**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 20-F**

 

**(Mark One)**
| **o**      |   | **REGISTRATION STATEMENT  PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                        |
|------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                                                                                                                                                                                                                                       |
|       |   | **OR**                                                                                                                                                                                                                                                                                                                                                                     |
|       |   |                                                                                                                                                                                                                                                                                                                                                                       |
| **ý** |   | **ANNUAL REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                                  |
|       |   |                                                                                                                                                                                                                                                                                                                                                                       |
|       |   | **For the  fiscal year ended December 31, 2002.**                                                                                                                                                                                                                                                                                                                          |
|       |   |                                                                                                                                                                                                                                                                                                                                                                       |
|       |   | **OR**                                                                                                                                                                                                                                                                                                                                                                     |
|       |   |                                                                                                                                                                                                                                                                                                                                                                       |
| **o**      |   | **TRANSITION REPORT PURSUANT  TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (No Fee  Required)**                                                                                                                                                                                                                                                           |
|       |   |                                                                                                                                                                                                                                                                                                                                                                       |
|       |   | **For the transition period  from                           to                           .** |
|       |   |                                                                                                                                                                                                                                                                                                                                                                       |
|       |   | **Commission File  Number:            0-7212**                                                                                                                                                                                                                                                                 |

 

**QSOUND LABS, INC.**

(Exact name of registrant as specified in its charter)

 

**Alberta,Canada**

(Jurisdiction of incorporation or organization)

 

**#400,3115 – 12th Street N.E.Calgary, AlbertaT2E 7J2CANADATel (403) 291-2492****Fax (403) 250-1521**

(Address of principal executive offices)

 

Securities registered or to be registered pursuant to Section 12(b) ofthe Act:

 

**Title of eachclass Name of each exchange on which registered**

 

**None**

 

Securities registered or to be registered pursuant to Section 12(g) ofthe Act:

 

**Common Shares - withoutnominal or par value.**

 

Securities for which there is a reporting obligation pursuant to Section15(d) of the Act:  **None.**

Indicate the number of outstanding shares of each of the issuer’sclasses of capital or common stock as of the close of the period covered by theannual report:

 

**Common Shares at December 31,2001:   7,156,074**

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

Yes  **ý**                   No  o

 

Indicate by check mark which financial statement item the registrant haselect to follow.

 

Item 17  ý             Item18  o

 

 

----

 

TABLE OF CONTENTS

 
| PART I                                                            |                                                             |
|-------------------------------------------------------------------|------------------------------------------------------------------|
|                                                              |                                                             | ITEM 1. IDENTITY OF DIRECTORS,  SENIOR MANAGEMENT AND ADVISORS |
|                                                              |                                                             | A. Directors and  Senior Management |
|                                                              |                                                             | B. Advisors |
|                                                              |                                                             | C. Auditors |
|                                                              | ITEM  2. OFFER STATISTICS AND EXPECTED TIMETABLE                 |
|                                                              |                                                             | A. Offer  Statistics |
|                                                              |                                                             | B. Method and Expected  Timetable |
|                                                              | ITEM  3. KEY INFORMATION                                         |
|                                                              |                                                             | A.  Selected Financial Data |
|                                                              |                                                             | B.  Capitalization and Indebtedness |
|                                                              |                                                             | C.  Reasons For the Offer and Use of Proceeds |
|                                                              |                                                             | D.   Risk Factors |
|                                                              | ITEM 4. INFORMATION  ON THE COMPANY                              |
|                                                              |                                                             | A.  History and Development of the Company |
|                                                              |                                                             | B.  Business Overview |
|                                                              |                                                             | C.  Organizational Structure |
|                                                              |                                                             | D.   Property, Plants and Equipment |
|                                                              | ITEM  5.  OPERATING AND FINANCIAL REVIEW AND  PROSPECTS     |
|                                                              | ITEM  5.  OPERATING AND FINANCIAL REVIEW AND  PROSPECTS     |
|                                                              |                                                             | A.   Results of Operations |
|                                                              |                                                             | B.   Liquidity and Capital Resources |
|                                                              |                                                             | C.   Research and Development |
|                                                              |                                                             | D.   Trends |
|                                                              | ITEM 6.   DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES        |
|                                                              |                                                             | A.   Directors and Senior Management |
|                                                              |                                                             | B.  Compensation |
| Options Grants During the Most Recently Completed  Financial Year |
|                                                              |                                                             | C.  Board  Practices |
|                                                              |                                                             | D. Employees |
|                                                              |                                                             | E.  Share  Ownership |
|                                                              | ITEM 7.   MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS |
|                                                              |                                                             | A.   Major Shareholders |
|                                                              |                                                             | B.   Related Party Transactions |
|                                                              |                                                             | C.   Interests of Experts and Counsel |
|                                                              | ITEM 8. FINANCIAL INFORMATION                                    |
|                                                              |                                                             | A.  Consolidated Statements and Other  Financial Information |
|                                                              |                                                             | B.  Significant Changes |
|                                                              | ITEM 9.   THE OFFER AND LISTING                             |
|                                                              |                                                             | A. Offer and Listing Details |
|                                                              |                                                             | B.  Plan  of Distribution |
|                                                              |                                                             | C.   Markets |
|                                                              |                                                             | D.   Selling Shareholders |
|                                                              | ITEM 10.   ADDITIONAL INFORMATION                           |
|                                                              |                                                             | A.   Share Capital |
|                                                              |                                                             | B.   Memorandum and Articles of Association |
|                                                              |                                                             | C.   Material Contracts |
|                                                              |                                                             | D.   Exchange Controls |
|                                                              |                                                             | E.   Taxation |
|                                                              |                                                             | F.   Dividends and Paying Agents |
|                                                              |                                                             | G.   Statements by Experts |
|                                                              |                                                             | H.   Documents on display |
|                                                              |                                                             | I.   Subsidiary Information |
|                                                                   |                                                                  |  |  |  |

 

2

----

 
|                               | ITEM 11.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
|------------------------------------|----------------------------------------------------------------------------|
|                               | ITEM 12. DESCRIPTION OF SECURITIES OTHER THAN  EQUITY SECURITIES           |
| PART II                            |
|                               | ITEM 13. DEFAULTS, DIVIDEND ARREARAGES AND  DELINQUENCIES                  |
|                               | ITEM 14. MATERIAL MODIFICATIONS TO THE RIGHTS  OF SECURITY HOLDERS         |
|                               | ITEM 15. CONTROLS AND PROCEDURES                                           |
|                               | ITEM 16. [RESERVED]                                                        |
| PART III                           |
|                               | ITEM 17. FINANCIAL STATEMENTS                                              |
|                               | ITEM 18. FINANCIAL STATEMENTS                                              |
|                               | ITEM 19. EXHIBITS                                                          |
| SIGNATURE                          |
| CERTIFICATION                      |
| Consolidated  Financial Statements |

 

3

----

 

**Note:  All referencesto dollar amounts in this annual report are stated in United States Dollarsunless otherwise stated.  On July 9,2001 our shareholders approved a one-for-four share consolidation. Unlessotherwise indicated, all share and option figures in this annual report havebeen adjusted retroactively to reflect the share consolidation.**

 

The terms “QSound”, “ourcompany”, “the company”, “we”, “us” and “our” as used in this annual report onForm 20-F (this “annual report”) refer to QSound Labs, Inc. and itssubsidiaries, including QSound Ltd., QCommerce Inc. and QTelNet Inc., as acombined entity, except where the context requires otherwise.

 

**CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS**

 

This annual reportcontains forward-looking statements reflecting management’s current expectations.These statements relate to our future plans, objectives, expectations andintentions. We use words such as “may”, “expect,” “anticipate,” “project,”“believe,” “plan,” “intend,” “future,” and other similar expressions toidentify forward-looking statements. These forward-looking statements involve inherent risks anduncertainties that may cause actual results to differ materially from thoseanticipated in the forward-looking statements. Factors that could contribute todifferences include, but are not limited to, those discussed in Item 3.D,entitled “Risk Factors”, and elsewhere in this annual report. The informationcontained in this annual report is accurate only as of the date of this annualreport and we assume no obligation to update the forward looking information toreflect actual results or changes in the factors affecting the forward-lookinginformation.

 

 

# **PART I**

 

### **ITEM 1.**IDENTITY OF DIRECTORS, SENIOR MANAGEMENTAND ADVISORS 

 

### **A. Directors andSenior Management**

 

Not Applicable.

 

### **B. Advisors**

 

Not Applicable.

 

### **C. Auditors**

 

Not Applicable.

 

## **ITEM 2. OFFER STATISTICS AND EXPECTED TIMETABLE**

 

### **A. OfferStatistics**

 

Not Applicable.

 

### **B. Method andExpected Timetable**

 

Not Applicable.

 

## **ITEM 3.KEY INFORMATION**

 

### **A.  Selected Financial Data**

 

The following table setsforth certain selected consolidated financial information with respect toQSound for the periods indicated.  Itshould be read in conjunction with Item 5. “Operating and Financial Reviewand Prospects” and our Consolidated Financial Statements.

 

4

----

 

The selected datapresented below for, and as of the end of, each of the years in the five-yearperiod ended December 31, 2002, are derived from the consolidated financialstatements of QSound and its subsidiaries, which financial statements have beenaudited by KPMG LLP, independent auditors. The consolidated financial statements as of December 31, 2002 and 2001,and for each of the years in the three-year period ended December 31, 2002, andthe report thereon, are included elsewhere in this report.  These financial statements have beenprepared in accordance with generally accepted accounting principles in Canadawhich, except as indicated in Note 15. to the Consolidated FinancialStatements, are also, in all material respects, in accordance with generallyaccepted accounting principles in the United States.  The financial statements have been audited in accordance withboth Canadian and United States Generally Accepted Auditing Standards.

 

The selected financialdata presented below has been prepared in accordance with generally acceptedaccounting principles in the United States.

 

Selected Financial DataYears ended December 31, 2002, 2001, 2000, 1999, and 1998(Under United States GAAP in United States Dollars)

 
|                                                       |   | **2002**    |        | **2001**    |   | **2000**    |   | **1999**    |        | **1998**    |   |
|------------------------------------------------------------|--------|-------------|-------------|-------------|--------|-------------|--------|-------------|-------------|-------------|--------|
| **Revenue:**                                               |   |        |        |        |   |        |   |        |        |        |   |
| Royalties, license fees and product sales                  |   | $           | 4,224,311   |        | $      | 3,025,994   |   | $           | 4,469,002   |        | $      | 3,625,623 |   | $ | 2,125,372 |   |
| Cost of product sales                                      |   | (271,530    | )           | (91,438     | )      | (208,298    | )      | (359,613    | )           | (283,352    | )      |
|                                                       |   | 3,952,781   |        | 2,934,556   |   | 4,260,704   |   | 3,266,010   |        | 1,842,020   |   |
| **Expenses:**                                              |   |        |        |        |   |        |   |        |        |        |   |
| Marketing                                                  |   | 895,820     |        | 1,074,139   |   | 1,360,698   |   | 1,630,674   |        | 1,301,990   |   |
| Operations                                                 |   | 235,201     |        | 275,077     |   | 375,000     |   | —      |        | —      |   |
| Product research and development                           |   | 643,524     |        | 951,017     |   | 1,610,436   |   | 1,444,389   |        | 1,292,313   |   |
| Administration                                             |   | 506,028     |        | 597,685     |   | 802,582     |   | 557,402     |        | 454,482     |   |
|                                                       |   | 2,280,573   |        | 2,897,918   |   | 4,148,716   |   | 3,632,465   |        | 3,048,785   |   |
|                                                       |   |        |        |        |   |        |   |        |        |        |   |
| Operating  profit (loss)                                   |   | 1,672,208   |        | 36,638      |   | 111,988     |   | (366,455    | )           | (1,206,765  | )      |
|                                                       |   |        |        |        |   |        |   |        |        |        |   |
| Depreciation  and amortization                             |   | (382,662    | )           | (831,193    | )      | (1,135,054  | )      | (543,728    | )           | (262,815    | )      |
| Impairment  of assets                                      |   | (100,000    | )           | —      |   | (5,163,504  | )      | —      |        | —      |   |
| Funding  past service pension costs                        |   | (55,189     | )           | —      |   | —      |   | —      |        | —      |   |
| Write-down  of investments                                 |   | —      |        | (8,300      | )      | (1,515,568  | )      | —      |        | —      |   |
| Write-off  of acquired in-process research and development |   | —      |        | —      |   | —      |   | (1,489,460  | )           | —      |   |
| Interest  and other income                                 |   | 29,833      |        | 73,568      |   | 154,787     |   | 73,116      |        | 93,664      |   |
| Gain  (loss) on sale of capital assets                     |   | 740         |        | 6,492       |   | (34,634     | )      | 23,714      |        | 150,889     |   |
| Gain  on sale of investments                               |   | —      |        | 24,327      |   | —      |   | —      |        | —      |   |
| Estimated  fair value of options                           |   | —      |        | —      |   | —      |   | (9,629      | )           | —      |   |
| Other                                                      |   | (35,978     | )           | (34,442     | )      | (225,048    | )      | —      |        | —      |   |
| Interest  on long-term debt                                |   | —      |        | —      |   | —      |   | —      |        | (12,382     | )      |
|                                                       |   | (543,256    | )           | (769,548    | )      | (7,919,020  | )      | (1,945,987  | )           | (30,644     | )      |
|                                                       |   |        |        |        |   |        |   |        |        |        |   |
| Net  income (loss) for the year                            |   | 1,128,952   |        | (732,910    | )      | (7,807,032  | )      | (2,312,442  | )           | (1,237,409  | )      |
| Deficit,  beginning of year                                |   | (39,401,001 | )           | (38,668,091 | )      | (30,861,059 | )      | (28,548,617 | )           | (27,215,963 | )      |
| Repurchase  of common shares                               |   | —      |        | —      |   | —      |   | —      |        | (95,245     | )      |
|                                                       |   |        |        |        |   |        |   |        |        |        |   |
| Deficit,  end of year                                      |   | $           | (38,272,049 | )           | $      | (39,401,001 | )      | $           | (38,668,091 | )           | $      | (30,861,059 | ) | $ | (28,548,617 | ) |
|                                                       |   |        |        |        |   |        |   |        |        |        |   |
| Comprehensive  income (loss)                               |   | $           | 1,128,952   |        | $      | (580,976    | )      | $           | (7,588,075  | )           | $      | (2,683,342 | ) | $ | (1,237,409 | ) |
|                                                       |   |        |        |        |   |        |   |        |        |        |   |
| Income  (loss) per common share, basic                     |   | $           | 0.16        |        | $      | (0.10       | )      | $           | (1.10       | )           | $      | (0.19 | ) | $ | (0.21 | ) |
| Income  (loss) per common share, diluted                   |   | $           | 0.15        |        | $      | (0.10       | )      | $           | (1.10       | )           | $      | (0.19 | ) | $ | (0.21 | ) |
|                                                       |   |        |        |        |   |        |   |        |        |        |   |
| Total  assets                                              |   | $           | 7,271,766   |        | $      | 5,966,007   |   | $           | 7,576,884   |        | $      | 10,101,243 |   | $ | 4,799,937 |   |
|                                                       |   |        |        |        |   |        |   |        |        |        |   |
| Net  assets                                                |   | $           | 6,930,361   |        | $      | 5,652,999   |   | $           | 6,664,766   |        | $      | 8,605,562 |   | $ | 4,583,445 |   |
|                                                       |   |        |        |        |   |        |   |        |        |        |   |
| Share  capital – preferred shares                     |   | $           | —      |        | $      | —      |   | $           | —      |        | $      | — |   | $ | — |   |
| Share  capital – common shares                        |   | $           | 44,088,094  |        | $      | 43,939,684  |   | $           | 45,479,152  |        | $      | 39,837,521 |   | $ | 33,141,690 |   |
| Contributed  surplus                                       |   | $           | 1,114,316   |        | $      | 1,114,316   |   | $           | 5,648       |        | $      | — |   | $ | — |   |
| Share  capital – common shares issued and outstanding |   | 7,156,074   |        | 7,085,574   |   | 7,383,014   |   | 6,666,925   |        | 6,004,497   |   |

 

5

----

 

The high and low exchangerates, the average rates (average of the exchange rates on the last day of eachmonth during the year) and the end of the period rates for Canadian dollars,expressed in U.S. dollars, from January 1, 1998 to April 24, 2003 based on theclosing rates of the Bank of Canada were as follows:

 

At April 24, 2003 theexchange rate was U.S. $0.6871 per CDN. $1.00

 
|           |   | **Month  End** |   | **High** |       | **Low** |       |        |       |
|----------------|--------|----------------|--------|----------|------------|---------|------------|-------------|------------|
|           |   |           |   |     |       |    |       |        |       |
| March  2003    |   | 0.6813         |   | 0.6847   |       | 0.6689  |       |        |       |
| February  2003 |   | 0.6739         |   | 0.6524   |       | 0.6742  |       |        |       |
| January  2003  |   | 0.6572         |   | 0.6589   |       | 0.6338  |       |        |       |
| December  2002 |   | 0.6339         |   | 0.6470   |       | 0.6329  |       |        |       |
|           |   |           |   |     |       |    |       |        |       |
|           |   | **Year  End**  |   | **High** | ** ** | **Low** | ** ** | **Average** | ** ** |
|           |   |           |   |     |       |    |       |        |       |
| 2002  Year     |   | 0.6339         |   | 0.6654   |       | 0.6179  |       | 0.6368      |       |
| 2001  Year     |   | 0.6278         |   | 0.6696   |       | 0.6237  |       | 0.6458      |       |
| 2000  Year     |   | 0.6669         |   | 0.6918   |       | 0.6510  |       | 0.6736      |       |
| 1999  Year     |   | 0.6929         |   | 0.6929   |       | 0.6618  |       | 0.6752      |       |
| 1998  Year     |   | 0.6522         |   | 0.7043   |       | 0.6376  |       | 0.6721      |       |

 

### **B. Capitalization and Indebtedness**

 

Not Applicable

 

### **C.  Reasons Forthe Offer and Use of Proceeds**

 

Not Applicable

 

### **D.  Risk Factors**

 

The following is a summary of certain risks and uncertainties which weface in our business. This summary is not meant to be exhaustive. These riskfactors should be read in conjunction with other cautionary statements which wemake in this annual report and in our other public reports, registrationstatements and public announcements. If any of the following risks actuallyoccur, our business, results of operations and financial condition could suffersignificantly.

 

***We may not maintain the level of profitability achieved in2002 and we may be unable achieve or sustain profitability in the future.***

 

Although we were profitable in 2002, we have a history of losses andthere is no guarantee that we will be able to achieve or sustain profitabilityin the future. In 2002 we derived a substantial segment of our revenues fromthe North American portion of our hearing aid license, which expired inFebruary, 2003. If we are not successful in increasing revenues from othersources, or if there is a material increase in our expenses, we may be unableto achieve profitability in the future. We cannot guarantee that we willincrease sales of our products and technologies, or that we will successfullydevelop and market any additional products, or achieve or sustain futureprofitability, and we may have to rely on the sale of shares or on debtfinancings in the future.

 

***General economic conditions have and may continue tonegatively affect our audio customers’ businesses.***

 

The currentdownturn in the economy has resulted in decreased consumer demand for PC andconsumer electronics, resulting in decreased business for our licensees.   In 2001 and 2002 we experienced revenuedecreases from these licensees, and our 2003 revenues from these licensees maysustain further decreases.

 

***The market price of our common shares has been and continuesto be volatile.***

 

The trading price of our common shares on the Nasdaq SmallCap Markethas been and continues to be volatile. During the twelve months ending on April 30, 2003 our stock price hasranged from a high of $2.280****to a low of $0.530.  The market price may be 

 

6

----

 

affected by announcements of, among other things, new products by ourcompetitors, fluctuations in our operating results, assertions of intellectualproperty infringement made by us against third parties or by third partiesagainst us and changes in our financial position.

 

***To succeed in the audio industry we must be able to identifyemerging technological and market trends, to enhance our existing technologiesand develop new technologies, and to achieve and maintain wide distribution ofour products.  If we are not successfulwe will be unable to become profitable in this industry.***

 

The audio industryis characterized by a number of factors including:

 

•      rapid technological changes

•      short technology and product life cycles

•      escalating pressure to provide improvedaudio solutions at increasingly lower prices

•      frequent introduction of new technologiesand products

•      development of audio enhancementtechnologies in-house by potential customers

 

It is important for us to be able to identify emerging trends in the PCmultimedia, consumer electronic and Internet audio environments, and to enhanceour existing technologies and develop new technologies and products to meetthese continually changing market requirements. The development of our productsand technologies must continue to focus on technological superiority over theofferings of our competitors while meeting the needs of our customers andpotential customers, including competitive pricing and expeditious completion ofdevelopment. Additionally, there must be sufficient consumer interest in anddemand for enhanced audio to motivate our customers to use our products andtechnologies in their offerings.  If wedo not continue to develop premium new technologies and products timely andcost effectively, we will not be able to achieve profitability in the audioindustry.

 

***Our success in the audio industry depends upon theperformance of our licensees and customers.***

 

Most of our revenues in the audio business are derived from, and we aredependent upon the performance of, our licensees, customers and partners.Factors that contribute to performance of these licensees, customers andpartners include, among others:

 

•      end-user demand for their products

•      timeliness, quality and pricing of theirproducts

•      success or failure of their distributionand commercialization efforts

•      adoption of new business models

•      competition in their markets

•      manufacturing uncertainties

•      general or regional economic conditions

 

As a consequence of the effect that these and similar factors may haveon our licensees, customers and partners, we may from time to time experiencesignificant fluctuations in our revenues.

 

***Our audio industry revenues come from a limited number ofaccounts and a significant change in the performance of these accounts may havea material effect on our revenues.***

 

The sources of our audio industry revenues are limited in number and areduction in the performance, or expiration or termination, of any of theseaccounts, or the securing of a new account of similar size, would have amaterial effect on our revenues. Although we continue to make efforts aimed at broadening our revenuesources, there is no assurance that we will be successful in acquiring newaccounts or business relationships.

 

***Our e-commerce offerings may not keep pace with evolvinge-commerce industry standards, business models and customer needs, and we maybe unable to expand our merchant base.***

 

The electronic commerce industry is characterized by a number of factorsincluding:

 

•      very rapid technological advances

•      rapidly evolving industry standards,business models and customer needs

•      low barriers to entry and large numbers ofnew entrants

 

7

----

 

•      acquisitions and consolidation by larger,well-financed e-commerce service providers

 

As new technologies are developed and introduced our e-commerceproducts may become less attractive to small business merchants. Existing andnew competitors entering the market may offer their products and services atreduced prices and we may have to adjust our prices accordingly. We acquire newmerchants primarily through acquisitions, and we face competition foracquisition targets from larger competitors.

 

***Our success in the electronic commerceindustry depends on the continued successful growth of this industry.  If the Internet does not continue to be awidely accepted vehicle for commerce, or if the Internet continues toexperience rapid growth which cannot be supported, our business will suffer.***

 

Our electronic commercebusiness depends on the continued growth of this industry and continuedacceptance of the Internet by consumers and merchants as an effective means ofconducting business.  The rapid growth ofelectronic commerce is a recent development and there is no certainty that theInternet will continue to develop and attract sufficient numbers of consumersand merchants to become an alternative to traditional methods of commerce. Ifthe Internet continues to grow and attract significant new users, existinginfrastructure may not be capable of supporting the increased activity.  Our business will suffer if the Internetdoes not become a widely accepted vehicle of commerce or if rapid growth is notsupported by new technological advances.

 

***System defects, failures, breaches of security or terroristattacks could disrupt our electronic commerce business.***

 

Our systems are vulnerable to interruptions of our hosting servicesresulting from factors including software or hardware defects,telecommunications failures, capacity limitations, fire and power losses,breaches of security terrorist attacks and vandalism.  The occurrence of any of these events could cause serviceinterruptions and could result in damage to our reputation and loss of merchantaccounts.

 

***Acquisition of our IP telephony assets exposes us to risks associatedwith product and business development.***

 

Our IP telephony business requires allocation of financial andpersonnel resources, hiring and training of new personnel, and effective andtimely integration with our existing operations.  If we do not manage and allocate our resources successfully, ourexisting businesses may suffer. There is no assurance we will be able to successfullymarket and sell our IP telephony products and technologies, or operate thisbusiness profitably.

 

***Our IP telephony technologies are subject to obsolescence from rapidtechnological advances and to reliance on third party licenses.***

 

The IP telephony industry is characterized by rapid technologicaladvances, evolving industry standards and frequent new product introductions. Unless we continue development andimprovement of our products and technologies we may be unable to achievesuccess in this industry.  There is noassurance that revenues will increase to offset new product development costs.We use technologies licensed from third parties in our IP telephony productsand we may be unable to license these technologies on favorable terms.

 

***Our business will suffer if we fail to compete effectivelywith our competitors.***

 

Each of the industries in which we engage is intenselycompetitive.  In these industries wehave competitors who have technologies and products that are similar to oursand compete directly with us.  Some ofthese competitors are large, established companies with significantly greaterresources than we have. More specifically:

 

•                  *audio industry*: Our major competitorsin audio enhancement are Sensaura Ltd. which concentrates on the PC multimediamarket; Dolby, SRS Labs, Inc. and Spatializer Audio Laboratories, Inc. whichcompete with us primarily in the consumer electronics market; DFX which focuseson audio enhancement software plug-ins for Internet media players; and LakeTechnology Limited, which is our principal competitor in the headphone audioenhancement area. We also compete with Dolby and SRS in the multi-channel hometheatre market.

 

•                  *electroniccommerce industry*: We face many competitors in the electroniccommerce industry and the number of companies providing products and servicessimilar to ours is increasing at a rapid rate. Examples of competitors areBigstep, Network Commerce Inc., Imergent, Yahoo,Microsoft and Verisign. These companies sell products and services similar tothose we offer, including building Internet-based electronic storefronts,hosting merchant sites and providing marketing services.

 

8

----

 

•                  *IP telephony industry*: We face significant competition in the IP telephony business, includingfrom much larger and established companies such as Multi-Tech, SpectraLink,Cisco, Polycom, Avaya, Alcatel, 3Com and Nortel Networks.  We expect competition to remain intense asexisting communications companies enter into and new entrants emerge in thismarket.

 

***Our products and technologies are based on our intellectualproperty.  If we fail to adequatelyprotect our intellectual property our business will suffer, and if we are suedfor infringement by a third party we will incur significant legal expenses.***

 

Our success depends largely on our ability to protect our proprietarytechnologies and to keep infringers from using and marketing ourtechnologies.  We rely upon U.S. andinternational patent, copyright, trade secret and trademark laws to protect ourintellectual property. We also rely on contractual obligations such asnon-disclosure agreements.  Despite ourefforts, third parties may copy our technologies and we may be unable toprevent the sale of infringing products. Also, third parties may successfully develop products which compete withour products and which do not infringe our intellectual property rights.  In addition, third parties may successfullyassert that our technologies and products infringe their products and that ourpatents are invalid. Our business will suffer if we are not successful indefending our intellectual property, and we will incur significant legalexpenses if we must defend third party infringement claims.

 

***If we experience rapid growth and do not manage iteffectively our business and financial results will suffer.***

 

If our technologies andproducts achieve wide acceptance we may experience rapid growth. We may have tohire more employees including additional management, improve our financial andcontrol systems, and expand and manage our technical, sales and supportservices operations.  We would needincreased revenues and/or additional funding to operate these increasedactivities.  If we do not manage ourgrowth effectively our business and financial results will suffer.

 

***We depend on key employees and our business may suffer if weare not able to keep these employees or hire and train replacements.***

 

Our success depends on the skills, experience and performance of oursenior management and certain other key personnel.  We do not carry key personnel insurance on these employees.Experienced management and highly skilled engineers and software programmersare critical to the success of our business. We could suffer adverse effects ifwe are unable to successfully retain our key personnel, or hire and trainsuitable replacements.

 

***We are incorporated in Alberta, Canada, some of ourdirectors and officers live in Canada, and most of our assets are in Canada,and investors may have difficulty starting legal claims and enforcing judgmentsagainst us and our directors and officers.***

 

We are incorporated in the Province of Alberta, Canada.  Certain of our directors and officers livein Canada, and most of our assets, and the assets of those officers anddirectors, are located in Canada.  As a result,it may be difficult for investors to effect service of legal process within theUnited States upon directors and officers who are not United States residents.Also, there is uncertainty as to the enforceability in Canada, in originalactions or for enforcement of judgments of U.S. courts, of civil liabilitiespredicated upon U.S. federal or state securities laws.

 

## **ITEM 4. INFORMATION ON THE COMPANY**

 

### **A.  History and Development of the Company**

 

QSound Labs, Inc. was reincorporated on July 10, 1990 in the province ofAlberta, Canada under the Business Corporations Act of Alberta, by way ofcontinuance from the province of British Columbia where QSound incorporated onDecember 6, 1968.  We changed our namefrom Archer Communications Inc. to QSound Labs, Inc. on June 28, 1993. Theaddress of our registered office is Suite 400 – 3115 12th Street NE,Calgary, Alberta, Canada T2E 7J2 and the telephone number is (403) 291-2492.

 

Since 1988 QSound’s main focus is development, licensing anddistribution of audio enhancement algorithms and software to the personalcomputer, consumer electronic and entertainment industries. In 2002 weintroduced our latest software audio engine (QVE) to complement our core audioenhancement technologies and in 2003 we refined the audio engine and introducedan optimized version for the growing mobile and hand-held devices markets. Alsoin 2003 we expanded our scope of activities through the addition of Internettelephony technologies that were acquired and are operated through our subsidiaryQTelNet Inc.  Since 1999 our subsidiaryQCommerce Inc. provides e-commerce enabling services to small businessmerchants.

 

9

----

 

**Capital Expenditures**

 

Our principalcapital expenditures for each of fiscal year 2002, 2001, and 2000 are detailedin the table below:

 
|                                |   | **2002** |    | **2001** |   | **2000** |   |
|-------------------------------------|--------|----------|---------|----------|--------|----------|--------|
| Sound  source and control equipment |   | $        | 6,060   |     | $      | 43       |   | $ | 9,919 |   |
| Furniture  and fixtures             |   | —   |    | 2,553    |   | 789      |   |
| Computer  equipment                 |   | 52,435   |    | 34,546   |   | 31,780   |   |
| Software  and production tooling    |   | 138,150  |    | 134,418  |   | 683,750  |   |
| Patents  and trademarks             |   | 52,436   |    | 44,730   |   | 62,254   |   |
| Total                               |   | $        | 249,081 |     | $      | 216,290  |   | $ | 788,492 |   |

 

In fiscal 2002 ourdivestitures consisted of computer equipment with a net book value of nil. Infiscal 2001 our divestitures consisted of furniture and fixtures with a cost of$2,000.  Software and production toolingof $383,750 that was allowed for in fiscal 2000 as part of the impairment ofassets charge was removed from the capital asset cost base in 2001.  In fiscal 2000 our divestitures consisted offurniture and fixtures with a cost of $27,895. There were no divestitures in fiscal 1999.

 

### **B. Business Overview**

 

QSound was engaged in two business segments in 2002:

 

a) Audio Business Segment QSound develops, marketsand distributes multimedia software solutions and licenses algorithms based onits patented, proprietary audio technology portfolio. Revenues are generated bylicensing to originalequipment manufacturers (“OEM’s”) and chip manufacturers in the computermultimedia, consumer electronics and health care industries and by sellingdownloadable software products, through third parties and directly, toconsumers over the Internet.

 

b) E-commerce Business Segment Our wholly owned Washingtonsubsidiary QCommerce Inc. provides electronic commerce services thatenable electronic commerce for small businesses (eSolutionsTM). QCommerceeSolutions provide Web merchants with all of the tools necessary to set up andoperate an on-line store, and with marketing and advertising services to drivetargeted traffic to the store.

 

##### Audio BusinessSegment

 

QSound is a world leaderin the development, marketing and distribution of audio enhancement and audiosynthesis technologies, and audio engines. The QSOUND® portfolio of proprietary technologies includes acomplete suite of virtual audio, reverberation, synthesis and enhancementalgorithms as well as all of the components required to create custom softwareaudio engines, namely, a music synthesiser, a digital audio playback engine, asample rate converter and a mixer.

 

We derive our audio business revenues principally from:

 

•                  licensing of QSOUND technologies tosemiconductor companies, PC multimedia and consumer electronics OEM’s, anduntil February 2003, our hearing aid license; and

 

•                  sales of downloadable softwareproducts over the Internet through third parties.

 

QSOUND Portfolio of Technologies

 

Since 1988, we have been engaged in the development and upgrading of acomplete suite of proprietary technologies to cover all aspects of enhancedaudio and audio synthesis requirements in the multimedia computer, consumerelectronics and entertainment industries. Additionally, during this time wedeveloped algorithms for use in digital hearing aids.  The QSOUND portfolio consists of:

 

•                  Software Engines

 

*microQTM*:  microQis a modular and scalable software digital audio engine providing functionssuch as polyphonic ringtones, game sound, music playback and recording forportable and embedded applications in the growing hand-held and mobile devicesmarkets.  microQ offers a highlyflexible modular architecture, a small memory footprint and support forindustry

 

10

----

 

standard (linear andcompressed) content formats.  microQ’score components consist of a digital audio playback engine, a wavetablesynthesis engine with a scalable sample set, a multi-channel stereo mixer and asample rate convertor.

 

*QVE*TM:   TheQSound Virtual Engine (“QVE”) is a scalable software audio engine for PCs,soundboards and other digital devices. QVE provides synthesis and digital audioplayback for entertainment audio applications, and is a platform forincorporating all of the proprietary algorithms described below.

 

*QMixer*TM:  QMixeris a high-performance audio mixer targeted at game developers. QMixer adds 3Dspeaker or headphone audio to regular stereo sound cards and also takesadvantage of available DirectSound®3D and EAXTM-compatible accelerationhardware. QMixer uses low CPU overhead and includes advanced resourcemanagement to dynamically distribute the rendering duties between hardware andsoftware.

 

•                  3D Audio Algorithms

 

*Q3D*TM:  Q3D 2.0 is our interactive sound positioningtechnology, which places multiple individual sounds in specific locationsoutside of the bounds of stereo speakers and headphones, and positions soundwith equal effectiveness via multiple speaker systems.  Q3D 2.0 also includes QSound EnvironmentalModelingTM (QEMTM), a reverberation engine which is compatible with theEnvironmental Audio ExtensionsTM (EAXTM) API from Creative Labs, Inc.

 

*QSURROUND*TM: QSURROUND creates virtual surround sound for audio played back over twospeaker and headphone entertainment systems. QSURROUND has been developed by QSound to take advantage of the DVDformat and the digital broadcast format, both of which have become standardsfor music, video game and movie playback. Using QSURROUND, decoded DolbyDigital, Dolby ProLogic® and MPEG2 multi-channel audio streams canbe played back over only two speakers, while maintaining the illusion of amulti-speaker system through creation of phantom or “virtual” speakers orheadphones, eliminating the need for additional speakers. Dolby Digital andMPEG2 are the current audio standards for DVD based personal computers and homeentertainment systems. QSURROUND has been certified by Dolby Laboratories foruse with Dolby Digital and ProLogic.

 

*QXPANDER*TM: QXPANDER processes existing pre-mixed stereo material to provide 3Denhancement for audio played back over traditional two speaker or headphonestereo.

 

*QMDV*TM:  QSOUNDMatrix Surround Decoder/Virtualizer (“QMDV”), a superset of QXPANDER, decodesstereo audio material which has been encoded using matrix surround encodingsuch as Dolby Surround, and virtualizes the decoded material to create amultiple speaker surround effect when the material is played back over stereospeakers.  For three speaker systems, acentre channel output is available.

 

•                  Synthesis Algorithms

 

*QSURROUND 5.1/QMSS*TM:  QSURROUND 5.1 and QSOUND Multiple Speaker System (“QMSS”) processstereo audio material including regular stereo content and decoded surround content downmixedto two channels from sources such as Dolby Surround®, Dolby Digital(AC3), DTS® and MPEG2 and “steer” acoustic images to create a distinctlydifferent output for each speaker in multiple-speaker systems.

 

*QIMMERSIONTM*: QIMMERSION is a superset of QMSS (four-channel) optimized for playbackover a combination of stereo speakers and headphones.

 

*QSIZZLE*TM:  QSIZZLE is a virtual, adjustable treble feature that allows the listenerto adjust the treble level.

 

*QRUMBLETM:*  QRUMBLE is a virtual, fully adjustable bass boost that creates dynamicbass effects set to the listener’s preference.

 

•                  Effects Algorithms

 

*QVERB*TM:   QVERBis a reverb feature that allows the listener to choose from a selection ofadjustable listening environments, such as hall, theatre and stadium.

 

*QBASS*TM:   QBASS is a fully adjustable bass boost feature that allows the listenerto optimize bass levels to the listener’s preference.

 

11

----

 

•                  Other

 

*Hearing Aid Technology:* QSound Labs and its joint venture partner the House Ear Institute, aleading hearing research institute based in Los Angeles, (collectively “HEAR”),have developed digital hearing aid technologies that enable sounds to beprocessed to meet individual needs. HEAR’s technologies reduce feedback, enable automatic adjustments to changinglevels of sound, and enhance directional hearing capacity.

 

Licensing

 

We license QSOUND technologies to semiconductorcompanies, which manufacture and sell QSOUND enhanced chips to PC multimediaand consumer electronics OEM’s. In certain instances we also have the right topurchase and resell these chips to OEM’s. We also license these technologies directly to OEM’s in the PC andconsumer electronics industries, and to a hearing aid manufacturer.

 

QSOUND technologies are shipped in:

 

•                  PC’s and PC peripherals includingsound cards, speakers and monitors

•                  stereo systems

•                  MP3 players

•                  home theatre systems, TV’s and VCR’s

•                  DVD players

•                  amplified and USB speakers

•                  video games

 

Licenses with semiconductor companies and OEM’s are negotiated on anindividual basis. Certain semiconductor licensees pay royalties directly to us,and in other cases OEM’s pay royalties to us when they purchase QSOUND-enhancedchips.  Some of our license agreementsprovide for per-unit payments and others are on a fixed periodic payment orlump sum payment basis. Included as part of the license are provisionsdictating the terms for use of QSound trademarks and logos with respect topackaging, the product and user manuals. The agreements do not have volumerequirements and may be terminated by the licensees or QSound without aprescribed financial penalty.

 

The following is a partial list of OEM’s whose products include QSOUNDtechnologies:

 

Addonics

AIWA

Amstrad International Ltd.

Arts Electronics Co. Ltd.

Atherton

AudioVox

Best Union

Cawa Industrial

ChangHong Electronics

CHIC

Digital Science

Esonic

Fidek

Fujitsu

Grow-Up Electronics

HIS

Hoontech

iLab

InterVideo

Jadestar

Jaton

Leaderwave

Lu Kee Electronics

M & T International

Maltagroup

Masco Digital

Matsushita

Micron

Nanaha Saga

Panasonic

Philips

RCA

Sanrupid Electronics

Sanyo

Go-Video

Shark

Sharp

Shenzhen Fenda

Shenzhen Lasonic

Shuttle

SoundForce

Starlite Electronics

Toshiba

VideoLogic

Vtrek Electric

Warpspeed

Yusan Industrial

Zoltrix

12

----

 
| Jointek |   |   |
|---------|--------|--------|

 

Our DSP semiconductor licensees include:

 

AKM

Cirrus Logic

MediaTek

Motorola

NEC

Philips Semiconductor

Samsung

Texas Instruments

TVIA

Zoran

 

In March, 2002 we entered into a three year jointdevelopment agreement with Royal Philips Electronics, one of the world’slargest electronics companies, to produce digital audio solutions for themulti-channel sound card market and other consumer electronic products. Underthis agreement Philips is the exclusive manufacturer of soundcards that includeour QVE soft audio engine, and to date Philips’ has released Acoustic Edge,Seismic Edge, Sonic Edge and Dynamic Edge soundcards featuring QSound-enabledSoundAgent2. Additionally, under the agreement Philips has the right of firstrefusal to develop, manufacture and distribute QMSS based products. InSeptember, 2002 Philips paid an upfront fee creditable against futureroyalties, and has agreed to pay ongoing royalties.  We also granted to Philips 500,000 warrants exercisable at $1.04per share which vested as to 250,000 warrants on each of September 25, 2002 andMarch 25, 2003, and a right of first refusal to acquire control of our company.

 

Our analog chip manufacturer licensees are Mitsumi Electric Co., Ltd.,Mitsubishi Electric Corporation and Nippon Precision Circuits Inc. Mitsumi has theright to distribute QXPANDER chips in Japan, Europe and Asia and we distributethese chips in the rest of the world. We have the right to distribute Mitsumi-manufactured QMDV chipsworld-wide.  Mitsubishi has the right tomarket and distribute QSOUND-enhanced chips world-wide except in China and HongKong, where we sell these chips.  NPCdistributes QSOUND-enhanced chips to Japanese companies and we sell these chipsto Japanese and non-Japanese companies.

 

Our previous business model included licensing of authoring toolsconsisting of QSOUND software and QSYSTEM hardware/software units, and ourQMIXER software audio engine, for use in the entertainment industry. Video gamedevelopers that have licensed QSOUND include:

 

Accolade

Activision

Bullfrog Productions

Capcom

Codemaster Software

Electronic Arts U.S.

Electronic Arts UK

Fathom Pictures

Grolier

Imagitec

Intelligent Games

Interactive World Productions

Kuju Entertainment

Laurent Parent

Looking Glass Technologies

Microprose

Microsoft

Mindscape

Motion Factory

Overtime Sports

Philips Interactive

Remedy Entertainment

Simis Eidos

Singletrac

Softkey Multimedia

Sony

Psygnosis

Pumpkin Studios

Telstar

Electronics Studio

Velocity

Virgin Interactive

Virtual Adventures

 

In August 1999, Starkey Laboratories, Inc. introduced Cetera digitalhearing aids that used HEAR’s binaural localization technology. Also, in 1999Starkey, QSound and House Ear amended their license agreement to add royaltiesfor non-Cetera digital hearing aids sold by Starkey.  The North American (excluding Mexico) portion of the licenseexpired in February, 2003 and in the license for the rest of the world willexpire in the third quarter of 2004. Currently, Starkey is shipping non-Ceteradigital hearing aids.

 

13

----

 

Downloadable Software Products

 

QSound has several standalone software products aswell as plug-in products for most media players and certain authoring tools.The majority of revenues to date have been derived from the plug-in productsthrough distribution by third parties over the Internet.

 

We have an agreement for distribution of our iQfx® family of software products withRealNetworks Inc., a leader in media delivery on the Internet. The iQfxfamily enhances playback of content over all of RealNetworks’ media players. Our thirdgeneration iQfx3 plug-in is made exclusively for RealNetworks’ RealOne Player®. Since the 2002 introduction of theRealOne Player and the concurrent change in RealNetworks’ business model,revenues from sales of iQfx3 have decreased from past years’ levels. RealNetworkscontinues to sell iQfx3, and the changes in strategy are not reflective ofiQfx3’s sales performance.

 

In  January, 2003 we introduced the iQms2plug-in for Windows Media Player 9 Series for Windows XP, and in February, 2003we released the QDVD plug-in for Intervideo’s popular DVD player, WinDVD.

 

QMAXTM II is our universal plug-in for Internet streaming audio, andworks with any sound source, including Windows Media Player, WinAmp, WinAmp3,RealOne, RealPlayer, MediaJukeBox and Sonique. QMAX II intercepts the audio player output and applies realtimeprocessing to optimize speaker and headphone audio. We have also developed anddistribute custom plug-ins for Microsoft Windows Media Player 9 Series, WinDVD,WinAmp, Linux platforms, MusicMatch and UltraPlayer.

 

AudioPixTM is a standalonesoftware product that enables Web users to combine images with music to createtheir own personalized multimedia presentations for personal or businessuse.  A free version of AudioPix is includedon Kodak Picture CD pursuant to a distribution agreement entered into in April,2000 with the Eastman Kodak Company, and AudioPix Pro is certified “KodakPicture Friendly” by Kodak. AudioPix and AudioPix Pro are available forpurchase from our Web site www.audiopix.com.

 

We distribute our downloadable consumer software from our Web sites www.qsound.com and www.audiopix.com.

 

We distribute a suite of plug-in software modules for popular audioediting platforms.  Q3D soundpositioning and QXPANDER audio enhancement modules are available for Digidesign’s®Pro Tools III® (QSYS/TDMTM and QX/TDMTM) and for DirectX®compatible PC digital audio editors from Sound Forge, Sonic Foundry andCakewalk (QTools/AXTM). QCreatorTM is a software application that allows users toadd 3D audio effects to normal WAV or AIFF computer sound files.

 

E-commerce Business Segment

 

QCommerce provides electronic commerce enablingservices to small businesses (eSolutionsTM). Our services include domain nameregistration, store set-up and hosting, merchant credit card account set-up,technical support services and marketing and advertising services to drivetargeted traffic to the merchant’s site. QCommerce eSolutions do not requireany software installation or download and merchants need only Internet accessand a web browser to use these services.

 

QCommerce derives itsrevenues primarily from monthly service subscription fees paid by merchants foron-line storefront hosting and related services.

 

We offer the followingproducts for use by our online merchants:

 

*QCommerce Internet Store*TM is afull-featured Internet-based storefront, shopping cart and transaction systemthat allows a merchant’s customers to browse products and purchase them usingan optional on-line, real-time secure credit card authorization andverification system, or by manually downloading orders directly from InternetStore’s administration area. Internet Store’s robust database management systemgives the merchant full control over administration processes including pricingdata, accounting information and detailed customer order records.

 

*emerchantPro*TM user-friendlysoftware products help small businesses build e-commerce web sites, catalog andsell their products or services online, process and ship orders, report ontheir web businesses and initiate live chats with customers to maximize sales.  Web sites can be up and running in minuteswith professional and interactive results.

 

*ChoiceworldTM.com*shopping portal is anon-line shopping directory that drives targeted traffic to a merchant’s on-linestore and makes shopping more convenient for consumers through expandedcategory listings, detailed site descriptors, and a product oriented searchengine. Choiceworld.com is listed in many of LookSmart’s network of searchengines, including msn.com,

 

14

----

 

altavista.com, about.com, and cnn.com. According to Media Metrix, theLookSmart network reaches 77%, or nearly four out of five, U.S. Internet users.

 

Acquisition of Internet Telephony Assets

 

In April, 2003 we acquired, through our wholly owned subsidiary QTelNetInc., all of the assets of e-tel Corporation, consisting primarily of Internettelephony-enabling software, hardware inventory and trademark rights, for thepurchase price of approximately $525,000 which was paid by way of cash and anoffset of $500,000 against a secured claim in the principal amount of $500,000owed by e-tel to QSound.

 

Internet telephonyprovides an alternative to using the conventional telephone system, or PublicSwitched Telephone Network (“PSTN”) for voice transmissions.  Using Voice over Internet Protocol (“VoIP”)technology to transmit voice data over the Internet bypasses the PSTN networkand therefore eliminates long distance telephone charges.  QTelNet’s products consist of FreeRideTM gatewaysand telephones that are targeted to small businesses customers who can usetheir existing Internet connections to accomplish inter-office long distancecommunications with toll quality voice performance.  FreeRide products comply with H.323 protocol standards forInternet telephony and work with any analog telephone line. Currently, FreeRideproducts are certified by or for use with the following switches: Lucent (IPImerge Centrex), Sprint PBX, Tadiron PBX and Telrad PBX.

 

QTelNet sells FreeRideproducts, primarily within North America, through a network of dealers that thecompany is in the process of establishing.

 

**Revenuesby Business Segment**

 

In fiscal 2002, our revenues were $3,649,238 from the audio businesssegment and $575,073 from the e-commerce business segment.  In fiscal 2001, our revenues were $2,454,800from the audio business segment and $571,194 from the e-commerce businesssegment.  In fiscal 2000, our revenueswere $3,025,102 from the audio business segment and $1,443,900 from the e-commercebusiness segment.

 

**Revenues by Geographic Market**

 

Audio Business:  In 2002product sales, royalty and licensing revenue came primarily from the UnitedStates. In 2000 and 2001 product sales revenue came primarily from the UnitedStates and license and royalty revenue was split between the United States andAsia.

 

E-commerce Business: Revenue for oure-commerce business segment has come primarily from the United States in 2000,2001 and 2002.

 

**Seasonality**

 

We generally experience increased royalty revenues in our audiobusiness segment in the second and third quarters for consumer electronics,hearing aids, and PC sales, all related to the Christmas shopping season. Thesesales activities decrease during the fourth and first quarters. In 2002 we didnot experience any seasonal changes in our e-commerce business segment.  All revenue from e-commerce was subscriptionbased, and this base remained relatively constant throughout the year. Overall,seasonality does not have a material effect on our business.

 

**MarketingChannels**

 

Our audio business segment sales and marketing activities are carriedout by in-house employees and by representatives and agents in Asia that coverJapan, Hong Kong, China, Singapore, South Korea, Malaysia, Thailand,Philippines, India and Indonesia.  Inaddition, certain of our semiconductor licensees market and promote theirQSOUND-enhanced products to third parties worldwide.  We distribute our downloadable software products through businesspartners, participants in our affiliate marketing program, and from our own websites.

 

Our e-commerce business segment sales and marketing activities arecarried on by our direct sales staff.

 

Since April, 2003, QTelNet sells FreeRide products, primarily withinNorth America, through a network of dealers that the company is in the processof establishing. (See Acquisition of Internet Telephony Assets in Item4. of this annual report.)

 

15

----

 

**IntellectualProperty**

 

QSOUND technologies and products are covered by a variety ofintellectual property protections which include patent, copyright, trade secretand trademark laws, and contractual obligations. However, there can be noassurance that competitors will not be able to produce non-infringingtechnologies, products or services, or that third parties will not assertinfringement claims against us.

 

We hold fifteen patents in the United States, including four patentswhich cover the fundamental technology applicable to our Q3D positional audio,QSURROUND, and stereo enhancement technologies. In addition, three patentscover the binaural hearing aid technology developed by QSound Labs and theHouse Ear Institute.  At the date ofthis annual report, an additional four patent applications for QSOUND complementaryand improved technologies have been filed and more applications are inprogress.  Patent applications have beenmade in eighteen foreign countries and a number of foreign patents have beengranted, including in Japan.

 

Our key trademarks, includingQSOUND, QSURROUND and the stylized “Q” logo are registered in the United Statesand in various foreign countries. QSound Labs has filed trademark applicationsfor many of its trademarks in the United States and internationally, andcarries on a trademark protection program on an ongoing basis for newtrademarks.

 

QCommerce’s e-commerce enabling technologies, including softwaredeveloped for Internet Store, are covered by copyright and trade secret laws,and contractual obligations.

 

QTelNet’s VoIP software and technologies are covered by copyright andtrade secret laws, and contractual obligations.  QTelNet’s products also include technologies that are licensedfrom third parties.

 

**Competition**

 

The audio, electronic commerce and IP telephony industries areintensely competitive.  We havecompetitors in these industries who have technologies and products that aresimilar to ours and compete directly with us. Many of these competitors are large, established companies withsignificantly greater resources than we have. More specifically:

 

•                  *audio industry*: Our major competitorsin audio enhancement are Sensaura Ltd. which concentrates on the PC multimediamarket; Dolby, SRS Labs, Inc. and Spatializer Audio Laboratories, Inc. whichcompete with us primarily in the consumer electronics market; DFX which focuseson audio enhancement software plug-ins for Internet media players; and LakeTechnology Limited, which is our principal competitor in the headphone audioenhancement area.  We also compete withmulti-speaker and virtual speaker technologies offered by Dolby and SRS Labs inthe multi-channel home theatre market. Certain major manufacturers of multimedia computers and peripherals, ofconsumer electronics products and of chips for use in these products havedeveloped or are in the process of developing their own 3D audio solutions forincorporation in their products.

 

•                  *electronic commerce industry*: We facemany competitors in the electronic commerce industry and the number ofcompanies providing products and services similar to ours is increasing at a rapidrate. Examples of competitors are Bigstep, Network Commerce Inc., ImergentInc., Yahoo, Microsoft and Verisign. Thesecompanies sell products and services similar to the ones we offer, includingbuilding Internet-based electronic storefronts, hosting merchant sites andproviding marketing services.  It is extremely likely that othercompanies will enter the market with new products and services similar to oure-commerce products and technologies, some of which are likely to be morecompetitively priced, have more attractive features or ease of use, and carrymore recognized branding, than our products and services.

 

•                  *IP telephony industry*: Weface significant competition in the IP telephony business, including from  large, established enterprises that offercomplete network solutions such as Cisco, Polycom, Avaya, Alcatel, 3Com andNortel Networks, as well as from large companies such as Multi-Tech andSpectraLink that focus more on the small business, remote office niche which isour target market. We expect competition to remain intense as existingcommunications companies enter into and new entrants emerge in thismarket.  Factors that affect our abilityto compete include product quality, performance and features, conformance toexisting and new standards, price, customer support and marketing anddistribution strategies.

 

16

----

 

There are no governmental regulations in the audio or e-commerceindustries that have a material effect on our business, other than regulationsthat affect the carrying on of business generally.  In the IP telephony industry our products are subject to testingand certification in the United States, Canada and other countries to satisfy avariety of regulatory requirements and protocols, such as for example to avoidinterference with radio frequencies and to comply with emission standards.

 

### **C. Organizational Structure**

 

QSound Labs, Inc. is the parent of the parent of QSound Ltd., aCalifornia corporation and wholly owned subsidiary that owns certain assetsincluding several patents, and QTelNet Inc., an Alberta corporation and whollyowned subsidiary that operates our Internet telephony activities.  QSound Ltd. is the parent of wholly owned subsidiaryQCommerce Inc., a Washington corporation, which operates our e-commercebusiness segment.

 

### **D.  Property**,Plants and Equipment

 

Our head office, including research facilities and a sound studio, islocated at 400 – 3115 12th Street NE, Calgary, AB, Canada T2E 7J2where we lease approximately 10,648 square feet of office space until October31, 2003 at a rental rate of $8,429 Cdn. per month. We have the option to renewthe lease for an additional two-year term at then prevailing market rates.  Our audio and e-commerce businesses and,since April, 2003 our Internet telephony business, are operated from ourCalgary office.

 

We own computers, software, electronics equipment, studio and audioequipment, and electronics laboratory and testing equipment, all of which isused by us in the development of our technologies and products.  All of this equipment is located at our headoffice in Calgary. We also own Web servers which are located mainly off-site**.**Inventoryprimarily consisting of components for Internet telephony products,QSOUND-enabled analog chips, UltraQ’s and AudioPix CD’s and is also housed atour Calgary office, and warehoused off-site.

 

## **ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS**

 

## **ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS**

 

The following discussion of the financial condition and results ofoperations of QSound and subsidiaries for the year ended December 31, 2002compared to the year ended December 31, 2001, and the year ended December 31,2001 compared with the year ended December 31, 2000 should be read in conjunctionwith the Consolidated Financial Statements of QSound and related Notes includedtherein as well as the information and data provided in Item 3. “KeyInformation” of this annual report.

 

**Critical Accounting Policies**

 

On December 12, 2001, theSecurities and Exchange Commission (“SEC”) issued Financial Reporting Release(“FRR”) No. 60, “Cautionary Advice Regarding Disclosure About CriticalAccounting Policies” which, among other things, encourages discussionconcerning the most critical accounting policies used in the preparation of theCompany’s financial statements. Critical accounting policies are defined asthose that are both very important to the portrayal of the Company’s financialcondition and results, and require management’s most difficult, subjective orcomplex judgments. We are required to make certain estimates, judgments andassumptions that we believe are reasonable based upon available information,historical experience and/or forecasts. These estimates, judgments andassumptions affect the reported amounts of assets and liabilities at the dateof the financial statements and the reported revenues and expenses during thereporting periods. Actual results could differ from these estimates.  The accounting policies which managementbelieves are the most critical to aid in fully understanding and evaluating ourreported financial results include those relating to inventory, goodwill,research and development costs, and our stock option plan.

 

Inventory

 

Inventory is comprised of finished goods and is stated at the lower ofcost, being determined by the first-in, first-out method, and net realizablevalue.  We regularly review quantitiesof inventory on hand, and an allowance is made for obsolete items based uponcurrent market demand and selling prices. Adverse changes in technology or new models could result in a decreaseddemand for our products which may require an additional allowance to be madefor obsolete inventory.

 

17

----

 

Goodwill

 

Goodwill is recorded atcost and up to December 31, 2001 was amortized on a straight-line basis overone to seven years, beginning in the year of acquisition.  We assess the recoverability of thisintangible asset by determining whether the unamortized balance of the goodwillcan be recovered through undiscounted future operating cash flows of theacquired operation over its remaining life. The amount of goodwill impairment, if any, is measured based onprojected discounted future operating cash flows using a discount ratereflecting our average cost of funds. The assessment of the recoverability of goodwill will be impacted ifestimated future operating cash flows are not achieved.

 

Effective January 1,2002, we adopted the new Canadian Institute of Chartered Accountants standardNo. 3062 - Goodwill and Other Intangibles (“CICA 3062”), which no longerpermits the amortization of goodwill and other indefinite life intangibles. Thenew standard requires that a fair value impairment test be performed annuallyon goodwill and other indefinite life intangibles. As required by CICA 3062,goodwill and indefinite life intangibles were tested for impairment as ofJanuary 1, 2002.  This transitionalimpairment test was completed, and it was determined that the fair value of theCorporation’s goodwill and indefinite life intangibles exceeded their carryingvalues.  Consequently, no impairmentloss was recorded.  Further impairmenttests will be conducted on December 31 each year.  The new standard is applied prospectively.  There has been no change in the carryingvalue of goodwill ($2,184,589) since December 31, 2001.

 

Research and development costs

 

Research and developmentcosts are expensed as incurred except if development costs are determined to berecoverable from and/or directly related to development of new products,processes or systems. In 2002, while $796,249 was spent on research anddevelopment, we capitalized only $152,725 of such costs.  The remaining $643,524 was expensed as itcould not be directly related to the development of new products, but insteadwas related to pure research and updates of existing products.

 

Stock option plan

 

No compensation expenseis recognized when stock options are issued to employees.  Any consideration paid by employees on exerciseof stock options or purchase of stock is credited to share capital. Had wedetermined compensation cost in 2002 based on the fair value at the grant datefor its stock options, $8,478 would have been recorded using the Black Scholesoption pricing model with the weighted-average assumptions of a risk freeinterest rate of 4.5%, volatility of 80%, expected option life of 3 years, andzero dividend yield.

 

Options issued tonon-employees are accounted for at fair value upon their vesting date.  During 2002 we granted 35,000 stock optionsfor 35,000 shares of the company as compensation for services performed bythird parties.  These options areexercisable at $1.75 per share and expire March 31, 2006.  Of these options, 5,000 had vested as ofDecember 31, 2002, and the remaining 30,000 were to vest during 2003 howeverthey have been cancelled subsequent to the December 31, 2002.  The fair value of the vested options grantedwas estimated on the day of grant using the Black Scholes option pricing modelwith the same assumptions as the employee options above, and $4,870 was chargedto income for these options.  During2001 the Company did not issue any stock options in connection with servicesperformed by third parties.

 

### **A.  Results of Operations**

 

QSound’s Consolidated Financial Statements are prepared in accordancewith generally accepted accounting principles in Canada. Except as disclosed inNote 15. to the Consolidated Financial Statements and as explained below, thereare no material differences as pertains to these statements between accountingprinciples generally accepted in Canada and in the United States.  We measure and report in United Statescurrency.

 

**Fiscal Year Ended December 31, 2002compared to Fiscal Year ended December 31, 2001**

 

**Revenues:**

 

Revenues for 2002 were $4,224,311 representing an increase from revenuesof $3,025,994 in 2001.  Revenue in theaudio segment increased by $1,194,438 due primarily to increased royalties fromthe hearing aid license.  In oure-commerce segment revenue increased marginally by $3,879 to $575,073 in 2002compared to $571,194 in 2001.  Thee-commerce business model based on monthly subscription fees has remainedrelatively stable in 2002 as we had predicted.

 

18

----

 

**Operating Costs:**

 

Operating costs decreased to $235,201 in 2002 from $275,077 in 2001reflecting the cost savings of consolidating our e-commerce operations into ourCalgary office.

 

**Marketing Costs:**

 

Marketing costs decreased to $895,820 in 2002 from $1,074,139 in2001.  In the audio segment costsincreased by $125,339 due to increased salary costs and greater use of outsideconsultants.  In the e-commerce segmentcosts decreased by $303,658 due to reduction in the marketing programs.

 

**Product Research andDevelopment:**

 

Research and development costs decreased to $643,524 in 2002 from$951,017 in 2001.  In the audio segmentresearch and developments costs decreased to $519,137 in 2002 from $522,888 in2001.  In the e-commerce segments costsdecreased to $124,387 in 2002 from $428,129 primarily due to downsizing ofUnited States engineering staff.

 

**Administration Costs:**

 

General and administrative expenses decreased to $506,028 in 2002 from$597,685 in 2001 due to the closing of the e-commerce segment’s United Statesoffice and consolidation of their administrative functions in the Calgaryoffice in 2001, as well as a reduction in both audio and e-commerce segments’administrative staff.

 

**Depreciation and Amortization:**

 

Depreciation and amortization costs decreased to $382,662 in 2002 from$831,193 in 2001 due primarily to no amortization being taken on goodwill asdetailed in the discussion of major accounting policies above.

 

**Impairment of Assets:**

 

Our company experienced shortfalls in revenue from anticipated revenueson the AudioPix product.  As a result,it was concluded that the value of this product was impaired and an impairmentcharge of $100,000 was taken.

 

**Funding of Past ServicePension Costs:**

 

In 2002 QSound resolved an outstanding contingency relating to anemployment contract that expired September 30, 2002 by putting in place anindividual pension plan for the individual. Subsequent to the year end $55,189 was contributed to the plan as a pastservice cost.

 

**Interest and Other Income:**

 

Interest and other income decreased to $29,833 in 2002 from $73,568 in2001 due to the decline in  interestrates in 2002.

 

**Fiscal Year Ended December 31,2001 compared to Fiscal Year ended December 31, 2000**

 

**Revenues:**

 

Revenues for 2001 were $3,025,994 representing a decrease from revenuesof $4,469,002 in 2000. Revenue in the audio segment decreased by $570,302 dueto decreased royalty and license fees resulting from general stagnation in theworld economy.  In our e-commercesegment revenue decreased by $872,706. Our earlier e-commerce revenue modelbased on one-time lump sum product license fees became untenable following thedot.com decline and we adopted a more stable model based on monthly servicesubscription fees.

 

**Operating Costs:**

 

Operating costs decreased to $275,077 in 2001 from $375,000 in 2000 dueto consolidation of our e-commerce operations into our Calgary office duringthe year.

 

19

----

 

**Marketing Costs:**

 

Marketing costs decreased to $1,074,139 in 2001 from $1,360,698 in2000.  In the audio segment costsdecreased by $377,386 due to cost cutting measures taken to reflect overallweakness in the PC and consumer electronics industries and decrease indiscretionary spending.  In thee-commerce segment costs increased by $90,827 due to continuing marketingprograms.

 

**Product Research andDevelopment:**

 

Research and development costs decreased to $951,017 in 2001 from$1,610,436 in 2000.  In the audiosegment research and development costs decreased to $522,888 in 2001 from$787,800 in 2000 primarily due to less use of outside consultants.  In the e-commerce segment costs decreased to$428,129 in 2001 from $822,636 in 2000 primarily due to the closing of theUnited States office and the reduction of United States engineering staff.

 

**Administration Costs:**

 

General and administrative expenses decreased to $597,685 in 2001 from$802,582 in 2002 due to consolidation of the administrative functions in theCalgary office, the closing of the United States office, and reduction inadministrative staff.

 

**Depreciation and Amortization:**

 

Depreciation and amortization costs decreased to $831,193 in 2001 from$2,535,856 in 2000 due primarily to the decreased amortization of goodwillresulting from the impairment charged taken in 2000.  No amortization of goodwill will be taken in 2002 as detailed inthe discussion of major accounting policies above.

 

**Impairment of Assets:**

 

We did not incur any impairment of assets in 2001 except for theinvestment described in “Write-down of Investments and Gain on Sale ofInvestments” below.

 

**Write-down of Investments and Gain on Sale ofInvestments:**

 

During the 2001 yearvirtually all of one of the marketable securities held for sale were disposedof for total proceeds of $218,827, resulting in a gain over book value of$24,327.  The remaining securities notsold were felt to have experienced a permanent decline in value, and a chargeof $8,300 was recorded to write down the value of the investment.

 

**Interest and Other Income:**

 

Interest and other income decreased in 2001 to $73,568from $154,788 due to interest rates declining in 2001.

 

**Loss and Gain on Sale of Assets:**

 

In 2001 we had a gain onsale of assets of $6,492 resulting from the disposal of sound source andcontrol equipment and furniture and fixtures.

 

 

### **B.  Liquidity and Capital Resources**

 

During 2002 the Company experienced an increase in revenues whiledecreasing costs.  This resulted in anincrease in cash from operations of $1,192,690.  While this increase occurred primarily in the audio segment,  the e-commerce segment contributed in excessof $100,000 cash from operations.

 

Our cash flow from audio business operations in 2003 is expected to comefrom royalties and licensing fees from current licensees and from new licensingarrangements for QSOUND audio enhancement and synthesis technologies, fromrevenues related to sales of QSOUND-enabled chips which are manufactured bythird parties and sold by those parties and by us, from revenue share and salesreceipts related to sales of downloadable software products, and from royaltiesderived from hearing aid sales outside of North America.

 

20

----

 

Our cash flow from e-commerce business operations is expected to comefrom monthly subscription fees paid by merchants for set-up and hosting ofon-line storefronts and sales of related services such as domain nameregistration and credit card processing capabilities.

 

The company will be expanding into cellular, handheld devices and IPtelephony markets in 2003 and each of these areas is also expected tocontribute cash flow.

 

During the year the company advanced $500,000 to e-tel Corporation.  The advance was secured by all of the assetsof e-tel. Subsequent to the end of the year the company enforced its securityand collected on the note by acquiring, through its wholly owned subsidiaryQTelNet Inc., software, inventory, in process research and development,equipment and furniture.  QTelNet is nowactively marketing the technology and inventory acquired and the companyexpects to fully recover it’s investment. (See Acquisition of Internet Telephony Assets in Item 4. of thisannual report.)

 

At the end of the first quarter of 2003 cash and cash equivalents were$2,861,893 and liabilities for the same period were $244,286, which consistedof $130,001 in accounts payable and accrued liabilities and $114,285 indeferred revenue.  We feel that with ourcurrent cash on hand and cash flows from operations we have sufficient capitalto carry out our business plan for 2003.

 

Due to the strengthening of the Canadian dollar and the continuedweakening of the United States dollar, $1,748,206 of our cash and cashequivalents as of March 31, 2003 are held in Canadian funds.  We feel this amount of Canadian funds shouldbe sufficient to satisfy our Canadian fund cash requirements for the remainderof the year thus protecting us from further foreign exchange fluctuations ofthe Canadian dollar.

 

During 2002, we received $34,815 from the exercise of options and warrants.  At December 31, 2002 we had $2,621,205 incash and short-term deposits compared to $2,047,892 in 2001.  At year-end December 31, 2002 we hadaccounts receivable from various customers outstanding of $929,519 (of which$926,046 has been collected as of April 24, 2003) and finished goods inventorywith a cost of $16,455 consisting of QSound-enabled analog chips, Audiopix CDsand UltraQ’s.

 

During 2001, we received $218,827 from the sale of investments and$6,654 from the sale of excess capital assets. At December 31, 2001 we had $2,047,892 in cash and short-term depositscompared to $2,264,639 in 2000.  Atyear-end December 31, 2001 we had accounts receivable from various customersoutstanding of $439,245 (of which $431,067 had been collected at June 11, 2002)and finished goods inventory with a cost of $28,587 consisting ofQSOUND-enabled analog chips, AudioPix CDs and UltraQ’s.

 

**Cash Flows**

 

Cash generated by operations in fiscal 2002 was $1,192,690 as comparedto $789,281 in 2001.  The increase wasdue primarily to increased royalties received on our hearing aid license andreduction in operating expenses.

 

Cash generated by operations in fiscal 2001 was $789,281 as compared tocash used in operations of $482,950 in 2000. The increase was due primarily to non-cash working capital decreasing to$240,189 in 2001 from $962,006 in 2000 and reduction in operating expenses.

 

Cash generated in financing in fiscal 2002 was $34,815 as compared tocash used in financing of $980,800 in fiscal 2001.  The cash generated in fiscal 2002 came from the exercise ofoptions.

 

Cash used in financing in fiscal 2001 was $980,800 as compared to cashgenerated by financing in fiscal 2000 of $1,854,244.  The cash was used to retire a debt to LookSmart and to repurchase241,615 common shares, resulting in an increase of $1,108,668 in contributedsurplus.

 

Cash used in investments increased to $654,192 in 2002 from $25,228 in2001. Capital assets were purchased for $113,880 and $41,052 was spent in theacquiring and renewing patents and trademarks. The $500,000 advanced to e-tel was recorded as an investment expenditureas the company enforced its security and collected on the note by acquiring,through its wholly owned subsidiary QTelNet Inc.,  title to all of the assets of e-tel.

 

Cash used in investments decreased to $25,228 in 2001 from $631,018 in2000. Capital assets were purchased for $216,291 and the eMerchant Pro hostingproperty was purchased for $34,418. Investments were sold for total proceeds of $218,827 and capital assetswere sold for proceeds of $6,654.

 

21

----

 

### **C.  Research and Development **

 

QSound carries out sustained research and developmentactivities in the audio business segment, allowing us to maintain our positionas a world leader in audio enhancement with cutting edge products andtechnologies. In 2001 and 2002 we concentrated on development and refinement ofour new QVE and microQ scalable software engines, as well continuing ourprevious research and development activities of developing new, and refiningand upgrading existing, audio synthesis and enhancement technologies. Our audioresearch and development costs were $519,137 in 2002, $522,888 in 2001 and$787,800 in 2000.  We also work jointlywith our licensees and business partners to adapt and optimize our technologiesfor their products. We worked with, among others, Philips, Intel, Zoran andMicrosoft in 2002, Philips, Motorola, Zoran and RealNetworks in 2001 andPhilips, Intervideo, Sanyo, Sharp and Toshiba in 2000.

 

In our e-commerce business segment, we carried out fewer research anddevelopment activities in 2002, reflecting the satisfactory performance of oure-commerce products, with expenditures of $124,387 for the year.  In 2001 e-commerce research and developmentcosts were $428,129 for activities comprised of upgrading and enhancement ofour products, and conversion of our merchant customers whose sites were enabledwith technologies of our earlier acquisition targets, to the upgraded InternetStore technology platform. In 2000 research and expenditure costs were $822,636for upgrading and enhancement of our e-commerce products.

 

### **D.  Trends**

 

Audio Segment

 

In 2002, hearing aid revenues from the North Americanportion of our hearing aid license constituted a substantial portion of ourrevenues. The North American portion of the license expired in February, 2003.Hearing aid royalties for the non-North American portion of the license, whichare significantly lesser than the North American portion, are expected toremain strong and to increase throughout the remainder of 2003. Due to generalstagnation of the world economy, we do not expect other audio royalties toincrease in 2003 but, at best, to continue flat at the 2002 level. Sales ofintegrated circuits are increasing and we expect the volume of sales to notonly continue but to increase throughout the remainder of the year. Managementexpects our revenue from Real Networks to remain constant throughout 2003 atlevels similar to the last quarter of 2002. We are continuing to develop additional revenue streams through newlicensing arrangements for our products and technologies, including audioengine licenses for cell phones and other mobile applications.

 

E-commerce Segment

 

Our e-commerce segment derives substantially all ofits revenue from a recurring service subscription base.  We expect this revenue to remain relativelyconstant throughout the year.  We havenow fully consolidated operations in Calgary, Canada, and as we realise thecost savings we expect the segment to remain operationally profitable at itscurrent level for the year.

 

IP Telephony Segment

 

We are in the process of establishing a North American dealer networkwhich we anticipate will be the main distribution channel for our IP telephonyproducts.

 

## **ITEM 6**.  DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES

 

### **A.  Directors and Senior Management**

 

The following table setsforth certain information with respect to our executive officers and directorsas of April 30, 2003.  All positionsindicated are with QSound Labs, Inc. only.

 
| **Name**         |   | **Position**                                 |
|------------------|--------|----------------------------------------------|
|             |   |                                         |
| David Gallagher  |   | President, Chief Executive Officer, Director |
|             |   |                                         |
| Francis Munoz    |   | Executive Vice President                     |
|             |   |                                         |
| Robert Starr     |   | Vice President – Business Development   |
|             |   |                                         |
| Joanna Varvos    |   | Corporate Secretary                          |
|             |   |                                         |
| Doug Drury       |   | Controller                                   |
|             |   |                                         |
| James Bonfiglio  |   | Director                                     |
|             |   |                                         |
| Brian Harrington |   | Director                                     |

 

 

22

----

 

David Gallagher has served as President and Chief Executive Officersince June, 1992 and as a director since June, 1991.  Mr. Gallagher joined our company 1989 and has acted asVice-President, Finance and as Chief Financial Officer. Mr. Gallagher has overtwenty years experience in technology development and commercialization.

 

Francis Munoz is Executive Vice President of theCompany since April, 1999.  Mr. Munozhas thirty-one years of experience in the information technology industry.  From January, 1997 to January, 1999 he wasGeneral Manager, Metronet Solutions, for Metronet Communications Group Inc., aCalgary based, local exchange carrier with national operations which waspurchased in March, 1999 by AT&T Canada. Previously, since 1991 Mr. Munoz was employed by Minerva TechnologiesInc., a software development consulting company, most recently as VicePresident, Business Development, where he created and developed the IT servicesoutsourcing business unit which was subsequently acquired by Metronet.

 

Robert Starr joined QSound as Vice President – Business Development inJune, 2002.  Mr. Starr has overtwenty-three years of high tech sales, marketing, and business developmentexperience, including seventeen years in audio-related products.  Prior to joining the company Mr. Starr wasDirector of Business Development at Beatnik Audio where he was responsible forlicensing audio software into mobile phones, PDAs, and set top boxes.  Prior, Mr. Starr was Vice President of Salesand Marketing at Staccato Systems, a start-up producing audio software for thePC and game developers, that was purchased by Analog Devices Inc. From 1986 to1997 Mr. Starr was a member of and managed the Sales and Marketing division ofYamaha Systems Technology where, as the first American employee, he wasinstrumental in establishing Yamaha semiconductors and software as the defacto standardfor PC sound cards. Mr. Starr has a BSEE from Oklahoma State University and anMBA from SIU Edwardsville.

 

Joanna Varvos is Corporate Secretary of QSound.  Ms. Varvos is a barrister and solicitor,admitted to the Law Society of Alberta in 1979.  Ms. Varvos has provided legal services to QSound Labs since 1989and was previously in private practice with a emphasis on corporate andsecurities law.

 

Doug Drury, a CertifiedManagement Accountant, is our Controller since December, 1999.  Mr. Drury has eighteen years of financialand accounting experience. Prior to joining our company Mr. Drury wasController of Meyers Sheet Metal Ltd., Master Plastics Inc. and Jenkins ControlSystems Ltd.  He also taught accountingat the University of Calgary and the Southern Alberta Institute of Technologyand operated his own public accounting firm from 1986 to December, 1997.

 

James Bonfiglio has been a director since 1992.  Mr. Bonfiglio, a business consultant since1995, has business experience including as President and CEO of Kroy Inc., amulti-national corporation specializing in manufacture and distribution ofpresentation products, labelling, lettering and bar-code equipment and otherspeciality industrial products, and of Home America, Phoenix, Arizona, the largestindependent appliance and electronic retail operation in the SouthwesternUnited States.

 

Brian Harrington has been a director since 2001. Mr. Harrington has extensive experience in thecomputer software industry. Since 1995 Mr. Harrington has worked with, and iscurrently a partner in, Western New Ventures Capital Corporation, an Albertaventure capital firm. Previously Mr. Harrington co-founded and operated twosuccessful software companies, PSI Energy Software, an oil and gas softwarecompany and The 10 PLANNER Corporation, a large scale financial modellingbusiness. Mr. Harrington is a director of Pancontinental Energy Inc. andBattrix Investments Ltd. which trade on the Canadian Venture Exchange.

 

There are no family relationships between any directors or officers ofQSound.  There are no arrangements orunderstandings between any director or officer of the company and any otherperson pursuant to which the director or officer was selected, except foremployment agreements between QSound and Messrs. Gallagher, Munoz, Starr andDrury.

 

### **B.  Compensation**

 

Remuneration paid or payable to our directors and executive officersduring fiscal year 2002 was $288,600 Cdn. for compensation paid to Messrs.Munoz and Drury and Ms. Varvos, and $218,471 U.S. paid to Messrs. Gallagher andStarr.  Our directors are not 

 

23

----

 

paid cash compensation for their services in their capacity asdirectors; however, directors are reimbursed for reasonable travel and lodgingexpenses incurred in the provision of such services and receive stock options.

 

Mr. Gallagherparticipates in a registered individual pension plan that was put in place in2002 to resolve an outstanding contingency relating to his employmentcontract.  In 2003 $55,189 which hadbeen set aside in 2002, was contributed to the plan.

 

The followingtable gives information concerning the compensation earned by our executiveofficers in 2002:

 

| **Name & Principal****Position**                         |   | **Salary**   |   | **Bonus** |
|--------------------------------------------------------------|--------|--------------|--------|-----------|
| David J. Gallagher   President, CEO and Director             |   | 159,192 U.S. |   | nil       |
| Francis Munoz   Executive Vice President                     |   | 100,000 Cdn. |   | nil       |
| Robert Starr(1)   Vice President – Business Development |   | 59,300 U.S.  |   |      |
| Joanna Varvos   Corporate Secretary                          |   | 107,100 Cdn. |   | nil       |
| Doug Drury   Controller                                      |   | 73,500 Cdn.  |   | nil       |

 

----

(1)Mr. Starr joined the Company on June17, 2002 at an annual salary of $110,000 U.S.

 

The following table givesinformation concerning stock options granted to our executive officers anddirectors during 2002.

 

 

# **Optio**ns Grants During the Most Recently Completed FinancialYear

** **

| **Name**                                               |   | **Securities  Under  Options  Granted** |   | **Exercise  or  Base Price** |      | **Market  Value of  Securities  Underlying  Options on Date of  Grant** |   | **Expiration  Date** |
|--------------------------------------------------------|--------|-----------------------------------------|--------|------------------------------|-----------|-------------------------------------------------------------------------|--------|----------------------|
| David J. Gallagher   President & CEO               |   | 100,000(1                               | )      | $                            | 1.65 U.S. |                                                                    | $      | 1.65 U.S.            |   | December 30,  2007 |
| Francis Munoz   Executive Vice   President             |   | 75,000(2                                | )      | $                            | 0.57 U.S. |                                                                    | $      | 0.57 U.S.            |   | August 9, 2007 |
| Robert Starr   Vice President   Business   Development |   | 200,000(3                               | )      | $                            | 0.62 U.S. |                                                                    | $      | 0.62 U.S.            |   | June 30, 2008 to    July 17, 2012 |

 

----

(1)   50,000 options have vested and 50,000 optionsvest September 30, 2003.

(2)   These options are subject to vesting inaccordance with performance criteria to be agreed to by the Company andMr. Munoz.

(3)   These options are subject to vesting asfollows: 66,666 options vest July on 1, 2003 and 5,000 options vest per monththereafter.

 

### **C.  Board Practices**

 

During 2002, the membersof our board of directors were Messrs. David Gallagher, James Bonfiglio andBrian Harrington.  Directors are electedannually by shareholders at our annual meeting of shareholders, and serve untiltheir successors are elected or appointed.

 

Our board of directorshas two standing committees: a compensation committee and an audit committee,whose members at the date of this annual report are Messrs. Bonfiglio andHarrington.  The compensation committeerecommends and establishes salaries, incentives and other forms of compensationfor our executive officers. The audit committee meets with our independent 

 

24

----

 

auditors and reviews ourfinancial statements, and provides an open avenue of communication among theindependent accountants, our financial and executive officers and the board ofdirectors.

 

We do not have anyservice contracts with directors, other than the employment contract with Mr.David Gallagher. Mr. Gallagher’s contract provides for discretionarybonuses if approved by the Compensation Committee, and participation in anypension and profit sharing plan established from time to time by the Board.  If terminated without cause, if Mr.Gallagher’s employment contract is not renewed for at least one year followingexpiration, if there is a change in control of the Company and Mr. Gallagherelects not to continue his employment, and in the event of death or disabilityMr. Gallagher is entitled to a lump sum payment equal to the greater of salaryfor the unexpired term of the employment agreement or one year.  A lump sum contribution to fund the Mr.Gallagher’s pension plan is also payable in the foregoing circumstances and inthe event of retirement between the ages of 60 and 65.  Mr. Gallagher’s employment contract issubject to renewal on September 30, 2004. If there is a change in control of QSound and Mr. Gallagher elects notto continue his employment, Mr. Gallagher is entitled to vesting of anyunvested options.

 

### **D. Employees**

 

At December 31, 2002 wehad 31 employees and persons engaged by contract on a fulltime basis, of whom12 were in research, product development and technical support, 8 were inmarketing and sales, 5 were in customer support and 6 were in administrativepositions. At December 31, 2001 we had 36 employees and persons engaged bycontract on a fulltime basis, of whom 12 were in research, product developmentand technical support, 10 were in marketing and sales, 7 were in customersupport and 7 were in administrative positions. Four of these employees werelocated in the United States and the remainder were located in Canada.  At December 31, 2000 we had 33 employees andpersons engaged by contract on a fulltime basis, of whom 14 were in research,product development and technical support, 13 were in marketing and sales, and6 were in administrative positions.

 

We are not subject to anycollective bargaining agreements and believe our relationship with ouremployees is satisfactory.

 

### **E.  Share Ownership**

 

The following tables showinformation as to share ownership by directors and executive officers as April30, 2002.

 

Shares

 
| **Name and Position**                                       |   | **Common Shares Owned or Controlled** |   | **Percent of Class** |
|-------------------------------------------------------------|--------|---------------------------------------|--------|----------------------|
| David Gallagher   President and CEO   and Director          |   | 16,000                                |   | *                    |
| Fran Munoz   Executive Vice President                       |   | 2,500                                 |   | *                    |
| Robert Starr   Vice President – Business   Development |   | 2,900                                 |   | *                    |
| Joanna Varvos   Corporate Secretary                         |   | 0                                     |   |                 |
| Doug Drury   Controller                                     |   | 1,000                                 |   | *                    |
| James Bonfiglio   Director                                  |   | 25,000                                |   | *                    |
| Brian Harrington   Director                                 |   | 750                                   |   | *                    |

----

* represents less than 1%

 

25

----

 

Options

 

| **Name and  Position**          |   | **Options** |   | **Exercise  Price** |   | **Expiry  Date** |                            |
|---------------------------------|--------|-------------|--------|---------------------|--------|------------------|---------------------------------|
| David  Gallagher                |   | 253,190     |   | $                   | 1.04   |             | July 22, 2006                   |   |
| President and  CEO              |   | 207,810     |   | $                   | 0.47   |             | December 2, 2006                |   |
| and Director                    |   | 100,000     | (1)    | $                   | 1.65   |             | December 30, 2007               |   |
| Fran  Munoz                     |   | 66,435      | (2)    | $                   | 1.04   |             | July 22, 2006                   |   |
| Executive  Vice President       |   | 75,000      |   | $                   | 0.57   |             | August 9, 2007                  |   |
| Robert  Starr                   |   | 200,000     | (3)    | $                   | 0.62   |             | June 30, 2008 to July  17, 2012 |   |
| Vice  President – Business |   |        |   |                |   |             |                            |
| Development                     |   |        |   |                |   |             |                            |
| Joanna  Varvos                  |   | 25,467      |   | $                   | 1.04   |             | July 22, 2006                   |   |
| Corporate  Secretary            |   | 71,533      |   | $                   | 0.47   |             | December 2, 2006                |   |
| Doug  Drury                     |   | 5,536       |   | $                   | 1.04   |             | July 22, 2006                   |   |
| Controller                      |   | 16,464      | (4)    | $                   | 0.47   |             | December 2, 2006                |   |
| James  Bonfiglio                |   | 114,760     |   | $                   | 1.04   |             | July 22, 2006                   |   |
| Director                        |   | 155,240     |   | $                   | 0.47   |             | December 2, 2006                |   |
| Brian  Harrington               |   | 28,750      |   | $                   | 0.47   |             | December 2, 2006                |   |
| Director                        |   |        |   |                |   |             |                            |

 

----

(1) 50,000 options havevested and 50,000 options vest September 30, 2003.

(2) These options aresubject to vesting in accordance with performance criteria to be agreed to bythe Company and Mr. Munoz.

(3) These options are subject to vestingas follows: 66,666 options vest July on 1, 2003 and 5,000 options vest permonth thereafter.

(4)These options aresubject to vesting in accordance with performance criteria to be agreed to bythe Company and Mr. Drury.

 

We may grant stock options to officers, directors, key employees andpersons or companies providing ongoing services for QSound or its subsidiariespursuant to our 1998 Stock Option Plan (“1998 Plan”). The board of directors ora committee appointed by the board may in its discretion from time to timegrant stock options under the 1998 Plan at exercise prices determined by theboard or the committee. The board or the committee may also delegate to anexecutive officer the authority to grant options to employees who are notinsiders.  The purchase price of sharescovered by each option granted by an executive officer may not be less theirmarket value on the date of grant. The term of each stock option must bedetermined by the board or committee when the option is granted, and may notexceed ten years from the date of grant. Options may be exercised for a period of 30 days after termination ofthe optionee’s employment, or the expiration of the term, whichever period isshorter.  If an optionee should diewhile a service provider of QSound or its subsidiaries, his or her options maybe exercised by the optionee’s legal representative until the earlier of oneyear after the date of death or the expiration of the term. The foregoing 30day and one year time periods may be increased by the board of directors. The1998 Plan may be amended by the board provided that any such amendment may notadversely affect any outstanding option without the consent of the optionee.Options granted under the 1998 Plan may also be amended upon agreement with theoptionee.

 

In the event there should be any subdivision or consolidation of ourcommon shares the price of shares then subject to each option is to be adjustedequitably so that the optionee’s proportionate interest is maintained withoutchange in the aggregate option price. If we are reorganized or merged with another corporation, provisionsshall be made to continue any options then outstanding and to prevent theirdilution or enlargement.

 

We may also grant options outside of the 1998 Plan, and we may grantoptions to employees who are not officers or directors under QSound’s EmployeeStock Option Plan. Any such options are generally granted on the same terms asoptions granted under the 1998 Plan. Shareholder approval of grants of over 25,000 options made to directorsand officers outside of the 1998 Plan is required by Nasdaq rules.

 

26

----

 

## **ITEM 7**.  MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS

 

### **A.  Major Shareholders**

 

We do not have anyshareholders that are beneficial owners of 5% or more of our common shares.

 

At April 30, 2003 we had 7,162,074 common shares issued andoutstanding.  At such date, there were393****shareholdersof record in the United States who collectively held approximately 86%****ofour outstanding common shares.

 

We are not directly orindirectly owned or controlled by any other corporation, foreign government orlegal person.  We know of noarrangements which may result in a change of control of our company at a futuredate.

 

### **B.  Related Party Transactions**

 

We did not have anymaterial transactions with any of our related parties during fiscal year 2002except for compensation of executive officers as employees or consultants.  (See “Compensation” in Item 6. B of this annualreport).

 

Except for immaterialadvances in the ordinary course of business that may have been outstanding on ashort-term basis, no related party was indebted to us during fiscal year 2002.

 

### **C.  Interests of Experts and Counsel**

 

Not applicable.

** **

## **ITEM8**. FINANCIAL INFORMATION

 

### **A.  Consolidated Statements and Other FinancialInformation**

 

See Item 17.

 

**Export Sales**

 

In the past three fiscalyears we have derived over 99% of our revenues from export sales made tocustomers outside Canada.  In 2002, 86%of our export sales were made to the United States, and a further 14% were madeto Asian companies located in Japan, Hong Kong and Taiwan. In 2001, 86% of ourexport sales were made to the United States and 13% were made to Asia.  In 2000 84% of our export sales were made tothe United States and 16% were made to Asia.

 

**Legal Proceedings**

 

From time to time we maybe involved in various disputes and litigation arising in the normal course ofbusiness. As of the date of this annual report we are not involved in any legalproceedings that are expected to have a material adverse effect on ourconsolidated financial position, results of operations or cash flows.

 

**Dividend Distribution**

 

We have never made adistribution of dividends.

 

### **B.  Significant Changes**

 

Other than theacquisition of Internet telephony assets described in Acquisition ofInternet Telephony Assets in Item 4. above, there have been no significantchanges since the date of the financial statements included in this annualreport.

 

27

----

 

## **ITEM9**.  THE OFFERAND LISTING

 

### **A. Offer and Listing Details**

 

**Price History**

 

Our shares traded during the periods and at the pricesset out below on The NASDAQ SmallCap Market. All numbers have beenadjusted to reflect the consolidation of our shares on a one-for-four basis inJuly, 2001.

 

The high and low market prices for the last five fiscal years:

 
| **Fiscal Year** |   | **High** |   | **Low** |   |
|-----------------|--------|----------|--------|---------|--------|
|            |   |     |   |    |   |
| 2002            |   | 2.280    |   | 0.530   |   |
| 2001            |   | 4.875    |   | 0.420   |   |
| 2000            |   | 21.500   |   | 1.376   |   |
| 1999            |   | 16.500   |   | 7.500   |   |
| 1998            |   | 12.000   |   | 5.000   |   |

 

The high and low market prices for the first full quarter of 2003, andfor each of the four quarters of  2002and 2001:

 
| **Quarter Ending** |   |   |   | **High** |   | **Low** |   |
|--------------------|--------|--------|--------|----------|--------|---------|--------|
|               |   |   |   |     |   |    |   |
| March              |   | 2003   |   | 2.140    |   | 1.030   |   |
| December           |   | 2002   |   | 2.280    |   | 0.710   |   |
| September          |   | 2002   |   | 0.870    |   | 0.550   |   |
| June               |   | 2002   |   | 1.300    |   | 0.530   |   |
| March              |   | 2002   |   | 2.000    |   | 0.700   |   |
| December           |   | 2001   |   | 0.750    |   | 0.420   |   |
| September          |   | 2001   |   | 1.720    |   | 0.560   |   |
| June               |   | 2001   |   | 2.875    |   | 1.400   |   |
| March              |   | 2001   |   | 4.875    |   | 2.000   |   |

 

The high and low marketprices for each of the last six months:

 
| **Month** |   |   |   | **High** |   | **Low** |   |
|-----------|--------|--------|--------|----------|--------|---------|--------|
|      |   |   |   |     |   |    |   |
| April     |   | 2003   |   | 1.800    |   | 1.200   |   |
| March     |   | 2003   |   | 1.500    |   | 1.030   |   |
| February  |   | 2003   |   | 2.010    |   | 1.300   |   |
| January   |   | 2003   |   | 2.140    |   | 1.630   |   |
| December  |   | 2001   |   | 2.100    |   | 1.540   |   |
| November  |   | 2002   |   | 2.280    |   | 1.710   |   |

 

### **B.  Plan of Distribution**

 

Not Applicable

 

### **C.  Markets**

 

Our shares trade (since January, 1989) on The NASDAQ SmallCap Marketunder the symbol QSND (formerly QSNDF).

 

### **D.  Selling Shareholders**

 

Not Applicable

 

**E. Expenses of the Issue**

 

Not Applicable

 

28

----

 

## **ITEM10**.  ADDITIONALINFORMATION

 

### **A.  Share Capital**

 

Not Applicable

 

### **B.  Memorandum and Articles of Association**

 

**Objects and Purposes**

 

Our objects and purposes,which are found in section 6. of our Articles of Continuance, allow usgenerally to engage in any act or activity that is not prohibited under thelaws of the province of Alberta.

 

**Directors**

 

Our by-laws and the lawsof the province of Alberta provide that a director must disclose the nature andextent of his or her interest, or the interest of a party in which the directorhas a material interest, in a material contract with our company.  The interest must be disclosed at the timethe contract is considered or after the interest arises, whichever occursfirst.  A director may not approve acontract in which the director or the related party has a material interestunless the contract is an arrangement by way of security for money lent to orobligations undertaken by the director, or relates to his remuneration, or is forindemnity insurance or with an affiliate. A material contract in which a director has an interest is not void orvoidable by reason only of the interest, or because the director is counted todetermine the presence of a quorum at the meeting where the contract isconsidered.  A director or formerdirector to whom a profit accrues as a result of the material contract is notliable to us for the profit only by reason of the interest if the interest ofthe director was disclosed, the contract was approved by the directors orshareholders and the contract was reasonable and fair to us when approved.

 

Our by-laws and the lawsof the province of Alberta provide that our directors may fix the remunerationof our directors, officers and employees. Under our by-laws the directors may also by resolution award specialremuneration to any director that provides services to us other than routinework ordinarily required of a director. Directors, officers and employees are entitled to be paid theirwork-related travelling and other expenses.

 

Under Alberta law and ourby-laws, our directors, or a delegated director, managing director or committeeof directors, may borrow money, issue debt obligations, give a guarantee ormortgage or otherwise create a security interest in the property of ourcompany.

 

We do not have an agelimit requirement for retirement of directors, and our directors are notrequired to hold our shares in order to be members of the board of directors.

 

**Dividends**

 

Our directors may declaredividends on issued shares. Dividends may consist of shares, money or property.No dividends may be declared if we have reasonable grounds to believe that weare, or would be after payment of the dividend, unable to pay our debts as theybecome due, or if the realizable value of our assets would be less than ouraggregate liabilities and stated capital. Our directors may attach preferentialdividend rights to first or second preferred shares. Dividends are paid topreferred shareholders, if their preferred shares carry the right to apreferential dividned, before they are paid to common shareholders.

 

**Shares**

 

We are authorized toissue an unlimited number  of commonshares, an unlimited number of first preferred shares, and an unlimited numberof second preferred shares.  At the dateof this annual report there are 7,162,074 common shares, and nopreferred shares, outstanding.

 

**Voting**

 

Holders of common sharesare entitled to one vote for each share they own on any matter that issubmitted to a shareholder vote, unless only a different class of shareholders,for example holders of preferred shares, is entitled to vote on thatmatter.  Our board of directors mayattach various voting rights and restrictions to preferred shares.  Shareholders elect our directors to hold office

 

29

----

 

until the next annualmeeting of shareholders, or until their successors are elected orappointed.  Our Articles of Continuancedo not provide for cumulative voting for the election of directors.

 

**OtherRights of Shareholders**

 

If we are dissolved orliquidated, we must use our assets to pay liabilities and any remaining assetswould be distributed first to preferred shareholders if their preferred sharescarry the right to distribution of assets in priority to distribution of assetsto common shareholders, and second to the holders of common shares, inproportion to the number of shares they own. Our common shares do not have any redemption or sinking fund provisions.  There is no liability on the part of anyshareholder to further capital calls and there are no provisions discriminatingagainst any existing or prospective shareholder as a result of owning asubstantial number of shares.

 

Shareholders may byspecial resolution change the rights of holders of our shares.  A special resolution means a resolutionpassed by a majority of not less than two-thirds of the votes cast byshareholders entitled to vote on the resolution.

 

We are required byAlberta law and our by-laws to hold an annual meeting of shareholders in eachyear not later than fifteen months following the last annual meeting.  All business other than the consideration offinancial statements and the auditor’s report, election of directors and reappointmentof the incumbent auditor, is special business. A notice in writing stating the time and place of the meeting, thenature of any special business to be transacted and the text of any proposedspecial resolution must be given to shareholders of record not less than 21days and not more than 50 days prior to the meeting. In addition, Canadiansecurities regulatory policy requires us to deliver these shareholder meetingmaterials to brokers and intermediaries who hold shares on behalf of beneficialshareholders who do not hold their shares of record.  The brokers and intermediaries must seek voting instructions fromthe beneficial shareholders. At meetings of shareholders two persons presentand each holding or representing by proxy at least one common share constitutea quorum for purposes of selecting a chairman for the meeting or adjourning themeeting. For transacting any business at a shareholders meeting, two personspresent and each holding or representing by proxy at least five percent of theshares entitled to vote at the meeting must be present.  Holders of five percent or more of issuedvoting shares may requisition the directors to call a meeting for the purposestated in the requisition.  If the directorsdo not call a meeting within twenty-one days of the requisition, any shareholderwho signed the requisition may call the meeting.  Shareholders may vote at meetings in person or by proxy.

 

There are no limitationson rights to hold our shares or to exercise voting rights imposed by Albertalaw or by our articles or by-laws. There are no provisions in our articles orby-laws that would have the effect of delaying, deferring or preventing achange in control of our company and that would operate only with respect to amerger, acquisition or corporate restructuring of our company orsubsidiaries.  Our by-laws do notcontain any provision governing the threshold above which share ownership mustbe disclosed.

 

### **C.  Material Contracts**

 

Wehave not entered into any contracts other than agreements entered into in theordinary course of business.

 

### **D.  Exchange Controls**

 

Thereare no government laws, decrees or regulations in Canada which restrict theexport or import of capital or which affect the remittance of dividends,interest or other payments to non-resident holders of our common shares.  However, any such remittance to a residentof the United States is generally subject to Canadian withholding tax pursuantto the Income Tax Act (Canada) (the “Act”). (For further information concerning such non-resident withholding tax,see Item 10 E. “Taxation” of this annual report.)

 

### **E.  Taxation**

 

The following is ageneral summary only and is not intended to be, nor should it be considered tobe, legal or income tax advice to any particular QSound shareholder or reliedupon for tax planning purposes. Accordingly each shareholder should consult their own independent taxadvisors for advice with respect to the income tax consequences to them havingregard to their own particular circumstances.

 

**U.S. Federal Income Tax Consequences**

 

The following is ageneral discussion of certain possible U.S. federal income tax consequences,under current law, generally applicable to a U.S. Holder (as hereinafterdefined) of common shares of QSound. This discussion is of a general nature only and 

 

30

----

 

does not take intoaccount the particular facts and circumstances, with respect to U.S. federalincome tax issues, of any particular U.S. Holder.  In addition, this discussion does not cover any state, local orforeign tax consequences.  (See“Taxation—Canadian Federal Income Tax Consequences” above).

 

The followingdiscussion is based upon the sections of the Internal Revenue Code of 1986, asamended (the “Code”), Treasury Regulations, published Internal Revenue Service(“IRS”) rulings, published administrative positions of the IRS and courtdecisions that are currently applicable, any or all of which could bematerially and adversely changed, possibly on a retroactive basis, at any timeand which are subject to differing interpretations.  This discussion does not consider the potential effects, bothadverse and beneficial, of any proposed legislation which, if enacted, could beapplied, possibly on a retroactive basis, at any time.

 

**This discussion is for generalinformation only and it is not intended to be, nor should it be construed tobe, legal or tax advice to any U.S. Holder or prospective U.S. Holder of commonshares of QSound, and no opinion or representation with respect to the U.S.federal income tax consequences to any such U.S. Holder or prospective U.S.Holder is made.  Accordingly, U.S.Holders and prospective U.S. Holders of common shares of QSound should consulttheir own financial advisor, legal counsel or accountant regarding the U.S.federal, state, local and foreign tax consequences of purchasing, owning anddisposing of common shares of QSound.**

 

U.S. Holders

 

As used herein, a“U.S. Holder” means a holder of common shares of QSound who is (i) a  citizen or individual resident of the U.S.,(ii) a corporation or partnership created or organized in or under the laws ofthe U.S. or of any political subdivision thereof, (iii) an estate whose incomeis taxable in the U.S. irrespective of source or (iv) a trust subject to theprimary supervision of a court within the U.S. and control of a U.S. fiduciaryas described Section 7701(a)(30) of the Code.

 

Persons NotCovered

 

This summary doesnot address the U.S. federal income tax consequences to persons (includingpersons who are U.S. Holders) subject to special provisions of U.S. federalincome tax law, including (i) tax-exempt organizations, (ii) qualifiedretirement plans, (iii) individual retirement accounts and other tax-deferredaccounts, (iv) financial institutions, (v) insurance companies, (vi) realestate investment trusts, (vii) regulated investment companies, (viii)broker-dealers, (ix) persons or entities that have a “functional currency”other than the U.S. dollar, (x) persons subject to the alternative minimum tax,(xi) persons who own their common shares of QSound as part of a straddle,hedging, conversion transaction, constructive sale or other arrangementinvolving more than one position, (xii) persons who acquired their commonshares of QSound through the exercise of employee stock options or otherwise ascompensation for services, (xiii) persons that own an interest in an entitythat owns common shares of QSound, (xiv) persons who own, exercise or disposeof any options, warrants or other rights to acquire common shares of QSound, or(xv) persons who own their common shares of QSound other than as a capitalasset within the meaning of Section 1221 of the Code.

 

Distribution on Common Shares of QSound

 

U.S. Holdersreceiving distributions (including constructive distributions) with respect tocommon shares of QSound are required to include in gross income for U.S.federal income tax purposes the gross amount of such distributions, equal tothe U.S. dollar value of such distributions on the date of receipt (based onthe exchange rate on such date), to the extent that QSound has current oraccumulated earnings and profits, without reduction for any Canadian income taxwithheld from such distributions.  SuchCanadian tax withheld may be credited, subject to certain limitations, againstthe U.S. Holder’s U.S. federal income tax liability or, alternatively, may bededucted in computing the U.S. Holder’s U.S. federal taxable income by thosewho itemize deductions.  (See moredetailed discussion at “Foreign Tax Credit” below).  To the extent that distributions from QSound exceed current oraccumulated earnings and profits of QSound, such distributions will be treatedfirst as a return of capital, to the extent of the U.S. Holder’s adjusted basisin the common shares, and thereafter as gain from the sale or exchange of thecommon shares of QSound.  (See moredetailed discussion at “Disposition of Common Shares of QSound” below)

 

In the case offoreign currency received as a distribution that is not converted by therecipient into U.S. dollars on the date of receipt, a U.S. Holder will have atax basis in the foreign currency equal to its U.S. dollar value on the date ofreceipt.  Generally any gain or lossrecognized upon a subsequent sale or other disposition of the foreign currency,including the exchange for U.S. dollars, will be ordinary income or loss.  However, an individual whose realized gaindoes not exceed $200 will not recognize that gain, to the extent that there areno expenses associated with the transaction that meet the requirements fordeductibility as a trade or business expense (other than travel expenses inconnection with a business trip) or as an expense for the production of income.

 

Dividends paid onthe common shares of QSound generally will not be eligible for the “dividendsreceived deduction” allowed to corporate shareholders receiving dividends fromcertain U.S. corporations.  Undercertain circumstances, a U.S. Holder that is 

 

31

----

 

a corporation andthat owns shares representing at least 10%of the total voting power and thetotal value of QSound’s outstanding shares may be entitled to a 70% deductionof the “U.S. source” portion of dividends received from QSound (unless QSoundqualifies as a “Foreign Personal Holding Company” or a “Passive ForeignInvestment Company” as defined below). The availability of the dividends received deduction is subject toseveral complex limitations which are beyond the scope of this discussion, andU.S. Holders of common shares of QSound should consult their own financialadvisor, legal counsel or accountant regarding the dividends received deduction.

 

Certaininformation reporting and backup withholding rules may apply with respect tocertain payments related to QSound’s common shares. In particular, a payor ormiddleman within the U.S., or in certain cases outside the U.S., will berequired to withhold 30% (which rate is scheduled for periodic adjustment) ofany payments to a U.S. Holder of QSound’s common shares of dividends on, orproceeds from the sale of, such common shares within the U.S., if a U.S. Holderfails to furnish its correct taxpayer identification number or otherwise failsto comply with, or establish an exemption from, the backup withholding taxrequirements. Any amounts withheld under the U.S. backup withholding tax ruleswill be allowed as a refund or a credit against the U.S. Holder’s U.S. federalincome tax liability, provided the required information is furnished to theIRS.  **U.S. Holders should consult their ownfinancial advisor, legal counsel or accountant regarding the informationreporting and backup withholding rules applicable to QSound’s common shares.**

 

Foreign Tax Credit

 

A U.S. Holder whopays (or has withheld from distributions) Canadian or other foreign income taxwith respect to the ownership of common shares of QSound may be entitled, atthe option of the U.S. Holder, to either receive a deduction or a tax creditfor U.S. federal income tax purposes with respect to such foreign tax paid orwithheld.  Generally, it will be more advantageousto claim a credit because a credit reduces U.S. federal income taxes on adollar-for-dollar basis, while a deduction merely reduces the taxpayer’s incomesubject to U.S. federal income tax. This election is made on a year-by-year basis and applies to all foreigntaxes paid by (or withheld from distributions to) the U.S. Holder during thatyear.

 

There aresignificant and complex limitations that apply to the foreign tax credit, amongwhich is the general limitation that the credit cannot exceed the proportionateshare of the U.S. Holder’s U.S. income tax liability that the U.S. Holder’s“foreign source” income bears to his or its worldwide taxable income.  In applying this limitation, the variousitems of income and deduction must be classified as either “foreign source” or“U.S. source.”  Complex rules governthis classification process.  Inaddition, this limitation is calculated separately with respect to specific classesof income such as “passive income,” “high withholding tax interest,” “financialservices income,” “shipping income,” and certain other classifications ofincome.  Dividends distributed by QSoundwill generally constitute “foreign source” income, and will be classified as“passive income” or, in the case of certain U.S. Holders, “financial servicesincome” for these purposes.

 

In addition, U.S.Holders that are corporations and that own 10% or more of the voting stock ofQSound may be entitled to an “indirect” foreign tax credit under Section 902 ofthe Code with respect to the payment of dividends by QSound under certaincircumstances and subject to complex rules and limitations.** The availability of the foreign tax credit and the application of thelimitations with respect to the foreign tax credit are fact specific, and eachU.S. Holder of common shares of QSound should consult their own financialadvisor, legal counsel or accountant regarding the foreign tax credit rules.**

 

Disposition of Common Shares of QSound

 

A U.S. Holder willrecognize gain or loss upon the sale or other taxable disposition of commonshares of QSound equal to the difference, if any, between (i) the amountof cash plus the fair market value of any property received, and (ii) theshareholder’s tax basis in the common shares of QSound.  This gain or loss will be capital gain orloss if the common shares are a capital asset in the hands of the U.S. Holder,which will be long-term capital gain or loss if the common shares of QSound areheld for more than one year.

 

Preferential taxrates apply to long-term capital gains of U.S. Holders that are individuals,estates or trusts. If the common shares of QSound are held for more than fiveyears, a lower long-term capital gains tax rate may apply. There are currentlyno preferential tax rates for long-term capital gains for a U.S. Holder that isa corporation (other than a corporation subject to Subchapter S of the Code).Deductions for net capital losses are subject to significant limitations.  For U.S. Holders that are not corporations,any unused portion of such net capital loss may be carried over to be used inlater tax years until such net capital loss is thereby exhausted.  For U.S. Holders that are corporations(other than corporations subject to Subchapter S of the Code), an unused netcapital loss may be carried back three years and carried forward five yearsfrom the loss year to be offset against capital gains until such net capitalloss is thereby exhausted.

 

32

----

 

Other Considerations for U.S. Holders

 

In the followingcircumstances, the above sections of this discussion may not describe the U.S.federal income tax consequences to U.S. Holders resulting from the ownershipand disposition of common shares of QSound:

 

*Foreign Personal Holding Company*

 

If at any timeduring a taxable year (i) more than 50% of the total voting power or the totalvalue of QSound’s outstanding shares is owned, directly or indirectly, by fiveor fewer individuals who are citizens or residents of the U.S. and (ii) 60% (or50% in certain cases) or more of QSound’s gross income for such year is“foreign personal holding company income” as defined in Section 553 of the Code(e.g., dividends, interest, royalties, certain gains from the sale of stock andsecurities, and certain gains from commodities transactions), QSound may betreated as a “Foreign Personal Holding Company” (“FPHC”)  In that event, U.S. Holders of common sharesof QSound would be required to include in gross income for such year their allocableportions of such “foreign personal holding company income” to the extent QSounddoes not actually distribute such income.

 

QSound does notbelieve that it currently qualifies as a FPHC. However, there can be no assurance that QSound will not be considered aFPHC for the current or any future taxable year.

 

*Foreign Investment Company*

 

If (i) 50% or moreof the total voting power or the total value of QSound’s outstanding shares isowned, directly or indirectly, by citizens or residents of the U.S., U.S.partnerships or corporations, or U.S. estates or trusts (as defined by the CodeSection 7701(a)(30)), and (ii) QSound is found to be engaged primarily in thebusiness of investing, reinvesting, or trading in securities, commodities, orany interest therein, QSound may be treated as a “Foreign Investment Company”(“FIC”) as defined in Section 1246 of the Code, causing all or part of any gainrealized by a U.S. Holder selling or exchanging common shares of QSound to betreated as ordinary income rather than capital gain.

 

QSound does notbelieve that it currently qualifies as a FIC. However, there can be no assurance that QSound will not be considered aFIC for the current or any future taxable year.

 

*Controlled Foreign Corporation*

 

If more than 50%of the total voting power or the total value of QSound’s outstanding shares isowned, directly or indirectly, by citizens or residents of the U.S., U.S.partnerships or corporations, or U.S. estates or trusts (as defined by the CodeSection 7701(a)(30)), each of which own, directly or indirectly, 10% or more ofthe total voting power of QSound’s outstanding shares (each a “10%Shareholder”), QSound could be treated as a “Controlled Foreign Corporation”(“CFC”) under Section 957 of the Code.

 

The classificationof QSound as a CFC would effect many complex results, including that 10%Shareholders of QSound would generally (i) be treated as having received acurrent distribution of QSound’s “Subpart F income” and (ii) would also besubject to current U.S. federal income tax on their pro rata shares of QSound’searnings invested in “U.S. property.” The foreign tax credit may reduce the U.S. federal income tax on theseamounts for such 10% Shareholders (See more detailed discussion at “Foreign TaxCredit” above).  In addition, underSection 1248 of the Code, gain from the sale or other taxable disposition ofcommon shares of QSound by a U.S. Holder that is or was a 10% Shareholder atany time during the five-year period ending with the sale is treated asordinary income to the extent of earnings and profits of QSound attributable tothe common shares sold or exchanged.

 

If QSound isclassified as both a Passive Foreign Investment Company as described below anda CFC, QSound generally will not be treated as a Passive Foreign InvestmentCompany with respect to 10% Shareholders. This rule generally will be effective for taxable years of 10%Shareholders beginning after 1997 and for taxable years of QSound ending withor within such taxable years of 10% Shareholders.

 

QSound does notbelieve that it currently qualifies as a CFC. However, there can be no assurance that QSound will not be considered aCFC for the current or any future taxable year.  **The CFC rules are very complicated, and U.S. Holders should consult theirown financial advisor, legal counsel or accountant regarding the CFC rules andhow these rules may impact their U.S. federal income tax situation.**

 

33

----

 

Passive ForeignInvestment Company

 

Certain U.S. income taxlegislation contains rules governing “Passive Foreign Investment Companies”(“PFIC”) which can have significant tax effects on U.S. Holders of foreigncorporations.  Section 1297 of the Codedefines a PFIC as a corporation that is not formed in the U.S. and, for anytaxable year, either (i) 75% or more of its gross income is “passive income” or(ii) the average percentage, by fair market value (or, if the corporation isnot publicly traded and either is a controlled foreign corporation or makes anelection, by adjusted tax basis), of its assets that produce or are held forthe production of “passive income” is 50% or more.  “Passive income” includes, for example, dividends, interest,certain rents and royalties, certain gains from the sale of stock and securities,and certain gains from commodities transactions.  However, gains resulting from commodities transactions aregenerally excluded from the definition of passive income if “substantially all”of a merchant’s, producer’s or handler’s business is as an active merchant,producer or handler of such commodities.

 

Forpurposes of the PFIC income test and the assets test, if a foreign corporationowns (directly or indirectly) at least 25% by value of the stock of anothercorporation, such foreign corporation shall be treated as if it (a) held a proportionateshare of the assets of such other corporation, and (b) received directly itsproportionate share of the income of such other corporation.  Also, for purposes of such PFIC tests,passive income does not include any interest, dividends, rents or royaltiesthat are received or accrued from a “related” person to the extent such amountis properly allocable to the income of such related person which is not passiveincome.  For these purposes, a person isrelated with respect to a foreign corporation if such person “controls” theforeign corporation or is controlled by the foreign corporation or by the samepersons that control the foreign corporation. For these purposes, “control” means ownership, directly or indirectly,of stock possessing more than 50% of the total voting power of all classes ofstock entitled to vote or of the total value of stock of a corporation.

 

U.S.Holders owning common shares of a PFIC are subject to the highest rate of taxon ordinary income in effect for the applicable taxable year and to an interestcharge based on the value of deferral of tax for the period during which thecommon shares of the PFIC are owned with respect to certain “excessdistributions” on and dispositions of PFIC stock under Section 1291 of theCode.  However, if the U.S. Holder makesa timely election to treat a PFIC as a qualified electing fund (“QEF”) withrespect to such shareholder’s interest therein, the above-described rulesgenerally will not apply.  Instead, theelecting U.S. Holder would include annually in his gross income his pro ratashare of the PFIC’s ordinary earnings and net capital gain regardless ofwhether such income or gain was actually distributed.  A U.S. Holder of a QEF can, however, elect to defer the paymentof U.S. federal income tax on such income inclusions.  In addition, subject to certain limitations, U.S. Holders owning,actually or constructively, marketable (as specifically defined) stock in aPFIC will be permitted to elect to mark that stock to market annually, rather thanbe subject to the tax regime of Section 1291 of Code as described above.  Amounts included in or deducted from incomeunder this alternative (and actual gains and losses realized upon disposition,subject to certain limitations) will be treated as ordinary gains or losses.

 

QSound believes that itdid not qualify as a PFIC for its fiscal year ended December 31, 2002, and doesnot anticipate that it will qualify as a PFIC for the fiscal year endingDecember 31, 2003.  However, there canbe no assurance that QSound will not be considered a PFIC for the current orany future taxable year.  There can beno assurance that QSound’s determination concerning its PFIC status will not bechallenged by the IRS, or that it will be able to satisfy record keeping requirementsthat will be imposed on QEFs in the event that it qualifies as a PFIC.

 

**The PFIC rules are very complicated, and U.S. Holders shouldconsult their own financial advisor, legal counsel or accountant regarding thePFIC rules and how these rules may impact their U.S. federal income taxsituation.**

 

**Canadian Federal IncomeTax Consequences**

 

Thefollowing is a general summary of certain Canadian federal income taxconsiderations generally applicable to a holder of QSound common shares who isnot a resident of Canada for the purposes of the *Income Tax Act* (Canada) (the“Act”) and who holds such common shares as capital property.  The discussion does not address all thepotentially relevant Canadian federal income tax matters and it does notaddress consequences peculiar to persons subject to special provisions offederal income tax law including a “financial institution” as defined in theAct subject to the mark to market rules or a shareholder an interest in whichwould be a “tax shelter” as defined in the Act.

 

Thissummary is based upon the current provisions of the Act and the Regulationsthereunder and our understanding of the current administrative practicespublished by the Canada Customs and Revenue Agency.  This summary takes into account proposals to amend the Act andRegulations announced prior to the date hereof (although no assurances can begiven that such changes will be enacted in the form presented or at all), butdoes not otherwise take into account or anticipate any other changes in law, whetherby judicial, governmental or legislative action or decision nor does it takeinto account any provincial, territorial, local or foreign tax 

 

34

----

 

considerationswhich may vary significantly from those discussed herein.  Accordingly, holders and prospective holdersof our shares should consult their own tax advisors about the federal,provincial, territorial, local and foreign tax consequences to them of purchasing,owning and disposing of such shares having regard to their particularcircumstances.

 

TheAct provides that dividends and other distributions which are deemed to bedividends and which are paid or credited, or are deemed to be paid or creditedby a corporation resident in Canada, to a person who is not resident of Canadafor purposes of the Act shall be subject to withholding tax equal to 25 percentof the gross amount of the dividend. This rate of withholding tax is subject to reduction if the provisionsof a tax treaty between Canada and the country in which the recipient isresident provide for a lesser rate of withholding tax.

 

Shareholderswho are residents of the United States for purposes of the Canada-United StatesIncome Tax Convention (1980) (the “1980 Convention”) will generally be entitledto the benefits of the 1980 Convention.

 

ArticleX of the 1980 Convention generally provides that the rate of Canadianwithholding tax on dividends paid or deemed to be paid by a corporationresident in Canada to a corporation resident in the U.S. that beneficially ownsat least 10 percent of the voting stock of the corporation paying the dividendshall not exceed 5 percent.  Otherwise,and except as described below, the rate of non-resident withholding shall notexceed 15 percent of the dividend.  Where the dividends are received by a resident of the UnitedStates carrying on business in Canada through a permanent establishment inCanada or by a person who performs independent personal services in Canada froma fixed base situated in Canada, and holding of the shares in respect of whichthe dividends are paid is effectively connected with that permanentestablishment, the dividends are generally subject to Canadian tax as businessprofits or income from rendering such services and the 1980 Convention does notlimit the Canadian tax payable on such income under the Act.

 

Generallya non-resident person is not subject to income tax in Canada on any capitalgain arising on the disposition of shares of a corporation which are listed ona prescribed stock exchange unless such shares constitute “taxable Canadianproperty” to such holder.  Generally,the shares will be taxable Canadian property to a non-resident person only if,at any time during the five year period immediately preceding the disposition,the non-resident person, either alone or together with persons with whom suchnon-resident did not deal at arm’s length, owned or had the right to acquire 25percent or more of the issued shares of any class or series of the capitalstock of the corporation, or the non-resident’s shares were acquired in a taxdeferred exchange in consideration for property that was itself taxableCanadian property.

 

ArticleXIII of the 1980 Convention generally provides that gains realized on thedisposition of shares of a corporation that is a resident of Canada by aresident of the United States for purposes of the 1980 Convention, may not betaxed in Canada unless the value of those shares is derived principally fromreal property situated in Canada or the shares form part of the businessproperty of a permanent establishment which the resident of the United Stateshas or had in Canada within the 12 month period preceding the date ofdisposition or if the shares pertain to a fixed base in Canada which is or wasavailable within the 12 month period preceding the date of disposition for thepurpose of performing independent personal services.  However, Article XIII permits Canada to tax gains on shares ofother corporations (including substituted shares), if the United States residentwas a resident of Canada for 120 months during any prior 20-consecutive-yearperiod and at any time during the preceding 10 years and owned our commonshares at the time the person emigrated from Canada

 

Insituations where our common shares constitute taxable Canadian property, andthe treaty benefits discussed above are not applicable, one-half of any capitalgain (a “taxable capital gain”) realized by a shareholder in a taxation yearmust be included in the shareholder’s income for the year for Canadian taxpurposes, and one-half of any capital loss (an “allowable capital loss”)realized by a shareholder in a taxation year may be deducted from taxablecapital gains realized by the shareholder in that year.  Allowable capital losses for a taxation yearin excess of taxable capital gains for that year generally may be carried backand deducted in any of the three preceding taxation years or carried forwardand deducted in any subsequent taxation year against net taxable capital gainsrealized in such years, to the extent and under the circumstances described inthe Act.

 

### **F.  Dividends and PayingAgents**

 

Not applicable.

 

### **G.  Statements byExperts**

 

Not Applicable

 

35

----

 

### **H.  Documents on display**

 

We are subject to theinformational requirements of the Securities Exchange Act of 1934 and we filereports, registration statements and other information with the SEC. Ourreports, registration statements other information can be inspected and copiedat the public reference facilities maintained by the SEC:

 
| Room 1024             |   | Suite 1400              |
|-----------------------|--------|-------------------------|
| 450 Fifth Street N.W. |   | 500 West Madison Street |
| Washington D.C. 20549 |   | Chicago, IL  60661 |

 

Copies of these materialscan also be obtained by mail at prescribed rates from the Public ReferenceSection of the SEC, 450 Fifth Street, N.W., Washington, D.C. 20549 or bycalling the SEC at 1-800-SEC-0330.

 

### **I.  Subsidiary Information**

 

Not Applicable

 

## **ITEM11**.  QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

**Foreign Currency**

 

Weuse the U.S. dollar as our currency of measurement and display.  We are exposed to foreign currencyfluctuation on our Canadian dollar denominated cash, receivables, andpayables.  Canadian dollar denominatedaccounts receivables are nominal. Canadian dollar denominated payables are all trade payables arising outof the normal course of business. Foreign currency risk arising from a decline or increase in the relativevalue of the Canadian dollar is managed to the extent that the estimatedrequirement for Canadian dollar denominated cash for the next fiscal year iskept equal to the amount of Canadian dollar cash on hand.  The majority of our overseas transactionsare conducted in U.S. dollars.

 

**Interest Rates**

 

QSound’s exposure tomarket risk for changes in interest rates, relates to our invested balances ofcash and cash equivalents. QSound’s investment policy specifies excess fundsare to be invested in a manner that preserves capital, provides liquidity andgenerates the highest available after-tax return. To limit exposure to marketrisk, QSound places its cash in banks and cash not required for immediateoperations are placed in bank term deposits and high quality, short-termcommercial paper. QSound does not invest in any derivative instruments. Thefair value of QSound’s cash and cash equivalents or related income would not besignificantly impacted by either a 100 basis point increase or decrease ininterest rates as most investments are at fixed rates and are relatively shortterm. All cash and cash equivalents are carried at fair value, whichapproximates cost.

 

## **ITEM 12**. DESCRIPTION OF SECURITIESOTHER THAN EQUITY SECURITIES 

 

Not Applicable.

 

# **PART II**

 

## **ITEM13**. DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES 

 

We are not in materialdefault on any of our obligations relating to indebtedness. We have notdeclared any dividends and are not delinquent with respect to the payment ofdividends.

 

## **ITEM14**. MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITYHOLDERS 

 

During our last fiscalyear, we have not materially modified any of the rights or instruments definingthe rights of our security holders.  Wedo not have any registered securities which are secured by our assets.  We do not have trustees or paying agents forour securities.

 

36

----

 

## **ITEM15**. CONTROLS AND PROCEDURES

 

Based on their evaluationof our disclosure controls and procedures (as defined in Rules 13a-14(c) and15d-14(c) under the Securities Exchange Act of 1934) as of a date within 90days of the filing date of this annual report on Form 20-F, our utive andFinancial Officer has concluded that our disclosure controls and procedures aredesigned to ensure that information required to be disclosed by us in thereports that we file or submit under the Exchange Act is recorded, processed,summarised and reported within the time periods specified in the SEC’s rulesand forms, and are operating in an effective manner.

 

There were no significantchanges in our internal controls or in other factors that could significantlyaffect these controls subsequent to the date of their most recent evaluation.

 

## **ITEM16**. [RESERVED] 

 

 

# **PART III**

 

## **ITEM17**. FINANCIAL STATEMENTS 

 

ConsolidatedFinancial Statements of QSound Labs, Inc. and subsidiaries:

 

Auditor’sReport to the Shareholders.

 

ConsolidatedBalance Sheets – December 31, 2002 and 2001.

 

ConsolidatedStatements of Operations and Deficit – Years ended December 31, 2002, 2001 and2000.

 

ConsolidatedCash Flows– Years ended December 31, 2002, 2001 and 2000.

 

Notes toConsolidated Financial Statements – Years ended December 31, 2002, 2001 and2000.

 

## **ITEM18**. FINANCIAL STATEMENTS 

 

Not Applicable.

 

## **ITEM19**. EXHIBITS

 

1.1  Articles of Continuance of QSound Labs, Inc.(formerly called Archer Communications Inc.). (Incorporated by reference to ourAnnual Report on Form 20-F filed June 29, 2001.)

 

1.2  By-law No. 1 dated July 2, 2002.

 

1.3  By-law No. 2 dated May 14, 1991.(Incorporated by reference to our Annual Report on Form 20-F filed June 29,2001.)

 

1.4  Articles of Amendment dated September 3,1991. (Incorporated by reference to our Annual Report on Form 20-F filed June29, 2001.)

 

1.5  Articles of Amendment dated July 8, 1992.(Incorporated by reference to our Annual Report on Form 20-F filed June 29,2001.)

 

1.6  Articles of Amendment dated June 25, 1993.(Incorporated by reference to our Annual Report on Form 20-F filed June 29,2001.)

 

1.7  Articles of Amendment dated November 26,1996. (Incorporated by reference to our Annual Report on Form 20-F filed June29, 2001.)

 

1.8  Articles of Amendment dated January 8, 1997.(Incorporated by reference to our Annual Report on Form 20-F filed June 29,2001.)

 

2.1  Not Applicable

 

37

----

 

3.1  Not Applicable

 

4.1  Form of Stock Option Agreement

 

4.2   QSound Labs, Inc. 1998 Stock Option Plan

 

4.3   Employment Agreement dated October 1, 2002between David Gallagher and QSound Labs, Inc.

 

5.1  Not applicable.

 

6.1  Not applicable.

 

7.1  Not applicable.

 

8.1 List of Subsidiaries

 

9.1  Not applicable.

 

10.1 Certification undersection 906 of the Sarbanes-Oxley Act of 2002.

 

10.2  KPMG Consent of Auditors

 

 

# **SIGNATURE**

 

 

Theregistrant hereby certifies that it certifiesthat it meets all of the requirements for filing on Form 20-F and that it has dulycaused and authorized the undersigned to sign this annual report on its behalf.

 

 
|   |   |   |   |   |   | QSound Labs, Inc.                     |   |
|--------|--------|--------|--------|--------|--------|---------------------------------------|--------|
|   |   |   |   |   |   |                                  |   |
|   |   |   |   |   |   |                                  |   |
|   |   |   |   |   |   | /s/ David Gallagher                   |   |
|   |   |   |   |   |   | David Gallagher                       |   |
|   |   |   |   |   |   | President and Chief Executive Officer |
|   |   |   |   |   |   |                                  |   |
|   |   |   |   |   |   | May 20, 2003                          |
|        |        |        |        |        |        |                                       |        |  |

 

 

# **CERTIFICATION**

 

I, David Gallagher,certify that:

 

1.             I have reviewed this annual report of QSound Labs, Inc,;

 

2.             Based on my knowledge, this annual report does notcontain any untrue statement of a material fact or omit to state a materialfact necessary in order to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this annual report;

 

3.             Based on my knowledge, the financial statements, andother financial information included in this annual report, fairly present inall material respects the financial condition, results of operations and cashflows of the registrant as of, and for, the periods presented in this annualreport;

 

4.             The registrant’s other certifying officers and I areresponsible for establishing and maintaining disclosure controls and procedures(as defined in Exchange Act Rules 13a – 14 and 15d – 14) for the registrant andwe have:

 

38

----

 

a) designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which theannual report is being prepared;

 

b) evaluated theeffectiveness of the issuer’s disclosure controls and procedures as of a datewithin 90 days prior to the filing date of this annual report (the “EvaluationDate”); and

 

c) presented in thisannual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.             The registrant’s other certifying officers and I havedisclosed, based on our most recent evaluation, to the registrant’s auditorsand the audit committee of registrant’s board of directors (or personsperforming the equivalent function):

 

a) all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weakness in internal controls; and

 

b) any fraud, whether ornot material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6.             The registrant’s other certifying officer and I haveindicated in this annual report whether or not there were significant changesin internal controls or in other factors that could significantly affect internalcontrols subsequent to the date of our most recent evaluation, including anycorrective actions with regard to significant deficiencies and materialweaknesses.

 

 
|   | /s/ David Gallagher                   |   |
|--------|---------------------------------------|--------|
|   | David Gallagher                       |
|   | President and Chief Executive Officer |
|   |                                  |
|   |                                  |
|   | May 20, 2003                          |

 

## **ConsolidatedFinancial** Statements

 

39

----

 

 

 

| Consolidated Financial  Statements of         |
|-----------------------------------------------|
|                                          |
| **QSOUND LABS, INC.**                         |
|                                          |
| Years ended December  31, 2002, 2001 and 2000 |
| (Expressed in United  States dollars)         |

 

40

----

 

**AUDITORS’REPORT TO THE SHAREHOLDERS**

 

We have audited the consolidated balance sheets of QSound Labs, Inc. asat December 31, 2002 and 2001 and the consolidated statements ofoperations and deficit and cash flows for each of the years in the three yearperiod ended December 31, 2002.  Thesefinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.

 

We conducted our audits in accordance with Canadian generally acceptedauditing standards and United States generally accepted auditingstandards.  Those standards require thatwe plan and perform an audit to obtain reasonable assurance whether thefinancial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.

 

In our opinion, these consolidated financial statements present fairly,in all material respects, the financial position of the Company as atDecember 31, 2002 and 2001 and the results of its operations and its cashflows for each of the years in the three year period ended December 31, 2002,in accordance with Canadian generally accepted accounting principles.

 

Accounting principles generally accepted in Canada vary in certainsignificant respects from accounting principles generally accepted in theUnited States.  Application ofaccounting principles generally accepted in the United States would haveaffected results of operations for each of the years in the three year periodended December 31, 2002 and total assets and shareholders’ equity as atDecember 31, 2002 and 2001 to the extent summarized in note 15 to theconsolidated financial statements.

 

 

/s/  KPMG LLP

Chartered Accountants

 

Calgary, Canada

March 21, 2003

 

41

----

 

**QSOUND LABS,INC.**

Consolidated Balance Sheets

 

December 31, 2002 and 2001

(Expressed in United States dollars)

 
|                                           |   | **2002**    |      | **2001**    |   |
|------------------------------------------------|--------|-------------|-----------|-------------|--------|
|                                           |   |        |      |        |   |
| **ASSETS**                                     |   |        |      |        |   |
| *Current assets*                               |   |        |      |        |   |
| Cash and cash  equivalents                     |   | $           | 2,621,205 |        | $      | 2,047,892 |   |
| Accounts  receivable                           |   | 929,519     |      | 439,245     |   |
| Inventory                                      |   | 16,455      |      | 28,587      |   |
| Deposits and  prepaid expenses                 |   | 58,674      |      | 85,365      |   |
|                                           |   | 3,625,853   |      | 2,601,089   |   |
|                                           |   |        |      |        |   |
| Note receivable  (note 2)                      |   | 500,000     |      | —      |   |
| Capital assets  (note 3)                       |   | 747,553     |      | 932,777     |   |
| Goodwill (note  4)                             |   | 2,184,589   |      | 2,184,589   |   |
| Other intangible  assets (note 5)              |   | 213,771     |      | 247,552     |   |
|                                           |   |        |      |        |   |
|                                           |   | $           | 7,271,766 |        | $      | 5,966,007 |   |
|                                           |   |        |      |        |   |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY** |   |        |      |        |   |
| *Current liabilities*                          |   |        |      |        |   |
| Accounts payable  and accrued liabilities      |   | $           | 220,894   |        | $      | 304,726 |   |
| Deferred revenue                               |   | 120,511     |      | 8,282       |   |
|                                           |   | 341,405     |      | 313,008     |   |
|                                           |   |        |      |        |   |
| *Shareholders’ equity*                    |   |        |      |        |   |
| Share capital  (note 6)                        |   | 43,886,036  |      | 43,737,626  |   |
| Contributed  surplus (note 6)                  |   | 1,114,316   |      | 1,114,316   |   |
| Deficit                                        |   | (38,069,991 | )         | (39,198,943 | )      |
|                                           |   |        |      |        |   |
| Commitments and  contingencies (note 14)       |   | 6,930,361   |      | 5,652,999   |   |
|                                           |   | $           | 7,271,766 |        | $      | 5,966,007 |   |

 

See accompanying notes to consolidated financial statements.

 

Approved by the Board:

 
| David Gallagher    |  Director |
|--------------------|----------------|
|               |           |
| James R. Bonfiglio |  Director |

 

42

----

 

**QSOUND LABS,INC.**

Consolidated Statements of Operations and Deficit

 

Years ended December 31, 2002, 2001 and 2000

(Expressed in United States dollars)

 
|                                     |   | **2002**    |        | **2001**    |   | **2000**    |   |
|------------------------------------------|--------|-------------|-------------|-------------|--------|-------------|--------|
|                                     |   |        |        |        |   |        |   |
| **REVENUE**                              |   |        |        |        |   |        |   |
| Royalties                                |   | $           | 2,663,550   |        | $      | 1,384,431   |   | $ | 1,286,990 |   |
| License fees                             |   | 147,167     |        | 40,683      |   | 772,081     |   |
| Product sales                            |   | 1,413,594   |        | 1,600,880   |   | 2,409,931   |   |
|                                     |   | 4,224,311   |        | 3,025,994   |   | 4,469,002   |   |
|                                     |   |        |        |        |   |        |   |
| Cost of product  sales                   |   | 271,530     |        | 91,438      |   | 208,298     |   |
|                                     |   | 3,952,781   |        | 2,934,556   |   | 4,260,704   |   |
|                                     |   |        |        |        |   |        |   |
| **EXPENSES**                             |   |        |        |        |   |        |   |
| Marketing                                |   | 895,820     |        | 1,074,139   |   | 1,360,698   |   |
| Operations                               |   | 235,201     |        | 275,077     |   | 375,000     |   |
| Product research  and development        |   | 643,524     |        | 951,017     |   | 1,610,436   |   |
| Administration                           |   | 506,028     |        | 597,685     |   | 802,582     |   |
|                                     |   | 2,280,573   |        | 2,897,918   |   | 4,148,716   |   |
|                                     |   |        |        |        |   |        |   |
| Operating profit                         |   | 1,672,208   |        | 36,638      |   | 111,988     |   |
|                                     |   |        |        |        |   |        |   |
| Depreciation and  amortization           |   | (382,662    | )           | (831,193    | )      | (2,535,856  | )      |
| Impairment of  assets                    |   | (100,000    | )           | —      |   | (5,163,504  | )      |
| Funding of past  service pension costs   |   | (55,189     | )           | —      |   | —      |   |
| Write-down of  investments               |   | —      |        | (8,300      | )      | (1,515,568  | )      |
| Interest and  other income               |   | 29,833      |        | 73,568      |   | 154,788     |   |
| Gain (loss) on  sale of capital assets   |   | 740         |        | 6,492       |   | (34,634     | )      |
| Gain on sale of  investments             |   | —      |        | 24,327      |   | —      |   |
| Other                                    |   | (35,978     | )           | (34,442     | )      | (225,048    | )      |
|                                     |   | (543,256    | )           | (769,548    | )      | (9,319,822  | )      |
|                                     |   |        |        |        |   |        |   |
| Net income  (loss) for the year          |   | 1,128,952   |        | (732,910    | )      | (9,207,834  | )      |
|                                     |   |        |        |        |   |        |   |
| Deficit,  beginning of year              |   | (39,198,943 | )           | (38,466,033 | )      | (29,258,199 | )      |
| Deficit, end of  year                    |   | $           | (38,069,991 | )           | $      | (39,198,943 | )      | $ | (38,466,033 | ) |
| Income (loss)  per common share, basic   |   | $           | 0.16        |        | $      | (0.10       | )      | $ | (1.30 | ) |
| Income (loss)  per common share, diluted |   | $           | 0.15        |        | $      | (0.10       | )      | $ | (1.30 | ) |

 

See accompanying notes to consolidated financial statements.

 

43

----

 

**QSOUND LABS,INC.**

Consolidated Statements of Cash Flows

 

Years ended December 31, 2002, 2001 and 2000

(Expressed in United States dollars)

 
|                                                    |   | **2002**  |      | **2001**  |   | **2000**  |   |
|---------------------------------------------------------|--------|-----------|-----------|-----------|--------|-----------|--------|
|                                                    |   |      |      |      |   |      |   |
| Cash provided by  (used in):                            |   |      |      |      |   |      |   |
|                                                    |   |      |      |      |   |      |   |
| **Operations:**                                         |   |      |      |      |   |      |   |
| Net income  (loss) for the year                         |   | $         | 1,128,952 |      | $      | (732,910  | )      | $ | (9,207,834 | ) |
| Items not  requiring (providing) cash:                  |   |      |      |      |   |      |   |
| Depreciation and  amortization                          |   | 382,662   |      | 831,193   |   | 2,535,856 |   |
| Impairment of  assets                                   |   | 100,000   |      | —    |   | 5,163,504 |   |
| Compensation  cost of options issued to non-employees   |   | 4,870     |      | —    |   | —    |   |
| Loss (gain) on  sale of capital assets                  |   | (740      | )         | (6,492    | )      | 34,634    |   |
| Gain on sale of  investments                            |   | —    |      | (24,327   | )      | —    |   |
| Write-down of  investments                              |   | —    |      | 8,300     |   | 1,515,568 |   |
| Changes in  non-cash working capital balances (note 10) |   | (423,054  | )         | 713,517   |   | (524,678  | )      |
|                                                    |   | 1,192,690 |      | 789,281   |   | (482,950  | )      |
|                                                    |   |      |      |      |   |      |   |
| **Financing:**                                          |   |      |      |      |   |      |   |
| Issuance of  common shares                              |   | 34,815    |      | —    |   | 2,757,233 |   |
| Repurchase of  common shares, net                       |   | —    |      | (430,800  | )      | (152,989  | )      |
| Repayments of  debt                                     |   | —    |      | (550,000  | )      | (750,000  | )      |
|                                                    |   | 34,815    |      | (980,800  | )      | 1,854,244 |   |
|                                                    |   |      |      |      |   |      |   |
| **Investments:**                                        |   |      |      |      |   |      |   |
| Investments, net                                        |   | —    |      | 218,827   |   | 23,638    |   |
| Purchase of  capital assets                             |   | (113,880  | )         | (216,291  | )      | (529,863  | )      |
| Purchase of  intangible asset                           |   | (41,052   | )         | (34,418   | )      | —    |   |
| Note receivable  (note 2)                               |   | (500,000  | )         | —    |   | —    |   |
| Goodwill                                                |   | —    |      | —    |   | (130,168  | )      |
| Proceeds from  sale of capital assets                   |   | 740       |      | 6,654     |   | 5,375     |   |
|                                                    |   | (654,192  | )         | (25,228   | )      | (631,018  | )      |
|                                                    |   |      |      |      |   |      |   |
| Increase  (decrease) in cash and cash equivalents       |   | 573,313   |      | (216,747  | )      | 740,276   |   |
| Cash and cash  equivalents, beginning of year           |   | 2,047,892 |      | 2,264,639 |   | 1,524,363 |   |
| Cash and cash  equivalents, end of year                 |   | $         | 2,621,205 |      | $      | 2,047,892 |   | $ | 2,264,639 |   |

 

See accompanying notes to consolidated financial statements.

 

44

----

 

**QSOUND LABS,INC.**

Notes to Consolidated Financial Statements

 

Years ended December 31, 2002, 2001 and 2000

(Expressed in United States dollars)

 

**Significant accounting policies:**

 

The accompanying consolidated financial statements are prepared inaccordance with accounting principles generally accepted in Canada which, inthe case of QSound Labs, Inc. (the “Company”), conform in all material respectswith those in the United States, except as outlined in note 15.  All amounts are expressed in United Statesdollars.

** **

**Use ofEstimates:**

 

The preparation of financial statements in conformity with generallyaccepted accounting principles requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expenses.  Actual results could differ from theseestimates.

 

The Company’s significant accounting policies are as follows:

 

**Basis ofpresentation:**

 

These consolidated financial statements include theaccounts of QSound Labs, Inc. a public company organized under the laws of theProvince of Alberta, Canada and its wholly-owned subsidiaries QCommerce, Inc.,QSound Ltd., QSound Electronics, Inc. and QKidz, Inc.  All significant inter-company transactions and balances have beeneliminated.  During 2002 QKidz Inc. waswound up.

 

**Cash andcash equivalents:**

 

Cash equivalents are short term deposits with originalmaturities of less than 90 days for which cost approximates market value.

 

**Inventory:**

 

Inventory is comprised of finished goods and is statedat the lower of cost, being determined by the first-in, first-out method, andnet realizable value.

 

**Capitalassets:**

 

Capital assets are recorded at cost and are amortizedannually, beginning the year after acquisition, over the expected useful lifeof the assets as follows:

 
| **Assets**                          |   | **Basis**         |   | **Rate** |   |
|-------------------------------------|--------|-------------------|--------|----------|--------|
|                                |   |              |   |     |   |
| Sound source and  control equipment |   | Declining balance |   | 20       | %      |
| Real time  systems                  |   | Declining balance |   | 30       | %      |
| Furniture and  fixtures             |   | Declining balance |   | 20       | %      |
| Computer  equipment                 |   | Declining balance |   | 30       | %      |
| Software and  production tooling    |   | Declining balance |   | 30       | %      |

 

The Company assesses impairment of capital assets by determiningwhether their recoverable amounts are less than their unamortized balance.  When an impairment is identified, the amountof impairment is charged to period earnings and is included in depreciation andamortization.

 

45

----

 

**Goodwill:**

 

Effective January 1, 2002, the Corporation adopted thenew Canadian Institute of Chartered Accountants standard No. 3062 - Goodwilland Other Intangibles (“CICA 3062”), which no longer permits the amortizationof goodwill and other indefinite life intangibles. The new standard requiresthat a fair value impairment test be performed annually on goodwill and otherindefinite life intangibles. As required by CICA 3062, goodwill and indefinitelife intangibles were tested for impairment as of January 1, 2002.  This transitional impairment test wascompleted, and it was  determined thatthe fair values of the Corporation’s goodwill and indefinite life intangiblesexceeded their carrying values. Consequently, no impairment loss was recorded.  Further impairment tests will be conducted on December 31 eachyear.  The new standard is appliedprospectively. There has been no change in the carrying value of goodwill($2,184,589) since December 31, 2001.

 

**Intangibleassets:**

 

Intangible assets are recorded at cost and amortizedover their estimated useful lives. The Company assesses the recoverability ofintangible assets by determining whether the unamortized balance can berecovered through future operating cash flows. The amount of intangible asset impairment, if any, is measured based onprojected discounted future operating cash flows using a discount rate reflectingthe Company’s average cost of funds. The assessment of the recoverability of intangible assets will beimpacted if estimated future operating cash flows are not achieved.

 

**Foreigncurrency translation:**

 

The Company translates monetary assets and liabilitiesat the rate of exchange in effect as at the balance sheet date, and revenuesand expenses at the average rates in effect during the year.  Foreign exchange gains and losses areincluded in the determination of net income or loss for the year.

 

**Revenuerecognition:**

 

Revenue from royalties is recorded as royalties areearned.  Amounts received for prepaidroyalties are recorded as deferred revenue and revenue is recognized when theroyalty is earned through the sale of units by the licensee.

 

Amounts received on a prepaid basis for license feesare recorded as deferred revenue and revenue is recognized after the softwareand/or hardware has been delivered and the Company has no further significantobligations to the purchaser. For long-term contracts revenue from license feesis recognized on a percentage of completion basis.

 

Revenue from product sales is recognized when productsare shipped pursuant to sales arrangements with customers and whencollectibility is reasonably assured.

 

**Researchand development costs:**

 

Research and development costs are expensed asincurred except if development costs are recoverable and directly related todevelopment of new products, processes or systems.

 

46

----

 

**Incometaxes:**

 

The Company uses the liability method of accountingfor income taxes under which future income tax assets and liabilities arerecognized for the estimated future tax consequences attributable todifferences between the financial statement carrying amounts of existing assetsand liabilities and their respective tax bases.  Future income tax assets and liabilities are measured usingenacted tax rates in effect for the year in which those temporary differencesare expected to be recovered or settled. The effect on future income tax assets and liabilities of a change intax rates is recognized as part of the provision for income taxes in the periodthat includes the enactment date.

 

**PerShare Amounts:**

 

Per share amounts are calculated using the weightedaverage number of common shares outstanding during the year.  The basic weighted average sharesoutstanding for the year ended December 31, 2002 was 7,095,552 (December 31,2001 – 7,252,764, December 31, 2000 – 7,100,815).  The diluted weighted average shares outstanding for the yearended December 31, 2002 was 7,455,833. For the years ended December 31, 2001 and 2000 the diluted weightedaverage shares outstanding were in all material respects the same as the basicweighted average shares outstanding. Diluted per share amounts are calculated using the treasury stockmethod.

 

**Stock-basedcompensation:**

 

Effective January 1, 2002, the Company adopted the newCanadian accounting standard relating to stock-based compensation.  Under this standard, the Company follows thesettlement date method of accounting for stock options granted to employees andthe fair value method for stock options granted to non-employees.  The Company discloses the pro-forma effecton income of accounting for stock options awarded to employees under the fairvalue method (see note 7).

 

**Comparativefigures:**

 

Certain comparative information has been restated toconform with the current year’s presentation.

 

**Changein accounting policy:**

 

In 2000, the Company adopted the new Canadianaccounting standard relating to earnings per share. The new standard requiresthe use of the treasury stock method for calculating diluted earnings pershare. Under this method all options whose average price is less than or equalto the average share price for the period to date are considered outstandingand all convertible securities are considered to be converted at the averageshare price for the period. The Company adopted this section retroactively withrestatement of all previous periods, effective December 31, 2000. There was noimpact on loss per share for the years ended December 31, 2001 and 2000.

 

47

----

 

**1.****              Businessacquisitions:**

 

On December 6, 2001 the Company acquired the eMerchantPro hosting property for consideration of $34,418.  The acquisition has been accounted for by the purchase method,and accordingly the results of the operations of the eMerchant Pro hostingproperty has been included in these financial statements from December 6,2001.  The entire purchase price hasbeen allocated to purchased customer list which is being amortized on astraight-line basis over five years.

 

On November 24, 2000 the Company acquired the iNetMall and Anthill.com website properties and an account receivable valued at$225,000 for consideration of $375,000, consisting of 500,000 pre-consolidationcommon shares valued at $1.00 per share which approximated the fair value atthat date and $100,000 cash. The 500,000 pre-consolidation common shares issuedpursuant to the acquisition were to be held in escrow and released based on theachievement of performance milestones specified in the acquisitionagreement.  At December 31, 2000,225,000 of the pre-consolidation common shares remained in escrow.  Due to the contingent nature of thecontract, no consideration was recorded with respect to the 225,000 escrowedpre-consolidation shares.  During 2001the performance milestones specified in the acquisition agreement were notachieved resulting in the shares held in escrow being cancelled.  The acquisition has been accounted for bythe purchase method, and accordingly the results of the operations of the iNetMall and Anthill.com website properties have been included in these financialstatements from November 24, 2000.   Theexcess of the purchase price over the fair value of net identifiable assetsacquired was allocated to goodwill in the amount of $150,000 and up to December31, 2001 was being amortized on a straight-line basis over seven years.

 

On May 17, 2000 the Company acquired the Webtailerwebsite property for consideration of $415,486, consisting of 222,222pre-consolidation common shares of the Company valued at their market price of$1.87 per share. The acquisition has been accounted for by the purchase method,and accordingly the results of the operations of the Webtailer website havebeen included in these financial statements from May 17, 2000.  The entire purchase price was allocated togoodwill.

 

On May 10, 2000 the Company acquired the Choicemallwebsite property for consideration of $3,393,800, consisting of 1,000,000pre-consolidation common shares of the Company and debt of $1,300,000.  The acquisition has been accounted for bythe purchase method, and accordingly the results of the operations of theChoicemall website have been included in these financial statements from May10, 2000.  The excess of the purchaseprice over the fair value of net identifiable assets acquired was allocated togoodwill in the amount of $3,393,800 and up to December 31, 2001 was beingamortized on a straight-line basis over seven years.

 

**2.****              Note receivable**

 

The Company has advanced $500,000 to a privatecompany.  The advance was secured by allof the assets of the private company. Subsequent to the end of the year the Company enforced its security andcollected on the note by acquiring title to furniture and equipment, software,inventory and in process research and development.

 

48

----

 

**3.****              Capital assets:**

 
| **2002**                            |   | **Cost**  |      | **Accumulated  depreciation** |   | **Net book  value** |   |
|-------------------------------------|--------|-----------|-----------|-------------------------------|--------|---------------------|--------|
|                                |   |      |      |                          |   |                |   |
| Sound source and  control equipment |   | $         | 544,872   |                          | $      | 514,948             |   | $ | 29,924 |   |
| Real time  systems                  |   | 905,534   |      | 893,349                       |   | 12,185              |   |
| Furniture and  fixtures             |   | 353,827   |      | 307,763                       |   | 46,064              |   |
| Computer  equipment                 |   | 808,650   |      | 608,628                       |   | 200,022             |   |
| Software and  production tooling    |   | 1,348,395 |      | 889,037                       |   | 459,358             |   |
|                                |   |      |      |                          |   |                |   |
|                                |   | $         | 3,961,278 |                          | $      | 3,213,725           |   | $ | 747,553 |   |

 
| **2001**                            |   | **Cost**  | ** ** | **Accumulated  depreciation** | ** ** | **Net book  value** | ** ** |
|-------------------------------------|--------|-----------|------------|-------------------------------|------------|---------------------|------------|
|                                |   |      |       |                          |       |                |       |
| Sound source and  control equipment |   | $         | 538,812    |                          | $          | 506,839             |       | $ | 31,973 |   |
| Real time  systems                  |   | 905,534   |       | 888,126                       |       | 17,408              |       |
| Furniture and  fixtures             |   | 353,827   |       | 297,021                       |       | 56,806              |       |
| Computer  equipment                 |   | 756,215   |       | 547,392                       |       | 208,823             |       |
| Software and  production tooling    |   | 1,214,729 |       | 596,962                       |       | 617,767             |       |
|                                |   |      |       |                          |       |                |       |
|                                |   | $         | 3,769,117  |                          | $          | 2,836,340           |       | $ | 932,777 |   |

 

Included in the accumulated depreciation above forsoftware and production tooling is a current year asset impairment charge of$100,000 (2001 - nil, 2000 - $383,750). The impairment charge was measured based on projected future operatingcash flows of purchased software.

 

**4.****              Goodwill**

 
| **2002 and 2001** |   | **Cost** |      | **Accumulated  amortization** |   | **Net book  value** |   |
|-------------------|--------|----------|-----------|-------------------------------|--------|---------------------|--------|
|              |   |     |      |                          |   |                |   |
| Goodwill          |   | $        | 9,894,777 |                          | $      | 7,710,188           |   | $ | 2,184,589 |   |
|                   |        |          |           |                               |        |                     |        |  |  |  |

 

**5.****              Otherintangible assets:**

 
| **2002**                 |   | **Cost** |    | **Accumulated  amortization** |   | **Net book  value** |   |
|--------------------------|--------|----------|---------|-------------------------------|--------|---------------------|--------|
|                     |   |     |    |                          |   |                |   |
| Patents and  trademarks  |   | $        | 780,503 |                          | $      | 594,266             |   | $ | 186,237 |   |
| Purchased  customer list |   | 34,418   |    | 6,884                         |   | 27,534              |   |
|                     |   | $        | 814,921 |                          | $      | 601,150             |   | $ | 213,771 |   |

 
| **2001**                 |   | **Cost** | ** ** | **Accumulated  amortization** | ** ** | **Net book  value** | ** ** |
|--------------------------|--------|----------|------------|-------------------------------|------------|---------------------|------------|
|                     |   |     |       |                          |       |                |       |
| Patents and  trademarks  |   | $        | 728,065    |                          | $          | 514,931             |       | $ | 213,134 |   |
| Purchased  customer list |   | 34,418   |       | —                        |       | 34,418              |       |
|                     |   | $        | 762,483    |                          | $          | 514,931             |       | $ | 247,552 |   |

 

49

----

 

**6.****              Share capital:**

 

On June 28, 2001, the shareholders of the Companyauthorized the board of directors to approve a share consolidation on thecommon shares of the Company.  On July3, 2001 the Directors of the Company approved a share consolidation on thebasis of one new common share for every four outstanding old commonshares.  This consolidation wasimplemented effective July 9, 2001.  Allreferences to income and loss per common share, and common shares repurchasedand outstanding, have been restated to reflect the impact of the July 9, 2001reverse stock split, on a retroactive basis.

 

Authorized:

 

The Company is authorized to issue an unlimited numberof common shares without par value and an unlimited number of first and secondpreferred shares.

 

Common shares issued and outstanding:

 
|                                                               |   | **Number of  Shares** |   | **Consideration** |       |
|--------------------------------------------------------------------|--------|-----------------------|--------|-------------------|------------|
| Balance at  December 31, 1999                                      |   | 6,666,925             |   | $                 | 39,635,463 |   |
|                                                               |   |                  |   |              |       |
| Issued for cash:                                                   |   |                  |   |              |       |
| On exercise of  warrants and options                               |   | 15,750                |   | 137,970           |       |
| On exercise of  options granted to directors and employees         |   | 82,625                |   | 739,603           |       |
| Private  placement                                                 |   | 180,909               |   | 2,030,000         |       |
| Business  acquisitions (note 1)                                    |   | 374,305               |   | 2,784,286         |       |
| Acquisition of  assets                                             |   | 28,750                |   | 258,750           |       |
| Repurchase of  common shares                                       |   | (22,500               | )      | (158,638          | )          |
| Share  subscription paid                                           |   | —                |   | (150,340          | )          |
| Shares held in  escrow (note 1)                                    |   | 56,250                |   | —            |       |
|                                                               |   |                  |   |              |       |
| Balance at  December 31, 2000                                      |   | 7,383,014             |   | $                 | 45,277,094 |   |
|                                                               |   |                  |   |              |       |
| Additional  shares issued due to conditions of reverse stock split |   | 425                   |   | —            |       |
| Repurchase of  common shares                                       |   | (241,615              | )      | (1,539,468        | )          |
| Cancellation of  shares held in escrow (note 1)                    |   | (56,250               | )      | —            |       |
|                                                               |   |                  |   |              |       |
| Balance at  December 31, 2001                                      |   | 7,085,574             |   | $                 | 43,737,626 |   |
|                                                               |   |                  |   |              |       |   |
| Issued for cash  on exercise of options                            |   | 70,500                |   | 34,815            |       |
| Additional  paid-in-capital stock options (note 7)                 |   | —                |   | 4,870             |       |
| Additional  paid-in capital warrants (note 8)                      |   | —                |   | 108,725           |       |
|                                                               |   |                  |   |              |       |
| Balance at  December 31, 2002                                      |   | 7,156,074             |   | $                 | 43,886,036 |   |

 

In 2001 year, the Company repurchased 241,615 common shares for$430,800.  The excess of the averagecost of the shares over the purchase price amounting to $1,108,668 has beenassigned to contributed surplus.

 

50

----

 

**7.****              Stock option plan:**

 

The Company has Stock Option Plans under which theBoard of Directors may grant stock options to directors, officers, consultantsand employees for the purchase of authorized but unissued common shares.  At December 31, 2002, stock options topurchase 1,595,922 common shares were outstanding and 349,696 shares arereserved for issuance under the option plans. The stock options are exercisable at prices ranging from $0.47 to $12.24per share and expire on various dates between 2002 and 2012.

 

During the year endedDecember 31, 2002, the Company granted 411,000 options to employees, directorsand officers (2001 – 1,137,310, 2000 - 147,611) with exercise prices at or greaterthan the market price of the Company’s stock on the date of grant.  Of the 411,000 options granted during theyear ended December 31, 2002, 36,000 options vested at the time of granting.  The remaining 405,000 options vest atvarious times depending upon individual specified performance criteria beingmet.  No compensation cost is recordedin the Company’s statement of operations and deficit.  Had compensation cost for stock options granted to employees beendetermined based on the fair value method, the company’s pro-forma net incomewould have been decreased by $8,478 to $1,120,474 and net income per commonshare would be unchanged at $0.16 per share.

 

During 2002 the Company granted 35,000 stock optionsin connection with services performed by third parties.  These options are exercisable at $1.75 andexpire March 31, 2006.   Of theseoptions, 5,000 had vested as of December 31, 2002, and the remaining 30,000vest during 2003.  The fair value of thevested options granted is estimated on the day of grant using the Black Scholesoption pricing model with the following assumptions; risk free interest rate –4.5%, volatility – 80%, expected option life (in years)  – 3, dividend yield – 0%.  $4,870 has been charged to income for theseoptions in 2002. During 2001 and 2000 the Company did not issue any stockoptions in connection with services performed by third parties.

 

Changes in options granted during the years endedDecember 31, 2002, 2001 and 2000 were as follows:

 
|                          |   | **Number of  Shares** |   | **Exercise  price  per share** |   | **Weighted  average  exercise price** |   |
|-------------------------------|--------|-----------------------|--------|--------------------------------|--------|---------------------------------------|--------|
| Balance at December 31, 1999  |   | 1,236,784             |   | 6.12 – 14.00              |   | 9.08                                  |   |
|                          |   |                  |   |                           |   |                                  |   |
| Granted                       |   | 147,611               |   | 6.00 –   9.00   |   | 8.44                                  |   |
| Exercised                     |   | (98,375               | )      | 6.12 – 12.24              |   | 8.76                                  |   |
| Cancelled or  expired         |   | (416,621              | )      | 6.00 – 12.24              |   | 9.56                                  |   |
| Repriced                      |   |                  |   |                           |   |                                  |   |
| Previous                      |   | (131,625              | )      | 10.00 – 14.00             |   | 12.04                                 |   |
| New                           |   | 131,625               |   | 9.00 –   9.00   |   | 9.00                                  |   |
|                          |   |                  |   |                           |   |                                  |   |
| Balance at  December 31, 2000 |   | 869,399               |   | 6.00 – 12.24              |   | 8.32                                  |   |
|                          |   |                  |   |                           |   |                                  |   |
| Granted                       |   | 1,137,310             |   | 0.47 –   2.12   |   | 0.76                                  |   |
| Cancelled or expired          |   | (186,109              | )      | 6.00 –   9.00   |   | 8.43                                  |   |
|                          |   |                  |   |                           |   |                                  |   |
| Balance at  December 31, 2001 |   | 1,820,600             |   | 0.47 – 12.24              |   | 3.59                                  |   |

 

51

----

 
|                          |   | **Number of  Shares** |   | **Exercise  price  per share**      |                    | **Weighted  average  exercise price** |   |
|-------------------------------|--------|-----------------------|--------|-------------------------------------|-------------------------|---------------------------------------|--------|
| Balance at December 31, 2001  |   | 1,820,600             |   | 0.47 – 12.24                   |                    | 3.59                                  |   |
|                          |   |                  |   |                                |                    |                                  |   |
| Granted                       |   | 446,000               |   | 0.57  –    1.75 |                    | 0.96                                  |   |
| Exercised                     |   | (70,500               | )      | 0.47  –    0.75 |                    | 0.49                                  |   |
| Cancelled or  expired         |   | (600,178              | )      | 2.12  – 12.00             |                    | 8.18                                  |   |
|                          |   |                  |   |                                |                    |                                  |   |
| Balance at  December 31, 2002 |   | 1,595,922             |   | $                                   | 0.47  – 12.24 |                                  | $      | 1.26 |   |
|                               |        |                       |        |                                     |                         |                                       |        |  |  |

 

The following tablesummarizes the information about stock options outstanding at December 31,2002:

 
|                          |       | **Options  Outstanding**                       |    | **Options  Exercisable**                       |   |
|-------------------------------|------------|------------------------------------------------|---------|------------------------------------------------|--------|
| **Range of  Exercise Prices** |       | **Number  Outstanding at  December 31,  2002** |    | **Weighted  Average  Remaining  Term (years)** |   | **Weighted  Average  Exercise  Price** |   | **Number  Exercisable at  December 31,  2002** |   | **Weighted  Average  Exercise  Price** |   |
| $                             |  0.47 |                                           | 565,297 |                                           | 3.7    |   | $ | 0.47 |   | 510,297 |   | $ | 0.47 |   |
| 0.57 to    0.62     |       | 275,000                                        |    | 8.2                                            |   | 0.61 |   | — |   | — |   |
| 1.04                          |       | 501,638                                        |    | 3.5                                            |   | 1.04 |   | 420,203 |   | 1.04 |   |
| 1.65 to    2.12     |       | 168,000                                        |    | 3.8                                            |   | 1.76 |   | 38,000 |   | 2.07 |   |
| 6.00 to 12.24                 |       | 85,987                                         |    | 2.1                                            |   | 8.93 |   | 85,987 |   | 8.93 |   |
|                          |       |                                           |    |                                           |   |   |   |   |   |   |   |
|                          |       | 1,595,922                                      |    |                                           |   |   |   | 1,054,487 |   |   |   |
|                               |            |                                                |         |                                                |        |  |  |  |  |  |  |  |  |  |

 

**8.**     **Warrants**

 

During 2002, the Company issued 250,000 common sharepurchase warrants as consideration for services received.  Each warrant entitles the holder to acquireone common share of the Company for $1.04 per share and expire March 25, 2007.  The company has entered into an agreement toissue an additional 250,000 common share purchase warrants under the sameconditions and terms provided certain performance criteria are met.

 

The fair value of the warrants was determined to be $108,725, was capitalized to software and production tooling, and was calculatedusing the Black Scholes pricing model with the following weighted averageassumptions:

 
| Risk free  interest rate |   | 4.5       | %      |
|--------------------------|--------|-----------|--------|
| Volatility               |   | 80        | %      |
| Life of the  warrant     |   | 4.5 years |   |
| Dividend yield           |   | 0         | %      |

 

52

----

 

**9.     Adjusted net income and earnings per share**

 
|                               |   | **2001** |     | **2000**  |   |
|------------------------------------|--------|----------|----------|-----------|--------|
| Reported net  loss                 |   | $        | (732,910 | )         | $      | (9,207,834 | ) |
| Add back  amortization of goodwill |   | 459,511  |     | 1,731,684 |   |
|                               |   |     |     |      |   |
| Adjusted net  loss                 |   | $        | (273,399 | )         | $      | (7,476,150 | ) |
|                               |   |     |     |      |   |
| Adjusted net loss  per share       |   | $        | (0.04    | )         | $      | (1.05 | ) |

 

**10.****       Changesin non-cash working capital balances:**

 
|                                      |   | **2002** |     | **2001** |   | **2000** |   |
|-------------------------------------------|--------|----------|----------|----------|--------|----------|--------|
|                                      |   |     |     |     |   |     |   |
| Accounts  receivable                      |   | $        | (490,274 | )        | $      | 727,696  |   | $ | 148,108 |   |
| Inventory                                 |   | 12,132   |     | 19,844   |   | 167,040  |   |
| Deposits and  prepaid expenses            |   | 26,691   |     | 15,087   |   | 226,823  |   |
| Accounts payable  and accrued liabilities |   | (83,832  | )        | (48,139  | )      | (147,784 | )      |
| Deferred revenue                          |   | 112,229  |     | (971     | )      | (918,865 | )      |
|                                      |   |     |     |     |   |     |   |
|                                      |   | $        | (423,054 | )        | $      | 713,517  |   | $ | (524,678 | ) |

 

**11.****       Income taxes:**

 

Income tax expense differs from the amount that wouldbe computed by applying the basic combined Canadian federal and provincialstatutory income tax rate to the income (loss) for the year.  The reasons for the differences are asfollows:

 
|                                                                               |   | **2002** |      | **2001** |   | **2000**   |   |
|------------------------------------------------------------------------------------|--------|----------|-----------|----------|--------|------------|--------|
|                                                                               |   |     |      |     |   |       |   |
| Income (loss)  for the year                                                        |   | $        | 1,128,952 |     | $      | (732,910   | )      | $ | (9,207,834 | ) |
|                                                                               |   |     |      |     |   |       |   |
| Combined  Canadian Federal and Provincial statutory rate                           |   | 39.24    | %         | 42.12    | %      | 44.62      | %      |
|                                                                               |   |     |      |     |   |       |   |
| Computed tax  (recovery)                                                           |   | 443,001  |      | (308,702 | )      | (4,108,536 | )      |
|                                                                               |   |     |      |     |   |       |   |
| Increase  (decrease) resulting from:                                               |   |     |      |     |   |       |   |
| Unrealized  (realized) benefit of future tax assets                                |   | (450,988 | )         | 193,127  |   | 2,749,000  |   |
| Income taxes  computed at different rates in the United States                     |   | 7,987    |      | 115,575  |   | 1,424,498  |   |
| Reduction of  unrealized future tax assets for enacted changes in income tax rates |   | —   |      | —   |   | (690,000   | )      |
| Non deductible  amortization                                                       |   | —   |      | —   |   | 625,038    |   |
|                                                                               |   |     |      |     |   |       |   |
| Actual expense  (recovery)                                                         |   | $        | —    |     | $      | —     |   | $ | — |   |

 

53

----

 

The tax effects of temporary differences that giverise to significant portions of future income tax assets are as follows:

 
|                         |   | **Canada** |    | **United  States** |   | **2002**   |   | **2001**    |    | **2000**    |   |
|------------------------------|--------|------------|---------|--------------------|--------|------------|--------|-------------|---------|-------------|--------|
|                         |   |       |    |               |   |       |   |        |    |        |   |
| Future income  tax assets:   |   |       |    |               |   |       |   |        |    |        |   |
| Capital assets               |   | $          | 564,000 |               | $      | —     |   | $           | 564,000 |        | $      | 402,000 |   | $ | 372,000 |   |
| Share issue  costs           |   | 6,000      |    | —             |   | 6,000      |   | 6,000       |    | 6,000       |   |
| Loss and SRED  carryforwards |   | 2,664,000  |    | 4,411,000          |   | 7,075,000  |   | 7,659,000   |    | 8,285,000   |   |
| Intangible  assets           |   | 133,000    |    | 1,581,000          |   | 1,714,000  |   | 1,845,000   |    | 1,898,000   |   |
| Investments                  |   | —     |    | 158,000            |   | 158,000    |   | 153,000     |    | 567,000     |   |
|                         |   | 3,367,000  |    | 6,150,000          |   | 9,517,000  |   | 10,065,000  |    | 11,128,000  |   |
| Less: Valuation  allowance   |   | (3,367,000 | )       | (6,150,000         | )      | (9,517,000 | )      | (10,065,000 | )       | (11,128,000 | )      |
|                         |   |       |    |               |   |       |   |        |    |        |   |
| Net future tax  assets       |   | $          | —  |               | $      | —     |   | $           | —  |        | $      | — |   | $ | — |   |

 

The Company has Canadian non-capital losscarry-forwards in the amount of $3,894,000 which expire at various datesbetween 2003 and 2008 and Canadian Scientific Research and ExperimentalDevelopment (SRED) expenditure carry-forwards in the amount of $3,523,000 whichhave no expiry.  The Company also hasUnited States net operating loss carry-forwards in the amount of $12,604,000which expire at various dates between 2004 and 2022.

 

**12.****       Segmented information:**

 

The Company operates in two operating segments consistingof Audio Projects (Audio) and E-Commerce Products. (“E-Commerce”).  Audio involves the developing and marketingof sound localization technology for use in various industries. E-Commerceinvolves the developing and marketing of internet business services.

 

For Audio products, during 2002 76% of total audiorevenue arose from two customers, each of which individually provided greaterthan 10% of total revenues.  For 2001,65% of total revenue arose from two customers, each of which individuallyprovided greater than 10% of total revenues. For 2000, 63% of total revenue arose from three customers, each of whichindividually provided greater than 10% of total revenues.

 

For E-Commerce products, during 2002 and 2001 no onecustomer contributed to more than 10% of total E-Commerce revenue. For 2000,64% of total E-Commerce revenue arose from two customers, each of whichindividually resulted in greater than 10% total revenues.

 
| **2002**                                 |   | **Audio** |      | **E-Commerce** |   | **Total** |   |
|------------------------------------------|--------|-----------|-----------|----------------|--------|-----------|--------|
|                                     |   |      |      |           |   |      |   |
| Revenues                                 |   | $         | 3,649,238 |           | $      | 575,073   |   | $ | 4,224,311 |   |
| Interest revenue                         |   | 25,867    |      | 1,402          |   | 27,269    |   |
| Amortization of  capital assets          |   | 410,633   |      | 57,230         |   | 467,863   |   |
| Segment profit                           |   | 1,027,351 |      | 101,601        |   | 1,128,952 |   |
| Segment assets                           |   | 4,844,886 |      | 2,426,880      |   | 7,271,766 |   |
| Goodwill                                 |   | —    |      | 2,184,589      |   | 2,184,589 |   |
| Expenditures for  segment capital assets |   | 263,554   |      | 103            |   | 263,657   |   |
|                                          |        |           |           |                |        |           |        |  |  |  |

 

54

----

 
| **2001**                                 |   | **Audio** |      | **E-Commerce** |   | **Total** |   |
|------------------------------------------|--------|-----------|-----------|----------------|--------|-----------|--------|
|                                     |   |      |      |           |   |      |   |
| Revenues                                 |   | $         | 2,454,800 |           | $      | 571,194   |   | $ | 3,025,994 |   |
| Interest revenue                         |   | 73,094    |      | 425            |   | 73,519    |   |
| Amortization of  capital assets          |   | 306,885   |      | 64,756         |   | 371,641   |   |
| Segment profit  (loss)                   |   | 384,429   |      | (1,117,339     | )      | (732,910  | )      |
| Segment assets                           |   | 3,463,729 |      | 2,502,278      |   | 5,966,007 |   |
| Goodwill                                 |   | —    |      | 2,184,589      |   | 2,184,589 |   |
| Expenditures for  segment capital assets |   | 132,021   |      | 39,539         |   | 171,560   |   |
|                                          |        |           |           |                |        |           |        |  |  |  |

 
| **2000**                                 |   | **Audio** | ** ** | **E-Commerce** | ** ** | **Total**  | ** ** |
|------------------------------------------|--------|-----------|------------|----------------|------------|------------|------------|
|                                     |   |      |       |           |       |       |       |
| Revenues                                 |   | $         | 3,025,102  |           | $          | 1,443,900  |       | $ | 4,469,002 |   |
| Interest revenue                         |   | 145,770   |       | 4,959          |       | 150,729    |       |
| Amortization of  capital assets          |   | 206,209   |       | 88,600         |       | 294,809    |       |
| Segment profit  (loss)                   |   | (522,875  | )          | (8,684,959     | )          | (9,207,834 | )          |
| Segment assets                           |   | 4,284,459 |       | 3,444,368      |       | 7,728,827  |       |
| Goodwill                                 |   | —    |       | 2,644,100      |       | 2,644,100  |       |
| Expenditures for  segment capital assets |   | 332,078   |       | 10,530         |       | 342,608    |       |
|                                          |        |           |            |                |            |            |            |  |  |  |

 
| **Geographic information** |   | **2002 Revenue** | ** ** | **2001  Revenue** | ** ** | **2000  Revenue** | ** ** |
|----------------------------|--------|------------------|------------|-------------------|------------|-------------------|------------|
|                       |   |             |       |              |       |              |       |
| Canada                     |   | $                | 3,443      |              | $          | 5,669             |       | $ | 2,179 |   |
| United States              |   | 3,636,657        |       | 2,607,868         |       | 3,736,159         |       |
| Asia                       |   | 584,211          |       | 412,457           |       | 730,664           |       |
|                       |   |             |       |              |       |              |       |
|                       |   | $                | 4,224,311  |              | $          | 3,025,994         |       | $ | 4,469,002 |   |

 

As at December 31, 2002substantially all of the Company’s product assets and employees were located inCanada.  As at December 31, 2001substantially all of the Company’s Audio product assets and employees werelocated in Canada and substantially all of the Company’s E-Commerce productassets were located in the Untied States.

 

**13.****       Financial instruments andrisk management:**

** **

The fair values of financial assets and liabilitiesapproximate their carrying values at December 31, 2002.

 

The Company is exposed to foreign currency fluctuationson its Canadian dollar denominated cash, receivables and payables.  Foreign currency risk arising from a declinein the relative value of the Canadian dollar is managed to the extent thatCanadian dollar denominated cash and receivables are equal to or exceedCanadian dollar payables.  The Companyhas not, at December 31, 2002, entered into foreign currency derivatives tohedge its exposure to foreign exchange risk.

 

55

----

 

The Company is exposed to credit risk on its accountsreceivable, royalties receivable and accrued revenue.  As at December 31, 2002 there were outstanding accountsreceivable balances from one entity which comprised 74% of the total balance.  As at December 31, 2001 there were outstandingaccounts receivable balances from two entities which comprised 45% and 22% ofthe total balance. The entities are primarily located in the UnitedStates.  These amounts have beencollected subsequent to the year end.

 

**14.****       Commitments and contingencies:**

 

The Company is involved in litigation and claims whicharise from time to time in the normal course of business.  In the opinion of management, any liabilitythat may arise from such contingencies would not have a significant adverseeffect on the consolidated financial position of the Company.

 

During the year the Company resolved an outstandingcontingency relating to an employment contract that expired September 30, 2002by putting in place an individual pension plan for the individual.  Subsequent to the year end, $ 55,189was contributed to the plan as a past service cost.

 

Under the terms of its lease agreements for officespace and equipment, the Company is obligated at December 31, 2002 to make thefollowing minimum lease payments over the next four years:

 
| 2002   |   | $      | 67,683 |   |
|--------|--------|--------|--------|--------|
| 2003   |   | 12,221 |   |
| 2004   |   | 12,221 |   |
| 2005   |   | 4,074  |   |
|   |   |   |   |
|   |   | $      | 96,199 |   |

 

**15.****       United States accountingprinciples:**

 

The financial statements have been prepared inaccordance with Canadian generally accepted accounting principles (“CanadaGAAP”).  Any differences in UnitedStates generally accepted accounting principles (“US GAAP”) as they pertain tothe Company’s financial statements are not material except as follows:

 

(a)          The Company follows SFAS115, “Accounting for Certain Investments in Debt and Equity Securities” forpurposes of reconciling to US GAAP. Long-term investments consist of equity securities.  The Company has classified its equitysecurities which are listed on a recognized public stock exchange asavailable-for-sale.

 

Available-for-sale securities are recorded at fairvalue.  Unrealized holding gains andlosses, net of the related tax effect, on available-for-sale securities areexcluded from earnings and are reported as a separate component of othercomprehensive income until realized. Realized gains and losses from the sale of available-for-sale securitiesare determined on a specific identification basis.

 

56

----

 

A decline in the market value of anyavailable-for-sale or held-to-maturity security below cost that is deemed to beother than temporary results in a reduction in carrying amount to fairvalue.  The impairment is charged toearnings and a new cost basis for the security is established.  Premiums and discounts are amortized oraccreted over the life of the related held-to-maturity or available-for-salesecurity as an adjustment to yield using the effective interest method.  Dividend and interest income are recognizedwhen earned.

 

(b)         The Company follows SFAS130 regarding comprehensive income for purposes of reconciliation to USGAAP.  Under US GAAP, items defined asother comprehensive income are separately classified in the financialstatements and the accumulated balance of other comprehensive income (loss) isreported separately in shareholders’ equity on the balance sheet.    The Company has recorded unrealizedholding gains and related unrealized future income tax expense on investmentsclassified as “available for sale” securities under US GAAP.

 

(c)          The Company applies theintrinsic value-based method of accounting prescribed by Accounting PrinciplesBoard (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”, andrelated interpretations, in accounting for its stock options issued to employees,directors and officers of the Company for purposes of reconciliation to USGAAP.  As such, compensation expensewould be recorded on the date of grant only if the current market price of theunderlying stock exceeded the exercise price. In addition, variable accounting would be applied to stock options thathave been repriced, whereby compensation expense would be recorded or recoveredon the date of reporting only if the current market price of the underlyingstock exceeded the exercise price.  SFASNo. 123, “Accounting for Stock-Based Compensation”, established accounting anddisclosure requirements using a fair value-based method of accounting forstock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to applythe intrinsic value-based method of accounting described above and has adoptedthe disclosure requirements of SFAS No. 123. Stock options issued to consultants and other third parties areaccounted for at their fair values in accordance with SFAS No. 123.

 

(d)         Under US GAAP a portionof the excess of the purchase price over the fair value of net identifiableassets acquired upon the acquisition of Virtual Spin, Inc. in 1999 wereallocated to assets to be used in research and development activities and wereexpensed at the date of the business combination.  Under Canadian GAAP these amounts are allocated to goodwill.

 

57

----

 

The effect on the loss for each of the years in thethree year period ended December 31, 2002 of the differences between Canadianand United States accounting principles is summarized as follows:

 
|                                                                     |   | **Years  ended December 31,** |      |
|--------------------------------------------------------------------------|--------|-------------------------------|-----------|
|                                                                     |   | **2002**                      |      | **2001** |   | **2000** |   |
|                                                                     |   |                          |      |   |   |   |   |
| Income (loss)  for the year as reported in accordance with Canadian GAAP |   | $                             | 1,128,952 |   | $ | (732,910 | ) | $ | (9,207,834 | ) |
| Amortization of  acquired in-process research and development            |   | —                        |      | — |   | 1,400,802 |   |
|                                                                     |   |                          |      |   |   |   |   |
| Income (loss)  under US GAAP                                             |   | $                             | 1,128,952 |   | $ | (732,910 | ) | $ | (7,807,032 | ) |
|                                                                     |   |                          |      |   |   |   |   |
| Income (loss)  per share under US GAAP                                   |   | $                             | 0.16      |   | $ | (0.10 | ) | $ | (1.10 | ) |

 

The components of comprehensive income are as follows:

 
|                                                                       |   | **Years  ended December 31,** |      |
|----------------------------------------------------------------------------|--------|-------------------------------|-----------|
|                                                                       |   | **2002**                      |      | **2001** |   | **2000** |   |
|                                                                       |   |                          |      |   |   |   |   |
| Income (loss)  under US GAAP                                               |   | $                             | 1,128,952 |   | $ | (732,910 | ) | $ | (7,807,032 | ) |
| Other  comprehensive income (loss):                                        |   |                          |      |   |   |   |   |
| Recovery of  other comprehensive income (loss) through sale of investments |   | —                        |      | 151,943 |   | — |   |
| Change in fair  values of available for sale long-term investments         |   | —                        |      | — |   | (151,943 | ) |
| Write down of  investment through net loss                                 |   | —                        |      | — |   | 370,900 |   |
|                                                                       |   |                          |      |   |   |   |   |
| Comprehensive  income (loss)                                               |   | $                             | 1,128,952 |   | $ | (580,967 | ) | $ | (7,588,075 | ) |
|                                                                       |   |                          |      |   |   |   |   |
| Accumulated  other comprehensive income (loss) beginning of year           |   | $                             | —    |   | $ | (151,943 | ) | $ | (370,900 | ) |
| Accumulated  other comprehensive income (loss) end of year                 |   | $                             | —    |   | $ | — |   | $ | (151,943 | ) |

 

For Canadian GAAP presentation of the statement ofoperations, depreciation and amortization, and impairment of asset charges havebeen excluded from the calculation of operating profit (loss).  United States GAAP requires that those chargesbe included in the calculation of operating profit (loss).

 

There was no difference in the weighted average numberof shares outstanding in the years ended December 31, 2002, 2001 and 2000 underCanadian and United States accounting principles.

 

58

----

 

The effect on the consolidated balance sheets of thedifference between Canadian and United States generally accepted accountingprinciples is as follows:

 
| **December 31, 2002**       |   | **As  reported  in accordance  with  Canadian GAAP** |      | **Differences** |   | **Under  US GAAP** |   |
|-----------------------------|--------|------------------------------------------------------|-----------|-----------------|--------|--------------------|--------|
|                        |   |                                                 |      |            |   |               |   |
| Current assets              |   | $                                                    | 3,625,853 |            | $      | —             |   | $ | 3,625,853 |   |
| Note receivable             |   | 500,000                                              |      | —          |   | 500,000            |   |
| Capital assets              |   | 933,790                                              |      | —          |   | 933,790            |   |
| Intangible  assets          |   | 2,212,123                                            |      | —          |   | 2,212,123          |   |
|                        |   | $                                                    | 7,271,766 |            | $      | —             |   | $ | 7,271,766 |   |
|                        |   |                                                 |      |            |   |               |   |
| Current  liabilities        |   | $                                                    | 341,405   |            | $      | —             |   | $ | 341,405 |   |
| Shareholder’s  equity: |   |                                                 |      |            |   |               |   |
| Common shares               |   | 43,886,036                                           |      | 202,058         |   | 44,088,094         |   |
| Contributed  Surplus        |   | 1,114,316                                            |      |            |   | 1,114,316          |   |
| Deficit                     |   | (38,069,991                                          | )         | (202,058        | )      | (38,272,049        | )      |
|                        |   |                                                 |      |            |   |               |   |
|                        |   | $                                                    | 7,271,766 |            | $      | —             |   | $ | 7,271,766 |   |

 
| **December 31, 2001**       |   | **As  reported  in accordance  with  Canadian GAAP** | ** ** | **Differences** | ** ** | **Under  US GAAP** | ** ** |
|-----------------------------|--------|------------------------------------------------------|------------|-----------------|------------|--------------------|------------|
|                        |   |                                                 |       |            |       |               |       |
| Current assets              |   | $                                                    | 2,601,089  |            | $          | —             |       | $ | 2,601,089 |   |
| Capital assets              |   | 1,145,911                                            |       | —          |       | 1,145,911          |       |
| Intangible  assets          |   | 2,219,007                                            |       | —          |       | 2,219,007          |       |
|                        |   |                                                 |       |            |       |               |       |
|                        |   | $                                                    | 5,966,007  |            | $          | —             |       | $ | 5,966,007 |   |
|                        |   |                                                 |       |            |       |               |       |
| Current  liabilities        |   | $                                                    | 313,008    |            | $          | —             |       | $ | 313,008 |   |
| Shareholder’s  equity: |   |                                                 |       |            |       |               |       |
| Common shares               |   | 43,737,626                                           |       | 202,058         |       | 43,939,684         |       |
| Contributed  surplus        |   | 1,114,316                                            |       | —          |       | 1,114,316          |       |
| Deficit                     |   | (39,198,943                                          | )          | (202,058        | )          | (39,401,001        | )          |
|                        |   |                                                 |       |            |       |               |       |
|                        |   | $                                                    | 5,966,007  |            | $          | —             |       | $ | 5,966,007 |   |

 

Included in the current liabilities above are accruedliabilities of $109,178 in 2002 and $149,368 in 2001.

 

59

----

 

During the years endedDecember 31, 2002, 2001 and 2000 the Company granted options to employees,directors and officers.  During 2002,411,000 options (2001 – 1,137,310, 2000 – 147,611) were granted with exerciseprices at or greater than the market price of the Company’s stock on the dateof grant.  No compensation cost isrecorded in the Company’s statement of operations and deficit.

 

In addition, in 2000 526,500 stock options werere-priced at greater than the market price of the Company’s stock on the dateof re-pricing and at year end. Accordingly, no compensation cost is recorded in the Company’s statementof operations and deficit for either the granting of the options nor there-pricing of the options.

 

The Company has calculated the fair value of stockoptions granted to employees using the Black Scholes option pricing model withthe following weighted-average assumptions:

 
|                             |   | **2002** |   | **2001** |   | **2000** |   |
|----------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                             |   |     |   |     |   |     |   |
| Risk free  interest rate         |   | 4.5      | %      | 4.5      | %      | 5.0      | %      |
| Volatility                       |   | 80.0     | %      | 113.3    | %      | 120.0    | %      |
| Expected option  life (in years) |   | 7.5      |   | 2.0      |   | 2.0      |   |
| Dividend yield                   |   | 0        | %      | 0        | %      | 0        | %      |

 

Had the Company determined compensation cost based onthe fair value at the grant date for its stock options under SFAS No. 123, theCompany’s net income and loss per shares would have been reduced to the proforma amounts indicated below:

 
|                                   |   | **2002**  |      | **2001**   |   | **2000**   |   |
|----------------------------------------|--------|-----------|-----------|------------|--------|------------|--------|
|                                   |   |      |      |       |   |       |   |
| Net income  (loss) under US GAAP:      |   |      |      |       |   |       |   |
| As reported                            |   | $         | 1,128,952 |       | $      | (732,910   | )      | $ | (7,807,032 | ) |
| Pro forma                              |   | 1,120,474 |      | (1,247,633 | )      | (7,966,758 | )      |
|                                   |   |      |      |       |   |       |   |
| Basic income  (loss) per common share: |   |      |      |       |   |       |   |
| As reported                            |   | $         | 0.16      |       | $      | (0.10      | )      | $ | (1.10 | ) |
| Pro forma                              |   | 0.16      |      | (0.17      | )      | (1.12      | )      |

 

 

 

60

----

 

 

EXIBITS  INDEX

 
| **Exhibit  No.** |   | **Description of Document**                                                                                                                                                     |
|------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |   |                                                                                                                                                                            |
| 1.1              |   | Articles of Continuance of QSound Labs, Inc.  (formerly called Archer Communications Inc.). (Incorporated by reference to  our Annual Report on Form 20-F filed June 29, 2001.) |
|             |   |                                                                                                                                                                            |
| 1.2              |   | By-law No. 1 dated July 2, 2002.                                                                                                                                                |
|             |   |                                                                                                                                                                            |
| 1.3              |   | By-law No. 2 dated May 14, 1991. (Incorporated by  reference to our Annual Report on Form 20-F filed June 29, 2001.)                                                            |
|             |   |                                                                                                                                                                            |
| 1.4              |   | Articles of Amendment dated September 3, 1991.  (Incorporated by reference to our Annual Report on Form 20-F filed June 29, 2001.)                                              |
|             |   |                                                                                                                                                                            |
| 1.5              |   | Articles of Amendment dated July 8, 1992.  (Incorporated by reference to our Annual Report on Form 20-F filed June 29,  2001.)                                                  |
|             |   |                                                                                                                                                                            |
| 1.6              |   | Articles of Amendment dated June 25, 1993.  (Incorporated by reference to our Annual Report on Form 20-F filed June 29,  2001.)                                                 |
|             |   |                                                                                                                                                                            |
| 1.7              |   | Articles of Amendment dated November 26, 1996.  (Incorporated by reference to our Annual Report on Form 20-F filed June 29,  2001.)                                             |
|             |   |                                                                                                                                                                            |
| 1.8              |   | Articles of Amendment dated January 8, 1997.  (Incorporated by reference to our Annual Report on Form 20-F filed June 29,  2001.)                                               |
|             |   |                                                                                                                                                                            |
| 4.1              |   | Form of Stock Option Agreement                                                                                                                                                  |
|             |   |                                                                                                                                                                            |
| 4.2              |   | QSound Labs, Inc. 1998 Stock Option Plan                                                                                                                                        |
|             |   |                                                                                                                                                                            |
| 4.3              |   | Employment Agreement dated October 1, 2002 between  David Gallagher and QSound Labs, Inc.                                                                                       |
|             |   |                                                                                                                                                                            |
| 8.1              |   | List of Subsidiaries                                                                                                                                                            |
|             |   |                                                                                                                                                                            |
| 10.1             |   | Certification under section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                             |
|             |   |                                                                                                                                                                            |
| 10.2             |   | KPMG Consent of Auditors                                                                                                                                                        |

 

61

----