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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, 2003



| ̈ | 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 of incorporation or organization) |  | (I.R.S. Employer Identification 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



As of November 4, 2003 there were
20,080,619 shares of the registrants $.001 par value common stock outstanding.



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##### Table of Contents

SONIC INNOVATIONS, INC.



TABLE OF CONTENTS



|           |  |                                                                                                                 |  | Page
|---------- |  | --------------------------------------------------------------------------------------------------------------- |  | ----
|PART I     |  | FINANCIAL INFORMATION                                                                                           |  |     
|           |  |                                                                                                                
|ITEM 1.    |  | Unaudited Condensed Consolidated Financial Statements:                                                          |  |     
|           |  |                                                                                                                
|           |  | Condensed Consolidated Balance Sheets as of September 30, 2003 and December 31, 2002                            |  | 3   
|           |  |                                                                                                                
|           |  | Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2003 and 2002 |  | 4   
|           |  |                                                                                                                
|           |  | Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2003 and 2002           |  | 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 Risk                                                      |  | 22  
|           |  |                                                                                                                
|ITEM 4.    |  | Controls and Procedures                                                                                         |  | 22  
|           |  |                                                                                                                
|PART II    |  | OTHER INFORMATION                                                                                               |  |     
|           |  |                                                                                                                
|ITEM 1.    |  | Legal Proceedings                                                                                               |  | 23  
|           |  |                                                                                                                
|ITEM 6(a). |  | Exhibits                                                                                                        |  | 23  
|           |  |                                                                                                                
|ITEM 6(b). |  | Reports on Form 8-K                                                                                             |  | 23  
|           | 
|SIGNATURE  |  | 24                                                                                                             



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PART I FINANCIAL INFORMATION



ITEM 1. UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



SONIC INNOVATIONS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)



|                                                      |  | September 30,2003 |         |   | December 31,2002 |  
|----------------------------------------------------- |  | ----------------- | ------- | - | ---------------- | -
|ASSETS                                                |  |                   |         |   |                  |  
|Current assets:                                       |  |                   |         |   |                  |  
|Cash and cash equivalents                             |  | $                 | 18,119  |   |                  | $
|Marketable securities, current portion                |  |                   | 11,341  |   |                  |  
|Accounts receivable, net                              |  |                   | 14,083  |   |                  |  
|Inventories                                           |  |                   | 8,642   |   |                  |  
|Prepaid expenses and other                            |  |                   | 2,139   |   |                  |  
|Receivable from insurance company                     |  |                   | 7,000   |   |                  |  
|                                                      |  |                   |         |   |                  |  
|Total current assets                                  |  |                   | 61,324  |   |                  |  
|Marketable securities, net of current portion         |  |                   | 5,361   |   |                  |  
|Property and equipment, net                           |  |                   | 6,223   |   |                  |  
|Goodwill and other indefinite-lived intangible assets |  |                   | 23,068  |   |                  |  
|Definite-lived intangible assets, net                 |  |                   | 3,809   |   |                  |  
|Other assets                                          |  |                   | 2,245   |   |                  |  
|                                                      |  |                   |         |   |                  |  
|Total assets                                          |  | $                 | 102,030 |   |                  | $
|                                                      |  |                   |         |   |                  |  
|LIABILITIES AND SHAREHOLDERS EQUITY                  |  |                   |         |   |                  |  
|Current liabilities:                                  |  |                   |         |   |                  |  
|Current portion of long-term loan                     |  | $                 | 1,159   |   |                  | $
|Lawsuit settlement                                    |  |                   | 7,000   |   |                  |  
|Accounts payable                                      |  |                   | 8,900   |   |                  |  
|Accrued payroll and related expenses                  |  |                   | 3,017   |   |                  |  
|Accrued warranty                                      |  |                   | 3,626   |   |                  |  
|Deferred revenue, current portion                     |  |                   | 2,396   |   |                  |  
|Accrued income taxes                                  |  |                   | 1,868   |   |                  |  
|Other accrued liabilities                             |  |                   | 1,888   |   |                  |  
|                                                      |  |                   |         |   |                  |  
|Total current liabilities                             |  |                   | 29,854  |   |                  |  
|Long-term loan, net of current portion                |  |                   | 7,536   |   |                  |  
|Deferred revenue, net of current portion              |  |                   | 2,878   |   |                  |  
|Other liabilities                                     |  |                   | 553     |   |                  |  
|                                                      |  |                   |         |   |                  |  
|Total liabilities                                     |  |                   | 40,821  |   |                  |  
|Shareholders equity:                                 |  |                   |         |   |                  |  
|Common stock                                          |  |                   | 21      |   |                  |  
|Additional paid-in capital                            |  |                   | 114,193 |   |                  |  
|Deferred stock-based compensation                     |  |                   | (50     | ) |                  |  
|Accumulated deficit                                   |  |                   | (52,654 | ) |                  |  
|Accumulated other comprehensive income                |  |                   | 3,472   |   |                  |  
|Treasury stock, at cost                               |  |                   | (3,773  | ) |                  |  
|                                                      |  |                   |         |   |                  |  
|Total shareholders equity                            |  |                   | 61,209  |   |                  |  
|                                                      |  |                   |         |   |                  |  
|Total liabilities and shareholders equity            |  | $                 | 102,030 |   |                  | $
|                                                      |  |                   |         |   |                  |  



See accompanying notes
to condensed consolidated financial statements.



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SONIC INNOVATIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)



|                                                            |  | Three months ended September 30, |        | Nine months endedSeptember 30, |     
|----------------------------------------------------------- |  | -------------------------------- | ------ | ------------------------------ | ----
|                                                            |  | 2003                             |        |                                | 2002
|Net sales                                                   |  | $                                | 23,084 |                                |     
|Cost of sales                                               |  |                                  | 10,540 |                                |     
|                                                            |  |                                  |        |                                |     
|Gross profit                                                |  |                                  | 12,544 |                                |     
|Selling, general and administrative expense                 |  |                                  | 9,374  |                                |     
|Research and development expense                            |  |                                  | 2,417  |                                |     
|Stock-based compensation expense                            |  |                                  | 28     |                                |     
|Severance related costs                                     |  |                                  | 1,015  |                                |     
|                                                            |  |                                  |        |                                |     
|Operating profit (loss)                                     |  |                                  | (290   | )                              |     
|Other income, net                                           |  |                                  | 44     |                                |     
|                                                            |  |                                  |        |                                |     
|Income (loss) before income taxes                           |  |                                  | (246   | )                              |     
|Provision for income taxes                                  |  |                                  | 142    |                                |     
|                                                            |  |                                  |        |                                |     
|Net income (loss)                                           |  | $                                | (388   | )                              |     
|                                                            |  |                                  |        |                                |     
|Basic and diluted earnings (loss) per common share          |  | $                                | (.02   | )                              |     
|                                                            |  |                                  |        |                                |     
|Weighted average number of common shares outstanding:       |  |                                  |        |                                |     
|Basic                                                       |  |                                  | 19,929 |                                |     
|                                                            |  |                                  |        |                                |     
|Diluted                                                     |  |                                  | 19,929 |                                |     
|                                                            |  |                                  |        |                                |     
|Stock-based compensation expense allocable to each caption: |  |                                  |        |                                |     
|Cost of sales                                               |  | $                                | 1      |                                |     
|Selling, general and administrative expense                 |  |                                  | 23     |                                |     
|Research and development expense                            |  |                                  | 4      |                                |     
|                                                            |  |                                  |        |                                |     
|Stock-based compensation expense                            |  | $                                | 28     |                                |     
|                                                            |  |                                  |        |                                |     
|Severance related costs allocable to each caption:          |  |                                  |        |                                |     
|Cost of sales                                               |  | $                                | 613    |                                |     
|Selling, general and administrative expense                 |  |                                  | 402    |                                |     
|                                                            |  |                                  |        |                                |     
|                                                            |  | $                                | 1,015  |                                |     
|                                                            |  |                                  |        |                                |     



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 ended September 30, |        
|------------------------------------------------------------------------------------ |  | ------------------------------- | -------
|                                                                                     |  | 2003                            |        
|Cash flows from operating activities:                                                |  |                                 |        
|Net income (loss)                                                                    |  | $                               | (1,070 
|Adjustments to reconcile net income (loss) to net cash used in operating activities: |  |                                 |        
|Depreciation and amortization                                                        |  |                                 | 2,024  
|Stock-based compensation                                                             |  |                                 | 105    
|Foreign currency transaction gain                                                    |  |                                 | (942   
|Changes in assets and liabilities, excluding the affect of acquisitions:             |  |                                 |        
|Accounts receivable, net                                                             |  |                                 | (864   
|Inventories                                                                          |  |                                 | (224   
|Prepaid expenses and other                                                           |  |                                 | (565   
|Other assets                                                                         |  |                                 | 17     
|Accounts payable and accrued expenses                                                |  |                                 | 1,392  
|                                                                                     |  |                                 |        
|Net cash used in operating activities                                                |  |                                 | (127   
|Cash flows from investing activities:                                                |  |                                 |        
|Acquisitions, net of cash acquired                                                   |  |                                 | (8,638 
|Purchases of property and equipment                                                  |  |                                 | (1,649 
|Investments and advances, net                                                        |  |                                 | (179   
|Proceeds from marketable securities, net                                             |  |                                 | 5,539  
|                                                                                     |  |                                 |        
|Net cash (used in) provided by investing activities                                  |  |                                 | (4,927 
|Cash flows from financing activities:                                                |  |                                 |        
|Principal payments on long-term obligations                                          |  |                                 | (102   
|Purchases of common stock for treasury                                               |  |                                 |       
|Proceeds from short-term loan                                                        |  |                                 | 13,000 
|Principal payment on short-tem loan                                                  |  |                                 | (13,000
|Proceeds from long-term loan                                                         |  |                                 | 8,445  
|Proceeds from exercise of stock options and employee stock purchase plan issuances   |  |                                 | 760    
|                                                                                     |  |                                 |        
|Net cash provided by (used in) financing activities                                  |  |                                 | 9,103  
|Effect of exchange rate changes on cash and cash equivalents                         |  |                                 | 380    
|                                                                                     |  |                                 |        
|Net increase (decrease) in cash and cash equivalents                                 |  |                                 | 4,429  
|Cash and cash equivalents, beginning of the period                                   |  |                                 | 13,690 
|                                                                                     |  |                                 |        
|Cash and cash equivalents, end of the period                                         |  | $                               | 18,119 
|                                                                                     |  |                                 |        



See accompanying notes
to condensed consolidated financial statements.



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SONIC INNOVATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share data)

(unaudited)



1. BASIS OF PRESENTATION AND ACCOUNTING
POLICIES



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, 2003 are not necessarily indicative of results that may be expected for the full year
ending December 31, 2003. 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, 2002 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 at the date of the financial statements and the reported amounts
of revenues and expenses during the reporting period. Actual results could differ from those estimates.



Revenue Recognition. Sales are recognized when (i) products are shipped, except for retail sales in Australia and Germany, which are recognized upon acceptance by the hearing impaired consumer, (ii) persuasive
evidence of an arrangement exists, (iii) title and risk of loss have 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 provision for sales returns, which is made at the time of sale. The Company generally has a 60-day return policy and allowances for sales returns are reflected in sales and accounts receivable. Allowances for sales returns were as
follows:



|                            |  | Three months ended September 30, |        |   | Nine months ended September 30, |  
|--------------------------- |  | -------------------------------- | ------ | - | ------------------------------- | -
|                            |  | 2003                             |        |   | 2002                            |  
|Beginning balance           |  | $                                | 3,287  |   |                                 | $
|Provisions and acquisitions |  |                                  | 4,516  |   |                                 |  
|Returns incurred            |  |                                  | (4,475 | ) |                                 |  
|                            |  |                                  |        |   |                                 |  
|Ending balance              |  | $                                | 3,328  |   |                                 | $
|                            |  |                                  |        |   |                                 |  



Revenues related to sales of extended
warranties are deferred and recognized on a straight-line basis over the warranty period.



Warranty.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. The warranty period ranges from one to three years.
The Company analyzes the amount of historical warranty by product family and model when evaluating the adequacy of the reserve. Because of the length of the warranty period, adjustments to the originally recorded provisions may be necessary from
time to time. The following table reflects changes in the Companys reserve for warranty during the three and nine months ended September 30, 2003 and 2002.



|                           |  | Three months ended September 30, |        |   | Nine months ended September 30, |  
|-------------------------- |  | -------------------------------- | ------ | - | ------------------------------- | -
|                           |  | 2003                             |        |   | 2002                            |  
|Beginning balance          |  | $                                | 3,580  |   |                                 | $
|Provision and acquisitions |  |                                  | 1,148  |   |                                 |  
|Warranty incurred          |  |                                  | (1,102 | ) |                                 |  
|                           |  |                                  |        |   |                                 |  
|Ending balance             |  | $                                | 3,626  |   |                                 | $
|                           |  |                                  |        |   |                                 |  



Research and Development.
Research and development costs are expensed when incurred.



Severance
Related Costs. Severance related costs of $1,015 incurred in the three months ended September 30, 2003 related primarily to the rationalization of certain of our manufacturing and distribution operations. The balance remaining unpaid at
September 30, 2003 was $606.



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Derivative Instruments.The Company may enter into forward contracts and options with financial institutions to
help reduce the exposure to fluctuations between certain currencies. Theses contracts create limited earnings volatility because gains and losses associated with exchange rate movements are offset by movements in the underlying hedged items. The
Company does not enter into these contracts for trading or speculation purposes.



A roll forward of the Companys derivative financial instruments for the nine months ended September 30, 2003 was as follows:



|                                               |  | Euro |        | Australian dollar
|---------------------------------------------- |  | ---- | ------ | -----------------
|Contracts in 2003                              |  | $    | 12,951 |                  
|Expired in 2003                                |  |      | 12,951 |                  
|                                               |  |      |        |                  
|Contracts outstanding as of September 30, 2003 |  | $    |       |                  
|                                               |  |      |        |                  



The outstanding Australian dollar
contract was entered into on September 30, 2003.



2. ACQUISITION



In May 2003, the Company acquired 100% of the stock of
Sanomed Handelsgesellschaft mbH (Sanomed), which markets hearing aids directly to German hearing impaired customers through ear, nose and throat (ENT) physicians. Sanomed was founded in 1990 as a limited liability company.
The acquisition was effected through a wholly owned subsidiary of the Company, PALME Verwaltungsgellschaft mbH (subsequently changed to Sonic Innovations, GmbH). The Company accounted for this acquisition under the purchase method of accounting in
accordance with Statement of Financial Accounting Standards (SFAS) No. 141 Business Combinations. The results of operations of Sanomed are included in the consolidated results of the Company from May 1, 2003. The Company
acquired Sanomed to gain a location and meaningful presence in Germany.



The initial consideration paid by the Company was $13,000. The Company incurred an additional $341 of expenses associated with the acquisition. Additional consideration of up to a maximum of $4,600 may be payable over a three-year period
based on sales performance.



The following table sets forth the
Companys preliminary allocation of the purchase consideration to the tangible and intangible assets acquired and liabilities assumed:



|Cash and cash equivalents             |  | $ | 5,669  |  
|------------------------------------- |  | - | ------ | -
|Accounts receivable                   |  |   | 3,388  |  
|Inventories                           |  |   | 914    |  
|Other assets                          |  |   | 812    |  
|Accounts payable and accrued expenses |  |   | (1,579 | )
|Deferred revenue                      |  |   | (3,214 | )
|Income tax and other liabilities      |  |   | (2,565 | )
|Definite-lived intangible assets      |  |   | 2,321  |  
|Goodwill                              |  |   | 7,595  |  
|                                      |  |   |        |  
|Total                                 |  | $ | 13,341 |  
|                                      |  |   |        |  



The Company is in the
process of obtaining an independent appraisal of the fair values of the acquired assets and liabilities. The results of this appraisal may change the Companys preliminary allocation of the purchase consideration.



Included in other assets in the above table is Sonic Innovations, Inc. common
stock of $370 previously purchased by Sanomed. This amount was classified as treasury stock in the consolidated financial statements.



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



|                                                      |  | Three months endedSeptember 30, |        | Nine months endedSeptember 30,
|----------------------------------------------------- |  | ------------------------------- | ------ | ------------------------------
|                                                      |  | 2003                            |        |                               
|Net sales                                             |  | $                               | 23,084 |                               
|Operating profit (loss)                               |  |                                 | (290   | )                             
|Net income (loss)                                     |  |                                 | (388   | )                             
|Basic and diluted earnings (loss) per common share:   |  |                                 |        |                               
|Basic                                                 |  | $                               | (0.02  | )                             
|                                                      |  |                                 |        |                               
|Diluted                                               |  | $                               | (0.02  | )                             
|                                                      |  |                                 |        |                               
|Weighted average number of common shares outstanding: |  |                                 |        |                               
|Basic                                                 |  |                                 | 19,929 |                               
|                                                      |  |                                 |        |                               
|Diluted                                               |  |                                 | 19,929 |                               
|                                                      |  |                                 |        |                               



3. INVENTORIES



Inventories are stated at the lower of cost or market value using the
first-in, first-out (FIFO) method and consisted of the following:



|                |  | September 30,2003 |       | December 31,2002
|--------------- |  | ----------------- | ----- | ----------------
|Raw materials   |  | $                 | 908   |                 
|Components      |  |                   | 2,281 |                 
|Work in process |  |                   | 290   |                 
|Finished goods  |  |                   | 5,163 |                 
|                |  |                   |       |                 
|Total           |  | $                 | 8,642 |                 
|                |  |                   |       |                 



Provision is made to
reduce excess and obsolete inventories to their estimated net realizable value. As of September 30, 2003 and December 31, 2002, reserves for excess and obsolete inventories were $1,845 and $1,111, respectively.



4. INTANGIBLE ASSETS



Intangible assets were as follows:



|                                                |  | September 30, 2003
|----------------------------------------------- |  | ------------------
|                                                |  | OriginalCost      
|Definite-lived intangible assets                |  | $                 
|Goodwill and indefinite-lived intangible assets |  |                   
|                                                |  |                   
|Total intangible assets                         |  | $                 
|                                                |  |                   



|                                                |  | December 31, 2002
|----------------------------------------------- |  | -----------------
|                                                |  | OriginalCost     
|Definite-lived intangible assets                |  | $                
|Goodwill and indefinite-lived intangible assets |  |                  
|                                                |  |                  
|Total intangible assets                         |  | $                
|                                                |  |                  



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In 2003, intangibles and goodwill increased by $10,230 as a result of the Sanomed acquisition described
in Note 2 and milestone payments made in connection with a previous acquisition. During the nine months ended September 30, 2003, the impact of currency translation increased the carrying value of intangibles by $2,064. Amortization expense was $218
and $52 for the three-month periods ended September 30, 2003 and 2002, respectively, and $337 and $155 for the nine-month periods ended September 30, 2003 and 2002, respectively. Annual forecasted amortization expense for the years 2003 through 2007
is as follows:



|                            |  | 2003 |     | 2004 |   | 2005 |  | 2006 |     | 2007
|--------------------------- |  | ---- | --- | ---- | - | ---- |  | ---- | --- | ----
|Annual amortization expense |  | $    | 514 |      | $ | 685  |  | $    | 643 |     



Definite-lived
intangible assets include technology licenses, trade names, distribution agreements, customer lists and non-compete agreements.



5. OTHER ASSETS



Other assets consisted of the following:



|                         |  | September 30,2003 |       | December 31,2002
|------------------------ |  | ----------------- | ----- | ----------------
|Investments and advances |  | $                 | 1,998 |                 
|Other                    |  |                   | 247   |                 
|                         |  |                   |       |                 
|Total                    |  | $                 | 2,245 |                 
|                         |  |                   |       |                 



Investments and
advances consisted of one investment and one advance to two separate business partners and several advances to customers. Advances are secured by the assets of the business, life insurance policies and/or personal guarantees and bear interest at
rates ranging from 5% to 8% with terms from one to five years. Investments and advances are stated at cost, net of valuation allowances of $143 and $110 as of September 30, 2003 and December 31, 2002, respectively.



6. LONG-TERM LOAN



The $13,000 purchase price of the Sanomed acquisition was funded by a short-term loan from a U.S. bank. During the third
quarter, the loan was repaid and partially replaced with a long-term loan of 7,500 ($8,695 as of September 30, 2003) from a German bank. Interest on the loan is 1.0% above a EURIBOR rate as defined in the loan agreement. As collateral for the
loan, the Company has obtained a standby letter of credit of $9,821 at a cost of 0.6% secured by its cash and marketable securities. The Companys effective interest rate for the period from the inception of the loan through September 30, 2003
was 3.78%. The loan agreement requires that the Company make quarterly principal repayments of a minimum of 250.



7. INCOME TAXES



For the first nine months of 2003, certain of the Companys non-U.S. operations were profitable, resulting in a provision for income taxes of $142
and $607 for the three and nine months ended September 30, 2003, respectively. The Companys provision for income taxes is based on the estimated annualized effective income tax rate for each tax jurisdiction. If changes in conditions cause
actual results to be more or less favorable, adjustments to the effective income tax rate would be required. The Company has not provided for U.S. deferred income taxes or foreign withholding taxes on the undistributed earnings of its non-U.S.
subsidiaries since these earnings are intended to be reinvested indefinitely.



For the three and nine months ended September 30, 2002, no income tax provision or benefit was recorded because operating losses were incurred in most tax jurisdictions and tax loss carryforwards offset tax provisions
in other tax jurisdictions.



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8. COMPREHENSIVE INCOME (LOSS)



Comprehensive income (loss) for the three and nine months ended September 30, 2003 and 2002 consisted of the following:



|                                         |  | Three months endedSeptember 30, |      |   | Nine months ended September 30,
|---------------------------------------- |  | ------------------------------- | ---- | - | -------------------------------
|                                         |  | 2003                            |      |   | 2002                           
|Net income (loss)                        |  | $                               | (388 | ) |                                
|Foreign currency translation gain (loss) |  |                                 | 153  |   |                                
|                                         |  |                                 |      |   |                                
|Comprehensive income (loss)              |  | $                               | (235 | ) |                                
|                                         |  |                                 |      |   |                                



Foreign currency
translation gain/(loss) reflects changes in the exchange rates of foreign currencies relative to the U.S. dollar on the translation of the Companys net investment in its foreign subsidiaries.



9. STOCK-BASED COMPENSATION



The Company accounts for stock options issued to employees, officers and
directors under Accounting Principles Board (APB) Opinion No. 25, which requires compensation cost to be recognized only if an options exercise price is below the fair market value of the Companys common stock at the grant
date.



SFAS No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure, provides alternative methods of transition for a voluntary change to the fair market value based method of accounting for stock-based employee compensation and requires new prominent disclosures
in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company has elected to adopt the disclosure only provisions
of SFAS No. 148.



If compensation expense for all stock
options, including employee stock purchase plan (ESPP) options, had been determined using the fair value based method, the Companys net income (loss) and basic and diluted earnings (loss) per share would have been as follows:



|                                                                        |  | Three months ended September 30, |        |   | Nine months ended September 30, |  
|----------------------------------------------------------------------- |  | -------------------------------- | ------ | - | ------------------------------- | -
|                                                                        |  | 2003                             |        |   | 2002                            |  
|Net income (loss) as reported                                           |  | $                                | (388   | ) |                                 | $
|Stock-based compensation expense included in reported net income (loss) |  |                                  | 28     |   |                                 |  
|Pro forma after-tax impact of options at fair value                     |  |                                  | (756   | ) |                                 |  
|Pro forma after-tax impact of ESPP discount                             |  |                                  | (74    | ) |                                 |  
|                                                                        |  |                                  |        |   |                                 |  
|Pro forma net loss                                                      |  | $                                | (1,190 | ) |                                 | $
|                                                                        |  |                                  |        |   |                                 |  
|Basic and diluted earnings (loss) per share as reported                 |  | $                                | (0.02  | ) |                                 | $
|                                                                        |  |                                  |        |   |                                 |  
|Pro forma basic and diluted loss per share                              |  | $                                | (0.06  | ) |                                 | $
|                                                                        |  |                                  |        |   |                                 |  



The fair value of stock options is
estimated on the date of grant using the Black-Scholes option-pricing model. The following table outlines the assumptions used in the Black-Scholes model:



|                              |  | Three months ended September 30, |   |  | Nine months ended September 30, |  
|----------------------------- |  | -------------------------------- | - |  | ------------------------------- | -
|                              |  | 2003                             |   |  | 2002                            |  
|Stock Options:                |  |                                  |   |  |                                 |  
|Dividend yield                |  | 0.0                              | % |  | 0.0                             | %
|Risk-free interest rate       |  | 3.1                              | % |  | 4.8                             | %
|Expected option life in years |  | 5.0                              |   |  | 5.0                             |  
|Expected volatility           |  | 50.7                             | % |  | 91.2                            | %
|ESPP:                         |  |                                  |   |  |                                 |  
|Dividend yield                |  | 0.0                              | % |  | 0.0                             | %
|Risk-free interest rate       |  | 1.0                              | % |  | 4.6                             | %
|Expected option life in years |  | 0.5                              |   |  | 0.5                             |  
|Expected volatility           |  | 63.1                             | % |  | 88.0                            | %



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10. 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 (loss) per share is calculated based upon the weighted average shares of common stock outstanding, plus the dilutive effect of common stock equivalents outstanding. Dilutive common stock equivalents for the three
months ended September 30, 2002 consisted of 1,313 shares pertaining to 3,258 stock options. Antidilutive common stock equivalents, consisting of stock options of 4,774 and 1,029 for the three months ended September 30, 2003 and 2002, respectively,
were excluded from diluted earnings (loss) per share calculations.



11.
SEGMENT INFORMATION



The table below presents selected
information for the Companys geographic segments. Rest-of-world (ROW) includes export sales from the U.S. to ROW countries.



|                                      |  | NorthAmerica |        |   | Europe |   | ROW    |  | Total |       
|------------------------------------- |  | ------------ | ------ | - | ------ | - | ------ |  | ----- | ------
|Three months ended September 30, 2003 |  |              |        |   |        |   |        |  |       |       
|Net sales to external customers       |  | $            | 10,382 |   |        | $ | 8,902  |  | $     | 3,800 
|Operating profit (loss)               |  |              | (1,358 | ) |        |   | 857    |  |       | 211   
|Three months ended September 30, 2002 |  |              |        |   |        |   |        |  |       |       
|Net sales to external customers       |  |              | 10,415 |   |        |   | 3,952  |  |       | 3,950 
|Operating profit (loss)               |  |              | (681   | ) |        |   | 335    |  |       | 577   
|Nine months ended September 30, 2003  |  |              |        |   |        |   |        |  |       |       
|Net sales to external customers       |  |              | 30,592 |   |        |   | 20,422 |  |       | 10,971
|Operating profit (loss)               |  |              | (3,814 | ) |        |   | 1,199  |  |       | 962   
|Nine months ended September 30, 2002  |  |              |        |   |        |   |        |  |       |       
|Net sales to external customers       |  |              | 29,521 |   |        |   | 10,553 |  |       | 10,698
|Operating profit (loss)               |  |              | (3,140 | ) |        |   | 810    |  |       | 1,459 
|September 30, 2003                    |  |              |        |   |        |   |        |  |       |       
|Identifiable segment assets           |  |              | 55,955 |   |        |   | 34,192 |  |       | 11,883
|Long-lived assets                     |  |              | 9,336  |   |        |   | 17,330 |  |       | 8,679 
|December 31, 2002                     |  |              |        |   |        |   |        |  |       |       
|Identifiable segment assets           |  |              | 50,305 |   |        |   | 14,047 |  |       | 10,394
|Long-lived assets                     |  |              | 8,776  |   |        |   | 6,764  |  |       | 7,143 



12. LEGAL PROCEEDINGS



The Company is a defendant in a lawsuit filed in October
2000 claiming that the Company and certain of its officers and directors violated federal securities laws by providing materially false and misleading information or concealing information about the Companys relationship with Starkey
Laboratories, Inc. The complaint alleges that as a result of false statements or omissions, the Company was able to complete its initial public offering, artificially inflate its financial projections and results and have its stock trade at inflated
levels. The Company continues to deny these allegations. The Company has reached an agreement in principle to settle the securities class action lawsuits that have been consolidated under the caption Lynda Steinbeck et al. v. Sonic Innovations,
Inc., et al., in the United States District Court for the District of Utah. The terms of the settlement call for a cash payment of $7,000, which will be funded by the Companys directors and officers liability insurance. The settlement
should have no impact on the Companys results of operations, liquidity or equity position. Final settlement is contingent on negotiation and execution of a formal settlement stipulation and court approvals of the settlement following
notification to members of the class and an opportunity for class members to object.



13. RECENTLY ENACTED ACCOUNTING STANDARDS



In
June 2002, the Financial Accounting Standards Board (FASB) issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which requires a liability to be recorded for costs associated with an exit or
disposal activity when that liability is incurred and can be measured at fair value. A liability is incurred when an event obligates the entity to transfer or use assets (i.e., when an event leaves the company little or no discretion to avoid
transferring or using the assets in the future). Under previous accounting rules, if a companys management approved an exit plan, the company generally could record the costs of that plan as a liability on the approval date, even if the
company did not incur the costs until a later date. Under SFAS No. 146, some of those costs might qualify for immediate recognition, while others might be recorded during one or more future periods. The Company adopted SFAS No. 146 on January 1,
2003 with no impact on its results of operations and financial position.



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In November 2002, the FASB issued Financial Interpretation No. 45, Guarantors Accounting and
Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others (FIN 45), which expanded previously issued accounting guidance and disclosure requirements for certain guarantees. FIN 45 requires
recognition of an initial liability for the fair value of an obligation assumed by issuing a guarantee. The provision for initial recognition and measurement of the liability will be applied on a prospective basis to guarantees issued or modified
after December 31, 2002. The Company adopted FIN 45 on January 1, 2003 with no impact on its results of operations and financial position.



In November 2002, the Emerging Issues Task Force (EITF) reached a consensus on Issue No. 00-21, Accounting for Revenue Arrangements with
Multiple Deliverables. The EITF concluded that revenue arrangements with multiple elements should be divided into separate units of accounting if the deliverables in the arrangement have value to the customer on a standalone basis, if there is
objective and reliable evidence of the fair value of the undelivered elements, and as long as there are no rights of return or additional performance guarantees by the Company. The provisions of EITF Issue No. 00-21 are applicable to agreements
entered into in fiscal periods beginning after June 15, 2003. The Company adopted the consensus in the third quarter 2003 with no impact on its results of operations and financial condition.



In January 2003, the FASB issued Financial Interpretation No. 46,
Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 (FIN 46), which addresses the consolidation by business enterprises of variable interest entities as defined therein and applies immediately to
variable interests in variable interest entities created or obtained after January 31, 2003. The Company adopted FIN 46 on January 31, 2003 with no impact on its results of operations and financial position.



In April 2003, the FASB issued SFAS No. 149, Amendments of Statement
133 on Derivative Instruments and Hedging Activities. This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain instruments embedded in other contracts and for hedging activities under
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. This statement requires that contracts with comparable characteristics be accounted for similarly. In particular, this statement clarifies under what
circumstances a contract with an initial net investment meets the characteristic of a derivative, clarifies when a derivative contains a financing component, amends the definition of an underlying hedged risk to conform to language used in FIN 45
and amends certain other existing pronouncements. SFAS No. 149, the provisions of which are to be applied prospectively, is effective for contracts entered into or modified after September 30, 2003. The Company adopted SFAS No. 149 on October 1,
2003 with no impact on its results of operations and financial position.



In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This statement establishes standards for how an issuer
classifies and measures in its balance sheet certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that a company classify a financial instrument that is within this statements scope as a
liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the company. Many of those instruments were previously classified as equity. SFAS No. 150 requires a company to classify the following
instruments as liabilities (or assets in some circumstances): mandatorily redeemable financial instruments; obligations to repurchase company equity shares by transferring assets; and certain obligations to issue a variable number of company equity
shares. SFAS No. 150 was effective for all financial instruments entered into or modified after May 31, 2003, and otherwise was effective at the beginning of the first interim period beginning after June 15, 2003. The Company adopted SFAS No. 150 on
July 1, 2003 with no impact on its results of operations and financial position.



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 factors: market transition from analog to digital hearing aids, particularly lower priced digital aids;
growth of low-priced digital hearing aid market segment; anticipation of improvement in European sales in the fourth quarter 2003; anticipation of gross profit improvement due to increased unit sales; anticipation of gross margin improvement due to
absorption benefits of additional volume and cost reduction efforts on several fronts; shift of sales mix toward lower-priced products and the resultant negative impact on overall average selling prices and gross margin; increased selling, general
and administrative expense; quarterly variations in selling and marketing expenses; decreased research and development expense in the fourth quarter 2003 due to timing of payments to a third-party IC contractor and increased research and development
expense thereafter; the Companys goal for research and development expense to be at approximately 10% of net sales; amortization of deferred stock-based compensation; use of cash to fund operations and acquisitions of complimentary businesses
and technologies; and sufficiency of cash to fund our operations. 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 entitled, Factors That May Affect Future Performance elsewhere in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2002. Our critical
accounting policies are described in our Annual Report on Form 10-K for the year ended December 31, 2002.



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OVERVIEW



We design, develop, manufacture and market advanced digital hearing aids designed to provide the highest levels of satisfaction for hearing impaired
customers. Capitalizing on our advanced understanding of human hearing, we have developed patented digital signal processing (DSP) technologies and embedded them in the smallest single-chip DSP platform ever installed in a hearing aid.
In countries where we have a direct presence, we sell finished hearing aids principally to hearing care professionals, except in Australia and Germany where we principally sell hearing aids directly to hearing impaired consumers. In countries where
we do not have a direct presence, we sell finished hearing aids and hearing aid kits principally to distributors.



In reporting our financial condition and results of operations, we report three geographic segments. We generally evaluate our operating results on a
company-wide basis because all of our products are sourced from the United States, and all research and development and considerable marketing and administrative support are provided globally from the United States.



RESULTS OF OPERATIONS



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



|                                            |  | Three monthsended September 30, |    |  | Nine monthsended September 30, |  
|------------------------------------------- |  | ------------------------------- | -- |  | ------------------------------ | -
|                                            |  | 2003                            |    |  | 2002                           |  
|Net sales                                   |  | 100.0                           | %  |  | 100.0                          | %
|Cost of sales                               |  | 45.7                            |    |  | 47.4                           |  
|                                            |  |                                 |    |  |                                |  
|Gross profit                                |  | 54.3                            |    |  | 52.6                           |  
|Selling, general and administrative expense |  | 40.6                            |    |  | 38.9                           |  
|Research and development expense            |  | 10.5                            |    |  | 11.9                           |  
|Stock-based compensation expense            |  | 0.1                             |    |  | 0.5                            |  
|Severance related costs                     |  | 4.4                             |    |  | 0.0                            |  
|                                            |  |                                 |    |  |                                |  
|Operating profit (loss)                     |  | (1.3                            | )  |  | 1.3                            |  
|Other income, net                           |  | 0.2                             |    |  | 0.9                            |  
|                                            |  |                                 |    |  |                                |  
|Income (loss) before income taxes           |  | (1.1                            | )  |  | 2.2                            |  
|Provision for income taxes                  |  | 0.6                             |    |  | 0.0                            |  
|                                            |  |                                 |    |  |                                |  
|Net income (loss)                           |  | (1.7                            | )% |  | 2.2                            | %
|                                            |  |                                 |    |  |                                |  



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 were $23,084 for the quarter ended September 30, 2003, a 26% increase from $18,317 for the quarter ended September 30, 2002.
Net sales for the nine months ended September 30, 2003 were $61,985, a 22% increase from $50,772 recorded for the nine months ended September 30, 2002. The increase was mainly a result of sales from businesses acquired in Germany in May 2003 and the
Netherlands in October 2002 and the favorable effect of foreign currency exchange rates resulting from the weaker U.S. dollar.



By geography, North American sales in the third quarter 2003 of $10,382 were comparable to the third quarter 2002 sales of $10,415. A small decrease in
U.S. sales offset a 28% increase in Canadian sales. For the nine months ended September 30, 2003, North American sales were $30,592 compared to $29,521 for the corresponding period in 2002, an increase of 4%. We believe that the transition from
lower priced analog aids to higher priced digital aids, along with the poor economic climate, have caused consumers to seek out lower priced digital aids. Because we do not sell analog products while our competitors do, we believe customers that are
shifting from analog aids find it easier to migrate to our competitors low priced digital aids.



European sales of $8,902 in the third quarter 2003 were up 125% from third quarter 2002 sales of $3,952 and increased by 94% to $20,422 for the nine
months ended September 30, 2003, up from $10,553 for the corresponding period in 2002, as a result of acquisitions of businesses in Germany in May 2003 and the Netherlands in October 2002 and the favorable effect of foreign currency exchange rates,
offset somewhat by slowing sales in much of the rest of Europe. Our Natura 3 product line is beginning to be more fully introduced in Europe and we expect to see improvement in European sales in the fourth quarter 2003.



Rest-of-world sales of $3,800 decreased 4% from third quarter 2002 sales of
$3,950 and increased by 3% to $10,971 for the nine months ended September 30, 2003, up from $10,698 for the corresponding period in 2002, as continued growth of our Australian business offset the loss of business in Japan and Brazil.



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We generally have a 60-day return policy for our hearing aid products. Sales returns were $4,475 and
$3,996 for the quarters ended September 30, 2003 and 2002, respectively. Sales returns as a percentage of hearing aid sales were 16.2% in the third quarter 2003, down from 17.9% in the third quarter 2002. Sales returns were $12,079 and $11,476 for
the nine months ended September 30, 2003 and 2002, respectively. Sales returns as a percentage of hearing aid sales were 16.0% for the nine months ended September 30, 2003, down from 18.4% for the nine months ended September 30, 2002. The decrease
in sales returns as a percentage of sales was mainly a result of (i) a shift in U.S. sales mix towards lower-priced products (lower-priced hearing aids are generally returned at a lower rate) and (ii) a higher level of non-U.S. sales (a lower return
rate exists outside the U.S.).



Cost of Sales.Cost of
sales consists of manufacturing costs, royalty expenses, quality assurance costs and costs associated with product remakes and repairs. Cost of sales was $10,540 for the quarter ended September 30, 2003, an increase of $1,851 (21%) from cost of
sales of $8,689 for the quarter ended September 30, 2002. Gross margin of 54.3% in the third quarter 2003 established a Company historical record high and was improved from third quarter 2002 gross margin of 52.6% mainly due to better overhead
absorption due to increased unit volume, a favorable foreign currency exchange rate impact and the transition to selling Sonic Innovations products rather than third party products in Germany with the resultant manufacturing profit being added to
consolidated gross profit. In addition, the product mix shift toward our lower-priced products appears to be slowing down. Cost of sales was $28,981 for the nine months ended September 30, 2003, an increase of $4,487 (18%) from cost of sales of
$24,494 for the nine months ended September 30, 2002. Gross margin of 53.2% in the nine months ended September 30, 2003 increased from gross margin of 51.8% in the nine months ended September 30, 2002 primarily due to cost reductions and the impact
of acquisitions. We expect gross margin to improve going forward as we experience the absorption benefits of additional volume and continue with our cost reduction efforts on a number of fronts.



We provide for the cost of remaking and repairing products under warranty at
the time of sale. Warranty periods range from one to three years for hearing aids. Warranty costs were $1,102 and $946 for the quarters ended September 30, 2003 and 2002, respectively and $2,835 and $2,489 for the nine months ended September 30,
2003 and 2002, respectively. The increase in warranty costs was principally due to the increase in sales.



Selling, General and Administrative.Selling, general and administrative expense consists primarily of wages and benefits for personnel, sales
commissions, promotions and advertising, marketing support, conventions and administrative expenses. Selling, general and administrative expense was $9,374, or 41% of net sales, for the quarter ended September 30, 2003, an increase of $2,250 (32%)
from selling, general and administrative expense of $7,124, or 39% of net sales, for the quarter ended September 30, 2002. Selling, general and administrative expense was $26,350, or 43% of net sales, for the nine months ended September 30, 2003, an
increase of $5,865 (29%) from selling, general and administrative expense of $20,485, or 40% of net sales, for the nine months ended September 30, 2002. The increase in selling, general and administrative expense for the three and nine months ended
September 30, 2003 was principally a result of our acquisition activity and the negative effect of foreign currency exchange rates. Excluding acquisitions and the effect of foreign currency exchange rates, selling, general and administrative expense
actually decreased in 2003 from 2002 levels.



We expect
selling, general and administrative expense to increase in dollars, although not necessarily as a percentage of sales. In addition, selling and marketing expenses may vary from quarter to quarter as a result of our new product introductions, the
timing of our advertising campaigns, and convention costs.



Research and Development.Research and development expense consists primarily of wages and benefits for personnel, consulting, software, intellectual property, clinical study and engineering support costs. Research and development
expense was $2,417, or 11% of net sales, for the quarter ended September 30, 2003, an increase of $230 (11%) from research and development expense of $2,187, or 12% of net sales, for the quarter ended September 30, 2002. Research and development
expense was $7,187, or 12% of net sales, for the nine months ended September 30, 2003, an increase of $808 (13%) from research and development expense of $6,379, or 13% of net sales, for the nine months ended September 30, 2002. The increase in
research and development expense for the three and nine months ended September 30, 2003 was principally due to costs associated with the design, development and introduction of the Natura 3 product family and assistance in the design and development
of advanced integrated circuitry by a third-party contractor. We expect research and development expense to decrease in the fourth quarter 2003 due to the timing of payments to the third-party IC contractor. Thereafter, we expect research and
development expenses to increase in dollars, although not necessarily as a percentage of sales. Our goal is for research and development expense to be at approximately 10% of net sales.



Stock-based Compensation.Deferred stock-based compensation represents the difference between the exercise price and
the deemed fair value of our common stock on the grant date for stock options granted in the one-year period preceding the initial filing of our initial public offering and is being amortized over the vesting periods of the individual stock options,
periodically adjusted for employee separations. For the quarters ended September 30, 2003 and 2002, stock-based compensation expense was $28 and $86,



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respectively. For the nine months ended September 30, 2003 and 2002, stock-based compensation expense was $105 and $285, respectively. As of September 30,
2003, deferred stock-based compensation of $50 is expected to be amortized as follows: October 1 to December 31, 2003 - $12; 2004 - $27; and 2005 - $11.



Severance Related Expenses.Severance related expenses of $1,015 in the third quarter 2003 related primarily to the rationalization of certain of
our manufacturing and distribution operations.



Other
Income. Other income in the third quarter 2003 was $44, compared to other income of $172 in the third quarter 2002. The decrease resulted from lower interest income rates on investments and interest expense on a loan procured in connection with
our German acquisition. Other income in the nine months ended September 30, 2003 of $1,190 increased slightly from other income of $1,012 in the nine months ended September 30, 2002 as a result of higher foreign currency exchange gains resulting
from the impact of a weaker U.S. dollar on the intercompany balances between our U.S. parent company and our non-U.S. subsidiaries, offset somewhat by lower interest income due to reduced investment balances and interest rates and interest expense
on our acquisition related loan.



Income Taxes.For the
three and nine months ended September 30, 2003, certain of our non-U.S. operations were profitable, resulting in a provision for income taxes of $142 and $607 for the three and nine months ended September 30, 2003, respectively. We have not provided
for U.S. deferred income taxes or foreign withholding taxes on the undistributed earnings of our non-U.S. subsidiaries since these earnings are intended to be reinvested indefinitely.



Net Income (Loss).Net loss for the three months ended September 30, 2003 was $(388) ($0.02 per share) compared to
net income for the three months ended September 30, 2002 of $403 ($0.02 per share). Net loss for the nine months months ended September 30, 2003 was $(1,070) ($0.05 per share) compared to net income for the nine months ended September 30, 2002 of
$141 ($0.01 per share).



LIQUIDITY AND CAPITAL RESOURCES



Net cash used in operating activities of $127 for the nine months ended
September 30, 2003 resulted from a net loss of $1,070 and changes in assets and liabilities of $244, offset, in part, by net non-cash expenses of $1,187.



Net cash used in investing activities of $4,927 for the nine months ended September 30, 2003 resulted from net cash paid for acquisitions of $8,638,
purchases of property and equipment of $1,649 and net advances to certain customers of $179, offset, in part, by net proceeds from the maturity and sale of marketable securities of $5,539.



Net cash provided by financing activities of $9,101 for the nine months ended
September 30, 2003 resulted from proceeds from a long-term Euro loan of 7,500 ($8,695 at September 30, 2003) and stock option exercises and employee stock purchase plan issuances of $760, offset, in part, by repayment of long-term obligations of
$103.



In May 2003, we signed a definitive purchase agreement
to acquire Sanomed Handelsgesellschaft mbH, a privately held company headquartered in Hamburg, Germany. Sanomed markets various manufacturers hearing aids throughout Germany. The initial purchase price was approximately $13,000, with the
potential for contingent purchase price of approximately $4,600 provided certain sales milestones are achieved over the next three years. The acquisition was funded by a $13,000 short-term loan, which was retired and partially replaced with a
long-term loan of 7,500 ($8,695 as of September 30, 2003). The loan agreement requires quarterly principal repayments of 250.



As of September 30, 2003, we had $34,821 in cash, cash equivalents and marketable securities and $8,695 in debt. We anticipate using cash to fund
operations and make acquisitions of complementary businesses and technologies. While we do not expect net cash flows from operations to be significant in the near term, we do expect to have sufficient cash to fund our operating requirements into the
foreseeable future.



RECENTLY ENACTED ACCOUNTING STANDARDS



In June 2002, the Financial Accounting Standards Board (FASB)
issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which requires a liability to be recorded for costs associated with an exit or disposal activity when that liability is incurred and can be measured
at fair value. A liability is incurred when an event obligates the entity to transfer or use assets (i.e., when an event leaves the company little or no discretion to avoid transferring or using the assets in the future). Under previous



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accounting rules, if a companys management approved an exit plan, the company generally could record the costs of that plan as a liability on the
approval date, even if the company did not incur the costs until a later date. Under SFAS No. 146, some of those costs might qualify for immediate recognition, while others might be recorded during one or more future periods. We adopted SFAS No. 146
on January 1, 2003 with no impact on our results of operations and financial position.



In November 2002, the FASB issued Financial Interpretation No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others (FIN
45), which expanded previously issued accounting guidance and disclosure requirements for certain guarantees. FIN 45 requires recognition of an initial liability for the fair value of an obligation assumed by issuing a guarantee. The provision
for initial recognition and measurement of the liability will be applied on a prospective basis to guarantees issued or modified after December 31, 2002. We adopted FIN 45 on January 1, 2003 with no impact on our results of operations and financial
position.



In November 2002, the Emerging Issues Task Force
(EITF) reached a consensus on Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. The EITF concluded that revenue arrangements with multiple elements should be divided into separate units of
accounting if the deliverables in the arrangement have value to the customer on a standalone basis, if there is objective and reliable evidence of the fair value of the undelivered elements, and as long as there are no rights of return or additional
performance guarantees by the Company. The provisions of EITF Issue No. 00-21 are applicable to agreements entered into in fiscal periods beginning after June 15, 2003. We adopted the consensus in the third quarter 2003 with no impact on our results
of operations and financial condition.



In December 2002, the
FASB issued SFAS No. 148, Accounting for Stock-Based CompensationTransition and Disclosure, which amends SFAS No. 123 Accounting for Stock-Based Compensation, and gives companies electing to expense employee stock
options three methods to do so. In addition, the statement amends the disclosure requirements to require more prominent disclosures about the method of accounting for stock-based employee compensation and the effect of the method used on reported
results in both annual and interim financial statements. We have elected to continue using the intrinsic value method of accounting for stock-based compensation. Therefore, SFAS No. 148 will not have any effect on our results of operations and
financial position. See Note 9 for additional disclosures regarding stock-based compensation.



In January 2003, the FASB issued Financial Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 (FIN 46), which addresses the consolidation by
business enterprises of variable interest entities as defined therein and applies immediately to variable interests in variable interest entities created or obtained after January 31, 2003. We adopted FIN 46 on January 31, 2003 with no impact on our
results of operations and financial position.



In April 2003,
the FASB issued SFAS No. 149, Amendments of Statement 133 on Derivative Instruments and Hedging Activities. This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain instruments
embedded in other contracts and for hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. This statement requires that contracts with comparable characteristics be accounted for similarly.
In particular, this statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, clarifies when a derivative contains a financing component, amends the definition of an underlying
hedged risk to conform to language used in FIN 45 and amends certain other existing pronouncements. SFAS No. 149, the provisions of which are to be applied prospectively, is effective for contracts entered into or modified after September 30, 2003.
We adopted SFAS No. 149 on October 1, 2003 with no impact on our results of operations and financial position.



In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.
This statement establishes standards for how an issuer classifies and measures in its balance sheet certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that a company classify a financial
instrument that is within this statements scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the company. Many of those instruments were previously classified as equity. SFAS
No. 150 requires a company to classify the following instruments as liabilities (or assets in some circumstances): mandatorily redeemable financial instruments; obligations to repurchase company equity shares by transferring assets; and certain
obligations to issue a variable number of company equity shares. SFAS No. 150 was effective for all financial instruments entered into or modified after May 31, 2003, and otherwise was effective at the beginning of the first interim period beginning
after June 15, 2003. We adopted SFAS No. 150 on July 1, 2003 with no 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 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.





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WE HAVE A HISTORY OF LOSSES AND NEGATIVE OPERATING CASH FLOWS



We reported net loss of $0.4 million for the quarter ended September 30,
2003. We have a history of losses and an accumulated deficit of $52.7 million at September 30, 2003. Cash and marketable securities decreased from $35.6 million at December 31, 2002 to $34.8 million at September 30, 2003. We may incur net losses and
negative operating cash flows in the future. Whether or not we achieve and maintain profitability will depend in significant part on increasing our net sales, maintaining or improving our gross margin and reducing, or limiting increases to, our
operating expenses. Consequently, it is possible that we will not achieve or maintain 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. Some of our competitors have invested in or advanced money, offered forgivable loans and provided other monetary incentives
to retail hearing aid operations. Although we have implemented similar programs on a limited basis, we may not choose to, or be able to, match these incentives, which could put us at a competitive disadvantage. In addition, competitors may purchase
or establish their own network of owned or franchised retail hearing aid operations, which could cause us to lose existing customers. 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 quarterly and annual operating results have
fluctuated in the past and may fluctuate significantly in the future. These fluctuations could cause our stock price to fluctuate significantly or decline. Factors that may cause fluctuations in our operating results include the following: general
economic conditions; the competitive performance of our products; government reimbursement levels for hearing aids; distribution or market acceptance of our products, particularly our newer products where eventual market acceptance may not follow
early indications; difficulties in relationships with our customers; demand for and market acceptance of our products; cancellation of or a reduction in orders from larger customers; manufacturing problems; high levels of returns, remakes and
repairs; changes in our product or customer mix; competitive pressures resulting in lower selling prices or significant promotional costs; unanticipated delays or problems in the introduction of new products; regulatory requirements; difficulties in
managing international operations; difficulty in integrating and managing acquired operations that could result in poor performance and write-downs of acquired intangible assets; the effect of future acquisitions, if any; component availability and
pricing; the effect of international conflicts and threats; inability to forecast revenue accurately; nonpayment of accounts and notes receivable; write-offs of intangible assets created as a result of acquisitions; the announcement or introduction
of new products or services by our competitors; and other business factors beyond our control.



If net sales for a particular period were below our expectations, it is 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. To manage and expand businesses that we have acquired, we will be required to (i) improve financial and management information controls and reporting
systems and procedures; (ii) hire, train and manage additional qualified personnel; (iii) expand our direct and indirect sales channels; and (iv) transition acquired businesses to sell more of our branded products. Establishing and maintaining
adequate financial controls is particularly challenging in small companies acquired outside the U.S. where the accounting personnel are less familiar with U.S. accounting standards and where separation of duties is inherently more difficult because
of the smaller staff.



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As part of our business strategy, we may continue to make acquisitions that complement or expand our
existing business. Our acquisition of businesses and expansion of operations 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) loss of key employees of acquired businesses; (iv) loss of key customers of acquired businesses, (v) diversion of managements attention from other business concerns;
and (vi) risks of entering markets in which we have no direct or limited prior experience.



Acquisitions of other businesses may result in the utilization of cash and marketable securities, dilutive issuances of equity securities and the incurrence of debt. In addition, acquisitions may (i) result in the
creation of certain definite-lived intangible assets that increase amortization expense, or (ii) result in the creation of goodwill and other indefinite-lived intangible assets that subsequently may result in large write-offs should these assets
become impaired.



THE LOSS OF ANY LARGE CUSTOMER OR A REDUCTION IN ORDERS
FROM ANY LARGE CUSTOMER COULD SIGNIFICANTLY REDUCE OUR NET SALES AND HARM OUR OPERATING RESULTS



We anticipate that our operating results in any given period will continue to depend in part upon revenues from a small 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 current customers, and we may be unable to recruit replacement or
additional customers. We are selling hearing aids to several audiology clinic consolidators that have a large number of owned or franchised retail hearing aid clinics. We are subject to the risk of losing our larger customers, incurring significant
reductions in sales to these customers or reducing future prices in order to maintain our business. In addition, we are subject to the risk of being unable to collect receivable balances from these customers. We had one hearing aid customer who
accounted for 4% of net sales in the first nine months of 2003 and 7% of net sales in 2002. This customer accounted for 4% of our gross accounts receivable balance at September 30, 2003.



WE ARE A DEFENDANT IN A CLASS ACTION LAWSUIT IN WHICH THE PLAINTIFF IS CLAIMING THAT WE AND CERTAIN OF OUR OFFICERS AND DIRECTORS
VIOLATED FEDERAL SECURITIES LAWS



We are a defendant in a
lawsuit filed in October 2000 claiming that we and certain of our officers and directors violated federal securities laws by providing materially false and misleading information or concealing information about the our relationship with Starkey
Laboratories, Inc. The complaint alleges that as a result of false statements or omissions, we were able to complete our initial public offering, artificially inflate our financial projections and results and have our stock trade at inflated levels.
We continue to deny these allegations. We have reached an agreement in principle to settle the securities class action lawsuits that have been consolidated under the caption Lynda Steinbeck et al. v. Sonic Innovations, Inc., et al., in the
United States District Court for the District of Utah. The terms of the settlement call for a cash payment of $7.0 million, which will be funded by Sonic Innovations directors and officers liability insurance. The settlement should have no
impact on our financial results, liquidity or equity position. Final settlement is contingent on negotiation and execution of a formal settlement stipulation and court approvals of the settlement following notification to members of the class and an
opportunity for class members to object.



WE RELY ON SEVERAL SOLE SOURCE OR
LIMITED SOURCE SUPPLIERS AND CONTRACTORS, AND OUR BUSINESS WILL BE SERIOUSLY HARMED IF THESE SUPPLIERS AND CONTRACTORS ARE NOT ABLE TO MEET OUR REQUIREMENTS AND ALTERNATIVE SOURCES ARE NOT AVAILABLE



Certain components used in our products are currently available only from a
single or limited number of suppliers. For example, our proprietary digital signal processing chips are manufactured by a single supplier. Our relationship with this supplier is critical to our business because only a small number of suppliers would
be able or willing to produce our chips in the relatively small quantities and with the exacting specifications we require. This supplier may not be willing or able to satisfy our future advanced technology requirements. Under our agreement with
this supplier, we are required to make minimum annual purchases, which may be higher than our requirements. The receivers and microphones used in all our products are available from only two suppliers. We also rely on contractors for certain hearing
aid component assembly and advanced integrated circuit design and development and are therefore subject to their performance, over which we have little control. We may be forced to cease producing our products if we experience significant shortages
of critical components from these key suppliers or lose the services of our contractors. Finding a substitute part, process, supplier or contractor may be expensive, time-consuming or impossible.



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WE HAVE HIGH LEVELS OF PRODUCT RETURNS, REMAKES AND REPAIRS, AND OUR NET SALES AND OPERATING RESULTS WILL BE LOWER IF
THESE LEVELS REMAIN HIGH OR INCREASE



We generally offer a
60-day return policy and a minimum of a one-year warranty on our hearing aids. Sales returns were $12.1 million in the first nine months of 2003, $16.3 million in 2002 and $15.7 million in 2001. Warranty costs for remakes and repairs were $2.8
million in the nine months half of 2003, $3.1 million in 2002 and $2.7 million in 2001. We may not be able to attain lower levels of returns, remakes and repairs and, in fact, these levels may increase, 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 DO NOT GAIN MARKET SHARE AS RAPIDLY AS WE ANTICIPATE, OUR 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 may require hiring (i) expert personnel who are difficult to find and attract or (ii) external vendors to perform complex tasks. 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 revenue in excess of the costs of development. 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. If our products do not gain market share as rapidly as we anticipate, our net sales and operating results will suffer.



WE MAY BE UNABLE TO EXPAND OUR MANUFACTURING CAPABILITIES SUFFICIENTLY OR TO FIND THIRD PARTIES TO MANUFACTURE OUR PRODUCTS, WHICH WOULD
LIMIT OUR ABILITY TO DEVELOP AND DELIVER SUFFICIENT QUANTITIES OF PRODUCTS IN A TIMELY MANNER



To be successful, we must manufacture our products in commercial quantities in compliance with regulatory requirements at acceptable costs. We may not be
able to expand our manufacturing capabilities at acceptable costs or enter into agreements with third parties with respect to these activities. We would incur significant expenses if we expanded our facilities and hired additional personnel.



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 infringe the proprietary rights of third parties, 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
patents or other 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 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. Additionally, some foreign laws do not protect our proprietary rights to the same extent as United States laws. If
we fail to successfully enforce our intellectual property rights, our competitive position will suffer.





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SELLING THROUGH NON-TRADITIONAL DISTRIBUTION CHANNELS 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 Germany and Austrialia we sell our products direct to the hearing impaired consumer, and in several other markets we sell our products through
non-traditional hearing aid retail channels. Our current initiatives or any future initiatives could alienate our traditional hearing care professional customers. It is possible that our hearing care professional customers will react by reducing or
discontinuing their purchases from us. In such a scenario, the resulting loss of revenue may not be offset by revenue from new distribution channels, and we may choose not to continue using any of these new channels. Should hearing care
professionals react unfavorably to such a strategy, 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 INTERNATIONAL SALES AND OPERATING RESULTS



We anticipate that international sales will continue to 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
international sales and operating results to decrease. For example, in order to market our products in the European Union (EU), we are required to have the EUs CE Mark certification. Any failure to maintain our CE Mark
certification would significantly reduce our net sales and operating results. In addition, we face foreign currency risks primarily as a result of the revenues we derive from sales made outside the U.S. and from the 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.



WE MAY NOT BE ABLE TO MAINTAIN OR EXPAND OUR
BUSINESS IF WE ARE UNABLE TO HIRE AND RETAIN SUFFICIENT TECHNICAL AND SALES PERSONNEL



Competition for qualified personnel in technology industries can be intense. If we are unable to hire and retain sufficient technical and sales personnel our business and operating results may suffer.



IF OUR STOCK PRICE DOES NOT INCREASE, WE MAY HAVE DIFFICULTY RETAINING KEY EMPLOYEES



Stock options are an important component of the
compensation of our key personnel. If our stock price does not increase in the future, we may face difficulty retaining key employees and may need to exchange existing options for new options or issue new options to motivate and retain our key
employees, which would be dilutive to the equity of our shareholders. In addition, recently announced accounting rules likely will require us to expense the value of options vesting or granted after January 1, 2005. This will result in lower
reported earnings per share as compared to current accounting practice and may lead the Company to seek alternative means of providing incentive compensation, which could be less effective at attracting, retaining and motivating key employees.



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, WE MAY SUFFER FINES, INJUNCTIONS OR OTHER PENALTIES



Our products are considered to be medical devices and are, accordingly,
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
its 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.



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TECHNOLOGY STOCKS HAVE EXPERIENCED EXTREME VOLATILITY, AND OUR STOCK PRICE COULD BE EXTREMELY VOLATILE. CONSEQUENTLY,
YOU MAY NOT BE ABLE TO RESELL YOUR SHARES AT OR ABOVE THE PRICE YOU PAID FOR THEM



The stock market in general, and technology stocks in particular, have experienced extreme volatility that has often been unrelated to the operating performance of particular companies. These broad market fluctuations
may adversely affect the market price of our common stock.



THERE MAY BE
SALES OF A SUBSTANTIAL AMOUNT OF OUR COMMON STOCK BY VENTURE CAPITAL SHAREHOLDERS OR OUR DIRECTORS AND OFFICERS, AND THESE SALES COULD CAUSE OUR STOCK PRICE TO FALL



Sales of substantial amounts of our common stock in the public market, or the perception that such sales will occur, could
adversely affect the market price of our common stock. Approximately 5.0 million of our outstanding shares of common stock continue to be held by venture capital firms that have not yet distributed their shares to their limited partners. In
addition, some of our officers have adopted trading plans under SEC Rule 10b5-1 in order to dispose of a portion of their shares in an orderly manner. Other officers or directors may adopt such a trading plan in the future.



INSIDERS HAVE SIGNIFICANT CONTROL OVER US, WHICH COULD DELAY OR PREVENT A CHANGE IN
CONTROL AND MAY NEGATIVELY AFFECT YOUR INVESTMENT



Our
officers, directors and their affiliated entities together control over 19% of our outstanding common stock. As a result, these shareholders, if they acted together, would be able to exert a significant degree of influence over matters requiring
shareholder approval, including the election of directors and approval of significant corporate transactions. In addition, this concentration of ownership may delay or prevent a change in control, which could cause our stock price to decline.



PROVISIONS IN OUR CHARTER DOCUMENTS, OUR SHAREHOLDERS RIGHTS PLAN AND
DELAWARE LAW MAY DETER TAKEOVER EFFORTS THAT YOU 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.





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ITEM 3. QUANTITATIVE AND QUALITATIVE
DISCLOSURES ABOUT MARKET RISK



Interest Rate Risk.
We generally invest our cash in money market funds and corporate debt securities that are subject to minimal credit and market risk considering that they mature quickly (expected maturities of 18 months or less from date of purchase) and provided
that we hold them to maturity, which is our intention. The interest rates on our customer advances approximate the market rates for comparable instruments and are fixed. We believe the market risks associated with these financial instruments are
minimal.



Foreign Currency Risk. We face foreign
currency risks primarily as a result of the revenues we receive from sales made outside the U.S. and from intercompany account balances between our U.S. parent and our international subsidiaries. In the third quarter 2003, approximately 57% of our
net sales and 42% of our operating expenses (excluding severance related costs) were denominated in currencies other than the U.S. dollar. Inventory purchases are 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 Australian dollar, Euro, Canadian dollar, British pound sterling and Danish krone 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 or 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. We regularly monitor our foreign currency risks and may take measures to reduce the impact of foreign exchange
fluctuations on our operating results.



Average currency
exchange rates to convert one U.S. dollar into each local currency for the three and nine months ended September 30, 2003 and 2002 were as follows:



|                       |  | Three monthsended September 30, |  | Nine monthsended September 30,
|---------------------- |  | ------------------------------- |  | ------------------------------
|                       |  | 2003                            |  | 2002                          
|Australian dollar      |  | 1.52                            |  | 1.83                          
|Euro                   |  | 0.89                            |  | 1.02                          
|Canadian dollar        |  | 1.38                            |  | 1.56                          
|British pound sterling |  | 0.62                            |  | 0.65                          
|Danish krone           |  | 6.60                            |  | 7.55                          



We hedge certain
intercompany balances against future movements in foreign currency exchange rates by using foreign exchange forward contracts. Gains and losses on the contracts are intended to offset foreign exchange gains or losses from the revaluation of
liabilities denominated in currencies other than the functional currency of the reporting entity. Our foreign exchange forward contracts generally mature within 90 days. We do not intend to utilize derivative financial instruments for trading
purposes.



As of September 30, 2003, we had one
outstanding hedge contract covering our Australian intercompany balance for $2,287, which expires on December 31, 2003.



ITEM 4. CONTROLS AND PROCEDURES



Evaluation of disclosure controls and procedures. Our management evaluated, with the participation of our Chief Executive Officer and our Chief
Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have
concluded that our disclosure controls and procedures are effective to ensure that information we are required to provide in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported
appropriately.



Changes in internal control over financial
reporting. There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our
internal control over financial reporting.



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PART II - OTHER INFORMATION



ITEM 1. LEGAL PROCEEDINGS



The
Company is a defendant in a lawsuit filed in October 2000 claiming that the Company and certain of its officers and directors violated federal securities laws by providing materially false and misleading information or concealing information about
the Companys relationship with Starkey Laboratories, Inc. The complaint alleges that as a result of false statements or omissions, the Company was able to complete its initial public offering, artificially inflate its financial projections and
results and have its stock trade at inflated levels. The Company continues to deny these allegations. The Company has reached an agreement in principle to settle the securities class action lawsuits that have been consolidated under the caption
Lynda Steinbeck et al. v. Sonic Innovations, Inc., et al., in the United States District Court for the District of Utah. The terms of the settlement call for a cash payment of seven million dollars, which will be funded by the Companys
directors and officers liability insurance. The settlement should have no impact on Sonic Innovations financial results, liquidity or equity position. Final settlement is contingent on negotiation and execution of a formal settlement
stipulation and court approvals of the settlement following notification to members of the class and an opportunity for class members to object.



ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K



(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
|32.1      |  | Section 1350 Certification of Chief Executive Officer               
|32.2      |  | Section 1350 Certification of Chief Financial Officer               



(b) Reports on Form 8-K.



On
July 30, 2003, the registrant furnished a Current Report on Form 8-K (items 7 and 12) to report current earnings for its second quarter and six months ended June 30, 2003.



On August 5, 2003, the registrant furnished a Current Report on Form 8-K/A (items 2 and 7) to amend the Current Report on
Form 8-K of Sonic Innovations, Inc. dated May 22, 2003 regarding the acquisition of Sanomed Handelsgesellschaft mbH. The sole purpose of the amendment was to provide the audited historical financial statements of the acquired business as required by
Item 7(a) and the unaudited pro forma financial statements required by Item 7(b), which financial statements and information were excluded form the original filing in reliance on Items 7(a)(4) and 7(b)(2), respectively, of Form 8-K.



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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 14, 2003



/s/ STEPHEN L. WILSONStephen L. Wilson Senior Vice President and Chief Financial Officer (Principal Financial Officer)




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