**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-K**

| **(Mark One)**                                       | ** **                                                                                              |
|------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
| **x**                                                | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**     |
| **For the fiscal year ended December 31, 2005** |
| **or**                                               |
| **o**                                                | **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**

****

**SRSLABS, INC.**

(Exact name ofregistrant as specified in its charter)

| **Delaware******(State or other jurisdiction of  incorporation or organization) | **33-0714264******(I.R.S. Employer  Identification No.) |
|---------------------------------------------------------------------------------|---------------------------------------------------------|

 

**2909 Daimler Street, SantaAna, California 92705**

(Address of principalexecutive offices) (Zip Code)

**(949) 442-1070**

(Registrant’s telephonenumber, including area code)

Securitiesregistered pursuant to Section 12(b) of the Act: **None**

Securities registered pursuant to Section 12(g) of the Act:

**CommonStock, Par Value $0.001 Per Share**

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes  ̈ No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes  ̈ No x

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

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K(§229.405 of this chapter) is not contained herein, and will not be contained,to the best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K.  ̈

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

| Large accelerated  filer  ̈ |   | Accelerated  filer  ̈ |   | Non-accelerated  filer x |
|--------------------------------------|--------|--------------------------------|--------|-------------------------------|

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o   No ý

The aggregate market valueof the registrant’s voting Common Stock held by non-affiliates of theregistrant was approximately $60,577,545 (computed using the closing price of$6.10 per share of Common Stock on June 30, 2005, as reported by theNasdaq Stock Market).

As of March 15, 2006,15,150,467 shares of the registrant’s Common Stock, par value $0.001 per share,were outstanding. Of that amount, 674,098 shares were held as treasury shares.

**DOCUMENTSINCORPORATED BY REFERENCE**

**Portions of the registrant’s Proxy Statementprepared in connection with the Annual Meeting of Stockholders to be held in2006 are incorporated by reference in Part III of this Form 10-K.**

 

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**SRSLABS, INC.**

**AnnualReport on Form 10-K**

**Table of Contents**

|                   | ** ** | ** **                                                                                                         | ** ** | **Page** | ** ** |
|-------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| **PART I**   |
| Item 1.           |       | Business                                                                                                           |       | 4        |       |
| Item 1A.          |       | Risk  Factors                                                                                                      |       | 15       |       |
| Item 1B.          |       | Unresolved Staff Comments                                                                                          |       | 18       |       |
| Item 1C.          |       | Executive Officers of the Registrant                                                                               |       | 18       |       |
| Item 2.           |       | Properties                                                                                                         |       | 20       |       |
| Item 3.           |       | Legal  Proceedings                                                                                                 |       | 21       |       |
| Item 4.           |       | Submission of Matters to a Vote of Security Holders                                                                |       | 21       |       |
| **PART II**  |
| Item 5.           |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       | 22       |       |
| Item  6.          |       | Selected  Financial Data                                                                                           |       | 24       |       |
| Item 7.           |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operation                         |       | 25       |       |
| Item 7A.     |       | Quantitative and Qualitative Disclosures About Market  Risk                                                        |       | 38       |       |
| Item 8.           |       | Financial Statements and Supplementary Data                                                                        |       | 39       |       |
| Item 9.           |       | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosure                         |       | 39       |       |
| Item 9A.     |       | Controls and Procedures                                                                                            |       | 39       |       |
| Item  9B.         |       | Other  Information                                                                                                 |       | 39       |       |
| **PART III** |
| Item 10.          |       | Directors and Executive Officers of the Registrant                                                                 |       | 40       |       |
| Item 11.          |       | Executive Compensation                                                                                             |       | 40       |       |
| Item 12.          |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters     |       | 40       |       |
| Item 13.          |       | Certain Relationships and Related Transactions                                                                     |       | 40       |       |
| Item 14.          |       | Principal Accountant Fees and Services                                                                             |       | 40       |       |
| **PART IV**  |
| Item 15.          |       | Exhibits, Financial Statement Schedules                                                                            |       | 41       |       |
| Signatures        |       | 47                                                                                                                 |       |

 

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You should carefully consider the risk factorsdescribed below and in Item 1A of this Form 10-K, as well as theother information included in this Annual Report on Form 10-K priorto making a decision to invest in our securities. The risks and uncertaintiesdescribed below are not the only ones facing our company. Additional risks anduncertainties not presently known or that we currently believe to be lesssignificant may also adversely affect us. Unless the context requiresotherwise, references to “the Company,” “we,” “us,” “our” and “SRS Labs” referspecifically to SRS Labs and its direct and indirect subsidiaries as well asthe CHS/SRS LLC joint venture described in this Report.

**SPECIALNOTE REGARDING FORWARD-LOOKING STATEMENTS**

On one or more occasions,we may make statements regarding our assumptions, projections, expectations,targets, intentions or beliefs about future events. All statements other thanstatements of historical facts included in this Annual Report on Form 10-Krelating to expectation of future financial performance, continued growth,changes in economic conditions or capital markets and changes in customer usagepatterns and preferences, are forward-looking statements.

Words or phrases such as “anticipates,”“believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “projects,”“targets,” “will likely result,” “will continue,” “may,” “could” or similarexpressions identify forward-looking statements. Forward-lookingstatements involve risks and uncertainties, which could cause actual results oroutcomes to differ materially from those expressed. We caution that while wemake such statements in good faith and we believe such statements are based onreasonable assumptions, including without limitation, management’s examinationof historical operating trends, data contained in records and other dataavailable from third parties, it is possible that our expectations will not berealized.

Asmore particularly discussed in Item 1A of this Form 10-K, someimportant factors that could cause actual results or outcomes for SRS Labs orour subsidiaries to differ materially from those discussed in forward-lookingstatements include:

·                    changes ingeneral economic conditions in the markets in which we may compete andfluctuations in demand in the sound technology licensing and semiconductorindustries;

·                    our ability tobuild and strengthen our brand;

·                    our ability tosustain historical margins as each of our industries develop;

·                    increasedcompetition;

·                    pricingpressures on consumer electronics manufacturers;

·                    increasedcosts;

·                    exposure torisks in our licensing business related to product and customer concentration;

·                    exposure torisks of international operations, particularly Asia and the People’s Republicof China;

·                    reliance onintellectual property;

·                    our ability toretain key members of management;

·                    the financialuncertainties related to the disposition of our semiconductor business;

·                    adverse state,federal or foreign legislation or regulation or adverse determinations byregulators; and

·                    other factorsidentified from time to time in our filings with the Securities and ExchangeCommission.

Any forward-looking statement speaks only as ofthe date on which such statement is made, and, except as required by law, weundertake no obligation to update any forward-looking statement toreflect events or circumstances after the date on which such statement is madeor to reflect the occurrence of unanticipated events. New factors emerge fromtime to time, and it is not possible for management to predict all suchfactors.

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**PART I**

**Item 1.**                        Business

**Overview**

SRS Labs is a leading developer and provider of audioand voice technology solutions for the home entertainment, portable mediadevice, personal telecommunications, personal computer, automotive, andbroadcast markets, and a developer and provider of application specificintegrated circuits, or ASICs, and standard integrated circuits, or ICs.

Historically, we have operated in the two businesssegments, licensing and semiconductors.

*Licensing:**  *ThroughSRS Labs, the parent company, and our wholly-owned subsidiary, SRSWOWcast.com,inc., doing business as SRSWOWcast Technologies, or SRSWOWcast, the licensingsegment develops and licenses audio, voice and surround sound technologysolutions to many of the world’s leading original equipment manufacturers, orOEMs, software providers and semiconductor companies, and licenses and marketshardware and software products for the Internet and professional audio markets.

In September 2004, we entered into a strategicalliance with Coming Home Studios LLC, or CHS to use and promote SRS Labstechnologies, promote CHS productions and to promote each company’s respectivebrands. In connection with the strategic alliance, the Company and CHSestablished a joint venture, CHS/SRS, LLC, or the Joint Venture, to produce anddistribute six concert videos by *Duran Duran, Boz Scaggs,Godsmack and All Access* featuring our Circle Surround technology. InJuly 2005, we replaced CHS as the manager of the Joint Venture. As a resultof becoming the manager of the Joint Venture, we have control over the JointVenture’s business strategy and decisions; accordingly, we are required underapplicable accounting rules to consolidate the financial statements of theJoint Venture into our financial statements commencing with the third quarterof fiscal 2005. In the consolidated financial statements, all inter-companyaccounts and transactions between the Company and the Joint Venture have beeneliminated. Previously, we accounted for our 50% equity ownership in the JointVenture as an investment using the equity method.

On February 23, 2006, our Board of Directors, orthe Board, authorized management to take all reasonable steps to divest ourentire equity interest in the Joint Venture. We have not yet estimated thecosts we will incur in connection with the divestiture of our equity interestin the Joint Venture. Furthermore, we recorded an asset impairment charge of $3.3 million related to our investmentin the Joint Venture, which is included in our consolidated results ofoperations for the quarter ended December 31, 2005. The impairment chargewas determined based on (a) sales to date and expected future net cashflows to the Company from the Joint Venture, and (b) the estimated cost tocomplete the remaining three unreleased Concert Videos and their expected salesonce completed.

*Semiconductors:**  *Through Valence Technology Limited,a Hong Kong company, and its subsidiaries, which we collectively refer to asValence, we operate a fabless semiconductor business which develops, designsand markets standard and custom analog ICs, digital signal processors, or DSPs,and mixed signal integrated circuits primarily to OEMs, and original designmanufacturers, or ODMs, in the Asia Pacific region.

On February 23, 2006, the Board approved a planto sell Valence in order to focus increased management attention and financialresources on what it believes to be a larger and expanding market opportunityfor its licensing business. We have retained Kaufman Bros., L.P., a financialadvisor based in New York City, to assist us in facilitating a sale. As aresult of our decision to sell Valence, we will account for the semiconductorbusiness segment as a discontinued operation beginning in the quarter ending March 31,2006. See Note 14 to the Company’s consolidated financial statements.

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In2003, we reported our revenues in the following five segments: licensing,semiconductors, component distribution, product sales and Internet andbroadcast. In 2004, we decided to reduce our segments to licensing andsemiconductors because the revenues attributable to the other three segmentswere not material. Revenue from the component distribution segment is nowreported in the semiconductor segment and revenues from product sales andInternet and broadcast segments are now reported in the licensing segment.Segment information for prior years has been restated to conform to the currentyear presentation. The following table shows our revenues, cost of sales andgross margin by product segment for the last three fiscal years:

| ** **          | ** ** | **Years ended December 31,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Licensing:**      |       |                                        |       |   |   |   |   |
| Total revenues      |       | $                                           | 14,795,810 |   | $ | 10,831,704 |   | $ | 9,101,399 |   |
| Cost of sales       |       | 3,204,021                                   | (a)        | 228,147 |   | 102,979 |   |
| Gross margin        |       | $                                           | 11,591,789 |   | $ | 10,603,557 |   | $ | 8,998,420 |   |
| **Semiconductors:** |       |                                        |       |   |   |   |   |
| Total revenues      |       | $                                           | 8,432,449  |   | $ | 10,770,684 |   | $ | 10,712,382 |   |
| Cost of sales       |       | 3,411,649                                   |       | 3,725,062 |   | 3,953,100 |   |
| Gross margin        |       | $                                           | 5,020,800  |   | $ | 7,045,622 |   | $ | 6,759,282 |   |
| **Total:**          |       |                                        |       |   |   |   |   |
| Total revenues      |       | $                                           | 23,228,259 |   | $ | 21,602,388 |   | $ | 19,813,781 |   |
| Cost of sales       |       | 6,615,670                                   | (a)        | 3,953,209 |   | 4,056,079 |   |
| Gross margin        |       | $                                           | 16,612,589 |   | $ | 17,649,179 |   | $ | 15,757,702 |   |

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(a)           Cost of sales includesthe write-off of the capitalized production costs of $2.8 million related to CHS/SRSLLC.

Further financial information for business segments,geographic areas and customer concentration is included in this Annual Reporton Form 10-K under “Item 8. Financial Statements and SupplementalData” and in Notes 1 and 11 to the Notes to Consolidated Financial Statements.Revenues for each of our business segments as a percentage of consolidatedrevenues and additional discussion relating to our revenues are presented under“Item 7. Management’s Discussion and Analysis of Financial Condition andResults of Operations.” Reference also is made to “Item 1A. Risk Factors” for adiscussion relating to certain business risks relating to our business.

SRS Labs was incorporatedin the State of California on June 23, 1993 and reincorporated in the Stateof Delaware on June 28, 1996. Our executive offices are located at 2909Daimler Street, Santa Ana, California 92705. Our telephone numberis (949) 442-1070.

**Our Products and Technologies**

*Licensing*

Our licensingbusiness develops and markets audio rendering, voice and surround soundtechnologies to OEMs, ODMs, semiconductor manufacturers, and software providersin the home entertainment,portable media device, personal telecommunications, automotive and personalcomputer markets. Our portfolio oflicensable technologies includes a wide range of techniques for the processing and delivery of audio, voice andsurround sound, including the following:

·       *Surround Sound*—Our surround sound technology, CircleSurround®, is a complete encoding and decoding format. Circle Surround *encoding*enables the distribution of up to 6.1 channels ofaudio over existing two-channel carriers such as digital media files, standarddefinition and high-definition 

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television, FM radio, andCDs. Circle Surround *decoding*decodesCircle Surround encoded material for multi-channel playback or creates upto 6.1 channels of audio from older formats of material, including mono,stereo, 4-channel surround or other matrix surround formats. CircleSurround decoding is available in three solutions: Circle Surround, CircleSurround IITM and Circle Surround AutomotiveTM.

·       *Audio Rendering*—Our audio rendering technologies optimizedevice audio output and enable the presentation of 3D and multichannel audiocontent over two speakers. These technologies include the ability to render5.1multichannel content over two speakers, to create a wider sound stage formore natural audio, to improve the perceived bass response in small speakers,and to dynamically position audio sources in a virtual 3D space using headphones,and to reposition the audio image for non-optimally placed speakers. Our audiotechnologies include: SRS Xspace 3DTM, SRS WOWTM, SRS WOW XTTM, SRS WOW HDTM, SRSTruBass®, SRS FOCUS®, SRS HeadphoneTM, SRS DialogClarityTM, SRS TruSurround® XT,SRS 3D® Sound and SRS AutoTM.

·       *Voice Processing*—Our VIPTM and Noise ReductionTM technologies, dramatically reduce noise toproduce much clearer and crisper dialog over wireless communication devices andimprove the intelligibility of the human voice in a variety of listeningsituations, including high ambient background environments.

The SRS Labs portfolio oftechnologies can address a broad spectrum of product applications within thevertical markets that we have targeted. Our technologies may be implemented ina variety of methods, including discrete analog components, chip modules,analog semiconductors, DSPs and software. These various implementation optionsoffer customers flexibility when incorporating our technologies into products.

*Semiconductors*

Our fabless semiconductor business designs, developsand markets custom and proprietary analog, digital and mixed signal integratedcircuits. These products address a wide range of applications in the consumerelectronics, home entertainment, telecommunications and personal computermarkets. We market our semiconductor products in two categories: (a) customASICs for specific OEM customers primarily in the Asia Pacific region, and (b) standardintegrated circuits marketed under the brand name, ASP Microelectronics, orASP, many of which include our audio, voice and surround sound technologies.

As of the end of 2005, approximately 39 engineers supported our IC designcapabilities. We outsource the manufacturing of these ASICs to a network offabrication partners throughout Asia Pacific, including CharteredSemiconductor, Samsung and Tower Semiconductor Limited in Israel.

In addition to performingcontract design work, we also design, develop and market standard ICs for theAsia Pacific manufacturing market under the ASP brand name. The productscreated are based upon management’s analysis of trends in the market, knowledgegained from long standing relationships with customers and overall businessexperience. The general purpose integrated circuits offered includemicro-controllers for DVD Players, set-top box receivers and audio/videoequipment; ICs for telecommunication and game equipment; small signaltransistors and ICs used mainly in the manufacture of consumer products such astelevision sets, radios, telephones, computer mother boards, add-on boards andaudio hi-fi systems. Many of these products are developed by utilizing ourcustom design libraries, advanced mixed signal design technologies, systemlevel expertise, software knowledge and understanding of customer requirements.Many of these chips include SRS audio technologies and by the end of 2005, 38%of the ASP product line included SRS audio chips.

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**Our Customers and Markets**

Welicense our technologies and sell our semiconductors throughout the WesternHemisphere, the Asia Pacific region and in Europe. The following table presentsour revenue by geographic area. For product sales, revenue is allocated basedon the country to which product was shipped. For licensing-relatedrevenue, the allocation is based on the location of the licensee’s corporateheadquarters. The Americas region includes North, Central and South America.

| ** **                      | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                    | ** ** | **%** | ** ** | **2004** | ** ** | **%** | ** ** | **2003** | ** ** | **%** | ** ** |
| ***Geographic  Area Revenue:*** |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Hong Kong                       |       | $                                           | 7,672,588  |   | 33 | % | $ | 9,975,904 |   | 46 | % | $ | 9,235,976 |   | 47 | % |
| Japan                           |       | 5,644,518                                   |       | 24 | % | 4,906,343 |   | 23 | % | 5,402,565 |   | 27 | % |
| Korea                           |       | 4,217,780                                   |       | 18 | % | 1,456,063 |   | 7 | % | 381,416 |   | 2 | % |
| China                           |       | 2,734,596                                   |       | 12 | % | 2,028,224 |   | 9 | % | 2,193,863 |   | 11 | % |
| Americas                        |       | 2,300,263                                   |       | 10 | % | 2,354,668 |   | 11 | % | 875,461 |   | 5 | % |
| Other Asia Pacific              |       | 383,420                                     |       | 2 | % | 205,817 |   | 1 | % | 845,529 |   | 4 | % |
| Europe                          |       | 275,094                                     |       | 1 | % | 675,369 |   | 3 | % | 878,971 |   | 4 | % |
| Total                           |       | $                                           | 23,228,259 |   | 100 | % | $ | 21,602,388 |   | 100 | % | $ | 19,813,781 |   | 100 | % |

 

*Licensing*

Through our licensing business segment, we market ourportfolio of technologies to the following vertical markets: homeentertainment; personal telecommunications; portable media; personal computersand automotive. Our license agreements typically have multi-year or automaticrenewal terms, and either require per-unit royalty payments for all productsimplementing our technologies or provide for a fixed annual or quarterlyroyalty payment. License agreements also specify the use of our trademarks andlogos on the product, within the packaging and in the user’s manual. Agreementsalso require our product review and approval to guarantee the quality of thetechnology implementation and the correct usage of our logos and trademarks. Webelieve these terms ensure the quality and consistency of the technology andelevate the awareness of the SRS brand in the marketplace. Most agreements donot have volume requirements and may be terminated by the licensees or uswithout substantial financial penalty. Commencing in 2003, we embarked on astrategy to further diversify our concentration across markets.

Thefollowing chart shows the percentage of our licensing revenue we received in2005 and 2004 from each of these markets.
|  |   |  |
|--|--------|--|

 

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**Home Entertainment**

Home entertainmentproducts represent the largest current market for our technologies and havehistorically been the largest revenue contributor to our licensing business.Manufacturers in this market utilize our technologies to differentiate theirproducts from their competitors while improving functionality and productperformance. In many instances, manufacturers license multiple technologiesfrom us for multiple product lines and divisions. Product categories withinthis market include HD televisions (such as LCD and Plasma televisions),set-top boxes, DVD players, audio/video receivers, and completehome-theater-in-a-box systems.

*Televisions.*   Ouraudio technologies are widely used by television manufacturers as adifferentiating feature and as a solution to audio challenges thatmanufacturers encounter. As television makers continue to migrate from bulkytube models to thinner digital displays, manufacturers are finding that theyhave less room for speakers, which may compromise the overall audio quality ofthe television. We provide manufacturers with patented solutions for accuratelypresenting surround sound, improving bass response, increasing dialog clarity,and creating a more natural sound stage. These solutions improve the audioquality of the set without the expense of additional equipment or largerspeakers. In 2005, our technologies continued to grow in popularity for use inflat panel TVs from LG, Samsung, and Sony.

*DVD Players &Set-top Boxes.**  *Althoughthey present surround sound content, DVD players and set-top-boxes aretypically connected to two-channel televisions. Our SRS TruSurround XTtechnology creates a surround sound experience over any existing two-speakersystem, including the internal speakers of a television. This technology alsocreates a virtual surround experience from stereo material.

*A/V Receivers &Home-Theater-in-a-Box.**  *Theaudio/visual receiver is the central hub for a typical home theater system.Many homes are now being equipped with “home-theater-in-a-box” systems thatcome complete with a DVD player, VCR, CD player, set-top box, and 5.1 speakers.Our portfolio of technologies addresses the needs of this market by improvingaudio performance and by providing surround sound rendering.

**Personal Telecommunications**

SRS Labs provides thepersonal telecommunications market with both voice and audio renderingtechnologies. Mobile phones are adding multimedia at a rapid pace. New servicesinclude digital music downloads, ring-tones and true-tones, streaming video,gaming, and television viewing. In 2004 and 2005, KDDI, SK Telecom, Sprint, andVerizon joined NTT DoCoMo and others with new multimedia services. SRS Labs’strong presence in the home entertainment market, our suite of voicetechnologies, and our existing start into the mobile market with customers likeNEC present a growth opportunity for SRS Labs. SRS solutions address specificneeds in the mobile market. For example, our technologies address needs likevoice intelligibility in noisy environments, clarity of dialog in videocontent, poor bass-response of small speakers, hampered stereo imaging innarrow-set speakers, and 3D audio for interactive gaming.

**Portable Media**

MP3 players and otherportable media players enable consumers to enjoy audio and video content whileon the go. As volume for these devices increases, consumer pricing pressureleads to wider use of cost-effective components by manufacturers to keepproduction costs low. Also, the small footprint of these devices limits speakersize and speaker spacing. Our solutions enable vendors of portable mediadevices to increase the quality of their audio output without increasinghardware component costs. In 2005, customers using SRS technologies in theirportable media player products included LG, Reigncom (iRiver), and Samsung.

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**Personal Computers**

Personal computers (PCs)in the home are often used as media hubs. Through PCs, users enjoy and managecollections of music, and movies along with downloaded and recorded televisionprogramming. This content is now being distributed through the home usingnetworked media adapter products. Throughout these systems, there is a need foroptimizing playback on the computer speakers, presenting a home theaterexperience on a laptop, transmitting surround sound around the home, andenjoying content on headphones. Technology solutions from SRS are wellpositioned to fill these needs. In 2005, Toshiba and Fujitsu were among thecustomers using SRS technologies in their personal computer and relatedproducts.

**Automotive**

SRS Labs has invested inresearch to create solutions specific to the needs of the automotive market.Within vehicles, audio and video content is played from multiple sources andthen presented on both speakers and headphones. Stereo content from sourceslike CDs, MP3 players, and HD Radio® needs to be presented on all speakers inthe car, some of which may not be optimally placed and may not have strong bassresponse. Surround sound content from DVDs, radio, and downloaded music needsto be rendered on both car speakers with a maximum sweet spot and on rear-seatheadphones. Our automotive solutions like SRS CS Auto, SRS Circle Surround II,and SRS TruSurround XT meet these needs and provide manufacturers in thissegment with a fully tunable solution. In 2005, customers using our automotivetechnology included Fujitsu-Ten, Kenwood, and Philips.

*Semiconductors*

Our custom ASIC customersinclude the Asia-based manufacturing facilities for consumer electronics,telecommunications and personal computer manufacturers headquartered in NorthAmerica, Europe and Asia Pacific.

We believe our expertisein design work allows us to offer our customers a shorter development cycle,smaller die size and faster turnaround time for final production, whichstrengthens our relationships with our customers and helps us retain ourcompetitive advantage in the Asia Pacific region.

Our target customers forICs are the original design manufacturers, or ODMs and OEMs of a variety oftelevision applications, including LCD, projection, CRT and plasma televisions,as well as personal telecommunications, automotive, portable audio and personalcomputer equipment.

**CustomerConcentration**

For fiscal year 2005, therewas no customer that accounted for more than 10% of consolidated revenues. Forfiscal year 2004, one customer in the semiconductor segment accounted forapproximately 10% or $2,180,065 of consolidated revenues. For fiscal year 2003,one customer in the semiconductor segment accounted for approximately 11% or$2,107,790 of consolidated revenues. Given the significant amount of revenuesderived from these customers, the loss of any such customer or theuncollectibility of related receivables could have a material adverse effect onour financial condition and results of operations.

**Our Strategy**

As explained above, we arepursuing the divestiture of our semiconductor business in order to focus on ourlicensing business. Consequently, the following discussion addresses the keyelements of the strategy for our licensing business.

Our sales strategy is toidentify high-growth markets, develop needed technology solutions andfeatures and work with software and semiconductor platform partners to makethese technologies widely 

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availableand easy-to-implement by OEMs and ODMs. We believe that we will continueto strengthen our market position as a world leader in audio and voicetechnology by employing the strategy of providing a continuous stream ofpatented audio and voice technologies, penetrating new licensing accounts,expanding relationships with existing licensees, creating a broad platform ofsoftware and semiconductor partners and developing strong brand awareness ofthe SRS logo.

The mission of our licensingplatform efforts is to achieve comprehensive and strategic coverage for ourtechnology solutions within all of our targeted vertical product markets inorder to expand sales and licensing opportunities. By developing strongrelationships with the leading software and semiconductor companies, our audiotechnologies can be delivered to customers worldwide across high growth andhigh volume product applications.

We work together with ourplatform partners (leading semiconductor manufacturers and middleware orfirmware software providers) to provide our mutual customers with thetechnology, which best fits their needs. We also together solicit othercustomers who use the platform. Many times, a platform partner will becomeenabled with our technology due to a customer request. Other platforms becomeenabled with our technology due to their identification as a key component toenter a new market.

As a technology licensingcompany, one of our greatest assets is the strength of our brand. Since brandrecognition drives licensing sales, we have invested in strategies thatincrease consumer awareness of SRS Labs with the ultimate goal of establishingour brand with both product manufacturers and consumers around the world as thesymbol for high-quality audio. The three primary vehicles that we use tofurther the proliferation of our brand are: (a) placement of the SRS logoby OEMS on products and in co-marketing programs; (b) online brandingprograms; and (c) use, and recognition of use, of SRS technology by contentand broadcast professionals.

*OEM Marketing Programs.**  *In the majority of products which use SRStechnologies, our logo is either prominently displayed on the product itselfor, in the case of software products and mobile phones, featured in thegraphical user interface. This consistent logo exposure is considered a keytool in reaching consumers worldwide. In addition, we work with our OEMcustomers as they launch new products that feature SRS technologies. We supplycomplete SRS corporate and technology tool kits with a wide array of material,including SRS logos, illustrations, technology explanations and suggesteddemonstration material. In 2005, for example, we worked with Dell to place SRSCircle Surround encoded high-definition video and our logo into their saleskiosks.

*Online Branding.**  *Online exposure has also been an important part ofour branding strategy. A beneficial component of our relationship withMicrosoft is that the SRS logo displayed in the audio control panel ofMicrosoft’s Windows® Media Player links to an SRS technology page. As a result,SRS has received significant traffic and opportunities to create brandawareness with consumers and to educate consumers on the benefits of SRStechnology.

Our online efforts alsoinclude the direct sale of plug-ins for Windows Media Player. Revenue from thesale of these products is not significant, but gives us a valuabledemonstration platform to showcase our audio technologies.

*Use of SRS Technology byContent and Broadcast Professionals.**  *We develop,license and sell professional hardware and software products to enablecontent companies, broadcasters and music publishers to encode their materialusing our SRS Circle Surround technology. When SRS Circle Surround isprofessionally used, the logo is often displayed within the content itself, onthe packaging material, or in the case of radio an announcement that thebroadcast is being delivered in SRS Circle Surround. We have concentrated onthree key market segments in the professional audio space: television, radioand music, and have developed a line of hardware and software products to address these markets. These products are solddirectly to professional customers and are also available from selected dealersand distributors servicing the professional audio and broadcast communities. Wedid not generate significant revenue from the sale of 

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professionalhardware equipment in 2005. The primary purpose of this business is to enableour other businesses and to increase awareness for SRS Labs within the contentcommunity.

**Sales and Marketing**

We have two types ofrevenue collection systems with our licensees—bundled or non-bundled. Under abundled agreement, royalty revenue may be collected by our platform partner atthe time the solution is sold to an OEM or ODM. Most often, however, we collectrevenue directly from our licensees. These licensing arrangements with OEMs orODMs authorize them to design, build and sell products containing ourtechnology. Under this licensing method, OEM product licensees are free tochoose a semiconductor solution from the platform partner that best suits theirtechnical and cost-of-goods-sold requirements. We receive royalties directlyfrom the licensed OEM or ODM for the use of our technologies in licensed productsmanufactured and shipped by the OEM or ODM. Many major OEMs have licenses orpurchase products manufactured by a licensed ODM for the use of one or more ofour technologies and for the use and display of our trademarks. In the case ofthe platform partner who bundles our technology within their solution, the costof the solution includes our royalty at the time it is sold. The platformpartner remits that royalty directly back to us on behalf of the licensee, thusstreamlining the royalty collection process of royalty reporting.

Our process for selectingparticular platform partners for distributing our technology is based onseveral criteria including: (a) segment leadership—we target chip partnersthat hold preeminent positions in market segments characterized by high growth,volume and/or margins; (b) volume—platforms which will maximize exposureof our technologies to a large number of potential OEMs; (c) synergy—platformswhich serve to position our technologies along with compatible and additivetechnologies for integrated delivery; and (d) convergence potential—whichenable us to establish a presence on platforms that intersect mergingfunctional features. An example of this would be the platforms for new personalmultifunctional devices that include mobile phone, personal digital assistant,or PDA, and MP3 capabilities.

To implement our licensingsales strategy within our identified vertical markets, we have established adirect sales force and a worldwide network of independent sales agents. In NorthAmerica, we employ a direct sales force to market our portfolio of audio andvoice technologies to the OEM community. Internationally, we maintain officesin Japan, Hong Kong and Korea to support our multi-national OEMcustomers. We actively promote the use of our trademarks and logos and directcustomers to prominently display the appropriate SRS technology logo onproducts, packaging and in advertising. We work closely with our licensees toenhance their success in selling finished products and semiconductor productsthat incorporate our technologies through a variety of licensee supportprograms. These programs include engineering support, sales training, tradeshowsupport, publicity and media relations programs, customized marketingmaterials, advertising, speaking engagements and industry conferences. Wherepossible, we use the Internet to provide technology demonstrations. We conductin-person technology demonstrations or presentations for the press and othercompanies to promote our technologies and products.

We also regularlyparticipate in tradeshows and conferences to increase awareness of ourtechnologies and to market our technologies and products. We work closely withour licensees and Platform Partners to actively explore additional opportunitiesto place our technologies in new products and/or markets.

**Backlog**

Backlog is applicable onlyto our semiconductor business. Sales of semiconductors are primarily madepursuant to standard purchase orders for the delivery of ASIC and IC products.Order quantities and delivery schedules are frequently changed to reflectproduct availability, scheduling at our fabrication partner facilities orchanges in our customers’ needs. Customer orders can be canceled or rescheduledwithout significant penalty to the customer. Accordingly, our backlog at anyparticular date is not 

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representativeof actual sales for any succeeding period. For this reason, we believe thatbacklog is not generally a good indicator of future revenue. As of December 2005and 2004, the backlog of orders for ASIC and IC products to non-affiliatedparties was $961,194 and $1,539,567, respectively. We expect that all orsubstantially the entire current backlog of orders for 2005 will be completedin 2006.

**Research andDevelopment**

Our customers compete inmarkets that are characterized by rapidly changing technology and continuousimprovement in products and services. Our research and development expendituresin 2005, 2004, and 2003 were approximately 26.1%, 30.0% and 28.9% of totaloperating expenses respectively. These expenses consist of salaries and relatedcosts of employees and consultants engaged in ongoing research, design anddevelopment activities and costs for engineering materials and supplies.

As of December 31,2005, we had 51 employees in our R&D group representing 45% of our totalhuman resources. Our software, hardware and application engineers focus ondeveloping intellectual property, technology solutions and consumer products.Twelve engineers are based in the U.S. and support of our licensing businesswith the remaining 39 engineers based in Hong Kong and support of oursemiconductor business.

**Competition**

We compete in each of ourbusiness segments with a number of different companies, which produce a varietyof technologies, processes and products.

*Licensing*

Competition in the audio,voice and surround sound technology licensing business includes other licensingcompanies who offer competing technologies as well as the internal engineeringdepartment of our licensees, who may develop audio technologies for use intheir own products.

In the field of audioimprovement, we compete directly with other audio providers, including Audistryby Dolby, BBE Sound, and Qsound. Our 3D positional audio technology directlycompetes with technologies from QSound and Synoptic. We believe that our basstechnology, TruBass, competes directly with several technologies, includingMaxxBass from Waves, Ltd, Vi.B.E from Spatializer, and non-proprietarybass systems, such as Bass Boost, that are included on a variety of electronicsproducts, including televisions, portable stereos and speaker products. Becauseour audio technologies work with any existing recorded material, whether mono,stereo or surround sound, most of our audio technologies, including SRS 3D, SRSFOCUS, SRS TruBass and SRS Dialog Clarity, can be used either as an alternativeor as a complement to almost any competing audio technology.

Our surround soundrendering technologies compete primarily with Dolby Virtual Speaker and oursurround sound format competes directly with the Dolby ProLogic family.However, our surround sound decoders and renderers are compatible with thirdparty content formats, creating an opportunity for cooperation. Specifically,our surround sound decoders compete primarily with Dolby ProLogic II and DTSNEO 6.

Many companies in thewireless and telecommunications industry are investigating methods to increasethe quality of a voice signal; but we believe that their development workfocuses on techniques to reduce noise and provide echo cancellation. We are notaware of any direct competing technologies to our voice technology, VIP, whichprocesses the actual voice signal to improve intelligibility leveraging thenature of the human speech pattern. VIP is compatible to these other noisecancellation techniques.

Many of the companiesreferenced above have, or may have, substantially greater resources than us todevote to advance their existing technologies and develop new products. Webelieve that we compete based primarily on the quality and performance of ourproprietary technologies, brand name awareness, 

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the easeand cost of implementing our technologies, the ability to meet OEMs’ needs todifferentiate their products, and the strength of our licensee relationships.However, there can be no assurance that based on these factors, we willcontinue to be competitive with existing or future products or technologies ofour competitors.

In the broadcast andprofessional audio markets, our Circle Surround technology competes directlywith surround sound formats from Dolby Laboratories and DTS, Inc., whichmarket professional products for the encoding and creation of multichannelcontent. Both of these companies have more established reputations, greatertechnical, sales, marketing and distribution capabilities and stronger brandpresence in the movie/cinema, television broadcast and music recording segmentsof professional audio. These competitors also have established or may establishstrategic relationships with potential customers of our Circle Surroundtechnology that may affect our customers’ decisions to purchase products orlicense technology from us.

*Semiconductors*

The Asia Pacificsemiconductor industry is dominated by several major suppliers, such asMotorola, National Semiconductor and Texas Instruments. These establishedsemiconductor companies usually do not offer custom design services tomanufacturers and will only do so if the number of semiconductors required bysuch manufacturers is very large. Instead, they supply standard IC products totheir customers. We occasionally compete with smaller design houses in Japan,Taiwan or Korea, such as Sunplus, but most of these design houses are focusedon standard semiconductor chip categories, such as random access memory, micro-controllerand other non-proprietary functional processes.

We believe that our ASICteam is more flexible in its strategy of designing new products, as well asmore responsive in the service provided to clients. With 19 years ofexperience in the Asia Pacific semiconductor market, our large accumulateddesign IP library can be reused for different designs and can support a shorterchip development cycle and a lower chip cost. Using our proprietary software,many of our designs can be re-targeted for different foundries and processes,which allows us to reduce risk and cost. We have strong in-house testingcapabilities, using state-of-the-art software and hardware development tools.We also believe that our expertise in local business practices and a strongfranchise of relationships with clients gives us a competitive advantage overnewcomers to the industry and large multi-national firms.

Our ability to developstandard ICs that incorporate our audio technologies has opened up new chipsales opportunities, but could in the future cause channel conflict with ournetwork of SRS technology semiconductor partners. Our objective has been tominimize this conflict by concentrating our design and sales efforts on chipproducts for markets and product applications that are underserved by ourexisting semiconductor partners.

The markets in which wesell our products are also subject to significant price competition.Accordingly, we expect to continue to experience declines in the selling pricesof our products over the life cycle of each product. In order to offsetdeclines in the selling prices of our products, we have been required to reducethe costs of products through product design changes, manufacturing processchanges, volume discounts and other savings negotiated with our manufacturingsubcontractors. Since we do not operate our own manufacturing facilities, wemay not be able to reduce costs as rapidly as competitors who perform their ownmanufacturing. Our gross margins are affected by our ability to design andintroduce, in a timely manner, lower-cost versions of existing products orhigher gross margin new products, and our ability to successfully manage ourmanufacturing subcontractor relationships.

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**IntellectualProperty Rights and Proprietary Information**

We operate in industrieswhere innovation, investment in new ideas and protection of intellectualproperty rights are important for success. We rely on a variety of intellectualproperty protections for our products and services, including patent, copyright,trademark and trade secret laws and contractual obligations. We pursue a policyof enforcing such rights. There can be no assurance, however, that ourintellectual property rights will be adequate to ensure our competitiveposition, or that competitors will not be able to produce a non-infringingcompetitive product or service. There can be no assurance that third partieswill not assert infringement claims against us, or that if required to obtainany third party licenses as a result of an infringement dispute, we will beable to obtain such licenses. Although we believe that our patents andtrademarks are important to each of our business segments, such patents andtrademarks are especially important to the licensing business segments.

In order to protect theunderlying technology concepts, we have filed and/or obtained patents for allof our marketed technologies including technologies marketed under thetrademarks SRS, TruSurround, TruSurround XT, FOCUS, Circle Surround, CircleSurround II, WOW, VIP and TruBass. In addition, we have numerous issued patentsand patents pending for speaker and other acoustic reproduction technologies.We pursue a general practice of filing patent applications for our technologiesin the United States and various foreign countries where our licenseesmanufacture, distribute or sell licensed products. We continually update andadd new applications to our patent portfolio to address changing worldwidemarket conditions and our new technological innovations. The range of expirationdates for our patents extend between the years 2006 to 2015. We have multiplepatents covering unique aspects and improvements for many of our technologies.Accordingly, the expiration of any single patent is not likely to significantlyaffect our intellectual property position or the ability to generate licensingrevenue.

Our strategy forprotection of our trademarks identifying the various SRS technology solutionsis commensurate with our strategy for obtaining patent protection.Specifically, we routinely file U.S. federal and foreign trademarkapplications for the various word names and logos used to market our technologysolutions to licensees and the general public. The duration of the U.S. andforeign registered trademarks can typically be maintained indefinitely,provided proper maintenance fees are paid and trademarks are continually usedor licensed by us.

**Seasonality**

Due to the dependence ofboth our licensing and semiconductor businesses on the consumer electronicsmarket, we experience seasonal fluctuation in sales and earnings. Inparticular, we believe that the licensing business experiences seasonalityrelating to the Christmas season in the fourth quarter, and the semiconductorbusiness located in the Asia Pacific region experiences seasonality related tothe Chinese New Year in the first quarter. We have moved toward diversifyingour key market segments in the consumer electronics industry in an effort toeven out our seasonal fluctuation.

**Employees**

As of December 31,2005, we employed 113 persons, 23 in finance and administration; 51 in researchand development, engineering and product development; and 39 in sales andmarketing. Of the 113 employees, we employ 74 individuals in our semiconductorbusiness; 12 in finance and administration; 39 in research and development,engineering and product development; and 23 in sales and marketing. All of thesemiconductor employees are located overseas. None of our employees are coveredby a collective bargaining agreement or are presently represented by a laborunion. We have not experienced any labor problems or a work stoppage andbelieve we have good relations with our employees.

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**Available Information**

Our Internet address is *www.srslabs.com*. There we make available, free of charge,our annual report on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K, and any amendments to those reports, assoon as reasonably practicable after we electronically file such material withor furnish it to the SEC. Our SEC reports can be accessed through the investorrelations section of our website. The information found on our website is notpart of this or any other report we file with or furnish to the SEC.

**Item 1A.**                RiskFactors

*We are exposed to risks in our licensing businessrelated to product and customer concentration.*

Currently, our licensing revenue is concentrated inthe home theater market with the majority of revenue generated from theinclusion of SRS technology inside televisions, DVD players and set-top boxes.We expect that the consumer home entertainment market will continue to accountfor a significant portion of our licensing revenues for the foreseeable future.While consumer spending in general on consumer electronic products hasincreased, retail prices for certain consumer electronics products that includeour audio technology, such as DVD players, have decreased significantly.Indications are that this trend will continue for the foreseeable future. Fromtime to time, certain of our OEM and semiconductor manufacturer customers mayaccount for a significant portion of revenue from a particular productapplication, such as DVD players, set-top boxes or televisions. Consumerelectronics products manufacturers could decide to exclude our audio renderingtechnology from their home theater products altogether in an effort to reducecost. The loss of any such customer could have a material adverse affect on ourfinancial condition and results of operations.

*Our business is highly dependent on the consumerelectronics market, which is characterized by short product life cycles,fluctuations in demand and seasonality, and is subject to risks related toproduct transitions and supply of other components.*

The consumer electronics market is characterized byintense competition, rapidly evolving technology, and ever-changing consumerpreferences. These factors result in the frequent introduction of new products,short product life cycles and significant price competition. The dynamic natureof this market limits our, as well as our customers’ ability to accuratelyforecast quarterly and annual sales. If we, or our customers, are unable tomanage product transitions, our business and results of operations could benegatively affected.

*Pricing pressures on the consumer electronicsproduct manufacturers, who incorporate our technologies into their products,could limit the licensing fees we charge for our technologies, which could adverselyaffect our revenues.*

The markets for the consumer electronics products inwhich our technologies are incorporated are intensely competitive and pricesensitive. Retail prices for consumer electronics products that include ourtechnologies, such as DVD players and home theater systems, have decreasedsignificantly, and we expect prices to continue to decrease for the foreseeablefuture. In response, manufacturers have sought to reduce their product costs,which can result in downward pressure on the licensing fees we charge ourcustomers who incorporate our technologies. A decline in the licensing fees wecharge could materially and adversely affect our operating results.

*We conduct operations in a number of countries andare subject to risks of international operations, particularly in Asia and the People’s Republic of China.*

We have significant operations in Hong Kong, thePeople’s Republic of China (PRC) and other parts of Asia that requirerefinement to adapt to the changing market conditions in those regions. Our 

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operations in Asia, andinternational operations in general, are subject to risks of unexpected changesin, or impositions of, legislative or regulatory requirements.

Our customers geographically located in the AsiaPacific markets accounted for approximately 89%, 86%, and 91% of total Companysales in 2005, 2004 and 2003, respectively and are expected to continue toaccount for a substantial percentage of sales in the future. The economicclimate in Asia continues to be impacted by increases in unemployment, declinesin consumer spending, currency devaluation and bank failures. Any of thesefactors, should they continue, could significantly reduce the demand for theend user goods in which our products and technologies are used.

The PRC economy has experienced significant growth inthe past decade; but such growth has been uneven across geographic and economicsectors. There can be no assurance that such growth will continue or that anypotential currency devaluation in the region will not have a negative effect onour business, including Valence. The PRC economy has also experienced deflationin the past, which may continue in the future. The current economic situationmay adversely affect our profitability over time as expenditures for consumerelectronics products and information technology may decrease due to the resultsof slowing domestic demand and deflation.

Hong Kong is a Special Administrative Region of thePRC with its own government and legislature. Hong Kong enjoys a high degree ofautonomy from the PRC under the principle of “one country, two systems.” It ispossible that Hong Kong may not continue to enjoy autonomy from the PRC.

The Hong Kong dollar has remained relatively constantdue to the U.S. dollar peg and currency board system that has been in effect inHong Kong since 1983. Since mid-1997, interest rates in Hong Kong havefluctuated significantly and real estate and retail sales have declined. It ispossible that the Hong Kong economy may deteriorate or that the historicalcurrency peg of the Hong Kong dollar to the U.S. dollar may not be maintained.Continued declining consumer spending in Hong Kong, deflation or thediscontinuation of the currency peg could adversely affect our business.

*Our ability to generate revenues and meet withcustomers may be effected by widespread illness*

Widespread illnesses such as the SARS illness and theAvian Influenza, or Asia Bird Flu, could impact our operations or our consumerelectronics licensee’s operations. For example, our ability to visit ourcustomers, our ability to conduct sales meetings or presentations, and sellthrough rates of electronics products to end consumers may be dramaticallyeffected by either widespread or perceived potential illnesses.

*We are uncertain of the total costs associated withthe planned divestiture of Valence.*

In order for us to focus on our licensing business,our Board approved on February 23, 2006 the sale of our semiconductorbusiness. In connection with such sale, the Company may incur cash and non-cashaccounting charges, which at the present cannot be reasonably estimated. Thetiming and amount of the net charges may have a negative impact to thestatement of operations.

*If the sale of consumer electronics productsincorporating our technologies does not grow in emerging markets, our abilityto increase our licensing revenue may be limited.*

We also expect that growth in our licensing revenuewill depend, in part, upon the growth of sales of consumer electronics productsincorporating our technologies in other countries, including China and India,as consumers in these markets have more disposable income and are increasinglypurchasing entertainment products with surround sound capabilities. However, ifour licensing revenue from the use of our technologies in these new markets orgeographic areas does not expand, our prospects could be adversely affected.

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*We have a long and unpredictable sales cycle, whichcan result in uncertainty and delays in generating additional revenues.*

Historically, because of the complexity of ourtechnologies, it can take a significant amount of time and effort to explainthe benefits of our technologies and to negotiate a sale. For example, ittypically takes six to nine months after our first contact with a prospective customerbefore we start licensing our technology to that customer. In addition,purchases of our products are usually made in connection with new designstarts, the timing of which is outside of our control. Accordingly, we may beunable to predict accurately the timing of any significant future sales of ourproducts. We may also spend substantial time and management attention onpotential license agreements that are not consummated, thereby foregoing otheropportunities.

*If our patents and other intellectual propertyrights do not adequately protect our products, we may lose market share to ourcompetitors and be unable to operate our business profitably.*

Our ability to compete may be affected by our abilityto protect our proprietary information. We have filed numerous U.S. and foreignpatent applications and to date have a number of issued U.S. and foreignpatents covering various aspects of our technologies. There can be no assurancethat the steps taken by us to protect our intellectual property will be adequateto prevent misappropriation of our technology or that our competitors will notindependently develop technologies that are substantially equivalent orsuperior to our technology. In addition, the laws of certain foreign countriesmay not protect our intellectual property rights to the same extent, as do thelaws of the U.S. It is possible that third parties may assert claims orinitiate litigation against us or our customers with respect to existing orfuture products. In addition, we may initiate claims or litigation againstthird parties for infringement of our proprietary rights or to determine thescope and validity of our proprietary rights.

*If we lose the services of our key personnel, or ifwe are unable to attract and retain other key personnel, we may not be able tomanage our operations or meet our growth objectives.*

Our future success depends to a large extent upon thecontinued service of key personnel, including engineering, sales and marketingstaff, and highly skilled semiconductor design staff. We anticipate that anyfuture growth will require us to recruit and hire a number of new personnel inengineering, operations, finance, sales and marketing. Competition for suchpersonnel can be intense, and it is possible that we may not be able to recruitand retain necessary personnel to operate our business and support futuregrowth.

*The market price of our common stock is volatileand your investment in our common stock could suffer a decline in value.*

The trading price of ourcommon stock has been, and will likely continue to be, subject to widefluctuations in response to quarterly variations in our operating results,announcements of new products or technological innovations by us or ourcompetitors, strategic alliances between us and third parties, general marketfluctuations and other events and factors. Changes in earnings estimates madeby brokerage firms and industry analysts relating to the markets in which we dobusiness, or relating to us specifically, have in the past resulted in, andcould in the future result in, an immediate and adverse effect on the marketprice of the common stock. Even though our stock is quoted on the Nasdaq StockMarket, our stock has had and may continue to have low trading volume and highvolatility. The historically low trading volume of our stock makes it morelikely that a severe fluctuation in volume, either up or down, willsignificantly impact the stock price. Since our shares are thinly traded, ourshareholders may have difficulty selling our common stock.

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*Ourcertificate of incorporation and bylaws as well as Delaware law containprovisions that could discourage transactions resulting in a change in control,which may negatively affect the market price of our common stock.*

Our certificate of incorporation, our bylaws andDelaware law contain provisions that might enable our management to discourage,delay or prevent change in control. In addition, these provisions could limitthe price that investors would be willing to pay in the future for shares of ourcommon stock.

*We face intense competition from companies withgreater brand recognition and resources.*

The digital audio, consumer electronics, andentertainment markets are intensely competitive, subject to rapid change, andsignificantly affected by new product introductions and other market activitiesof industry participants

Many of our currentand potential competitors enjoy substantial competitive advantages, including:

·       greater name recognition;

·       a longer operating history;

·       more developed distributionchannels and deeper relationships with semiconductor and consumer electronicsproducts manufacturers;

·       a more extensive customerbase;

·       broader product and serviceofferings;

·       greater resources forcompetitive activities, such as research and development, strategicacquisitions, alliances, joint ventures, sales and marketing, and lobbyingindustry and government standards; and

·       more technicians andengineers.

As a result, these currentand potential competitors may be able to respond more quickly and effectivelythan we can to new or changing opportunities, technologies, standards, orcustomer requirements.

**Item 1B.**               UnresolvedStaff Comments.

None.

**Item 1C.**               ExecutiveOfficers of the Registrant

Thefollowing table sets forth the executive officers of SRS Labs, Inc., theirages as of March 1, 2006, and the positions currently held by each person:

| **Name**           | ** ** | ** ** | ** ** | **Age**                                                                  | ** ** | **Position** |
|--------------------|------------|------------|------------|--------------------------------------------------------------------------|------------|--------------|
| Thomas C.K. Yuen   |       | 54         |       | Chairman, Chief  Executive Officer and President                         |
| Ulrich Gottschling |       | 47         |       | Chief Financial Officer,  Treasurer and Secretary                        |
| Alan Kraemer       |       | 55         |       | Executive Vice  President, Chief Technology Officer                      |
| David Frerichs     |       | 36         |       | Executive Vice  President, Strategic Marketing and Corporate Development |
| Lionel Cheng       |       | 48         |       | President, ValenceTech,  Limited                                         |
| Janet Biski        |       | 50         |       | Vice President                                                           |
| Michael Franzi     |       | 50         |       | Vice President,  Sales & Licensing                              |
| Sarah Yang         |       | 39         |       | Vice President, Software Engineering                                     |

 

The Chief Executive Officer, President and ChiefFinancial Officer are elected annually by the Board at its first meetingfollowing the annual meeting of stockholders. Other executive officers may be 

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appointed by the Board ofDirectors at such meeting or at any other meeting. All executive officers serveat the pleasure of the Board of Directors.

**ThomasC.K. Yuen**   has served as Chairman, ChiefExecutive Officer, President and a director of SRS Labs since January 1994.Mr. Yuen also serves as Chairman of the Board and Chief Executive Officerand a Director of ValenceTech Limited, its wholly-owned subsidiary ValenceTechnology Limited, and of SRS WOWcast, Inc. Prior to joining SRS Labs, Mr. Yuenco-founded Irvine-based AST Research, Inc. in 1981. He served as AST’sco-chairman and chief operating officer. Under his leadership, AST became aFortune 500 company in 1991, and its stock was named the Best Performing NASDStock of 1991. Mr. Yuen departed AST in 1992 and focused his efforts oninvesting in new projects. Before co-founding AST, he held various engineeringand project management positions with Hughes Aircraft Company, Sperry Univac andComputer Automation. Mr. Yuen was born in Shanghai, China and raised inHong Kong. He received his Bachelor of Science Degree in Electrical Engineeringfrom University of California, Irvine in 1974 with School Honors. He is also anHonorary Professor of China Nationality University in Beijing. Mr. Yuen isthe recipient of several awards from University of California, Irvine,including the UCI Medal in 1990; the outstanding Engineering Alumni Award in1987 and the Distinguished Alumnus Award in 1986. He was named one of the top25 executives of the computer industry by the Computer Reseller News Magazinein 1988 and 1991. In 1997, Mr. Yuen received the Director of the Yearaward from the Orange County Foundation of Corporate Directors.

**UlrichGottschling****  **hasserved as Chief Financial Officer, Secretary and Treasurer of SRS Labs since****January 2006. Previously, Mr. Gottschlingserved as CFO of Valor Computerized Systems, Inc. (VCS), which offersintegrated software solutions from design-through-manufacturing to theelectronics supply chain, from 1999 to 2005 and as Vice President of Operationsof VCS since 2000. He was also President, CFO and a member of the board ofdirectors of E4ENET.Com, Inc., an affiliated company of VCS, which offersbusiness-to-business collaboration technology. Prior to joining VCS, Mr. Gottschlingwas CFO of Sound Source Interactive, Inc, a publicly-held entertainmentsoftware company, from 1995 to 1999 and also served as President and ChiefOperating Officer of Sound Source from 1997 to 1999.

**AlanKraemer**   has served as Chief Technology Officerof SRS Labs since January 2005. He has also served as Executive Vice President, Technology and BusinessDevelopment since June 2004. Prior thereto, he served as VicePresident, Engineering of the Company since April 2000 and Director ofEngineering since February 1994. In addition, Mr. Kraemer served asPresident of Sierra Digital Productions, Inc., a compact disc productionand recording company, since August 1989. Prior to joining SRS Labs, Mr. Kraemerserved as Senior Vice President of Engineering of De LaRue Printrak, amanufacturer of automatic fingerprint identification systems, Vice President ofEngineering for AST Research, a personal computer manufacturer, Vice Presidentof Engineering with Point4 Data Corporation, and as****Directorof Software Engineering of Northrop Electronics.

**DavidFrerichs**   has served as Executive Vice President,Strategic Marketing and Corporate Development since November 2005. Priorto joining SRS, he was Vice President, US general manager at CodingTechnologies, a European audio compression IP licensing company, from July 2002to November 2005. From June 1999 to July 2002, he served asfounder then as President of iM Networks, a small venture-backed corporation,which later formed a joint venture in Japan with Softbank Broadmedia.Previously, he held senior product marketing management positions. Mr. Frerichsholds a BS in Computer Engineering from the University of Illinois,Urbana/Champaign.

**LionelCheng**   has served as acting President of Valencesince September 2005. Mr. Chengoriginally joined Valence in May 2004 to serve as Vice President ofOperations and Marketing. Prior to joining Valence, he held the position ofGeneral Manager for the Asia Pacific region from April 2003 to October 2004at Egenera, Inc., a U.S.-based firm focused on improving data centers.Before Egenera, he held the position of Director & General Manager atOasis Computer Consultant, LTd. from May 2001 to 

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April 2003. Mr. Chenghas also served as Vice President of Business Development & GeneralManager for Asia Online Ltd from June 2000 to April 2001. Inaddition, he previously held management positions at Tektronix, AST ResearchInc. and PC Plus Ltd./Swire Systems Ltd. Mr. Cheng’s experience inmanagement throughout the Asia Pacific region spans more than 20 years.

**JanetBiski**   has served as Vice President since January 2006and prior to as Chief Financial Officer and Treasurer of SRS Labs since December 2002.Ms. Biski has also served as Secretary of SRS Labs from November 2004to December 2005. Previously, she was a founder and served as ChiefFinancial Officer and Vice President of Operations for AccentCare, Inc., ahome-care company, from April 1999 to December 2002. During that time,AccentCare successfully completed 15 acquisitions and grew revenues toapproximately $100M. Prior to joining AccentCare, Ms. Biski served as VicePresident, Chief Financial Officer, Secretary and Treasurer of SRS Labs from1994 to 1999. Ms. Biski was part of the management team in its earlystart-up phase and successfully led the Company through the completion of itsinitial public offering. Ms. Biski also participated in SRS Labs’acquisition of Valence as well as several of the company’s technology acquisitions.Early in her career, Ms. Biski was a regional controller for FujitsuBusiness Systems, and held various financial management positions at IBM/ROLM. Ms. Biskihas a BS in Accounting from the State University of New York.

**MichaelFranzi**   has served as Vice President, Sales andLicensing since August 2005. Before joining SRS, Mr. Franzi was ChiefMarketing Officer at THX, formerly a division of Lucasfilm, from October 2004to July 2005. THX is a leading supplier of technology solutions andservices for the consumer electronics, cinema, DVD authoring, games andautomotive markets. Prior to THX, Mr. Franzi was VP of Americas: Marketingand Sales for a subsidary company of KDDI Corporation from November 2003to October 2004. There he successfully launched many innovative productsfor real time monitoring of video quality, into the professional TV broadcastand post-production markets. Prior to that, he was Vice President, WorldwideSales and Marketing for Planar Systems from September 2000 to February 2003.Previously, he held senior sales and marketing management positions at leadingtechnology companies including Tektronix, Inc. and Conexant Systems. Mr. Franziholds a Bachelors of Science in Electrical Engineering from the University ofPittsburgh and has attended executive management classes at Wharton BusinessSchool.

**Sarah Yang****  **has served as Vice President ofSoftware Engineering since January 2006 and as Senior Director of SoftwareEngineering since 2004. Previously, Ms. Yang served as Director ofSoftware Engineering from 2001. Ms. Yang joined SRS Labs in February of2000 as senior DSP engineer. Prior to joining SRS, Ms. Yang was SeniorConsultant at CSC and has held senior software engineering positions at VicorCorporation and National Instruments. Ms. Yang holds an MS in Physics fromTexas A&M University and an MS in Electrical Engineering from The Instituteof Acoustics in China.

**Item 2.**                        Properties

Our worldwide headquarters are located in Santa Ana,California, in a 23,400 square foot facility consisting of office and warehousespace. The lease is for a term of three years scheduled to expire on May 31,2008. We lease this facility from Daimler Commerce Partners, L.P., the generalpartner of which is Conifer Investments, Inc. The sole shareholders ofConifer are Thomas C.K. Yuen, our Chairman, Chief Executive Officer andPresident, and his spouse, Misako Yuen, as co-trustees of the Thomas YuenFamily Trust. Mr. and Mrs. Yuen also serve as the executive officersof Conifer. Mr. and Mrs. Yuen, as co-trustees of the Trust,beneficially own a significant amount of our outstanding shares of commonstock. We paid the Daimler Commerce Partners rent of $222,066, $210,600,$208,260 in 2005, 2004 and 2003, respectively. The terms and conditions of thelease are competitive based on a review of similar properties in the area withsimilar terms and conditions.

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Valence’s principal executive offices and research anddevelopment facility are located in Kwun Tong, Kowloon, Hong Kong in a 16,600square foot facility under two lease agreements, which expire in November 2006.Pursuant to these leases, we paid rent of $153,971 during 2005, $148,349 during 2004 and $330,826 during 2003.

Our worldwide headquartershouse personnel responsible for the development of our technologies and theadministration of the licensing business. The Valence facilities are used inconnection with the design and marketing of ASICs, ICs and the sale of consumerelectronic products and components. We believe that our current facilities areadequate to support our current requirements.

**Item 3.**                        LegalProceedings

From time to time we maybe involved in various disputes and litigation matters arising in the normalcourse of business. We are currently not involved in any legal proceedings thatare expected to have a material adverse effect on our consolidated financialposition, results of operations or cash flows.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders

None.

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**PART II**

**Item 5.**                        Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities

**Market for Common Stock**

Ourcommon stock trades on the Nasdaq National Market under the symbol SRSL. Thetable below reflects the high and low sales prices of the common stock asreported by The Nasdaq Stock Market, Inc. for the periods indicated.

| ** **       | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------|------------|----------|------------|---------|------------|
| **Fiscal 2005**  |       |     |       |    |       |
| First Quarter    |       | $        | 6.50       |    | $          | 3.70 |   |
| Second Quarter   |       | $        | 6.12       |    | $          | 3.46 |   |
| Third Quarter    |       | $        | 6.71       |    | $          | 5.03 |   |
| Fourth Quarter   |       | $        | 6.90       |    | $          | 5.34 |   |
| **Fiscal  2004** |       |     |       |    |       |
| First Quarter    |       | $        | 12.00      |    | $          | 5.76 |   |
| Second Quarter   |       | $        | 7.85       |    | $          | 3.98 |   |
| Third Quarter    |       | $        | 6.77       |    | $          | 3.81 |   |
| Fourth Quarter   |       | $        | 7.45       |    | $          | 5.21 |   |

 

At March 15, 2006,the last sale price of the Common Stock was $5.75 per share.

**Holders**

At March 15, 2006,there were 411 stockholders of record.

**Dividend Policy**

We have never paid cashdividends on the Common Stock. We currently intend to retain our availablefunds for future growth and, therefore, we do not anticipate paying anydividends in the foreseeable future.

**SecuritiesAuthorized for Issuance Under Equity Compensation Plans**

The followingequity compensation plans have been approved by our stockholders: the SRS Labs, Inc.Stock Option, Nonqualified Stock Option and Restricted Stock Purchase Plan (the“1993 Plan”), the SRS Labs, Inc. Amended and Restated 1996 Long-TermIncentive Plan (the “1996 Plan”), and the SRS Labs, Inc. Amended andRestated 1996 Non-employee Directors’ Stock Option Plan (the “Non-employeeDirectors Plan”). A description of the material features of each of these plansis included in Note 10 to the Notes to Consolidated Financial Statements underthe caption “Stock Award/Option Plans/Warrants.” We do not have any equitycompensation plans other than those approved by our stockholders.

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Thefollowing table sets forth information regarding the number of shares of ourcommon stock that may be issued pursuant to our equity compensation plans orarrangements as of the end of fiscal 2005.

**EquityCompensation Plan Information**

| ** **                                              | ** ** | **(a)**    | ** **      | **(b)**                                                                                                                                          | ** ** | **(c)**                                                                                                     | ** ** |
|---------------------------------------------------------|------------|------------|-----------------|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|
| **Plan category**                                  | ** ** | ** ** | ** **      | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities remaining  available for future issuance  under equity compensation plans  (excluding securities  reflected in column(a))** | ** ** |
| Equity  compensation plans approved by security holders |       |       | 4,444,254(1)(3) |                                                                                                                                             |       |                                                                                                        | $          | 4.41 |   |   |   | 2,562,863(2) |   |   |
|                                                         |            |            |                 |                                                                                                                                                  |            |                                                                                                             |            |  |  |  |  |  |  |  |  |  |

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(1)          Represents shares ofcommon stock that may be issued pursuant to outstanding options granted underthe following plans: 4,314,254 shares under the 1996 Plan and 130,000 sharesunder the Non-employee Directors Plan.

(2)          Represents shares ofcommon stock that may be issued pursuant to options available for future grantsunder the following plans: 2,192,863 shares under the 1996 Plan and 370,000shares under the Non-employee Directors Plan.

(3)          Nooptions have been granted under the 1993 plan since June 7, 1996. The 1993plan expired on December 10, 2003.

**Purchasesof Equity Securities by the Issuer and Affiliated Purchaser**

On March 25, 2005, the Board adopted a stockrepurchase program authorizing the purchase of shares of up to $3,000,000 ofits common stock for a period from April 2005 to March 2006. As of March 6,2006, total purchases under the program since inception were 232,223 shares atan average purchase price of $4.56 per share. There were no purchases by theCompany during the quarter ended December 31, 2005.

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**Item 6.**                        SelectedFinancial Data

Thefollowing selected financial information as of and for the dates and periodsindicated have been derived from our audited consolidated financial statements.The information set forth below is not necessarily indicative of results offuture operations, and should be read in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” in Part II,Item 7 of this Annual Report on Form 10-K and our consolidatedfinancial statements and related notes included elsewhere in this Report.

| ** **                                                                                        | ** ** | **Years Ended December 31,**                       | ** ** |
|---------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                                                        | ** ** | **2005**                                                          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                                        | ** ** | **(In thousands except per share data)** | ** ** |
| Revenues:                                                                                         |       |                                                              |       |   |   |   |   |   |   |   |   |
| Licensing                                                                                         |       | $                                                                 | 14,796     |   | $ | 10,832 |   | $ | 9,102 |   | $ | 8,224 |   | $ | 5,181 |   |
| Semiconductor                                                                                     |       | 8,432                                                             |       | 10,770 |   | 10,712 |   | 10,778 |   | 10,250 |   |
| Total revenues                                                                                    |       | 23,228                                                            |       | 21,602 |   | 19,814 |   | 19,002 |   | 15,431 |   |
| Cost of sales:                                                                                    |       |                                                              |       |   |   |   |   |   |   |   |   |
| Licensing                                                                                         |       | 447                                                               |       | 228 |   | 103 |   | 154 |   | 415 |   |
| Semiconductor                                                                                     |       | 3,411                                                             |       | 3,725 |   | 3,953 |   | 4,600 |   | 6,289 |   |
| Write-off of capitalized production costs                                                         |       | 2,757                                                             |       | — |   | — |   | — |   | — |   |
| Total cost of  sales                                                                              |       | 6,615                                                             |       | 3,953 |   | 4,056 |   | 4,754 |   | 6,704 |   |
| Gross margin                                                                                      |       | 16,613                                                            |       | 17,649 |   | 15,758 |   | 14,248 |   | 8,727 |   |
| Operating expenses:                                                                               |       |                                                              |       |   |   |   |   |   |   |   |   |
| Sales and marketing                                                                               |       | 6,891                                                             |       | 5,445 |   | 5,487 |   | 4,626 |   | 4,475 |   |
| Research and development                                                                          |       | 4,700                                                             |       | 4,767 |   | 4,264 |   | 4,189 |   | 3,576 |   |
| General and administrative                                                                        |       | 6,401                                                             |       | 5,675 |   | 5,053 |   | 4,890 |   | 5,167 |   |
| Total operating expenses                                                                          |       | 17,992                                                            |       | 15,887 |   | 14,804 |   | 13,705 |   | 13,218 |   |
| (Loss) income  from operations                                                                    |       | (1,379                                                            | )          | 1,762 |   | 954 |   | 543 |   | (4,491 | ) |
| Write-off of investment                                                                           |       | (185                                                              | )          | — |   | — |   | — |   | — |   |
| Equity in income of investee                                                                      |       | 91                                                                |       | 32 |   | — |   | — |   | — |   |
| Other income, net                                                                                 |       | 670                                                               |       | 595 |   | 538 |   | 774 |   | 797 |   |
| Minority interest                                                                                 |       | —                                                            |       | — |   | 5 |   | 78 |   | 193 |   |
| (Loss) income  before income tax expense                                                          |       | (803                                                              | )          | 2,389 |   | 1,497 |   | 1,395 |   | (3,501 | ) |
| Income tax  expense                                                                               |       | 621                                                               |       | 810 |   | 1,038 |   | 589 |   | 377 |   |
| Net (Loss) income                                                                                 |       | $                                                                 | (1,424     | ) | $ | 1,579 |   | $ | 459 |   | $ | 806 |   | $ | (3,878 | ) |
| Net (loss) income  per common share:                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Basic                                                                                             |       | $                                                                 | (0.10      | ) | $ | 0.11 |   | $ | 0.04 |   | $ | 0.06 |   | $ | (0.31 | ) |
| Diluted                                                                                           |       | $                                                                 | (0.10      | ) | $ | 0.10 |   | $ | 0.03 |   | $ | 0.06 |   | $ | (0.31 | ) |
| Weighted average number  of shares used in the calculation of net (loss) income per common share: |       |                                                              |       |   |   |   |   |   |   |   |   |
| Basic                                                                                             |       | 14,118                                                            |       | 13,950 |   | 13,033 |   | 12,648 |   | 12,630 |   |
| Diluted                                                                                           |       | 14,118                                                            |       | 15,781 |   | 14,421 |   | 12,862 |   | 12,630 |   |
| Balance sheet data:                                                                               |       |                                                              |       |   |   |   |   |   |   |   |   |
| Working capital                                                                                   |       | $                                                                 | 8,849      |   | $ | 7,192 |   | $ | 12,335 |   | $ | 14,401 |   | $ | 19,615 |   |
| Total assets                                                                                      |       | 35,065                                                            |       | 35,502 |   | 31,491 |   | 29,307 |   | 28,263 |   |
| Stockholders’  equity                                                                        |       | 30,813                                                            |       | 32,431 |   | 27,950 |   | 25,282 |   | 24,536 |   |

 

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**Item7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operation

We are a leading developerand provider of audio and voice technology solutions for the homeentertainment, portable media device, personal telecommunications, personalcomputer, automotive, and broadcast markets, and a developer and provider ofapplication specific integrated circuits, or ASICs, and standard integratedcircuits, or ICs.

In 2003 we reported ourrevenues in the following five segments: licensing, semiconductors, componentdistribution, product sales, and Internet and broadcast. In 2004, we decided toreduce our segments to licensing and semiconductors because of the materialityof the revenues attributable to the other three segments. For all periodsreported, revenue from the component distribution segment is reported in thesemiconductor segment and revenues from product sales and Internet andbroadcast segments are reported in the licensing segment.

*Licensing:****  ***Thelicensing segment develops and licenses audio and voice technology solutions tomany of the world’s leading OEMs, software providers and semiconductorcompanies, and licenses and markets hardware and software products for theInternet and professional audio markets.

In September 2004, weentered into a strategic alliance with Coming Home Studios LLC, or CHS to useand promote SRS Labs technologies, promote CHS productions and to promote eachcompany’s respective brands. In connection with the strategic alliance, theCompany and CHS established a joint venture, CHS/SRS, LLC, or the JointVenture, to produce and distribute six concert videos by *Duran Duran,Boz Scaggs, Godsmack and All Access* featuring our Circle Surroundtechnology, or the Concert Videos. Initially, Coming Home Studios LLC was themanager of the CHS/SRS Joint Venture; however, due to the Company’s concernsabout production delays and completion risks with respect to the ConcertVideos, the Company became manager of the CHS/SRS Joint Venture in July, 2005. Asa result of becoming the manager of, and providing financial support to theJoint Venture, the Company was required under FASB Interpretation No. 46, *Consolidation of Variable Interest Entities* (FIN 46R), toconsolidate the financial statements of the Joint Venture into our financialstatements commencing with the third quarter of fiscal 2005. In theconsolidated financial statements, all inter-company accounts and transactionsbetween the Company and the Joint Venture have been eliminated. Previously, weaccounted for our 50% equity ownership in the Joint Venture as an investmentusing the equity method.

In February 2006, ourBoard of Directors, or the Board, authorized management to take all reasonablesteps to divest our entire equity interest in the Joint Venture. We have notyet estimated the costs we will incur in connection with the divestiture of ourequity interest in the Joint Venture.

In addition, we recordedan asset impairment charge of $3.3million related to our investment in the Joint Venture, which is included inour consolidated results of operations for the quarter ended December 31,2005. See “Critical Accounting Policies—*Valuation of long livedassets—Impairment,*” herein. The impairment charge was determinedbased on (a) sales to date and expected future net cash flows to theCompany from the Joint Venture, and (b) the estimated cost to complete theremaining three unreleased Concert Videos and their expected sales oncecompleted. Because the impairment does not relate to cash charges, we do notexpect the impairment charge will result in future cash expenditures, exceptfor certain legal and accounting expenses related to the disposition of ourinterest in the Joint Venture. Because we are required to consolidate thefinancial statements of the Joint Venture, the impairment amount has beenrecorded as: a $2,757,172 charge to cost of goods sold principally related to awrite down of capitalized production costs, a $348,167 charge to general and administrativeexpenses, and a $185,304 charge to write off our remaining investment in theJoint Venture which is included in Other Income/Expense. The amounts includedin the Company’s Consolidated Statements of Cash Flows for the year endedDecember 31, 2005 as write off of investment in LLC, reflects the Company’s capitalcontribution of $2,943,966, capitalized costs associated with the Joint Ventureof $149,766, its proportionate share of profit from the Joint Venture of$123,454, and the consolidated net equity of the LLC in the amount of $96,859.

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*Semiconductor:**  *Through Valence Technology Limited,a Hong Kong company and its subsidiaries, which we collectively refer to asValence, we operate a fabless semiconductor company which develops, designs andmarkets standard and custom, analog, DSPs, and mixed signal, integratedcircuits primarily to OEMs and ODMs in the Asia Pacific region.

In February 2006, theBoard approved a plan to sell Valence in order to focus increased managementattention and financial resources on what it believes to be a larger andexpanding market opportunity for its licensing business. As a result of ourdecision to sell Valence, we will account for the semiconductor businesssegment as a discontinued operation beginning in the quarter ending March 31,2006.

**Critical Accounting Policies**

Our discussion andanalysis of our results of operations and liquidity and capital resources arebased on our consolidated financial statements which have been prepared inaccordance with accounting principles generally accepted in the United States.

The preparation of thesefinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses, anddisclosure of contingent assets and liabilities. We base our estimates onhistorical and anticipated results and trends and on various other assumptionsthat we believe are reasonable under the circumstances, including assumptionsas to future events. These estimates form the basis for making judgments aboutthe carrying value of assets and liabilities that are not readily apparent fromother sources. By their nature, estimates are subject to an inherent degree ofuncertainty. Actual results may differ from our estimates.

The following represents asummary of our critical accounting policies, defined as those policies that webelieve are: (a) the most important to the portrayal of our financialcondition and results of operations, and (b) that require management’smost difficult, subjective or complex judgments, often as a result of the needto make estimates about the matters that are inherently uncertain. Our mostcritical accounting estimates include valuation of accounts receivable, whichimpacts operating expenses; valuation of inventory, which impacts gross margin;valuation of intangible assets and capitalization of software, which primarilyimpacts operating expenses when we impair assets or accelerate theirdepreciation; and recognition and measurement of current and deferred incometax assets and liabilities, which impacts our tax provision. We discuss each ofthese policies below, as well as the estimates and judgments involved. We alsohave other policies that we consider key accounting policies, such as ourpolicies for revenue recognition; however, these policies do not meet thedefinition of critical accounting estimates, because they do not generallyrequire us to make estimates or judgments that are difficult or subjective.

*Accounts Receivable*

We perform ongoing creditevaluations of our customers and adjust credit limits based upon paymenthistory, the customer’s current credit worthiness and various other factors, asdetermined by our review of their current credit information. We continuouslymonitor collections and payments from our customers and maintain allowances fordoubtful accounts based upon specific customer circumstances, current economictrends, historical experience and the age of past due receivables. While suchcredit losses have historically been within our expectations and the provisionsestablished, we cannot guarantee that we will continue to experience the samecredit loss rates that we have in the past. Unanticipated changes in theliquidity or financial position of our customers may require additionalprovisions for doubtful accounts.

*Inventory*

Inventory is stated at thelower of cost or net realizable value. We periodically assess our inventory forpotential obsolescence and lower-of-cost-or-market issues. We make estimates ofinventory obsolescence, providing reserves when necessary, based on, amongother factors, demand for inventory based on backlog, product pricing, theability to liquidate or sell older inventory, and the impact of introducing newproducts. 

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Ifactual market conditions or our customers’ product demands are less favorablethan those projected, additional provisions may be required.

*Intangible Assets &Capitalization of Software*

In accordance withStatement of Financial Accounting Standards, or SFAS, No. 142, “Goodwilland Other Intangible Assets”, we assess potential impairments to intangibleassets when there is evidence that events or changes in circumstances indicatethat the carrying amount of an asset may not be recovered. Our judgmentsregarding the existence of impairment indicators and future cash flows relatedto intangible assets are based on operational performance of our acquiredbusinesses, market conditions and other factors. If the carrying value of areporting unit exceeds its fair value, goodwill is considered impaired and asecond test is performed to measure the amount of impairment loss, if any. Todate, we have not recognized any impairment of our goodwill and otherintangible assets in connection with our adoption of SFAS 142. However, noassurances can be given that future evaluation of goodwill will not result incharges as a result of future impairment.

In accordance withStatement of Financial Accounting Standards, or SFAS, No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets,” all of our intangibleassets that have definite lives are being amortized on a straight-line basisover their estimated useful lives. Costs paid by us related to theestablishment and transfer of patents, primarily legal costs, are capitalizedand amortized over periods ranging from five to ten years, depending on theestimated life of the technology patented. Consideration for the purchase ofassets in excess of the fair market value of specifically identified tangibleassets has been capitalized as intangible and is being amortized over periodsranging from three to 11 years depending on the useful life of the asset. Weannually evaluate the recoverability of our patents and intangible assets basedon the estimated future undiscounted cash flows. Should the carrying value ofpatents or intangible assets exceed the estimated future undiscounted cashflows for the expected periods of benefit, such assets will be written down tofair value.

Costs incurred in theresearch, design and development of software for sale to others as a separateproduct or embedded in a product and sold as part of the product as a whole arecharged to expense until technological feasibility is established. UnderStatement of Financial Accounting Standards, or SFAS, No. 86, “Accountingfor the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,”we capitalize software purchased from third parties if the related softwareproduct under development has reached technological feasibility or if there arealternative future uses for the purchased software, provided that capitalizedamounts will be realized over a period not exceeding five years. Costs incurredprior to the establishment of technological feasibility are charged to researchand development expense. The establishment of technological feasibility andongoing assessment of recoverability of capitalized software development costsrequire considerable judgment by management with respect to certain externalfactors, including, but not limited to, anticipated future revenues, estimatedeconomic life and changes in software and hardware technologies. Under SFASNo. 86, annual amortization of software development costs are equal to thegreater of (a) the ratio that current gross revenues for a product bear tothe total of current and anticipated future gross revenues for that product or(b) the straight-line method over the remaining estimated economic life ofthe product including the period being reported on. We are using thestraight-line method of amortization because the software can be used for manyproducts and the estimates required to be made under the ratio that currentgross revenues for products bear to the total of the current and anticipatedfuture gross revenues for that product could result in under reporting ofexpense. Upon the general release of the software product to customers,capitalization ceases and such costs are amortized to cost of sales using thestraight-line method on a product-by-product basis over the estimated life,which is generally three years. To the extent that amounts capitalized forsoftware development costs become impaired due to a decline in demand or theintroduction of new technology, such amounts will be written-off. All otherresearch and development expenditures are charged to research and developmentexpense in the period incurred.

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*Impairment oflong-lived assets*

The Company evaluates therecoverability of long-lived assets with finite lives in accordance with SFAS No. 144,“Accounting for the Impairment of Long-Lived Assets.” The Company assessespotential impairments to its long-lived assets when there is evidence thatevents or changes in circumstances indicate that the carrying amount of anasset may not be recovered. An impairment loss is recognized when the carryingamount of the long-lived asset is not recoverable and exceeds its fair value.The carrying amount of a long-lived asset is not recoverable if it exceeds thesum of the undiscounted cash flows expected to result from the use and eventualdisposition of the asset. Any required impairment loss is measured as theamount by which the carrying amount of a long-lived asset exceeds its fairvalue and is recorded as a reduction in the carrying value of the related assetand a charge to operating results. As discussed further in Note 3 to the Notesto the Consolidated Financial Statements, based upon our most recent assessmentas of December 31, 2005, we have determined there was a $3.3 millionimpairment in the value of our investment in the Joint Venture.

*Income Taxes*

In preparing our consolidated financial statements, weestimate our income taxes in each of the countries in which we operate. Theprocess used to make these estimates includes an assessment of the current taxexpense, the results from tax examinations and the effects of temporarydifferences resulting from the different treatment of transactions for tax andfinancial accounting purposes. These differences result in deferred tax assetsand liabilities, which are included in our consolidated balance sheet. Weaccount for income taxes in accordance with Statement of Financial AccountingStandards, or SFAS, No. 109, “Accounting for Income Taxes,” which requiresthat deferred tax assets and liabilities be recognized using enacted tax ratesfor the effect of temporary differences between the book and tax bases ofrecorded assets and liabilities. SFAS 109 also requires that deferred taxassets be reduced by a valuation allowance if it is more likely than not thatsome portion or all of the deferred tax asset will not be realized. We evaluatethe reliability of our deferred tax assets by assessing our valuation allowanceand by adjusting the amount of such allowance, if necessary. At December 31,2005, we had net deferred tax assets primarily resulting from temporarydifferences between the book and tax bases of assets and liabilities, and lossand credit carry forwards. We continue to provide a valuation allowance oncertain deferred tax assets based on an assessment of the likelihood of theirrealization. In reaching our conclusion, we evaluated certain relevant criteriaincluding deferred tax liabilities that can be used to offset deferred taxassets, estimates of future taxable income of appropriate character within thecarry-forward period available under the tax law, and tax planning strategies.Our judgments regarding future taxable income may change due to marketconditions, changes in U.S. or international tax laws, and other factors. Thesechanges, if any, may require material adjustments to these deferred tax assets,resulting either in a tax benefit, if it is estimated that future taxableincome is likely, or a reduction in the value of the deferred tax assets, if itis determined that their value is impaired, resulting in a reduction in netincome or an increase in net loss in the period when such determinations aremade.

Our income tax provisionis based on calculations and assumptions that will be subject to examination bythe taxing authorities in the jurisdictions in which we operate. Should theactual results differ from our estimates, we would have to adjust the incometax provision in the period in which the facts and circumstances that give riseto the revision become known. Tax law and rate changes are reflected in theincome tax provision in the period in which such changes are enacted.

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**Results of Operations**

The following table setsforth certain consolidated operating data as a percentage of total revenue forthe years ended December 31, 2005, 2004, and 2003:

**Percentage of TotalRevenue**

| ** **                         | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------|------------|---------------------------------------------|------------|
| ** **                         | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Revenues:**                      | ** ** |                                        | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Licensing                          |       |                                        | 64         | % |   |   | 50 | % |   |   | 46 | % |   |
| Semiconductor                      |       |                                        | 36         |   |   |   | 50 |   |   |   | 54 |   |   |
| Total revenues                     |       |                                        | 100        |   |   |   | 100 |   |   |   | 100 |   |   |
| Cost of sales:                     |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Licensing                          |       |                                        | 14         | (a) |   |   | 1 |   |   |   | 0 |   |   |
| Semiconductor                      |       |                                        | 15         |   |   |   | 17 |   |   |   | 20 |   |   |
| Total cost of  sales               |       |                                        | 29         |   |   |   | 18 |   |   |   | 20 |   |   |
| Gross margin                       |       |                                        | 71         |   |   |   | 82 |   |   |   | 80 |   |   |
| Operating expenses                 |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                |       |                                        | 30         |   |   |   | 26 |   |   |   | 28 |   |   |
| Research and development           |       |                                        | 20         |   |   |   | 22 |   |   |   | 22 |   |   |
| General and administrative         |       |                                        | 27         |   |   |   | 26 |   |   |   | 25 |   |   |
| Total operating expenses           |       |                                        | 77         |   |   |   | 74 |   |   |   | 75 |   |   |
| Operating (loss)  income           |       |                                        | (6         | ) |   |   | 8 |   |   |   | 5 |   |   |
| Equity in income of investee       |       |                                        | 0          |   |   |   | 0 |   |   |   | 0 |   |   |
| Other income, net                  |       |                                        | 2          |   |   |   | 3 |   |   |   | 3 |   |   |
| Minority interest                  |       |                                        | 0          |   |   |   | 0 |   |   |   | 0 |   |   |
| (Loss) income  before income taxes |       |                                        | (4         | ) |   |   | 11 |   |   |   | 8 |   |   |
| Income tax  expense                |       |                                        | 2          |   |   |   | 4 |   |   |   | 6 |   |   |
| Net (loss) income                  |       |                                        | (6         | )% |   |   | 7 | % |   |   | 2 | % |   |

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(a)           Costof sales includes the write-off of the capitalized production costs of $2.8million related to CHS/SRS LLC.

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**YearEnded December 31, 2005 Compared to Year Ended December 31, 2004**

*Revenues*

Totalrevenues for fiscal 2005 were $23,228,259 compared to $21,602,388 in fiscal2004, an increase of $1,625,871 or 7.5%. Licensing revenues were $14,795,810 infiscal 2005, compared to $10,831,704 in fiscal 2004, an increase of $3,964,106or 36.6%. This increase is attributable to our diversification strategy, whichgenerated revenues in new product categories such as portable audio devices,mobile phones, and PCs, and continued demand in the home theater market, whichincludes set-top boxes and televisions. The following table presents our mix oflicensing revenues by market segment:

| ** **                                                | ** ** | **Years Ended**  | ** ** |
|-----------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                | ** ** | **December 31,** | ** ** |
| ** **                                                | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Home  Entertainment (TV, Set-Top Box, A/V Receiver, DVD)  |       |                  | 51         | % |   |   | 67 | % |   |
| Portable Media  Devices (Digital Media Player, Headphone) |       |                  | 23         | % |   |   | 12 | % |   |
| PC (Software,  Hardware)                                  |       |                  | 12         | % |   |   | 10 | % |   |
| Personal  Telecommunications (Mobile phone, PDA)          |       |                  | 11         | % |   |   | 10 | % |   |
| Automotive                                                |       |                  | 3          | % |   |   | 1 | % |   |
|                                                      |       |                  | 100        | % |   |   | 100 | % |   |

 

Semiconductor revenueswere $8,432,449 in fiscal 2005 compared to $10,770,684 in fiscal 2004, adecrease of $2,338,235 or 21.7%. In 2005, ASIC semiconductor revenue wasnegatively affected by a decline in demand for our products utilized in thetraditional CD Combo and Boombox markets due to increased sales of MP3 players,and the phasing out of certain of our ASIC products due to changes in customerdemand. This decrease in our ASIC revenues was partially offset by increases inour ASP revenues due to the introduction of several new ASP products. ASICsemiconductor revenue accounted for $5,301,396 or 62.9% in fiscal 2005 comparedto $7,752,537 or 72.0% in fiscal 2004, a decrease of $2,451,141 or 31.6%. ASPchips accounted for $3,131,053 or 37.1% in fiscal 2005 semiconductor revenuecompared to $3,018,147 or 28.0% in fiscal 2004, an increase of $112,906 or 3.7%.The growth in ASP revenues is partially attributable to increased demand forASP chips as compared to traditional ASIC chips.

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*Gross Margin*

Costof sales consists primarily of fabrication costs, assembly and test costs, andthe cost of materials and overhead from operations. Included in cost of salesfor fiscal 2005 is the write down of capitalized production costs of $2,757,172related to the Joint Venture. Gross margins are dependent on the mix ofproducts sold, services provided and royalties earned. The following tablepresents the our gross margin percentages for fiscal year 2005 compared tofiscal year 2004:

| ** **                                                         | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                         | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| **Licensing**                                                      |       |                                   |       |   |   |   |   |
| Licensing revenue as a percentage of total revenue                 |       |                                   | 63.7       | % |   |   | 50.1 | % |   |
| Licensing gross margin                                             |       |                                   | 78.3       | %(a) |   |   | 97.9 | % |   |
| **Semiconductor**                                                  |       |                                   |       |   |   |   |   |   |   |
| ASIC revenue as a percentage of total semiconductor  revenue  |       |                                   | 62.9       | % |   |   | 72.0 | % |   |
| ASIC gross margin                                                  |       |                                   | 63.7       | % |   |   | 65.1 | % |   |
| ASP revenue as a percentage of total semiconductor  revenue        |       |                                   | 37.1       | % |   |   | 28.0 | % |   |
| ASP gross margin                                                   |       |                                   | 52.5       | % |   |   | 66.3 | % |   |
| Total semiconductor revenue as a percentage of total  revenue      |       |                                   | 36.3       | % |   |   | 49.9 | % |   |
| Total semiconductor gross margin                                   |       |                                   | 59.5       | % |   |   | 65.4 | % |   |
| **Total Gross Margin**                                             |       |                                   | 71.5       | % |   |   | 81.7 | % |   |

----

(a)           Decreasein gross margin is due to write-off of capitalized production costs of $2.8million.

*Sales and Marketing*

Sales and marketingexpenses consist primarily of employee salaries, sales consultants’ fees andrelated expenses, sales commissions and product promotion costs. Sales andmarketing expenses were $6,890,666 for fiscal year 2005, of which $5,192,090and $1,698,576 was incurred by the licensing and semiconductor segment,respectively. Sales and marketing expenses were $5,445,224**for fiscal year 2004, of which $4,550,100and $895,124 was incurred by the licensing and semiconductor segment,respectively. Overall sales and marketing expenses were $1,445,442 or 26.5%higher in fiscal 2005 due to increased staffing in the licensing segment,increased commissions on higher licensing revenues and continued advertisingcampaigns to brand the SRS logo. As a percentage of total revenues, sales andmarketing expenses increased from 25.2% for fiscal year 2004, to 29.7% forfiscal year 2005.

*Research andDevelopment*

Research and developmentexpenses consist of salaries and related costs of employees engaged in ongoingresearch, design and development activities and costs for engineering materialsand supplies. Research and development expenses were $4,700,016 for fiscal year2005, of which $2,224,237 and $2,475,779 was incurred by licensing andsemiconductor, respectively. Research and development expenses were $4,767,004for fiscal year 2004, of which $2,261,886 and $2,505,118 was incurred by thelicensing and semiconductor segment, respectively. The overall decrease inresearch and development expenses of $66,988 or 1.4% is primarily attributableto minor adjustments in staffing in both segments. We expect that research and development expenses will increase in 2006as we continue to expand our intellectual property, which we believe iscritical to our business. We expect that research and development expenses willfluctuate as a percentage of revenue due to change in sales volume. As apercentage of total revenues, research and development expenses decreased from22.1% for fiscal year 2004, to 20.2% for fiscal year 2005.

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*General andAdministrative*

General and administrativeexpenses consist primarily of employee-related expenses, legal costs associatedwith the administration of intellectual property and other professional fees.General and administrative expenses were $6,401,021 for fiscal year 2005, ofwhich $4,345,465 and $2,055,556 was incurred by the licensing and semiconductorsegment, respectively.  General andadministrative expenses were $5,675,294 for fiscal year 2004, of which$3,492,995 and $2,182,299 was incurred by the licensing and semiconductorsegment, respectively.  Corporateoverhead costs of $1,173,327 and $1,128,529 were allocated to the semiconductorsegment in 2005 and 2004, respectively, and are included in the above amounts.The overall increase of $725,727, or 12.8%, was primarily attributable toincreased professional fees, public company expenses, including costs incurredfor Sarbanes-Oxley 404 compliance, write-down of Joint Venture assets of$348,167, and increased amortization associated with the increasedcapitalization of patents and purchased technology absorbed by the licensingsegment, offset by decreases in headcount related costs in the semiconductorsegment. As a percentage of total revenues, general and administrative expensesincreased from 26.3% for fiscal year 2004, to 27.6% for fiscal year 2005.

*Equity in Income ofInvestee*

Equity in income ofinvestee of $91,096 represents the Company’s proportionate share of profit fromthe Joint Venture prior to the consolidation of the Joint Venture’s financialstatement with our consolidated financial statements.

*Other Income, Net*

Other income, net,consists principally of interest income and write-off of investment in theJoint Venture. Other income, net, was $484,526 for fiscal year 2005, comparedto $594,922 for fiscal year 2004, a decrease of $110,396 or 18.6%. The decreaseis primarily attributable to loss on our investment in the Joint Venture in2005.

*Provision forIncome Taxes*

The income tax provision for fiscal 2005 was $620,893compared to $810,416 for fiscal 2004 a decrease of $189,523 or 23.4%. Theprovision consists primarily of taxes paid on licensing revenues sourced fromcountries requiring foreign tax withholdings and taxes paid on profits in HongKong at the rate of 17.5%. The lower tax expense in fiscal 2005 resulted fromdecreased taxable income in our foreign subsidiary and higher taxable incomefrom our U.S. operations for which we apply net operating loss carry-forwardsto offset taxable income. Additionally, in 2005, we benefited from the U.S.Japan tax treaty, which eliminated source-country withholdings on royalties.That treaty became effective on July 1, 2004.

We had federal and statenet operating loss carry-forwards at December 31, 2005 of approximately$18,686,000 and $9,333,000, respectively. The net operating loss carry-forwardsbegan expiring in 2003 and will continue through 2025. In addition, we hadfederal tax credit carry-forwards of approximately $1,914,000, atDecember 31, 2005, which begin to expire in 2011. As of December 31,2005, a valuation allowance of $11,668,869 was established based on ourassessment of our future ability to realize certain deferred tax assets.

**YearEnded December 31, 2004 Compared to Year Ended December 31, 2003**

*Revenues*

Totalrevenues for fiscal 2004 were $21,602,388 compared to $19,813,781 in fiscal2003, an increase of $1,788,607 or 9.0%. Licensing revenues were $10,831,704 infiscal 2004, compared to $9,101,399 in fiscal 2003, an increase of $1,730,305or 19.0%. This increase is attributable to our diversification strategy, which 

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generated revenues in new product categories such asmobile phones, portable audio devices, and PCs and increased penetration in theCompany’s key home theater market, including set-top boxes and televisions,which incorporate SRS Labs’ technologies. The following table presents theCompany’s licensing revenues mix by market segment:

| ** **                                                | ** ** | **Years Ended**  | ** ** |
|-----------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                | ** ** | **December 31,** | ** ** |
| ** **                                                | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Home  Entertainment (TV, Set-Top Box, A/V Receiver, DVD)  |       |                  | 67         | % |   |   | 81 | % |   |
| Portable Media  Devices (Digital Media Player, Headphone) |       |                  | 12         | % |   |   | 7 | % |   |
| PC (Software,  Hardware)                                  |       |                  | 10         | % |   |   | 5 | % |   |
| Personal  Telecommunications (Mobile phone, PDA)          |       |                  | 10         | % |   |   | 6 | % |   |
| Automotive                                                |       |                  | 1          | % |   |   | 1 | % |   |
|                                                      |       |                  | 100        | % |   |   | 100 | % |   |

 

Semiconductor revenueswere $10,770,684 in fiscal 2004 compared to $10,712,382 in fiscal 2003, anincrease of $58,302 or 0.5%. In 2004, semiconductor revenue growth was affectedby management changes, foundry capacity constraints and competitive pressurerelated to its customers’ products. Semiconductor revenues are composed of bothASIC and ASP. ASIC accounted for $7,752,537 or 72.0% in fiscal 2004 compared to$8,168,751 or 76.3% in fiscal 2003, a decrease of $416,214 or 5.1%. ASP chipsaccounted for $3,018,147 or 28.0% in fiscal 2004 compared to $2,543,631 or23.7% in fiscal 2003, an increase of $474,516 or 18.7%, of which SRS technologychips accounted for 60.8% of ASP growth. The growth in ASP is attributable tonew design wins with new chip offerings including SRS chips.

*Gross Margin*

Costof sales consists primarily of fabrication costs, assembly and test costs, andthe cost of materials and overhead from operations. Gross margins are dependenton the mix of products sold, services provided and royalties earned. Thefollowing table presents the Company’s gross margin percentages for fiscal year2004 compared fiscal year 2003:

| ** **                                                    | ** ** | **Years Ended December 31,**                                      | ** ** |
|---------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                    | ** ** | **      2004      ** | ** ** | **      2003      ** | ** ** |
| **Licensing**                                                 |       |                                                                             |       |   |   |   |   |   |   |
| Licensing revenue as a percentage of total revenue            |       |                                                                             | 50.1       | % |   |   | 45.9 | % |   |
| Licensing gross margin                                        |       |                                                                             | 97.9       | % |   |   | 98.9 | % |   |
| **Semiconductor**                                             |       |                                                                             |       |   |   |   |   |   |   |
| ASIC revenue as a percentage of total semiconductor  revenue  |       |                                                                             | 72.0       | % |   |   | 76.3 | % |   |
| ASIC gross margin                                             |       |                                                                             | 65.1       | % |   |   | 63.2 | % |   |
| ASP revenue as a percentage of total semiconductor  revenue   |       |                                                                             | 28.0       | % |   |   | 23.7 | % |   |
| ASP gross margin                                              |       |                                                                             | 66.3       | % |   |   | 62.8 | % |   |
| Total semiconductor revenue as a percentage of total  revenue |       |                                                                             | 49.9       | % |   |   | 54.1 | % |   |
| Total semiconductor gross margin                              |       |                                                                             | 65.4       | % |   |   | 63.1 | % |   |
| **Total Gross Margin**                                        |       |                                                                             | 81.7       | % |   |   | 79.5 | % |   |

 

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*Sales and Marketing*

Sales and marketingexpenses consist primarily of employee salaries, sales consultants’ fees andrelated expenses, sales commissions and product promotion costs. Sales andmarketing expenses were $5,445,224 for fiscal year 2004, of which $4,550,100and $895,124 was incurred by licensing and semiconductor, respectively. Salesand marketing expenses were $5,487,159**forfiscal year 2003, of which $4,193,274 and $1,293,885 was incurred by licensingand semiconductor, respectively. Overall, sales and marketing expenses were$41,935 or 0.8% higher in fiscal 2003 due to strong consumer advertisingcampaigns to market the SRS Labs’ speaker products and to brand the SRS logo toconsumers worldwide, offset by decreases in semiconductor costs related tochanges in headcount. As a percentage of total revenues, sales and marketingexpenses decreased from 27.7% for fiscal year 2003, to 25.2% for fiscal year2004.

*Research and Development*

Research and developmentexpenses consist of salaries and related costs of employees engaged in ongoingresearch, design and development activities and costs for engineering materialsand supplies. Research and development expenses were $4,767,004 for fiscal year2004, of which $2,261,886 and $2,505,118 was incurred by the licensing andsemiconductor segment, respectively.  Research and development expenses were$4,263,682 for fiscal year 2003, of which $1,875,863 and $2,387,819 wasincurred by the licensing and semiconductor segment, respectively. The overallincrease of $503,322 or 11.8% is primarily attributable to increased costs inthe licensing segment associated with personnel and expenses associated withsupporting the Company’s customers in its five key markets. We expect that research and development willcontinue to be critical to our business as we introduce new products, but suchexpenses will fluctuate as a percentage of revenue due to change in salesvolume. As a percentage of total revenues, research and developmentexpenses increased from 21.5% for fiscal year 2003, to 22.1% for fiscal year2004.

*General and Administrative*

General and administrativeexpenses consist primarily of employee-related expenses, legal costs associatedwith the administration of intellectual property and other professional fees. Generaland administrative expenses were $5,675,294 for fiscal year 2004, of which$3,492,995 and $2,182,299 was incurred by the licensing and semiconductorsegment, respectively. General and administrative expenses were $5,053,387 forfiscal year 2003, of which $4,048,864 and $1,004,523 was incurred by thelicensing and semiconductor segment, respectively. In fiscal 2004, the Companybegan allocating a portion of its corporate overhead costs included in thelicensing segment to the semiconductor segment. In fiscal 2004, $1,128,529 incorporate overhead costs was allocated to the semiconductor segment and isincluded in the above amount. The overall increase of $621,907 or 12.3% wasprimarily attributable to increased professional fees, public company expenses,including costs incurred for Sarbanes-Oxley 404 compliance and increasedamortization associated with the increased capitalization of patents andpurchased technology. As a percentage of total revenues, general andadministrative expenses increased from 25.5% for fiscal year 2003, to 26.3% forfiscal year 2004.

*Equity in Income of Investee*

Equity in income ofinvestee represents the Company’s proportionate share of profit from the JointVenture. For fiscal 2004, the joint venture is accounted for using the equitymethod and profits are recognized following the guidance for equity methodaccounting. For fiscal 2004, the profit recognized under the agreement was$32,358.

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*Other Income, Net*

Other income, net,consists principally of interest income and realized gains on sale ofsecurities. Other income, net, was $594,922 for fiscal year 2004, compared to$538,278 for fiscal year 2003, an increase of $56,644 or 10.5%. The increase isprimarily attributable to investment gains from sales of U.S. Treasury securitiesin 2004.

*Minority Interest*

Minority interestrepresents the minority shareholders’, 13%, proportionate share of losses inSRSWOWcast. Minority interest was $0 for fiscal year 2004, compared to $5,430for fiscal year 2003. In February 2003, SRS Labs completed an exchangeoffer with the minority shareholders of SRSWOWcast, pursuant to which SRS Labsacquired all of the outstanding shares of Series A Convertible PreferredStock of SRSWOWcast in exchange for the issuance of shares of our common stock.As a result of the exchange offer, SRSWOWcast became a wholly owned subsidiaryof SRS Labs.

*Provision for Income Taxes*

The income tax provisionfor fiscal 2004 was $810,416 compared to $1,038,463 for fiscal 2003 a decreaseof $228,047 or 22.0%. The provision consists primarily of taxes paid onlicensing revenues sourced from countries requiring foreign tax withholdingsand taxes paid on profits in Hong Kong at the rate of 17.5%. The lower taxexpense in fiscal 2004 resulted from decreased taxable income in our foreignsubsidiary and higher taxable income from our U.S. operations for which weapply net operating loss carry-forwards to offset taxable income. Additionally,in 2004, we benefited from the U.S. Japan tax treaty, which eliminatedsource-country withholdings on royalties. That treaty became effective on July 1,2004.

We had federal and statenet operating loss carry-forwards at December 31, 2004 of approximately$21,555,000 and $13,141,000, respectively. The net operating losscarry-forwards began expiring in 2003 and will continue through 2024. Inaddition, we had federal tax credit carry-forwards of approximately $1,150,733,which begin to expire in 2011. As of December 31, 2004, a valuationallowance of $10,491,223 was established based on our assessment of our futureability to realize certain deferred tax assets.

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**SelectedQuarterly Operating Results**

Thefollowing table sets forth certain quarterly summary financial data for theeight quarters in the period ended December 31, 2005. The quarterlyinformation is based upon financial statements prepared by us on a basisconsistent with our audited consolidated financial statements and, inmanagement’s opinion, includes all adjustments, consisting only of normalrecurring adjustments necessary for a fair presentation of the information forthe periods presented. This information should be read in conjunction with ouraudited consolidated financial statements and notes thereto appearing elsewherein this Report. Our quarterly operating results have varied significantly inthe past and are expected to vary significantly in the future. Due to roundingdifferences, the quarters in a given year may not add precisely to the annualnumbers for that year.

| ** **                           | ** ** | **Three Months Ended**                                     | ** ** |
|--------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                           | ** ** | **Mar 31,**                                                     | ** ** | **June 30,** | ** ** | **Sep 30,** | ** ** | **Dec 31,** | ** ** | **Mar 31,** | ** ** | **June 30,** | ** ** | **Sep 30,** | ** ** | **Dec 31,** | ** ** |
| ** **                           | ** ** | **2005**                                                             | ** ** | **2005** | ** ** | **2005** | ** ** | **2005** | ** ** | **2004** | ** ** | **2004** | ** ** | **2004** | ** ** | **2004** | ** ** |
| ** **                           | ** ** | **(In thousands except per share amounts)** | ** ** |
| Revenues:                            |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Licensing                            |       | $                                                                    | 3,264      |   |   | $ | 3,540 |   |   | $ | 3,723 |   | $ | 4,269 |   | $ | 2,927 |   |   | $ | 2,485 |   |   | $ | 2,728 |   | $ | 2,691 |   |
| Semiconductor                        |       | 1,985                                                                |       |   | 2,521 |   |   | 1,930 |   | 1,997 |   | 2,416 |   |   | 2,932 |   |   | 3,644 |   | 1,778 |   |
| Total revenues                       |       | 5,249                                                                |       |   | 6,061 |   |   | 5,653 |   | 6,266 |   | 5,343 |   |   | 5,417 |   |   | 6,372 |   | 4,469 |   |
| Gross margin                         |       | 4,464                                                                |       |   | 4,967 |   |   | 4,798 |   | 2,383 |   | 4,434 |   |   | 4,331 |   |   | 4,951 |   | 3,933 |   |
| Operating  expenses                  |       | 4,344                                                                |       |   | 4,464 |   |   | 4,188 |   | 4,995 |   | 4,458 |   |   | 3,889 |   |   | 4,024 |   | 3,516 |   |
| (Loss) income  from operations       |       | 120                                                                  |       |   | 503 |   |   | 610 |   | (2,612 | ) | (24 | ) |   | 442 |   |   | 927 |   | 417 |   |
| Net (loss) income                    |       | $                                                                    | 221        |   |   | $ | 514 |   |   | $ | 704 |   | (2,864 | ) | $ | (25 | ) |   | $ | 230 |   |   | $ | 804 |   | $ | 569 |   |
| Net (loss) income per  common share: |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                |       | $                                                                    | 0.02       |   |   | $ | 0.04 |   |   | $ | 0.05 |   | $ | (0.20 | ) | $ | 0.00 |   |   | $ | 0.02 |   |   | $ | 0.06 |   | $ | 0.04 |   |
| Diluted                              |       | $                                                                    | 0.01       |   |   | $ | 0.03 |   |   | $ | 0.05 |   | $ | (0.20 | ) | $ | 0.00 |   |   | $ | 0.01 |   |   | $ | 0.05 |   | $ | 0.04 |   |

 

**Liquidityand Capital Resources**

At December 31, 2005cash, cash equivalents and long-term investments were $25,829,509 compared to$24,273,179 as of December 31, 2004, an increase of $1,556,330. Of that,$8,752,339 was held in cash and cash equivalents, an increase of $1,740,427from cash and cash equivalents of $7,011,912 held at December 31, 2004primarily resulting from positive cash flow generated by operating activities.Cash and cash equivalents generally consist of cash, money market funds andother money market instruments with original maturities of three months orless. We held $17,077,170 in investments available for sale at December 31,2005, as compared to $17,261,267 at December 31, 2004 a decrease of  $184,097. Investments consist of U.S.government securities rated AAA. In fiscal 2005, 2004 and 2003, operations werefunded primarily from cash from operations.

Net cash provided byoperating activities was $2,994,327 and $2,535,210 for fiscal 2005 and 2004,respectively. The $459,117 increase in net cash provided by operatingactivities in fiscal year 2005, compared to fiscal year 2004, was primarily aresult of non-cash items including the write-down of the investment in theJoint Venture of $3,314,045, depreciation and amortization of $1,385,374,offset by a net loss of $1,424,385 and increase in accounts receivable of$1,537,127. Accounts receivable increased 112% during fiscal 2005 due toincreases in both licensing and semiconductor revenues during the fourthquarter of 2005 as compared to the fourth quarter of 2004. The total days salesoutstanding on a consolidated basis were 46 days at December 31, 2005compared to 22 days at December 31, 2004 due to increases in bothlicensing and semiconductor revenues during the fourth quarter of 2005, whichresulted in higher than average accounts receivable and days sales outstanding.Prepaid expenses and other current assets decreased $400,733 in fiscal 2005 dueto a decrease in advanced payments of promotional costs as of year-

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end. Infiscal 2005, accounts payable and accrued liabilities increased $612,565 and$315,955, respectively primarily due to an increase in professional fees anddeferred revenues increased $100,726 due to increased prepayment of licensefees.

Our net cash used ininvesting activities was $1,184,323 and $10,805,115 for fiscal 2005 and 2004,respectively. The decrease in cash used for investing activities in fiscal 2005is due primarily to purchases of furniture, fixtures and equipment of $276,484and expenditures related to patents and intangible assets of $440,515. During fiscal2004, we entered into a strategic alliance with Coming Home Studios LLC, whichused cash of $481,081 and $2,563,732 during 2005 and 2004, respectively.

Our net financingactivities used cash of $69,577 during fiscal 2005 and provided cash of$2,486,197 during fiscal years 2004. Our financing activities during 2005 and2004 primarily consisted of proceeds from the exercise of employee stockoptions of $990,013 and $3,711,451, respectively, offset by the purchase oftreasury shares for $1,059,590 and $1,225,254, respectively.

We recorded an impairmentcharge of $3.3 million as of December 31, 2005, based on a total loss ofthe carrying value of the Company’s investment in the Joint Venture. Becausethe impairment does not relate to cash charges, we do not expect the impairmentcharge will result in future cash expenditures, except for certain legal andaccounting expenses related to the disposition of the Company’s interest in theJoint Venture.

We believe our existingcash balances and investments together with cash generated from operatingactivities will be sufficient to meet our anticipated cash needs for at leastthe next twelve months. Our future capital requirements will depend on manyfactors, including our level of revenues, the timing and extent of spending tosupport product development efforts, the expansion of sales and marketingactivities, the timing of introductions of new products, the costs to ensureaccess to adequate manufacturing capacity, and the continuing market acceptanceof our products. We could be required, or could elect, to seek additionalfunding through public or private equity or debt financing. It is possible thatsuch additional funds will not be available on terms acceptable to us or atall.

**ContractualCash Obligations and Contingent Liabilities and Commitments**

Wehave contractual obligations and commitments with regards to operating leasearrangements. The following table quantifies our expected contractualobligations and commitments subsequent to December 31, 2005:

| ** **                       | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| ** **                       | ** ** | ** **                                | ** ** | **Less than** | ** ** | ** ** | ** ** | **More than 3** | ** ** |
| **Contractual Obligations** | ** ** | ** **                                | ** ** | **Total** | ** ** | **1 year** | ** ** | **1-3 years** | ** ** | **years** | ** ** |
| Operating lease  obligations     |       | $                                         | 758,458    |   | $ | 414,377 |   | $ | 344,081 |   |   | — |   |   |
| Total                            |       | $                                         | 758,458    |   | $ | 414,377 |   | $ | 344,081 |   |   | — |   |   |
|                                  |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**RecentAccounting Pronouncements**

*Accounting Changes and Error Corrections*

In May 2005, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 154, “AccountingChanges and Error Corrections, a replacement of APB Opinion No. 20 andFASB Statement No. 3,” (“SFAS No. 154”). SFAS No. 154 carriesforward without change the guidance contained in APB Opinion No. 20 forreporting the correction of an error in previously issued financial statementsand changes the requirements for the accounting for and reporting of a changein accounting principle. SFAS No. 154 is effective for accounting changesand corrections of errors made in fiscal years beginning after December 15,2005. The adoption of SFAS No. 154 is not expected to have a significantimpact on the Company’s results of operations or financial position.

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*Inventory Costs*

In November 2004, theFASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43,Chapter 4” (“SFAS No. 151”), to clarify that abnormal amounts of idlefacility expense, freight, handling costs, and wasted material(spoilage) should be recognized as current period charges, and that fixedproduction overheads should be allocated to inventory based on normal capacityof production facilities. This statement is effective for inventory costs incurredduring fiscal years beginning after June 15, 2005. Accordingly, theCompany will adopt SFAS No. 151 in the fiscal year beginning January 1,2006. The adoption of SFAS No. 151 is not expected to have a significantimpact on the Company’s results of operations or financial position.

*Share-Based Payment*

In March 2005, theSEC issued guidance on FASB SFAS 123(R), Share-Based Payments (“SFAS No. 123R”).Staff Accounting Bulletin No. 107 (“SAB 107”) was issued toassist preparers by simplifying some of the implementation challenges ofSFAS No. 123R while enhancing the information that investors receive.SAB 107 creates a framework that is premised on two themes: (a) considerablejudgment will be required by preparers to successfully implement SFAS No. 123R,specifically when valuing employee stock options; and (b) reasonableindividuals, acting in good faith, may conclude differently on the fair valueof employee stock options. Key topics covered by SAB 107 include: (a) valuationmodels—SAB 107 reinforces the flexibility allowed by SFAS No. 123Rto choose an option-pricing model that meets the standard’s fair valuemeasurement objective; (b) expected volatility—SAB 107 providesguidance on when it would be appropriate to rely exclusively on eitherhistorical or implied volatility in estimating expected volatility; and (c) expectedterm—the new guidance includes examples and some simplified approaches todetermining the expected term under certain circumstances. The Company willapply the principles of SAB 107 in conjunction with its adoption ofSFAS No. 123R.

In December 2004, theFASB issued SFAS No. 123R. This standard requires all share-basedpayments to employees, including grants of employee stock options, to beexpensed in the financial statements based on their fair values beginning withthe first annual period beginning after June 15, 2005 (the first quarterof fiscal year 2006 for the Company). The pro forma disclosures permitted underSFAS No. 123 will no longer be allowed as an alternative presentationto recognition in the financial statements. Under SFAS No. 123R, theCompany must determine the appropriate fair value model to be used for valuingshare-based payments, the amortization method for compensation cost and thetransition method to be used at the date of adoption. The transition methodsinclude modified prospective and modified retrospective adoption options. Underthe modified retrospective option, prior periods may be restated either as ofthe beginning of the year of adoption or for all periods presented. Themodified prospective method requires that compensation expense be recorded forall unvested stock options and restricted stock at the beginning of the firstquarter of adoption of SFAS No. 123R, while the retroactive methodsrecord compensation expense for all unvested stock options and restricted stockbeginning with the first period restated. The Company will adopt SFAS No. 123Rin its first quarter of fiscal year 2006 on a modified prospective basis, whichwill require recognition of compensation expense for all stock option or otherequity-based awards that vest or become exercisable after the effective date.The Company intends to use the Black-Scholes valuation method to estimate thefair value of its options. The Company believes that its adoption will have amaterial negative impact on its consolidated results of operations andfinancial position.

**Item7A.**                Quantitative andQualitative Disclosures About Market Risk

We are exposed to avariety of risks, including foreign currency fluctuations and changes ininterest rates affecting investment earnings.

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**Foreign Currency**

International salesrepresent a significant portion of our total revenues. To date, all of ourlicensing revenues have been denominated in U.S. dollars and most costshave been incurred in U.S. dollars. Valence’s operations are in Hong Kongand customers in the PRC, and, accordingly, we are exposed to transaction gainsand losses that could result from changes in foreign currency exchange rates.We use the local currency (Hong Kong dollars) as the functional currency forValence. The Hong Kong dollar has remained relatively constant due to theU.S. dollar peg and currency board system that has been in effect in HongKong since 1983. To date, most of our semiconductor revenue and expensesincurred have been denominated in Hong Kong dollars. Translation adjustmentsresulting from the process of translating foreign currency financial statementsinto U.S. dollars were not significant in fiscal 2005, 2004, and 2003.Cash balances maintained by Valence in excess of normal operating requirementsare invested in U.S. denominated bank accounts further reducing balancesheet exposure to changes in foreign currency exchange rates. Under the currentcircumstances, we believe that the foreign currency market risk is notmaterial, however, it is possible that the Hong Kong economy may worsen or thatthe historical currency peg of the Hong Kong dollar to the U.S. dollar notbe maintained. We actively monitor our foreign exchange exposure and, shouldcircumstances change, intend to implement strategies to reduce our risk at suchtime that it determines that the benefits of such strategies outweigh theassociated costs. It is possible that management’s efforts to reduce foreignexchange exposure will not be successful.

**Interest Rates**

Our exposure to marketrisk includes changes in interest rates, which relates primarily to ourinvested balances of cash, cash equivalents and investments. Our investmentpolicy specifies excess funds are to be invested in a manner that preservescapital, provides liquidity and generates the highest available after-taxreturn. To limit exposure to market risk, we place our cash in banks, cashequivalents in high quality, short-term commercial paper and money market fundsand investments consisting of U.S. government securities and U.Sgovernment-backed securities. We do not invest in any derivativeinstruments. All cash, cash equivalents and investments are carried at fairvalue, which approximates cost.

**Item8.**                        FinancialStatements and Supplementary Data

The financial statementinformation, including the Report of Independent Registered Public AccountingFirm, required by this Item 8 is set forth on pages 48 to 77 of thisAnnual Report on Form 10-K and is hereby incorporated into thisItem 8 by reference. The Quarterly Financial Information required by thisItem 8 is set forth in Item 7 of this Annual Report on Form 10-Kand is hereby incorporated into this Item 8 by reference.

**Item9.**                        Changes inand Disagreements with Accountants on Accounting and Financial Disclosure

None.

**Item9A.**                Controls andProcedures

*Evaluation of DisclosureControls and Procedures.**  *Our Chief Executive Officer and President and ourChief Financial Officer have evaluated the effectiveness of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended) as of the end of the periodcovered by this Annual Report on Form 10-K and, based on thisevaluation, have concluded that our disclosure controls and procedures areeffective.

*Changes in InternalControls.**  *Therehave been no changes in our internal controls over financial reporting thatoccurred during our fourth quarter ended December 31, 2005 that havematerially affected, or are reasonably likely to materially affect, ourinternal controls over financial reporting.

**Item 9B.**               OtherInformation

None.

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**PART III**

**Item 10.**                 Directorsand Executive Officers of the Registrant

Information regarding ourexecutive officers is included in Item 1C of Part I of this AnnualReport on Form 10-K and is hereby incorporated into thisItem 10 by reference. The information set forth under the captions “Electionof Directors,” “Information About the Board of Directors and Committees of theBoard” and “Transactions with Management and Others—Section 16(a) BeneficialOwnership Reporting Compliance” in our definitive proxy statement (the “ProxyStatement”) for the Annual Meeting of Stockholders that is scheduled to occurin June 2006, is incorporated herein by reference. The Proxy Statementwill be filed with the SEC no later than 120 days after the close offiscal 2005.

**Item 11.**                 ExecutiveCompensation

Except as specificallyprovided, the information set forth under the captions “Compensation ofExecutive Officers” and “Information About the Board of Directors andCommittees of the Board—Compensation of Directors” in the Proxy Statement isincorporated herein by reference. The Proxy Statement will be filed with theSEC not later than 120 days after the close of fiscal 2005. The Report onExecutive Compensation and the Performance Graph set forth under the caption “Compensationof Executive Officers” in the Proxy Statement shall not be deemed incorporatedby reference herein and shall not otherwise be deemed “filed” as part of thisAnnual Report on Form 10-K.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters

Information regarding security ownership of certainbeneficial owners and management is incorporated by reference to theinformation set forth under the caption “Security Ownership of CertainBeneficial Owners and Management” in the Proxy Statement. The Proxy Statementwill be filed with the SEC no later than 120 days after the close offiscal 2005.

Information regardingequity compensation plans required by this Item 12 is included inItem 5 of Part II of this Annual Report on Form 10-K andis incorporated into this Item by reference.

**Item 13.**                 CertainRelationships and Related Transactions

The information set forthunder the caption “Transactions with Management and Others” in the ProxyStatement is incorporated herein by reference. The Proxy Statement will befiled with the Commission not later than 120 days after the close offiscal 2005.

**Item 14.**                 PrincipalAccountant Fees and Services

Information regardingprincipal accountant fees and services is incorporated by reference to theinformation set forth under the caption “Relationship of the Company withIndependent Registered Public Accounting Firm” in the Proxy Statement. TheProxy Statement will be filed with the SEC not later than 120 days afterthe close of fiscal 2005.

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**PART IV**

**Item 15.**                 Exhibits,Financial Statement Schedule

**(1)   Financial Statements**

|                                                                                                                                           | ** ** | Page | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|------|------------|
| Report of Independent Registered Public Accounting  Firm—BDO Seidman, LLP                                                            |       | 48   |       |
| Consolidated  Balance Sheets as of December 31, 2005 and 2004                                                                        |       | 49   |       |
| Consolidated Statements of Operations for the years  ended December 31, 2005, 2004 and 2003                                          |       | 50   |       |
| Consolidated Statements of Stockholders’ Equity and  Comprehensive Income for the years ended December 31, 2005, 2004 and  2003 |       | 51   |       |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2005, 2004 and 2003                                          |       | 52   |       |
| Notes to Consolidated Financial Statements                                                                                                |       | 53   |       |

 

**(2)   Financial Statement Schedule**

|                                                                                                                            | ** ** | **Page** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| Schedule II—Valuation and Qualifying Accounts and  Reserves for the years ended December 31, 2005, 2004 and 2003 |       | 77       |       |

 

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The financialstatement schedule included on page 77 to this Annual Report on Form 10-K and inPart II, Item 8 herein is filed as part of this Annual Report on Form 10-K.All other schedules are omitted because they are not applicable or the requiredinformation is shown in the consolidated financial statements or related notes.

**(3)   Exhibits**

Theexhibits listed below are hereby filed with the SEC as part of this AnnualReport on Form 10-K. We will furnish a copy of any exhibit uponrequest, but a reasonable fee will be charged to cover our expenses infurnishing such exhibit.

|            | **Exhibit   Number** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                      | ** ** | **Description** |
|------------|----------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 3.1        |                 | Certificate of  Incorporation of the Company, previously filed with the SEC 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 SEC 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 SEC as Exhibit 3.1 to the Company’s  Quarterly Report on Form 10-Q for the period ended  September 30, 1999, filed with the SEC on November 12, 1999, 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 SEC 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 SEC 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 SEC 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 Arnold I. Klayman,  previously filed with the SEC as Exhibit 10.10 to the Registration  Statement Amendment No. 1, which is incorporated herein by reference.                                                                                                                                                                                  |
| 10.4       |                 | Amendment to  Employment Agreement dated as of March 14, 1997, between the Company and  Arnold I. Klayman, previously filed with the SEC as Exhibit 10.5 to the  1996 Annual Report, which is incorporated herein by reference.                                                                                                                                                                                       |
| 10.5       |                 | Employment  Agreement dated July 1, 1996, between the Company and Alan D. Kraemer,  previously filed with the SEC as Exhibit 10.11 to the Registration  Statement Amendment No. 1, which is incorporated herein by reference.                                                                                                                                                                                    |
| 10.6       |                 | SRS  Labs, Inc. Incentive Stock Option, Nonqualified Stock Option and  Restricted Purchase Plan—1993, as amended and restated, previously filed with  the SEC as Exhibit 10.12 to the Company’s Registration Statement on  Form SB-2 filed with the SEC on June 3, 1996 (File  No. 333-4974-LA) (the “Registration Statement”), which is  incorporated herein by reference.        |
| 10.7       |                 | Stock Option  Agreement dated January 19, 1994, between the Company and Stephen V.  Sedmak, as amended, previously filed with the SEC as Exhibit 10.13 to  the Registration Statement, which is incorporated herein by reference.                                                                                                                                                                                     |
| 10.8       |                 | SRS  Labs, Inc. Amended and Restated 1996 Non-employee Directors Stock  Option Plan, as amended, previously filed with the SEC as Appendix B to  the Company’s Definitive Proxy Statement dated and filed with the SEC on  April 30, 2003, which is incorporated herein by reference.                                                                                                                       |

42

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| 10.9  |   | Annual Incentive Bonus  Plan, previously filed with the SEC as Exhibit 10.18 to the Registration  Statement Amendment No. 1, which is incorporated herein by reference.                                                                                                                                                                                                                                                                                                         |
|-------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.10 |   | SRS  Labs, Inc. Supplemental Executive Incentive Bonus Plan, previously filed  with the SEC as Exhibit 10.14 to the 1996 Annual Report, which is  incorporated herein by reference.                                                                                                                                                                                                                                                                                             |
| 10.11 |   | Form of  Indemnification Agreement, previously filed with the SEC as  Exhibit 10.20 to the Registration Statement Amendment No. 1, which  is incorporated herein by reference.                                                                                                                                                                                                                                                                                             |
| 10.12 |   | Employment  Agreement dated November 4, 2002 by and between the Company and Janet  Biski.                                                                                                                                                                                                                                                                                                                                                                                            |
| 10.13 |   | Non-employee  Director Compensation Policy adopted by the Company’s Board of Directors on  January 28, 2005, previously filed with the SEC as Exhibit 10.1 to  the Company’s Current Report on Form 8-K filed with the SEC on  February 3, 2005, which is incorporated herein by reference.                                                                                                                                                                 |
| 10.14 |   | Form of  Non-Employee Director Stock Option Agreement under the SRS Labs, Inc.  Amended and Restated 1996 Non-Employee Directors’ Stock Option Plan (Initial  Appointment), previously filed with the SEC as Exhibit 10.2 to the  Company’s Current Report on Form 8-K file with the SEC on  February 3, 2005, which is incorporated herein by reference.                                                                                              |
| 10.15 |   | Form of  Non-Employee Director Stock Option Agreement under the SRS Labs, Inc.  Amended and Restated 1996 Non-Employee Directors’ Stock Option Plan  (Re-Election), previously filed with the SEC as Exhibit 10.3 to the  Company’s Current Report on Form 8-K file with the SEC on  February 3, 2005, which is incorporated herein by reference.                                                                                                      |
| 10.16 |   | Form of  Non-Employee Director Stock Option Agreement under the SRS Labs, Inc.  Amended and Restated 1996 Long-Term Incentive Plan, previously filed with the  SEC as Exhibit 10.4 to the Company’s Current Report on Form 8-K  file with the SEC on February 3, 2005, which is incorporated herein by  reference.                                                                                                                                          |
| 10.17 |   | Employment Letter  with Michael Oswald, Vice President and General Counsel, dated  November 9, 2004, previously filed with the SEC as Exhibit 10.5 to  the Company’s Current Report on Form 8-K filed with the SEC on  February 3, 2005, which is incorporated herein by reference.                                                                                                                                                                              |
| 10.18 |   | Form of  Nonqualified Stock Option Agreement under the SRS Labs, Inc. Amended and  Restated 1996 Long-Term Incentive Plan dated March 29, 2005 (With  Schedule of Optionees Attached—Thomas C.K. Yuen, Janet M. Biski, Alan D.  Kraemer, Philip Wong and Jennifer Drescher), previously filed with the SEC as  Exhibit 10.1 to the Company’s Current Report Form 8-K filed  with the SEC on April 4, 2005, which is incorporated herein by  reference. |
| 10.19 |   | SRS  Labs, Inc. 2005 Change in Control Protection Plan approved  April 27, 2005, previously filed with the SEC as Exhibit 10.1 to  the Company’s Current Report on Form 8-K filed with the SEC on  May 3, 2005, which is incorporated herein by reference.                                                                                                                                                                                                  |
| 10.20 |   | Form of  Participation Agreement under the SRS Labs, Inc. 2005 Change in Control  Protection Plan for Selected Executive Officers (With Schedule of Parties  Attached—Thomas C.K. Yuen, Janet M. Biski and Alan D. Kraemer) approved April 27,  2005, previously filed with the SEC as Exhibit 10.2 to the Company’s  Current Report on Form 8-K filed with the SEC on May 3, 2005,  which is incorporated herein by reference.                   |
| 10.21 |   | Form of  Participation Agreement under the SRS Labs, Inc. 2005 Change in Control  Protection Plan for Selected Employees (With Schedule of Parties  Attached—Philip Wong and Jennifer Drescher) approved April 27, 2005,  previously filed with the SEC as Exhibit 10.3 to the Company’s Current  Report on Form 8-K filed with the SEC on May 3, 2005, which  is incorporated herein by reference.                                               |

43

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| 10.22 |   | SRS Labs, Inc. 2005  Profit Sharing and Bonus Plan approved April 27, 2005, previously filed  with the SEC as Exhibit 10.4 to the Company’s Current Report on  Form 8-K filed with the SEC on May 3, 2005, which is  incorporated herein by reference.                                                                       |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.23 |   | SRS  Labs, Inc. Amended and Restated 1996 Long-Term Incentive Plan, as  amended, previously filed with the SEC as Exhibit 10.5 to the Company’s  Current Report on Form 8-K filed with the SEC on May 3, 2005,  which is incorporated herein by reference.                                                                        |
| 10.24 |   | Employment Letter  Agreement dated June 24, 2005 by and between the Company and Michael  Franzi, previously filed with the SEC as Exhibit 10.1 to the Company’s  Current Report on Form 8-K filed with the SEC on August 18,  2005, which is incorporated herein by reference.                                                    |
| 10.25 |   | Stock Option  Agreement dated August 17, 2005 by and between the Company and Michael  Franzi, previously filed with the SEC as Exhibit 10.2 to the Company’s  Current Report on Form 8-K filed with the SEC on August 18,  2005, which is incorporated herein by reference.                                                       |
| 10.26 |   | Separation  Agreement dated September 30, 2005 by and between the Company and Philip  Wong, previously filed with the SEC as Exhibit 10.1 to the Company’s  Current Report on Form 8-K filed with the SEC on  September 30, 2005, which is incorporated herein by reference.                                                      |
| 10.27 |   | Employment Letter  Agreement dated September 30, 2005 by and between the Company and David  Frerichs, previously filed with the SEC as Exhibit 10.1 to the Company’s  Current Report on Form 8-K filed with the SEC on November 17,  2005, which is incorporated herein by reference.                                             |
| 10.28 |   | Employment Letter  Agreement dated December 21, 2005 by and between the Company and Ulrich  E. Gottschling, previously filed with the SEC as Exhibit 99.1 to the  Company’s Current Report on Form 8-K filed with the SEC on  December 29, 2005, which is incorporated herein by reference.                                       |
| 10.29 |   | Participation  Agreement for Ulrich E. Gottschling under the SRS Labs, Inc. 2005 Change  in Control Protection Plan, dated January 12, 2006, previously filed  with the SEC as Exhibit 99.1 to the Company’s Current Report on  Form 8-K filed with the SEC on January 18, 2006, which is  incorporated herein by reference. |
| 10.30 |   | Participation  Agreement for Michael Franzi under the SRS Labs, Inc. 2005 Change in  Control Protection Plan, dated January 12, 2005, previously filed with  the SEC as Exhibit 99.2 to the Company’s Current Report on Form 8-K  filed with the SEC on January 18, 2006, which is incorporated herein by  reference.        |
| 10.31 |   | Nonqualified  Stock Option Agreement by and between the Company and Ulrich E. Gottschling,  dated January 12, 2006, previously filed with the SEC as  Exhibit 99.6 to the Company’s Current Report on Form 8-K  filed with the SEC on January 18, 2006, which is incorporated herein by  reference.                               |
| 10.32 |   | Nonqualified  Stock Option Agreement by and between the Company and Sarah Yang, dated  January 12, 2006, previously filed with the SEC as Exhibit 99.7 to the  Company’s Current Report on Form 8-K filed with the SEC on  January 18, 2006, which is incorporated herein by reference.                                           |
| 10.33 |   | Form of  Nonqualified Stock Option Agreement under the SRS Labs, Inc. 1996  Amended and Restated Long-Term Incentive Plan, as Amended, previously filed  with the SEC as Exhibit 99.8 to the Company’s Current Report on  Form 8-K filed with the SEC on January 18, 2006, which is  incorporated herein by reference.       |

44

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|       | ** ** | **Other Material Contracts**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|-------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.34 |       | 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 SEC as  Exhibit 10.6 to the Company’s Registration Statement on Form SB-2,  specifically included in Amendment No. 3 to such Registration Statement  filed with the SEC on August 7, 1996 (File No. 333-4974-LA),  which is incorporated herein by reference.                                                                                         |
| 10.35 |       | Industrial Real  Estate Lease dated May 30, 1997, between the Company and Daimler  Commerce Partners, L.P., previously filed with the SEC as Exhibit 10.1  to the Company’s Quarterly Form 10-QSB for the quarterly period  ended June 30, 1997, filed with the SEC on August 13, 1997, which  is incorporated herein by reference.                                                                                                                                                                                       |
| 10.36 |       | Tenancy Agreement  commencing November 16, 2003 by and between Jugada Company Limited and  Valence Technology Limited relating to premises located at workshop No 01-07  on the 20th floor of APEC Plaza, No. 49 Hoi Yuen  Road, Kwun Tong, Kowloon Hong Kong, previously filed with the SEC as  Exhibit 10.20 to the Company’s Annual Report on Form 10-K for  the fiscal year ended December 31, 2003, filed with the SEC on  March 30, 2004, which is incorporated herein by reference.                      |
| 10.37 |       | Tenancy Agreement  commencing November 16, 2003, by and between Jugada Company Limited and  Valence Semiconductor Design Limited relating to the premises located at  Workshops Nos. 1 through 10 and on the 19th Floor of APEC Plaza, No. 49 Hoi Yuen  Road, Kwun Tong, Hong Kong, previously filed with the SEC as  Exhibit 10.21 to the Company’s Annual Report on Form 10-K for  the fiscal year ended December 31, 2003, filed with the SEC on  March 30, 2004, which is incorporated herein by reference. |
| 10.38 |       | 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 SEC  as Exhibit 10.17 to the Company’s Registration Statement on Form SB-2,  specifically included in Amendment No. 2 to such Registration Statement  file with the SEC on August 2, 1996 (File No. 333-4974-LA),  which is incorporated herein by reference.                                                                                      |
| 10.39 |       | Strategic  Alliance Agreement between the Company and Coming Home Studios LLC, dated  September 23, 2004 filed with the SEC as Exhibit 10.1 to the  Company’s Current Report on Form 8-K, previously filed with the SEC  on September 28, 2004, which is incorporated herein by reference.                                                                                                                                                                                                                                     |
| 10.40 |       | CHS/SRS, LLC  Operating Agreement between the Company and Coming Home Studios, LLC, dated  September 23, 2004, previously filed with the SEC as Exhibit 10.2  to the Company’s Current Report on Form 8-K filed with the SEC on  September 28, 2004, which is incorporated herein by reference.                                                                                                                                                                                                                                |
| 10.41 |       | Warrant Agreement  between the Company and Coming Home Studios, LLC, dated September 23,  2004, previously filed with the SEC as Exhibit 10.3 to the Company’s  Current Report on Form 8-K filed with the SEC on  September 28, 2004, which is incorporated herein by reference.                                                                                                                                                                                                                                               |
| 10.42 |       | Production  Services Agreement between the Company and Coming Home Studios, LLC, dated  September 23, 2004, previously filed with the SEC as Exhibit 10.4  to the Company’s Current Report on Form 8-K filed with the SEC on  September 28, 2004, which is incorporated herein by reference.                                                                                                                                                                                                                                   |

45

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| 14   |   | SRS Labs, Inc. Code  of Business Conduct and Ethics adopted by the Board of Directors November 6,  2002, previously filed with the SEC as Exhibit 14 to the Company’s  Annual Report on Form 10-K for the fiscal year ended  December 31, 2003, filed with the SEC on March 30, 2004, which is  incorporated herein by reference. |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 21   |   | Subsidiaries of  the Company, previously filed with the SEC as Exhibit 21 to the  Company’s Annual Report on Form 10-K for the fiscal year ended  December 31, 2003, filed with the SEC on March 30, 2004, which is  incorporated herein by reference.                                                                                      |
| 23.1 |   | Consent of  Independent Registered Public Accounting Firm, BDO Seidman LLP, dated  March 23, 2006.                                                                                                                                                                                                                                                              |
| 31.1 |   | Certification of  the Chief Executive Officer of SRS Labs, Inc., pursuant to 18 U.S.C  Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                           |
| 31.2 |   | Certification of  the Chief Financial Officer of SRS Labs, Inc., pursuant to 18 U.S.C  Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                           |
| 32.1 |   | Certification of  Chief Executive Officer of SRS Labs, Inc., pursuant to 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                              |
| 32.2 |   | Certification of Chief  Financial Officer of SRS Labs, Inc., pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                              |

 

 

46

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
| Dated:  March 23, 2006 |   | By:    |     | /s/ Thomas C.K.  Yuen                                 |
|-----------------------------|--------|--------|----------|-------------------------------------------------------|
| * *                    |   |   | * * | *Chairman  of the Board and  Chief Executive Officer* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

| ** **             | **Name** | ** **                                           | ** ** | ** **           | **Capacity** | ** ** | ** ** | ** ** | **Date** | ** ** |
|------------------------|----------|------------------------------------------------------|------------|----------------------|--------------|------------|------------|------------|----------|------------|
| /s/ THOMAS C.K. YUEN   |     | Director,  Chairman of the Board and Chief Executive |       | March 23,  2006 |
| Thomas C.K. Yuen       |     | Officer (Principal  Executive Officer)               |       |                 |
| /s/ ULRICH GOTTSCHLING |     | Chief Financial  Officer (Principal Financial and    |       | March 23,  2006 |
| Ulrich Gottschling     |     | Accounting Officer)                                  |       |                 |
| /s/ DAVID R. DUKES     |     | Director                                             |       | March 23,  2006 |
| David R. Dukes         |     |                                                 |       |                 |
| /s/ WINSTON E. HICKMAN |     | Director                                             |       | March 23,  2006 |
| Winston E. Hickman     |     |                                                 |       |                 |
| /s/ CAROL L MILTNER    |     | Director                                             |       | March 23,  2006 |
| Carol L. Miltner       |     |                                                 |       |                 |
| /s/ SAM YAU            |     | Director                                             |       | March 23,  2006 |
| Sam Yau                |     |                                                 |       |                 |

 

47

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

To the Board of Directors and Stockholders ofSRS Labs, Inc.Santa Ana, California

We have audited the accompanying consolidated balancesheets of SRS Labs, Inc. and Subsidiaries as of December 31, 2005 and2004, and the related consolidated statements of operations, stockholders’equity and comprehensive (loss) income and cash flows for each of the threeyears in the period ended December 31, 2005. We have also audited theschedule listed in the accompanying index, Item 15(2). These consolidatedfinancial statements and schedule are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on the consolidatedfinancial statements and schedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements and the schedules are free ofmaterial misstatement. The Company is not required to have, nor are we engagedto perform, an audit of its internal control over financial reporting. Ouraudits included consideration of internal control over financial reporting as abasis for designing audit procedures that are appropriate in the circumstances,but not for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements andschedules, assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall presentation of thefinancial statements and schedules. We believe that our audits provide areasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the consolidatedfinancial position of SRS Labs, Inc. and Subsidiaries as of December 31,2005 and 2004, and the results of their operations and their cash flows foreach of the three years in the period ended December 31, 2005, inconformity with accounting principles generally accepted in the United Statesof America.

Also,in our opinion, the consolidated financial statement schedule presents fairly,in all material respects, the information set forth therein.

| **/s/** | ** ** | **BDO SEIDMAN,  LLP** |   |   |
|---------|------------|-----------------------|--------|--------|
|    |       | BDO Seidman, LLP      |   |   |

 

Costa Mesa, CaliforniaFebruary 24, 2006

48

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**SRS LABS, INC.CONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                                         | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                         |       |                        |       |                        |       |
| **Current Assets**                                                                                                                                                                 |       |                        |       |                        |       |
| Cash and cash equivalents                                                                                                                                                          |       | $                           | 8,752,339  |                        | $          | 7,011,912 |   |
| Accounts receivable, net of allowance for doubtful  accounts of $99,203 in 2005 and $32,962 in 2004                                                                                |       | 2,789,551                   |       | 1,318,665                   |       |
| Inventories, net of reserve of $127,007 in 2005 and  $240,825 in 2004                                                                                                              |       | 614,647                     |       | 571,280                     |       |
| Prepaid expenses and other current assets, including  other receivables of $8,817 in 2005 and $9,004 in 2004                                                                       |       | 944,556                     |       | 1,337,506                   |       |
| Deferred income taxes                                                                                                                                                              |       | —                      |       | 23,406                      |       |
| **Total Current Assets**                                                                                                                                                           |       | 13,101,093                  |       | 10,262,769                  |       |
| Investments available for sale                                                                                                                                                     |       | 17,077,170                  |       | 17,261,267                  |       |
| Investment in LLC                                                                                                                                                                  |       | —                      |       | 2,596,090                   |       |
| Furniture, fixtures and equipment, net                                                                                                                                             |       | 1,485,919                   |       | 1,995,579                   |       |
| Intangible assets, net                                                                                                                                                             |       | 2,487,066                   |       | 2,660,955                   |       |
| Goodwill                                                                                                                                                                           |       | 533,031                     |       | 533,031                     |       |
| Deferred income taxes                                                                                                                                                              |       | 380,386                     |       | 192,750                     |       |
| **Total Assets**                                                                                                                                                                   |       | $                           | 35,064,665 |                        | $          | 35,502,441 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                     |       |                        |       |                        |       |
| **Current Liabilities**                                                                                                                                                            |       |                        |       |                        |       |
| Accounts payable                                                                                                                                                                   |       | $                           | 1,597,370  |                        | $          | 984,805 |   |
| Accrued liabilities                                                                                                                                                                |       | 2,117,040                   |       | 1,640,714                   |       |
| Deferred revenue                                                                                                                                                                   |       | 537,636                     |       | 436,910                     |       |
| Income taxes payable                                                                                                                                                               |       | —                      |       | 8,628                       |       |
| **Total Current Liabilities**                                                                                                                                                      |       | 4,252,046                   |       | 3,071,057                   |       |
| Commitments,  contingencies and subsequent events (Note 7 and 14)                                                                                                                  |       |                        |       |                        |       |
| **Stockholders’  Equity**                                                                                                                                                     |       |                        |       |                        |       |
| 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; 14,953,690 and 14,671,416 shares issued; 14,279,592 and  14,229,541 outstanding for 2005 and 2004, respectively |       | 14,955                      |       | 14,672                      |       |
| Additional paid-in capital                                                                                                                                                         |       | 63,574,518                  |       | 62,523,292                  |       |
| Accumulated other comprehensive loss                                                                                                                                               |       | (496,021                    | )          | (309,722                    | )          |
| Accumulated deficit                                                                                                                                                                |       | (29,277,388                 | )          | (27,853,003                 | )          |
| Treasury stock at cost 674,098 and 441,875 shares at  December 31, 2005 and 2004, respectively                                                                                |       | (3,003,445                  | )          | (1,943,855                  | )          |
| **Total Stockholders’ Equity**                                                                                                                                                |       | 30,812,619                  |       | 32,431,384                  |       |
| **Total  Liabilities And Stockholders’ Equity**                                                                                                                               |       | $                           | 35,064,665 |                        | $          | 35,502,441 |   |

 

See accompanyingnotes to the consolidated financial statements.

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**SRS LABS, INC.CONSOLIDATED STATEMENTSOF OPERATIONS**

| ** **                                                                              | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                              | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue:                                                                                |       |                                        |       |   |   |   |   |
| Licensing                                                                               |       | $                                           | 14,795,810 |   | $ | 10,831,704 |   | $ | 9,101,399 |   |
| Semiconductor                                                                           |       | 8,432,449                                   |       | 10,770,684 |   | 10,712,382 |   |
| Total revenues                                                                          |       | 23,228,259                                  |       | 21,602,388 |   | 19,813,781 |   |
| Cost of sales:                                                                          |       |                                        |       |   |   |   |   |
| Licensing                                                                               |       | 446,849                                     |       | 228,147 |   | 102,979 |   |
| Write-off of capitalized production costs                                               |       | 2,757,172                                   |       | — |   | — |   |
| Semiconductor                                                                           |       | 3,411,649                                   |       | 3,725,062 |   | 3,953,100 |   |
| Total cost of  sales                                                                    |       | 6,615,670                                   |       | 3,953,209 |   | 4,056,079 |   |
| Gross margin                                                                            |       | 16,612,589                                  |       | 17,649,179 |   | 15,757,702 |   |
| Operating  expenses                                                                     |       |                                        |       |   |   |   |   |
| Sales and marketing                                                                     |       | 6,890,666                                   |       | 5,445,224 |   | 5,487,159 |   |
| Research and development                                                                |       | 4,700,016                                   |       | 4,767,004 |   | 4,263,682 |   |
| General and administrative                                                              |       | 6,401,021                                   |       | 5,675,294 |   | 5,053,387 |   |
| Total operating  expenses                                                               |       | 17,991,703                                  |       | 15,887,522 |   | 14,804,228 |   |
| (Loss) income from  operations                                                          |       | (1,379,114                                  | )          | 1,761,657 |   | 953,474 |   |
| Write-off of  investment                                                                |       | (185,304                                    | )          | — |   | — |   |
| Equity in income  of investee                                                           |       | 91,096                                      |       | 32,358 |   | — |   |
| Other income, net                                                                       |       | 669,830                                     |       | 594,922 |   | 538,278 |   |
| Minority interest                                                                       |       | —                                      |       | — |   | 5,430 |   |
| (Loss) income  before income tax expense                                                |       | (803,492                                    | )          | 2,388,937 |   | 1,497,182 |   |
| Income tax  expense                                                                     |       | 620,893                                     |       | 810,416 |   | 1,038,463 |   |
| Net (loss) income                                                                       |       | $                                           | (1,424,385 | ) | $ | 1,578,521 |   | $ | 458,719 |   |
| Net (loss) income per  common share:                                                    |       |                                        |       |   |   |   |   |
| Basic                                                                                   |       | $                                           | (0.10      | ) | $ | 0.11 |   | $ | 0.04 |   |
| Diluted                                                                                 |       | $                                           | (0.10      | ) | $ | 0.10 |   | $ | 0.03 |   |
| Weighted average shares  used in the calculation of net (loss) income per common share: |       |                                        |       |   |   |   |   |
| Basic                                                                                   |       | 14,117,795                                  |       | 13,950,457 |   | 13,033,002 |   |
| Diluted                                                                                 |       | 14,117,795                                  |       | 15,781,206 |   | 14,420,810 |   |

 

See accompanying notes to consolidated financial statements

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**SRS LABS, INC.CONSOLIDATED STATEMENTSOF STOCKHOLDERS’ EQUITYAND COMPREHENSIVE (LOSS) INCOME**

| ** **                                                     | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**    | ** ** | **Accumulated Other** | ** ** | ** **   | ** ** | ** **  | ** ** | ** **           | ** ** | **Comprehensive  (Loss) Income  for the** | ** ** |
|----------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-------------------|------------|----------------------------|------------|--------------|------------|-------------|------------|----------------------|------------|-----------------------------------------------------|------------|
| ** **                                                     | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Comprehensive** | ** ** | **Accumulated**            | ** ** | **Treasury** | ** ** | ** **  | ** ** | **Years Ended** | ** ** |
| ** **                                                     | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**       | ** ** | **(Loss) Income**     | ** ** | **Deficit**  | ** ** | **Stock**   | ** ** | **Total**            | ** ** | **December 31,**                               | ** ** |
| BALANCE, Jan 1, 2003                                           |       | 12,651,014            |       | 12,877      |       | 55,966,589        |       |                       | (88,564    | )            |       | (29,890,243 | )          | (718,601             | )          | 25,282,058                                          |       |   |   |   |   |
| Proceeds from exercise of stock options                        |       | 473,784               |       | 474         |       | 1,424,035         |       |                       | —     |         |       | —      |       | —               |       | 1,424,509                                           |       |   |   |   |   |
| Deferred stock option compensation                             |       |                  |       | —      |       | 72,945            |       |                       | —     |         |       | —      |       | —               |       | 72,945                                              |       |   |   |   |   |
| Issuance of Common Stock                                       |       | 332,184               |       | 332         |       | 959,680           |       |                       |       |         |       |        |       | —               |       | 960,012                                             |       |   |   |   |   |
| Unrealized loss on investments available for sale,  net of tax |       |                  |       |        |       | —            |       |                       | (247,782   | )            |       | —      |       | —               |       | (247,782                                            | )          |   | (247,782 | ) |   |
| Net income                                                     |       |                  |       | —      |       | —            |       |                       | —     |         |       | 458,719     |       | —               |       | 458,719                                             |       |   | 458,719 |   |   |
| BALANCE, Dec 31, 2003                                     |       | 13,456,982            |       | 13,683      |       | 58,423,249        |       |                       | (336,346   | )            |       | (29,431,524 | )          | (718,601             | )          | 27,950,461                                          |       |   | $ | 210,937 |   |   |
| Proceeds from exercise of stock options                        |       | 989,134               |       | 989         |       | 3,710,462         |       |                       |       |         |       |        |       | —               |       | 3,711,451                                           |       |   |   |   |   |
| Tax benefit from exercise of stock options                     |       | —                |       | —      |       | 296,996           |       |                       | —     |         |       | —      |       | —               |       | 296,996                                             |       |   |   |   |   |
| Deferred stock option compensation                             |       | —                |       | —      |       | 92,585            |       |                       | —     |         |       | —      |       | —               |       | 92,585                                              |       |   |   |   |   |
| Treasury Stock                                                 |       | (216,575              | )          | —      |       |              |       |                       |       |         |       |        |       | (1,225,254           | )          | (1,225,254                                          | )          |   |   |   |   |
| Unrealized gain on investments available for sale,  net of tax |       |                  |       | —      |       | —            |       |                       | 26,624     |         |       | —      |       | —               |       | 26,624                                              |       |   | 26,624 |   |   |
| Net income                                                     |       | —                |       | —      |       | —            |       |                       | —     |         |       | 1,578,521   |       | —               |       | 1,578,521                                           |       |   | 1,578,521 |   |   |
| BALANCE, Dec 31, 2004                                          |       | 14,229,541            |       | $           | 14,672     |              | $          | 62,523,292                 |       |         | $          | (309,722    | )          |                 | $          | (27,853,003                                         | )          | $ | (1,943,855 | ) | $ | 32,431,384 |   |   | $ | 1,605,145 |   |   |
| Proceeds from exercise of stock options                        |       | 282,274               |       | 283         |       | 989,730           |       |                       | —     |         |       | —      |       | —               |       | 990,013                                             |       |   |   |   |   |
| Tax benefit from exercise of stock options                     |       | —                |       | —      |       | 5,694             |       |                       | —     |         |       | —      |       | —               |       | 5,694                                               |       |   |   |   |   |
| Deferred stock option compensation                             |       | —                |       | —      |       | 55,802            |       |                       | —     |         |       | —      |       | —               |       | 55,802                                              |       |   |   |   |   |
| Treasury Stock                                                 |       | (232,223              | )          | —      |       |              |       |                       |       |         |       |        |       | (1,059,590           | )          | (1,059,590                                          | )          |   |   |   |   |
| Unrealized loss on investments available for sale,  net of tax |       | —                |       | —      |       | —            |       |                       | (186,299   | )            |       | —      |       | —               |       | (186,299                                            | )          |   | (186,299 | ) |   |
| Net loss                                                       |       | —                |       | —      |       | —            |       |                       | —     |         |       | (1,424,385  | )          | —               |       | (1,424,385                                          | )          |   | (1,424,385 | ) |   |
| BALANCE,  Dec 31, 2005                                    |       | 14,279,592            |       | $           | 14,955     |              | $          | 63,574,518                 |       |         | $          | (496,021    | )          |                 | $          | (29,277,388                                         | )          | $ | (3,003,445 | ) | $ | 30,812,619 |   |   | $ | (1,610,684 | ) |   |

 

See accompanying notes to consolidated financial statements

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**SRS LABS, INC.CONSOLIDATED STATEMENTSOF CASH FLOWS**

| ** **                                                                                | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Cash Flows From Operating  Activities:**                                                | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net (loss) income                                                                         |       | $                                           | (1,424,385 | ) | $ | 1,578,521 |   | $ | 458,719 |   |
| Adjustments to reconcile  net (loss) income to net cash provided by operating activities: |       |                                        |       |   |   |   |   |
| Depreciation and amortization                                                             |       | 1,385,374                                   |       | 1,322,544 |   | 1,167,825 |   |
| Minority interest                                                                         |       | —                                      |       | — |   | (5,430 | ) |
| Provision for doubtful accounts                                                           |       | 66,241                                      |       | 58,508 |   | 38,839 |   |
| Provision (benefit) for obsolete inventory                                                |       | (9,731                                      | )          | (41,651 | ) | 48,686 |   |
| Deferred taxes                                                                            |       | (164,230                                    | )          | 384 |   | (30,898 | ) |
| (Accretion) amortization of (discount) premium on  investments available for sale         |       | (2,202                                      | )          | 5,980 |   | 6,394 |   |
| Net realized gain on investments available for sale                                       |       | —                                      |       | (139,375 | ) | (20,026 | ) |
| Deferred stock option compensation                                                        |       | 55,802                                      |       | 92,585 |   | 72,945 |   |
| Loss on disposition of furniture, fixtures and  equipment                                 |       | 1,417                                       |       | 6,791 |   | 10,257 |   |
| Impairment on intangible assets                                                           |       | —                                      |       | 43,266 |   | — |   |
| Equity in income of investment.                                                           |       | (91,096                                     | )          | (32,358 | ) |   |   |
| Write-off of investment in LLC.                                                           |       | 3,314,045                                   |       | — |   | — |   |
| Changes in  operating assets and liabilities, net of consolidation of CHS/SRS LLC:        |       |                                        |       |   |   |   |   |
| Accounts receivable                                                                       |       | (1,537,127                                  | )          | (146,750 | ) | (194,842 | ) |
| Inventories                                                                               |       | (26,826                                     | )          | 223,391 |   | 5,676 |   |
| Prepaid expenses and other current assets                                                 |       | 400,733                                     |       | (263,810 | ) | (625,742 | ) |
| Accounts payable                                                                          |       | 612,565                                     |       | (519,046 | ) | 492,819 |   |
| Accrued liabilities                                                                       |       | 315,955                                     |       | 54,131 |   | (650,545 | ) |
| Deferred revenue                                                                          |       | 100,726                                     |       | 417,424 |   | (103,822 | ) |
| Income taxes payable                                                                      |       | (2,934                                      | )          | (125,325 | ) | 117,005 |   |
| Net cash provided by operating activities                                                 |       | 2,994,327                                   |       | 2,535,210 |   | 787,860 |   |
| **Cash Flows From Investing  Activities:**                                                |       |                                        |       |   |   |   |   |
| Purchase of furniture, fixtures and equipment                                             |       | (276,484                                    | )          | (1,116,889 | ) | (505,084 | ) |
| Proceeds from sales of furniture, fixtures and equipment                                  |       | 13,757                                      |       | 550 |   | — |   |
| Purchase of investments available for sale                                                |       | —                                      |       | (11,986,038 | ) | (20,956,112 | ) |
| Proceeds from sale of investments available for sale                                      |       | —                                      |       | 5,375,000 |   | 16,862,523 |   |
| Investment in LLC                                                                         |       | —                                      |       | (2,563,732 | ) | — |   |
| Capitalized production costs                                                              |       | (481,081                                    | )          | — |   | — |   |
| Expenditures related to patents and intangible assets                                     |       | (440,515                                    | )          | (514,006 | ) | (538,936 | ) |
| Net cash used in investing activities                                                     |       | (1,184,323                                  | )          | (10,805,115 | ) | (5,137,609 | ) |
| **Cash Flows From Financing  Activities:**                                                |       |                                        |       |   |   |   |   |
| Purchase of treasury stock                                                                |       | (1,059,590                                  | )          | (1,225,254 | ) | — |   |
| Proceeds from exercise of stock options                                                   |       | 990,013                                     |       | 3,711,451 |   | 1,424,509 |   |
| Net cash (used in) provided by financing activities                                       |       | (69,577                                     | )          | 2,486,197 |   | 1,424,509 |   |
| **Net Decrease in Cash and Cash Equivalents**                                             |       | 1,740,427                                   |       | (5,783,708 | ) | (2,925,240 | ) |
| **Cash and Cash Equivalents, Beginning of Period**                                        |       | 7,011,912                                   |       | 12,795,620 |   | 15,720,860 |   |
| **Cash and Cash Equivalents, End of Period**                                              |       | $                                           | 8,752,339  |   | $ | 7,011,912 |   | $ | 12,795,620 |   |
| **Supplemental Disclosures of  Cash Flow Information:**                                   |       |                                        |       |   |   |   |   |
| Cash paid during  the period for:                                                         |       |                                        |       |   |   |   |   |
| Income taxes                                                                              |       | $                                           | 420,836    |   | $ | 1,047,624 |   | $ | 1,129,334 |   |
| **Supplemental Disclosure of  Non-Cash Activities:**                                      |       |                                        |       |   |   |   |   |
| Unrealized gain/(loss) on investments, net                                                |       | $                                           | (186,299   | ) | $ | 26,624 |   | $ | (247,782 | ) |
| Tax benefit on employee stock plans                                                       |       | $                                           | 5,694      |   | $ | 296,996 |   | $ | — |   |
| Issuance of Common stock for minority interest                                            |       | $                                           | —     |   | $ | — |   | $ | 960,012 |   |
| Fair market value of assets consolidated, inclusive  of cash of $48,919                   |       | $                                           | 63,512     |   | $ | — |   | $ | — |   |
| Fair market value  of liabilities assumed in the consolidation                            |       | $                                           | 160,372    |   | $ | — |   | $ | — |   |

 

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**SRS LABS, INC.NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**1.**   Organizationand Significant Accounting Policies

*Organization*

SRS Labs is a developer and provider of audio andvoice technology solutions for the home entertainment, portable media device,personal telecommunications, personal computer, automotive, and broadcastmarkets, and a developer and provider of application specific integratedcircuits, or ASICs, and standard integrated circuits, or ICs.

Historically, we have operated in the two business segments,licensing and semiconductors.

*Licensing:**  *ThroughSRS Labs, the parent company, and our wholly-owned subsidiary, SRSWOWcast.com,inc., doing business as SRSWOWcast Technologies, or SRSWOWcast, the licensingsegment develops and licenses audio, voice and surround sound technologysolutions to many of the world’s leading original equipment manufacturers, orOEMs, software providers and semiconductor companies, and licenses and marketshardware and software products for the Internet and professional audio markets.

In September 2004, we entered into a strategicalliance with Coming Home Studios LLC, or CHS, to use and promote SRS Labstechnologies, promote CHS productions and to promote each company’s respectivebrands. In connection with the strategic alliance, the Company and CHSestablished a joint venture, CHS/SRS, LLC, or the Joint Venture, to produce anddistribute six concert videos by *Duran Duran, Boz Scaggs,Godsmack and All Access* featuring our Circle Surround technology(the “Concert Videos”). Initially, Coming Home Studios LLC was the manager ofthe CHS/SRS Joint Venture; however, due to the Company’s concerns aboutproduction delays and completion risks with respect to the Concert Videos, theCompany became manager of the CHS/SRS Joint Venture in July 2005. As aresult of becoming the manager of, and providing financial support to the JointVenture, the Company was required under FASB Interpretation No. 46, *Consolidation of Variable Interest Entities* (FIN 46R), toconsolidate the financial statements of the Joint Venture into our financial statementscommencing with the third quarter of fiscal 2005. In the consolidated financialstatements, all inter-company accounts and transactions between the Company andthe Joint Venture have been eliminated. Previously, we accounted for our 50%equity ownership in the Joint Venture as an investment using the equity method.

On February 23, 2006, our Board of Directors, orthe Board, authorized management to take all reasonable steps to divest ourentire equity interest in the Joint Venture. We have not yet estimated thecosts we will incur in connection with the divestiture of our equity interestin the Joint Venture. Furthermore, we recorded an asset impairment charge of $3.3 million related to our investmentin the Joint Venture, which is included in our consolidated results ofoperations for the quarter ended December 31, 2005. See Note 3.

*Semiconductors:**  *Through Valence Technology Limited,a Hong Kong company, and its subsidiaries, which we collectively refer to asValence, we operate a fabless semiconductor business which develops, designsand markets standard and custom analog ICs, digital signal processors, or DSPs,and mixed signal integrated circuits primarily to OEMs, and original designmanufacturers, or ODMs, in the Asia Pacific region.

On February 23, 2006,the Board approved a plan to sell Valence in order to focus increasedmanagement attention and financial resources on our licensing business. Thedecision to sell Valence was based on the Board’s belief that our licensingbusiness operates in a larger market than our semiconductor 

53

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marketand that our licensing business will be able to expand its market share. Wehave retained Kaufman Bros., L.P., a financial advisor based in New York City,to assist us in facilitating a sale. As a result of our decision to sellValence, we will account for the semiconductor business segment as adiscontinued operation beginning in the quarter ending March 31, 2006. SeeNote 14 to the Company’s consolidated financial statements.

*Basis ofPresentation*

The consolidated financialstatements have been prepared in accordance with accounting principlesgenerally accepted in the United States of America and include the Company andits wholly-owned subsidiaries, Valence and SRSWOWcast, and the JointVenture after elimination of all intercompany accounts and transactions.

*Cash Equivalents*

Cash and cash equivalentsgenerally consist of cash, money market funds and other money marketinstruments with original or remaining maturities of three months or less atthe date of purchase.

*Investments*

The Company accounts forinvestments in accordance with Statement of Financial Accounting Standards(SFAS) No. 115, “Accounting for Certain Investments in Debt andEquity Securities.” Investments, consisting primarily of U.S. government securities,are classified as available for sale and are reported at fair value, based onquoted market prices, in the accompanying consolidated balance sheets. Thosesecurities with a maturity date of one year or less are classified as currentassets. Unrealized gains and losses, net of applicable income taxes, arereported as a separate component of stockholders’ equity.

*Inventories*

Inventories, which consistof finished goods, are stated at the lower of cost or net realizable value.Cost is calculated using the weighted average method and is comprised ofmaterial costs and, where applicable, subcontracting and overhead costs thathave been incurred in bringing the inventories to their present location andcondition. Net realizable value represents the estimated selling price lesscosts to be incurred in selling and distribution. Fair market value isdetermined by comparison with recent purchases or net realizable value. Netrealizable value is based on forecasts for sales of the Company’s products inthe ensuing years. Should demand for the Company’s products prove to besignificantly less than anticipated, the ultimate realizable value of theCompany’s inventories could be substantially less than the amount shown on theaccompanying consolidated balance sheets.

*Furniture, Fixturesand Equipment*

Furniture, fixtures andequipment are stated at cost, net of accumulated depreciation and amortization.Depreciation and amortization are calculated using the straight-line method,which amortizes cost over the lesser of the estimated useful lives of therespective assets or the term of the related lease. Useful lives range from twoto five years.

*Intangible Assets*

Costs paid by the Company related to the establishmentand transfer of patents, primarily legal costs, are capitalized and amortized,depending on the estimated life of the technology patented. These assets arebeing amortized over periods ranging from three to eleven years depending onthe useful life of the asset.

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The Company annuallyevaluates the recoverability of its patents and intangible assets based on theestimated future undiscounted cash flows. Should the carrying value of patentsor intangible assets exceed the estimated future undiscounted cash flows forthe expected periods of benefit, such assets would be written down to fairvalue. Based upon its most recent assessment, the Company has determined thatthere was no impairment as of December 31, 2005.

*Capitalization ofsoftware development costs*

Costs incurred in the research, design and developmentof software for sale to others as a separate product or embedded in a productand sold as part of the product as a whole are charged to expense untiltechnological feasibility is established. Under SFAS No. 86, “Accountingfor the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,”the Company capitalizes software purchased from third parties if the relatedsoftware product under development has reached technological feasibility or ifthere are alternative future uses for the purchased software, provided thatcapitalized amounts will be realized over a period not exceeding five years.Costs incurred prior to the establishment of technological feasibility arecharged to research and development expense. The establishment of technologicalfeasibility and ongoing assessment of recoverability of capitalized softwaredevelopment costs require considerable judgment by management with respect tocertain external factors, including, but not limited to, anticipated futurerevenues, estimated economic life and changes in software and hardwaretechnologies. Under SFAS No. 86, annual amortization of softwaredevelopment costs are equal to the greater of (a) the ratio that currentgross revenues for a product bear to the total of current and anticipated futuregross revenues for that product or (b) the straight-line method over theremaining estimated economic life of the product including the period beingreported on. Capitalized software costs are included in intangible assets, netin the accompanying consolidated balance sheets. The Company uses thestraight-line method of amortization because the software can be used for manyproducts and the estimates required to be made under (a) could result inunder reporting of expense. Upon the general release of the software product tocustomers, capitalization ceases and such costs are amortized to cost of salesusing the straight-line method on a product-by-product basis over the estimatedlife, which is generally three years. To the extent that amounts capitalizedfor software development costs become impaired due to a decline in demand orthe introduction of new technology, such amounts will be written-off. All otherresearch and development expenditures are charged to research and developmentexpense in the period incurred.

Capitalizedsoftware as of December 31, 2005 and 2004 is as follows:

| ** **                                                                                                                                                                                                                                                                                                | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Capitalized  software                                               |       | $                     | 595,568    |   | $ | 464,568 |   |
| Accumulated  amortization                                                                                                                                                                                                                                                                                 |       | (309,990              | )          | (193,003 | ) |
| Capitalized software,  net                                                                                                                                                                                                                                                                                |       | $                     | 285,578    |   | $ | 271,565 |   |

 

TheCompany recorded amortization expense of $116,987, 106,826 and $28,401 for eachof the years ended December 31, 2005, 2004 and 2003, respectively. As of December 31,2005, the weighted average useful life of the Company’s capitalized software isapproximately 2.0 years. The following table shows the estimatedamortization expense for those assets for each of the five succeeding fiscalyears.

| **Year ending December 31,** | ** ** | ** ** | ** ** | **Estimated  Expense** | ** ** |
|---------------------------------------------|------------|------------|------------|------------------------|------------|
| 2006                                        |       | $          | 141,629    |                   |
| 2007                                        |       | 89,357     |       |
| 2008                                        |       | 50,434     |       |
| 2009                                        |       | 4,158      |       |
| 2010                                        |       | —     |       |
|                                             |            |            |            |                        |            |  |

 

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*Impairment oflong-lived assets*

The Company evaluates therecoverability of long-lived assets with finite lives in accordance with SFAS No. 144,“Accounting for the Impairment of Long-Lived Assets.” The Company assessespotential impairments to its long-lived assets when there is evidence thatevents or changes in circumstances indicate that the carrying amount of anasset may not be recovered. An impairment loss is recognized when the carryingamount of the long-lived asset is not recoverable and exceeds its fair value.The carrying amount of a long-lived asset is not recoverable if it exceeds thesum of the undiscounted cash flows expected to result from the use and eventualdisposition of the asset. Any required impairment loss is measured as theamount by which the carrying amount of a long-lived asset exceeds its fairvalue and is recorded as a reduction in the carrying value of the related assetand a charge to operating results. As discussed further in Note 3, based uponour most recent assessment as of December 31, 2005, we have determinedthere was a $3.3 million impairment in the value of our investment in the JointVenture.

*Goodwill*

Goodwill represents theexcess of purchase price and related costs over the value assigned to the nettangible and identifiable intangible assets of businesses acquired. Effectiveas of the beginning of fiscal 2002, the Company adopted SFAS No. 142, “Goodwilland Other Intangible Assets,” which, among other things, establishes newstandards for goodwill acquired in a business combination, eliminates theamortization of goodwill and requires the carrying value of goodwill andidentifiable intangibles to be evaluated for impairment on an annual basis.Starting in fiscal 2002, the Company no longer records goodwill amortization.In accordance with SFAS No. 142, all of our intangible assets that havedefinite lives are being amortized on a straight-line basis over theirestimated useful lives and goodwill is tested annually for impairment. Basedupon our most recent assessment as of December 31, 2005, we havedetermined there was no impairment.

*Minority Interest in Consolidated Subsidiary*

Minority interest inconsolidated subsidiary represents the minority stockholders’ proportionateshare of the equity of SRSWOWcast. At December 31, 2002, the Company ownedapproximately 87% of the capital stock of SRSWOWcast. In February 2003,SRS Labs completed an exchange offer with the minority shareholders ofSRSWOWcast, pursuant to which SRS Labs acquired all 3,000,000 outstandingshares of SRSWOWcast’s Series A Convertible Preferred Stock in exchangefor the issuance of 332,184 shares of SRS Labs common stock. As a result of theexchange offer, an intangible asset in the amount of $640,071 for a 10-yearlicense agreement was recorded, and SRSWOWcast became a wholly-ownedsubsidiary of SRS Labs.

*Use of Estimates*

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported revenues and expenses during the reporting periods.Actual results could materially differ from these estimates.

*Revenue Recognition*

Royalty revenuesassociated with ongoing royalty license agreements are recognized upon receiptof reports from licensees stating the number of products implementing SRSpatented technologies on which royalties are due, generally one quarter inarrears. The Company also has arrangements under which license fees are prepaidupfront, in addition to ongoing per-unit license fees. In such cases, theprepaid fees are recorded as deferred revenues and recognized as revenue uponreceipt of reports from licensees 

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statingthe number of products shipped on which royalties are due. Licensing revenuesfor one-time technology transfer fees are recognized in the period in which thelicense agreement is consummated and the related technology and passage oftitle is transferred. Revenue from product sales is generally recognized uponshipment at which point title passes. Certain products may be sold underconsignment agreements, and revenue is recognized upon reported distributorsales. Design revenue under design contracts is recognized on thepercentage-of-completion method. Estimates are reviewed and revisedperiodically throughout the lives of the contracts. Any revisions are recordedin the accounting period in which the revisions are made. Commission incomederived from our distribution activities is recognized on an accrual basis inthe period when earned.

*Research and Development*

Research and developmentexpenses include costs and expenses associated with the development of ourdesign methodology and the design and development of new products, includinginitial nonrecurring engineering and product verification charges fromfoundries. Research and development is expensed as incurred.

*Advertising Expense*

Advertising costs arecharged to expense as incurred. The Company expensed $85,992, $67,112, and$505,514 for the years ended December 31, 2005, 2004 and 2003,respectively. Prepaid expenses include advertising costs of $19,138 and $46,471for years ended December 31, 2005 and 2004, respectively.

*Income Taxes*

The Company accounts forincome taxes in accordance with SFAS No. 109, “Accounting for IncomeTaxes.” Deferred taxes on income result from temporary differences between thereporting of income for financial statement and tax reporting purposes. Avaluation allowance related to a deferred tax asset is recorded when it is morelikely than not that some portion or all of the deferred tax asset will not berealized.

*Foreign Currency Translation*

Our reporting currency isthe U.S. dollar, while the functional currency of Valence is the Hong Kongdollar. Assets and liabilities of Valence are translated at the rate ofexchange on the balance sheet date. Revenues and expenses are translated usingthe average exchange rate for the period. Translation adjustments resultingfrom the process of translating foreign currency financial statements into U.S.dollars are included as a separate component of stockholders’ equity(accumulated other comprehensive income). There were no foreign currencytranslation gains or losses during the years ended December 31, 2005, 2004and 2003. Transaction losses arising on exchange of foreign currency arerecognized as incurred in the statements of operations and aggregated $13,854,$4,676, $6,689 during the years ended December 31, 2005, 2004 and 2003,respectively.

*Net (Loss) Income Per Common Share*

The Company applies SFASNo. 128, “Earnings per Share,” which requires the disclosure of basic anddiluted net income or loss per share for all current and prior periods. Basicnet income or loss per common share is computed by dividing net income or loss availableto common stockholders by the weighted average number of common sharesoutstanding during each year. Diluted net income or loss per common sharereflects the maximum dilution, based on the average price of our common stockeach period and is computed similar to basic income or loss per share exceptthat the denominator is increased to include the number of additional sharesthat would have been outstanding if potentially dilutive stock options andwarrants had been exercised.

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Basicand diluted net (loss) income per share computed in accordance withSFAS 128 for the years ended December 31 are as follows:

| ** **                                               | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|----------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| BASIC EPS                                                |       |       |       |       |       |       |       |
| Net (loss) income                                        |       | $          | (1,424,385 | )          | $          | 1,578,521  |       | $ | 458,719 |   |
| Denominator: weighted average common shares  outstanding |       | 14,117,795 |       | 13,950,457 |       | 13,033,002 |       |
| Net (loss) income  per share—basic                  |       | $          | (0.10      | )          | $          | 0.11       |       | $ | 0.04 |   |
| DILUTED EPS                                              |       |       |       |       |       |       |       |
| Net (loss) income                                        |       | $          | (1,424,385 | )          | $          | 1,578,521  |       | $ | 458,719 |   |
| Denominator: weighted average common shares outstanding  |       | 14,117,795 |       | 13,950,457 |       | 13,033,002 |       |
| Common equivalent  shares outstanding:                   |       |       |       |       |       |       |       |
| Options                                                  |       | —     |       | 1,830,749  |       | 1,387,808  |       |
| Total shares                                             |       | 14,117,795 |       | 15,781,206 |       | 14,420,810 |       |
| Net (loss) income  per share—diluted                |       | $          | (0.10      | )          | $          | 0.10       |       | $ | 0.03 |   |

 

There were 4,444,254,164,000, 1,816,276 potentially dilutive options outstanding at December 31,2005, 2004 and 2003, respectively, that were not included above because theywould be anti-dilutive.

*Stock-BasedCompensation*

The Company accounts for stock-based employeecompensation arrangements in accordance with the provisions of AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued toEmployees,” Financial Accounting Standards Board Interpretation No. 44 (“FIN44”) “Accounting for Certain Transactions Involving Stock Compensation—anInterpretation of APB 25,” and complies with the disclosure provisions of SFAS No. 148,“Accounting for Stock-Based Compensation, Transition and Disclosure.” Under APBNo. 25, compensation expense is based on the difference, if any, on thedate of the grant, between the fair value of the Company’s stock and theexercise price. The Company accounts for stock issued to non-employees inaccordance with the provisions of SFAS No. 148 and EITF Issue No. 96-18,“Accounting for Equity Instruments that are Issued to other than Employees forAcquiring, or in Conjunction with Selling Goods or Services.”

The Company amortizes stock-based compensation usingthe straight-line method over the remaining vesting periods of the relatedoptions, which is generally four years. Pro forma information regarding net(loss) income and (loss) income per share is required to be determined as if wehad accounted for employee stock options under the fair value method of SFAS No. 123,as amended by SFAS No. 148.

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Thefollowing table illustrates the effect on net (loss) income and (loss) incomeper share if the Company’s had applied the fair value recognition provisions ofSFAS No. 123, as amended by SFAS No. 148, to stock-based employee compensation:

| ** **                                                                                                     | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Net (loss) income  (attributable to common shareholder)—as reported                                       |       | $          | (1,424,385 | )          | $          | 1,578,521  |       | $ | 458,719 |   |
| Add: stock based  employee compensation expense included in reported net (loss) income, net of  40% tax effect |       | 33,481     |       | 55,550     |       | 43,768     |       |
| Less fair value  of stock-based employee compensation expense                                                  |       | (1,136,471 | )          | (1,594,917 | )          | (2,277,304 | )          |
| Net (loss) income  (attributable to common shareholder)—pro forma                                         |       | (2,527,375 | )          | 39,154     |       | (1,774,817 | )          |
| Net (loss) income per  share:                                                                                  |       |       |       |       |       |       |       |
| Basic, as  reported                                                                                            |       | $          | (0.10      | )          | $          | 0.11       |       | $ | 0.04 |   |
| Basic, pro forma                                                                                               |       | $          | (0.18      | )          | $          | 0.00       |       | $ | (0.14 | ) |
| Diluted, as  reported                                                                                          |       | $          | (0.10      | )          | $          | 0.10       |       | $ | 0.03 |   |
| Diluted, pro forma                                                                                             |       | $          | (0.18      | )          | $          | 0.00       |       | $ | (0.12 | ) |

 

Thefair value of each option grant was estimated on the date of grant using theBlack-Scholes option-pricing model with the following weighted averageassumptions used for grants during the years ended December 31 withexpected option lives of 6.25 years and a dividend rate of zero:

| ** **               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk free  interest rate |       |     | 4.1        | %        |       |     | 3.5        | % |   |   | 2.9 | % |   |
| Expected volatility      |       |     | 58         | %        |       |     | 75         | % |   |   | 75 | % |   |

 

Because FAS No. 123has not been applied to options granted prior to January 1, 1995, theresulting pro forma compensation cost may not be representative of that to beexpected in the future years.

*Fair Value ofFinancial Instruments*

Management believes thecarrying amounts of cash and cash equivalents, accounts receivable and accountspayable approximate fair value due to the short period of time between originationof the instruments and their expected realization. The carrying amounts ofinvestments available for sale are reported at fair value based on quotedmarket prices (Note 2).

*CustomerConcentration*

For the fiscal year ended December 31,2005 no customer accounted for 10% or more of revenues. During the fiscal yearended December 31, 2004, one customer accounted for approximately 10% ofrevenues. During the fiscal year ended December 31, 2003 one customeraccounted for approximately 11% of revenues. At December 31, 2005, onecustomer accounted for approximately 23% of total receivables. At December 31,2004 five customers accounted for 22%, 21%, 12%, 11% and 11% of totalreceivables respectively. Given the significant amount of revenues derived fromthese customers, the loss of any such customer or the uncollectibility ofrelated receivables could have a material adverse effect on the Company’sfinancial condition and results of operations.

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*Concentrations ofCredit Risk*

Financial instruments, which potentially subject theCompany to concentrations of credit risk, consist primarily of cashequivalents, investments and trade accounts receivable. The Company places itscash in banks and its cash equivalents in commercial paper and money marketfunds at certain financial institutions in excess of amounts insured by federalagencies. The Company does not believe that as a result of this concentrationwe are subject to any unusual financial risk beyond the normal risk associatedwith commercial banking relationships. The Company performs periodicevaluations of the relative credit standing of these financial institutions.Investments consist of U.S. government securities rated AAA. The Company hasnot experienced any significant losses on its cash equivalents or investments.

The Company’s tradereceivables are derived from sales to OEMs and distributors in theconsumer electronics, home theater, computer, game, broadcast, Internet andtelecommunications markets primarily in Asia, North America and Europe. TheCompany makes periodic evaluations of the creditworthiness of its customers andmanages its exposure to losses from bad debts by limiting the amount of creditextended whenever deemed necessary and generally does not require collateral.The Company maintains an allowance for estimated uncollectible accountsreceivable and such losses have historically been within management’sexpectations.

*Geographic Risk*

The Company’s significant operations in Hong Kong, thePeople’s Republic of China (“PRC”) and other parts of Asia have required, andwill continue to require, refinement to adapt to the changing market conditionsin the region. The Company’s operations in Asia, and international operationsin general, are subject to risks of unexpected changes in, or impositions oflegislative or regulatory requirements.

Customers geographicallylocated in the Asia Pacific markets accounted for approximately 89%, 86% and91%, of total Company sales in 2005, 2004 and 2003, respectively and areexpected to continue to account for a substantial percentage of sales in thefuture.

**Recent Accounting Pronouncements**

*Accounting Changesand Error Corrections*

In May 2005, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 154, “AccountingChanges and Error Corrections, a replacement of APB Opinion No. 20 andFASB Statement No. 3,” (“SFAS No. 154”). This statement carriesforward without change the guidance contained in APB Opinion No. 20 forreporting the correction of an error in previously issued financial statementsand changes the requirements for the accounting for and reporting of a changein accounting principle. This Statement is effective for accounting changes andcorrections of errors made in fiscal years beginning after December 15,2005. The adoption of SFAS No. 154 is not expected to have a significantimpact on the Company’s results of operations or financial position.

*Inventory Costs*

In November 2004, theFASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43,Chapter 4” (“SFAS No. 151”), to clarify that abnormal amounts of idlefacility expense, freight, handling costs, and wasted material(spoilage) should be recognized as current period charges, and that fixedproduction overheads should be allocated to inventory based on normal capacityof production facilities. This statement is effective for inventory costsincurred during fiscal years beginning after June 15, 2005. Accordingly,the Company will adopt SFAS No. 151 in the fiscal year beginning January 1,2006. The adoption of SFAS No. 151 is not expected to have a significantimpact on the Company’s results of operations or financial position.

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*Share-Based Payment*

In March 2005, the SEC issued guidance on FASBSFAS 123(R), Share-Based Payments (“SFAS No. 123R”). StaffAccounting Bulletin No. 107 (“SAB 107”) was issued to assistpreparers by simplifying some of the implementation challenges of SFAS No. 123Rwhile enhancing the information that investors receive. SAB 107 creates aframework that is premised on two themes: (a) considerable judgment willbe required by preparers to successfully implement SFAS No. 123R,specifically when valuing employee stock options; and (b) reasonableindividuals, acting in good faith, may conclude differently on the fair valueof employee stock options. Key topics covered by SAB 107 include: (a) valuationmodels—SAB 107 reinforces the flexibility allowed by SFAS No. 123Rto choose an option-pricing model that meets the standard’s fair valuemeasurement objective; (b) expected volatility—SAB 107 providesguidance on when it would be appropriate to rely exclusively on eitherhistorical or implied volatility in estimating expected volatility; and (c) expectedterm—the new guidance includes examples and some simplified approaches todetermining the expected term under certain circumstances. The Company willapply the principles of SAB 107 in conjunction with its adoption ofSFAS No. 123R.

In December 2004, theFASB issued SFAS No. 123R. This standard requires all share-basedpayments to employees, including grants of employee stock options, to beexpensed in the financial statements based on their fair values beginning withthe first annual period beginning after June 15, 2005 (the first quarterof fiscal year 2006 for the Company). The pro forma disclosures permitted underSFAS No. 123 will no longer be allowed as an alternative presentationto recognition in the financial statements. Under SFAS No. 123R, theCompany must determine the appropriate fair value model to be used for valuingshare-based payments, the amortization method for compensation cost and thetransition method to be used at the date of adoption. The transition methodsinclude modified prospective and modified retrospective adoption options. Underthe modified retrospective option, prior periods may be restated either as ofthe beginning of the year of adoption or for all periods presented. Themodified prospective method requires that compensation expense be recorded forall unvested stock options and restricted stock at the beginning of the firstquarter of adoption of SFAS No. 123R, while the retroactive methodsrecord compensation expense for all unvested stock options and restricted stockbeginning with the first period restated. The Company will adopt SFAS No. 123Rin its first quarter of fiscal year 2006 on a modified prospective basis, whichwill require recognition of compensation expense for all stock option or otherequity-based awards that vest or become exercisable after the effective date.The Company intends to use the Black-Scholes valuation method to estimate thefair value of its options. The Company believes that its adoption will have anegative material impact on its consolidated results of operations andfinancial position.

*Reclassifications*

Certain amounts aspreviously reported have been reclassified to conform to the current yearpresentation.

**2.**   InvestmentSecurities Available for Sale

Investments with maturities greater than one year fromthe balance sheet date are classified as long-term investments. The Companyinvests its excess cash in US Treasury and Agency securities, and tax-exemptsecurities with approved financial institutions with a minimum investment gradeof “A1.” The investments available for sale consist mainly of bonds and includeonly marketable securities with secondary or resale markets to ensure portfolioliquidity.

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Thefollowing table summarizes the Company’s investment securities available forsale: 

| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2005**              | ** ** | **2004** | ** ** |
| U.S. Government  securities available for sale: |       |                  |       |   |   |
| Cost                                            |       | $                     | 17,491,890 |   | $ | 17,489,688 |   |
| Unrealized losses                               |       | (414,720              | )          | (228,421 | ) |
| Estimated fair value                            |       | $                     | 17,077,170 |   | $ | 17,261,267 |   |

 

Thecontractual maturities of investments are shown below. Actual maturities maydiffer from contractual maturities.

| ** **                                    | ** ** | **December 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|-----------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **Cost**                        | ** ** | **Estimated  Fair Value**  | ** ** | **Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| US Government  securities available for sale: |       |                            |       |                            |       |   |   |   |   |
| Due in one year or less                       |       | $                               | —     |                            | $          | — |   | $ | — |   | $ | — |   |
| Due in one to five years                      |       | 17,491,890                      |       | 17,077,170                      |       | 17,489,688 |   | 17,261,267 |   |
|                                          |       | $                               | 17,491,890 |                            | $          | 17,077,170 |   | $ | 17,489,688 |   | $ | 17,261,267 |   |

 

Thefollowing table summarizes sales of available for sale securities for the yearsended December 31, 2005, 2004 and 2003. Realized gains and losses areincluded in Other income, net in the accompanying consolidated income statement.Specific identification was used to determine costs in computing realized gainsor losses.

| ** **          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Proceeds from  sale |       |                                        | $          | — |   |   | $ | 5,375,000 |   | $ | 16,862,523 |   |
| Realized gains      |       |                                        | $          | — |   |   | $ | 139,375 |   | $ | 36,739 |   |
| Realized losses     |       |                                        | $          | — |   |   | $ | — |   | $ | (16,713 | ) |

 

**3.**   Investment in LLC

In September 2004, we entered into a strategicalliance with Coming Home Studios LLC, or CHS to use and promote SRS Labstechnologies, promote CHS productions and to promote each company’s respectivebrands. In connection with the strategic alliance, the Company and CHSestablished a joint venture, CHS/SRS, LLC, or the Joint Venture, to produce anddistribute six concert videos by *Duran Duran, Boz Scaggs,Godsmack and All Access* featuring our Circle Surround technology. Inconnection with the strategic alliance, SRS and CHS entered into fouragreements:  a Strategic Alliance Agreement, the CHS/SRS LLC OperatingAgreement, a Warrant Agreement and a Production Services Agreement.

In the Strategic Alliance Agreement, CHS and SRS agreeto work together to identify and implement co-promotional opportunities,including trade shows, movie theaters, video streaming, concert DVDs, artistendorsements, bundling and premium deals, web-based promotional clips and roadshows. The initial term of the agreement expires on July 9, 2006 and isautomatically renewable for successive one-year terms.

The Operating Agreement governs the joint venturebetween CHS and SRS formed to complete and distribute the Concert Videos.

Pursuant to the Operating Agreement each of CHS andSRS contributed capital with a value of $1,800,000. CHS’ capital contributionto CHS/SRS, LLC consists of the artist agreements and related 

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contracts pursuant towhich CHS/SRS, LLC will produce and distribute the Concert Videos. SRS Labssubsequently made additional capital contributions of $1,143,966 to raise itsaggregate capital contribution to $2,943,966. In addition, the Companycapitalized $149,766 consisting of costs associated with the formation of theLLC. CHS/SRS, LLC contracted with CHS to complete production of the ConcertVideos pursuant to the Production Services Agreement. Profits from thedistribution of the Concert Videos and related assets was to be allocated anddistributed equally until SRS and CHS have both received 1.75 times theiroriginal capital contributions, after which profits were to be allocated anddistributed 90% to CHS and 10% to SRS. We recognize and accrue profits as weget sales and/or royalty reports and recognize and accrue expenses in theperiod incurred. As of December 31, 2005, three of the concert videos, BozScaggs, Godsmack and Duran Duran have been released.

Under the Warrant Agreement, SRS paid CHS $40,000 toacquire a warrant to purchase up to 122,000 units of Class A membershipinterests in CHS, which represents approximately 10% of the equity of CHS, foran exercise price of $9.836 per unit, subject to adjustment based on valuationof CHS at the time of an additional funding. The warrant is immediately vestedand exercisable for up to two years. It is transferable and contains customaryantidilution and price protection provisions for warrants of this type.

Under the Production Services Agreement, CHS/SRS, LLCcontracted with CHS as an independent contractor to perform all productionservices and to provide all other services, personnel, materials and elementsfor the production, completion and delivery of the Concert Videos. CHS, as theindependent contractor, shall receive an aggregate of $365,000 in productionfees for all of its services under the Production Services Agreement. CHS isresponsible for payment of all costs and expenses in connection with theproduction and completion of the Concert Videos.

Initially, Coming Home Studios LLC was the manager ofthe CHS/SRS Joint Venture; however, due to the Company’s concerns aboutproduction delays and completion risks with respect to the Concert Videos, theCompany became manager of the CHS/SRS Joint Venture in July 2005. As aresult of becoming the manager of, and providing financial support to, the JointVenture, we were required under FASB Interpretation No. 46, *Consolidation of Variable Interest Entities* (FIN 46R) toconsolidate the financial statements of the Joint Venture into our financialstatements beginning with the third quarter of fiscal 2005. All inter-companyaccounts and transactions between us and the Joint Venture have been eliminatedin the Company’s financial statements. Previously, we accounted for ourinterest (50% of the equity ownership) in the Joint Venture as an investmentusing the equity method. Therefore, profits of $91,096 and $32,358 generatedfrom these videos have been recognized and included in “Equity in Income ofInvestee” in the Consolidated Statements of Operations for the fiscal yearended 2005 and 2004, resepectively.

As discussed in Note 1, in accordance with FinancialAccounting Standards Board Statement No. 144, *Accounting for the Impairment or Disposal of Long Lived Assets,*weevaluate the recoverability of certain long-lived assets whenever events orchanges in circumstances indicate that the carrying amount may not berecoverable. To date, only three of the six concert videos that the JointVenture was to produce have been completed and distributed, and sales of thethree completed concert videos have been significantly below pre-releaseforecasts. Management therefore tested the recoverability of our investment inthe Joint Venture against the expected future cash flows to us from the JointVenture. Based on (a) sales to date and expected future sales of the threecompleted concert videos, and (b) the estimated cost to complete theremaining three concert videos and their expected sales once completed,management concluded that the carrying amount of the Company’s investment inthe Joint Venture is not recoverable and that the value of the asset is zero asof December 31, 2005. On February 23, 2006, the Board authorizedmanagement to take all reasonable steps to divest the Company’s entire equityinterest in the Joint Venture.

 

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In the fourth quarter 2005,the Company recorded an impairment charge of $3.3 million, based on a totalloss of the carrying value of the investment in the Joint Venture. Because theimpairment does not relate to cash charges, we do not expect the impairmentcharge will result in future cash expenditures, except for certain legal andaccounting expenses related to the disposition of our interest in the JointVenture. Because we are required to consolidate the financial statements of theJoint Venture, the impairment amount has been recorded as: a $2,757,172 chargeto cost of goods sold principally related to a write down of capitalizedproduction costs, a $348,167 charge to general and administrative expenses, anda $185,304 charge to write off our remaining investment in the Joint Venturewhich is included in Other Income/Expense. The amounts included in theCompany’s Consolidated Statements of Cash Flows for the year ended December 31,2005 as write off of investment in LLC, reflects the Company’s capitalcontribution of $2,943,966, capitalized costs associated with the Joint Ventureof $149,766, its proportionate share of profit from the Joint Venture of$123,454, and the consolidated net equity of the LLC in the amount of $96,859.

**4.**                 Furniture,Fixtures and Equipment

Furniture,fixtures and equipment, net, consist of the following:

| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Furniture,  fixtures and equipment              |       | $                     | 1,694,436  |   | $ | 1,664,129 |   |
| Computer  equipment                             |       | 4,973,660             |       | 4,827,317 |   |
| Leasehold  improvements                         |       | 430,374               |       | 387,806 |   |
|                                            |       | 7,098,470             |       | 6,879,252 |   |
| Less accumulated  depreciation and amortization |       | (5,612,551            | )          | (4,883,673 | ) |
|                                            |       | $                     | 1,485,919  |   | $ | 1,995,579 |   |

 

Depreciation andamortization expense is reflected in operating expenses totaling $770,970,$775,949 and $703,727 for the years ended December 31, 2005, 2004 and2003, respectively in the accompanying consolidated financial statements basedon applicable asset use.

**5.**                 Acquisitionof Minority Interest in SRSWOWcast

On February 28, 2003, the Company purchased theminority interest of the shareholders of SRSWOWcast, also known as WOWcast, inwhich SRS Labs acquired all 3,000,000 shares of SRSWOWcast’s Series AConvertible Preferred Stock in exchange for the issuance of 332,184 shares ofSRS Labs common stock trading at $2.89 per share at the close of day onthe transaction date. The acquisition resulted in a purchase price of $960,012.

SRSWOWcast develops and markets professional softwareand hardware products and consumer software plug-in that incorporateproprietary audio rendering, voice and surround sound technologies.SRS Labs, as the majority shareholder has consistently included theresults of SRS WOWcast in all previously reported consolidated financialstatements. The acquisition was a strategic initiative, which allows theCompany to own 100% of the rights to the license of the Circle Surroundtechnology. Full ownership of the technology license will aid in the deploymentand marketing of such and will help the Company to compete more effectively.

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Thefollowing table summarizes the stated values of the assets acquired andliabilities assumed at the date of acquisition:

| Current Assets                 |   | $       | 324,002 |   |
|--------------------------------|--------|---------|---------|--------|
| Property &  Equipment |   | 3,774   |    |
| Current  Liabilities           |   | (7,835  | )       |
| Intangible Assets              |   | 640,071 |    |
| Purchase Price                 |   | $       | 960,012 |   |

 

Current assets primarilyconsisted of cash; accounts receivable and prepaid expenses and currentliabilities were valued at stated value. Property and equipment was valued atnet book value. The $640,071 of acquired intangible assets was assigned to alicense agreement, which is being amortized over the useful life of10 years.

**6.**                 Goodwill andIntangible Assets

On January 1, 2002 the Company adopted SFAS No. 142,“Goodwill and Other Intangible Assets,” which, among other things, establishesnew standards for goodwill acquired in a business combination, eliminates theamortization of goodwill and requires the carrying value of goodwill andidentifiable intangibles to be evaluated for impairment on an annual basis.

In accordance with SFAS No. 142, all of ourintangible assets that have definite lives are being amortized on astraight-line basis over their estimated useful lives and goodwill is evaluatedto determine if fair value of the asset has decreased below its carrying value.At December 31, 2005 and December 31, 2004, we evaluated goodwill anddetermined that no adjustment to impair goodwill was necessary.

Goodwilland intangible assets consist of the following:

| ** **                                                                                                                                                                     | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                     | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Goodwill                                                                                                                                                                       |       | $                     | 533,031    |   | $ | 533,031 |   |
| Patents                                                                                                                                                                        |       | $                     | 2,339,543  |   | $ | 2,038,582 |   |
| Accumulated  amortization                                                                                                                                                      |       | (1,093,368            | )          | (891,178 | ) |
| Patents, net                                                                                                                                                                   |       | 1,246,175             |       | 1,147,404 |   |
| Other  Intangibles:                                                                                                                                                            |       |                  |       |   |   |
| Assets acquired in the purchase of our subsidiary  Valence Technology in 1998: Covenant not to compete, Developed Technology,  ASP brand name, Cell Library, and Customer List |       | 4,910,400             |       | 4,910,400 |   |
| Asset acquired in purchase of our subsidiary  SRSWOWcast in February 2003                                                                                                 |       | 640,071               |       | 640,071 |   |
| Poly Planar purchased technology for speaker  products                                                                                                                         |       | 120,000               |       | 120,000 |   |
| Capitalized software and hardware for several  technologies                                                                                                                    |       | 525,840               |       | 394,840 |   |
| Total of Other Intangibles                                                                                                                                                     |       | 6,196,311             |       | 6,065,311 |   |
| Accumulated  amortization, other intangibles                                                                                                                                   |       | (4,955,420            | )          | (4,551,760 | ) |
| Other  intangibles, net                                                                                                                                                        |       | 1,240,891             |       | 1,513,551 |   |
| Intangible assets, net                                                                                                                                                         |       | $                     | 2,487,066  |   | $ | 2,660,955 |   |

 

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Amortizationperiods range from three to eleven years depending on the estimated useful lifeof the asset. Amortization expense consists of the following:

| ** **                                                                                     | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Patents                                                                                        |       | $                                          | 202,190    |   | $ | 161,475 |   | $ | 149,427 |   |
| Other intangibles:                                                                             |       |                                       |       |   |   |   |   |
| Covenant not to compete, developed technology, ASP  brand name, cell library and customer list |       | 211,808                                    |       | 211,158 |   | 214,506 |   |
| Asset acquired in purchase of our subsidiary  SRSWOWcast in February                           |       | 64,007                                     |       | 64,007 |   | 53,339 |   |
| Poly Planar purchased technology                                                               |       | 4,000                                      |       | 24,000 |   | 24,000 |   |
| Capitalized software and hardware                                                              |       | 123,845                                    |       | 85,955 |   | 3,776 |   |
| Total intangible  amortization expense                                                         |       | $                                          | 605,850    |   | $ | 546,595 |   | $ | 445,048 |   |

 

As of December 31,2005, the weighted average useful life of the Company’s patents and intangibleassets is approximately 3.6 years. The following table shows the estimatedamortization expense for those assets for each of the five succeeding fiscalyears and thereafter.

| **Year ending December 31,** | ** ** | ** ** | ** ** | **Estimated expense** | ** ** |
|---------------------------------------------|------------|------------|------------|----------------------------|------------|
| 2006                                        |       |       | $          | 669,966                    |       |   |
| 2007                                        |       |       | 585,718    |                       |       |
| 2008                                        |       |       | 340,322    |                       |       |
| 2009                                        |       |       | 191,130    |                       |       |
| 2010                                        |       |       | 185,175    |                       |       |
| Thereafter                                  |       |       | 514,755    |                       |       |

 

**7.**                 Commitments andContingencies

The Company leases office space and certain equipmentunder non-cancelable operating leases expiring through 2008. The Company leasesits corporate office and storage facilities located in Santa Ana, California,under a lease agreement with a partnership that is affiliated with a principalstockholder and executive officer of the Company. The lease is for a term ofthree years scheduled to expire on May 31, 2008. Additionally, the Companyleases office and warehouse facilities in Hong Kong from unrelated parties.Total rent expense was $389,057, $370,788 and $550,854 for the years ended December 31,2005, 2004, and 2003, respectively, of which $222,066, $210,600 and $208,260was paid to the related party, respectively.

Futureannual minimum lease payments under non-cancelable operating leases at December 31,2005, are as follows:

| **Year ending December 31,** | ** ** | ** ** | ** ** | **Facility** | ** ** | **Facility-Related  Party** | ** ** | **Office  Equipment** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|------------|------------|--------------|------------|-----------------------------|------------|-----------------------|------------|-----------|------------|
| 2006                                        |       | $          | 171,101    |         |       | $                           | 230,256    |                  |       |      | $          | 13,020 |   |   | $ | 414,377 |   |
| 2007                                        |       | 2,637      |       |         | 230,256    |                        |       |                  | 11,949     |      |       | 244,842 |   |
| 2008                                        |       | —     |       |         | 95,940     |                        |       |                  | 3,299      |      |       | 99,239 |   |
| 2009                                        |       | —     |       |         | —     |                        |       |                  | —     |      |       | — |   |
| 2010                                        |       | —     |       |         | —     |                        |       |                  | —     |      |       | — |   |
| Total                                       |       | $          | 173,738    |         |       | $                           | 556,452    |                  |       |      | $          | 28,268 |   |   | $ | 758,458 |   |

 

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*Litigation*

The Company is involvedfrom time to time in litigation or claims arising in the ordinary course of itsbusiness. While the ultimate liability, if any, arising from these claimscannot be predicted with certainty, the Company believes that the resolution ofthese matters will not likely have a material adverse effect on the Company’sconsolidated financial statements.

*Indemnifications*

The Company enters into standard license agreements inits ordinary course of business. Pursuant to these agreements, the Companyagrees to indemnify its customers for losses suffered or incurred by them as aresult of any patent, copyright, or other intellectual property infringementclaim by any third party with respect to the Company’s products. Theseagreements generally have perpetual terms. The maximum amount ofindemnification the Company could be required to make under these agreements isgenerally limited to the license fees received by the Company. The Companyestimates the fair value of its indemnification obligation as insignificant,based upon its history of litigation concerning product and patent infringementclaims. Accordingly, the Company has no liabilities recorded forindemnification under these agreements as of December 31, 2005.

The Company has agreementswhereby our officers and directors are indemnified for certain events oroccurrences while the officer or director is, or was serving, at our request insuch capacity. The maximum potential amount of future payments we could berequired to make under these indemnification agreements is unlimited; however,we have a directors and officers’ insurance policy that reduces our exposureand enables us to recover a portion of any future amounts paid. As a result ofour insurance policy coverage, we believe the estimated fair value of theseindemnification agreements is minimal. Currently, we have no liabilitiesrecorded for these agreements as of December 31, 2005.

*Warranties*

The Company offers itscustomers a warranty that its software products will substantially conform totheir functional specifications. To date, there have been no payments ormaterial costs incurred related to fulfilling these warranty obligations.Accordingly, the Company has no liabilities recorded for these warranties as ofDecember 31, 2005. The Company assesses the need for a warranty reserve ona quarterly basis. There can be no guarantee that a warranty reserve will notbecome necessary in the future.

*EmploymentContracts*

The Company entered intoemployment agreements with its Chief Executive Officer and seven otherpersonnel of the Company (collectively “Agreements”), including one officer ofValence. Each of the Agreements was entered into for an initial multi-year termthat has since expired and all are now automatically renewed annually onvarious anniversary dates. Under terms of each of the Agreements, the Companymay be obligated to pay a severance payment ranging from one to two years ofthe respective employee’s base salary, depending on the date of termination, ifthe employment is terminated by the Company without cause.

*Change in ControlPlan*

The Compensation Committeeof the Board, the sponsor of the Company’s 2005 Change in Control ProtectionPlan (the “Change in Control Plan”), has designated certain of its executiveofficers as participants in the Change in Control Plan. The Change in ControlPlan generally provides that if a participant’s employment is terminatedwithout cause or if the participant resigns for good reason during a two-yearperiod following a change in control, as defined in the Change in Control Plan,the participant will be entitled to receive a severance payment. Under theChange in Control Plan, the size of severance 

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paymentthat would be due to a participant upon the occurrence of a covered terminationranges from to one to two times the participant’s average taxable income duringthe five years preceding the change in control, depending on the participant’sposition with the Company. The Change in Control Plan also provides that theCompany will pay a participant’s COBRA premiums for a period of 18 monthsfollowing a covered termination.

**8.**                 Income Taxes

Thecomponents of (loss) income from continuing operations before income taxes areas follows:

| ** ** | ** ** | **Years ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| U.S.       |       | $                                           | 142,753    |   | $ | 615,196 |   | $ | (562,239 | ) |
| Foreign    |       | (946,245                                    | )          | 1,773,741 |   | 2,059,421 |   |
| Total      |       | $                                           | (803,492   | ) | $ | 2,388,937 |   | $ | 1,497,182 |   |

 

Theprovision for income taxes consists of the following:

| ** **                         | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------|------------|---------------------------------------------|------------|
| ** **                         | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Current:                           |       |                                        |       |   |   |   |   |
| Federal                            |       | $                                           | 51,831     |   | $ | 23,356 |   | $ | — |   |
| State                              |       | 17,127                                      |       | 7,873 |   | 1,600 |   |
| Foreign                            |       | 716,165                                     |       | 778,803 |   | 1,067,761 |   |
| Total                              |       | 785,123                                     |       | 810,032 |   | 1,069,361 |   |
| Deferred:                          |       |                                        |       |   |   |   |   |
| Federal                            |       | (1,011,869                                  | )          | 106,117 |   | (292,145 | ) |
| State                              |       | 69,869                                      |       | 46,699 |   | (113,085 | ) |
| Foreign                            |       | (164,230                                    | )          | 384 |   | (30,897 | ) |
| Change in valuation allowance, net |       | 942,000                                     |       | (152,816 | ) | 405,229 |   |
| Total                              |       | (164,230                                    | )          | 384 |   | (30,898 | ) |
| Total income tax  provision        |       | $                                           | 620,893    |   | $ | 810,416 |   | $ | 1,038,463 |   |

 

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Thereconciliation of the income tax expense (benefit) computed at U.S. federalstatutory rates to the provision for income taxes is as follows:

| ** **                               | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------|------------|---------------------------------------------|------------|
| ** **                               | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Tax at U.S.  federal statutory rates     |       | $                                           | (273,187   | ) | $ | 812,239 |   | $ | 509,042 |   |
| State income  taxes, net of federal      |       | 28,345                                      |       | 37,583 |   | (16,690 | ) |
| Nondeductible  expenses                  |       | 107,321                                     |       | — |   | — |   |
| Change in  valuation allowance, net      |       | 942,000                                     |       | 336,682 |   | 820,652 |   |
| Research and  development credit         |       | (125,000                                    | )          | — |   | — |   |
| Change in  beginning deferred balance    |       | (99,571                                     | )          | — |   | — |   |
| Tax exempt  interest                     |       | (123,661                                    | )          | — |   | — |   |
| Foreign tax rate  differential and other |       | 164,646                                     |       | (376,088 | ) | (274,541 | ) |
| Total income tax expense                 |       | $                                           | 620,893    |   | $ | 810,416 |   | $ | 1,038,463 |   |

 

Deferredincome taxes reflect the net tax effects of temporary differences between thecarrying amounts of assets and liabilities for financial reporting purposes andthe amounts used for income tax purposes. Significant components of the Company’sdeferred tax assets and liabilities are as follows:

| ** **                       | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Deferred tax assets:             |       |                  |       |   |   |
| Depreciation and amortization    |       | $                     | 1,104,178  |   | $ | 1,204,088 |   |
| Accruals                         |       | 789,341               |       | 558,198 |   |
| Investment in LLC                |       | 955,849               |       | — |   |
| Net operating loss carryforwards |       | 7,178,133             |       | 8,095,361 |   |
| Tax credit carryforwards         |       | 2,238,883             |       | 1,231,090 |   |
| Other                            |       | (211,102              | )          | (211,102 | ) |
| Foreign income taxes             |       | (6,027                | )          | (170,256 | ) |
| Valuation allowance              |       | (11,668,869           | )          | (10,491,223 | ) |
| Total net  deferred tax assets   |       | $                     | 380,386    |   | $ | 216,156 |   |

 

The Company has federal and state net operating losscarryforwards at December 31, 2005, of approximately $18,686,000 and$9,333,000 respectively. These net operating loss carryforwards began to expirein 2003 and will continue to expire through 2025. In addition, the Company hasfederal tax credit carryforwards of approximately $1,914,000 at December 31,2005, which will begin to expire in 2011.

As of December 31, 2005, a valuation allowance of$11,668,869 has been provided based on the Company’s assessment of the futurerealizability of certain deferred tax assets. The valuation allowance ondeferred tax assets relates to future deductible temporary differences, capitalloss carry forwards, foreign credit carryforwards and net operating losscarryforwards for which the Company has concluded it is more likely than notthat these items will not be realized in the ordinary course of operations.Management periodically evaluates the recoverability of the deferred tax assetsand recognizes the tax benefit only as reassessment demonstrates they are realizable.At such time it is determined that it is more likely than not that the deferredtax assets are realizable, the valuation allowance is adjusted. This assessmentis based on projections of future taxable income, which is impacted in futureperiods, by income before taxes and stock option exercises. The amount of thenet deferred tax assets considered realizable, however, could be reduced in thenear term if actual future earnings are lower than estimated, or if there aredifferences in the timing or amount of future reversals of existing taxabletemporary differences. A portion of the increase in the valuation allowance, asdisclosed in the table above for the Deferred Assets and Liabilities, 

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is due to additional netoperating losses attributable to the exercise of non-qualified stock options.The effect of the valuation allowance related to these stock options has beenreported in equity.

Undistributed earnings of the Company’s foreignsubsidiaries are considered to be indefinitely reinvested and, accordingly, noprovision for U.S. federal and state income taxes has been provided thereon.Upon distribution of those earnings in the form of dividends or otherwise, theCompany would be subject to U.S. income taxes and possibly withholding taxespayable to the foreign countries, but may be able to offset net operatinglosses and unrecognized foreign tax credit carryforwards. Determination of theamount of unrecognized deferred income tax liability is not practicable becauseof the complexities associated with its hypothetical calculation.

The use of losscarryforwards and tax credit carry forwards may become limited in the event ofan ownership change as defined under I.R.C. code section 382.

**9.**                 Stockholders’Equity

*Stock Repurchases*

On June 30, 2004, the Company’s Board ofDirectors authorized the repurchase of up to $3,000,000 of its outstandingcommon stock for a period from July 1, 2004 to December 31, 2004 (the“2004 Repurchase Program”). The Company repurchased 216,575 shares at a cost of$1,225,254 under the 2004 Repurchase Program.

On March 24,2005, the Company’s Board of Directors authorized the repurchase of up to$3,000,000 of the outstanding shares of the Company’s common stock for a periodfrom April 2005 to March 2006 (the “2005 Repurchase Program”).Purchases may be made from time to time in the open market, block purchases orprivately negotiated transactions,depending on market conditions, shareprice and other factors. All repurchased shares are reflected as treasury stockin the accompanying consolidated balance sheets. The following table showsactivity under the 2005 Repurchase Program for the year ending December 31,2005:

| ** **                       | ** ** | **December 31,  2005** | ** ** |
|----------------------------------|------------|-----------------------------|------------|
| Shares  repurchased              |       | 232,223                     |       |
| Average price per  share         |       | $                           | 4.56       |   |
| Total repurchase authorized      |       | $                           | 3,000,000  |   |
| Repurchases under  the plan      |       | $                           | (1,059,590 | ) |
| Authorized repurchase  remaining |       | $                           | 1,940,410  |   |

 

*Stock Award/OptionPlans/Warrants*

In June 1997, the Company’s Board of Directorsadopted and the Company’s stockholders approved the Amended and Restated 1996Long-Term Incentive Plan (the “1996 Plan”), for which 2,000,000 shares of theCompany’s common stock were reserved for issuance to officers, employees andconsultants of the Company. If any award granted under the 1996 Plan expires,terminates or is forfeited before the exercise thereof or the payment in fullthereof, the shares covered by the unexercised or unpaid portion will becomeavailable for new grants under the 1996 Plan. In June 1998, the Company’sBoard of Directors adopted and the Company’s stockholders approved an amendmentto the 1996 Plan to increase the number of shares in the plan by 2,500,000.Also in June 1998, in a separate amendment, the Company’s Board ofDirectors and the Company’s stockholders approved an amendment to allow alldirectors of the Company and any subsidiary of the Company to participate inthe 1996 Plan. In June 2000, the Company’s Board of Directors adopted andthe Company’s stockholders approved an amendment to the 1996 Plan to increasethe number of shares in the plan by 2,500,000. In June 2003, the Company’sBoard of Directors 

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adopted and the Company’sshareholders approved an amendment to the 1996 Plan to increase the number ofshares in the plan by 1,500,000. The Compensation Committee or, in the absenceof a Compensation Committee, the Board of Directors, has been appointed toadminister the 1996 Plan. Options issued under the 1996 Plan vest in the mannerprescribed by the Compensation Committee or the Board, as applicable. As of December 31,2005, options to purchase 4,314,254 shares of the Company’s common stock wereoutstanding under the 1996 Plan.

In July 1996, the Company’s Board of Directorsadopted and the Company’s stockholders approved the 1996 Non-employee DirectorsStock Option Plan (the “Non-employee Directors Plan”), a non-discretionaryformula plan for which 120,000 shares of the Company’s common stock arereserved for issuance to the Company’s non-employee directors. A committeeconsisting of all directors who are not eligible to participate in theNon-employee Directors Plan administers the Non-employee Directors Plan. Withthe exception of the initial option granted to a non-employee director, whichvests immediately, options granted under the Non-employee Directors Plan vestover a three-year period, the first installment vesting on the date of grant.In June 1999, the shareholders approved the Amended and Restated 1996Non-employee Directors’ Stock Option Plan (the “Amended Non-employee DirectorsPlan”). Among the changes set forth in the Amended Non-employee Directors Planwas to increase by 130,000 the number of shares of common stock that may beissued. In June 2001, the Company’s Board of Directors adopted and theCompany’s stockholders approved an amendment to the Amended Non-employeeDirectors Plan to increase the number of shares in the plan by 250,000. As of December 31,2005, options to purchase 130,000 shares of common stock were outstanding underthe Amended Non-employee Directors Plan.

Thefollowing table summarizes stock option activity under the Company’s stockoption and warrant plans for the periods indicated:

| ** **                             | ** ** | **Options  Outstanding** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|----------------------------------------|------------|--------------------------|------------|--------------------------------------------|------------|
| Outstanding at  January 1, 2003   |       |                     | 6,024,942  |                                       |       |   | $ | 4.11 |   |   |
| Granted                                |       |                     | 561,400    |                                       |       |   | $ | 4.17 |   |   |
| Stock options exercised                |       |                     | (473,784   | )                                          |       |   | $ | 3.01 |   |   |
| Forfeited                              |       |                     | (654,723   | )                                          |       |   | $ | 5.97 |   |   |
| Outstanding at  December 31, 2003 |       |                     | 5,457,835  |                                       |       |   | $ | 3.99 |   |   |
| Granted                                |       |                     | 1,199,000  |                                       |       |   | $ | 6.34 |   |   |
| Stock options exercised                |       |                     | (989,134   | )                                          |       |   | $ | 3.75 |   |   |
| Forfeited                              |       |                     | (946,160   | )                                          |       |   | $ | 5.23 |   |   |
| Outstanding at  December 31, 2004 |       |                     | 4,721,541  |                                       |       |   | $ | 4.38 |   |   |
| Granted                                |       |                     | 588,775    |                                       |       |   | $ | 5.37 |   |   |
| Stock options exercised                |       |                     | (282,274   | )                                          |       |   | $ | 3.51 |   |   |
| Forfeited                              |       |                     | (583,788   | )                                          |       |   | $ | 5.62 |   |   |
| Outstanding at  December 31, 2005 |       |                     | 4,444,254  |                                       |       |   | $ | 4.41 |   |   |

 

The weighted average fair value of options grantedduring 2005, 2004 and 2003 was $5.37, $6.49 and $4.15 respectively. Optionsgranted during 2005 generally vest over four years and the options generallyexpire in 10 years.

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Thefollowing table summarizes information concerning currently outstanding andexercisable options and warrants:

| **Range of Exercise Prices** | ** ** | ** ** | ** ** | **Number of  Options   Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Exercisable  As of  12/31/2005** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|---------------------------------------------|------------|------------|------------|------------------------------------------------|------------|---------------------------------------------------------|------------|--------------------------------------------|------------|-----------------------------------------|------------|--------------------------------------------|------------|
| $1.91 -  $3.80                              |       |       | 1,967,712  |                                           |       |                                                    | 5.2        |                                       |       |                                    | $          | 2.9438                                     |       |   | 1,800,202 |   |   | $ | 2.9597 |   |   |
| $3.81 -  $5.70                              |       |       | 1,440,542  |                                           |       |                                                    | 4.0        |                                       |       |                                    | $          | 4.9465                                     |       |   | 1,096,343 |   |   | $ | 5.0752 |   |   |
| $5.71 -  $7.60                              |       |       | 973,500    |                                           |       |                                                    | 8.0        |                                       |       |                                    | $          | 6.0481                                     |       |   | 289,245 |   |   | $ | 6.3521 |   |   |
| $7.61 -  $9.50                              |       |       | 22,500     |                                           |       |                                                    | 4.2        |                                       |       |                                    | $          | 8.6111                                     |       |   | 22,500 |   |   | $ | 8.6111 |   |   |
| $9.51 -  $11.40                             |       |       | 20,000     |                                           |       |                                                    | 4.4        |                                       |       |                                    | $          | 10.5625                                    |       |   | 20,000 |   |   | $ | 10.5625 |   |   |
| $17.10 -  $19.00                            |       |       | 20,000     |                                           |       |                                                    | 4.2        |                                       |       |                                    | $          | 19.0000                                    |       |   | 20,000 |   |   | $ | 19.0000 |   |   |
|                                        |       |       | 4,444,254  |                                           |       |                                                    | 5.4        |                                       |       |                                    | $          | 4.4082                                     |       |   | 3,248,290 |   |   | $ | 4.1605 |   |   |

 

The total optionsexercisable as of December 31, 2005, 2004 and 2003 were 3,248,290, 2,940,631and 3,604,383, respectively, with weighted average exercise prices of $4.16,4.20 and 4.33, respectively. During the years ended December 31, 2005, 2004 and2003 the Company recorded $55,802, $92,585 and $72,945 respectively, ofdeferred compensation expense related to stock options granted to non-employeecontractors.

**10.**          Saleof Stock by Subsidiary

On September 29, 2000, the Company’s wholly-ownedsubsidiary SRSWOWcast and certain investors, which included shareholders,directors and an executive officer of the Company, entered into a Series APreferred Stock and Warrant Purchase Agreement (the “Private PlacementAgreement”) relating to the purchase and sale of 3,000,000 shares of SRSWOWcastSeries A Convertible Preferred Stock (“Preferred Stock”) for a purchaseprice of $2.00 per share or $6,000,000 in the aggregate (the “Private Placement”).Pursuant to the Private Placement Agreement, investors received an immediatelyexercisable, three year warrant evidencing a right to purchase one-tenth of ashare of SRSWOWcast’s common stock for each share of Preferred Stock purchasedby such investor, exercisable at $2.50 per whole share. The fair value of thewarrants was zero at the date of issuance. In accordance with SAB No. 51, “Accountingfor Sales of Stock by a Subsidiary,” the Company recorded $5,154,995 ofadditional paid-in capital associated with the Private Placement. In February 2003,the Company completed an exchange offer with the minority shareholders ofSRSWOWcast, pursuant to which SRS Labs acquired all 3,000,000 outstandingshares of SRSWOWcast Series A Convertible Preferred Stock in exchange forthe issuance of 332,184 shares of SRS Labs common stock. As a result of theexchange offer, an intangible asset in the amount of $640,071 was recorded andSRSWOWcast became a wholly owned subsidiary of SRS Labs.

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**11.**   Segment Information

TheCompany operates two business segments—semiconductors and licensing. In 2003,the Company reported its revenues in the following five segments: licensing,semiconductors, component distribution, product sales, and Internet and broadcast.In 2004, the Company decided to reduce its segments to licensing andsemiconductor because the revenue attributable to the discontinued segmentswere not material compared to revenues relating to semiconductors andlicensing. Segment information for the 2003 segments has been restated toconform to the current year presentation. Revenue from the componentdistribution segment is now reported in the semiconductor segment and revenuesfrom product sales and Internet and broadcast segments are now reported in thelicensing segment.

| ** **       | ** ** | **SRS Labs  Licensing** | ** ** | **Valence  Semiconductor(b)** | ** ** | **Total** | ** ** |
|------------------|------------|------------------------------|------------|-------------------------------|------------|-----------|------------|
| **Fiscal 2005**  |       |                         |       |                          |       |      |       |   |   |
| Total revenues   |       | $                            | 14,795,810 |                          |       | $         | 8,432,449  |   |   | $ | 23,228,259 |   |
| Cost of sales    |       | 3,204,021                    | (a)        |                          | 3,411,649  |      |       | 6,615,670 | (a) |
| Gross margin     |       | $                            | 11,591,789 |                          |       | $         | 5,020,800  |   |   | $ | 16,612,589 |   |
| **Fiscal  2004** |       |                         |       |                          |       |      |       |   |   |
| Total revenues   |       | $                            | 10,831,704 |                          |       | $         | 10,770,684 |   |   | $ | 21,602,388 |   |
| Cost of sales    |       | 228,147                      |       |                          | 3,725,062  |      |       | 3,953,209 |   |
| Gross margin     |       | $                            | 10,603,557 |                          |       | $         | 7,045,622  |   |   | $ | 17,649,179 |   |
| **Fiscal  2003** |       |                         |       |                          |       |      |       |   |   |
| Total revenues   |       | $                            | 9,101,399  |                          |       | $         | 10,712,382 |   |   | $ | 19,813,781 |   |
| Cost of sales    |       | 102,979                      |       |                          | 3,953,100  |      |       | 4,056,079 |   |
| Gross margin     |       | $                            | 8,998,420  |                          |       | $         | 6,759,282  |   |   | $ | 15,757,702 |   |

----

(a)           Cost of sales includesthe write-off of the capitalized production costs of $2.8 million related toCHS/SRS LLC.

(b)          See Note 14 for furtherinformation regarding management’s decision to sell its semiconductor business.

For fiscal year 2005, there was no customer thataccounted for more than 10% of consolidated revenues. For fiscal year 2004, onecustomer in the semiconductor segment accounted for approximately 10% or$2,180,065 of consolidated revenues. For fiscal year 2003, one customer in thesemiconductor segment accounted for approximately 11% or $2,107,790 ofconsolidated revenues.

The following schedule presents the Company’s revenueby geographic area. For product sales, revenue is allocated based on thecountry to which product was shipped. For licensing-related revenue, theallocation is based on the location of the licensee’s corporate headquarters.The Americas region includes North, Central and South America.

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| ** **                      | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                    | ** ** | **%** | ** ** | **2004** | ** ** | **%** | ** ** | **2003** | ** ** | **%** | ** ** |
| ***Geographic  Area Revenue:*** |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Hong Kong                       |       | $                                           | 7,672,588  |   | 33 | % | $ | 9,975,904 |   | 46 | % | $ | 9,235,976 |   | 47 | % |
| Japan                           |       | 5,644,518                                   |       | 24 | % | 4,906,343 |   | 23 | % | 5,402,565 |   | 27 | % |
| Korea                           |       | 4,217,780                                   |       | 18 | % | 1,456,063 |   | 7 | % | 381,416 |   | 2 | % |
| China                           |       | 2,734,596                                   |       | 12 | % | 2,028,224 |   | 9 | % | 2,193,863 |   | 11 | % |
| Americas                        |       | 2,300,263                                   |       | 10 | % | 2,354,668 |   | 11 | % | 875,461 |   | 5 | % |
| Other Asia Pacific              |       | 383,420                                     |       | 2 | % | 205,817 |   | 1 | % | 845,529 |   | 4 | % |
| Europe                          |       | 275,094                                     |       | 1 | % | 675,369 |   | 3 | % | 878,971 |   | 4 | % |
| Total                           |       | $                                           | 23,228,259 |   | 100 | % | $ | 21,602,388 |   | 100 | % | $ | 19,813,781 |   | 100 | % |

 

 

| ** **                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2005**              | ** ** | **2004** | ** ** |
| ***Geographic  Area Long-lived Assets:*** |       |                  |       |   |   |
| Asia Pacific                              |       | $                     | 1,593,662  |   | $ | 2,028,787 |   |
| United States                             |       | 425,288               |       | 499,823 |   |
| Total                                     |       | $                     | 2,018,950  |   | $ | 2,528,610 |   |

 

**12.**   Related-PartyTransactions

**The Company leases its corporateoffice and storage facilities located in Santa Ana, California, under a leaseagreement with a partnership that is affiliated with a stockholder and officerof the Company. The lease has a term of three years, expiring May 31,2008. We paid the partnership rent of $222,066 during 2005, $210,600 during2004, and $208,260 during 2003. See Note 7. As described in Note 10,certain shareholders, directors and an executive officer of the Company purchasedpreferred shares issued by a subsidiary of the Company.**

The Company and SierraDigital Productions, Inc. (“Sierra Digital”) entered into a ConsultingAgreement dated August 23, 1994, pursuant to which Sierra Digital providesproduct definition, development and design services on a 100% time commitmentbasis to the Company in connection with the Company’s research and developmentof its sound technologies. The president and sole shareholder of Sierra Digitalis Alan D. Kraemer, the Company’s Chief Technology Officer. Pursuant to theConsulting Agreement, the Company paid to Sierra Digital a monthly retainer of$10,083 per month plus expenses. This agreement terminated on June 30,2003. The Company paid Sierra Digital $70,583 during Fiscal 2003.

**13.**   Employee BenefitPlan

The Company’s employeesbased in the United States may participate in a salary deferral plan (the “401(k) Plan”)in which eligible employees can contribute up to 75% of their eligiblecompensation. The Company also may contribute on a discretionary basis. Duringthe years ended December 31, 2005, 2004, and 2003, the Company contributedapproximately $93,700, $99,800 and $81,800, respectively to the 401(k) Plan.

**14.**   Subsequent Events

On February 23, 2006, the Board of Directors ofthe Company authorized management to take all reasonable steps to divest theCompany’s entire equity interest in the Joint Venture. The Company has not yetestimated the costs it will incur in connection with the divestiture of itsequity interest in the CHS/SRS Joint Venture.

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On February 23, 2006, the Board of Directors ofthe Company approved a plan to sell the Company’s Hong Kong-based semiconductorbusiness, Valance Technology Limited, in order to focus increased managementattention and financial resources on what it believes to be a larger andexpanding market opportunity for its licensing business. We have retainedKaufman Bros., L.P., a financial advisor based in New York City, to assist usin facilitating a sale. As a result of our decision to sell Valence, we willaccount for the semiconductor business segment as a discontinued operationbeginning in the quarter ending March 31, 2006.

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Thefollowing represents the condensed summary balance sheet and income statementof the semiconductor business on a stand-alone basis.

**SUMMARY BALANCESHEET**

| ** **                                                   | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ASSETS                                                       |       |                        |       |                        |       |
| Cash and cash  equivalents                                   |       | $                           | 2,455,496  |                        | $          | 4,236,124 |   |
| Accounts receivable, net  of allowance for doubtful accounts |       | 902,771                     |       | 241,274                     |       |
| Inventories, net of  reserve                                 |       | 527,416                     |       | 478,492                     |       |
| Other                                                        |       | 309,456                     |       | 701,785                     |       |
| Total Current Assets                                         |       | 4,195,139                   |       | 5,657,675                   |       |
| Investments available  for sale                              |       | 9,907,410                   |       | 9,949,600                   |       |
| Furniture, fixtures and  equipment, net                      |       | 1,060,631                   |       | 1,495,755                   |       |
| Total Assets                                                 |       | $                           | 15,163,180 |                        | $          | 17,103,030 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                    |       |                        |       |                        |       |
| Current Liabilities                                          |       | $                           | 2,016,355  |                        | $          | 3,142,796 |   |
| Stockholders’ Equity                                    |       |                        |       |                        |       |
| Common stock                                                 |       | 8,910,256                   |       | 8,910,256                   |       |
| Additional paid-in  capital                                  |       | 427,308                     |       | 427,308                     |       |
| Retained Earnings                                            |       | 3,745,601                   |       | 4,516,820                   |       |
| Other                                                        |       | 63,660                      |       | 105,850                     |       |
| Total Stockholders’  Equity                             |       | 13,146,825                  |       | 13,960,234                  |       |
| Total Liabilities and Stockholders’ Equity              |       | $                           | 15,163,180 |                        | $          | 17,103,030 |   |

 

**SUMMARYSTATEMENTS OF OPERATIONS**

| ** **                               | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------|------------|---------------------------------------------|------------|
| ** **                               | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue                                  |       | $                                           | 8,432,449  |   | $ | 10,770,684 |   | $ | 10,712,383 |   |
| Cost of sales                            |       | 3,411,649                                   |       | 3,725,062 |   | 3,953,102 |   |
| Gross margin                             |       | 5,020,800                                   |       | 7,045,622 |   | 6,759,281 |   |
| Operating expenses                       |       |                                        |       |   |   |   |   |
| Sales and marketing                      |       | 1,698,578                                   |       | 895,124 |   | 1,293,885 |   |
| Research and development                 |       | 2,475,779                                   |       | 2,505,118 |   | 2,387,819 |   |
| General and  administrative              |       | 882,229                                     |       | 1,053,770 |   | 1,004,523 |   |
| Corporate expense  allocation            |       | 1,173,327                                   |       | 1,128,529 |   | — |   |
| Total operating expenses                 |       | 6,229,913                                   |       | 5,582,541 |   | 4,686,227 |   |
| (Loss) income from  operations           |       | (1,209,113                                  | )          | 1,463,081 |   | 2,073,054 |   |
| Other income, net                        |       | 262,870                                     |       | 310,659 |   | 199,449 |   |
| (Loss) income before  income tax expense |       | (946,243                                    | )          | 1,773,740 |   | 2,272,503 |   |
| Income tax (benefit)  expense            |       | (175,024                                    | )          | 287,289 |   | 406,633 |   |
| Net (loss) income                        |       | $                                           | (771,219   | ) | $ | 1,486,451 |   | $ | 1,865,870 |   |

 

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**SCHEDULEIIVALUATION AND QUALIFYING ACCOUNTS AND RESERVES**

| ** **                                   | ** ** | **Balance at  Beginning  of Period** | ** ** | **Additions  (Reductions)  Charged to  Expense** | ** ** | **Deductions** | ** ** | **Other, Net(b)** | ** ** | **Balance  at End  of Period** | ** ** |
|----------------------------------------------|------------|------------------------------------------------|------------|-------------------------------------------------------|------------|----------------|------------|------------------------|------------|------------------------------------------|------------|
| For the year ended  December 31, 2005:  |       |                                           |       |                                                  |       |           |       |                   |       |                                     |       |   |   |   |   |
| Allowance for doubtful accounts              |       | $                                              | 32,962     |                                                  |       | $              | 66,241     |                   |       | $                                        | —     |   |   | $ | — |   |   | $ | 99,203 |   |
| Inventory reserve                            |       | $                                              | 240,825    |                                                  |       | $              | (9,731     | )                      |       | $                                        | (104,087   | ) |   | $ | — |   |   | $ | 127,007 |   |
| Valuation allowance for deferred tax assets  |       | $                                              | 10,491,223 |                                                  |       | $              | —     |                   |       | $                                        | —     |   |   | $ | 1,177,646 |   |   | $ | 11,668,869 |   |
| For the year ended  December 31, 2004:  |       |                                           |       |                                                  |       |           |       |                   |       |                                     |       |   |   |   |   |
| Allowance for doubtful accounts              |       | $                                              | 87,628     |                                                  |       | $              | 58,508     |                   |       | $                                        | (113,174   | ) |   | $ | — |   |   | $ | 32,962 |   |
| Inventory reserve                            |       | $                                              | 867,923    |                                                  |       | $              | (41,651    | )                      |       | $                                        | (585,447   | )(a) |   | $ | — |   |   | $ | 240,825 |   |
| Valuation allowance for deferred tax assets  |       | $                                              | 9,284,836  |                                                  |       | $              | —     |                   |       | $                                        | —     |   |   | $ | 1,206,387 |   |   | $ | 10,491,223 |   |
| For the year ended  December 31, 2003:  |       |                                           |       |                                                  |       |           |       |                   |       |                                     |       |   |   |   |   |
| Allowance for doubtful accounts              |       | $                                              | 49,049     |                                                  |       | $              | 38,839     |                   |       | $                                        | (260       | ) |   | $ | — |   |   | $ | 87,628 |   |
| Inventory reserve                            |       | $                                              | 857,986    |                                                  |       | $              | 48,686     |                   |       | $                                        | (38,749    | ) |   | $ | — |   |   | $ | 867,923 |   |
| Valuation  allowance for deferred tax assets |       | $                                              | 8,087,836  |                                                  |       | $              | —     |                   |       | $                                        | —     |   |   | $ | 1,197,000 |   |   | $ | 9,284,836 |   |

----

(a)           The reduction relates to the scrapping of componentinventory that was fully reserved for and was offset by a credit to thecorresponding inventory account.

(b)           The Other, Net is comprised of the net changes to thevaluation allowance for deferred tax assets including additional net operatinglosses attributable to the exercise of non-qualified stock optins.

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**EXHIBIT INDEX**

|            | **Exhibit   Number** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                     | ** ** | **Description** |
|------------|----------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 3.1        |                 | Certificate of  Incorporation of the Company, previously filed with the SEC 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 SEC 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 SEC as Exhibit 3.1 to the Company’s  Quarterly Report on Form 10-Q for the period ended September 30,  1999, filed with the SEC on November 12, 1999, 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 SEC 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 SEC 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 SEC 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 Arnold I. Klayman,  previously filed with the SEC as Exhibit 10.10 to the Registration  Statement Amendment No. 1, which is incorporated herein by reference.                                                                                                                                                                                 |
| 10.4       |                 | Amendment to  Employment Agreement dated as of March 14, 1997, between the Company and  Arnold I. Klayman, previously filed with the SEC as Exhibit 10.5 to the  1996 Annual Report, which is incorporated herein by reference.                                                                                                                                                                                      |
| 10.5       |                 | Employment  Agreement dated July 1, 1996, between the Company and Alan D. Kraemer,  previously filed with the SEC as Exhibit 10.11 to the Registration  Statement Amendment No. 1, which is incorporated herein by reference.                                                                                                                                                                                   |
| 10.6       |                 | SRS Labs, Inc.  Incentive Stock Option, Nonqualified Stock Option and Restricted Purchase  Plan—1993, as amended and restated, previously filed with the SEC as Exhibit 10.12  to the Company’s Registration Statement on Form SB-2 filed with  the SEC on June 3, 1996 (File No. 333-4974-LA) (the “Registration  Statement”), which is incorporated herein by reference.        |
| 10.7       |                 | Stock Option  Agreement dated January 19, 1994, between the Company and Stephen V.  Sedmak, as amended, previously filed with the SEC as Exhibit 10.13 to  the Registration Statement, which is incorporated herein by reference.                                                                                                                                                                                    |
| 10.8       |                 | SRS Labs, Inc.  Amended and Restated 1996 Non-employee Directors Stock Option Plan, as  amended, previously filed with the SEC as Appendix B to the Company’s  Definitive Proxy Statement dated and filed with the SEC on April 30,  2003, which is incorporated herein by reference.                                                                                                                      |
| 10.9       |                 | Annual Incentive  Bonus Plan, previously filed with the SEC as Exhibit 10.18 to the  Registration Statement Amendment No. 1, which is incorporated herein by  reference.                                                                                                                                                                                                                                             |
| 10.10      |                 | SRS Labs, Inc.  Supplemental Executive Incentive Bonus Plan, previously filed with the SEC as  Exhibit 10.14 to the 1996 Annual Report, which is incorporated herein by  reference.                                                                                                                                                                                                                                  |

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| 10.11 |   | Form of  Indemnification Agreement, previously filed with the SEC as Exhibit 10.20  to the Registration Statement Amendment No. 1, which is incorporated  herein by reference.                                                                                                                                                                                                                                                                                                  |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.12 |   | Employment  Agreement dated November 4, 2002 by and between the Company and Janet  Biski.                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.13 |   | Non-employee  Director Compensation Policy adopted by the Company’s Board of Directors on January 28,  2005, previously filed with the SEC as Exhibit 10.1 to the Company’s  Current Report on Form 8-K filed with the SEC on February 3,  2005, which is incorporated herein by reference.                                                                                                                                                                      |
| 10.14 |   | Form of  Non-Employee Director Stock Option Agreement under the SRS Labs, Inc.  Amended and Restated 1996 Non-Employee Directors’ Stock Option Plan (Initial  Appointment), previously filed with the SEC as Exhibit 10.2 to the  Company’s Current Report on Form 8-K file with the SEC on February 3,  2005, which is incorporated herein by reference.                                                                                                   |
| 10.15 |   | Form of  Non-Employee Director Stock Option Agreement under the SRS Labs, Inc.  Amended and Restated 1996 Non-Employee Directors’ Stock Option Plan  (Re-Election), previously filed with the SEC as Exhibit 10.3 to the  Company’s Current Report on Form 8-K file with the SEC on February 3,  2005, which is incorporated herein by reference.                                                                                                           |
| 10.16 |   | Form of  Non-Employee Director Stock Option Agreement under the SRS Labs, Inc.  Amended and Restated 1996 Long-Term Incentive Plan, previously filed with the  SEC as Exhibit 10.4 to the Company’s Current Report on Form 8-K  file with the SEC on February 3, 2005, which is incorporated herein by  reference.                                                                                                                                               |
| 10.17 |   | Employment Letter  with Michael Oswald, Vice President and General Counsel, dated November 9,  2004, previously filed with the SEC as Exhibit 10.5 to the Company’s  Current Report on Form 8-K filed with the SEC on February 3,  2005, which is incorporated herein by reference.                                                                                                                                                                                   |
| 10.18 |   | Form of  Nonqualified Stock Option Agreement under the SRS Labs, Inc. Amended and  Restated 1996 Long-Term Incentive Plan dated March 29, 2005 (With  Schedule of Optionees Attached—Thomas C.K. Yuen, Janet M. Biski, Alan D.  Kraemer, Philip Wong and Jennifer Drescher), previously filed with the SEC as  Exhibit 10.1 to the Company’s Current Report Form 8-K filed  with the SEC on April 4, 2005, which is incorporated herein by  reference. |
| 10.19 |   | SRS Labs, Inc.  2005 Change in Control Protection Plan approved April 27, 2005,  previously filed with the SEC as Exhibit 10.1 to the Company’s Current  Report on Form 8-K filed with the SEC on May 3, 2005, which  is incorporated herein by reference.                                                                                                                                                                                                       |
| 10.20 |   | Form of  Participation Agreement under the SRS Labs, Inc. 2005 Change in Control  Protection Plan for Selected Executive Officers (With Schedule of Parties  Attached—Thomas C.K. Yuen, Janet M. Biski and Alan D. Kraemer) approved April 27,  2005, previously filed with the SEC as Exhibit 10.2 to the Company’s  Current Report on Form 8-K filed with the SEC on May 3, 2005,  which is incorporated herein by reference.                        |
| 10.21 |   | Form of  Participation Agreement under the SRS Labs, Inc. 2005 Change in Control  Protection Plan for Selected Employees (With Schedule of Parties Attached—Philip  Wong and Jennifer Drescher) approved April 27, 2005, previously filed  with the SEC as Exhibit 10.3 to the Company’s Current Report on Form 8-K  filed with the SEC on May 3, 2005, which is incorporated herein by  reference.                                                    |

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| 10.22 |   | SRS Labs, Inc.  2005 Profit Sharing and Bonus Plan approved April 27, 2005, previously  filed with the SEC as Exhibit 10.4 to the Company’s Current Report on Form 8-K  filed with the SEC on May 3, 2005, which is incorporated herein by  reference.                                                                       |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.23 |   | SRS Labs, Inc.  Amended and Restated 1996 Long-Term Incentive Plan, as amended, approved April 27,  2005, previously filed with the SEC as Exhibit 10.5 to the Form 8-K  filed with the SEC on May 3, 2005, which is incorporated herein by  reference.                                                                           |
| 10.24 |   | Employment Letter  Agreement dated June 24, 2005 by and between the Company and Michael  Franzi, previously filed with the SEC as Exhibit 10.1 to the Company’s  Current Report on Form 8-K filed with the SEC on August 18,  2005, which is incorporated herein by reference.                                                    |
| 10.25 |   | Stock Option  Agreement dated August 17, 2005 by and between the Company and Michael  Franzi, previously filed with the SEC as Exhibit 10.2 to the Company’s  Current Report on Form 8-K filed with the SEC on August 18,  2005, which is incorporated herein by reference.                                                       |
| 10.26 |   | Separation Agreement  dated September 30, 2005 by and between the Company and Philip Wong,  previously filed with the SEC as Exhibit 10.1 to the Company’s Current  Report on Form 8-K filed with the SEC on September 30, 2005,  which is incorporated herein by reference.                                                      |
| 10.27 |   | Employment Letter  Agreement dated September 30, 2005 by and between the Company and David  Frerichs, previously filed with the SEC as Exhibit 10.1 to the Company’s  Current Report on Form 8-K filed with the SEC on November 17,  2005, which is incorporated herein by reference.                                             |
| 10.28 |   | Employment Letter  Agreement dated December 21, 2005 by and between the Company and Ulrich  E. Gottschling, previously filed with the SEC as Exhibit 99.1 to the  Company’s Current Report on Form 8-K filed with the SEC on December 29,  2005, which is incorporated herein by reference.                                       |
| 10.29 |   | Participation  Agreement for Ulrich E. Gottschling under the SRS Labs, Inc. 2005 Change  in Control Protection Plan, dated January 12, 2006, previously filed  with the SEC as Exhibit 99.1 to the Company’s Current Report on Form 8-K  filed with the SEC on January 18, 2006, which is incorporated herein by  reference. |
| 10.30 |   | Participation  Agreement for Michael Franzi under the SRS Labs, Inc. 2005 Change in  Control Protection Plan, dated January 12, 2005, previously filed with  the SEC as Exhibit 99.2 to the Company’s Current Report on Form 8-K  filed with the SEC on January 18, 2006, which is incorporated herein by  reference.        |
| 10.31 |   | Nonqualified  Stock Option Agreement by and between the Company and Ulrich E. Gottschling,  dated January 12, 2006, previously filed with the SEC as Exhibit 99.6  to the Company’s Current Report on Form 8-K filed with the SEC on January 18,  2006, which is incorporated herein by reference.                                |
| 10.32 |   | Nonqualified  Stock Option Agreement by and between the Company and Sarah Yang, dated January 12,  2006, previously filed with the SEC as Exhibit 99.7 to the Company’s  Current Report on Form 8-K filed with the SEC on January 18,  2006, which is incorporated herein by reference.                                           |
| 10.33 |   | Form of  Nonqualified Stock Option Agreement under the SRS Labs, Inc. 1996  Amended and Restated Long-Term Incentive Plan, as Amended, previously filed  with the SEC as Exhibit 99.8 to the Company’s Current Report on Form 8-K  filed with the SEC on January 18, 2006, which is incorporated herein by  reference.       |

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|       | ** ** | **Other Material Contracts**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|-------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.34 |       | 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 SEC as Exhibit 10.6  to the Company’s Registration Statement on Form SB-2, specifically  included in Amendment No. 3 to such Registration Statement filed with  the SEC on August 7, 1996 (File No. 333-4974-LA), which  is incorporated herein by reference.                                                                                         |
| 10.35 |       | Industrial Real  Estate Lease dated May 30, 1997, between the Company and Daimler  Commerce Partners, L.P., previously filed with the SEC as Exhibit 10.1  to the Company’s Quarterly Form 10-QSB for the quarterly period  ended June 30, 1997, filed with the SEC on August 13, 1997, which  is incorporated herein by reference.                                                                                                                                                                                       |
| 10.36 |       | Tenancy Agreement  commencing November 16, 2003 by and between Jugada Company Limited and  Valence Technology Limited relating to premises located at workshop No 01-07  on the 20th floor of APEC Plaza, No. 49 Hoi Yuen  Road, Kwun Tong, Kowloon Hong Kong, previously filed with the SEC as Exhibit 10.20  to the Company’s Annual Report on Form 10-K for the fiscal year  ended December 31, 2003, filed with the SEC on March 30, 2004,  which is incorporated herein by reference.                      |
| 10.37 |       | Tenancy Agreement  commencing November 16, 2003, by and between Jugada Company Limited and  Valence Semiconductor Design Limited relating to the premises located at  Workshops Nos. 1 through 10 and on the 19th Floor of APEC Plaza, No. 49 Hoi Yuen  Road, Kwun Tong, Hong Kong, previously filed with the SEC as Exhibit 10.21  to the Company’s Annual Report on Form 10-K for the fiscal year  ended December 31, 2003, filed with the SEC on March 30, 2004,  which is incorporated herein by reference. |
| 10.38 |       | 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 SEC  as Exhibit 10.17 to the Company’s Registration Statement on Form SB-2,  specifically included in Amendment No. 2 to such Registration Statement  file with the SEC on August 2, 1996 (File No. 333-4974-LA),  which is incorporated herein by reference.                                                                                      |
| 10.39 |       | Strategic  Alliance Agreement between the Company and Coming Home Studios LLC, dated September 23,  2004 filed with the SEC as Exhibit 10.1 to the Company’s Current Report  on Form 8-K, previously filed with the SEC on September 28,  2004, which is incorporated herein by reference.                                                                                                                                                                                                                                     |
| 10.40 |       | CHS/SRS, LLC  Operating Agreement between the Company and Coming Home Studios, LLC, dated September 23,  2004, previously filed with the SEC as Exhibit 10.2 to the Company’s  Current Report on Form 8-K filed with the SEC on September 28,  2004, which is incorporated herein by reference.                                                                                                                                                                                                                                |
| 10.41 |       | Warrant Agreement  between the Company and Coming Home Studios, LLC, dated September 23,  2004, previously filed with the SEC as Exhibit 10.3 to the Company’s  Current Report on Form 8-K filed with the SEC on September 28,  2004, which is incorporated herein by reference.                                                                                                                                                                                                                                               |
| 10.42 |       | Production  Services Agreement between the Company and Coming Home Studios, LLC, dated September 23,  2004, previously filed with the SEC as Exhibit 10.4 to the Company’s  Current Report on Form 8-K filed with the SEC on September 28,  2004, which is incorporated herein by reference.                                                                                                                                                                                                                                   |

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| 14   |   | SRS Labs, Inc.  Code of Business Conduct and Ethics adopted by the Board of Directors November 6,  2002, previously filed with the SEC as Exhibit 14 to the Company’s  Annual Report on Form 10-K for the fiscal year ended December 31,  2003, filed with the SEC on March 30, 2004, which is incorporated herein  by reference. |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 21   |   | Subsidiaries of  the Company, previously filed with the SEC as Exhibit 21 to the Company’s  Annual Report on Form 10-K for the fiscal year ended December 31,  2003, filed with the SEC on March 30, 2004, which is incorporated herein  by reference.                                                                                      |
| 23.1 |   | Consent of  Independent Registered Public Accounting Firm, BDO Seidman LLP, dated March 23,  2006.                                                                                                                                                                                                                                                              |
| 31.1 |   | Certification of  the Chief Executive Officer of SRS Labs, Inc., pursuant to 18 U.S.C Section 1350,  as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                           |
| 31.2 |   | Certification of  the Chief Financial Officer of SRS Labs, Inc., pursuant to 18 U.S.C Section 1350,  as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                           |
| 32.1 |   | Certification of  Chief Executive Officer of SRS Labs, Inc., pursuant to 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                              |
| 32.2 |   | Certification of Chief  Financial Officer of SRS Labs, Inc., pursuant to 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                              |

 

 

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