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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



Commission File No. 000-30335



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SONIC INNOVATIONS, INC.

(Exact name of registrant as specified in its charter)



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|                                                              |  |                                    
|------------------------------------------------------------- |  | -----------------------------------
|DELAWARE                                                      |  | 87-0494518                         
|(State or other jurisdiction ofincorporation or organization) |  | (I.R.S. EmployerIdentification No.)



2795 East Cottonwood
Parkway, Suite 660

Salt Lake City, UT 84121-7036

(Address of principal executive offices)



(801) 365-2800

(Registrants telephone number, including area code)



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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. x  Yes ̈No



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



Indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.): ̈Yes    
x  No



As of
November 2, 2005, there were 21,490,886 shares of the registrants $0.001 par value common stock outstanding.



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1



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##### Table of Contents

SONIC INNOVATIONS, INC.

TABLE OF CONTENTS



|                              |  |                                                                                                                 |  |     
|----------------------------- |  | --------------------------------------------------------------------------------------------------------------- |  | ----
|                              |  |                                                                                                                 |  | Page
|PART I. FINANCIAL INFORMATION |  |                                                                                                                
|                              |  |                                                                                                                
|ITEM 1.                       |  | Condensed Consolidated Financial Statements (Unaudited):                                                        |  |     
|                              |  |                                                                                                                
|                              |  | Condensed Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004                            |  | 3   
|                              |  |                                                                                                                
|                              |  | Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2005 and 2004 |  | 4   
|                              |  |                                                                                                                
|                              |  | Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2005 and 2004           |  | 5   
|                              |  |                                                                                                                
|                              |  | Notes to Condensed Consolidated Financial Statements                                                            |  | 6   
|                              |  |                                                                                                                
|ITEM 2.                       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                           |  | 12  
|                              |  |                                                                                                                
|ITEM 3.                       |  | Quantitative and Qualitative Disclosures about Market Risks                                                     |  | 21  
|                              |  |                                                                                                                
|ITEM 4.                       |  | Controls and Procedures                                                                                         |  | 22  
|                              | 
|PART II. OTHER INFORMATION    |  |                                                                                                                
|                              |  |                                                                                                                
|ITEM 6.                       |  | Exhibits                                                                                                        |  | 23  
|                              | 
|SIGNATURE                     |  | 24                                                                                                             
|                              | 
|CERTIFICATIONS                |  |                                                                                                                



2



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##### Table of Contents

PART I. FINANCIAL INFORMATION



|ITEM 1. | CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
|------- | -------------------------------------------------------



SONIC INNOVATIONS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)



|                                                                                 |  |                   |         |   |                  |   |         |  
|-------------------------------------------------------------------------------- |  | ----------------- | ------- | - | ---------------- | - | ------- | -
|                                                                                 |  | September 30,2005 |         |   | December 31,2004 |  
|ASSETS                                                                           |  |                   |         |   |                  |   |         |  
|Current assets:                                                                  |  |                   |         |   |                  |   |         |  
|Cash and cash equivalents                                                        |  | $                 | 8,238   |   |                  | $ | 8,221   |  
|Marketable securities                                                            |  |                   | 858     |   |                  |   | 10,482  |  
|Restricted cash, cash equivalents and marketable securities                      |  |                   | 9,102   |   |                  |   | 10,571  |  
|Accounts receivable, net of allowance for doubtful accounts of $1,555 and $1,617 |  |                   | 15,482  |   |                  |   | 16,092  |  
|Inventories                                                                      |  |                   | 12,401  |   |                  |   | 9,799   |  
|Prepaid expenses and other                                                       |  |                   | 2,586   |   |                  |   | 2,969   |  
|                                                                                 |  |                   |         |   |                  |   |         |  
|Total current assets                                                             |  |                   | 48,667  |   |                  |   | 58,134  |  
|Long-term marketable securities                                                  |  |                   |        |   |                  |   | 2,321   |  
|Restricted long-term marketable securities                                       |  |                   |        |   |                  |   | 754     |  
|Property and equipment, net of accumulated depreciation of $15,282 and $13,097   |  |                   | 9,146   |   |                  |   | 10,086  |  
|Goodwill and indefinite-lived intangible assets                                  |  |                   | 31,350  |   |                  |   | 34,972  |  
|Definite-lived intangible assets, net                                            |  |                   | 4,472   |   |                  |   | 7,328   |  
|Other assets                                                                     |  |                   | 958     |   |                  |   | 1,691   |  
|                                                                                 |  |                   |         |   |                  |   |         |  
|Total assets                                                                     |  | $                 | 94,593  |   |                  | $ | 115,286 |  
|                                                                                 |  |                   |         |   |                  |   |         |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                             |  |                   |         |   |                  |   |         |  
|Current liabilities:                                                             |  |                   |         |   |                  |   |         |  
|Current portion of loan payable                                                  |  | $                 | 1,204   |   |                  | $ | 1,364   |  
|Payables to former owners of acquired businesses                                 |  |                   | 2,908   |   |                  |   | 3,627   |  
|Accounts payable                                                                 |  |                   | 5,685   |   |                  |   | 8,315   |  
|Accrued payroll and related expenses                                             |  |                   | 3,977   |   |                  |   | 3,085   |  
|Accrued warranty                                                                 |  |                   | 4,694   |   |                  |   | 4,526   |  
|Deferred revenue                                                                 |  |                   | 3,320   |   |                  |   | 5,455   |  
|Other accrued liabilities                                                        |  |                   | 4,149   |   |                  |   | 5,419   |  
|                                                                                 |  |                   |         |   |                  |   |         |  
|Total current liabilities                                                        |  |                   | 25,937  |   |                  |   | 31,791  |  
|Loan payable, net of current portion                                             |  |                   | 5,419   |   |                  |   | 7,161   |  
|Deferred revenue, net of current portion                                         |  |                   | 3,980   |   |                  |   | 4,444   |  
|Other liabilities                                                                |  |                   | 106     |   |                  |   | 787     |  
|                                                                                 |  |                   |         |   |                  |   |         |  
|Total liabilities                                                                |  |                   | 35,442  |   |                  |   | 44,183  |  
|Shareholders equity:                                                            |  |                   |         |   |                  |   |         |  
|Common stock                                                                     |  |                   | 22      |   |                  |   | 22      |  
|Additional paid-in capital                                                       |  |                   | 120,300 |   |                  |   | 118,135 |  
|Deferred stock-based compensation                                                |  |                   | (1,383  | ) |                  |   | (8      | )
|Accumulated deficit                                                              |  |                   | (61,301 | ) |                  |   | (50,797 | )
|Accumulated other comprehensive income                                           |  |                   | 5,286   |   |                  |   | 7,524   |  
|Treasury stock, at cost                                                          |  |                   | (3,773  | ) |                  |   | (3,773  | )
|                                                                                 |  |                   |         |   |                  |   |         |  
|Total shareholders equity                                                       |  |                   | 59,151  |   |                  |   | 71,103  |  
|                                                                                 |  |                   |         |   |                  |   |         |  
|Total liabilities and shareholders equity                                       |  | $                 | 94,593  |   |                  | $ | 115,286 |  
|                                                                                 |  |                   |         |   |                  |   |         |  



See
accompanying notes to condensed consolidated financial statements.



3



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##### Table of Contents



SONIC INNOVATIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)



|                                                      |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|----------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                                      |  | Three months endedSeptember 30, |        |   | Nine months endedSeptember 30, |  
|                                                      |  | 2005                            |        |   | 2004                           |   |        | 2005 |  |   | 2004    |  
|Net sales                                             |  | $                               | 24,353 |   |                                | $ | 22,456 |      |  | $ | 80,429  |   |  | $ | 73,100 |  
|Cost of sales                                         |  |                                 | 11,024 |   |                                |   | 10,456 |      |  |   | 36,477  |   |  |   | 32,848 |  
|Asset impairment charge                               |  |                                 | 694    |   |                                |   |       |      |  |   | 694     |   |  |   |       |  
|                                                      |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Gross profit                                          |  |                                 | 12,635 |   |                                |   | 12,000 |      |  |   | 43,258  |   |  |   | 40,252 |  
|Selling, general and administrative expense           |  |                                 | 12,748 |   |                                |   | 10,203 |      |  |   | 42,262  |   |  |   | 30,809 |  
|Research and development expense                      |  |                                 | 2,192  |   |                                |   | 2,520  |      |  |   | 6,680   |   |  |   | 7,420  |  
|Asset impairment and restructuring charges            |  |                                 | 6,247  |   |                                |   |       |      |  |   | 6,247   |   |  |   |       |  
|                                                      |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Operating profit (loss)                               |  |                                 | (8,552 | ) |                                |   | (723   | )    |  |   | (11,931 | ) |  |   | 2,023  |  
|Other income (expense), net                           |  |                                 | 96     |   |                                |   | (6     | )    |  |   | 184     |   |  |   | (84    | )
|                                                      |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Income (loss) before income taxes                     |  |                                 | (8,456 | ) |                                |   | (729   | )    |  |   | (11,747 | ) |  |   | 1,939  |  
|Provision (benefit) for income taxes                  |  |                                 | (1,166 | ) |                                |   | (69    | )    |  |   | (1,243  | ) |  |   | 387    |  
|                                                      |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Net income (loss)                                     |  | $                               | (7,290 | ) |                                | $ | (660   | )    |  | $ | (10,504 | ) |  | $ | 1,552  |  
|                                                      |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Earnings (loss) per common share:                     |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Basic                                                 |  | $                               | (0.34  | ) |                                | $ | (0.03  | )    |  | $ | (0.49   | ) |  | $ | 0.08   |  
|                                                      |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Diluted                                               |  | $                               | (0.34  | ) |                                | $ | (0.03  | )    |  | $ | (0.49   | ) |  | $ | 0.07   |  
|                                                      |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Weighted average number of common shares outstanding: |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Basic                                                 |  |                                 | 21,488 |   |                                |   | 20,860 |      |  |   | 21,332  |   |  |   | 20,652 |  
|                                                      |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Diluted                                               |  |                                 | 21,488 |   |                                |   | 20,860 |      |  |   | 21,332  |   |  |   | 22,383 |  
|                                                      |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  



See
accompanying notes to condensed consolidated financial statements.



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SONIC INNOVATIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)



|                                                                                                                     |  |                                |         |   |      |   |        |  
|-------------------------------------------------------------------------------------------------------------------- |  | ------------------------------ | ------- | - | ---- | - | ------ | -
|                                                                                                                     |  | Nine months endedSeptember 30, |        
|                                                                                                                     |  | 2005                           |         |   | 2004 |  
|Cash flows from operating activities:                                                                                |  |                                |         |   |      |   |        |  
|Net income (loss)                                                                                                    |  | $                              | (10,504 | ) |      | $ | 1,552  |  
|Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:                   |  |                                |         |   |      |   |        |  
|Depreciation and amortization                                                                                        |  |                                | 4,173   |   |      |   | 2,450  |  
|Stock-based compensation                                                                                             |  |                                | 262     |   |      |   | 21     |  
|Foreign currency losses (gains)                                                                                      |  |                                | 483     |   |      |   | (51    | )
|Asset impairment charge                                                                                              |  |                                | 5,755   |   |      |   |       |  
|Changes in assets and liabilities:                                                                                   |  |                                |         |   |      |   |        |  
|Accounts receivable, net                                                                                             |  |                                | (679    | ) |      |   | 1,711  |  
|Inventories                                                                                                          |  |                                | (3,238  | ) |      |   | 68     |  
|Prepaid expenses and other                                                                                           |  |                                | (288    | ) |      |   | (584   | )
|Other assets                                                                                                         |  |                                | (440    | ) |      |   | 289    |  
|Accounts payable, accrued liabilities and deferred revenue                                                           |  |                                | (6,009  | ) |      |   | 1,479  |  
|                                                                                                                     |  |                                |         |   |      |   |        |  
|Net cash provided by (used in) operating activities                                                                  |  |                                | (10,485 | ) |      |   | 6,935  |  
|Cash flows from investing activities:                                                                                |  |                                |         |   |      |   |        |  
|Payments related to acquisitions of businesses and intangibles                                                       |  |                                | (2,675  | ) |      |   | (3,466 | )
|Purchases of property and equipment                                                                                  |  |                                | (2,192  | ) |      |   | (3,863 | )
|Investments and advances, net                                                                                        |  |                                | 1,675   |   |      |   | (698   | )
|Proceeds from (purchases of) marketable securities, net                                                              |  |                                | 12,656  |   |      |   | (1,613 | )
|                                                                                                                     |  |                                |         |   |      |   |        |  
|Net cash provided by (used in) investing activities                                                                  |  |                                | 9,464   |   |      |   | (9,640 | )
|Cash flows from financing activities:                                                                                |  |                                |         |   |      |   |        |  
|Principal payments on loan payable                                                                                   |  |                                | (949    | ) |      |   | (918   | )
|Decrease in restricted cash, cash equivalents and marketable securities, net                                         |  |                                | 1,512   |   |      |   | 76     |  
|Proceeds from pre-acquisition receivables payable to previous owners of acquired business, net of payments and taxes |  |                                | 501     |   |      |   | 2,573  |  
|Proceeds from exercise of stock options and employee stock purchases                                                 |  |                                | 528     |   |      |   | 2,173  |  
|                                                                                                                     |  |                                |         |   |      |   |        |  
|Net cash provided by financing activities                                                                            |  |                                | 1,592   |   |      |   | 3,904  |  
|Effect of exchange rate changes on cash and cash equivalents                                                         |  |                                | (554    | ) |      |   | (88    | )
|                                                                                                                     |  |                                |         |   |      |   |        |  
|Net increase in cash and cash equivalents                                                                            |  |                                | 17      |   |      |   | 1,111  |  
|Cash and cash equivalents, beginning of the period                                                                   |  |                                | 8,221   |   |      |   | 8,630  |  
|                                                                                                                     |  |                                |         |   |      |   |        |  
|Cash and cash equivalents, end of the period                                                                         |  | $                              | 8,238   |   |      | $ | 9,741  |  
|                                                                                                                     |  |                                |         |   |      |   |        |  
|Supplemental cash flow information:                                                                                  |  |                                |         |   |      |   |        |  
|Cash paid for interest                                                                                               |  | $                              | 212     |   |      | $ | 98     |  
|Cash paid for income taxes                                                                                           |  |                                | 3,447   |   |      |   | 1,776  |  



See
accompanying notes to condensed consolidated financial statements.



5



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SONIC INNOVATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share data)

(unaudited)



1. BASIS OF PRESENTATION



The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States
of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for
complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. The results of operations for the three and nine months
ended September 30, 2005 are not necessarily indicative of results that may be expected for the full year ending December 31, 2005. For further information, refer to the consolidated financial statements and footnotes thereto included in
the Companys Annual Report on Form 10-K for the year ended December 31, 2004 as filed with the Securities and Exchange Commission.



Principles of Consolidation.The consolidated financial statements include the accounts of Sonic Innovations, Inc. and its wholly owned subsidiaries. All
intercompany balances and transactions are eliminated in consolidation.



Use
of Estimates.The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets
and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates affecting the financial
statements are those related to allowance for doubtful accounts, sales returns, inventory obsolescence, long-lived asset impairment, warranty accruals and deferred income tax asset valuation allowances. Actual results could differ from those
estimates.



Revenue Recognition and Concentrations of Credit Risk.Sales
are recognized when (i) products are shipped, except for hearing aid retail sales, which are recognized upon acceptance by the consumer, (ii) persuasive evidence of an arrangement exists, (iii) title and risk of loss has transferred,
(iv) the price is fixed and determinable, (v) contractual obligations have been satisfied, and (vi) collectability is reasonably assured. Net sales consist of product sales less provisions for sales returns, which are made at the time
of sale. Revenues related to sales of separately priced extended service contracts are deferred and recognized on a straight-line basis over the contractual periods. The Company performs ongoing credit evaluations of its customers and provides for
doubtful accounts. No single customer comprised more than 10% of (i) net sales in the three and nine months ended September 30, 2005 and 2004 or (ii) accounts receivable as of September 30, 2005 and December 31, 2004. The
Company generally has a 60-day return policy, and allowances for sales returns are reflected as a reduction of sales and accounts receivable. If actual sales returns differ from the Companys estimates, revisions to the allowance for sales
returns will be required. Allowances for sales returns were as follows:



|                             |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|---------------------------- |  | -------------------------------- | ------ | - | ------------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                             |  | Three months ended September 30, |        |   | Nine months ended September 30, |  
|                             |  | 2005                             |        |   | 2004                            |   |        | 2005 |  |   | 2004    |  
|Balance, beginning of period |  | $                                | 3,888  |   |                                 | $ | 2,814  |      |  | $ | 2,815   |   |  | $ | 3,487  |  
|Provisions                   |  |                                  | 4,159  |   |                                 |   | 2,807  |      |  |   | 12,289  |   |  |   | 8,846  |  
|Returns processed            |  |                                  | (4,187 | ) |                                 |   | (3,110 | )    |  |   | (11,244 | ) |  |   | (9,822 | )
|                             |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  
|Balance, end of period       |  | $                                | 3,860  |   |                                 | $ | 2,511  |      |  | $ | 3,860   |   |  | $ | 2,511  |  
|                             |  |                                  |        |   |                                 |   |        |      |  |   |         |   |  |   |        |  



Warranty Costs.The Company
provides for the cost of remaking and repairing products under warranty at the time of sale. These costs are included in cost of sales. When evaluating the adequacy of the warranty accrual, the Company analyzes the amount of historical and expected
warranty costs by geography, by product family, by model and by warranty period as appropriate. If actual product failure rates or repair and remake costs differ from the Companys estimates, revisions to the warranty accrual will be required.



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Accrued warranty costs were as follows:



|                             |  |                                  |        |   |                                 |   |        |      |  |   |        |   |  |   |        |  
|---------------------------- |  | -------------------------------- | ------ | - | ------------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                             |  | Three months ended September 30, |        |   | Nine months ended September 30, |  
|                             |  | 2005                             |        |   | 2004                            |   |        | 2005 |  |   | 2004   |  
|Balance, beginning of period |  | $                                | 4,692  |   |                                 | $ | 4,059  |      |  | $ | 4,526  |   |  | $ | 4,115  |  
|Provisions                   |  |                                  | 1,147  |   |                                 |   | 1,298  |      |  |   | 3,820  |   |  |   | 3,288  |  
|Costs incurred               |  |                                  | (1,145 | ) |                                 |   | (1,063 | )    |  |   | (3,652 | ) |  |   | (3,109 | )
|                             |  |                                  |        |   |                                 |   |        |      |  |   |        |   |  |   |        |  
|Balance, end of period       |  | $                                | 4,694  |   |                                 | $ | 4,294  |      |  | $ | 4,694  |   |  | $ | 4,294  |  
|                             |  |                                  |        |   |                                 |   |        |      |  |   |        |   |  |   |        |  



Derivative Instruments.The
Company enters into readily marketable forward contracts with financial institutions to minimize the short-term impact of foreign currency fluctuations on certain intercompany balances. The Company does not enter into these contracts for trading or
speculation purposes. Gains and losses on the contracts are included in the results of operations and offset foreign exchange gains or losses recognized on the revaluation of certain intercompany balances. The Companys foreign exchange forward
contracts mature in three months or less from the contract date. On September 29, 2005, the Company entered into forward contracts for $1,147 (1,400 Canadian dollars), $3,440 (2,830 Euro), $957 (530 British pounds sterling) and $4,533 (6,000
Australian dollars), all of which expire on December 31, 2005.



Marketable Securities.The Company designates the classification of its marketable securities at the time of purchase and re-evaluates this designation as of each balance sheet date. As of September 30, 2005 and
December 31, 2004, the Companys investment portfolio consisted of principally U.S. government obligations classified as held-to-maturity and was presented at its amortized cost, which approximated market value. The amortized cost of U.S.
government obligations is adjusted for amortization of premiums and accretion of discounts to maturity. If a decline in the market value below cost that is deemed other than temporary were to occur, the decline would be included in the results of
operations resulting in the establishment of a new cost basis. For the three and nine months ended September 30, 2005 and 2004, the Company did not experience any declines in market value which were deemed other than temporary.



Comprehensive Income (Loss).The Companys comprehensive income (loss) consisted
of net income (loss) plus changes in foreign currency translation adjustments, which were not adjusted for income taxes as they relate to specific indefinite investments in subsidiaries, as follows:



|                                         |  |                                 |        |   |                                |   |      |      |  |   |         |   |  |   |       |  
|---------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ---- | ---- |  | - | ------- | - |  | - | ----- | -
|                                         |  | Three months endedSeptember 30, |        |   | Nine months endedSeptember 30, |  
|                                         |  | 2005                            |        |   | 2004                           |   |      | 2005 |  |   | 2004    |  
|Net income (loss)                        |  | $                               | (7,290 | ) |                                | $ | (660 | )    |  | $ | (10,504 | ) |  | $ | 1,552 |  
|Foreign currency translation adjustments |  |                                 | 89     |   |                                |   | 655  |      |  |   | (2,238  | ) |  |   | (487  | )
|                                         |  |                                 |        |   |                                |   |      |      |  |   |         |   |  |   |       |  
|Comprehensive income (loss)              |  | $                               | (7,201 | ) |                                | $ | (5   | )    |  | $ | (12,742 | ) |  | $ | 1,065 |  
|                                         |  |                                 |        |   |                                |   |      |      |  |   |         |   |  |   |       |  



Stock-Based Compensation.The
Company maintains various stock-based compensation programs and accounts for these programs under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees
(APB 25) and related interpretations. No compensation expense is recognized for (i) employee stock option grants because all options granted had an exercise price equal to the market value of the underlying common stock on the date
of grant and (ii) the discount associated with the employee stock purchase program because it is not considered compensatory.



The Company granted, net of forfeitures, 4,200 and 376,700 unvested shares of common stock to employees valued at $26 and $1,637, respectively in the three and nine
months ended September 30, 2005, respectively, the cost of which is being amortized on a straight-line basis over the vesting period.



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The following table illustrates the effect on net income (loss) and earnings (loss) per share if the Company had applied
the fair market value recognition provisions of Statement of Financial Standards (SFAS) No. 123 Accounting for Stock-Based Compensation in calculating its stock-based compensation expense.



|                                                                                         |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|---------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                                                                         |  | Three months endedSeptember 30, |        |   | Nine months endedSeptember 30, |  
|                                                                                         |  | 2005                            |        |   | 2004                           |   |        | 2005 |  |   | 2004    |  
|Net income (loss) as reported                                                            |  | $                               | (7,290 | ) |                                | $ | (660   | )    |  | $ | (10,504 | ) |  | $ | 1,552  |  
|Add: Stock-based employee compensation included in reported net income (loss)            |  |                                 | 103    |   |                                |   | 7      |      |  |   | 262     |   |  |   | 21     |  
|Deduct: Stock-based employee compensation expense determined under the fair value method |  |                                 | (197   | ) |                                |   | (942   | )    |  |   | (789    | ) |  |   | (2,786 | )
|                                                                                         |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Pro forma loss                                                                           |  | $                               | (7,384 | ) |                                | $ | (1,595 | )    |  | $ | (11,031 | ) |  | $ | (1,213 | )
|                                                                                         |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Basic earnings (loss) per common share as reported                                       |  | $                               | (0.34  | ) |                                | $ | (0.03  | )    |  | $ | (0.49   | ) |  | $ | 0.08   |  
|                                                                                         |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Diluted earnings (loss) per common share as reported                                     |  | $                               | (0.34  | ) |                                | $ | (0.03  | )    |  | $ | (0.49   | ) |  | $ | 0.07   |  
|                                                                                         |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  
|Pro forma basic and diluted loss per common share                                        |  | $                               | (0.34  | ) |                                | $ | (0.08  | )    |  | $ | (0.52   | ) |  | $ | (0.06  | )
|                                                                                         |  |                                 |        |   |                                |   |        |      |  |   |         |   |  |   |        |  



Earnings (Loss) Per Common Share.Basic earnings (loss) per common share is calculated based upon the weighted average shares of common stock outstanding during the period. Diluted earnings per share is calculated based upon the weighted average number of shares of common stock
outstanding, plus the dilutive effect of common stock equivalents calculated using the treasury stock method.

Dilutive common stock equivalents for the
nine months ended September 30, 2004 consisted of 1,731 shares pertaining to 3,319 stock options and unvested shares of common stock. Antidilutive common stock equivalents, consisting of stock options of 4,719, 4,662, 4,412 and 1,081 for the three
and nine months ended September 30, 2005 and the three and nine months ended September 30, 2004, respectively were excluded from diluted earnings (loss) per share calculations.



New Accounting Pronouncements.In November 2004, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (SFAS) No. 151, Inventory Costsan amendment of ARB No. 43, Chapter 4, which clarifies that abnormal inventory costs such as costs of idle facilities, excess freight and handling
costs and wasted materials (spoilage) are required to be recognized as current period charges. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005. The Company is currently evaluating the provisions of SFAS
No. 151 and does not believe that the adoption will have a material effect on its results of operations and financial position.



In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment, which requires all share-based payments to employees, including grants of employee
stock options, to be recognized as an expense. The value is recognized over the requisite service period based on fair values measured on grant dates. The new standard may be adopted using either the modified prospective method or the modified
retrospective method. In March 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment, which clarified the SECs expectations with regard
to the assumptions underlying the fair value estimates of options. In April 2005, the SEC amended the compliance dates for SFAS No. 123R such that the new standard will be effective for the Company beginning January 1, 2006. The Company is
currently evaluating the effect and the alternative adoption methods of these statements on its results of operations and financial position.



In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, which replaces APB Opinion No. 20, Accounting
Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements, and requires that a voluntary change in accounting principle be applied retrospectively to all prior period financial statements presented,
unless it is impracticable to do so. SFAS No. 154 also provides that a change in method of depreciating or amortizing a long-lived non-financial asset be accounted for as a change in estimate effected by a change in accounting principle, and
also provides that correction of errors in previously issued financial statements should be termed a restatement. SFAS No. 154 is effective for fiscal years beginning after December 15, 2005. The Company does not believe the
adoption of SFAS No. 154 will have a material effect on its results of operations and financial position.



2. ACQUISITIONS



Tympany, Inc.
(Tympany). In December 2004, the Company acquired 100% of the stock of Tympany, the developer of the Otogram, a machine that automates the four most commonly performed tests for diagnosing hearing loss.



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The initial purchase price of $2,262, including expenses of $254, consisted of $1,200 in cash and 196 shares of the
Companys common stock valued at $808 based on the average closing price of the common stock for the period beginning two days before and ending two days after the closing of the transaction. In addition, a $500 loan made by the Company to
Tympany prior to the acquisition was recorded as additional consideration. Contingent consideration will be paid based on the following schedule: 2005  35% of net 2005 Tympany revenue, plus 10% of a defined portion of net 2005 hearing aid
sales less a base amount; 2006  35% of net 2006 Tympany revenue, plus 10% of a defined portion of net 2006 hearing aid sales less 105% of a base amount; and 2007  20% of the lesser of 2007 or 2006 net Tympany revenue, plus 35% of any
excess of 2007 net Tympany revenue over 2006 net Tympany revenue, plus 10% of a defined portion of net 2007 hearing aid sales less 110% of a base amount. Payments will be made semi-annually in a combination of cash (60%) and Company common
stock (40%). During the third quarter 2005, the Company recorded an asset impairment charge related to goodwill and definite-lived intangibles recorded in connection with the acquisition of Tympany (see Note 4). The results of operations of Tympany
are included in the results of operations of the Company from December 1, 2004.



The following table sets forth summary pro forma condensed consolidated financial information as if the acquisition had taken place at the beginning of the periods presented:



|                                                                       |  |                                      |        |   |                                     |   |        |  
|---------------------------------------------------------------------- |  | ------------------------------------ | ------ | - | ----------------------------------- | - | ------ | -
|                                                                       |  | Three months endedSeptember 30, 2004 |        |   | Nine months endedSeptember 30, 2004 |  
|Net sales                                                              |  | $                                    | 23,241 |   |                                     | $ | 75,014 |  
|Operating loss                                                         |  | $                                    | (3,508 | ) |                                     | $ | (3,560 | )
|Net loss                                                               |  | $                                    | (3,518 | ) |                                     | $ | (4,155 | )
|Basic and diluted loss per common share                                |  | $                                    | (0.17  | ) |                                     | $ | (0.20  | )
|Basic and diluted weighted average number of common shares outstanding |  |                                      | 21,056 |   |                                     |   | 20,848 |  



During the second quarter 2005, the
Company settled a lawsuit filed by Tympanys former contract manufacturer for $875, of which Tympanys former owners were responsible for $313. The Company recorded goodwill of $562 pertaining to this settlement.



Sanomed Handelsgesellschaft mbH (Sanomed). In May 2003, the Company
acquired 100% of the stock of Sanomed, a distribution company that markets hearing aids directly to German hearing impaired customers through ear-nose-throat (ENT) physicians. Under the terms of the purchase agreement, contingent consideration in
the form of an earn-out has been paid in the amounts of $1,508 and $1,556 based on targeted sales performance for the one year periods ended May 31, 2005 and 2004, respectively. Additional contingent consideration of up to a maximum of $1,810
may be payable based on achieving targeted sales performance for the one year period ending May 31, 2006. Under the terms of the purchase agreement, the Company is required to remit to the former owners of Sanomed any money collected on certain
accounts receivable that were deemed uncollectible prior to the acquisition. As of September 30, 2005, the Company had collected $9,564 of such accounts receivable, and the net after tax amount of $5,738 will be remitted to the former owners in
2005.



In May 2004, the Company acquired 100% of the stock of a
Switzerland-based hearing aid retail chain. Contingent consideration in the form of an earn-out of 225 CHF ($175) was paid in the second quarter 2005 based on targeted sales performance for the one year period ended April 30, 2005.



3. INVENTORIES



Inventories are stated at the lower of cost or market value using the first-in, first-out method and were
as follows:



|                             |  |                    |        |                   |   |      
|---------------------------- |  | ------------------ | ------ | ----------------- | - | -----
|                             |  | September 30, 2005 |        | December 31, 2004
|Raw materials and components |  | $                  | 7,097  |                   | $ | 4,823
|Work-in-process              |  |                    | 136    |                   |   | 117  
|Finished goods               |  |                    | 5,168  |                   |   | 4,859
|                             |  |                    |        |                   |   |      
|Total                        |  | $                  | 12,401 |                   | $ | 9,799
|                             |  |                    |        |                   |   |      



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4. INTANGIBLE ASSETS



Goodwill and indefinite-lived intangible assets were as follows:



|                                                              |  |                                     |        |  
|------------------------------------------------------------- |  | ----------------------------------- | ------ | -
|                                                              |  | Nine months endedSeptember 30, 2005 |       
|Balance, beginning of period                                  |  | $                                   | 34,972 |  
|Additional purchase price consideration and transaction costs |  |                                     | 3,336  |  
|Asset impairment charge                                       |  |                                     | (4,227 | )
|Effects of foreign currency fluctuations                      |  |                                     | (2,731 | )
|                                                              |  |                                     |        |  
|Balance, end of period                                        |  | $                                   | 31,350 |  
|                                                              |  |                                     |        |  



Definite-lived intangible assets were
as follows:



|                                             |  |              |                       |                    |                          |                   |                       |       |                          |   |       |  |   |      
|-------------------------------------------- |  | ------------ | --------------------- | ------------------ | ------------------------ | ----------------- | --------------------- | ----- | ------------------------ | - | ----- |  | - | -----
|                                             |  | Useful Lives |                       | September 30, 2005 |                          | December 31, 2004
|                                             |  |              | Gross Carrying Amount |                    | Accumulated Amortization |                   | Gross Carrying Amount |       | Accumulated Amortization
|Purchased technology and technology licenses |  | 3-13 years   |                       | $                  | 2,941                    |                   | $                     | 970   |                          | $ | 3,633 |  | $ | 570  
|Brand names                                  |  | 3-15 years   |                       |                    | 2,829                    |                   |                       | 802   |                          |   | 3,373 |  |   | 624  
|Non-compete agreements                       |  | 5 years      |                       |                    | 410                      |                   |                       | 193   |                          |   | 843   |  |   | 153  
|Customer databases                           |  | 2-5 years    |                       |                    | 331                      |                   |                       | 176   |                          |   | 769   |  |   | 131  
|Distribution agreements                      |  | 2-5 years    |                       |                    | 316                      |                   |                       | 288   |                          |   | 357   |  |   | 274  
|Software and other intangibles               |  | 1-5 years    |                       |                    | 221                      |                   |                       | 147   |                          |   | 227   |  |   | 122  
|                                             |  |              |                       |                    |                          |                   |                       |       |                          |   |       |  |   |      
|Total                                        |  |              |                       | $                  | 7,048                    |                   | $                     | 2,576 |                          | $ | 9,202 |  | $ | 1,874
|                                             |  |              |                       |                    |                          |                   |                       |       |                          |   |       |  |   |      



Amortization expense for
definite-lived intangible assets is calculated using the straight-line method over the estimated useful lives of the assets. Estimated annual amortization expense for the years 2005 through 2009 is as follows: remaining 2005 - $215; 2006 - $778;
2007 - $737; 2008 - $588; and 2009 - $520.



The lack of progress toward
profitability, a changing business model and the termination of the management team at Tympany during the third quarter 2005 resulted in the Company performing an impairment analysis of the Tympany assets. The impairment analysis, which was
performed in accordance with SFAS Nos. 142 and 144, resulted in impairment losses of $4,227 related to goodwill and $1,528 related to definite-lived intangibles. The total asset impairment charge of $5,755 was reflected in the results of operations
for the three months ended September 30, 2005 based upon managements estimate of the impairment loss and an appraisal from a third-party valuation company.



5. LOAN PAYABLE



The Company obtained a loan from a German bank in 2003 to fund the acquisition of Sanomed. As of September 30, 2005, the balance of the loan was 5,500 Euro ($6,623).
The interest rate applicable to the loan is 1.0% above the EURIBOR rate (2.29% as of September 30, 2005). The loan is collateralized by a letter of credit from a U.S. bank, and the Company pledged certain amounts of its cash, cash equivalents
and marketable securities as security to obtain a reduced interest rate of 0.6% on this letter of credit. The loan payments are 250 Euro ($301 as of September 30, 2005) per quarter. The effective interest rates on this loan for the nine
months ended September 30, 2005 and 2004 were 3.95% and 3.91%, respectively.



6. LEGAL PROCEEDINGS



The Companys wholly owned
subsidiary, Tympany, filed a declaratory judgment action in March 2004 against BioCell and International Biophysics Corp. (collectively, IBC) stemming from a dispute regarding manufacturing services performed by IBC for Tympany. IBC
counterclaimed and sought, among other claims, lost profits and punitive damages. The Company settled this lawsuit in the second quarter 2005 by paying IBC $875, of which $313 will be reimbursed to the Company by the former owners of Tympany.



In July 2005, Energy Transportation Group, Inc. brought suit in the U.S.
District Court for Delaware against a number of hearing aid companies, including the Company, for infringement of one or more claims of two U.S. patents pertaining to programmable digital hearing aid systems. The lawsuit seeks injunctive relief and
damages from the defendants. The Company strongly denies the allegation and will defend itself vigorously; however, litigation is inherently uncertain and there can be no assurance that the outcome will not materially and adversely affect the
Companys results of operations and financial position.



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From time to time the Company is subject to legal proceedings, claims and litigation arising in the ordinary course of
the business. Most of these legal actions are brought against the Company by others and, when the Company feels it is necessary to protect its stockholders investment, the Company may initiate legal actions against others. Actions can stem
from disputes regarding the ownership of intellectual property, customer claims regarding the function or safety of the Companys products, government regulation or employment issues, among other sources. Litigation is inherently uncertain, and
therefore the Company cannot predict the eventual outcome of any such lawsuits. However, the Company does not expect that the ultimate resolution of any known legal action, other than as described above, will have a material adverse effect on its
results of operations and financial position.



7. SEGMENT INFORMATION



The Company is a hearing healthcare company that designs, develops,
manufactures and markets advanced digital hearing aids and proprietary auditory testing equipment. The Company has four operating segments for which separate information is available and evaluated regularly by management in deciding how to allocate
resources and assess performance. The Company evaluates performance based on operating income, among other things.



The Companys four operating segments include hearing aid operations in North America, Europe and Rest-of World and a fourth operating segment that sells and leases
auditory testing equipment. Inter-segment sales are eliminated in consolidation. This information is used by the chief operating decision maker to assess the segments performance and in allocating the Companys
resources. The Company does not allocate hearing aid research and development expenses to its hearing aid business operations. During the three-month period ended September 30, 2005, the Company determined that the auditory testing
equipment operation constituted a separate segment under SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information and has restated the corresponding items of segment information for prior periods to conform
to the current period presentation.



|                                                   |  |               |        |                          |        |   |               |  |   |        |  |   |         |   |  |   |        |   |  |   |         |  
|-------------------------------------------------- |  | ------------- | ------ | ------------------------ | ------ | - | ------------- |  | - | ------ |  | - | ------- | - |  | - | ------ | - |  | - | ------- | -
|                                                   |  | Hearing Aids  |        | AuditoryTestingEquipment |        |   | Unallocated   |  |   | Total  | 
|                                                   |  | North America |        |                          | Europe |   | Rest-of-world |  |   |       
|Three months ended September 30, 2005              |  |               |        |                          |        |   |               |  |   |        |  |   |         |   |  |   |        |   |  |   |         |  
|Net sales to external customers                    |  | $             | 9,337  |                          |        | $ | 9,194         |  | $ | 4,763  |  | $ | 1,059   |   |  | $ |       |   |  | $ | 24,353  |  
|Asset impairment and restructuring charges         |  |               |       |                          |        |   | 208           |  |   |       |  |   | 6,733   |   |  |   |       |   |  |   | 6,941   |  
|Operating profit (loss)                            |  |               | 757    |                          |        |   | 381           |  |   | 297    |  |   | (8,015  | ) |  |   | (1,972 | ) |  |   | (8,552  | )
|Three months ended September 30, 2004              |  |               |        |                          |        |   |               |  |   |        |  |   |         |   |  |   |        |   |  |   |         |  
|Net sales to external customers                    |  |               | 8,408  |                          |        |   | 9,974         |  |   | 4,074  |  |   |        |   |  |   |       |   |  |   | 22,456  |  
|Asset impairment and restructuring charges charges |  |               |       |                          |        |   |              |  |   |       |  |   |        |   |  |   |       |   |  |   |        |  
|Operating profit (loss)                            |  |               | 692    |                          |        |   | 947           |  |   | 158    |  |   |        |   |  |   | (2,520 | ) |  |   | (723    | )
|Nine months ended September 30, 2005               |  |               |        |                          |        |   |               |  |   |        |  |   |         |   |  |   |        |   |  |   |         |  
|Net sales to external customers                    |  |               | 28,759 |                          |        |   | 33,398        |  |   | 13,786 |  |   | 4,486   |   |  |   |       |   |  |   | 80,429  |  
|Asset impairment and restructuring charges         |  |               |       |                          |        |   | 208           |  |   |       |  |   | 6,733   |   |  |   |       |   |  |   | 6,941   |  
|Operating profit (loss)                            |  |               | (299   | )                        |        |   | 4,420         |  |   | 722    |  |   | (10,822 | ) |  |   | (5,952 | ) |  |   | (11,931 | )
|Nine months ended September 30, 2004               |  |               |        |                          |        |   |               |  |   |        |  |   |         |   |  |   |        |   |  |   |         |  
|Net sales to external customers                    |  |               | 27,639 |                          |        |   | 33,071        |  |   | 12,390 |  |   |        |   |  |   |       |   |  |   | 73,100  |  
|Asset impairment and restructuring charges         |  |               |       |                          |        |   |              |  |   |       |  |   |        |   |  |   |       |   |  |   |        |  
|Operating profit (loss)                            |  |               | 2,762  |                          |        |   | 5,467         |  |   | 1,214  |  |   |        |   |  |   | (7,420 | ) |  |   | 2,023   |  
|As of September 30, 2005                           |  |               |        |                          |        |   |               |  |   |        |  |   |         |   |  |   |        |   |  |   |         |  
|Identifiable segment assets                        |  |               | 33,642 |                          |        |   | 41,530        |  |   | 15,220 |  |   | 4,201   |   |  |   |       |   |  |   | 94,593  |  
|Goodwill and indefinite-lived intangible assets    |  |               | 2,228  |                          |        |   | 21,651        |  |   | 7,471  |  |   |        |   |  |   |       |   |  |   | 31,350  |  
|Long-lived assets                                  |  |               | 7,217  |                          |        |   | 24,836        |  |   | 10,440 |  |   | 2,475   |   |  |   |       |   |  |   | 44,968  |  
|As of December 31, 2004                            |  |               |        |                          |        |   |               |  |   |        |  |   |         |   |  |   |        |   |  |   |         |  
|Identifiable segment assets                        |  |               | 46,241 |                          |        |   | 46,243        |  |   | 15,014 |  |   | 7,788   |   |  |   |       |   |  |   | 115,286 |  
|Goodwill and indefinite-lived intangible assets    |  |               | 2,166  |                          |        |   | 22,563        |  |   | 7,646  |  |   | 2,597   |   |  |   |       |   |  |   | 34,972  |  
|Long-lived assets                                  |  |               | 8,607  |                          |        |   | 26,826        |  |   | 10,544 |  |   | 6,409   |   |  |   |       |   |  |   | 52,386  |  



Long-lived assets consist of property
and equipment, definite-lived and indefinite-lived intangible assets, and goodwill. In addition to the U.S., the Company operates in two countries, Germany and Australia, in which assets and net sales were in excess of 10% of consolidated amounts.



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8. RESTRUCTURING



During the third quarter 2005, the Company initiated a restructuring plan in order to improve our profitability and cash flow from operations. During
the third quarter of 2005, we recorded a restructuring charge of $1,186, which includes $1,010 of personnel termination benefits and $176 of operating lease termination costs. The Company expects to incur additional restructuring costs
during the fourth quarter 2005.



Accrued restructuring costs have been
reported as Other accrued liabilities in the accompanying condensed consolidated balance sheets.



The following table represents restructuring activity in the third quarter 2005:



|                                      |  |                  |   |                      |   |             |  |   |               |   |  |   |      
|------------------------------------- |  | ---------------- | - | -------------------- | - | ----------- |  | - | ------------- | - |  | - | -----
|                                      |  | BeginningBalance |   | RestructuringAccrual |   | AmountsPaid |  |   | EndingBalance
|Three Months Ended September 30, 2005 |  | $                |  |                      | $ | 1,186       |  | $ | (39           | ) |  | $ | 1,147



|ITEM 2. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Amounts in thousands, except per share data)
|------- | -----------------------------------------------------------------------------------------------------------------------------------



The following discussion contains forward-looking statements that involve risks and
uncertainties. These statements refer to our future results, plans, objectives, expectations and intentions. These forward-looking statements include statements regarding the following: negative attitudes toward hearing aids to decrease in the
future because of improvements in technology and more cosmetically acceptable devices; the Innova platform improving upon our noise reduction and directionality features and enabling a broad product line with more price points; using the primary
care physician to screen for hearing loss; providing more patients for hearing aid retailers; expectations for a net loss in the fourth quarter 2005 due to losses at Tympany; European sales increasing as Innova is introduced in non-English speaking
European markets in the fourth quarter 2005; Australian sales continuing to increase in the future as a result of Innova; selling, general and administrative expense increasing slightly in the fourth quarter 2005 from the third quarter 2005 level;
fourth quarter 2005 research and development expense remaining consistent with the third quarter 2005 level but beginning to increase in 2006; continued short-term losses at Tympany as we adjust the business model and re-evaluate and restructure the
business; other income/expense not being a significant item for the balance of 2005; decreases in cash balances; changes in accounting treatment contemplated by SFAS No. 123R; financial instrument credit risks; and sufficiency of cash to fund
our operations into 2006.



Our actual results could differ materially and
adversely from those anticipated in such forward-looking statements. Factors that could contribute to these differences include, but are not limited to, the risks discussed in the section titled Factors That May Affect Future Performance
included elsewhere in this Quarterly Report on Form 10-Q. Our critical accounting policies are described in our Annual Report on Form 10-K for the year ended December 31, 2004.



OVERVIEW



Sonic Innovations is a hearing healthcare company. We design, develop, manufacture and market advanced digital hearing aids designed to provide the highest levels of
satisfaction for hearing impaired consumers and proprietary auditory testing equipment that automates the four most commonly performed hearing tests. Capitalizing on what we believe is an advanced understanding of human hearing, we have developed
patented digital signal processing technologies and embedded them in our hearing aids. In countries where we have direct (owned) operations, we sell directly to hearing care professionals, and in several of those countries, we also sell hearing aids
directly to hearing impaired consumers. In other parts of the world where we do not have direct operations, we sell principally to distributors. From our inception, we have focused all our efforts and investment on the therapeutic side of hearing
care by developing high-performance digital hearing aids. In December 2004, we acquired Tympany and now offer diagnostic equipment to further help hearing impaired individuals.



Market



The hearing aid market is large at both the wholesale (manufacturing) level (approximately $2 billion) and the retail level ($5 billion). It is estimated that only 24% of
those who could benefit from a hearing aid actually wear one. There are many



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factors that cause this low market penetration rate, such as negative attitudes toward hearing aid benefit, the stigma of wearing hearing aids, and the high
cost of hearing aids. We believe that these negative attitudes will decrease as hearing aid technology continues to improve and more cosmetically acceptable devices enter the market place.



Strategy



Our strategy to gain share in this expanding market is twofold. First, we must develop innovative, technologically superior products. In
March 2005, we launched a new high-end product line, Innova, which we believe is feature rich and further improves on our best-of-class digital signal processing. Second, we must continue to make progress in non-traditional distribution channels and
with alternative distribution strategies. Our new Innova product platform offers state-of-the-art features and, most importantly, improves upon our two strongest features  noise reduction and directionality. Noise reduction allows the hearing
aid to improve listening comfort and speech understanding in noise so that speech sounds are clearer. To our knowledge, we have the only digital noise reduction algorithm that has been clinically proven to improve speech intelligibility with
background noise present. Directionality allows for the hearing aid wearer to better understand speech sounds through the use of directional microphones in the device. Our directional microphone technology helps the hearing aid wearer focus on
sounds originating from the front by de-emphasizing noise sounds originating from all other directions. Innova significantly improves on our directionality capabilities by the inclusion of new directional focus algorithm. In addition, our new
platform technology provides us the opportunity to develop a broad product line of full-featured hearing aids that can allow us to compete effectively at more price points of the hearing aid market.



We are competing in an industry that includes six larger competitors who have significant
marketing and distribution capabilities. This makes it difficult for us to compete using the traditional distribution channel. For this reason, we are interested in non-traditional distribution methods. We believe we are making progress with this
strategy in several countries. In Germany, we sell direct to the consumer and use the ear-nose-throat (ENT) doctor to perform the hearing aid fitting. In Australia and Switzerland, we sell direct to the consumer through retail stores. In
Austria, our largest customer is a chain of electronics stores that also sells hearing aids. In the Netherlands, our largest customer is a chain of optical stores that also sells hearing aids. In the U.S., as a result of our purchase of Tympany in
December 2004, we plan to use the primary care physician (PCP) to screen patients for hearing loss. Tympanys Otogram allows the PCP to test patients for hearing loss with little disruption to the normal office routine. If the
patient has a hearing loss, the PCP can refer the patient to a hearing aid retailer. Retailers typically complain that the most difficult part of running a successful hearing aid retail business is getting enough patients into the office at a
reasonable cost. We hope to solve the retailers chief complaint  lack of patients  with this non-traditional approach.



Financial Results



The net loss of $7,290 in the third quarter 2005 resulted from an asset impairment charge of $5,755 related to the writedown of intangible assets recorded in connection with our acquisition of Tympany, a restructuring
charge of $1,186 related principally to personnel reductions at Tympany, and a loss of $1,282 prior to asset impairment and restructuring charges in the Tympany operation. We expect that we will have a net loss in the fourth quarter 2005 due to
ongoing losses at Tympany.



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RESULTS OF OPERATIONS



The following table sets forth selected statement of operations information for the periods indicated expressed as a percentage of net sales.



|                                            |  |                                     |    |  |                                    |    |  |       |    |  |       |  
|------------------------------------------- |  | ----------------------------------- | -- |  | ---------------------------------- | -- |  | ----- | -- |  | ----- | -
|                                            |  | For three months endedSeptember 30, |    |  | For nine months endedSeptember 30, |   
|                                            |  | 2005                                |    |  | 2004                               |    |  | 2005  |    |  | 2004  |  
|Net sales                                   |  | 100.0                               | %  |  | 100.0                              | %  |  | 100.0 | %  |  | 100.0 | %
|Asset impairment charge                     |  | 2.8                                 |    |  |                                   |    |  | 0.9   |    |  |      |  
|Cost of sales                               |  | 45.3                                |    |  | 46.6                               |    |  | 45.4  |    |  | 44.9  |  
|                                            |  |                                     |    |  |                                    |    |  |       |    |  |       |  
|Gross profit                                |  | 51.9                                |    |  | 53.4                               |    |  | 53.7  |    |  | 55.1  |  
|Selling, general and administrative expense |  | 52.3                                |    |  | 45.4                               |    |  | 52.5  |    |  | 42.1  |  
|Research and development expense            |  | 9.0                                 |    |  | 11.2                               |    |  | 8.3   |    |  | 10.2  |  
|Asset impairment and restructuring charges  |  | 25.7                                |    |  |                                   |    |  | 7.7   |    |  |      |  
|                                            |  |                                     |    |  |                                    |    |  |       |    |  |       |  
|Operating profit (loss)                     |  | (35.1                               | )  |  | (3.2                               | )  |  | (14.8 | )  |  | 2.8   |  
|Other income (expense), net                 |  | 0.4                                 |    |  | 0.0                                |    |  | 0.2   |    |  | (0.1  | )
|                                            |  |                                     |    |  |                                    |    |  |       |    |  |       |  
|Income (loss) before income taxes           |  | (34.7                               | )  |  | (3.2                               | )  |  | (14.6 | )  |  | 2.7   |  
|Provision (benefit) for income taxes        |  | (4.8                                | )  |  | (0.3                               | )  |  | (1.5  | )  |  | 0.6   |  
|                                            |  |                                     |    |  |                                    |    |  |       |    |  |       |  
|Net income (loss)                           |  | (29.9                               | )% |  | (2.9                               | )% |  | (13.1 | )% |  | 2.1   | %
|                                            |  |                                     |    |  |                                    |    |  |       |    |  |       |  



Net Sales.Net sales consist of
product sales less a provision for sales returns, which is made at the time of the related sale. Net sales by reportable segment were as follows:



|                           |  |                                 |        |      |                                |        |  |     |      |  |      |        |        |   |        |  |     |  
|-------------------------- |  | ------------------------------- | ------ | ---- | ------------------------------ | ------ |  | --- | ---- |  | ---- | ------ | ------ | - | ------ |  | --- | -
|                           |  | Three months endedSeptember 30, |        |      | Nine months endedSeptember 30, |       
|                           |  | 2005                            |        | 2004 |                                | Change |  |     | 2005 |  | 2004 |        | Change |  
|Hearing aids:              |  |                                 |        |      |                                |        |  |     |      |  |      |        |        |   |        |  |     |  
|North America              |  | $                               | 9,337  |      | $                              | 8,408  |  | 11  | %    |  | $    | 28,759 |        | $ | 27,639 |  | 4   | %
|Europe                     |  |                                 | 9,194  |      |                                | 9,974  |  | (8  | )    |  |      | 33,398 |        |   | 33,071 |  | 1   |  
|Rest-of-world              |  |                                 | 4,763  |      |                                | 4,074  |  | 17  |      |  |      | 13,786 |        |   | 12,390 |  | 11  |  
|Auditory testing equipment |  |                                 | 1,059  |      |                                |       |  | N/A |      |  |      | 4,486  |        |   |       |  | N/A |  
|                           |  |                                 |        |      |                                |        |  |     |      |  |      |        |        |   |        |  |     |  
|Total                      |  | $                               | 24,353 |      | $                              | 22,456 |  | 8   | %    |  | $    | 80,429 |        | $ | 73,100 |  | 10  | %
|                           |  |                                 |        |      |                                |        |  |     |      |  |      |        |        |   |        |  |     |  



Net sales in the third quarter 2005
were a third quarter record of $24,353, which was up 8% from third quarter 2004 net sales of $22,456, but down considerably from the prior quarters sales level. Net sales for the nine months ended September 30, 2005 were $80,429, an
increase of 10% from the nine months ended September 30, 2004 net sales of $73,100. The increase from last years third quarter and for the nine months ended September 30, 2005 was almost completely the result from introduction of our
next-generation Innova product family in the U.S. market earlier this year and the acquisition of Tympany, Inc. late last year. Innova currently addresses only the high-end portion of the global hearing aid market.



North American sales in the third quarter 2005 of $9,337 were up $929, or 11% from third
quarter 2004 net sales of $8,408. North American sales for the nine months ended September 30, 2005 were $28,759, an increase of 4% from sales for the nine months ended September 30, 2004 of $27,639. These increases were the result of the
introduction of the Companys Innova product family earlier this year. Third quarter U.S. sales increased 6% from last years third quarter level and were slightly above the nine months ended September 30, 2004. Canadian three and
nine months ended September 30, 2005 sales increased 58% and 44%, respectively over last years levels.



European sales in the third quarter 2005 of $9,194 were down $780, or 8%, from third quarter 2004 sales of $9,974. European sales of $33,398 for the nine months ended
September 30, 2005 were up $327, or 1%, from the nine months ended September 30, 2004 sales of $33,071. This was mainly the result of increased sales in England, the Netherlands and an acquisition in Switzerland, offset partially by a
decrease in Denmark sales. In general, the third quarter is weak in Europe as a result of the normal European vacation schedule; and this was compounded by not being able to introduce Innova because non-English language hearing aid programming
software was not yet available. Innova will be introduced in the non-English speaking markets in November 2005, which should result in improved sales levels in Europe in the fourth quarter 2005.



Rest-of-world sales of $4,763 in the third quarter 2005 were up 17% from the third quarter
2004 sales of $4,074. Rest-of-world sales of $13,786 in the nine months ended September 30 2005 were up 11% from the nine months ended September 30



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2004 sales of $12,390. This was mainly due to the introduction of Innova into the Australian market earlier this year. We expect Australian sales to continue
to increase moving forward as we benefit from the introduction of the Innova technology and Innova related marketing initiatives.



Auditory testing equipment sales were $1,059 in the third quarter 2005 and $4,486 for the nine months ended September 30, 2005. We purchased Tympany in December
2004, and it is currently generating significant losses on this level of sales volume.



Consumers have continued to seek out lower-priced digital hearing aids, which in combination with competitive pricing has put pressure on our overall average selling price and gross margin. However, with the introduction of Innova, our
overall average selling price increased in the second and third quarters of 2005 over 2004.



We generally have a 60-day return policy for our hearing aids. Provisions for sales returns were $4,159 and $2,807 in the third quarter 2005 and 2004, respectively and $12,289 and $8,846 for the nine months ended
September 30, 2005 and 2004, respectively. Actual sales returns were $4,187 and $3,110 in the third quarter 2005 and 2004, respectively and $11,244 and $9,822 for the nine months ended September 30, 2005 and 2004, respectively. The
increases were primarily due to the higher sales levels in 2005. In addition, in the second and third quarters of 2005 (i) we had a higher percentage of sales in the U.S. where return rates are considerably higher than outside the U.S. and
(ii) we had a higher percentage of high-priced Innova product sales as a percentage of total sales. Generally, in the hearing aid business, the higher the price of the hearing aid, the greater the rate at which it is returned. We believe that
the hearing aid industry, particularly in the U.S., experiences a high level of product returns due to factors such as statutorily required liberal return policies and product performance that is inconsistent with hearing impaired consumers
expectations.



Gross Profit.Cost of sales primarily consists of
manufacturing costs, royalty expenses, quality costs and costs associated with product remakes and repairs (warranty). Gross profit and gross margin by reportable segment were as follows:



|                           |  |                                  |        |   |                                 |       |   |      |   |        |      |      |   |  |   |        |  |      |   |  |   |        |  |      |  
|-------------------------- |  | -------------------------------- | ------ | - | ------------------------------- | ----- | - | ---- | - | ------ | ---- | ---- | - |  | - | ------ |  | ---- | - |  | - | ------ |  | ---- | -
|                           |  | Three months ended September 30, |        |   | Nine months ended September 30, |      
|                           |  | 2005                             |        |   | 2004                            |       |   | 2005 |   |        | 2004 |     
|Hearing aids:              |  |                                  |        |   |                                 |       |   |      |   |        |      |      |   |  |   |        |  |      |   |  |   |        |  |      |  
|North America              |  | $                                | 5,097  |   |                                 | 54.6  | % |      | $ | 4,654  |      | 55.4 | % |  | $ | 16,070 |  | 55.9 | % |  | $ | 15,827 |  | 57.3 | %
|Europe                     |  |                                  | 4,519  |   |                                 | 49.2  |   |      |   | 4,738  |      | 47.5 |   |  |   | 17,175 |  | 51.4 |   |  |   | 16,281 |  | 49.2 |  
|Rest-of-world              |  |                                  | 3,336  |   |                                 | 70.0  |   |      |   | 2,608  |      | 64.0 |   |  |   | 9,428  |  | 68.4 |   |  |   | 8,144  |  | 65.7 |  
|Auditory testing equipment |  |                                  | (317   | ) |                                 | (30.0 | ) |      |   |       |      |     |   |  |   | 585    |  | 13.0 |   |  |   |       |  |      |  
|                           |  |                                  |        |   |                                 |       |   |      |   |        |      |      |   |  |   |        |  |      |   |  |   |        |  |      |  
|Total                      |  | $                                | 12,635 |   |                                 | 51.9  | % |      | $ | 12,000 |      | 53.4 | % |  | $ | 43,258 |  | 53.7 | % |  | $ | 40,252 |  | 55.1 | %
|                           |  |                                  |        |   |                                 |       |   |      |   |        |      |      |   |  |   |        |  |      |   |  |   |        |  |      |  



Gross profit in the third quarter 2005
of $12,635 established a third quarter record and was up 5% from last years third quarter level of $12,000. Third quarter 2005 gross margin, excluding the asset impairment charge of $694, of 54.7% was up from 53.4% in last years third
quarter, despite lower margin Tympany sales in 2005, mainly because average selling prices improved due to Innova. Gross profit for the nine months ended September 30, 2005 of $43,258 was up 7% from the nine months ended September 30, 2004
level of $40,252. Gross margin, excluding the asset impairment charge, for the nine months ended September 30, 2005 of 54.7% was down slightly from 55.1% for the nine months ended September 30, 2004. Innova, as a premium performing-premium
priced product, has improved our overall selling price. However, an increase in Canadian sales as a percentage of North American sales reduced the North America gross margin in 2005. Rest-of-world gross margin increased due to a higher percentage of
retail business and the introduction of Innova in Australia.



Provisions for
warranty decreased from $1,298 in the third quarter 2004 to $1,147 in the third quarter 2005 and increased from $3,288 for the nine months ended September 30, 2004 to $3,820 for the nine months ended September 30, 2005. Actual warranty
expenditures were $1,145 and $1,063 in the third quarter 2005 and 2004, respectively. Actual warranty expenditures were $3,652 and $3,109 for the nine months ended September 30, 2005 and 2004, respectively. The provisions as compared with
actual warranty expenditures are higher due to increased sales and, specifically, increased sales of higher-end products like Innova, which have longer warranty periods, except that the third quarter 2005 was impacted by geographic mix.



Selling, General and Administrative. Selling, general and administrative expense
primarily consists of wages and benefits for sales and marketing personnel, sales commissions, promotions and advertising, marketing support, distribution and administrative expenses.



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Selling, general and administrative expense in dollars and as a percent of sales by reportable segment was as follows:



|                           |  |                                  |        |  |                                 |   |  |      |        |  |      |   |  |   |        |  |       |   |  |   |        |  |      |  
|-------------------------- |  | -------------------------------- | ------ |  | ------------------------------- | - |  | ---- | ------ |  | ---- | - |  | - | ------ |  | ----- | - |  | - | ------ |  | ---- | -
|                           |  | Three months ended September 30, |        |  | Nine months ended September 30, |  
|                           |  | 2005                             |        |  | 2004                            |   |  | 2005 |        |  | 2004 |  
|Hearing aids:              |  |                                  |        |  |                                 |   |  |      |        |  |      |   |  |   |        |  |       |   |  |   |        |  |      |  
|North America              |  | $                                | 4,340  |  | 46.5                            | % |  | $    | 3,963  |  | 47.1 | % |  | $ | 16,369 |  | 56.9  | % |  | $ | 13,065 |  | 47.3 | %
|Europe                     |  |                                  | 3,930  |  | 42.7                            |   |  |      | 3,790  |  | 38.0 |   |  |   | 12,546 |  | 37.6  |   |  |   | 10,815 |  | 32.7 |  
|Rest-of-world              |  |                                  | 3,039  |  | 63.8                            |   |  |      | 2,450  |  | 60.2 |   |  |   | 8,707  |  | 63.2  |   |  |   | 6,929  |  | 55.9 |  
|Auditory testing equipment |  |                                  | 1,439  |  | 135.8                           |   |  |      |       |  |     |   |  |   | 4,640  |  | 103.4 |   |  |   |       |  |     |  
|                           |  |                                  |        |  |                                 |   |  |      |        |  |      |   |  |   |        |  |       |   |  |   |        |  |      |  
|Total                      |  | $                                | 12,748 |  | 52.3                            | % |  | $    | 10,203 |  | 45.4 | % |  | $ | 42,262 |  | 52.5  | % |  | $ | 30,809 |  | 42.1 | %
|                           |  |                                  |        |  |                                 |   |  |      |        |  |      |   |  |   |        |  |       |   |  |   |        |  |      |  



Selling, general and administrative
expense in the third quarter 2005 of $12,748 was up $2,545, or 25%, from last years third quarter level of $10,203. Selling, general and administrative expense for the nine months ended September 30, 2005 of $42,262 was up $11,453, or
37%, from the nine months ended September 30, 2004 level of $30,809. This was principally a result of our December 2004 acquisition of Tympany, significant training and marketing costs incurred in the North America segment connected with the
introduction of Innova, and increased selling and marketing costs in Australia and Germany. As a percentage of sales, selling, general and administrative expense increased from 45.4% in the third quarter 2004 to 52.3% in the third quarter 2005 and
from 42.1% in the nine months ended September 30, 2004 to 52.5% in the nine months ended September 30, 2005. Excluding Tympany, third quarter 2005 selling, general and administrative expense as a percentage of sales would have been 48.5%
and the nine months ended September 30, 2005 selling, general and administrative expense would have been 49.5%. We expect selling, general and administrative expense to increase slightly in the fourth quarter 2005 from the third quarter 2005
level.



Research and Development. Research and development expense
primarily consists of wages and benefits for research, development, engineering, regulatory and clinical personnel, and also includes consulting, intellectual property, clinical study and engineering support costs. Research and development expense
in the third quarter 2005 of $2,192 decreased by $328, or 13%, from last years third quarter level of $2,520. Research and development expense for the nine months ended September 30, 2005 of $6,680 decreased by $740, or 10%, from the nine
months ended September 30, 2004 level of $7,420. As a percentage of sales, research and development expenses went from 11.2% in the third quarter 2004 to 9.0% in the third quarter 2005 and from 10.2% for the nine months ended September 30,
2004 to 8.3% for the nine months ended September 30, 2005. This decrease occurred despite research and development expenses of $728 associated with Tympany, mainly as a result of the timing of expenses relating to our development of the next
generation integrated circuitry in the Innova product family. We expect fourth quarter 2005 research and development expense to remain consistent with the third quarter 2005 level, but to begin to increase in 2006.



Asset Impairment and Restructuring Charges.In December 2004, we acquired 100% of the
stock of Tympany, the developer of the Otogram, a machine that automates the four most commonly performed tests for diagnosing hearing loss. Due to the lack of progress toward profitability, a changing business model and the termination of the
management team at Tympany in the third quarter 2005, we determined that Tympany assets were impaired and recorded an asset impairment charge of $5,755 related to the write-down of the intangible assets recorded in connection with the acquisition of
Tympany of which $694 is cost of sales and $6,247 is operating expenses. In addition, we recorded $1,186 of restructuring charges primarily related to personnel reductions at Tympany.



We expect that we will continue to generate losses at Tympany in the short-term as we adjust the business and continue to re-evaluate and
restructure the business as appropriate.



Other Income/Expense. Other
income/expense primarily consists of foreign currency gains and losses and interest income and interest expense. Other income was $96 in the third quarter 2005 compared to other expense of $6 in the third quarter 2004. Other income was $184 for the
nine months ended September 30, 2005 compared to other expense of $84 for the nine months ended September 30, 2004. Other income/expense is not expected to be a significant item for us for the balance of 2005.



Provision/Benefit for Income Taxes. We had an income tax benefit in the third quarter
2005 of $1,166 compared to an income tax benefit of $69 in the third quarter 2004. We had an income tax benefit for the nine months ended September 30, 2005 of $1,243 compared to an income tax provision of $387 for the nine months ended
September 30, 2004. The third quarter 2005 income tax benefit included $686 related to the elimination of a tax contingency in a foreign location. The



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provisions/benefits related primarily to pre-tax earnings or losses in certain countries outside the U.S. Income taxes on U.S. profits have been
substantially negated by our net operating loss carry-forward. Our net operating loss carry-forwards total almost $40,000. Our effective tax rate going forward will depend on our mix of profitability between countries and is not easily predictable.



LIQUIDITY AND CAPITAL RESOURCES



Net cash used in operating activities was $10,485 for the nine months ended
September 30, 2005. Negative cash flow resulted from the net loss of $10,504, as positively affected by certain non-cash expenses including depreciation and amortization of $4,173, stock-based compensation of $262, foreign currency losses of
$483 and an asset impairment charge of $5,755. In addition, cash was used to increase (i) accounts receivable by $679 principally as a result of increased sales; (ii) inventory by $3,238 principally as a result of the build of Innova
hearing aids and Tympany Otogram machines; (iii) prepaid expenses and other by $288; and (iv) other assets by $440. Cash was also used to decrease accounts payable and accrued expenses by $6,009. We assumed significant Tympany accounts
payable upon its acquisition in December 2004 and paid them off over the nine months ended September 30, 2005.



Net cash provided by investing activities of $9,464 for the nine months ended September 30, 2005 resulted from net proceeds from the maturity of marketable
securities of $12,656 and the repayments of customer advances of $1,675, partially offset by cash paid related to acquisitions of businesses and intangibles of $2,675 and purchases of property and equipment of $2,192.



Net cash provided by financing activities of $1,592 for the nine months ended
September 30, 2005 resulted from proceeds from the collection of $501 of certain accounts receivable that were deemed uncollectible prior to the acquisition of Sanomed and which are payable to the former owners, proceeds from stock option
exercises and employee stock purchases of $528, and a decrease in restricted cash, cash equivalents and marketable securities of $1,512. These positive cash flow items were partially offset by loan principal payments of $949.



Our cash and marketable securities, including restricted amounts, totaled $18,198 as of
September 30, 2005. We expect our cash balance to decrease in the fourth quarter 2005 as we pay approximately $1,400 to the former owners of Sanomed for amounts collected on accounts receivable that had been deemed uncollectible prior to the
acquisition, more than $500 to the former owners of Tympany relating to an earn-out, and approximately $300 on our loan payable.



In addition, we may use cash to fund acquisitions of complementary businesses and technologies. We believe that our cash and marketable securities balance will be
adequate to meet our operating, working capital and investment requirements into 2006.



RECENT ACCOUNTING PRONOUNCEMENTS



In November 2004, the
Financial Accounting Standards Board (FASB) issued SFAS No. 151, Inventory Costsan amendment of ARB No. 43, Chapter 4, which clarifies that abnormal inventory costs such as costs of idle facilities, excess
freight and handling costs and wasted materials (spoilage) are required to be recognized as current period charges. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005. We are currently evaluating the provisions of
SFAS No. 151 and do not believe the adoption will have a material effect on our results of operations and financial position.



In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment, which requires all share-based payments to employees, including grants of employee
stock options, to be recognized as an expense. The value is recognized over the requisite service period based on fair values measured on grant dates. The new standard may be adopted using either the modified prospective method or the modified
retrospective method. In March 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment, which clarified the SECs expectations with regard
to the assumptions underlying the fair value estimates of options. In April 2005, the SEC amended the compliance dates for SFAS No. 123R such that the new standard will be effective for us beginning January 1, 2006. We are currently
evaluating the effect of these statements and the alternative adoption methods on our results of operations and financial position.



In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, which replaces APB Opinion No. 20, Accounting
Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements, and requires that a voluntary change in accounting principle be applied retrospectively to all prior period financial statements presented,
unless it is impracticable to do so. SFAS No. 154 also provides that a change in method of depreciating or amortizing a long-lived non-financial asset be accounted for as a change in estimate effected by a change in accounting principle, and
also provides that correction of errors in previously issued financial statements should be termed a



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restatement. SFAS No. 154 is effective for fiscal years beginning December 15, 2005. We do not believe the adoption of SFAS
No. 154 will have a material impact on our results of operations and financial position.



FACTORS THAT MAY AFFECT FUTURE PERFORMANCE



Our future results, plans, objectives, expectations and intentions could be negatively affected by any of the following risk factors. Investors should understand that it is not possible to predict or identify all such factors,
and we are under no obligation to update these factors. Investors should not consider the factors listed as a complete statement of all potential risks and uncertainties.



We have a history of losses.



We have a history of losses and a significant accumulated deficit and have yet to become consistently profitable. We may incur net losses in the future. Whether or not we
achieve consistent profitability or increase profitability will depend in significant part on increasing our net sales, maintaining or improving our gross margin and maintaining or limiting increases in our operating expenses. Consequently, it is
possible that we will not achieve consistent profitability or increase profitability on a quarterly or annual basis in the future.



We face aggressive competition in our business, and if we do not compete effectively our net sales and operating results will suffer.



We encounter aggressive competition from a number of competitors worldwide, six of which
have far greater sales and more extensive financial and business resources than we have. We may not choose to, or be able to, match the type or the volume of incentives that our competitors provide to hearing aid retailers, which could put us at a
competitive disadvantage. In addition, some competitors have purchased or established their own network of owned or franchised retail hearing aid operations or are adding to those networks, all of which could cause us to lose existing customers and
make it difficult to recruit new customers. If any of our competitors were to merge with one another, it could make it significantly more difficult for us to compete. If we fail to compete effectively, our net sales and operating results will
suffer.



Our financial results may fluctuate significantly, which may cause
our stock price to decline.



Our financial results have fluctuated
significantly in the past and may fluctuate significantly in the future. These fluctuations could cause our stock price to vary significantly or decline. Factors that may cause fluctuations in our operating results include the following: general
economic conditions; hearing aid market conditions; the competitive performance of our products; delays or problems completing or introducing new products; expenses associated with trying innovative distribution methods; expenses associated with
increasing our sales, marketing or distribution capabilities; difficulties in integrating and managing acquired operations that could result in poor performance, additional expenses or write-downs of acquired intangible assets; changes in government
healthcare systems and reductions in reimbursement levels for hearing aids or diagnostic hearing testing; distribution of our products; competitive pressures resulting in lower selling prices or significant promotional costs; difficulties in
relationships with our customers; demand for and market acceptance of our products, particularly new products where eventual market acceptance may not follow early indications; reductions in orders from larger customers; high levels of returns,
remakes and repairs; changes in our product or customer mix; regulatory requirements; difficulties in managing international operations; the effect of future acquisitions, if any; the effect of international conflicts and threats; inability to
forecast revenue accurately; nonpayment of receivables; the announcement or introduction of new products or services by our competitors; manufacturing problems; component availability and pricing; and other business factors beyond our control.



If net sales for a particular period were below our expectations, it is highly
unlikely that we could proportionately reduce our operating expenses for that period. Therefore, any revenue shortfall would have a disproportionately negative effect on our operating results for the period. You should not rely on our results for
any one quarter as an indication of our future performance. In future quarters, our operating results may be below the expectations of public market analysts or investors. If this occurs, our stock price would very likely decrease.



We have made a number of acquisitions and could make additional acquisitions, which could
be difficult to integrate, disrupt our business, dilute the equity of our shareholders and harm our operating results.



We may not be able to meet performance expectations for, or successfully integrate, businesses we have acquired or may acquire on a timely basis or at all. For example,
it is too soon to evaluate whether Tympany, Inc., which was acquired in December 2004 and which is currently generating significant losses, will achieve our expectations and positively affect our overall business. In the third quarter 2005, we
incurred an asset impairment charge of $5,755 related to the write-down of Tympany intangible assets.



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As part of our business strategy, we may continue to make acquisitions that complement or expand our existing business.
Acquisitions involve risks, including (i) the inability to successfully integrate acquired businesses or to realize anticipated synergies, economies of scale or other expected value; (ii) difficulties in managing and coordinating
operations at new sites; (iii) the loss or termination of key employees of acquired businesses; (iv) the loss of key customers of acquired businesses; (v) performance of acquired products; (vi) unanticipated expenses in
connection with refining and improving acquired products; (vii) diversion of managements attention from other business concerns; and (vii) risks of entering businesses and markets in which we have no direct or limited prior
experience. Acquisitions may result in the utilization of cash and marketable securities, dilutive issuances of equity securities and the incurrence of debt, any of which would weaken our financial position. In addition, acquisitions may result in
the creation of (i) certain definite-lived intangible assets that increase amortization expense, (ii) goodwill and other indefinite-lived intangible assets that subsequently may result in large write-offs should these assets become
impaired and (iii) earn-out or other payments that may need to be currently expensed rather than capitalized as additional goodwill.



Our internal control over financial reporting may not be considered effective, resulting in possible regulatory sanctions.



Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we are required to furnish
an annual report on our internal control over financial reporting. This report contains an assessment by our management of the effectiveness of our system of internal control over financial reporting (including the disclosure of any material control
weaknesses) and a statement that our auditors have attested to and reported on managements evaluation of such system of internal control. While we strive to maintain an effective system of internal control, if we or our auditors were unable to
attest to the effectiveness of our system of internal control, we would not be able to comply with the Sarbanes-Oxley Act of 2002, and our business and our stock price could be adversely affected.



The loss of any large customer or a reduction in orders from any large customer could
reduce our net sales and harm our operating results.



We anticipate that
our operating results in any given period will depend in part upon revenues from a number of larger customers. Our customers are not generally contractually obligated to purchase any fixed quantities of products, and they may stop placing orders
with us at any time. We may be unable to retain our larger customers, and we may be unable to recruit replacement or additional customers. We are selling hearing aids to a number of retail chains that have a large number of owned or franchised
locations. We are subject to the risk of losing our larger customers, incurring significant reductions in sales to these customers, reducing future prices in response to demands from these customers or incurring substantial marketing expenses in
order to maintain their business. In addition, we are subject to the risk of being unable to collect receivable balances from these customers.



We rely on several suppliers and contractors, and our business will be seriously harmed if these suppliers and contractors are not able to meet our requirements.



Certain critical components used in our products are currently available
only from a single or limited number of suppliers. For example, each of our proprietary digital signal processing chips is manufactured by a single supplier. These suppliers may not be willing or able to satisfy our requirements. We also rely on a
limited number of contractors for certain hearing aid component assemblies, Otogram assembly and advanced integrated circuitry development and are therefore subject to their performance, over which we have little control. We may lose the services of
these key suppliers or contractors. Finding a substitute part, process, supplier or contractor may be expensive and time-consuming, or may prove impossible in the near-term.



We have high levels of product returns, remakes and repairs, and our net sales and operating results will be lower if these levels
increase.



We generally offer a minimum 60-day return policy and various
warranties on our hearing aids. In general, the hearing aid industry has high levels of returns, remakes and repairs, and our level of returns, remakes and repairs is comparable to that of the industry. We may not be able to attain lower levels of
returns, remakes and repairs and, in fact, these levels may increase, particularly on newly introduced products, which could reduce our net sales and operating results.



If we fail to develop new and innovative products, our competitive position will suffer, and if our new products are not well accepted,
our net sales and operating results will suffer.



In order to be
successful, we must develop new products and be a leader in the commercialization of new technology innovations in the hearing aid market. Technological innovation is expensive and unpredictable and among other things, requires hiring
(i) expert personnel who are difficult to find and attract, or (ii) external contractors to perform complex tasks.



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Without the timely introduction of new products, our existing products are likely to become technologically obsolete over time, which would harm our
business. We may not have the technical capabilities necessary to develop further technologically innovative products. In addition, any enhancements to, or new generations of, our products, even if successfully developed, may not generate
significant revenues. Our products may be rendered obsolete by changing consumer preferences or the introduction of products embodying new technologies or features by us or our competitors. Obsolescence of our products, a breakthrough
new method of addressing hearing loss or the introduction of technologically superior products by new or existing competitors could cause us a rapid loss of sales or market share, which would have a significant adverse effect on our net sales,
operating results and stock price.



Because of the complexity of our
products, there may be undiscovered errors or defects that could harm our business or reputation.



Our products are complex and may contain undetected defects, errors or failures. Our customers may discover errors after new products have been introduced and sold. The occurrence of any defects, errors or failures
could result in the loss of or delay in market acceptance of our new products, which could harm our reputation and business and adversely affect our net sales and operating results.



Third parties have claimed and may claim in the future that we are infringing their intellectual property, and we could suffer
significant expense or be prevented from selling products if these claims are successful.



Third parties have claimed and may claim in the future that we are infringing their intellectual property rights. While we do not believe that any of our products currently infringe the proprietary rights of others,
we may be unaware of intellectual property rights of others that may cover some of our technology. Whether or not we actually infringe a third partys rights, any litigation regarding intellectual property could be costly and time-consuming and
divert our management and key personnel from our business operations. Claims of intellectual property infringement might also require us to make one-time payments or enter into costly royalty or license agreements.



Because our success depends on our proprietary technology, if third parties infringe our
intellectual property, we may be forced to expend significant resources enforcing our rights or suffer competitive injury.



Our success depends in large part on our proprietary technology. We rely on a combination of patents, copyrights, trademarks, trade secrets, confidentiality procedures
and licensing arrangements to establish and protect our proprietary technology. These laws, procedures and provisions provide only limited protection. Additionally, some foreign laws do not protect our proprietary rights to the same extent as U.S.
laws. If we fail to successfully enforce our intellectual property rights, our competitive position will suffer, and litigation to enforce these rights would be expensive and may prove ineffective.



Selling through non-traditional distribution channels or in non-traditional ways could
harm our relationships with existing customers and cause them to purchase fewer of our products, which would reduce our net sales and operating results.



In several countries, we sell hearing aids directly to the hearing impaired consumer, and in some markets we are selling our products through non-traditional distribution
channels, such as high-volume general retail and electronics retail stores and the ear-nose-throat physician. Our current initiatives or any future initiatives directed toward alternate distribution could alienate our traditional hearing aid
dispenser customers. For example, our Hearing Health Network could cause hearing aid dispensers that do not qualify or otherwise choose not to participate in this program to reduce or discontinue their purchases from us. Any loss of traditional
revenue may not be offset by revenue from alternative distribution channels, and we may choose not to continue using any of these alternative channels. Should hearing aid dispensers react unfavorably to such initiatives, they would likely purchase
fewer of our products, which would reduce our net sales and operating results and damage our competitive position.



We are dependent on international operations, which exposes us to a variety of risks that could result in lower sales and operating results.



International sales, particularly in Germany and Australia, account for a material portion
of our net sales. Our reliance on international operations exposes us to related risks and uncertainties, which, if realized, could cause our sales and operating results to decrease. There is significant government or public hearing aid
reimbursement in a number of countries outside the U.S., which if reduced or eliminated would likely have a negative effect on our sales. For example, reimbursement levels are trending downward in Germany, which has negatively affected our sales in
that country. Other changes in the healthcare systems of countries outside the U.S., such as instituting co-payments or co-insurance, would likely have negative effects on our sales. In order to market our products in the European Union (EU), we are
required to have the EUs CE Mark



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certification. Any failure to maintain our CE Mark certification would significantly reduce our net sales and operating results. We work under different
legal regulatory and governmental regimes in various countries, which could delay our ability to sell products or cause us additional expense in determining how to comply, and taking any actions necessary to comply, with local legal, regulatory and
governmental requirements. In addition, we may need to adapt local practices to satisfy requirements applicable in the United States. We face foreign currency risks primarily as a result of the revenues we derive from sales made outside the U.S.,
expenses incurred outside the U.S. and intercompany account balances between our U.S. parent company and our non-U.S. subsidiary companies. Fluctuations in the exchange rates between the U.S. dollar and other currencies could negatively affect the
sales price of our products in international markets or lead to currency exchange losses. In general, our net sales and operating results benefit from a weakening U.S. dollar. If the U.S. dollar were to strengthen materially from current levels, our
net sales and operating results would suffer.



Accounting for stock-based
compensation will negatively affect our results.



New accounting rules
will require us to expense the value of stock options beginning January 1, 2006. This will result in lower reported earnings per share as compared to current accounting practice and may lead us to seek alternative means of providing incentive
compensation, which could be less effective at attracting, retaining and motivating key employees or have other negative consequences.



Complications may result from hearing aid use, and we may incur significant expense if we are sued for product liability.



Although we have not experienced any significant product liability issues to date, we may be
held liable if any product we develop causes injury or is found otherwise unsuitable. If we are sued for an injury caused by our products, the resulting liability could result in significant expense beyond our products liability insurance limits,
which would harm our operating results.



If we fail to comply with food and
drug administration regulations or various sales-related laws, we may suffer fines, injunctions or other penalties.



Our products are subject to regulation in the U.S. by the Food and Drug Administration (FDA) and similar entities in other countries. We must comply with facility
registration and product listing requirements of the FDA and similar entities and adhere to the FDAs Quality System Regulations. Noncompliance with applicable FDA and similar entities requirements can result in fines, injunctions, civil
penalties, recall or seizure of products, total or partial suspension of production or criminal prosecution. We must also maintain compliance with federal, state and foreign laws regarding sales incentives, techniques, referrals and other programs,
some of which are unclear or may be read broadly enough to prohibit standard sales programs such as discounts, free training or frequent buyer awards. While we intend to comply with the law in each of these jurisdictions, if our
practices, or those of a competitor, were to attract unfavorable press or governmental attention, our sales could be adversely affected or we could be subject to fines or governmental injunctions. Any such action would have an adverse effect on our
net sales or operating results.



There may be sales of our stock by our
directors and officers, and these sales could cause our stock price to fall.



Sales of our stock by our directors and officers, or the perception that such sales will occur, could adversely affect the market price of our stock. Some of our officers have adopted trading plans under SEC Rule 10b5-1 in order to dispose
of a portion of their stock in an orderly manner. Other officers or directors may adopt such a trading plan in the future.



Provisions in our charter documents, our shareholders rights plan and Delaware law may deter takeover efforts that shareholders feel would be beneficial to shareholder
value.



Our certificate of incorporation and bylaws, shareholder rights
plan and Delaware law contain provisions that could make it harder for a third party to acquire us without the consent of our board of directors. While we believe these provisions provide for an opportunity to receive a higher bid by requiring
potential acquirers to negotiate with our board of directors, these provisions apply even if the offer may be considered beneficial by some shareholders, and a takeover bid otherwise favored by a majority of our shareholders might be rejected by our
board of directors.



|ITEM 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS (Amounts in thousands)
|------- | ----------------------------------------------------------------------------------



Interest Rate Risk. We generally invest our cash in money market funds and investment grade corporate debt securities, which we
believe are subject to minimal credit and market risk considering that they are relatively short-term (expected maturities of 18 months or less from date of purchase) and provided that we hold them to maturity, which is our intention.



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Derivative Instruments. We enter into readily marketable forward contracts with financial institutions to minimize
the short-term impact of foreign currency fluctuations on certain intercompany balances. We do not enter into these contracts for trading or speculation purposes. Gains and losses on the contracts are included in net income and offset foreign
exchange gains or losses recognized on the revaluation of certain intercompany balances. Our foreign exchange forward contracts generally mature three months from the contract date. On September 29, 2005, we entered into forward contracts for
$1,147 (1,400 Canadian dollars), $3,440 (2,830 Euro), $957 (530 British pounds sterling) and $4,533 (6,000 Australian dollars), all of which expire on December 31, 2005.



Foreign Currency Risk. We face foreign currency risks primarily as a result of the revenues we derive from sales made outside the
U.S., expenses incurred outside the U.S., and from intercompany account balances between our U.S. parent and our non-U.S. subsidiaries. In the third quarter 2005, approximately 62% of our net sales and 50% of our operating expenses were denominated
in currencies other than the U.S. dollar. For the nine months ended September 30, 2005, approximately 63% of our net sales and 46% of our operating expenses were denominated in currencies other than the U.S. dollar. Inventory purchases were
transacted primarily in U.S. dollars. The local currency of each foreign subsidiary is considered the functional currency, and revenue and expenses are translated at average exchange rates for the reported periods. Therefore, our foreign sales and
expenses will be higher in a period in which there is a weakening of the U.S. dollar and will be lower in a period in which there is a strengthening of the U.S. dollar. The Euro and Australian dollar are our most significant foreign currencies.
Given the uncertainty of exchange rate fluctuations and the varying performance of our foreign subsidiaries, we cannot estimate the affect of these fluctuations on our future business, results of operations and financial condition. Fluctuations in
the exchange rates between the U.S. dollar and other currencies could effectively increase or decrease the selling prices of our products in international markets where the prices of our products are denominated in U.S. dollars. We regularly monitor
our foreign currency risks and may take measures to reduce the impact of foreign exchange fluctuations on our operating results. To date, we have not used derivative financial instruments for hedging, trading or speculating on foreign currency
exchange, except to hedge intercompany balances.



For the nine months ended
September 30, 2005 and 2004, average currency exchange rates to convert one U.S. dollar into each local currency for which we had sales greater than 10% of consolidated net sales were as follows:



|                  |  |      |  |     
|----------------- |  | ---- |  | ----
|                  |  | 2005 |  | 2004
|Euro              |  | 0.79 |  | 0.82
|Australian dollar |  | 1.30 |  | 1.37



|ITEM 4. | CONTROLS AND PROCEDURES
|------- | -----------------------



Evaluation of Disclosure Controls and Procedures .Under the supervision and with the participation of our management, including our principal executive officer
and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the
Exchange Act), as of the end of the period covered by this report. Based on this evaluation, our principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, our
disclosure controls and procedures were effective to provide reasonable assurance that information required to be included in our Exchange Act reports is properly recorded, processed, summarized and reported within the time periods specified.



Changes in Internal Controls Over Financial Reporting.During the
period covered by this report, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, such internal controls over financial reporting.



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PART II - OTHER INFORMATION



|ITEM 6. | EXHIBITS
|------- | --------



(a) Exhibits required to be filed by Item 601 of Regulation S-K:



|          |  |                                                                                  
|--------- |  | ---------------------------------------------------------------------------------
|Exhibit # |  | Description                                                                      
|31.1      |  | Rule 13a-14(a) / 15-d-14(a) Certification of Chief Executive Officer             
|          | 
|31.2      |  | Rule 13a-14(a) / 15-d-14(a) Certification of Chief Financial Officer             
|          | 
|32        |  | Section 1350 Certification of Chief Executive Officer and Chief Financial Officer



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SIGNATURE



Pursuant to the requirements 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.



Date: November 9, 2005



/s/ STEPHEN L. WILSONStephen L. WilsonSenior Vice President and Chief FinancialOfficer and Secretary




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