Report
of Independent Registered Public Accounting Firm

to
the Shareholders of QSound Labs, Inc.



We have audited the
accompanying consolidated balance sheet of QSound Labs, Inc. as at December 31,
2005 and the consolidated statement of operations and deficit and cash flows for
the year ended December 31, 2005. These consolidated financial statements are
the responsibility of the Company's management. Our responsibility is to
express an opinion on these consolidated financial statements based on our
audit.



We conducted our audit in accordance
with Canadian generally accepted auditing standards and the standards of the
Public Company Accounting Oversight Board (United States). These  standards
require that we plan and perform an audit to obtain reasonable assurance whether
the financial statements are free of material misstatement. The Company is not
required to have, nor were we engaged to perform an audit of its internal
control over financial reporting. Our audit included consideration of internal
control over financial reporting as a basis for designing audit procedures that
are appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such option. An audit includes examining,
on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.



In our opinion, these consolidated
financial statements present fairly, in all material respects, the

financial position of the Company as at
December 31, 2005 and the results of its operations and its cash flows for the
year ended December 31, 2005 in accordance with Canadian generally accepted
accounting principles.



Canadian generally accepted accounting
principles vary in certain significant respects from accounting principles
generally accepted in the United States of America. Information relating to the
nature and effect of such differences are presented in Note 22 to the
consolidated financial statements.



The consolidated balance sheet as at
December 31, 2004 and the consolidated statements of operations and cash flows
for the two years ended December 31, 2004 were audited by another firm of
chartered accountants who expressed an unqualified opinion on these financial
statements in their report dated February 25, 2005.



Grant Thornton LLP

Chartered Accountants

Calgary, Canada

March 29, 2006



---

Consolidated

Balance sheets

December 31, 2005 and 2004

(Expressed in United States dollars)

|                                        |                                               |         |              |         |              | 
|--------------------------------------- | --------------------------------------------- | ------- | ------------ | ------- | ------------ | 
|                                        |                                               |         | 2005         |         | 2004        
|ASSETS                                  |                                               |         |              |        
|Current assets                          |                                               |         |              |        
|                                        | Cash and cash equivalents                     | $       | 1,222,729    | $       | 3,327,543   
|                                        | Accounts receivable (net) and accrued revenue |         | 401,524      |         | 210,967     
|                                        | Note receivable (note 4)                      |         | 82,648       |         |            
|                                        | Inventory                                     |         | 40,438       |         | 162,568     
|                                        | Deposits and prepaid expenses                 |         | 76,146       |         | 61,438      
|                                        |                                               |         |              |         |             
|                                        |                                               |         | 1,823,485    |         | 3,762,516   
|                                        |                                               |         |              |         |             
|Property and equipment (note 5)         |                                               | 670,635 |              | 809,171
|Deferred development costs (note 6)     |                                               | 352,750 |              | 64,974 
|Intangible assets (note 7)              |                                               | 155,445 |              | 591,173
|                                        |                                               |         |              |         |             
|                                        |                                               | $       | 3,002,315    | $       | 5,227,834   
|                                        |                                               |         |              |         |             
|LIABILITIES AND SHAREHOLDERS EQUITY    |                                               |         |              |        
|Current liabilities                     |                                               |         |              |        
|                                        | Accounts payable and accrued liabilities      | $       | 285,786      | $       | 245,664     
|                                        | Deferred revenue                              |         | 45,011       |         | 59,745      
|                                        |                                               |         |              |         |             
|                                        |                                               |         | 330,797      |         | 305,409     
|                                        |                                               |         |              |         |             
|Shareholders equity                    |                                               |         |              |        
|                                        | Share capital (note 8)                        |         | 45,979,055   |         | 45,792,526  
|                                        | Warrants (note 9)                             |         | 1,502,331    |         | 1,502,331   
|                                        | Contributed surplus (note 10)                 |         | 1,442,408    |         | 1,329,136   
|                                        | Deficit                                       |         | (46,252,276) |         | (43,701,568)
|                                        |                                               |         |              |         |             
|                                        |                                               |         | 2,671,518    |         | 4,922,425   
|                                        |                                               |         |              |         |             
|Commitments and contingencies (note 21) |                                               |         |              |        
|                                        |                                               |         |              |         |             
|                                        |                                               | $       | 3,002,315    | $       | 5,227,834   

See accompanying notes to consolidated financial statements.







Approved by the Board:

David Gallagher: Director                                                      Patty Chakour: Director







---

Consolidated

Statements of Operations and Deficit

Years ended December 31, 2005, 2004 and 2003

(Expressed in United States dollars)



|                                                    |                                                |              |           |              |           |              |            
|--------------------------------------------------- | ---------------------------------------------- | ------------ | --------- | ------------ | --------- | ------------ | -----------
|                                                    |                                                |              | 2005      |              | 2004      |              | 2003       
|REVENUE                                             |                                                |              |           |              |           |             
|                                                    | Royalties, license and engineering fees        | $            | 1,056,509 | $            | 1,162,303 | $            | 779,396    
|                                                    | Product sales                                  |              | 486,731   |              | 1,050,875 |              | 1,263,692  
|                                                    |                                                |              |           |              |           |              |            
|                                                    |                                                |              | 1,543,240 |              | 2,213,178 |              | 2,043,088  
|                                                    | Cost of product sales                          |              | 179,781   |              | 419,290   |              | 425,091    
|                                                    |                                                |              |           |              |           |              |            
|                                                    |                                                |              | 1,363,459 |              | 1,793,888 |              | 1,617,997  
|EXPENSES                                            |                                                |              |           |              |           |             
|                                                    | Marketing                                      |              | 963,255   |              | 1,129,781 |              | 1,242,271  
|                                                    | Operations                                     |              | 213,163   |              | 234,481   |              | 169,667    
|                                                    | Product engineering                            |              | 902,427   |              | 908,984   |              | 834,333    
|                                                    | Administration                                 |              | 796,038   |              | 661,659   |              | 552,876    
|                                                    | Stock based compensation                       |              | 134,793   |              | 320,432   |              | 90,439     
|                                                    | Foreign exchange loss (gain)                   |              | 2,832     |              | 41,955    |              | (153,849)  
|                                                    | Amortization                                   |              | 360,898   |              | 457,572   |              | 308,717    
|                                                    |                                                |              |           |              |           |              |            
|                                                    |                                                |              | 3,373,406 |              | 3,754,864 |              | 3,044,454  
|                                                    |                                                |              |           |              |           |              |            
|Loss before other items                             |                                                | (2,009,947)  |           | (1,960,976)  |           | (1,426,457) 
|                                                    |                                                |              |           |              |           |              |            
|OTHER ITEMS                                         |                                                |              |           |              |           |             
|                                                    | Interest income                                |              | 56,700    |              | 78,727    |              | 41,164     
|                                                    | (Loss) gain on sale of property and equipment  |              |          |              | (15,616)  |              | 2,204      
|                                                    | Impairment of property and equipment (note 12) |              | (89,754)  |              |          |              | (102,900)  
|                                                    | Impairment of intangible assets (note 13)      |              | (428,453) |              |          |              |           
|                                                    | Impairment of goodwill (note 14)               |              |          |              |          |              | (2,184,589)
|                                                    | Termination expenses                           |              | (41,380)  |              | (3,880)   |              | (26,647)   
|                                                    | Other                                          |              | (163)     |              | (1,697)   |              | 137        
|                                                    |                                                |              |           |              |           |              |            
|                                                    |                                                |              | (503,050) |              | 57,534    |              | (2,270,631)
|                                                    |                                                |              |           |              |           |              |            
|Loss before taxes                                   |                                                | (2,512,997)  |           | (1,903,442)  |           | (3,697,088) 
|Foreign withholding tax                             |                                                | (37,711)     |           | (22,504)     |           | (8,543)     
|                                                    |                                                |              |           |              |           |              |            
|Net loss for year                                   |                                                | (2,550,708)  |           | (1,925,946)  |           | (3,705,631) 
|                                                    |                                                |              |           |              |           |              |            
|Deficit, beginning of year                          |                                                | (43,701,568) |           | (41,775,622) |           | (38,069,991)
|                                                    |                                                |              |           |              |           |              |            
|Deficit, end of year                                | $                                              | (46,252,276) | $         | (43,701,568) | $         | (41,775,622)
|                                                    |                                                |              |           |              |           |              |            
|Loss per common share (basic and diluted) (note 15) | $                                              | (0.30)       | $         | (0.25)       | $         | (0.52)      

See accompanying notes to consolidated financial statements







---

Consolidated

Statements of Cash Flows

Years ended December 31, 2005, 2004 and 2003

(Expressed in United States dollars)

|                                                 |                                                        |                                               |             |           |             |           |             |          
|------------------------------------------------ | ------------------------------------------------------ | --------------------------------------------- | ----------- | --------- | ----------- | --------- | ----------- | ---------
|                                                 |                                                        |                                               | 2005        |           | 2004        |           | 2003       
|Cash provided by (used in):                      |                                                        |                                               |             |           |             |          
|                                                 |                                                        |                                               |             |           |             |           |            
|OPERATIONS                                       |                                                        |                                               |             |           |             |          
|                                                 | Loss for the year                                      | $                                             | (2,550,708) | $         | (1,925,946) | $         | (3,705,631)
|                                                 |                                                        |                                               |             |           |             |           |            
|                                                 | Items not requiring (providing) cash:                  |                                               |             |           |             |           |            
|                                                 |                                                        | Amortization                                  |             | 360,898   |             | 457,572   |             | 308,717  
|                                                 |                                                        | Stock based compensation                      |             | 134,793   |             | 320,432   |             | 90,439   
|                                                 |                                                        | Loss (gain) on sale of property and equipment |             |          |             | 15,616    |             | (2,204)  
|                                                 |                                                        | Impairment of property and equipment          |             | 89,754    |             |          |             | 102,900  
|                                                 |                                                        | Impairment of intangible assets               |             | 428,453   |             |          |             |         
|                                                 |                                                        | Impairment of goodwill                        |             |          |             |          |             | 2,184,589
|                                                 |                                                        |                                               |             |           |             |           |            
|                                                 | Changes in non-cash working capital balances (note 17) |                                               | (57,747)    |           | (47,817)    |           | 581,497    
|                                                 |                                                        |                                               |             |           |             |           |            
|                                                 |                                                        |                                               | (1,594,557) |           | (1,180,143) |           | (439,693)  
|                                                 |                                                        |                                               |             |           |             |           |            
|FINANCING                                        |                                                        |                                               |             |           |             |          
|                                                 | Issuance of common shares, net                         |                                               | 165,008     |           | 2,120,657   |           | 22,940     
|                                                 | Issuance of warrants                                   |                                               |            |           | 904,019     |           |           
|                                                 |                                                        |                                               |             |           |             |           |            
|                                                 |                                                        |                                               | 165,008     |           | 3,024,676   |           | 22,940     
|                                                 |                                                        |                                               |             |           |             |           |            
|INVESTMENTS                                      |                                                        |                                               |             |           |             |          
|                                                 | Note receivable                                        |                                               | (82,648)    |           |            |           |           
|                                                 | Purchase of property and equipment                     |                                               | (188,890)   |           | (164,457)   |           | (98,026)   
|                                                 | Purchase of deferred development costs                 |                                               | (352,750)   |           |            |           |           
|                                                 | Purchase of intangible assets                          |                                               | (50,977)    |           | (418,056)   |           | (51,394)   
|                                                 | Proceeds from sale of property and equipment           |                                               |            |           | 4,430       |           | 6,061      
|                                                 |                                                        |                                               |             |           |             |           |            
|                                                 |                                                        |                                               | (675,265)   |           | (578,083)   |           | (143,359)  
|                                                 |                                                        |                                               |             |           |             |           |            
|(Decrease) increase in cash and cash equivalents |                                                        | (2,104,814)                                   |             | 1,266,450 |             | (560,112)
|Cash and cash equivalents, beginning of year     |                                                        | 3,327,543                                     |             | 2,061,093 |             | 2,621,205
|                                                 |                                                        |                                               |             |           |             |           |            
|Cash and cash equivalents, end of year           | $                                                      | 1,222,729                                     | $           | 3,327,543 | $           | 2,061,093

See accompanying notes to consolidated financial statements









---

Notes

to Consolidated Financial Statements

Years Ended December 31, 2005, 2004, and 2003

(Expressed in United States dollars)



1.

Organization:



Since its inception in 1988, QSound Labs, Inc. (the Company) has established itself as a leading audio technology company. The Company has developed proprietary audio solutions that include virtual surround sound, positional audio and stereo enhancement for mobile devices, consumer electronics, PC/multimedia, and Internet markets. The Companys cutting-edge audio technologies create rich 3D audio environments allowing consumers to enjoy stereo surround sound from two, four and up to 7.1 speaker systems.



The Companys subsidiary QCommerce Inc. provides complete e-commerce solutions for small and medium sized businesses.



The Companys subsidiary QTelNet Inc. delivers award-winning, highly interoperable Voice Over IP solutions.



2.

Significant accounting policies:



The accompanying consolidated financial statements are prepared in accordance with accounting principles generally accepted in Canada which, in the case of the Company, conform in all material respects with those in the United States, except as outlined in note 22.  All amounts are expressed in United States dollars.



The Companys significant accounting policies are as follows:



Use of Estimates:

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses.  Actual results could differ from these estimates.



Basis of presentation:

These consolidated financial statements include the accounts of QSound Labs, Inc. a public company organized under the laws of the Province of Alberta, Canada and its wholly-owned subsidiaries.  All intercompany transactions and balances have been eliminated on consolidation.



Cash and cash equivalents:

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



Inventory:

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



Property and equipment:

Property and equipment is recorded at cost and is amortized annually, beginning the year after acquisition, over the expected useful life of 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 property and equipment by comparing the carrying value of the property and equipment and its recoverable value.  When the carrying value exceeds its recoverable value from future undiscounted cash flows, an impairment is recognized and charged to period earnings equal to the excess of the carrying value over the recoverable value.



Research and development costs:

Research costs are expensed as incurred.  Development costs are expensed as incurred except if they relate to a specific product or process that management believes is technically and economically feasible and recoverable, in which case these costs are deferred.



Deferred development costs are amortized against the related expected revenue as that revenue is recognized.



The Company assesses impairment of deferred development costs by determining whether their recoverable amounts are less than their unamortized balance.  When a potential impairment is identified, the amount of impairment is calculated by reference to the related net expected future cash flows and charged to period earnings.



Goodwill:

The Company uses the purchase method to account for all business combinations and identifies separate from goodwill, other intangible assets that arise.  Pursuant to this policy, goodwill is no longer amortized, but is tested for impairment on an annual basis.   In 2003, an analysis of the recorded goodwill was completed and an assessed goodwill impairment of the remaining balance was recognized as at December 31, 2003.



Intangible assets:

Patents and trademarks, and purchased customer list are recorded at cost and are amortized beginning the year after acquisition, over the expected useful life of the assets, which has been estimated to be 5 years.  Their carrying value is tested for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable.



Licensing rights are recorded at cost and amortized over the estimated life.  The Company assesses impairment of licensing rights by determining whether their recoverable amounts are less than their unamortized balance.  When a potential impairment is identified, the amount of impairment is calculated as the amount the carrying value of the licensing rights exceeds the expected future cash flows and charged to period earnings.



Foreign currency translation:

The Companys functional currency is United States Dollars.  The Company translates monetary assets and liabilities into United States dollars at the rate of exchange in effect as at the balance sheet date, and revenues and expenses at the average rates in effect during the year.  Foreign exchange gains and losses on translation of these amounts are included in the determination of net income or loss for the year.



Revenue recognition:

The Company generates revenue from sale of licenses for software products, royalties, and engineering fees.  The Company recognizes revenue, when all of the following criteria are met:  persuasive evidence of an arrangement exists, delivery of the software product has occurred or the services have been performed, the price is fixed or determinable, customer acceptance, if applicable, has been received, and collection is reasonably assured.



Software license fees, royalties, and engineering fees collected on projects in advance of revenue being recognized are recorded as deferred revenue.



The Company also generates revenue from the sale of products.  Revenue from product sales is recognized when products are shipped pursuant to sales arrangements with customers (which is when title passes), collectibility is reasonably assured and the Company does not have obligations for additional deliverables that are essential to the functionality of the product.



---

Interest income:

Interest income is recognized as it is earned.



Income taxes:

The Company uses the liability method of accounting for income taxes under which future income tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Future income tax assets and liabilities are measured using enacted or substantively enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled.  The effect on future income tax assets and liabilities as a result of a change in tax rates is recognized as part of the provision for income taxes in the period that includes the substantive enactment date.



To the extent that future income tax assets are not considered to be more likely than not realized, a valuation allowance is provided.



Per share amounts:

Per share amounts are calculated using the weighted average number of common shares outstanding during the year. Diluted per share amounts are calculated using the treasury stock method.



Stock based compensation:

The Company accounts for stock based compensation under the fair value method. Under the fair value based method, compensation cost is measured at fair value at the date of grant and is expensed over the vesting period.  In accordance with one of the transitional options permitted under amended CICA Handbook Section 3870, the Company elected to early adopt the fair value based method for all employee stock options granted on or after January 1, 2003, and accordingly, recognized compensation expense related to stock options granted to employees beginning in 2003. Pro forma disclosure of the fair value of stock options granted to employees during 2002 has been provided (note 11).  Consideration paid by employees to the Company on the exercise of stock options are recorded in share capital upon receipt, along with the amount of non-cash stock based compensation expense recognized in contributed surplus.



3.

Joint venture:



During 2005, the Company entered into a joint venture agreement (the Agreement) for the development of and sale of software for the gaming industry.  Under the terms of the Agreement, the Company has provided the financing to the joint venture necessary to undertake the software development.  In return, the Company has control over the venture under the Agreement until such time as its financing is repaid through the sale of the related software being developed.  As such, these financial statements include 100% of the assets, liabilities, revenues and expenses of the joint venture as follows:



|                           |   |          
|-------------------------- | - | ---------
|Accounts receivable        | $ | 754      
|Deferred development costs |   | 352,750  
|Net joint venture equity   |   | (353,504)
|                           |   |          
|Engineering fee revenue    |   | 40,254   
|Expenses                   |   | 19,750   



Upon repayment of its financing, the Companys interest in the joint venture will be 45% at which point the Company will record a disposition and account for its interest in the joint venture using the proportionate consolidation method.



During 2005, the Company provided the joint venture financing in the amount of $353,504 plus funded the expenses of $19,750.  These amounts were paid to a joint venture partner to facilitate the software development.



4.

Note receivable:



The note receivable is due from a joint venture partner, bears interest at 8% per annum, and is due June 30, 2006.  The joint venture partners interest in the joint venture has been pledged as security.







---

5.

Property and equipment:



|                                   |   |           |                          |           |                |        
|---------------------------------- | - | --------- | ------------------------ | --------- | -------------- | -------
|2005                               |   | Cost      | Accumulated amortization |           | Net book value
|Sound source and control equipment | $ | 545,463   | $                        | 529,346   | $              | 16,117 
|Real time systems                  |   | 905,534   |                          | 901,354   |                | 4,180  
|Furniture and fixtures             |   | 230,668   |                          | 207,750   |                | 22,918 
|Computer equipment                 |   | 1,095,705 |                          | 809,061   |                | 286,644
|Software and production tooling    |   | 1,632,281 |                          | 1,291,505 |                | 340,776
|                                   |   |           |                          |           |                |        
|                                   | $ | 4,409,651 | $                        | 3,739,016 | $              | 670,635



Included in the accumulated amortization above for computer equipment is a 2005 year asset impairment charge of $1,362.  Included in the accumulated amortization above for software and production tooling is a 2005 year asset impairment charge of $88,392.



|                                   |   |           |                          |           |                |        
|---------------------------------- | - | --------- | ------------------------ | --------- | -------------- | -------
|2004                               |   | Cost      | Accumulated amortization |           | Net book value
|Sound source and control equipment | $ | 545,463   | $                        | 523,174   | $              | 22,289 
|Real time systems                  |   | 905,534   |                          | 899,563   |                | 5,971  
|Furniture and fixtures             |   | 228,654   |                          | 203,298   |                | 25,356 
|Computer equipment                 |   | 997,224   |                          | 728,490   |                | 268,734
|Software and production tooling    |   | 1,543,888 |                          | 1,057,067 |                | 486,821
|                                   |   |           |                          |           |                |        
|                                   | $ | 4,220,763 | $                        | 3,411,592 | $              | 809,171



6.

Deferred development costs:

|                           |   |         |   |        
|-------------------------- | - | ------- | - | -------
|                           |   | 2005    |   | 2004   
|Software development costs | $ | 804,564 | $ | 451,814
|Accumulated amortization   |   | 451,814 |   | 386,840
|                           |   |         |   |        
|Net book value             | $ | 352,750 | $ | 64,974 



In accordance with the accounting policy of the Company, included in the deferred development costs are $352,750 (2004 - $nil) that are not yet in commercial production and therefore not subject to amortization.  In 2005, amortization of  $64,974 (2004 - $112,711) was recorded and included in amortization expense.



7.

Intangible assets:



|                        |   |           |                          |           |                |        
|----------------------- | - | --------- | ------------------------ | --------- | -------------- | -------
|2005                    |   | Cost      | Accumulated amortization |           | Net book value
|Patents and trademarks  | $ | 928,906   | $                        | 780,344   | $              | 148,562
|Purchased customer list |   | 34,418    |                          | 27,535    |                | 6,883  
|Licensing rights        |   | 428,453   |                          | 428,453   |                |       
|                        |   |           |                          |           |                |        
|                        | $ | 1,391,777 | $                        | 1,236,332 | $              | 155,445



|                        |   |           |                          |         |                |        
|----------------------- | - | --------- | ------------------------ | ------- | -------------- | -------
|2004                    |   | Cost      | Accumulated amortization |         | Net book value
|Patents and trademarks  | $ | 877,929   | $                        | 728,976 | $              | 148,953
|Purchased customer list |   | 34,418    |                          | 20,651  |                | 13,767 
|Licensing rights        |   | 428,453   |                          |        |                | 428,453
|                        |   |           |                          |         |                |        
|                        | $ | 1,340,800 | $                        | 749,627 | $              | 591,173







---



Included in the accumulated amortization above for licensing rights is a 2005 year asset impairment charge of $428,453.



8.

Share capital:



Authorized:

The Company is authorized to issue an unlimited number of common shares without par value and an unlimited number of first and second preferred shares.  No preferred shares are outstanding.



Common shares issued and outstanding:



|                                                                       |                        |                                                                                      |            |           |          
|---------------------------------------------------------------------- | ---------------------- | ------------------------------------------------------------------------------------ | ---------- | --------- | ---------
|                                                                       | Number of Shares       | Consideration                                                                       
|Balance December 31, 2002                                              | 7,156,074              | $                                                                                    | 43,772,441
|                                                                       |                        |                                                                                      |           
|Issued for cash on exercise of options                                 | 43,170                 |                                                                                      | 22,940    
|Reclassification from contributed surplus on exercise of stock options |                       |                                                                                      | 5,864     
|Balance December 31, 2003                                              | 7,199,244              |                                                                                      | 43,801,245
|                                                                       |                        |                                                                                      |           
|Issued for cash:                                                       |                        |                                                                                      |           
|                                                                       | On exercise of options | 857,015                                                                              |            | 1,174,218
|                                                                       | Private placement      |                                                                                      |            |          
|                                                                       |                        | Cash received                                                                        | 347,826    |           | 2,000,000
|                                                                       |                        | Less financing costs paid in cash                                                    |           |           | (149,541)
|                                                                       |                        | Less warrants valued under Black-Scholes as part of private placement costs (note 9) |           |           | (380,862)
|                                                                       |                        | Less deemed allocation to warrants (note 9)                                          |           |           | (904,019)
|Reclassification from contributed surplus on exercise of stock options |                       |                                                                                      | 251,485   
|Balance December 31, 2004                                              | 8,404,085              |                                                                                      | 45,792,526
|                                                                       |                        |                                                                                      |           
|Issued for cash on exercise of options                                 | 257,900                |                                                                                      | 201,000   
|Reclassification from contributed surplus on exercise of stock options |                       |                                                                                      | 21,521    
|Less financing costs paid in cash                                      |                       |                                                                                      | (35,992)  
|                                                                       |                        |                                                                                      |           
|Balance December 31, 2005                                              | 8,661,985              | $                                                                                    | 45,979,055



9.

Warrants:



|                             |                    |               |          
|---------------------------- | ------------------ | ------------- | ---------
|                             | Number of Warrants | Consideration
|Balance December 31, 2002    | 250,000            | $             | 108,725  
|Issued for services received | 250,000            |               | 108,725  
|Balance December 31, 2003    | 500,000            |               | 217,450  
|Issued for services received | 75,000             |               | 380,862  
|Issued for cash              | 660,869            |               | 904,019  
|Balance December 31, 2004    | 1,235,869          |               | 1,502,331
|Expired                      | (521,739)          |               |         
|                             |                    |               |          
|Balance December 31, 2005    | 714,130            | $             | 1,502,331



The warrants issued in 2004 for services received were allocated to share issue costs.  The warrants issued in 2003 for services received were capitalized to software and production tooling.







---





The fair value of the warrants issued for services received was calculated using the Black-Scholes pricing model with the following weighted average assumptions:



|                        |                     |          
|----------------------- | ------------------- | ---------
|                        | 2004                | 2003     
|Risk free interest rate | 4.5%                | 4.5%     
|Volatility              | 93%                 | 80%      
|Life of the warrant     | 7 months to 5 years | 4.5 years
|Dividend yield          | 0%                  | 0%       



The amount allocated to the warrants issued for cash was calculated taking the total cash proceeds of the shares issued in the private placement on a pro-rata basis with the fair value of the warrants issued using the Black-Scholes pricing model using the assumptions stated above and the market value of the shares issued in the private placement.



The following table summarizes the information about warrants outstanding at December 31, 2005:



|                                     |                |   |                        |  |    
|------------------------------------ | -------------- | - | ---------------------- |  | ---
|Warrants Outstanding and Exercisable | Exercise Price |   | Remaining Term (years)
|500,000                              |                | $ | 1.04                   |  | 1.2
|75,000                               |                |   | 7.77                   |  | 4.0
|139,130                              |                |   | 9.12                   |  | 4.0
|                                     |                |   |                        |  |    
|714,130                              |                | $ | 3.32                   |  | 2.0



Each warrant is exercisable for one common share of the Company.



10.

Contributed surplus:



|                                         |   |          
|---------------------------------------- | - | ---------
|Balance December 31, 2002                | $ | 1,119,185
|                                         |   |          
|Increase due to stock based compensation |   | 90,439   
|Decrease due to stock options exercised  |   | (5,864)  
|Balance December 31, 2003                |   | 1,203,760
|                                         |   |          
|Increase due to stock based compensation |   | 376,861  
|Decrease due to stock options exercised  |   | (251,485)
|Balance December 31, 2004                |   | 1,329,136
|                                         |   |          
|Increase due to stock based compensation |   | 134,793  
|Decrease due to stock options exercised  |   | (21,521) 
|                                         |   |          
|Balance December 31, 2005                | $ | 1,442,408



11.

Stock option plan:



The Company has a stock option plan under which the Board of Directors may grant stock options to directors, officers, consultants and employees for the purchase of authorized but unissued common shares.  At December 31, 2005, stock options to purchase 977,533 common shares are outstanding.  The stock options are exercisable at prices ranging from $0.47 to $4.56 per share and expire on various dates between 2006 and 2015.



During the year ended December 31, 2005, the Company granted 180,933 (2004  570,720; 2003  280,000) options to employees and directors with exercise prices at or greater than the market price of the Companys stock on the date of grant.  Of these 180,933 (2004  570,720; 2003  280,000) options, 7,000 (2004  245,720; 2003  30,000) vested immediately.  The remaining 173,933 (2004  325,000; 2003  250,000) options vest at various times depending upon individual specified performance criteria being met. At December 31, 2005, 22,500 of these options had vested.







---

In 2005, the Company did not grant any options to non-employees (2004  60,000; 2003  55,000) in connection with services to be performed. All of these options vest depending upon specified performance criteria being met.  At December 31, 2005, all of these options had vested or had been cancelled.



The fair value of the vested options granted during 2005, 2004 and 2003 is estimated on the day of grant using the Black-Scholes option pricing model with the following assumptions;



|                            |                     |                    |             
|--------------------------- | ------------------- | ------------------ | ------------
|                            | 2005                | 2004               | 2003        
|Risk free interest rate     | 4.5%                | 4.5%               | 4.5%        
|Weighted average volatility | 66%                 | 94%                | 105%        
|Expected life of option     | 90 days to 10 years | 15 days to 5 years | 3 to 5 years
|Dividend yield              | 0%                  | 0%                 | 0%          



For the year ended December 31, 2005, $134,793 (2004  $320,432; 2003  $90,439) has been recognized as compensation cost related to options granted to employees and directors.  In 2005, no compensation cost (2004  $56,429; 2003 - $59,619) has been recognized as compensation cost related to options issued to non-employees.  In 2004, the compensation costs related to options issued to non-employees has been capitalized to intangible assets.  In 2003, the compensation costs related to options issued to non-employees has been expensed to marketing expenses.



No compensation cost was recorded in the Companys statement of operations and deficit for options granted in 2002 to employees, directors and officers.  Had compensation cost for stock options granted in 2002 been determined based on the fair value method, the Companys pro-forma net loss for the year ended December 31, 2005 would have been increased by $21,982 to $2,572,690, the pro-forma net loss for 2004 would have been increased by $81,620  to $2,007,566, and the pro-forma net loss for 2003 would have increased by $103,602 to $3,809,233.  Pro-forma loss per common share (basic and diluted) would have not changed for 2005 while 2004 and 2003 would have both been increased by $0.01 to $0.26 in 2004, and $0.53 in 2003.



Changes in options granted during the years ended December 31, 2005, 2004 and 2003 were as follows:



|                          |                  |                          |                                 |   |       |   |     
|------------------------- | ---------------- | ------------------------ | ------------------------------- | - | ----- | - | ----
|                          | Number of Shares | Exercise price per share | Weighted average exercise price
|Balance December 31, 2002 | 1,595,922        | $                        | 0.47                            |  | 12.24 | $ | 1.26
|                          |                  |                          |                                 |   |       |   |     
|Granted                   | 335,000          |                          | 1.00                            |  | 1.48  |   | 1.24
|Exercised                 | (43,170)         |                          | 0.47                            |  | 1.00  |   | 0.53
|Cancelled or expired      | (148,987)        |                          | 1.21                            |  | 12.24 |   | 5.97
|Balance December 31, 2003 | 1,738,765        |                          | 0.47                            |  | 1.75  |   | 0.87
|                          |                  |                          |                                 |   |       |   |     
|Granted                   | 630,720          |                          | 1.65                            |  | 5.00  |   | 2.58
|Exercised                 | (857,015)        |                          | 0.47                            |  | 5.00  |   | 1.37
|Cancelled or expired      | (354,970)        |                          | 1.21                            |  | 1.72  |   | 1.36
|Balance December 31, 2004 | 1,157,500        |                          | 0.47                            |  | 4.56  |   | 1.29
|                          |                  |                          |                                 |   |       |   |     
|Granted                   | 180,933          |                          | 2.40                            |  | 3.57  |   | 2.59
|Exercised                 | (257,900)        |                          | 0.47                            |  | 4.56  |   | 0.78
|Cancelled or expired      | (103,000)        |                          | 2.05                            |  | 4.56  |   | 3.34
|Balance December 31, 2005 | 977,533          |                          | 0.47                            | - | 4.56  | $ | 1.45



---

The following table summarizes the information about stock options outstanding at December 31, 2005:



|                         |              |                                     |                                          |                                  |      |                                     |                                 |         |   |     
|------------------------ | ------------ | ----------------------------------- | ---------------------------------------- | -------------------------------- | ---- | ----------------------------------- | ------------------------------- | ------- | - | ----
|                         |              | Options Outstanding                 |                                          | Options Exercisable             
|Range of
Exercise Prices |              | Number
Outstanding at
Dec. 31, 2005 | Weighted-
Average
Remaining
Term (Years) | Weighted-
Average
Exercise Price |      | Number
Exercisable at
Dec. 31, 2005 | Weighted Average
Exercise Price
|$                        | 0.47         |                                     | 219,307                                  | 0.9                              | $    | 0.47                                |                                 | 219,307 | $ | 0.47
|                         | 1.04 to 1.75 |                                     | 413,693                                  | 1.0                              | 1.21 |                                     | 413,693                         | 1.21   
|                         | 1.88 to 2.40 |                                     | 309,533                                  | 5.3                              | 2.19 |                                     | 188,100                         | 2.06   
|                         | 3.57 to 4.56 |                                     | 35,000                                   | 4.4                              | 3.71 |                                     | 5,000                           | 4.56   
|                         |              |                                     | 977,533                                  | 2.5                              | $    | 1.45                                |                                 | 826,100 | $ | 1.23



12.

Impairment of property and equipment:



In accordance with the Companys accounting policy, an analysis of property and equipment was completed in 2005.  As a result of the re-evaluation of a telephony project, an assessed property and equipment impairment of $89,754 was recognized on some telephony assets during 2005.  In 2003, an assessed property and equipment impairment of $102,900 was recognized on an audio segment asset.



13.

Impairment of intangible asset:



In accordance with the Companys accounting policy, an analysis of intangible assets was completed in 2005.  As a result of the re-evaluation of a telephony project, an assessed intangible assets impairment of $428,453 was recognized during 2005.



14.

Impairment of goodwill:



In accordance with the Companys accounting policy, an analysis of the recorded goodwill was completed in 2003.  As a result of the declining activity in the E-Commerce operating segment, an assessed goodwill impairment of $2,184,589 was recognized as at December 31, 2003.



15.

Loss per share:



|                                              |   |             |   |             |   |            
|--------------------------------------------- | - | ----------- | - | ----------- | - | -----------
|Basic loss per share                          |   | 2005        |   | 2004        |   | 2003       
|Net loss                                      | $ | (2,550,708) | $ | (1,925,946) | $ | (3,705,631)
|Weighted average number of shares outstanding |   | 8,497,201   |   | 7,628,238   |   | 7,171,217  
|                                              |   |             |   |             |   |            
|Loss per share                                | $ | (0.30)      | $ | (0.25)      | $ | (0.52)     



|                                                       |   |             |   |             |   |            
|------------------------------------------------------ | - | ----------- | - | ----------- | - | -----------
|Diluted loss per share                                 |   | 2005        |   | 2004        |   | 2003       
|Net Loss                                               | $ | (2,550,708) | $ | (1,925,946) | $ | (3,705,631)
|Weighted average number of shares outstanding          |   | 8,497,201   |   | 7,628,238   |   | 7,171,217  
|Weighted average stock options potentially exercisable |   | 704,827     |   | 1,570,357   |   | 588,919    
|Weighted average warrants potentially exercisable      |   | 379,674     |   | 384,578     |   | 139,894    
|Weighted average number of diluted shares outstanding  |   | 9,581,702   |   | 9,583,173   |   | 7,900,030  
|                                                       |   |             |   |             |   |            
|Diluted loss per share                                 | $ | (0.30)      | $ | (0.25)      | $ | (0.52)     



In calculating the weighted average number of diluted shares above, the Company excluded 59,000 stock options (2004  57,000; 2003  253,987) and 214,130 warrants (2003  735,869; 2003 - nil) because the exercise price was greater than the average market price for the year.







---



16.

Defined benefit pension plan:



During the 2002 year the Company established an individual pension plan for the president to resolve an outstanding compensation contingency.  The company does not have a pension plan for other employees.



Under the terms of the plan, the Company will make yearly contributions to the plan up to the date of retirement of the individual.  All contributions to the plan are expected to return 7.5% per annum.  Should the plan not achieve the 7.5% expected return, the Company will be responsible for any shortfall.



Information regarding the individual pension plan is outlined below:



|                           |                                             |           |         |           |          |           |          | 
|-------------------------- | ------------------------------------------- | --------- | ------- | --------- | -------- | --------- | -------- | 
|                           |                                             | 2005      |         | 2004      |          | 2003     
|                           |                                             |           |         |           |          |          
|Fair value of plan assets  | $                                           | 302,827   | $       | 255,628   | $        | 200,695  
|Accrued benefit obligation |                                             | (283,799) |         | (236,744) |          | (188,056)
|                           |                                             |           |         |           |          |          
|Funded Status:             |                                             |           |         |           |          |          
|                           | Plan assets in excess of benefit obligation |           | 19,028  |           | 18,884   |           | 12,639  
|                           | Unamortized net actuarial loss (gain)       |           | (8,124) |           | (14,403) |           | (11,231)
|                           |                                             |           |         |           |          |          
|Accrued benefit asset      | $                                           | 10,904    | $       | 4,481     | $        | 1,408    



The financial statements presented do no reflect the accrued benefit asset shown above, since it is considered insignificant.



Economic assumptions used to determine benefit obligation and periodic expense were:



|                                                     |  |       |  |       |  |      
|---------------------------------------------------- |  | ----- |  | ----- |  | -----
|                                                     |  | 2005  |  | 2004  |  | 2003 
|                                                     |  |       |  |       |  |      
|Discount rate                                        |  | 5.50% |  | 5.75% |  | 6.25%
|Expected rate of return on assets                    |  | 7.50% |  | 7.50% |  | 7.50%
|Rate of compensation increase                        |  | 5.50% |  | 5.50% |  | 5.50%
|Average remaining service period of covered employee |  | 12    |  | 13    |  | 14   



Actuarial evaluations are required every three years, the next evaluation being January 1, 2006.



Pension expense, included in the Companys marketing expense, is as follows:



|                                              |   |          |   |          |   |        
|--------------------------------------------- | - | -------- | - | -------- | - | -------
|                                              |   | 2005     |   | 2004     |   | 2003   
|                                              |   |          |   |          |   |        
|Current service cost                          | $ | 18,551   | $ | 16,063   | $ | 13,886 
|Interest on accrued benefit obligation        |   | 20,743   |   | 15,667   |   | 6,241  
|Expected return on plan assets                |   | (19,734) |   | (15,560) |   | (6,182)
|                                              |   |          |   |          |   |        
|Pension expense included in marketing expense | $ | 19,560   | $ | 16,170   | $ | 13,945 



The company expects to contribute $20,589 to the plan in 2006.









---



17.

Supplementary cash flow information:



|                                             |   |           |   |          |   |         
|-------------------------------------------- | - | --------- | - | -------- | - | --------
|Changes in non-cash working capital balances |   | 2005      |   | 2004     |   | 2003    
|Accounts receivable                          | $ | (190,557) | $ | 10,227   | $ | 708,325 
|Inventory                                    |   | 122,130   |   | (55,191) |   | (90,920)
|Deposits and prepaid expenses                |   | (14,708)  |   | 21,483   |   | (24,247)
|Accounts payable and accrued liabilities     |   | 40,122    |   | 12,466   |   | 12,303  
|Deferred revenue                             |   | (14,734)  |   | (36,802) |   | (23,964)
|                                             |   |           |   |          |   |         
|                                             | $ | (57,747)  | $ | (47,817) | $ | 581,497 
|                                             |   |           |   |          |   |         
|Interest received in cash                    | $ | 55,981    | $ | 85,546   | $ | 38,664  
|                                             |   |           |   |          |   |         
|Income taxes paid in cash                    | $ | 37,711    | $ | 22,504   | $ | 8,543   



18.

Income taxes:



Income tax expense differs from the amount that would be computed by applying the basic combined Canadian federal and provincial statutory income tax rate to the income (loss) for the year.  The reasons for the differences are as follows:



|                                                        |                                                                                   |             |         |             |         |             |        
|------------------------------------------------------- | --------------------------------------------------------------------------------- | ----------- | ------- | ----------- | ------- | ----------- | -------
|                                                        |                                                                                   | 2005        |         | 2004        |         | 2003       
|Loss for the year                                       | $                                                                                 | (2,512,997) | $       | (1,903,442) | $       | (3,697,088)
|Combined Canadian Federal and Provincial statutory rate |                                                                                   | 33.62%      |         | 33.87%      |         | 36.75%     
|Computed tax (recovery)                                 |                                                                                   | (844,870)   |         | (644,696)   |         | (1,358,680)
|Increase  (decrease) resulting from:                    |                                                                                   |             |         |             |         |            
|                                                        | Change in valuation allowance                                                     |             | 768,000 |             | 165,000 |             | 506,000
|                                                        | Income taxes computed at different rates in the United States                     |             | (2,903) |             | (1,214) |             | 10,487 
|                                                        | Reduction of unrealized future tax assets for enacted changes in income tax rates |             | 36,714  |             | 223,049 |             | 73,137 
|                                                        | Stock based compensation                                                          |             | 45,317  |             | 108,530 |             | 33,236 
|                                                        | Other permanent differences                                                       |             | 35,453  |             | 171,835 |             | 744,363
|Actual expense (recovery)                               | $                                                                                 | 37,711      | $       | 22,504      | $       | 8,543      



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



|                             |   |             |               |             |      |             |      |            
|---------------------------- | - | ----------- | ------------- | ----------- | ---- | ----------- | ---- | -----------
|                             |   | Canada      | United States |             | 2005 |             | 2004
|Future income tax assets:    |   |             |               |             |      |             |      |            
|Capital assets               | $ | 1,341,000   | $             |            | $    | 1,341,000   | $    | 981,000    
|Share issue costs            |   | 35,000      |               |            |      | 35,000      |      | 31,000     
|Loss and SRED carry-forwards |   | 3,197,000   |               | 3,505,000   |      | 6,702,000   |      | 6,306,000  
|Intangible assets            |   | 200,000     |               | 85,000      |      | 285,000     |      | 277,000    
|Investments                  |   |            |               | 158,000     |      | 158,000     |      | 158,000    
|                             |   | 4,773,000   |               | 3,748,000   |      | 8,521,000   |      | 7,753,000  
|Less: Valuation allowance    |   | (4,773,000) |               | (3,748,000) |      | (8,521,000) |      | (7,753,000)
|                             |   |             |               |             |      |             |      |            
|Net future tax assets        | $ |            | $             |            | $    |            | $    |           



In 2005, management determined that the basis used in estimating future income tax assets differed from actual income tax returns filed.  Accordingly, the value of these assets has been recalculated to reflect income tax returns filed, and the comparative figures for 2004 and 2003 have been adjusted in the above tables.  Additionally, the valuation allowance has been adjusted accordingly resulting in total net future tax assets of zero as previously reported.







---

The Company has Canadian Scientific Research and Experimental Development (SRED) expenditure carry-forwards in the amount of $4,777,000 which have no expiry.  The Company also has Canadian non-capital loss carry-forwards and United States net operating loss carry-forwards which expire in the following years:



|     |   |           |               |           
|---- | - | --------- | ------------- | ----------
|     |   | Canada    | United States
|2006 | $ | 889,259   | $             | 2,053,162 
|2007 |   | 86        |               |          
|2008 |   | 86        |               | 776,287   
|2009 |   |          |               | 373,177   
|2010 |   | 1,435,341 |               | 412,789   
|2011 |   |          |               | 107,980   
|2012 |   |          |               | 59,918    
|2014 |   | 1,187,240 |               |          
|2015 |   | 1,416,649 |               |          
|2018 |   |          |               | 2,052,039 
|2019 |   |          |               | 164,364   
|2020 |   |          |               | 1,295,294 
|2021 |   |          |               | 1,422,885 
|2022 |   |          |               | 188,145   
|2023 |   |          |               | 716,280   
|2024 |   |          |               | 149,172   
|2025 |   |          |               | 241,617   
|     |   |           |               |           
|     | $ | 4,928,661 | $             | 10,013,109



19.

Segmented information:



The Company operates in three operating segments consisting of Audio Products (Audio), E-Commerce Products (E-Commerce), and Voice Over Internet Protocol Products (Telephony).  Audio involves the developing and marketing of sound enhancement technology for use in various industries. E-Commerce involves the developing and marketing of internet business services.  Telephony involves the developing and marketing of telecommunication over internet equipment and software.



|                                        |   |             |            |           |   |           |   |            
|--------------------------------------- | - | ----------- | ---------- | --------- | - | --------- | - | -----------
|2005                                    |   | Audio       | E-Commerce | Telephony |   | Total    
|Revenues                                | $ | 1,304,832   | $          | 182,940   | $ | 55,468    | $ | 1,543,240  
|Interest revenue                        |   | 54,470      |            | 12        |   | 2,219     |   | 56,701     
|Amortization                            |   | 211,464     |            | 27,045    |   | 122,389   |   | 360,898    
|Segment loss before other items         |   | (1,243,781) |            | (233,166) |   | (533,000) |   | (2,009,947)
|Segment assets                          |   | 2,495,997   |            | 84,574    |   | 421,744   |   | 3,002,315  
|Expenditures for property and equipment |   | 73,881      |            | 25,201    |   | 89,808    |   | 188,890    
|Expenditures for intangible assets      |   | 50,563      |            | 414       |   |          |   | 50,977     



|                                                         |   |           |            |           |   |             |   |            
|-------------------------------------------------------- | - | --------- | ---------- | --------- | - | ----------- | - | -----------
|2004                                                     |   | Audio     | E-Commerce | Telephony |   | Total      
|Revenues                                                 | $ | 1,820,028 | $          | 245,238   | $ | 147,912     | $ | 2,213,178  
|Interest revenue                                         |   | 78,254    |            | 12        |   | 461         |   | 78,727     
|Amortization                                             |   | 251,362   |            | 35,273    |   | 170,937     |   | 457,572    
|Segment loss before other items                          |   | (653,710) |            | (138,369) |   | (1,168,897) |   | (1,960,976)
|Segment assets                                           |   | 4,037,007 |            | 109,600   |   | 1,081,227   |   | 5,227,834  
|Expenditures for property and equipment                  |   | 154,884   |            | 811       |   | 8,762       |   | 164,457    
|Expenditures for intangible assets                       |   | 46,032    |            |          |   | 372,024     |   | 418,056    
|Stock based compensation capitalized as intangible asset |   |          |            |          |   | 56,429      |   | 56,429     









---



|                                        |   |           |            |           |   |           |   |            
|--------------------------------------- | - | --------- | ---------- | --------- | - | --------- | - | -----------
|2003                                    |   | Audio     | E-Commerce | Telephony |   | Total    
|Revenues                                | $ | 1,511,312 | $          | 346,456   | $ | 185,320   | $ | 2,043,088  
|Interest revenue                        |   | 41,132    |            |          |   | 32        |   | 41,164     
|Amortization                            |   | 261,713   |            | 47,004    |   |          |   | 308,717    
|Segment loss before other items         |   | (596,419) |            | (65,628)  |   | (764,410) |   | (1,426,457)
|Segment assets                          |   | 2,731,693 |            | 175,363   |   | 869,523   |   | 3,776,579  
|Expenditures for property and equipment |   | 20,682    |            | 867       |   | 576,477   |   | 598,026    
|Expenditures for intangible assets      |   | 51,354    |            |          |   | 40        |   | 51,394     



|                       |              |              |              |           |   |          
|---------------------- | ------------ | ------------ | ------------ | --------- | - | ---------
|Geographic information | 2005 Revenue | 2004 Revenue | 2003 Revenue
|Canada                 | $            | 10,472       | $            | 73,294    | $ | 64,449   
|United States          |              | 966,980      |              | 1,418,029 |   | 1,515,602
|Asia                   |              | 489,625      |              | 644,503   |   | 456,194  
|Europe                 |              | 49,026       |              | 72,102    |   | 4,365    
|Other                  |              | 27,137       |              | 5,250     |   | 2,478    
|                       |              |              |              |           |   |          
|                       | $            | 1,543,240    | $            | 2,213,178 | $ | 2,043,088



As at December 31, 2005 and 2004, substantially all of the Companys product assets and employees were located in Canada.  As at December 31, 2003, substantially all of the Companys Audio and E-Commerce product assets and employees were located in Canada and all of the Companys Telephony product assets were located in Canada.  In 2003, 25% of the Companys Telephony employees were located in Canada and 75% were located in the United States.



20.

Financial instruments and risk management:



The fair values of financial assets and liabilities approximate their carrying values at December 31, 2005 due to their short maturity terms.



The Company is exposed to foreign currency fluctuations on its Canadian dollar denominated cash, receivables and payables.  Foreign currency risk arising from a decline in the relative value of the Canadian dollar is managed to the extent that Canadian dollar denominated cash and receivables are equal to or exceed Canadian dollar payables.  The Company has not, at December 31, 2005, entered into foreign currency derivatives to hedge its exposure to foreign exchange risk.



The Company is exposed to credit risk on its accounts receivable and accrued revenue.  As at December 31, 2005, there were outstanding accounts receivable and accrued revenue balances from three entities which comprised 49% of the total balance.  These entities are located in the United States and Asia.  While none of these amounts have been collected subsequent to the year end management believes that all are fully collectable.



As at December 31, 2004, there were outstanding accounts receivable balances from four entities which comprised 61% of the total balance.  These entities are located in the United States and Asia.  These amounts have been collected subsequent to the 2004 year end.



As at December 31, 2003, there were outstanding accounts receivable balances from two entities which comprised 57% of the total balance.  These entities are located in the United States and Asia.  These amounts have been collected subsequent to the 2003 year end.



During 2005, two customers contributed 23% of the total revenues, each providing greater than 10% of the total revenues.  For 2004 and 2003, no one individual customer provided greater than 10% of total revenues.







---

For Audio, during 2005, 38% of total Audio revenue arose from three customers, each of which individually provided greater than 10% of total Audio revenues.  For 2004, 52% of total Audio revenue arose from four customers, each of which individually provided greater than 10% of total Audio revenues.  For 2003, 74% of total Audio revenue arose from three customers, each of which individually provided greater than 10% of total Audio revenues.



For E-Commerce, during 2005, 2004, and 2003, no one customer contributed to more than 10% of total E-Commerce revenue.



For Telephony, during 2005, 32% of total Telephony revenue arose from two customers, each of which individually provided greater than 10% of total Telephony revenues.  For 2004, 37% of total Telephony revenue arose from three customers, each of which individually provided greater than 10% of total Telephony revenues.  For 2003, 61% of total Telephony revenue arose from two customers, each of which individually provided greater than 10% of total Telephony revenues.



21.

Commitments and contingencies:



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



In 2004, QTelNet Inc. entered into an agreement with a third party for the development of a telephony product.  Under the agreement, QTelNet provided funding and loans, and the Company issued 50,000 stock options exercisable at $2.05 U.S. and vesting at the rate of 4,166 options per month, to the third party in exchange for the development.  The development was never completed, or a product delivered, by the third party.  Under the agreement, any dispute must be settled first by mediation and arbitration and then by the courts.  QTelNet has commenced mediation.  The options have been cancelled and QTelNet Inc. is seeking repayment of $485,000 Cdn. for recovery of intangible asset.  The third party has countered that it is owed $300,000 Cdn. from its inability to exercise the options, and $290,000 Cdn. in additional development funds.  The Company and QTelNet believe that they have good defenses and that these claims are without merit, therefore no amounts have been accrued in the consolidated financial statements.



Under the terms of its lease agreements for office space and equipment, the Company is obligated at December 31, 2005 to make the following minimum lease payments over the next five years and in total:



|     |   |        
|---- | - | -------
|2006 | $ | 97,047 
|2007 |   | 97,047 
|2008 |   | 83,313 
|2009 |   | 14,646 
|2010 |   | 8,544  
|     |   |        
|     | $ | 300,597



Minimum lease payments of $92,756 (2004 - $88,458; 2003 - $70,564) are included in the calculation of the loss for the year.



22.

United States accounting principles:



The financial statements have been prepared in accordance with Canadian generally accepted accounting principles (Canadian GAAP).  Any differences in United States generally accepted accounting principles (US GAAP) as they pertain to the Companys financial statements are not material except as follows:



(a)

The Company follows SFAS 130 regarding comprehensive income for purposes of reconciliation to US GAAP.  Under US GAAP, items defined as other comprehensive income are separately classified in the financial statements and the accumulated balance of other comprehensive income (loss) is reported separately in shareholders equity on the balance sheet.    For all periods presented, comprehensive income (loss) equals net income (loss).







---



(b)

Prior to 2003, the Company had applied the intrinsic value-based method of accounting prescribed by Accounting Principles Board (APB") Opinion No. 25, "Accounting for Stock Issued to Employees", and related interpretations, in accounting for its stock options issued to employees, directors and officers of the Company for purposes of reconciliation to US GAAP.  As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price.  In addition, variable accounting would be applied to stock options that have been repriced, whereby compensation expense would be recorded or recovered on the date of reporting only if the current market price of the underlying stock exceeded the exercise price.  SFAS No. 123, "Accounting for Stock-Based Compensation", established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans.  As allowed by SFAS No. 123, the Company had elected to continue to apply the intrinsic value-based method of accounting described above and adopted the disclosure requirements of SFAS No. 123.  Stock options issued to consultants and other third parties are accounted for at their fair values in accordance with SFAS No. 123.  In accordance with the adoption of the fair value-based method for Canadian GAAP purposes, the Company elected to prospectively adopt the fair value-based method under US GAAP, as provided for under SFAS No. 123, effective January 1, 2003.  Prior to 2003, under US GAAP, $202,058 of stock based compensation costs for stock options issued to third parties were expensed.  No entry was made under Canadian GAAP.



(c)

Under US GAAP, $80,871 of the deferred development costs were expensed to product engineering.  Under Canadian GAAP these costs were recorded as deferred development costs.



Other differences between Canadian and United States accounting principles are summarized as follows:



There was no difference in the weighted average number of shares outstanding in the years ended December 31, 2005, 2004 and 2003 under Canadian and United States GAAP.



The effect on the loss for each of the years in the three year period ended December 31, 2005 of the differences between Canadian and United States generally accepted accounting principles is summarized as follows:



|                                                                   |   |             |   |             |   |            
|------------------------------------------------------------------ | - | ----------- | - | ----------- | - | -----------
|Years ended December 31,                                           |   | 2005        |   | 2004        |   | 2003       
|Net loss for the year as reported in accordance with Canadian GAAP | $ | (2,550,708) | $ | (1,925,946) | $ | (3,705,631)
|Development expense                                                |   | (80,871)    |   |            |   |           
|                                                                   |   |             |   |             |   |            
|Net loss under US GAAP                                             | $ | (2,631,579) | $ | (1,925,946) | $ | (3,705,631)
|                                                                   |   |             |   |             |   |            
|Net loss per share (basic and diluted) under US GAAP               | $ | (0.31)      | $ | (0.25)      | $ | (0.52)     



The effect on the consolidated balance sheets of the difference between Canadian and United States generally accepted accounting principles is as follows:







---



|                           |                                              |             |              |               |           |           |             
|-------------------------- | -------------------------------------------- | ----------- | ------------ | ------------- | --------- | --------- | ------------
|December 31, 2005          | As reported
in accordance with
Canadian GAAP | Differences |              | Under
US GAAP
|Current assets             | $                                            | 1,823,485   | $            |              | $         | 1,823,485
|Property and equipment     |                                              | 670,635     |              |              |           | 670,635  
|Deferred development costs |                                              | 352,750     |              | (80,871)      |           | 271,879  
|Intangible assets          |                                              | 155,445     |              |              |           | 155,445  
|                           |                                              |             |              |               |           |          
|                           | $                                            | 3,002,315   | $            | (80,871)      | $         | 2,921,444
|                           |                                              |             |              |               |           |          
|                           |                                              |             |              |               |           |          
|Current liabilities        | $                                            | 330,797     | $            |              | $         | 330,797  
|Shareholders equity:      |                                              |             |              |               |           |          
|                           | Common shares                                |             | 45,979,055   |               | 202,058   |           | 46,181,113  
|                           | Warrants                                     |             | 1,502,331    |               |          |           | 1,502,331   
|                           | Contributed Surplus                          |             | 1,442,408    |               |          |           | 1,442,408   
|                           | Deficit                                      |             | (46,252,276) |               | (282,929) |           | (46,535,205)
|                           |                                              |             |              |               |           |          
|                           | $                                            | 3,002,315   | $            | (80,871)      | $         | 2,921,444



|                           |                                              |             |              |               |           |           |             
|-------------------------- | -------------------------------------------- | ----------- | ------------ | ------------- | --------- | --------- | ------------
|December 31, 2004          | As reported
in accordance with
Canadian GAAP | Differences |              | Under
US GAAP
|Current assets             | $                                            | 3,762,516   | $            |              | $         | 3,762,516
|Property and equipment     |                                              | 809,171     |              |              |           | 809,171  
|Deferred development costs |                                              | 64,974      |              |              |           | 64,974   
|Intangible assets          |                                              | 591,173     |              |              |           | 591,173  
|                           |                                              |             |              |               |           |          
|                           | $                                            | 5,227,834   | $            |              | $         | 5,227,834
|                           |                                              |             |              |               |           |          
|                           |                                              |             |              |               |           |          
|Current liabilities        | $                                            | 305,409     | $            |              | $         | 305,409  
|Shareholders equity:      |                                              |             |              |               |           |          
|                           | Common shares                                |             | 45,792,526   |               | 202,058   |           | 45,994,584  
|                           | Warrants                                     |             | 1,502,331    |               |          |           | 1,502,331   
|                           | Contributed Surplus                          |             | 1,329,136    |               |          |           | 1,329,136   
|                           | Deficit                                      |             | (43,701,568) |               | (202,058) |           | (43,903,626)
|                           |                                              |             |              |               |           |          
|                           | $                                            | 5,227,834   | $            |              | $         | 5,227,834



Included in the current liabilities above are accrued liabilities of $138,731 in 2005 and $95,360 in 2004.



Aggregate amortization expense for intangible assets for each of the five succeeding fiscal years is estimated to be:



|     |   |        
|---- | - | -------
|2006 | $ | 55,991 
|2007 |   | 40,161 
|2008 |   | 29,695 
|2009 |   | 19,402 
|2010 |   | 10,196 
|     |   |        
|     | $ | 155,445









---

During the years ended December 31, 2005, 2004 and 2003 the Company granted options to employees, directors and officers.  Compensation cost is recorded in the Companys statement of operations and deficit for options granted and vested during 2005, 2004 and 2003 in accordance with the adoption of the fair value based method effective January 1, 2003.



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



|                            |                     |                    |             
|--------------------------- | ------------------- | ------------------ | ------------
|                            | 2005                | 2004               | 2003        
|Risk free interest rate     | 4.5%                | 4.5%               | 4.5%        
|Weighted average volatility | 66%                 | 94%                | 105%        
|Expected life of option     | 90 days to 10 years | 15 days to 5 years | 3 to 5 years
|Dividend yield              | 0%                  | 0%                 | 0%          



Had the Company determined compensation cost based on the fair value at the grant date for its stock options issued in 2002 under SFAS No. 123, the Companys net income (loss) and basic and diluted income (loss) per share would have been reduced to the pro forma amounts indicated below:



|                                                       |                                                                                                                                            |      |             |      |             |      |            
|------------------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------------ | ---- | ----------- | ---- | ----------- | ---- | -----------
|                                                       |                                                                                                                                            | 2005 |             | 2004 |             | 2003
|Net loss under US GAAP:                                |                                                                                                                                            |      |             |      |             |     
|                                                       | As reported                                                                                                                                | $    | (2,631,579) | $    | (1,925,946) | $    | (3,705,631)
|                                                       | Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effect |      | (21,982)    |      | (81,620)    |      | (103,602)  
|                                                       |                                                                                                                                            |      |             |      |             |     
|                                                       | Pro forma                                                                                                                                  | $    | (2,653,561) | $    | (2,007,566) | $    | (3,809,233)
|                                                       |                                                                                                                                            |      |             |      |             |     
|Basic and diluted loss per common share under US GAAP: |                                                                                                                                            |      |             |      |             |     
|                                                       | As reported                                                                                                                                | $    | (0.31)      | $    | (0.26)      | $    | (0.52)     
|                                                       | Pro forma                                                                                                                                  | $    | (0.31)      | $    | (0.26)      | $    | (0.53)     



23. Comparative figures:



Certain comparative information has been reclassified to conform with the current years presentation.  The reclassifications that have occurred are as follows:



Property and equipment, deferred development costs, and intangible assets:

In prior years, intangible assets consisted of only patents and trademarks and purchased customer list.  All other items were shown as one figure as capital assets.  In the current years presentation licensing rights have been shown as part of intangible assets, and deferred development costs have been shown separately.



Cost of product sales:

In prior years, a write down of inventory in 2003 was included in impairment of assets.  In the current years presentation this amount has been included as part of cost of product sales.



Stock based compensation and operating expenses:

In prior years, stock based compensation had been included in marketing, operations, product engineering, and administration expenses.  In the current years presentation stock based compensation has been shown separately.



Foreign exchange loss (gain):

In prior years, a foreign exchange gain realized in 2003 had been shown as part of other expenses.  In the current years presentation this gain has been shown as part of foreign exchange loss (gain).







---

Foreign withholding tax, termination expense and other:

In prior years, foreign withholding tax, termination expense, and other were shown together as other.  In the current years presentation these amounts have been shown separately.



Consolidated statements of cash flows and notes to financial statements:

The comparative figures in the consolidated statements of cash flows and in the notes to the financial statements have been reclassified in accordance with the items described above to conform with the current years presentation.



24.

Subsequent event



Subsequent to the year end, the Company has entered into a convertible loan agreement for $1,000,000.  The loan bears interest at US prime rate, payable quarterly.  The term of the loan is the shorter of 5 years or the date of conversion.  The amount owed can be converted for $3.25 per share at any time at the option of the lender.  Conversion may take place in whole or in part, however a minimum of 25,000 shares ($81,250) is to be converted each time.  As part of the transaction, 400,000 warrants, exercisable at $4.50, with a term equal to the loan, will be issued.  The warrants may be exercised at any time during the term in lots of 25,000 warrants or more.  The Company has agreed to file a short form registration statement under the United States Securities Act of 1933 to register the Shares issued upon conversion of the Loan and exercise of the warrants, provided that QSound is not obligated to file more that one such registration statement annually during the Term.