<PAGE>   1

================================================================================

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

                                  FORM 10-KSB
(MARK ONE)

     [X]   ANNUAL REPORT UNDER SECTION 13 OR 15(d)OF THE
           SECURITIES EXCHANGE ACT OF 1934

                  FOR THE FISCAL YEAR ENDED: DECEMBER 31, 1997

                                       OR

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

        FOR THE TRANSITION PERIOD FROM                TO

                        COMMISSION FILE NUMBER: 0-21123

                                 SRS LABS, INC.
                 (NAME OF SMALL BUSINESS ISSUER IN ITS CHARTER)

<TABLE>
<S>                                            <C>
                   DELAWARE                                      33-0714264
       (STATE OR OTHER JURISDICTION OF                        (I.R.S. EMPLOYER
        INCORPORATION OR ORGANIZATION)                      IDENTIFICATION NO.)
</TABLE>

                2909 DAIMLER STREET, SANTA ANA, CALIFORNIA 92705
              (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

         ISSUER'S TELEPHONE NUMBER, INCLUDING AREA CODE: (714) 442-1070

           SECURITIES REGISTERED UNDER SECTION 12(b) OF THE ACT: NONE

             SECURITIES REGISTERED UNDER SECTION 12(g) OF THE ACT:

                         COMMON STOCK, $.001 PAR VALUE
                                (TITLE OF CLASS)

     Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 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
[ ]

     Check if there is no disclosure of delinquent filers in response to Item
405 of Regulation S-B contained herein, and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-KSB or any amendment to
this Form 10-KSB.  [X]

     State the issuer's revenue for its most recent year: $10,081,283

     State the aggregate market value of the voting and non-voting common equity
held by non-affiliates (based on the closing sale price of such common stock on
the specified date) as of March 26, 1998: $62,174,285. Shares of common stock
held by each officer and director and by each person who owns greater than 10%
of the outstanding shares of common stock have been excluded from this
computation on the basis that such persons may be deemed to be affiliates. This
determination of affiliate status is not a conclusive determination for other
purposes.

     State the number of shares of common stock of the issuer outstanding as of
March 26, 1998: 11,505,754

                      DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the registrant's Proxy Statement prepared in connection with
the Annual Meeting of Stockholders to be held in 1998 are incorporated by
reference in Part III of this Form 10-KSB.

================================================================================
<PAGE>   2

                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                           PAGE
                                                                           ----
<S>          <C>                                                           <C>
PART I
  Item 1.    DESCRIPTION OF BUSINESS.....................................    1
  Item 2.    DESCRIPTION OF PROPERTY.....................................   12
  Item 3.    LEGAL PROCEEDINGS...........................................   13
  Item 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.........   13
PART II
  Item 5.    MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS....   14
  Item 6.    MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION...   16
  Item 7.    FINANCIAL STATEMENTS........................................   23
  Item 8.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
             AND FINANCIAL DISCLOSURE....................................   39
PART III
  Item 9.    DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL
             PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT..   39
  Item 10.   EXECUTIVE COMPENSATION......................................   39
  Item 11.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
  Item 12.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS..............   39
PART IV
  Item 13.   EXHIBITS AND REPORTS ON FORM 8-K............................   39
SIGNATURES...............................................................   44
</TABLE>

                                        i
<PAGE>   3

                                     PART I

ITEM 1. DESCRIPTION OF BUSINESS

     SRS Labs, Inc. (the "Company") develops, markets and licenses proprietary
audio technologies for use in four worldwide markets: consumer home audio and
video, computer multimedia, car audio and professional sound. The Company
licenses its flagship technology, SRS (-)(R), the Sound Retrieval System(R)
("SRS"), to leading original equipment manufacturers ("OEMs") including Apple,
Kenwood, Packard Bell/NEC, Pioneer, Sharp, Sony and Thomson Consumer Electronics
("RCA"). SRS creates an immersive 3D sound image from any audio source with as
few as two conventional stereo speakers. The technology is based on the
fundamentals of the human hearing system and recreates the multitude of spatial
cues that are present in a live listening environment but that are lost in
recording and playback. SRS can be easily and inexpensively incorporated by OEMs
into the manufacture of a wide variety of audio-related consumer products such
as TVs, computers, stereo receivers, VCRs, car radios, video games and musical
instruments. The technology can also be encoded onto CDs, cassettes or video
tapes during the recording process and reproduced through a conventional stereo
system, multimedia computer, radio or television broadcast, or the Internet.

     SRS was originally developed by Hughes Aircraft Company ("Hughes
Aircraft"), which spent significant resources to develop and patent SRS and
related audio technologies. Since acquiring the SRS technology from Hughes
Aircraft in June 1993, the Company has improved the performance of SRS, reduced
the cost for OEMs to implement the technology and introduced the technology to a
variety of consumer applications. Since June 1993, the Company's licensee base
has grown from two to 170 licensees as of December 31, 1997.

     The Company also develops licensing relationships with semiconductor
manufacturers to incorporate SRS and certain of the Company's other technologies
directly into the semiconductors which can then be purchased by the OEMs.
Semiconductor manufacturer licensees of the Company include AKM Semiconductor,
Chromatic Research, Crystal Semiconductor, a subsidiary of Cirrus Logic
("Crystal Semiconductor"), Fujitsu Semiconductor, LSI Logic, New Japan Radio
("NJRC"), Medianix, Mitsubishi, Motorola, Philips, S3, SGS-Thomson and Toshiba
Semiconductor. Through these alliances, the Company believes that it will be
able to expand its OEM licensee and revenue bases as the semiconductor
manufacturers' sales forces promote the easier and more cost-effective
implementation of the Company's technologies. The Company believes this will
further facilitate the implementation of SRS and the Company's other
technologies as standards and further establish the Company as a leader in
providing technology solutions. Audio technology from the Company has been
included in more than 23 million products worldwide.

     During the fiscal year ended December 31, 1997 ("Fiscal 1997"), the number
of companies actually shipping products including the Company's technology
increased from 39 to 55. This growth is reflected in the quarter-by-quarter
increase in licensing revenue which is directly associated with the number of
products shipped. See Part II, Item 6. Management's Discussion and Analysis or
Plan of Operation -- Selected Quarterly Operating Results, in this Report. As of
December 31, 1997, there were a total of 35 semiconductor chips containing one
of the Company's technologies. Chromatic Research, Crystal Semiconductor, Intel,
(motherboards only), Mitsubishi, NJRC, Seponix, S3 and SGS-Thomson all shipped
semiconductors which included SRS during Fiscal 1997.

     The Company offered a portfolio of six technologies during Fiscal 1997,
SRS, F(-)CUS(TM) ("FOCUS"), TRUSURROUND(TM) ("TRUSURROUND") BASER(R), ORB(R)
(Optimum Reflective Baffle) ("ORB") and AVT(TM) (Acoustic Vector Technology)
("AVT"). See "Description of Business -- The Company's Technologies," herein.

     During the first quarter of the fiscal year ending December 31, 1998
("Fiscal 1998"), the Company consummated two acquisitions that increased the
Company's technology offerings and allow the Company to further expand into the
Pacific Rim market. In January 1998, the Company acquired all rights to VIP(TM),
Voice Intelligibility Processor ("VIP"), which is a patented voice processing
technology that improves the intelligibility of the spoken voice, especially in
high ambient noise environments. The VIP technology can be used in a wide range
of applications to enhance speech intelligibility, including public address
systems;
                                        1
<PAGE>   4

telecommunications products, including cellular phones and speaker phones;
hearing aids; wireless products, such as mobile radios; broadcast equipment;
headphones; and microphones. VIP also complements a wide variety of existing
voice technologies, including noise cancellation, voice recognition and voice
automation to improve the understanding of the spoken word in all languages.

     In March 1998, the Company acquired all of the outstanding capital stock of
Valence Technology Inc., a privately held British Virgin Islands company with
its principal business operations in Hong Kong and China ("Valence"). Valence,
which conducts its business through its subsidiaries based in Hong Kong and
China, is engaged in two primary areas of business. The first includes the
design, manufacture and marketing of ASIC (application-specific integrated
circuit) and other semiconductor products. The second area of business is the
design, manufacture and marketing of consumer electronics products, including
sub-components and its own Valence brand high-end product line of VCD (video
compact disc) players, amplifiers and electronic games primarily for the China
market. Valence operates five offices, two of which are located in Hong Kong and
three of which are located in China (Chengdu, Shanghai and Shenzhen), with a
total of 130 employees. Valence was a recent recipient of the prestigious
Technology Achievement Award at the Hong Kong Awards for Industry. Unless
otherwise specified herein, all references to the Company in this Report shall
mean SRS Labs, Inc. and shall not include Valence or any of the subsidiaries of
Valence.

     The Company was incorporated in the State of California on June 23, 1993
and reincorporated in the State of Delaware on June 28, 1996. The Company
successfully completed its initial public offering in August 1996, raising
approximately $22 million. The Company's executive offices are located at 2909
Daimler Street, Santa Ana, California 92705. Its telephone number is (714)
442-1070 and its address on the World Wide Web is http://www.srslabs.com.

INDUSTRY OVERVIEW

     Advanced audio technology is becoming increasingly significant in
televisions, stereo components, multimedia computers, automobiles, video and
arcade games, movie theaters, musical instruments, virtual reality entertainment
centers, and the Internet. The Company believes that increasing demand for
advanced audio technology is being driven by: (i) increased consumer
sophistication and demand for a better listening experience; (ii) competition
among OEMs who constantly seek affordable technologies that differentiate their
products; and (iii) the growth of the multimedia entertainment market through
the convergence of traditionally separate product markets such as televisions
and personal computers. As such, the Company believes that the markets described
above represent a large and expanding worldwide opportunity for its proprietary
audio enhancement technologies.

     Mono and stereo have been the audio standards for the past 60 years. Mono
uses a single channel of sound, while stereo uses two channels of sound, each
directed to a separate speaker. Although an improvement over mono, stereo is
limited in providing a realistic listening experience. In order to experience a
true stereo image, the listener must be located in a specific, centrally-located
listening position commonly referred to as the "sweet spot." Additionally, the
stereo image is presented in front of the listener and confined to the area
between the speakers. Moreover, the sound image is discretely identifiable as
emanating from speaker enclosures, which is in contrast to live environments
where the listener experiences an immersive 3D sound image.

     Quadraphonic and surround sound technologies were developed in attempts to
overcome some of the limitations of stereo and provide more realistic listening
experiences. Surround sound places speakers strategically around the room in an
attempt to recreate the ambience and sense of space present in a live listening
environment. Surround sound is similar to stereo in that it requires an encoding
process and must be played back through a special decoder that directs sound to
four, five or six speakers. Although an improvement over stereo, surround sound
also has several shortcomings. While sounds can be heard from the front and rear
with proper speaker placement, specific sounds can still be attributed to
individual speakers rather than "immersing" the listener as in a live listening
environment. In addition, surround sound requires two, three or four speakers to
be added to the traditional two-speaker stereo configuration. Accordingly,
implementing surround sound requires additional space for speakers and a
significant upgrade from conven-

                                        2
<PAGE>   5

tional stereo equipment. In addition, since surround sound requires special
encoding, the listener's existing audio library does not fully benefit from
surround sound.

     Numerous other audio technologies have been developed and introduced.
Dolby(R) and DBX(R) noise reduction, which were developed to reduce the amount
of background "hiss" encountered during recording and playback, have become
standards. Dolby(R), ProLogic(TM), THX(R), DTS(R), SDDS(R), DolbySRD(R) and
AC3(TM) (Dolby Digital) are other examples of audio technologies. Regardless of
the methodology, audio enhancement technologies generally attempt to achieve the
common objective of providing the listener with a more realistic listening
experience.

THE SRS SOLUTION

     The Company's flagship audio technology, SRS, produces a realistic,
natural, 3D sound image from any audio source using as few as two conventional
stereo speakers. The technology is based on research into the fundamentals of
the human hearing system, and recreates the multitude of spacial cues that are
present in a live listening environment but that are lost in recording and
playback. SRS eliminates the "sweet spot" associated with traditional stereo,
thus SRS does not require the listener to be positioned in a specific location
to experience the immersive 3D sound image. The technology enhances any stereo
or surround sound system and is relatively inexpensive to implement. Finally,
SRS enhances any prerecorded audio material and does not require special
encoding. With the capability to enhance any audio media, SRS has a larger
sphere of application and market potential than many other audio enhancement
technologies which require special encoding at the time of recording.

     SRS can be easily and inexpensively incorporated by OEMs into the
manufacture of a wide variety of audio-related consumer products such as TVs,
computers, stereo receivers, VCRs, car radios, video games, and musical
instruments. The markets for these consumer electronics products are highly
competitive and generally dominated by large manufacturers. The Company licenses
its technology to manufacturers who differentiate their products by continually
adding new features and increasing product performance. The Company has a number
of additional technologies, and the SRS licensing relationship provides OEMs
with access to the Company's current and future audio technologies.

     The Company licenses its technologies to OEMs in four primary markets:
consumer home audio, multimedia personal computers, automobile sound systems and
professional audio equipment (such as movie theaters and musical instruments).
The Company believes that, as the multimedia entertainment industry expands and
brings together such related technologies as home theaters, computers, stereos,
DVD players, cable TV, telephone lines, cellular and satellite systems, and the
Internet, the broad application of the Company's technologies allow it to be
well-positioned to provide unique audio solutions to a wide variety of
manufacturers and consumers.

COMPANY STRATEGY

     The Company's objective is to become a worldwide leader in developing,
marketing and licensing proprietary entertainment enhancement technologies that
address large and expanding markets. The Company's stated strategy is
"Penetrate," "Expand" and "Provide a continuous stream of technologies."
"Penetrate" means to add new customers, new chip partners, and new geographies.
"Expand" means to migrate the Company's technologies into multiple product lines
within each customer. "Provide a continuous stream of technologies" means to
continuously increase the number of technologies available for license. Key
elements of the Company's strategy include:

          Enhance Position as a Technology Innovator. The Company seeks to
     identify specific limitations and opportunities in the audio, multimedia,
     voice processing, entertainment and convergence markets and to develop or
     acquire proprietary technology that can be commercialized in a manner
     similar to SRS, and offered as a solution or innovation to new and existing
     OEM customers and chip partners. For example, TRUSURROUND was developed
     internally for the multi-channel audio market and has been successfully
     introduced in computers, televisions and audio receivers. FOCUS, BASER, AVT
     and SRS Headphone are additional new technologies that were developed
     in-house and are in the process of being
                                        3
<PAGE>   6

     commercialized. During the first quarter of Fiscal 1998, the Company
     acquired all rights to VIP, a patented voice processing technology that
     re-establishes the intelligibility cues for the spoken voice that become
     masked in the presence of conflicting and high ambient noise in the
     listening environment. The acquisition of VIP is strategically significant
     because it opens new markets for the Company such as the
     telecommunications, cellular telephone and hearing aid markets and provides
     additional technology licensing opportunities with existing customers. The
     internal development program and the acquisition of VIP clearly demonstrate
     the Company's business strategy to maintain a continuous stream of
     technologies to attract new licensing customers and to enhance the
     relationships with existing customers. The Valence acquisition also is
     strategically important to enhance the Company's position as a technology
     innovator. A large measure of the current and future success of the SRS
     technology is its implementation in silicon chips. While successful, the
     current chip strategy relies solely on chip partners to bring new chip
     solutions to the market. The award-winning Valence engineering team should
     allow the Company to create and market new chip and component designs, as
     well as bring new and/or more cost-effective chips to the market more
     expeditiously. Management believes that the improved capability and shorter
     time to market will increase the visibility of the Company's technologies
     which, in turn, will help drive demand and create additional opportunities
     in the market place.

          Target Global Industry Leaders and Markets. To facilitate broad and
     rapid adoption of its technologies, the Company targets brand name leaders
     in the OEM market, leading semiconductor manufacturers and emerging
     geographic markets. The Company has grown its OEM licensing customer base
     from two in June 1993 to over 170 as of December 31, 1997. OEM Licensees
     include Apple, Compaq, Hitachi, IBM, Kenwood, Mitsubishi, Packard Bell/NEC,
     Pioneer, RCA, Sharp, Sony and Toshiba. The Company also has 15
     semiconductor licensees as of December 31, 1997, which include AKM
     Semiconductor, Chromatic Research, Crystal Semiconductor, Fujitsu
     Semiconductor, LSI Logic, Medianix, Mitsubishi, Motorola, Philips,
     SGS-Thomson and Toshiba Semiconductor. The Company has had good success
     licensing OEMs in the U.S., Japan and Korea where the SRS technology has
     become the market share leader in 3D audio. During Fiscal 1997 and the
     first Quarter of Fiscal 1998, the Company added dedicated marketing
     resources to focus on Europe and China. The Company's chip strategy,
     working through licensed semiconductor partners to gain new OEM customers
     and open new markets, has started showing significant success. The Company
     attributes 50 new OEM customers during the third and fourth quarters of
     Fiscal 1997 to the Company's chip strategy and the added support of the new
     dedicated marketing resources. Additionally, the Company has penetrated
     Europe, South America and China, all significant new geographic markets for
     the Company. China, India and the rest of Southeast Asia is of particular
     interest to the Company because approximately one half of the world's
     population is located in those regions. The economies in such regions are
     beginning to grow and consumers are beginning to spend money on products
     that include the Company's technologies. This highlights another strategic
     benefit of the Valence acquisition. Because Valence is Hong Kong-based with
     three existing offices in mainland China, Valence will become the
     cornerstone for the Company's China/ Southeast Asia strategy. As a
     licensing company, doing business in North America and Europe has been well
     established. However, the China/Southeast Asia market is not as mature and
     does not have a well-defined licensing business protocol; therefore, doing
     business there requires a different business strategy. Valence will allow
     the Company to do business in China and Southeast Asia with a strong
     understanding of "local" business customs and protocols. Management
     believes that Valence will significantly assist the Company in quickly and
     safely growing the business in this rapidly emerging new market.

          Provide Superior Licensee Support. The Company believes that consumer
     acceptance of SRS and the Company's other technologies is best realized by
     the joint efforts of the Company and its licensees. Consequently, the
     Company dedicates significant resources to its OEM and semiconductor
     licensee relationships in the areas of product development, product launch,
     training of licensee employees, and ongoing promotional programs designed
     to differentiate the licensee's products and highlight the SRS solution.
     The Company believes that its independent status as a licensor facilitates
     the acceptance of its technologies because the Company does not compete
     with its licensees and can encourage multiple parties within the same
     industry to adopt and promote its technologies. The acquisition of Valence
     will significantly increase the support services available from the Company
     to the Asian market.
                                        4
<PAGE>   7

          Leverage Relationships and Technologies. The Company believes that its
     licensing relationships and technologies provide a solid foundation from
     which to create new business opportunities. The Company continually works
     with licensees to improve the performance of SRS and expand the use of SRS
     and the Company's other technologies within the licensees' product lines.
     For example, RCA and Sony, which have historically used SRS only in their
     television sets, have introduced new lines of other consumer home audio
     products featuring SRS. Pioneer and Sony have also introduced new products
     incorporating TRUSURROUND. In addition, the Company has established
     relationships with semiconductor manufacturers to incorporate the Company's
     technologies into analog semiconductors and digital signal processors. The
     Company believes that these alliances will allow the Company to expand its
     licensee and revenue bases by utilizing the sales forces of the
     semiconductor manufacturers and by providing OEMs with an easier and more
     cost-effective implementation of the Company's technologies, as well as
     facilitating the establishment of SRS as a standard.

          Build Brand Name Awareness. The Company seeks to establish SRS and its
     other proprietary technologies as industry standards and significant
     product differentiators for its licensees, with the objective of making SRS
     part of the consumer buying decision. In order to accomplish this
     objective, the Company actively promotes the use of Company trademarks and
     directs licensees to prominently display the SRS logo on products,
     packaging and in advertising. In the cinema market, theaters utilizing SRS
     feature a 30-second movie trailer (similar to Dolby(R) and THX(R)) at the
     beginning of each show with the phrase, "SRS(-) . . . everything else is
     only stereo." Additionally, the Company uses advertising, public relations,
     direct mail, newsletters and its World Wide Web page on the Internet to
     build brand name awareness. With 170 licensees as of December 31, 1997 and
     SRS-based products now available in every major industrial country in the
     world, the Company believes that the SRS logos are associated with
     leading-edge multimedia technology, quality audio and an optimum listening
     experience.

THE COMPANY'S TECHNOLOGIES

     The Company's technology strategy is to provide a continuing stream of
technologies to attract new licensees, enhance relationships with existing
licensees and to strengthen the Company's position as a leader in audio
enhancement technology. The Company's flagship technology, SRS, is a patented
audio technology that creates an immersive 3D sound image from any audio source
using as few as two conventional stereo speakers. SRS compensates for the
difference between the way microphones record and the way that humans hear. The
result is that SRS eliminates the "sweet spot," the centrally-located position
required for a listener to experience the stereo effect of a typical stereo
system. SRS differs from many other technologies in that it works with any
existing recorded material and thus can be used with a listener's existing audio
library. SRS may be implemented through discrete analog components, analog
semiconductors and digital signal processors. These methodologies offer
licensees significant flexibility with respect to the manner in which SRS is
implemented.

     The Company has developed complementary technologies called FOCUS,
TRUSURROUND and BASER for which patents are pending. FOCUS repositions sound and
creates a proper stereo image in environments where speaker location is not
optimal. Thus, the listener will experience a true stereo image as if the
speakers were properly placed in front of the listener, even if the speakers are
on the floor, behind furniture or facing each other. FOCUS is particularly well
suited for use in automobiles where front speakers are located more often in the
doors or under the dashboard. FOCUS is licensed together with SRS. TRUSURROUND
was designed to enhance multi-channel audio systems such as Dolby Digital AC3,
the new standard for DVD. TRUSURROUND renders six channels of audio through two
speakers plus a subwoofer, without any loss of audio material, providing the
listener with a listening experience very similar to a full six-speaker system.
TRUSURROUND has been implemented in chips from Zoran, Chromatic, AKM, NJRC and
Toshiba. Other chip companies are in the process of completing their designs.

     BASER has been developed to provide a "second generation" bass enhancement.
BASER can be implemented to provide sub-woofer bass response when no sub-woofer
is present, or can be utilized in conjunction with a sub-woofer to provide
enhanced bass response. VIP restores voice intelligibility cues that become
masked in the presence of conflicting and high ambient noise in the listening
environment. Paging
                                        5
<PAGE>   8

systems, cellular telephones and hearing aids are three common products that
could benefit from VIP which improves the ability to hear and understand
electronically transmitted spoken voice in noisy environments.

     The Company also has commercialized speaker technologies. One such
technology, ORB, provides a unique approach to the physical design of speakers
by incorporating a baffle that creates a 180 degree dispersion of sound. Another
speaker technology, AVT, projects the listening material so that the human ear
can more easily identify the direction of ambient sounds.

     The Company's flagship technology, SRS, is the subject of numerous license
agreements and continues to be actively marketed by the Company. The
TRUSURROUND, FOCUS and ORB technologies also have been licensed by the Company
and continue to be actively marketed by the Company. The BASER, VIP and AVT
technologies have not yet been licensed but are actively being marketed by the
Company. Licensing royalties and technology transfer fees associated with SRS,
TRUSURROUND, FOCUS and ORB have accounted for virtually all of the Company's
revenues through December 31, 1997.

MARKETS AND OEM PRODUCTS

     The Company licenses its patented technologies in four worldwide target
markets: consumer home audio, computer multimedia, car audio and professional
sound. Consumer purchases of new products in these markets represent
multi-billion dollar annual spending. There is also a large installed base of
non-SRS audio products and SRS can be used to upgrade most of these existing
audio products through the use of stand-alone SRS processor units manufactured
by several OEMs.

  Consumer Home Audio

     The Company believes that the consumer home audio market currently
represents the largest potential market for licensing its technologies. Audio
enhancement technology is becoming increasingly significant in televisions,
stereo components, home theater and other home entertainment products. The
markets for these consumer electronics products are highly competitive and OEMs
are constantly seeking new technologies to differentiate their products.

     Television sets were the first products to incorporate SRS. Since
television speakers are typically small and relatively close together, it is
especially difficult to reproduce a true-to-life sound image. Anam, Hitachi, LG
Electronics, Pioneer, RCA, Samsung, Sharp and Sony feature SRS, and, in some
cases, TRUSURROUND, in their premium and core lines of television sets.

     Other consumer home audio products such as stereo receivers and tuners,
powered speakers, compact disc players, VCRs, VCDs, DVDs, laser disc players,
mini component systems, boom boxes, camcorders and TV cable set top units can
all be enhanced through the use of SRS or TRUSURROUND. Hyundai, Kenwood, LG
Electronics, RCA, Sanyo, Samsung, Sharp and Sony all market consumer home audio
products featuring SRS or TRUSURROUND.

     One of the Company's key strategies is to expand the use of SRS into the
various product lines of each OEM. Based on RCA's success with SRS in
televisions, RCA has introduced the RCA High Performance Audio line of home
stereo products featuring SRS. Hyundai, Kenwood, Pioneer, Samsung, Sharp, Sony
and other OEMs have also introduced SRS into multiple product lines.

     A number of semiconductor manufacturers have licensed SRS for
implementation into semiconductors designed for consumer home audio products.
AKM, Mitsubishi, NJRC, Seponix, SGS-Thompson and Toshiba are currently shipping
semiconductors for use in consumer home audio products.

  Computer Multimedia

     Consumers are increasingly purchasing multimedia personal computers
incorporating a CD-ROM drive and speakers and typically supporting higher
resolution graphics and sound and, in certain cases, additional capabilities
such as digital video and data and/or voice communications. The demand for these
capabilities has been driven by the proliferation of multimedia-based
entertainment and education applications and video

                                        6
<PAGE>   9

games, as well as the widespread use of the Internet. The personal computer and
peripherals market is characterized by intense competition and short product
lifecycles. As a result, the Company believes PC and peripheral OEMs are more
likely to quickly implement new technologies such as SRS. Packard Bell, a leader
in the consumer PC market, established a strategic relationship with the Company
in January 1995, whereby Packard Bell licensed SRS for inclusion in all of its
personal computers. Each one of the top ten U.S. computer manufacturers ships at
least one computer product with either SRS or TRUSURROUND. In addition, non-U.S.
companies like Aztech, Daewoo, Nakamichi, Olivetti, Samsung, Sony and Trigem
also ship SRS-enhanced computer products.

     The new generation of multimedia systems are focused on higher quality
audio. A number of semiconductor manufacturers have licensed SRS and/or
TRUSURROUND for implementation into semiconductors designed for computer
multimedia products. Crystal Semiconductor, NJRC, Chromatic Research, Seponix
and S3 are currently shipping such semiconductors.

  Car Audio

     The Company believes the unique listening environment inherent in cars
represents a significant market for SRS, FOCUS and BASER. The compartment of the
automobile creates distinct audio challenges that are significantly different
from more traditional listening environments. The location of front speakers in
doors as opposed to the dashboard in front of the driver, the construction of
the automobile and the non-optimal listener positions make it difficult to
provide quality audio in an automobile. Many auto manufacturers are featuring
improved sound systems as a differentiator and marketing advantage. The use of
SRS, FOCUS and BASER inexpensively addresses these difficult challenges in the
automobile environment. In January 1997, the Company formally introduced FOCUS
at the Winter Consumer Electronics Show.

  Professional Sound

     The Company defines the professional sound market as including cinemas,
musical instruments, professional recording equipment and karaoke systems. The
Company believes that implementation of SRS into movie theaters is an
inexpensive alternative to or enhancement of current audio technologies for the
cinema such as DolbySRD(R), DTS(R) and SDDS(R), and provides an important avenue
to increase consumer awareness of SRS. Over 1,500 theaters worldwide have
implemented SRS 3D Cinema Sound(TM). The Company does not anticipate that the
professional sound market will be a significant source of revenues in the
foreseeable future, but it believes it is an important avenue to increase
consumer awareness of the Company's technologies.

LICENSEE PROGRAM

     As a technology development and licensing company, in Fiscal 1997, the
Company's primary focus was to create economic and inventive ways for licensees
to implement the Company's technologies. The Company has two general types of
licensees: OEM licensees that build SRS and the Company's other technologies
into consumer products; and semiconductor licensees that build SRS and the
Company's other technologies into semiconductors for use by the OEM licensees.
The number of the Company's licensees has grown from two in June 1993 to 170
licensees as of December 31, 1997, and SRS has been implemented into an
estimated twenty-three million products in numerous product lines. In Fiscal
1998, the Company will continue as a technology development and licensing
company while at the same time developing Valence's business of designing,
manufacturing and marketing semiconductors and consumer electronic products.

                                        7
<PAGE>   10

OEM LICENSEES

     The following table identifies many of the Company's OEM licensees and the
market or markets in which such licensees are participating or are planning to
participate, as of December 31, 1997:

                                 OEM LICENSEES

                              COMPUTER MULTIMEDIA

<TABLE>
<S>                                           <C>
Acer Peripherals Ltd.                         Lian Sheng Electron Technology Co.
Advanced Digital Systems                      Liu Fang Digital System Co. Ltd.
Alpha Systems Labs                            Mediatrix Peripherals Inc.
Atlantis Computers, Inc. ("NuReality")        Megaworld
Apple Computer, Inc.                          MICS Computers, Inc.
ATP Corporation                               Midiland
Aura Systems, Inc.                            Nakamichi Corporation
Aztech Systems Ltd.                           Ning Bo Moifang Electric Co.
Boca Research, Inc.                           NMB Technologies
Chareon Somboon                               Packard Bell/NEC
Chicony Corporation                           Palnet Company Ltd.
Core Dynamics, Inc.                           Peony Electronic Products
Daewoo Telecom Ltd.                           Pioneer Electronic Corporation
Detector Co., Ltd.                            Reveal Computer Products, Inc.
Diamond Multimedia Systems, Inc.              Samsung Electronics Co., Ltd.
Diotech SMT Products                          SC & T2 International, Inc.
Dual Technology Corporation                   Seohan Electronics, Inc.
En K Telecom Co., Ltd.                        Shanling Electronics Co., Ltd.
Ever Prosperity                               Sharp Electronics, Inc.
Formosa Industrial Computing, Inc.            Sony Corporation
Golden Reagent Investment Ltd.                Sugiyama Electronics
Goldtron Multimedia Limited                   TeleVideo Systems, Inc.
Green-Tech Corporation, Ltd.                  Toshiba Corporation
GVC Corporation                               Trigem
Intel Corporation                             Umax Computer Corporation
Kenwood Corporation                           Yuan Zhi Electronical
KDS Co., Ltd.                                 Zhong Shan Subor
Leadtek Research, Inc.
</TABLE>

                                        8
<PAGE>   11
<TABLE>
<S>                                           <C>
CONSUMER HOME AUDIO                           CAR AUDIO
Anam Electronics Co., Ltd.                    Hatai Electronics Co.
Brother                                       Hyundai Electronics Industries Co., Ltd.
Daewoo Telecom Ltd.                           Kenwood Corporation
Digital Video Systems                         Nakamichi Corporation
Dooin Electronics                             Pioneer Electronic Corporation
Family TSI Company                            Roadmaster U.S.A.
Foshan Ruixing Sahdow (Ruixing Video)
Fujian Start Corp.                            PROFESSIONAL SOUND
Guang Dong Idall Electrical Appliance Co.,    ASSA
Ltd.                                          Elf Systems Co., Ltd.
Hatai Electronics Co.                         Kawai Musical Instruments Mfg. Co., Ltd.
Hitachi Ltd.                                  Peavy Electronics
Hyundai Electronics Industries Co., Ltd.      Smart Devices, Inc.
Jazz Hipster                                  St. Louis Music
Kenwood Corporation                           Star Entertainment Co., Ltd.
King Top                                      Young Chang America, Inc. ("Kurzweil")
LG Electronics, Inc.
Nakamichi Corporation
Nanjing Panda Electronics, Ltd.
NuReality
Pioneer Electronic Corporation
Samsung Electronics Co., Ltd.
Sharp Electronics Corporation
Shenzen
Shen Zhen Solive
Sony Corporation
Sun Young Electronics, Inc.
Tai Kwang Industrial Co., Ltd.
Thomson Consumer Electronics S.A. ("RCA")
Thomson Consumer Electronics, Inc. ("RCA")
</TABLE>

     License agreements with OEMs have terms which typically range from one to
ten years and require per unit royalty payments for all products implementing
the Company's technologies. Certain agreements provide for a fixed annual or
quarterly royalty payment. License agreements also specify the use of the
Company's trademarks and logos and provide for product review and approval by
the Company. The agreements do not have volume requirements and may be
terminated by the OEM or the Company without substantial financial penalty.

     The Company has experienced significant concentration and fluctuations in
the use of the Company's technologies by certain licensees. For the year ended
December 31, 1995 ("Fiscal 1995"), RCA and Reveal Computer accounted for 38% and
24%, respectively, of the Company's license revenues. For the year ended
December 31, 1996 ("Fiscal 1996"), Packard Bell and NEC accounted for 28% and
10%, respectively, of the Company's license revenues. In June 1997, Packard Bell
and NEC merged to form Packard Bell/NEC. For Fiscal 1997, Packard Bell/NEC and
Crystal Semiconductor accounted for 25% and 14%, respectively, of the Company's
license revenues.

SEMICONDUCTOR LICENSEES

     In order to reduce the cost of implementation of its technologies and
increase market penetration, the Company has developed a strategy to work more
closely with semiconductor manufacturers. The Company's semiconductor strategy
is to establish relationships with leading semiconductor manufacturers who will
incorporate certain of the Company's technologies into analog semiconductors and
digital signal processors.

     The acquisition of Valence by the Company is anticipated to positively
effect the relationships with semiconductor manufacturers. Valence's chip design
capabilities will help shorten time to market for new chips and, when necessary,
Valence can produce a chip which can be used to "seed" a market, thereby
reducing potential risk for semiconductor partners.

                                        9
<PAGE>   12

     The following table identifies the semiconductor manufacturers who have
entered into licensing agreements with the Company as of December 31, 1997:

                            SEMICONDUCTOR LICENSEES

<TABLE>
    <S>                                       <C>
    AKM Semiconductor                         New Japan Radio Co., Ltd.
    Chromatic Research, Inc.                  Nippon Precision Circuits Inc./Seiko Group ("Seiko")
    Crystal Semiconductor                     Philips Semiconductors
    Fujitsu Semiconductor Corporation         S3 Inc.
    Industrial Technology Research Institute  Seponix Corporation
    LSI Logic Corp.                           Toshiba Semiconductor Corporation
    Medianix Semiconductor, Inc.              SGS-Thomson Microelectronics
    Mitsubishi Electric Corporation           Valence Technology Inc.
    Motorola Incorporated                     Yamaha Corporation
</TABLE>

     The Company has primarily followed the Dolby licensing model, whereby
licensees are free to choose a semiconductor solution from a number of choices
and, regardless of the semiconductor choice, the licensee pays a royalty
directly to the Company. In certain markets such as the computer multimedia
market, the Company has implemented a different model whereby the royalty is
"bundled" into the cost of the semiconductor. This provides the OEM with an
easier business decision and simplifies the process for the semiconductor
manufacturer. In this model, the royalty is collected directly from the
semiconductor company after the chip has been sold to the OEM. This "bundled"
licensing model will also be used in geographic markets, like China, where
intellectual property and royalties are not well established in business
practice.

     The Company believes that the business relationships based on SRS, as well
as those based on technologies such as FOCUS, TRUSURROUND, BASER and VIP, will
increase the Company's channels of distribution by leveraging the sales forces
of the semiconductor manufacturers. These relationships also will provide OEMs
with an easier and more cost-effective implementation of the Company's
technologies. The Company believes it will develop additional revenue streams
from new technologies implemented and marketed through licensed semiconductor
manufacturers.

LICENSEE SUPPORT

     The Company seeks to work closely with its licensees to enhance their
success in selling products and semiconductors that incorporate the Company's
technologies through a variety of targeted licensee support programs. The
Company's licensee support programs include customized audio-CDs to showcase the
OEM products and semiconductors and the Company's technology, sales training,
press tours and targeted mailings.

     The Company's corporate communications program includes press releases,
monthly technical updates, quarterly newsletters and sales informational
mailings. The Company also produces and distributes audio CD/CD ROMs that
demonstrate SRS and TRUSURROUND and provides technical assistance and general
consumer-related information on the World Wide Web. The Company conducts tours
and presentations for the press and other media outlets to promote the Company's
technologies and licensee products.

     The Company regularly participates in trade shows to increase awareness of
its technologies, to support its licensees and to generate new licensee
relationships with existing and potential customers. The Company also has
initiated a development program with its OEM and semiconductor licensees to
actively explore other opportunities to utilize the Company's technologies in
new products and/or markets. The Company has also retained the services of an
outside public relations firm to supplement these communications efforts
produced by the Company's internal marketing department.

RESEARCH AND DEVELOPMENT

     The Company has spent approximately 15.8%, 15.8% and 11.2% of total
operating expenses on research and development in Fiscal 1995, 1996 and 1997,
respectively. The Company's research and development

                                       10
<PAGE>   13

efforts have been primarily targeted at developing new technologies, improving
the performance of its existing technologies and reducing the cost for OEMs to
implement its technologies. Research and development efforts are also focused on
responding to licensees' requirements with respect to implementing the Company's
technologies, expanding applications for the Company's technologies in the
Company's four target markets and exploring implementation of the Company's
technologies in new markets. The acquisition of Valence is anticipated to expand
the resources available to develop new and enhanced technologies and improve
implementations of the Company's existing technologies.

     The market for the Company's technologies is subject to rapid and
significant changes and frequent new technology and product introductions. The
Company believes that its future success will depend on its ability to continue
to enhance its existing technologies and to introduce or acquire new
technologies on a competitive basis. There can be no assurance, however, that
the Company will be able to successfully enhance existing technologies or
introduce or acquire new technologies.

MARKETING AND ADVERTISING

     In addition to its licensee support programs, the Company markets its
business on a worldwide basis. As part of the Company's global strategy, its
sales and marketing efforts are organized into new business development and
licensee relationship management functions. The Company develops new business
opportunities through a combination of its dedicated sales force, independent
sales agents and semiconductor licensees which identify potential licensees and
pursue interactive product development with these licensees. An integral part of
the Company's sales and marketing worldwide is conducted by its independent
sales agents. The Company actively promotes the use of Company trademarks, and
directs licensees to prominently display the SRS logo on products, packaging and
in advertising. In the cinema market, theaters utilizing SRS feature a 30-second
movie trailer (similar to Dolby(R) and THX(R)) at the beginning of each show
with the phrase, "SRS(-) . . . everything else is only stereo." Additionally,
the Company uses public relations, direct mail, newsletters and its World Wide
Web page on the Internet to build brand name awareness.

COMPETITION

     The Company participates in geographic markets and product market segments
which are very competitive. As the Company has realized success and gained a
position of market share leader in 3D audio, numerous competitive technologies
and competitors have emerged. Competition tends to be product market segment
specific, and management is not aware of any company that offers a full
complement of technologies that compete with the total offerings of the Company.
In the general field of 3D audio enhancement for multiple markets, Qsound Labs
and Spatializer continue to be the most visible competitors. In the computer
multimedia market, Harmon International offers a competitive technology to the
Company's TRUSURROUND technology and Aureal offers technologies that compete
with SRS and TRUSURROUND. Wave, an Israeli company, offers technology that
competes with BASER, and Virtual Listening Systems offers technology that
potentially competes with SRS Headphone. The Company is not aware of any direct
competitors for VIP. The Company's technologies may, in the future, compete with
audio technologies developed by other companies, some of whom may be current
customers of the Company.

     With respect to Valence, there are numerous semiconductor companies which
tend to dominate the global markets such as Intel, Texas Instruments, National
Semiconductor and Motorola. Many of these companies are chip partners with the
Company. Within every major market there is a need and a place for local, niche
participants, such as Valence, that do not compete directly with the industry
giants. In Valence's home markets, sensitivity to local business practices and
ongoing flexibility are as important as global size and reputation. Often, it is
firms like Valence that fulfill specific needs in a market and create new
markets for the larger global leaders to enter as these markets begin to mature.

     Certain of these companies that compete with the Company and Valence have,
or may have, substantially greater resources than the Company to devote to
further technologies and new product developments. The Company believes that it
will compete based primarily on the quality and performance of its proprietary
technologies, brand name awareness, the ease and cost of implementing its
technologies, the ability to meet

                                       11
<PAGE>   14

OEMs' needs to differentiate their products, and the strength of its licensee
relationships. There can be no assurance that based on these factors the Company
will continue to be competitive with existing or future products or technologies
of its competitors.

INTELLECTUAL PROPERTY RIGHTS AND PROPRIETARY INFORMATION

     The Company operates in an industry where innovation, investment in new
ideas and protection of its resulting intellectual property rights are important
for success. The Company relies on a variety of intellectual property
protections for its products and services, including patent, copyright,
trademark and trade secret laws, and contractual obligations, and pursues a
policy of vigorously enforcing such rights. There can be no assurance, however,
that the Company's intellectual property rights will be adequate to ensure the
Company's competitive position, or that competitors will not be able to produce
a non-infringing competitive product or service. There can be no assurance that
third parties will not assert infringement claims against the Company, or, that
if required to obtain any third-party licenses as a result of an infringement
dispute, the Company will be able to obtain such licenses. The Company believes
that its patents and trademarks are important to its business.

     SRS is the subject of five U.S. patents containing a combined total of 275
claims. The expiration dates for these U.S. patents are May 31, 2005, June 20,
2006, September 12, 2006, October 5, 2010 and August 26, 2014, respectively. In
addition, the Company has 55 issued foreign patents relating to SRS and over 40
additional foreign patents pending. The expiration dates for these foreign
patents vary depending on the particular patent and the particular country, but
in most cases the duration of such foreign patents will extend into the year
2006.

     The Company also owns three U.S. patents for speaker technology and one for
VIP. Foreign patents are both issued and pending in countries worldwide for the
Company's speaker technologies and the VIP technology. The expiration dates for
these U.S. patents are April 4, 2006, June 6, 2006, January 10, 2010 and October
17, 2012, respectively. The expiration dates for these foreign patents varies
depending on the particular patent and the particular country, but, in most
cases, the duration of such foreign patents will extend into the year 2006. The
Company has multiple new audio technology patents pending in the U.S. and
worldwide for improvements to SRS and its FOCUS and TRUSURROUND technologies.

     The Company also is the owner of the federally registered trademarks
SRS(R), the SRS logo "(-)(R)", Sound Retrieval System(R), ORB(R), BASER(R) and
"everything else is only stereo(R)." Trademark applications have been filed for
F(-)CUS(TM), TRUSURROUND(TM), VIP(TM) AVT(TM), Dr. 3D(TM), 3D STEREO(TM), 3D
STEREO II(TM), 3D CINEMA SOUND(TM), MEGA WIDE(TM), MEGA SPACE(TM) and ORS(TM).
The initial duration of the Company's registered trademarks ranges from August
23, 1998 to September 23, 2001. The duration of these trademarks can be
maintained indefinitely provided proper maintenance fees are paid and the
trademarks are continually used or licensed by the Company. The Company
currently intends to maintain all of these trademarks.

EMPLOYEES

     The Company employed 16 full-time individuals and one part-time individual
as of December 31, 1997. None of the Company's employees are covered by a
collective bargaining agreement or is presently represented by a labor union.
The Company has not experienced any work stoppages and considers its employee
relations to be good.

ITEM 2. DESCRIPTION OF PROPERTY

     The Company's corporate headquarters are located in Santa Ana, California,
in a 23,400 square foot facility consisting of office and warehouse space. The
Company leases the facility from Daimler Commerce Partners, L.P. (the
"Partnership"), an affiliated partnership. The general partner of the
Partnership is Conifer Investments, Inc. ("Conifer"). The sole shareholders of
Conifer are Thomas C.K. Yuen and Misako Yuen, as co-trustees of the Thomas Yuen
Family Trust (the "Trust"), and the executive officers of Conifer include Mr.
and Mrs. Yuen. Mr. and Mrs. Yuen, as co-trustees of the Trust, also beneficially
own a significant amount of
                                       12
<PAGE>   15

the Company's outstanding shares of common stock. Mr. Yuen is the Chairman of
the Board and Chief Executive Officer of the Company.

     The original lease with the Partnership, pursuant to which the Company
leased 11,700 square feet of space, commenced on June 1, 1994, and expired on
May 31, 1997. Upon the expiration of the original lease, the Company entered
into a new lease agreement with the Partnership to lease 23,400 square feet of
space at the same facility. The lease term commenced on June 1, 1997 and will
expire on May 31, 2000. At the time of expiration, the Company will have an
option to renew the lease for two additional years commencing on June 1, 2000
and terminating on May 31, 2002. Rent for the year beginning June 1, 1997 was
$.59 per square foot per month plus common area expenses, real property taxes,
utilities, insurance premiums and maintenance. Pursuant to the leases with the
Partnership, the Company paid the Partnership rent of $63,180 during Fiscal
1995, $63,430 during Fiscal 1996 and $129,369 during Fiscal 1997.

     The Company, through Valence and its subsidiaries, leases several offices
and warehouses in Hong Kong and China. Valence's principal operations are
conducted at two leased facilities located in Hong Kong. The principal executive
offices of Valence are located in Kowloon Tong, Hong Kong, in a 3,037 square
foot office facility under a lease that expires in August 1998. Valence's other
principal office is located in Kwun Tong, Kowloon, Hong Kong, in a 7,453 square
foot office facility under a lease that expires in December 2000.

     The Company believes that the current facilities of the Company and its
subsidiaries will be adequate to meet the Company's needs for the foreseeable
future. Should the Company need further additional space, management believes
that the Company will be able to secure additional space at reasonable rates.

ITEM 3. LEGAL PROCEEDINGS

     As of March 26, 1998, neither the Company nor any of its subsidiaries was a
party to any pending legal proceeding.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     Not applicable.

                                       13
<PAGE>   16

                                    PART II

ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

MARKET FOR COMMON STOCK

     The common stock of the Company, par value $.001 per share (the "Common
Stock"), trades on the Nasdaq Stock Market as a National Market System Security
under the symbol SRSL. There was no active trading market for the Common Stock
prior to August 8, 1996, the effective date of the Company's initial public
offering.

     The table below reflects the high and low sales prices of the Common Stock,
as reported by The Nasdaq Stock Market, Inc., from August 8, 1996 through the
end of Fiscal 1997.

<TABLE>
<CAPTION>
                                                              HIGH      LOW
                                                              ----      ---
<S>                                                           <C>       <C>
FISCAL 1996
  Third Quarter (beginning August 8, 1996)..................  $15 5/8   $8
  Fourth Quarter............................................   16        8 5/8

FISCAL 1997
  First Quarter.............................................   11 1/8    7 1/4
  Second Quarter............................................   11 7/8    9 1/8
  Third Quarter.............................................   10 3/4    4 5/8
  Fourth Quarter............................................    8 5/8    5
</TABLE>

HOLDERS

     At March 26, 1998, there were 393 stockholders of record and an estimated
2,300 beneficial holders.

DIVIDEND POLICY

     The Company has never paid cash dividends on the Common Stock. The Company
currently intends to retain its available funds from earnings for future growth
and, therefore, does not anticipate paying any dividends in the foreseeable
future.

SALES OF UNREGISTERED SECURITIES

     During Fiscal 1997, the Company did not sell any of its equity securities
that were not registered under the Securities Act of 1933, as amended (the
"Securities Act").

     During the first quarter of Fiscal 1998, the Company acquired certain
assets, including the VIP technology, of R.G.A. & Associates, Ltd., d/b/a
ToteVision and VIP Labs ("R.G.A."), pursuant to an Asset Purchase Agreement
dated January 28, 1998 (the "VIP Acquisition"). The approximate aggregate
purchase price of such assets was $1,000,000. In connection with the VIP
Acquisition, on January 28, 1998, the Company (i) issued to R.G.A. 25,000 shares
of Common Stock, (ii) granted to R.G.A. a four-year warrant (the "VIP Warrant"),
whereby R.G.A., or its registered assigns, may purchase up to 100,000 shares of
Common Stock for $9.467 per share (subject to adjustment) and (iii) paid R.G.A.
$500,000 in cash. In addition, the Company agreed to pay to R.G.A. for four
years' royalties based upon certain percentages from 10% to 15% of licensing
royalties generated from use of the VIP patents. Subsequent to the closing of
the VIP Acquisition and pursuant to the terms of the VIP Warrant, on February
20, 1998, R.G.A. nominated three persons who performed services for R.G.A. in
connection with the VIP Acquisition to receive a portion of the VIP Warrant. On
February 27, 1998, such three persons acknowledged receipt of warrants dated
February 26, 1998 to purchase 2,500, 2,500 and 1,000 shares of Common Stock,
respectively, with R.G.A. acknowledging on February 27, 1998 receipt of the
balance of the VIP Warrant dated February 26, 1998 (i.e., to purchase 94,000
shares of Common Stock).

                                       14
<PAGE>   17

     In addition, during the first quarter of Fiscal 1998, the Company acquired
all of the outstanding stock of Valence in two separate, but related,
transactions with Valence's five shareholders (the "Valence Acquisition"),
pursuant to two Stock Purchase Agreements dated as of February 24, 1998.
Pursuant to one of the Stock Purchase Agreements, the Company acquired 45% of
the outstanding shares of capital stock of Valence from four British Virgin
Islands corporations, in each case, the sole shareholder of which was a key
employee of Valence or one of Valence's subsidiaries (the "Management
Shareholders"). The aggregate purchase price paid by the Company to the
Management Shareholders was $13,500,000, payable $1,394,222 in cash and
$12,105,778 in shares of Common Stock valued at $7.2032 per share, or 1,680,611
shares, pursuant to a formula set forth in the Stock Purchase Agreement. Such
shares of Common Stock were issued to three of the four Management Shareholders.
Pursuant to the second Stock Purchase Agreement, the Company acquired 55% of the
outstanding shares of capital stock of Valence from the remaining shareholder of
Valence for $6,000,000 in cash.

     In connection with the Valence Acquisition, three of the four Management
Shareholders (the same three that acquired the shares of Common Stock,
referenced above) and their respective sole shareholders entered into
noncompetition agreements with the Company. In consideration for these
agreements and for a nominal cash payment equal to the par value of the shares,
the Company issued an aggregate of an additional 125,000 shares of Common Stock
to such Management Shareholders.

     The above-referenced securities were issued in reliance on the private
offering exemption set forth in Section 4(2) of the Securities Act on the basis
that they were issued under circumstances not involving a public offering.

USE OF PROCEEDS

     The effective date of the Company's initial public offering of its Common
Stock was August 8, 1996 (SEC Registration No. 333-4974-LA). During Fiscal 1997,
the Company did not utilize (except with respect to temporary investment) any of
its net offering proceeds from such public offering. During the first quarter of
Fiscal 1998, the Company utilized $7,894,222 of the $22,052,955 net offering
proceeds as follows:

<TABLE>
<CAPTION>
                                       DIRECT OR INDIRECT PAYMENTS TO
                                        DIRECTORS, OFFICERS, GENERAL
                                      PARTNERS OF THE ISSUER OR THEIR
                                     ASSOCIATES; TO PERSONS OWNING TEN
                                      PERCENT OF MORE OF ANY CLASS OF
                                      EQUITY SECURITIES OF THE ISSUER;     DIRECT OR INDIRECT
                                      AND TO AFFILIATES OF THE ISSUER      PAYMENTS TO OTHERS
                                     ----------------------------------   --------------------
<S>                                  <C>                                  <C>
Construction of plant, building and
  facilities.......................                  --                                 --
Purchase and installation of
  machinery and equipment..........                  --                                 --
Purchase of real estate............                  --                                 --
Acquisition of other
  business(es).....................                  --                      $   7,894,222(1)
Repayment of indebtedness..........                  --                                 --
Working capital....................                  --                                 --
Temporary investment (cash and
  municipal bonds).................                  --                      $  14,158,733(2)
</TABLE>

---------------
(1) In connection with the VIP Transaction, the Company utilized $500,000 of the
    proceeds as part of the consideration to purchase the VIP technology. In
    connection with the Valence Transaction, the Company utilized an aggregate
    of $7,394,222 of the net proceeds, $1,394,222 in partial payment for 45% of
    the outstanding shares of Valence common stock held by four of the five
    shareholders of Valence, and $6,000,000 in payment for 55% of the
    outstanding shares of Valence common stock held by the remaining shareholder
    of Valence.

(2) The remaining funds are temporarily invested in cash and municipal bonds
    pending application.

                                       15
<PAGE>   18

ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

     The following table sets forth selected financial data of the Company from
its inception (June 23, 1993) through December 31, 1993, and for the fiscal
years ended December 31, 1994, 1995, 1996, and 1997, which has been derived from
the Company's audited financial statements. The following information should be
read in conjunction with the Financial Statements and Notes thereto included
elsewhere in this Report.

<TABLE>
<CAPTION>
                                                 JUNE 23, 1993
                                              (DATE OF INCEPTION)       FISCAL YEAR ENDED DECEMBER 31,
                                                TO DECEMBER 31,      ------------------------------------
                                                     1993             1994      1995      1996     1997
                                             ---------------------   -------   -------   ------   -------
                                             (IN THOUSANDS, EXCEPT PER SHARE AND SELECTED OPERATING DATA)
<S>                                          <C>                     <C>       <C>       <C>      <C>
Revenues:
  Royalty revenues.........................         $  125           $   547   $   823   $4,620   $ 8,671
  Other revenues...........................            228               440        21      772     1,410
                                                    ------           -------   -------   ------   -------
          Total revenues...................            353               987       844    5,392    10,081
Cost of sales..............................            227               678        15       95       210
                                                    ------           -------   -------   ------   -------
  Gross margin.............................            126               309       829    5,297     9,871
Operating costs and expenses
  Sales and marketing......................            149               674       937    1,163     2,112
  Research and development.................              6               340       384      522       596
  General and administrative...............            132             1,079     1,107    1,616     2,615
                                                    ------           -------   -------   ------   -------
          Total operating expenses.........            287             2,093     2,428    3,301     5,323
                                                    ------           -------   -------   ------   -------
Income (loss) from operations..............           (161)           (1,784)   (1,599)   1,996     4,548
  Interest income (expense), net...........            (71)              (92)      (41)     366     1,088
                                                    ------           -------   -------   ------   -------
Income (loss) from operations before
  provision for income taxes...............           (232)           (1,876)   (1,640)   2,362     5,636
Provision for income taxes.................              1                 1         1      501     1,863
                                                    ------           -------   -------   ------   -------
Net income (loss)..........................           (233)           (1,877)   (1,641)   1,861     3,773
                                                    ======           =======   =======   ======   =======
  Net income (loss) per share of common
     stock:
          Basic............................         $(0.08)          $ (0.38)  $ (0.28)  $ 0.24   $  0.39
                                                    ======           =======   =======   ======   =======
          Diluted..........................         $   --           $    --   $    --   $ 0.21   $  0.35
                                                    ======           =======   =======   ======   =======
Weighted average number of shares used in
  the calculation of net income per common
  share:
          Basic............................          2,554             4,942     5,928    7,625     9,556
                                                    ======           =======   =======   ======   =======
          Diluted..........................             --                --        --    8,686    10,852
                                                    ======           =======   =======   ======   =======
Balance Sheet Data:
     Working Capital.......................             10              (645)      431    3,375     9,075
     Total Assets..........................          1,533               927     1,698   26,674    31,542
     Long-term obligations, net of current
       portion.............................            861               340       211       69        --
     Stockholders' Equity (deficit)........           (100)             (227)      888   25,151    29,420
Selected Operating Data:
  Total licensees..........................              2                19        43       82       170
</TABLE>

OVERVIEW

     The Company develops, markets and licenses proprietary audio technologies
for use in four worldwide markets: consumer home audio, computer multimedia, car
audio and professional sound. The Company licenses its flagship technology, SRS,
to leading OEMs and semiconductor manufacturers.

     On March 2, 1998, the Company acquired all of the outstanding capital stock
of Valence. Valence, which conducts its business through its subsidiaries based
in Hong Kong and China, is engaged in two primary areas of business, namely, the
design, manufacture and marketing of ASIC (application-specific integrated
circuit)

                                       16
<PAGE>   19

products and consumer electronic products. The aggregate purchase price of
$19,500,000 consisted of approximately $7,400,000 in cash and approximately
$12,100,000 in shares of Common Stock. The acquisition will be accounted for as
a purchase. The acquisition, which for accounting purposes had an effective date
of February 1, 1998, will have a material impact on the Company's financial
statements as of and for the three months ended March 31, 1998 and for reporting
periods thereafter. Additionally, because of the impact that the acquisition
will have on the Company's future financial statements, those future financial
statements may not be directly comparable to the Company's historical financial
statements.

     This Management's Discussion and Analysis or Plan of Operation should be
read in conjunction with the Company's Financial Statements and Notes thereto
included in Part II, Item 7 of this Report.

RESULTS OF OPERATIONS

YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996

  Revenues

     Total revenue in Fiscal 1997 was $10,081,283 compared to $5,392,280 in
Fiscal 1996, an increase of 87.0%. This increase resulted primarily from
increased shipments of products incorporating SRS on which royalties are paid by
licensees. Of the $10,081,283 in revenues in Fiscal 1997, $1,410,000 related to
one-time license fees and $8,671,283 related to on-going royalties, as compared
to $5,392,280 in revenues in Fiscal 1996, which included $772,180 in one-time
license fees and $4,620,100 related to on-going royalties. The number of
licensees as of December 31, 1997 was 170, compared to 82 as of December 31,
1996.

  Cost of Sales

     Cost of sales consists primarily of fees paid to third-party
representatives for sales administration and support. Cost of sales in Fiscal
1997 was $210,348 compared to $95,378 in Fiscal 1996, an increase of 120.5%. As
a percentage of total revenues, cost of sales increased to 2.1% in Fiscal 1997
from 1.8% in Fiscal 1996. This increase resulted from the increase in license
revenue on which the Company pays fees to third-party representatives.

  Sales and Marketing

     Sales and marketing expenses were $2,111,839 in Fiscal 1997 compared to
$1,163,409 in Fiscal 1996, an increase of 81.5%. This increase was primarily
attributable to increased staffing to promote new technologies, increased travel
costs to support the Company's global presence and an increase in marketing and
promotional activities aimed at establishing SRS as an international standard.
As a percentage of total revenues, sales and marketing expenses decreased to
20.9% in Fiscal 1997 from 21.6% in Fiscal 1996 as the Company leveraged its
expenses on higher sales volumes.

  Research and Development

     Research and development expenses were $595,689 in Fiscal 1997 compared to
$521,482 in Fiscal 1996, an increase of 14.2%. This increase was primarily
attributable to an increase in expenses associated with the internal development
of new and existing technologies. As a percentage of total revenues, research
and development expenses decreased to 5.9% in Fiscal 1997 from 9.7% in Fiscal
1996 as the Company leveraged its expenses on higher sales volumes.

  General and Administrative

     General and administrative expenses were $2,615,706 in Fiscal 1997 compared
to $1,615,648 in Fiscal 1996, an increase of 61.9%. This increase was primarily
attributable to increased staffing, increased professional fees associated with
maintaining patent and trademark rights in the U.S. and foreign countries, costs
associated with being a public company and general management expenses for the
support of licensing activities and new business development. As a percentage of
total revenues, general and administrative

                                       17
<PAGE>   20

expenses decreased to 25.9% in Fiscal 1997 from 30.0% in Fiscal 1996 as the
Company leveraged its expenses on higher sales volumes.

  Interest Income, net

     Interest income was $1,088,718 in Fiscal 1997 compared to $365,583 in
Fiscal 1996, an increase of 197.8%. The increase represents the difference in
earned interest for a full year in Fiscal 1997, as opposed to a partial year's
worth of earnings in Fiscal 1996. The interest is earned on investment of the
proceeds from the Company's initial public offering which took place on August
8, 1996.

  Provision for Income Taxes

     The effective tax rate for Fiscal 1997 was 33.1% compared to 21.2% for
Fiscal 1996. Higher pre-tax earnings for Fiscal 1997 and the full utilization of
the net operating loss carryforwards in Fiscal 1996 were responsible for the
increase in the effective rate.

YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995

  Revenues

     Total revenue in Fiscal 1996 was $5,392,280 compared to $843,789 in the
fiscal year ended December 31, 1995 (" Fiscal 1995"), an increase of 539.1%.
This increase resulted primarily from growth of the licensee base from 43
licensees at the end of 1995 to 82 licensees at December 31, 1996, and increased
shipments of products incorporating SRS on which royalties are paid by
licensees. Of the $5,392,280 in revenues in Fiscal 1996, $772,180 related to
one-time license fees and $4,620,100 related to on-going royalties.

  Cost of Sales

     Cost of sales consists primarily of fees paid to third-party
representatives for sales administration and support. Cost of sales in Fiscal
1996 was $95,378 compared to $14,957 in Fiscal 1995, an increase of 537.7%. Cost
of sales was 1.8% of total revenues in both Fiscal 1996 and 1995.

  Sales and Marketing

     Sales and marketing expenses were $1,163,409 in Fiscal 1996 compared to
$937,293 in Fiscal 1995, an increase of 24.1%. This increase was primarily
attributable to increased staffing and an increase in marketing and promotional
activities. As a percentage of total revenues, sales and marketing expenses
decreased to 21.6% in Fiscal 1996 from 111.1% in Fiscal 1995 as the Company
leveraged its expenses on higher sales volumes.

  Research and Development

     Research and development expenses were $521,482 in Fiscal 1996 compared to
$383,948 in Fiscal 1995, an increase of 35.8%. This increase was primarily
attributable to increased staffing and an increase in expenses associated with
the internal development of new and existing technologies. As a percentage of
total revenues, research and development expenses decreased to 9.7% in Fiscal
1996 from 45.5% in Fiscal 1995, as the Company leveraged its expenses on higher
sales volumes.

  General and Administrative

     General and administrative expenses were $1,615,648 in Fiscal 1996 compared
to $1,106,519 in Fiscal 1995, an increase of 46.0%. This increase was primarily
attributable to increased staffing and general management expenses for support
of the licensing activities and new business development. As a percentage of
total revenues, general and administrative expenses decreased to 30.0% in Fiscal
1996 from 131.1% in Fiscal 1995 as the Company leveraged its expenses on higher
sales volumes.

                                       18
<PAGE>   21

  Interest Income (expense), net

     Interest income was $365,583 in Fiscal 1996 compared to interest expense of
$41,035 in Fiscal 1995. The increase is due to interest earned on investing the
proceeds from the Company's initial public offering.

  Provision for Income Taxes

     Income tax expense in Fiscal 1996 was $500,937 compared to $800 in Fiscal
1995, which represented minimum state income taxes as the Company had a net loss
during that period. Income tax expenses in Fiscal 1996 are partially offset by
the use of federal and state tax loss carryforwards.

SELECTED QUARTERLY OPERATING RESULTS (UNAUDITED)

     The following table sets forth certain quarterly financial data for the
eight quarters in the period ended December 31, 1997. The quarterly information
is based upon unaudited financial statements prepared by the Company on a basis
consistent with the Company's audited financial statements and, in management's
opinion, includes all adjustments, consisting only of normal recurring
adjustments necessary for a fair presentation of the information for the periods
presented. This information should be read in conjunction with the Company's
audited Financial Statements and Notes thereto appearing elsewhere in this
Report. The operating results for any quarter are not necessarily indicative of
results for any future period. The Company's quarterly operating results have
varied significantly in the past and are expected to vary significantly in the
future.

<TABLE>
<CAPTION>
                                                                    THREE MONTHS ENDED
                                 -----------------------------------------------------------------------------------------
                                 MARCH 31,   JUNE 30,   SEPT. 30,   DEC. 31,   MARCH 31,   JUNE 30,   SEPT. 30,   DEC. 31,
                                   1996        1996       1996        1996       1997        1997       1997        1997
                                 ---------   --------   ---------   --------   ---------   --------   ---------   --------
                                                           (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                              <C>         <C>        <C>         <C>        <C>         <C>        <C>         <C>
Revenues:
  Royalty Revenues.............   $  985      $  890     $1,151      $1,594     $1,802      $2,016     $1,930      $2,923
  Other Revenues...............       50         174        300         248        410         100        575         325
                                  ------      ------     ------      ------     ------      ------     ------      ------
         Total Revenues........    1,035       1,064      1,451       1,842      2,212       2,116      2,505       3,248
Gross Margin...................    1,030       1,047      1,421       1,799      2,173       2,040      2,434       3,224
Operating Expenses.............      729         657        774       1,141      1,327         966      1,153       1,877
                                  ------      ------     ------      ------     ------      ------     ------      ------
Operating Income...............      301         390        647         658        846       1,074      1,281       1,347
  Net Income...................      218         289        633         721        695         848      1,083       1,147
Net Income per share of common
  stock:
    Basic......................   $  .03      $  .05     $  .08      $  .08     $  .07      $  .09     $  .11      $  .12
    Diluted....................   $  .03      $  .04     $  .07      $  .07     $  .07      $  .08     $  .11      $  .11
</TABLE>

RECENTLY ISSUED ACCOUNTING STANDARDS

     In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 130, Reporting Comprehensive Income, and SFAS No. 131, Disclosures about
Segments of an Enterprise and Related Information. SFAS No. 130 established
standards for reporting and display of comprehensive income and its components
in a full set of general-purpose financial statements. SFAS No. 131 established
standards of reporting by publicly-held business enterprises and disclosure of
information about operating segments in annual financial statements and, to a
lesser extent, in interim financial reports issued to stockholders. SFAS Nos.
130 and 131 are effective for the Company beginning in 1998. As these standards
deal with the form and content of financial statement disclosures, the Company
does not anticipate that the adoption of these new standards will have a
material impact on its financial position or results of operations.

LIQUIDITY AND CAPITAL RESOURCES

     In August 1996, the Company completed an initial public offering of
3,107,452 shares of common stock at $8.00 per share. Net proceeds to the Company
were approximately $22 million.

                                       19
<PAGE>   22

     From inception through August 1996, the Company financed its operations
primarily through the private placement of equity securities. As of December 31,
1996 and 1997, cash, cash equivalents, and investments totaled $24,425,782 and
$26,013,790, respectively. The Company's cash provided by operating activities
decreased to $1,829,621 for Fiscal 1997 from $2,255,320 for Fiscal 1996,
primarily resulting from an increase in the Company's royalty receivable.
Royalty receivable increased by $3,286,961 due primarily to the increase in
licensing royalties and the execution of licensing agreements during the last
quarter of the period.

     The Company's principal source of liquidity at December 31, 1997 consisted
of cash, cash equivalents and investments. The Company has adopted investment
guidelines which restrict the types and quality of investments the Company is
authorized to enter into. At December 31, 1997, the Company had cash and cash
equivalents of $4,446,753 and investments of $21,567,037. Investments consist of
municipal bonds rated a minimum of A1.

     On March 2, 1998, the Company acquired all of the outstanding shares of
capital stock of Valence for an aggregate purchase price of $19,500,000,
consisting of approximately $7,400,000 in cash and approximately 1,800,000
shares of Common Stock.

     On March 4, 1998 the Company obtained a bank line of credit. The total
availability under the line is $10 million and expires June 1, 2000. Borrowings
under the facility are collateralized by certain of the Company's marketable
securities and bear interest at the rate of LIBOR plus 0.75% or the bank's prime
rate. As of March 26, 1998, the Company had loans outstanding of $7,000,000.

     In connection with the acquisition of all of the outstanding shares of
capital stock of Valence, the Company has provided Valence $7,000,000 to pay off
its short-term debt and other obligations. These funds were drawn by the Company
under the above-referenced line of credit. The Company also expects to provide
Valence with up to an additional $8,000,000 in working capital over the next six
months.

     Based on current plans and business conditions, the Company expects that
its cash, cash equivalents, investments and/or available borrowings under its
line of credit together with any amounts generated from operations will be
sufficient to meet the Company's cash requirements for at least the next 12
months. However, there can be no assurance that the Company will not be required
to seek other financing sooner or that such financing, if required, will be
available on terms satisfactory to the Company.

FORWARD-LOOKING INFORMATION AND CERTAIN FACTORS

     Included in Part I, Item 1. Description of Business, this Item 6 and
elsewhere in this Report are certain forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995, reflecting
management's current expectations. Examples of such forward-looking statements
include the expectations of the Company with respect to statements made under
the caption "Company Strategy" in Part I, Item 1 of this Report, and statements
regarding its expectations relating to the acquisitions of Valence and the VIP
technology. Although the Company believes that its expectations are based upon
reasonable assumptions, there can be no assurances that the Company's financial
goals will be realized. Such forward-looking statements involve known and
unknown risks, uncertainties and other factors that may cause the actual
results, performance or achievements of the Company, or industry results, to be
materially different from any future results, performance or achievements
expressed or implied by such forward-looking statements. Numerous factors may
affect the Company's actual results and may cause results to differ materially
from those expressed in forward-looking statements made by or on behalf of the
Company. Such factors include, among others, those set forth below. The Company
assumes no obligation to update the forward-looking information or the factors
listed below to reflect actual results or changes in the factors affecting such
forward-looking information.

  Quarterly Fluctuations

     The Company's operating results may fluctuate from those in prior quarters
and will continue to be subject to quarterly and other fluctuations due to a
variety of factors, including the extent to which the Company's licensees
incorporate SRS or the Company's other technologies into their products, the
gain or loss

                                       20
<PAGE>   23

of significant customers, competitive pressures on selling prices, the
acceptance of new or enhanced versions of the Company's technologies, the rate
that the Company's semiconductor licensees manufacture and distribute chips to
OEMs, the ability of the Company to secure one-time license fees for its
technologies from new and existing licensees, seasonal customer demand, the
Company's ability to continue to effectively compete with others in the field of
audio enhancement technologies, processes and products and general business
economic conditions, particularly those effecting the consumer electronics
market.

  Integration of Valence

     As a result of the acquisition of Valence, the success of the Company will
depend in large part on its ability to successfully integrate the operations of
Valence with the Company. The degree to which the Company can successfully
integrate such operations will depend on a number of factors, including the
Company's ability to expand the scope of its operations beyond technology
licensing into the new business of manufacturing electronic and semiconductor
products and the Company's ability to increase its market penetration in China.

  Currency Risk/Stability of Asian Markets

     The Company expects that international sales will continue to represent a
significant portion of total revenues. To date, all of the Company's revenues
have been denominated in U.S. dollars and most costs have been incurred in U.S.
dollars. It is the Company's expectation that licensing revenues will continue
to be denominated in U.S. dollars for the foreseeable future. With its
acquisition of Valence and the Company's anticipated expansion of its business
in China and other parts of Asia, the Company's consolidated operations and
financial results could be significantly affected by risks associated with
international activities, including economic and labor conditions, political
instability, tax laws (including U.S. taxes on foreign subsidiaries) and changes
in the value of the U.S. dollar versus the local currency in which the products
are sold. The Company intends to actively monitor its foreign exchange exposure
and to implement strategies to reduce its foreign exchange risk at such time
that the Company determines the benefits of such strategies outweigh the
associated costs. Countries in the Asia Pacific region have recently experienced
weakness in their currency, banking and equity markets. These weaknesses could
adversely affect consumer demand for Valence's products, the U.S. dollar value
of the Company's and its subsidiaries' foreign currency denominated sales, the
availability and supply of product components to Valence and ultimately the
Company's consolidated results of operations.

  Competitive Pressures

     As a result of existing and new competitors into the 3D audio market, the
Company has experienced, and anticipates that it will continue to experience,
increased pricing pressures due to aggressive pricing from certain of the
Company's competitors. Due to competitive pricing pressures, the Company may,
from time to time, reduce the average unit royalty fees charged to its
customers. In order to offset declines in average unit selling prices, the
Company depends upon increased usage of its technologies by existing customers
and expansion into new market segments. The degree to which the Company can
expand usage of its technology by both new and existing customers will depend on
a number of factors including semiconductor development and delivery schedules,
the ability of the Company to manage expansion in international marketing and
sales and timely introduction of new technologies. There is no assurance that
the Company will achieve the desired volume growth to offset the negative effect
to revenue caused by the reduction in average unit price.

  Semiconductor Solutions

     The delivery of the Company's technologies to OEMs in a semiconductor-based
solution improves the Company's ability to deliver cost-effective, reliable
solutions to its customers. The existence of semiconductor-based technology
solutions, however, increases the dependence of the Company's operating results
on the ability of semiconductor manufacturers to timely deliver such solutions
to the marketplace. The Company's reliance on outside semiconductor
manufacturers reduces the Company's ability to control the supply of products to
the marketplace. The occurrence of any supply problems for the Company's
products, as well as a

                                       21
<PAGE>   24

lack of semiconductor manufacturers' sales focus, may have an adverse effect on
the Company's operating results.

  Volatility of Stock Price

     The trading price of the Common Stock has been, and will likely continue to
be, subject to wide fluctuations in response to quarterly variations in the
Company's operating results, announcements of new products or technological
innovations by the Company or its competitors, general market fluctuations and
other events and factors. Changes in earnings estimates made by brokerage firms
and industry analysts relating to the market in which the Company does business,
or relating to the Company specifically, have in the past resulted and could in
the future result in an immediate and adverse effect on the market price of the
Common Stock.

  Year 2000 Compliance

     Many of the world's computer systems currently record years in a two-digit
format. Such computer systems will be unable to properly interpret dates beyond
the year 1999, which could lead to business disruptions in the U.S. and
internationally (the "Year 2000" issue). The potential costs and uncertainties
associated with the Year 2000 issue will depend on a number of factors,
including software, hardware and the nature of the industry in which the Company
operates. Additionally, companies must coordinate with other entities with which
they electronically interact, such as customers and creditors.

     The Company and its subsidiaries are currently evaluating all internal
operating systems and in 1998 will initiate a comprehensive project to update
their accounting software to programs that are Year 2000 compliant. The Company
expects to complete the project in early 1999, and the total cost for this
project, based on management's best estimates, could range as high as
$1,500,000, including the cost of new systems, which will be capitalized.

     In addition, the Company is actively working with all of its major
suppliers and customers to assess their Year 2000 compliance efforts and the
Company's exposure to them. At this time, it is not possible to quantify the
aggregate cost to the Company and its subsidiaries related to the Year 2000
compliance issues facing the Company's major suppliers and customers.

                                       22
<PAGE>   25

ITEM 7. FINANCIAL STATEMENTS

                         INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                              PAGE
                                                              ----
<S>                                                           <C>
Independent Auditors' Report................................   24
Balance Sheets as of December 31, 1996 and 1997.............   25
Statements of Operations for the years ended December 31,
  1995, 1996 and 1997.......................................   26
Statements of Stockholders' Equity (Deficit) for the years
  ended December 31, 1995, 1996 and 1997....................   27
Statements of Cash Flows for the years ended December 31,
  1995, 1996 and 1997.......................................   28
Notes to Financial Statements...............................   29
</TABLE>

                                       23
<PAGE>   26

                          INDEPENDENT AUDITORS' REPORT

To the Board of Directors
and Stockholders of
SRS Labs, Inc.:

     We have audited the accompanying balance sheets of SRS Labs, Inc. (the
"Company") as of December 31, 1996 and 1997, and the related statements of
operations, stockholders' equity (deficit) and cash flows for each of the three
years in the period ended December 31, 1997. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

     We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

     In our opinion, such financial statements present fairly, in all material
respects, the financial position of SRS Labs, Inc. as of December 31, 1996 and
1997, and the results of its operations and its cash flows for each of the three
years in the period ended December 31, 1997, in conformity with generally
accepted accounting principles.

/s/ DELOITTE & TOUCHE LLP

Costa Mesa, California
February 6, 1998 (March 4, 1998, as to Note 10)

                                       24
<PAGE>   27

                                 SRS LABS, INC.

                                 BALANCE SHEETS

                                     ASSETS

<TABLE>
<CAPTION>
                                                                    DECEMBER 31,
                                                              -------------------------
                                                                 1996          1997
                                                              -----------   -----------
<S>                                                           <C>           <C>
CURRENT ASSETS (Note 2):
  Cash and cash equivalents.................................  $ 3,455,997   $ 4,446,753
  Investments available for sale (Note 3)...................           --     2,010,775
  Royalty receivable........................................      702,966     3,989,927
  Interest receivable.......................................      325,822       316,815
  Other receivables (Note 7)................................       20,030         4,714
  Prepaid expenses..........................................      105,919       257,428
  Deferred income taxes (Note 6)............................      218,936       170,674
                                                              -----------   -----------
          Total current assets..............................    4,829,670    11,197,086
INVESTMENTS AVAILABLE FOR SALE (Note 3).....................   20,969,785    19,556,262
FURNITURE, FIXTURES AND EQUIPMENT, net of accumulated
  depreciation (Notes 2 and 4)..............................      281,189       245,779
PATENTS, net of accumulated amortization of $46,913 (1996)
  and $76,294 (1997)........................................      126,827       201,323
GOODWILL, net of accumulated amortization of $594,002 (1996)
  and $805,781 (1997) (Note 2)..............................      280,052       112,350
DEFERRED INCOME TAXES (Note 6)..............................      186,576       229,223
                                                              -----------   -----------
                                                              $26,674,099   $31,542,023
                                                              ===========   ===========

LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
  Accounts payable (Note 8).................................  $   275,554   $   202,352
  Accrued liabilities, including deferred income of $256,686
     (1996) and $41,635 (1997) and accrued salaries of
     $129,216 (1996) and $185,000 (1997)....................      566,139       826,242
  Income taxes payable......................................      433,021     1,011,426
  Current portion of consideration due on asset purchase
     (Notes 2 and 8)........................................      180,000        81,804
                                                              -----------   -----------
          Total current liabilities.........................    1,454,714     2,121,824
CONSIDERATION DUE ON ASSET PURCHASE, net of current portion
  (Notes 2 and 8)...........................................       68,635            --
COMMITMENTS AND CONTINGENCIES (Note 5) STOCKHOLDERS' EQUITY
  (Note 7):
  Preferred stock -- $0.001 par value; 2,000,000 shares
     authorized; no shares issued and outstanding...........           --            --
  Common stock -- $0.001 par value; 56,000,000 shares
     authorized; 9,468,548 (1996) and 9,609,867 (1997)
     shares issued and outstanding..........................        9,469         9,610
  Additional paid-in capital................................   24,678,961    25,022,437
  Deferred compensation.....................................      154,386       231,087
  Unrealized gain on investments available for sale, net of
     income taxes of $58,795 (1996) and $109,696 (1997).....       87,688       163,600
  Retained earnings.........................................      220,246     3,993,465
                                                              -----------   -----------
          Total stockholders' equity........................   25,150,750    29,420,199
                                                              -----------   -----------
                                                              $26,674,099   $31,542,023
                                                              ===========   ===========
</TABLE>

                See accompanying notes to financial statements.
                                       25
<PAGE>   28

                                 SRS LABS, INC.

                            STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                                YEAR ENDED DECEMBER 31,
                                                        ---------------------------------------
                                                           1995           1996          1997
                                                        -----------    ----------    ----------
<S>                                                     <C>            <C>           <C>
REVENUES (Note 8):
  Royalty revenues....................................  $   822,559    $4,620,100    $8,671,283
  Other revenues......................................       21,230       772,180     1,410,000
                                                        -----------    ----------    ----------
          Total revenues..............................      843,789     5,392,280    10,081,283
COST OF SALES.........................................       14,957        95,378       210,348
                                                        -----------    ----------    ----------
GROSS MARGIN..........................................      828,832     5,296,902     9,870,935
SALES AND MARKETING...................................      937,293     1,163,409     2,111,839
RESEARCH AND DEVELOPMENT..............................      383,948       521,482       595,689
GENERAL AND ADMINISTRATIVE (Note 8)...................    1,106,519     1,615,648     2,615,706
                                                        -----------    ----------    ----------
INCOME (LOSS) FROM OPERATIONS.........................   (1,598,928)    1,996,363     4,547,701
INTEREST INCOME (EXPENSE), net........................      (41,035)      365,583     1,088,718
                                                        -----------    ----------    ----------
INCOME (LOSS) BEFORE PROVISION FOR INCOME TAXES.......   (1,639,963)    2,361,946     5,636,419
PROVISION FOR INCOME TAXES (Note 6)...................          800       500,937     1,863,200
                                                        -----------    ----------    ----------
NET INCOME (LOSS).....................................  $(1,640,763)   $1,861,009    $3,773,219
                                                        ===========    ==========    ==========
NET INCOME (LOSS) PER COMMON SHARE:
  BASIC...............................................  $     (0.28)   $     0.24    $     0.39
                                                        ===========    ==========    ==========
  DILUTED.............................................  $        --    $     0.21    $     0.35
                                                        ===========    ==========    ==========
WEIGHTED AVERAGE SHARES USED IN THE CALCULATION OF NET
  INCOME (LOSS) PER COMMON SHARE:
  BASIC...............................................    5,927,615     7,625,075     9,556,015
  DILUTED.............................................           --     8,686,408    10,852,281
</TABLE>

                See accompanying notes to financial statements.
                                       26
<PAGE>   29

                                 SRS LABS, INC.

                  STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)

<TABLE>
<CAPTION>
                                                                                        UNREALIZED
                                        COMMON STOCK      ADDITIONAL                     GAINS ON      RETAINED
                                     ------------------     PAID-IN       DEFERRED     INVESTMENTS,    EARNINGS
                                      SHARES     AMOUNT     CAPITAL     COMPENSATION       NET         (DEFICIT)       TOTAL
                                     ---------   ------   -----------   ------------   ------------   -----------   -----------
<S>                                  <C>         <C>      <C>           <C>            <C>            <C>           <C>
BALANCE, January 1, 1995...........  5,141,302   $5,142   $ 1,877,858     $     --       $     --     $(2,110,026)  $  (227,026)
  Issuance of common stock
    (Note 7).......................    857,730     858      2,682,643           --             --              --     2,683,501
  Reclassification of accumulated
    deficit (Note 7)...............         --      --     (2,110,026)          --             --       2,110,026            --
  Deferred compensation (Note 7)...         --      --             --       21,965             --              --        21,965
  Ascribed value of services
    contributed (Note 7)...........         --      --         50,000           --             --              --        50,000
  Net loss.........................         --      --             --           --             --      (1,640,763)   (1,640,763)
                                     ---------   ------   -----------     --------       --------     -----------   -----------
BALANCE, December 31, 1995.........  5,999,032   6,000      2,500,475       21,965             --      (1,640,763)      887,677
  Issuance of common stock
    (Note 7).......................  3,107,452   3,107     22,049,848           --             --              --    22,052,955
  Proceeds from exercise of stock
    options........................    362,064     362         99,638           --             --              --       100,000
  Deferred compensation (Note 7)...         --      --             --      132,421             --              --       132,421
  Ascribed value of services
    contributed (Note 7)...........         --      --         29,000           --             --              --        29,000
  Unrealized gain on investments
    available for sale, net of tax
    (Note 3).......................         --      --             --           --         87,688              --        87,688
  Net income.......................         --      --             --           --             --       1,861,009     1,861,009
                                     ---------   ------   -----------     --------       --------     -----------   -----------
BALANCE, December 31, 1996.........  9,468,548   9,469     24,678,961      154,386         87,688         220,246    25,150,750
  Proceeds from exercise of stock
    options........................    141,319     141        144,461           --             --              --       144,602
  Tax benefit associated with
    exercise of stock options......         --      --        199,015           --             --              --       199,015
  Deferred compensation (Note 7)...         --      --             --       76,701             --              --        76,701
  Unrealized gain on investments
    available for sale, net of tax
    (Note 3).......................         --      --             --           --         75,912              --        75,912
  Net income.......................         --      --             --           --             --       3,773,219     3,773,219
                                     ---------   ------   -----------     --------       --------     -----------   -----------
BALANCE, December 31, 1997.........  9,609,867   $9,610   $25,022,437     $231,087       $163,600     $ 3,993,465   $29,420,199
                                     =========   ======   ===========     ========       ========     ===========   ===========
</TABLE>

                See accompanying notes to financial statements.
                                       27
<PAGE>   30

                                 SRS LABS, INC.

                            STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                               YEAR ENDED DECEMBER 31,
                                                       ----------------------------------------
                                                          1995           1996          1997
                                                       -----------   ------------   -----------
<S>                                                    <C>           <C>            <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)....................................  $(1,640,763)  $  1,861,009   $ 3,773,219
Adjustments to reconcile net income (loss) to net
  cash provided by (used in) operating activities:
  Depreciation and amortization......................      240,109        285,063       341,152
  Deferred income taxes..............................           --       (405,512)        5,615
  Amortization of premium on investments available
     for sale........................................           --         27,300       109,817
  Loss on disposal of furniture, fixtures and
     equipment.......................................        7,095             --            --
  Accretion of consideration due on asset purchase...       50,990         38,064        23,844
  Increase in deferred compensation..................       21,965        132,421        76,701
  Ascribed value of services contributed.............       50,000         29,000            --
  Changes in operating assets and liabilities:
     Increase in royalty receivable..................      (42,961)      (660,005)   (3,286,961)
     Decrease in accounts receivable.................       51,659         11,961            --
     Decrease (increase) in interest receivable......           --       (325,822)        9,007
     Decrease in inventories.........................        6,638          1,144            --
     Decrease (increase) in prepaid expenses and
       other receivables.............................     (546,140)       463,689      (136,193)
     (Decrease) increase in accounts payable.........     (118,112)       121,642       (73,202)
     Increase in other accrued liabilities...........      222,846        301,140       260,103
     Decrease in interest payable....................       (8,191)            --            --
     Increase in income taxes payable................           --        374,226       726,519
                                                       -----------   ------------   -----------
          Net cash provided by (used in) operating
            activities...............................   (1,704,865)     2,255,320     1,829,621
CASH FLOWS FROM INVESTING ACTIVITIES:
  Purchase of furniture, fixtures and equipment......     (105,653)      (157,654)      (64,582)
  Expenditures related to patents....................           --       (114,641)     (103,877)
  Purchases of investments, available for sale.......           --    (22,050,602)     (580,256)
  Proceeds from sale of investments, available for
     sale............................................           --      1,200,000            --
                                                       -----------   ------------   -----------
          Net cash used in investing activities......     (105,653)   (21,122,897)     (748,715)
CASH FLOWS FROM FINANCING ACTIVITIES:
  Principal payments on note payable.................     (311,907)            --            --
  Payment of consideration due on asset purchase.....     (231,421)      (213,468)     (234,752)
  Issuance of common stock...........................    2,683,501     22,152,955            --
  Exercise of stock options..........................           --             --       144,602
                                                       -----------   ------------   -----------
          Net cash provided by (used in) financing
            activities...............................    2,140,173     21,939,487       (90,150)
                                                       -----------   ------------   -----------
NET INCREASE IN CASH AND CASH EQUIVALENTS............      329,655      3,071,910       990,756
CASH AND CASH EQUIVALENTS, beginning of period.......       54,432        384,087     3,455,997
                                                       -----------   ------------   -----------
CASH AND CASH EQUIVALENTS, end of period.............  $   384,087   $  3,455,997   $ 4,446,753
                                                       ===========   ============   ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION --
  Cash paid during the period for:
     Income taxes....................................  $       800   $    126,711   $   811,700
                                                       ===========   ============   ===========
     Interest........................................  $    20,721   $         --   $        --
                                                       ===========   ============   ===========
SUPPLEMENTAL DISCLOSURES OF NONCASH TRANSACTIONS
  Additional consideration accrued for asset purchase
     (Note 2)........................................  $    51,243   $     33,080   $    44,077
  Unrealized gain on investments, net (Note 3).......  $        --   $     87,688   $    75,912
  Tax benefit associated with exercise of stock
     options.........................................  $        --   $         --   $   199,015
</TABLE>

                See accompanying notes to financial statements.
                                       28
<PAGE>   31

                                 SRS LABS, INC.

                         NOTES TO FINANCIAL STATEMENTS
              FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997

 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     Description of Business -- SRS Labs, Inc. (the "Company") was incorporated
under the laws of the State of California on June 23, 1993 and reincorporated
under the laws of the State of Delaware on June 28, 1996. The Company licenses
SRS, a three dimensional audio sound enhancement technology, and related
technologies to original equipment manufacturers ("OEMs") of various types of
media equipment as well as semiconductor manufacturers who sell their SRS
integrated chips to OEMs.

     The Company's success is dependent on its licensing of proprietary
technology to companies engaged in the manufacture of consumer electronics
primarily in the multi-media equipment sector. The Company's licensees, which
are located throughout the world, are subject to several market risks, including
but not limited to, changing consumer preferences, consumer demand and
technology changes. The market for the Company's technologies is also highly
competitive. Changes in these and other market conditions could adversely impact
future operating results of the Company. Additionally, the Company's future
operating success is dependent, at least in part, on its ability to maintain
proprietary technology and enforce its rights under its patents.

     Cash Equivalents -- The Company considers all highly-liquid investments
with an original maturity of three months or less to be cash equivalents.

     Investments -- Investments, consisting primarily of municipal bonds, have
been classified as available for sale and are reported at fair value, based on
quoted market prices, in the accompanying balance sheets. Unrealized gains, net
of applicable income taxes, are reported as a separate component of
stockholders' equity.

     Furniture, Fixtures and Equipment -- Furniture, fixtures and equipment are
stated at cost, net of accumulated depreciation. Depreciation is provided for
using the straight-line method which amortizes cost over the estimated useful
lives of the respective assets or as to leasehold improvements, the term of the
related lease if less than the estimated service life ranging from three to five
years.

     Patents -- Costs paid by the Company related to the establishment and
transfer of patents, primarily legal costs, are capitalized and amortized over
periods ranging from five to ten years, depending on the estimated life of the
technology patented.

     Goodwill -- Consideration for the purchase of assets in excess of the fair
market value of specifically identified tangible assets has been capitalized as
goodwill in the accompanying balance sheets. Goodwill is being amortized over an
estimated useful life of five years. The recoverability of goodwill is
determined by comparing the carrying value of goodwill to the estimated future
operating income of the Company on an undiscounted cash flow basis. Should the
carrying value of goodwill exceed the estimated operating income for the
expected period of benefit, an impairment for the excess is recorded at that
time.

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

     Revenue Recognition -- Royalty revenues associated with ongoing royalty
license agreements are recognized when license payments are due upon receipt of
reports from licensees stating the number of products implementing SRS on which
royalties are due. Licensing revenues for one-time technology transfer fees,
which are included in other revenues, are recognized in the period in which the
license agreement is consummated and the related technology is transferred.

     Research and Development -- Research and development costs are expensed as
incurred.

                                       29
<PAGE>   32
                                 SRS LABS, INC.

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997

     Income Taxes -- Effective January 1, 1995, the Company revoked its election
to be taxed as an S corporation for federal and state tax purposes. For all
periods prior to January 1, 1995, the Company elected to be treated as an S
corporation for both federal and state taxation purposes. Due to the Company's
net loss in periods in which the Company was an S corporation, pro forma income
taxes are not reflected in the accompanying financial statements (see Note 7).
The Company accounts for income taxes in accordance with Statement of Financial
Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. Deferred taxes
on income result from temporary differences between the reporting of income for
financial statements and tax reporting purposes.

     Net Income (Loss) Per Common Share -- Effective December 31, 1997, the
Company adopted SFAS No. 128, Earnings per Share, which requires the disclosure
of basic and diluted earnings per share for all current and prior periods. Basic
net income (loss) per common share is computed by dividing income available to
common stockholders by the weighted-average number of shares of common shares
outstanding during each year. Diluted net income per common share reflects the
maximum dilution, based on the average price of the Company's common stock each
period and is computed similar to basic income (loss) per share except that the
denominator is increased to include the number of additional shares that would
have been outstanding if potentially dilutive stock options had been exercised.

     The following is an illustration of the reconciliation of the numerators
and the denominators of the basic and diluted net income (loss) per common share
computations:
<TABLE>
<CAPTION>
                              FOR YEAR ENDED DECEMBER 31, 1995          FOR YEAR ENDED DECEMBER 31, 1996
                           ---------------------------------------   --------------------------------------
                             INCOME         SHARES       PER SHARE     INCOME        SHARES       PER SHARE
                           (NUMERATOR)   (DENOMINATOR)    AMOUNT     NUMERATOR    (DENOMINATOR)    AMOUNT
                           -----------   -------------   ---------   ----------   -------------   ---------
<S>                        <C>           <C>             <C>         <C>          <C>             <C>
Basic:
  Income (loss) available
    to common
    stockholders.........  (1,640,763)     5,927,615      $(0.28)     1,861,009     7,625,075       $0.24
                                                          ======                                    =====
  Effect of Dilutive
    Securities:
  Stock Options..........                        N/A                                1,061,333
                                           ---------                                ---------
Diluted:
  Income available to
    common stockholders
    plus assumed
    conversion...........         N/A            N/A         N/A     $1,861,009     8,686,408       $0.21
                           ==========      =========      ======     ==========     =========       =====

<CAPTION>
                              FOR YEAR ENDED DECEMBER 31, 1997
                           ---------------------------------------
                             INCOME         SHARES       PER SHARE
                           (NUMERATOR)   (DENOMINATOR)    AMOUNT
                           -----------   -------------   ---------
<S>                        <C>           <C>             <C>
Basic:
  Income (loss) available
    to common
    stockholders.........   3,773,219      9,556,015       $0.39
                                                           =====
  Effect of Dilutive
    Securities:
  Stock Options..........                  1,296,266
                                          ----------
Diluted:
  Income available to
    common stockholders
    plus assumed
    conversion...........  $3,773,219     10,852,281       $0.35
                           ==========     ==========       =====
</TABLE>

     Initial Public Offering -- In August 1996, the Company completed an initial
public offering of 3,107,452 shares of its common stock at an offering price of
$8 per share for net proceeds of approximately $22 million.

     Reverse Stock Split and Reincorporation -- On June 27, 1996, the Company
effected a .7241279-for-one stock split of its authorized and outstanding shares
of common stock. On June 28, 1996 the Company reincorporated in the State of
Delaware and increased its authorized shares of common stock to 56,000,000
shares and shares of preferred stock to 2,000,000 shares. All share and per
share data relating to periods prior to the reverse stock split and
reincorporation have been restated to give effect to the reverse stock split.

     Stock-Based Compensation -- The Company accounts for stock-based awards to
employees using the intrinsic value method in accordance with Accounting
Principle Board's Opinion (APB) No. 25, Accounting for Stock Issued to
Employees.

     Customer Concentration -- During the years ended December 31, 1995, 1996
and 1997, two customers (not necessarily the same customers each year) accounted
for 62%, 38% and 39%, respectively, of license revenue. Given the significant
amount of revenues derived from these customers, the loss of any such

                                       30
<PAGE>   33
                                 SRS LABS, INC.

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997

customer or the uncollectibility of related receivables could have a material
adverse effect on the Company's financial condition and results of operations.

     Concentrations of Credit Risk -- Royalty receivable, which represents the
Company's only significant financial instrument with potential credit risk, is
from customers in various industries and geographic locations. The Company makes
periodic evaluations of the creditworthiness of its customers and generally does
not require collateral. To date, the Company has not experienced any material
write-offs or collection problems.

     Recent Accounting Pronouncements -- In June 1997, the Financial Accounting
Standards Board ("FASB") issued SFAS No. 130, Reporting Comprehensive Income,
and SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information. SFAS No. 130 established standards for reporting and display of
comprehensive income and its components in a full set of general-purpose
financial statements. SFAS No. 131 established standards of reporting by
publicly-held business enterprises and disclosure of information about operating
segments in annual financial statements and, to a lesser extent, in interim
financial reports issued to stockholders. SFAS Nos. 130 and 131 are effective
for the Company beginning in 1998. As these standards deal with the form and
content of financial statement disclosures, the Company does not anticipate that
the adoption of these new standards will have a material impact on its financial
position or results of operations.

     Reclassifications -- Certain amounts as previously reported have been
reclassified to conform to the current year presentation.

 2. TECHNOLOGY ACQUISITION

     On June 30, 1993 (the "Closing Date"), the Company purchased from Hughes
Aircraft Company ("Hughes") certain assets related to Hughes' Sound Retrieval
System (SRS) and ORB product lines for $200,000 cash, a $625,481 note payable
and future royalty payments, subject to certain minimums. The note payable was
paid in full during 1995. The assets acquired included inventory, equipment and
the direct ownership of the SRS technology (goodwill) which had estimated fair
market values at the date of acquisition of $719,030, $106,451 and $678,594,
respectively.

     In accordance with the purchase agreement with Hughes (the "Hughes
Agreement"), the Company is required to pay Hughes additional consideration
based on certain percentages, ranging from 10% to 63% of gross profits, from the
sale of certain products to, and licensing royalties from, certain existing and
target customers, as defined in the Hughes Agreement. Such additional amounts
are payable for a period equal to the longer of the term of the applicable
license agreements or five years. This additional consideration is subject to a
minimum of $180,000 per year (the "Guaranteed Minimum") for five years from the
Closing Date. The aggregate Guaranteed Minimum has been discounted at 10%,
yielding an initial value of $678,594, and is included as part of the purchase
price on June 30, 1993. This balance is reflected as "goodwill" and
"consideration due on asset purchase" in the accompanying balance sheets.
Additional consideration paid during the five-year period in excess of the
Guaranteed Minimum is capitalized and amortized over the remaining estimated
life of goodwill (see Note 1). At the end of the five years subsequent to the
Closing Date, the Company is required to pay Hughes royalties based upon certain
percentages, ranging from 10% to 50% of gross profits from the sale of certain
product to, and licensing royalties from two customers, as defined in the Hughes
Agreement, for an indefinite period.

     In addition, the Company is required to pay Hughes a royalty of 3% of net
sales of all SRS or ORB products manufactured by the Company, excluding
inventory acquired from Hughes as specified in the Hughes Agreement, over the
remaining lives of the applicable patents. There were no sales of applicable
products in the years ended December 31, 1995, 1996 and 1997.

                                       31
<PAGE>   34
                                 SRS LABS, INC.

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997

     Under the terms of the Hughes Agreement, all license fees subject to the
Guaranteed Minimum will be deposited into an escrow account to cover any amounts
due to Hughes under the Hughes Agreement. The note payable and Guaranteed
Minimum payments are secured by assets held in trust owned by one of the
Company's stockholders and substantially all of the Company's assets.

 3. INVESTMENT SECURITIES AVAILABLE FOR SALE

     The following table summarizes the Company's investment securities
available for sale as of December 31, 1996 and 1997.

<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                    --------------------------
                                                       1996           1997
                                                    -----------    -----------
<S>                                                 <C>            <C>
Municipal bonds available for sale:
  Cost............................................  $20,823,302    $21,293,741
  Gross unrealized gains..........................      146,555        273,296
  Gross unrealized losses.........................          (72)
                                                    -----------    -----------
  Estimated fair value............................  $20,969,785    $21,567,037
                                                    ===========    ===========
</TABLE>

     The contractual maturities of investments at December 31, 1996 and 1997 are
shown below. Actual maturities may differ from contractual maturities.

<TABLE>
<CAPTION>
                                        1996                        1997
                              -------------------------   -------------------------
                                             ESTIMATED                   ESTIMATED
                                 COST       FAIR VALUE       COST       FAIR VALUE
                              -----------   -----------   -----------   -----------
<S>                           <C>           <C>           <C>           <C>
Municipal bonds:
  Due in one year or less...  $        --   $        --   $ 2,007,939   $ 2,010,775
  Due in one to five
     years..................   19,823,302    19,969,785    18,285,802    18,556,262
  Due in five to ten
     years..................           --            --            --            --
  Due after ten years.......    1,000,000     1,000,000     1,000,000     1,000,000
                              -----------   -----------   -----------   -----------
                              $20,823,302   $20,969,785   $21,293,741   $21,567,037
                              ===========   ===========   ===========   ===========
</TABLE>

 4. FURNITURE, FIXTURES AND EQUIPMENT

     Furniture, fixtures and equipment consist of the following at December 31,
1996 and 1997:

<TABLE>
<CAPTION>
                                                            DECEMBER 31,
                                                       ----------------------
                                                         1996         1997
                                                       ---------    ---------
<S>                                                    <C>          <C>
Furniture and fixtures...............................  $ 319,866    $ 343,395
Equipment............................................    133,944      174,997
Leasehold improvements...............................      4,641        4,641
                                                       ---------    ---------
                                                         458,451      523,033
Less accumulated depreciation........................   (177,262)    (277,254)
                                                       ---------    ---------
                                                       $ 281,189    $ 245,779
                                                       =========    =========
</TABLE>

 5. COMMITMENTS AND CONTINGENCIES

     The Company leases office space and certain equipment under noncancelable
operating leases.

                                       32
<PAGE>   35
                                 SRS LABS, INC.

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997

     The Company leases its office and storage facilities under a lease
agreement with a partnership which is affiliated with a stockholder and officer
of the Company. The original lease term commenced on June 1, 1994 and expired on
May 31, 1997. Upon expiration, the Company entered into a new lease agreement
for additional space at the same facility with the same lessor. The new lease is
for a term of three years commencing June 1, 1997, with an option to extend the
term for an additional two years thereafter. Total rent expense incurred on
office facilities was $46,447 (net of sublease income of $16,733), $63,430 and
$129,369 for the years ended December 31, 1995, 1996 and 1997, respectively.
Future annual minimum lease payments under noncancelable operating leases at
December 31, 1997 are as follows:

<TABLE>
<CAPTION>
                                                          OFFICE
                                             FACILITY    EQUIPMENT     TOTAL
                                             --------    ---------    --------
<S>                                          <C>         <C>          <C>
1998.......................................  $165,672     $ 8,164     $173,836
1999.......................................   165,672       8,164      173,836
2000.......................................    69,030       6,777       75,807
2001.......................................        --       4,836        4,836
                                             --------     -------     --------
                                             $400,374     $27,941     $428,315
                                             ========     =======     ========
</TABLE>

     As of December 31, 1997, the Company had employment agreements with two
employees. Minimum aggregate compensation remaining under those employment
agreements is $185,000 (1998) and $130,000 (1999).

 6. INCOME TAXES

     For the years ended December 31, 1995, 1996 and 1997, the provision for
income taxes consists of the following:

<TABLE>
<CAPTION>
                                                      DECEMBER 31,
                                          ------------------------------------
                                            1995         1996          1997
                                          ---------    ---------    ----------
<S>                                       <C>          <C>          <C>
Current:
  Federal...............................  $      --    $ 574,970    $1,078,637
  State.................................        800      168,256       482,791
  Foreign...............................         --      163,223       296,157
                                          ---------    ---------    ----------
                                                800      906,449     1,857,585
Deferred:
  Federal...............................   (530,298)     371,428       (15,724)
  State.................................    (97,932)      47,884        21,339
  Valuation Allowance...................    628,230     (824,824)           --
                                          ---------    ---------    ----------
                                          $     800    $ 500,937    $1,863,200
                                          =========    =========    ==========
</TABLE>

                                       33
<PAGE>   36
                                 SRS LABS, INC.

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997

     The reconciliation of the provision for income taxes computed at U.S.
federal statutory rates to the provision for income taxes for the years ended
December 31, 1995, 1996 and 1997 is as follows:

<TABLE>
<CAPTION>
                                                      DECEMBER 31,
                                          ------------------------------------
                                            1995         1996          1997
                                          ---------    ---------    ----------
<S>                                       <C>          <C>          <C>
Tax at U.S. federal statutory rates.....  $(540,859)   $ 803,062    $1,916,382
State income taxes......................    (64,107)     142,653       334,079
Tax exempt interest.....................         --     (105,862)     (365,194)
Restoration of deferred income tax
  assets in connection with the
  Company's conversion to a C
  corporation...........................   (196,594)     126,123            --
Change in valuation allowance...........    824,824     (824,824)           --
Accruals without tax effect.............    (22,464)     359,785       (22,067)
                                          ---------    ---------    ----------
          Total income tax expense......  $     800    $ 500,937    $1,863,200
                                          =========    =========    ==========
</TABLE>

     Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax assets and liabilities are as follows:

<TABLE>
<CAPTION>
                                                      DECEMBER 31,
                                            ---------------------------------
                                              1995         1996        1997
                                            ---------    --------    --------
<S>                                         <C>          <C>         <C>
Deferred tax assets:
  State income taxes......................  $ (48,490)   $ 30,816    $121,952
  Depreciation and amortization...........    154,615     186,576     247,038
  Accruals not currently deductible.......    193,974     188,120      30,907
  Other...................................     45,220          --          --
  Net operating losses....................    479,505          --          --
                                            ---------    --------    --------
                                              824,824     405,512     399,897
  Valuation allowance.....................   (824,824)         --          --
                                            ---------    --------    --------
          Total net deferred tax assets...  $      --    $405,512    $399,897
                                            =========    ========    ========
</TABLE>

     For all periods prior to January 1, 1995, the Company elected to be treated
as an S corporation under the provisions of the Internal Revenue Code. Effective
January 1, 1995, the Company converted to a C corporation and became subject to
regular federal and state income taxes on a go-forward basis.

 7. STOCKHOLDERS' EQUITY

     Sales of Common Stock -- On January 9, 1995, the Company entered into a
Stock Purchase Agreement with Packard Bell Electronics, Inc. ("Packard Bell"),
pursuant to which Packard Bell purchased 572,061 newly issued shares of common
stock at $2.62 per share for a total purchase price of $1,500,000. In connection
with the Stock Purchase Agreement, Packard Bell also entered into (i) a License
Agreement with the Company to license SRS for use in multimedia computers, and
(ii) a Stock Option Agreement with the Company whereby the Company granted an
option to purchase 382,104 shares of common stock at an exercise price of $4.14
per share.

     During the years ended December 31, 1995 and 1996, the Company recorded
$50,000 and $29,000, respectively, of additional paid-in capital related to the
estimated fair value of services performed by a Company officer for which no
cash consideration was paid by the Company.

                                       34
<PAGE>   37
                                 SRS LABS, INC.

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997

     In August 1996, the Company completed an initial public offering of
3,107,452 shares of its common stock at an offering price of $8.00 per share for
net proceeds of approximately $22 million.

     Reclassification -- Upon electing to revoke its election to be taxed as an
S corporation (see Note 1), on January 1, 1995, in accordance with a regulation
of the Securities and Exchange Commission, the Company reclassified its
accumulated deficit of $2,110,026 to additional paid-in capital.

     Stock Award/Option Plans -- On December 10, 1993, the Company's Board of
Directors and shareholders adopted an Incentive Stock Option, Nonqualified Stock
Option and Restricted Stock Purchase Plan (the "1993 Plan"). Under the 1993
Plan, 801,971 shares of the Company's common stock are reserved for issuance to
executives, employees and non-employee directors of the Company at the
discretion of the Board of Directors or the committee administering the 1993
Plan. The Compensation Committee of the Board has been appointed to administer
the 1993 Plan. Options issued under the 1993 Plan vest in the manner prescribed
by the Compensation Committee. As of December 31, 1997, options to purchase
801,971 shares of the Company's common stock were granted under the 1993 Plan.

     In January 1994, the Company entered into stock option agreements with two
Company officers whereby options to purchase 181,032 shares of the Company's
common stock were granted to each of the officers at an exercise price of $0.14
per share (collectively, the "Executive Option Agreements").

     In June 1997, the Company's Board of Directors adopted, and the Company's
stockholders approved, the Amended and Restated 1996 Long-Term Incentive Plan
(the "1996 Plan"), for which 2,000,000 shares of the Company's common stock are
reserved for issuance to officers, employees and consultants of the Company. The
Compensation Committee of the Board of Directors has been appointed to
administer the 1996 Plan. Options issued under the 1996 Plan vest in the manner
prescribed by the Compensation Committee. As of December 31, 1997, options to
purchase 1,131,301 shares of the Company's common stock were granted under the
1996 Plan.

     In July 1996, the Company's Board of Directors adopted, and the Company's
stockholders approved, the 1996 Non-employee Directors Stock Option Plan (the
"Non-employee Directors Plan"), a non-discretionary formula plan for which
120,000 shares of the Company's common stock are reserved for issuance to the
Company's Non-employee Directors. The Non-employee Directors Plan is
administered by a committee consisting of all directors who are not eligible to
participate in the Non-employee Directors Plan and the Chief Financial Officer
of the Company. With the exception of the initial option granted to a
non-employee director, which vests immediately, options granted under the
Non-employee Directors Plan vest over a three-year period, the first installment
vesting on the date of grant. As of December 31, 1997, options to purchase
45,000 shares of common stock were granted under the Non-employee Directors
Plan.

                                       35
<PAGE>   38
                                 SRS LABS, INC.

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997

     The following table summarizes stock option activity under the 1993 Plan,
the 1996 Plan, the Executive Option Agreements, the Non-employee Director Plan
and the stock option grant to Packard Bell for the periods indicated:

<TABLE>
<CAPTION>
                                                                       WEIGHTED
                                                                       AVERAGE
                                                          OPTIONS      EXERCISE
                                                        OUTSTANDING     PRICE
                                                        -----------    --------
<S>                                                     <C>            <C>
Outstanding at January 1, 1995........................     939,194      $ 0.28
  Granted.............................................     936,424      $ 3.81
                                                        ----------
Outstanding at December 31, 1995......................   1,875,618      $ 2.04
  Granted.............................................     688,386      $ 8.11
  Stock options exercised.............................    (362,064)     $ 0.28
  Forfeited...........................................     (25,344)     $10.36
                                                        ----------
Outstanding at December 31, 1996......................   2,176,596      $ 4.16
  Granted.............................................   1,366,801      $ 5.70
  Stock options exercised.............................    (141,319)     $ 1.02
  Forfeited...........................................  (1,017,582)     $ 7.68
                                                        ----------
Outstanding at December 31, 1997......................   2,384,496      $ 3.69
                                                        ==========
</TABLE>

     The following table summarizes information concerning currently outstanding
and exercisable options:

<TABLE>
<CAPTION>
                                       WEIGHTED
                                       AVERAGE
                        NUMBER OF     REMAINING        WEIGHTED                       WEIGHTED
                         OPTIONS     CONTRACTUAL       AVERAGE         NUMBER         AVERAGE
                       OUTSTANDING       LIFE       EXERCISE PRICE   EXERCISABLE   EXERCISE PRICE
                       -----------   ------------   --------------   -----------   --------------
<S>                    <C>           <C>            <C>              <C>           <C>
Range of exercise
  prices:
  $0.14 - $ 0.76.....     457,174      73 months        $0.26           426,395        $0.22
  $2.62 - $ 4.56.....     902,026      87 months        $3.80           632,107        $3.90
  $5.00 - $10.50.....   1,025,296     105 months        $5.12           238,262        $5.04
                        ---------                                     ---------
                        2,384,496                       $3.69         1,296,764        $2.90
                        =========                                     =========
</TABLE>

     On December 1, 1995, options were granted for the purchase of up to 300,875
common shares at prices of $4.14 to $4.56 per share, which the Company's Board
of Directors deemed the fair market value of the common stock at the date of
grant. The Company will record compensation expense resulting from the
difference between the option price per share and the estimated fair market
value of the common stock ($4.99) determined by a third-party appraisal
completed in May 1996, totaling $236,456. This amount will be recorded ratably
over the vesting period of the respective options. During the years ended
December 31, 1995, 1996 and 1997, the Company had recorded $21,965, $132,421 and
$56,397, respectively, of deferred compensation expense associated with these
stock option grants.

                                       36
<PAGE>   39
                                 SRS LABS, INC.

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997

     SFAS No. 123, Accounting for Stock-Based Compensation, requires the
disclosure of pro forma net income and earnings per share had the Company
adopted the fair value method as of the beginning of fiscal 1995. Under SFAS No.
123, the fair value of stock-based awards to employees is calculated through the
use of option pricing models, even though such models were developed to estimate
the fair value of freely tradable, fully transferable options without vesting
restrictions, which significantly differ from the Company's stock option awards.
These models also require subjective assumptions, including future stock price
volatility and expected time to exercise, which greatly affect the calculated
values. The Company's calculations were made using the Black-Scholes option
pricing model with the following weighted average assumptions:

<TABLE>
<CAPTION>
                                           1995         1996         1997
                                         ---------    ---------    ---------
<S>                                      <C>          <C>          <C>
Expected Life..........................  60 months    60 months    60 months
Stock Volatility.......................         1%           1%          69%
Risk-Free Interest Rate................      5.50%        5.50%        5.45%
</TABLE>

     The Company's calculations are based on a single-option valuation approach
and forfeitures are recognized as they occur. If the computed fair values of the
1995, 1996 and 1997 awards had been amortized to expense over the vesting period
of the awards, pro forma net income (loss) would have been ($1,659,858), or
($.28) per share in 1995, $1,762,497, or $.21 per share in 1996 and $3,429,526,
or $.32 per share in 1997. However, the impact of outstanding nonvested stock
options granted prior to 1995 has been excluded from the pro forma calculation;
accordingly, the 1995, 1996 and 1997 pro forma adjustments are not indicative of
future period pro forma adjustments, when the calculation will apply to all
applicable stock options.

 8. RELATED PARTY TRANSACTIONS

     The Company shares certain general and administrative expenses with an
affiliated company which is 100% owned by a Company officer/stockholder.
Pursuant to a written agreement, one-half of these expenses are allocated to the
Company.

     Total revenue from an affiliated company during the years ended December
31, 1995, 1996 and 1997, which is 100% owned by a Company officer/stockholder,
amounted to $71,217, $28,449 and $17,779, respectively. As of December 31, 1996
and 1997 accounts receivable from this affiliated company were $3,000 and
$4,395, respectively. Amounts due to this affiliated company were $12,639 and
$18,266 as of December 31, 1996 and 1997, respectively.

     An officer/stockholder of the Company has pledged certain personal assets
to secure amounts due related to the acquisition of certain assets (see Note 2).

     A stockholder of the Company paid $1,500,000 and $2,500,000 in license
royalties to the Company during the years ended December 31, 1996 and 1997.

 9. EMPLOYEE BENEFIT PLAN

     The Company's employees may participate in a salary deferral plan (the
"401(k) Plan") in which eligible employees can contribute up to 15% of their
eligible compensation. The Company also may contribute on a discretionary basis.
During the years ended December 31, 1995, 1996 and 1997, the Company did not
contribute to the 401(k) Plan.

10. SUBSEQUENT EVENTS

     On January 28, 1998, the Company completed the acquisition of all rights
associated with the VIP (Voice Intelligibility Processor) technology from R.G.A.
& Associates ("R.G.A."). The approximate aggregate purchase price of the
acquisition was $1,000,000, consisting of $500,000 in cash, 25,000 shares of

                                       37
<PAGE>   40
                                 SRS LABS, INC.

                   NOTES TO FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997

the Company's common stock and 100,000 warrants to purchase the Company's common
stock. In connection with the acquisition, the Company entered into an agreement
to pay R.G.A. royalties based upon certain percentages ranging from 10% to 15%
of licensing royalties generated from VIP for a period of 4 years.

     On March 2, 1998, the Company acquired all of the outstanding shares of
capital stock of Valence Technology Inc., a British Virgin Islands holding
company with its principal business operations in Hong Kong and China
("Valence"). Valence, which conducts its business through its subsidiaries based
in Hong Kong and China, is engaged in two primary areas of business, namely, the
design, manufacture and marketing of ASIC (application-specific integrated
circuit) products and consumer electronic products. The aggregate purchase price
of $19,500,000 consisted of approximately $7,400,000 in cash and approximately
1,680,000 shares of the Company's common stock. The acquisition will be
accounted for as a purchase. In connection with such acquisition, three of the
four shareholders and their respective sole shareholders, each of whom was a key
employee of Valence or one of its subsidiaries, entered into noncompetition
agreements with the Company. In consideration for these agreements and for a
nominal cash payment equal to the par value of the shares, the Company issued an
aggregate of an additional 125,000 shares of its common stock to such three
shareholders.

     On March 4, 1998, the Company obtained a revolving line of credit (the
"Credit Agreement") with a bank which expires on June 1, 2000 and is secured by
certain of the Company's investments. The total availability under the line of
credit is the lesser of $10 million or a percentage of the fair market value of
the collateral. The line of credit bears interest at the bank's prime rate or
LIBOR plus 0.75%.

                                       38
<PAGE>   41

ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

     Not Applicable.

                                    PART III

ITEM 9.DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE
       WITH SECTION 16(A) OF THE EXCHANGE ACT

     The information set forth under the captions "ELECTION OF DIRECTORS" and
"TRANSACTIONS WITH MANAGEMENT AND OTHERS -- Section 16(a) Beneficial Ownership
Reporting Compliance" in the Company's definitive proxy statement (the "Proxy
Statement") for the Annual Meeting of Stockholders scheduled to be held in June
1998, is incorporated herein by reference. The Proxy Statement will be filed
with the U.S. Securities and Exchange Commission (the "Commission") not later
than 120 days after the close of Fiscal 1997.

ITEM 10. EXECUTIVE COMPENSATION

     The information set forth under the captions "COMPENSATION OF EXECUTIVE
OFFICERS" and "INFORMATION ABOUT THE BOARD OF DIRECTORS AND COMMITTEES OF THE
BOARD -- Compensation of Directors" in the Proxy Statement is incorporated
herein by reference.

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The information set forth under the caption "SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT" in the Proxy Statement is incorporated herein
by reference.

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     The information set forth under the caption "TRANSACTIONS WITH MANAGEMENT
AND OTHERS" in the Proxy Statement is incorporated herein by reference.

                                    PART IV

ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K

(a) EXHIBITS.

     The Exhibits listed below are hereby filed with the Commission as part of
this Report.

<TABLE>
<CAPTION>
EXHIBIT
  NO.                            DESCRIPTION
-------                          -----------
<C>      <S>
   2.1   Stock Purchase Agreement dated as of February 24, 1998, by
         and among the Company, Valence Technology Inc., Thomrose
         Holdings (BVI) Limited, Rayfa (BVI) Limited, Cape Spencer
         International Limited, and Anki (BVI) Limited, previously
         filed with the Commission as Exhibit 2.1 to the Company's
         Current Report on Form 8-K filed with the Commission on
         March 13, 1998 (the "Form 8-K"), which is incorporated
         herein by reference.
   2.2   Stock Purchase Agreement dated as of February 24, 1998, by
         and between the Company and North 22 Capital Partners 2,
         Inc., previously filed with the Commission as Exhibit 2.2 to
         the Form 8-K, which is incorporated herein by reference.
   2.3   Asset Purchase Agreement dated as of January 28, 1998,
         between the Company and R.G.A. & Associates, Ltd. d/b/a
         ToteVision and VIP Labs(R).
   3.1   Certificate of Incorporation of the Company, previously
         filed with the Commission as Exhibit 3.1 to the Company's
         Registration Statement on Form SB-2, specifically included
         in Amendment No. 1 to such Registration Statement filed with
         the Commission on July 3, 1996 (File No. 333-4974-LA) (the
         "Registration Statement Amendment No. 1"), which is
         incorporated herein by reference.
</TABLE>

                                       39
<PAGE>   42

<TABLE>
<CAPTION>
EXHIBIT
  NO.                            DESCRIPTION
-------                          -----------
<C>      <S>
   3.2   Bylaws of the Company, previously filed with the Commission
         as Exhibit 3.2 to the Registration Statement Amendment No.
         1, which is incorporated herein by reference.

         Material Contracts Relating to Management Compensation Plans
         or Arrangements

  10.1   Employment Agreement dated July 1, 1996, between the Company
         and Thomas C.K. Yuen, previously filed with the Commission
         as Exhibit 10.8 to the Registration Statement Amendment No.
         1, which is incorporated herein by reference.
  10.2   Amendment to Employment Agreement dated as of March 14,
         1997, between the Company and Thomas C.K. Yuen, previously
         filed with the Commission as Exhibit 10.2 to the Company's
         Annual Report on Form 10-KSB for the fiscal year ended
         December 31, 1996, filed with the Commission on March 31,
         1997 (the "1996 Annual Report"), which is incorporated
         herein by reference.
  10.3   Employment Agreement dated July 1, 1996, between the Company
         and Stephen V. Sedmak, previously filed with the Commission
         as Exhibit 10.9 to the Registration Statement Amendment No.
         1, which is incorporated herein by reference.
  10.4   Employment Agreement dated July 1, 1996, between the Company
         and Arnold I. Klayman, previously filed with the Commission
         as Exhibit 10.10 to the Registration Statement Amendment No.
         1, which is incorporated herein by reference.
  10.5   Amendment to Employment Agreement dated as of March 14,
         1997, between the Company and Arnold I. Klayman, previously
         filed as Exhibit 10.5 to the 1996 Annual Report, which is
         incorporated herein by reference.
  10.6   Employment Agreement dated July 1, 1996, between the Company
         and Alan D. Kraemer, previously filed with the Commission as
         Exhibit 10.11 to the Registration Statement Amendment No. 1,
         which is incorporated herein by reference.
  10.7   Letter Agreement of Employment dated September 6, 1996,
         between the Company and Robert A. Veri, previously filed as
         Exhibit 10.7 to the 1996 Annual Report, which is
         incorporated herein by reference.
  10.8   SRS Labs, Inc. Incentive Stock Option, Nonqualified Stock
         Option and Restricted Purchase Plan -- 1993, as amended and
         restated, previously filed with the Commission as Exhibit
         10.12 to the Company's Registration Statement on Form SB-2
         filed with the Commission on June 3, 1996 (File No.
         333-4974-LA) (the "Registration Statement"), which is
         incorporated herein by reference.
  10.9   Stock Option Agreement dated January 19, 1994, between the
         Company and Stephen V. Sedmak, as amended, previously filed
         with the Commission as Exhibit 10.13 to the Registration
         Statement, which is incorporated herein by reference.
  10.10  Stock Option Agreement dated January 19, 1994, between the
         Company and James S. Lucas, previously filed with the
         Commission as Exhibit 10.14 to the Registration Statement,
         which is incorporated herein by reference.
  10.11  SRS Labs, Inc. Amended and Restated 1996 Long-Term Incentive
         Plan, previously filed with the Commission as Appendix A to
         the Company's definitive Proxy Statement dated April 30,
         1997, filed with the Commission on April 30, 1997, which is
         incorporated herein by reference.
  10.12  SRS Labs, Inc. 1996 Nonemployee Directors Stock Option Plan,
         previously filed with the Commission as Exhibit 10.16 to the
         Registration Statement Amendment No. 1, which is
         incorporated herein by reference.
  10.13  Annual Incentive Bonus Plan, previously filed with the
         Commission as Exhibit 10.18 to the Registration Statement
         Amendment No. 1, which is incorporated herein by reference.
  10.14  SRS Labs, Inc. Supplemental Executive Incentive Bonus Plan,
         previously filed with the Commission as Exhibit 10.14 to the
         1996 Annual Report, which is incorporated herein by
         reference.
  10.15  Form of Indemnification Agreement, previously filed with the
         Commission as Exhibit 10.20 to the Registration Statement
         Amendment No. 1, which is incorporated herein by reference.
</TABLE>

                                       40
<PAGE>   43

<TABLE>
<CAPTION>
EXHIBIT
  NO.                            DESCRIPTION
-------                          -----------
<C>      <S>
  10.16  Employment Agreement dated as of March 2, 1998, by and among
         the Company, Valence Technology Inc., and Thomas Wah Tong
         Wan.
  10.17  Employment Agreement dated as of March 2, 1998, by and among
         the Company, Valence Semiconductor Design Limited, and Choi
         Yat Ming.
  10.18  Employment Agreement dated as of March 2, 1998, by and among
         the Company, LEC Electronic Components Limited, and Wong Yin
         Bun.
  10.19  Noncompetition Agreement dated as of March 2, 1998, by and
         among the Company, Thomrose Holdings (BVI) Limited, and
         Thomas Wah Tong Wan, previously filed with the Commission as
         Exhibit 2.5 to the Form 8-K, which is incorporated herein by
         reference.
  10.20  Noncompetition Agreement dated as of March 2, 1998, by and
         among the Company, Cape Spencer International Limited and
         Wong Yin Bun, previously filed with the Commission as
         Exhibit 2.6 to the Form 8-K, which is incorporated herein by
         reference.
  10.21  Noncompetition Agreement dated as of March 2, 1998, by and
         among the Company, Rayfa (BVI) Limited and Choi Yat Ming,
         previously filed with the Commission as Exhibit 2.7 to the
         Form 8-K, which is incorporated herein by reference.

         Other Material Contracts

  10.22  Shareholders Agreement dated as of January 27, 1994, between
         the Company and the Shareholders of the Company named
         therein, previously filed with the Commission as Exhibit 9.3
         to the Company's Registration Statement on Form SB-2,
         specifically included in Amendment No. 2 to such
         Registration Statement filed with the Commission on August
         2, 1996 (File No. 333-4974-LA) (the "Registration Statement
         Amendment No. 2"), which is incorporated herein by
         reference.
  10.23  Shareholders Agreement II dated as of January 9, 1995,
         between the Company and the Shareholders of the Company
         named therein, previously filed with the Commission as
         Exhibit 9.1 to the Registration Statement, which is
         incorporated herein by reference.
  10.24  Shareholders Agreement III dated as of April 21, 1995,
         between the Company and the Shareholders of the Company
         named therein, previously filed with the Commission as
         Exhibit 9.2 to the Registration Statement, which is
         incorporated herein by reference. 10.25 Asset Purchase
         Agreement dated as of June 30, 1993, between the Company and
         Hughes Aircraft, previously filed with the Commission as
         Exhibit 10.1 to the Registration Statement, which is
         incorporated herein by reference.
  10.25  Asset Purchase Agreement dated as of June 30, 1993, between
         the Company and Hughes Aircraft, previously filed with the
         Commission as Exhibit 10.1 to the Registration Statement,
         which is incorporated herein by reference.
  10.26  First Amendment to Security Agreement dated as of September
         14, 1994, by and among the Company, Hughes Aircraft,
         Cruttenden & Company, Walter W. Cruttenden III, Pacific
         National Bank and The Thomas Yuen Family Trust, previously
         filed with the Commission as Exhibit 10.2 to the
         Registration Statement, which is incorporated herein by
         reference.
  10.27  Stock Purchase Agreement dated as of January 9, 1995,
         between the Company and Packard Bell Electronics, Inc. d/b/a
         Packard Bell Corporation, previously filed with the
         Commission as Exhibit 10.3 to the Registration Statement
         Amendment No. 2, which is incorporated herein by reference.
  10.28  Amended and Restated Stock Option Agreement dated as of
         January 9, 1995, between the Company and Packard Bell
         Electronics, Inc. d/b/a/ Packard Bell Corporation,
         previously filed with the Commission as Exhibit 10.4 to the
         Registration Statement, which is incorporated herein by
         reference.
</TABLE>

                                       41
<PAGE>   44

<TABLE>
<CAPTION>
EXHIBIT
  NO.                            DESCRIPTION
-------                          -----------
<C>      <S>
  10.29  License Agreement dated as of January 9, 1995, between the
         Company and Packard Bell Electronics, Inc. d/b/a/ Packard
         Bell Corporation, previously filed with the Commission as
         Exhibit 10.5 to the Company's Registration Statement on Form
         SB-2, specifically included in Amendment No. 3 to such
         Registration Statement filed with the Commission on August
         7, 1996 (File No. 333-4974-LA) (the "Registration Statement
         Amendment No. 3"), which is incorporated herein by
         reference.
  10.30  License Agreement dated as of June 27, 1988, between Hughes
         Aircraft and Sony Corporation, as amended and assigned to
         the Company, previously filed with the Commission as Exhibit
         10.6 to the Registration Statement Amendment No. 3, which is
         incorporated herein by reference.
  10.31  Real Property Lease dated June 1, 1994, between the Company
         and Daimler Commerce Partners, L.P., a California Limited
         Partnership, previously filed with the Commission as Exhibit
         10.7 to the Registration Statement, which is incorporated
         herein by reference.
  10.32  Industrial Real Estate Lease dated May 30, 1997, between the
         Company and Daimler Commerce Partners, L.P., previously
         filed with the Commission as Exhibit 10.1 to the Company's
         Form 10-QSB for the quarterly period ended June 30, 1997,
         filed with the Commission on August 13, 1997, which is
         incorporated herein by reference.
  10.33  Tenancy Agreement dated September 1, 1995, by and between
         Hong Kong Industrial Technology Centre Corporation and
         Valence Semiconductor Design Limited relating to the
         premises located at Unit 413 on the Fourth Floor of the Hong
         Kong Industrial Technology Centre.
  10.34  Tenancy Agreement commencing January 1, 1998, by and between
         Jugada Company Limited and Valence Semiconductor Design
         Limited relating to the premises located at Workshops Nos.
         1, 2, 3, 4, 5, 6, 7 and 8 on the 19th Floor of APEC Plaza,
         No. 49 Hoi Yuen Road, Kwun Tong, Hong Kong.
  10.35  Stock Divestment Agreement dated July 1, 1996, between the
         Company, Thomas C.K. Yuen, Stephen V. Sedmak and Walter W.
         Cruttenden III, previously filed with the Commission as
         Exhibit 10.17 to the Registration Statement Amendment No. 2,
         which is incorporated herein by reference.
  10.36  Services Agreement dated July 1, 1996, between the Company
         and Sierra Digital Productions, Inc., previously filed with
         the Commission as Exhibit 10.19 to the Registration
         Statement Amendment No. 1, which is incorporated herein by
         reference.
  10.37  Registration Rights Agreement dated as of January 28, 1998,
         by and between the Company and R.G.A. & Associates, Ltd.,
         d/b/a ToteVision and VIP Labs(R) and William S. Taraday.
  10.38  Warrant to Purchase 94,000 Shares of Common Stock of the
         Company dated February 26, 1998, held by R.G.A. &
         Associates, Ltd., d/b/a ToteVision and VIP Labs(R).
  10.39  Warrant to Purchase 2,500 Shares of Common Stock of the
         Company dated February 26, 1998, held by Herbert H. Wax.
  10.40  Warrant to Purchase 2,500 Shares of Common Stock of the
         Company dated February 26, 1998, held by Steven E. Loyd.
  10.41  Warrant to Purchase 1,000 Shares of Common Stock of the
         Company dated February 26, 1998, held by the Van Valkenberg
         Furber Law Group, P.L.L.C.
  10.42  Business Loan Agreement dated March 4, 1998, between the
         Company and Bank of America National Trust and Savings
         Association.
  21     Subsidiaries.
  23     Consent of Deloitte & Touche LLP dated March 30, 1998.
  24     Power of attorney (included on page 44 of the Form 10-KSB).
  27.1   Financial Data Schedule (FYE 1997).
  27.2   Financial Data Schedule (Q 1-3, 1997, Restated).
  27.3   Financial Data Schedule (Q 3 and FYE 1996, Restated).
</TABLE>

                                       42
<PAGE>   45

(b) REPORTS ON FORM 8-K.

     No reports on Form 8-K were filed during the fourth quarter of the fiscal
year covered by this Form 10-KSB.

                (This portion of page intentionally left blank)

                                       43
<PAGE>   46

                                   SIGNATURES

     In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.

                                          SRS LABS, INC., a Delaware corporation

Date: March 30, 1998                      By:       /s/  THOMAS C.K. YUEN
                                              ----------------------------------
                                                     Thomas C.K. Yuen
                                                Chairman of the Board and
                                                 Chief Executive Officer

                               POWER OF ATTORNEY

     KNOW ALL MEN BY THESE PRESENTS, that such person whose signature appears
below constitutes and appoints Stephen V. Sedmak and Janet M. Biski, and each of
them his true and lawful attorneys-in-fact and agents, with full power of
substitution and resubstitution, for him and in his name, place and stead, in
any and all capacities, to sign any and all amendments to this Form 10-KSB and
to file the same, with all exhibits thereto, and other documents in connection
therewith, with the U.S. Securities and Exchange Commission, granting unto said
attorneys-in-fact and agents, and each of them, full power and authority to do
and perform each and every act and thing requisite and necessary to be done in
and about the premises, as fully to all intents and purposes as he might or
could do in person, hereby ratifying and confirming all that said
attorneys-in-fact and agents, or any of them, or their or his substitute or
substitutes, may lawfully do or cause to be done by virtue hereof.

     In accordance with the Exchange Act, this report has been signed below by
the following persons on behalf of the registrant and in the capacities and on
the dates indicated.

<TABLE>
<CAPTION>
                          NAME                                      CAPACITY                  DATE
                          ----                                      --------                  ----
<S>                                                       <C>                            <C>

                  /s/ THOMAS C.K. YUEN                      Director, Chairman of the    March 30, 1998
--------------------------------------------------------    Board and Chief Executive
                    Thomas C.K. Yuen                      Officer (Principal Executive
                                                                    Officer)

                 /s/ STEPHEN V. SEDMAK                    Director, President and Chief  March 30, 1998
--------------------------------------------------------        Operating Officer
                   Stephen V. Sedmak

                   /s/ JANET M. BISKI                         Vice President, Chief      March 30, 1998
--------------------------------------------------------  Financial Officer, Secretary
                     Janet M. Biski                         and Treasurer (Principal
                                                            Financial and Accounting
                                                                    Officer)

                                                           Director and Vice President
--------------------------------------------------------
                    Thomas W.T. Wan

                    /s/ JOHN AUYEUNG                                Director             March 30, 1998
--------------------------------------------------------
                      John Auyeung

               /s/ JEFFREY I. SCHEINROCK                            Director             March 30, 1998
--------------------------------------------------------
                 Jeffrey I. Scheinrock

                      /s/ JOHN TU                                   Director             March 30, 1998
--------------------------------------------------------
                        John Tu
</TABLE>

                                       44
<PAGE>   47

                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
    EXHIBIT
      NO.                             DESCRIPTION
    -------                           -----------
    <C>       <S>
      2.1     Stock Purchase Agreement dated as of February 24, 1998, by
              and among the Company, Valence Technology Inc., Thomrose
              Holdings (BVI) Limited, Rayfa (BVI) Limited, Cape Spencer
              International Limited, and Anki (BVI) Limited, previously
              filed with the Commission as Exhibit 2.1 to the Company's
              Current Report on Form 8-K filed with the Commission on
              March 13, 1998 (the "Form 8-K"), which is incorporated
              herein by reference.
      2.2     Stock Purchase Agreement dated as of February 24, 1998, by
              and between the Company and North 22 Capital Partners 2,
              Inc., previously filed with the Commission as Exhibit 2.2 to
              the Form 8-K, which is incorporated herein by reference.
      2.3     Asset Purchase Agreement dated as of January 28, 1998,
              between the Company and R.G.A. & Associates, Ltd. d/b/a
              ToteVision and VIP Labs(R).
      3.1     Certificate of Incorporation of the Company, previously
              filed with the Commission as Exhibit 3.1 to the Company's
              Registration Statement on Form SB-2, specifically included
              in Amendment No. 1 to such Registration Statement filed with
              the Commission on July 3, 1996 (File No. 333-4974-LA) (the
              "Registration Statement Amendment No. 1"), which is
              incorporated herein by reference.
      3.2     Bylaws of the Company, previously filed with the Commission
              as Exhibit 3.2 to the Registration Statement Amendment No.
              1, which is incorporated herein by reference.

              Material Contracts Relating to Management Compensation Plans
              or Arrangements

     10.1     Employment Agreement dated July 1, 1996, between the Company
              and Thomas C.K. Yuen, previously filed with the Commission
              as Exhibit 10.8 to the Registration Statement Amendment No.
              1, which is incorporated herein by reference.
     10.2     Amendment to Employment Agreement dated as of March 14,
              1997, between the Company and Thomas C.K. Yuen, previously
              filed with the Commission as Exhibit 10.2 to the Company's
              Annual Report on Form 10-KSB for the fiscal year ended
              December 31, 1996, filed with the Commission on March 31,
              1997 (the "1996 Annual Report"), which is incorporated
              herein by reference.
     10.3     Employment Agreement dated July 1, 1996, between the Company
              and Stephen V. Sedmak, previously filed with the Commission
              as Exhibit 10.9 to the Registration Statement Amendment No.
              1, which is incorporated herein by reference.
     10.4     Employment Agreement dated July 1, 1996, between the Company
              and Arnold I. Klayman, previously filed with the Commission
              as Exhibit 10.10 to the Registration Statement Amendment No.
              1, which is incorporated herein by reference.
     10.5     Amendment to Employment Agreement dated as of March 14,
              1997, between the Company and Arnold I. Klayman, previously
              filed as Exhibit 10.5 to the 1996 Annual Report, which is
              incorporated herein by reference.
     10.6     Employment Agreement dated July 1, 1996, between the Company
              and Alan D. Kraemer, previously filed with the Commission as
              Exhibit 10.11 to the Registration Statement Amendment No. 1,
              which is incorporated herein by reference.
     10.7     Letter Agreement of Employment dated September 6, 1996,
              between the Company and Robert A. Veri, previously filed as
              Exhibit 10.7 to the 1996 Annual Report, which is
              incorporated herein by reference.
     10.8     SRS Labs, Inc. Incentive Stock Option, Nonqualified Stock
              Option and Restricted Purchase Plan -- 1993, as amended and
              restated, previously filed with the Commission as Exhibit
              10.12 to the Company's Registration Statement on Form SB-2
              filed with the Commission on June 3, 1996 (File No.
              333-4974-LA) (the "Registration Statement"), which is
              incorporated herein by reference.
</TABLE>
<PAGE>   48

<TABLE>
<CAPTION>
    EXHIBIT
      NO.                             DESCRIPTION
    -------                           -----------
    <C>       <S>
     10.9     Stock Option Agreement dated January 19, 1994, between the
              Company and Stephen V. Sedmak, as amended, previously filed
              with the Commission as Exhibit 10.13 to the Registration
              Statement, which is incorporated herein by reference.
     10.10    Stock Option Agreement dated January 19, 1994, between the
              Company and James S. Lucas, previously filed with the
              Commission as Exhibit 10.14 to the Registration Statement,
              which is incorporated herein by reference.
     10.11    SRS Labs, Inc. Amended and Restated 1996 Long-Term Incentive
              Plan, previously filed with the Commission as Appendix A to
              the Company's definitive Proxy Statement dated April 30,
              1997, filed with the Commission on April 30, 1997, which is
              incorporated herein by reference.
     10.12    SRS Labs, Inc. 1996 Nonemployee Directors Stock Option Plan,
              previously filed with the Commission as Exhibit 10.16 to the
              Registration Statement Amendment No. 1, which is
              incorporated herein by reference.
     10.13    Annual Incentive Bonus Plan, previously filed with the
              Commission as Exhibit 10.18 to the Registration Statement
              Amendment No. 1, which is incorporated herein by reference.
     10.14    SRS Labs, Inc. Supplemental Executive Incentive Bonus Plan,
              previously filed with the Commission as Exhibit 10.14 to the
              1996 Annual Report, which is incorporated herein by
              reference.
     10.15    Form of Indemnification Agreement, previously filed with the
              Commission as Exhibit 10.20 to the Registration Statement
              Amendment No. 1, which is incorporated herein by reference.
     10.16    Employment Agreement dated as of March 2, 1998, by and among
              the Company,Valence Technology Inc., and Thomas Wah Tong
              Wan.
     10.17    Employment Agreement dated as of March 2, 1998, by and among
              the Company, Valence Semiconductor Design Limited, and Choi
              Yat Ming.
     10.18    Employment Agreement dated as of March 2, 1998, by and among
              the Company, LEC Electronic Components Limited, and Wong Yin
              Bun.
     10.19    Noncompetition Agreement dated as of March 2, 1998, by and
              among the Company, Thomrose Holdings (BVI) Limited, and
              Thomas Wah Tong Wan, previously filed with the Commission as
              Exhibit 2.5 to the Form 8-K, which is incorporated herein by
              reference.
     10.20    Noncompetition Agreement dated as of March 2, 1998, by and
              among the Company, Cape Spencer International Limited and
              Wong Yin Bun, previously filed with the Commission as
              Exhibit 2.6 to the Form 8-K, which is incorporated herein by
              reference.
     10.21    Noncompetition Agreement dated as of March 2, 1998, by and
              among the Company, Rayfa (BVI) Limited and Choi Yat Ming,
              previously filed with the Commission as Exhibit 2.7 to the
              Form 8-K, which is incorporated herein by reference.

              Other Material Contracts

     10.22    Shareholders Agreement dated as of January 27, 1994, between
              the Company and the Shareholders of the Company named
              therein, previously filed with the Commission as Exhibit 9.3
              to the Company's Registration Statement on Form SB-2,
              specifically included in Amendment No. 2 to such
              Registration Statement filed with the Commission on August
              2, 1996 (File No. 333-4974-LA) (the "Registration Statement
              Amendment No. 2"), which is incorporated herein by
              reference.
     10.23    Shareholders Agreement II dated as of January 9, 1995,
              between the Company and the Shareholders of the Company
              named therein, previously filed with the Commission as
              Exhibit 9.1 to the Registration Statement, which is
              incorporated herein by reference.
     10.24    Shareholders Agreement III dated as of April 21, 1995,
              between the Company and the Shareholders of the Company
              named therein, previously filed with the Commission as
              Exhibit 9.2 to the Registration Statement, which is
              incorporated herein by reference.
</TABLE>
<PAGE>   49

<TABLE>
<CAPTION>
    EXHIBIT
      NO.                             DESCRIPTION
    -------                           -----------
    <C>       <S>
     10.25    Asset Purchase Agreement dated as of June 30, 1993, between
              the Company and Hughes Aircraft, previously filed with the
              Commission as Exhibit 10.1 to the Registration Statement,
              which is incorporated herein by reference.
     10.26    First Amendment to Security Agreement dated as of September
              14, 1994, by and among the Company, Hughes Aircraft,
              Cruttenden & Company, Walter W. Cruttenden III, Pacific
              National Bank and The Thomas Yuen Family Trust, previously
              filed with the Commission as Exhibit 10.2 to the
              Registration Statement, which is incorporated herein by
              reference.
     10.27    Stock Purchase Agreement dated as of January 9, 1995,
              between the Company and Packard Bell Electronics, Inc. d/b/a
              Packard Bell Corporation, previously filed with the
              Commission as Exhibit 10.3 to the Registration Statement
              Amendment No. 2, which is incorporated herein by reference.
     10.28    Amended and Restated Stock Option Agreement dated as of
              January 9, 1995, between the Company and Packard Bell
              Electronics, Inc. d/b/a/ Packard Bell Corporation,
              previously filed with the Commission as Exhibit 10.4 to the
              Registration Statement, which is incorporated herein by
              reference.
     10.29    License Agreement dated as of January 9, 1995, between the
              Company and Packard Bell Electronics, Inc. d/b/a/ Packard
              Bell Corporation, previously filed with the Commission as
              Exhibit 10.5 to the Company's Registration Statement on Form
              SB-2, specifically included in Amendment No. 3 to such
              Registration Statement filed with the Commission on August
              7, 1996 (File No. 333-4974-LA) (the "Registration Statement
              Amendment No. 3"), which is incorporated herein by
              reference.
     10.30    License Agreement dated as of June 27, 1988, between Hughes
              Aircraft and Sony Corporation, as amended and assigned to
              the Company, previously filed with the Commission as Exhibit
              10.6 to the Registration Statement Amendment No. 3, which is
              incorporated herein by reference.
     10.31    Real Property Lease dated June 1, 1994, between the Company
              and Daimler Commerce Partners, L.P., a California Limited
              Partnership, previously filed with the Commission as Exhibit
              10.7 to the Registration Statement, which is incorporated
              herein by reference.
     10.32    Industrial Real Estate Lease dated May 30, 1997, between the
              Company and Daimler Commerce Partners, L.P., previously
              filed with the Commission as Exhibit 10.1 to the Company's
              Form 10-QSB for the quarterly period ended June 30, 1997,
              filed with the Commission on August 13, 1997, which is
              incorporated herein by reference.
     10.33    Tenancy Agreement dated September 1, 1995, by and between
              Hong Kong Industrial Technology Centre Corporation and
              Valence Semiconductor Design Limited relating to the
              premises located at Unit 413 on the Fourth Floor of the Hong
              Kong Industrial Technology Centre.
     10.34    Tenancy Agreement commencing January 1, 1998, by and between
              Jugada Company Limited and Valence Semiconductor Design
              Limited relating to the premises located at Workshops Nos.
              1, 2, 3, 4, 5, 6, 7 and 8 on the 19th Floor of APEC Plaza,
              No. 49 Hoi Yuen Road, Kwun Tong, Hong Kong.
     10.35    Stock Divestment Agreement dated July 1, 1996, between the
              Company, Thomas C.K. Yuen, Stephen V. Sedmak and Walter W.
              Cruttenden III, previously filed with the Commission as
              Exhibit 10.17 to the Registration Statement Amendment No. 2,
              which is incorporated herein by reference.
     10.36    Services Agreement dated July 1, 1996, between the Company
              and Sierra Digital Productions, Inc., previously filed with
              the Commission as Exhibit 10.19 to the Registration
              Statement Amendment No. 1, which is incorporated herein by
              reference.
     10.37    Registration Rights Agreement dated as of January 28, 1998,
              by and between the Company and R.G.A. & Associates, Ltd.,
              d/b/a ToteVision and VIP Labs(R) and William S. Taraday.
</TABLE>
<PAGE>   50

<TABLE>
<CAPTION>
    EXHIBIT
      NO.                             DESCRIPTION
    -------                           -----------
    <C>       <S>
     10.38    Warrant to Purchase 94,000 Shares of Common Stock of the
              Company dated February 26, 1998, held by R.G.A. &
              Associates, Ltd., d/b/a ToteVision and VIP Labs(R).
     10.39    Warrant to Purchase 2,500 Shares of Common Stock of the
              Company dated February 26, 1998, held by Herbert H. Wax.
     10.40    Warrant to Purchase 2,500 Shares of Common Stock of the
              Company dated February 26, 1998, held by Steven E. Loyd.
     10.41    Warrant to Purchase 1,000 Shares of Common Stock of the
              Company dated February 26, 1998, held by the Van Valkenberg
              Furber Law Group, P.L.L.C.
     10.42    Business Loan Agreement dated March 4, 1998, between the
              Company and Bank of America National Trust and Savings
              Association.
     21       Subsidiaries.
     23       Consent of Deloitte & Touche LLP dated March 30, 1998.
     24       Power of attorney (included on page 44 of the Form 10-KSB).
     27.1     Financial Data Schedule (FYE 1997).
     27.2     Financial Data Schedule (Q 1-3, 1997, Restated).
     27.3     Financial Data Schedule (Q 3 and FYE 1996, Restated).
</TABLE>