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

                                   FORM 10-K
                            ------------------------

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

                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1999

                                       OR

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

          FOR THE TRANSITION PERIOD FROM ____________ TO ____________

                         COMMISSION FILE NUMBER 0-21123

                                 SRS LABS, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
                            ------------------------

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

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

                                 (949) 442-1070
              (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

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

          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
                    COMMON STOCK, PAR VALUE $.001 PER SHARE

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

     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.  [ ]

     The aggregate market value of the registrant's voting Common Stock held by
non-affiliates of the registrant was approximately $183,303,194 (computed using
the closing price of $26.625 per share of Common Stock on March 17, 2000, as
reported by The Nasdaq Stock Market, Inc.).

     There were 12,181,220 shares of the registrant's Common Stock, par value
$.001 per share, outstanding on March 17, 2000.

                      DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the registrant's Proxy Statement prepared in connection with
the Annual Meeting of Stockholders to be held in 2000 are incorporated by
reference in Part III of this Form 10-K.

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                                 SRS LABS, INC.

                               TABLE OF CONTENTS

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                                                                        PAGE
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                                PART I
Item 1.   Business....................................................    3
Item 2.   Properties..................................................   13
Item 3.   Legal Proceedings...........................................   14
Item 4.   Submission of Matters to a Vote of Security Holders.........   14
                               PART II
Item 5.   Market for Registrant's Common Equity and Related
            Stockholder Matters.......................................   15
Item 6.   Selected Consolidated Financial Data........................   17
Item 7.   Management's Discussion and Analysis of Financial Condition
            and Results of Operations.................................   18
Item 7A.  Quantitative and Qualitative Disclosures About Market
            Risk......................................................   29
Item 8.   Financial Statements and Supplementary Data.................   31
Item 9.   Changes in and Disagreements With Accountants on Accounting
            and Financial Disclosure..................................   54
                               PART III
Item 10.  Directors and Executive Officers of the Registrant..........   54
Item 11.  Executive Compensation......................................   54
Item 12.  Security Ownership of Certain Beneficial Owners and
            Management................................................   54
Item 13.  Certain Relationships and Related Transactions..............   54
                               PART IV
Item 14.  Exhibits, Financial Statement Schedules and Reports on Form
            8-K.......................................................   55
Signatures............................................................   60
</TABLE>

     This Annual Report on Form 10-K contains forward-looking statements within
the meaning of Section 21E of the Securities Exchange Act of 1934, as amended,
and Section 27A of the Securities Act of 1933, as amended, reflecting
management's current expectations. Examples of such forward-looking statements
include the expectations of the Company with respect to its strategy. Although
the Company believes that its expectations are based upon reasonable
assumptions, there can be no assurances that the Company's financial goals will
be realized. Such forward-looking statements involve known and unknown risks,
uncertainties and other factors that may cause the actual results, performance
or achievements of the Company, or industry results, to be materially different
from any future results, performance or achievements expressed or implied by
such forward-looking statements. Numerous factors may affect the Company's
actual results and may cause results to differ materially from those expressed
in forward-looking statements made by or on behalf of the Company. For this
purpose, any statements contained herein that are not statements of historical
fact may be deemed to be forward-looking statements. Without limiting the
foregoing, the words, "believes," "anticipates," "plans," "expects" and similar
expressions are intended to identify forward-looking statements. The important
factors discussed under the caption "Factors That May Affect Future Results" in
Item 7. Management's Discussions and Analysis of Financial Condition and Results
of Operations, herein, among others, could cause actual results to differ
materially from those indicated by forward-looking statements made herein and
presented elsewhere by management. Such forward-looking statements represent
management's current expectations and are inherently uncertain. Investors are
warned that actual results may differ from management's expectations. The
Company assumes no obligation to update the forward-looking information to
reflect actual results or changes in the factors affecting such forward-looking
information.

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                                     PART I

ITEM 1. BUSINESS

OVERVIEW

     SRS Labs, Inc. (the "Company" or "SRS Labs") was incorporated in the State
of California on June 23, 1993 and reincorporated in the State of Delaware on
June 28, 1996. The Company's executive offices are located at 2909 Daimler
Street, Santa Ana, California 92705. Its telephone number is (949) 442-1070, and
its address on the World Wide Web is http://www.srslabs.com.

     SRS Labs, Inc. is a developer and provider of technology solutions for the
consumer electronics, computer, game and telecommunications markets. For the
fiscal year ended December 31, 1999 ("Fiscal 1999"), the Company's principal
business activities in these markets included:

     - Developing and licensing audio and voice technologies to original
       equipment manufacturers ("OEMs") and semiconductor manufacturers around
       the world; and

     - Through its subsidiary, Valence Technology Inc. and its foreign
       subsidiaries (collectively, "Valence"), designing and selling technology
       solutions through custom application specific integrated circuits
       ("ASICs") to OEMs; and designing, distributing and manufacturing
       components, sub-assemblies and finished goods for the OEM and retail
       communities within the Company's targeted markets.

     The Company was formed in 1993 by purchasing all rights and assets of
various audio and speaker technologies from the Hughes Aircraft Company. The
Company successfully completed its initial public offering in August 1996,
raising approximately $22 million. From the Company's inception in 1993 until
February 1998, the Company derived substantially all of its revenues from audio
technology licensing activities for the consumer electronics, computer and game
markets. The primary technologies that contributed to revenue were SRS(R) (Sound
Retrieval System(R)) ("SRS"), which produces a 3D sound-enhanced stereo image
from any mono or stereo source, and TruSurround(TM), a "virtual" audio
technology which processes multi-channel surround sound through any standard
pair of stereo speakers.

     On March 2, 1998, the Company acquired 100% of the outstanding stock of
Valence Technology Inc., a British Virgin Islands holding company with its
principal business operations in Hong Kong and China. This acquisition
significantly expanded the Company's business activities from the original
licensing model to include the design, manufacture and marketing of chips,
components and products. Valence and its subsidiaries operate offices that are
located in Hong Kong and China.

     In addition to the acquisition of Valence, during the fiscal year ended
December 31, 1998 ("Fiscal 1998"), the Company acquired two additional
technologies. In the first quarter of Fiscal 1998, the Company acquired certain
rights to Voice Intelligibility Processor ("VIP"), a patented voice processing
technology that improves the intelligibility of the spoken voice, especially in
high ambient noise environments and, in the following quarter, acquired certain
rights to Circle Surround, a patented audio delivery system that allows
multi-channel surround sound to be encoded into a two-channel stereo format and
allows an encoded two-channel audio source to be decoded into a multi-channel
surround format.

KEY BUSINESS DEVELOPMENTS IN FISCAL 1999

     In Fiscal 1999, the Company re-engineered its business model and
operational structure. Valence, while continuing to expand its ASICs business,
exited certain of the lower margin distribution product lines and directed more
of its resources to develop and market solutions that integrate the SRS
technologies. In addition, the Company began to explore the feasibility of
selling a minority interest in Valence Technology Inc. to the public by listing
such shares on a foreign exchange. This strategy materialized when ValenceTech
Limited, the ultimate successor corporation to Valence Technology Inc., filed an
application to list on the Growth Enterprise Market of the Hong Kong Stock
Exchange on March 3, 2000. The Company anticipates retaining 75% ownership of
Valence Tech Limited upon completion of an initial public offering in Asia
targeted for the second quarter of the fiscal year ended December 31, 2000.

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     With respect to the licensing business, the Company changed its focus from
entering into technology licenses with PC chip manufacturers to developing a new
business model which focuses on Internet audio. This new focus resulted in the
Company launching the WOWThing product family and establishing a new Delaware
wholly-owned subsidiary, SRSWOWcast.com, Inc., to be the platform to launch this
business. In March 2000, Microsoft Corporation ("Microsoft") and the Company
entered into a strategic alliance whereby Microsoft and the Company entered into
a License Agreement relating to the Company's WOW Technology. In addition,
Microsoft made an equity investment into the Company and was granted a warrant
to purchase additional shares of the Company's common stock as well as a warrant
to purchase shares of common stock in SRSWOWcast.com, Inc.

     The Company's technologies were also implemented in new consumer products
in Fiscal 1999. Some of the most notable implementations included the Kenwood
receiver (Circle Surround), the Sony Walkman (SRS Headphones), Philips and Sony
DVD players (TruSurround), as well as Hitachi TVs (Focus). In addition to these
new implementations, the Company entered into new licenses with key industry
manufacturers including Loewe, ST Microelectronics and TCE in Europe; Yamaha and
Marantz in Japan; Konka and TCL in China; Samsung and LG in Korea and Cirrus
Logic, Lucent and Peavey in the United States.

DESCRIPTION OF THE COMPANY'S BUSINESS

     SRS currently operates in two business segments: (a) the development and
marketing of technology in the forms of integrated circuits designed and
distributed through Valence and the licensing of technologies developed by the
Company to OEMs and semiconductor manufacturers, and (b) the sale of consumer
electronic products and components. A summary of the Company's operations and
activities by business segment and geographic area is set forth below. The
financial information for business segments and geographic areas is included in
Note 10 to the Notes to Consolidated Financial Statements, included herein under
Item 8 of this Report. Reference also is made to "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of
Operations -- Factors That May Affect Future Results" for a discussion relating
to certain business risks relating to the business of the Company and its
subsidiaries.

     During the year ended December 31, 1997 ("Fiscal 1997"), licensing revenue
accounted for all of the Company's revenue while in Fiscal 1998 and Fiscal 1999,
chip and licensing revenue accounted for 35% and 52%, respectively, of
consolidated revenue and product and component sales revenues accounted for 65%
and 48% of consolidated revenue, respectively. See Item 7, "Management's
Discussion and Analysis of Financial Condition and Results of Operations,"
herein. For Fiscal 1999, a single customer, STD Manufacturing, accounted for 21%
of the Company's consolidated revenues and approximately 40% of its chip and
licensing revenues.

  TECHNOLOGY SOLUTIONS AND LICENSING

     Design and Sale of Integrated Circuits

     The Company, through Valence, designs and sells custom analog, digital and
mixed signal application specific integrated circuits (ASICs) for OEM
manufacturers worldwide. Applications for these ASICs include consumer audio and
video electronic products, internet appliances and electronic educational toys,
video game players, car audio systems, set-top boxes, VCD and DVD players,
smart-cards, cordless telephone sets, speakers, digital power amphifers, and
pagers. Based in China and Hong Kong, over 20 engineers, with state-of-the-art
equipment and software, support Valence's custom chip design capabilities.
Valence sells these custom designed chips to its contracted customers,
outsourcing the manufacturing to a network of fabrication partners throughout
Asia Pacific, including Chartered Semiconductor, Samsung Electronics Co., LTD
and Tower Semiconductor Limited in Israel. As of December 1999 and 1998, the
backlog orders of ASIC design work to non-affiliated parties was $828,052 and
$721,661, respectively. The Company expects that all or substantially all of the
current backlog orders for Fiscal 1999 will be completed in Fiscal 2000.

     Valence's ASIC customers are industry leading consumer electronics,
telecommunications, game and personal computer manufacturers in North America
and Europe, as well as in Asia Pacific. Due to nondisclosure agreements,
specific current customers cannot be disclosed, but previous design projects
have

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been performed for such international companies as Creative Technology Limited,
Innovision Research and Technology Limited, National Semiconductor Corporation,
Raytron Inc., Toshiba Corporation, System LSI Division and Utron Technology Inc.
Under many of the design contracts, Valence negotiates to retain ownership of
the specific designs. These designs form a significant library of intellectual
property that can be used in future projects.

     In addition to performing contract design work, Valence designs, produces
and sells ICs to OEMs of consumer electronics, games, telecommunication and
personal computer equipment in Asia Pacific under the brand name ASP
Microelectronics. The general purpose integrated circuits offered include
micro-controllers, PROM and ROMs for DVD Players, set-top box receivers and
audio/video equipment; ICs for telecommunication and game equipment; small
signal transistors and ICs used mainly in the manufacture of consumer products
such as television sets, radios, telephones, computer mother boards, add-on
boards and audio hi-fi systems. The products created are based upon management's
analysis of trends in the market, knowledge gained from long standing
relationships with customers and overall business experience. Many of these
products are developed by capitalizing upon the Valence's custom design
libraries.

     Technologies and Licensing

     The Company's technology portfolio covers a wide range of audio, voice and
speaker technologies. The Company licenses these technologies to product and
semiconductor manufacturers, as well as develops and markets implementation
options and finished goods that feature these proprietary and patented
technologies.

     The Company's technology strategy continues to be the development,
acquisition and license of audio and voice technologies to product and
semiconductor manufacturers in the consumer electronics, computer, game and
telecommunications markets around the world. By providing a continuous stream of
patented audio and voice technologies, enhancing relationships with existing
licensees and attracting new licensees, the Company believes that it will
strengthen its market position as a world leader in audio and voice technology.

     The Company's technologies may be implemented in a variety of methods,
including discrete analog components, chip modules, analog semiconductors,
digital signal processors and software. These various implementation options
offer customers significant flexibility when incorporating the Company's
technologies into products. The markets which the Company's technologies address
include a wide variety of audio and voice-related consumer products such as TVs,
computers, stereo receivers, VCRs, video games, musical instruments, cellular
phones, cordless phones, public address equipment and car audio equipment. The
markets for these consumer electronics products are highly competitive and
generally dominated by large manufacturers. The Company provides technology to
these manufacturers who need to differentiate their products by continually
adding new features and increasing product performance.

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

     The Company has primarily followed a licensing model whereby licensees are
free to choose a semiconductor solution from a number of choices and, regardless
of the semiconductor selection, the licensee pays a royalty directly to the
Company after the licensee's product has been shipped. However, this methodology
is not well established in the computer multimedia industry or the Chinese
consumer electronics marketplace. To address these market conditions, the
Company has implemented an alternate royalty collection method, whereby the
royalty is "bundled" into the cost of the semiconductor product when it is sold
to the product manufacturer. This methodology simplifies the business process
for the product manufacturer, the semiconductor manufacturer and the Company.
Under this model, the royalty is remitted directly to the Company by the
semiconductor manufacturer after the chip has been delivered to the product
manufacturer.

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     Portfolio of Audio and Voice Technologies

     The portfolio of audio, voice and speaker technologies offered by the
Company includes SRS(R), TruSurround(TM), FOCUS(R), Baser(R), ORB(R), AVT(TM),
VIP(TM), Circle Surround(R), SRS Headphone(TM), WOW(TM), TruBass(TM),
WOWVoice(TM) and NuVoice(TM). SRS, FOCUS and TruSurround are currently the
subject of numerous license agreements and are actively marketed by the Company.
Baser and ORB are speaker technologies that were included in the original
technology acquisition from Hughes Aircraft and have not been actively promoted.
VIP and Circle Surround were acquired during the first and second quarters of
Fiscal 1998, respectively, and did not contribute significantly to revenue in
Fiscal 1998 or 1999. SRS Headphone, WOW, AVT and TruBass were developed
internally and were introduced to the marketplace in Fiscal 1998 and also did
not contribute significantly to revenues in Fiscal 1998 or 1999. Licensing
royalties associated with SRS, TruSurround, FOCUS, and technology transfer fees
for new technologies have accounted for virtually all of the Company's licensing
revenues to date.

     - SRS 3D SOUND

     SRS 3D Sound is one of the world's leading 3D audio enhancement
technologies. The patented technology broadens any mono or stereo audio signal
and creates a realistic 3D sound image from just two standard stereo speakers.
SRS is based on the fundamentals of the human hearing system and recreates the
multitude of spatial cues that are present in a live listening environment but
are lost in recording and playback. SRS eliminates the "sweet spot" associated
with traditional stereo; accordingly, it does not require the listener to be
positioned in a specific location to experience the immersive 3D sound image.

     The technology can also be encoded onto CDs, cassettes or videotapes during
the recording process and reproduced through a conventional stereo system,
multimedia computer, radio and television broadcast, or the Internet. SRS was
originally developed by Hughes Aircraft, which spent significant resources to
develop and patent SRS and related audio technologies. Since acquiring the SRS
technology from Hughes Aircraft in June 1993, the Company has improved the
performance of SRS, reduced the cost for OEMs to implement the technology,
secured licensing relationships with various semiconductor manufacturers who
offer the technology in various analog and digital chip options, and introduced
the technology to a wider variety of consumer applications.

     To date, products have been shipped with SRS technology from more than 180
manufacturers including Acer Peripherals, Ltd., Daewoo Telecom Ltd., Hitachi
Ltd., IBM, Kawai Musical Instruments Mfg. Co., Ltd., Kenwood Corporation, Young
Chang America, Inc. (Kurzweil), LG Electronics, Inc., Packard Bell/ NEC, Pioneer
Electronic Corporation, Thomson Consumer Electronics, Inc. (RCA), Thompson
Multimedia, SA, Samsung Electronics Co., Ltd., Sharp Electronics Corporation,
Smart Devices, Inc., Sony Corporation and Toshiba Corporation. Semiconductor
manufacturers who offer SRS technology in their chip offerings include Cirrus
Logic (Crystal Semiconductor), Fujitsu Semiconductor Corporation, Mitsubishi
Electric Corporation, New Japan Radio Co. Ltd., Philips Semiconductors,
STMicroelectronics, Toshiba Semiconductor Corporation and Zoran Corporation.

     - TRUSURROUND

     TruSurround is a Dolby-certified virtual audio technology, which creates an
immersive surround sound experience from just two standard speakers from a
multi-channel audio source, such as Dolby Digital or Dolby Pro Logic. It was
originally designed to take advantage of the 5.1 channel audio standard for DVD,
Dolby Digital, without requiring the use of six speakers. TruSurround processes
the six discrete channels of digital audio into just two channels, retaining all
of the original audio information and giving the listener the perception that
they are surrounded by additional "phantom" speakers.

     TruSurround has been successfully introduced to the consumer electronics
marketplace and is featured in a wide variety of products, including televisions
from Sony Corporation, and DVD players from Pioneer Electronic Corporation and
Philips Consumer Electronics B.V. Semiconductor companies who offer TruSurround
in analog or digital implementation options for various applications in consumer
electronics currently include AKM Semiconductor, New Japan Radio Co., Ltd.,
STMicroelectronics, Mitsubishi Electric

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Corporation and Zoran Corporation. The Company believes that the eventual
worldwide use of the DVD format will offer further opportunities for revenue
growth.

     - FOCUS

     In many audio environments, speakers are not placed directly in front of a
listener making it difficult to achieve a realistic sound experience from
speakers that are below the plane of the listener's ear. The Company developed
FOCUS as a technology solution for this problem. Originally designed for use in
automobiles where front speakers are often placed under the dashboard or facing
each other in the door panels, the patented FOCUS technology electronically
repositions the sound image to create the appropriate perception of image
height. In addition to automobiles, FOCUS is ideally suited for any product
application where speakers cannot be placed in optimal locations for either
space or aesthetic reasons, such as big screen TVs, home in-wall speakers and
commercial applications such as drive-through restaurant communications. The
first analog and digital chip options of FOCUS became available for sampling to
OEMs from Mitsubishi Electric Corporation, New Japan Radio Co., Ltd. and
STMicroelectronics during the last half of Fiscal 1998. Focus has been
successfully incorporated into consumer electronics products marketed by Hitachi
Limited and Marantz Japan, Inc.

     - SPEAKER TECHNOLOGIES

     The Company holds patents for speaker technologies originally developed at
Hughes Aircraft. One such technology, ORB, provides a unique approach to the
physical design of speakers by incorporating a baffle that creates a 180 degrees
dispersion of sound. Another speaker technology, referred to as AVT, projects
the listening material so that the human ear can more easily identify the
direction of ambient sounds. A third speaker technology, BASER, is a
high-efficiency design for a subwoofer product.

     - VIP -- VOICE INTELLIGIBILITY PROCESSOR TECHNOLOGY

     VIP is a patented audio processing technology that improves the
intelligibility of the spoken voice in a variety of challenging listening
situations. VIP selectively processes only those spectral portions of the speech
signal that the brain uses for cognition, without requiring increase in gain or
volume. SRS inventor Arnold Klayman, who is now the principal audio scientist at
the Company, originally developed the VIP technology at Hughes Aircraft. During
a divestiture in 1994, Hughes sold this non-core business division to VIP Labs.
From 1994 until the acquisition by the Company, VIP Labs further developed the
technology as well as selectively marketed a stand-alone signal processor for
use in the professional sound reinforcement industry.

     The Company believes that the market opportunities for VIP are significant
and include cellular phones, wireless products, hearing aids, public address and
emergency warning systems, talking toys, voice recognition products, Voice Over
IP (Internet protocol) and other Internet applications. The Company directly
offers both software and hardware implementation options for VIP. VIP software
is available as digital code that may be ported to DSP chips used by
manufacturers of cellular phones, paging systems, digital televisions, sound
reinforcement equipment and hearing aids. VIP is also available as software that
may be executed on computer platforms to improve a variety of voice-related
processes. Hardware options are marketed by the Company as a DSP chip and
subassembly board for sale to OEMs of sound reinforcement equipment.

     During the first quarter of Fiscal 1999, the Company announced the first
licensing contracts for VIP. On January 26, 1999, the Company announced that
Samsung Electronics Co., Ltd. ("Samsung") has licensed VIP for use in cellular
and wireless products. On February 2, 1999, the Company announced the license of
VIP by Lucent Technologies. VIP has also been successfully implemented by
Samsung in a semiconductor chip targeted at the cellular and traditional
telephone applications.

     - CIRCLE SURROUND

     Circle Surround ("CS") is a patented audio delivery system that allows
multi-channel surround sound to be encoded into a two-channel stereo format and
then allows an encoded two-channel audio source or traditional audio source to
be decoded into a multi-channel surround format.

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     Circle Surround can be used in the recording process of music or movies and
then implemented in a decoding playback device, such as a home audio receiver,
DVD player or car audio product. When used as an encoding/decoding technology,
CS encodes five discrete channels of sound through only two channels (the same
space required for stereo). In the playback device, CS then takes the two
channels of encoded material and decodes them back into the original five
recorded channels for playback through a multi-channel (surround sound) home
theater or cinema system equipped with four or five speakers plus a subwoofer.
In addition, CS creates multiple channel surround sound from the wealth of
legacy stereo and surround encoded material available on traditional music CDs,
VHS tapes, television or AM/FM broadcast.

     Circle Surround technology is available for product manufacturers worldwide
in the following formats: analog ICs through a relationship with Analog Devices;
DSP implementations from Cirrus Logic and AKM, digital software code from the
Company; and reference boards, sub-systems and finished products for the home
and car audio market from Valence. Current manufacturers who have announced
products with Circle Surround include Haitai Electronics Co., Ltd. (Sherwood),
Theta Digital, Kenwood Corporation, Loewe Optic GmbH and Amiosonic Electronics
Co. Smart Devices, Inc. has included Circle Surround in a line of movie theater
audio processors that are marketed to cinemas around the world. Hundreds of
music CDs have been encoded with CS by audiophile record labels such as Telarc,
DMP and Northsound, which market the CDs through traditional retail channels and
online music sites.

     - SRS HEADPHONE, WOW AND TRUBASS

     In Fiscal 1998, the Company developed and began marketing three additional
audio technologies to the consumer electronics, computer and game markets.
Introduced in early 1998, SRS Headphone is based on the core SRS 3D sound
technology and provides 3D sound enhancement to a mono, stereo or surround sound
signal, but is optimized to work with any pair of headphones. In January 1999,
Mitsubishi Semiconductor announced the availability of the M62458FP, the first
analog IC implementation of this technology. In November 1998, at COMDEX in Las
Vegas, the computer industry's leading tradeshow, the Company introduced two
additional technologies, WOW(TM) and TruBass(TM). WOW is the Company's next
generation audio enhancement for speakers and headphones. It significantly
improves the spatial imaging and bass response from traditional loudspeakers and
headphone products. The TruBass(TM) technology is a psycho-acoustic process that
creates the perception of dramatically increased bass performance in smaller
speaker systems and headphones without requiring additional physical components.

     Product applications for these technologies include multimedia speakers,
powered home audio speakers, mini stereo systems, portable "boom boxes", car
radios, portable headset audio systems, televisions and other products in the
consumer audio, car audio and professional sound markets.

     In addition to licensing these technologies, the Company anticipates using
its chip design expertise and network of manufacturing partners to market chip
modules of these technologies to product manufacturers around the world. SRS
Headphone and TruBass have been licensed to and incorporated into products by
manufacturers that include Sony Corporation, Yamaha Corporation and Sennheiser
Electronic GmbH & Co. KG. The Company announced in September 1999 the WOW Thing
family of software and hardware products which have been marketed on the
Internet web site www.wowthing.com. The first product in the family is the WOW
Thing Processor Box, a hardware product which provides a combination of audio
enhancement technologies using the WOW technology. The second product in the
family consists of WOW Thing software plug-ins designed for use with the Winamp
Media Player to improve significantly the sound quality of compressed Internet
music such as MP3 music files.

     - WOWVOICE AND NUVOICE

     In Fiscal 2000, the Company introduced two new technologies, WOWVoice(TM)
and NuVoice(TM). These technologies are specifically designed for telephone
voice quality and intelligibility enhancement applications. The Company is now
actively marketing these new technologies to potential customers.

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PRODUCT AND COMPONENT SALES

     The Company, through Valence, is an authorized non-exclusive distributor in
Hong Kong and/or China for semiconductor products from Lucent Technologies
Microelectronics Asia/Pacific, National Semiconductor Hong Kong Ltd., Philips
Hong Kong Ltd., Utron Technology Co. Ltd., Analog Devices, Incorporated, as well
as its own ASP-brand. Access to multiple suppliers of similar ICs provides value
to customers by insuring an adequate supply of components and "just in time
delivery" of goods to meet their production schedules.

     In the normal course of business, Valence carries in its inventory selected
products that it distributes to meet rapid delivery requirements of customers.
Valence significantly improved the inventory turns towards the end of Fiscal
1999. The Company provides normal and customary merchandise return policy and
generally does not provide payment terms. As of December 1999 and 1998, the
backlog orders of components were $3,180,021 and $2,985,305, respectively. The
Company expects that all or substantially all of the backlog orders for Fiscal
1999 will be filled in Fiscal 2000.

     In addition to distributing semiconductor products, Valence and its
subsidiaries incorporate these components in assembly kits and reference boards
for use in audio products, video compact disc ("VCD") players and
telecommunication and wireless infrastructure equipment. Asia Pacific customers
include Acer, Daeyoung, Huawei Technologies Co., Ltd., Idall, Konka and SAST.
Consumer electronic home entertainment products offered under the Valence brand
name that include state-of-the-art technology with unique features are VCD and
karaoke players, audio/video receivers, game products and home entertainment
amplifiers. The Company introduced new products to the China market during
Fiscal 1999 with Circle Surround, TruSurround and TruBass.

     The Company's team of software, hardware and application engineers offers
value-added engineering services, such as the design of application software in
FPGAs (field programmable gate arrays), ASICs and system design. Local support
is very valuable to many manufacturers who have limited experience in the design
and manufacturing of products, especially handling surface mount technology
equipment. The Company's qualified engineers can solve its customers'
manufacturing and design problems locally and on a timely basis.

     The Company introduced in September 1999 its first e-commerce product on
www.wowthing.com, the WOW Thing Processor Box which enhances the sound quality
of music downloaded over the Internet as well as audio performance of computer
and home entertainment products and speakers. Other audio enhancement products
for computer, home entertainment and game applications are in development for
future introduction into the market place.

SALES AND MARKETING

     Integrated Circuits and Licensing

     The Company's sales and marketing strategies target the consumer
electronics, computer, game and telecommunications industries. To implement its
strategy, the Company has established a direct sales force and a worldwide
network of independent sales agents and distributors. The Company has
established distributors in Korea, Taiwan, Japan, Singapore, Hong Kong and
China. The Company actively promotes the use of its trademarks and logos and
directs customers to prominently display the appropriate SRS technology logo on
products, packaging and in advertising.

     The Company's corporate communications program includes press releases and
sales informational mailings to its customers around the world. The Company also
distributes audio CD/CD ROMs that demonstrate SRS technology and provides
technical assistance and general consumer-related information on the World Wide
Web. The Company conducts tours and presentations for the press and other media
outlets to promote the Company's technologies and products.

     The Company regularly participates in tradeshows and conferences to
increase awareness of its technologies and to market its technologies and
products. The Company also works closely with its licensees

                                        9
<PAGE>   10

and semiconductor partners to actively explore other opportunities to utilize
the Company's technologies in new products and/or markets.

     Product and Component Sales

     The consumer electronics market in China is an important market for the
Company. One way the Company participates in this market is through the design
and distribution of components and assembly kits to DVD and VCD manufacturers.
DVD and VCD players, which allow the playing of digital video on a compact disc
format, are well suited for a broad range of applications, including music,
video, education, training, movies and Karaoke. In a few short years, DVD and
VCD have become and will continue to be the standard video format and have
received mass-market adoption in China.

     Through its distribution agreements and close relationships with leading
digital video chip suppliers in China, such as National Semiconductor and
Philips Hong Kong Ltd., the Company designs, develops and markets complete DVD
and VCD players, as well as assembly kits and reference boards, at very
competitive prices.

     During Fiscal 1998, through a network of manufacturing partners in China,
the Company also produced and began offering home entertainment products under
the brand name "Valence." The consumer electronics market in China is highly
competitive with many leading companies marketing to consumers in the larger
cities in China; therefore, the Company focuses its sales efforts on secondary
markets. The Company has established a network of eight to ten regional
distributors in various cities in China, who then sell the Valence-branded
products to smaller distributors, dealers and retail establishments.

     In Fiscal 1999, the Company focused on the design and development of
product and technology solutions either on a customer's request or under its own
marketing and R&D initiatives. Product and technology solutions developed and
sold were for applications in DVD players, VCD players, digital power
amplifiers, set-top boxes, and surround sound decoders. The technology solutions
can be readily incorporated into end products, thus enabling a Company's
customer to shorten its time-to-market by reducing its own design and
development cycle time.

RESEARCH AND DEVELOPMENT

     The Company has spent approximately 11.2%, 17.1% and 25.5% of total
operating expenses on research and development in Fiscal 1997, 1998 and 1999,
respectively. The percentage calculation for 1998 excludes expense related to
acquired in-process research and development.

     The Company's research and development group includes 32 software, hardware
and application engineers who focus on developing intellectual property,
technology solutions and consumer products. Seven engineers are based in the
U.S. with the remainder based in Hong Kong and China.

     The U.S.-based engineering group is focused upon developing new audio and
voice technologies, improving the performance of existing technologies and
reducing the implementation cost of the Company's technologies. These engineers
also are focused on assisting customers to implement the Company's technologies
and supporting the Company's sales and marketing efforts on a worldwide basis.

     Through Valence, the Company operates one of the largest independent IC
design houses in Hong Kong, whose activities are primarily engaged in working on
custom design ASIC projects for clients in the consumer electronics, game and
telecommunications industries. These clients range from local producers to
large, multi-national manufacturers around the world. In 1998, ASP
Microelectronics, one of Valence's subsidiaries, was awarded the Hong Kong
Industry Award's HKITCC Technological Achievement Award. In 1999, VSD
Electronics Ltd., another Valence subsidiary, was awarded the Hong Kong Industry
Award's HKITCC Certificate of Merit in Technology Achievement.

     The market for the Company's technologies and products is subject to rapid
and significant changes and frequent new technology and product introductions.
The Company believes that its future success will depend on its ability to
continue to enhance its existing technologies and to introduce or acquire new
technologies on a

                                       10
<PAGE>   11

competitive basis. There can be no assurance, however, that the Company will be
able to successfully enhance existing technologies and products or introduce or
acquire new technologies and products.

COMPETITION

     The Company competes in each of its business segments with a number of
companies which produce a variety of audio and voice enhancement technologies,
processes and products. These technologies, processes and products include:
THX(R), a certification program that indicates if a movie theater or particular
piece of audio equipment meets certain specifications; Dolby(R) A-type, B-type
and C-type noise reduction; Dolby SR(R), which provides noise reduction and
encodes analog sound using four sound channels; ProLogic(TM), a surround sound
system incorporating an active center channel; DolbySRD(R), which encodes a six
channel digital sound track on a movie print; DTS(R), which uses CDs to
reproduce six channels of digital sound synchronized with a movie print; and
SDDS(R), which encodes six or eight channels of digital sound on both sides of a
movie print. Because SRS works with any existing recorded material whether mono,
stereo, surround sound or other encoding process, SRS can be used either as an
alternative or as a complement and enhancement to almost any competing audio
technology. As a multi-channel encode/decode technology, Circle Surround
competes more directly with the various surround sound technologies listed
above.

     The Company also directly competes in the field of 3D audio enhancement
with other 3D audio providers, including Aureal, Qsound Labs, Inc., Sensaura and
Spatializer. The Company is not aware of any direct competing technologies to
its voice intelligibility technology, VIP. The Company believes that TruBass
might directly compete with several technologies, including MaxxBass from Waves,
Ltd. and non-proprietary bass enhancement circuits, such as Bass Boost, that are
included on a variety of electronics products, including televisions, audio
systems and speaker products.

     In addition, the Company's technologies may, in the future, compete with
audio technologies developed by other companies, some of whom may be current
licensees of the Company.

     Certain of these companies referenced above have, or may have,
substantially greater resources than the Company to devote to further
technologies and new product developments. The Company believes that it will
compete based primarily on the quality and performance of its proprietary
technologies, brand name awareness, the ease and cost of implementing its
technologies, the ability to meet OEMs' needs to differentiate their products,
and the strength of its licensee relationships. There can be no assurance that
based on these factors the Company will continue to be competitive with existing
or future products or technologies of its competitors.

     The Company's competitors to its semiconductor IC business are primarily
fabless semiconductor design houses and manufacturers located in Taiwan, Japan
and Korea. Given that Taiwan is focusing on the development of the personal
computer industry, most of the fabless semiconductor design houses in Taiwan
also focus on the design of dynamic random access memory, static random access
memory and semiconductors for personal computer applications. These fabless
semiconductor design houses focus less on semiconductors for consumer
electronics such as home audio and video products, communications equipment and
electronic games players.

     Although the Chinese semiconductor industry is dominated by several major
chip suppliers, such as Motorola, National Semiconductor and Texas Instruments,
within every major market there is need for local, niche participants, such as
the Company. Generally speaking, established semiconductor companies do not
offer semiconductor design services to manufacturers and will only do so if the
volume of semiconductors required by such manufacturers is of a very large
quantity. Instead, they supply standard semiconductors to such manufacturers.
These standard semiconductors may not be the most suitable components for the
manufacturers as they may require additional semiconductor components to perform
the designed functions required in their products. In such cases, these
semiconductors will be bulkier, heavier and more expensive compared to using
just one custom-designed system-on-chip ASIC. The Company's ASIC team is more
flexible in its strategy of designing new products, as well as more responsive
and flexible in the service provided to clients. With fourteen years of
background in the Chinese semiconductor market, the Company's personnel

                                       11
<PAGE>   12

has expertise in local business practices and a strong franchise of
relationships with clients that the Company believes gives it a competitive
advantage over newcomers to the industry or the large multi-national firms.

     The Company's (through Valence and its subsidiaries) chip and component
distribution contracts to distribute products for third party semiconductor
manufacturers in the domestic Chinese market are not exclusive, and the Company
competes with other distributors, such as Arrow Electronics, Future Electronics
and Avnet Inc. In addition, the semiconductor companies who manufacture the
components and chips also sell directly to manufacturers within China.

     Through a network of manufacturing partners in China, the Company during
Fiscal 1998 produced and offered home entertainment products for wholesale and
distribution through retailers, under the brand name "Valence." In Fiscal 1999,
the Company focused on the development and marketing of product and technology
solutions targeted at applications in DVD players, VCD players, digital power
amplifiers, set-top boxes, and surround sound decoders. The technology solutions
can be readily incorporated into end products, thus enabling a Company's
customer to shorten its time-to-market by reducing its own design and
development cycle time. Although the overall consumer electronics market in
China is vast, it is highly competitive with many large manufacturers competing
in the retail channel with established brand names.

     The markets in which the Company sells its products are subject to extreme
price competition, thus the Company expects to continue to experience declines
in the selling prices of its products over the life cycle of each product. In
order to offset declines in the selling prices of its products, the Company must
continue to reduce the costs of products through product design changes,
manufacturing process changes, volume discounts and other savings negotiated
with its manufacturing subcontractors. Since the Company does not operate its
own manufacturing facilities with respect to ASICs or product or component
sales, it may not be able to reduce its costs as rapidly as its competitors who
perform their own manufacturing. The failure of the Company to design and
introduce, in a timely manner, lower cost versions of existing products or
higher gross margin new products, or to successfully manage its manufacturing
subcontractor relationships could have a material adverse effect on the
Company's gross margins.

INTELLECTUAL PROPERTY RIGHTS AND PROPRIETARY INFORMATION

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

     SRS is the subject of five U.S. patents containing a combined total of 276
claims. The expiration dates for these U.S. patents are May 31, 2005, June 20,
2006, September 12, 2006, October 5, 2010 and April 27, 2015, respectively. In
addition, the Company has 49 issued foreign patents relating to SRS and over 59
additional foreign patents pending. The expiration dates for these foreign
patents varies depending on the particular patent and the particular country,
but in most cases the duration of such foreign patents will extend into the year
2006.

     The Company also owns four U.S. patents for speaker technologies and has 30
issued foreign patents for these technologies with several other foreign patents
pending. The expiration dates for these U.S. patents are April 4, 2006, June 6,
2006, January 10, 2010 and October 7, 2016, respectively. The expiration dates
for these foreign patents varies depending on the particular patent and the
particular country, but in most cases the duration of such foreign patents will
extend into the year 2006.

                                       12
<PAGE>   13

     The Company owns U.S. patents for VIP, FOCUS, TruSurround and Circle
Surround with numerous foreign patents pending for each of these technologies.
In addition, the Company has multiple new audio technology patents pending in
the U.S. and worldwide for improvements to SRS and for its FOCUS, TruSurround
and TruBass technologies.

     The Company is the owner of the following federally registered trademarks:
SRS(R), the SRS symbol "(o)(R)", Sound Retrieval System(R), ORB(R), BASER(R),
"everything else is only stereo", 3D Stereo(R), 3D Stereo II(R), 3D Cinema
Stereo(R), F( -- )CUS(R), Dr. 3D(R), TruSurround(R) and Circle Surround(R).
Trademark applications are pending for AVT(TM), VIP(TM), TruBass(TM), WOW
Thing(TM), NuVoice(TM), Power 3D Audio(TM), XTREME BASS(TM), Best Sounding Site
on the World Wide Web(TM) and WOW(TM). The duration of the federally registered
trademarks can be maintained indefinitely, provided proper maintenance fees are
paid and the trademarks are continually used or licensed by the Company. The
Company also has foreign trademarks either registered or pending for many of the
aforementioned trademarks.

SEASONALITY

     Due to the Company's dependence on the consumer electronics market, the
substantial seasonality of sales in the market could impact the Company's
revenues and net income. In particular, the Company believes that there is
seasonality relating to the Christmas season as well as the Chinese New Year in
the Asia Pacific region, which fall into the fourth and first quarters,
respectively.

EMPLOYEES

     The Company and its subsidiaries employed 73 persons and 43 persons,
respectively, in its IC Chip and Licensing and Product and Component Sales
business segments as of December 31, 1999. Of the aggregate number of employees,
86 are employed by Valence and its subsidiaries and are located overseas. None
of the Company's employees are covered by a collective bargaining agreement or
are presently represented by a labor union. The Company has not experienced any
work stoppages and considers its employee relations to be good.

ITEM 2. PROPERTIES

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

     Pursuant to the Company's lease agreement with the Partnership, the Company
leases all 23,400 square feet of space at the above-referenced facility. The
lease is for a term of three years which commenced June 1, 1997 and is scheduled
to expire on May 31, 2000. At the time of expiration, the Company will have an
option to renew the lease, under similar terms and conditions, for two
additional years commencing on June 1, 2000 and terminating on May 31, 2002. The
Company intends to exercise such renewal rights. The Company paid the
Partnership rent of $129,369 during Fiscal 1997, $165,672 during Fiscal 1998 and
$165,672 during Fiscal 1999.

     The Company, through Valence and its subsidiaries, leases several offices
and warehouses in Hong Kong and China. Valence's principal operations are
conducted at two leased facilities located in Hong Kong. The principal executive
offices of Valence are located in Kowloon Tong, Hong Kong, in a 3,726 square
foot office facility under a lease which expires in August 2000. Valence's other
principal office is located in Kwun Tong, Kowloon, Hong Kong, in a 7,453 square
foot office facility under a lease which expires in December 2000. Pursuant to
these leases, the Company paid rent of $461,044 during Fiscal 1998, and $429,672
during Fiscal 1999. Management of Valence expects to reach renewal agreements
with respect to each of the above-

                                       13
<PAGE>   14

referenced facilities. To the extent that management is unable to reach such
agreements, it believes that it will be able to secure comparable space at
reasonable rates.

     The Company's corporate headquarters house personnel responsible for the
development of the Company's technologies, as well as the administration of the
Company's license program, while the Valence facilities are used in connection
with the design and marketing of ASICs and the sale of consumer electronic
products and components.

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

ITEM 3. LEGAL PROCEEDINGS

     On April 23, 1999, Dolby Laboratories, Inc. ("Dolby") filed a civil lawsuit
in the United States District Court for the Central District of California (the
"Court") against the Company and Smart Devices, Inc. ("Smart Devices"). Smart
Devices is a licensee of the Company under the SRS(R) and CIRCLE SURROUND(R)
technologies. The complaint sought both preliminary and permanent injunctions,
monetary damages in an unspecified amount and further equitable relief, based
upon allegations of false advertising, unfair competition, trademark
infringement and false labeling relating to the CIRCLE SURROUND EX trademark. On
May 17, 1999, the Company filed an answer to such complaint generally denying
the allegations made by the plaintiff under each claim for relief and denying
that the plaintiff is entitled to any relief under each stated claim for relief.
In addition, the Company also responded by alleging affirmative defenses to each
claim for relief. The Company did not provide a defense for Smart Devices.

     On November 23, 1999, a Stipulation of Dismissal (the "Stipulation") was
entered by the Court. Pursuant to the Stipulation, the parties, Dolby and the
Company, agreed to dismiss the above-referenced action as between themselves
with prejudice based upon a Settlement Agreement and Mutual Release (the
"Settlement Agreement"). The Stipulation did not affect the claims that Dolby
has asserted against Smart Devices. Pursuant to the Settlement Agreement, (a)
the Company agreed (i) to pay Dolby $50,000, (ii) to abandon the Intent-To-Use
application it had filed for the mark "Circle Surround EX"; (iii) not to
register or use as a trademark the term "Circle Surround EX" (iv) not to oppose
Dolby's application for registration of marks "Surround EX" and "Dolby Digital
Surround EX" and to consent to Dolby's use of such marks; and (v) that it will
not attempt to register or use as a trademark the phrase "Surround EX" alone;
and (b) Dolby agreed to pay to the Company $45,000 to assist in the deferment of
the costs to be incurred by the Company in changing its trademark. The
Stipulation expressly stated that it will not be construed as an admission of
liability or infringement by either Dolby or the Company.

     From time to time, the Company is a party to ordinary disputes arising in
the normal course of business. The Company does not believe that the outcome of
any current legal proceedings will have a material adverse effect on the
Company's business, financial condition or results of operations.

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

     Not applicable.

                                       14
<PAGE>   15

                                    PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

MARKET FOR COMMON STOCK

     The common stock of the Company, par value $.001 per share (the "Common
Stock"), trades on the Nasdaq Stock Market as a National Market System Security
under the symbol SRSL. The table below reflects the high and low sales prices of
the Common Stock as reported by The Nasdaq Stock Market, Inc. for the periods
indicated.

<TABLE>
<CAPTION>
                                                             HIGH        LOW
                                                             ----        ---
<S>                                                          <C>         <C>
FISCAL 1998
  First Quarter............................................  $10 1/4     $6 1/4
  Second Quarter...........................................    9 5/8      4 7/8
  Third Quarter............................................    7 5/8      3 3/8
  Fourth Quarter...........................................    5 3/8      2 3/8
FISCAL 1999
  First Quarter............................................  $ 5 5/8     $3 1/16
  Second Quarter...........................................    4 1/4      2 5/8
  Third Quarter............................................    4 5/8      2 7/8
  Fourth Quarter...........................................    7 5/8      2 15/16
</TABLE>

     At March 17, 2000, the last sale price of the Common Stock was $26.625 per
share.

HOLDERS

     At March 17, 2000, there were 407 stockholders of record.

DIVIDEND POLICY

     The Company has never paid cash dividends on the Common Stock. The Company
currently intends to retain its available funds from earnings for future growth
and, therefore, does not anticipate paying any dividends in the foreseeable
future. See Item 7. "Management's Discussion and Analysis and Results of
Operations -- Liquidity and Capital Resources" for a discussion regarding
certain restrictions which relate to the Company's ability to pay cash
dividends.

USE OF PROCEEDS

     The effective date of the Company's initial public offering of shares of
Common Stock was August 8, 1996 (SEC Registration No. 333-4974-LA). During the
fourth quarter of Fiscal 1999, the Company utilized approximately $1,552,999 of
the $22,052,955 net offering proceeds for working capital. The table below sets
forth at December 31, 1999, the amount of the net offering proceeds used for the
purposes noted in the table.

                                       15
<PAGE>   16

<TABLE>
<CAPTION>
                                                 DIRECT OR INDIRECT PAYMENTS TO
                                                  DIRECTORS, OFFICERS, GENERAL
                                                PARTNERS OF THE ISSUER OR THEIR
                                               ASSOCIATES, TO PERSONS OWNING TEN
                                                PERCENT OR MORE OF ANY CLASS OF      DIRECT OR INDIRECT
                                              EQUITY SECURITIES OF THE ISSUER, AND      PAYMENTS TO
                                                  TO AFFILIATES OF THE ISSUER              OTHERS
                                              ------------------------------------   ------------------
<S>                                           <C>                                    <C>
Construction of plant, building and
  facilities................................                  --                                 --
Purchase and installation of machinery and
  equipment.................................                  --                                 --
Purchase of real estate.....................                  --                                 --
Acquisition of other business(es)/assets....                  --                         $8,394,222(1)
Repayment of indebtedness...................                  --                                 --
Working capital.............................                  --                         $4,316,000
Temporary investment (cash and municipal
  bonds)....................................                  --                         $9,342,733
</TABLE>

---------------
(1) During the second quarter of Fiscal 1998, the Company utilized $500,000 of
    the net offering proceeds as part of the consideration to acquire assets
    related to the Circle Surround technology. During the first quarter of
    Fiscal 1998, the Company utilized an aggregate of $7,894,222 in connection
    with two other acquisitions (see Note 2 to the Notes to the Consolidated
    Financial Statements included under Item 8 of this Report).

                                       16
<PAGE>   17

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

     The following table sets forth selected financial data of the Company for
the fiscal years ended December 31, 1995, 1996, 1997, 1998 and 1999 which has
been derived from the Company's consolidated audited financial statements. The
following information should be read in conjunction with the Consolidated
Financial Statements and Notes thereto included elsewhere in this Report.

<TABLE>
<CAPTION>
                                                     FISCAL YEAR ENDED DECEMBER 31,
                                          ----------------------------------------------------
                                           1995       1996       1997        1998       1999
                                          -------    -------    -------    --------    -------
                                                  (IN THOUSANDS EXCEPT PER SHARE DATA)
<S>                                       <C>        <C>        <C>        <C>         <C>
Revenues:
  Chip and licensing revenues...........  $   844    $ 5,392    $10,081    $ 15,762    $18,624
  Product and component sales...........       --         --         --      28,963     17,172
                                          -------    -------    -------    --------    -------
          Total revenues................      844      5,392     10,081      44,725     35,796
Cost of sales...........................       15         95        210      29,819     22,003
                                          -------    -------    -------    --------    -------
  Gross margin..........................      829      5,297      9,871      14,906     13,793
Operating costs and expenses:
  Sales and marketing...................      937      1,163      2,112       6,846      5,148
  Research and development..............      384        522        596       2,555      4,142
  General and administrative............    1,107      1,616      2,615       5,531      6,932
  Acquired in-process research and
     development........................       --         --         --      18,510         --
                                          -------    -------    -------    --------    -------
          Total operating costs and
            expenses....................    2,428      3,301      5,323      33,442     16,222
                                          -------    -------    -------    --------    -------
Income (loss) from operations...........   (1,599)     1,996      4,548     (18,536)    (2,429)
  Other income (expense), net...........      (41)       366      1,088         705        735
                                          -------    -------    -------    --------    -------
Income (loss) from operations before
  income tax expense (benefit)..........   (1,640)     2,362      5,636     (17,831)    (1,695)
Income tax expense (benefit)............        1        501      1,863        (273)       (49)
                                          -------    -------    -------    --------    -------
Net income (loss).......................  $(1,641)   $ 1,861    $ 3,773    $(17,558)   $(1,744)
                                          =======    =======    =======    ========    =======
  Net income (loss) per common share:
     Basic..............................  $ (0.28)   $  0.24    $  0.39    $  (1.54)   $ (0.15)
                                          =======    =======    =======    ========    =======
     Diluted............................  $ (0.28)   $  0.21    $  0.35    $  (1.54)   $ (0.15)
                                          =======    =======    =======    ========    =======
Weighted average number of shares used
  in the calculation of net income per
  common share:
     Basic..............................    5,928      7,625      9,556      11,410     11,696
     Diluted............................    5,928      8,686     10,852      11,410     11,696
Balance sheet data:
  Working capital.......................  $   431    $ 3,375    $ 9,075    $  7,644    $10,953
  Total assets..........................    1,698     26,674     31,542      45,535     39,101
  Short-term debt and current portion of
     long-term obligations..............      180        180         82       8,000      8,000
  Long-term obligations, net of current
     portion............................      211         69         --          --         --
  Stockholders' equity..................      888     25,151     29,420      26,072     25,040
</TABLE>

                                       17
<PAGE>   18

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

OVERVIEW

     SRS Labs, Inc. is a developer and provider of technology solutions for the
consumer electronics, computer, game and telecommunications markets. As of the
end of Fiscal 1999, the Company's principal business activities in these markets
included:

     - Developing and licensing audio and voice technologies to original
       equipment manufacturers ("OEMs") and semiconductor manufacturers around
       the world; and

     - Through its subsidiary, Valence Technology Inc. and its foreign
       subsidiaries (collectively, "Valence"), designing and selling technology
       solutions through custom application specific integrated circuits
       ("ASICs") to OEMs; and designing, distributing and manufacturing
       components, sub-assemblies and finished goods for the OEM and retail
       communities within the Company's targeted markets.

     From the Company's inception in 1993 until February 1998, the Company
derived substantially all of its revenue from royalties received from technology
licenses. On March 2, 1998, the Company acquired all of the outstanding capital
stock of Valence Technology Inc., a British Virgin Islands holding company with
its principal business operations in Hong Kong and China for an aggregate
purchase price, excluding non-compete agreements and acquisition costs, of
$19,500,000 consisting of approximately $7,400,000 in cash and approximately
1,680,611 shares of the Company's common stock, $.001 par value per share (the
"Common Stock"). The acquisition was accounted for as a purchase with an
effective date of February 1, 1998. The acquisition of Valence had a material
impact on the Company's Fiscal 1998 and 1999 financial statements. Accordingly,
current and future financial statements may not be directly comparable to the
Company's historical financial statements.

     During the first quarter of Fiscal 1998, the Company acquired certain
rights to Voice Intelligibility Processor ("VIP"), which is a patented voice
processing technology that improves the intelligibility of the spoken voice,
especially in high ambient noise environments. Aggregate consideration,
including acquisition costs, was $1,138,710 and was comprised of $620,178 in
cash, 25,000 shares of Common Stock and warrants to purchase 100,000 shares of
Common Stock at $9.47 per share.

     During the second quarter of Fiscal 1998, the Company acquired certain
rights to Circle Surround, a patented audio delivery system that allows
multi-channel surround sound to be encoded into a two-channel stereo format and
allows an encoded two-channel audio source or a traditional stereo audio source
to be decoded into a multi-channel surround format. The aggregate purchase
price, including acquisition costs, was $834,985 and was comprised of $534,985
in cash and 35,294 shares of Common Stock.

     SRS currently operates in two business segments: (a) the development and
marketing of technology in the forms of integrated circuits designed and
distributed through Valence and the licensing of technologies developed by the
Company to product and semiconductor manufacturers and (b) the sale of consumer
electronic products and components.

                                       18
<PAGE>   19

RESULTS OF OPERATIONS

     The following table sets forth certain consolidated operating data as a
percentage of total revenues for the years ended December 31, 1997, 1998 and
1999:

<TABLE>
<CAPTION>
                                                          PERCENTAGE OF TOTAL
                                                          REVENUE YEARS ENDED
                                                              DECEMBER 31,
                                                          --------------------
                                                          1997    1998    1999
                                                          ----    ----    ----
<S>                                                       <C>     <C>     <C>
Chip and licensing revenue..............................  100%     35%     52%
Product and component sales.............................   --      65      48%
                                                          ---     ---     ---
  Total revenue.........................................  100     100     100
Cost of sales...........................................    2      67      61
                                                          ---     ---     ---
Gross margin............................................   98      33      39
Sales and marketing.....................................   21      15      14
Research and development................................    6       6      12
General and administrative..............................   26      12      20
Acquired in-process research and development............    0      41       0
                                                          ---     ---     ---
  Total operating expense...............................   53      74      46
Operating income (loss).................................   45     (41)     (7)
Other income, net.......................................   11       2       2
                                                          ---     ---     ---
Income (loss) before income taxes.......................   56     (39)     (5)
Income tax expense (benefit)............................   18      --      --
                                                          ---     ---     ---
  Net income (loss).....................................   38%    (39)%    (5)%
                                                          ===     ===     ===
</TABLE>

  YEAR ENDED DECEMBER 31, 1999 COMPARED TO YEAR ENDED DECEMBER 31, 1998

     Impact of Valence Acquisition

     The Company's consolidated financial results for Fiscal 1998 include the
results of the Valence operations beginning as of February 1, 1998. Accordingly,
results for the year ended December 31, 1999 may not be directly comparable to
results for the year ended December 31, 1998.

     Revenues

     Chip and licensing revenue consists of design fees and sales of custom
application specific integrated circuits (ASICs) by Valence to OEM manufacturers
and sales of general purpose ICs designed by the Company under the brand name
ASP Microelectronics. Licensing revenues are royalties generated primarily from
the license of the Company's audio technologies. License and royalty agreements
generally provide for the license of technologies for a specified period of time
for either a single fee or a fee based on the number of units distributed by the
licensee. Product and component sales represent (a) the manufacture and sale of
Valence's own branded product line of VCD players, amplifiers and game products
and (b) the distribution of semiconductor products, manufacturing components and
sub-assemblies to OEMs for the Hong Kong and China markets.

     Total revenues for Fiscal 1999 were $35,795,583, consisting of chip and
licensing revenue of $18,624,221 and product and component revenue of
$17,171,362. This contrasts with Fiscal 1998, where chip and licensing revenues
were $15,762,370, and product and component revenues were $28,962,671. Excluding
chip design revenue, licensing revenue decreased 38.2% from the same period last
year due to the following factors: (a) the shift in the PC market to lower cost
models which cannot bear the cost of performance enhancement technologies such
as those offered by SRS Labs; (b) the reduced growth rate of the Chinese economy
which reduced demand for consumer electronics products in the region and
negatively impacted the sales of semiconductor ICs that include the Company's
audio technologies; and (c) the trend by consumer electronic manufacturers to
initially adopt the Company's new technologies into their higher end models with
limited volume potential for the short term. Revenue from custom ASIC chip
design and chip sales related to

                                       19
<PAGE>   20

Valence's activities increased 48% from the same prior year period primarily due
to the Company's decision to focus on higher margin chip and licensing revenues
and de-emphasize certain lower margin distribution activities. The 41% decrease
in product revenues in Fiscal 1999 also is due to the Company's decision to
de-emphasize certain lower margin distribution activities.

     Gross Margin

     Cost of sales for Fiscal 1999 consists primarily of component cost,
fabrication costs, assembly and test costs, and the cost of materials and
overhead from operations. Gross margin for the twelve months ended December 31,
1999 increased to 38.5% from 33.3% for the same period in 1998. The increase
resulted primarily from the shift in the Company's revenue base towards higher
margin chip and licensing sales and away from lower margin component
distribution.

     Sales and Marketing

     Sales and marketing expenses consist primarily of employee-related
expenses, sales commissions and product promotion costs. Sales and marketing
expenses were $5,148,458 in Fiscal 1999 compared to $6,845,674 in Fiscal 1998, a
decrease of 24.8%. This decrease is attributable primarily to lower advertising,
promotional, trade show and travel costs, resulting from the Company's efforts
during 1999 to reduce costs in these areas. As a percentage of total revenues,
sales and marketing expenses decreased to 14.4% in Fiscal 1999 from 15.3% in
Fiscal 1998.

     Research and Development

     Research and development expenses consist of salaries and related costs of
employees engaged in ongoing research, design and development activities and
costs for engineering materials and supplies. Research and development expenses
were $4,141,571 in Fiscal 1999 compared to $2,554,883 in Fiscal 1998, an
increase of 62.1%. This increase is primarily attributable to ASIC related
research and development, and design and development of ASP branded products
based on SRS technologies. As a percentage of total revenues, research and
development expenses increased to 11.6% in Fiscal 1999 from 5.7% in Fiscal 1998.
Management believes that research and development expenses will increase in the
future as a result of the Company's continual product development efforts.

     General and Administrative

     General and administrative expenses consist primarily of employee-related
expenses, legal costs associated with the administration of intellectual
property, professional fees and various other administrative costs. General and
administrative expenses were $6,932,397 in Fiscal 1999 compared to $5,530,957 in
Fiscal 1998, an increase of 25.3%. The increase was primarily attributable to
headcount added to support new business development, costs incurred for due
diligence activities related to potential acquisitions, and costs incurred to
reserve for certain non-collectible accounts receivable. As a percentage of
total revenues, general and administrative expenses increased to 19.4% in Fiscal
1999 from 12.4% in Fiscal 1998.

     As part of the Valence acquisition, the Company allocated a portion of the
purchase price to various intangible assets totaling approximately $5,910,400.
This amount was capitalized and is being amortized on a straight line basis over
periods ranging from three to eleven years with the related amortization expense
of $1,205,988 and $1,180,489 included in general and administrative expenses for
the years ended December 31, 1999 and 1998 respectively. See Note 2 of the Notes
to the Consolidated Financial Statements for more information concerning the
purchase price allocation associated with the Valence acquisition.

     Acquired In-Process Research and Development

     The Company's Consolidated Statement of Operations for the year ended
December 31, 1998 includes the one-time charge of $18,510,378 for the write-off
of acquired in-process research and development expenses associated with the
Valence acquisition and the acquisition of certain assets associated with the
VIP technology. The in-process research and development expenses arose from new
product projects that were
                                       20
<PAGE>   21

under development at the date of the acquisition and expected to eventually lead
to new products but had not yet established technological feasibility and for
which no future alternative use was identified. The valuation of the in-process
research and development projects was based upon the discounted expected future
net cash flows of the products over the products' expected lives, reflecting the
estimated stages of completion of the projects and the estimated costs to
complete the projects.

     New product development projects underway at Valence at the time of the
Valence acquisition included, among others, ASICs for consumer electronics,
computing and voice and audio applications, home entertainment systems, digital
multimedia players and digital power amplifiers. The Company estimated that
these projects were approximately 63% complete at the date of acquisition and
estimated that the cost to complete these projects will aggregate approximately
$7 million and will be incurred over a three-year period.

     New product development projects utilizing the VIP technology at the time
of the VIP acquisition included, among others, digital and analog sound
reinforcement, wireless and non-wireless telecommunications applications,
hearing aid applications and headphone and microphone applications. The Company
estimated that these projects were approximately 62% complete at the date of
acquisition and estimated that the cost to complete these projects will
aggregate approximately $525,000 and will be incurred over a two-year period.

     Uncertainties that could impede the progress of converting a development
project to a developed technology include the availability of financial
resources to complete the project, failure of the technology to function
properly, continued economic feasibility of developed technologies, customer
acceptance, customer demand and customer qualification of such new technology
and general competitive conditions in the industry. There can be no assurance
that the acquired in-process research and development projects will be
successfully completed and commercially introduced.

     Other Income, Net

     Other income, net consists primarily of interest income, interest expense,
realized gains and losses on the sale of investments and foreign currency
transaction gains and losses at Valence. Net interest income was $448,117 in
Fiscal 1999 compared to $694,760 in Fiscal 1998, a decrease of 35.5%. The
decrease is primarily attributable to lower average cash and investment balances
during the current year as compared to the prior year due to the $7,894,222 paid
in conjunction with the acquisitions of Valence and VIP and interest expense on
the outstanding borrowings under the Company's line of credit obtained during
Fiscal 1998.

     Provision for Income Taxes

     The income tax provision for Fiscal 1999 was $49,662 compared to a benefit
of $273,156 for Fiscal 1998. The Company recognized a tax benefit in Fiscal 1998
primarily due to a taxable loss recognized for U.S. federal income tax purposes
related to domestic operations. In addition, the Company benefited from certain
tax credits and statutory tax rates in the Asian countries where Valence has its
principal business operations which are lower than United States statutory
rates. The Company had federal and state net operating loss carry forwards at
December 31, 1999, of approximately $3.4 million and $3.1 million, respectively.
These net operating loss carry forwards will begin to expire in 2019 and 2003,
respectively. In addition, the Company has federal tax credit carry forwards of
approximately $541,000 which will begin to expire in 2003. As of December 31,
1999, a valuation allowance of $1,154,401 has been provided based on the
Company's assessment of the future realizeability of certain deferred tax
assets. Approximately $125,000 of the valuation allowance is attributable to the
potential tax benefit of stock option transactions that will be credited
directly to additional paid in capital, if realized.

  YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997

     Revenues

     Total revenues for Fiscal 1998 were $44,725,040, which includes revenues
generated by Valence since February 1, 1998. This contrasts with Fiscal 1997
where revenues were $10,081,283 and were generated solely

                                       21
<PAGE>   22

from licensing activities. Excluding chip design revenue, licensing revenue
decreased 45.8% from the same period last year due to the following factors: (a)
the shift in the PC market to lower cost models, which cannot bear the cost of
performance enhancement technologies such as those offered by SRS Labs; (b) the
Asian financial crisis which reduced demand for consumer electronics products in
the region and negatively impacted the sales of semiconductor ICs that include
the Company's audio technologies; and (c) the trend by consumer electronic
manufacturers to adopt the Company's technologies into their higher end models
which has limited volume growth of models using the Company's licensed audio
technologies. The licensing revenue decrease was offset by the custom ASIC chip
design and chip sales of $10,294,851 related to Valence's activities. Revenue
generated from product and component sales in Fiscal 1998 is attributable to
Valence and therefore is not comparable to Fiscal 1997. Revenues in future
quarters are expected to consist primarily of ASIC design and product and
electronic component sales.

     Cost of sales for Fiscal 1998 consisted primarily of fabrication costs,
assembly and test costs, and the cost of materials and overhead from operations.
Cost of sales for Fiscal 1997 consisted primarily of fees paid to third party
representatives for sales administration and support. Gross margin for the
twelve months ended December 31, 1998 decreased to 33.3% from 97.9% for the same
period in Fiscal 1997. The decrease resulted from the shift in the Company's
revenue base towards product and electronic component sales, which have
significantly lower margins than the Company's historic licensing revenue base.
Gross margins in future quarters will primarily reflect the cost of
manufacturing products for sale as opposed to licensing transactions which
typically have higher gross margins.

     Sales and Marketing

     Sales and marketing expenses consist primarily of employee-related
expenses, sales commissions and product promotion. Sales and marketing expenses
were $6,845,674 in Fiscal 1998 compared to $2,111,839 in Fiscal 1997, an
increase of 224.2% which was attributable to the Valence acquisition and an
increase in domestic staffing to promote new technologies. As a percentage of
total revenues, sales and marketing expenses decreased to 15.3% in Fiscal 1998
from 20.9% in Fiscal 1997, as a result of the higher revenue base.

     Research and Development

     Research and development expenses consist of salaries and related costs of
employees engaged in ongoing research, design and development activities and
costs for engineering materials and supplies. Research and development expenses
were $2,554,883 in Fiscal 1998 compared to $595,689 in Fiscal 1997, an increase
of 328.9%, primarily attributable to the Valence acquisition. As a percentage of
total revenues, research and development expenses decreased to 5.7% in Fiscal
1998 from 5.9% in Fiscal 1997, as a result of the higher revenue base.

     General and Administrative

     General and administrative expenses consist primarily of employee-related
expenses, legal costs associated with the administration of intellectual
property and other professional fees. General and administrative expenses were
$5,530,957 in Fiscal 1998 compared to $2,615,706 in Fiscal 1997, an increase of
111.5%, primarily attributable to the Valence acquisition and increased staffing
at corporate headquarters to support new business development. As a percentage
of total revenues, general and administrative expenses decreased to 12.4% in
Fiscal 1998 from 25.9% in Fiscal 1997 as a result of the higher revenue base.

     As part of the Valence acquisition, the Company allocated a portion of the
purchase price to various intangible assets totaling approximately $5,910,400.
See the discussion above and in Note 2 of the Notes to the Consolidated
Financial Statements for more information concerning the purchase price
allocation associated with the Valence acquisition.

     Acquired In-Process Research and Development

     See the discussion above relating to the acquired in-process research and
development expenses related to the Valence acquisition.
                                       22
<PAGE>   23

     Other Income, Net

     Other income, net consists primarily of interest income, interest expense,
realized gains and losses on the sale of investments and foreign currency
transaction gains and losses at Valence. Net interest income was $694,760 in
Fiscal 1998 compared to $1,088,718 in Fiscal 1997, a decrease of 36.2%. The
decrease is primarily attributable to lower average cash and investment balances
during the current year as compared to the prior year due to the $7,894,222 paid
in conjunction with the acquisitions of Valence and VIP and interest expense on
the outstanding borrowings under the Company's line of credit obtained during
Fiscal 1998. The Company also recognized $86,337 of realized gains on the sale
of investments available for sale and a foreign exchange transaction loss
related to the Valence operations of $76,105 in Fiscal 1998.

     Provision for Income Taxes

     The income tax benefit for Fiscal 1998 was $273,156 compared to income tax
expense of $1,863,200 for Fiscal 1997. The Company recognized a tax benefit in
Fiscal 1998 primarily due to a taxable loss recognized for U.S. federal income
tax purposes related to domestic operations. In addition, the Company benefited
from certain tax credits and statutory tax rates in the Asian countries where
Valence has its principal business operations which are lower than United States
statutory rates.

SELECTED QUARTERLY OPERATING RESULTS (UNAUDITED)

     The following table sets forth certain quarterly financial data for the
eight quarters in the period ended December 31, 1999. The quarterly information
is based upon unaudited financial statements prepared by the Company on a basis
consistent with the Company's audited consolidated financial statements and, in
management's opinion, includes all adjustments, consisting only of normal
recurring adjustments necessary for a fair presentation of the information for
the periods presented. This information should be read in conjunction with the
Company's audited Consolidated Financial Statements and Notes thereto appearing
elsewhere in this Report. The acquisition of Valence in the first quarter of
Fiscal 1998 has had and will continue to have a material impact on the Company's
Fiscal 1998 and 1999 financial statements and for the reporting periods
thereafter; accordingly, the operating results for any quarter are not
necessarily indicative of results for any future period. The Company's quarterly
operating results have varied significantly in the past and are expected to vary
significantly in the future.

<TABLE>
<CAPTION>
                                                               THREE MONTHS ENDED
                            ----------------------------------------------------------------------------------------
                            MARCH 31,    JUNE 30,   SEP. 30,   DEC. 31,   MARCH 31,   JUNE 30,   SEP. 30,   DEC. 31,
                              1998         1998       1998       1998       1999        1999       1999       1999
                            ---------    --------   --------   --------   ---------   --------   --------   --------
                                                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                         <C>          <C>        <C>        <C>        <C>         <C>        <C>        <C>
Revenues:
  Chip and licensing......  $  2,882     $ 4,524    $ 3,936    $ 4,420     $ 4,104     $3,990    $ 4,830     $5,700
  Product and component...     4,175       7,101      7,382     10,305       3,613      4,214      5,175      4,170
                            --------     -------    -------    -------     -------     ------    -------     ------
          Total
            revenues......     7,057      11,625     11,318     14,725       7,717      8,204     10,005      9,870
Gross margin..............     2,659       4,238      3,507      4,502       2,441      3,301      3,940      4,110
Operating expenses........    21,351(a)    3,480      3,291      5,320       4,352      3,301      3,713      4,857
                            --------     -------    -------    -------     -------     ------    -------     ------
Operating income (loss)...   (18,692)        758        216       (818)     (1,911)        --        227       (747)
     Net income (loss)....   (18,211)        720        192       (259)     (1,497)         6        310       (563)
Net income (loss) per
  Common share:
     Basic................  $  (1.68)    $   .06    $   .02    $  (.02)    $  (.13)    $   --    $   .03     $ (.05)
     Diluted..............  $  (1.68)    $   .06    $   .02    $  (.02)    $  (.13)    $   --    $   .03     $ (.05)
</TABLE>

---------------
(a) Operating expenses for the three month period ended March 31, 1998 included
    $18,510,378 related to the write-off of acquired in-process research and
    development

                                       23
<PAGE>   24

LIQUIDITY AND CAPITAL RESOURCES

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

     As of December 31, 1999 and 1998, cash, cash equivalents, and investments
totaled $25,312,411 and $24,430,859, respectively. Net cash provided by
operating activities during Fiscal 1999 was $1,633,177 and was generated
primarily from decreases in accounts receivable, inventory, and other assets,
plus non-cash depreciation and amortization, offset by a net decrease in
accounts payable and accrued liabilities. Net cash provided by investing
activities of $1,667,744 resulted primarily from sales of the Company's
investments. Net cash provided by financing activities of $327,515 resulted
primarily from sale of common stock pursuant to exercise of the Company's stock
options. Net cash provided by operating activities during Fiscal 1998 was
$5,022,088 and was generated primarily from decreases in accounts receivable and
inventory and increases in accounts payable, offset by increases in prepaid
expense and other assets. During Fiscal 1998, net cash provided by investing
activities of $1,499,433 resulted primarily from the sale of the Company's
investments, offset by cash used in the acquisition of Valence and the
acquisition of new technologies. Net cash provided by financing activities of
$1,372,968 resulted primarily from borrowings under the Company's credit line
offset by payments on Valence's current debt.

     Inventories in Fiscal 1999 decreased from $4,632,968 at December 31, 1998
to $2,726,193 at December 31, 1999. This decrease was primarily a result of
disposing of slow-moving and obsolete inventory of Valence's distribution
business. Valence also exited from certain of the lower margin distribution
business which enabled it to carry less inventories to support customer demands.
Prepaid expenses and other current assets decreased from $3,244,233 at December
31, 1998 to $729,881 at December 31, 1999, primarily due to the collection of
other receivables of $2,131,352 during Fiscal 1999. Accounts payable decreased
from $10,632,505 at December 31, 1998 to $2,882,686 at December 31, 1999
primarily due to the decrease in component sales volume at Valence, which
resulted in reduced inventory levels and purchasing activity, as well as payment
of various other trade payables by Valence. Accrued liabilities increased from
$422,843 at December 31, 1998 to $1,658,964 at December 31, 1999 primarily due
to the timing of the payment of certain recurring compensation related expenses
plus the recording of a customer deposit.

     The Company's principal source of liquidity at December 31, 1999 consisted
of cash, cash equivalents and investments. The Company has adopted investment
guidelines restricting the types and minimum quality of investments the Company
is authorized to purchase. At December 31, 1999, the Company had cash and cash
equivalents of $15,969,678 and investments of $9,342,733. Investments consist of
municipal bonds rated a minimum of A1.

     On March 2, 1998, the Company acquired all of the outstanding shares of
capital stock of Valence for an aggregate purchase price of $19,500,000,
excluding acquisition costs and non-compete agreements, consisting of
approximately $7,400,000 in cash and approximately 1,680,611 shares of the
Company's common stock.

     On March 4, 1998, the Company obtained a revolving line of credit (and
letter of credit facility) with a bank which expires on April 1, 2001 and is
secured by certain of the Company's investments. The total availability under
the line of credit is the lesser of $10 million or a percentage of the fair
market value of the collateral. The line of credit bears interest at the bank's
prime rate (8.5% as of December 31, 1999) or LIBOR plus 0.75% (6.875% as of
December 31, 1999). As of December 31, 1999, the Company had $8.0 million
outstanding under the line of credit and was contingently liable for $1,000,000
under an irrevocable letter of credit which expires July 31, 2000. The
collateral requirements under the above-referenced credit facility may have the
effect of restricting the amount available to pay cash dividends.

     In November 1999, Valence and its subsidiaries obtained a credit facility
with a bank that provides for borrowings aggregating approximately $5,000,000.
The facility has no fixed expiration date and is collateralized by certain of
the Valence's assets on deposit with the bank. The facility provides for a
variety of import/ export trade instruments which bear interest rates ranging
from 1% over the Hong Kong Dollar prime rate to 1.75% over LIBOR. The facility
also provides for a revolving line of credit of up to $3,500,000 which bears

                                       24
<PAGE>   25

interest at 1.25% over the related collateral deposit interest rate. At December
31, 1999, there were no obligations outstanding under this credit facility.

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

SUBSEQUENT EVENTS

     As noted in Item 1, Business, of this Report, on March 3, 2000 ValenceTech
Limited (the ultimate successor entity to Valence Technology Inc. for purposes
of listing common shares on the Growth Emerging Market of the Stock Exchange of
Hong Kong Limited (the "GEM")) filed an application to list its common shares on
the GEM in connection with an initial public offering. The Company estimates
that the completion of the offering will occur during the second quarter of
Fiscal 2000. As contemplated in the offering documents, approximately one-third
of the net proceeds of the offering is earmarked to be repatriated to the
Company. The amount of such repatriation is currently not determinable.

     For a discussion relating to the strategic alliance between the Company and
Microsoft Corporation consummated in March 2000, see Item 1, Business in this
Report. Also see Note 13 to the Notes to Consolidated Financial Statements,
included herein under Item 8 of this Report.

YEAR 2000 ISSUE UPDATE

     The Company did not experience any significant malfunctions or errors in
its operating or business systems when the date changed from 1999 to 2000. Based
on operations since January 1, 2000, the Company does not expect any significant
impact to its ongoing business as a result of the "Year 2000 issue." However, it
is possible that the full impact of the date change, which was of concern due to
computer programs that use two digits instead of four digits to define years,
has not been fully recognized. For example, it is possible that Year 2000 or
similar issues such as leap year-related problems may occur with billing,
payroll, or financial closings at month, quarterly, or year end. The Company
believes that any such problems are likely to be minor and correctable. In
addition, the Company could still be negatively affected if its customers or
suppliers are adversely affected by the year 2000 or similar issues. The Company
currently is not aware of any significant Year 2000 or similar problems that
have arisen for its customers and suppliers.

     The Company expended less than $200,000 on Year 2000 readiness efforts from
Fiscal 1997 to Fiscal 1999. These efforts included replacing some outdated,
noncompliant hardware and noncompliant software as well as identifying and
remediating Year 2000 problems.

RECENT ACCOUNTING PRONOUNCEMENTS

     In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, which is effective for fiscal years
beginning after June 15, 2000. This standard establishes accounting and
reporting standards for derivative instruments and for hedging activities and
requires that an entity recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments
at fair value. The Company does not believe that its adoption of this new
standard will have a material impact on its financial position or results of
operations.

FACTORS THAT MAY AFFECT FUTURE RESULTS

  QUARTERLY FLUCTUATIONS

     The Company's operating results may fluctuate from those in prior quarters
and will continue to be subject to quarterly and other fluctuations due to a
variety of factors, including the extent to which the Company's licensees
incorporate the Company's technologies into their products; the timing of orders
from, and the shipments, to major customers; the timing of new product
introductions by the Company; the gain or

                                       25
<PAGE>   26

loss of significant customers; competitive pressures on selling prices; the
market acceptance of new or enhanced versions of the Company's technologies; the
rate that the Company's semiconductor licensees manufacture and distribute chips
to product manufacturers; and fluctuations in general economic conditions,
particularly those affecting the consumer electronics market. Due to the
Company's dependence on the consumer electronics market, the substantial
seasonality of sales in the market could impact the Company's revenues and net
income. As a result, the Company believes that period-to-period comparisons of
its results of operations are not necessarily meaningful and should not be
relied upon as indications of future performance. The Company believes that
there is seasonality relating to the Christmas season as well as the Chinese New
Year within the Asia region, which fall into the fourth and first quarters,
respectively.

  VALENCE'S BUSINESS

     The Company derived a significant amount of its revenue from Valence's ASIC
and component distribution business. Valence's engineering team focuses on the
design of custom ASIC to meet specific customers' requirements and outsources
the production of the design to mask houses, foundries and packaging houses
located primarily in Asia. The operations of Valence could be affected by a
variety of factors, including the timing of customer orders, the timing of
development revenue, changes in the mix of products distributed and the mix of
distribution channels employed, the emergence of a new industry standards,
product obsolescence and changes in pricing policies by the Company, its
competitors or its suppliers.

     The ASIC business' revenue is concentrated in a limited number of customers
in the areas of consumer electronics, communications products, computers and
computer peripherals. As such, the loss of any such customers or any bad debt
arising from them may have a material adverse impact on the Company's financial
condition and results of operation. Beginning in Fiscal 1999, Valence began to
exit from certain lower margin product offerings in the distribution side of the
business and has begun developing and distributing products that are related to
or incorporate the Company's proprietary technologies. As a result, the
immediate loss in revenue of the low margin distribution business will not be
entirely offset by the new proprietary technology based products, which will
take time to develop and be introduced into the marketplace. There can be no
assurance that the Company will be able to quickly introduce new products to
offset the loss in revenue or that the new products developed will receive a
favorable market acceptance.

     The public offering of common shares of ValenceTech Limited in Hong Kong is
intended to bring new capital to grow Valence's core business while, at the same
time, adding significant value to the Company's shareholders. Although the
Company expects that such offering will be completed during the second quarter
of Fiscal 2000, there is no assurance that the offering will be completed during
that time period or at all. Changes in the economic environment of Hong Kong
and/or the PRC may adversely affect the offering or, if the offering is
completed, may adversely affect the market price of the common shares.

     The acquisition of Valence has added significant diversity to the Company's
overall business structure and the Company's opportunities. The Company
recognizes that in the presence of such corporate diversity, and in particular
with regard to the semiconductor industry, there will always exist a potential
for a conflict among sales channels between the Company and certain of the
Company's technology licensees. Although the operations of the Company's
licensing business and those of Valence are generally complementary, there can
be no assurances that sales channel conflicts will not arise. If such potential
conflicts do materialize, the Company may or may not be able to mitigate the
effect of such perceived conflicts, which, if not resolved, may impact the
results of operations.

  INTERNET BUSINESS

     In Fiscal 1999, the Company launched its Internet business with the
formation of SRSWOWcast.com, Inc. SRSWOWcast.com plans to develop and acquire
engaging and audio based content to generate and retain visitor traffic to its
web site. The revenue of SRSWOWcast.com will, in turn, depend on fees charged to
third party businesses for advertising on the site as well as e-commerce
products sold to visitors to the site. The Company has planned for other
Internet subsidiaries in different geographical regions to be launched at a
later date by duplicating the business model of SRSWOWcast.com and with content
that is adapted for local

                                       26
<PAGE>   27

culture and taste. However, there can be no assurance that SRSWOWcast.com and
other planned subsidiaries or business ventures will be able to develop or
acquire the content necessary to attract significant Internet traffic or able to
generate substantial revenue from advertising and e-commerce.

  PRODUCT BUSINESS

     In Fiscal 1999, the Company developed and marketed on its e-commerce site,
www.wowthing.com, its first consumer audio product, the WOW Thing Processor Box.
The WOW Thing Processor Box enhances the sound quality of music downloaded over
the Internet as well as audio performance of computer and home entertainment
products and speakers. This was the Company's first entry into the consumer
market in the United States which is both competitive and demands products with
short life cycles.

     The Company intends to expand its offerings of high-end audio enhancement
products in the year 2000 and beyond. There can be no assurance that the Company
will be able to develop an effective distribution channel and build a brand
recognition as a product manufacturer. And as the business increases, it is
anticipated that significant capital will be required to finance product
inventory and account receivables. As a result, the Company is subject to risks
of product obsolescence, bad debt and insufficient finance to grow the business.

     The Company also recognizes that as new consumer audio products are
developed and marketed by the Company, there will always exist a potential for a
conflict and competition between the Company and certain of the Company's
technology licensees. Although the intended products of the Company and those of
its licenses do not generally overlap, there can be no assurances that the
Company's products will not compete with those of their licensees. If such
conflicts do materialize, it is uncertain whether the Company will be able to
mitigate the effect of such conflicts, which, if not resolved, may impact the
results of operations.

  ECONOMIC RISKS ASSOCIATED WITH DOING BUSINESS IN ASIA, PARTICULARLY IN HONG
KONG AND THE PRC

     The Company's significant operations in China and Asia have required, and
will continue to require, refinement to adapt to the changing market conditions
in the region. The Company's operations in Asia, and internationally in general,
are subject to risks of unexpected changes in, or impositions of legislative or
regulatory requirements.

     The PRC economy has experienced significant growth in the past decade, but
such growth has been uneven across geographic and economic sectors and has
recently been slowing. There can be no assurance that such growth will not
continue to decrease or that any slow down will not have a negative effect on
the Company's business, including Valence. The PRC economy is also experiencing
deflation which may continue in the future. The current economic situation may
adversely affect the Company's profitability over time as expenditures for
consumer electronics products and information technology may decrease due to the
results of slowing domestic demand and deflation.

     Hong Kong is a Special Administrative Region of the PRC with its own
government and legislature. Hong Kong enjoys a high degree of autonomy from the
PRC under the principle of "one country, two systems". The Company can give no
assurance that Hong Kong will continue to enjoy autonomy from the PRC.

     The Hong Kong dollar has remained relative constant due to the US dollar
peg and currency board system that has been in effect in Hong Kong since 1983.
Since mid-1997, interest rates in Hong Kong have fluctuated significantly and
real estate and retail sales have declined. The Company can give no assurance
that the Hong Kong economy will not worsen or that the historical currency peg
of the Hong Kong dollar to the U.S. dollar will be maintained. Continued
recession in Hong Kong, deflation or the discontinuation of the currency peg
could adversely affect the Company's business.

  CURRENCY RISK/STABILITY OF ASIAN MARKETS

     The Company expects that international sales will continue to represent a
significant portion of total revenues. To date, all of the Company's licensing
revenues have been denominated in U.S. dollars and most
                                       27
<PAGE>   28

costs have been incurred in U.S. dollars. It is the Company's expectation that
licensing revenues will continue to be denominated in U.S. dollars for the
foreseeable future. Because Valence and its subsidiaries' business is primarily
focused in Asia and because of the Company's anticipated expansion of its
business in China and other parts of Asia, the Company's consolidated operations
and financial results could be significantly affected by risks associated with
international activities, including economic and labor conditions, political
instability, tax laws (including U.S. taxes on foreign subsidiaries) and changes
in the value of the U.S. dollar versus the local currency in which the products
are sold. In addition, the Company's valuation of assets recorded as a result of
the Valence acquisition may also be adversely impacted by the currency
fluctuations relative to the U.S. dollar. The Company intends to actively
monitor its foreign exchange exposure and to implement strategies to reduce its
foreign exchange risk at such time that the Company determines the benefits of
such strategies outweigh the associated costs. However, there is no guarantee
that the Company will take steps to insure against such risks, and should such
risks occur, there is no guarantee that the Company will not be significantly
impacted. Countries in the Asia Pacific region have experienced weakness in
their currency, banking and equity markets. These weaknesses could adversely
affect consumer demand for Valence's products, the U.S. dollar value of the
Company's and its subsidiaries' foreign currency denominated sales, the
availability and supply of product components to Valence and ultimately, the
Company's consolidated results of operations.

  COMPETITIVE PRESSURES

     The Company's existing and potential competitors include both large and
emerging domestic and international companies that have substantially greater
financial, manufacturing, technical, marketing, distribution and other
resources. The Company's present or future competitors may be able to develop
products and technologies comparable or superior to those offered by the
Company, and to adapt more quickly than the Company to new technologies or
evolving market needs. The Company believes that the competitive factors
affecting the market for the Company's products and technologies include product
performance, price and quality; product functionality and features; the ease of
integration; and implementation of the products and technologies with other
hardware and software components in the OEM's products. In addition, the markets
in which the Company competes are intensely competitive and are characterized by
rapid technological changes, declining average sales prices and rapid product
obsolescence. Accordingly, there can be no assurance that the Company will be
able to continue to compete effectively in its respective markets, that
competition will not intensify or that future competition will not have a
material adverse effect on the Company's business, operating results, cash flows
and financial condition.

  IMPORTANCE OF INTELLECTUAL PROPERTY

     The Company's ability to compete may be affected by its ability to protect
its proprietary information. The Company has filed several U.S. and foreign
patent applications and to date has a number of issued U.S. and foreign patents
covering various aspects of its technologies. There can be no assurance that the
steps taken by the Company to protect its intellectual property will be adequate
to prevent misappropriation of its technology or that the Company's competitors
will not independently develop technologies that are substantially equivalent or
superior to the Company's technology. In addition, the laws of certain foreign
countries may not protect the Company's intellectual property rights to the same
extent, as do the laws of the U.S. The semiconductor industry is characterized
by frequent claims and litigation regarding patent and other property rights.
The Company is not currently a party to any claims of this nature. There can be
no assurances that third parties will not assert additional claims or initiate
litigation against the Company or its customers with respect to existing or
future products. In addition, the Company may initiate claims or litigation
against third parties for infringement of the Company's proprietary rights or to
determine the scope and validity of the proprietary rights of the Company or
others.

  MANAGEMENT OF GROWTH; DEPENDENCE ON KEY PERSONNEL

     The continued growth of the Company and its subsidiaries has placed, and
will continue to place, a significant strain on its administrative, operational
and financial resources, and has increased, and will continue

                                       28
<PAGE>   29

to increase, the level of responsibility for both existing and new management
personnel. The Company's future success depends in part on the continued service
of its key engineering, sales, marketing and executive personnel, including
highly skilled semiconductor design personnel. The Company anticipates that any
future growth will require it to recruit and hire a number of new personnel in
engineering, operations, finance, sales and marketing. Competition for such
personnel is intense, and there can be no assurance that the Company can retain
and recruit necessary personnel to operate its business and support future
growth. The Company's ability to manage its growth successfully also will
require the Company to continue to expand and improve its administrative,
operational, management and financial systems and controls.

  VOLATILITY OF STOCK PRICE

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

  ACQUISITIONS

     From time-to-time, the Company expects to make acquisitions of businesses
or technologies that are complementary to its business strategy. Such future
acquisitions would expose the Company to risks commonly encountered in
acquisitions of businesses. Such risks include, among others, difficulty of
assimilating the operations, information systems and personnel of the acquired
businesses, the potential disruption of the Company's ongoing business; and the
inability of management to maximize the financial and strategic position of the
Company through successful incorporation of the acquired technologies, employees
and customers. There can be no assurance that any potential acquisition will be
consummated or, if consummated, that it will not have a material adverse effect
on the Company's business, financial condition and results of operations.

  ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT

     Uncertainties that could impede the progress of converting a development
project to a developed technology include the availability of financial
resources to complete the project, failure of the technology to function
properly, continued economic feasibility of developed technologies, customer
acceptance, customer demand and customer qualification of such new technology
and general competitive conditions in the industry. There can be no assurance
that the acquired in-process research and development projects associated with
the acquisitions of Valence and VIP will be successfully completed and
commercially introduced.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     The Company is exposed to a variety of risks, including foreign currency
fluctuations and changes in interest rates affecting the cost of its debt.

FOREIGN CURRENCY

     The Company has subsidiary operations in Hong Kong and China, and
accordingly, the Company is exposed to transaction gains and losses that could
result from changes in foreign currency exchange rates. The Company uses the
local currency (Hong Kong dollars) as the functional currency for its
subsidiaries. Translation adjustments resulting from the process of translating
foreign currency financial statements into U.S. dollars were nil in Fiscal 1998
and 1999 due to the fact that the value of the Hong Kong dollar is currently
pegged to the U.S. dollar, and the exchange rate remained constant throughout
such fiscal years. Under the current circumstances, the Company believes that
the foreign currency market risk is not material. The Company actively monitors
its foreign exchange exposure and, should circumstances change, intends to

                                       29
<PAGE>   30

implement strategies to reduce its risk at such time that it determines that the
benefits of such strategies outweigh the associated costs. There can be no
assurance that management's efforts to reduce foreign exchange exposure will be
successful.

INTEREST RATES

     The Company's line of credit bears interest based on the lending bank's
prime rate or LIBOR. The interest rate on the balance of $8 million outstanding
at December 31, 1999 was 6.875%. If interest rates were to increase by 10%, the
impact on the Company's consolidated financial statements would be additional
interest expense of approximately $55,000.

                                       30
<PAGE>   31

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                         INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                              PAGE
                                                              ----
<S>                                                           <C>
CONSOLIDATED FINANCIAL STATEMENTS:
  Independent Auditors' Report..............................   32
  Consolidated Balance Sheets as of December 31, 1998 and
     1999...................................................   33
  Consolidated Statements of Operations for the years ended
     December 31, 1997, 1998 and 1999.......................   34
  Consolidated Statements of Comprehensive Income (Loss) for
     the years ended December 31, 1997, 1998 and 1999.......   34
  Consolidated Statements of Stockholders' Equity for the
     years ended December 31, 1997, 1998 and 1999...........   35
  Consolidated Statements of Cash Flows for the years ended
     December 31, 1997, 1998 and 1999.......................   36
  Notes to Consolidated Financial Statements................   38

FINANCIAL STATEMENT SCHEDULE:
  Schedule II -- Valuation and Qualifying Accounts and
     Reserves for the years ended December 31, 1998 and
     1999...................................................   53
</TABLE>

                                       31
<PAGE>   32

                          INDEPENDENT AUDITORS' REPORT

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

     We have audited the accompanying consolidated balance sheets of SRS Labs,
Inc. (the "Company") as of December 31, 1998 and 1999, and the related
consolidated statements of operations, comprehensive income (loss),
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 1999. Our audits also included the financial statement
schedule listed in the Index at Item 14(a)(2). These financial statements and
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements and
financial statement schedule based on our audits.

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

     In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of SRS Labs, Inc. as of December
31, 1998 and 1999, and the results of its operations and its cash flows for each
of the three years in the period ended December 31, 1999, in conformity with
accounting principles generally accepted in the United States of America. Also,
in our opinion, such financial statement schedule, when considered in relation
to the basic financial statements taken as a whole, presents fairly in all
material respects the information set forth therein.

/s/ DELOITTE & TOUCHE LLP

Costa Mesa, California
March 3, 2000
(March 9, 2000 as to Note 13)

                                       32
<PAGE>   33

                                 SRS LABS, INC.

                          CONSOLIDATED BALANCE SHEETS

                                     ASSETS

<TABLE>
<CAPTION>
                                                              DECEMBER 31,    DECEMBER 31,
                                                                  1998            1999
                                                              ------------    ------------
<S>                                                           <C>             <C>
Current Assets
  Cash and cash equivalents.................................  $ 12,341,242    $ 15,969,678
  Investments available for sale............................     1,519,425       3,011,250
  Accounts receivable, net of allowance for doubtful
     accounts of $422,138 in 1998 and $1,083,961 in 1999....     5,320,686       2,495,157
  Inventories, net of reserve of $653,370 in 1998 and
     $624,844 in 1999.......................................     4,632,968       2,726,193
  Prepaid expenses and other current assets, including other
     receivables of $2,131,352 in 1998 and $161,258 in
     1999...................................................     3,244,233         729,881
  Deferred income taxes.....................................        17,456          81,467
                                                              ------------    ------------
          Total Current Assets..............................    27,076,010      25,013,626
  Investments available for sale............................    10,570,192       6,331,483
  Furniture, fixtures and equipment, net....................     1,219,433       1,166,757
  Intangible assets, net....................................     6,669,671       5,425,273
  Deferred income taxes.....................................            --         740,889
  Other assets..............................................            --         422,493
                                                              ------------    ------------
          Total Assets......................................  $ 45,535,306    $ 39,100,521
                                                              ============    ============

                           LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
  Accounts payable..........................................  $ 10,632,505    $  2,882,686
  Accrued liabilities.......................................       422,843       1,658,964
  Line of credit............................................     8,000,000       8,000,000
  Income taxes payable......................................       376,545       1,518,548
                                                              ------------    ------------
          Total Current Liabilities.........................    19,431,893      14,060,198
Deferred income taxes.......................................        31,240              --
Commitments and contingencies
Stockholders' Equity
  Preferred stock -- $.001 par value; 2,000,000 shares
     authorized; no shares issued and outstanding...........            --              --
  Common stock -- $.001 par value; 56,000,000 shares
     authorized; 11,688,893 and 11,890,691 shares issued;
     and 11,688,893 and 11,819,591 outstanding for 1998 and
     1999, respectively.....................................        11,689          11,891
  Additional paid-in capital................................    39,170,103      40,312,336
  Deferred stock option compensation........................       313,302         264,557
  Cumulative other comprehensive income.....................       141,389          23,330
  Retained deficit..........................................   (13,564,310)    (15,308,510)
  Treasury stock at cost, -0- and 71,100 shares at December
     31, 1998 and 1999......................................            --        (263,281)
                                                              ------------    ------------
          Total Stockholders' Equity........................    26,072,173      25,040,323
                                                              ------------    ------------
          Total Liabilities And Stockholders' Equity........  $ 45,535,306    $ 39,100,521
                                                              ============    ============
</TABLE>

          See accompanying notes to consolidated financial statements
                                       33
<PAGE>   34

                                 SRS LABS, INC.

                     CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                              YEAR ENDED DECEMBER 31,
                                                     ------------------------------------------
                                                        1997            1998           1999
                                                     -----------    ------------    -----------
<S>                                                  <C>            <C>             <C>
REVENUES
Chip and licensing revenue.........................  $10,081,283    $ 15,762,369    $18,624,221
Product and component sales........................           --      28,962,671     17,171,362
                                                     -----------    ------------    -----------
          TOTAL REVENUES...........................   10,081,283      44,725,040     35,795,583
COST OF SALES......................................      210,348      29,819,071     22,002,817
                                                     -----------    ------------    -----------
GROSS MARGIN.......................................    9,870,935      14,905,969     13,792,766
EXPENSES
Sales and marketing................................    2,111,839       6,845,674      5,148,458
Research and development...........................      595,689       2,554,883      4,141,571
General and administrative.........................    2,615,706       5,530,957      6,932,397
Acquired in-process research and development.......           --      18,510,378             --
                                                     -----------    ------------    -----------
          TOTAL EXPENSES...........................    5,323,234      33,441,892     16,222,426
          INCOME (LOSS) FROM OPERATIONS............    4,547,701     (18,535,923)    (2,429,660)
OTHER INCOME, NET..................................    1,088,718         704,992        735,122
                                                     -----------    ------------    -----------
INCOME (LOSS) BEFORE INCOME TAX EXPENSE
  (BENEFIT)........................................    5,636,419     (17,830,931)    (1,694,538)
INCOME TAX EXPENSE (BENEFIT).......................    1,863,200        (273,156)        49,662
                                                     -----------    ------------    -----------
NET INCOME (LOSS)..................................  $ 3,773,219    $(17,557,775)   $(1,744,200)
                                                     ===========    ============    ===========
Net income (loss) per common share:
  Basic............................................  $      0.39    $      (1.54)   $     (0.15)
                                                     ===========    ============    ===========
  Diluted..........................................  $      0.35    $      (1.54)   $     (0.15)
                                                     ===========    ============    ===========
Weighted average shares used in the calculation of
  net income (loss) per common share:
  Basic............................................    9,556,015      11,410,346     11,696,272
                                                     ===========    ============    ===========
  Diluted..........................................   10,852,281      11,410,346     11,696,272
                                                     ===========    ============    ===========
</TABLE>

                                 SRS LABS, INC.

             CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

<TABLE>
<CAPTION>
                                                               YEAR ENDED DECEMBER 31,
                                                      -----------------------------------------
                                                         1997           1998           1999
                                                      ----------    ------------    -----------
<S>                                                   <C>           <C>             <C>
Net income (loss)...................................  $3,773,219    $(17,557,775)   $(1,744,200)
Other comprehensive income (loss)
  Foreign currency translation......................          --              --         (4,827)
  Unrealized gain (loss) on investments available
     for sale, net of tax...........................      75,912         (22,211)      (113,232)
                                                      ----------    ------------    -----------
Comprehensive income (loss).........................  $3,849,131    $(17,579,986)   $(1,862,259)
                                                      ==========    ============    ===========
</TABLE>

          See accompanying notes to consolidated financial statements
                                       34
<PAGE>   35

                                 SRS LABS, INC.

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
                                                                                                                     CUMULATIVE
                                                                                                                        OTHER
                                     COMMON STOCK                                       DEFERRED       RETAINED     COMPREHENSIVE
                                 --------------------     ADDITIONAL      TREASURY    STOCK OPTION     EARNINGS        INCOME
                                   SHARES     AMOUNT    PAID-IN CAPITAL     STOCK     COMPENSATION    (DEFICIT)        (LOSS)
                                 ----------   -------   ---------------   ---------   ------------   ------------   -------------
<S>                              <C>          <C>       <C>               <C>         <C>            <C>            <C>
BALANCE, January 1, 1997.......   9,468,548   $ 9,469     $24,678,961     $      --    $ 154,386     $    220,246     $  87,688
  Proceeds from exercise of
    stock options..............     141,319       141         144,461            --           --               --            --
  Tax benefit associated with
    exercise of stock
    options....................          --        --         199,015            --           --               --            --
  Deferred stock option
    compensation...............          --        --              --            --       76,701               --            --
  Unrealized gain on
    investments available for
    sale, net of tax...........          --        --              --            --           --               --        75,912
  Net income...................          --        --              --            --           --        3,773,219            --
                                 ----------   -------     -----------     ---------    ---------     ------------     ---------
BALANCE, December 31, 1997.....   9,609,867     9,610      25,022,437            --      231,087        3,993,465       163,600
  Proceeds from exercise of
    stock options..............     213,121       213         311,199            --           --               --            --
  Tax benefit associated with
    exercise of stock
    options....................          --        --          13,623            --           --               --            --
  Deferred stock option
    compensation...............          --        --              --            --       82,215               --            --
  Unrealized loss on
    investments available for
    sale, net of tax...........          --        --              --            --           --               --       (22,211)
  Issuance of common stock to
    acquire Valence............   1,680,611     1,681      12,104,097            --           --               --            --
  Issuance of common stock for
    noncompetition
    agreements.................     125,000       125         900,275            --           --               --            --
  Issuance of common stock and
    warrants to acquire VIP....      25,000        25         518,507            --           --               --            --
  Issuance of common stock to
    acquire Circle Surround....      35,294        35         299,965            --           --               --            --
  Net loss.....................          --        --              --            --           --      (17,557,775)           --
                                 ----------   -------     -----------     ---------    ---------     ------------     ---------
BALANCE, December 31, 1998.....  11,688,893    11,689      39,170,103            --      313,302      (13,564,310)      141,389
  Proceeds from exercise of
    stock options..............     201,798       202         760,857            --     (170,263)              --            --
  Tax benefit associated with
    exercise of stock
    options....................          --        --         381,376            --           --               --            --
  Deferred stock option
    compensation...............          --        --                            --      121,518               --            --
  Treasury stock...............     (71,100)       --              --      (263,281)          --               --            --
  Unrealized gain on
    investments available for
    sale, net of tax...........          --        --              --            --           --               --      (113,232)
  Currency translation
    adjustment.................          --        --              --            --           --               --        (4,827)
  Net loss.....................          --        --              --            --           --       (1,744,200)           --
                                 ----------   -------     -----------     ---------    ---------     ------------     ---------
BALANCE, December 31, 1999.....  11,819,591   $11,891     $40,312,336     $(263,281)   $ 264,557     $(15,308,510)    $  23,330
                                 ==========   =======     ===========     =========    =========     ============     =========

<CAPTION>

                                    TOTAL
                                 ------------
<S>                              <C>
BALANCE, January 1, 1997.......  $ 25,150,750
  Proceeds from exercise of
    stock options..............       144,602
  Tax benefit associated with
    exercise of stock
    options....................       199,015
  Deferred stock option
    compensation...............        76,701
  Unrealized gain on
    investments available for
    sale, net of tax...........        75,912
  Net income...................     3,773,219
                                 ------------
BALANCE, December 31, 1997.....    29,420,199
  Proceeds from exercise of
    stock options..............       311,412
  Tax benefit associated with
    exercise of stock
    options....................        13,623
  Deferred stock option
    compensation...............        82,215
  Unrealized loss on
    investments available for
    sale, net of tax...........       (22,211)
  Issuance of common stock to
    acquire Valence............    12,105,778
  Issuance of common stock for
    noncompetition
    agreements.................       900,400
  Issuance of common stock and
    warrants to acquire VIP....       518,532
  Issuance of common stock to
    acquire Circle Surround....       300,000
  Net loss.....................   (17,557,775)
                                 ------------
BALANCE, December 31, 1998.....    26,072,173
  Proceeds from exercise of
    stock options..............       590,796
  Tax benefit associated with
    exercise of stock
    options....................       381,376
  Deferred stock option
    compensation...............       121,518
  Treasury stock...............      (263,281)
  Unrealized gain on
    investments available for
    sale, net of tax...........      (113,232)
  Currency translation
    adjustment.................        (4,827)
  Net loss.....................    (1,744,200)
                                 ------------
BALANCE, December 31, 1999.....  $ 25,040,323
                                 ============
</TABLE>

          See accompanying notes to consolidated financial statements
                                       35
<PAGE>   36

                                 SRS LABS, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                       YEAR ENDED DECEMBER 31,
                                                              ------------------------------------------
                                                                 1997            1998           1999
                                                              -----------    ------------    -----------
<S>                                                           <C>            <C>             <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)...........................................  $ 3,773,219    $(17,557,775)   $(1,744,200)
Adjustments to reconcile net income (loss) to net cash
  provided by operating activities:
    Provision for doubtful accounts.........................           --         (82,785)   $ 1,040,271
    Provision for obsolete inventory........................           --         353,814        628,006
    Depreciation and amortization...........................      341,152       1,888,635      2,127,736
    Deferred income taxes...................................        5,615        (298,205)      (836,140)
    Write-off of acquired in-process research and
      development...........................................           --      18,510,378             --
    Realized gain on sales of investments available for
      sale..................................................           --         (86,337)            --
    Amortization of premium on investments available for
      sale..................................................      109,817          62,534         54,964
    Accretion of consideration due on asset purchase........       23,844           8,196             --
    Increase in deferred stock option compensation..........       76,701          82,215        121,518
    Currency translation adjustment.........................           --              --         (4,827)
    Loss on disposition of furniture, fixtures and
      equipment.............................................           --              --          1,594
    Changes in operating assets and liabilities, net of the
      effect of acquisitions:
      Accounts receivable...................................   (3,286,961)      2,024,562      1,785,258
      Inventories...........................................           --       1,645,004      1,278,769
      Prepaid expenses and other assets.....................     (127,186)     (2,212,510)     2,091,859
      Accounts payable......................................      (73,202)      1,878,303     (7,749,819)
      Accrued liabilities...................................      260,103        (403,399)     1,236,121
      Income taxes payable..................................      726,519        (790,542)     1,602,067
                                                              -----------    ------------    -----------
    Net cash provided by operating activities...............    1,829,621       5,022,088      1,633,177
                                                              -----------    ------------    -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of furniture, fixtures and equipment...............      (64,582)       (466,368)      (464,037)
Proceeds from sales of investments available for sale.......           --       9,467,572      2,500,000
Purchases of investments available for sale.................     (580,256)             --             --
Cash paid for acquisitions, less cash acquired..............           --      (6,911,216)            --
Expenditures related to patents.............................     (103,877)       (590,555)      (368,219)
                                                              -----------    ------------    -----------
    Net cash (used in) provided by investing activities.....     (748,715)      1,499,433      1,667,744
                                                              -----------    ------------    -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from line of credit................................           --       8,000,000             --
Payments on subsidiary debt.................................           --      (6,846,737)            --
Payment of consideration due on asset purchase..............     (234,752)        (91,707)            --
Exercise of stock options...................................      144,602         311,412        590,796
Purchase of treasury stock..................................           --              --       (263,281)
                                                              -----------    ------------    -----------
    Net cash (used in) provided by financing activities.....      (90,150)      1,372,968        327,515
                                                              -----------    ------------    -----------
NET INCREASE IN CASH AND CASH EQUIVALENTS...................      990,756       7,894,489      3,628,436
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD..............    3,455,997       4,446,753     12,341,242
                                                              -----------    ------------    -----------
CASH AND CASH EQUIVALENTS, END OF PERIOD....................  $ 4,446,753    $ 12,341,242    $15,969,678
                                                              ===========    ============    ===========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
  Cash paid during the period for:
    Interest................................................  $        --    $    488,732    $   179,194
    Income taxes............................................  $   811,700    $    640,079    $        --
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND
  FINANCING ACTIVITIES:
    Additional consideration accrued for asset purchase.....  $    44,077    $      8,196    $        --
    Unrealized gain (loss) on investments, net..............  $    75,912    $    (22,211)   $   113,232
    Tax benefit associated with exercise of stock options...  $   199,015    $     13,623    $   381,376
</TABLE>

          See accompanying notes to consolidated financial statements
                                       36
<PAGE>   37

     The Company acquired the stock of Valence Technology Inc. ("Valence") on
March 2, 1998 (Notes 2 and 9) and issued 1,680,611 shares of common stock in
payment of $12,105,778 of the acquisition price. The acquisition was accounted
for as a purchase having an effective date of February 1, 1998.

     In conjunction with the acquisition, certain liabilities were assumed as
follows:

<TABLE>
<S>                                                           <C>
Fair value of assets acquired...............................  $ 14,076,279
Acquired in-process research and development costs..........    17,471,668
Acquired intangible assets..................................     5,910,400
Total consideration, including acquisition costs............   (21,879,033)
                                                              ------------
Liabilities assumed.........................................  $ 15,579,314
                                                              ============
</TABLE>

     The Company issued 125,000 shares of common stock in consideration for
certain non-competition agreements with the key employees of Valence. The shares
have an ascribed fair value of $900,400 (Notes 2 and 9).

     The Company issued 25,000 shares of common stock and warrants to purchase
100,000 shares of common stock in conjunction with the acquisition of Voice
Intelligibility Processor ("VIP"). The shares and warrants have an ascribed fair
value of $176,575 and $341,957, respectively (Notes 2 and 9).

     The Company issued 35,294 shares of common stock in conjunction with the
acquisition of certain rights associated with the Circle Surround technology.
The shares have an ascribed fair value of $300,000 (Notes 2 and 9).

                                       37
<PAGE>   38

                                 SRS LABS, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999

 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES

     Organization

     SRS Labs, Inc. (the "Company" or "SRS") was incorporated under the laws of
the State of California on June 23, 1993 and reincorporated under the laws of
the State of Delaware on June 28, 1996.

     The Company is a developer and provider of technology solutions for the
consumer electronics, computer, game and telecommunications markets. For the
fiscal year ended December 31, 1999, the Company's principal business activities
in these markets included:

     - Developing and licensing audio and voice technologies to original
       equipment manufacturers ("OEMs") and semiconductor manufacturers around
       the world; and

     - Through its subsidiary, Valence Technology Inc. and its foreign
       subsidiaries, designing and selling technology solutions through custom
       application specific integrated circuits ("ASICs") to OEMs; and
       designing, distributing and manufacturing components, sub-assemblies and
       finished goods for the OEM and retail communities within the Company's
       targeted markets.

     Basis of Presentation

     The consolidated financial statements include the Company and its wholly
owned subsidiaries, Valence Technology Inc. ("Valence") and SRSWOWcast.com,
Inc., after elimination of all intercompany accounts and transactions.

     Cash Equivalents

     Cash and cash equivalents generally consist of cash, money market funds and
other money market instruments with original or remaining maturities of three
months or less at the date of purchase.

     Investments

     The Company accounts for investments in accordance with Statement of
Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain
Investments in Debt and Equity Securities". Investments, consisting primarily of
municipal bonds, have been classified as available for sale and are reported at
fair value, based on quoted market prices, in the accompanying consolidated
balance sheets. Unrealized gains and losses, net of applicable income taxes, are
reported as a separate component of stockholders' equity.

     Inventories

     Inventories, which consist of finished goods, are stated at the lower of
cost or net realizable value. Cost is calculated using the weighted average
method and is comprised of material costs and, where applicable, subcontracting
and overhead costs that have been incurred in bringing the inventories to their
present location and condition. Net realizable value represents the estimated
selling price less estimated costs to completion and costs to be incurred in
selling and distribution.

     Furniture, Fixtures and Equipment

     Furniture, fixtures and equipment are stated at cost, net of accumulated
depreciation and amortization. Depreciation and amortization are provided for
using the straight-line method, which amortizes cost over the lesser of the
estimated useful lives of the respective assets or the term of the related
lease. Useful lives range from three to five years.

                                       38
<PAGE>   39
                                 SRS LABS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999

     Patents and Other Intangible Assets

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

     Consideration for the purchase of assets in excess of the fair market value
of specifically identified tangible assets has been capitalized as other
intangible assets in the accompanying consolidated balance sheets. These assets
are being amortized over periods ranging from three to eleven years depending on
the useful life of the asset. The Company annually evaluates the recoverability
of its intangible assets based on the estimated future undiscounted cash flows.
Should the carrying value of intangible assets exceed the estimated operating
incomes for the expected periods of benefit, impairment for the excess is
recorded at that time.

     Other Assets

     Other assets consist primarily of notes receivable with expected collection
dates beyond December 31, 2000.

     Use of Estimates

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

     Revenue Recognition

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

     Revenue from product sales is generally recognized upon shipment. Design
revenue under design contracts is recognized on the percentage-of-completion
method. Estimates are reviewed and revised periodically throughout the lives of
the contracts. Any revisions are recorded in the accounting period in which the
revisions are made.

     Commission income derived from the Company's distribution activities is
recognized on an accrual basis in the period when earned.

     Research and Development

     Research and development expenses include costs and expenses associated
with the development of the Company's design methodology and the design and
development of new products, including initial nonrecurring engineering and
product verification charges from foundries. Research and development is
expensed as incurred.

                                       39
<PAGE>   40
                                 SRS LABS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999

     Income Taxes

     The Company accounts for income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes." Deferred taxes on income result from temporary
differences between the reporting of income for financial statement and tax
reporting purposes.

     Foreign Currency Translation

     The Company's reporting currency is the U.S. dollar, while the functional
currency of Valence is the Hong Kong dollar. Assets and liabilities of Valence
are translated at the rate of exchange on the balance sheet date. Revenues and
expenses are translated using the average exchange rate for the period.
Translation adjustments resulting from the process of translating foreign
currency financial statements into U.S. dollars are included as a separate
component of stockholders' equity (other comprehensive income). Translation
adjustments were $0 and $4,827 during the years ended December 31, 1998 and
1999. Transaction gains and losses arising on exchange are recognized as
incurred in the statements of operations and aggregated $76,000 (gain) and
$26,775 (loss) during the years ended December 31, 1998 and 1999.

     Net Income (Loss) Per Common Share

     Effective December 31, 1997, the Company adopted SFAS No. 128, "Earnings
per Share," which requires the disclosure of basic and diluted earnings per
share for all current and prior periods. Basic net income (loss) per common
share is computed by dividing income available to common stockholders by the
weighted-average number of common shares outstanding during each year. Diluted
net income per common share reflects the maximum dilution, based on the average
price of the Company's common stock each period and is computed similar to basic
income (loss) per share except that the denominator is increased to include the
number of additional shares that would have been outstanding if potentially
dilutive stock options had been exercised. Common stock equivalents have not
been included in calculating diluted net income (loss) per share where inclusion
would be anti-dilutive.

     The following is an illustration of the reconciliation of the numerators
and the denominators of the basic and diluted net income (loss) per common share
computations:
<TABLE>
<CAPTION>
                                    FOR YEAR ENDED DECEMBER 31, 1997           FOR YEAR ENDED DECEMBER 31, 1998
                                 ---------------------------------------   ----------------------------------------
                                   INCOME         SHARES       PER SHARE      INCOME         SHARES       PER SHARE
                                 (NUMERATOR)   (DENOMINATOR)    AMOUNT     (NUMERATOR)    (DENOMINATOR)    AMOUNT
                                 -----------   -------------   ---------   ------------   -------------   ---------
<S>                              <C>           <C>             <C>         <C>            <C>             <C>
Basic:
Income (loss) available to
 common stockholders...........  $3,773,219      9,556,015       $0.39     $(17,557,775)   11,410,346      $(1.54)
                                                                 =====                                     ======
Diluted Effect of dilutive
 securities....................          --      1,296,266                           --            --
                                 ----------     ----------                 ------------    ----------
Stock options
Income available to common
 stockholders plus assumed
 conversion....................  $3,773,219     10,852,281       $0.35     $(17,557,775)   11,410,346      $(1.54)
                                 ==========     ==========       =====     ============    ==========      ======

<CAPTION>
                                    FOR YEAR ENDED DECEMBER 31, 1999
                                 ---------------------------------------
                                   INCOME         SHARES       PER SHARE
                                 (NUMERATOR)   (DENOMINATOR)    AMOUNT
                                 -----------   -------------   ---------
<S>                              <C>           <C>             <C>
Basic:
Income (loss) available to
 common stockholders...........  $(1,744,200)   11,696,272      $(0.15)
                                                                ======
Diluted Effect of dilutive
 securities....................           --            --
                                 -----------    ----------
Stock options
Income available to common
 stockholders plus assumed
 conversion....................  $(1,744,200)   11,696,272      $(0.15)
                                 ===========    ==========      ======
</TABLE>

     Stock-Based Compensation

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

     Fair Value of Financial Instruments

     Management believes the carrying amounts of cash and cash equivalents,
accounts receivable and accounts payable approximate fair value due to the short
period of time between origination of the instruments

                                       40
<PAGE>   41
                                 SRS LABS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999

and their expected realization. Management also believes the carrying amounts of
investments available for sale approximate fair value as the investments are
recorded at fair value based on quoted market prices (Note 3). Management
believes the carrying amount of balances outstanding under the line of credit
approximate fair value as the underlying interest rates reflect market rates.

     Customer Concentration

     During the years ended December 31, 1997 and 1998, two customers (not
necessarily the same customers each year) accounted for 39% and 40%,
respectively, of revenues. For Fiscal 1999, one customer accounted for 21% of
revenues. Given the significant amount of revenues derived from these customers,
the loss of any such customer or the uncollectibility of related receivables
could have a material adverse effect on the Company's financial condition and
results of operations.

     Concentrations of Credit Risk

     Financial instruments, which potentially subject the Company to
concentrations of credit risk, consist primarily of cash equivalents,
investments, trade accounts receivable and the bank credit line. The Company
places its cash in banks and its cash equivalents in commercial paper.
Investments consist primarily of short-term and long-term municipal bonds. The
Company has not experienced any significant losses on its cash equivalents or
investments. Market risk on the bank credit line relates to changes in the
bank's lending rates, including the bank's reference rate and LIBOR, on which
interest charges on the Company's borrowings under the line are based.

     The Company's trade receivables are derived from sales to manufacturers and
distributors in the consumer electronics, computer and communications markets
primarily in Asia, North America and Europe. The Company makes periodic
evaluations of the creditworthiness of its customers and manages its exposure to
losses from bad debts by limiting the amount of credit extended whenever deemed
necessary and generally does not require collateral. The Company maintains a
provision for potential credit losses and such losses have historically been
within management's expectations.

     Geographic Risk

     The Asian consumer electronics markets accounted for approximately 94% and
92% of total Company sales in 1999 and 1998 and are expected to continue to
account for a substantial percentage of sales in the future. The recent economic
crisis in Asia has been characterized by declines in consumer spending, currency
devaluation, unemployment and bank failures. Any of these factors, should they
continue, could significantly reduce the demand for the end user goods in which
the Company's products are used.

     Recent Accounting Pronouncements

     In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
Accounting for Derivative Instruments and Hedging Activities, which is effective
for fiscal years beginning after June 15, 2000. This standard establishes
accounting and reporting standards for derivative instruments and for hedging
activities and requires that an entity recognize all derivatives as either
assets or liabilities in the statement of financial position and measure those
instruments at fair value. The Company does not believe that the adoption of
this new standard will have a material impact on its financial position or
results of operations.

     Reclassifications

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

                                       41
<PAGE>   42
                                 SRS LABS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999

 2. ACQUISITIONS

     On March 2, 1998, the Company acquired (the "Acquisition") all of the
outstanding shares of capital stock of Valence Technology Inc., a British Virgin
Islands holding company with its principal business operations in Hong Kong and
China ("Valence"). Valence, which conducts its operations through its
subsidiaries based in Hong Kong and China, is engaged in the following business
activities: (i) the development and marketing of technology in the form of
integrated circuits (ASICs) to original equipment manufacturers and (ii) the
sale of consumer electronic and telecommunications products and components.

     The Valence acquisition included certain assets and liabilities and all
intellectual property rights to the products as well as in-process research and
development activities. The aggregate purchase price of $19,500,000, excluding
acquisition costs and non-compete agreements, consisted of approximately
$7,400,000 in cash, of which the Company utilized its existing cash balances and
1,680,611 shares of the Company's common stock with a fair value of $12,105,778.
The acquisition was accounted for as a purchase having an effective date of
February 1, 1998, and accordingly, the total purchase price was allocated to the
assets acquired and liabilities assumed at their estimated fair values in
accordance with APB Opinion No. 16. The Company's consolidated statement of
operations for the year ended December 31, 1998 includes a charge of $17.5
million for the write-off of acquired in-process research and development
expense associated with the Valence acquisition. In connection with the
acquisition, three of the four management shareholders and their respective sole
shareholders, each of whom was a key employee of Valence or one of its
subsidiaries, entered into non-competition agreements with the Company. In
consideration for these agreements and for a nominal cash payment equal to the
par value of the shares, the Company issued 125,000 additional shares of its
common stock, with a fair value of $900,400 in aggregate, to such three
shareholders. The following summarizes the consideration granted for the
acquisition of Valence and the non-compete agreements, the allocation of the
purchase price and other purchase accounting adjustments:

<TABLE>
<S>                                                           <C>
Cash........................................................  $ 7,394,222
Common stock................................................   13,006,178
                                                              -----------
Total purchase price........................................   20,400,400
Deficiency in net assets acquired...........................    1,503,035
Acquisition costs...........................................    1,478,633
                                                              -----------
Excess of purchase price over net assets acquired...........  $23,382,068
                                                              ===========
Allocation to:
  In-process research and development.......................  $17,471,668
  Developed technology......................................    1,200,000
  Cell library..............................................    1,150,000
  Customer list.............................................    1,000,000
  Workforce.................................................    1,000,000
  Non-compete agreement.....................................      900,400
  Brand name................................................      660,000
                                                              -----------
                                                              $23,382,068
                                                              ===========
</TABLE>

     The in-process research and development expenses arose from new product
projects that were under development at the date of the acquisition and expected
to eventually lead to new products, but had not yet established technological
feasibility and for which no future alternative use was identified. The
valuation of the in-process research and development projects was based upon the
discounted expected future net cash flows of the products over the products'
expected life, reflecting the estimated stages of completion of the projects and
the estimated costs to complete the projects.

                                       42
<PAGE>   43
                                 SRS LABS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999

     New product development projects underway at Valence at the time of the
acquisition included, among others, ASICs for consumer electronics, computing
and voice and audio applications, home entertainment systems, digital multimedia
players and digital power amplifiers. The Company estimated that these projects
were approximately 63% complete at the date of acquisition and estimated that
the cost to complete these projects will aggregate approximately $7 million and
will be incurred over a three-year period.

     Uncertainties that could impede the progress of converting a development
project to a developed technology include the availability of financial
resources to complete the project, failure of the technology to function
properly, continued economic feasibility of developed technologies, customer
acceptance, customer demand and customer qualification of such new technology
and general competitive conditions in the industry. There can be no assurance
that the in-process research and development projects will be successfully
completed and commercially introduced.

     The following unaudited pro forma consolidated condensed statement of
operations for the year ended December 31, 1997 has been prepared by combining
the statement of operations of SRS for the year ended December 31, 1997 with the
consolidated statement of operations of Valence for the year ended March 31,
1998. Pro forma results for the year ended December 31, 1998 do not differ
materially from the results of operations set forth in the accompanying
statement of operations. The pro forma information is presented for information
purposes only and is not necessarily indicative of what actually would have
occurred if the acquisition had been in effect for the entire period presented,
or of future operations of the combined companies.

<TABLE>
<CAPTION>
                                                                  PRO FORMA
                                                                 YEAR ENDED
                                                              DECEMBER 31, 1997
                                                              -----------------
<S>                                                           <C>
Revenues....................................................     $47,377,020
Costs and expense...........................................      45,369,225
                                                                 -----------
Net income..................................................     $ 2,007,795
                                                                 ===========
Net income per share........................................     $      0.16
                                                                 ===========
</TABLE>

     On February 28, 1998, the Company acquired certain rights to a proprietary
technology, Voice Intelligibility Processor ("VIP"), from a third party. The
aggregate consideration, including acquisition costs, was $1,138,710 and was
comprised of $620,178 in cash, 25,000 shares of the Company's common stock with
a fair value of $176,575 and warrants to purchase 100,000 shares of the
Company's common stock at $9.47 per share with a fair value of $341,957. The
portion of the purchase price allocated to acquired in-process research and
development, $1,038,710, was charged to the Company's operations. The remainder
of the purchase price was allocated to an intangible asset and is being
amortized over eight years.

     The following summarizes the consideration granted for the acquisition of
VIP, the allocation of the purchase price and other purchase accounting
adjustments:

<TABLE>
<S>                                                           <C>
Cash........................................................  $  500,000
Common stock and warrants...................................     518,532
Acquisition costs...........................................     120,178
                                                              ----------
          Total purchase price..............................  $1,138,710
                                                              ==========
Allocation to:
  In-process research and development.......................  $1,038,710
  Intangible assets.........................................     100,000
                                                              ----------
                                                              $1,138,710
                                                              ==========
</TABLE>

                                       43
<PAGE>   44
                                 SRS LABS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999

     The in-process research and development expenses arose from new product
projects that were under development at the date of the acquisition and expected
to eventually lead to new products, but had not yet established technological
feasibility and for which no future alternative use was identified. The
valuation of the in-process research and development projects was based upon the
discounted expected future net cash flows of the products over the products'
expected life, reflecting the estimated stages of completion of the projects and
the costs to complete the projects.

     New product development projects utilizing the VIP technology at the time
of the acquisition included, among others, digital and analog sound
reinforcement, wireless and non-wireless telecommunications applications,
hearing aid applications, and headphone and microphone applications. The Company
estimated that these projects were approximately 62% complete at the date of
acquisition and estimated that the cost to complete these projects will
aggregate approximately $525,000 and will be incurred over a two-year period.

     Uncertainties that could impede the progress of converting a development
project to a developed technology include the availability of financial
resources to complete the project, failure of the technology to function
properly, continued economic feasibility of developed technologies, customer
acceptance, customer demand and customer qualification of such new technology
and general competitive conditions in the industry. There can be no assurance
that the in-process research and development projects will be successfully
completed and commercially introduced.

     The Company's financial statements for the year ended December 31, 1998,
reflect one-time charges related to in-process research and development expenses
of $17,471,668 associated with the Valence acquisition and $1,038,710 associated
with the VIP acquisition.

     On May 21, 1998, the Company acquired certain rights to a proprietary
technology, Circle Surround, from a third party. The aggregate consideration,
including acquisition costs, was $834,985 and was comprised of $534,985 in cash
and 35,294 shares of the Company's common stock with a fair value of $300,000.
The purchase price was allocated to an intangible asset and is being amortized
over ten years.

 3. INVESTMENT SECURITIES AVAILABLE FOR SALE

     The following table summarizes the Company's investment securities
available for sale as of December 31, 1998 and 1999:

<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                     -------------------------
                                                        1998           1999
                                                     -----------    ----------
<S>                                                  <C>            <C>
Municipal bonds available for sale:
  Cost.............................................  $11,849,972    $9,295,010
  Unrealized gains.................................      239,645        47,723
                                                     -----------    ----------
  Estimated fair value.............................  $12,089,617    $9,342,733
                                                     ===========    ==========
</TABLE>

                                       44
<PAGE>   45
                                 SRS LABS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999

     The contractual maturities of investments at December 31, 1998 and 1999,
are shown below. Actual maturities may differ from contractual maturities.

<TABLE>
<CAPTION>
                                        1998                         1999
                             --------------------------    ------------------------
                                             ESTIMATED                   ESTIMATED
                                COST        FAIR VALUE        COST       FAIR VALUE
                             -----------    -----------    ----------    ----------
<S>                          <C>            <C>            <C>           <C>
Municipal bonds:
  Due in one year or
     less..................  $ 1,505,168    $ 1,519,425    $2,993,206    $3,011,250
  Due in one to five
     years.................    9,344,804      9,570,192     6,301,804     6,331,483
  Due in five to ten
     years.................           --             --            --            --
  Due after ten years......    1,000,000      1,000,000            --            --
                             -----------    -----------    ----------    ----------
                             $11,849,972    $12,089,617    $9,295,010    $9,342,733
                             ===========    ===========    ==========    ==========
</TABLE>

 4. FURNITURE, FIXTURES AND EQUIPMENT

     Furniture, fixtures and equipment, net, consist of the following at
December 31, 1998 and 1999:

<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                     -------------------------
                                                        1998          1999
                                                     ----------    -----------
<S>                                                  <C>           <C>
Furniture, fixtures and equipment..................  $  753,446    $   847,117
Computer equipment.................................   1,008,751      1,366,595
Leasehold improvements.............................     138,900        145,408
                                                     ----------    -----------
                                                      1,901,097      2,359,120
Less accumulated depreciation and amortization.....    (681,664)    (1,192,363)
                                                     ----------    -----------
                                                     $1,219,433    $ 1,166,757
                                                     ==========    ===========
</TABLE>

 5. INTANGIBLE ASSETS

     Intangible assets consist of the following:

<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                    --------------------------
                                                       1998           1999
                                                    -----------    -----------
<S>                                                 <C>            <C>
Goodwill..........................................  $   711,886    $   711,886
Patents...........................................    1,786,497      2,154,716
Developed technology..............................    1,200,000      1,200,000
Cell library......................................    1,150,000      1,150,000
Customer list.....................................    1,000,000      1,000,000
Workforce.........................................    1,000,000      1,000,000
Non-compete agreement.............................      900,400        900,400
Brand name........................................      660,000        660,000
                                                    -----------    -----------
                                                      8,408,783      8,777,002
Less accumulated amortization.....................   (1,739,112)    (3,351,729)
                                                    -----------    -----------
                                                    $ 6,669,671    $ 5,425,273
                                                    ===========    ===========
</TABLE>

     Amortization periods range from three to eleven years depending on the
estimated useful life of the asset.

 6. FINANCING ARRANGEMENTS

     On March 4, 1998, the Company obtained a revolving line of credit (and
letter of credit facility) with a bank which expires on April 1, 2001 and is
secured by certain of the Company's investments. The total

                                       45
<PAGE>   46
                                 SRS LABS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999

availability under the line of credit is the lesser of $10 million or a
percentage of the fair market value of the collateral. The line of credit bears
interest at the bank's prime rate (8.5% as of December 31, 1999) or LIBOR plus
0.75% (6.875% as of December 31, 1999). As of December 31, 1999, the Company had
$8.0 million outstanding under the line of credit and was contingently liable
for $1,000,000 under an irrevocable letter of credit which expires July 31,
2000.

     In November 1999, Valence and its subsidiaries obtained a credit facility
with a bank that provides for borrowings aggregating approximately $5,000,000.
The facility has no fixed expiration date and is collateralized by certain of
Valence's assets on deposit with the bank. The facility provides for a variety
of import/ export trade instruments which bear interest rates ranging from 1%
over the Hong Kong Dollar prime rate to 1.75% over LIBOR. The facility also
provides for a revolving line of credit of up to $3,500,000 which bears interest
at 1.25% over the related collateral deposit interest rate. At December 31,
1999, there were no obligations outstanding under this credit facility.

 7. COMMITMENTS AND CONTINGENCIES

     The Company leases office space and certain equipment under noncancelable
operating leases expiring through 2001.

     The Company leases its corporate office and storage facilities located in
Santa Ana, California, under a lease agreement with a partnership which is
affiliated with a stockholder and officer of the Company. The lease is for a
term of three years, commencing June 1, 1997, with an option to extend the term
for an additional two years thereafter. Additionally, the Company leases several
offices and warehouses in Hong Kong and China from unrelated parties. Total rent
expense incurred on office facilities and equipment was $129,369, $646,498 and
$604,198 for the years ended December 31, 1997, 1998, and 1999, respectively, of
which $129,369, $165,672 and $165,672 was paid to related parties, respectively.
Future annual minimum lease payments under noncancelable operating leases at
December 31, 1999, are as follows:

<TABLE>
<CAPTION>
                YEAR ENDING                               OFFICE
               DECEMBER 31,                  FACILITY    EQUIPMENT     TOTAL
               ------------                  --------    ---------    --------
<S>                                          <C>         <C>          <C>
  2000.....................................  $317,562     $ 9,306     $326,868
  2001.....................................        --       7,000        7,000
                                             --------     -------     --------
                                             $317,562     $16,306     $338,868
                                             ========     =======     ========
</TABLE>

     Litigation -- The Company is involved from time to time in litigation or
claims arising in the ordinary course of its business. While the ultimate
liability, if any, arising from these claims cannot be predicted with certainty,
the Company believes that the resolution of these matters will not likely have a
material adverse effect on the Company's financial statements.

                                       46
<PAGE>   47
                                 SRS LABS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999

 8. INCOME TAXES

     For the years ended December 31, 1997, 1998 and 1999, the provision
(benefit) for income taxes consists of the following:

<TABLE>
<CAPTION>
                                                     DECEMBER 31,
                                        --------------------------------------
                                           1997         1998          1999
                                        ----------    ---------    -----------
<S>                                     <C>           <C>          <C>
Current:
  Federal.............................  $1,078,637    $(679,205)   $    35,553
  State...............................     482,791       35,963         88,282
  Foreign.............................     296,157      668,291        761,967
                                        ----------    ---------    -----------
                                         1,857,585       25,049        885,802
Deferred:
  Federal.............................     (15,724)    (161,286)    (1,583,931)
  State...............................      21,339     (136,919)      (281,414)
  Foreign.............................          --           --       (125,196)
  Valuation allowance.................          --           --      1,154,401
                                        ----------    ---------    -----------
                                             5,615     (298,205)      (836,140)
                                        ----------    ---------    -----------
                                        $1,863,200    $(273,156)   $    49,662
                                        ==========    =========    ===========
</TABLE>

     The reconciliation of the provision (benefit) for income taxes computed at
U.S. federal statutory rates to the provision for income taxes for the years
ended December 31, 1996, 1997 and 1998 is as follows:

<TABLE>
<CAPTION>
                                                     DECEMBER 31,
                                       ----------------------------------------
                                          1997          1998           1999
                                       ----------    -----------    -----------
<S>                                    <C>           <C>            <C>
Tax at U.S. federal statutory
  rates..............................  $1,916,382    $(6,240,826)   $  (593,088)
State income taxes...................     334,079        (75,645)      (127,467)
Tax exempt interest..................    (365,194)      (150,766)       (35,862)
Change in valuation allowance........          --             --      1,028,398
Intangibles..........................          --      5,940,367             --
Other................................     (22,067)       253,714       (222,319)
                                       ----------    -----------    -----------
          Total income tax expense
            (benefit)................  $1,863,200    $  (273,156)   $    49,662
                                       ==========    ===========    ===========
</TABLE>

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

<TABLE>
<CAPTION>
                                                      DECEMBER 31,
                                           -----------------------------------
                                             1997        1998         1999
                                           --------    --------    -----------
<S>                                        <C>         <C>         <C>
Deferred tax assets (liabilities):
  State income taxes.....................  $121,952    $(54,085)   $  (149,765)
  Depreciation and amortization..........   247,038     (13,810)        78,191
  Accruals not currently deductible......    30,907       5,383         74,223
  Net operating losses...................        --      26,712      1,433,151
  Tax credits............................        --      22,016        540,957
  Valuation allowance....................        --          --     (1,154,401)
                                           --------    --------    -----------
          Total net deferred tax assets
            (liability)..................  $399,897    $(13,784)   $   822,356
                                           ========    ========    ===========
</TABLE>

                                       47
<PAGE>   48
                                 SRS LABS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999

     The Company has federal and state net operating loss carry forwards at
December 31, 1999, of approximately $3.4 million and $3.1 million, respectively.
These net operating loss carry forwards will begin to expire in 2019 and 2003,
respectively. In addition, the Company has federal tax credit carry forwards of
approximately $541,000 which will begin to expire in 2003.

     As of December 31, 1999, a valuation allowance of $1,154,401 has been
provided based on the Company's assessment of the future realizability of
certain deferred tax assets. Approximately $126,000 of the valuation allowance
is attributable to the potential tax benefit of stock option transactions that
will be credited directly to additional paid in capital, if realized.

 9. STOCKHOLDERS' EQUITY

  ISSUANCE OF COMMON STOCK

     Stock Repurchases

     During the fiscal year ended December 31, 1998 ("Fiscal 1998"), the
Company's Board of Directors authorized the repurchase of up to 500,000 of the
outstanding shares of the Company's common stock. As of December 31, 1999,
71,100 shares had been repurchased at a cost of $263,281. Such repurchased
shares are reflected as treasury stock in the accompanying consolidated balance
sheets.

     On March 2, 1998, the Company issued 1,680,611 shares of common stock in
conjunction with the acquisition of Valence (Note 2). On February 28, 1998, the
Company issued 25,000 shares of common stock in conjunction with the acquisition
of the VIP technology (Note 2). On May 29, 1998, the Company issued 35,294
shares of common stock in conjunction with the acquisition of the Circle
Surround technology (Note 2).

     Stock Award/Option Plans

     On December 10, 1993, the Company's Board of Directors and shareholders
adopted an Incentive Stock Option, Nonqualified Stock Option and Restricted
Stock Purchase Plan (the "1993 Plan"). Under the 1993 Plan, 801,971 shares of
the Company's common stock are reserved for issuance to executives, employees
and non-employee directors of the Company at the discretion of the Board of
Directors or the committee administering the 1993 Plan. The Compensation
Committee of the Board or, in the absence of a Compensation Committee, the Board
has been appointed to administer the 1993 Plan. Options issued under the 1993
Plan vest in the manner prescribed by the Compensation Committee or the Board,
as applicable. As of December 31, 1999, options to purchase 801,971 shares of
the Company's common stock were granted under the 1993 Plan.

     In June 1997, the Company's Board of Directors adopted and the Company's
stockholders approved the Amended and Restated 1996 Long-Term Incentive Plan
(the "1996 Plan"), for which 2,000,000 shares of the Company's common stock were
reserved for issuance to officers, employees and consultants of the Company. If
any award granted under the 1996 Plan expires, terminates or is forfeited before
the exercise thereof or the payment in full thereof, the shares covered by the
unexercised or unpaid portion will become available for new grants under the
1996 Plan. In June 1998, the Company's Board of Directors adopted and the
Company's stockholders approved an amendment to 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 of Directors and the Company's stockholders
approved an amendment to allow all directors of the Company and any subsidiary
of the Company to participate in the 1996 Plan. The Compensation Committee or,
in the absence of a Compensation Committee, the Board of Directors has been
appointed to administer the 1996 Plan. Options issued under the 1996 Plan vest
in the manner prescribed by the Compensation Committee or the Board, as

                                       48
<PAGE>   49
                                 SRS LABS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999

applicable. As of December 31, 1999, options to purchase 5,149,445 shares of the
Company's common stock were granted under the 1996 Plan.

     In July 1996, the Company's Board of Directors adopted and the Company's
stockholders approved the 1996 Non-employee Directors Stock Option Plan (the
"Non-employee Directors Plan"), a non-discretionary formula plan for which
120,000 shares of the Company's common stock are reserved for issuance to the
Company's non-employee directors. The Non-employee Directors Plan is
administered by a committee consisting of all directors who are not eligible to
participate in the Non-employee Directors Plan. With the exception of the
initial option granted to a non-employee director, which vests immediately,
options granted under the Non-employee Directors Plan vest over a three-year
period, the first installment vesting on the date of grant. In June 1999, the
shareholders approved the Amended and Restated 1996 Nonemployee Directors' Stock
Option Plan. Among the changes set forth in the Amended and Restated Plan was to
increase by 130,000 the number of shares of common stock that may be issued. As
of December 31, 1999, options to purchase 100,000 shares of common stock were
granted under the Non-employee Directors Plan.

     On February 28, 1998, warrants were granted for the purchase of up to
100,000 common shares of the Company at a price per share of $9.47 to certain
parties in connection with the acquisition of VIP ("VIP Warrants") (Note 2).

     The following table summarizes stock option activity under all of the
Company's stock option plans and the VIP Warrants (Note 2) for the periods
indicated:

<TABLE>
<CAPTION>
                                                                       WEIGHTED
                                                       OPTIONS         AVERAGE
                                                     OUTSTANDING    EXERCISE PRICE
                                                     -----------    --------------
<S>                                                  <C>            <C>
Outstanding at January 1, 1997.....................   2,176,596         $4.16
  Granted..........................................   1,366,801         $5.70
  Stock options exercised..........................    (141,319)        $1.02
  Forfeited........................................  (1,017,582)        $7.68
                                                     ----------
Outstanding at December 31, 1997...................   2,384,496         $3.69
  Granted..........................................   2,898,500         $5.06
  Stock options exercised..........................    (213,121)        $1.44
  Forfeited........................................    (150,667)        $4.88
                                                     ----------
Outstanding at December 31, 1998...................   4,919,208         $4.54
  Granted..........................................   1,255,875         $3.39
  Stock options exercised..........................    (201,798)        $2.93
  Forfeited........................................    (888,742)        $5.17
                                                     ----------
Outstanding at December 31, 1999...................   5,084,543         $4.23
                                                     ==========
</TABLE>

                                       49
<PAGE>   50
                                 SRS LABS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999

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

<TABLE>
<CAPTION>
                                    WEIGHTED                        EXERCISABLE
                   NUMBER OF        AVERAGE           WEIGHTED         AS OF          WEIGHTED
   RANGE OF         OPTIONS        REMAINING          AVERAGE       DECEMBER 31,      AVERAGE
EXERCISE PRICES   OUTSTANDING   CONTRACTUAL LIFE   EXERCISE PRICE       1999       EXERCISE PRICE
---------------   -----------   ----------------   --------------   ------------   --------------
<S>               <C>           <C>                <C>              <C>            <C>
$0.00 - $ 1.05       252,807          4.2             $0.2634          252,807        $0.2634
$2.10 - $ 3.15       850,177          6.8             $2.7064          500,834        $2.7023
$3.15 - $ 4.20     1,680,331          7.4             $3.6602          513,481        $4.1390
$4.20 - $ 5.25       756,237          6.7             $4.9789          560,135        $4.9716
$5.25 - $ 6.30     1,263,250          8.4             $5.5019          364,875        $5.5090
$6.30 - $ 7.35       129,500          8.1             $6.6578           41,750        $6.6504
$7.35 - $ 8.40        30,000          6.6             $8.0000           30,000        $8.0000
$9.45 - $10.50       122,241          2.9             $9.6467          120,430        $9.6359
                   ---------          ---             -------        ---------        -------
                   5,084,543          7.2             $4.2314        2,384,312        $4.2017
</TABLE>

     On December 1, 1995, options were granted for the purchase of up to 300,875
common shares at prices of $4.14 to $4.56 per share, which the Company's Board
of Directors deemed the fair market value of the common stock at the date of
grant. The Company recorded compensation expense resulting from the difference
between the option price per share and the estimated fair market value of the
common stock ($4.99) determined by a third-party appraisal completed in May
1996, totaling $236,456. This amount is recorded ratably over the vesting period
of the respective options. During the years ended December 31, 1997, 1998 and
1999, the Company recorded $56,397, $26,828 and $7,306, respectively, of
deferred compensation expense associated with these stock option grants. In
addition, during the years ended December 31, 1997, 1998 and 1999, the Company
recorded $20,304, $55,387 and $114,212, respectively, of deferred compensation
expense related to stock options granted to non-employee contractors.

     On March 5, 1999, pursuant to a technology license agreement entered into
by the Company and a customer, options were granted to the customer to purchase
up to 50,000 shares of common stock at an exercise price of $3.94 per share. The
fair value of the grant is being recognized as compensation expense ratably over
the vesting period of the options. The Company recognized $30,857 of
compensation expense relating to these options in Fiscal 1999. In addition to
the 50,000 options granted in 1999, the Company has an obligation to grant up to
200,000 additional options if the customer meets specified performance criteria
as defined by the agreement. The exercise price of additional option grants will
be the fair market value of the common stock at the date of grant.

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

<TABLE>
<CAPTION>
                                                    DECEMBER 31,
                                         -----------------------------------
                                           1997         1998         1999
                                         ---------    ---------    ---------
<S>                                      <C>          <C>          <C>
Expected life..........................  60 months    60 months    60 months
Stock volatility.......................         69%          57%          65%
Risk-free interest rate................       5.45%        5.50%         5.9%
</TABLE>

                                       50
<PAGE>   51
                                 SRS LABS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999

     The Company's calculations are based on a single option valuation approach
and forfeitures are recognized as they occur. If the computed fair values of the
1997, 1998 and 1999 awards had been amortized to expense over the vesting period
of the awards, pro forma net income (loss) would have been $3,429,526, or $.32
per share in 1997; ($18,684,945), or ($1.77) per share in 1998; and ($3,392,244)
or ($.35) per share in 1999. However, the impact of outstanding nonvested stock
options granted prior to 1995 has been excluded from the pro forma calculation;
accordingly, the 1997, 1998 and 1999 pro forma adjustments are not indicative of
future period pro forma adjustments, when the calculation will apply to all
applicable stock options.

10. SEGMENT INFORMATION

     The Company operates in two business segments: (i) the development and
marketing of technology either in the form of integrated circuits through
Valence (ASICs) or the licensing of technologies developed by the Company to
original equipment manufacturers and semiconductor manufacturers and (ii) the
sale of consumer electronic products and components. The Company does not
allocate operating expenses or specific assets to these segments. Therefore,
segment information includes only net revenues, cost of sales and gross margin.
Prior to the acquisition of Valence, the Company operated in the single business
segment of licensing audio technologies. Therefore, segment information is
presented for 1999 and 1998 only.

<TABLE>
<CAPTION>
                                                  BUSINESS SEGMENTS
                                   -----------------------------------------------
                                    CHIPS AND        PRODUCT AND
                                    LICENSING      COMPONENT SALES        TOTAL
                                   -----------    -----------------    -----------
<S>                                <C>            <C>                  <C>
Year ended December 31, 1998
Net revenues.....................  $15,762,369       $28,962,671       $44,725,040
Cost of sales....................    4,084,805        25,734,266        29,819,071
                                   -----------       -----------       -----------
Gross margin.....................  $11,677,564       $ 3,228,405       $14,905,969
                                   ===========       ===========       ===========
Year ended December 31, 1999
Net revenues.....................  $18,624,221       $17,171,362       $35,795,583
Cost of sales....................    6,095,197        15,907,620        22,002,817
                                   -----------       -----------       -----------
Gross margin.....................  $12,529,024       $ 1,263,742       $13,792,766
                                   ===========       ===========       ===========
</TABLE>

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

<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                    --------------------------
                  REGION REVENUE                       1998           1999
                  --------------                    -----------    -----------
<S>                                                 <C>            <C>
Asia Pacific......................................  $41,502,348    $33,536,423
Americas..........................................    3,017,596      1,268,918
Europe............................................      205,096        990,242
                                                    -----------    -----------
          Total...................................  $44,725,040    $35,795,583
                                                    ===========    ===========
</TABLE>

11. RELATED-PARTY TRANSACTIONS

     The Company shares certain general and administrative expenses with an
affiliated company which is 100% owned by a Company officer/stockholder.
Pursuant to a written agreement which was terminated on December 31, 1997,
one-half of these expenses were allocated to the Company during 1997.

     The Company leases its corporate office and storage facilities located in
Santa Ana, California, under a lease agreement with a partnership which is
affiliated with a stockholder and officer of the Company. The

                                       51
<PAGE>   52
                                 SRS LABS, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
              FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999

original lease term commenced on June 1, 1994 and expired on May 31, 1997. Upon
expiration, the Company entered into a new lease agreement for additional space
at the same facility with the same lessor. The new lease is for a term of three
years, commencing June 1, 1997, with an option to extend the term for an
additional two years thereafter.

     During the years ended December 31, 1997, 1998 and 1999, total revenue from
an affiliated company which is 100% owned by a Company officer/stockholder,
amounted to $17,779, $6,834 and $1,326, respectively. As of December 31, 1998
and 1999, accounts receivable from this affiliated company were $9,646 and $0,
respectively. Amounts due to this affiliated company were $1,747 and $0 as of
December 31, 1998 and 1999, respectively.

     A stockholder of the Company paid $2,500,000 in license royalties to the
Company during the year ended December 31, 1997. There were no license royalties
from this stockholder during the years ended December 31, 1998 or 1999.

12. EMPLOYEE BENEFIT PLAN

     The Company's employees based in the United States may participate in a
salary deferral plan (the "401(k) Plan") in which eligible employees can
contribute up to 15% of their eligible compensation. The Company also may
contribute on a discretionary basis. During the years ended December 31, 1997,
1998 and 1999, the Company did not contribute to the 401(k) Plan.

13. SUBSEQUENT EVENTS

     On March 3, 2000, ValenceTech Limited (a newly formed holding company of
Valence Technology Inc.) filed an application to list its shares on the Growth
Enterprise Market (GEM) of the Hong Kong Stock Exchange.

     On March 9, 2000, the Company entered into a technology and marketing
alliance with a third party. In conjunction with this transaction, the third
party purchased 290,529 shares of the Company's common stock for $17.21 per
share or $5 million in the aggregate. The difference between the purchase price
and the fair value of the common stock on the date of purchase, totalling
approximately $555,000, will be recorded as an expense by the Company during the
quarter ended March 31, 2000. Additionally, the Company granted to the third
party a warrant to purchase up to 200,000 shares of the common stock of SRS
Labs, Inc. and the Company's wholly-owned subsidiary, SRSWOWcast.com,Inc.,
granted a warrant to purchase up to 1,250,000 shares of its common stock. The
fair value of these warrants, aggregating approximately $2,550,000, also will be
recorded as an expense by the Company during the quarter ended March 31, 2000.

                                       52
<PAGE>   53

                                  SCHEDULE II

                 VALUATION AND QUALIFYING ACCOUNTS AND RESERVES

<TABLE>
<CAPTION>
                                                                      ADDITIONS
                                                       ADDITIONS     (REDUCTIONS)
                                         BALANCE AT      DUE TO       CHARGED TO                  BALANCE
                                         BEGINNING      BUSINESS      COSTS AND                    AT END
                                         OF PERIOD    ACQUISITIONS     EXPENSE      DEDUCTIONS   OF PERIOD
                                         ----------   ------------   ------------   ----------   ----------
<S>                                      <C>          <C>            <C>            <C>          <C>
For the year ended December 31, 1998:
  Allowance for doubtful accounts......   $     --     $  647,600     $  (82,785)   $(142,677)   $  422,138
                                          ========     ==========     ==========    =========    ==========
  Inventory reserve....................   $     --     $1,275,097     $  353,814    $(975,541)   $  653,370
                                          ========     ==========     ==========    =========    ==========
For the year ended December 31, 1999:
  Allowance for doubtful accounts......   $422,138     $       --     $1,040,271    $(378,448)   $1,083,961
                                          ========     ==========     ==========    =========    ==========
  Inventory reserve....................   $653,370     $       --     $  628,006    $(656,532)   $  624,844
                                          ========     ==========     ==========    =========    ==========
</TABLE>

                                       53
<PAGE>   54

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

     Not Applicable.

                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     The information set forth under the captions "ELECTION OF DIRECTORS" and
"TRANSACTIONS WITH MANAGEMENT AND OTHERS -- Section 16(a) Beneficial Ownership
Reporting Compliance" in the Company's definitive proxy statement (the "Proxy
Statement") for the Annual Meeting of Stockholders scheduled to be held in June
2000, is incorporated herein by reference. The Proxy Statement will be filed
with the U.S. Securities and Exchange Commission (the "Commission") not later
than 120 days after the close of Fiscal 1999.

ITEM 11. EXECUTIVE COMPENSATION

     Except as specifically provided, the information set forth under the
captions "COMPENSATION OF EXECUTIVE OFFICERS" and "INFORMATION ABOUT THE BOARD
OF DIRECTORS AND COMMITTEES OF THE BOARD -- Compensation of Directors" in the
Proxy Statement is incorporated herein by reference. The Proxy Statement will be
filed with the Commission not later than 120 days after the close of Fiscal
1999. The Report on Executive Compensation and the Performance Graph set forth
under the caption "COMPENSATION OF EXECUTIVE OFFICERS" in the Proxy Statement
shall not be deemed incorporated by reference herein and shall not otherwise be
deemed "filed" as part of this Annual Report on Form 10-K.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The information set forth under the caption "SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT" in the Proxy Statement is incorporated herein
by reference. The Proxy Statement will be filed with the Commission not later
than 120 days after the close of Fiscal 1999.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     The information set forth under the caption "TRANSACTIONS WITH MANAGEMENT
AND OTHERS" in the Proxy Statement is incorporated herein by reference. The
Proxy Statement will be filed with the Commission not later than 120 days after
the close of Fiscal 1999.

                                       54
<PAGE>   55

                                    PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a) Documents Filed as Part of This Report:

     (1) Financial Statements

     The financial statements included in Part II, Item 8 herein are filed as
part of this Annual Report on Form 10-K.

     (2) Financial Statement Schedules

     The financial statement schedule included in Part II, Item 8 herein is
filed as part of this Annual Report on Form 10-K. All other schedules are
omitted as the required information is inapplicable or the information is
presented in the consolidated financial statements or related notes.

     (3) Exhibits

     The exhibits listed below are hereby filed with the Commission as part of
this Annual Report on Form 10-K.

<TABLE>
<CAPTION>
    EXHIBIT
    NUMBER                             DESCRIPTION
    -------                            -----------
    <C>        <S>
     2.1       Stock Purchase Agreement dated as of February 24, 1998, by
               and among the Company, Valence Technology Inc., Thomrose
               Holdings (BVI) Limited, Rayfa (BVI) Limited, Cape Spencer
               International Limited, and Anki (BVI) Limited, previously
               filed with the Commission as Exhibit 2.1 to the Company's
               Current Report on Form 8-K filed with the Commission on
               March 13, 1998 (the "Form 8-K"), which is incorporated
               herein by reference.
     2.2       Stock Purchase Agreement dated as of February 24, 1998, by
               and between the Company and North 22 Capital Partners 2,
               Inc., previously filed with the Commission as Exhibit 2.2 to
               the Form 8-K, which is incorporated herein by reference.
     2.3       Asset Purchase Agreement dated as of January 28, 1998,
               between the Company and R.G.A. & Associates, Ltd. d/b/a
               ToteVision and VIP Labs(R) previously filed with the
               Commission as Exhibit 2.3 to the Company's Annual Report on
               Form 10-KSB for the fiscal year ended December 31, 1997
               filed with the Commission on March 31, 1998 (the "1997
               Annual Report"), which is incorporated herein by reference.
     2.4       Asset Purchase Agreement dated as of May 21, 1998 by and
               between Rocktron Corporation and the Company, previously
               filed with the Commission as Exhibit 2.1 to the Company's
               Quarterly Report on Form 10-Q for the period ended June 30,
               1998 (the "June 1998 10-Q"), which is incorporated herein by
               reference.
     3.1       Certificate of Incorporation of the Company, previously
               filed with the Commission as Exhibit 3.1 to the Company's
               Registration Statement on Form SB-2, specifically included
               in Amendment No. 1 to such Registration Statement filed with
               the Commission on July 3, 1996 (File No. 333-4974-LA) (the
               "Registration Statement Amendment No. 1"), which is
               incorporated herein by reference.
     3.2       Bylaws of the Company, previously filed with the Commission
               as Exhibit 3.1 to the Company's Quarterly Report on Form
               10-Q for the period ended September 30, 1999, filed with the
               Commission 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 Commission
               as Exhibit 10.8 to the Registration Statement Amendment No.
               1, which is incorporated herein by reference.
</TABLE>

                                       55
<PAGE>   56

<TABLE>
<CAPTION>
    EXHIBIT
    NUMBER                             DESCRIPTION
    -------                            -----------
    <C>        <S>
    10.2       Amendment to Employment Agreement dated as of March 14,
               1997, between the Company and Thomas C.K. Yuen, previously
               filed with the Commission as Exhibit 10.2 to the Company's
               Annual Report on Form 10-KSB for the fiscal year ended
               December 31, 1996, filed with the Commission on March 31,
               1997 (the "1996 Annual Report"), which is incorporated
               herein by reference.
    10.3       Employment Agreement dated July 1, 1996, between the Company
               and Arnold I. Klayman, previously filed with the Commission
               as Exhibit 10.10 to the Registration Statement Amendment No.
               1, which is incorporated herein by reference.
    10.4       Amendment to Employment Agreement dated as of March 14,
               1997, between the Company and Arnold I. Klayman, previously
               filed as Exhibit 10.5 to the 1996 Annual Report, which is
               incorporated herein by reference.
    10.5       Employment Agreement dated July 1, 1996, between the Company
               and Alan D. Kraemer, previously filed with the Commission as
               Exhibit 10.11 to the Registration Statement Amendment No. 1,
               which is incorporated herein by reference.
    10.6       SRS Labs, Inc. Incentive Stock Option, Nonqualified Stock
               Option and Restricted Purchase Plan -- 1993, as amended and
               restated, previously filed with the Commission as Exhibit
               10.12 to the Company's Registration Statement on Form SB-2
               filed with the Commission on June 3, 1996 (File No.
               333-4974-LA) (the "Registration Statement"), which is
               incorporated herein by reference.
    10.7       Stock Option Agreement dated January 19, 1994, between the
               Company and Stephen V. Sedmak, as amended, previously filed
               with the Commission as Exhibit 10.13 to the Registration
               Statement, which is incorporated herein by reference.
    10.8       SRS Labs, Inc. Amended and Restated 1996 Long-Term Incentive
               Plan, previously filed with the Commission as Appendix A to
               the Company's Definitive Proxy Statement dated April 30,
               1998, filed with the Commission on April 30, 1998, which is
               incorporated herein by reference.
    10.9       SRS Labs, Inc. 1996 Amended and Restated Nonemployee
               Directors Stock Option Plan, previously filed with the
               Commission as Appendix A to the Company's Definitive Proxy
               Statement dated and filed with the Commission on April 29,
               1999, which is incorporated herein by reference.
    10.10      Annual Incentive Bonus Plan, previously filed with the
               Commission as Exhibit 10.18 to the Registration Statement
               Amendment No. 1, which is incorporated herein by reference.
    10.11      SRS Labs, Inc. Supplemental Executive Incentive Bonus Plan,
               previously filed with the Commission as Exhibit 10.14 to the
               1996 Annual Report, which is incorporated herein by
               reference.
    10.12      Form of Indemnification Agreement, previously filed with the
               Commission as Exhibit 10.20 to the Registration Statement
               Amendment No. 1, which is incorporated herein by reference.
    10.13      Employment Agreement dated as of March 2, 1998, by and among
               the Company, Valence Technology Inc., and Thomas Wah Tong
               Wan, previously filed with the Commission as Exhibit 10.16
               to the 1997 Annual Report, which is incorporated herein by
               reference.
    10.14      Employment Agreement dated as of March 2, 1998, by and among
               the Company, Valence Semiconductor Design Limited, and Choi
               Yat Ming, previously filed with the Commission as Exhibit
               10.17 to the 1997 Annual Report, which is incorporated
               herein by reference.
    10.15      Employment Agreement dated as of March 2, 1998, by and among
               the Company, LEC Electronic Components Limited, and Wong Yin
               Bun, previously filed with the Commission as Exhibit 10.18
               to the 1997 Annual Report, which is incorporated herein by
               reference.
</TABLE>

                                       56
<PAGE>   57

<TABLE>
<CAPTION>
    EXHIBIT
    NUMBER                             DESCRIPTION
    -------                            -----------
    <C>        <S>
    10.16      Noncompetition Agreement dated as of March 2, 1998, by and
               among the Company, Thomrose Holdings (BVI) Limited, and
               Thomas Wah Tong Wan, previously filed with the Commission as
               Exhibit 2.5 to the Company's Current Report on Form 8-K
               filed with the Commission on March 13, 1998 (the "Form
               8-K"), which is incorporated herein by reference.
    10.17      Noncompetition Agreement dated as of March 2, 1998, by and
               among the Company, Cape Spencer International Limited and
               Wong Yin Bun, previously filed with the Commission as
               Exhibit 2.6 to the Form 8-K, which is incorporated herein by
               reference.
    10.18      Noncompetition Agreement dated as of March 2, 1998, by and
               among the Company, Rayfa (BVI) Limited and Choi Yat Ming,
               previously filed with the Commission as Exhibit 2.7 to the
               Form 8-K, which is incorporated herein by reference.
    10.19      Employment Agreement dated as of July 1, 1998 by and between
               the Company and John AuYeung, previously filed with the
               Commission as Exhibit 10.1 to the Company's Quarterly Report
               on Form 10-Q for the period ended September 30, 1998, which
               is incorporated herein by reference.
    10.20      Severance Agreement, dated February 23, 1999, by and between
               the Company and Thomas P. Parkinson, previously filed as
               Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q
               for the period ended March 31, 1999, filed with the
               Commission on May 17, 1999, which is incorporated herein by
               reference.
    10.21      Employment Agreement dated August 27, 1999 by and between
               the Company and James F. Gardner.
OTHER MATERIAL CONTRACTS
    10.22      Shareholders Agreement dated as of January 27, 1994, between
               the Company and the Shareholders of the Company named
               therein, previously filed with the Commission as Exhibit 9.3
               to the Company's Registration Statement on Form SB-2,
               specifically included in Amendment No. 2 to such
               Registration Statement filed with the Commission on August
               2, 1996 (File No. 333-4974-LA) (the "Registration Statement
               Amendment No. 2"), which is incorporated herein by
               reference.
    10.23      Shareholders Agreement II dated as of January 9, 1995,
               between the Company and the Shareholders of the Company
               named therein, previously filed with the Commission as
               Exhibit 9.1 to the Registration Statement, which is
               incorporated herein by reference.
    10.24      Shareholders Agreement III dated as of April 21, 1995,
               between the Company and the Shareholders of the Company
               named therein, previously filed with the Commission as
               Exhibit 9.2 to the Registration Statement, which is
               incorporated herein by reference.
    10.25      Asset Purchase Agreement dated as of June 30, 1993, between
               the Company and Hughes Aircraft, previously filed with the
               Commission as Exhibit 10.1 to the Registration Statement,
               which is incorporated herein by reference.
    10.26      Stock Purchase Agreement dated as of January 9, 1995,
               between the Company and Packard Bell Electronics, Inc. d/b/a
               Packard Bell Corporation, previously filed with the
               Commission as Exhibit 10.3 to the Registration Statement
               Amendment No. 2, which is incorporated herein by reference.
    10.27      Amended and Restated Stock Option Agreement dated as of
               January 9, 1995, between the Company and Packard Bell
               Electronics, Inc. d/b/a Packard Bell Corporation, previously
               filed with the Commission as Exhibit 10.4 to the
               Registration Statement, which is incorporated herein by
               reference.
</TABLE>

                                       57
<PAGE>   58

<TABLE>
<CAPTION>
    EXHIBIT
    NUMBER                             DESCRIPTION
    -------                            -----------
    <C>        <S>
    10.28      License Agreement dated as of January 9, 1995, between the
               Company and Packard Bell Electronics, Inc. d/b/a Packard
               Bell Corporation, previously filed with the Commission as
               Exhibit 10.5 to the Company's Registration Statement on Form
               SB-2, specifically included in Amendment No. 3 to such
               Registration Statement filed with the Commission on August
               7, 1996 (File No. 333-4974-LA) (the "Registration Statement
               Amendment No. 3"), which is incorporated herein by
               reference.
    10.29      License Agreement dated as of June 27, 1988, between Hughes
               Aircraft and Sony Corporation, as amended and assigned to
               the Company, previously filed with the Commission as Exhibit
               10.6 to the Registration Statement Amendment No. 3, which is
               incorporated herein by reference.
    10.30      Industrial Real Estate Lease dated May 30, 1997, between the
               Company and Daimler Commerce Partners, L.P., previously
               filed with the Commission as Exhibit 10.1 to the Company's
               Form 10-QSB for the quarterly period ended June 30, 1997,
               filed with the Commission on August 13, 1997, which is
               incorporated herein by reference.
    10.31      Tenancy Agreement dated September 7, 1998, by and between
               Hong Kong Industrial Technology Centre Corporation and
               Valence Semiconductor Design Limited relating to the
               premises located at Unit 413 on the Fourth Floor of the Hong
               Kong Industrial Technology Centre.
    10.32      Tenancy Agreement commencing January 1, 1998, by and between
               Jugada Company Limited and Valence Semiconductor Design
               Limited relating to the premises located at Workshops Nos.
               1, 2, 3, 4, 5, 6, 7 and 8 on the 19th Floor of APEC Plaza,
               No. 49 Hoi Yuen Road, Kwun Tong, Hong Kong, previously filed
               with the Commission as Exhibit 10.34 to the 1997 Annual
               Report, which is incorporated herein by reference.
    10.33      Stock Divestment Agreement dated July 1, 1996, between the
               Company, Thomas C.K. Yuen, Stephen V. Sedmak and Walter W.
               Cruttenden III, previously filed with the Commission as
               Exhibit 10.17 to the Registration Statement Amendment No. 2,
               which is incorporated herein by reference.
    10.34      Services Agreement dated July 1, 1996, between the Company
               and Sierra Digital Productions, Inc., previously filed with
               the Commission as Exhibit 10.19 to the Registration
               Statement Amendment No. 1, which is incorporated herein by
               reference.
    10.35      Registration Rights Agreement dated as of January 28, 1998,
               by and between the Company and R.G.A. & Associates, Ltd.,
               d/b/a ToteVision and VIP Labs(R) and William S. Taraday,
               previously filed with the Commission as Exhibit 10.37 to the
               1997 Annual Report, filed with the Commission on March 31,
               1998, which is incorporated herein by reference.
    10.36      Warrant to Purchase 94,000 Shares of Common Stock of the
               Company dated February 26, 1998, held by R.G.A. &
               Associates, Ltd., d/b/a ToteVision and VIP Labs(R),
               previously filed with the Commission as Exhibit 10.38 to the
               1997 Annual Report, which is incorporated herein by
               reference.
    10.37      Warrant to Purchase 2,500 Shares of Common Stock of the
               Company dated February 26, 1998, held by Herbert H. Wax,
               previously filed with the Commission as Exhibit 10.39 to the
               1997 Annual Report, which is incorporated herein by
               reference.
    10.38      Warrant to Purchase 2,500 Shares of Common Stock of the
               Company dated February 26, 1998, held by Steven E. Loyd,
               previously filed with the Commission as Exhibit 10.40 to the
               1997 Annual Report, which is incorporated herein by
               reference.
    10.39      Warrant to Purchase 1,000 Shares of Common Stock of the
               Company dated February 26, 1998, held by the Van Valkenberg
               Furber Law Group, P.L.L.C., previously filed with the
               Commission as Exhibit 10.41 to the 1997 Annual Report, which
               is incorporated herein by reference.
</TABLE>

                                       58
<PAGE>   59

<TABLE>
<CAPTION>
    EXHIBIT
    NUMBER                             DESCRIPTION
    -------                            -----------
    <C>        <S>
    10.40      Registration Rights Agreement dated as of May 21, 1998,
               previously filed with the Commission as Exhibit 10.1 to the
               June 1998 Form 10-Q, which is incorporated herein by
               reference.
    10.41      Credit and Security Agreement dated as of July 6, 1999, by
               and between the Company and City National Bank.
    10.42      Securities Account Control Agreement dated as of July 6,
               1999, by and among the Company, Investors Bank & Trust
               Company, Salomon Brothers Asset Management Inc. and City
               National Bank.
    10.43      Revolving Credit Note dated July 6, 1999, by the Company in
               favor of City National Bank.
    21         Subsidiaries.
    23         Consent of Deloitte & Touche LLP dated March 24, 2000
    24         Power of attorney (included on page 60 of the Form 10-K).
    27         Financial Data Schedule.
</TABLE>

(b) Reports on Form 8-K.

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

                                       59
<PAGE>   60

                                   SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

                                                         SRS LABS, INC., a
Delaware corporation

Date: March 28, 2000                      By:     /s/ THOMAS C.K. YUEN
                                            ------------------------------------
                                                      Thomas C.K. Yuen
                                              Chairman of the Board and Chief
                                                      Executive Officer

                               POWER OF ATTORNEY

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

     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
                        NAME                                      CAPACITY                   DATE
                        ----                                      --------                   ----
<C>                                                    <C>                              <S>
                /s/ THOMAS C.K. YUEN                   Director, Chairman of the Board  March 28, 2000
-----------------------------------------------------    and Chief Executive Officer
                  Thomas C.K. Yuen                      (Principal Executive Officer)

                  /s/ JOHN AUYEUNG                       Director and Executive Vice    March 28, 2000
-----------------------------------------------------    President, Chief Operating
                    John AuYeung                          Officer, Chief Financial
                                                           Officer, Secretary and
                                                       Treasurer (Principal Financial
                                                           and Accounting Officer)

                 /s/ THOMAS W.T. WAN                     Director and Vice President    March 28, 2000
-----------------------------------------------------
                   Thomas W.T. Wan

                /s/ ROBERT PFANNKUCH                              Director              March 28, 2000
-----------------------------------------------------
                  Robert Pfannkuch

                /s/ STEPHEN V. SEDMAK                             Director              March 28, 2000
-----------------------------------------------------
                  Stephen V. Sedmak

              /s/ JEFFREY I. SCHEINROCK                           Director              March 28, 2000
-----------------------------------------------------
                Jeffrey I. Scheinrock

                     /s/ JOHN TU                                  Director              March 28, 1999
-----------------------------------------------------
                       John Tu
</TABLE>

                                       60
<PAGE>   61

                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
    EXHIBIT
    NUMBER                             DESCRIPTION
    -------                            -----------
    <C>        <S>
       2.1     Stock Purchase Agreement dated as of February 24, 1998, by
               and among the Company, Valence Technology Inc., Thomrose
               Holdings (BVI) Limited, Rayfa (BVI) Limited, Cape Spencer
               International Limited, and Anki (BVI) Limited, previously
               filed with the Commission as Exhibit 2.1 to the Company's
               Current Report on Form 8-K filed with the Commission on
               March 13, 1998 (the "Form 8-K"), which is incorporated
               herein by reference.
       2.2     Stock Purchase Agreement dated as of February 24, 1998, by
               and between the Company and North 22 Capital Partners 2,
               Inc., previously filed with the Commission as Exhibit 2.2 to
               the Form 8-K, which is incorporated herein by reference.
       2.3     Asset Purchase Agreement dated as of January 28, 1998,
               between the Company and R.G.A. & Associates, Ltd. d/b/a
               ToteVision and VIP Labs(R) previously filed with the
               Commission as Exhibit 2.3 to the Company's Annual Report on
               Form 10-KSB for the fiscal year ended December 31, 1997
               filed with the Commission on March 31, 1998 (the "1997
               Annual Report"), which is incorporated herein by reference.
       2.4     Asset Purchase Agreement dated as of May 21, 1998 by and
               between Rocktron Corporation and the Company, previously
               filed with the Commission as Exhibit 2.1 to the Company's
               Quarterly Report on Form 10-Q for the period ended June 30,
               1998 (the "June 1998 10-Q"), which is incorporated herein by
               reference.
       3.1     Certificate of Incorporation of the Company, previously
               filed with the Commission as Exhibit 3.1 to the Company's
               Registration Statement on Form SB-2, specifically included
               in Amendment No. 1 to such Registration Statement filed with
               the Commission on July 3, 1996 (File No. 333-4974-LA) (the
               "Registration Statement Amendment No. 1"), which is
               incorporated herein by reference.
       3.2     Bylaws of the Company, previously filed with the Commission
               as Exhibit 3.1 to the Company's Quarterly Report on Form
               10-Q for the period ended September 30, 1999, filed with the
               Commission 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 Commission
               as Exhibit 10.8 to the Registration Statement Amendment No.
               1, which is incorporated herein by reference.
      10.2     Amendment to Employment Agreement dated as of March 14,
               1997, between the Company and Thomas C.K. Yuen, previously
               filed with the Commission as Exhibit 10.2 to the Company's
               Annual Report on Form 10-KSB for the fiscal year ended
               December 31, 1996, filed with the Commission on March 31,
               1997 (the "1996 Annual Report"), which is incorporated
               herein by reference.
      10.3     Employment Agreement dated July 1, 1996, between the Company
               and Arnold I. Klayman, previously filed with the Commission
               as Exhibit 10.10 to the Registration Statement Amendment No.
               1, which is incorporated herein by reference.
      10.4     Amendment to Employment Agreement dated as of March 14,
               1997, between the Company and Arnold I. Klayman, previously
               filed as Exhibit 10.5 to the 1996 Annual Report, which is
               incorporated herein by reference.
      10.5     Employment Agreement dated July 1, 1996, between the Company
               and Alan D. Kraemer, previously filed with the Commission as
               Exhibit 10.11 to the Registration Statement Amendment No. 1,
               which is incorporated herein by reference.
</TABLE>
<PAGE>   62

<TABLE>
<CAPTION>
    EXHIBIT
    NUMBER                             DESCRIPTION
    -------                            -----------
    <C>        <S>
      10.6     SRS Labs, Inc. Incentive Stock Option, Nonqualified Stock
               Option and Restricted Purchase Plan -- 1993, as amended and
               restated, previously filed with the Commission as Exhibit
               10.12 to the Company's Registration Statement on Form SB-2
               filed with the Commission on June 3, 1996 (File No.
               333-4974-LA) (the "Registration Statement"), which is
               incorporated herein by reference.
      10.7     Stock Option Agreement dated January 19, 1994, between the
               Company and Stephen V. Sedmak, as amended, previously filed
               with the Commission as Exhibit 10.13 to the Registration
               Statement, which is incorporated herein by reference.
      10.8     SRS Labs, Inc. Amended and Restated 1996 Long-Term Incentive
               Plan, previously filed with the Commission as Appendix A to
               the Company's Definitive Proxy Statement dated April 30,
               1998, filed with the Commission on April 30, 1998, which is
               incorporated herein by reference.
      10.9     SRS Labs, Inc. 1996 Amended and Restated Nonemployee
               Directors Stock Option Plan, previously filed with the
               Commission as Appendix A to the Company's Definitive Proxy
               Statement dated and filed with the Commission on April 29,
               1999, which is incorporated herein by reference.
      10.10    Annual Incentive Bonus Plan, previously filed with the
               Commission as Exhibit 10.18 to the Registration Statement
               Amendment No. 1, which is incorporated herein by reference.
      10.11    SRS Labs, Inc. Supplemental Executive Incentive Bonus Plan,
               previously filed with the Commission as Exhibit 10.14 to the
               1996 Annual Report, which is incorporated herein by
               reference.
      10.12    Form of Indemnification Agreement, previously filed with the
               Commission as Exhibit 10.20 to the Registration Statement
               Amendment No. 1, which is incorporated herein by reference.
      10.13    Employment Agreement dated as of March 2, 1998, by and among
               the Company, Valence Technology Inc., and Thomas Wah Tong
               Wan, previously filed with the Commission as Exhibit 10.16
               to the 1997 Annual Report, which is incorporated herein by
               reference.
      10.14    Employment Agreement dated as of March 2, 1998, by and among
               the Company, Valence Semiconductor Design Limited, and Choi
               Yat Ming, previously filed with the Commission as Exhibit
               10.17 to the 1997 Annual Report, which is incorporated
               herein by reference.
      10.15    Employment Agreement dated as of March 2, 1998, by and among
               the Company, LEC Electronic Components Limited, and Wong Yin
               Bun, previously filed with the Commission as Exhibit 10.18
               to the 1997 Annual Report, which is incorporated herein by
               reference.
      10.16    Noncompetition Agreement dated as of March 2, 1998, by and
               among the Company, Thomrose Holdings (BVI) Limited, and
               Thomas Wah Tong Wan, previously filed with the Commission as
               Exhibit 2.5 to the Company's Current Report on Form 8-K
               filed with the Commission on March 13, 1998 (the "Form
               8-K"), which is incorporated herein by reference.
      10.17    Noncompetition Agreement dated as of March 2, 1998, by and
               among the Company, Cape Spencer International Limited and
               Wong Yin Bun, previously filed with the Commission as
               Exhibit 2.6 to the Form 8-K, which is incorporated herein by
               reference.
      10.18    Noncompetition Agreement dated as of March 2, 1998, by and
               among the Company, Rayfa (BVI) Limited and Choi Yat Ming,
               previously filed with the Commission as Exhibit 2.7 to the
               Form 8-K, which is incorporated herein by reference.
      10.19    Employment Agreement dated as of July 1, 1998 by and between
               the Company and John AuYeung, previously filed with the
               Commission as Exhibit 10.1 to the Company's Quarterly Report
               on Form 10-Q for the period ended September 30, 1998, which
               is incorporated herein by reference.
</TABLE>
<PAGE>   63

<TABLE>
<CAPTION>
    EXHIBIT
    NUMBER                             DESCRIPTION
    -------                            -----------
    <C>        <S>
      10.20    Severance Agreement, dated February 23, 1999, by and between
               the Company and Thomas P. Parkinson, previously filed as
               Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q
               for the period ended March 31, 1999, filed with the
               Commission on May 17, 1999, which is incorporated herein by
               reference.
      10.21    Employment Agreement dated August 27, 1999 by and between
               the Company and James F. Gardner.
OTHER MATERIAL CONTRACTS
      10.22    Shareholders Agreement dated as of January 27, 1994, between
               the Company and the Shareholders of the Company named
               therein, previously filed with the Commission as Exhibit 9.3
               to the Company's Registration Statement on Form SB-2,
               specifically included in Amendment No. 2 to such
               Registration Statement filed with the Commission on August
               2, 1996 (File No. 333-4974-LA) (the "Registration Statement
               Amendment No. 2"), which is incorporated herein by
               reference.
      10.23    Shareholders Agreement II dated as of January 9, 1995,
               between the Company and the Shareholders of the Company
               named therein, previously filed with the Commission as
               Exhibit 9.1 to the Registration Statement, which is
               incorporated herein by reference.
      10.24    Shareholders Agreement III dated as of April 21, 1995,
               between the Company and the Shareholders of the Company
               named therein, previously filed with the Commission as
               Exhibit 9.2 to the Registration Statement, which is
               incorporated herein by reference.
      10.25    Asset Purchase Agreement dated as of June 30, 1993, between
               the Company and Hughes Aircraft, previously filed with the
               Commission as Exhibit 10.1 to the Registration Statement,
               which is incorporated herein by reference.
      10.26    Stock Purchase Agreement dated as of January 9, 1995,
               between the Company and Packard Bell Electronics, Inc. d/b/a
               Packard Bell Corporation, previously filed with the
               Commission as Exhibit 10.3 to the Registration Statement
               Amendment No. 2, which is incorporated herein by reference.
      10.27    Amended and Restated Stock Option Agreement dated as of
               January 9, 1995, between the Company and Packard Bell
               Electronics, Inc. d/b/a Packard Bell Corporation, previously
               filed with the Commission as Exhibit 10.4 to the
               Registration Statement, which is incorporated herein by
               reference.
      10.28    License Agreement dated as of January 9, 1995, between the
               Company and Packard Bell Electronics, Inc. d/b/a Packard
               Bell Corporation, previously filed with the Commission as
               Exhibit 10.5 to the Company's Registration Statement on Form
               SB-2, specifically included in Amendment No. 3 to such
               Registration Statement filed with the Commission on August
               7, 1996 (File No. 333-4974-LA) (the "Registration Statement
               Amendment No. 3"), which is incorporated herein by
               reference.
      10.29    License Agreement dated as of June 27, 1988, between Hughes
               Aircraft and Sony Corporation, as amended and assigned to
               the Company, previously filed with the Commission as Exhibit
               10.6 to the Registration Statement Amendment No. 3, which is
               incorporated herein by reference.
      10.30    Industrial Real Estate Lease dated May 30, 1997, between the
               Company and Daimler Commerce Partners, L.P., previously
               filed with the Commission as Exhibit 10.1 to the Company's
               Form 10-QSB for the quarterly period ended June 30, 1997,
               filed with the Commission on August 13, 1997, which is
               incorporated herein by reference.
      10.31    Tenancy Agreement dated September 7, 1998, by and between
               Hong Kong Industrial Technology Centre Corporation and
               Valence Semiconductor Design Limited relating to the
               premises located at Unit 413 on the Fourth Floor of the Hong
               Kong Industrial Technology Centre.
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<PAGE>   64

<TABLE>
<CAPTION>
    EXHIBIT
    NUMBER                             DESCRIPTION
    -------                            -----------
    <C>        <S>
      10.32    Tenancy Agreement commencing January 1, 1998, by and between
               Jugada Company Limited and Valence Semiconductor Design
               Limited relating to the premises located at Workshops Nos.
               1, 2, 3, 4, 5, 6, 7 and 8 on the 19th Floor of APEC Plaza,
               No. 49 Hoi Yuen Road, Kwun Tong, Hong Kong, previously filed
               with the Commission as Exhibit 10.34 to the 1997 Annual
               Report, which is incorporated herein by reference.
      10.33    Stock Divestment Agreement dated July 1, 1996, between the
               Company, Thomas C.K. Yuen, Stephen V. Sedmak and Walter W.
               Cruttenden III, previously filed with the Commission as
               Exhibit 10.17 to the Registration Statement Amendment No. 2,
               which is incorporated herein by reference.
      10.34    Services Agreement dated July 1, 1996, between the Company
               and Sierra Digital Productions, Inc., previously filed with
               the Commission as Exhibit 10.19 to the Registration
               Statement Amendment No. 1, which is incorporated herein by
               reference.
      10.35    Registration Rights Agreement dated as of January 28, 1998,
               by and between the Company and R.G.A. & Associates, Ltd.,
               d/b/a ToteVision and VIP Labs(R) and William S. Taraday,
               previously filed with the Commission as Exhibit 10.37 to the
               1997 Annual Report, filed with the Commission on March 31,
               1998, which is incorporated herein by reference.
      10.36    Warrant to Purchase 94,000 Shares of Common Stock of the
               Company dated February 26, 1998, held by R.G.A. &
               Associates, Ltd., d/b/a ToteVision and VIP Labs(R),
               previously filed with the Commission as Exhibit 10.38 to the
               1997 Annual Report, which is incorporated herein by
               reference.
      10.37    Warrant to Purchase 2,500 Shares of Common Stock of the
               Company dated February 26, 1998, held by Herbert H. Wax,
               previously filed with the Commission as Exhibit 10.39 to the
               1997 Annual Report, which is incorporated herein by
               reference.
      10.38    Warrant to Purchase 2,500 Shares of Common Stock of the
               Company dated February 26, 1998, held by Steven E. Loyd,
               previously filed with the Commission as Exhibit 10.40 to the
               1997 Annual Report, which is incorporated herein by
               reference.
      10.39    Warrant to Purchase 1,000 Shares of Common Stock of the
               Company dated February 26, 1998, held by the Van Valkenberg
               Furber Law Group, P.L.L.C., previously filed with the
               Commission as Exhibit 10.41 to the 1997 Annual Report, which
               is incorporated herein by reference.
      10.40    Registration Rights Agreement dated as of May 21, 1998,
               previously filed with the Commission as Exhibit 10.1 to the
               June 1998 Form 10-Q, which is incorporated herein by
               reference.
      10.41    Credit and Security Agreement dated as of July 6, 1999, by
               and between the Company and City National Bank.
      10.42    Securities Account Control Agreement dated as of July 6,
               1999, by and among the Company, Investors Bank & Trust
               Company, Salomon Brothers Asset Management Inc. and City
               National Bank.
      10.43    Revolving Credit Note dated July 6, 1999, by the Company in
               favor of City National Bank.
      21       Subsidiaries.
      23       Consent of Deloitte & Touche LLP dated March 24, 2000
      24       Power of attorney (included on page 60 of the Form 10-K).
      27       Financial Data Schedule.
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