**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, 2006,
                  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 if the registrant is a well-know seasoned issuer, as defined
        in
        Rule 405 of the Securities Act
 Yes
        [  ]    No [X]
 
 Indicate
        by check mark if the registrant is not required to file reports pursuant
        to
        Section 13 or Section 15(d)
 Required
        [X]   Not Required [  ]
 
 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, 2006 was approximately $7,495,000, calculated using
        a
        closing price of $0.0094 per share on June 30, 2006. 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 19, 2007, there were issued and outstanding 1,642,139,820 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 a large accelerated filer, an
        accelerated filer, or a non-accelerated filer. See definition of “accelerated
        filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
        one):
 Large
        Accelerated Filer [  ]   Accelerated Filer [  ]  
Non-Accelerated Filer [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**
  2006
        FORM
        10-K ANNUAL REPORT
 
 
 
 TABLE
        OF
        CONTENTS
 
 Part
                  I
              PageItem
                  1.
              Business
              3Item
                  1A.
              Risk
                  Factors
              13Item
                  2.
              Properties
              21Item
                  3.
              Legal
                  Proceedings
              21Item
                  4.
              Submission
                  of Matters to a Vote of Security Holders
              22Part
                  IIItem
                  5.
              Market
                  for Registrant's Common Equity, Related Stockholder Matters and
                  Issuer
                  Purchases of Equity Securities
              23Item
                  6.
              Selected
                  Financial Data
              27Item
                  7.
              Management's
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              28Item
                  7A.
              Quantitative
                  and Qualitative Disclosures About Market Risk
              43Item
                  8.
              Financial
                  Statements and Supplementary Data
              44Item
                  9.
              Changes
                  in and Disagreements with Accountants on Accounting and Financial
                  Disclosure
              44Item
                  9A.
              Controls
                  and Procedures
              44Item
                  9B.
              Other
                  Information
              45Part
                  IIIItem
                  10.
              Directors,
                  Executive Officers and Corporate Governance
              45Item
                  11.
              Executive
                  Compensation
              47Item
                  12.
              Security
                  Ownership of Certain Beneficial Owners and Management and Related
                  Stockholder Matters
              53Item
                  13.
              Certain
                  Relationships and Related Transactions, and Director
                  Independence
              54Item
                  14.
              Principal
                  Accountant Fees and Services
              55Part
                  IVItem
                  15.
              Exhibits
                  and Financial Statement Schedules
              56
 
 
  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 “MANAGEMENT’S
        DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS,” 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 STATEMENT, 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”) is engaged in providing
        value-added speech technologies through Fonix Speech, Inc. (“Fonix Speech”). 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 personal software for consumer
        applications including video games, e.Dictionaries and mobile navigation
        devices
        with GPS, wireless and mobile devices, computer telephony, and server solutions.
        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 licensing of speech-enabling technologies, unit royalties, maintenance
        contracts and services.
 
 We
        are
        continually developing new product offerings utilizing our TTS and ASR
        technologies 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, sales of our equity and
        debt
        securities and loans, have not been sufficient to cover operating expenses.
        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 and convertible debentures have been
        implemented, and we rely on, first, cash generated from operations, and second, convertible
        debt financing arrangements .
        In
        addition to anticipated revenues generated from current and future customers,
        we
        will need to generate approximately $2.5 to $5 million to continue operations
        for the next twelve months. There can be no assurance that we will be able
        to
        obtain such financing or that the terms will be favorable to the
        Company.
 
 We
        previously operated a telecommunications business, the results of which were
        included in prior SEC filings. On October 2, 2006, LecStar Telecom Inc.,
        a
        Georgia corporation (“LecStar Telecom”), LecStar DataNet, Inc., a Georgia
        corporation (“LecStar DataNet”), LTEL Holdings Corporation (“LTEL Holdings”), a
        Delaware corporation, and Fonix Telecom Inc., a Delaware corporation (“Fonix
        Telecom”), each of which are direct or indirect subsidiaries of Fonix, filed for
        bankruptcy protection in the United States Bankruptcy Court for the District
        of
        Delaware (the “Bankruptcy Court”). The case numbers are as follows: LTEL
        Holdings Corporation, 06-11081 (BLS); LecStar Telecom, Inc., 06-11082 (BLS);
        LecStar DataNet, Inc., 06-11083 (BLS); Fonix Telecom, Inc., 06-11084
        (BLS).)
 
  3
  LecStar
        Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom sought protection
        under Chapter 7 of title 11 of the U.S. Bankruptcy Code, 11 U.S.C ss 101
        et seq.
        (the “Bankruptcy Code”). Pursuant to Bankruptcy Code Section 701, on October 3,
        2006, Alfred Thomas Guliano was appointed the interim trustee for LecStar
        Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom. As these subsidiary
        companies were in Chapter 7 Bankruptcy proceedings as of the date of this
        Annual
        Report, the results of their operations have been treated as discontinued
        operations.
 
 Company
        Internet addresses are as follows:
 Fonix
        Corporation - www.fonix.com
 Fonix
        Speech, Inc. - www.fonixspeech.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 as our “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, 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.
 
 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, offered wire
        line
        voice, data, long distance and Internet services to business and residential
        customers throughout BellSouth’s Southeastern United States operating territory.
        On October 2, 2006, LecStar, LTEL Holdings, and Fonix Telecom, each of which
        are
        direct or indirect subsidiaries of Fonix, filed for bankruptcy protection
        in the
        United States Bankruptcy Court for the District of Delaware, as discussed
        above .
 
 **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 comprising mobile and wireless devices, video game consoles, electronic
        devices for the assistive and language learning markets, robots, appliances,
        automotive telematics, computer telephony and server applications.
 
 Original
        Equipment Manufacturers (“OEMs”) or Original Design Manufacturers (“ODMs”)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.
 
  4
  *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. Fonix
        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 (now AT&T Wireless) 2125, 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
        Personal Information Management (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, OEMs and 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.
 
 o
              **Mobile
                  Operators**:
                  Fonix markets VoiceDial and VoiceCentral through mobile operators
                  such as
                  AT&T Wireless (formerly Cingular), T-Mobile, Orange, Vodafone and
                  Verizon. VoiceDial can be delivered several ways, including loading
                  software directly on the device or over-the-air activation.
 
  5
  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®, one of 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 partners include Microsoft,
        Intel, Hitachi, O2, Code
        Factory, Casio and HTC.
 
 o
              **The
                  Language Learning Market -
                  e.Dictionaries**
 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 (i) Fonix DECTalk’s small memory footprint and high
        intelligibility and (iI) Fonix VoiceIn’s high-recognition-rate capabilities.
        Speech-enabled language learning is an emerging market, especially in Asia.
        Multiple OEMs currently sell 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 or spoken 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 solution including Fonix speech technology. Current OEMs marketing
        e.Dictionary devices featuring Fonix technology include Casio, Casio Soft,
        Canon, Huapu, Seiko Instruments, AOne Pro and Brilliant Systems.
 
  6
  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.
 
 §
              **Video
                  Game Consoles**
 Fonix
        VoiceIn® Game Edition is Fonix Speech’s award-winning
        software solution for voice command and control in Xbox®, Xbox 360TM,
        PlayStation®2, PlayStation®3 and PC video games. Management believes that 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
        360TM, PlayStation®2, PlayStation®3 and PC platforms. In 2006, Fonix added
        specialized tools for game developers including Fonix VoiceIn Karaoke Edition
        and Fonix VoiceIn Phonetic Edition. Fonix VoiceIn is optimized for game
        development where memory and processing power are at a premium.
 
 Fonix
        Speech Video Game 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 360TM developer’s
        kit. Cross-platform game developers can use the same voice command software
        for
        PlayStation®2 ,
        PlayStation®3 and
        PC
        games. Game developers worldwide can now build games that utilize a common
        application program interface across Xbox®, Xbox 360TM, PlayStation®2, PlayStation®3 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. Currently, Fonix VoiceIn is included on 20
        video
        game 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.
 
 Fonix
        Speech Video Game Market Opportunities
 
 In
        the
        video games 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
        VoiceIn Karaoke Edition is a
        new
        Fonix speech solution specifically designed for karaoke game developers.
        Fonix
        technology compares the timing, pitch and voice of the karaoke singer to
        the
        reference song and reports on the accuracy of the karaoke singing. Karaoke
        singers can better enjoy the experience, and improve future performances,
        by
        accurately measuring their talent against a professional song
        track.
   Fonix
        VoiceIn Phonetic Edition is a new Fonix technology for videogame developers
        and
        animators. Fonix VoiceIn **** PE
        speech
        technology aligns word phonetics with audio data, allowing animators to more
        precisely synchronize an animated characters’ facial movements with the phonetic
        components of speech. The technology utilizes input text to break down the
        phonetic components of words. The result is more realistic facial movement
        as
        animated characters “speak.”
  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.
 
  7
  §
              **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 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.
 
 o
              **511
                  Traffic Information System**
 In
        July
        2000, the 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. Potential competitors in the telephony/server market include
        Nuance and Avaya.
 
 
 
 
 
 
 
  8
  **Fonix
        Speech Marketing and Sales Activities**
 
 Fonix
        Speech expects to expand sales through partners, OEMs, ODMs, 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.
 
 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.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  9
  **Fonix
        Speech Platforms, Ports, and Processors**
 
 Fonix
        Speech supports multiple microprocessors ("Chips"); including Win32, WinCE,
        QNX,
        Linux, 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
 
 
  10
  **RECENT
        DEVELOPMENTS**
 
 ***Series
        E Debentures*** *-* On
        December 7, 2006, the Company entered into a Securities Purchase Agreement,
        dated as of December 1, 2006 (the “Agreement”), with Southridge Partners LP
        (“Southridge”) relating to the purchase and sale of a Series E 9% Secured
        Subordinated Convertible Debenture (the “Southridge Debenture”) in the principal
        amount of $850,000.
 
 Pursuant
        to the Agreement, Southridge paid the purchase price by tendering a prior
        debenture in the aggregate amount (including principal and interest) of
        $641,000, and agreed that an advance to the Company in the amount of $75,000
        made in November 2006 would also constitute part of the purchase price.
        Southridge agreed to fund the remaining $134,000 upon the effectiveness of
        a
        registration statement, to be filed by the Company, to register the resales
        of
        shares issuable to Southridge upon conversion of the Southridge
        Debenture.
 
 The
        Southridge Debenture is convertible into shares of our Class A common stock.
        The
        number of shares issuable is determined by dividing the amount of the Southridge
        Debenture being converted by the conversion price, which is the average of
        the
        two lowest per share market values for the twenty trading days immediately
        preceding the conversion date multiplied by seventy percent. The conversion
        price is subject to adjustment as set forth in the Southridge Debenture.
        Southridge has agreed not to convert the Southridge Debenture to the extent
        that
        such conversion would cause Southridge to beneficially own in excess of 4.999%
        of the then-outstanding shares of Class A common stock of the Company except
        in
        the case of a merger by the Company or other organic change.
 
 The
        Company also entered into a Registration Rights Agreement (the “Registration
        Agreement”) with Southridge pursuant to which the Company agreed to file a
        registration statement to register the resale by Southridge of shares of
        the
        Company’s common stock issuable upon conversion of the Southridge Debenture.
        Under the Registration Agreement, the Company agreed to file a registration
        statement to register the resale by Southridge of up to 300,000,000 shares
        of
        Fonix Class A common stock. The registration statement was filed in January
        2007, but as of the date of this Report, had not been declared
        effective.
 
 In
        addition to the Southridge Debenture, on December 7, 2006, the Company entered
        into a Securities Purchase Agreement, dated as of December 1, 2006 (the
“McCormack Agreement”), with McCormack Avenue, Ltd (“McCormack”), relating to
        the purchase and sale of a Series E 9% Secured Subordinated Convertible
        Debenture (the “McCormack Debenture”) in the principal amount of
        $1,039,000.
 
 Pursuant
        to the McCormack Agreement, McCormack paid the purchase price by tendering
        outstanding promissory notes in the amounts of $300,000 and $350,000, together
        with combined interest thereon of $64,000, and agreed that advances to the
        Company in the amount of $325,000, made in September, October, and November
        2006, would also constitute part of the purchase price.
 
 The
        McCormack Debenture is convertible into shares of the Registrant’s Class A
        common stock. The number of shares issuable is determined by dividing the
        amount
        of the Debenture being converted by the conversion price, which is the average
        of the two lowest per share market values for the twenty trading days
        immediately preceding the conversion date multiplied by seventy percent.
        The
        conversion price is subject to adjustment as set forth in the Debenture.
        McCormack agreed not to convert the Debenture to the extent that such conversion
        would cause McCormack to beneficially own in excess of 4.999% of the
        then-outstanding shares of Class A common stock of the Company except in
        the
        case of a merger by the Company or other organic change.
 
 The
        Company also entered into a Registration Rights Agreement (the “McCormack
        Registration Agreement”) with McCormack pursuant to which the Company agreed to
        file a registration statement to register the resale by McCormack of shares
        of
        the Company’s common stock issuable upon conversion of the Debenture. As of the
        date of this Report, we had not filed the registration statement relating
        to the
        McCormack Debenture.
 
 The
        Company received no new capital in connection with the issuance and sale
        of the
        Debenture.
 
  11
  ***Breckenridge
        Complaint*** *-* ****** On
        June
        6, 2006, Breckenridge filed a complaint against the Company in the Supreme
        Court
        of the State of New York, County of Nassau (the “Court”), in connection with a
        settlement agreement between the Company and Breckenridge entered into in
        September 2005. In the Complaint, Breckenridge alleged that the Company failed
        to pay certain amounts due under the settlement agreement in the amount of
        $450,000. The Company denied the allegations of Breckenridge’s complaint and
        filed a motion for summary judgment. Breckenridge also filed for summary
        judgment on its complaint.
 
 On
        February 2, 2007, the Court granted Breckenridge’s motion for summary judgment,
        denied the Company’s summary judgment motion, and directed that a hearing be
        held to determine the amount owed by the Company to Breckenridge. The Company
        and Breckenridge entered into a stipulation that the Company owed Breckenridge
        $1,530,000 plus interest at a rate of 9% from September 15, 2006 to the date
        of
        entry of judgment.
 
 The
        Court’s judgment, dated as of March 15, 2007, states that the Company owes an
        aggregate of $1,602,000 to Breckenridge. The
        Company has accrued for this settlement in the accompanying financial
        statements. To date,
        Breckenridge has not taken any action to collect on the judgment.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  12
  **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. 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. Additionally,
        statements that relate to future business development, financial projections,
        capital raising, capital requirements, growth of markets or customer bases,
        or
        future business combinations may also include forward-looking statements.
        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. Fonix disclaims any intention
        or
        obligation to update any forward-looking statement contained herein.***
 
 **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 $21,943,000, $22,631,000 and $15,148,000 for the years
        ended December 31, 2006, 2005 and 2004, respectively. As of December 31,
        2006,
        we had an accumulated deficit of $291,200,000, negative working capital of
        $52,957,000, derivative liabilities of $20,941,000 related to the issuance
        of
        Series L Preferred Stock and Series E Debentures, net liabilities of
        discontinued subsidiaries of $20,819,000 related to the telecom assets subject
        to bankruptcy, accrued liabilities and accrued settlement obligation of
        $3,584,000, accounts payable of $1,504,000 and current portion of notes payable
        of $3,683,000.
 
 We
        expect
        to continue to spend significant amounts to 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.
 
 **Continuing
        debt obligations could impair our ability to continue as a going
        concern.**
 
 As
        of
        December 31, 2006, we had debt obligations of $6,671,000, accrued liabilities
        and accrued settlement obligation of $3,584,000 and vendor accounts payable
        of
        approximately $1,504,000. At present, our revenues from existing licensing
        arrangements and Speech Product sales are not sufficient to offset our ongoing
        operating expenses or to pay in full our current debt obligations.
 
 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, 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.
 
  13
  **The
        Breckenridge Judgment for $1,602,000 could impair our ability to continue
        as a
        going concern.**
 
 On
        March
        15, 2007, the New York State trial court entered a judgment against us for
        $1,602,000 and in favor of the Breckenridge Fund (the “Breckenridge Judgment”).
        The judgment arises out of our failure to pay the balance due under a settlement
        agreement with Breckenridge entered into in September 2005.
 
 The
        Company does not have cash sufficient to pay the Breckenridge Judgment. The
        Company presently does not have resources to acquire cash to pay the
        Breckenridge Judgment. The Company has been unable to negotiate a settlement
        under which it would pay the Breckenridge Judgment.
 
 If
        the
        Company continues to be unable to obtain resources sufficient to pay the
        Breckenridge Judgment, or a lesser amount agreed to as a result of further
        settlement discussions, Breckenridge could attempt to collect the balance
        due
        under the Breckenridge Judgment by attaching and executing on property of
        the
        Company, subject to existing security interests. Such collection activity
        could
        be disruptive to the Company’s business and future prospects. Management may
        have to devote considerable time to defending against Breckenridge collection
        activities. There is substantial risk, therefore, that the existence of the
        Breckenridge Judgment and all collection activity arising in connection with
        the
        judgment could adversely affect our business, operations and financial condition
        and we may be forced to curtail our operations, sell part or all o four assets
        or seek protection under bankruptcy laws.
 
 **We
        currently do not have access to the Seventh Equity Line or other equity lines
        of
        credit, which could have a material adverse effect on our ability to continue
        operations.**
 
 Since
        2000, we have relied substantially on equity lines of credit for financing
        our
        operations. Pursuant to these equity lines, we historically have drawn funds
        against the equity line and put shares of our Class A common stock to the
        equity
        line investor in repayment of the draws. In light of current SEC regulations
        and
        interpretations by the SEC, we terminated the Seventh Equity Line and as
        of the
        date of the Report, we did not have access to an equity line of credit or
        similar financing arrangements. Although we are seeking to negotiate additional
        financing sources and reviewing our options, there can be no guarantee that
        we
        will be able to enter into arrangements for financing that will be on terms
        that
        will be satisfactory to us. Any inability to enter into new financing
        arrangements could have a material adverse impact on our ability to continue
        our
        operations, and we may be required to seek protection under the bankruptcy
        laws.
 
 **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 recently terminated the Seventh Equity Line agreement in light of regulatory
        changes, and we do not anticipate that we will be able to enter into another
        similar financing arrangement in the near future. We have recently issued
        two
        convertible debentures which are convertible into shares of our Class A common
        stock, but we will need to receive additional capital in the near future
        to be
        able to continue as a going concern.
 
  14
  **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 the outstanding
        Debentures.**
 
 The
        following table describes the number of shares of Class A common stock that
        would be issuable, assuming that the full principal amount of the Southridge
        Debenture and the McCormack Debenture were converted into shares of our Class
        A
        common stock as of March 19, 2007 (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
                Conversion
                  of Southridge Debenture
                (Principal
                  amount of $850,000)
              
              Shares
                  issuable upon
                Conversion
                  of McCormack Debenture
                (Principal
                  amount of $1,039,000)
              
              Total
                  shares issuable upon conversion
                of
                  outstanding Debentures$0.001
              
              850,000,000
              
              1,039,000,000
              
              1,889,000,000$0.002
              
              425,000,000
              
              519,500,000
              
              944,500,000$0.003
              
              283,333,333
              
              346,333,333
              
              629,666,666$0.005
              
              170,000,000
              
              207,800,000
              
              377,800,000$0.01
              
              85,000,000
              
              103,900,000
              
              188,900,000$0.02
              
              42,500,000
              
              51,950,000
              
              94,450,000$0.05
              
              17,000,000
              
              20,780,000
              
              37,780,000
  Given
        the
        formulas for calculating the shares to be issued in connection with conversions
        of the Southridge Debenture and the McCormack Debenture, there effectively
        is no
        limitation on the number of shares of Class A common stock which may be issued
        in connection with conversions of the Southridge Debenture and the McCormack
        Debenture, except for the number of shares registered under the prospectus
        and
        the registration statement covering the resale of shares issued in connection
        with the Southridge Debenture and the McCormack Debenture. As such, shareholders
        are subject to the risk of substantial dilution to their interests as a result
        of our issuance of shares in connection with conversions of the Southridge
        Debenture and the McCormack Debenture.
 
 **Existing
        shareholders likely will experience increased dilution with decreases in
        market
        value of Class A common stock in connection with shares issued upon conversion
        of the Southridge Debenture and the McCormack Debenture, 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 conversions of the Southridge Debenture and the
        McCormack Debenture is based, in part, on the market price of the Class A
        common
        stock and includes a discount from the market price equal to 70% of the average
        of the two lowest closing bid prices of the Class A common stock over a
        specified trading period. As a result, the lower the market price of our
        Class A
        common stock at and around the time Southridge or McCormack convert the
        Southridge Debenture or the McCormack Debenture, respectively, the more shares
        of Class A common stock Southridge and McCormack would receive. Any increase
        in
        the number of shares of Class A common stock issued upon conversion of the
        Southridge Debenture and the McCormack Debenture 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 issued upon conversion of the Southridge Debenture, 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 Southridge issued in connection
        with a
        conversions of the Southridge Debenture could encourage short sales of Class
        A
        common stock by market participants other than Southridge. 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 Southridge converts principal amount of the Southridge
        Debenture, we issue shares to Southridge, which Southridge 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.
 
  15
  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, Southridge 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 Southridge or any other person. We will make copies of this
        prospectus available to Southridge 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
        Southridge 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 conversions of the Debenture.
 
 **Certain
        restrictions on the extent of conversions of the Southridge Debenture may
        have
        little, if any, effect on the adverse impact of our issuance of shares in
        connection with the Southridge Debenture, 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
        has agreed, subject to certain exceptions listed in the Southridge Debenture,
        to
        refrain from converting amounts of the Debenture which would result in
        Southridge owning more than 4.999% of the then-outstanding shares of Class
        A
        common stock. These restrictions, however, do not prevent Southridge from
        selling shares of Class A common stock received in connection with a conversion,
        and then receiving additional shares of Class A common stock in connection
        with
        a subsequent conversion. In this way, Southridge 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.
 
 **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.**
 
 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 VoiceSignal. 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.
 
 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.
 
  16
  **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, 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.**
 
 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
        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.
 
 **An
        inability to market and develop additional services may adversely affect
        our
        ability to retain existing customers or attract new customers.**
 
 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.
 
  17
  **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.
 
 **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.
 
 **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.
 
  18
  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.
 
 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.
 
  19
  **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 could 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.
 
 **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 nine patents issued and allowed
        by
        the United States Patent and Trademark Office and seven 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*
 
  20
  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.
 
 **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
                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.
 
 **ITEM
                3.**
              **LEGAL
                  PROCEEDINGS**
 
 **Breckenridge
        Complaint** - On
        June 6, 2006, Breckenridge filed a complaint against the Company in the Supreme
        Court of the State of New York, County of Nassau (the “Court”), in connection
        with a settlement agreement between the Company and Breckenridge entered
        into in
        September 2005. In the Complaint, Breckenridge alleged that the Company failed
        to pay certain amounts due under the settlement agreement in the amount of
        $450,000. The Company denied the allegations of Breckenridge’s complaint and
        filed a motion for summary judgment. Breckenridge also filed for summary
        judgment on its complaint.
 
 On
        February 2, 2007, the Court granted Breckenridge’s motion for summary judgment,
        denied the Company’s summary judgment motion, and directed that a hearing be
        held to determine the amount owed by the Company to Breckenridge. The Company
        and Breckenridge entered into a stipulation that the Company owed Breckenridge
        $1,530,000 plus interest at a rate of 9% from September 15, 2006 to the date
        of
        entry of judgment.
 
 The
        Court’s judgment, dated as of March 15, 2007, states that the Company owes an
        aggregate of $1,602,000 to Breckenridge. The Company has accrued for this
        settlement in the accompanying financial statements. To date, Breckenridge
        has
        not taken any action to collect on the judgment.
 
  21
  **ITEM
                4.**
              **SUBMISSION
                  OF MATTERS TO A VOTE OF SECURITY
                  HOLDERS**
 
 ***2006
        Annual Meeting of Shareholders***
 
 On
        June
        23, 2006, we held our Annual Meeting of Shareholders in Salt Lake City, Utah.
        The record date for the meeting was May 5, 2006, on which date there were
        725,556,921 shares of our class A common stock outstanding.
 
 The
        first
        matter voted upon at the meeting was the election of directors. The following
        directors were elected:
 
 **DIRECTOR**
              
              **SHARES**
                **VOTED
                  IN FAVOR**
              
              **SHARES**
                **VOTED
                  AGAINST**Thomas
                  A. Murdock
              
              509,110,346
              
              60,974,771Roger
                  D. Dudley
              
              509,210,311
              
              60,874,806William
                  A. Maasberg, Jr.
              
              512,869,900
              
              57,215,217
 
 The
        second matter voted upon at the meeting was the approval of the Board of
        Directors’ selection of Hansen, Barnett & Maxwell as our independent
        registered public accounting firm for the fiscal year ending December 31,
        2005
        and 2006. The results of the voting were 525,290,918 shares in favor, 42,205,569
        shares against and 2,588,630 shares abstaining.
 
 The
        third
        matter voted upon at the meeting was the approval of an amendment to our
        Certificate of Incorporation to increase our authorized capital from 800,000,000
        shares of common stock to 5,000,000,000 shares of common stock. The results
        of
        the voting were 486,959,479 shares in favor, 81,945,287 shares against and
        1,180,351 shares abstaining.
 
 The
        fourth matter voted upon at the meeting was a shareholder proposal relating
        to
        our adopting corporate governance guidelines and setting a company policy
        relating to an independent board of directors. The results of the voting
        were
        68,861,283 shares in favor, 31,045,652 shares against, 1,484,923 shares
        abstaining and 468,693,259 shares were not voted.
 
 
 
 
 
 
 
 
 
 
 
  22
  **PART
        II**
 
 **ITEM
                  5.**
              **MARKET
                  FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
                  PURCHASES OF EQUITY
                  SECURITIES**
 
 ***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 2005 and 2006 and for the first quarter of 2007, through
        March 19, 2007. The quotations reflect inter-dealer prices, without retail
        mark-up, mark-down or commissions and may not represent actual transactions.
 
  **Calendar
                  Year**2007
              
              2006
              
              2005High
              
              Low
              
              High
              
              Low
              
              High
              
              LowFirst
                  Quarter*
              
              $
              0.003
              
              $
              0.002
              
              $
              0.003
              
              $
              0.015
              
              $
              0.19
              
              $
              0.04Second
                  Quarter
              
              
              
              
              
              
              
              $
              0.002
              
              $
              0.008
              
              $
              0.11
              
              $
              0.02Third
                  Quarter
              
              
              
              
              
              
              
              $
              0.009
              
              $
              0.005
              
              $
              0.07
              
              $
              0.03Fourth
                  Quarter
              
              
              
              
              
              
              
              $
              0.005
              
              $
              0.003
              
              $
              0.03
              
              $
              0.02*Through
                  March 19, 2007
  The
        high
        and low sales prices for our Class A common stock on March 19, 2007, were
        $0.002
        and $0.002, respectively. As of March 19, 2007, there were 1,642,139,820
        shares
        of Fonix Class A common stock outstanding, held by approximately 1,036 holders
        of record and approximately 26,000 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, 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 $655,000. 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.
 
 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.
 
  23
  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.
 
 For
        the
        year ended December 31, 2006, we received $3,378,000 in funds drawn under
        the
        Seventh Equity Line, less commissions and fees of $114,000 and issued
        300,000,000 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.
 
 ***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.
 
 ***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.
 
  24
  For
        the
        year ended December 31, 2006, we issued 15,028,249 shares of our Class A
        common
        stock upon conversion of 266 shares of our Series J Preferred
        Stock.
 
 ***Series
        K Preferred Stock*** -
        Effective 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 entitled 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 were payable
        in
        cash or shares of our Class A common stock, at our option.
 
 The
        shares of Series K Preferred Stock were issued pursuant to a Series K 5%
        Convertible Preferred Stock Exchange Agreement (the “Series K Agreement”), in
        connection with which Southridge exchanged 1,093 shares of Series J Convertible
        Preferred Stock for 1,093 shares of Series K Convertible Preferred
        Stock.
 
 The
        Series K Preferred Stock was convertible into shares of our Class A common
        stock
        at the option of the holder by using a conversion price of $0.01 per
        share.
 
 For
        the
        year ended December 31, 2006, we issued 109,300,000 shares of Class A common
        stock upon conversion of 1,093 shares of our Series K Preferred
        Stock.
 
 ***Series
        L Preferred Stock***  On
        September 7, 2006, we entered into a Series L 9% Convertible Preferred Stock
        Exchange Agreement (the "Exchange Agreement") with McCormack and Kenzie
        Financial (“Kenzie”), a British Virgin Islands company. Pursuant to the Exchange
        Agreement, McCormack and Kenzie exchanged all of the shares of Series H
        Preferred Stock that they acquired from sale of LTEL Holdings, for 1,960.8
        and
        39.2 shares, respectively, of our Series L 9% Convertible Preferred Stock
        (the
        "Series L Preferred Stock").
 
 For
        the
        year ended December 31, 2006, we issued 489,870,090 shares of our Class A
        common
        stock upon conversion of 142 shares of our Series L Preferred Stock
 
 Subsequent
        to December 31, 2006 and through March 19, 2007, we issued 267,507,174 shares
        of
        our Class A common stock upon conversion of 45 shares of our Series L 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 as discontinued operations. 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 SFAS 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.
 
  25
  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 had an indefinite life and therefore was 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
        had a weighted-average useful life of approximately 2.7 years.
 
 Dividends
        on the stated value of the outstanding Series H Preferred Stock were payable
        at
        the rate of 5% per annum as and when declared by the Board of Directors.
        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 previously
        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 was secured
        by
        the assets and capital stock of our subsidiary and the capital stock of LTEL
        and
        LecStar.
 
 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 $1,251,000
        and
        27,275,299 shares of our Class A common stock as payment of $1,126,000 of
        dividends on Series H Preferred Stock.
 
 For
        the
        year ended December 31, 2006, we issued 2,838,412 shares of our Class A common
        stock as payment of $65,000 of dividends on Series H Preferred
        Stock.
 
 There
        have been no repurchases of equity securities by Fonix during the years ended
        December 31, 2006, 2005 or 2004.
 
 
  26
  **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, 2006, 2005, 2004, 2003 and 2002. 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,****2006**
              
              **2005**
              
              **2004**
              
              **2003**
              
              **2002****Statement
                  of Operations Data:**Revenues
              
              $
              1,329,000
              
              $
              1,358,000
              
              $
              1,229,000
              
              $
              2,384,000
              
              $
              3,065,000Cost
                  of Revenues
              
              
              18,000
              
              
              70,000
              
              
              33,000
              
              
              1,029,000
              
              
              657,000Selling,
                  general and administrative expenses
              
              
              5,356,000
              
              
              4,762,000
              
              
              4,706,000
              
              
              7,004,000
              
              
              11,929,000Legal
                  settlement expense
              
              
              -
              
              
              2,080,000
              
              
              -
              
              
              -
              
              
              -Product
                  development and research
              
              
              2,143,000
              
              
              2,196,000
              
              
              2,559,000
              
              
              5,141,000
              
              
              8,193,000Amortization
                  of intangible assets
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              31,000Impairment
                  loss on convertible note receivable
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,114,000Impairment
                  loss on intangible assets
              
              
              -
              
              
              -
              
              
              -
              
              
              302,000
              
              
              -Other
                  expense, net
              
              
              (4,508,000
              )
              
              (1,044,00
              )
              
              (543,000
              )
              
              (2,451,000
              )
              
              (1,039,000
              )Loss
                  from continuing operations, before equity in net loss of
                  affiliate
              
              
              (10,696,000
              )
              
              (8,794,000
              )
              
              (6,612,000
              )
              
              (13,183,000
              )
              
              (19,441,000
              )Equity
                  in loss of affiliate
              
              
              -
              
              
              -
              
              
              -
              
              
              (360,000
              )
              
              (457,000
              )Net
                  loss from continuing operations
              
              
              (10,696,000
              )
              
              (8,794,000
              )
              
              (6,612,000
              )
              
              (13,543,000
              )
              
              (19,898,000
              )Net
                  loss from discontinued operations
              
              
              (11,247,000
              )
              
              (13,837,000
              )
              
              (8,536,000
              )
              
              -
              
              
              -Net
                  loss
              
              
              (21,943,000
              )
              
              (22,631,000
              )
              
              (15,148,000
              )
              
              (13,543,000
              )
              
              (19,898,000
              )Preferred
                  stock dividends
              
              
              (18,735,000
              )
              
              (1,265,000
              )
              
              (3,927,000
              )
              
              -
              
              
              -Net
                  loss attributable to common stockholders
              
              
              (40,678,000
              )
              
              (23,896,000
              )
              
              (19,075,000
              )
              
              (13,543,000
              )
              
              (19,898,000
              )Basic
                  and diluted net loss per common share from continuing
                  operations
              
              $
              (0.04
              )
              $
              (0.04
              )
              $
              (0.12
              )
              $
              (0.50
              )
              $
              (1.73
              )Basic
                  and diluted net loss per common share from discontinued
                  operations
              
              $
              (0.01
              )
              $
              (0.05
              )
              $
              (0.10
              )
              
              -
              
              
              -Basic
                  and diluted weighted average number of common shares
                  outstanding
              
              
              768,076,936
              
              
              261,894,849
              
              
              89,795,728
              
              
              26,894,005
              
              
              11,471,564
 
 
 **As
                  of December 31,****2006**
              
              **2005**
              
              **2004**
              
              **2003**
              
              **2002****Balance
                  Sheet Data:**Current
                  assets
              
              $
              9,000
              
              $
              1,465,000
              
              $
              2,120,000
              
              $
              342,000
              
              $
              691,000Total
                  assets
              
              
              2,805,000
              
              
              9,293,000
              
              
              19,000,000
              
              
              3,173,000
              
              
              6,523,000Current
                  liabilities
              
              
              52,966,000
              
              
              20,469,000
              
              
              15,700,000
              
              
              13,530,000
              
              
              15,120,000Long-term
                  debt, net of current portion
              
              
              2,988,000
              
              
              4,050,000
              
              
              5,358,000
              
              
              40,000
              
              
              3,000Stockholders’
                  (deficit)
              
              
              (53,149,000
              )
              
              (15,226,000
              )
              
              (2,058,000
              )
              
              (10,397,000
              )
              
              (8,599,000
              )
 
  27
  **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. ACTUAL RESULTS COULD DIFFER MATERIALLY
        FROM
        THE RESULTS ANTICIPATED BY FONIX AND DISCUSSED IN THE FORWARD-LOOKING
        STATEMENTS. WHEN USED IN THIS ANNUAL 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.
        ADDITIONALLY, STATEMENTS THAT RELATE TO THE FUTURE BUSINESS DEVELOPMENT,
        FINANCIAL PROJECTIONS, CAPITAL RAISING, CAPITAL REQUIRMENTS, GROWTH OF MARKETES
        OR CUSTOMER BASES, OR FUTURE BUSINESS COMBINATIONS MAY ALSO INCLUDE
        FORWARD-LOOKING STATEMENTS.** ****** **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," ABOVE. FONIX CORPORATION
        SPECIFICALLY DISCLAIMS ANY OBLIGATION OR INTENTION TO UPDATE ANY FORWARD
        LOOKING
        STATEMENT.**
 
 The
        following Management’s discussion and Analysis of financial Condition and
        Results of Operations (“MD&A”) is intended to help the reader understand
        Fonix Corporation, our operations and our present business environment. MD&A
        is provided as a supplement to, and should be read in conjunction with, our
        consolidated financial statements and the accompanying notes thereto contained
        in Item 8 of this report. This overview summarizes MD&A, which includes the
        following sections:
 
 ·
              *Overview*-
                  a general description of our business and the markets in which
                  we operate;
                  our objective; our areas of focus; and challenges and risks of
                  our
                  business.
 
 ·
              *Significant
                  Accounting Policies*-
                  a
                  discussion of accounting policies that require critical judgments
                  and
                  estimates.
 
 ·
              *Results
                  of Operations*-
                  an analysis of our Company’s consolidated results of operations for the
                  three years presented in our consolidated financial statements.
                  Except to
                  the extent that differences among our operating segments are material
                  to
                  an understanding of our business as a whole, we present the discussion
                  in
                  the MD&A on a consolidated
                  basis.
 
 ·
              *Liquidity
                  and Capital Resources*-
                  an analysis of cash flows; off-balance sheet arrangements and aggregate
                  contractual obligations; the impact of foregoing exchange; an overview
                  of
                  financial position; and the impact of inflation and changing
                  prices.
 
 We
        intend
        for this discussion to provide the reader with information that will assist
        in
        understanding our financial statements, the changes in certain key items
        in
        those financial statements from year to year, and the primary factors that
        accounted for those changes, as well as how certain accounting principles
        affect
        our financial statements. The discussion also provides information about
        the
        financial results of the various segments of our business to provide a better
        understanding of how those segments and their results affect the financial
        condition and results of operations of the Company as a whole. This discussion
        should be read in conjunction with our financial statements as of December
        31,
        2006, and the year then ended and the notes accompanying those financial
        statements.
 
  28
  *Overview*
 
 We
        are
        engaged in providing value-added speech technologies through Fonix Speech,
        Inc.
        (“Fonix Speech”). 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 licensing of speech-enabling technologies,
        maintenance contracts and services.
 
 We
        previously operated a telecommunications business, the results of which were
        included in prior SEC filings. On October 2, 2006, LecStar Telecom Inc.,
        a
        Georgia corporation (“LecStar Telecom”), LecStar DataNet, Inc., a Georgia
        corporation (“LecStar DataNet”), LTEL Holdings Corporation (“LTEL Holdings”), a
        Delaware corporation, and Fonix Telecom Inc., a Delaware corporation (“Fonix
        Telecom”), each of which are direct or indirect subsidiaries of Fonix, filed for
        bankruptcy protection in the United States Bankruptcy Court for the District
        of
        Delaware (the “Bankruptcy Court”). The case numbers are as follows: LTEL
        Holdings Corporation, 06-11081 (BLS); LecStar Telecom, Inc., 06-11082 (BLS);
        LecStar DataNet, Inc., 06-11083 (BLS); Fonix Telecom, Inc., 06-11084 (BLS).)
 
 LecStar
        Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom sought protection
        under Chapter 7 of title 11 of the U.S. Bankruptcy Code, 11 U.S.C ss 101
        et seq.
        (the “Bankruptcy Code”). Pursuant to Bankruptcy Code Section 701, on October 3,
        2006, Alfred Thomas Guliano was appointed the interim trustee for LecStar
        Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom. As these subsidiary
        companies were in Chapter 7 Bankruptcy proceedings, as of the date of this
        Report, the results of their operations have been included as discontinued
        operations.
 
 For
        the
        years ended December 31, 2006, 2005 and 2004, we generated revenues of
        $1,329,000, $1,358,000 and $1,189,000, respectively; incurred net losses
        of
        $21,943,000, $22,631,000 and $15,148,000, respectively, and had negative
        cash
        flows from operating activities of $4,048,000, $8,643,000 and $13,247,000,
        respectively. As of December 31, 2006, we had an accumulated deficit of
        $291,200,000, negative working capital of $52,957,000, accrued liabilities
        and
        accrued settlement liability of $3,584,000, derivative liabilities of
        $20,941,000 related to the issuance of Series L Preferred Stock and Series
        E
        Convertible Debentures, net liabilities of discontinued subsidiaries of
        $20,819,000 related to the telecom subsidiaries subject to bankruptcy (LecStar
        Telecom, LecStar DataNet, LTEL Holdings and Fonix Telecom), accounts payable
        of
        $1,504,000 and current portion of notes payable of $3,683,000. We expect
        to
        continue to incur significant losses and negative cash flows from operating
        activities at least through December 31, 2007, primarily due to expenditure
        requirements associated with continued marketing and development of our
        speech-enabling technologies.
 
 We
        are
        continually developing new product offerings in the ASR 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.
 
 Historically,
        our cash resources, limited to collections from customers, draws on equity
        lines
        of credit and loans, have not been sufficient to cover operating expenses.
        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 convertible
        debt financing arrangements. We will need to generate approximately $2.5
        to $5
        million to continue operations for the next twelve months. There can be no
        assurance that we will be able to obtain such financing or that, if we can
        obtain such financing, it will be on terms favorable to us.
 
  29
  ***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.
 
 ***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.
 
  30
  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.
 
 Deferred
        revenue as of December 31, 2006, and 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
                $
                460,000
 ***Cost
        of revenues*** **-** 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.
 
 ***Stock-Based
        Employee Compensation***  ***-*** Effective
        January 1, 2006, we adopted Statement of Financial Accounting Standards No.
        123(R), “Share-Based Payment” (“SFAS 123(R)”), an amendment of SFAS No. 123,
“Accounting for Stock-Based Compensation,” using the modified prospective
        transition method. Under this transition method, compensation costs are
        recognized beginning with the effective date: (a) based on the requirements
        of
        SFAS 123(R) for all share-based awards granted after the effective date and
        (b)
        based on the requirements of SFAS 123 for all awards granted to employees
        prior
        to the effective date of SFAS 123(R) that remain unvested on the effective
        date.
        Accordingly, we did not restate the results of prior periods. The most notable
        change resulting from the adoption of SFAS 123(R) is that compensation expense
        associated with stock options is now recognized in our Statements of Operations,
        rather than being disclosed in a pro forma footnote to our financial statements.
 
 Prior
        to
        January 1, 2006, we accounted for stock options granted under our Stock Option
        Plans under the recognition and measurement provisions of Accounting Principles
        Board Opinion No. 25, *Accounting
        for Stock Issued to Employees* ,
        and
        related interpretations, as permitted by Statement of Financial Accounting
        Standards No. 123, *Accounting
        for Stock-Based Compensation* .
 
 ***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.
 
  31
  ***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***
  ***Uncorrected
        Misstatements*** *-* In
        September 2006, the Securities Exchange Commission issued Staff Accounting
        Bulletin No. 108 (“SAB No. 108”). SAB No. 108 addresses how the effects of prior
        year uncorrected misstatements should be considered when quantifying
        misstatements in current year financial statements. SAB No. 108 requires
        companies to quantify misstatements using a balance sheet and income statement
        approach and to evaluate whether either approach results in quantifying an
        error
        that is material in light of relevant quantitative and qualitative factors.
        When
        the effect of initial adoption is material, companies will record the effect
        as
        a cumulative effect adjustment to beginning of year retained earnings and
        disclose the nature and amount of each individual error being corrected in
        the
        cumulative adjustment. SAB No. 108 will be effective beginning January 1,
        2007
        and it is anticipated that the initial adoption of SAB No. 108 will not have
        a
        material impact on our financial statements.
  ***Uncertainty
        in Income*** *Taxes
        -* In
        June
        2006, the FASB issued FASB Interpretation No. 48 (“FIN-48”), “Accounting for
        Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109.” The
        interpretation clarifies the accounting for uncertainty in income taxes
        recognized in an entity's financial statements in accordance with SFAS No.
        109,
“Accounting for Income Taxes.” Specifically, FIN-48 prescribes a recognition
        threshold and a measurement attribute for the financial statement recognition
        and measurement of a tax position taken or expected to be taken. The provisions
        of FIN-48 are effective for financial statements for fiscal years beginning
        after December 15, 2006. Accordingly, the Company is to adopt FIN-48 on January
        1, 2007. The adoption of FIN-48 is not expected to have a material effect
        on our
        financial position or results of operations.
 
 ***Fair
        Value Measurements*** *-* In
        September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS
        157”). SFAS 157 provides guidance for using fair value to measure assets and
        liabilities. The standard also responds to investors’ request for expanded
        information about the extent to which a company measures assets and liabilities
        at fair value, the information used to measure fair value, and the effect
        of
        fair value measurements on earnings. SFAS 157 will be effective for the
        Company’s fiscal year beginning January 1, 2008. We are currently reviewing the
        effect that the adoption of SFAS 157 will have on our financial
        statements.
 
 ***Accounting
        Changes and Error Corrections -*** In
        May
        2005, the Financial Accounting Standards Board (“FASB”) issued Statement of
        Financial Accounting Standards No. 154 (“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.
 
 ***Results
        of Continued Operations***
 
 ***Fiscal
        Year 2006 Compared to 2005***
 
 Durin g
        2006,
        we recorded revenues of $1,329,000, a decrease of $29,000 from $1,358,000
        in
        2005. The decrease was primarily due to decreased non-recurring engineering
        speech revenues of $133,000, partially offset by increased royalties of
        $104,000.
 
  32
  Cost
        of
        revenues was $18,000 a decrease of $52,000 from $70,000 in 2005. The decrease
        is
        primarily due to the decreased costs of third party royalty fees.
 
 Selling,
        general and administrative expenses were $5,356,000 in 2006, an increase
        of
        $594,000 from $4,762,000 in 2005. The increase is primarily due to the increased
        bad debt expense of $1,214,000, increased
        salary and wage expenses of $143,000, increased occupancy related expenses
        of
        $39,000, increased promotions of $19,000 and increased consulting expenses
        of
        $14,000, partially offset by  decreased legal
        and accounting fees of $377,000, decreased other operating expense of $ 261,000, decreased
        investor relations expenses of $84,000 , decreased
        travel expenses of $63,000, decreased taxes, licenses and permits of $48,000 and decreased depreciation expenses of $2,000.
 
 We
        incurred research and product development expenses of $2,143,000 in 2006,
        a
        decrease of $53,000 from $2,196,000 in 2005. The decrease was primarily due
        to
        an overall decreased consulting expenses of $74,000 and decreased other operating expenses of $27,000 ,
        partially offset by increased occupancy related expenses of $21,000, increased
        travel expenses of $14,000 and increase in salaries and wage-related expenses
        of
        $13,000.
 
 Net
        interest and other expense was $4,508,000 for 2006, an increase of $3,464,000
        from $1,044,000 for 2005. The overall increase was due to the loss on derivative
        liability of $2,771,000, increase in interest expense of $439,000, decreased
        gain on forgiveness of liabilities of $142,000, decreased gain on sale of
        investments of $104,000 and decreased interest income of $8,000.
 
 ***Fiscal
        Year 2005 Compared to 2004***
 
 Durin g
        2005,
        we recorded revenues of $1,358,000 an increase of $129,000 from $1,229,000
        in
        2004. The increase was primarily due to increased non-recurring engineering
        speech revenues of $245,000 partially offset by decreased royalties of $86,000
        and decreased services revenue of $30,000.
 
 Cost
        of
        revenues was $70,000 in 2005 an increase of $37,000 from $33,000 in 2004. The
        increase is primarily due to the decreased costs of third party royalty
        fees.
 
 Selling,
        general and administrative expenses were $4,762,000 in 2005, an increase
        of
        $56,000 from $4,706,000 in 2004. The increase is primarily due to the increased
        salary and wage expenses of $415,000, increased other operating expense of
        $
        312,000, increased occupancy related expenses of $16,000 and increased taxes,
        licenses and permits of $8,000, partially offset by  decreased legal
        and accounting fees of $385,000, decreased
        investor relations expenses of $114,000, decreased travel expenses of $81,000, decreased
        promotions of $48,000, decreased depreciation expenses of $37,000 and decreased
        consulting expenses of $30,000.
 
 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).
 
 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 $1,044,000 for 2005, an increase of $501,000
        from
        $543,000 for 2004. The overall increase was due to the increase in interest
        expense of $230,000 and decreased gain on forgiveness of liabilities of
        $376,000, partially offset by gains recognized on disposal of investments
        of
        $104,000 and increased interest income of $1,000.
 
  33
  ***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, 2006 and 2005. 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, 2006**
              
              **Jun
                  30, 2006**
              
              **Sep
                  30, 2006**
              
              **Dec
                  31, 2006**(Unaudited)Net
                  sales
              
              $
              272,000
              
              $
              366,000
              
              $
              386,000
              
              $
              305,000Gross
                  profit
              
              
              267,000
              
              
              365,000
              
              
              380,000
              
              
              299,000Net
                  loss from continuing operations
              
              
              (1,851,000
              )
              
              (1,849,000
              )
              
              (4,486,000
              )
              
              (2,510,000
              )Net
                  loss from discontinued operations
              
              
              (2,230,000
              )
              
              (2,656,000
              )
              
              (6,361,000
              )
              
              --Preferred
                  stock dividends
              
              
              (1,849,000
              )
              
              (254,000
              )
              
              (16,192,000
              )
              
              (440,000
              )Net
                  loss attributable to common stockholders
              
              
              (5,930,000
              )
              
              (4,759,000
              )
              
              (27,039,000
              )
              
              (2,950,000
              )Basic
                  and diluted loss per common share
              
              $
              (0.01
              )
              $
              (0.01
              )
              $
              (0.01
              )
              $
              (0.01
              )
 
 
 **For
                  the Quarter Ended****Mar
                  31, 2005**
              
              **Jun
                  30, 2005**
              
              **Sep
                  30, 2005**
              
              **Dec
                  31, 2005**(Unaudited)Net
                  sales
              
              $
              310,000
              
              $
              410,000
              
              $
              258,000
              
              $
              380,000Gross
                  profit
              
              
              303,000
              
              
              404,000
              
              
              238,000
              
              
              343,000Net
                  loss from continuing operations
              
              
              (1,664,000
              )
              
              (1,649,000
              )
              
              (3,932,000
              )
              
              (1,549,000
              )Net
                  loss from discontinued operations
              
              
              (2,416,000
              )
              
              (2,688,000
              )
              
              (2,583,000
              )
              
              (6,150,000
              )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
              )
              
              (7,968,000
              )Basic
                  and diluted loss per common share
              
              $
              (0.03
              )
              $
              (0.02
              )
              $
              (0.02
              )
              $
              (0.02
              )
 
 ***Liquidity
        and Capital Resources***
 
 We
        must
        raise additional funds to be able to satisfy our cash requirements during
        the
        next 12 months. It
        is
        anticipated that we will need to raise approximately $2.5 to $5 million over
        the
        next 12 months to meet obligations and continue our product development,
        corporate operations and marketing expenses. 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. We
        are
        working with game developers and other potential licensors of our speech
        product
        offerings to develop additional revenue streams for our speech technologies. 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.
 
  34
  Our
        cash
        resources are limited to collections from customers, 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, 2006, we
        had
        negative working capital of $52,957,000, derivative liabilities of $20,941,000
        related to the issuance of Series L Preferred Stock and Series E Convertible
        Debentures, net liabilities of discontinued subsidiaries of $20,819,000 related
        to the telecom assets subject to bankruptcy, accrued liabilities and accrued
        settlement obligation of $3,584,000, accounts payable of $1,504,000 and current
        portion of notes payable of $3,683,000.
 
 We
        had
        $1,329,000 in revenue and a loss of $21,943,000 for the year ended December
        31,
        2006. Net cash used in operating activities of $4,048,000 for the year ended
        December 31, 2006, resulted principally from the net loss incurred of
        $21,943,000, increased other assets of $93,000, decreased accrued payroll
        of
        $9,000 and decreased deferred revenues of $6,000, partially offset by the
        results of discontinued operations of $11,644,000, the loss on derivative
        liability of $2,772,000, the write-down of intercompany receivables of
        $1,214,000, non-cash accretion of the discount on notes payable of $832,000,
        increased other accrued liabilities of $689,000, increased accounts payable
        of
        $549,000, decreased prepaid expenses and other current assets of $135,000,
        non-cash accretion of the discount on legal settlement obligation of $117,000
        and depreciation expense of $58,000. Net cash used in investing activities
        of
        $12,000 for the year ended December 31, 2006, consisted of the purchase of
        equipment of $12,000. Net cash provided by financing activities of $3,897,000
        consisting primarily of the receipt of $3,504,000 in cash related to the
        sale of
        shares of Class A common stock, $650,000 in proceeds from the issuance of
        debentures, $419,000 in proceeds from related party notes, proceeds from
        notes
        payable of $330,000 and proceeds from a credit advance of $75,000, partially
        offset by the results of discontinued operations of $536,000, payments on
        accrued settlement obligation of $440,000 and payments on related party notes
        of
        $105,000.
 
 We
        had
        negative working capital of $52,957,000 at December 31, 2006, compared to
        negative working capital of $19,004,000 at December 31, 2005. Current assets
        decreased by $1,456,000 to $9,000 from $1,465,000 from December 31, 2005,
        to
        December 31, 2006. Current liabilities increased by $32,497,000 to $52,966,000
        from $20,469,000 during the same period. The change in working capital from
        December 31, 2005, to December 31, 2006, reflects, in part, the derivative
        liability recognized in connection with the issuance of Series L Preferred
        Stock
        and the Series E Debentures of $20,941,000, the loss of assets related to
        discontinued operations, net liabilities of discontinued subsidiaries of
        $20,819,000 related to discontinued operations and increases in current portion
        of notes payable, accrued liabilities and accounts payable, partially offset
        by
        decreases in accrued settlement obligation due to payments made during the
        year
        ended December 31, 2006. Total assets were $2,805,000 at December 31, 2006,
        compared to $9,293,000 at December 31, 2005.
 
 ***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, was originally due and payable
        on June
        10, 2003. Fonix and the Lenders have agreed to postpone the maturity date
        on
        several occasions. The note was due September 30, 2006. As of March 19, 2007,
        we
        had not made payment against the outstanding balance due on the note. 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. 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. 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.
 
  35
  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 under the note from the Lenders. The balance due the Lenders
        at December 31, 2005, was $486,000. For the year ended December 31, 2006,
        we
        received additional advances and other consideration from the Lenders in
        the
        aggregate amount of $419,000 and made principal payments to the Lenders against
        the note of $105,000. The principal balance due at December 31, 2006 was
        $800,000.
 
 The
        unpaid balance of $800,000 at December 31, 2006, is secured by our assets,
        including our stock of Fonix Speech. As of December 31, 2006, the Lenders
        had
        not converted any of the outstanding balance or interest into common stock
        nor
        had they declared the note in default.
 
 ***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.
 
 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 Holdings in
        2004,
        we issued a 5%, $10,000,000, secured, six-year note (the “Note”) payable to
        McCormack Avenue, Ltd. (“McCormack”). Under the terms of the Note, quarterly
        interest only payments were required through January 15, 2005, with quarterly
        principal and interest payments beginning April 2005 and continuing through
        January 2010. Interest on the 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 Holdings and its subsidiaries. The Note was valued
        at
        $4,624,000 based on an imputed interest rate of 25 percent per annum.
 
 The
        discount on the Note is based on an imputed interest rate of 25%. The carrying
        amount of the Note of $5, 542,000
        at December 31, 2006, was net of unamortized discount of $3,191,000. As of
        the
        date of this Report, we had not made any scheduled payments for 2006 or
        2007.
 
 On
        September 8, 2006, we received a default notice (the “Default Notice”) from
        McCormack in respect of the Note. Under the terms of the Note, and a related
        Security Agreement between us and McCormack dated February 24, 2004 (the
        “Security Agreement”), McCormack may declare all liabilities, indebtedness, and
        obligations of Fonix to McCormack under the Security Agreement and the Note
        immediately due and owing upon an event of default. The Note defines an event
        of
        default to include the non-payment by us of a scheduled payment which is
        not
        cured within 60 days.
 
 In
        the
        Default Notice, McCormack stated that it intended to exercise its rights,
        including any and all rights set forth in the Note as amended.
 
  36
  Also
        on
        September 8, 2006, McCormack provided to us a Notice of Sale, stating
        McCormack’s intention to sell at public auction all of the collateral referred
        to in the Security Agreement, consisting of the capital stock and assets
        of
        LecStar Telecom, LecStar DataNet and LTEL Holdings. To date, no sale of the
        assets or capital stock of LecStar Telecom, LecStar DataNet nor LTEL Holdings
        has occurred.
 
 McCormack
        has notified us that notwithstanding the Series L Exchange Agreement between
        us
        and McCormack discussed above, McCormack has not waived any of its rights
        in
        connection with the Note, the Modification Agreement, the Security Agreement,
        or
        the Supplemental Security Agreement.
 
 During
        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
        were due and payable during May and June of 2006. These notes were exchanged
        in
        December 2006 for the Southridge Debenture discussed below.
 
 During
        the third quarter of 2006, we entered into a debenture agreement with an
        unrelated third party for $619,000. The debenture accrues interest at 9%
        annually and was due and payable on September 30, 2006. This debenture was
        exchanged in December 2006 for the Southridge Debenture discussed
        below.
 
 ***Series
        D Debentures***
 
 On
        October 11, 2002, we 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.
 
 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.
 
  37
  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
        March
        2004, we 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 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, (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.
 
 ***Equity
        Lines of Credit***
 
 We
        have
        previously entered into several equity lines of credit with Queen, LLC (the
        “Equity Line Investor”). The two most recent were the Sixth Equity Line of
        Credit and the Seventh Equity Line of Credit.
 
 ***Sixth
        Equity Line of Credit*** -
        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 had 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 were 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 was 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 was tendered.
 
 The
        Equity Line Investor was 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.
 
  38
  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.
 
 Under
        the
        Seventh Equity Line Agreement, we had 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 were 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 were limited as
        to the
        amount of shares we may put to the Equity Line Investor in connection with
        each
        put; we could 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 was 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 was 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.
 
 We
        granted registration rights to the Equity Line Investor and filed three
        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 10, 2006. All of the shares registered by
        the
        second registration statement had been sold as of July 26, 2006. We filed
        a
        third registration statement on June 26, 2006, to register additional shares
        under the Seventh Equity Line. However, that registration statement was not
        declared effective, and no shares were sold under that registration
        statement.
 
 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. We issued
        100,000,000 shares of Class A common stock to the Equity Line Investor as
        puts
        under the Seventh Equity Line totaling $3,127,000.
 
 For
        the
        year ended December 31, 2006, we received $3,378,000 in funds drawn under
        the
        Seventh Equity Line, less commissions and fees of $114,000. We issued
        300,000,000 shares of Class A common stock to the Equity Line Investor as
        puts
        under the Seventh Equity Line totaling $3,378,000.
 
 In
        January 2007, we terminated the Seventh Equity Line, and we have withdrawn
        the
        third registration statement related to the Seventh Equity Line. As such,
        as of
        the date of this report, we did not have an equity line of credit financing
        available to us.
 
 ***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.
  In
        accordance with SFAS 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.
 
  39
  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*** ****
 
 For
        the
        year ended December 31, 2006, we granted options to employees to purchase
        58,000
        shares of Class A common stock. The options have an exercise prices ranging
        from
        $0.01 to $0.02 per share, which was the quoted fair market value of the stock
        on
        the dates of grant. The options granted vest over the three years following
        issuance. Options expire within ten years from the date of grant if not
        exercised. Using the Black-Scholes pricing model, the weighted average fair
        value of the employee options was $0.01 per share. As of December 31, 2006,
        we
        had a total of 907,642 options to purchase Class A common stock
        outstanding.
 
 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.
 
 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.
 
  40
  As
        of
        December 31, 2006, we had warrants to purchase a total of 15,000 shares of
        Class
        A common stock outstanding that expire through 2010.
 
 ***Summary
        of Contractual Obligations***
 
 The
        following summary reflects payments due under long-term obligations as of
        December 31, 2006:
 
 **Total**
              
              **Less
                  Than One**
              
              **One
                  to Three**
              
              **Three
                  to Five**
              
              **More
                  than Five**Notes
                  payable
              
              $
              11,392,000
              
              $
              3,683,000
              
              $
              2,554,000
              
              $
              5,155,000
              
              
              --Operating
                  lease obligations
              
              
              2,453,000
              
              
              715,000
              
              
              1,180,000
              
              
              558,000
              
              
              --Series
                  E debentures
              
              
              1,755,000
              
              
              --
              
              
              --
              
              
              1,755,000
              
              
              --Preferred
                  stock dividends
              
              
              8,363,000
              
              
              1,673,000
              
              
              3,345,000
              
              
              3,345,000
              
              
              **Total
                  contractual cash obligations
              
              $
              23,963,000
              
              $
              6,071,000
              
              $
              7,079,000
              
              $
              10,813,000
  **
        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’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
        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
        proceed to implement our strategy and to reach our objectives, we anticipate
        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
        adopted by us has significant risks, and shareholders and others interested
        in
        Fonix and our Class A common stock should carefully consider the risks set
        forth
        below and under the heading “Certain Significant Risk Factors” in Item 1, Part
        I, of this report.
 
 As
        noted
        above, as of December 31, 2006, we had an accumulated deficit of $291,200,000
        negative working capital of $52,957,000 ,
        derivative liability of $20,941,000 related to the issuance of Series L
        Preferred Stock and Series E Convertible Debentures, net liabilities of
        discontinued subsidiaries of $20,819,000 related to the telecom assets (LecStar
        Telecom, LecStar DataNet, LTEL Holdings and Fonix Telecom) subject to
        bankruptcy, accrued liabilities and accrued settlement obligation of $3,584,000,
        accounts payable of $1,504,000 and current portion of notes payable of
        $3,683,000. Further,
        on March 15, 2007, the New York State trial court entered the Breckenridge
        Judgment in the amount of $1,602,000. Sales of products and revenue from
        licenses based on our technologies have not been sufficient to finance ongoing
        operations. 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 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 debt
        instruments. 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 previous annual reports 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.
 
  41
  **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; development of complementary technologies, products, marketing,
        and
        strategic alliance opportunities; 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; 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.
 
                 
 42
  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 of this
        report, 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;
 
 •
              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 significant number of 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.
 
 
 **ITEM
                7A**
              **QUANTITATIVE
                  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**
 
 We
        believe our exposure to overall foreign currency risk is not material. We
        do not
        manage or maintain market risk sensitive instruments for trading or other
        purposes and are not exposed to the effects of interest rate fluctuations
        as all
        of our debt has fixed interest rates.
 
 We
        report
        our operations in US dollars and our currency exposure, although considered
        by
        us as immaterial, is primarily between the US dollar and the Japanese Yen.
        Exposure to other currency risks is also not material as international
        transactions are settled in US dollars. Any future financing undertaken by
        us
        will be denominated in US dollars. In addition, all of our bank deposits
        are
        maintained in U.S. dollars.
  43
  **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, 2006 and 2005
              F-3Consolidated
                  Statements of Operations and Comprehensive Loss for the Years Ended
                  December 31, 2006, 2005 and 2004
              F-4Consolidated
                  Statements of Stockholders’ Deficit for the Years Ended December 31, 2004,
                  2005 and 2006
              F-5Consolidated
                  Statements of Cash Flows for the Years Ended December 31, 2006,
                  2005 and
                  2004
              F-6Notes
                  to Consolidated Financial Statements
              F-8
 
 **ITEM9.**
              **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 beginning with our Form 10-K for the
        fiscal
        year ending December 31, 2007, 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, 2008. 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.
 
  44
  **ITEM
                  9B.**
              **OTHER
                  INFORMATION**
 
 None.
 **PART
        III**
 
 **ITEM10.**
              **DIRECTORS,
                  EXECUTIVE OFFICERS, AND CORPORATE
                  GOVERNANCE**
 
 The
        following table sets forth certain information concerning the executive officers
        and directors of Fonix as of March 9, 2007:
 
 Name
              
              Age
              
              PositionThomas
                  A. Murdock (1)*
              
              62
              
              Director,
                  President & Chief Executive OfficerRoger
                  D. Dudley (2)*
              
              54
              
              Director,
                  Executive Vice President & Chief Financial OfficerWilliam
                  A. Maasberg, Jr. (1) (2)
              
              67
              
              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.
  45
  **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, 2006, we are aware of the following untimely
        filings:
 
 Messrs.
        Murdock and Dudley filed late Forms 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.
 
   46
  **ITEM
                11.**
              **EXECUTIVE
                  COMPENSATION**
 
 **Compensation
        Discussion and Analysis**
 
 The
        following is a discussion of the Company’s program for compensation of its named
        executive officers and directors. As of the date of this Report, the
        compensation committee of the Board of Directors was responsible for determining
        the Company’s compensation program.
 
 *Compensation
        Program Objectives*
 
 The
        Company’s compensation program is designed to encompass several factors in
        determining the compensation of the Company’s named executive officers. The
        following are the main objectives of the compensation program for the Company’s
        named executive officers:
 
 -
              Retain
                  qualified officers.
 -
              Provide
                  overall corporate direction for the officers and also to provide
                  direction
                  that is specific to officer’s respective areas of authority. The level of
                  compensation amongst the officer group, in relation to one another,
                  is
                  also considered in order to maintain a high level of satisfaction
                  within
                  the leadership group. We consider the relationship that the officers
                  maintain to be one of the most important elements of the leadership
                  group.
 -
              Provide
                  a performance incentive for the officers.
 
 The
        Company’s compensation program is designed to reward the officers in the
        following areas:
 
 -
              achievement
                  of specific goals;
 -
              professional
                  education and development;
 -
              creativity
                  in the form of innovative ideas and analysis for new programs and
                  projects;
 -
              new
                  program implementation;
 -
              attainment
                  of company goals, budgets, and
                  objectives;
 -
              results
                  oriented determination and
                  organization;
 -
              positive
                  and supportive direction for company personnel;
                  and
 -
              community
                  involvement.
 
 As
        of the
        date of this Report, there were three principal elements of named executive
        officer compensation. The Compensation Committee determines the portion of
        compensation allocated to each element for each individual named executive
        officer. The discussions of compensation practices and policies are of
        historical practices and policies. Our Compensation Committee is expected
        to
        continue these policies and practices, but will reevaluate the practices
        and
        policies as it considers advisable.
 
 The
        elements of the compensation program include:
 
 -
              Base
                  salary;
 -
              Stock
                  options and stock awards;
 -
              Employee
                  benefits in the form of:
 -
              health
                  and dental insurance;
 -
              auto
                  reimbursement
 -
              Other
                  de minimis benefits.
 
 *Base
        salary*
 
 Base
        salary is intended to provide competitive compensation for job performance
        and
        to attract and retain qualified named executive officers. The base salary
        level
        is determined by considering several factors inherent in the market place
        such
        as: the size of the company; the prevailing salary levels for the particular
        office or position; prevailing salary levels in a given geographic locale;
        and
        the qualifications and experience of the named executive officer.
 
  47
  *Stock
        options and stock awards*
 
 Stock
        ownership is provided to enable named executive officers and directors to
        participate in the success of the Company. The direct or potential ownership
        of
        stock will also provide the incentive to expand the involvement of the named
        executive officer to include, and therefore be mindful of, the perspective
        of
        stockholders of the Company.
 
 *Employee
        benefits*
 
 Several
        of the employee benefits for the named executive officers are selected to
        provide security for the named executive officers. Most notably, health
        insurance coverage is intended to provide a level of protection to that will
        enable the named executive officers to function without having the distraction
        of having to manage undue risk. The health insurance also provides access
        to
        preventative medical care which will help the named executive officers function
        at a high energy level, to manage job related stress, and contribute to the
        overall well being of the named executive officers, all of which contribute
        to
        an enhanced job performance.
 
 *Other
        de minimis benefits*
 
 Other
        de
        minimis employee benefits such as cell phones and auto usage reimbursements
        are
        directly related to job functions but contain a personal use element which
        is
        considered to be a goodwill gesture that contributes to enhanced job
        performance.
 
 As
        discussed above, the Compensation Committee determines the portion of
        compensation allocated to each element for each individual named executive
        officer. As a general rule, base salary is competitively based while giving
        consideration to employee retention, qualifications, performance, and general
        market conditions. Typically, stock options are based on the current market
        value of the option and how that will contribute to the overall compensation
        of
        the named executive officer. Consideration is also given to the fact that
        the
        option has the potential for an appreciated future value. As such this future
        value may in fact be the most significant factor of the option, but it is
        also
        more difficult to quantify as a benefit to the named executive officer.
 
 Accordingly,
        in determining the compensation program for the Company, as well as setting
        the
        compensation for each named executive officer, the Compensation Committee
        of the
        Board of Directors attempts to attract the interest of the named executive
        officer within in the constraints of a compensation package that is fair
        and
        equitable to all parties involved.
 
  48
  **EXECUTIVE
        COMPENSATION**
 
 
 **SUMMARY
        COMPENSATION TABLE**
  Name
                  and Principal Position
              
              Year
              
              Salary
                ($)
              
              Bonus
                ($)
              
              Stock
                Awards
                ($)
              
              Option
                Grants
                ($)
              
              Non-Equity
                Incentive
                  Plan
                Compensation
                ($)
              
              Change
                  in
                Pension
                  Value
                and
                Nonqualified
                Deferred
                Compensation
                Earnings
                ($)
              
              All
                  Other Compensation
              
              Total
                ($)Thomas
                  A. Murdock
                Chief
                  Executive Officer &
                President
                  (2)
              
              2006
              
              $
                  309,400 (1)
              
              --
              
              --
              
              --
              
              --
              
              --
              
              $
                  13,543 (3)
              
              $
                  322,943Roger
                  D. Dudley
                Executive
                  vice President &
                Chief
                  Financial Officer (2)
              
              2006
              
              $
                  309,400 (1)
              
              --
              
              --
              
              --
              
              --
              
              --
              
              $
                  12,465 (3)
              
              $
                  321,865William
                  A. Maasberg, Jr.
                Chief
                  Operating Officer
              
              2006
              
              $
                  125,000
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --
              
              $
                  125,000
 
 
 (1)
              Due
                  to cash flow difficulties, Messrs. Murdock and Dudley were not
                  paid their
                  full contracted rate of $309,400 for 2006, but were paid $256,100
                  and
                  $256,100 respectively. The shortfall of $53,300 for Mr. Murdock
                  and
                  $53,300 for Mr. Dudley has been included in the outstanding balance
                  of the
                  related party note at December 31, 2006.
 (2)
                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 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.
 
 (3)
                These
                    amounts relate to expenses paid by the Company for the use of
                    automobiles
                    for the named executive officers.


49


**GRANTS
        OF PLAN-BASED AWARDS**
 **For
        Fiscal Year Ended December 31, 2006**
 
 Name
              
              Grant
                  Date
              
              Estimated
                  Future Payouts Under
                Non-Equity
                  Incentive Plan Awards
              
              Estimated
                  Future Payouts Under
                Equity
                  Incentive Plan Awards
              
              All
                Other
                Stock
                Awards:
                Number
                  of
                Shares
                  of
                Stock
                  or
                Units
                (#)
              
              All
                Other
                Option
                Awards:
                  Number of
                Securities
                Underlying
                Options
                (#)
              
              Exercise
                Price
                  or
                Base
                Price
                  of
                Option
                Awards
                ($/Sh)Threshold
                ($)
              
              Target
                ($)
              
              Maximum
                ($)
              
              Threshold
                (#)
              
              Target
                (#)
              
              Maximum
                (#)Thomas
                  A. Murdock
              
              N/A
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --Roger
                  D. Dudley
              
              N/A
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --William
                  A. Maasberg, Jr.
              
              N/A
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --
 
 For
        the
        year ended December 31, 2006, there were no grants of plan based
        awards.
 
 **OUTSTANDING
        EQUITY AWARDS AT FISCAL 2006 YEAR-END**
 
 Option
                  Awards
              
              Stock
                  AwardsName
              
              Number
                  of Securities Underlying Unexercised Options (#)
                  Exercisable
              
              Number
                  of Securities Underlying Unexercised Options
                (#)
                Unexercisable
              
              Equity
                  Incentive Plan Awards: Number of Securities Underlying Unexercised
                  Unearned
                Options
                (#)
              
              Option
                Exercise
                Price
                  ($)
              
              Option
                  Expiration
                Date
              
              Number
                  of Shares or
                Units
                  of
                Stock
                  That
                Have
                  Not
                Vested
                  (#)
              
              Market
                  Value
                of
                  Shares or
                Units
                  of
                StockThat
                Have
                  Not
                Vested
                  ($)
              
              Equity
                Incentive
                Plan
                  Awards:
                Number
                  of
                Unearned
                Shares,
                  Units,
                or
                  Other
                Rights
                That
                  Have
                Not
                  Vested
                (#)
              
              Equity
                Incentive
                Plan
                  Awards:
                Market
                  or
                Payout
                  Value
                of
                  Unearned
                Shares,
                  Units,
                or
                  Other
                Rights
                That
                  Have
                Not
                  Vested
                ($)Thomas
                  A. Murdock
              
              126,500
              
              --
              
              --
              
              $0.04
              
              2010
              
              --
              
              $355
              
              --
              
              --Roger
                  D. Dudley
              
              126,500
              
              --
              
              --
              
              $0.04
              
              2010
              
              --
              
              $355
              
              --
              
              --William
                  A. Maasberg, Jr.
              
              42,500
              
              --
              
              --
              
              $0.04
              
              2010
              
              --
              
              $119
              
              --
              
              --
 
 This
        table lists the securities underlying unexercised options as of December
        31,
        2006, and related information.
 
 **OPTION
        EXERCISES AND STOCK VESTED**
 **For
        Fiscal Year Ended December 31, 2006**
 
 Option
                  Awards
              
              Stock
                  AwardsName
                  of Executive Officer
              
              Number
                  of
                Shares
                  Acquired
                on
                  Exercise
                (#)
              
              Value
                  Realized
                on
                  Exercise
                ($)
              
              Number
                  of
                Shares
                  Acquired
                on
                  Vesting
                (#)
              
              Value
                  Realized
                on
                  Vesting
                ($)Thomas
                  A.. Murdock
              
              --
              
              --
              
              --
              
              --Roger
                  D. Dudley
              
              --
              
              --
              
              --
              
              --William
                  A. Maasberg, Jr.
              
              --
              
              --
              
              --
              
              --
 
 For
        the
        year ended December 31, 2006, there were no option exercises.
 
  50
  **PENSION
        BENEFITS**
 **For
        Fiscal Year Ended December 31, 2006**
 
 Name
              
              Plan
                  Name
              
              Number
                  of
                Years
                  Credited
                Service
                (#)
              
              Present
                Valueof
                Accumulated
                Benefit
                ($)
              
              Payments
                DuringLast
                Fiscal
                  Year
                ($)Thomas
                  A. Murdock
              
              N/A
              
              --
              
              --
              
              --Roger
                  D. Dudley
              
              N/A
              
              --
              
              --
              
              --William
                  A. Maasberg, Jr.
              
              N/A
              
              --
              
              --
              
              --
 
 For
        the
        year ended December 31, 2006, there were no pension benefits paid. We do
        not
        currently have a pension plan.
 
 
 **NONQUALIFIED
        DEFERRED COMPENSATION**
 **For
        Fiscal Year Ended December 31, 2006**
 
 Name
              
              Executive
                Contributions
                  in
                Last
                  FY
                ($)
              
              Registrant
                Contributions
                in
                  Last FY
                ($)
              
              Aggregate
                Earnings
                in
                  Last FY
                ($)
              
              Aggregate
                Withdrawals/
                Distributions
                ($)
              
              Aggregate
                Balance
                  at
                Last
                  FYE
                ($)Thomas
                  A. Murdock
              
              --
              
              --
              
              --
              
              --
              
              --Roger
                  D. Dudley
              
              --
              
              --
              
              --
              
              --
              
              --William
                  A. Maasberg, Jr.
              
              --
              
              --
              
              --
              
              --
              
              --
 
 For
        the
        year ended December 31, 2006, there was no non-qualified
        compensation.
 
 **DIRECTOR
        COMPENSATION**
 **For
        Fiscal Year Ended December 31, 2006**
 
 Name
              
              Fees
                  Earned
                or
                  Paid in
                Cash
                ($)
              
              Stock
                Awards
                ($)
              
              Option
                Awards
                ($)
              
              Non-Equity
                Incentive
                  Plan
                Compensation
                ($)
              
              Change
                  in
                Pension
                Valueand
                Nonqualified
                Deferred
                Compensation
                Earnings
                ($)
              
              All
                  Other
                Compensation
                ($)
              
              Total
                ($)Thomas
                  A. Murdock
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --Roger
                  D. Dudley
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --William
                  A. Maasberg, Jr.
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --
              
              --
 
 For
        the
        year ended December 31, 2006, no compensation was paid to the directors for
        their service as directors.
 
 **Board
        of Directors Meetings, Committees and Director
        Compensation**
 
 Our
        board
        of directors took action at 2 duly noticed meetings of the board during
        2006. Each director attended (in person or telephonically) all of the meetings
        of Fonix’s board of directors. During 2006, 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.
 
  51
  **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 2006. Similar grants have been made
        to our under our 1998 Stock Option Plan, as set forth elsewhere in this
        report.
 
 **Stock
        Performance Graph**
 
 The
        following graph compares the yearly cumulative total returns from the Company’s
        Class A common stock during the five fiscal year period ended December 31,
        2006,
        with the cumulative total return on the Media General Index and the Standard
        Industrial Classification (SIC) Code Index for the same period. The comparison
        assumes $100 was invested on December 31, 2001, in the Company’s Class A common
        stock and in the common stock of the companies in the referenced Indexes
        and
        further assumes reinvestment of dividends.
  
 **2001**
              
              **2002**
              
              **2003**
              
              **2004**
              
              **2005**
              
              **2006****FONIX
                  CORPORATION**
              
              
              **100.00**
              
              
              **38.46**
              
              
              **10.70**
              
              
              **4.64**
              
              
              **0.47**
              
              
              **0.07****NASDAQ
                  MARKET INDEX**
              
              
              **100.00**
              
              
              **42.78**
              
              
              **75.97**
              
              
              **95.23**
              
              
              **95.42**
              
              
              **86.56****SIC
                  CODE INDEX - 7373**
              
              
              **100.00**
              
              
              **69.75**
              
              
              **104.88**
              
              
              **113.70**
              
              
              **116.19**
              
              
              **128.12**
 
  52
  **ITEM
                12.**
              **SECURITY
                  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
                  STOCKHOLDER MATTERS**
 
 The
        following table sets forth, as of March 19, 2007, 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. 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
              548,035,715(2)
              25.02%Roger
                  D. Dudley
                Executive
                  Vice President &
                Chief
                  Financial Officer, Director
              300,995,794(3)
              15.49%William
                  A. Maasberg
                Chief
                  Operating Officer, Director
              42,500(4)
              *All
                  Officers and Directors as a Group (3 persons)
              849,074,009
              34.08%
 
 *  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 547,869,394 shares of Common
        Stock issuable as of March 19, 2007, 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, 2007, 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 247,019,929 shares issuable as of March 19, 2007, 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) 300,849,465 shares of Common Stock issuable as of March 19, 2007, 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.
 
 (4) Consisting
        of options to purchase 42,500 shares of Common Stock.
 
  53
  
 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
              
              
              907,642
              
              
              $    
                  0.13
              
              
              19,437,358Equity
                  compensation plans not approved by shareholders
              
              
              --
              
              
              --
              
              
              --Total
              
              
              907,642
              
              
              $    
                  0.13
              
              
              19,437,358
 
 **ITEM
                  13.**
              **CERTAIN
                  RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
                  INDEPENDENCE**
 
 **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 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, was originally due and payable
        on June
        10, 2003. Fonix and the Lenders have agreed to postpone the maturity date
        on
        several occasions. The note was due September 30, 2006. As of March 19, 2007,
        we
        had not made payment against the outstanding balance due on the note. 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. 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. 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 under the note from the Lenders. The balance due the Lenders
        at December 31, 2005 was $486,000. For the year ended December 31, 2006 we
        received additional advances and other consideration from the Lenders in
        the
        aggregate amount of $419,000 and made principal payments to the Lenders against
        the note of $105,000. The principal balance due at December 31, 2006 was
        $800,000.
 
 The
        unpaid balance of $800,000 at December 31, 2006, is secured by our assets,
        including our stock of Fonix Speech. As of December 31, 2006, the Lenders
        had
        not converted any of the outstanding balance or interest into common stock
        nor
        had they declared the note in default.
 
 As
        of
        December 31, 2006, none of our directors were “independent directors” as each
        was employed by the Company as an executive officer, as discussed
        above.
 
  54
  **ITEM
                14.**
              **PRINCIPAL
                  ACCOUNTANT FEES AND
                  SERVICES**
 
 ( 1)
        AUDIT
        FEES
 
 The
        aggregate fees billed for the fiscal years ended December 31, 2006 and 2005, for
        professional services rendered by Hansen Barnett & Maxwell, P.C., 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 2006 and 2005 were $97,000 and $203,000,
        respectively.
 
 (2)
        AUDIT-RELATED FEES
 
 The
        aggregate fees billed for the fiscal year ended December 31, 2006 and 2005
        for
        assurance and related services by Hansen Barnett & Maxwell, P.C., that are
        reasonably related to the performance of the audit or review of the registrant's
        financial statements for fiscal year 2006 and 2005 were $19,000 and $28,000,
        respectively.
 
 (3)
        TAX
        FEES
 
 The
        aggregate fees billed for each of the fiscal years ended December 31, 2006
        and
        2005, for professional services rendered by Hansen Barnett & Maxwell, P.C.
        for tax compliance, tax advice, and tax planning, for those fiscal years
        were
        $1,000 and $1,000, 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, 2006
        and
        2005, for products and services provided by Hansen Barnett & Maxwell, P.C.
        other than those services reported above, for those fiscal years were $0
        and
        $34,000. The other fees billed in 2006 and 2005 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, P.C. 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.
 
 
  55
  **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, 2006 and 2005
 
 Consolidated
        Statements of Operations for the Years Ended December 31, 2006, 2005 and
        2004
 
 Consolidated
        Statements of Stockholders’ Deficit for the Years Ended December 31, 2006, 2005
        and 2004
 
 Consolidated
        Statements of Cash Flows for the Years Ended December 31, 2006, 2005 and
        2004
 
 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
 
 21
              Subsidiaries
                  of Registrant
  31.1
              Certification
                  of Chief Executive Officer Pursuant to Section 302 of the
                  Sarbanes-Oxley Act of 2002
 31.2
                Certifications
                    of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley
                    Act of 2002
 32.1
              Certification
                  of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley
                  Act of 2002
  32.2
                Certification
                    of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley
                    Act of 2002
  56
  **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
                  , 2007
              By:
              /s/ Thomas A.
                  MurdockThomas
                  A. Murdock, President and
                Chief
                  Executive OfficerDate:March
                  , 2007
              By:
              /s/ Roger D.
                  DudleyRoger
                  D. Dudley, Executive Vice President Finance and
                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
                Chief
                  Executive Officer
              William
                  A. Maasberg, Jr.
                DirectorMarch
                  28, 2007
              March
                  28, 2007Date
              Date
 
 
 
 /s/
        Roger D. Dudley
 Roger
        D.
        Dudley, Executive Vice President,
 Chief
        Financial Officer, and Director
 
 March
        28, 2007
 Date
 
 
 
 
 
 
 57




**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, 2006 and 2005
              F-3Consolidated
                  Statements of Operations and Comprehensive Loss for the Years Ended
                  December 31, 2006, 2005 and 2004
              F-4Consolidated
                  Statements of Stockholders’ Deficit for the Years Ended December 31, 2004,
                  2005 and 2006
              F-5Consolidated
                  Statements of Cash Flows for the Years Ended December 31, 2006,
                  2005 and
                  2004
              F-6Notes
                  to Consolidated Financial Statements
              F-8
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
  **H****ANSEN****,
                  B****ARNETT****&
                  M****AXWELL,
                  P.C.**A
                  Professional CorporationCERTIFIED
                  PUBLIC ACCOUNTANTS
              
              **Registered
                  with the Public Company**AND
              
              **Accounting
                  Oversight Board**BUSINESS
                  CONSULTANTS5
                  Triad Center, Suite 750
                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, 2006 and 2005, and the related consolidated
        statements of operations and comprehensive loss, stockholders’ deficit, and cash
        flows for each of the three years in the period ended December 31, 2006.
        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, 2006 and 2005, and the results of their
        operations and their cash flows for each of the three years in the period
        ended
        December 31, 2006, 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, 2006. As of December 31, 2006, the Company
        had
        an accumulated deficit of $291,200,000, and negative working capital of
        $52,957,000. 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.
 
 As
        discussed in Note 1 of the consolidated financial statements, the Company
        adopted Statement of Financial Accounting Standards No. 123 (R), Share-Based
        Payment, effective January 1, 2006.
 
  **HANSEN, BARNETT & MAXWELL.
                  P.C.**
 Salt
        Lake
        City, Utah
 March
        28,
        2007
  F-2
 **Fonix
        Corporation**
 **CONSOLIDATED
        BALANCE SHEETS**
 
 **December
                  31,**
              
              **December
                  31,****2006**
              
              **2005****ASSETS****Current
                  assets**Cash
                  and cash equivalents
              
              $
              5,000
              
              $
              168,000Accounts
                  receivable, net of an allowance for doubtful accounts of $0 and
                  $137,000,
                  respectively
              
              
              -
              
              
              1,121,000Prepaid
                  expenses and other current assets
              
              
              4,000
              
              
              176,000**Total
                  current assets**
              
              
              9,000
              
              
              1,465,000**Property
                  and equipment,**net of accumulated depreciation of $1,261,000 and $1,594,000,
                  respectively
              
              
              48,000
              
              
              947,000**Deposits
                  and other assets**
              
              
              117,000
              
              
              1,592,000**Intangible
                  assets**
              
              
              -
              
              
              2,658,000**Goodwill**
              
              
              2,631,000
              
              
              2,631,000**Total
                  assets**
              
              $
              2,805,000
              
              $
              9,293,000**LIABILITIES
                  AND STOCKHOLDERS' DEFICIT****Current
                  liabilities**Accrued
                  liabilities
              
              $
              2,054,000
              
              $
              8,138,000Accounts
                  payable
              
              
              1,504,000
              
              
              6,770,000Net
                  liabilities of discontinued subsidiaries
              
              
              20,819,000
              
              
              -Derivative
                  liability
              
              
              20,941,000
              
              
              -Accrued
                  payroll and other compensation
              
              
              214,000
              
              
              223,000Accrued
                  settlement obligation, net of unamortized discount of $0 and $118,000,
                  respectively
              
              
              1,530,000
              
              
              1,853,000Deferred
                  revenues
              
              
              460,000
              
              
              923,000Notes
                  payable - related parties
              
              
              800,000
              
              
              486,000Series
                  E debentures
              
              
              1,754,000
              
              
              -Current
                  portion of notes payable
              
              
              2,883,000
              
              
              1,847,000Deposits
                  and other
              
              
              7,000
              
              
              229,000**Total
                  current liabilities**
              
              
              52,966,000
              
              
              20,469,000**Long-term
                  notes payable, net of current portion**
              
              
              2,988,000
              
              
              4,050,000**Total
                  liabilities**
              
              
              55,954,000
              
              
              24,519,000**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; 0 shares and 2,000 shares outstanding
              
              
              -
              
              
              4,000,000Series
                  J, convertible; 0 shares and 1,359 shares outstanding, respectively
              
              
              -
              
              
              1,359,000Series
                  K, convertible; 0 shares and 0 shares outstanding, respectively
              
              
              -
              
              
              -Series
                  L, convertible; 1,858 shares and 0 shares outstanding ,
                  respectively
              
              
              -
              
              
              -Common
                  stock, $0.0001 par value; 5,000,000,000 shares authorized;Class
                  A voting, 1,309,965,981 shares and 392,929,230 shares outstanding,
                  respectively
              
              
              131,000
              
              
              39,000Class
                  B non-voting, none outstanding
              
              
              -
              
              
              -Additional
                  paid-in capital
              
              
              236,936,000
              
              
              228,905,000Outstanding
                  warrants to purchase Class A common stock
              
              
              474,000
              
              
              474,000Cumulative
                  foreign currency translation adjustment
              
              
              10,000
              
              
              18,000Accumulated
                  deficit
              
              
              (291,200,000
              )
              
              (250,521,000
              )**Total
                  stockholders' deficit**
              
              
              (53,149,000
              )
              
              (15,226,000
              )**Total
                  liabilities and stockholders' deficit**
              
              $
              2,805,000
              
              $
              9,293,000
  See
        accompanying notes to consolidated financial statements.
 F-3
  **Fonix
        Corporation**
 **CONSOLIDATED
        STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS**
 
 **Years
                  Ended December 31,****2006**
              
              **2005**
              
              **2004**RevenuesSpeech
                  licenses, royalties and maintenance
              
              $
              1,329,000
              
              $
              1,358,000
              
              $
              1,189,000Services
              
              
              -
              
              
              -
              
              
              40,000Total
                  Revenue
              
              
              1,329,000
              
              
              1,358,000
              
              
              1,229,000Cost
                  of revenuesSpeech
                  licenses, royalties and maintenance
              
              
              18,000
              
              
              70,000
              
              
              33,000Total
                  cost of revenues
              
              
              18,000
              
              
              70,000
              
              
              33,000Gross
                  profit
              
              
              1,311,000
              
              
              1,288,000
              
              
              1,196,000Expenses:Selling,
                  general and administrative
              
              
              5,356,000
              
              
              4,762,000
              
              
              4,706,000Legal
                  settlement expense
              
              
              -
              
              
              2,080,000
              
              
              -Product
                  development and research
              
              
              2,143,000
              
              
              2,196,000
              
              
              2,559,000Total
                  expenses
              
              
              7,499,000
              
              
              9,038,000
              
              
              7,265,000Other
                  income (expense):Interest
                  and other income
              
              
              -
              
              
              8,000
              
              
              7,000Interest
                  expense
              
              
              (1,737,000
              )
              
              (1,298,000
              )
              
              (1,068,000
              )Loss
                  on derivative liability
              
              
              (2,771,000
              )
              
              -
              
              
              -Gain
                  on sale of investments
              
              
              -
              
              
              104,000
              
              
              -Gain
                  on forgiveness of liabilities
              
              
              -
              
              
              142,000
              
              
              518,000Other
                  expense, net
              
              
              (4,508,000
              )
              
              (1,044,000
              )
              
              (543,000
              )Net
                  loss from continuing operations
              
              
              (10,696,000
              )
              
              (8,794,000
              )
              
              (6,612,000
              )Net
                  loss from discontinued operations
              
              
              (11,247,000
              )
              
              (13,837,000
              )
              
              (8,536,000
              )Net
                  loss
              
              
              (21,943,000
              )
              
              (22,631,000
              )
              
              (15,148,000
              )Preferred
                  stock dividends
              
              
              (18,735,000
              )
              
              (1,265,000
              )
              
              (3,927,000
              )Loss
                  attributable to common stockholders
              
              $
              (40,678,000
              )
              $
              (23,896,000
              )
              $
              (19,075,000
              )Basic
                  and diluted loss per common share from continuing
                  operations
              
              $
              (0.04
              )
              $
              (0.04
              )
              $
              (0.12
              )Basic
                  and diluted loss per common share from discontinued
                  operations
              
              $
              (0.01
              )
              $
              (0.05
              )
              $
              (0.10
              )Net
                  loss
              
              $
              (21,943,000
              )
              $
              (22,631,000
              )
              $
              (15,148,000
              )Other
                  comprehensive (loss) income - foreign currency translation
              
              
              8,000
              
              
              10,000
              
              
              (22,000
              )Comprehensive
                  loss
              
              $
              (21,935,000
              )
              $
              (22,621,000
              )
              $
              (15,170,000
              )
 
 See
        accompanying notes to consolidated financial statements.
 
  F-4
 **Fonix
        Corporation**
 **CONSOLIDATED
        STATEMENTS OF STOCKHOLDERS’ DEFICIT**
 Additional
                
                Outstanding
                    Warrants
                  to
                    Purchase
                
                Cumulative
                      Foreign
                    CurrencyPreferred
                    Stock
                
                Common
                    Stock
                
                Paid-in
                
                Common
                
                Translation
                
                AccumulatedShares
                
                Amount
                
                Shares
                
                Amount
                
                Capital
                
                Stock
                
                Adjustment
                
                Deficit
                
                TotalBALANCE,
                    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
                )Issuance
                    of common stock under equity lines of credit
                
                
                -
                
                
                -
                
                
                300,000,000
                
                
                30,000
                
                
                3,250,000
                
                
                -
                
                
                -
                
                
                -
                
                
                3,280,000Shares
                    issued for payment of principal and interest on long-term
                    debt
                
                
                -
                
                
                -
                
                
                
                
                
                -
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -Shares
                    issued for payment of dividends on Series H Preferred
                
                
                -
                
                
                -
                
                
                2,838,412
                
                
                -
                
                
                65,000
                
                
                -
                
                
                -
                
                
                -
                
                
                65,000Exchange
                    of Series J Preferred for Series K Preferred
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Series
                    J Preferred Stock beneficial conversion dividend
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                1,587,000
                
                
                -
                
                
                -
                
                
                (1,587,000
                )
                
                -Exchange
                    of Series H Preferred for Series L Preferred
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -Series
                    L Preferred Stock beneficial conversion dividend
                
                
                -
                
                
                (4,000,000
                )
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (16,000,000
                )
                
                (20,000,000
                )Conversion
                    of Series J Preferred into common stock
                
                
                (266
                )
                
                (266,000
                )
                
                15,028,249
                
                
                2,000
                
                
                264,000
                
                
                -
                
                
                -
                
                
                -
                
                
                -Conversion
                    of Series K Preferred into common stock
                
                
                (1,093
                )
                
                (1,093,000
                )
                
                109,300,000
                
                
                11,000
                
                
                1,082,000
                
                
                -
                
                
                -
                
                
                -
                
                
                -Conversion
                    of Series L Preferred into common stock
                
                
                (142
                )
                
                -
                
                
                489,870,090
                
                
                49,000
                
                
                1,783,000
                
                
                -
                
                
                -
                
                
                -
                
                
                1,832,000Cumulative
                    foreign currency translation adjustment
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (8,000
                )
                
                -
                
                
                (8,000
                )Dividend
                    on Series H Preferred
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (693,000
                )
                
                (693,000
                )Dividend
                    on Series J Preferred
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (5,000
                )
                
                (5,000
                )Dividend
                    on Series K Preferred
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (11,000
                )
                
                (11,000
                )Dividend
                    on Series L Preferred
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (440,000
                )
                
                (440,000
                )Net
                    loss for year ended December 31, 2006
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (21,943,000
                )
                
                (21,943,000
                )BALANCE,
                    DECEMBER 31, 2006
                
                
                168,525
                
                $
                500,000
                
                
                1,309,965,981
                
                $
                131,000
                
                $
                236,936,000
                
                $
                474,000
                
                $
                10,000
                
                $
                (291,200,000
                )
                $
                (53,149,000
                )
  See
          accompanying notes to consolidated financial statements. F-5
 **Fonix
          Corporation**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
 
 **Years
                  Ended December 31,****2006**
              
              **2005**
              
              **2004****Cash
                  flows from operating activities**Net
                  loss
              
              $
              (21,943,000
              )
              $
              (22,631,000
              )
              $
              (15,148,000
              )Adjustments
                  to reconcile net loss to net cash used in operating
                  activities:Discontinued
                  operations
              
              
              11,644,000
              
              
              13,977,000
              
              
              8,536,000Loss
                  on derivative liability
              
              
              2,772,000
              
              
              -
              
              
              -Accretion
                  of discount on notes payable
              
              
              832,000
              
              
              741,000
              
              
              613,000Non-cash
                  expense related to the issuance of preferred stock
              
              
              -
              
              
              250,000
              
              
              41,000Stock
                  issued for interest expense on long-term debt
              
              
              -
              
              
              500,000
              
              
              125,000Accretion
                  of discount on legal settlement
              
              
              117,000
              
              
              -
              
              
              -Write
                  down of intercompany receivable
              
              
              1,214,000
              
              
              -
              
              
              -Legal
                  settlement expense
              
              
              -
              
              
              2,011,000
              
              
              -Gain
                  on sale of preferred stock
              
              
              -
              
              
              (104,000
              )
              
              -Gain
                  on forgiveness of liabilities
              
              
              -
              
              
              (142,000
              )
              
              (518,000
              )Depreciation
              
              
              58,000
              
              
              59,000
              
              
              113,000Foreign
                  exchange loss (gain)
              
              
              (8,000
              )
              
              10,000
              
              
              (22,000
              )Changes
                  in assets and liabilitiesAccounts
                  receivable
              
              
              1,000
              
              
              -
              
              
              3,000Prepaid
                  expenses and other current assets
              
              
              135,000
              
              
              (65,000
              )
              
              (31,000
              )Intercompany
                  account
              
              
              -
              
              
              (1,119,000
              )
              
              -Other
                  assets
              
              
              (93,000
              )
              
              (33,000
              )
              
              (11,000
              )Accounts
                  payable
              
              
              549,000
              
              
              (128,000
              )
              
              (949,000
              )Accrued
                  payroll and other compensation
              
              
              (9,000
              )
              
              (1,433,000
              )
              
              (5,308,000
              )Other
                  accrued liabilities
              
              
              689,000
              
              
              (544,000
              )
              
              (609,000
              )Deferred
                  revenues
              
              
              (6,000
              )
              
              8,000
              
              
              (82,000
              )Net
                  cash provided by (used) in operating activities
              
              
              (4,048,000
              )
              
              (8,643,000
              )
              
              (13,247,000
              )**Cash
                  flows from investing activities**Proceeds
                  from sale of long term investments
              
              
              -
              
              
              104,000
              
              
              -Payment
                  of deposit into escrow
              
              
              -
              
              
              -
              
              
              (395,000
              )Purchase
                  of property and equipment
              
              
              (12,000
              )
              
              (29,000
              )
              
              (127,000
              )Net
                  cash used in investing activities
              
              
              (12,000
              )
              
              75,000
              
              
              (522,000
              )**Cash
                  flows from financing activities**Proceeds
                  from issuance of Class A common stock, net
              
              
              3,504,000
              
              
              7,827,000
              
              
              12,239,000Proceeds
                  from related party note payable
              
              
              419,000
              
              
              50,000
              
              
              (250,000
              )Proceeds
                  from debentures
              
              
              650,000
              
              
              650,000
              
              
              -Proceeds
                  from credit advance
              
              
              75,000
              
              
              -
              
              
              -Proceeds
                  from issuance of Series I Preferred Stock
              
              
              -
              
              
              -
              
              
              3,010,000Proceeds
                  from notes payable
              
              
              330,000
              
              
              -
              
              
              -Payments
                  on related party note payable
              
              
              (105,000
              )
              
              -
              
              
              -Payments
                  of accrued settlement obligation
              
              
              (440,000
              )
              
              -
              
              
              -Payment
                  of dividends on Series H Preffed Stock
              
              
              -
              
              
              -
              
              
              (349,000
              )Discontinued
                  operations
              
              
              (536,000
              )
              
              -
              
              
              -Principal
                  payments on notes payable
              
              
              -
              
              
              (100,000
              )
              
              (622,000
              )Net
                  cash provided by financing activities
              
              
              3,897,000
              
              
              8,427,000
              
              
              14,028,000**Net
                  increase (decrease) in cash and cash equivalents**
              
              
              (163,000
              )
              
              (141,000
              )
              
              259,000**Cash
                  and cash equivalents at beginning of year**
              
              
              168,000
              
              
              309,000
              
              
              50,000**Cash
                  and cash equivalents at end of year**
              
              $
              5,000
              
              $
              168,000
              
              $
              309,000
  See
        accompanying notes to consolidated financial statements.
 F-6
 **Fonix
        Corporation**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS (continued)**
 
 **Years
                  Ended December 31,****2006**
              
              **2005**
              
              **2004****Supplemental
                  Disclosure of Cash Flow Information**Cash
                  paid during the year for interest
              
              $
              22,000
              
              $
              310,000
              
              $
              1,200,000Cash
                  paid during the year for income taxes
              
              
              -
              
              
              -
              
              
              -
 
 **Supplemental
        Schedule of Non-cash Investing and Financing Activities**
 
 **For
        the Year Ended December 31, 2006**
 
 Issued
        15,028,249 shares of Class A common stock in conversion of 266 shares of
        Series
        J Convertible Preferred Stock.
 
 Issued
        109,300,000 shares of Class A common stock in conversion of 1,093 shares
        of
        Series K Convertible Preferred Stock.
 
 Issued
        2,838,412 shares of Class A common stock as payment of $65,000 of dividends
        on
        Series H Preferred Stock.
 
 Accrued
        $693,000 of dividends on Series H Preferred Stock.
 
 Issued
        2,000 shares of Series L Convertible Preferred Stock with a face value of
        $20,000,000 in exchange for 2,000 shares of Series H Preferred Stock with
        a face
        value of $20,000,000.
 
 Issued
        489,870,090 shares of Class A common stock in conversion of 142 shares of
        Series
        L Preferred Stock.
 
 **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.
 
 See
        accompanying notes to consolidated financial statements.
 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”) provides value-added speech technologies through its
        subsidiary, Fonix Speech, Inc. (“Fonix Speech”). The Company offers
        speech-enabling technologies including automated speech recognition (“ASR”) and
        text-to-speech (“TTS”) through Fonix Speech to markets for wireless and mobile
        devices, computer telephony, server solutions and personal software for consumer
        applications. The Company has received various patents for certain elements
        of
        our core technologies and have filed applications for other patents covering
        various aspects of its technologies. The Company seeks 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 licensing of
        speech-enabling technologies, maintenance contracts and services.
 
 The
        Company previously operated a telecommunications business, the results of
        which
        were included in prior SEC filings. On October 2, 2006, LecStar Telecom Inc.,
        a
        Georgia corporation (“LecStar Telecom”), LecStar DataNet, Inc., a Georgia
        corporation (“LecStar DataNet”), LTEL Holdings Corporation (“LTEL Holdings”), a
        Delaware corporation, and Fonix Telecom Inc., a Delaware corporation (“Fonix
        Telecom”), each of which are direct or indirect subsidiaries of Fonix, filed for
        bankruptcy protection in the United States Bankruptcy Court for the District
        of
        Delaware (the “Bankruptcy Court”). The case numbers are as follows: LTEL
        Holdings Corporation, 06-11081 (BLS); LecStar Telecom, Inc., 06-11082 (BLS);
        LecStar DataNet, Inc., 06-11083 (BLS); Fonix Telecom, Inc., 06-11084 (BLS).)
 
 LecStar
        Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom sought protection
        under Chapter 7 of Title 11 of the U.S. Bankruptcy Code, 11 U.S.C ss 101
        et seq.
        (the “Bankruptcy Code”). Pursuant to Bankruptcy Code Section 701, on October 3,
        2006, Alfred Thomas Guliano was appointed the interim trustee for LecStar
        Telecom, LecStar DataNet, LTEL Holdings, and Fonix Telecom. As these subsidiary
        companies were in Chapter 7 Bankruptcy proceedings as of the date of this
        Report, the results of their operations have been treated as discontinued
        operations.
 
 ***Business
        Condition*** **-** For
        the
        years ended December 31, 2006, 2005 and 2004, we generated revenues of
        $1,329,000, $1,358,000 and $1,229,000, respectively; incurred net losses
        of
        $21,943,000, $22,631,000 and $15,148,000, respectively, and had negative
        cash
        flows from operating activities of $4,048,000, $8,643,000 and $13,247,000,
        respectively. As of December 31, 2006, we had an accumulated deficit of
        $291,200,000, negative working capital of $52,957,000, accrued liabilities
        and
        accrued settlement liability of $3,584,000, derivative liabilities of
        $20,941,000 related to the issuance of Series L Preferred Stock and Series
        E
        Convertible Debentures, net liabilities of discontinued subsidiaries of
        $20,819,000 related to the telecom subsidiaries subject to bankruptcy (LecStar
        Telecom, LecStar DataNet, LTEL Holdings and Fonix Telecom), accounts payable
        of
        $1,504,000 and current portion of notes payable of $3,683,000. We expect
        to
        continue to incur significant losses and negative cash flows from operating
        activities at least through December 31, 2007, primarily due to expenditure
        requirements associated with continued marketing and development of our
        speech-enabling technologies.
 
 The
        Company’s cash resources, limited to collections from customers, sales of the
        Company's equity and debt securities and loans, have not been sufficient to
        cover operating expenses. As a result, some payments to vendors have been
        delayed. On March 15, 2007, the New York State trial court entered judgment
        against the Company and in favor of the Breckenridge Fund in the amount of
        $1,602,000, which judgment has not been paid.
 
 These
        factors, as well as the risk factors set out elsewhere in the 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 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.
  F-8
  **Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**
  The
        Company has not consolidated the assets, liabilities or operations related
        to
        the discontinued subsidiaries as these assets are under the control of the
        court
        appointed bankruptcy trustee pursuant to the filing for protection under
        Chapter
        7 of the Bankruptcy Code by LecStar Telecom, Inc., LecStar DataNet, Inc.,
        LTEL
        Holdings and Fonix Telecom, Inc. on October 2, 2006. The accompanying footnotes
        do not include disclosures related to the operations of the aforementioned
        companies and represent solely the operations of Fonix Speech, Inc.
 
 ***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.
        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 had the
        UNE-P
        platform to offer to its customers. The Company recorded an impairment charge
        of
        $2,236,000 in the accompanying financial statements for the year ended December
        31, 2005. All of the intangible assets related to LecStar and have been
        classified as discontinued operations in these 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. As of December 31, 2006, 2005 and 2004, the fair
        value of goodwill was greater than the carrying value. Therefore, no impairment
        was deemed necessary.
 
  F-9
  **Fonix
        Corporation and Subsidiaries**
 **Notes
        to Consolidated Financial Statements**
 
 ***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.
 
 Deferred
        revenue as of December 31, 2006, 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
              $
              460,000
 ***Cost
          of Revenues -*** 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.
 
  F-10
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 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*** -
        Effective January 1, 2006, the Company adopted Statement of Financial Accounting
        Standards No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), an amendment of
        SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) using the
        modified prospective transition method. Under this transition method,
        compensation costs are recognized beginning with the effective date: (a)
        based
        on the requirements of SFAS 123(R) for all share-based awards granted after
        the
        effective date; and (b) based on the requirements of SFAS 123 for all awards
        granted to employees prior to the effective date of SFAS 123(R) that remain
        unvested on the effective date. Accordingly, the Company did not restate
        the
        results of prior periods. The most notable change resulting from the adoption
        of
        SFAS123(R) is that compensation expense associated with stock options is
        now
        recognized in the Company’s Statements of Operations, rather than being
        disclosed in a pro forma footnote to the Company’s financial
        statements.
 
 Prior
        to
        January 1, 2006, the Company accounted for stock options granted under its
        Stock
        Option Plans under the recognition and measurement provisions of Accounting
        Principles Board Opinion No. 25, *Accounting
        for Stock Issued to Employees* )
        and
        related interpretations, as permitted by SFAS 123. Had the Company determined
        compensation cost based on the fair value at the grant date for its stock
        options under SFAS No. 123, the Company’s net loss would have been increased to
        the pro forma amounts indicated below for years ended December 31, 2005 and
        2004:
 
 **Year
                  Ended December 31,**
              
              **2005**
              
              **2004**Net
                  loss, as reported
              
              $
              (22,631,000
              )
              $
              (15,148,000
              )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
              )Pro
                  forma net loss
              
              $
              (22,705,000
              )
              $
              (15,215,000
              )Basic
                  and diluted net loss per common share:As
                  reported
              
              $
              (0.09
              )
              $
              (0.21
              )Pro
                  forma
              
              
              (0.09
              )
              
              (0.21
              )
   F-11
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 ***Advertising
        Costs*** -
        Advertising costs are expensed when incurred. Total advertising expense was
        $40,000, $80,000 and $121,000 for the years ended December 31, 2006, 2005
        and
        2004, 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, 2006, 2005 and
        2004,
        there were outstanding common stock equivalents to purchase or receive
        5,647,746,872 shares, 97,634,670 shares and 22,708,797 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, 2006,
        2005,
        and 2004:
 
 **Years
                  Ended December 31,****2006**
              
              **2005**
              
              **2004****Per**
              
              
              
              **Per**
              
              
              
              **Per****Share**
              
              
              
              **Share**
              
              
              
              **Share****Amount**
              
              **Amount**
              
              **Amount**
              
              **Amount**
              
              **Amount**
              
              **Amount**Net
                  loss from continuing operations
              
              $
              (10,696,000
              )
              
              
              
              $
              (8,794,000
              )
              
              
              
              $
              (6,612,000
              )Net
                  loss from discontinued operations
              
              
              (11,247,000
              )
              $
              (0.01
              )
              
              (13,837,000
              )
              $
              (0.05
              )
              
              (8,536,000
              )
              $
              (0.10
              )Net
                  loss
              
              
              (21,943,000
              )
              
              
              
              
              (22,631,000
              )
              
              
              
              
              (15,148,000
              )Preferred
                  stock dividends
              
              
              (18,735,000
              )
              
              
              
              
              (1,265,000
              )
              
              
              
              
              (3,927,000
              )Net
                  loss attributable to common stockholders
              
              $
              (40,678,000
              )
              $
              (0.05
              )
              $
              (23,896,000
              )
              $
              (0.09
              )
              $
              (19,075,000
              )
              $
              (0.21
              )Weighted-average
                  common shares outstanding
              
              
              768,076,936
              
              
              
              
              
              261,894,849
              
              
              
              
              
              89,795,728
  ***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 and 6).
 
 ***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***
  ***Uncorrected
        Misstatements*** *-* In
        September 2006, the Securities Exchange Commission issued Staff Accounting
        Bulletin No. 108 (“SAB No. 108”). SAB No. 108 addresses how the effects of prior
        year uncorrected misstatements should be considered when quantifying
        misstatements in current year financial statements. SAB No. 108 requires
        companies to quantify misstatements using a balance sheet and income statement
        approach and to evaluate whether either approach results in quantifying an
        error
        that is material in light of relevant quantitative and qualitative factors.
        When
        the effect of initial adoption is material, companies will record the effect
        as
        a cumulative effect adjustment to beginning of year retained earnings and
        disclose the nature and amount of each individual error being corrected in
        the
        cumulative adjustment. SAB No. 108 will be effective beginning January 1,
        2007
        and it is anticipated that the initial adoption of SAB No. 108 will not have
        a
        material impact on the Company’s financial statements.
  F-12
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 ***Uncertainty
        in Income*** *Taxes
        -* In
        June
        2006, the FASB issued FASB Interpretation No. 48 (“FIN-48”), “Accounting for
        Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109.” The
        interpretation clarifies the accounting for uncertainty in income taxes
        recognized in an entity's financial statements in accordance with SFAS No.
        109,
“Accounting for Income Taxes.” Specifically, FIN-48 prescribes a recognition
        threshold and a measurement attribute for the financial statement recognition
        and measurement of a tax position taken or expected to be taken. The provisions
        of FIN-48 are effective for financial statements for fiscal years beginning
        after December 15, 2006. Accordingly, the Company is to adopt FIN-48 on January
        1, 2007. The adoption of FIN-48 is not expected to have a material effect
        on the
        Company’s financial position or results of operations.
 
 ***Fair
        Value Measurements*** *-* In
        September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS
        157”). SFAS 157 provides guidance for using fair value to measure assets and
        liabilities. The standard also responds to investors’ request for expanded
        information about the extent to which a company measures assets and liabilities
        at fair value, the information used to measure fair value, and the effect
        of
        fair value measurements on earnings. SFAS 157 will be effective for the
        Company’s fiscal year beginning January 1, 2008. The Company is currently
        reviewing the effect that the adoption of SFAS 157 will have on its financial
        statements.
 
 ***Share
        Based Payment -*** In
        December 2004, the FASB issued SFAS No. 123(R), *Share-Based
        Payment,* which
        is
        a revision to SFAS No. 123. SFAS No. 123(R) established standards for the
        accounting for transactions in which an entity exchanges its equity instruments
        for goods or services. Primarily, SFAS No. 123(R) 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.
        123(R) 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
        Bulletin 107, SFAS No. 123(R) is effective as of the beginning of the annual
        reporting period that begins after December 15, 2005. Under these guidelines,
        the Company adopted SFAS 123(R) as of January 1, 2006. The adoption of SFAS
        123(R) did not have a material impact on the Company.
 
 ***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. 123(R).
        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 as discontinued
        operations. 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 SFAS 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 year ended December 31,
        2004:
  F-14
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 **2004**Revenues
              
              $
              18,006,000Net
                  Loss
              
              $
              (16,648,000
              )Basic
                  and diluted net loss per common share
              
              $
              (0.18
              )
 
 As
        of the
        date of this report, the bankruptcy proceedings related to LecStar had not
        been
        finalized. The Company has classified the operations from LecStar as
        discontinued operations in these statements.
 
 **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.
 
  F-15
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 **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
  
  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 $58,000, $59,000 and $113,000 for the years ended December 31,
        2006,
        2005, and 2004, respectively. Property and equipment consisted of the following
        at December 31, 2006 and 2005:
 
 **2006**
              
              **2005**Computer
                  equipment
              
              $
              980,000
              
              $
              2,145,000Software
              
              
              201,000
              
              
              253,000Furniture
                  and fixtures
              
              
              128,000
              
              
              143,0001,309,000
              
              
              2,541,000Less
                  accumulated depreciation and amortization
              
              
              (1,261,000
              )
              
              (1,594,000
              )Net
                  Property and Equipment
              
              $
              48,000
              
              $
              947,000
  **NOTE
        5. GOODWILL AND INTANGIBLE ASSETS**
 
 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, 2006, 2005 and 2004. 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, 2006, 2005 and 2004, based on the same factors used by Houlihan,
        and determined that the carrying value of goodwill was not
        impaired.
 
 **NOTE
        6. NOTES PAYABLE**
 
 On
        February 24, 2004 ,
        LecStar
        had an asset securitization facility of $750,000. Assets securitized under
        this
        facility consisted of executory future cash flows from LecStar customers
        in the
        states of Georgia, Tennessee, Florida, and Louisiana. LecStar had 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 bore an interest rate of 6.5% and was 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. For the year ended
        December 31, 2006, the company made principal payments of $124,000.
 
 In
        connection with the acquisition of the capital stock of LTEL Holdings in
        2004,
        the Company issued a 5%, $10,000,000, secured, six-year note (the “Note”)
        payable to McCormack Avenue, Ltd. (“McCormack”). Under the terms of the Note,
        quarterly interest- only payments were required through January 15, 2005,
        with
        quarterly principal and interest payments of $319,000 beginning April 2005
        and
        continuing through January 2010. Interest on the 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 Holdings and
        its
        subsidiaries. The Note was originally valued at $4,624,000 based on an imputed
        interest rate of 25 percent per annum.
 
  F-16
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 The
        discount on the N ote
        is
        based on an imputed interest rate of 25%. The carrying amount of the Note
        of
        $5,541,000 at December 31, 2006, was net of unamortized discount of $3,192,000.
        As of the date of this report, the Company had not made any scheduled payments
        for 2006 or 2007.
 
 On
        September 8, 2006, the Company received a default notice (the “Default Notice”)
        from McCormack relating to the Note. Under the terms of the Note, and a related
        Security Agreement between the Company and McCormack dated February 24, 2004
        (the “Security Agreement”), McCormack may declare all liabilities, indebtedness,
        and obligations of the Company to McCormack under the Security Agreement
        and the
        Note immediately due and owing upon an event of default. The Note defines
        an
        event of default to include the non-payment by the Company of a scheduled
        payment which is not cured within 60 days .
 
 In
        the
        Default Notice, McCormack stated that it intended to exercise its rights,
        including any and all rights set forth in the Note, as amended.
 
 Also
        on
        September 8, 2006, McCormack provided to the Company a Notice of Sale, stating
        McCormack’s intention to sell at public auction all of the collateral referred
        to in the Security Agreement, consisting of the capital stock and assets
        of
        LecStar Telecom, LecStar DataNet, and LTEL Holdings. To date, no sale of
        the
        assets or capital stock of LecStar Telecom, LecStar DataNet nor LTEL Holdings
        has occurred. On October 2, 2006, LecStar Telecom, LecStar DataNet and LTEL
        Holdings filed for protection under Chapter 7 of the Bankruptcy Code. As
        of the
        date of this Report, the results of their operations have been treated as
        discontinued operations.
 
 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 notes, along with accrued interest of $64,000 and additional advances
        of $325,000 were exchanged for the McCormack Debenture (described in Note
        8).
 
 The
        Company entered into two promissory notes with an unrelated third party in
        the
        aggregate amount of $330,000. These notes accrue interest at 10% annually
        and
        are due and payable during the second quarter of 2007.
 
 
 
 
 
 
  F-17
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 The
        following schedule summarizes the Company’s current debt obligations and
        respective balances at December 31, 2006 and 2005:
 
 **Notes
                  Payable**
              
              **2006**
              
              **2005**5%
                  Note payable to a company, $8,733,000 and $8,733,000 face amount,
                  respectively, due in quarterly installments of $319,000, matures
                  January
                  2010, less unamortized discount based on interest imputed at 25%
                  of
                  $3,192,000 and $4,023,000, respectively
              
              $
              5,541,000
              
              $
              4,822,000Note
                  payable to a company, interest at 10%, matures June 2006
              
              
              --
              
              
              300,000Note
                  payable to a company, interest at 10%, matures June 2007
              
              
              235,000
              
              
              --Note
                  payable to a company, interest at 10%, matures June 2007
              
              
              95,000
              
              
              --Note
                  payable to a company, due in monthly installments of $23,000, interest
                  at
                  6.5%, matures January 2008, collateralized by trade accounts
                  receivable
              
              
              --
              
              
              537,000Note
                  payable to related parties, interest at 12%, matured September
                  2006,
                  secured by intellectual property rights
              
              
              800,000
              
              
              486,000Total
                  notes payable
              
              
              6,671,000
              
              
              6,383,000Less
                  current maturities
              
              
              (3,683,000
              )
              
              (2,333,000
              )Long-Term
                  Note Payable
              
              $
              2,988,000
              
              $
              4,050,000
 
 The
        following table shows the schedule of principal payments under notes payable
        and
        related party notes payable as of December 31, 2006:
  **Year
                  ending December 31,**
              
              **Payments**2007
              
              $
              3,683,0002008
              
              
              255,0002009
              
              
              328,0002010
              
              
              2,405,000$
              6,671,000
 
  F-18
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 **NOTE
        7. 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, was 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 was due September
        30,
        2006. As of the date of this report, the Company had not made payment against
        the outstanding balance due on the note. 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.
        During the year ended December 31, 2006, the Company received additional
        advances and other consideration from the Lenders in the aggregate amount
        of
        $419,000 and made principal payments to the Lenders against the note of
        $105,000. The principal balance due at December 31, 2006 was
        $800,000.
 
 The
        aggregate advances of $800,000 are secured by the Company’s intellectual
        property rights. As of December 31, 2006, the Lenders had not converted any
        of
        the outstanding balance or interest into common stock nor had they declared
        the
        note in default.
 
 **NOTE
        8. DEBENTURES**
 
 ***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 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%.
 
 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.
 
  F-19
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 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.
 
 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.
 
 In
        September 2005, the Company settled the three pending lawsuits between Fonix
        and
        Breckenridge.
 
 ***Series
        E Debentures*** - On
        December 7, 2006, the Company entered into a Securities Purchase Agreement,
        dated as of December 1, 2006 (the “Agreement”), with Southridge Partners, LP
        (“Southridge”) relating to the purchase and sale of a Series E 9% Secured
        Subordinated Convertible Debenture (the “Southridge Debenture”) in the principal
        amount of $850,000.
 
  F-20
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 Pursuant
        to the Agreement, Southridge paid the purchase price by tendering a prior
        debenture in the aggregate amount (including principal and interest) of
        $641,000, and agreed that an advance to the Company in the amount of $75,000
        made in November 2006 would also constitute part of the purchase price.
        Southridge agreed to fund the remaining $134,000 upon the effectiveness of
        a
        registration statement, to be filed by the Company, to register the resales
        of
        shares issuable to Southridge upon conversion of the Southridge Debenture.
        The
        registration statement was filed in January 2007, but as of the date of the
        Report, had not been declared effective.
 
 The
        Southridge Debenture is convertible into shares of the Company’s Class A common
        stock. The number of shares issuable is determined by dividing the amount
        of the
        Southridge Debenture being converted by the conversion price, which is the
        average of the two lowest per share market values for the twenty trading
        days
        immediately preceding the conversion date multiplied by seventy percent.
        The
        conversion price is subject to adjustment as set forth in the Southridge
        Debenture. Southridge has agreed not to convert the Southridge Debenture
        to the
        extent that such conversion would cause Southridge to beneficially own in
        excess
        of 4.999% of the then-outstanding shares of Class A common stock of the Company
        except in the case of a merger by the Company or other organic
        change.
 
 The
        Company also entered into a Registration Rights Agreement (the “Registration
        Agreement”) with Southridge pursuant to which the Company agreed to file a
        registration statement to register the resale by Southridge of shares of
        the
        Company’s common stock issuable upon conversion of the Southridge Debenture.
        Under the Registration Agreement, the Company agreed to file a registration
        statement to register the resale by Southridge of up to 300,000,000 shares
        of
        Fonix Class A common stock.
 
 In
        addition to the Southridge Debenture, on December 7, 2006, the Company entered
        into a Securities Purchase Agreement, dated as of December 1, 2006 (the
“McCormack Agreement”), with McCormack Avenue, Ltd. (“McCormack”), relating to
        the purchase and sale of a Series E 9% Secured Subordinated Convertible
        Debenture (the “McCormack Debenture”) in the principal amount of
        $1,039,000.
 
 Pursuant
        to the McCormack Agreement, McCormack paid the purchase price by tendering
        outstanding promissory notes in the amounts of $300,000 and $350,000, together
        with combined interest thereon of $64,000, and agreed that advances to the
        Company in the amount of $325,000, made in September, October, and November
        2006, would also constitute part of the purchase price.
 
 The
        McCormack Debenture is convertible into shares of the Registrant’s Class A
        common stock. The number of shares issuable is determined by dividing the
        amount
        of the Debenture being converted by the conversion price, which is the average
        of the two lowest per share market values for the twenty trading days
        immediately preceding the conversion date multiplied by seventy percent.
        The
        conversion price is subject to adjustment as set forth in the Debenture.
        McCormack agreed not to convert the Debenture to the extent that such conversion
        would cause McCormack to beneficially own in excess of 4.999% of the
        then-outstanding shares of Class A common stock of the Company except in
        the
        case of a merger by the Company or other organic change.
 
 The
        Company also entered into a Registration Rights Agreement (the “McCormack
        Registration Agreement”) with McCormack pursuant to which the Company agreed to
        file a registration statement to register the resale by McCormack of shares
        of
        the Company’s common stock issuable upon conversion of the Debenture. As of the
        date of this Report, the registration statement had not been filed.
 
 The
        Company received no new capital in connection with the issuance and sale
        of the
        Debenture.
 
 As
        the
        Series E Debentures are convertible into shares of common stock of the Company,
        the Company followed the accounting treatment in SFAS 150 “ *Accounting
        for Certain Financial Instruments with Characteristics of Both Liabilities
        and
        Equity,”* SFAS
        133
“ *Accounting
        for Derivative Instruments and Hedging Activities”* and
        EITF
        00-19 “ *Accounting
        for Derivative Financial Instruments Indexed to, and Potentially Settled
        in, a
        Company’s Own Stock.”* The
        Company recognized a derivative liability of $2,434,000 upon the issuance
        of the
        Series E Debentures due to the value of the conversion feature of the Series
        E
        Debentures. The liability was calculated using the Black-Scholes valuation
        model
        with the following assumptions: dividend yield of 0%, expected volatility
        of
        138%, risk-free rate of 3.75% and expected life of 5 years.
 
  F-21
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 **NOTE
        9. 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, 2006, 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 $20,000,000 stated value of the outstanding Series H Preferred Stock
        were
        payable at the rate of 5% per annum as and when declared by the Board of
        Directors. The annual dividend requirement was $1,000,000. If dividends were
        declared on Fonix's common stock, as a condition of that dividend, Fonix
        was
        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 were
        payable
        in cash or, at the option of Fonix, in shares of Class A common stock. The
        Company has accrued for the March 31, 2006, June 30, 2006 and the period
        from
        July 1, 2006 through September 7, 2006 dividend payments under the Series
        H
        Preferred Stock, but has not paid the dividends to the holders of the Series
        H
        Preferred Stock as of the date of this report.
 
 On
        September 7, 2006, the Company entered into an agreement to exchange the
        2,000
        shares of Series H Preferred Stock for shares of the Company’s Series L
        Preferred Stock. (See discussion below under “Series L Preferred Stock.”) As of
        December 31, 2006, no shares of Series H Preferred Stock remained
        outstanding.
 
 ***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.
 
 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.
 
  F-22
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 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 the
        Company 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.
 
 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, 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 its 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, no shares of Series I Preferred Stock remained
        outstanding.
 
  F-23
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 ***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 aggregate 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.
        For
        the year ended December 31, 2006, the Company issued 15,028,249 shares of
        its
        Class A common stock upon conversion of 266 shares of Series J Preferred
        Stock.
        As of December 31, 2006, no shares of Series J Preferred Stock remained
        outstanding.
 
 ***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 entitled 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 were payable in cash or
        shares
        of the Company’s Class A common stock, at the Company’s option.
 
 The
        shares of Series K Preferred Stock were issued pursuant to a Series K 5%
        Convertible Preferred Stock Exchange Agreement (the “Series K Agreement”), in
        connection with which Southridge exchanged 1,093 shares of Series J Convertible
        Preferred Stock for 1,093 shares of Series K Convertible Preferred
        Stock.
 
 The
        Series K Preferred Stock were convertible into common stock of the Company
        at
        the option of the holder by using a conversion price of $0.01 per
        share.
 
 For
        year
        ended December 31, 2006, the Company issued 109,300,000 shares of its Class
        A
        common stock upon conversion of all 1,093 shares of its Series K Preferred
        Stock. As of December 31, 2006, no shares of Series K Preferred Stock remained
        outstanding.
 
 ***Series
        L Preferred Stock*** - On
        September 7, 2006, the Company entered into a Series L 9% Convertible Preferred
        Stock Exchange Agreement (the "Exchange Agreement") with McCormack and Kenzie
        Financial (“Kenzie”), a British Virgin Islands company. Pursuant to the Exchange
        Agreement, McCormack and Kenzie exchanged all 2,000 shares of Series H Preferred
        Stock that they acquired from the sale of LTEL Holdings, for 1,960.8 and
        39.2
        shares, respectively, of the Company's Series L 9% Convertible Preferred
        Stock
        (the "Series L Preferred Stock").
 
  F-24
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 Because
        the shares of Series L Preferred Stock were issued in exchange for the remaining
        outstanding shares of Series H Preferred Stock, the Company did not receive
        any
        proceeds in connection with the issuance of the Series L Preferred Stock.
 
 The
        Series L Preferred Stock entitles McCormack and Kenzie to receive dividends
        in
        an amount equal to 9% of the then-outstanding balance of shares of Series
        L
        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 L Preferred Stock is convertible into common stock of the Company
        at the
        option of the holder by using a conversion price which was 80% of the average
        of
        the two (2) lowest closing bid prices for the twenty-day trading period prior
        to
        the conversion date.
 
 Redemption
        of the Series L Preferred Stock, whether at the Company’s option or that of
        McCormack or Kenzie, requires the Company to pay, as a redemption price,
        the
        stated value of the outstanding shares of Series L Preferred Stock to be
        redeemed, together with any accrued but unissued dividends thereon, multiplied
        by one hundred ten percent (110%).
 
 In
        connection with the issuance of the Series L Preferred Stock, the Company
        filed
        with the State of Delaware a Certificate of Designation and Series L 9%
        Convertible Stock Terms (the “Series L Terms”), which become a part of the
        Company’s Certificate of Incorporation, as amended.
 
 The
        Company accounted for the exchange as a redemption of the outstanding Series
        H
        Preferred Stock as the Series H Preferred Stock was not convertible into
        shares
        of common stock of the Company. The Series L Preferred Stock is convertible
        into
        shares of common stock of the Company. The Company followed the accounting
        treatment in SFAS 150 *,* SFAS
        133
        and EITF 00-19 *.* The
        Company recognized a derivative liability of $30,991,000 upon the redemption
        due
        to the value of the conversion feature of the Series L Preferred Stock. The
        liability was calculated using the Black-Scholes valuation model with the
        following assumptions: dividend yield of 0%, expected volatility of 140%,
        risk-free rate of 3.75% and expected life of 4 years. As the value of the
        derivative liability was greater than the face value of the Series L Preferred
        Stock, no value was prescribed to the Series L Preferred Stock. Also in
        connection with the redemption, the Company recognized a preferred stock
        dividend of $16,000,000, equal to the original discount the Company had assigned
        to the Series H Preferred Stock.
 
 For
        the
        year ended December 31, 2006, the Company issued 489,870,090 shares of our
        Class
        A common stock in conversion of 142 shares of its Series L Preferred Stock.
        At
        December 31, 2006, 1,858 shares of Series L Preferred Stock remained
        outstanding. Subsequent to December 31, 2006 and through the date of this
        report, the Company issued 267,507,174 shares of our Class A common stock
        in
        conversion of 45 shares of Series L Preferred Stock.
 
 **NOTE
        10. EQUITY LINES OF CREDIT**
 
 ***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.
 
  F-25
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 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.
 
 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
        the
        Company dated November 15, 2004.
 
 Under
        the
        Seventh Equity Line Agreement, the Company had 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 was 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
        was limited as to the amount of shares it may put to the Equity Line Investor
        in
        connection with each put; the Company could 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 was 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
        was 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.
 
 The
        Company granted registration rights to the Equity Line Investor and filed
        three
        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 10, 2006. All of the shares registered by
        the
        second registration statement had been sold as of July 26, 2006. The Company
        filed a third registration statement on June 26, 2006, to register additional
        shares under the Seventh Equity Line. However, that registration statement
        was
        not declared effective, and no shares were sold under that registration
        statement.
 
 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 $3,127,000.
 
  F-26
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 For
        the
        year ended December 31, 2006, the Company received $3,378,000 in funds drawn
        under the Seventh Equity Line, less commissions and fees of $114,000. The
        Company issued 300,000,000 shares of Class A common stock to the Equity Line
        Investor as puts under the Seventh Equity Line totaling $3,378,000.
 
 In
        January, 2007, the Company terminated the Seventh Equity Line, and the Company
        has withdrawn the third registration statement related to the Seventh Equity
        Line. As such, as of the date of this Report, the Company did not have an
        equity
        line of credit financing available to it.
 
 **NOTE
        11. COMMON STOCK**
 
 ***Common
        Stock*** **-** During
        2006, the Company issued 917,036,751 shares of Class A common stock. Of such
        shares, 300,000,000 were issued in connection with draws on the Seventh Equity
        Line, 15,028,249 shares were issued in conversion of 266 shares of Series
        J
        Preferred Stock, 109,300,000 shares were issued in conversion of 1,093 shares
        of
        Series K Preferred Stock, 2,838,412 shares were issued in payment of dividends
        on Series H Preferred Stock and 489,870,090 shares were issued in conversion
        of
        142 shares of Series L Preferred 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.
 
 **NOTE
        12. 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, 2006, there
        were
        19,092,358 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, 2006, 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,
        2006, shares available for grant under this plan were 135,000.
 
  F-27
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 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, 2006, shares available for grant
        under
        this plan were 22,500.
 
 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
        2006, the Company granted options to purchase 58,000 shares of Class A common
        stock at exercise prices ranging from $0.01 to $0.02. 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
        2005, the Company granted options to purchase 746,505 shares of Class A common
        stock in addition to the options 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.
 
  F-28
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 A
        summary
        of options granted under the Company’s various stock option plans for the years
        ended December 31, 2006, 2005 and 2004 is presented below:
 
 **2006**
              
              **2005**
              
              **2004****Stock
                  Options**
              
              **Weighted
                  Average Exercise Price**
              
              **Stock
                  Options**
              
              **Weighted
                  Average Exercise Price**
              
              **Stock
                  Options**
              
              **Weighted
                  Average Exercise Price**Outstanding
                  at beginning of the year
              
              
              1,331,205
              
              $
              0.132
              
              
              818.920
              
              $
              42.42
              
              
              808,901
              
              $
              41.41Granted
              
              
              58,000
              
              
              0.01
              
              
              1,160.955
              
              
              0.09
              
              
              110,600
              
              
              0.33Exercised
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Forfeited
              
              
              (481,563
              )
              
              0.13
              
              
              (647,810
              )
              
              59.11
              
              
              (100,581
              )
              
              37.44Outstanding
                  at end of the year
              
              
              907,642
              
              
              0.13
              
              
              1,331,205
              
              
              0.13
              
              
              818,920
              
              
              42.24Exercisable
                  at the end of the year
              
              
              776,774
              
              $
              0.13
              
              
              635,303
              
              $
              0.13
              
              
              552,204
              
              $
              62.09
 
 A
        summary
        of options outstanding and options exercisable under the Company’s various stock
        option plans at December 31, 2006 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**$
                    0.01 - 0.04
                
                
                487,855
                
                3.2
                    years
                
                $
                0.04
                
                
                452,855
                
                $
                0.040.12
                
                
                120,000
                
                8.1
                    years
                
                
                0.12
                
                
                39,999
                
                
                0.120.21
                    - 0.37
                
                
                297,600
                
                7.4
                    years
                
                
                0.22
                
                
                281,733
                
                
                0.223.60
                    - 61.24
                
                
                2,187
                
                4.7
                    years
                
                
                7.85
                
                
                2,187
                
                
                7.85$
                    0.01 - 61.24
                
                
                907,642
                
                6.2
                    years
                
                
                0.13
                
                
                776,774
                
                
                0.13
 The
        weighted average fair value of options granted during the years ended December
        31, 2006, 2005, and 2004 were $0.01, $0.09 and $0.30 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:
 
 **2006**
              
              **2005**
              
              **2004**Risk-free
                  interest rate
              
              3.75%
              
              3.75%
              
              4.02%Expected
                  dividend yield
              
              0.0%
              
              0.0%
              
              0.0%Expected
                  exercise lives
              
              5
                  years
              
              5
                  years
              
              5
                  yearsExpected
                  volatility
              
              143%
              
              143%
              
              144%
 
 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.
   
  F-29
 **** **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 ***Warrants*** - A
        summary of warrants granted by the Company during the years ended December
        31,
        2006, 2005, and 2004 is presented below:
 **2006**
                
                **2005**
                
                **2004****Shares**
                
                **Weighted
                    Average Exercise Price**
                
                **Shares**
                
                **Weighted
                    Average Exercise Price**
                
                **Shares**
                
                **Weighted
                    Average Exercise Price**Outstanding
                    at beginning of the year
                
                
                15,000
                
                $
                40.00
                
                
                980,389
                
                $
                1.10
                
                
                46,250
                
                $
                23.51Granted
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                965,389
                
                
                0.51Forfeited
                
                
                —
                
                
                —
                
                
                (965,389
                )
                
                0.51
                
                
                (31,250
                )
                
                15.60Outstanding
                    at end of the year
                
                
                15,000
                
                
                40.00
                
                
                15,000
                
                
                40.00
                
                
                980,389
                
                
                1.10Exercisable
                    at end of the year
                
                
                15,000
                
                
                40.00
                
                
                15,000
                
                
                40.00
                
                
                980,389
                
                
                1.10
 
 **NOTE
        13. RELATED-PARTY TRANSACTIONS**
 
 The
        secretary of the Company is a partner in a law firm that the Company uses
        to
        provide legal services. During 2006, 2005 and 2004, the Company incurred
        expenses of approximately $368,000, $533,000 and $604,000, respectively,
        to the
        law firm for services provided to the Company.
 
 **NOTE
        14. INCOME TAXES**
 
 At
        December 31, 2006 and 2005, net deferred income tax assets, before considering
        the valuation allowance, totaled $64,313,000 and $57,158,000, 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
        $8,187,000 for 2006, an increase of $8,249,000 for 2005 and a decrease of
        $1,748,000 for 2004.
 
 At
        December 31, 2006, the Company has unused federal net operating loss
        carryforwards available of approximately $159,302,000 and unused state net
        operating loss carryforwards of approximately $150,582,000 which may be applied
        against future taxable income, if any, and which expire in various years
        from
        2011 through 2026. 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, 2006 and 2005 are as follows:
 Deferred
                    income tax assets:
                
                **2006**
                ****
                **2005**Net
                    operating loss carryforwards:Federal
                
                $
                54,163,000
                
                $
                47,041,000State
                
                
                4,969,000
                
                
                4,278,000Research
                    expenditures credits
                
                
                2,487,000
                
                
                2,462,000Accrued
                    liabilities
                
                
                86,000
                
                
                70,000Deferred
                    revenues
                
                
                172,000
                
                
                344,000Amortization
                    of intangible assets
                
                
                2,437,000
                
                
                2,963,000Total
                    deferred income tax assets
                
                
                64,313,000
                
                
                57,158,000Valuation
                    allowance
                
                
                (64,313,000
                )
                
                (56,126,000
                )Deferred
                    income tax liability - intangible telecommunications
                    assets
                
                
                --
                
                
                (1,032,000
                )Net
                    deferred income tax assets
                
                $
                -
                
                $
                -
  
  F-30
  **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 A
        reconciliation of income taxes at the federal statutory rate to the Company’s
        effective rate is as follows:
 **Year
                    Ended December 31,****2006**
                
                **2005**
                
                **2004**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
        15. COMMITMENTS AND CONTINGENCIES**
 
 ***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.
 
 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.
 
 ***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, 2006, were as follows:
 
 **Year
                  ending December 31,**2007
              
              $
              350,0002008
              
              
              312,0002009
              
              
              312,0002010
              
              
              208,000$
              1,182,000
 
 The
        Company incurred rental expense of $350,000, $829,000 and $827,000 during
        2006,
        2005 and 2004, 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.
 
 **NOTE
        16. LITIGATION**
 
 **Breckenridge
        Complaint** - On
        June 6, 2006, Breckenridge filed a complaint against the Company in the Supreme
        Court of the State of New York, County of Nassau (the “Court”), in connection
        with a settlement agreement between the Company and Breckenridge entered
        into in
        September 2005. In the Complaint, Breckenridge alleged that the Company failed
        to pay certain amounts due under the settlement agreement in the amount of
        $450,000. The Company denied the allegations of Breckenridge’s complaint and
        filed a motion for summary judgment. Breckenridge also filed for summary
        judgment on its complaint.
 
  F-31
 **** **Fonix
          Corporation and Subsidiaries**
 **Notes
          to Consolidated Financial Statements**
 On
        February 2, 2007, the Court granted Breckenridge’s motion for summary judgment,
        denied the Company’s summary judgment motion, and directed that a hearing be
        held to determine the amount owed by the Company to Breckenridge. The Company
        and Breckenridge entered into a stipulation that the Company owed Breckenridge
        $1,530,000 plus interest at a rate of 9% from September 15, 2006 to the date
        of
        entry of judgment.
 
 The
        Court’s judgment, dated as of March 15, 2007, states that the Company owes an
        aggregate of $1,602,000 to Breckenridge. The Company has accrued for this
        settlement in the accompanying financial statements. To date, Breckenridge
        has
        not taken any action to collect on the judgment.
 
 **NOTE
        17. 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
        18. SIGNIFICANT CUSTOMERS**
 
 The
        Company’s revenues by geographic region for the years ended December 31, 2006,
        2005 and 2004 were:
 
 **2006**
              
              **2005**
              
              **2004**United
                  States
              
              $
              546,000
              
              41%
              
              $
              898,000
              
              66%
              
              $
              1,079,000
              
              88%Asia
                  Pacific
              
              
              591,000
              
              44%
              
              
              352,000
              
              26%
              
              
              62,000
              
              5%Other
              
              
              192,000
              
              15%
              
              
              108,000
              
              8%
              
              
              88,000
              
              7%$
              1,329,000
              
              
              
              
              $
              1,358,000
              
              
              
              
              $
              1,229,000
 
 For
        the
        year ended December 31, 2006, one customer accounted for 31% of total revenues
        and another customer accounted for 10% of total revenues. For the year ended
        December 31, 2005, one customer accounted for 17% of total revenues and another
        customer accounted for 15% of total revenues. For the year ended December
        31,
        2004, one customer accounted for 11% of total revenues.
 
 **NOTE
        19. SUBSEQUENT EVENTS**
 
 Through
        March 19, 2007, the Company has issued 332,173,839 shares of its Class A
        common
        stock in conversion of 55 shares of Series L Preferred Stock.
 
 On
        June
        6, 2006, Breckenridge filed a complaint against the Company in the Supreme
        Court
        of the State of New York, County of Nassau (the “Court”), in connection with a
        settlement agreement between the Company and Breckenridge entered into in
        September 2005. In the Complaint, Breckenridge alleged that the Company failed
        to pay certain amounts due under the settlement agreement in the amount of
        $450,000. The Company denied the allegations of Breckenridge’s complaint and has
        filed a motion for summary judgment. Breckenridge also filed for summary
        judgment on its complaint.
 
 On
        February 2, 2007, the Court granted Breckenridge’s motion for summary judgment,
        denied the Company’s summary judgment motion, and directed that a hearing be
        held to determine the amount owed by the Company to Breckenridge. The Company
        and Breckenridge entered into a stipulation that the Company owed Breckenridge
        $1,530,000 plus interest at a rate of 9% from September 15, 2006 to the date
        of
        entry of judgment.
 
 The
        Court’s judgment, dated as of March 15, 2007, states that the Company owes an
        aggregate of $1,602,000 to Breckenridge. The Company has accrued for this
        settlement in the accompanying financial statements. To date, Breckenridge
        has
        not taken any action to collect on the judgment.
 
 F-32