<PAGE>

                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-Q

(Mark One)
[X]     QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
              EXCHANGE ACT OF 1934

For the Quarterly period ended    March 31, 2003
                                  --------------

                                       OR

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

Commission File Number     1-14007
                           -------

                               SONIC FOUNDRY, INC.
                               -------------------
             (Exact name of registrant as specified in its charter)

                MARYLAND                                     39-1783372
    -------------------------------                      -------------------
    (State or other jurisdiction of                       (I.R.S. Employer
     incorporation or organization)                      Identification No.)

                     1617 Sherman Avenue, Madison, WI 53704
                     --------------------------------------
                    (Address of principal executive offices)

                                  (608)256-3133
                                  -------------
                             (Registrant's telephone
                           number including area code)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days
Yes  X     No ___
    ---

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).

Yes ___   No  X
             ---

State the number of shares outstanding of each of the issuer's common equity as
of the last practicable date:

                                                        Outstanding
               Class                                  April 29, 2003
               -----                                  --------------
    Common Stock, $0.01 par value                       27,784,509

<PAGE>

                                TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                        PAGE NO.
                                                                        --------
<S>                                                                     <C>
PART I   FINANCIAL INFORMATION

Item 1.  Consolidated Financial Statements

         Consolidated Balance Sheets - March 31, 2003 (Unaudited)
            and September 30, 2002 ....................................     3

         Consolidated Statements of Operations (Unaudited) -
            Three months ended March 31, 2003 and 2002 ................     5

         Consolidated Statements of Cash Flows (Unaudited) -
            Three months ended March 31, 2003 and 2002 ................     6

         Notes to Consolidated Financial Statements (Unaudited) .......     8

Item 2.  Management's Discussion and Analysis of Financial
            Condition and Results of Operations .......................    15

Item 3.  Quantitative and Qualitative Disclosures
            About Market Risk .........................................    22

Item 4.  Controls and Procedures ......................................    23

PART II  OTHER INFORMATION

Item 3.  Defaults under Senior Securities .............................    24

Item 6.  Exhibits and Reports on Form 8-K .............................    24
</TABLE>

                                        2

<PAGE>

                               Sonic Foundry, Inc.
                           Consolidated Balance Sheets
                        (in 000's except for share data)

<TABLE>
<CAPTION>
                                                                    March 31,     September 30,
                                                                      2003            2002
                                                                      ----            ----
                                                                   (unaudited)
<S>                                                                 <C>              <C>
Assets
Current Assets:
   Cash and cash equivalents                                        $  1,233        $ 3,704
   Accounts receivable, net of allowances of $542 and $729             3,303          3,886
   Accounts receivable, other                                            127             89
   Inventories                                                           403            362
   Prepaid expenses and other current assets                             405            619
                                                                    --------        -------
    Total current assets                                               5,471          8,660

Property and equipment:
   Buildings and improvements                                          2,477          2,450
   Equipment                                                          13,290         13,263
   Furniture and fixtures                                                573            567
                                                                    --------        -------
    Total property and equipment                                      16,340         16,280
    Less accumulated depreciation                                      9,241          7,584
                                                                    --------        -------
      Net property and equipment                                       7,099          8,696
Other assets:
   Goodwill and other intangibles, net                                 8,230          8,255
   Capitalized software development costs, net                         1,133          1,333
   Debt issuance costs, net of $568 and $323 of amortization             408            653
   Other assets                                                           38             46
                                                                    --------        -------
    Total other assets                                                 9,809         10,287
                                                                    --------        -------
Total assets                                                        $ 22,379        $27,643
                                                                    ========        =======
</TABLE>

See accompanying notes

                                        3

<PAGE>

                               Sonic Foundry, Inc.
                           Consolidated Balance Sheets
                        (in 000's except for share data)

<TABLE>
<CAPTION>
                                                                                      March 31,    September 30,
                                                                                        2003           2002
                                                                                        ----           ----
                                                                                     (unaudited)
<S>                                                                                  <C>            <C>
Liabilities and stockholders' equity
Current liabilities:
   Accounts payable                                                                    $   2,134     $   3,035
   Unearned revenue                                                                           87            62
   Accrued liabilities                                                                     1,189         1,090
   Accrued restructuring charges                                                              --            93
   Current portion of long-term debt                                                       1,351           574
   Convertible debt, net of discount                                                       4,438         3,482
   Current portion of capital lease obligations                                              302           820
                                                                                        --------      --------
   Total current liabilities                                                               9,501         9,156

   Long-term obligations, net of current portion                                              33           323
   Capital lease obligations, net of current portion                                          10            64
   Other liabilities                                                                         128           116

Stockholders' equity:
   Preferred stock, $.01 par value, authorized 5,000,000
      shares; none issued and outstanding                                                     --            --
   5% preferred stock, Series B, voting, cumulative,
      convertible, $.01 par value (liquidation preference at
      par), authorized 10,000,000 shares, none issued and
      outstanding                                                                             --            --
   Common stock, $.01 par value, authorized 100,000,000
      shares; 27,812,259 and 27,729,825 issued and 27,784,509 and 27,702,075
      outstanding at March 31, 2003 and September 30, 2002                                   278           277
   Additional paid-in capital                                                            167,070       167,028
   Accumulated deficit                                                                  (154,437)     (148,985)
   Receivable for common stock issued                                                        (26)          (26)
   Cumulative foreign currency translations                                                  (10)         (111)
   Unearned compensation                                                                     (18)          (49)
   Treasury stock, at cost, 27,750 shares                                                   (150)         (150)
                                                                                       ---------     ---------
   Total stockholders' equity                                                             12,707        17,984
                                                                                       ---------     ---------
Total liabilities and stockholders' equity                                             $  22,379     $  27,643
                                                                                       =========     =========
</TABLE>

See accompanying notes

                                       4

<PAGE>

                               Sonic Foundry, Inc
                            Statements of Operations
                        (in 000's except for share data)
                                   (Unaudited)

<TABLE>
<CAPTION>
                                               Three Months Ended March 31,       Six Months Ended March 31,
                                                  2003              2002             2003           2002
                                                  ----              ----             ----           ----
<S>                                             <C>               <C>              <C>            <C>
Revenue:
Software license fees                           $  4,321          $  4,013         $  8,442       $   7,704
Media services                                     2,034             2,438            3,945           4,785
                                                --------          --------         --------       ---------
     Total revenue                                 6,355             6,451           12,387          12,489
Cost of revenue:
Cost of software license fees                        898               969            1,729           1,968
Cost of media services                             1,615             1,798            3,266           3,575
                                                --------          --------         --------       ---------
     Total cost of revenue                         2,513             2,767            4,995           5,543
                                                --------          --------         --------       ---------

Gross margin                                       3,842             3,684            7,392           6,946

Operating expenses:
Selling and marketing expenses                     1,837             1,903            4,208           4,304
General and administrative expenses                1,584             1,662            3,285           3,263
Product development expenses                       1,329             1,815            2,890           3,662
                                                --------          --------         --------       ---------
     Total operating expense                       4,750             5,380           10,383          11,229
                                                --------          --------         --------       ---------
Loss from operations                                (908)           (1,696)          (2,991)         (4,283)

Other income (expense):
Interest expense                                    (287)             (154)            (554)           (189)
Non-cash interest expense                           (921)             (858)          (2,006)           (858)
Interest and other income                             11              (204)              10            (200)
                                                --------          --------         --------       ---------
     Total other income (expense)                 (1,197)           (1,216)          (2,550)         (1,247)
                                                --------          --------         --------       ---------
Loss before income taxes and cumulative
   effect of change in accounting principle       (2,105)           (2,912)          (5,541)         (5,530)
Income tax benefit                                    --                --               89              --
                                                --------          --------         --------       ---------
Loss before cumulative effect of change in
   accounting principle                           (2,105)           (2,912)          (5,452)         (5,530)
Cumulative effect of change in accounting
   principle                                          --                --               --         (44,732)
                                                --------          --------         --------       ---------

Net loss                                        $ (2,105)         $ (2,912)        $ (5,452)      $ (50,262)
                                                ========          ========         ========       =========

Loss per common share:
Loss before cumulative effect of change in
   accounting principle                         $  (0.08)         $  (0.11)        $  (0.20)      $   (0.21)
Cumulative effect of change in accounting
   principle                                          --                --               --          ( 1.71)
                                                --------          --------         --------       ---------
Net loss per common share -basic and diluted    $  (0.08)         $  (0.11)        $  (0.20)      $   (1.92)
                                                ========          ========         ========       =========
</TABLE>


See accompanying notes

                                       5

<PAGE>

                               Sonic Foundry, Inc.
                      Consolidated Statements of Cash Flows
                        (in 000's except for share data)
                                   (Unaudited)

<TABLE>
<CAPTION>
                                                                                       Six months ended
                                                                                           March 31,
                                                                                     2003             2002
                                                                                  ---------------------------
<S>                                                                                <C>             <C>
Operating activities
Net loss                                                                           $ (5,452)       $ (50,262)
Adjustments to reconcile net loss to net cash used in operating activities:
   Cumulative effect of change in accounting principle                                    -           44,732
   Amortization of capitalized software development costs                               225              193
   Depreciation and amortization of property and equipment                            1,656            1,703
   Amortization of debt discount and debt issue costs                                 2,006              858
   Noncash charge for common stock warrants and options                                  19              155
   Loss on sale of assets                                                                12              218
   Changes in operating assets and liabilities:
     Accounts receivable                                                                535             (176)
     Inventories                                                                        (41)             581
     Prepaid expenses and other assets                                                  222              405
     Accounts payable and accrued liabilities                                          (803)          (2,340)
                                                                                   --------        ---------
Total adjustments                                                                     3,861           46,329
                                                                                   --------        ---------
Net cash used in operating activities                                                (1,591)          (3,933)
                                                                                   --------        ---------

Investing activities
Acquisition, net of cash acquired                                                         -             (579)
Sales of property and equipment                                                          15                4
Purchases of property and equipment                                                     (37)            (262)
                                                                                   --------        ---------
Net cash used in investing activities                                                   (22)            (837)

Financing activities
Proceeds from sale of common stock                                                       38              174
Proceeds from debt, net                                                               1,069            6,675
Payments on long-term debt and capital leases                                        (1,565)            (757)
Payments on line of credit, net                                                        (451)               -
Cash placed in escrow                                                                     -           (1,000)
                                                                                   --------        ---------
Net cash provided by (used in) financing activities                                    (909)           5,092
Effect of exchange rate changes on cash                                                  51                3
                                                                                   --------        ---------
Net increase (decrease) in cash                                                      (2,471)             325
Cash and cash equivalents at beginning of period                                      3,704            7,809
                                                                                   --------        ---------

Cash and cash equivalents at end of period                                         $  1,233        $   8,134
                                                                                   ========        =========
</TABLE>

                                        6

<PAGE>

                               Sonic Foundry, Inc.
                Consolidated Statements of Cash Flows (continued)
                        (in 000's except for share data)
                                   (Unaudited)

<TABLE>
<S>                                                                <C>             <C>
Supplemental cash flow information:
   Interest paid                                                   $   (381)       $    (70)
   Income taxes refunded                                                180               -
Non-cash transactions -
     Capital lease acquisitions                                          38              17
     Issuance of options for deferred compensation plan                   -             104
     Issuance of warrants for consulting services                         -              49
     Conversion of exchangeable stock into common stock                   -           5,375
     Issuance of common stock and stock options for MediaSite             -           5,016
     Issuance of shares for Digital Savant                                -             541
     Issuance of shares for accrued royalties                             -             125
</TABLE>

     See accompanying notes

                                       7

<PAGE>

1.    Basis of Presentation and Significant Accounting Policies

Interim Financial Data

The accompanying financial statements have been prepared in accordance with
accounting principles generally accepted in the United States for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X.

Accordingly, they do not include all of the information and notes required by
accounting principles generally accepted in the United States ("GAAP") for
complete financial statements and should be read in conjunction with the
Company's annual report filed on Form 10-K for the fiscal year ended September
30, 2002. In the opinion of management, all adjustments (consisting only of
adjustments of a normal and recurring nature) considered necessary for a fair
presentation of the results of operations have been included. Operating results
for the six-month period ended March 31, 2003 are not necessarily indicative of
the results that might be expected for the year ended September 30, 2003.

Revenue Recognition
Software License Fees

Revenues from software license fees consist of fees charged for the licensing of
Windows-based software products in both our desktop software and media systems
businesses. Software license fees are recognized when persuasive evidence of an
arrangement exists, the software product has been delivered and no significant
obligations of the Company remain, the fee to the Company is fixed and
determinable, and collection of the resulting receivable is deemed probable.
Delivery occurs through the following methods:

   .  Direct Distribution: Direct revenues are recognized upon delivery to the
      end-user either via shipment of a boxed product from the Company's
      warehouse or electronic download. No returns are accepted.

   .  Retail Distribution: Retail revenues are recognized upon delivery to a
      third-party distributor, net of allowances for estimated returns.

   .  OEM: OEM revenues are generated through partnerships with hardware and
      software vendors who license the right to bundle one of the Company's
      products with the partner's products. Typically, this type of revenue is
      recognized as the partner sells through to the end-user.

   .  Consulting: Consulting revenues include fees recorded pursuant to
      long-term contracts, using the percentage of completion method of
      accounting, when significant customization or modification of a product is
      required.

   .  Consignment: Consignment revenues are recognized when a third-party
      reseller delivers the boxed product to their customer.

All desktop software products sold include free installation support and
professional software products sold include 60 days of free telephone support.
Costs associated with free support are accrued at the date of sale because the
free support is not significant. Customers that require additional post-contract
customer support ("PCS") are charged a separate fee either through a telephone
charge or annual subscription charge. Revenue and associated costs for PCS are
recognized as the services are performed or on a straight-line basis over the
contractual period.

Media Services

Revenues from services are typically recognized when persuasive evidence of a
contract exists, the service has been completed and no significant obligations
of the Company remain, the fee is fixed and determinable and collection of the
resulting receivable is deemed probable. The Company records revenue on a
percentage of completion method, generally by using the number of tapes
completed as a percentage of total tapes included in the contract, when
performing services of a duration of 30 days or more and all criteria for
recognition of service revenue are met other than completion.

                                       8

<PAGE>

We perform ongoing credit evaluations of our customers' financial condition and
generally do not require collateral. We maintain allowances for potential credit
losses and such losses have been within our expectations.

Inventories

Inventory consists of the following (in thousands):

                                                   March 31,    September 30,
                                                     2003           2002
                                               --------------------------------
Raw materials and supplies                          $  221         $  216
Work-in-process                                          2             10
Finished goods                                         180            136
                                                    ------         ------
                                                    $  403         $  362
                                                    ======         ======
Net Loss Per Share

The following table sets forth the computation of basic and diluted loss per
share:

<TABLE>
<CAPTION>
                                                  Three months ended            Six months ended
                                                       March 31,                    March 31,
                                                 2003            2002          2003           2002
                                            -----------------------------------------------------------
<S>                                            <C>             <C>           <C>            <C>
Denominator
Denominator for basic and diluted loss
   per share - weighted average common
   shares                                      27,784,509     26,760,584    27,743,519     26,213,343

Securities that could potentially dilute
   basic earnings per share in the future
   that are not included in the
   computation of diluted loss per share
   as their impact is anti-dilutive:
     Options, warrants and exchangeable
   shares                                           4,267      2,835,638         3,912      2,506,584
     Convertible subordinated debt                      -      1,814,058             -        907,029
</TABLE>

Accounting Pronouncements

In August 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards ("SFAS") No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets ("SFAS 144"), which addresses financial
accounting and reporting for the impairment or disposal of long-lived assets and
supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and
for Long-Lived Assets to be Disposed Of, and the accounting and reporting
provisions of APB Opinion No. 30, Reporting the Results of Operations for a
disposal of a segment of a business. FAS 144 is effective for fiscal years
beginning after December 15, 2001, with earlier application encouraged. The
Company adopted FAS 144 as of October 1, 2001. The adoption of the Statement had
no significant impact on the Company's financial position and results of
operations.

Effective October 1, 2001, the Company adopted Statement of Financial Accounting
Standards No. 142, Goodwill and Other Intangible Assets. Under SFAS No. 142,
goodwill is no longer amortized but reviewed for impairment annually, or more
frequently if certain indicators arise. The Company was required to complete the
initial step of a transitional impairment test within six months of adoption of
SFAS No. 142. During the quarter ended December 31, 2001, the Company retained
an outside valuation firm to assist in the completion of the transitional
impairment test. It was determined that the remaining goodwill of the services
reporting unit associated with the acquisitions of STV Communications, Inc. and
International Image Services, Inc. was entirely impaired, which resulted in a
$44,732,000 charge reflected as a cumulative effect of change in accounting
principle. See Note 5 for additional details.

                                       9

<PAGE>

Consistent with the Company's annual valuation policy, the intangible assets
associated with the purchase of MediaSite in October 2001 will be evaluated for
potential impairment as of July 1, 2003. An impairment charge for MediaSite, if
any, will be reflected as an operating expense in the income statement.

2.     Liquidity and Management's Plan

In the fall of 2002, the Company determined that operations of our desktop
software and services business would not provide sufficient cash flow along with
our existing cash reserves to fund planned growth of the systems division and
make remaining subordinated debt payments. In response, the Company retained an
advisor to evaluate the sale of certain operating assets.

In February 2003 the Company announced it had entered into a non-binding Letter
of Intent ("LOI") for the sale of assets utilized in the Media Services
division. Although exclusivity provisions of the LOI have expired, the Company
has continued to negotiate with the party that executed the LOI as well as other
interested third parties. The Company expects to complete the sale of the
services business for approximately $6 million, including an estimate of the
value of net working capital acquired, during the quarter ending June 30, 2003.
The transaction is subject to completion of certain conditions of the buyer
including satisfactory due diligence and assignment of certain contracts.

In addition to the anticipated sale of the services business, the Company is in
discussions with multiple, qualified parties concerning the sale of our desktop
software business. Although, no sale, nor exclusivity agreements have been
entered into regarding the desktop business, the Company expects to enter into a
definitive sale agreement with one of the interested parties and close the
transaction in mid 2003, which may be subject to approval by our shareholders.

The Media Services transaction, if consummated, is expected to provide the
Company with sufficient resources to:
    .  Retire a portion of the remaining balance due to subordinated debt
       holders
    .  Support operations until a desktop software transaction can be
       negotiated

A desktop software transaction, if consummated, is expected to provide the
Company with sufficient resources to:
    .  Retire the remaining balance due subordinated debt holders
    .  Retire the $1,000,000 bridge note (see note 7)
    .  Pursue a focused strategy of growing the systems software remaining
       business.

Management believes the proceeds of the transactions discussed above will
provide the Company with the ability to meet its cash flow obligations.
Accordingly, the financial statements have been prepared on the basis of a going
concern, which contemplates realization of assets and satisfaction of
liabilities in the normal course of business.

3.     Restructuring

As a result of rapidly changing market conditions, in December 2000 the
Company's Board of Directors authorized management to make a 40% workforce
reduction affecting all divisions of the Company in order to reduce future cash
expenditures. The restructuring charges were determined based upon plans
submitted by the Company's management and approved by the Board of Directors. As
a result of the workforce reduction, the Company exited four leased facilities
and disposed of fixed assets (mainly computer equipment and trade show assets)
that were no longer necessary for future operations. Future lease obligations of
facilities exited were accrued net of estimated sub-lease income to be generated
through the lease term. Computer equipment and trade show assets no longer
necessary for operations were written down from a carrying amount of $3.1
million to their anticipated net realizable value. As a result of the workforce
reductions, termination of leases and disposal of fixed assets, the Company
recorded restructuring charges of $3,782,000 during the first quarter of fiscal
2001. In the fourth quarter of fiscal 2001, the Company refined the net
realizable value of equipment no longer necessary in operations that was
identified in the December 2000 restructuring plan, which resulted in an
additional charge of $1,191,000. The remaining balance of the accrual was
utilized during the quarter ending March 31, 2003 upon expiration of the

                                       10

<PAGE>

remaining leases.

<TABLE>
<CAPTION>
(in thousands)                                  Severance and         Lease     Fixed asset
                                               Related Charges    Terminations   Disposals     Other      Total
                                               ---------------    ------------   ---------     -----      -----
<S>                                            <C>                <C>           <C>           <C>        <C>
Charge in December 2000                         $       1,470     $     1,555    $     594    $   163    $  3,782
Charge in September 2001                                    -               -        1,191          -       1,191
                                               ---------------------------------------------------------------------
  Total charges                                         1,470           1,555        1,785        163       4,973
Adjustments to December 2000 charge                         -            (503)         503          -           -
Amount paid in fiscal 2001, net                        (1,470)           (707)           -         (2)     (2,179)
Non-cash charges                                            -               -       (2,288)      (161)     (2,449)
                                               ---------------------------------------------------------------------
  Accrued liabilities at September 30, 2001                 -             345            -          -         345
Adjustments to December 2000 Charge                         -             (61)         121          -          60
Amount paid in fiscal 2002, net                             -            (191)           -          -        (191)
Non-cash charges                                            -               -         (121)         -        (121)
                                               ---------------------------------------------------------------------
Accrued liabilities at September 30, 2002        $          -     $        93    $       -    $     -    $     93
                                               ---------------------------------------------------------------------
Amount paid in fiscal 2003, net                             -             (93)           -          -         (93)
                                               ---------------------------------------------------------------------
                                                 $          -     $         -    $       -    $     -    $      -
                                               =====================================================================
</TABLE>

4.   Acquisitions

On October 15, 2001, the Company completed the asset purchase of MediaSite, Inc.
and formed the media systems business in order to provide automated rich media
publishing, management and access solutions. Under terms of the purchase
agreement, a wholly-owned subsidiary of the Company purchased the majority of
the assets of MediaSite and assumed certain of its liabilities in exchange for
3,880,000 shares of the Company's common stock and 300,000 warrants valued at
$1.20 per share. Also as part of the purchase, the Company capitalized $490,000
in closing costs, $3,101,000 in assumed liabilities and a $365,000 advance that
was issued to MediaSite in September 2001. Approximately $9,100,000 of the
purchase price was allocated to intangible assets. The Company obtained an
independent appraisal, which resulted in an allocation of $120,000 to the
Carnegie Mellon University license agreement, $130,000 to the MediaSite trade
name and $1,400,000 to acquired technology. All three were determined to have
useful lives of 5 years and will be amortized to cost of goods sold. The
remaining balance of $7,450,000 was assigned to goodwill and, in accordance with
SFAS No. 142, will not be amortized, but will be reviewed annually for
impairment.

On February 12, 2002 the Company's services division purchased all the
intellectual property rights to Media Taxi (TM) from Los Angeles based Digital
Savant, Inc. in exchange for $100,000 and 221,000 shares of the Company's common
stock. Media Taxi is a widely deployed browser-based media asset management
system focused on streamlining the management and distribution of marketing and
publicity materials for the entertainment industry. A large portion of the
acquisition price, $430,000, was assigned to goodwill and, in accordance with
SFAS No. 142, will not be amortized, but will be reviewed annually for
impairment. The remaining $240,000 was assigned to purchased technology and will
be amortized to cost of services over two years.

5.   Goodwill and Other Intangible Assets - Adoption of Statement No. 142

In July 2001, the FASB issued SFAS No. 142 Goodwill and Other Intangible Assets,
which established financial accounting and reporting for acquired goodwill and
other intangible assets and supersedes APB Opinion No. 17, Intangible Assets.
The Company early adopted SFAS No. 142 on October 1, 2001, the beginning of its
fiscal year. SFAS No. 142 requires that goodwill and intangible assets that have
indefinite useful lives not be amortized but, instead, tested at least annually
for impairment. Accordingly, the Company reclassified the net book value of
assembled workforce to goodwill and ceased amortization of all goodwill, on
October 1, 2001. Intangible assets that

                                       11

<PAGE>

have finite useful lives, primarily developed technology and know-how, continue
to be amortized over their useful lives.

The standard also requires that goodwill be tested for impairment annually. In
the year of adoption, the standard required a transitional goodwill impairment
evaluation, which was a two-step process. The first step was a screen for
whether there was an indication that goodwill was impaired as of October 1,
2001. At this time, the Company had two reporting units - software and services.
The entire goodwill balance, which had resulted from the 2000 acquisitions of
STV Communications, Inc. and International Image Services, Inc., related to the
services unit. To determine if the goodwill was impaired, the company retained
an independent appraisal firm to perform a valuation of the services unit using
the criteria prescribed under FAS 142. As of December 2001, the appraisers
completed this first step, which indicated that goodwill recorded during the
2000 acquisitions mentioned above was impaired as of October 1, 2001.

For the second step, the Company used the services of the same independent
appraisal firm to compare the implied fair value of the affected reporting
unit's goodwill to its carrying value in order to measure the amount of
impairment. The fair value of goodwill was determined by allocating the
reporting unit's fair value to all of its assets and liabilities in a manner
similar to a purchase price allocation in accordance with SFAS No. 141 Business
Combinations. As of December 2001, the appraisers concluded that goodwill was
100% impaired. Therefore, the Company recorded an impairment loss of $44.7
million as a cumulative effect of a change in accounting principle in its
statement of operations.

The circumstances leading to the goodwill impairment related to: 1) the
decreased demand for digital services such as encoding (especially from dot
coms); 2) significant reductions of STV's workforce; 3) the Company's decreased
market capitalization; and 4) a history of cash flow and operating losses for
the services unit. These negative trends provided evidence that initial growth
expectations of STV and International Image did not materialize. The fair value
used to determine the impairment was based on a combination of discounted cash
flow valuation techniques, market transactions and the prices of publicly traded
comparable companies.

6.   Convertible Subordinated Debt

In January and February 2002, the Company completed a $7,125,000 offering of
convertible subordinated debt with several investors. The promissory notes
("Notes") bear interest at 10% per annum and require the Company to repay
principal (if not converted) in monthly installments commencing on August 1,
2002. The aggregate amount of such monthly installments for all the Notes is
$330,000 with a final installment in the aggregate amount of $1,181,000 due on
the maturity date of February 1, 2004.

The Notes include a covenant requiring the Company to have $2.5 million of
available cash or debt at the end of each quarter. At March 31, 2003 total cash
and available debt was not sufficient to satisfy the covenant.

In December 2002, the Company reached an agreement with lenders totaling $4.75
million of original principal of the Notes to modify the original repayment
terms. The terms of the agreement defer approximately $900,000 of past due and
future principal payments until the earlier of January 20, 2003 or the
completion of one of the transactions contemplated in "Liquidity and Managements
Plan", the ("Transaction"). In return, the Company agreed to provide the lenders
with a second collateral position in all the assets of the Company and to
increase the rate of interest to 12% per annum. In addition, the Company reached
an agreement with lenders of original principal totaling $1.5 million to
accelerate the date on which payment in full of the Notes would be due to the
earlier of June 1, 2003 or the completion of the Transaction.

The agreement reached in December 2002 with the largest of the subordinated
lenders expired but was extended in April 2003 to the earlier of completion of a
Transaction or June 30, 2003. As consideration for extension, the Company agreed
to reduce the exercise price of 775,511 warrants issued along with the
convertible notes from their original exercise price of $2.94 per share to an
amount equal to the average of the closing price on the 10 trading days
preceding and following April 7, 2003. The Company anticipates using a
significant portion of the proceeds from the sale of the media services business
to repay the debt.

The Notes may be converted into shares of our common stock, in whole or in part,
at any time. The conversion price

                                       12

<PAGE>

is $2.45 per share, subject to potential anti-dilution adjustments. The
Investors also received 1,163,000 warrants to purchase shares of common stock at
an exercise price of $2.94.

The Company also paid the placement agents $502,000 in commissions and issued
them 154,000 warrants to purchase common stock at an exercise price of $2.94.
The commissions and value of the warrants are classified as debt issuance costs
in the accompanying balance sheet. As mentioned above, 775,511 warrants were
repurchased in April 2003.

Warrants granted to the Investors and the placement agents expire in February
2006.

The value allocated to the warrants issued was measured at the date of grant
because the number of shares was fixed and determinable. The value was
determined based upon a Black-Scholes option pricing model with the following
assumptions: risk-free interest rate of 3%, dividend yield of 0%, expected
common stock market price volatility factor of 1.5 and the expected life of the
warrants. The valuation of the investor warrants reduced the carrying value of
the debt by $2.8 million and was recorded as a debt discount. The debt discount
recorded for the warrant valuation caused a beneficial embedded conversion
feature valued at $3.5 million, which was recorded as an additional debt
discount.

The debt discount is being amortized using an effective interest method over the
two-year term of the debt. The unamortized balance of the debt discount at March
31, 2003, was $1,474,000. The debt issuance costs are being amortized using the
straight-line method over the two-year term of the debt.

7.   Bridge Note

In November 2002 the Company completed a bridge financing transaction of
$1,000,000 with the brother of Rimas Buinevicius, Chief Executive Officer. Mr.
Buinevicius abstained from board of director discussion regarding approval of
the transaction. The note is backed by substantially all the assets of the
Company and is due, along with $250,000 of interest, at the earlier of March
2003 or upon completion of a transaction generating sufficient cash to allow for
payment. Although the note has matured, the lender has not demanded payment. The
Company expects to repay the note with the proceeds of a desktop software
business, if consummated.

8.   Discontinued Operations

In February 2003 the Company signed a Letter of Intent for the sale of assets
utilized in the Media Services division. Certain terms and conditions have
continued to be the subject of negotiation. Subject to completion of various
requirements of the proposed buyer, the Company expects to complete a
transaction during the quarter ending June 30, 2003. The sale is expected to
result in cash proceeds of approximately $6.0 million including an estimate of
the value of net working capital. Accordingly, the Company expects to present
Media Services as a discontinued operation in the third fiscal quarter. As of
March 31, 2003 the carrying amounts of the major classes of assets and
liabilities of the Media Services division were as follows:

                                                       March 31,
                                                         2003
                                                    ---------------
           Current Assets                             $   2,209

           Fixed Assets, net                              5,070

           Other Assets                                     578

           Current Liabilities                             (183)

           Other Liabilities                               (166)

                                       13

<PAGE>

9.   Employee Stock Options

As permitted by SFAS No. 123, "Accounting for Stock-Based Compensation," the
Company follows Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issued to Employees," in accounting for its stock option plans. Had the
Company accounted for its stock option plans based upon the fair value at the
grant date for options granted under the plan, based on the provisions of SFAS
123, the Company's pro forma net loss and pro forma net loss per share would
have been as follows (for purposes of pro forma disclosures, the estimated fair
value of the options is amortized to expense over the options' vesting period):

                                       Three Months Ended     Six Months Ended
                                             March 31,            March 31,
                                         2003       2002       2003       2002
                                         ----       ----       ----       ----
Pro forma net loss (in thousands)      ($2,256)   ($3,787)   ($5,909)  ($51,960)
Pro forma net loss per share            ($0.08)    ($0.14)    ($0.21)    ($1.98)

Pro forma information regarding net loss and net loss per share is required by
SFAS No. 123, and has been determined as if the Company had accounted for its
employee stock options under the minimum value method of that Statement for
option grants made prior to the Company's initial public offering and the
Black-Scholes method for grants made subsequent to such offering. With the
exception of volatility (which is ignored in the case of the minimum value
method), the following weighted-average assumptions were used for all periods
presented: risk-free interest rates of 1.7% to 6%, dividend yields of 0%;
expected common stock market price volatility factors ranging from .50 to 1.38
and a weighted-average expected life of the option of one to five years.

                                       14

<PAGE>

Item 2

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

The following discussion of the consolidated financial position and results of
operations of the Company should be read in conjunction with the consolidated
financial statements and notes thereto included elsewhere in this form 10-Q and
the Company's annual report filed on form 10-K for the fiscal year ended
September 30, 2002. In addition to historical information, this discussion
contains forward-looking statements such as statements of the Company's
expectations, plans, objectives and beliefs. These statements use such words as
"may," "will," "expect," "anticipate," "believe," "plan," and other similar
terminology. Actual results could differ materially due to changes in the market
acceptance of our products, market introduction or product development delays,
our ability to effectively integrate acquired businesses, global and local
business conditions, legislation and governmental regulations, competition, our
ability to effectively maintain and update our product portfolio, shifts in
technology, political or economic instability in local markets, and currency and
exchange rate fluctuations.

Overview

In accordance with FAS 131 disclosure on segment reporting, the SEC's guidance
has been to present financial information in a format that is used by the
Company's management to make decisions. The Company is a leading provider of
professional rich media solutions with three primary revenue centers:

Desktop Software develops sophisticated software tools used by professionals and
hobbyists for the creation, editing and publishing of digital audio and video.
We currently focus our software efforts on the Sound Forge(R), ACID(TM), and
Vegas(R) Video platforms.

Systems Software (formerly MediaSite) develops automated rich-media applications
and scalable solutions that allow media owners - including entertainment
companies, educational institutions, corporations and government organizations -
to deploy, manage, index and distribute video content on IP-based networks.

Services supplies media digitization, management and delivery solutions for
various industries, particularly the entertainment sector. These services
consist of conversion, reformatting and encoding of television, film and other
video content for multiple delivery platforms.

These three revenue centers, along with their respective production costs, are
analyzed independently from each other. However, because the majority of
operating expenses support all revenue centers, all items below gross margin are
analyzed on a combined basis.

Critical Accounting Policies

We have identified the following as critical accounting policies to our company
and have discussed the development, selection of estimates and the disclosure
regarding them with the audit committee of the board of directors:
   . Revenue recognition, sales returns, allowance for doubtful accounts and
     other credits;
   . Impairment of investments and
   . Impairment of long-lived assets.

Revenue Recognition, Sales Returns, Allowance for Doubtful Accounts and Other
Credits
We recognize revenue for licensing of software products upon shipment,
net of estimated returns, provided that collection is determined to be probable
and no significant obligations remain. Product revenue from distributors is
subject to agreements allowing limited rights of return, rebates, and price
protection. Accordingly, we reduce revenue recognized for estimated future
returns, price protection when given, and rebates at the time the related
revenue is recorded or promotion is offered. The estimates for returns are
adjusted periodically based upon historical rates of returns, inventory levels
in the distribution channel, and other related factors. The estimates and
reserves for

                                       15

<PAGE>

rebates and price protection are based on historical rates. While management
believes it can make reliable estimates for these matters, nevertheless unsold
products in these distribution channels are exposed to rapid changes in consumer
preferences or technological obsolescence due to new operating environments,
product updates or competing products. Significant judgments and estimates must
be made and used in connection with establishing reserves for sales returns,
price protection and rebates in any accounting period. Material differences may
result in the amount and timing of our revenue for any period if we made
different judgments or utilized different estimates. During fiscal 2001, returns
from software products sold to consumer retail distributors were higher than
historical rates incurred in fiscal 2000 and 1999. In response to economic
factors affecting the consumer retail market, we began recording revenues to
consumer retail distributors on a consignment basis in September 2001.

Please refer to Note 1 of our Notes to Consolidated Financial Statements for
further information on our revenue recognition policies.

The preparation of our consolidated financial statements also requires us to
make estimates regarding the collectability of our accounts receivables. We
specifically analyze the age of accounts receivable and analyze historical bad
debts, customer concentrations, customer credit-worthiness and current economic
trends when evaluating the adequacy of the allowance for doubtful accounts.

Impairment of Investments

We periodically evaluate whether any estimated decline in the fair value of our
long-term investment is other-than-temporary. Significant judgments and
estimates must be made to assess the fair value of our investment and determine
whether an other-than-temporary decline in fair value of our investment has
occurred. This evaluation consists of a review of qualitative and quantitative
factors, review of publicly available information regarding the investee and
discussions with investee management. Since our investment is in a private
company with no quoted market price, we also consider the implied value from any
recent rounds of financing completed. Based upon an evaluation of the facts and
circumstances during the quarter ended June 30, 2002, we determined that our
investment had a significant decline in fair value and that we were unlikely to
recover most, if any, of our investment. Accordingly, we wrote off the entire
$514,000 balance.

Impairment of long-lived assets

We assess the impairment of goodwill on an annual basis or whenever events or
changes in circumstances indicate that the fair value of the reporting unit to
which goodwill relates is less than the carrying value. Factors we consider
important which could trigger an impairment review include the following:

..    poor economic performance relative to historical or projected future
     operating results;

..    significant negative industry, economic or company specific trends;

..    changes in the manner of our use of the assets or the plans for our
     business; and

..    loss of key personnel

If we determine that the fair value of a reporting unit is less than its
carrying value including goodwill, based upon the annual test or the existence
of one or more of the above indicators of impairment, we would then measure
impairment based on a comparison of the implied fair value of reporting unit
goodwill with the carrying amount of goodwill. The implied fair value of
goodwill is determined by allocating the fair value of a reporting unit to its
assets (recognized and unrecognized) and liabilities in a manner similar to a
purchase price allocation. The residual fair value after this allocation is the
implied fair value of reporting unit goodwill. To the extent the carrying amount
of reporting unit goodwill is greater than the implied fair value of reporting
unit goodwill, we would record an impairment charge for the difference.

The Company evaluates all of its long-lived assets, including intangible assets
other than goodwill, for impairment in accordance with the provisions of SFAS
No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS
144 requires that long-lived assets and intangible assets other than goodwill be
evaluated for

                                       16

<PAGE>

impairment whenever events or changes in circumstances indicate that the
carrying value of an asset may not be recoverable based on expected undiscounted
cash flows attributable to that asset. Should events indicate that any of the
Company's assets are impaired; the amount of such impairment will be measured as
the difference between the carrying value and the fair value of the impaired
asset and recorded in earnings during the period of such impairment.

Results of Operations

The following chart has been presented to add clarification and should be read
in conjunction with the consolidated financial statements.

<TABLE>
<CAPTION>
                                  Three Months ended March 31,                Six months ended March 31,
                                    2003                  2002                 2003               2002
                          ------------------------------------------------------------------------------------
<S>                          <C>            <C>      <C>          <C>    <C>           <C>     <C>          <C>
  Desktop software
      license fees           $  4,103       100%     $  3,608     100%   $   8,051     100%    $  7,161     100%
  Cost of desktop
      software license
      fees                        712        17           846      23        1,386      17        1,809      25
                          ------------------------------------------------------------------------------------------
   Gross margin-desktop
      software license
      fees                   $  3,391        83%     $  2,762      77%   $   6,665      83%    $  5,352      75%

  Systems software
      license fees           $    218       100%     $    405     100%   $     391     100%    $    543     100%
  Cost of systems
  software license fees           186        85           123      74          343      88          159      29
                          ------------------------------------------------------------------------------------------
    Gross margin-systems
  software license fees      $     32        15%     $    282      26%   $      48     12%     $    384      71%

  Services                   $  2,034       100%     $  2,438     100%   $   3,945     100%    $  4,785     100%
  Cost of services              1,615        79         1,795      74        3,266      83        3,575      75
                          ------------------------------------------------------------------------------------------
    Gross margin-services    $    419        21%     $    640      26%   $     679      17%    $  1,210      25%
</TABLE>

Revenue from Software License Fees

Software license fees in the Statement of Operations includes both desktop and
systems software.

Revenues from desktop software license fees consist of fees charged for the
licensing of Windows based software products. The Company's primary focus is on
the platforms of ACID(R), Sound Forge(R), CD Architect(R) and Vegas(R) Video.
These software products are marketed to both consumers and producers of digital
media. We reach both our domestic and international markets through traditional
retail distribution channels, our direct sales effort and OEM partnerships.

Q2-2003 compared to Q2-2002 and YTD-2003 (six months) compared to YTD-2002
(six months)

Net revenues from desktop software license fees increased $495 or 14% from
Q2-2002 to Q2-2003. The net changes resulted from the following items:

     .    $1,257 of the increase resulted from sales of the release of Vegas 4.0
          and its complimentary DVD architect product during the quarter. Total
          Video product revenues were 47% of desktop software revenues.
     .    ACID and ACID Loop sales decreased $604 from Q2 2002. ACID was
          impacted by apparent reluctance of retail channel partners to commit
          to reloading of store inventory and implementation of typical
          promotional incentives with the pending sale of the business as well
          as Best Buy's decision to discontinue carrying our professional
          products in late fiscal 2002.

                                       17

<PAGE>

Net revenues from desktop software license fees increased $890 or 12% from YTD
Q2-2002 to YTD Q2-2003. The net changes resulted from the following items:

     .    $1,186 of the increase resulted from sales of the release of Vegas 4.0
          and its complimentary DVD architect product during the quarter.
     .    $510 of the increase resulted from sales of CD Architect. CD Architect
          development was discontinued in December 2000 and the product had no
          sales in 2002. In late 2002, we put additional development effort into
          the product and released a new version in Q1-2003.
     .    ACID and ACID Loop sales decreased $539 from YTD Q2 2002.

Gross Margin from Software License Fees

Costs of software in the Statement of Operations includes both desktop and
systems software.

Included in costs of desktop software license fees are product material costs,
assembly labor, freight, royalties on third party technology or intellectual
content, and amortization of previously capitalized product development and
localization costs.

Q2-2003 software gross margin dollars increased over Q2-2002 by $629 or 23%. The
improved margins on a percentage of revenues basis can be attributed to:
     .    A reduction in material costs associated with an increase in the
          number of electronic downloads (in Q2-2003, 32% of sales were
          electronic downloads vs. 19% in Q2-2002).
     .    Reduced obsolescence and scrap due to lower inventory levels.

YTD Q2-2003 software gross margin dollars increased over YTD Q2-2002 by $1,313
or 25%. The improved margins on a percentage of revenues basis can be attributed
to:
     .    Q1-2002 margins were negatively impacted by a one-time write-off of
          MPEG licenses as a result of a contract termination.
     .    A reduction in material costs associated with an increase in the
          number of electronic downloads (in YTD Q2-2003, 29% of sales were
          electronic downloads vs. 22% in YTD Q2-2002).
     .    Reduced obsolescence and scrap due to lower inventory levels.

Revenue from Systems Software

Revenue from our Systems software division, established upon the acquisition of
MediaSite, consist of fees charged for the licensing of software products and
custom software development. The primary focus is on the MediaSite Live(TM)
platform released in June 2002. In addition, the division markets MediaSite
Publisher(TM) and custom development solutions. Both products and the custom
development efforts are marketed to government agencies, educational
institutions, and corporations who need to deploy, manage, index and distribute
video content on IP-based networks. We reach both our domestic and international
markets through reseller networks, a direct sales effort and Integrator
partnerships.

System software revenues in Q2-2003 totaled $218; Q2-2002 sales were $405. The
revenues can be segmented as follows:
     .    MediaSite Live, accounted for nearly all sales in Q2-2003.
     .    MediaSite Publisher sales were $263 for Q2-2002. Custom development
          for a Federal agency accounted for $142 of revenue in Q2-2002. This
          contract was completed in May 2002.

System software revenues in YTD Q2-2003 totaled $391; YTD Q2-2002 sales were
$543. The revenues can be segmented as follows:
     .    MediaSite Live, accounted for nearly all sales in YTD Q2-2003.
     .    MediaSite Publisher sales were $280 for YTD Q2-2002.
     .    Custom development for a Federal agency accounted for $263 of revenue
          in Q2-2003. This contract was completed in May 2002.

                                       18

<PAGE>

Gross Margin from Systems Software

The significant components of cost of systems include:
  .  Cost of hardware that is bundled with MediaSite Live. Live sales should
     typically result in gross margins of approximately 60%.
  .  Amortization of MediaSite acquisition amounts assigned to purchased
     technology and other identified intangibles. We will be amortizing
     approximately $100 per quarter over the next 4 years for the identified
     intangibles of the MediaSite purchase.

Revenue from Services

Revenue from services includes tape duplication for broadcast distribution,
broadcast standard conversions, audio and video encoding, as well as fees for
consulting and development services.

Revenue from services declined $404 or 17%, from Q2-2002 to Q2-2003. Sales for
the operations in Los Angeles accounted for the majority of the difference.
Revenues from smaller customers were impacted to a greater extent than that of
our largest customers and appear to be a result of an overall decline in
entertainment industry advertising revenue. For the quarter, our traditional
duplication and conversion services accounted for all of the quarter-to-quarter
decline. Our digital restoration, digital conversion, encoding and High
Definition services were just under $300 in both periods. Revenues from
consulting and the MediaTaxi technology, acquired from Digital Savant in
February 2002, amounted to $13 during Q2-2003. The YTD decline of $840 or 18%
from YTD Q2-2002 to YTD Q2-2003 resulted from trends similar to the above.

Gross Margin from Services

Costs of services include compensation, benefits and other expenses associated
with production personnel, videotape costs, depreciation on production equipment
and an allocation for general and administrative expenses such as facility
costs. These costs have become relatively stable and fixed in dollars since
Q3-2001.

Gross Margin from services declined from 26% to 21% from Q2-2002 to Q2-2003. The
decline relates to the revenue decreases discussed above and demonstrates the
fixed nature of our cost of services. The headcount of production staff in Media
Services declined from 62 in Q2-2002 to 57 in Q2-2003. However, those savings
were offset slightly by $60 of amortization for the MediaTaxi technology
acquired in February 2002.

Operating Expenses

The following chart is provided to add clarification by presenting items as a
percentage of total revenues. This should be read in conjunction with the
unaudited consolidated financial statements presented in this filing.

<TABLE>
<CAPTION>
                                               Three months ended             Six months ended
                                                   March 31,                      March 31,
                                               2003          2002           2003          2002
                                             ------------------------------------------------------
<S>                                          <C>             <C>            <C>           <C>
Total revenues                                    100%          100%           100%          100%
Cost of revenues                                   39            43             40            44
                                             ------------------------------------------------------
  Gross margin                                     61            57             60            56

Operating expenses
  Selling and marketing expenses                   29            29             34            35
  General and administrative expenses              25            26             27            26
  Product development expenses                     21            28             23            29
                                             ------------------------------------------------------
      Total operating expenses                     75            83             84            90
                                             ------------------------------------------------------
</TABLE>

                                       19

<PAGE>

  Loss from operations            -14%          -26%         -24%         -34%
                                 ===============================================

Selling and Marketing Expenses

Selling and marketing expenses include: wages and commissions for sales,
marketing, business development and technical support personnel; our direct mail
catalog; and co-operative advertising with our software distributors, print
advertising and various promotional expenses for our products, services and
systems. Timing of these costs may vary greatly depending on introduction of new
offerings and entrance into new markets.

   Q2-2003 compared to Q2-2002 and YTD-2003 (six months) compared to YTD-2002
                                  (six months)

Selling and marketing expenses as a percentage of revenues and in gross dollars
remained relatively flat for both the quarter and YTD periods, although the mix
across divisions varied significantly.

The $66 or 3.5% decrease from Q2-2002 to Q2-2003 is attributable to:
  .  Nearly $100 decline in salaries, benefits, and travel for systems sales
     staff. In Q1-2003, we terminated two executives who worked primarily on the
     systems efforts.
  .  A $42 decline in public relations spending related to systems efforts in
     the government channel.
  .  Approximately $50 savings in desktop software advertising as Q2-2003
     desktop spending was primarily focused on the direct channel.
  .  Nearly $65 increase in direct catalog expenditures, primarily to promote
     the Vegas Video launch. There was not a major launch of any new product in
     Q2-2002.
  .  A $30 increase in Tradeshow spending for a mix of systems and desktop
     related tradeshows.

The $96 or 2.2% YTD decline resulted from offsets of the following variances:
  .  $270 decrease in direct catalog expenditures, $130 of which related to the
     acquisition of mailing lists. Over the past year we have built a larger
     database of names and no longer have to rely heavily on expensive lists for
     our catalog campaigns. Also, we promoted more special offers through less
     expensive email advertising in 2003.
  .  $400 increase in systems sales personnel expense of which $300 related to
     the Q1-2003 termination of two executives. The executives had severance
     arrangements that were expensed in Q1-2003.
  .  Cooperative and other desktop advertising declined $170 from year-to-year.
     Due to the nature of the Q1-2003 marketing development activity, $190 was
     recorded as a direct reduction of revenue rather than sales expense.

Direct sales and marketing expenses for Media Services, all of which will be
eliminated upon sale of the Media services division, amounted to $340 for
Q2-2003 and $710 for YTD.

General and Administrative Expenses

General and administrative ("G&A") expenses consist of personnel and related
costs associated with the facilities, finance, legal, human resource and
information technology departments, as well as other expenses not fully
allocated to functional areas.

   Q2-2003 compared to Q2-2002 and YTD-2003 (six months) compared to YTD-2002
                                  (six months)

G&A expenses as a percentage of revenues and in gross dollars remained
relatively flat for both the quarter and YTD periods.

The $78 or 4.7% decline from Q2-2002 to Q2-2003 resulted from:
  .  $55 reversal of the remaining accrual related to the 2000 restructuring.
     With the end of a building lease in February 2002, we no longer have any
     expenditures related to the restructuring.
  .  $60 decline in consulting expenses. 2002 had costs related to corporate
     branding and financing efforts.
  .  The above declines were slightly offset by an increase in legal fees
     related to various defense costs and general corporate activity regarding
     the sale of business units.

                                       20

<PAGE>

The YTD increase of $22 or 1% resulted from offsets of the above quarter
variances and:
  .  A Q1-2003 increase in legal fees, which reflects various defense costs and
     general corporate activity regarding the sale of business units.

Direct general and administrative expenses for Media Services, all of which will
be eliminated upon sale of the Media services division, amounted to $130 in
Q2-2003 and $330 for YTD. We also expect reductions in indirect expenses,
related to services provided by corporate staff and facilities, as a result of
the pending Media Services transaction.

Product Development Expenses

Product development expenses include salaries and wages of the software research
and development staff and an allocation of benefits, facility and administrative
expenses. Fluctuations in product development expenses correlate directly to
changes in headcount.

   Q2-2003 compared to Q2-2002 and YTD-2003 (six months) compared to YTD-2002
                                  (six months)

Product development expenses declined $486 or 27% from Q2-2002 to Q2-2003 and
$772 or 21% for the YTD. Attrition and workforce reductions in the Systems
division accounted for nearly $300 (quarter) and $400 (YTD) of the change. The
reduction in systems staff reflects a decision to focus on the newer MediaSite
Live product and offer no near term upgrades of the MediaSite Publisher product.
The remaining declines for both quarter and YTD related to attrition in both the
desktop and services business.

In accordance with SFAS Number 86, the Company capitalizes the cost of
development of software products that have reached technological feasibility and
then amortizes that cost over the anticipated life of the product. No
development costs for our core product line were capitalized during fiscal 2002
or the first quarter of 2003. Amortization of capitalized software development
was $55 in Q1-2002 and relates to Viscosity(TM), which was a result of the Jedor
acquisition in February 2000. Viscosity was fully amortized in January 2002.

Going forward we do not anticipate that any fiscal 2003 software development
efforts will qualify for capitalization under SFAS Number 86.

Direct Product development expenses for Media Services, all of which will be
eliminated upon sale of the Media services division, amounted to $83 in Q2-2003
and $163 for YTD.

Other Income (Expense)

The increase in interest expense was due to the subordinated debt issuance in
February 2002. (see Note 6 to the consolidated financial statements). In
addition, in Q2-2003 and YTD we recorded $150 and $250 of interest expense
related to the Bridge note (see note 7 to the consolidated financial
statements).

Cumulative Effect of Changes in Accounting Principle

Effective October 2001, the Company adopted Financial Accounting Standards Board
("SFAS") No. 142, "Goodwill and Other Intangible Assets." Under the new rules,
the Company ceased the amortization of goodwill associated with the services
reporting unit, which included the acquisitions of STV Communications and
International Image. Implementation of the new rules also requires an assessment
of the carrying value of goodwill using a number of criteria, including the
value of the overall enterprise as of October 1, 2001. The Company retained an
independent appraisal firm to assist in the assessment, which resulted in a
$44,732 write off of the entire remaining value of goodwill associated with the
services reporting unit. Future impairment charges, if any, associated with
MediaSite or other acquisitions will be reflected as an operating expense in the
statement of operations.

Liquidity and Capital Resources

                                       21

<PAGE>

Cash used in operating activities was $1,591 for YTD Q2-2003 compared to $3,933
in YTD Q2-2002. Cash used in operations decreased $2,342 due in part to a
reduction in operating expenses and improved gross margins from the desktop
software business - leading to reduced loss from operations from $4,283 in YTD
Q2-2002 to $2,991 in YTD Q2-2003. YTD Q2-2002 had greater outflows related to
accounts payable assumed in the MediaSite transaction and YTD Q2-2003 had
improved collections on accounts receivable.

Cash used in investing activities was $22 in Q2-2003 compared to $837 in
Q2-2002. The investing activities in the prior year included $579 for the
MediaSite acquisition. In addition, due to our current financial status, capital
expenditures were limited in the current quarter. No significant investing
activity is expected in the near future.

Cash provided by (used in) financing activities was ($909) in YTD Q2-2003
compared to cash provided of $5,092 in Q2-2002. In Q1-2003 we completed a bridge
financing transaction of $1,000 with the brother of Rimas Buinevicius, Chief
Executive Officer. We also incurred an additional $69 of debt under the employee
deferred compensation plan. The salary deferral and resulting increases to debt
concluded in December. The notes under the deferred compensation plan begin to
mature in January 2004. During YTD Q2-2003 we also paid $451 of the line of
credit of our Canadian operations. In Q1-2002, we deposited $1,000 with the
Ontario Superior Court of Justice to be held in trust until settlement of a
lawsuit with the former shareholders of International Image. We settled with
those former shareholders in summer and fall of 2002 and the deposit was
returned. In YTD Q2-2002 we issued convertible subordinated notes, net of
expenses of $6,675 (see note 6)


Recent Developments Impacting Liquidity

In February 2003 the Company announced it had entered into a non-binding Letter
of Intent ("LOI") for the sale of assets utilized in the Media Services
division. Although exclusivity provisions of the LOI have expired, the Company
has continued to negotiate with the party that executed the LOI as well as other
interested third parties. The Company expects to complete the sale of the
services business for approximately $6 million, including an estimate of the
value of net working capital acquired, during the quarter ending June 30, 2003.
The transaction is subject to completion of certain conditions of the buyer
including satisfactory due diligence and assignment of certain contracts.

In addition to the anticipated sale of the services business, the Company is in
discussions with multiple, qualified parties concerning the sale of our desktop
software business. Although no sale or exclusivity agreements have been entered
into regarding the desktop business, the Company expects to enter into a
definitive sale agreement with one of the interested parties and close the
transaction in mid 2003, which also may be subject to approval by our
stockholders.

The Media Services transaction, if consummated, is expected to provide the
Company with sufficient resources to:
   . Retire a portion of the remaining balance due to subordinated debt holders
   . Support operations until a desktop software transaction can be negotiated

A desktop software transaction, if consummated, is expected to provide the
Company with sufficient resources to:
   . Retire the remaining balance due subordinated debt holders
   . Retire the $1,000,000 bridge note (see note 7)
   . Pursue a focused strategy of growing the systems software business.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Derivative Financial Instruments

The Company is not party to any derivative financial instruments or other
financial instruments for which the fair value disclosure would be required
under SFAS No. 107, Derivative Financial Instruments, Other Financial
Instruments and Derivative Commodity Instruments. The Company's cash equivalents
consist of overnight investments in money market funds that are carried at fair
value. Accordingly, we believe that the market risk of such investments is
minimal.

                                       22

<PAGE>

Interest Rate Risk

The Company's cash equivalents are subject to interest rate fluctuations,
however, we believe this risk is immaterial due to the short-term nature of
these investments.

Foreign Currency Exchange Rate Risk

All international sales of our software products are denominated in US dollars.
However, the majority of transactions for our services division in Toronto are
denominated in Canadian dollars. Although these transactions are not generally
subject to significant foreign exchange rate gains and losses, they are
translated into US dollars as part of our consolidated financial statements and
therefore fluctuations in the exchange rate will affect our consolidated
financial statements. The Canadian dollar has been stable relative to the US
dollar and we have not engaged in any foreign currency hedging activities.


Item 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Based on evaluations as of a date within 90 days of the filing date of this
report, our principal executive officer and principal financial officer, with
the participation of our management team, have concluded that our disclosure
controls and procedures (as defined in Rules 13a-14 (c) and 15d-14 (c) under the
Securities Exchange Act) are effective to ensure that information required to be
disclosed by us in reports that we file or submit under the Securities Exchange
Act is recorded, processed, summarized and reported within the time periods
specified in the rules and forms of the SEC.

Changes in Internal Controls

There were no significant changes in our internal controls or in other factors
that could significantly affect these internal controls subsequent to the date
of their most recent evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.

                                       23

<PAGE>

                            PART II   OTHER INFORMATION

Item 3.   DEFAULTS UPON SENIOR SECURITIES

In December 2002, the Company reached an agreement with lenders totaling $4.75
million of original principal of the subordinated notes to modify the original
repayment terms. The terms of the agreement defer approximately $900,000 of past
due and future principal payments until the earlier of January 20, 2003 or the
completion of one of the transactions contemplated in "Liquidity and Managements
Plan", the ("Transaction"). In return, the Company agreed to provide the lenders
with a second collateral position in all the assets of the Company and to
increase the rate of interest to 12% per annum. The agreement was extended in
April 2003 to the earlier of completion of a Transaction or June 30, 2003. As
consideration for extension, the Company agreed to reduce the exercise price on
725,511 warrants issued along with the convertible notes from their original
exercise price of $2.94 per share to an amount equal to the average of the
closing price on the 10 trading days preceding and following April 7, 2003. The
Company anticipates using a significant portion of the proceeds from the sale of
the media services business to repay the debt.

The Notes include a covenant requiring the Company to have $2.5 million of
available cash or debt at the end of each quarter. At March 31, 2003 total cash
and available debt was not sufficient satisfy the covenant.

Item 6.   EXHIBITS AND REPORTS ON FORM 8-K

(a)  Exhibits (see exhibit list)

(b)  Reports on Form 8-K
     None

ITEM 6(a)

NUMBER                               DESCRIPTION
------    ----------------------------------------------------------------------

2.1       Amendment No. 1 to the Purchase Agreement dated February 11, 2002 by
          and between Sonic Foundry, Inc. and Omicron Partners, L.P, filed as
          exhibit 2.1 to the registration statement on Form S-3 filed on April
          29, 2002, and hereby incorporated by reference.

2.2       Note - Exhibit A to Amendment No. 1 to the Purchase Agreement, filed
          as exhibit 2.2 to the registration statement on Form S-3 filed on
          April 29, 2002, and hereby incorporated by reference.

2.3       Warrant - Exhibit B to Amendment No. 1 to the Purchase Agreement,
          filed as exhibit 2.3 to the registration statement on Form S-3 filed
          on April 29, 2002, and hereby incorporated by reference.

2.4       Registration Rights Agreement - Exhibit C to Amendment No. 1 to the
          Purchase Agreement, filed as exhibit 2.4 to the registration statement
          on Form S-3 filed on April 29, 2002, and hereby incorporated by
          reference.

3.1       Amended and Restated Articles of Incorporation of the Registrant,
          filed as Exhibit No. 3.1 to the registration statement on amendment
          No. 2 to Form SB-2 dated April 3, 1998 (Reg. No. 333-46005) (the
          "Registration Statement"), and hereby incorporated by reference.

3.2       Amended and Restated By-Laws of the Registrant, filed as Exhibit No.
          3.2 to the Registration Statement, and hereby incorporated by
          reference.

                                       24

<PAGE>

10.1*      Registrant's 1995 Stock Option Plan, as amended, filed as Exhibit No.
           4.1 to the Registration Statement on Form S-8 on September 8, 2000,
           and hereby incorporated by reference.

10.2*      Registrant's Non-Employee Directors' Stock Option Plan, filed as
           Exhibit No. 10.2 to the Registration Statement, and hereby
           incorporated by reference.

10.3*      Employment Agreement between Registrant and Rimas Buinevicius dated
           as of January 1, 2001, filed as Exhibit 10.4 to the Quarterly Report
           on Form 10-Q for the quarter ended March 31, 2001, and hereby
           incorporated by reference.

10.4*      Employment Agreement between Registrant and Monty R. Schmidt dated as
           of January 1, 2001, filed as Exhibit 10.5 to the Quarterly Report on
           Form 10-Q for the quarter ended March 31, 2001, and hereby
           incorporated by reference.

10.5*      Employment Agreement between Registrant and Curtis J. Palmer dated as
           of January 1, 2001, filed as Exhibit 10.6 to the Quarterly Report on
           Form 10-Q for the quarter ended March 31, 2001, and hereby
           incorporated by reference.

10.6       Digital Audio System License Agreement between Registrant and Dolby
           Laboratories Licensing Corporation dated July 28, 1997, filed as
           Exhibit No. 10.7 to the Registration Statement, and hereby
           incorporated by reference.

10.7       Digital Audio System License Agreement between Registrant and Dolby
           Laboratories Licensing Corporation dated July 28, 1997, filed as
           Exhibit No. 10.8 to the Registration Statement, and hereby
           incorporated by reference.

10.9       Convertible Debenture Purchase Agreement dated September 13, 1999
           between Purchasers and the Registrant filed as Exhibit No. 10.17 to
           the Current Report on form 8-K filed on September 24, 1999, and
           hereby incorporated by reference.

10.10      Commercial Lease between Registrant and Tenney Place Development, LLC
           regarding 1617 Sherman Ave., Madison, Wisconsin dated October 1,
           1999, filed as Exhibit No. 10.18 to the Annual Report on form 10-K
           for the period ended September 30, 1999, and hereby incorporated by
           reference.

10.11      Commercial Lease between Registrant and Hargol Management Limited
           regarding 23 Prince Andrew Place, Don Mills, Ontario, Canada dated
           January 15, 1990, filed as Exhibit No. 10.20 to the Amended Annual
           Report on Form 10-K/A for the year ended September 30, 2000, and
           hereby incorporated by reference.

10.12      Commercial Lease between Registrant and the Richlar Partnership
           regarding 1703 Stewart St., Santa Monica, CA, dated August 10, 1995,
           filed as Exhibit No. 10.21 to the Amended Annual Report on Form
           10-K/A for the year ended September 30, 2000, and hereby incorporated
           by reference.

10.13      Commercial Lease between Registrant and Thomas Seaman regarding 12233
           Olympic Blvd., Santa Monica, CA, dated January 23, 2000 filed as
           Exhibit No. 10.22 to the Amended Annual Report on Form 10-K/A for the
           year ended September 30, 2000, and hereby incorporated by reference.

10.14      Registration Rights Agreement, dated March 31, 2000, among the
           Company and Sony Pictures Entertainment Inc., filed as Exhibit 4.6 to
           the Registration Statement filed on Form S-3 on May 12, 2000, and
           hereby incorporated by reference.

10.15      Buyer Non-Voting Exchangeable Share Option Agreement, dated August
           24, 2000, among the Registrant, Dan McLellan, Curtis Staples, and
           Sonic Foundry (Nova Scotia), Inc., filed as

                                       25

<PAGE>

           Exhibit 4.3 to the Registration Statement filed on Form S-3 on
           November 7, 2000, and hereby incorporated by reference.

10.16      Support Agreement, dated August 24, 2000, between the Company and
           Sonic Foundry (Nova Scotia), Inc. filed as Exhibit 4.4 to the
           Registration Statement filed on Form S-3 on November 7, 2000 and
           hereby incorporated by reference.

10.17      Commercial Lease between Ewart Associates, L.P. and Sonic Foundry
           Systems Group, Inc. (now known as Sonic Foundry Media Systems, Inc.),
           regarding 925 Liberty Avenue, Pittsburgh, PA 15222, dated November
           30, 2001, filed as Exhibit No. 10.23 to the Quarterly Report on Form
           10-Q for the quarter ended March 31, 2002, and hereby incorporated by
           reference.

10.18      Commercial Lease between Stonewood East and Sonic Foundry Media
           Systems, Inc. regarding 12300 Perry Highway, Wexford, PA, dated
           January 13, 2002 filed as Exhibit No. 10.24 to the Quarterly Report
           on Form 10-Q for the quarter ended March 31, 2002, and hereby
           incorporated by reference.

10.19      Asset Purchase Agreement and Plan of Asset Transfer and
           Reorganization dated September 6, 2001 by and among Sonic Foundry,
           Inc., Sonic Foundry Systems Group, Inc. (formerly known as MediaSite
           Acquisition, Inc.), and MediaSite, Inc., filed as Exhibit No. 2.1 to
           the Current Report on Form 8-K dated October 30, 2001, and hereby
           incorporated by reference.

10.20      Asset Purchase Agreement dated February 6, 2002 by and among Sonic
           Foundry Media Services, Inc. and Digital Savant, Inc, filed as
           Exhibit No. 10.26 to the Quarterly Report on Form 10-Q for the
           quarter ended March 31, 2002, and hereby incorporated by reference.

10.21*     Registrant's 2001 Deferred Compensation Plan, filed as Exhibit 4.4 to
           Form S-8 on November 21, 2001 and hereby incorporated by reference.

10.22      Stock Restriction and Registration Agreement between Sonic Foundry,
           Inc., Zero Stage Capital VI Limited Partnership, Saturn Capital, Inc.
           and Saturn Partners Limited Partnership dated October 15, 2001 filed
           as Exhibit 4.4 to Form S-3 filed on December 21, 2001, and hereby
           incorporated by reference.

10.23*     Registrant's Amended 1999 Non-Qualified Plan, filed as Exhibit 4.1 to
           Form S-8 on December 21, 2001, and hereby incorporated by reference.

10.24      Software License and Marketing Agreement effective as of March 25,
           2002 between Registrant and Broderbund Properties LLC filed as
           Exhibit No. 99.2 to the Registration Statement on Form S-3 filed on
           August 13, 2002 and hereby incorporated by reference.

10.25      Amended and Restated License Agreement effective October 15, 2001
           between Carnegie Mellon University and MediaSite, Inc. filed as
           Exhibit No. 10.31 to the Quarterly Report on Form 10-Q for the
           quarter ended March 31, 2002, and hereby incorporated by reference.

10.26      Warrant Agreement filed as Exhibit 10.1 to Registration Statement No.
           333-98795 on Form S-3 filed on August 27, 2002 and hereby
           incorporated by reference.

10.27      Promissory Note between Registrant and Aris A. Buinevicius and Claire
           Horne for $1,250,000 dated November 18, 2002 filed as Exhibit No.
           10-27 to the Quarterly Report on Form 10-Q for the quarter ended
           December 31, 2002, and hereby incorporated by reference.

99.1       Section 906 Certification of Chief Executive Officer

99.2       Section 906 Certification of Chief Financial Officer

           * Compensatory Plan or Arrangement

                                       26

<PAGE>

SIGNATURES

Pursuant to the requirement of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

                                   Sonic Foundry, Inc.
                                   -------------------
                                      (Registrant)


April 30, 2003                By:  /s/ Rimas P. Buinevicius
                                   ------------------------
                                           Rimas P. Buinevicius
                                           Chairman and Chief Executive Officer

April 30, 2003                By:  /s/ Kenneth A. Minor
                                           Kenneth A. Minor
                                           Chief Financial Officer and Secretary

                                       27