fully paid, worldwide, non-exclusive license to Audium's software to make,
      manufacture, and use the software and any derivative works if Audium declared
      bankruptcy or ceases to do business.





Management
      determined that a 12 percent annual interest rate better reflected the risk
      characteristics of the Audium Note. Accordingly, interest was imputed at 12
      percent and the Audium Note was recorded at its original present value of
      $303,000. For the year ended December 31, 2003, we recorded interest income
      of
      $44,000, including contractual and imputed interest.





***Investment
      in Affiliate*** - In
      April 2001, the Company closed a stock purchase agreement with Audium, wherein
      the Company agreed to purchase up to $2,800,000 of Audium Preferred Stock at
      a
      price of $1.46 per share. At closing, the Company paid $200,000 in cash and
      gave
      Audium a non-interest bearing note (the “Fonix Note”) for the remaining
      $2,600,000. Interest on the Fonix Note was imputed at 12 percent resulting
      in a
      present value of $2,370,000. The resulting purchase price of the Audium
      Preferred Stock was $2,570,000.





Each
      share of Audium Preferred Stock is convertible into one share of Audium’s common
      stock. Holders of Audium Preferred Stock are entitled to eight percent
      cumulative dividends, a liquidation preference in excess of the original
      purchase price plus any declared but unpaid dividends, anti-dilution rights,
      and
      voting rights equal to the corresponding number of common shares into which
      it
      is convertible. The stock purchase agreement also entitles Fonix to elect one
      member of Audium’s board of directors. Audium also granted Fonix certain
      registration rights after the closing of a public offering by
      Audium.





At
      closing, Audium issued 14 Audium Preferred Stock certificates to Fonix, each
      certificate for 136,986 shares, and delivered one certificate in exchange for
      the initial payment of $200,000. The remaining certificates were held by Audium
      as collateral for the Fonix Note under the terms of a security agreement. For
      each payment of $200,000 or multiple payments that aggregate $200,000, Audium
      agreed to release to Fonix one certificate for 136,986 shares of Audium
      Preferred Stock.





The
      difference between the total purchase price of the Audium Preferred Stock and
      the Company’s portion of Audium's net stockholders' deficit at the time of the
      purchase was $2,701,000, which was allocated to capitalized software technology.
      The excess purchase price allocated to the capitalized software technology
      was
      amortized on a straight-line basis over a period of eight years through December
      31, 2010. After the impairment in the investment in Audium discussed below,
      the
      remaining excess purchase price was $1,008,000 and was amortized over the
      remaining portion of the 8-year period.





The
      investment in Audium did not provide the Company with rights to any technology
      developed by Audium; the Company must obtain a license should it choose to
      do
      so. Also, the Company did not own an interest sufficient to control Audium,
      if
      the Company were to convert the Audium Note to Audium Preferred Stock. As a
      result, management has determined that it was appropriate to account for the
      investment, which represented 26.7 percent of Audium’s voting stock, under the
      equity method and not as a research and development arrangement.










48








Audium
      has incurred losses since the Company acquired the Audium Preferred Stock and
      as
      such, Audium does not have the ability to declare or pay preferred dividends
      on
      the Preferred Stock. The Company recognized losses for the year ended December
      31, 2003 as follows:




**Year
                  Ended**
                **December
                  31, 2003**Company
                  share of Audium net loss
              
              $
              193,000Amortization
                  of difference between purchase price of Audium Preferred Stock
                  and
                  Company’s share of Audium’s net stockholders’ deficit
              
              
              167,000Total
                  equity in loss of affiliate
              
              $
              360,000





A
      summary
      of the results of Audium’s operations for the year ended December 31, 2003, and
      net assets as of December 31, 2003 is as follows:




**2003**Net
                  sales
              
              $
              637,000Loss
                  from operations
              
              
              (1,244,000
              )Non-operating
                  income
              
              
              524,000Net
                  loss
              
              
              (720,000
              )Current
                  assets
              
              $
              241,000Total
                  assets
              
              
              1,163,000Current
                  liabilities
              
              
              1,569,000Total
                  liabilities
              
              
              1,619,000Net
                  assets
              
              $
              (456,000
              )





The
      fair
      value of this investment was determined based on Audium's estimated future
      net
      cash flows considering the status of Audium's product development. The Company
      evaluated this investment for impairment annually and more frequently when
      indications of decline in value existed. An impairment loss that was other
      than
      temporary was recognized during the period it was determined to exist. An
      impairment was determined to be other-than-temporary if estimated future net
      cash flows were less than the carrying value of the investment. If projections
      indicated that the carrying value of the investment would not be recoverable,
      the carrying value was reduced by the estimated excess of the carrying value
      over the estimated discounted cash flows.





***Note
      Payable to Affiliate*** **** -
      The
      Fonix Note was payable in 13 monthly installments of $200,000 beginning on
      June
      1, 2001, and bore no interest unless an event of default occurred, in which
      case
      it would have borne interest at 12 percent per annum. No events of default
      occurred and the note was fully satisfied. The Fonix Note was secured by shares
      of Audium Preferred Stock as described above.





Management
      determined that a 12 percent annual interest rate reflected the risk
      characteristics of the Fonix Note. Accordingly, interest was imputed at 12
      percent and the Company recorded a present value of $2,370,000 for the note
      payable. For the year ended December 31, 2002, the Company recorded interest
      expense of $95,000 related to this note. Through December 31, 2002, payments
      amounting to $1,800,000 had been made under the Fonix note.







49








***Sale
      of Investment in Audium*** - On
      December 31, 2003, the Company entered into an agreement with Audium with
      respect to the Audium Note, the Fonix Note, and the Audium Preferred Stock.
      Under the agreement, Fonix agreed that the balance owing under the Audium Note
      would be offset against the balance owing under the Fonix Note, and accordingly,
      the Audium Note was deemed to be paid in full. Fonix further agreed to transfer
      to Audium all of its right, title, and interest in the Audium Preferred Stock
      in
      exchange for (a) Audium’s deeming the Fonix Note to be paid in full; (b)
      Audium’s granting to us a fully paid, worldwide, non-exclusive license to
      Audium’s software to make, sell, offer for sale, and use the software and any
      derivative software (the specific terms of which are being finalized), to be
      used if Audium declares bankruptcy, defaults under the agreement, or ceases
      to
      do business for a period of 60 days; and (c) Audium’s granting to Fonix a
      $1,800,000 prepaid license agreement to be applied to Audium’s run-time
      licenses. The prepaid license has a four-year life and allows the Company to
      utilize run-time licenses from Audium in the Company’s products. As the
      $1,800,000 prepaid license represents the amount of the investment the Company
      has made into Audium and that investment was reduced due to recognition of
      Fonix’s portion of Audium’s loss under the equity method of accounting for
      investments and through impairment charges during 2002, the Company did not
      value the prepaid license at December 31, 2003. The Company intends to utilize
      the licenses by offsetting the cost of run time licenses against the prepaid
      license. These transactions resulted in the Company recognizing a gain from
      the
      sale of Audium of $53,000 during December 2003, which gain is included in “other
      income (expense)” in the accompanying consolidated statements of
      operations.





***Notes
      Payable Related Parties***





During
      2002, two of our executive officers (the “Lenders”) sold shares of our Class A
      common stock owned by them and advanced the resulting proceeds amounting to
      $333,000 to us under the terms of a revolving line of credit and related
      promissory note. The funds were advanced for use in our operations. The advances
      bear interest at 12 percent per annum, which interest is payable on a
      semi-annual basis. The entire principal, along with unpaid accrued interest
      and
      any other unpaid charges or related fees, were originally due and payable on
      June 10, 2003. Fonix and the Lenders have agreed to postpone the maturity date
      on several occasions. The note is presently due March 31, 2006. All or part
      of
      the outstanding balance and unpaid interest may be converted at the option
      of
      the Lenders into shares of Class A common stock of Fonix at any time. The
      conversion price was the average closing bid price of the shares at the time
      of
      the advances. To the extent the market price of our shares is below the
      conversion price at the time of conversion, the Lenders are entitled to receive
      additional shares equal to the gross dollar value received from the original
      sale of the shares. A beneficial conversion option of $15,000 was recorded
      as
      interest expense in connection with this transaction. The Lenders may also
      receive additional compensation as determined appropriate by the Board of
      Directors.





In
      October 2002, the Lenders pledged 30,866 shares of the Company's Class A common
      stock to the Equity Line Investor in connection with an advance of $183,000
      to
      us under the Third Equity Line (see Note 12 to Consolidated Financial
      Statements). The Equity Line Investor subsequently sold the pledged shares
      and
      applied $82,000 of the proceeds as a reduction of the advance. The value of
      the
      pledged shares of $82,000 was treated as an additional advance from the
      Lenders.





During
      the fourth quarter of 2003, we made a principal payment of $26,000 against
      the
      outstanding balance of the promissory note. During 2004, we entered into an
      agreement with the holders of the promissory note to increase the balance of
      the
      note payable by $300,000 in exchange for a release of the $1,443,000 of accrued
      liabilities related to prior indemnity agreements between us and the note
      holders. We classified the release of $1,143,000 as a capital contribution
      in
      the Consolidated Financial Statements during the fourth quarter of 2004. We
      made
      principal payments against the note of $253,000 during the year ended December
      31, 2004. During the year ended December 31, 2005, we received an additional
      advance of $50,000 against the promissory note. The balance due at December
      31,
      2005 was $486,000.





The
      unpaid balance of $486,000 is secured by our intellectual property rights.
      As of
      December 31, 2005, the Lenders had not converted any of the outstanding balance
      or interest into common stock.





***Notes
      Payable***





During
      the first quarter of 2003, we entered into a promissory note with an unrelated
      third party converting accounts payable for outstanding lease payments of
      $114,000 to a note payable. This note accrued interest at 10% annually and
      required monthly minimum payments of the greater of $3,000 or 2% of aggregate
      proceeds from our Third Equity Line of Credit and subsequent equity lines of
      credit until the note was been fully paid. Under the loan agreement, we could
      not sell or transfer assets outside of the ordinary course of business, or
      enter
      a transaction resulting in a change of control, without written permission
      from
      the creditor. The note was paid in full during the year ended December 31,
      2004.







50








On
      February 28, 2003, LecStar established an asset securitization facility which
      provided LecStar with $750,000. Assets securitized under this facility consist
      of executory future cash flows from LecStar customers in the states of Georgia,
      Tennessee, Florida, and Louisiana. LecStar has pledged its interest in the
      special purpose securitization facility, LecStar Telecom Ventures LLC, and
      customer accounts receivable to the lender. We have recorded the $750,000 as
      a
      note payable in our consolidated financial statements. The note bears an
      interest rate of 6.5% and is due on February 27, 2007, with 24 equal monthly
      installments which began on March 6, 2005. During 2005, we made principal
      payments of $214,000.





In
      connection with the acquisition of the capital stock of LTEL in 2004, we issued
      a 5%, $10,000,000, secured, six-year note payable to McCormack Avenue, Ltd.
      Under the terms of the note payable, quarterly interest only payments are
      required through January 15, 2005, with quarterly principal and interest
      payments beginning April 2005 and continuing through January 2010. Interest
      on
      the promissory note is payable in cash or, at our option, in shares of our
      Class
      A common stock. The note is secured by the capital stock and all of the assets
      of LTEL and its subsidiaries. The note was valued at $4,624,000 based on an
      imputed interest rate of 25 percent per annum. The note has a mandatory
      prepayment clause wherein we are required to make prepayments in any given
      month
      where we receive net proceeds in excess of $900,000 from the Fifth Equity Line
      (or replacements thereof with the Equity Line Investor). The required prepayment
      is calculated by multiplying the net proceeds received over $900,000 by 33%.
      For
      the year ended December 31, 2004, we made mandatory prepayments on the note
      of
      $415,000. During 2005, we made mandatory prepayments of $102,000.





During
      the year ended December 31, 2004, we made scheduled interest only payments
      of
      $175,000, and issued 833,334 shares of our Class A common stock in satisfaction
      of the September 30, 2004, required interest only payment of $125,000. We also
      elected to make the December 31, 2004, payment in stock and issued 655,162
      shares of our Class A common stock in connection with this payment subsequent
      to
      December 31, 2004 in satisfaction of the December 31, 2004 required interest
      only payment of $124,000. During 2005, we elected to make all principal and
      interest payments in shares of our Class A common stock and issued 29,417,578
      shares. These shares were used in payment of $751,000 of principal plus accrued
      interest on the note. The discount on the note is based on an imputed interest
      rate of 25%. The carrying amount of the note of $4,709,000 at December 31,
      2005 is net
      of unamortized discount of $4,024,000.





During
      the fourth quarter of 2005, we entered into two promissory notes with an
      unrelated third party in the aggregate amount of $650,000. These notes accrue
      interest at 10% annually and are due and payable during the second quarter
      of
      2006.





***Series
      D Debentures***





On
      October 11, 2002, the Company issued $1,500,000 of Series D 12% Convertible
      Debentures (the "Debentures"), due April 9, 2003, and 194,444 shares of Class
      A
      common stock to Breckenridge Fund, LLC ("Breckenridge"), an unaffiliated third
      party, for $1,500,000 before offering costs of $118,000. The outstanding
      principal amount of the Debentures was convertible at any time at the option
      of
      the holder into shares of our common stock at a conversion price equal to the
      average of the two lowest closing bid prices of our Class A common stock for
      the
      twenty trading days immediately preceding the conversion date, multiplied by
      90%.





We
      determined that Breckenridge had received a beneficial conversion option on
      the
      date the Debentures were issued. The net proceeds of $1,382,000, were allocated
      to the Debentures and to the Class A common stock based upon their relative
      fair
      values and resulted in allocating $524,000 to the Debentures, $571,000 to the
      related beneficial conversion option, $373,000 to the 194,444 shares of Class
      A
      common stock, less $86,000 of deferred loan costs. The resulting $976,000
      discount on the Debentures and the deferred loan costs were amortized over
      the
      term of the Debentures as interest expense.





In
      connection with the issuance of the Debentures, we issued, as collateral to
      secure its performance under the Debenture, 2,083,333 shares of Class A common
      stock (the "Collateral Shares"), which were placed into an escrow pursuant
      to an
      escrow agreement. Under the escrow agreement, the Collateral Shares would not
      be
      released to Breckenridge unless we were delinquent with respect to payments
      under the Debenture.










51








The
      Debentures were originally due April 9, 2003. However, Fonix and Breckenridge
      agreed in January 2003 to modify the terms of the Debentures requiring the
      following principal payments plus accrued interest: $400,000 in January 2003;
      $350,000 in February 2003; $250,000 in March 2003; $250,000 in April 2003;
      and
      $250,000 in May 2003. Additionally, we agreed to release 237,584 of the
      Collateral Shares to Breckenridge as consideration (the "Released Shares")
      for
      revising the terms of the purchase agreement. The additional shares were
      accounted for as an additional discount of $285,000. The value of the shares
      was
      amortized over the modified term of the Debentures as interest expense. We
      did
      not make the last three payments as scheduled. Breckenridge asserted its rights
      under the Debenture agreement for penalties as we did not meet the prescribed
      payment schedule. Breckenridge asserted a claim of $379,000 which we disputed.
      Both parties subsequently agreed to satisfy the claim in full through the
      issuance of 1,550,000 shares of our Class A common stock with a value of
      $225,000. We transferred the shares to Breckenridge on October 20, 2003, in
      full
      satisfaction of the claim and recorded the penalty as interest
      expense.





In
      connection with the issuance of the Debentures, we entered into a registration
      rights agreement in which we agreed to register the resale of the shares
      underlying the Debentures, the Collateral Shares, and the Released Shares.
      We
      filed a registration statement on Form S-2, which became effective February
      14,
      2003. Additionally, we filed another registration statement on July 2, 2003,
      which was declared effective on July 7, 2003, which included shares issuable
      to
      Breckenridge in connection with the Debentures. We were obligated to file such
      post-effective amendments as necessary to keep the registration statements
      effective as required by the registration rights agreement.





Through
      December 31, 2003, we had paid $650,000 of the outstanding principal, together
      with $54,000 in accrued interest. Additionally, through December 31, 2003,
      the
      holder of the Debentures converted the remaining $850,000 principal amount
      and
      $41,000 in interest into 7,359,089 shares of Fonix Class A common
      stock.





As
      part
      of the Debenture agreement, we were required to pay Breckenridge a placement
      fee
      in the amount of $350,000 payable in stock at the conclusion of the Debenture.
      We satisfied the obligation through the issuance of 2,000,000 shares of our
      Class A common stock valued at $358,000, or $0.179 per share and 377,717 shares
      of our Class A common stock valued at $59,000, or $0.157 per share. We recorded
      the expense as interest expense in the accompanying financial
      statements.





In
      March
      2004, we discovered that during 2003 an aggregate of 2,277,778 shares of Class
      A
      common stock (the "Unauthorized Shares") were improperly transferred to the
      Debenture holder as a result of (i) the unauthorized release from escrow of
      the
      Collateral Shares (net of the Released Shares), and (ii) the transfer to the
      Debenture holder of a duplicate certificate for 194,445 shares where the
      original certificate was not returned to the transfer agent for cancellation.
      The Unauthorized Shares were, therefore, in excess of the shares the Debenture
      holder was entitled to receive. No consideration was paid to or received by
      us
      for the Unauthorized Shares during 2003; therefore, we did not recognize the
      Unauthorized Shares as being validly issued during 2003.





Upon
      discovering in March 2004 that the Unauthorized Shares had been improperly
      transferred to the Debenture holder, we attempted to settle the matter with
      the
      Debenture holder but was unable to reach a settlement. Accordingly, on May
      3,
      2004, we filed a lawsuit against the Debenture holder, alleging the improper
      transfer to and subsequent sale of the Unauthorized Shares by the Debenture
      holder. The lawsuit was subsequently dismissed without prejudice and refiled
      on
      October 12, 2004. The complaint sought (i) a declaratory judgment that we may
      set off the fair value of the Unauthorized Shares against the value we owed
      to
      the Debenture holder in connection with the Series I Preferred Stock transaction
      (see Note 10 to Consolidated Financial Statements), (ii) judgment against the
      Debenture holder for the fair value of the Unauthorized Shares, and (iii)
      punitive damages from the Debenture holder for improper conversion of the
      Unauthorized Shares.





In
      September 2005, we settled the three pending lawsuits between Fonix and
      Breckenridge. Details relating to the terms of the settlement are set forth
      in
      the Legal Proceedings Section above.










52






***Equity
      Lines of Credit***





***Third
      Equity Line of Credit*** ** -
      In June
      2002, we entered into a third equity line agreement (the "Third Equity Line")
      with the Equity Line Investor. Under the Third Equity Line, we had the right
      to
      draw up to $20,000,000 under terms substantially identical to the initial Equity
      Lines.




For
      the
      year ended December 31, 2003, we received $2,625,000 in funds drawn under the
      Third Equity Line, less commissions and fees of $62,000, and issued 5,000,000
      shares of Class A common stock to the Equity Line Investor.





***Fifth
      Equity Line of Credit*** ** -
      We
      entered, as of July 1, 2003, into a fifth private equity line agreement (the
      "Fifth Equity Line Agreement") with the Equity Line Investor. Under the Fifth
      Equity Line Agreement, we had the right to draw up to $20,000,000 against an
      equity line of credit ("the Fifth Equity Line") from the Equity Line Investor.
      We were entitled under the Fifth Equity Line Agreement to draw certain funds
      and
      to put to the Equity Line Investor shares of our Class A common stock in lieu
      of
      repayment of the draw. The number of shares to be issued is determined by
      dividing the amount of the draw by 90% of the average of the two lowest closing
      bid prices of our Class A common stock over the ten trading days after the
      put
      notice is tendered. The Equity Line Investor is required under the Fifth Equity
      Line Agreement to tender the funds requested by us within two trading days
      after
      the ten-trading-day period used to determine the market price.





For
      the
      year ended December 31, 2003, we received $7,382,000 in funds and a subscription
      receivable of $245,000 drawn under the Fifth Equity Line, less commissions
      and
      fees of $291,000, and issued 25,494,145 shares of Class A common stock to the
      Equity Line Investor.





For
      the
      year ended December 31, 2004 we received $12,618,000 in funds drawn under the
      Fifth Equity Line, less commissions and fees of $413,000, and issued 54,768,198
      shares of Class A common stock to the Equity Line Investor.





We
      issued
      5,480,405 shares of Class A common stock to the Equity Line Investor in full
      satisfaction of an outstanding put of $668,000 during the first quarter of
      2005.





***Sixth
      Equity Line of Credit*** -
      We
      entered, as of November 15, 2004, we entered into a sixth private equity line
      agreement (the "Sixth Equity Line Agreement") with the Equity Line Investor,
      on
      terms substantially similar to those of the previous equity lines. Under the
      Sixth Equity Line Agreement, we have the right to draw up to $20,000,000 against
      an equity line of credit ("the Sixth Equity Line") from the Equity Line
      Investor. We are entitled under the Sixth Equity Line Agreement to draw certain
      funds and to put to the Equity Line Investor shares of our Class A common stock
      in lieu of repayment of the draw. The number of shares to be issued is
      determined by dividing the amount of the draw by 90% of the average of the
      two
      lowest closing bid prices of our Class A common stock over the ten trading
      days
      after the put notice is tendered.





The
      Equity Line Investor is required under the Sixth Equity Line Agreement to tender
      the funds requested by us within two trading days after the ten-trading-day
      period used to determine the market price.





In
      connection with the Sixth Equity Line Agreement, we granted registration rights
      to the Equity Line Investor and filed a registration statement on Form S-2,
      which covered the resales of the shares to be issued under the Sixth Equity
      Line. We are obligated to maintain the effectiveness of the registration
      statement.





For
      the
      year ended December 31, 2005, we received $4,263,000 in funds drawn under the
      Sixth Equity Line, less commissions and fees of $141,000 and issued 75,000,000
      shares of Class A common stock to the Equity Line Investor.





***Seventh
      Equity Line of Credit*** - On May
      27, 2005, we entered into a seventh private equity line agreement (the "Seventh
      Equity Line Agreement") with the Equity Line Investor, on terms substantially
      similar to those of the Sixth Equity Line between Queen and us dated November
      15, 2004.







53








Under
      the
      Seventh Equity Line Agreement, we have the right to draw up to $20,000,000
      against an equity line of credit (the "Seventh Equity Line") from the Equity
      Line Investor. We are entitled under the Seventh Equity Line Agreement to draw
      certain funds and to put to the Equity Line Investor shares of the Company's
      Class A common stock in lieu of repayment of the draw. We are limited as to
      the
      amount of shares we may put to the Equity Line Investor in connection with
      each
      put; we may not put shares which would cause the Equity Line Investor to own
      more than 4.99% of our outstanding common stock on the date of the put notice.
      The number of shares to be issued in connection with each draw is determined
      by
      dividing the amount of the draw by 93% of the average of the two lowest closing
      bid prices of our Class A common stock over the ten trading days after the
      put
      notice is tendered. The Equity Line Investor is required under the Seventh
      Equity Line Agreement to tender the funds requested by us within two trading
      days after the ten-trading-day period used to determine the market
      price.





The
      amount of funds available to us depends on the number of shares registered
      for
      resale by the Equity Line Investor. For example, if the Company were to draw
      down $3,000,000 under the Seventh Equity Line, the number of shares issuable
      would be approximately 167,000,000 shares as of March 10, 2006. We currently
      have a registration statement registers the resale of up to 300,000,000 shares,
      excluding any shares issued as blackout shares. Accordingly, we would need
      to
      file additional registration statements to be able to draw $3,000,000 at current
      market prices. By way of information, during 2005, our stock price has ranged
      from $0.02 to $0.19 per share.





As
      of
      March 10, 2006, we had 481,309,900 shares of our Class A common stock issued
      and
      outstanding. An issuance of 167,000,000 would constitute an increase of
      approximately 35%.





Pursuant
      to the Seventh Equity Line Agreement, we granted to the Equity Line Investor
      a
      right of first refusal (the “Refusal Right”) with respect to additional
      financing transactions. Under the Refusal Right, for a period of 180 days after
      the effective date of a registration statement filed to register resales by
      the
      Equity Line Investor, we may not offer or sell, with certain exceptions, shares
      of our common stock in a financing transaction without first offering that
      financing transaction to the Equity Line Investor. The Equity Line Investor
      then
      has the right to choose to offer financing to us on the same terms or to allow
      us to proceed with the financing transaction with other investors.





In
      connection with the Seventh Equity Line Agreement, we entered into an agreement
      with the Equity Line Investor to terminate all previous equity lines, and cease
      further draws or issuances of shares in connection with all previous equity
      lines. As such, as of the date of this report, the only active equity line
      of
      credit was the Seventh Equity Line.





Also
      in
      connection with the Seventh Equity Line Agreement, we granted registration
      rights to the Equity Line Investor and have filed two registration statements
      which cover the resales of the shares to be issued under the Seventh Equity
      Line. All of the shares registered by the first registration statement had
      been
      sold as of October 24, 2005. . The second registration statement filed in
      connection with the Seventh Equity Line was declared effective by the SEC on
      February 13, 2006.





For
      the
      year ended December 31, 2005, we received $3,127,000 in funds drawn under the
      Seventh Equity Line, less commissions and fees of $106,000 and issued
      100,000,000 shares of Class A common stock to the Equity Line Investor.





We
      presently are authorized to issue up to 800,000,000 shares of our Class A common
      stock. As of March 10, 2006, we had 481,309,900 shares of Class A common stock
      issued and outstanding. We intend to seek shareholder approval for an amendment
      to our charter to increase the authorized capital to 5,000,000,000 shares.
      However, if we do not receive such approval, we believe that we would be able
      to
      continue to draw funds under the Seventh Equity Line, assuming no growth in
      revenues and no reduction in expenses, for approximately twelve to eighteen
      months, absent other arrangements.





***Acquisitions***





***LecStar
      Acquisition*** ** -
      On
      February 24, 2004, we acquired all of the capital stock of LTEL Holdings
      Corporation (“LTEL”) and its wholly-owned subsidiaries, LecStar Telecom, Inc.,
      and LecStar DataNet, Inc. (collectively “LecStar”). The results of LecStar's
      operations are included in the consolidated financial statements from February
      24, 2004. We acquired LecStar to provide us with a recurring revenue stream,
      a
      growing customer base, new marketing channels for our Core Technologies and
      Speech Products, and to reduce our cost of capital.









54








In
      accordance with FAS No. 141, “Business Combinations,” the aggregate purchase
      price was $12,800,000 and consisted of the issuance of 7,036,802 shares of
      Class
      A common stock valued at $4,175,000 or $0.59 per share, 2,000 shares of 5%
      Series H nonvoting, nonconvertible preferred stock (the "Series H Preferred
      Stock") with a stated value of $10,000 per share valued at $4,000,000, and
      a 5%
      $10,000,000 secured, six-year promissory note (the "Note") valued at $4,624,000.
      The number of shares of Class A common stock issued under the terms of the
      purchase agreement was determined by dividing $3,000,000 by 90 percent of the
      average closing bid price of our common stock for the first 30 of the 33
      consecutive trading days immediately preceding the date certain regulatory
      approvals were deemed effective. Under the terms of the acquisition agreement,
      the number of Class A common shares was determinable on February 19, 2004.
      Accordingly, the value of the shares of Class A common stock was established,
      in
      accordance with SFAS No. 141, as the average market price of our common stock
      over the three-day period through February 19, 2004. The values of the Series
      H
      Preferred Stock and the Note were determined based on the estimated
      risk-adjusted cost of capital for us at the date of the acquisition.





The
      fair
      value of the Series H Preferred Stock was based on an imputed yield rate of
      25
      percent per annum and the discount on the Note of $5,376,000 was based on an
      imputed interest rate of 25 percent per annum.





The
      purchase price was allocated to the assets acquired and liabilities assumed
      based on their estimated fair values. Negative goodwill was not recognized
      in
      connection with the acquisition of LecStar. Instead, the excess of the fair
      value of the net assets over the purchase price was allocated as a pro rata
      reduction of the amounts that otherwise would have been assigned to the
      long-term assets. At February 24, 2004, the purchase price was allocated to
      the
      assets acquired and the liabilities assumed as follows:


Current
                  Assets
              
              $
              2,390,000Investments
              
              
              237,000Property
                  and equipment
              
              
              148,000Deposits
                  and other assets
              
              
              984,000Intangible
                  assets
              
              
              18,500,000Total
                  assets acquired
              
              
              22,259,000Current
                  liabilities
              
              
              (8,923,000
              )Long-term
                  portion of notes payable
              
              
              (536,000
              )Total
                  liabilities assumed
              
              
              (9,459,000
              )Net
                  Assets Acquired
              
              $
              12,800,000





Of
      the
      $18,500,000 of acquired intangible assets, $1,110,000 was assigned to LecStar's
      brand name, which has an indefinite life and therefore is not subject to
      amortization; $14,430,000 was assigned to the local telephone exchange customer
      base, with a 2.9-year weighted-average useful life; and $2,960,000 was assigned
      to established marketing contracts and agreements with utility companies, with
      a
      1.8-year estimated useful life. Total intangible assets subject to amortization
      have a weighted-average useful life of approximately 2.7 years.





***Stock
      Options and Warrants*** ****





On
      January 19, 2005 we entered into an option exchange program with our employees,
      wherein we gave eligible Fonix employees the opportunity to exchange outstanding
      stock options for the same number of new options to be issued at least six
      months and one day from the expiration of the offer. As a result of the option
      exchange program, we cancelled 414,450 options to purchase shares of our Class
      A
      common stock effective February 22, 2005. On August 23, 2005 we granted 414,450
      options to employees participating in the option exchange program at $0.04
      per
      share.





During
      2005, we granted options to purchase 746,505 shares of Class A common stock
      in
      addition to the option granted in connection with the option exchange program
      described above. The options were granted at exercise prices ranging from $0.04
      to $0.12. All options were granted at the quoted market price on the date of
      grant. All options granted vest over three years following issuance. If not
      exercised, all options expire within ten years from the date of
      grant.







55








During
      2004, we granted options to purchase 110,600 shares of Class A common stock
      at
      exercise prices ranging from $0.21 to $0.37. All options were granted at the
      quoted market price at the date of grant. All options granted vest over three
      years following issuance. If not exercised, all options expire within ten years
      from the date of grant.





As
      of
      December 31, 2005, we had warrants to purchase a total of 15,000 shares of
      Class
      A common stock outstanding.





***Summary
      of Contractual Obligations***





The
      following summary reflects payments due under long-term obligations as of
      December 31, 2005:


**Total**
              
              **Less
                  Than One**
              
              **One
                  to Three**
              
              **Three
                  to Five**
              
              **More
                  than Five**Notes
                  payable
              
              $
              11,905,000
              
              $
              2,332,000
              
              $
              2,554,000
              
              $
              7,019,000
              
              
              --Operating
                  lease obligations
              
              
              2,453,000
              
              
              715,000
              
              
              1,180,000
              
              
              558,000
              
              
              --Preferred
                  stock dividends
              
              
              5,275,000
              
              
              1,055,000
              
              
              2,110,000
              
              
              2,110,000
              
              
              **Total
                  contractual cash obligations
              
              $
              19,633,000
              
              $
              4,102,000
              
              $
              5,844,000
              
              $
              9,687,000




**
      Preferred stock dividends do not have a definite life, therefore dividend
      payment requirements greater than five years cannot reasonably be
      estimated.







***Other***





We
      presently have no plans to purchase new research and development or office
      facilities.





**Corporate
      Outlook**





Fonix
      offers businesses and consumers competitive technologies for integrated
      communication needs such as Voice over Internet Protocol (“VoIP”), Broadband
      over Power Line (“BPL”), switched telecommunication services and value-added
      embedded speech interface solutions. Fonix delivers its telecommunicationsand
      speech products and services through three incorporated subsidiaries: Fonix
      Telecom, Inc., LecStar Telecom, Inc. and Fonix Speech, Inc. Integration
      of company support functions and overhead will create organization-wide
      operational and financial efficiencies.





Fonix’s focus
      on
      providing competitive and value-added solutions for customers and partners
      requires a broad set of technologies, service offerings and channel
      capabilities. Management anticipates and expects further development of
      complementary technologies, added product and application developments, access
      to market channels and additional opportunities for strategic alliances in
      other
      industry segments.





We
      expect
      to employ a consolidation-driven growth strategy in the telecommunication
      industry using Fonix Telecom as the platform. Fonix Telecom provides
      facilities-based local telephone service and interconnection services in
      Georgia, North Carolina, South Carolina, and Florida, delivers VoIP services
      and
      has expanded its partner relationship with Duke Energy, a major utilities
      company serving customers in the Southern states, to deliver BPL services to
      business and residential customers. We anticipate strategic acquisitions of
      synergistic companies that will result in a stable revenue stream and an
      expanded customer base. Fonix Telecom continues to provide customers with the
      new VoIP and/or BPL solutions.




LecStar
      Telecom will continue to deliver an array of wireline voice, data and
      carrier-grade local and long distance telephone services utilizing traditional
      lines in the Southeast. LecStar’s customer base is limited as a consequence of increased
      regulatory flexibility and retail and wholesale pricing freedoms.







56








We
      will
      continue to leverage our research and development of speech technologies to
      deliver software applications and engines to device manufacturers looking to
      incorporate speech interfaces into end-user products. Fonix Speech’s
      award-wining technologies provide competitive embedded speech solutions for
      mobile/wireless devices, videogames, telephony systems and products for the
      assistive market based on Fonix’s proprietary and patented TTS and ASR
      technologies.





As
      we
      implement our strategy to reach corporate objectives, management anticipates
      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
      has significant risks, and shareholders and others interested in Fonix and
      our
      Class A common stock should carefully consider the risks set forth under the
      heading “Certain Significant Risk Factors” in Item 1, Part I,
      above.





As
      noted
      above, as of December 31, 2005, we had an accumulated deficit of $250,521,000,
      negative working capital of $19,004,000, accrued liabilities and accrued legal
      settlement obligations of $10,214,000 and accounts payable $6,770,000. Sales
      of
      products and telecommunications services and revenue from licenses based on
      our
      technologies have not been sufficient to finance ongoing operations. We have
      limited capital available under an equity line of credit. These matters raise
      substantial doubt about our ability to continue as a going concern. Our
      continued existence is dependent upon several factors, including our success
      in
      (1) increasing telecommunications services, and speech license, royalty and
      services revenues, (2) raising sufficient additional funding, and (3) minimizing
      operating costs. Until sufficient revenues are generated from operating
      activities, we expected to continue to fund our operations through the sale
      of
      our equity securities, primarily in connection with the Seventh Equity Line.
      We
      are currently pursuing additional sources of liquidity in the form of
      traditional commercial credit, asset based lending, or additional sales of
      our
      equity securities to finance our ongoing operations. Additionally, we are
      pursuing other types of commercial and private financing, which could involve
      sales of our assets or sales of one or more operating divisions. Our sales
      and
      financial condition have been adversely affected by our reduced credit
      availability and lack of access to alternate financing because of our
      significant ongoing losses and increasing liabilities and payables. As we have
      noted in our annual report and other public filings, if additional financing
      is
      not obtained in the near future, we will be required to more significantly
      curtail our operations or seek protection under bankruptcy laws.





**Information
      Concerning Forward-Looking Statements**





Certain
      of the statements contained in this report (other than the historical financial
      data and other statements of historical fact) are forward-looking statements.
      These statements include, but are not limited to our expectations with respect
      to the development of a diversified revenue base; delivery of our VoiceDial
      application; the market volume of educational electronic dictionary devices;
      our
      ability to capitalize in markets including toys, appliances, and other devices;
      the market demand for videogames; our growth strategies and the implementation
      of our Core Technologies and potential results; our payment of dividends on
      our
      common stock; our ability to meet customer demand for speech technologies and
      solutions; the availability of telecommunications services; development of
      complementary technologies, products, marketing, and strategic alliance
      opportunities; the impacts on legacy CLECs of recent regulatory changes; the
      cost-efficiency of LecStar’s business strategy; the impact of legislative
      initiatives on local exchange competition; profitability of language learning
      tools; the status of traditional operator systems; our ability to continue
      operations in the event we do not receive approval to amend our articles of
      incorporation; the comparability of our speech-enabled Speech Products to other
      products; our intentions with respect to strategic collaborations and marketing
      arrangements; our intentions with respect to use of licenses; our plans with
      respect to development and acquisition of speech solutions; our goals with
      respect to supplying speech solutions for OEMs; our expectations with respect
      to
      continued financial losses; our expectations with respect to revenues from
      our
      telecommunication activities; and our intentions with respect to financing
      our
      operations in the future. Additional forward-looking statements may be found
      in
      the “Certain Significant Risk Factors” Section of this report, together with
      accompanying explanations of the potential risks associated with such
      statements.





Forward-looking
      statements made in this report, are made based upon management’s good faith
      expectations and beliefs concerning future developments and their potential
      effect upon Fonix. There can be no assurance that future developments will
      be in
      accordance with such expectations, or that the effect of future developments
      on
      Fonix will be those anticipated by management. Forward-looking statements may
      be
      identified by the use of words such as “believe,” “expect,” “plans,” “strategy,”
“prospects,” “estimate,” “project,” “anticipate,” “intends” and other words of
      similar meaning in connection with a discussion of future operating or financial
      performance.









57








You
      are
      cautioned not to place undue reliance on these forward looking statements,
      which
      are current only as of the date of this Report. We disclaim any intention or
      obligation to update or revise any forward-looking statements, whether as a
      result of new information, future events, or otherwise. Many important factors
      could cause actual results to differ materially from management’s expectations,
      including those listed in the “Certain Significant Risk Factors” Section, as
      well as the following:





•
            unpredictable
                difficulties or delays in the development of new products and
                technologies;





•
            changes
                in U.S. or international economic conditions, such as inflation,
                interest
                rate fluctuations, foreign exchange rate fluctuations or recessions
                in
                Fonix's markets;





•
            pricing
                changes to our supplies or products or those of our competitors,
                and other
                competitive pressures on pricing and
                sales;





•
            integration
                of acquired businesses, especially integration of
                LecStar;





•
            changes
                in laws or different interpretations of laws including particularly
                potential revisions to the 1996 Telecommunications Act, which could
                have a
                material impact on our telecommunications business and
                operations;





•
            recent
                FCC rules relating to independent local exchange carrier obligations
                to
                provide access to unbundled network elements, unbundled local switching,
                and unbundled loops and transport;





•
            increases
                by the FCC in Total Element Long Run Incremental Cost, or TELRIC,
                rates
                and inter-carrier compensation;





•
            the
                outcome of BellSouth’s appeal of the Georgia Public Service Commission
                order requiring BellSouth to pursue the change of law clause in its
                interconnection agreements (as discussed in more detail in the Risk
                Factors section);





•
            potential
                IRS rules relating to taxation of communications services, including
                Voice
                over Internet Protocol and other IP-based services, applications,
                and
                technologies;





•
            difficulties
                in obtaining or retaining the management, engineering, and other
                human
                resource competencies that we need to achieve our business
                objectives;





•
            the
                impact on Fonix or a subsidiary from the loss of a significant customer
                or
                a few customers;





•
            risks
                generally relating to our international operations, including
                governmental, regulatory or political
                changes;





•
            transactions
                or other events affecting the need for, timing and extent of our
                capital
                expenditures; and





•
            the
                extent to which we reduce outstanding
                debt.













58






**ITEM 8.**
            **FINANCIAL
                STATEMENTS AND SUPPLEMENTARY
                DATA**





Index
      to
      Consolidated Financial Statements:





Report
                of Independent Registered Public Accounting Firm
            F-2**CONSOLIDATED
                FINANCIAL STATEMENTS:**Consolidated
                Balance Sheets as of December 31, 2005 and 2004
            F-3Consolidated
                Statements of Operations and Comprehensive Loss for the Years Ended
                December 31, 2005, 2004 and 2003
            F-4Consolidated
                Statements of Stockholders’ Equity (Deficit) for the Years Ended December
                31, 2003, 2004 and 2005
            F-5Consolidated
                Statements of Cash Flows for the Years Ended December 31, 2005, 2004
                and
                2003
            F-6Notes
                to Consolidated Financial Statements
            F-8





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





None.





**ITEM
              9a.**
            **CONTROLS
                AND PROCEDURES**





Evaluation
      of Disclosure Controls and Procedures .
      Our
      Chief Executive Officer and our Chief Financial Officer, after evaluating the
      effectiveness of the Company’s “disclosure controls and procedures” (as defined
      in the Securities Exchange Act of 1934 (Exchange Act) Rules 13a-15(e) or
      15d-15(e)) as of the end of the period covered by this annual report, have
      concluded that our disclosure controls and procedures are effective based on
      their evaluation of these controls and procedures required by paragraph (b)
      of
      Exchange Act Rules 13a-15 or 15d-15.





Changes
      in Internal Control Over Financial Reporting .
      There
      were no changes in our internal control over financial reporting identified
      in
      connection with the evaluation required by paragraph (d) of Exchange Act Rules
      13a-15 or 15d-15 that occurred during our last fiscal quarter that have
      materially affected, or are reasonably likely to materially affect, our internal
      control over financial reporting.





Section
      404 Assessment .
      Section
      404 of the Sarbanes-Oxley Act of 2002 requires management’s annual review and
      evaluation of our internal controls, and an attestation of the effectiveness
      of
      these controls by our independent registered public accounting firm beginning
      with our Form 10-K for the fiscal year ending on December 31, 2007. We are
      dedicating significant resources, including management time and effort, and
      incurring substantial costs in connection with our ongoing Section 404
      assessment. We are currently documenting and testing our internal controls
      and
      considering whether any improvements are necessary for maintaining an effective
      control environment at our company. The evaluation of our internal controls
      is
      being conducted under the direction of our senior management. In addition,
      our
      management is regularly discussing the results of our testing and any proposed
      improvements to our control environment with our Audit Committee. We will
      continue to work to improve our controls and procedures, and to educate and
      train our employees on our existing controls and procedures in connection with
      our efforts to maintain an effective controls infrastructure at our
      Company.





Limitations
      on Effectiveness of Controls .
      A
      system of controls, however well designed and operated, can provide only
      reasonable, and not absolute, assurance that the system will meet its
      objectives. The design of a control system is based, in part, upon the benefits
      of the control system relative to its costs. Control systems can be circumvented
      by the individual acts of some persons, by collusion of two or more people,
      or
      by management override of the control. In addition, over time, controls may
      become inadequate because of changes in conditions, or the degree of compliance
      with the policies or procedures may deteriorate. In addition, the design of
      any
      control system is based in part upon assumptions about the likelihood of future
      events.







59








**ITEM
              9b.**
            **OTHER
                INFORMATION**





None.


**PART
      III**





**ITEM
              10.**
            **DIRECTORS
                AND EXECUTIVE OFFICERS OF
                FONIX**





The
      following table sets forth certain information concerning the executive officers
      and directors of Fonix as of March 10, 2006:





Name
            Age
            PositionThomas
                A. Murdock (1)*
            61
            Director,
                President & Chief Executive OfficerRoger
                D. Dudley (2)*
            53
            Director,
                Executive Vice President & Chief Financial OfficerWilliam
                A. Maasberg, Jr. (1) (2)
            66
            Director,
                Chief Operating Officer




(1)
            Member,
                Compensation Committee


(2)
            Member,
                Audit Committee


*
            Committee
                Chairman





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





THOMAS
      A.
      MURDOCK is a co-founder of Fonix and has served as an executive officer and
      member of our board of directors since June 1994. He has been our chief
      executive officer since January 26, 1999. Mr. Murdock also has served as
      president of SCC Asset Management Inc., formerly Studdert Companies Corporation
      (“SCC”), a related party, since 1992. For much of his career, Mr. Murdock was a
      commercial banker and a senior corporate executive with significant
      international emphasis and experience.





ROGER
      D.
      DUDLEY is a co-founder of Fonix and has served as an executive officer and
      member of our board of directors since June 1994. Mr. Dudley currently serves
      as
      our executive vice president and chief financial officer. After several years
      at
      IBM in marketing and sales, he began his career in the investment banking
      industry. He has extensive experience in corporate finance, equity and debt
      private placements and asset management.





WILLIAM
      A. MAASBERG, Jr. became a director of Fonix in September 1999 and was named
      chief operating officer February 1, 2000. From December 1997 through February
      1999, Mr. Maasberg was vice president and general manager of the AMS Division
      of
      Eyring Corporation which manufactures multi-media electronic work instruction
      software application. He was also a co-founder and principal in Information
      Enabling Technologies, Inc. (“IET”), and LIBRA Corporation (“LIBRA”), two
      companies focusing on software application development, and served in several
      key executive positions with both IET and LIBRA from May 1976 through November
      1997. Mr. Maasberg worked for IBM Corporation from July 1965 through May 1976
      in
      various capacities. He received his B.S. Degree from Stanford University in
      Electrical Engineering and his M.S. in Electrical Engineering from the
      University of Southern California.





**Audit
      Committee Financial Expert**





The
      Board
      of Directors has determined that we do not have an audit committee financial
      expert. We have been seeking to add an individual with these qualifications
      to
      our Board of Directors but have been unable to find a suitable individual.
      We
      continue to search for someone who meets the qualifications of an audit
      committee financial expert.










60








**Compliance
      With Section 16(a) of the Exchange Act**





Section
      16(a) of the Securities Exchange Act of 1934 requires our officers and
      directors, and persons who beneficially own more than 10% of a registered class
      of our equity securities, to file reports of ownership and changes in ownership
      with the Securities and Exchange Commission. Officers, directors and greater
      than 10% shareholders are required by regulation of the Securities and Exchange
      Commission to furnish us with copies of all Section 16(a) forms which they
      file.
      Based solely on its review of the copies of such forms furnished to us during
      the fiscal year ended December 31, 2005, we are aware of the following untimely
      filings:





Messrs.
      Murdock and Dudley filed late Forms 5. Additionally, Messrs. Murdock, Dudley
      and
      Maasberg received options in 2005 in connection with our option exchange program
      which should have been reported on a Form 4 but which were reported on the
      Form
      5.





**Code
      of Ethics Disclosure**





In
      March
      2004, our Board of Directors adopted a Code of Ethics, or the Code, that applies
      to its and our executive officers, including, among others, our chief executive
      officers and senior financial officers, as well as all of our employees at
      all
      levels, including our subsidiaries. The Code is designed to deter wrongdoing
      and
      to matters of business ethics including, but not limited to:





•
            Business
                Ethics - The Code states that it is the policy of the Company that
                each
                employee should conduct his or her affairs with uncompromising honesty
                and
                integrity.





•
            Public
                Reports - The Code notes that Fonix is a public reporting company,
                and
                expresses the policy that any employee who has a responsibility for
                assisting in preparation of public reports or other public filings
                must
                assure that the information contained in the report or filing is
                complete,
                accurate, and true in every
                respect.





•
            Conflicts
                of Interest - The Code discusses possible situations of conflicts
                of
                interest, and requires that potential conflicts of interest be cleared
                through the Company's Audit
                Committee.





•
            The
                Code prohibits gifts, bribes, or kickbacks being given or received
                by
                Fonix employees. Additionally, the Code prohibits: loans to officers
                or
                directors; improper use or theft of Company property; falsifying
                records;
                abuse of Company, customer, associate, or vendor information; gathering
                information regarding competitors of the Company; defamation or
                misstatements; and improper use of Company or third-party
                software.





A
      copy of
      our Code of Ethics was an exhibit to the annual report filed for 2003.
      Additionally, we undertake to provide to any person without charge, upon
      request, a copy of our Code of Ethics. Such request may be made in writing
      to
      the Board of Directors at our address listed on the first page of this
      report.












61







**ITEM
              11.**
            **EXECUTIVE
                COMPENSATION**





The
      following table sets forth information concerning the compensation paid or
      accrued to all persons serving as our chief executive officer and our most
      highly compensated executive officers other than its chief executive officer
      who
      were serving as executive officers at December 31, 2005, and whose annual
      compensation exceeded $100,000 during such year (collectively the “Named
      Executive Officers”):





**Summary
      Compensation Table**


**Annual
                  Compensation**
              **Long-Term**
                **Compensation****Name
                  and Principal Position**
              **Year**
              **Salary**
              
              **Other**
                **Annual
                  Bonus**
              **Securities
                  Underlying**
                **Options/SARs
                  (5)**Thomas
                  A. Murdock (1)
              2003
              $
                  309,400
              
              --
              0/0Chief
                  Executive Officer & President
              2004
              $
                  232,000
              (2)
              --
              0/02005
              $
                  261,025
              
              --
              126,500/0Roger
                  D. Dudley (1)
              2003
              $
                  309,400
              
              --
              0/0Executive
                  Vice President & Chief Financial Officer
              2004
              $
                  232,000
              (2)
              --
              0/02005
              $
                  261,025
              
              --
              126,500/0William
                  A. Maasberg, Jr. (3)
              2003
              $
                  225,000
              
              --
              0/0Chief
                  Operating Officer
              2004
              $
                  150,000
              (4)
              --
              0/02005
              $
                  150,000
              
              --
              42,500/0


(1)
            We
                have executive employment agreements with Messrs. Murdock and Dudley.
                The
                expiration date is December 31, 2010. The material terms of each
                executive
                employment agreement with Messrs. Murdock and Dudley are identical
                and are
                as follows: the annual base salary for each executive officer is
                $309,400
                and may be adjusted upward in future years as deemed appropriate
                by the
                board of directors.





Each
      such
      executive officer also is entitled to customary insurance benefits, office
      and
      support staff and an automobile allowance. In addition, if any executive is
      terminated without cause during the contract term, then all salary then and
      thereafter due and owing under the executive employment agreement shall, at
      the
      executive’s option, be immediately paid in a lump sum payment to the executive
      officer, and all stock options, warrants and other similar rights granted by
      us
      and then vested or earned shall be immediately granted to the executive officer
      without restriction or limitation of any kind.





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





(2)
            Due
                to cash flow difficulties, Messrs. Murdock and Dudley agreed to a
                decrease
                in their annual compensation from $309,400 to $232,000 for 2004 and
                part
                of 2005.










62








(3)  We
      had an
      employment agreement with Mr. Maasberg that was effective February 1, 2000.
      The
      terms of the agreement established the annual base salary of $225,000. Mr.
      Maasberg is entitled to customary insurance benefits, office and support staff.
      The original employment contract expired January 31, 2003 and was extended
      through December 31, 2005.





(4)  Due
      to
      cash flow difficulties, Mr. Maasberg agreed to a decrease in his annual
      compensation from $225,000 to $150,000.





(5)
            All
                options granted in 2005 were granted pursuant to our 1998 Stock Option
                Plan and were granted in accordance with our option exchange program.





































































63







**Option
      Grants in Fiscal Year 2005**




Individual
                  Grants
              
              
              
              
              Potential
                  Realizable Value at Assumed Annual Rates of Stock Price Appreciation
                  for
                  Option Term(a)
              (b)
              (c)
              (d)
              (e)
              (f)
              (g)Name
              Number
                  of Securities Underlying Options Granted (#)
              %
                  of Total Options to Employees in Fiscal Year
              Exercise
                  Price ($/share)
              Expiration
                  Date
              5%
              10%Thomas
                  A. Murdock
              20,000
              1.7%
              $0.04
              4/30/06
              $   
                  827
              $   
                  855Thomas
                  A. Murdock
              5,000
              0.4%
              $0.04
              10/28/07
              $   
                  222
              $   
                  244Thomas
                  A. Murdock
              3,750
              0.3%
              $0.04
              3/18/08
              $   
                  169
              $   
                  189Thomas
                  A. Murdock
              10,000
              0.9%
              $0.04
              11/30/08
              $   
                  465
              $   
                  531Thomas
                  A. Murdock
              6,250
              0.5%
              $0.04
              2/9/10
              $   
                  306
              $   
                  362Thomas
                  A. Murdock
              35,000
              3.0%
              $0.04
              7/20/10
              $
                  1,744
              $
                  2,087Thomas
                  A. Murdock
              12,500
              1.1%
              $0.04
              12/7/11
              $   
                  657
              $   
                  815Thomas
                  A. Murdock
              18,750
              1.6%
              $0.04
              1/17/12
              $   
                  990
              $
                  1,230Thomas
                  A. Murdock
              5,000
              0.4%
              $0.04
              12/26/10
              $   
                  253
              $   
                  307Thomas
                  A. Murdock
              5,000
              0.4%
              $0.04
              12/7/11
              $   
                  263
              $   
                  326Thomas
                  A. Murdock
              5,000
              0.4%
              $0.04
              3/4/12
              $   
                  265
              $   
                  331Roger
                  D. Dudley
              20,000
              1.7%
              $0.04
              4/30/06
              $   
                  827
              $   
                  855Roger
                  D. Dudley
              5,000
              0.4%
              $0.04
              10/28/07
              $   
                  222
              $   
                  244Roger
                  D. Dudley
              3,750
              0.3%
              $0.04
              3/18/08
              $   
                  169
              $   
                  189Roger
                  D. Dudley
              10,000
              0.9%
              $0.04
              11/30/08
              $   
                  465
              $   
                  531Roger
                  D. Dudley
              6,250
              0.5%
              $0.04
              2/9/10
              $   
                  306
              $   
                  362Roger
                  D. Dudley
              35,000
              3.0%
              $0.04
              7/20/10
              $
                  1,744
              $ 2,087Roger
                  D. Dudley
              12,500
              1.1%
              $0.04
              12/7/11
              $   
                  657
              $   
                  815Roger
                  D. Dudley
              18,750
              1.6%
              $0.04
              1/17/12
              $   
                  990
              $
                  1,230Roger
                  D. Dudley
              5,000
              0.4%
              $0.04
              12/26/10
              $   
                  253
              $   
                  307Roger
                  D. Dudley
              5,000
              0.4%
              $0.04
              12/7/11
              $   
                  263
              $   
                  326Roger
                  D. Dudley
              5,000
              0.4%
              $0.04
              3/4/12
              $   
                  265
              $   
                  331William
                  A. Maasberg, Jr.
              6,250
              0.5%
              $0.04
              2/1/10
              $   
                  306
              $   
                  361William
                  A. Maasberg, Jr.
              2,500
              0.2%
              $0.04
              2/9/10
              $   
                  122
              $   
                  145William
                  A. Maasberg, Jr.
              6,250
              0.5%
              $0.04
              12/7/11
              $   
                  329
              $   
                  407William
                  A. Maasberg, Jr.
              7,500
              0.6%
              $0.04
              1/17/12
              $   
                  396
              $   
                  492William
                  A. Maasberg, Jr.
              5,000
              0.4%
              $0.04
              9/3/09
              $   
                  240
              $   
                  281William
                  A. Maasberg, Jr.
              5,000
              0.4%
              $0.04
              12/26/10
              $   
                  253
              $   
                  307William
                  A. Maasberg, Jr.
              5,000
              0.4%
              $0.04
              12/7/11
              $   
                  263
              $   
                  326William
                  A. Maasberg, Jr.
              5,000
              0.4%
              $0.04
              3/4/12
              $   
                  265
              $   
                  331










64







**Aggregated
      Option/SAR Exercises in Last Fiscal Year**


**and
      Related December 31, 2005 Option/SAR Values**


(a)
              (b)
              (c)
              (d)
              (e)Name
              Shares
                  Acquired on Exercise (#)
              Value
                  Realized ($)
              Number
                  of Securities Underlying Unexercised Options/SARs at
                December
                  31, 2005 Exercisable/Unexercisable (#)
              Value
                  of In-the-Money Options/SARs at
                December
                  31, 2005 Exercisable/Unexercisable ($)Thomas
                  A. Murdock
              0
              $
                  0
              126,250/0
              $0/$0Roger
                  D. Dudley
              0
              $
                  0
              126,250/0
              $0/$0William
                  A. Maasberg, Jr.
              0
              $
                  0
              42,500/0
              $0/$0








**Board
      of Directors Meetings, Committees and Director
      Compensation**





Our
      board
      of directors took action at 4 duly noticed meetings of the board during 2005.
      Each director attended (in person or telephonically) all of the meetings of
      Fonix’s board of directors. During 2005, our board of directors had the
      following committees: Audit Committee, comprised of Messrs. Dudley (chairman)
      and Maasberg; and Compensation Committee, comprised of Messrs. Murdock
      (chairman) and Maasberg. These standing committees conducted meetings in
      conjunction with meetings of the full board of directors.





**Compensation
      of Directors**





Prior
      to
      April 1996, our directors received no compensation for their service. We
      historically have reimbursed our directors for actual expenses incurred in
      traveling to and participating in directors’ meetings, and we intend to continue
      that policy for the foreseeable future. On March 30, 1996, our board of
      directors adopted, and our shareholders subsequently approved, our 1996
      Directors’ Stock Option Plan (the “Directors’ Plan”). Under the Directors’ Plan,
      members of the Board as constituted on the date of adoption received options
      to
      purchase 5,000 shares of our Class A common stock for each year (or any portion
      thereof consisting of at least six months) during which such persons had served
      on the board for each of fiscal years 1994 and 1995 and were granted 5,000
      shares for each of fiscal years 1996 through 2002, which options vested after
      completion of at least six months’ service on the board during those fiscal
      years. These options have terms of ten years. No options were granted to our
      directors under the Directors’ Plan during 2004. Similar grants have been made
      to our under our 1998 Stock Option Plan, as set forth elsewhere in this
      report.






































65







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





The
      following table sets forth, as of March 10, 2006, the number of shares of Common
      Stock of Fonix beneficially owned by all persons known to be holders of more
      than five percent of our Common Stock and by the executive officers and
      directors of Fonix individually and as a group. This table also includes
      Southridge Partners, LP, and Queen, LLC, who may be deemed to beneficially
      own
      shares of our common stock sufficient to require their inclusion in this table.
      Additional information relating to Southridge partners and Queen is provided
      in
      notes (5) and (6) to the table below. Unless indicated otherwise, the address
      of
      the stockholder is our principal executive offices, 9350 South 150 East, Suite
      700, Sandy, Utah 84070.





**Name
                  and Address of 5% Beneficial**
                **Owners,
                  Executive Officers, and**
                **Directors**
              **Number
                  of Shares**
                **Beneficially
                  Owned**
              **Percent
                  of Class (1)**Thomas
                  A. Murdock
                Chairman
                  of the Board & Chief
                Executive
                  Officer
              24,313,496(2)
              4.84%Roger
                  D. Dudley
                Executive
                  Vice President & Chief
                Financial
                  Officer, Director
              12,156,148(3)
              2.49%William
                  A. Maasberg
                Chief
                  Operating Officer, Director
              42,500(4)
              *Southridge
                  Partners, LP
              4,813,099(5)
              1.00%Queen
                  LLC
              0(6)
              *All
                  Officers and Directors as a Group (3 persons)
              41,638,493
              8.04%





*  Less
      than
      1 percent.





(1) Percentages
      rounded to nearest 1/100th of one percent. Except as indicated in the footnotes
      below, each of the persons listed exercises sole voting and investment power
      over the shares of Common Stock listed for each such person in the
      table.





(2) Includes
      40,000 shares of Common Stock deposited in a voting trust (the “Voting Trust”)
      as to which Mr. Murdock is the sole trustee and 24,313,496 shares of Common
      Stock issuable as of March 10, 2006, into the Voting Trust under a convertible
      promissory note (the “Convertible Note”) held by Mr. Murdock and Mr. Dudley.
      Persons who have deposited their shares of Common Stock into the Voting Trust
      have dividend and liquidation rights (“Economic Rights”) in proportion to the
      number of shares of Common Stock they have deposited in the Voting Trust, but
      have no voting rights with respect to such shares. All voting rights associated
      with the shares deposited into the Voting Trust are exercisable solely and
      exclusively by the Trustee of the Voting Trust. The Voting Trust expires, unless
      extended according to its terms, on the earlier of March 31, 2006, or any of
      the
      following events: (i) the Trustee terminates it; (ii) the participating
      shareholders unanimously terminate it; or (iii) we are dissolved or liquidated.
      Although as the sole trustee of the Voting Trust Mr. Murdock exercises the
      voting rights of all of the shares deposited into the Voting Trust, and
      accordingly has listed all shares in the table above, he has no economic or
      pecuniary interest in any of the shares deposited into the Voting Trust except
      for 12,156,748 shares issuable as of March 10, 2006, under the Convertible
      Note
      as to which he will directly own Economic Rights when issued. Also includes
      71
      shares owned directly by Mr. Murdock, and options to purchase 126,250 shares
      of
      the Company’s Common Stock.





(3) Includes
      (i) 12,156,748 shares of Common Stock issuable as of March 10, 2006, under
      the
      Convertible Note which will be deposited into the Voting Trust when issued,
      (ii)
      71 shares owned directly by Mr. Dudley, (iii) 8 shares owned by Mr. Dudley’s
      minor children, (iv) options to purchase 126,250 shares of the Company’s Common
      Stock, and (v) 20,000 shares held in the Voting Trust.










66








(4) Consisting
      of options to purchase 42,500 shares of Common Stock.





(5) As
      of
      March 10, 2006, Southridge Partners owned 862 shares of our Series K 5%
      Convertible Preferred Stock (the “Series K Preferred Stock”). The Series K
      Preferred Stock has a per-share stated value of $1,000 per share, and is
      convertible at a fixed conversion price of $0.01 per share. As such, a
      hypothetical conversion of the remaining 862 shares of Series K Preferred Stock
      would result in the issuance of 86,200,000 shares of our Class A common stock.
      The certificate of designation of the Series K Preferred Stock prohibits
      Southridge Partners from converting shares of Series K Preferred Stock that
      would result in its owning more than 1.0% of our then outstanding Class A common
      stock, which as of March 10, 2006, was 4,813,099 shares, as shown in the table
      above. Nevertheless, because the beneficial ownership of Southridge Partners
      and
      Queen, LLC, the Equity Line Investor, may be aggregated due to certain
      affiliations between those entities, Southridge Partners may, through
      conversions of the Series K Preferred Stock and the operation of the Seventh
      Equity Line, under SEC regulations be deemed to beneficially own more than
      5.00%
      of our common stock, which would require its inclusion in this
      table.





(6) As
      of
      March 10, 2006, Queen, LLC, the Equity Line Investor, owned no shares of our
      Class A common stock. However, because the beneficial ownership of Southridge
      Partners and Queen, LLC, may be aggregated due to certain affiliations between
      those entities, discussed in more detail note (5) above, Queen may, through
      conversions of the Series K Preferred Stock by Southridge and the operation
      of
      the Seventh Equity Line, under SEC regulations be deemed to beneficially own
      more than 5.00% of our common stock, which would require its inclusion in this
      table.




Plan
                  Category
              Number
                  of securities to be
                issued
                  upon exercise of
                outstanding
                  options,
                warrants,
                  and rights
              Weighted
                  average exercise
                price
                  of outstanding options,
                warrants,
                  and rights
              Number
                  of securities
                remaining
                  available for
                future
                  issuance under equity
                compensation
                  plansEquity
                  compensation plans approved by shareholders
              1,331,205
              $0.13
              19,013,795Equity
                  compensation plans not approved by shareholders
              --
              --
              --Total
              1,331,205
              $0.13
              19,013,795





*2002
      Employee Compensation Plan*





On
      February 6, 2003, the Fonix Board of Directors adopted the 2002 Employee
      Compensation Plan (the “2002 Plan”). Shares of Class A common stock issued under
      the 2002 Plan would have been in partial payment of wages and salaries earned
      by
      employees during the plan period, which ran from December 1, 2002, through
      May
      31, 2003. Each then current employee had agreed to the terms of the 2002
      Plan.





The
      Board
      of Directors subsequently abandoned the 2002 Employee Compensation Plan, and
      no
      shares were issued under the plan.








**ITEM
              13.**
            **CERTAIN
                RELATIONSHIPS AND RELATED
                TRANSACTIONS**





**SCC
      Asset Management Inc.(“SCC”) (formerly Studdert Companies
      Corp.)**





SCC
      is a
      Utah corporation that provides investment and management services. The officers,
      directors and owners of SCC are Thomas A. Murdock and Roger D. Dudley, each
      of
      whom is a director and executive officer of Fonix.





Prior
      to
      October 2002, we subleased office space at market rates from SCC Asset
      Management, Inc., formerly Studdert Companies Corp. Messrs. Murdock and Dudley
      and a former executive officer of Fonix personally guaranteed these leases
      in
      favor of SCC’s landlord. The subleases required monthly rental payments of
      $10,000. During October 2002, we assumed SCC’s lease obligation. The subleases
      were terminated effective February 2003. On March 18, 2003, we executed a
      promissory note with the landlord in the amount of $114,000 covering outstanding
      lease obligations. The note was paid in full in March 2004.







67








**Loans
      from Senior Management to Company**





During
      2002, two of our executive officers (the “Lenders”) sold shares of our Class A
      common stock owned by them and advanced the resulting proceeds amounting to
      $333,000 to us under the terms of a revolving line of credit and related
      promissory note. The funds were advanced for use in our operations. The advances
      bear interest at 10 percent per annum, which interest is payable on a
      semi-annual basis. The entire principal, along with unpaid accrued interest
      and
      any other unpaid charges or related fees, were originally due and payable on
      June 10, 2003. Fonix and the Lenders have agreed to postpone the maturity date
      on several occasions. The note is presently due March 31, 2006. All or part
      of
      the outstanding balance and unpaid interest may be converted at the option
      of
      the Lenders into shares of Class A common stock of Fonix at any time. The
      conversion price was the average closing bid price of the shares at the time
      of
      the advances. To the extent the market price of our shares is below the
      conversion price at the time of conversion, the Lenders are entitled to receive
      additional shares equal to the gross dollar value received from the original
      sale of the shares. A beneficial conversion option of $15,000 was recorded
      as
      interest expense in connection with this transaction. The Lenders may also
      receive additional compensation as determined appropriate by the Board of
      Directors.





In
      October 2002, the Lenders pledged 30,866 shares of the Company's Class A common
      stock to the Equity Line Investor in connection with an advance of $183,000
      to
      us under the Third Equity Line (see Note 12 to Consolidated Financial
      Statements). The Equity Line Investor subsequently sold the pledged shares
      and
      applied $82,000 of the proceeds as a reduction of the advance. The value of
      the
      pledged shares of $82,000 was treated as an additional advance from the
      Lenders.





During
      the fourth quarter of 2003, we made a principal payment of $26,000 against
      the
      outstanding balance of the promissory note. During 2004, we entered into an
      agreement with the holders of the promissory note to increase the balance of
      the
      note payable by $300,000 in exchange for a release of the $1,443,000 of accrued
      liabilities related to prior indemnity agreements between us and the note
      holders. We classified the release of $1,143,000 as a capital contribution
      in
      the Consolidated Financial Statements during the fourth quarter of 2004. We
      made
      principal payments against the note of $253,000 during the year ended December
      31, 2004. During the year ended December 31, 2005, we received an additional
      advance of $50,000 against the promissory note. The balance due at December
      31,
      2005 was $485,000. Subsequent to December 31, 2005 we received an additional
      advance of $55,000 against the promissory note. The balance due at March 10,
      2006 was $436,000.





The
      unpaid balance of $436,000 is secured by our intellectual property rights.
      As of
      December 31, 2005, the Lenders had not converted any of the outstanding balance
      or interest into common stock.





**ITEM
              14.**
            **PRINCIPAL
                ACCOUNTANT FEES AND
                SERVICES**





( 1)
      AUDIT
      FEES





The
      aggregate fees billed for the fiscal years ended December 31, 2005 and 2004,
      for
      professional services rendered by Hansen Barnett & Maxwell, for the audit of
      the registrant's annual financial statements and review of the financial
      statements included in the registrant's Form 10-Q or services that are normally
      provided by the accountant in connection with statutory and regulatory filings
      or engagements for fiscal year 2005 and 2004 were $203,000 and $260,000,
      respectively.





(2)
      AUDIT-RELATED FEES





The
      aggregate fees billed for the fiscal year ended December 31, 2005 and 2004
      for
      assurance and related services by Hansen Barnett & Maxwell, that are
      reasonably related to the performance of the audit or review of the registrant's
      financial statements for fiscal year 2005 and 2004 were $28,000 and $21,000,
      respectively.







68








(3)
      TAX
      FEES





The
      aggregate fees billed for each of the fiscal years ended December 31, 2005
      and
      2004, for professional services rendered by Hansen Barnett & Maxwell for tax
      compliance, tax advice, and tax planning, for those fiscal years were $1,000
      and
      $6,000, respectively. Services provided included preparation of federal and
      state income tax returns.





(4)
      ALL
      OTHER FEES





The
      aggregate fees billed in each of the fiscal years ended December 31, 2005 and
      2004, for products and services provided by Hansen Barnett & Maxwell other
      than those services reported above, for those fiscal years were $34,000 and
      $27,000. The other fees billed in 2005 and 2004 related to Hansen Barnett &
Maxwell’s participation in the accounting due diligence related to various
      acquisition opportunities. This participation was approved by the Board of
      Directors prior to commencement. Hansen Barnett & Maxwell made no management
      decisions. Their role was to review and analyze information related to the
      possible acquisitions as directed by the Company’s management.





(5)
      AUDIT
      COMMITTEE POLICIES AND PROCEDURES





Not
      applicable.





(6)
      If
      greater than 50 percent, disclose the percentage of hours expended on the
      principal accountant's engagement to audit the registrant's financial statements
      for the most recent fiscal year that were attributed to work performed by
      persons other than the principal accountant's full-time, permanent
      employees.





Not
      applicable.



















































69







**PART
      IV**





**ITEM
      15.**  **EXHIBITS
      AND FINANCIAL STATEMENT SCHEDULES**





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





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





Consolidated
      Balance Sheets as of December 31, 2005 and 2004





Consolidated
      Statements of Operations for the Years Ended December 31, 2005, 2004 and
      2003





Consolidated
      Statements of Stockholders’ Equity (Deficit) for the Years Ended December 31,
      2005, 2004 and 2003





Consolidated
      Statements of Cash Flows for the Years Ended December 31, 2005, 2004 and
      2003





Notes
      to
      Consolidated Financial Statements








2.
            Financial
                Statement Schedules: None








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





Exhibit
              No.
            Description
                of Exhibit





22
            Subsidiaries
                of Registrant





31
            Certifications
                of President and Chief Financial
                Officer





32
            Certification
                of President and Chief Financial Officer Pursuant to Section 906
                of the
                Sarbanes-Oxley Act of 2002.













70






**SIGNATURES**





Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the registrant has duly caused this report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized.





Fonix
                CorporationDate:March
                20, 2006
            By:
            /s/ Thomas A.
                MurdockThomas
                A. Murdock, President andChief
                Executive OfficerDate:March
                20, 2006
            By:
            /s/ Roger D.
                DudleyRoger
                D. Dudley, Executive Vice President Financeand
                Chief Financial Officer(Principal
                Financial and Accounting Officer)








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








/s/
                Thomas A.
                Murdock
            /s/
                William A. Maasberg,
                Jr.Thomas
                A. Murdock, President, and
            William
                A. Maasberg, Jr.Chief
                Executive Officer
            DirectorMarch
                20, 2006
            March
                20, 2006Date
            Date











/s/
      Roger D.
      Dudley


Roger
      D.
      Dudley, Executive Vice President,


Chief
      Financial Officer, and Director





March
      20, 2006


Date

















71






**FONIX
      CORPORATION AND SUBSIDIARIES**








**INDEX
      TO FINANCIAL STATEMENTS**








Report
                of Independent Registered Public Accounting Firm
            F-2**CONSOLIDATED
                FINANCIAL STATEMENTS:**Consolidated
                Balance Sheets as of December 31, 2005 and 2004
            F-3Consolidated
                Statements of Operations and Comprehensive Loss for the Years Ended
                December 31, 2005, 2004 and 2003
            F-4Consolidated
                Statements of Stockholders’ Equity (Deficit) for the Years Ended December
                31, 2003, 2004 and 2005
            F-5Consolidated
                Statements of Cash Flows for the Years Ended December 31, 2005, 2004
                and
                2003
            F-6Notes
                to Consolidated Financial Statements
            F-8





































**H****ANSEN****,
                B****ARNETT****&
                M****AXWELL**A
                Professional CorporationCERTIFIED
                PUBLIC ACCOUNTANTS
            
            **Registered
                with the Public Company**5
                Triad Center, Suite 750
            
            **Accounting
                Oversight Board**Salt
                Lake City, UT 84180-1128Phone:
                (801) 532-2200Fax:
                (801) 532-7944www.hbmcpas.com











**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**








To
      the
      Board of Directors and the Stockholders


Fonix
      Corporation





We
      have
      audited the accompanying consolidated balance sheets of Fonix Corporation and
      subsidiaries as of December 31, 2005 and 2004, and the related consolidated
      statements of operations and comprehensive loss, stockholders’ equity (deficit),
      and cash flows for each of the three years in the period ended December 31,
      2005. 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 audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audits to obtain reasonable assurance about whether the
      consolidated financial statements are free of material misstatement. An audit
      includes examining, on a test basis, evidence supporting the amounts and
      disclosures in the consolidated 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 provide a reasonable basis for our opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the financial position of Fonix Corporation and
      subsidiaries as of December 31, 2005 and 2004, and the results of their
      operations and their cash flows for each of the three years in the period ended
      December 31, 2005, in conformity with accounting principles generally accepted
      in the United States of America.





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 incurred significant losses
      and negative cash flows from operating activities during each of the three
      years
      in the period ended December 31, 2005. As of December 31, 2005, the Company
      had
      an accumulated deficit of $250,521,000, and negative working capital of
      $19,004,000. The Company has current accrued liabilities and accrued settlement
      obligation of approximately $10,214,000 and vendor accounts payable amounting
      to
      approximately $6,770,000 and current portion of notes payable of approximately
      $2,333,000. 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.








**HANSEN,
                BARNETT & MAXWELL**


Salt
      Lake
      City, Utah


March
      7,
      2006







F-2




**Fonix
      Corporation and
      Subsidiaries**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**




**December
                31,**
            
            **December
                31,****2005**
            
            **2004****ASSETS****Current
                assets**Cash
                and cash equivalents
            
            $
            168,000
            
            $
            423,000Accounts
                receivable, net of an allowance for doubtful accounts of $137,000
                and
                $175,000, respectively
            
            
            1,121,000
            
            
            1,541,000Prepaid
                expenses and other current assets
            
            
            176,000
            
            
            156,000**Total
                current assets**
            
            
            1,465,000
            
            
            2,120,000**Long-term
                investments**
            
            
            -
            
            
            237,000**Property
                and equipment,**net of accumulated depreciation of $1,594,000 and $1,465,000,
                respectively
            
            
            947,000
            
            
            236,000**Deposit
                in escrow**
            
            
            -
            
            
            395,000**Deposits
                and other assets**
            
            
            1,592,000
            
            
            1,072,000**Intangible
                assets,**net
                of accumulated amortization of $11,210,000 and $5,453,000,
                respectively
            
            
            2,658,000
            
            
            12,309,000**Goodwill**
            
            
            2,631,000
            
            
            2,631,000**Total
                assets**
            
            $
            9,293,000
            
            $
            19,000,000**LIABILITIES
                AND STOCKHOLDERS' DEFICIT****Current
                liabilities**Accrued
                liabilities
            
            $
            8,138,000
            
            $
            6,815,000Accounts
                payable
            
            
            6,770,000
            
            
            5,225,000Accrued
                payroll and other compensation
            
            
            223,000
            
            
            1,756,000Accrued
                settlement obligation, net of unamortized discount of $178,000 and
                $0,
                respectively
            
            
            1,853,000
            
            
            -Deferred
                revenues
            
            
            923,000
            
            
            984,000Notes
                payable - related parties
            
            
            486,000
            
            
            513,000Current
                portion of notes payable
            
            
            1,847,000
            
            
            214,000Deposits
                and other
            
            
            229,000
            
            
            193,000**Total
                current liabilities**
            
            
            20,469,000
            
            
            15,700,000**Long-term
                notes payable, net of current portion**
            
            
            4,050,000
            
            
            5,358,000**Total
                liabilities**
            
            
            24,519,000
            
            
            21,058,000**Commitments
                and contingencies****Stockholders'
                deficit**Preferred
                stock, $0.0001 par value; 50,000,000 shares authorized;Series
                A, convertible; 166,667 shares outstanding (aggregate liquidation
                preference of $6,055,000)
            
            
            500,000
            
            
            500,000Series
                H, nonconvertible; 2,000 shares outstanding (aggregate liquidation
                preference of $20,000,000)
            
            
            4,000,000
            
            
            4,000,000Series
                I, convertible; 0 shares and 2,250 shares outstanding, respectively
            
            
            -
            
            
            2,250,000Series
                  J, convertible; 1,359 shares and 0 shares outstanding, respectively
                (aggregate
                  liquidation preference of $1,359,000)
            
            
            1,359,000
            
            
            -Series
                K, convertible; 0 shares and 0 shares outstanding, respectively
            
            
            -
            
            
            -Common
                stock, $0.0001 par value; 800,000,000 shares authorized;Class
                A voting, 392,929,230 shares and 131,200,170 shares outstanding,
                respectively
            
            
            39,000
            
            
            13,000Class
                B non-voting, none outstanding
            
            
            -
            
            
            -Additional
                paid-in capital
            
            
            228,905,000
            
            
            217,061,000Outstanding
                warrants to purchase Class A common stock
            
            
            474,000
            
            
            735,000Cumulative
                foreign currency translation adjustment
            
            
            18,000
            
            
            8,000Accumulated
                deficit
            
            
            (250,521,000
            )
            
            (226,625,000
            )**Total
                stockholders' deficit**
            
            
            (15,226,000
            )
            
            (2,058,000
            )**Total
                liabilities and stockholders' deficit**
            
            $
            9,293,000
            
            $
            19,000,000




See
      accompanying notes to condensed consolidated financial statements.




F-3






**Fonix
      Corporation and Subsidiaries**


**CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS**


**AND
      COMPREHENSIVE LOSS**





**Years
                Ended December 31,****2005**
            
            **2004**
            
            **2003**RevenuesTelecommunications
            
            $
            14,833,000
            
            $
            13,673,000
            
            $
            -Speech
                licenses, royalties and maintenance
            
            
            1,358,000
            
            
            1,199,000
            
            
            1,963,000Services
            
            
            -
            
            
            30,000
            
            
            391,000Hardware
            
            
            -
            
            
            -
            
            
            30,000Total
                Revenue
            
            
            16,191,000
            
            
            14,902,000
            
            
            2,384,000Cost
                of revenuesTelecommunications
                costs
            
            
            9,349,000
            
            
            6,136,000
            
            
            -Impairment
                loss on capitalized software technology
            
            
            -
            
            
            -
            
            
            822,000Services
            
            
            -
            
            
            -
            
            
            76,000Licenses,
                royalties and maintenance
            
            
            70,000
            
            
            33,000
            
            
            58,000Amortization
                of capitalized software technology
            
            
            -
            
            
            -
            
            
            52,000Hardware
            
            
            -
            
            
            -
            
            
            21,000Total
                cost of revenues
            
            
            9,419,000
            
            
            6,169,000
            
            
            1,029,000Gross
                profit
            
            
            6,772,000
            
            
            8,733,000
            
            
            1,355,000Expenses:Selling,
                general and administrative
            
            
            13,290,000
            
            
            13,356,000
            
            
            7,004,000Legal
                settlement expense
            
            
            2,080,000
            
            
            -
            
            
            -Impairment
                of intangible assets
            
            
            3,346,000
            
            
            738,000
            
            
            302,000Amortization
                of intangible assets
            
            
            6,305,000
            
            
            5,453,000
            
            
            -Product
                development and research
            
            
            2,196,000
            
            
            2,559,000
            
            
            5,141,000Total
                expenses
            
            
            27,217,000
            
            
            22,106,000
            
            
            12,447,000Other
                income (expense):Interest
                income
            
            
            8,000
            
            
            7,000
            
            
            43,000Gain
                on sale of investments
            
            
            251,000
            
            
            -
            
            
            -Gain
                on forgiveness of liabilities
            
            
            142,000
            
            
            518,000
            
            
            -Interest
                expense
            
            
            (2,587,000
            )
            
            (2,300,000
            )
            
            (1,973,000
            )Equity
                in net loss of affiliate
            
            
            -
            
            
            -
            
            
            (360,000
            )Other
            
            
            -
            
            
            -
            
            
            (161,000
            )Other
                income (expense), net
            
            
            (2,186,000
            )
            
            (1,775,000
            )
            
            (2,451,000
            )Net
                loss
            
            
            (22,631,000
            )
            
            (15,148,000
            )
            
            (13,543,000
            )Preferred
                stock dividends
            
            
            (1,265,000
            )
            
            (3,927,000
            )
            
            -Loss
                attributable to common stockholders
            
            $
            (23,896,000
            )
            $
            (19,075,000
            )
            $
            (13,543,000
            )Basic
                and diluted loss per common share
            
            $
            (0.09
            )
            $
            (0.21
            )
            $
            (0.50
            )Net
                loss
            
            $
            (22,631,000
            )
            $
            (15,148,000
            )
            $
            (13,543,000
            )Other
                comprehensive income (loss) - foreign currency translation
            
            
            10,000
            
            
            (22,000
            )
            
            (2,000
            )Comprehensive
                loss
            
            $
            (22,621,000
            )
            $
            (15,170,000
            )
            $
            (13,545,000
            )







See
      accompanying notes to condensed consolidated financial statements.








F-4





**Fonix
      Corporation and Subsidiaries**


**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)**


**YEARS
      ENDED DECEMBER 31, 2003, 2004 AND 2005**




Outstanding
              
              
              
              CumulativeWarrants
              
              
              
              ForeignAdditional
              
              to
                  Purchase
              
              Deferred
              
              CurrencyPreferred
                  Stock
              
              Common
                  Stock
              
              Paid-in
              
              Common
              
              Consulting
              
              Translation
              
              AccumulatedShares
              
              Amount
              
              Shares
              
              Amount
              
              Capital
              
              Stock
              
              Expenses
              
              Adjustment
              
              Deficit
              
              TotalBALANCE,
                  DECEMBER 31, 2002
              
              
              166,667
              
              $
              500,000
              
              
              12,306,333
              
              $
              1,000
              
              $
              183,515,000
              
              $
              1,360,000
              
              $
              -
              
              $
              32,000
              
              $
              (194,007,000
              )
              $
              (8,599,000
              )Issuance
                  of common stock under equity lines of credit
              
              
              -
              
              
              -
              
              
              30,494,145
              
              
              3,000
              
              
              9,928,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              9,931,000Expiration
                  of warrants
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              26,000
              
              
              (26,000
              )
              
              -
              
              
              -
              
              
              -
              
              
              -Cumulative
                  foreign currency translation adjustment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (2,000
              )
              
              -
              
              
              (2,000
              )Additional
                  shares issued due to reverse split
              
              
              -
              
              
              -
              
              
              4,919
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Shares
                  issued related to Series D financing
              
              
              -
              
              
              -
              
              
              11,524,390
              
              
              1,000
              
              
              1,815,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,816,000Net
                  loss for year ended December 31, 2003
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (13,543,000
              )
              
              (13,543,000
              )BALANCE,
                  DECEMBER 31, 2003
              
              
              166,667
              
              
              500,000
              
              
              54,329,787
              
              
              5,000
              
              
              195,284,000
              
              
              1,334,000
              
              
              -
              
              
              30,000
              
              
              (207,550,000
              )
              
              (10,397,000
              )Issuance
                  of common stock under equity lines of credit
              
              
              -
              
              
              -
              
              
              54,768,198
              
              
              5,000
              
              
              11,332,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              11,337,000Issuance
                  of Series I Preferred Stock
              
              
              3,250
              
              
              429,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              429,000Shares
                  issued in connection with Series I Preferred Stock
              
              
              -
              
              
              -
              
              
              2,414,596
              
              
              1,000
              
              
              729,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              730,000Warrants
                  issued in connection with Series I Preferred Stock
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              262,000
              
              
              -
              
              
              -
              
              
              -
              
              
              262,000Beneficial
                  conversion feature on Series I Preferred
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,830,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,830,000Series
                  I Preferred Stock beneficial conversion dividend
              
              
              -
              
              
              2,821,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (2,821,000
              )
              
              -Cumulative
                  foreign currency translation adjustment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (22,000
              )
              
              -
              
              
              (22,000
              )Shares
                  issued for payment of interest on long-term debt
              
              
              -
              
              
              -
              
              
              833,334
              
              
              -
              
              
              125,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              125,000Shares
                  issued for payment of dividends on Series H Preferred
              
              
              -
              
              
              -
              
              
              1,666,667
              
              
              -
              
              
              249,000
              
              
              -
              
              
              -
              
              
              -
              
              
              (249,000
              )
              
              -Series
                  H Preferred Stock dividends accrued
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (601,000
              )
              
              (601,000
              )Additional
                  shares issued due to reverse split
              
              
              -
              
              
              -
              
              
              1,494
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Shares
                  issued in connection with LTEL acquisition
              
              
              -
              
              
              -
              
              
              7,036,802
              
              
              1,000
              
              
              4,174,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              4,175,000Issuance
                  of Series H Preferred Stock in LTEL acquistion
              
              
              2,000
              
              
              4,000,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              4,000,000Series
                  I Preferred stock dividends accrued
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (256,000
              )
              
              (256,000
              )Issuance
                  of stock for services
              
              
              -
              
              
              -
              
              
              1,713,423
              
              
              -
              
              
              334,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              334,000Conversion
                  of Series I Preferred into common stock
              
              
              (1,000
              )
              
              (1,000,000
              )
              
              8,435,869
              
              
              1,000
              
              
              999,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Forgiveness
                  of related party debt
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,144,000
              
              
              -
              
              
              -
              
              
              -
              
              
              
              
              
              1,144,000Expiration
                  of warrants
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              861,000
              
              
              (861,000
              )
              
              -
              
              
              -
              
              
              -
              
              
              -Net
                  loss for year ended December 31, 2004
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (15,148,000
              )
              
              (15,148,000
              )BALANCE,
                  DECEMBER 31, 2004
              
              
              170,917
              
              
              6,750,000
              
              
              131,200,170
              
              
              13,000
              
              
              217,061,000
              
              
              735,000
              
              
              -
              
              
              8,000
              
              
              (226,625,000
              )
              
              (2,058,000
              )Issuance
                  of common stock under equity lines of credit
              
              
              -
              
              
              -
              
              
              180,480,405
              
              
              18,000
              
              
              7,809,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              7,827,000Shares
                  issued for payment of principal and interest on long-term
                  debt
              
              
              -
              
              
              -
              
              
              29,417,578
              
              
              3,000
              
              
              1,248,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,251,000Shares
                  issued for payment of dividends on Series H Preferred
              
              
              -
              
              
              -
              
              
              27,275,299
              
              
              3,000
              
              
              1,123,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,126,000Conversion
                  of Series I Preferred into common stock
              
              
              (1,078
              )
              
              (1,078,000
              )
              
              18,482,083
              
              
              2,000
              
              
              1,076,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Exchange
                  of Series I Preferred for Series J Preferred
              
              
              280
              
              
              280,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              280,000Series
                  J Preferred Stock beneficial conversion dividend
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              161,000
              
              
              -
              
              
              -
              
              
              -
              
              
              (161,000
              )
              
              -Conversion
                  of Series J Preferred into common stock
              
              
              (93
              )
              
              (93,000
              )
              
              3,795,918
              
              
              -
              
              
              93,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Shares
                  issued in conection with legal settlement
              
              
              -
              
              
              -
              
              
              2,277,777
              
              
              -
              
              
              73,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              73,000Cumulative
                  foreign currency translation adjustment
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              10,000
              
              
              -
              
              
              10,000Cancellation
                  of warrants
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              261,000
              
              
              (261,000
              )
              
              -
              
              
              -
              
              
              -
              
              
              -Dividend
                  on Series H Preferred
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (1,000,000
              )
              
              (1,000,000
              )Dividend
                  on Series I Preferred
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (86,000
              )
              
              (86,000
              )Dividend
                  on Series J Preferred
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (18,000
              )
              
              (18,000
              )Net
                  loss for year ended December 31, 2005
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (22,631,000
              )
              
              (22,631,000
              )BALANCE,
                  DECEMBER 31, 2005
              
              
              170,026
              
              $
              5,859,000
              
              
              392,929,230
              
              $
              39,000
              
              $
              228,905,000
              
              $
              474,000
              
              $
              -
              
              $
              18,000
              
              $
              (250,521,000
              )
              $
              (15,226,000
              )





See
      accompanying notes to condensed consolidated financial statements.







F-5







**Fonix
      Corporation and Subsidiaries**


**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**








**Years
                Ended December 31,****2005**
            
            **2004**
            
            **2003****Cash
                flows from operating activities**Net
                loss
            
            $
            (22,631,000
            )
            $
            (15,148,000
            )
            $
            (13,543,000
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Non-cash
                expense related to the issuance of preferred stock
            
            
            250,000
            
            
            -
            
            
            640,000Stock
                issued for interest expense on long-term debt
            
            
            500,000
            
            
            125,000
            
            
            -Stock
                issued for services
            
            
            -
            
            
            41,000
            
            
            -Accretion
                of discount on notes receivable from affiliate
            
            
            -
            
            
            -
            
            
            (21,000
            )Accretion
                of discount on notes payable
            
            
            741,000
            
            
            613,000
            
            
            868,000Accretion
                of discount on legal settlement
            
            
            61,000
            
            
            -
            
            
            -Amortization
                of investment in affiliate
            
            
            -
            
            
            -
            
            
            167,000Impairment
                losses
            
            
            3,346,000
            
            
            738,000
            
            
            1,126,000Losses
                on asset disposals
            
            
            -
            
            
            -
            
            
            179,000Gain
                on sale of long-term assets
            
            
            (251,000
            )
            
            -
            
            
            -Gain
                on forgiveness of liabilities
            
            
            (95,000
            )
            
            (518,000
            )
            
            -Legal
                settlement expense
            
            
            2,080,000
            
            
            -
            
            
            -Amortization
                of intangibles
            
            
            6,305,000
            
            
            5,453,000
            
            
            68,000Depreciation
            
            
            285,000
            
            
            338,000
            
            
            321,000Equity
                in net loss of affiliate
            
            
            -
            
            
            -
            
            
            193,000Gain
                on sale of affiliate
            
            
            -
            
            
            -
            
            
            (53,000
            )Foreign
                exchange loss (gain)
            
            
            10,000
            
            
            (22,000
            )
            
            (5,000
            )Changes
                in assets and liabilities, net of effects from purchase of
                LTEL:Accounts
                receivable
            
            
            420,000
            
            
            738,000
            
            
            23,000Prepaid
                expenses and other current assets
            
            
            (20,000
            )
            
            (48,000
            )
            
            105,000Inventory
            
            
            -
            
            
            -
            
            
            49,000Other
                assets
            
            
            (520,000
            )
            
            (57,000
            )
            
            50,000Accounts
                payable
            
            
            1,563,000
            
            
            (1,336,000
            )
            
            (320,000
            )Accrued
                payroll and other compensation
            
            
            (1,533,000
            )
            
            (5,208,000
            )
            
            1,698,000Other
                accrued liabilities
            
            
            1,721,000
            
            
            1,415,000
            
            
            (474,000
            )Deferred
                revenues
            
            
            (61,000
            )
            
            (175,000
            )
            
            (314,000
            )Net
                cash used in operating activities
            
            
            (7,829,000
            )
            
            (13,051,000
            )
            
            (9,243,000
            )**Cash
                flows from investing activities**Proceeds
                from sale of long term investments
            
            
            488,000
            
            
            -
            
            
            -Payments
                of deposit into escrow
            
            
            -
            
            
            (395,000
            )
            
            -Cash
                received in connection with LTEL acquisition
            
            
            -
            
            
            47,000
            
            
            -Purchase
                of property and equipment
            
            
            (996,000
            )
            
            (256,000
            )
            
            (9,000
            )Net
                cash used in investing activities
            
            
            (508,000
            )
            
            (604,000
            )
            
            (9,000
            )**Cash
                flows from financing activities**Proceeds
                from issuance of Class A common stock, net
            
            
            7,827,000
            
            
            12,239,000
            
            
            9,686,000Proceeds
                from related party note payable
            
            
            50,000
            
            
            (250,000
            )
            
            -Proceeds
                from other notes payable
            
            
            650,000
            
            
            -
            
            
            -Proceeds
                from issuance of Series I Preferred Stock
            
            
            -
            
            
            3,010,000
            
            
            240,000Payments
                of accrued legal expense
            
            
            (130,000
            )
            
            -
            
            
            -Payment
                of dividend on Series H Preferred Stock
            
            
            -
            
            
            (349,000
            )
            
            -Principal
                payments on notes payable
            
            
            (315,000
            )
            
            (622,000
            )
            
            (1,051,000
            )Net
                cash provided by financing activities
            
            
            8,082,000
            
            
            14,028,000
            
            
            8,875,000**Net
                (decrease) increase in cash and cash equivalents**
            
            
            (255,000
            )
            
            373,000
            
            
            26,000**Cash
                and cash equivalents at beginning of year**
            
            
            423,000
            
            
            50,000
            
            
            24,000**Cash
                and cash equivalents at end of year**
            
            $
            168,000
            
            $
            423,000
            
            $
            50,000





See
      accompanying notes to condensed consolidated financial statements.








F-6


**Fonix
        Corporation and Subsidiaries**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF CASH FLOWS**
 (Continued)





**Years
                Ended December 31,****2005**
            
            **2004**
            
            **2003****Supplemental
                Disclosure of Cash Flow Information**Cash
                paid during the year for interest
            
            $
            310,000
            
            $
            1,200,000
            
            $
            44,000Cash
                paid during the year for income taxes
            
            
            -
            
            
            -
            
            
            -





**Supplemental
      Schedule of Non-cash Investing and Financing Activities**





**For
      the Year Ended December 31, 2005**





Issued
      18,482,083 shares of Class A common stock in conversion of 1,078 shares of
      Series I Convertible Preferred Stock.





Issued
      3,795,918 shares of Class A common stock in conversion of 93 shares of Series
      J
      Convertible Preferred Stock.





Issued
      27,275,299 shares of Class A common stock as payment of $1,113,000 of dividends
      on Series H Preferred Stock.





Issued
      29,417,578 shares of Class A common stock as payment of $1,248,000 of principal
      and interest on long-term debt.





Accrued
      $137,000 of dividends on Series H Preferred Stock.





Issued
      1,452 shares of Series J Preferred Stock with a value of $1,452,000 in exchange
      for 1,172 shares of Series I Preferred Stock with a value of $1,172,000, a
      placement fee of $250,000 and settlement expense of $30,000.





Issued
      2,277,000 shares of Class A common stock for a legal settlement expense valued
      at $73,000, or $0.03 per share.





**For
      the Year Ended December 31, 2004**





Issued
      8,453,869 shares of Class A common stock in conversion of 1,000 shares of Series
      I Preferred Stock.





Issued
      1,463,735 shares of Class A common stock in full satisfaction of $292,000 of
      liabilities.





Issued
      833,334 shares of Class A common stock as payment of $125,000 interest on
      long-term debt.





The
      Company purchased all of the capital stock of LTEL Holdings Corporation for
      $12,800,000. In conjunction with the acquisition, the Company acquired
      $22,259,000 of assets and assumed $9,459,000 of liabilities of LTEL Holdings
      Corporation by the issuance of 7,036,802 shares of Class A common stock valued
      at $4,176,000, the issuance of 2,000 shares of 5% Series H nonvoting,
      nonconvertible preferred stock valued at $4,000,000 and the issuance of a 5%
      $10,000,000 promissory note valued at $4,624,000.





Warrants
      for 31,250 shares of Class A common stock, valued at $860,000
      expired.





Series
      I
      Preferred Stock shares issued for $240,000 of advances received in
      2003.





Issued
      1,666,667 shares of Class A common stock for payment of $249,000 of dividends
      on
      Series H Preferred Stock. Accrued $252,000 and $256,000 of dividends on Series
      H
      Preferred Stock and Series I Preferred Stock, respectively.





**For
      the Year Ended December 31, 2003**





Issued
      7,359,080 shares of Class A common stock in conversion of $850,000 of Series
      D
      Debentures principal and $41,000 of related accrued interest.





Converted
      $113,768 of accounts payable into a note payable.





Issued
      639,732 shares of Class A common stock for $245,000 subscription
      receivable.





Issued
      237,584 shares of Class A common stock valued at $285,000 to Series D Debenture
      holder as consideration for revising terms of the Series D Debenture agreement.





Warrants
      for 5,000 shares of Class A common stock, valued at $26,000
      expired.










F-7




**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




**NOTE
      1. NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING
      POLICIES**





***Nature
      of Operations*** **** Fonix
      Corporation (“the Company”), a communications and technology company based in
      Salt Lake City, Utah, provides integrated telecommunications services through
      Fonix Telecom, Inc.(“Fonix Telecom”) and LecStar Telecom, Inc. and value-added
      speech technologies through Fonix Speech, Inc (“Fonix Speech”). On February 24,
      2004, the Company completed its acquisition of all of the capital stock of
      LTEL
      Holdings Corporation (“LTEL”) and its wholly owned subsidiaries, LecStar
      Telecom, Inc. and LecStar DataNet, Inc. (collectively “LecStar”).





Through
      Fonix Speech, the Company delivers speech interface development tools, solutions
      and applications (the “Speech Products”) that empower people to interact
      conversationally with information systems and devices. The Speech Products
      are
      based on the Company’s speech-enabling technologies, which include
      text-to-speech (“TTS”) and proprietary neural network-based automatic speech
      recognition (“ASR”). ASR and TTS technologies are sometimes collectively
      referred to in this report as “Core Technologies.” The Company has received
      various patents for certain elements of its Core Technologies and has filed
      applications for other patents covering various aspects of its technologies.
      The
      Company’s Speech Products enhance user productivity, ease of use and efficiency
      in a broad range of market segments, including mobile and wireless devices;
      entertainment game consoles; electronic devices for assistive, language
      learning, robots and appliances; computer telephony and server applications.
      Revenues for Fonix Speech are generated through licensing of speech-enabling
      technologies, royalty payments for the use of the Company’s technologies,
      maintenance contracts and services.





Through
      Fonix Telecom, the Company offers next-generation telecommunications products
      and services, including voice over Internet protocol (“VoIP”) and Broadband over
      Power Lines (“BPL”) through partner channels and product groups. Fonix Telecom
      also provides resell telecommunication services and products through its
      interconnection agreements with major incumbent carriers. Fonix Telecom is
      currently licensed to re-sell traditional telecommunication services and
      products in Georgia, Florida, North Carolina and South Carolina. Revenues for
      Fonix Telecom are generated through providing telecommunications
      services.





Through
      LecStar, the Company provides a full array of wireline voice, data, long
      distance and Internet telephone services utilizing traditional lines. LecStar
      Telecom, Inc., is certified by the Federal Communications Commission in nine
      states—Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi, North
      Carolina, South Carolina and Tennessee—as a competitive local exchange carrier
      (“CLEC”) to provide regulated local, long distance and international
      telecommunications services. LecStar
      serves small to medium-sized businesses and residential customers with a
      balanced focus on high-density metropolitan areas and under-served smaller
      communities. Services are offered at moderate discounts off BellSouth prices
      and
      are delivered through the cost-effective use of LecStar’s network facilities,
      Unbundled Network Elements (“UNEs”), and/or resold via services acquired through
      wholesale agreements with BellSouth and other carriers. LecStar’s provisioning
      systems are electronically interfaced with BellSouth, enabling the efficient
      ordering of services in real-time.





***Business
      Condition*** **-** For the
      years ended December 31, 2005, 2004 and 2003, the Company generated revenues
      of
      $16,191,000, $14,902,000 and $2,384,000, respectively; incurred net losses
      of
      $22,631,000, $15,148,000 and $13,543,000, respectively, and had negative cash
      flows from operating activities of $7,829,000, $13,051,000 and $9,243,000,
      respectively. As of December 31, 2005, the Company had an accumulated deficit
      of
      $250,521,000, negative working capital of $19,004,000, accrued liabilities
      and
      accrued legal settlement obligation of $10,214,000, accounts payable of
      $6,770,000 and current portion of notes payable of $2,333,000. The Company
      expects to continue to incur significant losses and negative cash flows from
      operating activities through December 31, 2007, primarily due to expenditure
      requirements associated with continued marketing and development of its
      speech-enabling technologies, further developing its telecommunications services
      business and from recent negative changes in federal regulations that may
      discontinue the Company’s ability to provide unbundled network elements (the
“UNE-P platform”) to its telecommunications customers.





The
      Company’s cash resources, limited to collections from customers, draws on the
      Seventh Equity Line and loans, have not been sufficient to cover operating
      expenses. As a result, some payments to vendors have been delayed. As of the
      date of this report, the Company had not been declared in default under the
      terms of any material agreements.







F-8




**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**





These
      factors, as well as the risk factors set out elsewhere in this Annual Report
      on
      Form 10-K, raise substantial doubt about the Company’s ability to continue as a
      going concern. The accompanying financial statements do not include any
      adjustments that might result from the outcome of this uncertainty. Management
      plans to fund further operations of the Company through revenues generated
      from
      its telecommunication operations, from cash flows from future license and
      royalty arrangements and with proceeds from additional issuance of debt and
      equity securities. 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. All significant intercompany balances
      and transactions have been eliminated in consolidation. Investments in 20-
      to
      50-percent-owned affiliates are accounted for using the equity method (see
      Note
      5).





***Accounting
      Estimates*** **-** The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States 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
      carrying values of the Company’s liabilities approximate their fair values. The
      estimated fair values have been determined using appropriate market information
      and valuation methodologies. The carrying values of the accrued settlement
      obligation and note payable approximate fair value because the stated or imputed
      interest rates approximate the Company’s borrowing rate.





***Concentration
      of Credit Risks*** **-** The
      Company’s cash and cash equivalents are maintained in bank deposit accounts
      which occasionally may exceed federally insured limits. Cash equivalents consist
      of highly liquid securities with maturities of three months or less when
      purchased. The Company has not experienced any losses with respect to these
      deposits. 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.





***Valuation
      of Long-lived Assets*** - The
      carrying values of the Company's long-lived assets are reviewed for impairment
      whenever events or changes in circumstances indicate that they may not be
      recoverable. When such an event occurs, the Company projects undiscounted cash
      flows to be generated from the use of the asset and its eventual disposition
      over the remaining life of the asset. If projections indicate that the carrying
      value of the long-lived asset will not be recovered, the carrying value of
      the
      long-lived asset, other than software technology, is reduced by the estimated
      excess of the carrying value over the projected discounted cash flows. The
      determination of whether the carrying value of software technology is
      recoverable is discussed below in the section titled “Software Technology
      Development and Production Costs” within this note.





***Intangible
      Assets*** -
      The
      customer base, contracts and agreements and brand names are amortized over
      their
      estimated useful lives unless they are deemed to have indefinite useful lives.
      For intangible assets subject to amortization, an impairment charge is
      recognized if the carrying amount is not recoverable and the carrying amount
      exceeds the fair value of the intangible asset. Intangible assets deemed to
      have
      indefinite useful lives, primarily the LecStar brand name, were not amortized,
      were tested for impairment on a quarterly basis and impairment was recognized
      when the carrying amount was not recoverable or exceeded its fair value. The
      Company recorded a charge of $1,124,000 during the year ended December 31,
      2003,
      to fully impair the carrying value of its speech related intangible assets.
      During the year ended December 31, 2004, the Company recorded an impairment
      loss
      on the intangible asset related to the contracts and agreements acquired of
      $738,000 based on estimated future cash flows. During the year ended December
      31, 2005, the Company determined that the carrying value of the LecStar brand
      name was impaired, based on estimated future cash flows, and recorded a charge
      of $1,110,000 to fully impair the carrying value of the asset. During December
      2005, the Company also determined that the intangible asset related to the
      LecStar customer base had become impaired due to decreased estimated future
      cash
      flows due to the overall cost increases as the Company no longer has the UNE-P
      platform to offer to its customers. The Company recorded an impairment charge
      of
      $2,236,000 in the accompanying financial statements.







F-9




**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**


***Goodwill*** -
      Goodwill represents the excess of the cost over the fair value of net assets
      of
      acquired businesses. Goodwill is not amortized, but is tested for impairment
      quarterly or when a triggering event occurs. The testing for impairment requires
      the determination of the fair value of the asset or entity to which the goodwill
      relates (the reporting unit). The fair value of a reporting unit is determined
      based upon a weighting of the quoted market price of the Company’s common stock
      and present value techniques based upon estimated future cash flows of the
      reporting unit, considering future revenues, operating costs, the risk-adjusted
      discount rate and other factors. Impairment is indicated if the fair value
      of
      the reporting unit is allocated to the assets and liabilities of that unit,
      with
      the excess of the fair value of the reporting unit over the amounts assigned
      to
      its assets and liabilities assigned to the fair value of goodwill. The amount
      of
      impairment of goodwill is measured by the excess of the goodwill’s carrying
      value over its fair value.





***Revenue
      Recognition -*** The
      Company recognizes revenue when pervasive evidence of an arrangement exists;
      services have been rendered or products have been delivered; the price to the
      buyer is fixed and determinable; and collectibility is reasonably assured.
      Revenues are recognized by the Company based on the various types of
      transactions generating the revenue. For software sales, the Company recognizes
      revenues in accordance with the provisions of Statement of Position No. 97-2,
      “Software Revenue Recognition,” and related interpretations *.* The
      Company generates revenues from licensing the rights to its software products
      to
      end users and from royalties. For telecommunications services, revenue is
      recognized in the period that the service is provided.





For
      Fonix
      Speech, revenue of all types is recognized when acceptance of functionality,
      rights of return, and price protection are confirmed or can be reasonably
      estimated, as appropriate. Revenues from development and consulting services
      are
      recognized on a completed-contract basis when the services are completed and
      accepted by the customer. The completed-contract method is used because the
      Company’s contracts are typically either short-term in duration or the Company
      is unable to make reasonably dependable estimates of the costs of the contracts.
      Revenue for hardware units delivered is recognized when delivery is verified
      and
      collection assured.





Revenue
      for products distributed through wholesale and retail channels and through
      resellers is recognized upon verification of final sell-through to end users,
      after consideration of rights of return and price protection. Typically, the
      right of return on such products has expired when the end user purchases the
      product from the retail outlet. Once the end user opens the package, it is
      not
      returnable unless the medium is defective.





When
      arrangements to license software products do not require significant production,
      modification or customization of software, revenue from licenses and royalties
      are recognized when persuasive evidence of a licensing arrangement exists,
      delivery of the software has occurred, the fee is fixed or determinable, and
      collectibility is probable. Post-contract obligations, if any, generally consist
      of one year of support including such services as customer calls, bug fixes,
      and
      upgrades. Related revenue is recognized over the period covered by the
      agreement. Revenues from maintenance and support contracts are also recognized
      over the term of the related contracts.





Revenues
      applicable to multiple-element fee arrangements are bifurcated among the
      elements such as license agreements and support and upgrade obligations using
      vendor-specific objective evidence of fair value. Such evidence consists
      primarily of pricing of multiple elements as if sold as separate products or
      arrangements. These elements vary based upon factors such as the type of
      license, volume of units licensed, and other related factors.





For
      Fonix
      Telecom and LecStar, telecommunications revenue is comprised of two main
      components: (1) fees paid by business and residential subscribers of voice
      and
      data services and (2) carrier access fees. Subscriber revenues include monthly
      recurring charges, usage charges and non-recurring charges. Monthly recurring
      charges are flat monthly fees for local phone and data services. Usage charges,
      which primarily include long distance fees, are generally billed on a per-minute
      or per-call basis. Non-recurring charges are generally one-time charges for
      installation or changes to the subscriber’s service. Carrier access fees are
      paid to the Company by other telecommunications carriers as compensation for
      originating and terminating the carriers’ long distance traffic. Revenue from
      monthly recurring charges is recognized ratably over the period the local phone
      and data services are provided. Revenue from usage charges non-recurring charges
      and carrier access fees is recognized on the date the services are
      provided.







F-10


**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




Deferred
      revenue as of December 31, 2005, consisted of the following:




**Description**
              **Criteria
                  for Recognition**
              **Amount**Deferred
                  unit royalties and license fees
              Delivery
                  of units to end users or expiration of contract
              $         
                  466,000Telecom
                  deferred revenue
              Service
                  provided for customer
              457,000Total
                  deferred revenue
              
              $         
                  923,000


Cost
      of Revenues Cost
      of
      revenues from telecommunications services consists mainly of billings from
      the
      incumbent local exchange carriers (“ILECs”) for access to the ILEC’s network.
      Cost of revenues from license, royalties, and maintenance consists of costs
      to
      distribute the product, installation and support personnel compensation,
      amortization and impairment of capitalized speech software costs, licensed
      technology, and other related costs. Cost of service revenues consists of
      personnel compensation and other related costs.





***Software
      Technology Development and Production Costs*** **** -
      All
      costs incurred to establish the technological feasibility of speech software
      technology to be sold, leased, or otherwise marketed are charged to product
      development and research expense. Technological feasibility is established
      when
      a product design and a working model of the software product have been completed
      and confirmed by testing. Costs to produce or purchase software technology
      incurred subsequent to establishing technological feasibility are capitalized.
      Capitalization of software costs ceases when the product is available for
      general release to customers. Costs to perform consulting or development
      services are charged to cost of revenues in the period in which the
      corresponding revenues are recognized. Costs of maintenance and customer support
      are charged to expense when related revenue is recognized or when these costs
      are incurred, whichever occurs first.





Capitalized
      software technology costs were amortized on a product-by-product basis.
      Amortization was recognized from the date the product was available for general
      release to customers as the greater of (a) the ratio that current gross revenue
      for a product bears to total current and anticipated future gross revenues
      for
      that product or (b) the straight-line method over the remaining estimated
      economic life of the products. Amortization was charged to cost of
      revenues.





The
      Company assessed unamortized capitalized software costs for possible write
      down
      on a quarterly basis based on net realizable value of each related product.
      Net
      realizable value was determined based on the estimated future gross revenues
      from a product reduced by the estimated future cost of completing and disposing
      of the product, including the cost of performing maintenance and customer
      support. The amount by which the unamortized capitalized costs of a software
      product exceeded the net realizable value of that asset was written
      off.





During
      2003, the Company modified its estimate of future cash flows to be provided
      by
      its software technology and determined that the carrying amount of the
      technology was in excess of future cash flows provided by the technology.
      Accordingly, the Company recorded a charge of $1,124,000 during the year ended
      December 31, 2003, to fully impair the carrying value of the speech software
      technology. $822,000 of the impairment was charged to cost of revenues and
      $302,000 was charged to operating expenses, based on the use of the
      software.





***Stock-based
      Compensation Plans*** -The
      Company accounts for its stock-based compensation issued to non-employees using
      the fair value method in accordance with SFAS No. 123, “Accounting for
      Stock-Based Compensation.” Under SFAS No. 123, stock-based compensation is
      determined as either the fair value of the consideration received or the fair
      value of the equity instruments issued, whichever is more reliably measurable.
      The measurement date for these issuances is the earlier of the date at which
      a
      commitment for performance by the recipient to earn the equity instruments
      is
      reached or the date at which the recipient’s performance is
      complete.







F-11


**Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**


At
      December 31, 2005, the Company has stock-based employee compensation plans,
      which are described more fully in Note 13. The Company accounts for the plans
      under the recognition method and measurement principles of APB Opinion No.
      25,
“Accounting for Stock Issued to Employees,” and the related Interpretations.
      Under APB Opinion No. 25, compensation related to stock options, if any, is
      recognized by the amount that the option’s exercise price on the measurement
      date is below the fair value of the Company’s common stock, and amortized to
      expense over the vesting period. Compensation expense for stock awards or
      purchases, if any, is recognized by the amount that the award or purchase price
      on the measurement date is below the fair value of the Company’s common stock,
      and is recognized on the date of award or purchase. These accounting policies
      resulted in the Company not recognizing any stock-based employee compensation
      cost during the years ended December 31, 2005, 2004, or 2003. The effect on
      net
      loss and net loss per common share if the Company had applied the fair value
      recognition provisions of SFAS No. 123 to employee stock-based compensation
      is
      as follows:





**Year
                Ended December 31,**
            
            **2005**
            
            **2004**
            
            **2003**Net
                loss, as reported
            
            $
            (22,631,000
            )
            $
            (15,148,000
            )
            $
            (13,543,000
            )Add
                back: Total stock-based employee compensation
            
            
            -
            
            
            -
            
            
            -Deduct:
                Total stock-based employee compensation determined under fair value
                based
                method for all awards
            
            
            (74,000
            )
            
            (67,000
            )
            
            (165,000
            )Pro
                forma net loss
            
            $
            (22,705,000
            )
            $
            (15,215,000
            )
            $
            (13,708,000
            )Basic
                and diluted net loss per common share:As
                reported
            
            $
            (0.09
            )
            $
            (0.21
            )
            $
            (0.50
            )Pro
                forma
            
            
            (0.09
            )
            
            (0.21
            )
            
            (0.51
            )








***Advertising
      Costs*** -
      Advertising costs are expensed when incurred. Total advertising expense was
      $80,000, $121,000 and $111,000 for the years ended December 31, 2005, 2004
      and
      2003, respectively.





***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. 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.





***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, 2005, 2004, and 2003,
      there were outstanding common stock equivalents to purchase or receive
      97,634,670 shares, 22,708,797 shares and 11,849,261 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, 2005, 2004,
      and 2003:





**Years
                Ended December 31,****2005**
            
            **2004**
            
            **2003****Per**
            
            
            
            **Per**
            
            
            
            **Per****Share**
            
            
            
            **Share**
            
            
            
            **Share****Amount**
            
            **Amount**
            
            **Amount**
            
            **Amount**
            
            **Amount**
            
            **Amount**Net
                loss
            
            $
            (22,631,000
            )
            
            
            
            $
            (15,148,000
            )
            
            
            
            $
            (13,543,000
            )Preferred
              stock dividends
            
            
            (1,265,000
            )
            
            
            
            
            (3,927,000
            )
            
            
            
            
            -Net
                loss attributable to common stockholders
            
            $
            (23,896,000
            )
            $
            (0.09
            )
            $
            (19,075,000
            )
            $
            (0.21
            )
            $
            (13,543,000
            )
            $
            (0.50
            )Weighted-average
                common shares outstanding
            
            
            261,894,849
            
            
            
            
            
            89,795,728
            
            
            
            
            
            26,894,005










F-12


**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




***Imputed
      Interest Expense and Income*** **-** Interest
      is imputed on long-term debt obligations and notes receivable where management
      has determined that the contractual interest rates are below the market rate
      for
      instruments with similar risk characteristics (see Notes 2, 5 and 7).





***Foreign
      Currency Translation*** **-** The
      functional currency of the Company’s Korean subsidiary is the South Korean won.
      Consequently, assets and liabilities of the Korean operations are translated
      into United States dollars using current exchange rates at the end of the year.
      All revenue is invoiced in South Korean won and revenues and expenses are
      translated into United States dollars using weighted-average exchange rates
      for
      the year.





***Comprehensive
      Income*** *-* ****** Other
      comprehensive income presented in the accompanying consolidated financial
      statements consists of cumulative foreign currency translation adjustments.





***Recently
      Enacted Accounting Standards***





***Inventory
      Costs -*** In
      November 2004, the FASB issued SFAS No. 151, *Inventory
      Costs,* which
      is
      an amendment of ARB No. 43. SFAS No. 151 requires idle facility expenses,
      freight, handling costs and wasted material (spoilage) costs to be recognized
      as
      current-period charges. It also requires that allocation of fixed production
      facilities. SFAS No. 151 will be effective for the Company beginning January
      1,
      2006 and resulting adjustments will be made on prospective basis. The Company
      does not anticipate that the adoption of this standard will have a significant
      impact on its business, results of operations or financial
      position.





***Share
      Based Payment -*** In
      December 2004, the FASB issued SFAS No. 123R, *Share-Based
      Payment,* which
      is
      a revision to SFAS No. 123. SFAS No. 123R established standards for the
      accounting for transactions in which an entity exchanges its equity instruments
      for goods or services. Primarily, SFAS No. 123R focuses on accounting for
      transactions in which an entity obtains employee services in share-based payment
      transactions. It also addresses transactions in which an entity incurs
      liabilities in exchange for goods or services that are based on the fair value
      of the entity’s equity instruments or that may be settled by the issuance of
      those equity instruments.





SFAS
      No.
      123R requires the Company to measure the cost of employee services received
      in
      exchange for an award of equity instruments based on the grant-date fair value
      of the award. That cost will be recognized over the period during which an
      employee is required to provide service in exchange for the award, which is
      usually the vesting period. No compensation cost is recognized for equity
      instruments for which employees do not render the requisite
      service.





In
      accordance with the Securities and Exchange Commission’s Staff Accounting
      Bulleting 107, SFAS No. 123R is effective as of the beginning of the annual
      reporting period that begins after December 15, 2005. Under these guidelines,
      the company will adopt SFAS 123R as of January 1, 2006. The Company does not
      expect that the adoption of this standard will have a material impact on its
      future results of operations.





***Accounting
      Changes and Error Corrections -*** In
      May
      2005, the FASB issued SFAS No. 154, *Accounting
      Changes and Error Corrections* ,
      which
      is a replacement of APB Opinion No. 20, *Accounting
      Changes,* and
      SFAS
      No. 3, *Reporting
      Accounting Changes in Interim Financial Statements.* SFAS
      No.
      154 changes the requirements for the accounting for and reporting a change
      in an
      accounting principle. Previously, most voluntary changes in accounting principle
      required recognition of a cumulative effect adjustment in the results of
      operations of the period of change. SFAS No. 154 requires retrospective
      application to prior periods unless it is impracticable to determine either
      the
      period-specific effects or the cumulative effect of the change. SFAS No. 154
      is
      effective for accounting changes and corrections of errors made in years
      beginning after December 15, 2005; however, it does not change the transition
      provisions of any existing accounting pronouncements, such as SFAS No. 123R.
      The
      Company does not believe the adoption of SFAS No. 154 will have a material
      effect on its business, results of operations, or financial
      position.










F-13


**Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**




**NOTE
      2. ACQUISITIONS**





***LecStar
      Acquisition*** *-* On
      February 24, 2004, Fonix acquired all of the capital stock of LTEL Holdings
      Corporation (“LTEL”) and its wholly-owned subsidiaries, LecStar Telecom, Inc.,
      and LecStar DataNet, Inc.(collectively “LecStar”). The results of LecStar's
      operations are included in the consolidated financial statements from February
      24, 2004. Fonix acquired LecStar to provide Fonix with a recurring revenue
      stream, a growing customer base, new marketing channels for its Core
      Technologies and Speech Products, and to reduce the cost of capital.





In
      accordance with FAS No. 141, “Business Combinations,” the aggregate purchase
      price was $12,800,000 and consisted of the issuance of 7,036,802 shares of
      Class
      A common stock valued at $4,175,000 or $0.59 per share, 2,000 shares of 5%
      Series H nonvoting, nonconvertible preferred stock (the “Series H Preferred
      Stock”) with a stated value of $10,000 per share valued at $4,000,000, and a 5%
      $10,000,000 secured, six-year promissory note (the “Note”) valued at $4,624,000.
      The number of shares of Class A common stock issued under the terms of the
      purchase agreement was determined by dividing $3,000,000 by 90 percent of the
      average closing bid price of Fonix’s common stock for the first 30 of the 33
      consecutive trading days immediately preceding the date certain regulatory
      approvals were deemed effective. Under the terms of the acquisition agreement,
      the number of Class A common shares was determinable on February 19, 2004.
      Accordingly, the value of the shares of Class A common stock was established,
      in
      accordance with SFAS No. 141, as the average market price of the Fonix common
      stock over the three-day period through February 19, 2004. The values of the
      Series H Preferred Stock and the Note were determined based on the estimated
      risk-adjusted cost of capital to Fonix at the date of the acquisition. The
      fair
      value of the Series H Preferred Stock was based on an imputed yield rate of
      25
      percent per annum and the discount on the Note of $5,376,000 was based on an
      imputed interest rate of 25 percent per annum.





The
      purchase price was allocated to the assets acquired and liabilities assumed
      based on their estimated fair values. Negative goodwill was not recognized
      in
      connection with the acquisition of LecStar. Instead, the excess of the fair
      value of the net assets over the purchase price was allocated as a pro rata
      reduction of the amounts that otherwise would have been assigned to the
      long-term assets. At February 24, 2004, the purchase price was allocated to
      the
      assets acquired and the liabilities assumed as follows:




Current
                  Assets
              
              $
              2,390,000Investments
              
              
              237,000Property
                  and equipment
              
              
              148,000Deposits
                  and other assets
              
              
              984,000Intangible
                  assets
              
              
              18,500,000Total
                  assets acquired
              
              
              22,259,000Current
                  liabilities
              
              
              (8,923,000
              )Long-term
                  portion of notes payable
              
              
              (536,000
              )Total
                  liabilities assumed
              
              
              (9,459,000
              )**Net
                  Assets Acquired**
              
              $
              12,800,000





Of
      the
      $18,500,000 of acquired intangible assets, $14,430,000 was assigned to the
      local
      telephone exchange customer base, with a 2.9-year weighted-average useful life;
      $2,960,000 was assigned to established marketing contracts and agreements with
      utility companies, with a 1.8-year estimated useful life and $1,110,000 was
      assigned to LecStar's brand name, which was determined to have an indefinite
      life and therefore was not subject to amortization. Total acquired intangible
      assets subject to amortization have a weighted-average useful life of
      approximately 2.7 years.





The
      following pro forma information is presented to reflect the operations of the
      Company and LecStar on a combined basis as if the acquisition of LecStar had
      been completed as of the beginning of the years ended December 31, 2004 and
      2003, respectively:







F-14


**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




**Years
                Ended December 31,****2004**
            
            **2003**Revenues
            
            $
            18,006,000
            
            $
            9,753,000Net
                Loss
            
            $
            (16,648,000
            )
            $
            (22,323,000
            )Basic
                and diluted net loss per common share
            
            $
            (0.18
            )
            $
            (0.70
            )





**NOTE
      3. CONVERTIBLE NOTES RECEIVABLE**





On
      December 1, 2001, the Company, as the lender, established a revolving line
      of
      credit and received a convertible promissory note from Unveil Technologies,
      Inc.(“Unveil”), that permitted Unveil to draw up to $2,000,000 for operations
      and other purposes. Unveil is a developer of natural language understanding
      solutions for customer resource management (“CRM”) applications. Fonix desired
      to obtain a license to Unveil’s CRM applications when completed and made the
      loan to Unveil to facilitate and expedite the development and commercialization
      of Unveil’s speech-enabled CRM software.





During
      the year ended December 31, 2002, Unveil drew $880,000 on the line of credit,
      bringing total draws on the line of credit to $1,450,000 as of December 31,
      2002. Due to limited resources available to the Company, additional requests
      for
      funding by Unveil under the line of credit were not met. The Company estimated
      an impairment loss during the third quarter of 2002 in the amount of $1,524,000,
      consisting of the outstanding balance on the line of credit plus accrued
      interest thereon as of that date. The Company advanced an additional $60,000
      to
      Unveil in October 2002. This advance was treated as a research and development
      expense.





During
      the first quarter of 2003, the Company entered into an agreement to terminate
      the revolving line of credit and satisfy the convertible promissory note with
      Unveil. In full settlement of the balance of $1,450,000 due under the note,
      the
      Company received a payment of $410,000 and 1,863,636 shares of Unveil’s Series A
      Preferred Stock (the “Unveil Preferred Stock”). Accordingly, the Company
      adjusted the estimated impairment, recorded in the third quarter of 2002, such
      that the carrying amount of the note receivable was equal to the amount received
      in January 2003. The Company did not allocate value to the Unveil Preferred
      Stock due to Unveil’s overall financial condition.





During
      the third quarter of 2005, the Company received notice from Unveil that it
      had
      accepted an offer from a third party to acquire all of the assets of Unveil.
      On
      October 3, 2005, the Company received a payment of $104,000 in redemption of
      its
      Series A Preferred Stock of Unveil.





**NOTE
      4. PROPERTY AND EQUIPMENT**





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




Computer
                equipment and software
            3
                to 5 yearsFurniture
                and fixtures
            5
                years














F-15






**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




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. Depreciation
      expense was $285,000, $338,000 and $321,000 for the years ended December 31,
      2005, 2004, and 2003, respectively. Property and equipment consisted of the
      following at December 31, 2005 and 2004:




**2005**
              
              **2004**Computer
                  equipment
              
              $
              2,145,000
              
              $
              1,293,000Software
              
              
              253,000
              
              
              246,000Furniture
                  and fixtures
              
              
              143,000
              
              
              162,0002,541,000
              
              
              1,701,000Less
                  accumulated depreciation and amortization
              
              
              (1,594,000
              )
              
              (1,465,000
              )Net
                  Property and Equipment
              
              $
              947,000
              
              $
              236,000





**NOTE
      5. INVESTMENT IN AFFILIATE**





In
      February 2001, the Company entered into a collaboration agreement with Audium
      Corporation (“Audium”) to provide an integrated platform for generating Voice
      XML solutions for Internet and telephony systems. Audium is a mobile application
      service provider that builds and operates mobile applications that allow access
      to Internet information and to complete online transactions using any telephone.
      The collaboration includes integration of the Company’s technologies with
      Audium’s mobile applications development capability.





***Note
      Receivable*** - In
      connection with the collaboration agreement with Audium, in February and May
      2001, the Company advanced an aggregate of $400,000 to Audium as a bridge loan
      (the “Audium Note”). The loan bore interest at a rate of 5 percent per year, had
      a term of four years, and was convertible into shares of Audium Series A
      Convertible Preferred Stock (“Audium Preferred Stock”). The Audium Note was
      convertible into shares of Audium Preferred Stock at a price of $1.46 per share
      upon the occurrence of certain events. The Audium Note was secured by Audium's
      intellectual property. Further, at the closing, Audium granted the Company
      a
      fully paid, worldwide, non-exclusive license to Audium's software to make,
      manufacture, and use the software and any derivative works if Audium declared
      bankruptcy or ceases to do business.





Management
      determined that a 12 percent annual interest rate better reflected the risk
      characteristics of the Audium Note. Accordingly, interest was imputed at 12
      percent and the Audium Note was recorded at its original present value of
      $303,000. For the year ended December 31, 2003, the Company recorded interest
      income of $43,000, including contractual and imputed interest.





***Investment
      in Affiliate*** - In
      April 2001, the Company closed a stock purchase agreement with Audium, wherein
      the Company agreed to purchase up to $2,800,000 of Audium Preferred Stock at
      a
      price of $1.46 per share. At closing, the Company paid $200,000 in cash and
      gave
      Audium a non-interest bearing note (the “Fonix Note”) for the remaining
      $2,600,000. Interest on the Fonix Note was imputed at 12 percent resulting
      in a
      present value of $2,370,000. The resulting purchase price of the Audium
      Preferred Stock was $2,570,000.





Each
      share of Audium Preferred Stock is convertible into one share of Audium’s common
      stock. Holders of Audium Preferred Stock are entitled to eight percent
      cumulative dividends, a liquidation preference in excess of the original
      purchase price plus any declared but unpaid dividends, anti-dilution rights,
      and
      voting rights equal to the corresponding number of common shares into which
      it
      is convertible. The stock purchase agreement also entitles Fonix to elect one
      member of Audium’s board of directors. Audium also granted Fonix certain
      registration rights after the closing of a public offering by
      Audium.





At
      closing, Audium issued 14 Audium Preferred Stock certificates to Fonix, each
      certificate for 136,986 shares, and delivered one certificate in exchange for
      the initial payment of $200,000. The remaining certificates were held by Audium
      as collateral for the Fonix Note under the terms of a security agreement. For
      each payment of $200,000 or multiple payments that aggregate $200,000, Audium
      agreed to release to Fonix one certificate for 136,986 shares of Audium
      Preferred Stock.










F-16


**Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**


The
      difference between the total purchase price of the Audium Preferred Stock and
      the Company’s portion of Audium's net stockholders' deficit at the time of the
      purchase was $2,701,000, which was allocated to capitalized software technology.
      The excess purchase price allocated to the capitalized software technology
      was
      amortized on a straight-line basis over a period of eight years through December
      31, 2010. After the impairment in the investment in Audium discussed below,
      the
      remaining excess purchase price was $1,008,000 and was amortized over the
      remaining portion of the 8-year period.





The
      investment in Audium did not provide the Company with rights to any technology
      developed by Audium; the Company must obtain a license should it choose to
      do
      so. Also, the Company did not own an interest sufficient to control Audium,
      if
      the Company were to convert the Audium Note to Audium Preferred Stock. As a
      result, management has determined that it was appropriate to account for the
      investment, which represented 26.7 percent of Audium’s voting stock, under the
      equity method and not as a research and development arrangement.





Audium
      has incurred losses since the Company acquired the Audium Preferred Stock and
      as
      such, Audium does not have the ability to declare or pay preferred dividends
      on
      the Preferred Stock. The Company recognized losses for the year ended December
      31, 2003 as follows:





**Year
                  Ended**
                **December
                  31, 2003**Company
                  share of Audium net loss
              
              $
              193,000Amortization
                  of difference between purchase price of Audium Preferred Stock
                  and
                  Company’s share of Audium’s net stockholders’ deficit
              
              
              167,000Total
                  equity in loss of affiliate
              
              $
              360,000





A
      summary
      of the results of Audium’s operations for the year ended December 31, 2003, and
      net assets as of December 31, 2003 is as follows:




**2003**Net
                  sales
              
              $
              637,000Loss
                  from operations
              
              
              (1,244,000
              )Non-operating
                  income
              
              
              524,000Net
                  loss
              
              
              (720,000
              )Current
                  assets
              
              $
              241,000Total
                  assets
              
              
              1,163,000Current
                  liabilities
              
              
              1,569,000Total
                  liabilities
              
              
              1,619,000Net
                  assets
              
              $
              (456,000
              )










F-17






**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




The
      fair
      value of this investment was determined based on Audium's estimated future
      net
      cash flows considering the status of Audium's product development. The Company
      evaluated this investment for impairment annually and more frequently when
      indications of decline in value existed. An impairment loss that was other
      than
      temporary was recognized during the period it was determined to exist. An
      impairment was determined to be other-than-temporary if estimated future net
      cash flows were less than the carrying value of the investment. If projections
      indicated that the carrying value of the investment would not be recoverable,
      the carrying value was reduced by the estimated excess of the carrying value
      over the estimated discounted cash flows.





***Note
      Payable to Affiliate*** **** -
      The
      Fonix Note was payable in 13 monthly installments of $200,000 beginning on
      June
      1, 2001, and bore no interest unless an event of default occurred, in which
      case
      it would have borne interest at 12 percent per annum. No events of default
      occurred and the note was fully satisfied. The Fonix Note was secured by shares
      of Audium Preferred Stock as described above.





Management
      determined that a 12 percent annual interest rate reflected the risk
      characteristics of the Fonix Note. Accordingly, interest was imputed at 12
      percent and the Company recorded a present value of $2,370,000 for the note
      payable. For the year ended December 31, 2002, the Company recorded interest
      expense of $95,000 related to this note. Through December 31, 2002, payments
      amounting to $1,800,000 had been made under the Fonix note.





***Sale
      of Investment in Audium*** - On
      December 31, 2003, the Company entered into an agreement with Audium with
      respect to the Audium Note, the Fonix Note, and the Audium Preferred Stock.
      Under the agreement, Fonix agreed that the balance owing under the Audium Note
      would be offset against the balance owing under the Fonix Note, and accordingly,
      the Audium Note was deemed to be paid in full. Fonix further agreed to transfer
      to Audium all of its right, title, and interest in the Audium Preferred Stock
      in
      exchange for (a) Audium’s deeming the Fonix Note to be paid in full; (b)
      Audium’s granting to the Company a fully paid, worldwide, non-exclusive license
      to Audium’s software to make, sell, offer for sale, and use the software and any
      derivative software (the specific terms of which are being finalized), to be
      used if Audium declares bankruptcy, defaults under the agreement, or ceases
      to
      do business for a period of 60 days; and (c) Audium’s granting to Fonix a
      $1,800,000 prepaid license agreement to be applied to Audium’s run-time
      licenses. The prepaid license has a four-year life and allows the Company to
      utilize run-time licenses from Audium in the Company’s products. As the
      $1,800,000 prepaid license represents the amount of the investment the Company
      has made into Audium and that investment was reduced due to recognition of
      Fonix’s portion of Audium’s loss under the equity method of accounting for
      investments and through impairment charges during 2002, the Company did not
      value the prepaid license at December 31, 2003. The Company intends to utilize
      the licenses by offsetting the cost of run time licenses against the prepaid
      license. These transactions resulted in the Company recognizing a gain from
      the
      sale of Audium of $53,000 during December 2003, which gain is included in “other
      income (expense)” in the accompanying consolidated statements of
      operations.





**NOTE
      6. GOODWILL AND INTANGIBLE ASSETS**





Goodwill
      relates solely to our speech-enabling business segment. The carrying value
      of
      goodwill is assessed for impairment quarterly. That assessment resulted in
      no
      impairment and the carrying value of goodwill remained unchanged at $2,631,000
      for the years ended December 31, 2005, 2004 and 2003. Goodwill is not subject
      to
      amortization. During 2002, the Company engaged Houlihan Valuation Advisors,
      an
      independent valuation firm, to assess the Company’s goodwill for impairment. The
      resulting appraisal indicated no impairment and goodwill was not considered
      impaired. The Company performed an internal valuation of goodwill at December
      31, 2005, 2004 and 2003 based on the same factors used by Houlihan, and
      determined that the carrying value of goodwill was not impaired.





***Intangible
      Assets -*** The
      components of other intangible assets at December 31, 2005, were as
      follows:




Gross
                  Carrying
                AmountCustomer
                  base - business
              
              $
              2,611,000Customer
                  base - residential
              
              
              47,000Total
                  Amortizing Intangible Assets
              
              
              2,658,000










F-18




**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




Customer
      base amortization was $5,202,000 and $4,334,000 for the years ended December
      31,
      2005 and 2004, respectively, and amortization related to contracts and
      agreements was $1,103,000 and $1,119,000 for the same periods, respectively.
      All
      amortization expense is charged to selling, general and administrative expense.
      During 2005, the Company recognized an impairment loss on the brand name asset
      acquired in connection with the LecStar acquisition of $1,110,000 based on
      the
      estimated future cash flows. During 2005, the Company recognized an impairment
      loss on the customer base acquired in connection with the LecStar acquisition
      of
      $2,236,000 based on estimated future cash flows. During 2004, the Company
      recognized an impairment loss on the contracts and agreements intangible asset
      acquired in connection with the LecStar acquisition of $738,000 based on
      estimated future cash flows.





Estimated
      aggregate future amortization expense for the succeeding three years ending
      December 31, is as follows:





2006
            
            $
            1,400,0002007
            
            
            715,0002008
            
            
            543,000








Speech
      software technology amortization expense was $52,000, during the year ended
      December 31, 2003, and was charged to cost of revenues. The Company did not
      incur any amortization expense related to its speech software technology during
      the years ended December 31, 2005 or 2004. The costs of patents include direct
      costs incurred by the Company in applying for patents covering its internally
      developed speech software technologies.





During
      2003, the Company modified its estimate of future cash flows to be provided
      by
      its speech-enabling intangible assets and determined that the carrying amount
      of
      intangibles was in excess of future cash flows provided by the intangibles.
      Accordingly, the Company recorded a charge of $1,124,000 during the year ended
      December 31, 2003, to fully impair the carrying value of the intangible assets.
      Of the impairment recognized, $822,000 related to speech software technology
      and
      was charged to cost of revenue, and $302,000 related to customer relationships
      and was charged to operating expenses.





**NOTE
      7. NOTES PAYABLE**





During
      the first quarter of 2003, the Company entered into a promissory note with
      an
      unrelated third party converting accounts payable for outstanding lease payments
      of $114,000 to a note payable. This note accrued interest at 10% annually and
      required monthly minimum payments of the greater of $3,000 or 2% of aggregate
      proceeds from the Company’s Third Equity Line of Credit and subsequent equity
      lines of credit until the note was been fully paid. Under the loan agreement,
      the Company could not sell or transfer assets outside of the ordinary course
      of
      business, or enter a transaction resulting in a change of control, without
      written permission from the creditor. The note was paid in full during the
      year
      ended December 31, 2004.





On
      February 24, 2004 LecStar had an asset securitization facility of $750,000.
      Assets securitized under this facility consist of executory future cash flows
      from LecStar customers in the states of Georgia, Tennessee, Florida, and
      Louisiana. LecStar has pledged its interest in the special purpose
      securitization facility, LecStar Telecom Ventures LLC, a wholly owned subsidiary
      of LTEL, and customer accounts receivable. The note bears an interest rate
      of
      6.5% and is due on February 27, 2007, with 24 equal monthly installments which
      began on March 6, 2005. During 2005, the Company made principal payments of
      $213,000.





In
      connection with the acquisition of the capital stock of LTEL in 2004, the
      Company issued a 5%, $10,000,000, secured, six-year note payable to McCormack
      Avenue, Ltd. Under the terms of the note payable, quarterly interest- only
      payments were required through January 15, 2005, with quarterly principal and
      interest payments of $319,000 due beginning April 2005 and continuing through
      January 2010. Interest on the promissory note is payable in cash or, at the
      Company’s option, in shares of the Company’s Class A common stock. The note is
      secured by the capital stock and all of the assets of LTEL and its subsidiaries.
      The note was valued at $4,624,000 based on an imputed interest rate of 25
      percent per annum. The note has a mandatory prepayment clause wherein the
      Company is required to make prepayments in any given month where the Company
      receives net proceeds in excess of $900,000 from the Fifth Equity Line (or
      replacements thereof with the Equity Line Investor). The required prepayment
      is
      calculated by multiplying the net proceeds received over $900,000 by 33%. For
      the year ended December 31, 2004, the Company made mandatory prepayments on
      the
      note of $415,000. During 2005, the Company made mandatory prepayments of
      $102,000.







F-19




**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




During
      the year ended December 31, 2004, the Company made scheduled interest only
      payments of $175,000, and issued 833,334 shares of the Company’s Class A common
      stock in satisfaction of the September 30, 2004 required interest-only payment
      of $125,000. The Company also elected to make the December 31, 2004, payment
      in
      stock and issued 655,162 shares of the Company’s Class A common stock in
      connection with this payment subsequent to December 31, 2004 in satisfaction
      of
      the December 31, 2004 required interest only payment of $124,000. During 2005,
      the Company elected to make all principal and interest payments in shares of
      its
      Class A common stock and issued 29,417,578 shares. These shares were issued
      in
      payment of $750,000 of principal, plus accrued interest on the note. The
      discount on the note is based on an imputed interest rate of 25%. The carrying
      amount of the note of $4,710,000 at December 31, 2005, was net of unamortized
      discount of $4,023,000.





During
      the fourth quarter of 2005, the Company entered into two promissory notes with
      an unrelated third party in the aggregate amount of $650,000. These notes accrue
      interest at 10% annually and are due and payable during the second quarter
      of
      2006.





The
      following schedule summarizes the Company’s current debt obligations and
      respective balances at December 31, 2005 and 2004:





**Notes
                Payable**
            
            **2005**
            
            **2004**5%
                Note payable to a company, $8,733,000 and $9,584,000 face amount,
                respectively, due in quarterly installments of $319,000, matures
                January
                2010, less unamortized discount based on interest imputed at 25%
                of
                $4,023,000 and $4,762,000, respectively
            
            $
            4,710,000
            
            $
            4,822,000Note
                payable to a company, interest at 10%, matures May 2006
            
            
            350,000
            
            
            --Note
                payable to a company, interest at 10%, matures June 2006
            
            
            300,000
            
            
            --Note
                payable to a company, due in monthly installments of $23,000, interest
                at
                6.5%, matures January 2008, collateralized by trade accounts
                receivable
            
            
            537,000
            
            
            750,000Note
                payable to related parties, interest at 5%, matures December
                2005
            
            
            --
            
            
            78,000Note
                payable to related parties, interest at 12%, matures March 2006,
                secured
                by intellectual property rights
            
            
            486,000
            
            
            435,000Total
                notes payable
            
            
            6,383,000
            
            
            6,085,000Less
                current maturities
            
            
            (2,333,000
            )
            
            (727,000
            )Long-Term
                Note Payable
            
            $
            4,050,000
            
            $
            5,358,000










F-20


**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




The
      following table shows the schedule of principal payments under notes payable
      and
      related party notes payable as of December 31, 2005:


**Year
                  ending December 31,**
              
              **Payments**2006
              
              $
              2,333,0002007
              
              
              201,0002008
              
              
              255,0002009
              
              
              328,0002010
              
              
              3,266,000Thereafter
              
              
              --$
              6,383,000







**NOTE
      8. RELATED-PARTY NOTES PAYABLE**





During
      2002, two executive officers of the Company (the “Lenders”) sold shares of the
      Company’s Class A common stock owned by them and advanced the resulting proceeds
      amounting to $333,000 to the Company under the terms of a revolving line of
      credit and related promissory note. The funds were advanced for use in Company
      operations. The advances bear interest at 12 percent per annum, which interest
      is payable on a semi-annual basis. The entire principal, along with unpaid
      accrued interest and any other unpaid charges or related fees, were originally
      due and payable on June 10, 2003. The Company and the Lenders have agreed to
      postpone the maturity date on several occasions. The note is presently due
      March
      31, 2006. All or part of the outstanding balance and unpaid interest may be
      converted at the option of the Lenders into shares of Class A common stock
      of
      the Company at any time. The conversion price was the average closing bid price
      of the shares at the time of the advances. To the extent the market price of
      the
      Company’s shares is below the conversion price at the time of conversion, the
      Lenders are entitled to receive additional shares equal to the gross dollar
      value received from the original sale of the shares. A beneficial conversion
      option of $15,000 was recorded as interest expense in connection with this
      transaction. The Lenders may also receive additional compensation as determined
      appropriate by the Board of Directors.





In
      October 2002, the Lenders pledged 30,866 shares of the Company's Class A common
      stock to the Equity Line Investor in connection with an advance of $183,000
      to
      the Company under the Third Equity Line. The Equity Line Investor subsequently
      sold the pledged shares and applied $82,000 of the proceeds as a reduction
      of
      the advance. The value of the pledged shares of $82,000 was treated as an
      additional advance from the Lenders.





During
      the fourth quarter of 2003, the Company made a principal payment of $26,000
      against the outstanding balance of the promissory note. During 2004, the Company
      entered into an agreement with the holders of the promissory note to increase
      the balance of the note payable by $300,000 in exchange for a release of the
      $1,443,000 of accrued liabilities related to prior indemnity agreements between
      the Company and the note holders. The Company classified the release of
      $1,143,000 as a capital contribution in the Consolidated Financial Statements
      during the fourth quarter of 2004. The Company made principal payments against
      the note of $254,000 during the year ended December 31, 2004. During the year
      ended December 31, 2005, the Company received an additional advance of $50,000
      against the promissory note. The balance due at December 31, 2005 was
      $486,000.





The
      aggregate advances of $486,000 are secured by the Company’s intellectual
      property rights. As of December 31, 2005, the Lenders had not converted any
      of
      the outstanding balance or interest into common stock.





**NOTE
      9. SERIES D CONVERTIBLE DEBENTURES**





On
      October 11, 2002, the Company issued $1,500,000 of Series D 12% Convertible
      Debentures (the “Debentures”), due April 9, 2003, and 194,444 shares of Class A
      common stock to The Breckenridge Fund, LLC (“Breckenridge”), an unaffiliated
      third party, for $1,500,000 before offering costs of $118,000. The outstanding
      principal amount of the Debentures was 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 average of the two lowest closing bid prices of the Company’s Class A
      common stock for the twenty trading days immediately preceding the conversion
      date, multiplied by 90%.







F-21


**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




The
      Company determined that Breckenridge had received a beneficial conversion option
      on the date the Debentures were issued. The net proceeds of $1,382,000 were
      allocated to the Debentures and to the Class A common stock based upon their
      relative fair values and resulted in allocating $524,000 to the Debentures,
      $571,000 to the related beneficial conversion option, $373,000 to the 194,444
      shares of Class A common stock, less $86,000 of deferred loan costs. The
      resulting $976,000 discount on the Debentures and the deferred loan costs were
      amortized over the term of the Debentures as interest expense.





In
      connection with the issuance of the Debentures, the Company issued, as
      collateral to secure its performance under the Debenture, 2,083,333 shares
      of
      Class A common stock (the “Collateral Shares”), which were placed into an escrow
      pursuant to an escrow agreement. Under the escrow agreement, the Collateral
      Shares would not be released to Breckenridge unless the Company was delinquent
      with respect to payments under the Debenture.





The
      Debentures were originally due April 9, 2003. However, the Company and
      Breckenridge agreed in January 2003 to modify the terms of the Debentures
      requiring the following principal payments plus accrued interest: $400,000
      in
      January 2003; $350,000 in February 2003; $250,000 in March 2003; $250,000 in
      April 2003; and $250,000 in May 2003. Additionally, the Company agreed to
      release 237,584 of the Collateral Shares to Breckenridge as consideration (the
      “Released Shares”) for revising the terms of the purchase agreement. The
      additional shares were accounted for as an additional discount of $285,000.
      The
      value of the shares was amortized over the modified term of the Debentures
      as
      interest expense. The Company did not make the last three payments as scheduled.
      Breckenridge asserted its rights under the Debenture agreement for penalties
      as
      the Company did not meet the prescribed payment schedule. Breckenridge asserted
      a claim of $379,000 which the Company disputed. Both parties subsequently agreed
      to satisfy the claim in full through the issuance of 1,550,000 shares of the
      Company’s Class A common stock with a value of $225,000. The Company transferred
      the shares to Breckenridge on October 20, 2003, in full satisfaction of the
      claim and recorded the penalty as interest expense.





In
      connection with the issuance of the Debentures, the Company entered into a
      registration rights agreement in which the Company agreed to register the resale
      of the shares underlying the Debentures, the Collateral Shares, and the Released
      Shares. The Company filed a registration statement on Form S-2, which became
      effective February 14, 2003. Additionally, the Company filed another
      registration statement on July 2, 2003, which was declared effective on July
      7,
      2003, which included shares issuable to Breckenridge in connection with the
      Debentures. The Company was obligated to file such post-effective amendments
      as
      necessary to keep the registration statements effective as required by the
      registration rights agreement.





Through
      December 31, 2003, the Company had paid $650,000 of the outstanding principal,
      together with $54,000 in accrued interest. Additionally, through December 31,
      2003, the holder of the Debentures converted the remaining $850,000 principal
      amount and $41,000 in interest into 7,359,089 shares of Fonix Class A common
      stock.





As
      part
      of the Debenture agreement, the Company was required to pay Breckenridge a
      placement fee in the amount of $350,000 payable in stock at the conclusion
      of
      the Debenture. The Company satisfied the obligation through the issuance of
      2,000,000 shares of the Company’s Class A common stock valued at $358,000, or
      $0.179 per share and 377,717 shares of the Company’s Class A common stock valued
      at $59,000, or $0.157 per share. The Company recorded the expense as interest
      expense in the accompanying financial statements.





In
      March
      2004, the Company discovered that during 2003 an aggregate of 2,277,777 shares
      of Class A common stock (the "Unauthorized Shares") were improperly transferred
      to the Debenture holder as a result of (i) the unauthorized release from escrow
      of the Collateral Shares (net of the Released Shares), and (ii) the transfer
      to
      the Debenture holder of a duplicate certificate for 194,445 shares where the
      original certificate was not returned to the transfer agent for cancellation.
      The Unauthorized Shares were, therefore, in excess of the shares the Debenture
      holder was entitled to receive. No consideration was paid to or received by
      the
      Company for the Unauthorized Shares during 2003; therefore, the Unauthorized
      Shares were not recognized as being validly issued during 2003.





Upon
      discovering in March 2004 that the Unauthorized Shares had been improperly
      transferred to the Debenture holder, the Company attempted to settle the matter
      with the Debenture holder but was unable to reach a settlement. Accordingly,
      on
      May 3, 2004, the Company filed a lawsuit against the Debenture holder, alleging
      the improper transfer to and subsequent sale of the Unauthorized Shares by
      the
      Debenture holder. The lawsuit was subsequently dismissed without prejudice
      and
      refiled on October 12, 2004. The complaint sought (i) a declaratory judgment
      that the Company may set off the fair value of the Unauthorized Shares against
      the value owed to the Debenture holder in connection with the Series I Preferred
      Stock transaction (ii) judgment against the Debenture holder for the fair value
      of the Unauthorized Shares, and (iii) punitive damages from the Debenture holder
      for improper conversion of the Unauthorized Shares.







F-22


**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




In
      September 2005, the Company settled the three pending lawsuits between Fonix
      and
      Breckenridge. Details relating to the terms of the settlement are set forth
      below in Note 10 below.





**NOTE
      10. PREFERRED STOCK**





The
      Company’s certificate of incorporation allows for the issuance of preferred
      stock in such series and having such terms and conditions as the Company’s board
      of directors may designate.





***Series
      A Convertible Preferred Stock*** - At
      December 31, 2005, there were 166,667 shares of Series A convertible preferred
      stock outstanding. Holders of the Series A convertible preferred stock have
      the
      same voting rights as common stockholders, have the right to elect one person
      to
      the board of directors and are entitled to receive 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 holders, each share of Series A convertible preferred stock is convertible
      into one share of Class A common stock and in the event that the common stock
      price has equaled or exceeded $10 per share for a 15 day period, the shares
      of
      Series A convertible preferred stock will automatically be converted into Class
      A common stock. In the event of liquidation, the holders are entitled to a
      liquidating distribution of $36.33 per share and a conversion of Series A
      convertible preferred stock at an amount equal to .0375 shares of Class A common
      stock for each share of Series A convertible preferred stock.





***Series
      H Preferred Stock*** - The
      Company issued 2,000 shares of 5% Series H nonvoting, nonconvertible Preferred
      Stock on February 24, 2004 in connection with the acquisition of LTEL. Dividends
      on the $10,000,000 stated value of the outstanding Series H Preferred Stock
      are
      payable at the rate of 5% per annum as and when declared by the Board of
      Directors. The annual dividend requirement is $1,000,000. If dividends are
      declared on Fonix's common stock, as a condition of that dividend, Fonix is
      required to pay three percent of the aggregate amount of such dividend to the
      Series H Preferred Stock. Dividends on the Series H Preferred Stock are payable
      in cash or, at the option of Fonix, in shares of Class A common stock.





Fonix
      has
      the option, but not the obligation, exercisable at any time, to redeem all
      or
      any portion of the outstanding Series H Preferred Stock. The redemption price
      is
      equal to any accumulated dividends on the redeemed shares plus a percentage
      of
      the $10,000 per share stated value of the redeemed shares, based on the date
      the
      redemption occurs in relation to the original issuance date as follows: before
      the second anniversary - 102%; thereafter but before the third anniversary
      -
      104%; thereafter but before the fourth anniversary - 106% and thereafter -
      108%.
      If shares of Series H Preferred Stock are redeemed, additional Series H
      preferred dividends will be recognized on the date of redemption in an amount
      equal to the difference between the amount paid to redeem the shares and their
      original fair value at the date of issuance of $2,000 per share.





***Series
      I Convertible Preferred Stock -*** On
      October 24, 2003, the Company entered into a private placement of shares of
      its
      Class A common stock with The Breckenridge Fund, LLC, a New York limited
      liability company (“Breckenridge”). Under the terms of the private placement,
      the Company agreed to issue 1,043,478 shares of its Class A common stock to
      Breckenridge for $240,000 (the “Private Placement Funds”).





Subsequent
      to the Company’s receiving the Private Placement Funds, but before any shares
      were issued in connection with the private placement, the Company agreed with
      Breckenridge to rescind the private placement of the shares and to restructure
      the transaction. The Company retained the Private Placement Funds as an advance
      in connection with the restructured transaction. The Company paid no interest
      or
      other charges to Breckenridge for use of the Private Placement
      Funds.









F-23


**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




Following
      negotiations with Breckenridge, on January 29, 2004, the Company issued to
      Breckenridge 3,250 shares of 8% Series I Convertible Preferred Stock (the
“Series I Preferred Stock”), for an aggregate purchase price of $3,250,000,
      including the Private Placement Funds which the Company had already received.
      The Preferred Stock was issued under a purchase agreement dated as of December
      31, 2003. The Series I Preferred Stock had a stated value of $1,000 per share.





In
      connection with the offering of the Series I Preferred Stock, the Company also
      issued to Breckenridge warrants to purchase up to 965,839 shares of the
      Company’s Class A common stock at $0.50 per share through December 31, 2008, and
      issued 2,414,596 shares of our Class A common stock.





The
      Series I Preferred Stock entitled Breckenridge to receive dividends in an amount
      equal to 8% of the then-outstanding shares of Preferred Stock. The dividends
      were payable in cash or shares of the Company’s Class A common stock, at the
      Company’s option.





On
      September 27, 2005, the Company agreed with Breckenridge to settle and
      discontinue the pending legal actions with Breckenridge. The three actions
      pending in the Supreme Court of New York, Nassau County, involved (i) the
      Company’s claims against Breckenridge for the improper transfer to and
      subsequent sale of shares of the Company’s common stock by Breckenridge; (ii)
      Breckenridge’s claims against the Company for failure to honor conversion
      notices or properly issue shares upon conversion of the Series I Preferred
      Stock
      by Breckenridge; and (iii) Breckenridge’s claims that the Company breached
      agreements in connection with the Series I Preferred Stock, and that pursuant
      to
      a security agreement, Breckenridge was entitled to damages and possession of
      the
      pledged collateral (collectively, the “Breckenridge Lawsuits”).





Pursuant
      to the settlement of the Breckenridge Lawsuits, the Company entered into a
      Mutual Release of Claims Agreement (the “Mutual Release”), pursuant to which the
      Company and Breckenridge agreed to settle and dismiss the Breckenridge Lawsuits,
      and to release any and all claims against each other relating to any prior
      transactions between the Company and Breckenridge. Pursuant to the Mutual
      Release, Breckenridge agreed to assign the remaining shares of Series I
      Preferred to Southridge Partners, LP, to release its security interest in the
      Company’s intellectual property, and to stipulate to the discontinuance with
      prejudice of the Breckenridge Lawsuits. The Company agreed to the release of
      the
      2,777,777 Unauthorized Shares of Class A common stock that occurred in March
      2004, which shares were valued at $73,000 and recognized as a legal settlement
      expense, and to pay to Breckenridge installment payments (the “Periodic
      Payments”) consisting of monthly payments of $130,000 from November 2005 through
      April 2006, and monthly payments of $165,000 from May 2006 through December
      2006, as well as approximately $397,000 which the Company had previously paid
      into an escrow account in connection with the Breckenridge
      Lawsuits.





The
      Company also entered into an agreement with Breckenridge and Southridge
      Partners, LP (“Southridge”) whereby Breckenridge agreed to assign to Southridge
      all remaining shares of the Company’s Series I Preferred, consisting of
      approximately 1,172 shares, together with all of Breckenridge’s rights,
      interests, duties, and obligations which Breckenridge received in connection
      with the purchase from the Company of the Series I Preferred Stock. Southridge
      paid approximately $1,203,000 for Breckenridge’s rights to the Series I
      Preferred Stock and accepted the assignment of the shares of Series I Preferred
      Stock and all assigned rights, interests, duties, and obligations, and we
      consented to the assignment.





Southridge
      is not affiliated with Fonix Corporation or its subsidiaries. Southridge
      Partners, LP, is an entity managed by Southridge Capital Management .





The
      effect of the Assignment Agreement was to terminate the Company’s rights,
      duties, and obligations relating to the Series I Preferred Stock with respect
      to
      Breckenridge, and to enter into a new agreement relating to such rights, duties,
      and obligations with Southridge.









F-24


**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




Additionally,
      the Company entered into a Security Agreement with Breckenridge relating to
      certain of our obligations in connection with the agreement with Breckenridge
      to
      discontinue the Breckenridge Lawsuits. Pursuant to the settlement agreement
      between the parties, the Company is required to make the Periodic Payments
      to
      Breckenridge. To secure those payments, the Company granted to Breckenridge
      a
      security interest in the proceeds that it receives in connection with draws
      on
      the Seventh Equity Line of Credit and any subsequent equity line-type financings
      in the event that we do not make a Periodic Payment when due. Specifically,
      the
      Company granted to Breckenridge the right to receive proceeds from our draws
      on
      the Seventh Equity Line and any subsequent equity line-type financings to the
      extent that we do not make a payment as required and after the applicable grace
      period or cure period has run. With respect to future equity line-type
      financings, the Company agreed to include in the documentation of such
      financings provisions granting to Breckenridge the right to make draws and
      to
      receive funds directly from the equity line provider in the event that we fail
      to make a payment as required, and then only to the extent of the amount of
      the
      payment.





For
      the
      year ended December 31, 2004, the Company issued 8,435,869 shares of the
      Company’s Class A common stock in response to conversion requests for 1,000
      shares of Series I Preferred Stock. For the year ended December 31, 2005, the
      Company issued 18,482,083 shares of the Company’s Class A common stock in
      response to conversion request for 1,078 shares of Series I Preferred Stock.
      As
      of December 31, 2005, there were 0 shares of Series I Preferred Stock
      outstanding.





***Series
      J Preferred Stock -*** On
      October 6, 2005, the Company entered into a Series J 5% Convertible Preferred
      Stock Exchange Agreement (the "Exchange Agreement") with Southridge Partners,
      LP
      ("Southridge"), a Delaware limited partnership. Pursuant to the Exchange
      Agreement, Southridge exchanged all of the shares of Series I Preferred Stock
      that it acquired from Breckenridge, for 1,452 shares of the Company's Series
      J
      5% Convertible Preferred Stock (the "Series J Preferred Stock").





Because
      the shares of Series J were issued in exchange for the remaining outstanding
      shares of Series I Preferred Stock, we did not receive any proceeds in
      connection with the issuance of the Series J Preferred Stock. The Company issued
      1,452 shares of Series J Preferred Stock in exchange for 1,172 shares of Series
      I Preferred Stock. Of the 280 additional shares that were issued to Southridge,
      250 were issued as a placement fee and were accounted for in the selling,
      general and administrative expense in the accompanying financial statements.
      The
      remaining 30 shares were issued as additional litigation expense and were
      accounted for as legal settlement expense.





The
      Series J Preferred Stock entitles Southridge to receive dividends in an amount
      equal to 5% of the then-outstanding balance of shares of Series J Preferred
      Stock. The dividends are payable in cash or shares of the Company's Class A
      common stock, at the Company's option. The aggregation liquidation preference
      at
      December 31, 2005 was $1,359,000.





The
      Series J Preferred Stock may be converted into common stock of the Company
      at
      the option of the holder by using a conversion price which shall be 90% of
      the
      average of the two (2) lowest closing bid prices for the twenty-day trading
      period prior to the conversion date. Through December 31, 2005, the Company
      issued 3,795,918 shares of Class A common stock upon conversion of 93 shares
      of
      Series J Preferred Stock.





Redemption
      of the Series J Preferred Stock, whether at our option or that of Southridge,
      requires us to pay, as a redemption price, the stated value of the outstanding
      shares of Series J Preferred Stock to be redeemed, together with any accrued
      but
      unissued dividends thereon, multiplied by one hundred ten percent
      (110%).





For
      the
      year ended December 31, 2005, the Company issued 3,795,918 shares of its Class
      A
      common stock upon conversion of 93 shares of its Series J Preferred
      Stock.





***Series
      K Preferred Stock*** - On
      February 3, 2006, the Company’s Board of Directors approved the designation and
      issuance of Series K 5% Convertible Preferred Stock (the “Series K Preferred
      Stock”). The Series K Preferred Stock entitles the holder to receive dividends
      in an amount equal to 5% of the stated value of the then-outstanding balance
      of
      shares of Series K Preferred Stock. The dividends are payable in cash or shares
      of the Company’s Class A common stock, at the Company’s option.





The
      Series K Preferred Stock may be converted into common stock of the Company
      at
      the option of the holder by using a conversion price of $0.01 per
      share.





Redemption
      of the Series K Preferred Stock, whether at the Company’s option or that of
      Southridge, requires the Company to pay, as a redemption price, the stated
      value
      of the outstanding shares of Series K Preferred Stock to be redeemed, together
      with any accrued but unissued dividends thereon, multiplied by one hundred
      ten
      percent (110%).









F-25





**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**


In
      connection with the issuance of the Series K Preferred Stock, the Company filed
      with the State of Delaware a Certificate of Designation and Series K 5%
      Convertible Stock Terms (the “Series K Terms”), which become a part of the
      Company’s Certificate of Incorporation, as amended.





Subsequent
      to filing, but prior to the issuance of any shares of Series K Preferred Stock,
      the Company agreed with Southridge to amend the Series K Terms to put a
      conversion cap of 1.0%, in lieu of a 4.99% conversion cap. The Company and
      Southridge entered into an Amended and Restated Series K 5% Convertible
      Preferred Stock Exchange Agreement, with the only change being the change in
      the
      conversion cap. The Company filed the amended Series K Terms with the Delaware
      Secretary of State.





**NOTE
      11. EQUITY LINES OF CREDIT**





***Third
      Equity Line of Credit*** - In
      June 2002, the Company entered into an equity line agreement (the “Third Equity
      Line”) with a private investor (the “Equity Line Investor”). Under the Third
      Equity Line, the Company had the right to draw up to $20,000,000 from the Equity
      Line Investor through a mechanism of draws and puts of stock. The company was
      entitled to draw funds and to “put” to the Equity Line Investor shares of the
      Company’s Class A common stock in lieu of repayment of the draw.





For
      the
      year ended December 31, 2003, the Company received $2,625,000 in funds drawn
      under the Third Equity Line, less commissions and fees of $62,000. The Company
      issued 5,000,000 shares of Class A common stock as puts under the Third Equity
      Line to the Equity Line Investor, totaling $2,564,000.





***Fifth
      Equity Line of Credit*** - The
      Company entered, as of July 1, 2003, into a fifth private equity line agreement
      (the “Fifth Equity Line Agreement”) with the Equity Line Investor. Under the
      Fifth Equity Line Agreement, the Company had the right to draw up to $20,000,000
      against an equity line of credit (“the Fifth Equity Line”) from the Equity Line
      Investor. The Company was entitled under the Fifth Equity Line Agreement to
      draw
      certain funds and to put to the Equity Line Investor shares of the Company’s
      Class A common stock in lieu of repayment of the draw. The number of shares
      to
      be issued is determined by dividing the amount of the draw by 90% of the average
      of the two lowest closing bid prices of the Company’s Class A common stock over
      the ten trading days after the put notice is tendered. The Equity Line Investor
      is required under the Fifth Equity Line Agreement to tender the funds requested
      by the Company within two trading days after the ten-trading-day period used
      to
      determine the market price.





For
      the
      year ended December 31, 2003, the Company received $7,382,000 in funds and
      a
      subscription receivable of $245,000 drawn under the Fifth Equity Line, less
      commissions and fees of $291,000. The Company and issued 25,494,145 shares
      of
      Class A common stock to the Equity Line Investor as puts under the Fifth Equity
      Line, totaling $7,367,000.





For
      the
      year ended December 31, 2004 the Company received $12,618,000 in funds drawn
      under the Fifth Equity Line, less commissions and fees of $413,000. The Company
      issued 54,768,198 shares of Class A common stock to the Equity Line Investor
      as
      puts under the Fifth Equity Line, totaling $11,337,000.





The
      Company issued 5,480,405 shares of Class A common stock to the Equity Line
      Investor in full satisfaction of an outstanding put under the Fifth Equity
      Line
      totaling $655,000 during the first quarter of 2005.





***Sixth
      Equity Line of Credit*** - On
      November 15, 2004, the Company entered into a sixth private equity line
      agreement (the “Sixth Equity Line Agreement”) with the Equity Line Investor, on
      terms substantially similar to those of the previous equity lines. Under the
      Sixth Equity Line Agreement, the Company has the right to draw up to $20,000,000
      against an equity line of credit (“the Sixth Equity Line”) from the Equity Line
      Investor. The Company is entitled under the Sixth Equity Line Agreement to
      draw
      certain funds and to put to the Equity Line Investor shares of the Company’s
      Class A common stock in lieu of repayment of the draw. The number of shares
      to
      be issued is determined by dividing the amount of the draw by 90% of the average
      of the two lowest closing bid prices of the Company’s Class A common stock over
      the ten trading days after the put notice is tendered. The Equity Line Investor
      is required under the Sixth Equity Line Agreement to tender the funds requested
      by the Company within two trading days after the ten-trading-day period used
      to
      determine the market price.









F-26





**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**


In
      connection with the Sixth Equity Line Agreement, the Company granted
      registration rights to the Equity Line Investor and filed a registration
      statement on Form S-2, which covered the resales of the shares to be issued
      under the Sixth Equity Line. The Company is obligated to maintain the
      effectiveness of the registration statement.





For
      the
      year ended December 31, 2005, the Company received $4,263,000 in funds drawn
      under the Sixth Equity Line, less commissions and fees of $141,000. The Company
      issued 75,000,000 shares of Class A common stock to the Equity Line Investor
      as
      puts under the Sixth Equity Line, totaling $4,138,000.





***Seventh
      Equity Line of Credit*** - On May
      27, 2005, the Company entered into a seventh private equity line agreement
      (the
      "Seventh Equity Line Agreement") with the Equity Line Investor, on terms
      substantially similar to those of the Sixth Equity Line between Queen and us
      dated November 15, 2004.





Under
      the
      Seventh Equity Line Agreement, the Company has the right to draw up to
      $20,000,000 against an equity line of credit (the "Seventh Equity Line") from
      the Equity Line Investor. The Company is entitled under the Seventh Equity
      Line
      Agreement to draw certain funds and to put to the Equity Line Investor shares
      of
      the Company's Class A common stock in lieu of repayment of the draw. The Company
      is limited as to the amount of shares we may put to the Equity Line Investor
      in
      connection with each put; the Company may not put shares which would cause
      the
      Equity Line Investor to own more than 4.99% of its outstanding common stock
      on
      the date of the put notice. The number of shares to be issued in connection
      with
      each draw is determined by dividing the amount of the draw by 93% of the average
      of the two lowest closing bid prices of our Class A common stock over the ten
      trading days after the put notice is tendered. The Equity Line Investor is
      required under the Seventh Equity Line Agreement to tender the funds requested
      by the Company within two trading days after the ten-trading-day period used
      to
      determine the market price.





Pursuant
      to the Seventh Equity Line Agreement, the Company granted to the Equity Line
      Investor a right of first refusal (the “Refusal Right”) with respect to
      additional financing transactions. Under the Refusal Right, for a period of
      180
      days after the effective date of a registration statement filed to register
      resales by the Equity Line Investor, the Company may not offer or sell, with
      certain exceptions, shares of our common stock in a financing transaction
      without first offering that financing transaction to the Equity Line Investor.
      The Equity Line Investor then has the right to choose to offer financing to
      the
      Company on the same terms or to allow us to proceed with the financing
      transaction with other investors.





In
      connection with the Seventh Equity Line Agreement, the Company entered into
      an
      agreement with the Equity Line Investor to terminate all previous equity lines,
      and cease further draws or issuances of shares in connection with all previous
      equity lines. As such, as of the date of this report, the only active equity
      line of credit was the Seventh Equity Line.





Also
      in
      connection with the Seventh Equity Line Agreement, the Company granted
      registration rights to the Equity Line Investor and has filed two registration
      statements which cover the resales of the shares to be issued under the Seventh
      Equity Line. All of the shares registered by the first registration statement
      had been sold as of October 24, 2005. The second registration statement filed
      in
      connection with the Seventh Equity Line was declared effective by the SEC on
      February 13, 2006.





For
      the
      year ended December 31, 2005, the Company received $3,127,000 in funds drawn
      under the Seventh Equity Line, less commissions and fees of $106,000. The
      Company issued 100,000,000 shares of Class A common stock to the Equity Line
      Investor as puts under the Seventh Equity Line totaling $3,034,000.





**NOTE
      12. COMMON STOCK AND COMMON STOCK SUBJECT TO REDEMPTION**





***Reverse
      Stock Split*** *-* On
      March
      24, 2003, the Company’s shareholders approved a one-for-forty reverse stock
      split to its outstanding Class A common stock and common stock options and
      warrants. The number of shares of Class A common stock and common stock options
      and warrants in the accompanying consolidated financial statements have been
      restated for the effects of the stock split for all periods
      presented.










F-27





**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**


***Common
      Stock*** **-** During
      2005, the Company issued 261,157,897 shares of Class A common stock. Of such
      shares, 180,480,405 were issued upon conversion of draws on the equity lines,
      29,417,578 were issued in payment of principal and interest on long-term debt,
      27,275,299 were issued in payment of dividends on Series H Preferred Stock,
      18,482,083 were issued in connection with conversions of Series I Preferred
      Stock, 3,795,918 were issued in connection with conversions of Series J
      Preferred Stock and 2,277,777 were issued in connection with legal
      settlement.





During
      2004, the Company issued 76,870,383 shares of Class A common stock. Of such
      shares, 54,768,198 were issued upon conversion of draws on the equity lines,
      10,850,465 were issued in connection with the issuance and conversion of Series
      I Preferred Stock, 7,036,802 were issued in connection with the LecStar
      acquisition, 1,713,423 were issued as payment for services rendered, 1,666,667
      were issued in payment of dividends on Series H Preferred Stock, 833,334 were
      issued as payment of interest on long-term debt and 1,494 were issued due to
      converting fractional shares in connection with the Company’s reverse stock
      split.





During
      2003, the Company issued 42,023,454 shares of Class A common stock. Of such
      shares, 30,494,145 were issued upon conversion of draws on the equity lines,
      11,524,390 were issued in connection with the Company’s Series D Debentures and
      4,919 were issued due to converting fractional shares in connection with the
      Company’s reverse stock split.





**NOTE
      13. STOCK OPTIONS AND WARRANTS**





***Common
      Stock Options*** - In
      1998, the Company’s board of directors and shareholders approved the 1998 Stock
      Option and Incentive Plan (“the “1998 Plan”) for directors, employees and other
      persons acting on behalf of the Company, under which the aggregate number of
      shares authorized for issuance was 250,000. The Company subsequently determined
      that it had issued 253,581 options in excess of the aggregate number authorized
      under the plan. In 2004, the Company’s board of directors approved an increase
      in the number of shares under the Plan from 250,000 to 550,000 to cover the
      additional options issued. In November 2004, the Board of Directors again
      amended the 1998 Plan to increase the aggregate number of shares under the
      1998
      Plan from 550,000 to 20,000,000. The purpose of this amendment is to cover
      any
      additional issuances of shares made in excess of the number authorized under
      the
      1998 Plan and to enable the Company to issue additional incentive stock options
      to key employees and non-qualified stock options, stock appreciation rights,
      cash and stock bonuses and other incentive grants to directors, employees and
      certain non-employees who have important relationships with the Company or
      its
      subsidiaries. At a meeting of shareholders held on December 30, 2004, the
      amendments to the 1998 Plan were approved. As of December 31, 2005, there were
      18,668,795 shares available for grant under this plan.





In
      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 187,500.
      As of December 31, 2005, there were 187,500 shares available for grant under
      this plan.





In
      1996,
      the Company’s board of directors and shareholders approved the 1996 Directors’
Stock Option Plan, under which the aggregate number of shares of Class A common
      stock authorized for issuance is 135,000. The plan provides that each director
      shall receive options to purchase 5,000 shares of Class A 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 Class A common stock on the date the options are
      granted. The option term is 10 years from date of grant. As of December 31,
      2005, shares available for grant under this plan were 135,000.





In
      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 22,500. The exercise price of these options is the closing market price
      of
      the Class A common stock on the date the options are granted. The term of the
      plan is 10 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, 2005, shares available for grant under
      this plan were 22,500.










F-28




**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




On
      January 19, 2005 the Company entered into an option exchange program with its
      employees, wherein the Company gave eligible Fonix employees the opportunity
      to
      exchange outstanding stock options for the same number of new options to be
      issued at least six months and one day from the expiration of the offer. As
      a
      result of the option exchange program, the Company cancelled 414,450 options
      to
      purchase shares of our Class A common stock effective February 22, 2005. On
      August 23, 2005 the Company granted 414,450 options to employees participating
      in the option exchange program at $0.04 per share.





During
      2005, the Company granted options to purchase 746,505 shares of Class A common
      stock in addition to the option granted in connection with the option exchange
      program described above. The options were granted at exercise prices ranging
      from $0.04 to $0.12. All options were granted at the quoted market price on
      the
      date of grant. All options granted vest over three years following issuance.
      If
      not exercised, all options expire within ten years from the date of
      grant.





During
      2004, the Company granted options to purchase 110,600 shares of Class A common
      stock at exercise prices ranging from $0.21 to $0.37. All options were granted
      at the quoted market price at the date of grant. All options granted vest over
      three years following issuance. If not exercised, all options expire within
      ten
      years from the date of grant.





A
      summary
      of options granted under the Company’s various stock option plans for the years
      ended December 31, 2005, 2004 and 2003 is presented below:


**2005**
              
              **2004**
              
              **2003****Stock
                  Options**
              
              **Weighted
                  Average Exercise Price**
              
              **Stock
                  Options**
              
              **Weighted
                  Average Exercise Price**
              
              **Stock
                  Options**
              
              **Weighted
                  Average Exercise Price**Outstanding
                  at beginning of the year
              
              
              818,920
              
              $
              42.42
              
              
              808,901
              
              $
              41.41
              
              
              634,652
              
              $
              65.60Granted
              
              
              1,160,955
              
              
              0.09
              
              
              110,600
              
              
              0.33
              
              
              261,125
              
              
              0.22Exercised
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Forfeited
              
              
              (647,810
              )
              
              59.11
              
              
              (100,581
              )
              
              37.44
              
              
              (86,876
              )
              
              37.27Outstanding
                  at end of the year
              
              
              1,331,205
              
              
              0.13
              
              
              818,920
              
              
              42.24
              
              
              808,901
              
              
              41.41Exercisable
                  at the end of the year
              
              
              635,303
              
              $
              0.13
              
              
              552,204
              
              $
              62.09
              
              
              461,850
              
              $
              81.73




A
      summary
      of options outstanding and options exercisable under the Company’s various stock
      option plans at December 31, 2005 is presented below:


**Options
                  Outstanding**
              
              **Options
                  Exercisable****Range
                  of Exercise Prices**
              
              **Number
                  Outstanding**
              
              **Weighted
                  Average Remaining Contractual Life**
              
              **Weighted
                  Average Exercise Price**
              
              **Number
                  Exercisable**
              
              **Weighted
                  Average Exercise Price**$            
                  0.04
              
              
              452,855
              
              
              4.2
                  years
              
              $
              0.04
              
              
              449,521
              
              $
              0.040.12
              
              
              577,500
              
              
              9.1
                  years
              
              
              0.12
              
              
              --
              
              
              --0.21
                  - 0.37
              
              
              297,600
              
              
              8.4
                  years
              
              
              0.22
              
              
              182,532
              
              
              0.223.60 - 61.24
              
              
              3,250
              
              
              5.7
                  years
              
              
              7.85
              
              
              3,250
              
              
              7.85$
                  0.04 - 61.24
              
              
              1,331,205
              
              
              7.2
                  years
              
              
              0.13
              
              
              635,303
              
              
              0.13







F-29





**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**


The
      weighted average fair value of options granted during the years ended December
      31, 2005, 2004, and 2003 were $0.09, $0.30 and $0.19 per share,
      respectively.





The
      fair
      value of options and warrants is estimated on the date granted using the
      Black-Scholes option pricing model with the following weighted-average
      assumptions used for grants during 2005, 2004, and 2003:




**2005**
              
              **2004**
              
              **2003**Risk-free
                  interest rate
              
              
              3.75
              %
              
              4.02
              %
              
              3.39
              %Expected
                  dividend yield
              
              
              0.0
              %
              
              0.0
              %
              
              0.0
              %Expected
                  exercise lives
              
              
              5
                  years
              
              
              5
                  years
              
              
              5
                  yearsExpected
                  volatility
              
              
              143
              %
              
              144
              %
              
              134
              %





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,
      2005, 2004, and 2003 is presented below:


**2005**
              
              **2004**
              
              **2003****Shares**
              
              **Weighted
                  Average Exercise Price**
              
              **Shares**
              
              **Weighted
                  Average Exercise Price**
              
              **Shares**
              
              **Weighted
                  Average Exercise Price**Outstanding
                  at beginning of the year
              
              
              980,389
              
              $
              1.10
              
              
              46,250
              
              $
              23.51
              
              
              51,250
              
              $
              25.60Granted
              
              
              —
              
              
              —
              
              
              965,389
              
              
              0.51
              
              
              —
              
              
              —Forfeited
              
              
              (965,389
              )
              
              0.51
              
              
              (31,250
              )
              
              15.60
              
              
              (5,000
              )
              
              45.00Outstanding
                  at end of the year
              
              
              15,000
              
              
              40.00
              
              
              980,389
              
              
              1.10
              
              
              46,250
              
              
              23.51Exercisable
                  at end of the year
              
              
              15,000
              
              
              40.00
              
              
              980,389
              
              
              1.10
              
              
              46,250
              
              
              23.51





**NOTE
      14. RELATED-PARTY TRANSACTIONS**





***SCC
      Asset Management, Inc.*** -
      SCC
      Asset Management, Inc.(“SCC”), formerly Studdert Companies Corp., is a Utah
      corporation that previously provided investment and management services to
      the
      Company. Two of the officers, directors and owners of SCC are directors and
      executive officers of the Company. A third officer, director and owner of SCC
      is
      a former director and executive officer of the Company. The Company rented
      office space under subleased office space from SCC. Payments under the leases
      were guaranteed by three officers, owners and directors of SCC noted above.
      The
      sublease required monthly payments of $10,000. Expenses relating to the sublease
      amounted to $137,000 in 2002. During October 2002, the Company assumed SCC’s
      lease obligation. The leases were terminated effective February 2003. On March
      18, 2003, the Company executed a promissory note with Zions Securities, the
      lessor, in the amount of $114,000 covering outstanding lease
      payments.




***Other
      Transactions*** - The
      secretary of the Company is a partner in a law firm that the Company uses to
      provide legal services. During 2005, 2004 and 2003, the Company incurred
      expenses of approximately $533,000, $604,000 and $538,000, respectively, to
      the
      law firm for services provided to the Company.





**NOTE
      15. INCOME TAXES**





At
      December 31, 2005 and 2004, net deferred income tax assets, before considering
      the valuation allowance, totaled $57,158,000 and $52,361,000, respectively.
      The
      amount and ultimate realization of the benefits from the deferred income tax
      assets are 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. The net change in the valuation allowance was an increase
      of
      $8,249,000 for 2005, a decrease of $1,748,000 for 2004 and an increase of
      $4,949,000 for 2003.









F-30


**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




At
      December 31, 2005, the Company has unused federal net operating loss
      carryforwards available of approximately $127,731,000 and unused state net
      operating loss carryforwards of approximately $119,011,000 which may be applied
      against future taxable income, if any, and which expire in various years from
      2011 through 2024. The Internal Revenue Code contains provisions which likely
      will 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 as of December 31, 2005 and 2004 are as follows:


Deferred
                    income tax assets:
                
                **2005**
                
                **2004**Net
                    operating loss carryforwards:Federal
                
                $
                47,041,000
                
                $
                42,140,000State
                
                
                4,278,000
                
                
                3,802,000Research
                    expenditures credits
                
                
                2,462,000
                
                
                2,438,000Accrued
                    liabilities
                
                
                70,000
                
                
                124,000Deferred
                    revenues
                
                
                344,000
                
                
                367,000Amortization
                    of intangible assets
                
                
                2,963,000
                
                
                3,490,000Total
                    deferred income tax assets
                
                
                57,158,000
                
                
                52,361,000Valuation
                    allowance
                
                
                (56,126,000
                )
                
                (47,697,000
                )Deferred
                    income tax liability - intangible telecommunications
                    assets
                
                
                (1,032,000
                )
                
                (4,664,000
                )Net
                    deferred income tax assets
                
                $
                -
                
                $
                -


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




**Year
                  Ended December 31,****2005**
              
              **2004**
              
              **2003**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
              
              
              3.3Non-deductible
                  items
              
              
              (0.5
              )
              
              (0.5
              )
              
              (0.5
              )Valuation
                  allowance
              
              
              (37.2
              )
              
              (37.2
              )
              
              (37.2
              )Effective
                  income tax rate
              
              
              0.0
              %
              
              0.0
              %
              
              0.0
              %





**NOTE
      16. COMMITMENTS AND CONTINGENCIES**





***U.S.
      Department of Labor Settlement Agreement*** ** -
      On
      March 5, 2003, the Company entered into a settlement agreement with the U.S.
      Department of Labor relating to back wages owed to former and current employees
      during 2002. Under the agreement the Company agreed to pay an aggregate of
      $4,755,000 to certain former and current employees in twenty-four installment
      payments. The first installment payment was due May 1, 2003. The Company
      completed the required payments under the agreement during 2005.





***Executive
      Employment Agreements*** **-** The
      Company has employment agreements with two executive officers that were
      initiated November 1, 1996 and amended effective January 31, 2000 to extend
      the
      term of the agreements and reduce the base compensation. The current annual
      base
      salary for each executive officer is $309,400. During 2002, the executive
      officers agreed to accept reduced cash compensation pursuant to the Company’s
      2002 Employee Compensation Plan. The current expiration date of the agreements
      is December 31, 2010.










F-31





**Fonix
        Corporation and Subsidiaries**
 **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 30 days of
      termination.





At
      expiration, one of the agreements was extended to December 31, 2003. The minimum
      annual salary required by this agreement total $150,000. The executive employees
      are also entitled to other normal benefits extended to executives and employees
      of the Company. In the event that, during the contract term, both a change
      of
      control occurs and, within six months after such change in control was to
      occurs, the executive officers’ services are terminated by the Company for any
      reason other than cause, death or retirement, the executive officers shall
      be
      entitled to receive an amount in cash equal to all base salary then and
      thereafter payable within 30 days of termination. The agreements contain
      non-disclosure, confidentiality, non-solicitation and non-competition clauses.
      Under the terms of the non-competition clause, each executive has agreed that
      for a period of 18 months after the termination of his employment with the
      Company the executive will not engage in any capacity in a business which
      competes with or may compete with the Company.





***Operating
      Lease Agreements*** - The
      Company leases certain facilities and equipment used in its operations. The
      amounts of commitments for non-cancelable operating leases in effect at December
      31, 2005, were as follows:


**Year
                  ending December 31,**2006
              
              $
              715,0002007
              
              
              681,0002008
              
              
              499,0002009
              
              
              324,0002010
              
              
              234,000$
              2,453,000




The
      Company incurred rental expense, net of subleases, of $829,000, $827,000 and
      $603,000 during 2005, 2004 and 2003, respectively, related to these leases.





***Forgiveness
      of Trade Payables and Accrued Interest*** - The
      Company negotiated reductions in amounts due various trade vendors amounting
      to
      $142,000 in 2005. During 2004, the Company negotiated reductions in amounts
      due
      to various trade vendors amounting to $518,000 and negotiated a release of
      an
      outstanding related party obligation of $1,143,000 that was accounted for as
      an
      increase in additional paid in capital for the Company. The Company negotiated
      reductions in amounts due various trade vendors amounting to $169,000 in
      2003.





**NOTE
      17. LITIGATION**





**Grenfell
      Litigation** - Two of
      the Company’s subsidiaries, LecStar Telecom and LecStar DataNet (collectively
“LecStar”), are among the defendants who were sued in the Superior Court of
      Fulton County, State of Georgia, by James D. Grenfell, the former CFO of the
      former parent of LecStar. The suit was filed in December 2003. The plaintiff
      in
      that case alleged that he had an unpaid judgment in the amount of $1,015,000
      plus interest against the former parent entities of LecStar and that the purpose
      of a transfer of the stock and business of LecStar in December 2002 was to
      avoid
      paying the judgment. The plaintiff sought a preliminary injunction prior to
      our
      acquisition of LecStar in February 2004. The Georgia state trial court denied
      the plaintiff's motion for injunctive relief. The plaintiff did not appeal.
      In
      September 2005, the plaintiff dismissed the action in Fulton County. In December
      2005, the plaintiff reasserted his claim in the Superior Court of Cobb County,
      State of Georgia, and, in addition to LecStar, the plaintiff named Fonix and
      LTEL Holdings as defendants in the new lawsuit. Fonix is the sole shareholder
      of
      LTEL Acquisition Corporation which is the sole shareholder of LTEL Holdings.
      Among other things, the plaintiff is seeking an attachment of stock and assets
      of LecStar, to unwind the previous transfer of the stock and business of LecStar
      in December 2002, and for money damages.







F-32





**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




The
      Company and LecStar have only recently been served with the summons and
      complaint in the new lawsuit. As yet no answers or other responsive pleadings
      have been filed. The Company and LecStar intend to aggressively defend against
      these claims. No assessment currently can be made of the likelihood of an
      unfavorable outcome.





**First
      Empire** - Claims
      similar to the claims brought in the Grenfell litigation were also asserted
      by
      other plaintiffs in First Empire Corporation, et al., v. LecStar Corporation,
      et
      al., filed in the Superior Court of Fulton County, State of Georgia. In the
      third amended complaint filed in October 2005, the plaintiffs named W. Dale
      Smith, Chad Smith, Michael Britt, and LTEL Holdings Corporation as defendants.
      Messrs Smith and Britt are former officers and directors of the former parent
      of
      LecStar, and are presently employees of LecStar. LTEL Holdings was the sole
      shareholder of LecStar when acquired by the Company in February 2004. In the
      third amended complaint, the plaintiffs allege that Dale Smith breached his
      fiduciary duty to the former parent of LecStar by participating in the
      transaction in which the parent lost control of LecStar, that LTEL procured
      that
      alleged wrongful conduct from Smith, that the transaction in which the former
      parent lost control of LecStar was a fraudulent conveyance, and that a
      constructive trust should be imposed on LecStar for the benefits of the
      plaintiffs.





Messrs.
      Smith and Britt and LTEL have filed an answer in the litigation. Messrs. Smith
      and Britt and LTEL have not been involved in discovery in this litigation
      because the litigation is in the early stages. Nonetheless, the Company believes
      that the claims of the plaintiffs are without merit, and management intends
      to
      vigorously defend against the claims of the plaintiffs.





The
      principal Series H preferred stockholder has placed 300 shares of Series H
      Preferred Stock in escrow (the “Escrow Shares”) for a period of 12 months from
      the date of acquisition as protection with respect to breaches of
      representations and warranties of the LTEL selling stockholders, including
      any
      liability or payment that may arise from the above mentioned legal action.
      As a
      result of the filing of the First Empire Litigation, the Company has asserted
      a
      claim for breach of certain representations and warranties. To the Company’s
      knowledge, the Escrow Shares have not been released.





**Greenwich
      Insurance Action** - The
      Greenwich litigation is an action filed in the United States District Court
      for
      the Northern District of Georgia, in which Greenwich Insurance Company is
      seeking a declaratory judgment against the directors and officers of the former
      parent entity of LecStar and others. Greenwich seeks an order that it is not
      liable for coverage under its directors and officers’ liability policy for
      claims asserted in the First Empire litigation against several individuals
      who
      were officers and directors of LecStar, including W. Dale Smith, Michael Britt
      and Chad Smith, all of whom are currently employed by LecStar. Greenwich also
      seeks recovery of fees advanced to law firms on behalf of these individuals
      for
      defense costs associated with the First Empire litigation, which Greenwich
      claims are in excess of $100,000. LecStar Telecom has agreed to assume defense
      costs incurred on behalf of Messrs. Smith and Britt in the Greenwich litigation.
      No answers or other responsive pleadings have been filed. It is the intent
      of
      the Company to aggressively defend against the plaintiff’s claims. However,
      Messrs. Smith and Britt may experience exposure to the loss of insurance
      coverage presently afforded under the policy of insurance provided by Greenwich.
      In that case, LecStar may have exposure for any liability associated with
      indemnity claims from the officers and directors arising from previously
      advanced and future defense costs, as well as the costs of defending the
      Greenwich claim itself.





**Settlement
      of Breckenridge Lawsuits** - On
      September 27, 2005, the Company agreed with The Breckenridge Fund, LLC
      (“Breckenridge”) to settle and discontinue the three pending legal actions
      between us and Breckenridge. The three actions pending in the Supreme Court
      of
      New York, Nassau County, involved (i) the Company’s claims against Breckenridge
      for the improper transfer to and subsequent sale of shares of the Company’s
      common stock by Breckenridge; (ii) Breckenridge’s claims against the Company for
      failure to honor conversion notices or properly issue shares upon conversion
      of
      the Company’s Series I 8% Convertible Preferred Stock (the “Series I Preferred”)
      by Breckenridge; and (iii) Breckenridge’s claims that the Company breached
      agreements in connection with the Series I Preferred, and that pursuant to
      a
      security agreement, Breckenridge was entitled to damages and possession of
      the
      pledged collateral (collectively, the “Breckenridge Lawsuits”).









F-33


**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




Pursuant
      to the Settlement of the Breckenridge Lawsuits, the Company entered into a
      Mutual Release of Claims Agreement (the “Mutual Release”), pursuant to which the
      Company and Breckenridge agreed to settle and dismiss the Breckenridge Lawsuits,
      and to release any and all claims against each other relating to any prior
      transactions between us and Breckenridge. Pursuant to the Mutual Release,
      Breckenridge agreed to assign the remaining shares of Series I Preferred to
      Southridge Partners, LP, to release its security interest in the Company’s
      intellectual property, and to stipulate to the discontinuance with prejudice
      of
      the Breckenridge Lawsuits. The Company agreed to pay to Breckenridge installment
      payments (the “Periodic Payments”) consisting of monthly payments of $130,000
      from November 2005 through April 2006, and monthly payments of $165,000 from
      May
      2006 through December 2006, as well as approximately $397,000 which the Company
      had previously paid into an escrow account in connection with the Breckenridge
      Lawsuits.





The
      Company also entered into an agreement (the “Assignment Agreement”) with
      Breckenridge and Southridge Partners, LP (“Southridge”) whereby Breckenridge
      agreed to assign to Southridge all remaining shares of the Company’s Series I
      Preferred, consisting of 1,172 shares, together with all of Breckenridge’s
      rights, interests, duties, and obligations which Breckenridge received in
      connection with the purchase from the Company of the Series I Preferred.
      Southridge paid $1,203,000 for Breckenridge’s rights to the Series I Preferred
      Stock and accepted the assignment of the shares of Series I Preferred and all
      assigned rights, interests, duties, and obligations, and we consented to the
      assignment.





The
      effect of the Assignment Agreement was to terminate the Company’s rights,
      duties, and obligations relating to the Series I Preferred with respect to
      Breckenridge, and to enter into a new agreement relating to such rights, duties,
      and obligations with Southridge.





Additionally,
      the Company entered into a Security Agreement with Breckenridge relating to
      certain of its obligations in connection with the agreement with Breckenridge
      to
      discontinue the Breckenridge Lawsuits. Pursuant to the settlement agreement
      between the parties, the Company is required to make the Periodic Payments
      to
      Breckenridge. To secure those payments, we granted to Breckenridge a security
      interest in the proceeds that the Company receive in connection with draws
      on
      the Seventh Equity Line of Credit and any subsequent equity line-type financings
      in the event that we do not make a Periodic Payment when due. Specifically,
      the
      Company granted to Breckenridge the right to receive proceeds from our draws
      on
      the Seventh Equity Line and any subsequent equity line-type financings to the
      extent that the Company does not make a payment as required and after the
      applicable grace period or cure period has run. With respect to future equity
      line-type financings, the Company agreed to include in the documentation of
      such
      financings provisions granting to Breckenridge the right to make draws and
      to
      receive funds directly from the equity line provider in the event that we fail
      to make a payment as required, and then only to the extent of the amount of
      the
      payment. The Company’s payment obligations which are secured under the Security
      Agreement consist of the monthly payments of $130,000 from November 2005 through
      April 2006, and the monthly payments of $165,000 from May 2006 through December
      2006.





The
      Company is involved in other 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 other matters will not materially
      affect our consolidated financial position, liquidity, or results of
      operations.





**NOTE
      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.





**NOTE
      19. SIGNIFICANT CUSTOMERS**





Of
      the
      Company’s revenues for 2005, 2004 and 2003, $16,191,000, $14,862,000 and
      $2,185,000 were from sources in the United States and $0, $40,000 and $199,000
      were from South Korea. During 2005 and 2004, no single customer generated more
      than 10 percent of the Company’s total revenue. During 2003, two customers
      accounted for 16.4% and 11.8% of the Company’s total revenues.







F-34





**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




**NOTE
      20. BUSINESS SEGMENTS**





Information
      related to Fonix’s reportable operating business segments is shown below.
      Fonix’s reportable segments are reported in a manner consistent with the way
      management evaluates the businesses. The Company identifies its reportable
      business segments based on differences in products and services. The accounting
      policies of the business segments are the same as those described in the summary
      of significant accounting policies. The products and services of each business
      segment are further described in Note 1. The Company has identified the
      following business segments:





***LecStar
      Telecom*** -
      Telecommunications services include wireline voice, data, long distance and
      Internet services to business and residential customers.





***Fonix
      Telecom*** *-* Telecommunications
      services include VoIP, BPL and wireline voice, data, long distance and Internet
      services to business and residential customers.





***Speech*** - The
      Company’s speech-enabling technologies include automated speech recognition and
      text-to-speech for wireless and mobile devices, computer telephony and server
      solutions, and personal software for consumer applications.





The
      following presents certain segment information as of and for year ended December
      31, 2005:





**LecStar
                Telecom**
            
            **Fonix
                Telecom**
            
            **Speech**
            
            **Total**Revenues
                from external customers
            
            $
            14,773,000
            
            $
            60,000
            
            $
            1,358,000
            
            $
            16,191,000Selling,
                general and administrative
            
            
            5,973,000
            
            
            2,555,000
            
            
            4,762,000
            
            
            13,290,000Legal
                settlement expense
            
            
            --
            
            
            --
            
            
            2,080,000
            
            
            2,080,000Impairment
                of intangible assets
            
            
            3,346,000
            
            
            --
            
            
            --
            
            
            3,346,000Depreciation
                and amortization
            
            
            6,105,000
            
            
            140,000
            
            
            60,000
            
            
            6,305,000Product
                development and research
            
            
            --
            
            
            --
            
            
            2,196,000
            
            
            2,196,000Interest
                expense
            
            
            1,289,000
            
            
            --
            
            
            1,298,000
            
            
            2,587,000Gain
                on sale of investments
            
            
            147,000
            
            
            --
            
            
            104,000
            
            
            251,000Segment
                loss
            
            
            (11,125,000
            )
            
            (2,712,000
            )
            
            (8,794,000
            )
            
            (22,631,000
            )Segment
                assets
            
            
            5,457,000
            
            
            824,000
            
            
            3,012,000
            
            
            9,293,000Expenditures
                for segment assets
            
            
            143,000
            
            
            824,000
            
            
            29,000
            
            
            996,000





The
      following presents certain segment information as of and for year ended December
      31, 2004:





**Telecom**
            
            **Speech**
            
            **Total**Revenues
                from external customers
            
            $
            13,673,000
            
            $
            1,229,000
            
            $
            14,902,000Selling,
                general and administrative
            
            
            (8,441,000
            )
            
            (4,915,000
            )
            
            (13,356,000
            )Depreciation
                and amortization
            
            
            (5,675,000
            )
            
            (116,000
            )
            
            (5,791,000
            )Interest
                expense
            
            
            (1,142,000
            )
            
            (1,158,000
            )
            
            (2,300,000
            )Gain
                on forgiveness of debt
            
            
            -
            
            
            518,000
            
            
            518,000Segment
                loss
            
            
            (8,536,000
            )
            
            (6,612,000
            )
            
            (15,148,000
            )Segment
                assets
            
            
            15,375,000
            
            
            3,625,000
            
            
            19,000,000Expenditures
                for segment assets
            
            
            126,000
            
            
            130,000
            
            
            256,000










F-35







**Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**




For
      the
      year ended December 31, 2003 the Company had only the speech operating
      segment.





**NOTE
      21. SUBSEQUENT EVENTS**





***Equity
      Line Proceeds -*** Subsequent
      to December 31, 2005 and through March 10, 2006 the Company received $1,000,000
      in funds drawn under the Seventh Equity Line, less commissions and fees of
      $34,000, and issued 50,252,421 additional shares of Class A common stock to
      the
      Equity Line Investor.





***Series
      J Preferred Stock*** *-* Subsequent
      to December 31, 2005 and prior to the Series K Preferred Stock Exchange, the
      Company issued 15,028,249 shares of its Class A common stock in conversion
      of
      266 shares of Series J Preferred Stock.





***Series
      K Preferred Stock*** - On
      February 6, 2006, the Company entered into a Series K 5% Convertible Preferred
      Stock Exchange Agreement (the “Exchange Agreement”) with Southridge Partners, LP
      (“Southridge”), a Delaware limited partnership. Pursuant to the Exchange
      Agreement, Southridge exchanged 1,093 shares of Series J 5% Convertible
      Preferred Stock for 1,093 shares of the Company’s Series K 5% Convertible
      Preferred Stock (the “Series K Preferred Stock”).





Because
      the shares of Series K were issued in exchange for the remaining outstanding
      shares of Series J Preferred Stock, the Company did not receive any proceeds
      in
      connection with the issuance of the Series K Preferred Stock.





In
      connection with the issuance of the Series K Preferred Stock, the Company
      recorded a beneficial conversion feature of $1,587,000 which was recognized
      as a
      preferred stock dividend.





Through
      March 10, 2006, the Company has issued 23,100,000 shares of its Class A common
      stock in conversion of 231 shares of Series K Preferred Stock.
























F-36