**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

**ANNUAL REPORT PURSUANT TO SECTION 13 OR15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

For the fiscal year ended December 31,2006

**CommissionFile Number: 0-21123**

****

**SRS LABS, INC.**

(Exact name of registrantas specified in its charter)

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

**2909Daimler Street, Santa Ana, California 92705**

(Address of principalexecutive offices) (Zip Code)

**(949) 442-1070**

(Registrant’s telephonenumber, including area code)

Securities registeredpursuant to Section 12(b) of the Act:

| **Title of each class**                       |   | **Name of  each exchange on which registered** |
|-----------------------------------------------|--------|------------------------------------------------|
| **Common  Stock, Par Value $0.001 Per Share** |   | **The  NASDAQ Stock Market LLC**               |
| ** **                                    |   | **(NASDAQ  Global Market)**                    |

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.Yes o No x

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

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x No  ̈

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

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

Large accelerated filer  ̈      Acceleratedfiler  ̈      Non-accelerated filer x

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

The aggregate market valueof the registrant’s voting Common Stock held by non-affiliates of theregistrant was approximately $58,137,678 (computed using the closing price of$4.99 per share of Common Stock on June 30, 2006, as reported by theNASDAQ Stock Market).

As of March 9, 2007,16,745,403 shares of the registrant’s Common Stock, par value $0.001 per share,were outstanding. Of that amount, 674,098 shares were held as treasury shares.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portionsof the registrant’s Proxy Statement prepared in connection with the AnnualMeeting of Stockholders to be held in 2007 are incorporated by reference in Part IIIof this Form 10-K.

 

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**SRS LABS, INC.Annual Report on Form 10-KTable of Contents**
|               | ** ** | ** **                                                                                                         | ** ** | **Page** |
|---------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|----------|
| ** **    |       | **PART I**                                                                                                    |       |     |
| Item 1.       |       | Business                                                                                                           |       | 4        |
| Item 1A.      |       | Risk  Factors                                                                                                      |       | 12       |
| Item 1B.      |       | Unresolved Staff Comments                                                                                          |       | 16       |
| Item 2.       |       | Properties                                                                                                         |       | 16       |
| Item 3.       |       | Legal  Proceedings                                                                                                 |       | 16       |
| Item 4.       |       | Submission of Matters to a Vote of Security Holders                                                                |       | 16       |
| ** **    |       | **PART II**                                                                                                   |       |     |
| Item 5.       |       | Market for Registrant’s Common Equity, Related Stockholder  Matters and Issuer Purchases of Equity Securities |       | 17       |
| Item  6.      |       | Selected  Financial Data                                                                                           |       | 19       |
| Item 7.       |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                        |       | 20       |
| Item 7A. |       | Quantitative and Qualitative Disclosures About Market  Risk                                                        |       | 30       |
| Item 8.       |       | Financial Statements and Supplementary Data                                                                        |       | 30       |
| Item 9.       |       | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosure                              |       | 30       |
| Item 9A. |       | Controls and Procedures                                                                                            |       | 31       |
| Item  9B.     |       | Other  Information                                                                                                 |       | 31       |
| ** **    |       | **PART III**                                                                                                  |       |     |
| Item 10.      |       | Directors, Executive Officers and Corporate Governance                                                             |       | 32       |
| Item 11.      |       | Executive Compensation                                                                                             |       | 32       |
| Item 12.      |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters     |       | 32       |
| Item 13.      |       | Certain Relationships and Related Transactions, and  Director Independence                                         |       | 32       |
| Item 14.      |       | Principal Accounting Fees and Services                                                                             |       | 32       |
| ** **    |       | **PART IV**                                                                                                   |       |     |
| Item 15.      |       | Exhibits, Financial Statements, Financial Statement  Schedule                                                      |       | 33       |
| Signatures    |       | 39                                                                                                                 |

 

 

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As used herein, the “Company,”“SRS Labs,” “SRS,” “we,” “us,” or “our” means SRS Labs, Inc., itswholly-owned subsidiary SRSWOWcast.com, Inc. and, for the applicableperiods, its former subsidiary ValenceTech Limited (collectively with itsdirect and indirect wholly-owned subsidiaries, “Valence”) and the former jointventure with Coming Home Studios LLC, CHS/SRS LLC. Circle Surround®, CircleSurround IITM, Circle Surround AutomotiveTM, SRS Xspace 3DTM, SRS WOWTM, SRS WOWXTTM, SRS WOW HDTM, SRS TruBass®, SRS FOCUS®, SRS HeadphoneTM, SRS DialogClarityTM,SRS TruSurround® XT, TruSurround® HD, SRS 3D® Sound, SRS CS AutoTM and VIPTMareour United States trademarks. All other trademarks and trade names appearingare the property of their respective owners.

**SPECIAL NOTEREGARDING FORWARD-LOOKING STATEMENTS**

Some of the statements in this Annual Report on Form 10-Kcontain forward-looking statements regarding our assumptions, projections,expectations, targets, intentions or beliefs about future events, which involverisks and uncertainties. All statements other than statements of historicalfacts included in this Annual Report, relating to expectation of futurefinancial performance, continued growth, changes in economic conditions orcapital markets and changes in customer usage patterns and preferences, areforward-looking statements. In some cases, you can identify forward-lookingstatements by terms such as may, will, should, expect, plan, intend, forecast,anticipate, believe, estimate, predict, potential, continue or the negative ofthese terms or other comparable terminology. The forward-looking statementscontained in this Annual Report involve known and unknown risks, uncertaintiesand situations that may cause our or our industry’s actual results, levelof activity, performance or achievements to be materially different from anyfuture results, levels of activity, performance or achievements expressed orimplied by these statements. Factors that might cause actual events or resultsto differ materially from those indicated by these forward-looking statementsmay include the matters listed in this Annual Report, including, but notlimited to, those listed under “Risk Factors” in Item 1A.

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**PART I**

**Item 1.**                        Business

**Overview**

SRS Labs is a leading developer and provider of audioand voice technology solutions for the home entertainment, portable mediadevice, personal telecommunications, personal computer, automotive, andbroadcast markets. Prior to September 29, 2006, the Company was also adeveloper and provider of application specific integrated circuits and standardintegrated circuits through its formerly wholly-owned subsidiary, Valence.

***Licensing:******  ***Our operations are conducted through SRS LabsInc., the parent company, and its wholly-owned subsidiary, SRSWOWcast.com, Inc.Our business is focused on developing and licensing audio, voice and surroundsound technology solutions to many of the world’s leading original equipmentmanufacturers (“OEMs”), software providers and semiconductor companies, andlicensing and marketing hardware and software products for the Internet andprofessional audio markets.

***Discontinued Operations:***

*Valence:*   ThroughSRS Labs, Inc.’s formerly wholly-owned subsidiary, Valence, we operated afabless semiconductor business which developed, designed and marketed standardand custom analog integrated circuits, digital signal processors, and mixedsignal integrated circuits primarily to OEMs and original design manufacturers(“ODMs”), in the Asia Pacific region.

On February 23, 2006, our Board of Directors (the“Board”) approved a plan to sell Valence in order to focus management’sattention and financial resources on our licensing business. On July 14,2006, we entered into a definitive Sale and Purchase Agreement to sell Valenceto Noblehigh Enterprises Inc. (“Noblehigh”). Noblehigh is owned by Willas ArrayElectronics (Holding) Limited as well as certain members of management of Valence(collectively referred to herein as the “Management Buyers”). The saletransaction was completed on September 29, 2006.

The sale to Noblehigh was effected through twosimultaneous transactions: (1) the repurchase by Valence of approximately74% of the outstanding shares of Valence from SRS using its existing cash and (2) thepurchase by Noblehigh of the remaining outstanding shares of Valence from SRSfor $4.3 million. The sale resulted in a gain on the disposal of discontinuedoperations of $237,625.

Additionally, we repurchased from the ManagementBuyers 357,625 shares of our common stock, which were obtained through theexercise of vested employee stock options, for an aggregate repurchase price of$2,114,586. Such shares were immediately canceled and are therefore notoutstanding as of December 31, 2006. The repurchase price per share paidfor such shares was equal to the average closing price of our common stock forthe seven trading days ending three days prior to the closing date of the saleof Valence.

*CHS/SRSLLC:**  *In September 2004,we entered into a strategic alliance with Coming Home Studios LLC (“CHS”) touse and promote SRS Labs’ technologies, to promote CHS productions and topromote each company’s respective brands. In connection with the strategicalliance, SRS and CHS established a joint venture, CHS/SRS, LLC (the “JointVenture”), to produce and distribute nine concert videos featuring our CircleSurround technology. Initially, CHS was the manager of the Joint Venture;however, SRS became the manager of the Joint Venture in July 2005.

The Company recorded an asset impairment charge of$3.3 million related to its investment in the Joint Venture in the fourthquarter of fiscal 2005 based on management’s estimates of the recoverability ofthe related assets. On February 23, 2006, the Board authorized managementto take all reasonable steps to divest our entire equity interest in the JointVenture. On June 30, 2006, we completed the sale of our 

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interest in the JointVenture to CHS in exchange for $200,000, the rights to all cash assets of theJoint Venture, and a promissory note in the amount of $175,000. We received$200,000 from CHS and the cash assets of the Joint Venture. Any amounts relatedto the promissory note and accrued interest thereon will be recorded at thetime the cash is received by us. We recorded a gain on disposal of our interestin the Joint Venture of $387,021.

Further financial information for business segments,geographic areas and customer concentration is included in this Annual Report onForm 10-K under “Item 8. Financial Statements and Supplemental Data”and in Notes 1 and 8 to the Notes to Consolidated Financial Statements.Reference also is made to “Item 1A. Risk Factors” for a discussion relating tocertain risks relating to our business.

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

**Our Products andTechnologies**

Our licensingbusiness is focused on developing and marketing audio rendering, voice andsurround sound technologies to OEMs, ODMs, semiconductor manufacturers, andsoftware providers in the homeentertainment, portable media devices, personal telecommunications, personalcomputers and automotive markets. Ourportfolio of licensable technologies includes a wide range of techniques forthe processing and delivery ofaudio, voice and surround sound, including the following:

·       *Surround Sound*—Our surround sound technology, CircleSurround, is a complete encoding and decoding format. Circle Surround *encoding*enables the distribution of up to 6.1 channels ofaudio over existing two-channel carriers such as digital media files, standarddefinition and high-definition television, FM radio, and CDs. Circle Surround *decoding*decodes Circle Surround encoded material for multi-channelplayback or creates up to 6.1 channels of audio from older formats of material,including mono, stereo, 4-channel surround or other matrix surroundformats. Circle Surround decoding is available in three solutions: CircleSurround, Circle Surround II and Circle Surround Automotive.

·       *Audio Rendering*—Our audio rendering technologies optimizedevice audio output and enable the presentation of 3D and multichannel audiocontent over two speakers. These technologies include the ability to render 5.1multichannel content over two speakers, to create a wider sound stage for morenatural audio, to improve the perceived bass response in small speakers, todynamically position audio sources in a virtual 3D space using headphones, andto reposition the audio image for non-optimally placed speakers. Our audiotechnologies include SRS Xspace 3D, SRS WOW, SRS WOW XT, SRS WOW HD, SRSTruBass, SRS FOCUS, SRS Headphone, SRS DialogClarity, SRS TruSurround XT,TruSurround HD, SRS 3D Sound and SRS CS Auto.

·       *Voice Processing*—Our VIPand Noise Reduction technologies, dramatically reduce noise to producemuch clearer and crisper dialog over wireless communication devices and improvethe intelligibility of the human voice in a variety of listening situations,including high ambient background environments.

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

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**Our Customers andMarkets**

Welicense our technologies throughout the Western Hemisphere, the Asia Pacificregion and in Europe. The following table presents our revenue by geographic area.For licensing-related revenue, the allocation is based on the location ofthe licensee’s corporate headquarters. For product and on-line sales, revenueis allocated to the Americas.

| ** **                      | ** **   | **Years ended December 31,** | ** **   |
|---------------------------------|--------------|---------------------------------------------|--------------|
| ** **                      | ** **   | **2006**                                    | ** **   | **%** | ** ** | **2005** | ** ** | **%** | ** ** | **2004** | ** ** | **%** | ** ** |
| ***Geographic  Area Revenue:*** | *** *** | *** ***                                | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** |
| Japan                           |         | $                                           | 8,115,378    |   | 44 | % | $ | 5,564,809 |   | 38 | % | $ | 4,906,343 |   | 45 | % |
| Korea                           |         | 5,652,550                                   |         | 30 | % | 3,980,660 |   | 27 | % | 1,456,063 |   | 14 | % |
| Greater China                   |         | 3,165,572                                   |         | 17 | % | 2,763,646 |   | 19 | % | 1,625,564 |   | 15 | % |
| Americas                        |         | 1,534,421                                   |         | 8 | % | 2,024,269 |   | 14 | % | 2,318,359 |   | 21 | % |
| Europe                          |         | 79,608                                      |         | 1 | % | 275,094 |   | 2 | % | 525,375 |   | 5 | % |
| Total                           |         | $                                           | 18,547,529   |   | 100 | % | $ | 14,608,478 |   | 100 | % | $ | 10,831,704 |   | 100 | % |

 

Through our licensing business, we market ourportfolio of technologies to the following vertical markets: home entertainment,portable media devices, personal telecommunications, personal computers andautomotive. Our license agreements typically have multi-year or automaticrenewal terms, and either require per-unit royalty payments for all productsimplementing our technologies or provide for a fixed annual or quarterlyroyalty payment. The license agreements also specify the use of our trademarksand logos on the product, within the packaging and in the user’s manual, andrequire our review and approval of the product to guarantee the quality of thetechnology implementation and the correct usage of our logos and trademarks. Webelieve these terms ensure the quality and consistency of the technology andelevate the awareness of the SRS brand in the marketplace. Most of our licensingagreements do not have volume requirements and may be terminated by thelicensees or us without substantial financial penalty.

Thefollowing chart shows the percentage of our licensing revenue we received in2006 and 2005 from each of these markets.

|  |   |  |
|--|--------|--|

 

**Home Entertainment**

Home entertainment products represent the largestcurrent market for our technologies and have in recent years been the largestrevenue contributor. Manufacturers in this market utilize our technologies todifferentiate their products from their competitors while improvingfunctionality and product performance. In many instances, manufacturers licensemultiple technologies from us for multiple product lines and divisions. Productcategories within this market include HD televisions (such as LCD and Plasma televisions),set-top boxes, DVD players, audio/video receivers, and completehome-theater-in-a-box systems.

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*Televisions.*   Ouraudio technologies are widely used by television manufacturers as adifferentiating feature and as a solution to audio challenges thatmanufacturers encounter. As television makers continue to migrate from bulkytube models to thinner digital displays, manufacturers are finding that theyhave less room for speakers, which may compromise the overall audio quality ofthe television. We provide manufacturers with patented solutions for accuratelypresenting surround sound, improving bass response, increasing dialog clarity,and creating a more natural sound stage. These solutions improve the audioquality of the television set without the expense of additional equipment orlarger speakers. In 2006, our technologies continued to grow in popularity foruse in flat panel televisions from companies such as LG, Samsung, Toshiba andSony.

*DVD Players &Set-top Boxes.**  *Althoughthey present surround sound content, DVD players and set-top-boxes aretypically connected to televisions with two-channel speakers. Our SRSTruSurround XT technology creates a surround sound experience over any existingtwo-speaker system, including the internal speakers of a television. Thistechnology also creates a virtual surround experience from stereo material.

**PersonalTelecommunications**

We provide the personaltelecommunications market with both voice and audio rendering technologies.Mobile phones are incorporating more multimedia features and functionality at arapid pace. New services include digital music downloads, ring-tones andtrue-tones, streaming video, gaming, and television viewing. Our strongpresence in the home entertainment market, our suite of voice technologies, andour entry into the mobile market with customers like NEC present a growthopportunity for us. Our solutions address specific needs in the mobile market.For example, our technologies address needs like voice intelligibility in noisyenvironments, clarity of dialog in video content, poor bass-response of smallspeakers, hampered stereo imaging in narrow-set speakers, and 3D positioningaudio for interactive gaming. Our technologies are licensed bytelecommunications companies such as Motorola, Samsung, Pantech and NEC.

**Portable Media**

MP3 players and otherportable media players enable consumers to enjoy audio and video content whileon the go. The audio contents are stored in a compressed industry standard MP3audio standard. As such, when the contents are decoded and played back throughminiature earphones, the contents generally suffer loss of audio quality. Ourtechnologies such as WOW and WOW HD are capable of improving the audio qualityduring playback. Our Mobile HD technologies also enable rendering of surroundsound through earphones when playing back surround sound encoded contents oftenused along with contemporary video contents. Associated with the increasingpopularity of MP3 players, including Apple’s iPOD, there has been a noticeablegrowth in the market for accessories, such as docking stations and miniaturespeaker systems. Thee small footprint of these devices limits speaker size andspeaker spacing. Our solutions enable vendors of these devices to increase thequality of their audio output generally without increasing hardware componentcosts. In 2006, we significantly expanded our efforts in licensing ourtechnologies to companies designing and manufacturing accessories for theportable media market.

**Personal Computers**

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

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**Automotive**

We have invested inresearch to create solutions specific to the needs of the automotive market.Within vehicles, audio and video content is played from multiple sources andthen presented on both speakers and headphones. Stereo content from sourceslike CDs, MP3 players, and High Definition Radio needs to be presented on allspeakers in the car, some of which may not be optimally placed and may not havestrong bass response. Surround sound content from DVDs, radio, and downloadedmusic needs to be rendered on both car speakers with a maximum sweet spot andon rear-seat headphones. Our automotive solutions like SRS CS Auto, SRS CircleSurround II, and SRS TruSurround XT meet these needs and provide manufacturersin this segment with a fully tunable solution.

**CustomerConcentration**

For fiscal year 2006,Samsung and Sony accounted for approximately 17% and 11% of our consolidatedrevenues, respectively. For fiscal year 2005, Samsung and Sony each accountedfor approximately 13% of our consolidated revenues. For fiscal year 2004, Sonyand ST Micro accounted for approximately 14% and 10% of our consolidatedrevenues, respectively. Given the significant amount of revenues derived fromthese customers, the loss of any such customer or the uncollectibility ofrelated receivables could have a material adverse effect on our consolidatedfinancial condition and consolidated results of operations.

**Our Strategy**

Our sales strategy is to identify high-growthmarkets, develop needed technology solutions and features and work withsoftware and semiconductor platform partners to make these technologies widelyavailable and easy to implement by OEMs and ODMs. We believe that we willcontinue to strengthen our market position as a leader in audio and voicetechnology by employing the strategy of providing a stream of patented audioand voice technologies, penetrating new licensing accounts, expandingrelationships with existing licensees, creating a broad platform of softwareand semiconductor partners and developing strong awareness of the SRS brand.

The mission of our licensing platform efforts is toachieve broad coverage for our technology solutions within all of our targetedproduct markets in order to expand sales and licensing opportunities. Bydeveloping strong relationships with leading software and semiconductorcompanies, our audio technologies can be delivered to customers worldwideacross high growth and high volume product applications.

We work together with our platform partners (leadingsemiconductor manufacturers and middleware or firmware software providers) toprovide our mutual customers with the technology that best fits their needs. Wealso together solicit other new customers to consider using the platform. Manytimes, a platform will become enabled with our technology due to customerrequests.

As a technology licensing company, the strength of ourbrand is an important asset. Since brand recognition drives licensing sales, wehave invested in strategies designed to increase consumer awareness of SRS Labswith the ultimate goal of establishing our brand with both productmanufacturers and consumers around the world as the symbol for high-qualityaudio. The three primary vehicles that we use to further the proliferation ofour brand are: (a) placement of the SRS logo by OEMs on products and inco-marketing programs; (b) online branding programs; and (c) use, andrecognition of use, of SRS technology by content and broadcast professionals.

*OEMMarketing Programs.**  *In themajority of products which use SRS technologies, our logo is either prominentlydisplayed on the product itself or, in the case of software products and mobilephones, featured in the graphical user interface. We believe this logo exposureis a key tool in reaching consumers 

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worldwide. In addition, wework with our OEM customers as they launch new products that feature SRStechnologies. We supply complete SRS corporate and technology tool kits with awide array of material, including SRS logos, illustrations, technologyexplanations and suggested demonstration material. In 2006, for example, weworked with Sharper Image to prominently display products with the SRS logo intheir retail stores, catalogs, SkyMall magazines and on their website.

*OnlineBranding.**  *Onlineexposure has also been an important part of our branding strategy. One benefitof our relationship with Microsoft is that the SRS logo displayed in the audiocontrol panel of Microsoft’s Windows Media Player links to an SRS technologypage. As a result, we have received significant traffic and opportunities tocreate brand awareness with consumers and educate consumers on the benefits ofour technology. Our online efforts also include the direct sale of plug-ins forWindows Media Player. Revenue from the sale of these products is notsignificant, but gives us a valuable demonstration platform to showcase ouraudio technologies.

*Use of SRS Technology byContent and Broadcast Professionals.**  *We develop,license and sell professional hardware and software products to enablecontent companies, broadcasters and music publishers to encode their materialusing our Circle Surround technology. When Circle Surround is professionallyused, the logo is often displayed within the content itself, on the packagingmaterial or, in the case of radio, an announcement that the broadcast is beingdelivered in Circle Surround. We have concentrated on three key market segmentsin the professional audio space: television, radio and music; and we havedeveloped a line of hardware and software products to address these markets. These products are sold directly toprofessional customers and are also available from selected dealers anddistributors servicing the professional audio and broadcast markets. We did notgenerate significant revenue from the sale of professional hardware equipmentin 2006; however, we believe that these facilitate the licensing of ourtechnology to OEMs that benefit from enhanced audio transmissions.

**Sales and Marketing**

We have two types of revenue collection systems withour licensees—bundled or non-bundled. Under a bundled agreement, royaltyrevenue may be collected by our platform partner at the time the solution issold to an OEM or ODM. Most often, however, we license our technologiesdirectly to OEMs and ODMs and collect revenue directly from them. Theselicensing arrangements with OEMs or ODMs authorize them to design, build andsell products containing our technology. Under this licensing approach, thelicensees are free to choose a semiconductor solution from the platform partnerthat best suits their technical and cost requirements. We receive royaltiesdirectly from the licensed OEM or ODM for the use of our technologies inlicensed products manufactured and shipped by the OEM or ODM. Many major OEMshave licenses or purchase products manufactured by a licensed ODM for the useof one or more of our technologies and for the use and display of ourtrademarks. In the case of the platform partner who bundles our technologywithin their solution, the cost of the solution includes our royalty at thetime it is sold. The platform partner remits that royalty directly back to uson behalf of the licensee.

Our process for selecting particular platform partnersfor distributing our technology is based on several criteria including: (a) segmentleadership—we target platform partners that hold preeminent positions in marketsegments characterized by high growth, volume and/or margins; (b) volume—weseek platforms that will maximize exposure of our technologies to a largenumber of potential OEMs; (c) synergy—we seek platforms which serve toposition our technologies along with compatible and additive technologies forintegrated delivery; and (d) convergence potential—we target arrangementsthat will enable us to establish a presence on platforms that intersect mergingfunctional features. An example of this convergence would be the platforms fornew personal multifunctional devices that include mobile phone, personaldigital assistant, and music capabilities.

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To implement our licensing sales strategy within ouridentified vertical markets, we have established a direct sales force and aworldwide network of independent sales agents. In North America, we employ adirect sales force to market our portfolio of audio and voice technologies tothe OEM community. Internationally, we maintain offices in Japan, Hong Kong,Taiwan, China, Spain and Korea to support our multi-national OEMcustomers. We actively promote the use of our trademarks and logos and directcustomers to prominently display the appropriate SRS technology logo onproducts and packaging and in advertising. We work closely with our licenseesto enhance their success in selling finished products and semiconductorproducts that incorporate our technologies through a variety of licenseesupport programs. These programs include engineering support, sales training,tradeshow support, publicity and media relations programs, customized marketingmaterials, advertising, speaking engagements and industry conferences. Wherepossible, we use the Internet to provide technology demonstrations. We conductin-person technology demonstrations or presentations for the press and othercompanies to promote our technologies and products.

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

**Research andDevelopment**

We license our products in markets that arecharacterized by rapidly changing technology and continuous improvements inproducts and services. Our research and development expenditures in 2006, 2005,and 2004 were $2,572,577, $2,224,237 and $2,261,886, respectively. Theseexpenses consist of salaries and related costs of employees and consultantsengaged in ongoing research, design and development activities and costs forengineering materials and supplies.

As of December 31,2006, we had 12 employees in our research and development group, representing31% of our total employees. Our software, hardware and application engineersfocus on developing intellectual property, technology solutions and consumerproducts. All engineers are based in the U.S. and support our licensingbusiness.

**Competition**

Competition in the audio, voice and surround soundtechnology licensing business includes other licensing companies who offercompeting technologies as well as the internal engineering departments of ourlicensees, who may develop audio technologies for use in their own products.

In the field of audio improvement, we compete directlywith other audio providers, including Audistry by Dolby, DTS, BBE Sound, andQsound. Our 3D positional audio technology directly competes with technologiesfrom QSound and Synoptic. We believe that our bass technology, TruBass,competes directly with several technologies, including MaxxBass from Waves, Ltd,Vi.B.E from Spatializer, and non-proprietary bass systems, such as Bass Boost,that are included on a variety of electronics products, including televisions,portable stereos and speaker products. Additionally, many of our OEM customers maintaintheir own audio improvement technologies. Because our audio technologies workwith any existing recorded material, whether mono, stereo or surround sound,most of our audio technologies, including SRS 3D, SRS FOCUS, SRS TruBass andSRS Dialog Clarity, can be used either as an alternative or as a complement tomost competing audio technologies.

Our surround sound rendering technologies competeprimarily with Dolby Virtual Speaker, and our surround sound format competesdirectly with the Dolby ProLogic technologies. However, our surround sounddecoders and renderers are compatible with third party content formats.

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Many companies in the wireless and telecommunicationsindustry are investigating methods to increase the quality of a voice signal;but we believe that their development work focuses on techniques to reducenoise and provide echo cancellation. Our voice technology, VIP, processes theactual voice signal to improve intelligibility. We are aware of one recentlyintroduced technology by NXP that direct competes with VIP.

Many of the companies referenced above have, or mayhave, substantially greater resources than us to devote to advancing theirexisting technologies and developing new products and technologies. We believethat we compete based primarily on the quality and performance of ourproprietary technologies, brand name awareness, the ease and cost ofimplementing our technologies, the ability to meet OEMs’ needs to differentiatetheir products, and the strength of our licensee relationships. We believe wecompete favorably based on these factors; however, there can be no assurancethat we will continue to be competitive with the existing or future products ortechnologies of our competitors.

In the broadcast andprofessional audio markets, our Circle Surround technology competes directlywith surround sound formats from Dolby and DTS, which market professionalproducts for the encoding and creation of multichannel content. Both of thesecompanies have more established reputations, greater technical, sales,marketing and distribution capabilities and stronger brand presence in themovie/cinema, television broadcast and music recording segments of professionalaudio. These competitors also have established or may establish strategicrelationships with potential customers of our Circle Surround technology, whichmay affect our customers’ decisions to purchase products or license technologyfrom us.

**IntellectualProperty Rights and Proprietary Information**

We operate in industries where innovation, investmentin new ideas and protection of intellectual property rights are important forsuccess. We rely on a variety of intellectual property protections for ourproducts and services, including patent, copyright, trademark and trade secretlaws and contractual obligations. We pursue a policy of enforcing such rights.There can be no assurance, however, that our intellectual property rights willbe adequate to ensure our competitive position or that competitors will not beable to produce non-infringing competitive products or services. There can beno assurance that third parties will not assert infringement claims against us,or that if required to obtain any third party licenses as a result of aninfringement dispute, we will be able to obtain such licenses.

In order to protect the underlying technologyconcepts, we have filed and/or obtained patents for all of our marketedtechnologies including technologies marketed under the trademarks SRS,TruSurround, TruSurround XT, FOCUS, Circle Surround, Circle Surround II, WOW,VIP and TruBass. In addition, we have numerous issued patents and patentspending for speaker and other acoustic reproduction technologies. We pursue ageneral practice of filing patent applications for our technologies in theUnited States and various foreign countries where our licensees manufacture,distribute or sell licensed products. We continue to update and add newapplications to our patent portfolio to address changing worldwide marketconditions and our new technological innovations. The range of expiration datesfor our patents extend between the years 2007 to 2016. We have multiple patentscovering unique aspects and improvements for many of our technologies.Accordingly, the expiration of any single patent may not significantly affectour intellectual property position or the ability to generate licensingrevenue.

We also routinelyfile U.S. federal and foreign trademark applications for the various wordnames and logos used to market our technology solutions to licensees and thegeneral public. The duration of the U.S. and foreign registered trademarks cantypically be maintained indefinitely, provided that proper maintenance fees arepaid and the trademarks are continually used or licensed by us.

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**Seasonality**

Due to the dependence onthe consumer electronics market, we experience seasonal fluctuation in salesand earnings. In particular, we believe that our business experiencesseasonality relating to the holiday season, resulting in higher revenues in thefourth and first quarters. We have moved toward diversifying our key marketsegments in the consumer electronics industry in an effort to reduce the impactof our seasonal fluctuations.

**Employees**

As of December 31,2006, we employed 39 persons, including 10 in finance and administration, 12 inresearch and development, engineering and product development, and 17 in salesand marketing. None of our employees are covered by a collective bargainingagreement or are presently represented by a labor union. We have notexperienced any labor problems or a work stoppage and believe we have goodrelations with our employees.

**AvailableInformation**

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

**Item 1A.**                RiskFactors

You should carefullyconsider the risk factors described below, as well as the other informationincluded in this Annual Report on Form 10-K, prior to making adecision to invest in our securities. The risks and uncertainties describedbelow are not the only ones facing our company. Additional risks anduncertainties not presently known or that we currently believe to be lesssignificant may also adversely affect us.

*We are exposed torisks in our licensing business related to product and customer concentration.*

Currently, we generate amajority of our revenue in the home theater market, principally through theinclusion of SRS technology inside LCD, Plasma and CRT televisions, and set-topboxes. We expect that the consumer home entertainment market will continue toaccount for a significant portion of our licensing revenues for the foreseeablefuture. While consumer spending in general on consumer electronic products hasincreased, retail prices for certain consumer electronics products that includeour audio technology, have decreased significantly. Indications are that thistrend will continue for the foreseeable future. From time to time, certain ofour OEM and semiconductor manufacturer customers may account for a significantportion of our revenue from a particular product application. For example, forthe year ended December 31, 2006, Samsung and Sony accounted for approximately18% and 11% of our consolidated revenues, respectively. Consumer electronicsproducts manufacturers could decide to exclude our audio rendering technologyfrom their products altogether in an effort to reduce cost. The loss of anysuch customer could have a material adverse affect on our financial conditionand results of operations.

*Our business ishighly dependent on the consumer electronics market, which is characterized byshort product life cycles, fluctuations in demand and seasonality, and issubject to risks related to product transitions and supply of other components.*

The consumer electronicsmarket is characterized by intense competition, rapidly evolving technology,and ever-changing consumer preferences. These factors result in the frequentintroduction of new 

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products,short product life cycles and significant price competition. As a result, wemay need to develop new products or technologies to integrate with the newproducts and technologies developed by our customers. If we are unable todevelop the necessary technologies to meet the changing needs of our customersor provide such technologies at competitive prices, our customers may reducetheir use of our technologies and our revenues may decline. In addition, thedynamic nature of this market limits our, as well as our customers’, ability toaccurately forecast quarterly and annual sales. If we, or our customers, areunable to adequately manage product transitions, our business and results ofoperations could be negatively affected.

*Pricing pressureson the consumer electronics product manufacturers, who incorporate ourtechnologies into their products, could limit the licensing fees we charge forour technologies, which could reduce our revenues.*

The markets for the consumerelectronics products in which our technologies are incorporated are intenselycompetitive and price sensitive. Retail prices for consumer electronicsproducts that include our technologies, have decreased significantly, and weexpect prices to continue to decrease for the foreseeable future. In response,manufacturers have sought to reduce their product costs, which can result indownward pressure on the licensing fees we charge our customers who incorporateour technologies into their products. Alternatively, our customers may seek toeliminate our technologies in their products in favor of internally developedtechnologies. A decline in the licensing fees we charge could materially andadversely affect our operating results.

*We face intensecompetition from companies with greater brand recognition and resources.*

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

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

·       greatername recognition;

·       alonger operating history;

·       moredeveloped distribution channels and deeper relationships with consumerelectronics products designers and manufacturers;

·       amore extensive customer base;

·       broaderproduct and service offerings;

·       greaterresources for competitive activities, such as research and development,strategic acquisitions, alliances, joint ventures, sales and marketing, andlobbying industry and government standards; and

·       moretechnicians and engineers.

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

*We are subject torisks associated with substantial international operations.*

We conduct salesand customer support operations in a number of countries throughout the worldthat require refinement to adapt to the changing market conditions on aregional basis. In addition, many of our significant customers areheadquartered in the Asia Pacific region, particularly Japan and Korea. Approximately91%, 84% and 74% of our sales were derived from customers with headquarterslocated in 

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theAsia Pacific markets during the years ended December 31, 2006, 2005 and2004, respectively. We expect to continue to derive a significant portion ofour net sales from sales to customers in these markets for the foreseeablefuture. Also, a substantial number of products incorporating our technologiesare manufactured, assembled and tested by third parties in Asia. As a result,we are subject to a number of risks of conducting business outside of theUnited States, any of which could have a material adverse impact on our resultsof operations, including:

·       political,social and economic instability, and the risk of war, terrorist activities orother international incidents in Asia and elsewhere abroad;

·       difficultiesand costs of staffing and managing foreign operations;

·       unexpectedchanges in, or impositions of, government requirements;

·       adversechanges in tariffs and other protectionist laws and business practices thatfavor local competitors;

·       potentiallylonger payment cycles and greater difficulty in collecting receivables fromforeign entities;

·       theburdens of complying with a variety of non-U.S. laws and reduced protection ofour intellectual property in some countries;

·       potentiallyadverse tax consequences and the complexities of foreign value added taxsystems; and

·       other factors beyond ourcontrol, including natural disasters and major health concerns.

*Our ability togenerate revenues and meet with customers may be affected by widespreadillness.*

Widespread illnesses suchas the SARS illness and the Avian Influenza, or Asia Bird Flu, could impact ouroperations or our consumer electronics licensee’s operations. For example, ourability to visit our customers, our ability to conduct sales meetings or presentations,and sell through rates of electronics products to end consumers may bedramatically effected by either widespread or perceived potential illnesses.

*If the sale ofconsumer electronics products incorporating our technologies does not grow inemerging markets, our ability to increase our licensing revenue may be limited.*

We also expect that growthin our licensing revenue will depend, in part, upon the growth of sales ofconsumer electronics products incorporating our technologies in other countries,including China and India, as consumers in these markets have more disposableincome and are increasingly purchasing entertainment products with surroundsound capabilities. These countries have rapidly expanding and growingeconomies that are less mature than economies of other regions in which wederive significant portions of our revenue. Because of this, changes toemployment patterns, currency fluctuations and political uncertainties couldimpact our ability to grow our licensing revenues in these regions.

*We have a long andunpredictable sales cycle, which can result in uncertainty and delays ingenerating additional revenues.*

Historically, because ofthe complexity of our technologies, it can take a significant amount of timeand effort to explain the benefits of our technologies to potential newcustomers and to negotiate a sale. For example, it typically takes six to ninemonths after our first contact with a prospective customer before we startlicensing our technology to that customer. In addition, purchases of ourproducts are usually made in connection with new design starts by ourcustomers, the timing of which is outside of our control. Accordingly, we maybe unable to predict accurately the timing of any significant future sales ofour 

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products.We may also spend substantial time and management attention on potentiallicense agreements that are not consummated, or in which the consumerelectronic product ultimately does not sell in large quantities, therebyforegoing other higher revenue opportunities.

*If our patents andother intellectual property rights do not adequately protect our products, wemay lose market share to our competitors and be unable to operate our businessprofitably.*

Our ability to compete maybe affected by our ability to protect our proprietary information. We havefiled numerous U.S. and foreign patent applications and to date have a numberof issued U.S. and foreign patents covering various aspects of ourtechnologies. There can be no assurance that the steps taken by us to protectour intellectual property will be adequate to prevent misappropriation of ourtechnology or that our competitors will not independently develop technologiesthat are substantially equivalent or superior to our technology. In addition,the laws of certain foreign countries may not protect our intellectual propertyrights to the same extent as do the laws of the U.S. It is possible that thirdparties may assert claims or initiate litigation against us or our customerswith respect to existing or future products. In addition, we may initiateclaims or litigation against third parties for infringement of our proprietaryrights or to determine the scope and validity of our proprietary rights. Claimsand litigation brought against us or initiated by us could be costly and timeconsuming and could divert our management from our business.

*If we lose theservices of our key personnel, or if we are unable to attract and retain otherkey personnel, we may not be able to manage our operations or meet our growthobjectives.*

Our future success dependsto a large extent upon the continued service of key personnel, includingengineering, sales and administrative staff. We anticipate that any futuregrowth will require us to recruit and hire a number of new personnel inengineering, operations, finance, sales and marketing. Competition for suchpersonnel can be intense, and it is possible that we may not be able to recruitand retain necessary personnel to operate our business and support futuregrowth.

*The market price ofour common stock is volatile and your investment in our common stock couldsuffer a decline in value.*

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

*Our certificate ofincorporation and bylaws as well as Delaware law contain provisions that coulddiscourage transactions resulting in a change in control, which may negativelyaffect the market price of our common stock.*

Our certificate ofincorporation, our bylaws and Delaware law contain provisions that might enableour management to discourage, delay or prevent a change in control. Inaddition, these provisions could limit the price that investors would bewilling to pay in the future for shares of our common stock.

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**Item 1B.**               UnresolvedStaff Comments.

None.

**Item 2.**                        Properties

Our worldwide headquarters are located in Santa Ana,California, in a 23,400 square foot facility consisting of office and warehousespace. The lease is for a term of three years scheduled to expire on May 31,2008. We lease this facility from Daimler Commerce Partners, L.P., the generalpartner of which is Conifer Investments, Inc. The sole shareholders ofConifer are Thomas C.K. Yuen, our Chairman, Chief Executive Officer and President,and his spouse, Misako Yuen, as co-trustees of the Thomas Yuen Family Trust. Mr. andMrs. Yuen also serve as the executive officers of Conifer. Mr. and Mrs. Yuen,as co-trustees of the trust, beneficially own a significant amount of ouroutstanding shares of common stock. We paid the Daimler Commerce Partners rentof $230,256, $222,066 and $210,600 in 2006, 2005 and 2004, respectively. Webelieve the terms and conditions of the lease are competitive based on a reviewof similar properties in the area with similar terms and conditions.

Our worldwide headquartershouse personnel responsible for the development of our technologies and theadministration of the licensing business. We believe that our currentfacilities are adequate to support our current requirements.

**Item 3.**                        LegalProceedings

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

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

None.

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**PART II**

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

**Market for CommonStock**

Ourcommon stock trades on the NASDAQ Global Market under the symbol SRSL. Thetable below reflects the high and low sales prices of our common stock asreported by The NASDAQ Stock Market, Inc. for the periods indicated.
|                  | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------|------------|----------|------------|---------|------------|
| **Fiscal 2006**  |       |     |       |    |       |
| First Quarter    |       | $        | 6.72       |    | $          | 5.11 |   |
| Second Quarter   |       | $        | 6.32       |    | $          | 4.60 |   |
| Third Quarter    |       | $        | 6.25       |    | $          | 4.39 |   |
| Fourth Quarter   |       | $        | 11.63      |    | $          | 5.80 |   |
| **Fiscal  2005** |       |     |       |    |       |
| First Quarter    |       | $        | 6.50       |    | $          | 3.70 |   |
| Second Quarter   |       | $        | 6.12       |    | $          | 3.46 |   |
| Third Quarter    |       | $        | 6.71       |    | $          | 5.03 |   |
| Fourth Quarter   |       | $        | 6.90       |    | $          | 5.34 |   |

 

At March 9, 2007, thelast sale price our common stock was $11.01 per share.

**Holders**

At March 9, 2007,there were 403 stockholders of record.

**Dividend Policy**

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

**SecuritiesAuthorized for Issuance Under Equity Compensation Plans**

The following equitycompensation plans have been approved by our stockholders: the SRS Labs, Inc.Stock Option, Nonqualified Stock Option and Restricted Stock Purchase Plan (the“1993 Plan”), the SRS Labs, Inc. Amended and Restated 1996 Long-TermIncentive Plan (the “1996 Plan”), the SRS Labs, Inc. Amended and Restated1996 Non-employee Directors’ Stock Option Plan (the “Non-employee DirectorsPlan”) and the SRS Labs, Inc. 2006 Stock Incentive Plan (the “2006 Plan”).A description of the material features of each of these plans is included inNote 7 to the Notes to Consolidated Financial Statements under the caption “StockAward/Option Plans/Warrants.”  No optionshave been granted under the 1993 plan since June 7, 1996. The 1993 planexpired on December 10, 2003 and no options or other rights to acquireequity are outstanding under that plan. On June 22, 2006, the Company’sstockholders voted to approve the 2006 Plan, and to discontinue the issuance ofany awards under the 1996 Plan.  We donot have any equity compensation plans other than those approved by ourstockholders. The following table sets forth information regarding the numberof shares of our common stock that may be issued pursuant to our equitycompensation plans or arrangements as of December 31, 2006.

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**EquityCompensation Plan Information**

| ** **                                              | ** ** | **(a)**    | ** ** | **(b)**                                                                                                                                          | ** ** | **(c)**                                                                                                     | ** ** |
|---------------------------------------------------------|------------|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|
| **Plan category**                                  | ** ** | ** ** | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities remaining  available for future issuance  under equity compensation plans  (excluding securities  reflected in column(a))** | ** ** |
| Equity  compensation plans approved by security holders |       |       | 2,360,088  | (1)                                                                                                                                              |       |                                                                                                        | $          | 4.91 |   |   |   | 1,715,000 | (2) |   |
|                                                         |            |            |            |                                                                                                                                                  |            |                                                                                                             |            |  |  |  |  |  |  |  |  |  |

 

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(1)          Represents shares ofcommon stock that may be issued pursuant to outstanding options granted underthe following plans: 2,105,088 shares under the 1996 Plan, 130,000 shares underthe Non-employee Directors Plan and 125,000 shares under the 2006 Plan.

(2)          Representsshares of common stock that may be issued pursuant to future grants under thefollowing plans: 340,000 shares under the Non-employee Directors Plan and1,375,000 shares under the 2006 Plan.

**Purchases of EquitySecurities by the Issuer and Affiliated Purchaser**

On June 30, 2004, the Board authorized therepurchase of up to $3,000,000 of our outstanding common stock for a periodfrom July 1, 2004 to December 31, 2004 (the “2004 Repurchase Program”).We repurchased 216,575 shares of our common stock at a cost of $1,225,254 underthe 2004 Repurchase Program.

On March 25, 2005, the Board adopted a stockrepurchase program authorizing the purchase of up to $3,000,000 of our commonstock during the period from April 2005 to March 2006. As of March 31,2006 (the end of the repurchase program), total purchases under the programsince inception were 232,223 shares at an average purchase price of $4.56 pershare.

In connection with the sale of Valence on September 29,2006, we repurchased 357,625 shares of our common stock at an aggregate cost of$2,114,586, which were immediately cancelled.

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**Item 6.**                        SelectedFinancial Data

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

| ** **                                                                       | ** ** | **Years Ended December 31,**                       | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2006**                                                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                       | ** ** | **(In thousands except per share data)** | ** ** |
| Revenues                                                                         |       | $                                                                 | 18,547     |   | $ | 14,608 |   | $ | 10,832 |   | $ | 9,102 |   | $ | 8,224 |   |
| Cost of sales.                                                                   |       | 171                                                               |       | 236 |   | 228 |   | 103 |   | 154 |   |
| Gross margin                                                                     |       | 18,376                                                            |       | 14,372 |   | 10,604 |   | 8,999 |   | 8,070 |   |
| Operating expenses:                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Sales and marketing                                                              |       | 7,345                                                             |       | 5,192 |   | 4,550 |   | 4,193 |   | 3,792 |   |
| Research and development                                                         |       | 2,573                                                             |       | 2,224 |   | 2,262 |   | 1,876 |   | 1,890 |   |
| General and  administrative                                                      |       | 5,660                                                             |       | 5,170 |   | 4,622 |   | 4,048 |   | 3,924 |   |
| Total operating expenses                                                         |       | 15,578                                                            |       | 12,586 |   | 11,434 |   | 10,117 |   | 9,606 |   |
| Operating income (loss)                                                          |       | 2,798                                                             |       | 1,786 |   | (830 | ) | (1,118 | ) | (1,536 | ) |
| Other income, net                                                                |       | 1,136                                                             |       | 673 |   | 595 |   | 543 |   | 852 |   |
| Income (loss) from  continuing operations before income taxes                    |       | 3,934                                                             |       | 2,459 |   | (235 | ) | (575 | ) | (684 | ) |
| Income taxes                                                                     |       | 868                                                               |       | 796 |   | 523 |   | 631 |   | 421 |   |
| Income (loss) from  continuing operations                                        |       | 3,066                                                             |       | 1,663 |   | (758 | ) | (1,206 | ) | (1,105 | ) |
| Discontinued operations:                                                         |       |                                                              |       |   |   |   |   |   |   |   |   |
| Income (loss) from  discontinued operations net of income taxes (benefit)        |       | 1,017                                                             |       | (3,087 | ) | 2,337 |   | 1,665 |   | 1,911 |   |
| Gain on disposal of  discontinued operations                                     |       | 625                                                               |       | — |   | — |   | — |   | — |   |
| Income (loss) from  discontinued operations.                                     |       | 1,642                                                             |       | (3,087 | ) | 2,337 |   | 1,665 |   | 1,911 |   |
| Net income (loss)                                                                |       | $                                                                 | 4,708      |   | $ | (1,424 | ) | $ | 1,579 |   | $ | 459 |   | $ | 806 |   |
| Income (loss) from continuing operations per common  share:                      |       |                                                              |       |   |   |   |   |   |   |   |   |
| Basic                                                                            |       | $                                                                 | 0.21       |   | $ | 0.12 |   | $ | (0.05 | ) | $ | (0.09 | ) | $ | (0.09 | ) |
| Diluted                                                                          |       | $                                                                 | 0.20       |   | $ | 0.12 |   | $ | (0.05 | ) | $ | (0.09 | ) | $ | (0.09 | ) |
| Income (loss) from discontinued operations per  common share:                    |       |                                                              |       |   |   |   |   |   |   |   |   |
| Basic                                                                            |       | $                                                                 | 0.11       |   | $ | (0.22 | ) | $ | 0.17 |   | $ | 0.13 |   | $ | 0.15 |   |
| Diluted                                                                          |       | $                                                                 | 0.11       |   | $ | (0.22 | ) | $ | 0.15 |   | $ | 0.12 |   | $ | 0.15 |   |
| Net income (loss) per common share:                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Basic                                                                            |       | $                                                                 | 0.31       |   | $ | (0.10 | ) | $ | 0.11 |   | $ | 0.04 |   | $ | 0.06 |   |
| Diluted                                                                          |       | $                                                                 | 0.30       |   | $ | (0.10 | ) | $ | 0.10 |   | $ | 0.03 |   | $ | 0.06 |   |
| Weighted average number of shares used in the  calculation of per share amounts: |       |                                                              |       |   |   |   |   |   |   |   |   |
| Basic                                                                            |       | 14,956                                                            |       | 14,118 |   | 13,950 |   | 13,033 |   | 12,648 |   |
| Diluted                                                                          |       | 15,466                                                            |       | 14,118 |   | 15,781 |   | 14,421 |   | 12,862 |   |
| Balance sheet data:                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Working capital                                                                  |       | $                                                                 | 34,697     |   | $ | 8,849 |   | $ | 7,192 |   | $ | 12,335 |   | $ | 14,401 |   |
| Total assets                                                                     |       | $                                                                 | 45,049     |   | $ | 35,065 |   | $ | 35,502 |   | $ | 31,491 |   | $ | 29,307 |   |
| Stockholders’ equity                                                        |       | $                                                                 | 42,744     |   | $ | 30,813 |   | $ | 32,431 |   | $ | 27,950 |   | $ | 25,282 |   |

 

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

**Overview**

SRS Labs is a leadingdeveloper and provider of audio and voice technology solutions for the homeentertainment, portable media device, personal telecommunications, personalcomputer, automotive, and broadcast markets. Prior to September 29, 2006,the Company was also a developer and provider of application specificintegrated circuits and standard integrated circuits through its formerlywholly-owned subsidiary, Valence Tech Limited.

***Licensing:******  ***Our operations are conducted through SRS Labs, Inc.,the parent company, and its wholly-owned subsidiary, SRSWOWcast.com, Inc. Ourbusiness is focused on developing and licensing audio, voice and surround soundtechnology solutions to many of the world’s leading OEMs, software providersand semiconductor companies, and license and marketing hardware and softwareproducts for the Internet and professional audio markets.

***DiscontinuedOperations:***

*Valence:*   ThroughSRS Labs, Inc.’s formerly wholly-owned subsidiary, ValenceTech Limited, weoperated a fabless semiconductor business which developed, designed andmarketed standard and custom analog integrated circuits, digital signalprocessors, and mixed signal integrated circuits primarily to OEMs and ODMs, inthe Asia Pacific region.

On February 23, 2006,our Board approved a plan to sell Valence in order to focus management’sattention and financial resources on our licensing business. On July 14,2006, we entered into a definitive Sale and Purchase Agreement to sell Valenceto Noblehigh Enterprises Inc. Noblehigh is owned by Willas Array Electronics(Holding) Limited as well as certain members of management of Valence(collectively referred to herein as the “Management Buyers”). The saletransaction was completed on September 29, 2006 and accordingly theresults of the operations of Valence through the date of sale are included asdiscontinued operations in the accompanying consolidated statement ofoperations for the years ended December 31, 2006, 2005 and 2004. Thetransaction did not require approval from SRS stockholders.

The sale to Noblehigh waseffected through two simultaneous transactions: (1) the repurchase byValence of approximately 74% of the outstanding shares of Valence from SRSusing its existing cash and (2) the purchase by Noblehigh of the remainingoutstanding shares of Valence from SRS for $4.3 million. The sale resulted in again on the disposal of discontinued operations of $237,625 in the accompanyingconsolidated statement of operations for the year ended December 31, 2006.

Additionally, werepurchased from the Management Buyers 357,625 shares of our common stock,which were obtained through the exercise of vested employee stock options, foran aggregate repurchase price of $2,114,586. Such shares were immediatelycanceled and are therefore not outstanding as of December 31, 2006. Therepurchase price per share paid for such shares was equal to the averageclosing price of our common stock for the seven trading days ending three daysprior to the closing date of the sale of Valence. See Note 11 of our Notes tothe Consolidated Financial Statements.

*CHS/SRS LLC:**  *In September 2004, we entered into a strategicalliance with Coming Home Studios LLC  touse and promote SRS Labs’ technologies, to promote CHS productions and topromote each company’s respective brands. In connection with the strategicalliance, SRS and CHS established a Joint Venture, CHS/SRS, LLC, to produce anddistribute nine concert videos featuring our Circle Surround technology. Initially,CHS was the manager of the Joint Venture; however, SRS became the manager ofthe Joint Venture in July 2005. As a result of becoming the manager of,and providing financial support to, the Joint Venture, we were required underFinancial Accounting Standards Board Interpretation No. 46, *Consolidation of Variable Interest Entities,* to consolidatethe financial statements of the Joint Venture into our consolidated financialstatements commencing with the third quarter of fiscal 2005. Previously, weaccounted for our 50% equity ownership in the Joint Venture as an investmentusing the equity method.

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The Company recorded anasset impairment charge of $3.3 million related to our investment in the JointVenture in the fourth fiscal quarter of 2005. On February 23, 2006, ourBoard authorized management to take all reasonable steps to divest our entireequity interest in the Joint Venture. On June 30, 2006, we completed thesale of our interest in the Joint Venture to CHS in exchange for $200,000, therights to all cash assets of the Joint Venture, and a promissory note in theamount of $175,000. We received $200,000 from CHS and the cash assets of thejoint venture. Any amounts related to the promissory note and accrued interestthereon will be recorded at the time the cash is received by us. We recorded again on disposal of our interest in the Joint Venture of $387,021 in theaccompanying consolidated statement of operations for the year ended December 31,2006.

**Critical Accounting Policies**

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

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

The following represents asummary of our critical accounting policies, defined as those policies that webelieve are: (a) the most important to the portrayal of our financialcondition and results of operations, and (b) that require management’smost difficult, subjective or complex judgments, often as a result of the needto make estimates about the matters that are inherently uncertain. Our mostcritical accounting estimates include revenue recognition; valuation ofaccounts receivable, which impacts operating expenses; valuation of intangibleassets and capitalization of software, which primarily impacts operatingexpenses when we impair assets or accelerate their depreciation; recognitionand measurement of current and deferred income tax assets and liabilities,which impacts our tax provision; and stock based compensation, which impactsoperating expenses. We discuss each of these policies below, as well as theestimates and judgments involved. We also have other policies that we considerkey accounting policies; however, these policies do not meet the definition ofcritical accounting estimates, because they do not generally require us to makeestimates or judgments that are difficult or subjective.

*Revenue Recognition*

Royalty revenuesassociated with ongoing royalty license agreements are recognized upon receiptof reports from licensees stating the number of products implementing SRSpatented technologies on which royalties are due, generally one quarter inarrears. The Company also has arrangements under which license fees are prepaidupfront, in addition to ongoing per-unit license fees. In such cases, theprepaid fees are recorded as deferred revenues and recognized as revenue uponreceipt of reports from licensees stating the number of products shipped onwhich royalties are due. Licensing revenues for one-time technology transferfees are recognized in the period in which the license agreement is consummatedand the related technology and passage of title is transferred. Revenue fromproduct sales is generally recognized upon shipment at which point titlepasses. Certain products may be sold under consignment agreements, and revenueis recognized upon reported distributor sales. Design revenue under designcontracts is recognized on the percentage-of-completion method. Estimates arereviewed and revised periodically throughout the lives of the contracts. Anyrevisions are recorded in the accounting period in which the revisions aremade.

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*Accounts Receivable*

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

*Intangible Assets, Capitalization of Software andImpairment of Long-Lived Assets*

In accordance withStatement of Financial Accounting Standards No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets*(“SFAS No. 144”),all of our intangible assets that have definite lives are being amortized on astraight-line basis over their estimated useful lives. Costs paid by us relatedto the establishment and transfer of patents, primarily legal costs, arecapitalized and amortized over ten years. We annually evaluate therecoverability of our patents and intangible assets based on the estimatedfuture undiscounted cash flows. Should the carrying value of patents orintangible assets exceed the estimated future undiscounted cash flows for theexpected periods of benefit, such assets will be written down to fair value. Asdiscussed further in Note 4 to the Notes to the Consolidated FinancialStatements, based upon our most recent assessment as of December 31, 2006,we have determined there was no impairment in the value of our long-livedassets.

Costs incurred in theresearch, design and development of software for sale to others as a separateproduct or embedded in a product and sold as part of the product as a whole arecharged to expense until technological feasibility is established. UnderStatement of Financial Accounting Standards No. 86, *Accountingfor the Costs of Computer Software to be Sold, Leased or Otherwise Marketed*(“SFASNo. 86”), we capitalize software purchased from third parties if therelated software product under development has reached technologicalfeasibility or if there are alternative future uses for the purchased software,provided that capitalized amounts will be realized over a period ofapproximately three years. Costs incurred prior to the establishment oftechnological feasibility are charged to research and development expense. Theestablishment of technological feasibility and ongoing assessment of recoverabilityof capitalized software development costs require considerable judgment bymanagement with respect to certain external factors, including, but not limitedto, anticipated future revenues, estimated economic life and changes insoftware and hardware technologies. Under SFAS No. 86, annual amortizationof software development costs are equal to the greater of (a) the ratiothat current gross revenues for a product bear to the total of current andanticipated future gross revenues for that product or (b) thestraight-line method over the remaining estimated economic life of the productincluding the period being reported on. We are using the straight-line methodof amortization because the software can be used for many products and theestimates required to be made under the ratio that current gross revenues forproducts bear to the total of the current and anticipated future gross revenuesfor that product could result in under reporting of expense. Upon the generalrelease of the software product to customers, capitalization ceases and suchcosts are amortized to cost of sales using the straight-line method on aproduct-by-product basis over the estimated life, which is generally threeyears. To the extent that amounts capitalized for software development costsbecome impaired due to a decline in demand or the introduction of newtechnology, such amounts will be written-off. All other research anddevelopment expenditures are charged to research and development expense in theperiod incurred.

*Income Taxes*

In preparing ourconsolidated financial statements, we estimate our income taxes in each of thecountries in which we operate. The process used to make these estimatesincludes an assessment of the 

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currenttax expense, the results from tax examinations and the effects of temporarydifferences resulting from the different treatment of transactions for tax andfinancial accounting purposes. These differences result in deferred tax assetsand liabilities, which are included in our consolidated balance sheet. Weaccount for income taxes in accordance with Statement of Financial AccountingStandards No. 109, *Accounting for IncomeTaxes*(“SFAS No. 109”), which requires that deferred tax assetsand liabilities be recognized using enacted tax rates for the effect oftemporary differences between the book and tax bases of recorded assets andliabilities. SFAS No. 109 also requires that deferred tax assets bereduced by a valuation allowance if it is more likely than not that someportion or all of the deferred tax asset will not be realized. We evaluate thereliability of our deferred tax assets by assessing our valuation allowance andby adjusting the amount of such allowance, if necessary. At December 31,2006, we had net deferred tax assets primarily resulting from temporarydifferences between the book and tax bases of assets and liabilities, and lossand credit carry forwards. We continue to provide a valuation allowance oncertain deferred tax assets based on an assessment of the likelihood of theirrealization. In reaching our conclusion, we evaluated certain relevant criteriaincluding deferred tax liabilities that can be used to offset deferred taxassets, estimates of future taxable income of appropriate character within thecarry-forward period available under the tax law, and tax planning strategies.Our judgments regarding future taxable income may change due to marketconditions, changes in U.S. or international tax laws, and other factors. Thesechanges, if any, may require material adjustments to these deferred tax assets,resulting either in a tax benefit, if it is estimated that future taxableincome is likely, or a reduction in the value of the deferred tax assets, if itis determined that their value is impaired, resulting in a reduction in netincome or an increase in net loss in the period when such determinations aremade.

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

*Stock Based Compensation*

On January 1, 2006,we adopted the provisions of SFAS No. 123(R), *Share-Based Payment*(“SFAS No. 123R”) using themodified prospective application transition method. SFAS No. 123R requiresmeasurement of all employee stock based compensation awards using a fair-valuemethod and recording of such expense in the consolidated financial statementsover the requisite service period. Previously, we had applied the provisions ofAccounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*(“APB 25”) andrelated interpretations and elected to utilize the disclosure option ofStatement of Financial Accounting Standards No. 123, *Accounting for Stock-Based Compensation*(“SFASNo. 123”). In fiscal 2006, we recorded stock-based compensation expense of$1,460,910 under the fair-value provisions of SFAS No. 123R, compared to$55,802 in fiscal 2005 and $92,585 in fiscal 2004 under the provisions of APB25 and related interpretations.

To determine the expectedterm of our employee stock options granted in fiscal 2006, we utilized thesimplified approach as defined by SEC Staff Accounting Bulletin No. 107, *Share-Based Payment*(“SAB 107”). Thisapproach resulted in an expected term of 6.25 years for options that vest overfour years. To determine the risk-free interest rate, we utilized an averageinterest rate based on U.S. Treasury instruments whose term was consistent withthe expected term of our awards. To determine the expected stock pricevolatility, we examined the historical volatilities for our common stock andthose of our peers. See Note 7 (“Stockholders’ Equity and Stock-BasedCompensation”) of our Notes to Consolidated Financial Statements for furtherdiscussion.

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**Results of Operations**

The following table setsforth certain consolidated operating data as a percentage of total revenue forthe years ended December 31, 2006, 2005, and 2004:

**Percentageof Total Revenue**

| ** **                                                      | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                      | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues                                                        |       |                                        | 100        | % |   |   | 100 | % |   |   | 100 | % |   |
| Cost of sales                                                   |       |                                        | 1          |   |   |   | 2 |   |   |   | 2 |   |   |
| Gross margin                                                    |       |                                        | 99         |   |   |   | 98 |   |   |   | 98 |   |   |
| Operating expenses                                              |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                                             |       |                                        | 39         |   |   |   | 36 |   |   |   | 42 |   |   |
| Research and development                                        |       |                                        | 14         |   |   |   | 15 |   |   |   | 21 |   |   |
| General and administrative                                      |       |                                        | 31         |   |   |   | 36 |   |   |   | 42 |   |   |
| Total operating expenses                                        |       |                                        | 84         |   |   |   | 87 |   |   |   | 105 |   |   |
| Operating income  (loss)                                        |       |                                        | 15         |   |   |   | 11 |   |   |   | (7 | ) |   |
| Other income                                                    |       |                                        | 6          |   |   |   | 5 |   |   |   | 5 |   |   |
| Income (loss)  from continuing operations before income taxes   |       |                                        | 21         |   |   |   | 16 |   |   |   | (2 | ) |   |
| Income taxes                                                    |       |                                        | 5          |   |   |   | 5 |   |   |   | 5 |   |   |
| Income (loss)  from continuing operations                       |       |                                        | 16         |   |   |   | 11 |   |   |   | (7 | ) |   |
| Discontinued operations  :                                      |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from discontinued operations net of  income taxes |       |                                        | 6          |   |   |   | (21 | ) |   |   | 21 |   |   |
| Gain on disposal of discontinued operations                     |       |                                        | 3          |   |   |   | 0 |   |   |   | 0 |   |   |
| Income (loss)  from discontinued operations                     |       |                                        | 9          |   |   |   | (21 | ) |   |   | 21 |   |   |
| Net income (loss)                                               |       |                                        | 25         | % |   |   | (10 | )% |   |   | 14 | % |   |

 

**Year Ended December 31,2006 Compared to Year Ended December 31, 2005**

*Revenues*

Totalrevenues for fiscal 2006 were $18,547,529 compared to $14,608,478 in fiscal 2005,an increase of $3,939,051 or 27%. This increase is primarily attributable toincreases in royalties related to the sales of flat panel televisions andmonitors, which grew by $5,282,295 or 133%, and increases in the automotivemarket, which grew by $602,786 or 130%. The majority of the increases in flatpanel televisions and monitors revenues are the direct result of our receipt oflarger royalty payments from many of the multinational television OEMs,including Sony, Samsung, LG and Toshiba, or their respective manufacturers. Itis our understanding that the global unit volumes of flat panel televisions andmonitors is expected to continue to increase in 2007 and for the foreseeablefuture. While we continue to have good relationships with many of the majorglobal television OEMs and are not aware of any significant customer losses,there can be no assurance that we will be successful in growing or maintainingthis market of our business. Revenues in the automotive market increasedsubstantially in 2006 as compared to 2005. This is primarily due to increasedrevenues from one customer in Japan who provides line install, dealer optionand after market automotive audio systems to many of the significant Japaneseautomotive manufactures, including Toyota, Honda, Subaru and Nissan. We expectthe revenues in this segment to grow in 2007; however, at a slower rate ofincrease. While we continue to be notified of design wins in this segment,revenues can be delayed significantly due to the length of time between designwin and production. Revenues in our portable media devices segment and personaltelecommunications segments fell by 13% and 6%, respectively. The decrease inrevenue in portable media devices is primarily attributable to the loss of onecustomer. Revenues from that customer continued in the first and secondquarters of fiscal 2006; however, no substantive revenues were received fromthat customer in the third and fourth quarters 

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of 2006, nor do we expect at this time to receivesignificant revenues from this customer in the future. The decrease in personaltelecommunications revenues is primarily attributable to one customer who hasexperienced a decrease in its sales of handset units. We continue to beincluded in the customer’s products; however, sales of these products were atlower levels in 2006 than during 2005. The following table represents our mixof licensing revenues by market source:

| ** **                                                | ** ** | **Years Ended**  | ** ** |
|-----------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                | ** ** | **December 31,** | ** ** |
| ** **                                                | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Home  entertainment (TV, set-top box, A/V receiver, DVD)  |       |                  | 61         | % |   |   | 51 | % |   |
| Portable media  devices (digital media player, headphone) |       |                  | 16         | % |   |   | 23 | % |   |
| PC (software,  hardware)                                  |       |                  | 9          | % |   |   | 12 | % |   |
| Personal  telecommunications (mobile phone, PDA)          |       |                  | 8          | % |   |   | 11 | % |   |
| Automotive                                                |       |                  | 6          | % |   |   | 3 | % |   |
|                                                      |       |                  | 100        | % |   |   | 100 | % |   |

 

*Sales and Marketing*

Sales and marketingexpenses consist primarily of employee salaries, sales consultants’ fees andrelated expenses, sales commissions and costs associated with brandingactivities. Sales and marketing expenses were $7,345,133 for fiscal year 2006,as compared to $5,192,090**forfiscal year 2005. Overall sales and marketing expenses were $2,153,043, or 41%,higher in fiscal 2006 due in large part to increased staffing as we added salespersonnel/consultants in the United States, Europe, Taiwan and Korea. TheCompany hired a Vice President of Sales-Licensing in August 2005 and anExecutive Vice President of Marketing and Business Development in December 2005(who separated from the company in July 2006). Additionally, we increasedstaffing at the corporate level to support our branding and marketingactivities. Some of these staffing increases were moderated during the secondhalf of fiscal 2006 as the Company increased its branding and marketingactivities at the local level, and reduced expenditures at the corporate level.We also noted increased commissions on higher licensing revenues. Lastly, werecorded $515,762 in stock based compensation expense for sales and marketingpersonnel during 2006 as compared to zero in 2005, due to the adoption of SFAS No. 123Rat the beginning of fiscal 2006. In 2007, we expect to continue to invest inour sales and marketing activities, particularly by hiring additional salespersonnel and increasing our branding efforts. As a percentage of total revenues,sales and marketing expenses increased from 36% for fiscal year 2005, to 39%for fiscal year 2006.

*Research andDevelopment*

Research and developmentexpenses consist of salaries and related costs of employees engaged in ongoingresearch, design and development activities and costs for engineering materialsand supplies. Research and development expenses were $2,572,577 for fiscal year2006, as compared to $2,224,237 for fiscal year 2005. The overall increase inresearch and development expenses of $348,340, or 16%, is primarilyattributable to $331,480 in stock based compensation expense for engineeringpersonnel during 2006 as compared to zero in 2005, due to the adoption of SFAS No. 123Rat the beginning of fiscal 2006. We expectthat research and development expenses will increase substantially in 2007 aswe continue to expand our intellectual property portfolio, which we believe iscritical to our business, and as we seek to accelerate the implementation ofour technology with a greater number of customers and devices. We expect thatresearch and development expenses will fluctuate as a percentage of revenue dueto fluctuations in our revenues. As a percentage of total revenues,research and development expenses decreased from 15% for fiscal year 2005, to14% for fiscal year 2006.

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*General and Administrative*

General and administrativeexpenses consist primarily of employee-related expenses, legal costs associatedwith the administration of intellectual property, and other professional feesand costs associated with being a publicly held company. General andadministrative expenses were $5,660,260 for fiscal year 2006 as compared to$5,170,256 for fiscal year 2005. The overall increase of $490,004, or 9%, wasprimarily attributable to $512,525 in stock based compensation expense forcorporate employees and directors during 2006 as compared to $55,802 in 2005,due to the adoption of SFAS No. 123R at the beginning of fiscal 2006. During2007, the Company will be required to comply with the Sarbanes-Oxley 404requirements, including independent auditor certification. The cost of suchcompliance is not yet known and may increase overall public company expenses in2007 as compared to fiscal 2006.  As apercentage of total revenues, general and administrative expenses decreasedfrom 35% for fiscal year 2005, to 31% for fiscal year 2006.

*Other Income, Net*

Other income, net,consists principally of interest income. Other income, net, was $1,135,870 forfiscal year 2006, compared to $673,132 for fiscal year 2005, an increase of$462,738 or 69%. This increase is primarily attributable to the increase ofinterest income due to higher interest rates and higher cash balances.

*Provision for Income Taxes*

The income tax provisionfor fiscal 2006 was $868,203 compared to $795,919 for fiscal 2005 an increaseof $72,284 or 9%. The provision consists primarily of taxes paid on licensingrevenues sourced from countries requiring foreign tax withholdings, principallyKorea and Taiwan.

We had federal and statenet operating loss carry-forwards at December 31, 2006 of $17,621,730 and$7,992,523, respectively. The net operating loss carry-forwards began expiringin 2003 and will continue through 2026. In addition, we had federal tax creditcarry-forwards of approximately $2,865,936, at December 31, 2006, whichbegin to expire in 2010, and federal and state tax capital loss carryforwardsof approximately $16,219,585, which begin to expire in 2011. As of December 31,2006, we continue to have a valuation allowance of $15,089,937 against ourdeferred tax assets, which was established primarily due to our cumulativelosses in recent years and based on our assessment of our future ability torealize certain deferred tax assets.

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

*Revenues*

Total revenues for fiscal2005 were $14,608,478 compared to $10,831,704 in fiscal 2004, an increase of$3,776,774 or 35%. This increase is primarily attributable to ourdiversification strategy, which generated revenues in new product categoriessuch as mobile phones, portable audio devices, and PCs and increasedpenetration in the home theater market, including set-top boxes andtelevisions, which incorporate SRS Labs’ technologies. The following tablepresents the Company’s licensing revenues mix by market source:

| ** **                                                | ** ** | **Years Ended**  | ** ** |
|-----------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                | ** ** | **December 31,** | ** ** |
| ** **                                                | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Home entertainment (TV,  set-top box, A/V receiver, DVD)  |       |                  | 51         | % |   |   | 67 | % |   |
| Portable media devices  (digital media player, headphone) |       |                  | 23         | % |   |   | 12 | % |   |
| PC (software, hardware)                                   |       |                  | 12         | % |   |   | 10 | % |   |
| Personal  telecommunications (mobile phone, PDA)          |       |                  | 11         | % |   |   | 10 | % |   |
| Automotive                                                |       |                  | 3          | % |   |   | 1 | % |   |
|                                                      |       |                  | 100        | % |   |   | 100 | % |   |

 

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*Sales and Marketing*

Sales and marketingexpenses consist primarily of employee salaries, sales consultants’ fees andrelated expenses, sales commissions and product promotion costs. Sales andmarketing expenses were $5,192,090 for fiscal year 2005 compared to $4,550,101**for fiscal year 2004. Overall, sales andmarketing expenses were $641,989, or 14%, higher in fiscal 2005 due toincreased staffing, increased commissions on higher licensing revenues andcontinued advertising campaigns to enhance our brand. As a percentage of totalrevenues, sales and marketing expenses decreased from 42% for fiscal year 2004,to 36% for fiscal year 2005.

*Research andDevelopment*

Research and developmentexpenses consist of salaries and related costs of employees engaged in ongoingresearch, design and development activities and costs for engineering materialsand supplies. Research and development expenses were $2,224,237 for fiscal year2005 compared to $2,261,886 for fiscal year 2004. The overall decrease inresearch and development expenses of $37,649, or 2%, was primarily attributableto minor adjustments in staffing. We expectthat research and development will continue to be critical to our business aswe introduce new products, but such expenses will fluctuate as a percentage ofrevenue due to fluctuations in our total revenues. As a percentage oftotal revenues, research and development expenses decreased from 21% for fiscalyear 2004 to 15% for fiscal year 2005 due to the increase in licensingrevenues.

*General and Administrative*

General and administrativeexpenses consist primarily of employee-related expenses, legal costs associatedwith the administration of intellectual property and other professional fees.General and administrative expenses were $5,170,256 for fiscal year 2005compared to $4,621,522 for fiscal year 2004. The overall increase of $548,734,or 12%, was primarily attributable to increased professional fees, publiccompany expenses, including costs incurred for Sarbanes-Oxley 404 compliancethat was ultimately delayed until 2007, and increased amortization associatedwith the increased capitalization of patents and purchased technology absorbedby the licensing segment. As a percentage of total revenues, general andadministrative expenses decreased from 43% for fiscal year 2004 to 35% forfiscal year 2005.

*Other Income, Net*

Other income, net,consists principally of interest income. Other income, net, was $673,132 forfiscal year 2005 compared to $594,922 for fiscal year 2004, an increase of$78,210 or 13%. This increase was primarily due to higher invested cashbalances.

*Provision forIncome Taxes*

The income tax provision for fiscal 2005 was $795,919compared to $523,128 for fiscal 2004, an increase of $272,791 or 52%. Theprovision consists primarily of taxes paid on licensing revenues sourced fromcountries requiring foreign tax withholdings. In 2005, we benefited from theU.S. Japan tax treaty, which eliminated source-country withholdings onroyalties. That treaty became effective on July 1, 2004. The decrease inwithholding in revenue sourced from Japan was offset by an increase inwithholding amounts on revenue sourced from Korea.

We had federal and statenet operating loss carry-forwards at December 31, 2005 of approximately$18,686,000 and $9,333,000, respectively. The net operating loss carry-forwardsbegan expiring in 2003 and will continue through 2025. In addition, we hadfederal tax credit carry-forwards of approximately $1,914,000, atDecember 31, 2005, which begin to expire in 2011. As of December 31,2005, a valuation 

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allowanceof $11,668,869 was established primarily due to our recent cumulative lossesand based on our assessment of our future ability to realize certain deferred taxassets.

**Selected QuarterlyOperating Results**

Thefollowing table sets forth certain quarterly summary consolidated financialdata for the eight quarters in the period ended December 31, 2006. Thequarterly information is based upon financial statements prepared by us on abasis consistent with our audited consolidated financial statements and, inmanagement’s opinion, includes all adjustments, consisting only of normalrecurring adjustments necessary for a fair presentation of the information forthe periods presented. This information should be read in conjunction with ouraudited consolidated financial statements and notes thereto appearing elsewherein this Report. Our quarterly operating results have varied significantly inthe past and are expected to vary significantly in the future. Due to roundingdifferences, the quarters in a given year may not add precisely to the annualnumbers for that year.

| ** **                                                    | ** ** | **Three Months Ended**                                     | ** ** |
|---------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                    | ** ** | **Mar 31,**                                                     | ** ** | **June 30,** | ** ** | **Sep 30,** | ** ** | **Dec 31,** | ** ** | **Mar 31,** | ** ** | **June 30,** | ** ** | **Sep 30,** | ** ** | **Dec 31,** | ** ** |
| ** **                                                    | ** ** | **2006**                                                             | ** ** | **2006** | ** ** | **2006** | ** ** | **2006** | ** ** | **2005** | ** ** | **2005** | ** ** | **2005** | ** ** | **2005** | ** ** |
| ** **                                                    | ** ** | **(In thousands except per share amounts)** | ** ** |
| Revenues                                                      |       | $                                                                    | 4,336      |   |   | $ | 4,260 |   |   | $ | 4,910 |   | $ | 5,042 |   | $ | 3,264 |   |   | $ | 3,540 |   |   | $ | 3,640 |   | $ | 4,164 |   |
| Gross margin                                                  |       | 4,288                                                                |       |   | 4,225 |   |   | 4,866 |   | 4,998 |   | 3,208 |   |   | 3,445 |   |   | 3,600 |   | 4,119 |   |
| Operating expenses                                            |       | 4,157                                                                |       |   | 3,875 |   |   | 3,649 |   | 3,897 |   | 3,032 |   |   | 3,002 |   |   | 2,869 |   | 3,684 |   |
| Income from  continuing operations                            |       | 151                                                                  |       |   | 406 |   |   | 1,276 |   | 1,233 |   | 206 |   |   | 435 |   |   | 707 |   | 314 |   |
| Income (loss) from  discontinued operations                   |       | 11                                                                   |       |   | 524 |   |   | 1,114 |   | (7 | ) | 15 |   |   | 79 |   |   | (3 | ) | (3,178 | ) |
| Net income (loss)                                             |       | $                                                                    | 163        |   |   | $ | 929 |   |   | $ | 2,391 |   | $ | 1,225 |   | $ | 221 |   |   | $ | 514 |   |   | $ | 704 |   | $ | (2,864 | ) |
| Income from continuing  operations per common share:          |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                         |       | $                                                                    | 0.01       |   |   | $ | 0.03 |   |   | $ | 0.09 |   | $ | 0.08 |   | $ | 0.01 |   |   | $ | 0.03 |   |   | $ | 0.05 |   | $ | 0.02 |   |
| Diluted                                                       |       | $                                                                    | 0.01       |   |   | $ | 0.02 |   |   | $ | 0.08 |   | $ | 0.07 |   | $ | 0.01 |   |   | $ | 0.03 |   |   | $ | 0.05 |   | $ | 0.02 |   |
| Income (loss) from  discontinued operations per common share: |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                         |       | $                                                                    | 0.00       |   |   | $ | 0.04 |   |   | $ | 0.07 |   | $ | 0.00 |   | $ | 0.00 |   |   | $ | 0.01 |   |   | $ | 0.00 |   | $ | (0.22 | ) |
| Diluted                                                       |       | $                                                                    | 0.00       |   |   | $ | 0.03 |   |   | $ | 0.07 |   | $ | 0.00 |   | $ | 0.00 |   |   | $ | 0.01 |   |   | $ | 0.00 |   | $ | (0.22 | ) |
| Net income (loss) per  common share:                          |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                         |       | $                                                                    | 0.01       |   |   | $ | 0.06 |   |   | $ | 0.16 |   | $ | 0.08 |   | $ | 0.02 |   |   | $ | 0.04 |   |   | $ | 0.05 |   | $ | (0.20 | ) |
| Diluted                                                       |       | $                                                                    | 0.01       |   |   | $ | 0.06 |   |   | $ | 0.15 |   | $ | 0.07 |   | $ | 0.01 |   |   | $ | 0.03 |   |   | $ | 0.05 |   | $ | (0.20 | ) |

 

**Liquidity andCapital Resources**

At December 31, 2006 cashand cash equivalents and investments available for sale were $40,238,130compared to $25,829,509 as of December 31, 2005, an increase of$14,408,621. The Company’s cash and cash equivalents were $35,011,425 as of December 31,2006, an increase of $26,259,086 from cash and cash equivalents of $8,752,339held at December 31, 2005. The increase is primarily a result of positivecash flow generated by operating activities, the sale of our interest inValence and the exercise of employee stock options. Cash and cash equivalentsgenerally consist of cash, money market funds and other money marketinstruments with original maturities of three months or less. We held$5,226,705 in investments available for sale at December 31, 2006, ascompared to $17,077,170 at December 31, 2005, a decrease of $11,850,465.The decrease in investments available for sale is due to investments maturingand the Company investing the proceeds in cash equivalents. Investments consistof U.S. government securities rated AAA. In fiscal 2006, 2005 and 2004,operations were funded primarily from cash from operating activities.

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Net cash provided by operating activities was$4,950,707 and $2,994,327 for fiscal 2006 and 2005, respectively. The$1,956,380 increase in net cash provided by operating activities in fiscal year2006, compared to fiscal year 2005, was primarily a result of net income forthe year and non-cash items of depreciation and amortization of $727,773 anddeferred stock compensation of $1,359,767, offset by net cash used bydiscontinued operations of $1,945,807 and a non-cash gain on disposal ofdiscontinued operations of $624,646. Accounts receivable decreased by $725,495during fiscal 2006 due to collection of several significant accounts prior toyear end. The total days sales outstanding were 23 days at December 31,2006 compared to 46 days at December 31, 2005. In fiscal 2006, accruedliabilities increased $493,338 primarily due to an increase in accruedcommissions and amounts due to employees under the 2006 Bonus and ProfitSharing Plan.

Our investing activities provided cash of $15,768,382in 2006 and used cash of $1,184,323 in 2005. The increase in cash frominvesting activities during 2006 is primarily due to the sale of investmentsheld for sale and proceeds received from the sale of our interests in Valenceand the Joint Venture. These amounts were partially offset by expendituresrelated to our patents and intangible assets of $520,881, purchases of propertyand equipment of $214,459, and discontinued operations of $180,216. The cashused for investing activities in fiscal 2005 is due primarily to purchases offurniture, fixtures and equipment of $154,851, expenditures related to patentsand intangible assets of $440,515, and discontinued operations of $597,706.

Our financing activities provided cash of $5,539,997during 2006 and used cash of $69,577 during 2005. During 2006, we received cashof $7,654,583 as the result of the exercise of employee stock options. This waspartially offset by our purchase of $2,114,586 of outstanding stock as part ofthe sale of our interest in Valence. Our financing activities during 2005primarily consisted of proceeds from the exercise of employee stock options of$990,013, offset by the purchase of outstanding stock for $1,059,590.

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

**Contractual CashObligations and Contingent Liabilities and Commitments**

Wehave contractual obligations and commitments with regards to operating leasearrangements. The following table quantifies our expected contractualobligations and commitments subsequent to December 31, 2006:

| ** **                       | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| ** **                       | ** ** | ** **                                | ** ** | **Less than** | ** ** | ** ** | ** ** | **More than** | ** ** |
| **Contractual Obligations** | ** ** | ** **                                | ** ** | **Total** | ** ** | **1 year** | ** ** | **1-3 years** | ** ** | **3 years** | ** ** |
| Operating lease  obligations     |       | $                                         | 341,444    |   | $ | 242,205 |   | $ | 99,239 |   |   | — |   |   |
|                                  |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Recent AccountingPronouncements**

In July 2006, the Financial Accounting StandardsBoard (“FASB”) issued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes (“FIN 48”)*. FIN 48 is aninterpretation of FASB Statement No. 109, *Accountingfor Income Taxes*, and it seeks to reduce the diversity in practiceassociated with certain aspects of measurement and recognition in accountingfor income taxes. In addition, FIN 48 requires expanded disclosure with respectto the uncertainty in income taxes and is effective as of the 

29

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beginning of our 2007fiscal year. We do not expect the adoption of FIN 48 to have a material impacton our consolidated financial position or results of operations.

In September 2006, the FASB issued Statement ofFinancial Accounting Standards No. 157, *FairValue Measurements*(“SFAS No. 157”). The purpose of SFAS No. 157is to define fair value, establish a framework for measuring fair value andenhance disclosures about fair value measurements. The measurement anddisclosure requirements are effective for periods beginning after November 15,2007. We do not expect the adoption of SFAS No. 157 will have a materialeffect on our consolidated financial position or results of operations.

In September 2006,the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108,*Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements*(“SAB 108”). SAB 108 provides interpretive guidance onhow to evaluate the materiality of an uncorrected misstatement in the currentyear financial statements using both an income statement approach (the “rolloverapproach”) and a balance sheet approach (the “iron curtain approach”). Therollover approach quantifies a misstatement based on the amount of the errororiginating in the current year income statement while the iron curtainapproach quantifies a misstatement based on the effects of correcting thecumulative misstatement existing in the balance sheet at the end of the currentyear. SAB 108 is effective for periods ending after November 15, 2006. Wedo not expect the adoption of SAB 108 to have a material impact on ourfinancial position or results of operations.

**Item 7A.**   Quantitativeand Qualitative Disclosures About Market Risk

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

**Item 8.   FinancialStatements and Supplementary Data**

The financial statementinformation, including the Report of Independent Registered Public AccountingFirm, required by this Item 8 is set forth on pages 42 to 65 of thisAnnual Report on Form 10-K and is hereby incorporated into thisItem 8 by reference. The quarterly financial information required by thisItem 8 is set forth in Item 7 of this Annual Report on Form 10-Kand is hereby incorporated into this Item 8 by reference.

**Item 9.   Changesin and Disagreements with Accountants on Accounting and Financial Disclosure**

On December 5, 2006, we engaged Squar, Milner, Peterson, Miranda &Williamson, LLP, Newport Beach, California (“Squar Milner”) as our independentregistered public accounting firm to audit our financial statements beginningwith the fiscal year ending December 31, 2006. On that date, we advisedBDO Seidman, LLP (“BDO”) of our decision to dismiss BDO as our independentregistered public accounting firm. Our Audit Committee unanimously approved theengagement of Squar Milner and the dismissal of BDO on December 5, 2006.

The Audit Committee believes the change of our independent registeredpublic accounting firm is in the best interest of the Company and the recentsimplification of our business model makes this an appropriate time for thechange.

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The reports of BDO on the Company’s financial statements for the yearsended December 31, 2004 and 2005 did not contain any adverse opinion ordisclaimer of opinion, and were not otherwise qualified as to uncertainty,audit scope or accounting principles.

During our two most recent fiscal years and through December 5, 2006,there were no disagreements with BDO on any matter of accounting principles orpractices, financial statement disclosure, or auditing scope or procedure,which disagreements if not resolved to the satisfaction of BDO would havecaused them to make reference thereto in their reports on the financialstatements for such years.

During our two most recent fiscal yearsand through December 5, 2006, we did not consult Squar Milner regardingeither (i) the application of accounting principles to a specifiedtransaction, either completed or proposed, or the type of audit opinion thatmight be rendered on the Company’s financial statements; or (ii) anymatter that was either the subject of a disagreement or a reportable event(each as defined in Item 304(a)(1) of Regulation S-K) or (iii) anyof the matters or events set forth in Item 304(a)(2)(i) and (ii) ofRegulation S-K.

**Item 9A.   Controlsand Procedures**

*Evaluation of Disclosure Controls and Procedures.*   Our ChiefExecutive Officer and President and our Chief Financial Officer have evaluatedthe effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended) asof the end of the period covered by this Annual Report on Form 10-Kand, based on this evaluation, have concluded that our disclosure controls andprocedures are effective.

*Changes in InternalControls.*   There have been nochanges in our internal controls over financial reporting that occurred duringour fourth quarter ended December 31, 2006 that have materially affected,or are reasonably likely to materially affect, our internal controls overfinancial reporting.

**Item 9B.   OtherInformation**

None.

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**PART III**

**Item 10.   Directors, Executive Officers and Corporate Governance**

The information set forthunder the captions “Election of Directors,” “Information About the Board ofDirectors and Committees of the Board” and “Transactions with Management andOthers—Section 16(a) Beneficial Ownership Reporting Compliance” inour definitive proxy statement (the “Proxy Statement”) for the Annual Meetingof Stockholders that is scheduled to occur in June 2007 is incorporatedherein by reference. The Proxy Statement will be filed with the Securities andExchange Commission (“SEC”) no later than 120 days after the end of fiscalyear 2006.

**Item 11.   ExecutiveCompensation**

Except as specificallyprovided, the information set forth under the captions “Compensation ofExecutive Officers” and “Information About the Board of Directors andCommittees of the Board—Compensation of Directors” in the Proxy Statement isincorporated herein by reference. The Proxy Statement will be filed with theSEC not later than 120 days after the end of fiscal year 2006.

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

 

Information regarding security ownership of certainbeneficial owners and management is incorporated by reference to theinformation set forth under the caption “Security Ownership of CertainBeneficial Owners and Management” in the Proxy Statement. The Proxy Statementwill be filed with the SEC no later than 120 days after the end of fiscalyear 2006.

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

**Item 13.   CertainRelationships and Related Transactions, and Director Independence**

The information set forthunder the captions “Transactions with Management and Others” and “InformationAbout the Board of Directors and Committees of the Board” in the ProxyStatement is incorporated herein by reference. The Proxy Statement will befiled with the SEC not later than 120 days after the end of fiscal year2006.

**Item 14.   PrincipalAccounting Fees and Services**

Information regarding principal accounting fees andservices is incorporated by reference to the information set forth under thecaption “Relationship of the Company with Independent Registered PublicAccounting Firm” in the Proxy Statement. The Proxy Statement will be filed withthe SEC not later than 120 days after the end of fiscal year 2006.

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**PART IV**

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

**(1)   Financial Statements**
|                                                                                                                                                               | ** ** | **Page** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| Report of Independent Registered Public Accounting  Firm—Squar, Milner, Peterson, Miranda & Williamson, LLP       |       |     | 40         |   |   |
| Report of Independent Registered Public Accounting  Firm—BDO Seidman, LLP                                                                                |       |     | 41         |   |   |
| Consolidated  Balance Sheets as of December 31, 2006 and 2005                                                                                            |       |     | 42         |   |   |
| Consolidated Statements of Operations for the years  ended December 31, 2006, 2005 and 2004                                                              |       |     | 43         |   |   |
| Consolidated Statements of Stockholders’ Equity and  Comprehensive Income (Loss) for the years ended December 31, 2006, 2005  and 2004              |       |     | 44         |   |   |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2006, 2005 and 2004                                                              |       |     | 45         |   |   |
| Notes to Consolidated Financial Statements                                                                                                                    |       |     | 46         |   |   |

 

**(2)   Financial Statement Schedule**
|                                                                                                                                               | ** ** | **Page** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| Schedule  II—Valuation and Qualifying Accounts and Reserves for the years ended  December 31, 2006, 2005 and 2004    |       |     | 65         |   |   |
|                                                                                                                                               |            |          |            |  |  |

 

33

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Thefinancial statement schedule included on page 65 to this Annual Report on Form 10-Kand in Part II, Item 8 herein is filed as part of this Annual Reporton Form 10-K. All other schedules are omitted because they are notapplicable or the required information is shown in the consolidated financialstatements or related notes.

**(3)   Exhibits**

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

**EXHIBIT INDEX**
| Exhibit   Number | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                 |
|------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1              |       | Certificate of  Incorporation of the Company, previously filed with the SEC as  Exhibit 3.1 to the Company’s Registration Statement on Form SB-2,  specifically included in Amendment No. 1 to such Registration Statement  filed with the SEC on July 3, 1996 (File No. 333-4974-LA)  (the “Registration Statement Amendment No. 1”), which is incorporated  herein by reference. |
| 3.2              |       | Bylaws of the  Company, previously filed with the SEC as Exhibit 3.1 to the Company’s  Quarterly Report on Form 10-Q for the period ended  September 30, 1999, filed with the SEC on November 12, 1999, which  is incorporated herein by reference.                                                                                                                                                    |
| ** **       | ** ** | **Material Contracts Relating to Management  Compensation Plans or Arrangements**                                                                                                                                                                                                                                                                                                                                               |
| 10.1             |       | Employment  Agreement dated July 1, 1996, between the Company and Thomas C.K. Yuen,  previously filed with the SEC as Exhibit 10.8 to the Registration  Statement Amendment No. 1, which is incorporated herein by reference.                                                                                                                                                                                    |
| 10.2             |       | Amendment to Employment  Agreement dated as of March 14, 1997, between the Company and Thomas  C.K. Yuen, previously filed with the SEC as Exhibit 10.2 to the  Company’s Annual Report on Form 10-KSB for the fiscal year ended  December 31, 1996, filed with the SEC on March 31, 1997 (the “1996  Annual Report”), which is incorporated herein by reference.                       |
| 10.3             |       | Employment Agreement  dated July 1, 1996, between the Company and Alan D. Kraemer, previously  filed with the SEC as Exhibit 10.11 to the Registration Statement  Amendment No. 1, which is incorporated herein by reference.                                                                                                                                                                                    |
| 10.4             |       | SRS Labs, Inc.  Amended and Restated 1996 Non-employee Directors Stock Option Plan, as  amended, previously filed with the SEC as Appendix B to the Company’s  Definitive Proxy Statement dated and filed with the SEC on April 30,  2003, which is incorporated herein by reference.                                                                                                                       |
| 10.5             |       | Form of  Indemnification Agreement, previously filed with the SEC as  Exhibit 10.20 to the Registration Statement Amendment No. 1, which  is incorporated herein by reference.                                                                                                                                                                                                                                   |
| 10.6             |       | Non-employee Director  Compensation Policy adopted by the Company’s Board of Directors on  January 28, 2005, previously filed with the SEC as Exhibit 10.1 to  the Company’s Current Report on Form 8-K filed with the SEC on  February 3, 2005, which is incorporated herein by reference.                                                                                                       |

34

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| 10.7  |   | Form of  Non-Employee Director Stock Option Agreement under the SRS Labs, Inc.  Amended and Restated 1996 Non-Employee Directors’ Stock Option Plan (Initial  Appointment), previously filed with the SEC as Exhibit 10.2 to the  Company’s Current Report on Form 8-K file with the SEC on  February 3, 2005, which is incorporated herein by reference.                                                                                                   |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.8  |   | Form of  Non-Employee Director Stock Option Agreement under the SRS Labs, Inc.  Amended and Restated 1996 Non-Employee Directors’ Stock Option Plan  (Re-Election), previously filed with the SEC as Exhibit 10.3 to the  Company’s Current Report on Form 8-K file with the SEC on  February 3, 2005, which is incorporated herein by reference.                                                                                                           |
| 10.9  |   | Form of  Non-Employee Director Stock Option Agreement under the SRS Labs, Inc.  Amended and Restated 1996 Long-Term Incentive Plan, previously filed with the  SEC as Exhibit 10.4 to the Company’s Current Report on Form 8-K  file with the SEC on February 3, 2005, which is incorporated herein by  reference.                                                                                                                                               |
| 10.10 |   | Form of  Nonqualified Stock Option Agreement under the SRS Labs, Inc. Amended and  Restated 1996 Long-Term Incentive Plan dated March 29, 2005 (With  Schedule of Optionees Attached—Thomas C.K. Yuen, Janet M. Biski, Alan D.  Kraemer, Philip Wong and Jennifer Drescher), previously filed with the SEC as  Exhibit 10.1 to the Company’s Current Report Form 8-K filed  with the SEC on April 4, 2005, which is incorporated herein by  reference. |
| 10.11 |   | SRS Labs, Inc. 2005  Change in Control Protection Plan approved April 27, 2005, previously  filed with the SEC as Exhibit 10.1 to the Company’s Current Report on  Form 8-K filed with the SEC on May 3, 2005, which is  incorporated herein by reference.                                                                                                                                                                                                       |
| 10.12 |   | Form of  Participation Agreement under the SRS Labs, Inc. 2005 Change in Control  Protection Plan for Selected Executive Officers (With Schedule of Parties  Attached—Thomas C.K. Yuen, Janet M. Biski and Alan D. Kraemer) approved  April 27, 2005, previously filed with the SEC as Exhibit 10.2 to  the Company’s Current Report on Form 8-K filed with the SEC on  May 3, 2005, which is incorporated herein by reference.                        |
| 10.13 |   | SRS Labs, Inc.  Amended and Restated 1996 Long-Term Incentive Plan, as amended, approved  April 27, 2005, previously filed with the SEC as Exhibit 10.5 to  the Form 8-K filed with the SEC on May 3, 2005, which is  incorporated herein by reference.                                                                                                                                                                                                               |
| 10.14 |   | Employment Letter  Agreement dated June 24, 2005 by and between the Company and Michael Franzi,  previously filed with the SEC as Exhibit 10.1 to the Company’s Current  Report on Form 8-K filed with the SEC on August 18, 2005,  which is incorporated herein by reference.                                                                                                                                                                                        |
| 10.15 |   | Stock Option Agreement  dated August 17, 2005 by and between the Company and Michael Franzi,  previously filed with the SEC as Exhibit 10.2 to the Company’s Current  Report on Form 8-K filed with the SEC on August 18, 2005,  which is incorporated herein by reference.                                                                                                                                                                                           |
| 10.16 |   | Employment Letter  Agreement dated December 21, 2005 by and between the Company and Ulrich  E. Gottschling, previously filed with the SEC as Exhibit 99.1 to the  Company’s Current Report on Form 8-K filed with the SEC on  December 29, 2005, which is incorporated herein by reference.                                                                                                                                                                           |
| 10.17 |   | Participation Agreement  for Ulrich E. Gottschling under the SRS Labs, Inc. 2005 Change in  Control Protection Plan, dated January 12, 2006, previously filed with  the SEC as Exhibit 99.1 to the Company’s Current Report on Form 8-K  filed with the SEC on January 18, 2006, which is incorporated herein by  reference.                                                                                                                                     |

35

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| 10.18 |   | Participation Agreement  for Michael Franzi under the SRS Labs, Inc. 2005 Change in Control  Protection Plan, dated January 12, 2005, previously filed with the SEC  as Exhibit 99.2 to the Company’s Current Report on Form 8-K  filed with the SEC on January 18, 2006, which is incorporated herein by  reference.                                                                   |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.19 |   | Nonqualified Stock  Option Agreement by and between the Company and Ulrich E. Gottschling, dated  January 12, 2006, previously filed with the SEC as Exhibit 99.6 to  the Company’s Current Report on Form 8-K filed with the SEC on  January 18, 2006, which is incorporated herein by reference.                                                                                           |
| 10.20 |   | Nonqualified Stock  Option Agreement by and between the Company and Sarah Yang, dated  January 12, 2006, previously filed with the SEC as Exhibit 99.7 to  the Company’s Current Report on Form 8-K filed with the SEC on  January 18, 2006, which is incorporated herein by reference.                                                                                                      |
| 10.21 |   | Form of  Nonqualified Stock Option Agreement under the SRS Labs, Inc. 1996  Amended and Restated Long-Term Incentive Plan, as Amended, previously filed  with the SEC as Exhibit 99.8 to the Company’s Current Report on  Form 8-K filed with the SEC on January 18, 2006, which is  incorporated herein by reference.                                                                  |
| 10.22 |   | SRS Labs, Inc. 2006  Profit Sharing and Bonus Plan approved on April 12, 2006, previously  filed with the SEC as Exhibit 99.1 to the Company’s Current Report on  Form 8-K filed with the SEC on April 18, 2006, which is  incorporated herein by reference.                                                                                                                            |
| 10.23 |   | Salary adjustment for  Lionel Cheung, President of Valence Tech, Limited, and President of its  wholly-owned subsidiary Valence Technology Limited, as approved on  April 25, 2006, previously filed with the SEC on the Company’s Current  Report on Form 8-K filed with the SEC on April 28, 2006,  which is incorporated herein by reference.                                                  |
| 10.24 |   | SRS Labs, Inc. 2006  Stock Incentive Plan, as approved by the Company’s shareholders on  June 22, 2006, previously filed with the SEC as Exhibit 10.1 to the  Company’s Current Report on Form 8-K filed with the SEC on  June 28, 2006, which is incorporated herein by reference.                                                                                                |
| 10.25 |   | Salary adjustment and  discretionary merit bonus for Ulrich E. Gottschling, Chief Financial Officer  of the Company, as approved on November 1, 2006, previously filed with  the SEC on the Company’s Current Report on Form 8-K filed with the  SEC on November 6, 2006, which is incorporated herein by reference.                                                                              |
| 10.26 |   | SRS Labs, Inc. 2007  Profit Sharing and Bonus Plan approved on December 12, 2006, previously  filed with the SEC as Exhibit 10.1 to the Company’s Current Report on  Form 8-K filed with the SEC on December 18, 2006, which is  incorporated herein by reference.                                                                                                                      |
| 10.27 |   | Salary adjustment for  Alan Kraemer, Executive Vice President, Chief Technology Officer, Sarah Yang,  Vice President, Software Engineering and Michael Franzi, Vice President,  Sales Licensing, as approved on February 8, 2007, previously filed with  the SEC on the Company’s Current Report on Form 8-K filed with the  SEC on February 13, 2007, which is incorporated herein by reference. |

36

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|       | ** ** | **Other  Material Contracts**                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|-------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.28 |       | License Agreement dated as of June 27, 1988,  between Hughes Aircraft and Sony Corporation, as amended and assigned to the  Company, previously filed with the SEC as Exhibit 10.6 to the Company’s  Registration Statement on Form SB-2, specifically included in  Amendment No. 3 to such Registration Statement filed with the SEC on  August 7, 1996 (File No. 333-4974-LA), which is  incorporated herein by reference.    |
| 10.29 |       | Industrial Real Estate  Lease dated May 30, 1997, between the Company and Daimler Commerce  Partners, L.P., previously filed with the SEC as Exhibit 10.1 to the  Company’s Quarterly Form 10-QSB for the quarterly period ended  June 30, 1997, filed with the SEC on August 13, 1997, which is  incorporated herein by reference.                                                                                                  |
| 10.30 |       | Stock Divestment  Agreement dated July 1, 1996, between the Company, Thomas C.K. Yuen,  Stephen V. Sedmak and Walter W. Cruttenden III, previously filed with the SEC  as Exhibit 10.17 to the Company’s Registration Statement on Form SB-2,  specifically included in Amendment No. 2 to such Registration Statement  file with the SEC on August 2, 1996 (File No. 333-4974-LA),  which is incorporated herein by reference. |
| 10.31 |       | Transition Agreement and  General Release between the Company and Janet Biski, dated March 31,  2006, previously filed with the SEC as Exhibit 99.1 to the Company’s  Current Report on Form 8-K filed with the SEC on April 4,  2006, which is incorporated herein by reference.                                                                                                                                                         |
| 10.32 |       | The Company’s Patent  Reward Program previously filed with the SEC as Exhibit 10.2 to the  Company’s Current Report on Form 8-K filed with the SEC on  June 28, 2006, which is incorporated herein by reference.                                                                                                                                                                                                                          |
| 10.33 |       | Promissory Note dated  June 30, 2006 between the Company and Coming Home Studios, LLC, as  previously filed with the SEC as Exhibit 10.2 to the Company’s Current  Report on Form 8-K filed with the SEC on July 7, 2006, which  is incorporated herein by reference.                                                                                                                                                                     |
| 10.34 |       | Security Agreement dated  June 30, 2006 between the Company and Coming Home Studios, LLC, as  previously filed with the SEC as Exhibit 10.3 to the Company’s Current  Report on Form 8-K filed with the SEC on July 7, 2006, which  is incorporated herein by reference.                                                                                                                                                                  |
| 10.35 |       | Assignment Agreement  dated June 30, 2006 between the Company and Coming Home Studios, LLC, as  previously filed with the SEC as Exhibit 10.4 to the Company’s Current  Report on Form 8-K filed with the SEC on July 7, 2006, which  is incorporated herein by reference.                                                                                                                                                                |
| 10.36 |       | First Amendment to the  Strategic Alliance Agreement dated June 30, 2006 between the Company and  Coming Home Studios, LLC, as previously filed with the SEC as  Exhibit 10.5 to the Company’s Current Report on Form 8-K  filed with the SEC on July 7, 2006, which is incorporated herein by  reference.                                                                                                                                |
| 10.37 |       | Separation Agreement and  General Release between the Company and David Frerichs dated July 12,  2006, as previously filed with the SEC as Exhibit 10.1 to the Company’s  Current Report on Form 8-K filed with the SEC on July 17,  2006, which is incorporated herein by reference.                                                                                                                                                     |
| 10.38 |       | Sale and Purchase  Agreement Relating to Ordinary Shares in the Issued Share Capital of Valence  Tech Ltd dated July 14, 2006 between the Company and Noblehigh  Enterprises, Inc. and Willas-Array Electronics (Holdings) Ltd., as  previously filed with the SEC as Exhibit 2.1 to the Company’s Current  Report on Form 8-K filed with the SEC on July 17, 2006, which  is incorporated herein by reference.                      |

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| 10.39 |   | Deed of Indemnity  between the Company and Noblehigh Enterprises, Inc., as previously filed  with the SEC as Exhibit 2.2 to the Company’s Current Report on  Form 8-K filed with the SEC on July 17, 2006, which is  incorporated herein by reference. |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 21    |   | Subsidiaries of the  Company.                                                                                                                                                                                                                                                   |
| 23.1  |   | Consent of Independent  Registered Public Accounting Firm, Squar, Milner, Peterson,  Miranda & Williamson, LLP, dated March 21, 2007.                                                                                                                             |
| 23.2  |   | Consent of Independent  Registered Public Accounting Firm, BDO Seidman LLP, dated March 21,  2007.                                                                                                                                                                         |
| 31.1  |   | Certification of the  Chief Executive Officer of SRS Labs, Inc., pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                                                                          |
| 31.2  |   | Certification of the  Chief Financial Officer of SRS Labs, Inc., pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                                                                          |
| 32.1  |   | Certification of Chief  Executive Officer of SRS Labs, Inc., pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                                         |
| 32.2  |   | Certification of Chief  Financial Officer of SRS Labs, Inc., pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                                         |

 

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

| Dated: March 22, 2007 |   | By:      | /s/ Thomas C.K. Yuen                                 |
|----------------------------|--------|----------|------------------------------------------------------|
| * *                   |   | * * | *Chairman of the Board and  Chief Executive Officer* |

 

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

|                         | **Name** | ** **                                           | ** ** | ** **           | **Capacity** | ** ** | ** ** | ** ** | **Date** | ** ** |
|-------------------------|----------|------------------------------------------------------|------------|----------------------|--------------|------------|------------|------------|----------|------------|
| /s/ THOMAS  C.K. YUEN   |     | Director,  Chairman of the Board and Chief Executive |       | March 22,  2007 |
| Thomas  C.K. Yuen       |     | Officer (Principal  Executive Officer)               |       |                 |
| /s/ ULRICH  GOTTSCHLING |     | Chief Financial  Officer (Principal Financial and    |       | March 22,  2007 |
| Ulrich  Gottschling     |     | Accounting Officer)                                  |       |                 |
| /s/ DAVID R.  DUKES     |     | Director                                             |       | March 22,  2007 |
| David  R. Dukes         |     |                                                 |       |                 |
| /s/ WINSTON E.  HICKMAN |     | Director                                             |       | March 22,  2007 |
| Winston  E. Hickman     |     |                                                 |       |                 |
| /s/ CAROL L  MILTNER    |     | Director                                             |       | March 22,  2007 |
| Carol  L. Miltner       |     |                                                 |       |                 |
| /s/ SAM YAU             |     | Director                                             |       | March 22,  2007 |
| Sam Yau                 |     |                                                 |       |                 |

 

39

----

**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

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

We have audited the accompanying consolidated balancesheet of SRS Labs, Inc. and Subsidiaries as of December 31, 2006, andthe related consolidated statements of operations, stockholders’ equity andcomprehensive income (loss) and cash flows for the year then ended. Our auditalso included 2006 information in the financial statement schedule listed inItem 15(2) herein. These financial statements and financial statementschedule are the responsibility of the Company’s management. Our responsibilityis to express an opinion on the financial statements and schedule based on ouraudit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements and financial statementschedule are free of material misstatement. The Company was not required tohave, nor were we engaged to perform, an audit of its internal control overfinancial reporting. Our audit included consideration of internal control overfinancial reporting as a basis for designing audit procedures that areappropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements and schedule, assessing the accounting principles usedand significant estimates made by management, as well as evaluating the overallpresentation of the financial statements and financial statement schedule. Webelieve that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of SRS Labs, Inc. and Subsidiaries as of December 31, 2006,and the consolidated results of their operations and their cash flows for theyear then ended, in conformity with accounting principles generally accepted inthe United States of America.

Also, in our opinion, the aforementioned financialstatement schedule, when considered in relation to the basic consolidatedfinancial statements taken as a whole, presents fairly, in all materialrespects, the 2006 financial information set forth therein.

Asdiscussed in Note 1 to the financial statements, in 2006, the Company changedits method of accounting for stock-based compensation to conform to FinancialAccounting Standards Board Statement No. 123(R), *Share-BasedPayment.*

| /s/    |   | SQUAR, MILNER, PETERSON,  MIRANDA & WILLIAMSON, LLP |   |   |
|--------|--------|--------------------------------------------------------------|--------|--------|
|   |   | Squar, Milner, Peterson, Miranda &  Williamson, LLP |   |   |

 

Newport Beach, CaliforniaFebruary 16, 2007

40

----

**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

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

We have audited the accompanying consolidated balancesheet of SRS Labs, Inc. and Subsidiaries as of December 31, 2005, andthe related consolidated statements of operations, stockholders’ equity andcomprehensive (loss) income and cash flows for each of the two years in theperiod ended December 31, 2005. We have also audited the schedule listedin the accompanying index, Item 15(2). These consolidated financial statementsand schedule are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on the consolidated financialstatements and schedule based on our audits.

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

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the consolidatedfinancial position of SRS Labs, Inc. and Subsidiaries as of December 31,2005, and the results of their operations and their cash flows for each of thetwo years in the period ended December 31, 2005, in conformity withaccounting principles generally accepted in the United States of America.

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

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

 

Costa Mesa, California

February 24, 2006

41

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**SRS LABS, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                                                                  | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                                                  | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| **Current Assets**                                                                                                                                                                                          | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                                                                                                   |       | $                           | 35,011,425 |                        | $          | 8,752,339 |   |
| Accounts receivable, net                                                                                                                                                                                    |       | 1,180,879                   |       | 1,886,780                   |       |
| Prepaid expenses and other current assets                                                                                                                                                                   |       | 808,940                     |       | 602,847                     |       |
| Assets held for sale                                                                                                                                                                                        |       | —                      |       | 1,859,127                   |       |
| **Total Current Assets**                                                                                                                                                                                    |       | 37,001,244                  |       | 13,101,093                  |       |
| Investments available for sale                                                                                                                                                                              |       | 5,226,705                   |       | 17,077,170                  |       |
| Property and equipment, net                                                                                                                                                                                 |       | 389,667                     |       | 425,288                     |       |
| Intangible assets, net                                                                                                                                                                                      |       | 2,045,139                   |       | 2,015,605                   |       |
| Deferred income taxes, net                                                                                                                                                                                  |       | 386,412                     |       | 380,386                     |       |
| Long term assets held for sale                                                                                                                                                                              |       | —                      |       | 2,065,123                   |       |
| **Total Assets**                                                                                                                                                                                            |       | $                           | 45,049,167 |                        | $          | 35,064,665 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                               | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| **Current Liabilities**                                                                                                                                                                                     | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Accounts payable                                                                                                                                                                                            |       | $                           | 609,899    |                        | $          | 741,811 |   |
| Accrued liabilities                                                                                                                                                                                         |       | 1,295,236                   |       | 801,898                     |       |
| Deferred revenue                                                                                                                                                                                            |       | 399,565                     |       | 537,636                     |       |
| Liabilities related to assets held for sale                                                                                                                                                                 |       | —                      |       | 2,170,701                   |       |
| **Total Current Liabilities**                                                                                                                                                                               |       | 2,304,700                   |       | 4,252,046                   |       |
| Commitments and  contingencies (Note 5)                                                                                                                                                                     |       |                        |       |                        |       |
| **Stockholders’  Equity**                                                                                                                                                                              | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Preferred stock—$0.001 par value; 2,000,000 shares  authorized; no shares issued and outstanding                                                                                                       |       | —                      |       | —                      |       |
| Common stock—$0.001 par value; 56,000,000 shares  authorized; 16,561,036 and 14,953,690 shares issued; 15,886,938 and  14,279,592 shares outstanding at December 31, 2006 and 2005,  respectively |       | 16,562                      |       | 14,955                      |       |
| Additional paid-in capital                                                                                                                                                                                  |       | 70,574,176                  |       | 63,574,518                  |       |
| Accumulated other comprehensive loss                                                                                                                                                                        |       | (273,295                    | )          | (496,021                    | )          |
| Accumulated deficit                                                                                                                                                                                         |       | (24,569,531                 | )          | (29,277,388                 | )          |
| Treasury stock at cost, 674,098 shares at  December 31, 2006 and 2005                                                                                                                                  |       | (3,003,445                  | )          | (3,003,445                  | )          |
| **Total Stockholders’ Equity**                                                                                                                                                                         |       | 42,744,467                  |       | 30,812,619                  |       |
| **Total  Liabilities And Stockholders’ Equity**                                                                                                                                                        |       | $                           | 45,049,167 |                        | $          | 35,064,665 |   |

 

See accompanying notes to the consolidated financial statements.

42

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**SRS LABS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS**

| ** **                                                       | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                       | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues                                                         |       | $                                           | 18,547,529 |   | $ | 14,608,478 |   | $ | 10,831,704 |   |
| Cost of sales                                                    |       | 171,094                                     |       | 236,484 |   | 228,147 |   |
| Gross margin                                                     |       | 18,376,435                                  |       | 14,371,994 |   | 10,603,557 |   |
| Operating  expenses:                                             |       |                                        |       |   |   |   |   |
| Sales and marketing                                              |       | 7,345,133                                   |       | 5,192,090 |   | 4,550,101 |   |
| Research and development                                         |       | 2,572,577                                   |       | 2,224,237 |   | 2,261,886 |   |
| General and administrative                                       |       | 5,660,260                                   |       | 5,170,256 |   | 4,621,522 |   |
| Total operating expenses                                         |       | 15,577,970                                  |       | 12,586,583 |   | 11,433,509 |   |
| Operating income (loss)                                          |       | 2,798,465                                   |       | 1,785,411 |   | (829,952 | ) |
| Other income, net                                                |       | 1,135,870                                   |       | 673,132 |   | 594,922 |   |
| Income (loss) from continuing operations before  income taxes    |       | 3,934,335                                   |       | 2,458,543 |   | (235,030 | ) |
| Income taxes                                                     |       | 868,203                                     |       | 795,919 |   | 523,128 |   |
| Income (loss)  from continuing operations                        |       | 3,066,132                                   |       | 1,662,624 |   | (758,158 | ) |
| Discontinued  operations (Note 11)                               |       |                                        |       |   |   |   |   |
| Income (loss) from discontinued operations, net of  income taxes |       | 1,017,079                                   |       | (3,087,009 | ) | 2,336,679 |   |
| Gain on disposal of discontinued operations                      |       | 624,646                                     |       | — |   | — |   |
| Income (loss)  from discontinued operations                      |       | 1,641,725                                   |       | (3,087,009 | ) | 2,336,679 |   |
| Net income (loss)                                                |       | $                                           | 4,707,857  |   | $ | (1,424,385 | ) | $ | 1,578,521 |   |
| Income (loss)  from continuing operations per common share:      |       |                                        |       |   |   |   |   |
| Basic                                                            |       | $                                           | 0.21       |   | $ | 0.12 |   | $ | (0.05 | ) |
| Diluted                                                          |       | $                                           | 0.20       |   | $ | 0.12 |   | $ | (0.05 | ) |
| Income (loss)  from discontinued operations per common share:    |       |                                        |       |   |   |   |   |
| Basic                                                            |       | $                                           | 0.11       |   | $ | (0.22 | ) | $ | 0.17 |   |
| Diluted                                                          |       | $                                           | 0.11       |   | $ | (0.22 | ) | $ | 0.15 |   |
| Net income (loss)  per common share:                             |       |                                        |       |   |   |   |   |
| Basic                                                            |       | $                                           | 0.31       |   | $ | (0.10 | ) | $ | 0.11 |   |
| Diluted                                                          |       | $                                           | 0.30       |   | $ | (0.10 | ) | $ | 0.10 |   |
| Weighted averaged  shares used in the per share calculation:     |       |                                        |       |   |   |   |   |
| Basic                                                            |       | 14,955,889                                  |       | 14,117,795 |   | 13,950,457 |   |
| Diluted                                                          |       | 15,465,822                                  |       | 14,117,795 |   | 15,781,206 |   |

 

See accompanying notes to the consolidated financial statements.

43

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**SRS LABS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITYAND COMPREHENSIVE INCOME (LOSS)**

| ** **                                                             | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated Other  Comprehensive** | ** ** | **Accumulated**        | ** ** | **Treasury** | ** ** | ** ** | ** ** | **Comprehensive** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|-------------------------------------------|------------|------------------------|------------|--------------|------------|------------|------------|-------------------|------------|
| ** **                                                             | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**                               | ** ** | **Income (Loss)** | ** ** | **Deficit**  | ** ** | **Stock**  | ** ** | **Total**         | ** ** | **Income (Loss)** | ** ** |
| BALANCE, January 1, 2004                                          |       | 13,456,982            |       |                    | $          | 13,683                                    |       |                   | $          | 58,423,249   |       |       | $          | (336,346          | )          |   |   | $ | (29,431,524 | ) |   | $ | (718,601 | ) | $ | 27,950,461 |   |   |   |   |   |
| Proceeds from exercise of stock options                                |       | 989,134               |       |                    | 989        |                                      |       | 3,710,462              |       |         | —     |       |       |              | —     |   |   | — |   | 3,711,451 |   |   |   |   |   |
| Tax benefit from exercise of stock options                             |       | —                |       |                    | —     |                                      |       | 296,996                |       |         | —     |       |       |              | —     |   |   | — |   | 296,996 |   |   |   |   |   |
| Deferred stock option compensation                                     |       | —                |       |                    | —     |                                      |       | 92,585                 |       |         | —     |       |       |              | —     |   |   | — |   | 92,585 |   |   |   |   |   |
| Treasury stock                                                         |       | (216,575              | )          |                    | —     |                                      |       | —                 |       |         | —     |       |       |              | —     |   |   | (1,225,254 | ) | (1,225,254 | ) |   |   |   |   |
| Unrealized gain on investments available for sale,  net of tax         |       | —                |       |                    | —     |                                      |       | —                 |       |         | 26,624     |       |       |              | —     |   |   | — |   | 26,624 |   |   | $ | 26,624 |   |   |
| Net income                                                             |       | —                |       |                    | —     |                                      |       | —                 |       |         | —     |       |       |              | 1,578,521  |   |   | — |   | 1,578,521 |   |   | 1,578,521 |   |   |
| BALANCE, December 31, 2004                                        |       | 14,229,541            |       |                    | $          | 14,672                                    |       |                   | $          | 62,523,292   |       |       | $          | (309,722          | )          |   |   | $ | (27,853,003 | ) |   | $ | (1,943,855 | ) | $ | 32,431,384 |   |   | $ | 1,605,145 |   |   |
| Proceeds from exercise of stock options                                |       | 282,274               |       |                    | 283        |                                      |       | 989,730                |       |         | —     |       |       |              | —     |   |   | — |   | 990,013 |   |   |   |   |   |
| Tax benefit from exercise of stock options                             |       | —                |       |                    | —     |                                      |       | 5,694                  |       |         | —     |       |       |              | —     |   |   | — |   | 5,694 |   |   |   |   |   |
| Deferred stock option compensation                                     |       | —                |       |                    | —     |                                      |       | 55,802                 |       |         | —     |       |       |              | —     |   |   | — |   | 55,802 |   |   |   |   |   |
| Treasury stock                                                         |       | (232,223              | )          |                    | —     |                                      |       | —                 |       |         | —     |       |       |              | —     |   |   | (1,059,590 | ) | (1,059,590 | ) |   |   |   |   |
| Unrealized loss on investments available for sale,  net of tax         |       | —                |       |                    | —     |                                      |       | —                 |       |         | (186,299   | )          |       |              | —     |   |   | — |   | (186,299 | ) |   | (186,299 | ) |   |
| Net loss                                                               |       | —                |       |                    | —     |                                      |       | —                 |       |         | —     |       |       |              | (1,424,385 | ) |   | — |   | (1,424,385 | ) |   | (1,424,385 | ) |   |
| BALANCE, December 31, 2005                                        |       | 14,279,592            |       |                    | $          | 14,955                                    |       |                   | $          | 63,574,518   |       |       | $          | (496,021          | )          |   |   | $ | (29,277,388 | ) |   | $ | (3,003,445 | ) | $ | 30,812,619 |   |   | $ | (1,610,684 | ) |   |
| Proceeds from exercise of stock options                                |       | 1,607,346             |       |                    | 1,607      |                                      |       | 6,501,799              |       |         | —     |       |       |              | —     |   |   | — |   | 6,503,406 |   |   |   |   |   |
| Proceeds from exercise of Valence management stock  options  (Note 11) |       | 357,625               |       |                    | 358        |                                      |       | 1,151,177              |       |         | —     |       |       |              | —     |   |   | — |   | 1,151,535 |   |   |   |   |   |
| Purchase of treasury stock                                             |       | —                |       |                    | —     |                                      |       | —                 |       |         | —     |       |       |              | —     |   |   | (2,114,586 | ) | (2,114,586 | ) |   |   |   |   |
| Cancellation of treasury stock                                         |       | (357,625              | )          |                    | (358       | )                                         |       | (2,114,228             | )          |         | —     |       |       |              | —     |   |   | 2,114,586 |   | — |   |   |   |   |   |
| Stock-based compensation                                               |       | —                |       |                    | —     |                                      |       | 1,460,910              |       |         | —     |       |       |              | —     |   |   | — |   | 1,460,910 |   |   |   |   |   |
| Currency translation adjustment                                        |       | —                |       |                    | —     |                                      |       | —                 |       |         | 81,303     |       |       |              | —     |   |   | — |   | 81,303 |   |   |   |   |   |
| Unrealized gain on investments available for sale,  net of tax         |       | —                |       |                    | —     |                                      |       | —                 |       |         | 141,423    |       |       |              | —     |   |   | — |   | 141,423 |   |   | 141,423 |   |   |
| Net income                                                             |       | —                |       |                    | —     |                                      |       | —                 |       |         | —     |       |       |              | 4,707,857  |   |   | — |   | 4,707,857 |   |   | 4,707,857 |   |   |
| BALANCE,  December 31, 2006                                       |       | 15,886,938            |       |                    | $          | 16,562                                    |       |                   | $          | 70,574,176   |       |       | $          | (273,295          | )          |   |   | $ | (24,569,531 | ) |   | $ | (3,003,445 | ) | $ | 42,744,467 |   |   | $ | 4,849,280 |   |   |

 

See accompanying notes to consolidated financial statements.

44

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**SRS LABS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                                | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Cash Flows From Operating Activities:**                                                 | ** ** | ** **                                  |       | ** ** | ** ** | ** ** | ** ** |
| Net income (loss)                                                                         |       | $                                           | 4,707,857  |   | $ | (1,424,385 | ) | $ | 1,578,521 |   |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                                        |       |   |   |   |   |
| Depreciation and  amortization                                                            |       | 727,773                                     |       | 840,073 |   | 765,135 |   |
| Provision for  doubtful accounts                                                          |       | (19,594                                     | )          | 38,010 |   | 113,174 |   |
| Deferred taxes                                                                            |       | (6,025                                      | )          | — |   | 2,401 |   |
| (Accretion)  amortization of (discount) premium on investments available for sale         |       | (1,904                                      | )          | (2,202 | ) | 5,980 |   |
| Net realized gain  on investments available for sale.                                     |       | (3,125                                      | )          | — |   | (139,375 | ) |
| Stock based  compensation expense                                                         |       | 1,359,767                                   |       | 55,802 |   | 92,585 |   |
| Loss (gain) on  disposition of furniture, fixtures and equipment                          |       | 1,582                                       |       | (5,030 | ) | 4,961 |   |
| Write-off of  intangible assets                                                           |       | 12,072                                      |       | — |   | 43,266 |   |
| Gain on disposal  of discontinued operations.                                             |       | (624,646                                    | )          | — |   | — |   |
| Changes in operating  assets and liabilities:                                             |       |                                        |       |   |   |   |   |
| Accounts  receivable                                                                      |       | 725,495                                     |       | (847,399 | ) | (534,701 | ) |
| Prepaid expenses  and other current assets                                                |       | (206,093                                    | )          | 186,539 |   | (180,907 | ) |
| Accounts payable                                                                          |       | (131,912                                    | )          | 295,312 |   | (436,897 | ) |
| Accrued  liabilities                                                                      |       | 493,338                                     |       | 355,906 |   | 167,884 |   |
| Deferred revenue                                                                          |       | (138,071                                    | )          | 100,726 |   | 417,424 |   |
| Income taxes  payable                                                                     |       | —                                      |       | (241,068 | ) | 296,996 |   |
| Net cash (used by)  provided by operating activities of discontinued operations           |       | (1,945,807                                  | )          | 3,642,043 |   | 338,763 |   |
| Net cash provided  by operating activities                                                |       | 4,950,707                                   |       | 2,994,327 |   | 2,535,210 |   |
| **Cash Flows From Investing Activities:**                                                 | ** ** | ** **                                  |       | ** ** | ** ** | ** ** | ** ** |
| Proceeds from sale  of investments available for sale                                     |       | 11,996,917                                  |       | — |   | 5,375,000 |   |
| Proceeds from sale  of Valence                                                            |       | 4,300,000                                   |       | — |   | — |   |
| Proceeds from sale  of equity interest in CHS/SRS LLC                                     |       | 387,021                                     |       | — |   | — |   |
| Purchase of  property and equipment                                                       |       | (214,459                                    | )          | (154,851 | ) | (368,636 | ) |
| Proceeds from  sales of furniture, fixtures and equipment                                 |       | —                                      |       | 8,749 |   | — |   |
| Purchase of  investments available for sale                                               |       | —                                      |       | — |   | (11,986,038 | ) |
| Expenditures  related to intangible assets                                                |       | (520,881                                    | )          | (440,515 | ) | (514,006 | ) |
| Net cash used by  investing activities of discontinued operations                         |       | (180,216                                    | )          | (597,706 | ) | (3,311,435 | ) |
| Net cash provided  by (used in) investing activities                                      |       | 15,768,382                                  |       | (1,184,323 | ) | (10,805,115 | ) |
| **Cash Flows From Financing Activities:**                                                 | ** ** | ** **                                  |       | ** ** | ** ** | ** ** | ** ** |
| Purchase of  treasury stock                                                               |       | (2,114,586                                  | )          | (1,059,590 | ) | (1,225,254 | ) |
| Proceeds from  exercise of stock options                                                  |       | 7,654,583                                   |       | 990,013 |   | 3,711,451 |   |
| Net cash provided  by (used in) financing activities                                      |       | 5,539,997                                   |       | (69,577 | ) | 2,486,197 |   |
| **Net  Increase (Decrease) in Cash and Cash Equivalents**                                 |       | 26,259,086                                  |       | 1,740,427 |   | (5,783,708 | ) |
| **Cash and  Cash Equivalents, Beginning of Year**                                         |       | 8,752,339                                   |       | 7,011,912 |   | 12,795,620 |   |
| **Cash and  Cash Equivalents, End of Year**                                               |       | $                                           | 35,011,425 |   | $ | 8,752,339 |   | $ | 7,011,912 |   |
| **Supplemental Disclosures of Cash Flow  Information:**                                   | ** ** | ** **                                  |       | ** ** | ** ** | ** ** | ** ** |
| Cash paid during the  period for:                                                         |       |                                        |       |   |   |   |   |
| Income taxes                                                                              |       | $                                           | 856,841    |   | $ | 420,836 |   | $ | 1,047,624 |   |
| **Supplemental Disclosure of Non-Cash Activities:**                                       | ** ** | ** **                                  |       | ** ** | ** ** | ** ** | ** ** |
| Unrealized  gain/(loss) on investments, net                                               |       | $                                           | 141,423    |   | $ | (186,299 | ) | $ | 26,624 |   |
| Tax benefit on  employee stock plans                                                      |       | $                                           | —     |   | $ | 5,694 |   | $ | 296,996 |   |

 

See accompanying notes to consolidated financial statements

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**SRS LABS, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1.**                 Organization andSignificant Accounting Policies

*Organization*

SRS Labs, Inc.(collectively with its subsidiaries, the “Company,” “SRS Labs,” or “SRS”) is aleading developer and provider of audio and voice technology solutions for thehome entertainment, portable media device, personal telecommunications,personal computer, automotive, and broadcast markets. Prior to September 29,2006, the Company also developed and provided application-specific integratedcircuits and standard integrated circuits, or ICs, through its formerwholly-owned subsidiary, Valence Tech Limited (“Valence”).

*Licensing:****  ***Through SRS Labs, Inc., the parent company,and its wholly-owned subsidiary, SRSWOWcast.com, Inc., or SRSWOWcast, theCompany develops and licenses audio, voice and surround sound technologysolutions to many of the world’s leading original equipment manufacturers (“OEMs”),software providers and semiconductor companies, and license and market hardwareand software products for the Internet and professional audio markets.

*Discontinued Operations:*

*Valence:*   Throughits former wholly-owned subsidiary, Valence, the company operated a fablesssemiconductor business which developed, designed and marketed standard andcustom analog ICs, digital signal processors, and mixed signal integratedcircuits primarily to OEMs and original design manufacturers (“ODMs”) in theAsia Pacific region.

On February 23, 2006,the Company’s Board of Directors (the “Board”) approved a plan to sell Valencein order to focus management’s attention and the Company’s financial resources onits licensing business. On July 14, 2006, the Company entered into adefinitive Sale and Purchase Agreement (“Purchase Agreement”) to sell Valenceto Noblehigh Enterprises Inc. (“Noblehigh”). Noblehigh is owned by Willas ArrayElectronics (Holding) Limited as well as certain members of management ofValence (collectively referred to herein as the “Management Buyers”). The saletransaction was completed on September 29, 2006 and, accordingly, theresults of the operations of Valence through the date of sale are included asdiscontinued operations in the accompanying consolidated statements ofoperations for all periods presented. The transaction did not require approvalby SRS’s stockholders. See Note 11.

*CHS/SRS LLC:*   InSeptember 2004, the Company entered into a strategic alliance with ComingHome Studios LLC (“CHS”), to use and promote SRS Labs’ technologies, to promoteCHS productions and to promote each company’s respective brands. In connectionwith the strategic alliance, the Company and CHS established a joint venture,CHS/SRS, LLC (the “Joint Venture”), to produce and distribute nine concertvideos featuring SRS Labs’ Circle Surround technology. Initially, CHS was themanager of the Joint Venture; however, the Company became the manager of theJoint Venture in July 2005. As a result of becoming the manager of, andproviding financial support to, the Joint Venture, the Company was requiredunder Financial Accounting Standards Board Interpretation No. 46(R), *Consolidation of Variable Interest Entities*, to consolidatethe financial statements of the Joint Venture into its consolidated financialstatements commencing with the third quarter of fiscal 2005. Previously, weaccounted for our 50% equity ownership in the Joint Venture as an investmentusing the equity method.

The Company recorded anasset impairment charge of $3.3 million related to our investment in the JointVenture in the fourth quarter of fiscal 2005. On February 23, 2006, theBoard authorized management to take all reasonable steps to divest the Company’sentire equity interest in the Joint 

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Venture.As a result of its decision to sell the Company’s interest in the JointVenture, the Company has accounted for the Joint Venture as discontinuedoperations in the consolidated financial statements for all periods presented.On June 30, 2006, the Company completed the sale of its interest in theJoint Venture to CHS in exchange for $200,000, the rights to all cash assets ofthe Joint Venture, and a promissory note in the amount of $175,000. The Companyrecorded a gain on disposal of its interest in the Joint Venture of $387,021 inthe Company’s accompanying consolidated statement of operations for the yearended December 31, 2006. Any amounts related to the promissory note andaccrued interest thereon will be recorded at the time the cash is received bySRS. See Note 11.

*Basis of Presentation*

The consolidated financialstatements have been prepared in accordance with accounting principlesgenerally accepted in the United States of America and include the Company andits wholly-owned subsidiary SRSWOWcast and the activities of itspreviously wholly-owned subsidiary Valence through the date of disposal (September 29,2006) and the Joint Venture through the date of disposal (June 30, 2006)after elimination of all intercompany accounts and transactions.

*Cash and Cash Equivalents*

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

*Investments*

The Company accounts forinvestments in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115,*Accounting for Certain Investments in Debt andEquity Securities*. Investments, consisting primarily of U.S.government securities, are classified as available for sale and are reported atfair value, based on quoted market prices, in the accompanying consolidatedbalance sheets. Those securities with a maturity date of one year or less areclassified as current assets. Unrealized gains and losses, net of applicableincome taxes, are reported as a separate component of stockholders’ equity.

*Property and Equipment*

Property and equipment arestated at cost, net of accumulated depreciation and amortization. The cost ofadditions and improvements are capitalized, while repairs and maintenance areexpensed as incurred. Depreciation and amortization are calculated using thestraight-line method, which amortizes cost over the lesser of the estimateduseful lives of the respective assets or the term of the related lease. Usefullives range from two to five years.

*Intangible Assets*

Costs paid by the Companyrelated to the establishment and transfer of patents, primarily legal costs,are capitalized and amortized, depending on the estimated life of thetechnology patented. These assets are being amortized over ten years.

The Company annuallyevaluates the recoverability of its patents and intangible assets based on theestimated future undiscounted cash flows. Should the carrying value of patentsor intangible assets exceed the estimated future undiscounted cash flows forthe expected periods of benefit, such assets would be written down to fairvalue. Based upon its most recent assessments, the Company has determined thatthere was no impairment as of December 31, 2006 and 2005.

*Capitalization of Software Development Costs*

Costs incurred in theresearch, design and development of software for sale to others as a separateproduct or embedded in a product and sold as part of the product as a whole arecharged to expense until 

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technologicalfeasibility is established. Under SFAS No. 86, *Accountingfor the Costs of Computer Software to be Sold, Leased or Otherwise Marketed*,the Company capitalizes software purchased from third parties if the relatedsoftware product under development has reached technological feasibility or ifthere are alternative future uses for the purchased software, provided thatcapitalized amounts will be realized over a period of approximately threeyears. Costs incurred for software purchased from third parties prior to theestablishment of technological feasibility are charged to research anddevelopment expense. The establishment of technological feasibility and ongoingassessment of recoverability of capitalized software development costs requireconsiderable judgment by management with respect to certain external factors,including, but not limited to, anticipated future revenues, estimated economiclife and changes in software and hardware technologies. Under SFAS No. 86,annual amortization of software development costs are equal to the greater of (a) theratio that current gross revenues for a product bear to the total of currentand anticipated future gross revenues for that product or (b) an amountdetermined using the straight-line method over the remaining estimated economiclife of the product including the period being reported on. Capitalizedsoftware costs are included in intangible assets, net in the accompanyingconsolidated balance sheets. The Company uses the straight-line method ofamortization because the software can be used for many products and theestimates required to be made under (a) could result in under- reportingof expense. Upon the general release of the software product to customers,capitalization ceases and such costs are amortized to cost of sales using thestraight-line method on a product-by-product basis over the estimated life,which is approximately three years. To the extent that amounts capitalized forsoftware development costs become impaired due to a decline in demand or theintroduction of new technology, such amounts will be written-off. All otherresearch and development expenditures are charged to research and developmentexpense in the period incurred.

Capitalizedsoftware as of December 31, 2006 and 2005 is as follows:

| ** **                 | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Capitalized  software      |       | $                     | 728,670    |   | $ | 595,568 |   |
| Accumulated  amortization  |       | (475,034              | )          | (309,990 | ) |
| Capitalized software,  net |       | $                     | 253,636    |   | $ | 285,578 |   |

 

The Company recordedamortization expense of $165,044, $116,987 and $106,826 for the years ended December 31,2006, 2005 and 2004, respectively. As of December 31, 2006, the weightedaverage remaining useful life of the Company’s capitalized software wasapproximately 2.0 years. The following table shows the estimatedamortization expense for those assets for each of the remaining three fiscalyears.

| **Years Ending December 31,** | ** ** | ** ** | ** ** | **Estimated  Expense** | ** ** |
|----------------------------------------------|------------|------------|------------|------------------------|------------|
| 2007                                         |       | $          | 133,727    |                   |
| 2008                                         |       | 94,793     |       |
| 2009                                         |       | 25,116     |       |
| Total                                        |       | $          | 253,636    |                   |

 

*Impairment ofLong-Lived Assets*

The Company evaluates therecoverability of long-lived assets with finite lives in accordance with SFAS No. 144,*Accounting for the Impairment or Disposal ofLong-Lived Assets*. The Company assesses potential impairments to itslong-lived assets when there is evidence that events or changes incircumstances indicate that the carrying amount of an asset may not berecovered. An impairment loss is recognized when the carrying amount of thelong-lived asset is not recoverable and exceeds its fair value. The carryingamount of a long-lived asset is not recoverable if it exceeds the sum of theundiscounted cash 

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flows expected to result from the use and eventualdisposition of the asset. Any required impairment loss is measured as theamount by which the carrying amount of a long-lived asset exceeds its fairvalue and is recorded as a reduction in the carrying value of the related assetand a charge to operating results. Based upon the most recent assessments as ofDecember 31, 2006 and 2005, the Company has determined there was noimpairment in the value of long-lived assets.

*Use of Estimates*

The preparation ofconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities as of the dateof the financial statements and the reported revenues and expenses during thereporting periods. Some of the estimates needed to be made by managementinclude the reserve for doubtful accounts, estimated useful lives of propertyand equipment and intangible assets, stock based compensation and the valuationallowance for the Company’s deferred tax asset. Actual results could materiallydiffer from these estimates.

*Revenue Recognition*

Revenues associated withongoing royalty license agreements are recognized upon receipt of reports fromlicensees stating the number of products implementing SRS patented technologieson which royalties are due, generally one quarter in arrears. The Company alsohas arrangements under which license fees are prepaid upfront, in addition toongoing per-unit license fees. In such cases, the prepaid fees are recorded asdeferred revenues and recognized as revenue upon receipt of reports fromlicensees stating the number of products shipped on which royalties are due.Licensing revenues for one-time technology transfer fees are recognized in theperiod in which the license agreement is consummated and the related technologyand passage of title is transferred. Revenue from product sales is generallyrecognized upon shipment, at which point title passes. Certain products may be soldunder consignment agreements, and revenue for such products is recognized uponreported distributor sales. Design revenue under design contracts is recognizedon the percentage-of-completion method. Estimates are reviewed and revisedperiodically throughout the lives of the contracts. Any revisions are recordedin the accounting period in which the revisions are made.

*Researchand Development*

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

*Income Taxes*

The Company accounts forincome taxes in accordance with SFAS No. 109, *Accountingfor Income Taxes*. Deferred taxes on income result from temporarydifferences between the reporting of income for financial statement and taxreporting purposes. A valuation allowance related to a deferred tax asset isrecorded when it is more likely than not that some or all of the deferred taxasset will not be realized.

*Discontinued Operations*

In accordance with SFAS No. 144,the Company accounts for the results of operations of a component of an entitythat has been disposed or that meets all of the “held for sale” criteria, asdiscontinued operations, if the component’s operations and cash flows have been(or will be) eliminated from the ongoing operations of the entity as a resultof the disposal transaction and the Company will not have any 

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significantcontinuing involvement in the operations of the component after the disposaltransaction. The “held for sale” classification requires having the appropriateapprovals by the Company’s management, Board, and stockholders, as applicable,and meeting other criteria. When all of these criteria are met, the componentis then classified as “held for sale” and its operations reported asdiscontinued operations.

At December 31, 2005,Valence and the Company’s Joint Venture were reclassified as discontinuedoperations and prior period assets and liabilities are reported as “held forsale.” For the years ended December 31, 2006, 2005 and 2004, the Company’scontinuing operations represent the business activities of its licensing segment.

*Net Income (Loss) Per Common Share*

The Company applies SFAS No. 128,*Earnings per Share*(“SFAS No. 128”),which requires the disclosure of basic and diluted net income or loss per sharefor all current and prior periods. Basic net income or loss per common share iscomputed by dividing net income or loss available to common stockholders by theweighted average number of common shares outstanding during each year. Dilutednet income or loss per common share reflects the maximum dilution, based on theaverage price of our common stock each period and is computed similar to basicincome or loss per share except that the denominator is increased to includethe number of additional shares that would have been outstanding if potentiallydilutive stock options and warrants had been exercised.

Basicand diluted net income (loss) per share computed in accordance with SFAS No. 128for the years ended December 31, 2006, 2005 and 2004 are as follows:

| ** **                                               | ** ** | **Years Ended December 31,** | ** ** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|------------|
| ** **                                               | ** ** | **2006**                                    | ** ** | **2005**   | ** ** | **2004** | ** ** | ** ** |
| BASIC EPS                                                |       |                                        |       |       |   |   |   |   |
| Numerator:                                               |       |                                        |       |       |   |   |   |   |
| Income (loss) from continuing operations                 |       | $                                           | 3,066,132  |       | $ | 1,662,624 |   | $ | (758,158 | ) |   |
| Income (loss) from discontinued operations               |       | 1,641,725                                   |       | (3,087,009 | ) | 2,336,679 |   |   |
| Net income (loss)                                        |       | $                                           | 4,707,857  |       | $ | (1,424,385 | ) | $ | 1,578,521 |   |   |
| Denominator: Weighted average common shares  outstanding |       | 14,955,889                                  |       | 14,117,795 |   | 13,950,457 |   |   |
| Income (loss)  from continuing operations per share      |       | $                                           | 0.21       |       | $ | 0.12 |   | $ | (0.05 | ) |   |
| Income (loss)  from discontinued operations per share    |       | $                                           | 0.11       |       | $ | (0.22 | ) | $ | 0.17 |   |   |
| Net income (loss)  per share                             |       | $                                           | 0.31       |       | $ | (0.10 | ) | $ | 0.11 |   |   |
| DILUTED EPS                                              |       |                                        |       |       |   |   |   |   |
| Numerator:                                               |       |                                        |       |       |   |   |   |   |
| Income (loss) from continuing operations                 |       | $                                           | 3,066,132  |       | $ | 1,662,624 |   | $ | (758,158 | ) |   |
| Income (loss) from discontinued operations               |       | 1,641,725                                   |       | (3,087,009 | ) | 2,336,679 |   |   |
| Net income (loss).                                       |       | $                                           | 4,707,857  |       | $ | (1,424,385 | ) | $ | 1,578,521 |   |   |
| Denominator: Weighted average common shares  outstanding |       | 14,955,889                                  |       | 14,117,795 |   | 13,950,457 |   |   |
| Common equivalent shares outstanding: Dilutive  options  |       | 509,933                                     |       | —     |   | 1,830,749 |   |   |
| Total diluted common shares                              |       | 15,465,822                                  |       | 14,117,795 |   | 15,781,206 |   |   |
| Income (loss) from continuing operations per share       |       | $                                           | 0.20       |       | $ | 0.12 |   | $ | (0.05 | ) |   |
| Income (loss) from discontinued operations per share     |       | $                                           | 0.11       |       | $ | (0.22 | ) | $ | 0.15 |   |   |
| Net income (loss)  per share                             |       | $                                           | 0.30       |       | $ | (0.10 | ) | $ | 0.10 |   |   |

 

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There were optionsoutstanding at December 31, 2006, 2005 and 2004 to purchase 1,196,763,4,444,254 and 164,000 shares of the Company’s common stock, respectively, thatwere not included above because they would be anti-dilutive.

*Stock-BasedCompensation*

On January 1, 2006,the Company adopted the provisions of SFAS No. 123(R), *Share-Based Payment*(“SFAS 123R”), usingthe modified prospective application transition method. SFAS No. 123Rrequires measurement of all employee stock-based compensation awards using afair-value method and recording of such expense in the consolidated financialstatements over the requisite service period. Previously, we had applied theprovisions of Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*(“APB25”) and related interpretations and elected to utilize the disclosure optionof SFAS No. 123, *Accounting forStock-Based Compensation*(“SFAS No. 123”). In fiscal 2006, werecorded stock-based compensation expense of $1,460,910 under the fair-valueprovisions of SFAS No.123R, compared to $55,802 in fiscal 2005 and $92,585 infiscal 2004 under the provisions of APB 25 and related interpretations. SeeNote 7.

*Fair Value ofFinancial Instruments*

Management believes thecarrying amounts of cash and cash equivalents, accounts receivable, accountspayable and accrued liabilities approximate fair value due to the short periodof time between origination of the instruments and their expected realization.The carrying amounts of investments available for sale are reported at fairvalue based on quoted market prices. See Note 2.

*CustomerConcentration*

For fiscal year 2006,Samsung and Sony accounted for approximately 17% and 11% of the Company’sconsolidated revenues, respectively. For fiscal year 2005, Samsung and Sonyeach accounted for approximately 13% of the Company’s consolidated revenues.For fiscal year 2004, Sony and ST Micro accounted for approximately 14% and 10%of the Company’s consolidated revenues, respectively. Given the significant amountof revenues derived from these customers, the loss of any such customer or theuncollectibility of related receivables could have a material adverse effect onthe Company’s consolidated financial condition and consolidated results ofoperations.

*Concentrations ofCredit Risk*

Financial instruments, which potentially subject theCompany to concentrations of credit risk, consist primarily of cashequivalents, investments and accounts receivable. The Company places its cashin banks and its cash and cash equivalents in commercial paper and money marketfunds at certain financial institutions in excess of amounts insured by federalagencies. The Company does not believe that it is subject to any unusualfinancial risk beyond the normal risk associated with commercial bankingrelationships. The Company performs periodic evaluations of the relative creditstanding of these financial institutions. Investments consist of U.S.government securities rated AAA. The Company has not experienced anysignificant losses on its cash equivalents or investments.

The Company’s accountsreceivables are derived from sales to OEMs, ODMs and platform partnersprimarily in Asia, North America and Europe. Customers’ headquartersgeographically located in the Asia Pacific markets accounted for approximately91%, 84% and 74%, of total Company sales in 2006, 2005 and 2004, respectivelyand are expected to continue to account for a substantial percentage of salesin the future. The Company makes periodic evaluations of the creditworthinessof its customers and manages its exposure to losses from bad debts by limitingthe amount of credit extended whenever deemed necessary 

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andgenerally does not require collateral. The Company maintains an allowance forestimated uncollectible accounts receivable and such losses have historicallybeen within management’s expectations.

*Recent AccountingPronouncements*

In July 2006, the Financial Accounting StandardsBoard (“FASB”) issued FASB Interpretation No. 48 (“FIN 48”), *Accounting for Uncertainty in Income Taxes*. FIN 48 is aninterpretation of FASB Statement No. 109, *Accountingfor Income Taxes*, and it seeks to reduce the diversity in practiceassociated with certain aspects of measurement and recognition in accountingfor income taxes. In addition, FIN 48 requires expanded disclosure with respectto the uncertainty in income taxes and is effective as of the beginning of our2007 fiscal year. We do not expect the adoption of FIN 48 to have a materialimpact on our consolidated financial position or consolidated results ofoperations.

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*(“SFAS No. 157”).The purpose of SFAS 157 is to define fair value, establish a framework formeasuring fair value and enhance disclosures about fair value measurements. Themeasurement and disclosure requirements are effective for periods beginningafter November 15, 2007. We do not expect the adoption of SFAS No. 157will have a material effect on our consolidated financial position orconsolidated results of operations.

In September 2006,the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108,*Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements*(“SAB 108”). SAB 108 provides interpretive guidance onhow to evaluate the materiality of an uncorrected misstatement in the currentyear financial statements using both an income statement approach (the “rolloverapproach”) and a balance sheet approach (the “iron curtain approach”). Therollover approach quantifies a misstatement based on the amount of the errororiginating in the current year income statement while the iron curtainapproach quantifies a misstatement based on the effects of correcting thecumulative misstatement existing in the balance sheet at the end of the currentyear. SAB 108 is effective for periods ending after November 15, 2006. Wedo not expect the adoption of SAB 108 to have a material impact on ourconsolidated financial position or consolidated results of operations.

*Reclassifications*

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

**2.**                 InvestmentsAvailable for Sale

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

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

| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2006**              | ** ** | **2005** | ** ** |
| U.S. Government  securities available for sale: |       |                  |       |   |   |
| Cost                                            |       | $                     | 5,500,000  |   | $ | 17,491,888 |   |
| Unrealized losses                               |       | (273,295              | )          | (414,718 | ) |
| Estimated fair  value                           |       | $                     | 5,226,705  |   | $ | 17,077,170 |   |

 

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

| ** **                                    | ** ** | **December 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|-----------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **Cost**                        | ** ** | **Estimated  Fair Value**  | ** ** | **Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| US Government  securities available for sale: |       |                            |       |                            |       |   |   |   |   |
| Due in one year or less                       |       | $                               | —     |                            | $          | — |   | $ | — |   | $ | — |   |
| Due in one to five years                      |       | 5,500,000                       |       | 5,226,705                       |       | 17,491,888 |   | 17,077,170 |   |
|                                          |       | $                               | 5,500,000  |                            | $          | 5,226,705 |   | $ | 17,491,888 |   | $ | 17,077,170 |   |

 

Thefollowing table summarizes sales of available for sale securities for the yearsended December 31, 2006, 2005 and 2004. Realized gains are included inOther income, net in the accompanying consolidated statements of operations.Specific identification was used to determine costs in computing realized gainsor losses.

| ** **          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Proceeds from  sale |       | $                                           | 11,996,917 |   |   | $ | — |   |   | $ | 5,375,000 |   |
| Realized gains      |       | $                                           | 3,125      |   |   | $ | — |   |   | $ | 139,375 |   |

 

**3.**                 Propertyand Equipment

Propertyand equipment, net, consist of the following:

| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Property and  equipment                         |       | $                     | 1,198,726  |   | $ | 1,219,885 |   |
| Computer  equipment                             |       | 930,231               |       | 824,869 |   |
| Leasehold  improvements                         |       | 94,840                |       | 62,240 |   |
|                                            |       | 2,223,797             |       | 2,106,994 |   |
| Less accumulated  depreciation and amortization |       | (1,834,130            | )          | (1,681,706 | ) |
|                                            |       | $                     | 389,667    |   | $ | 425,288 |   |

 

Depreciation andamortization expense totaling $246,098, $225,669 and $218,540 for the yearsended December 31, 2006, 2005 and 2004, respectively, is reflected ingeneral and administrative expenses.

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**4.**                 IntangibleAssets

Intangibleassets, net consist of the following:

| ** **                                                  | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                  | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Patents                                                     |       | $                     | 2,715,250  |   | $ | 2,339,543 |   |
| Accumulated  amortization                                   |       | (1,326,836            | )          | (1,093,368 | ) |
| Patents, net                                                |       | 1,388,414             |       | 1,246,175 |   |
| Other  intangibles:                                         |       |                  |       |   |   |
| License agreements acquired in purchase of  SRSWOWcast      |       | 640,071               |       | 640,071 |   |
| Poly Planar purchased technology for speaker  products      |       | 120,000               |       | 120,000 |   |
| Capitalized software and hardware for several  technologies |       | 658,942               |       | 525,840 |   |
| Total other intangibles                                     |       | 1,419,013             |       | 1,285,911 |   |
| Accumulated  amortization, other intangibles                |       | (762,288              | )          | (516,481 | ) |
| Other intangibles,  net                                     |       | 656,725               |       | 769,430 |   |
| Intangible assets, net                                      |       | $                     | 2,045,139  |   | $ | 2,015,605 |   |

 

Amortizationperiods range from three to ten years depending on the estimated useful life ofthe asset. Amortization expense consists of the following:

| ** **                                                  | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                  | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Patents                                                     |       | $                                           | 233,468    |   | $ | 202,190 |   | $ | 161,475 |   |
| Other intangibles:                                          |       |                                        |       |   |   |   |   |
| License agreements acquired in purchase of  SRSWOWcast      |       | 64,007                                      |       | 64,007 |   | 64,007 |   |
| Poly Planar purchased technology for speaker  products      |       | —                                      |       | 4,000 |   | 24,000 |   |
| Capitalized software and hardware for several  technologies |       | 181,800                                     |       | 123,845 |   | 85,955 |   |
| Total intangible  amortization expense                      |       | $                                           | 479,275    |   | $ | 394,042 |   | $ | 335,437 |   |

 

As of December 31,2006, the weighted average remaining useful life of the Company’s patents andintangible assets is approximately 6.4 years. The following table showsthe estimated amortization expense for those assets for each of the fivesucceeding fiscal years and thereafter.

| **Years Ending December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|
| 2007                                         |       | $          | 472,056    |       |
| 2008                                         |       | 365,511    |       |
| 2009                                         |       | 249,659    |       |
| 2010                                         |       | 222,746    |       |
| 2011                                         |       | 220,819    |       |
| Thereafter                                   |       | 514,348    |       |
| Total                                        |       | $          | 2,045,139  |       |

 

**5.**                 Commitmentsand Contingencies

*Leases*

The Company leases office space and certain equipmentunder non-cancelable operating leases expiring through 2008. The Company leasesits corporate office and storage facilities located in Santa Ana, California,under a lease agreement with a partnership that is affiliated with a principalstockholder, who is also an executive officer and a director, of the Company. Thelease is for a term of three years and expires on May 31, 2008.

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Futureannual minimum lease payments under non-cancelable operating leases for theremaining periods at December 31, 2006, are as follows:

| **Years Ending December 31,** | ** ** | ** ** | ** ** | **Facility-Related  Party** | ** ** | **Office  Equipment** | ** ** | **Total** | ** ** |
|----------------------------------------------|------------|------------|------------|-----------------------------|------------|-----------------------|------------|-----------|------------|
| 2007                                         |       |       | $          | 230,256                     |       |                  |       | $         | 11,949     |   |   | $ | 242,205 |   |
| 2008                                         |       |       | 95,940     |                        |       |                  | 3,299      |      |       | 99,239 |   |
| Total                                        |       |       | $          | 326,196                     |       |                  |       | $         | 15,248     |   |   | $ | 341,444 |   |

 

*Litigation*

The Company is involvedfrom time to time in litigation or claims arising in the ordinary course of itsbusiness. While the ultimate liability, if any, arising from these claimscannot be predicted with certainty, the resolution of any pending matters isnot expected to have a material adverse effect on the Company’s consolidatedfinancial statements.

*Indemnifications*

The Company enters into standard license agreements inits ordinary course of business. Pursuant to these agreements, the Companyagrees to indemnify its customers for losses suffered or incurred by them as aresult of any patent, copyright, or other intellectual property infringementclaim by any third party with respect to the Company’s products. Theseagreements generally have perpetual terms. The maximum amount ofindemnification the Company could be required to make under these agreements isgenerally limited to the license fees received by the Company. The Companyestimates the fair value of its indemnification obligation as insignificant,based upon its history of litigation concerning product and patent infringementclaims. Accordingly, the Company has no liabilities recorded forindemnification under these agreements as of December 31, 2006 and 2005.

The Company has agreementswhereby its officers and directors are indemnified for certain events oroccurrences while the officer or director is, or was, serving at our request insuch capacity. The maximum potential amount of future payments the Companycould be required to make under these indemnification agreements is unlimited;however, the Company has a directors and officers’ insurance policy thatreduces its exposure and enables the Company to recover a portion of any futureamounts paid. As a result of the insurance policy coverage, the Companybelieves the estimated fair value of these indemnification agreements isminimal. Currently, the Company has no liabilities recorded for theseagreements as of December 31, 2006 and 2005.

*Warranties*

The Company offers itscustomers a warranty that its software products will substantially conform totheir functional specifications. To date, there have been no payments ormaterial costs incurred related to fulfilling these warranty obligations.Accordingly, the Company has no liabilities recorded for these warranties as ofDecember 31, 2006 and 2005. The Company assesses the need for a warrantyreserve on a quarterly basis. There can be no guarantee that a warranty reservewill not become necessary in the future.

*EmploymentContracts*

The Company has employment agreements with its ChiefExecutive Officer and four other employees (collectively “Agreements”). Each ofthe Agreements was entered into for an initial term that has since expired andall are now automatically renewed annually on various anniversary dates. Underthe terms of each of the Agreements, the Company may be obligated to pay aseverance payment ranging from one to two years of the respective employee’sbase salary, depending on the date of termination, if the employee isterminated by the Company without cause.

55

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*Change in ControlPlan*

The Compensation Committeeof the Board, the sponsor of the Company’s 2005 Change in Control ProtectionPlan (the “Change in Control Plan”), has designated certain of its executiveofficers as participants in the Change in Control Plan. The Change in ControlPlan generally provides that if a participant’s employment is terminatedwithout cause or if the participant resigns for good reason during a two-yearperiod following a change in control, as defined in the Change in Control Plan,the participant will be entitled to receive a severance payment. Under theChange in Control Plan, the size of the severance payment that would be due toa participant upon the occurrence of a covered termination ranges from to oneto two times the participant’s average taxable income during the five yearspreceding the change in control, depending on the participant’s position withthe Company. The Change in Control Plan also provides that the Company will paya participant’s COBRA premiums for a period of 18 months following a coveredtermination.

**6.**                 IncomeTaxes

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

| ** **    | ** ** | **Years Ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States |       | $                                           | 3,934,335  |   | $ | 2,458,543 |   | $ | (235,030 | ) |
|               |            |                                             |            |  |  |  |  |  |  |  |

 

Theprovision for income taxes on continuing operations consists of the following:

| ** **                         | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------|------------|---------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current:                           |       |                                        |       |   |   |   |   |
| Federal                            |       | $                                           | (42,970    | ) | $ | 51,833 |   | $ | 23,356 |   |
| State                              |       | —                                      |       | 17,127 |   | 7,873 |   |
| Foreign                            |       | 905,148                                     |       | 726,959 |   | 489,498 |   |
| Total                              |       | 862,178                                     |       | 795,919 |   | 520,727 |   |
| Deferred:                          |       |                                        |       |   |   |   |   |
| Federal                            |       | 768,341                                     |       | (578,005 | ) | 106,117 |   |
| State                              |       | 52,673                                      |       | 143,881 |   | 46,699 |   |
| Foreign                            |       | 6,025                                       |       | — |   | — |   |
| Change in valuation allowance, net |       | (821,014                                    | )          | 434,124 |   | (150,415 | ) |
| Total                              |       | 6,025                                       |       | — |   | 2,401 |   |
| Total income tax  provision        |       | $                                           | 868,203    |   | $ | 795,919 |   | $ | 523,128 |   |

 

Thereconciliation of the income tax expense computed at U.S. federal statutoryrates to the provision for income taxes is as follows:

| ** **                                  | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Tax at U.S.  federal statutory rates        |       | $                                           | 1,377,017  |   | $ | 835,905 |   | $ | (79,910 | ) |
| State income  taxes, net of federal benefit |       | 226,067                                     |       | 143,333 |   | (13,702 | ) |
| Nondeductible  expenses                     |       | 13,137                                      |       | 107,320 |   | — |   |
| Change in  valuation allowance, net         |       | 821,014                                     |       | 434,126 |   | (150,415 | ) |
| Research and  development credit            |       | (220,712                                    | )          | (125,000 | ) | — |   |
| Change in  beginning deferred balance       |       | —                                      |       | (493,612 | ) | — |   |
| Foreign tax rate  differential and other    |       | (1,348,320                                  | )          | (106,153 | ) | 767,155 |   |
| Total income tax expense                    |       | $                                           | 868,203    |   | $ | 795,919 |   | $ | 523,128 |   |

 

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

| ** **                       | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Deferred tax  assets:            |       |                  |       |   |   |
| Depreciation and amortization    |       | $                     | 621,615    |   | $ | 1,104,178 |   |
| Accruals                         |       | 233,815               |       | 789,341 |   |
| Investment in LLC                |       | —                |       | 955,849 |   |
| Net operating loss carryforwards |       | 4,233,982             |       | 7,178,133 |   |
| Tax credit carryforwards         |       | 3,301,629             |       | 2,238,883 |   |
| Capital loss carryforwards       |       | 6,460,261             |       | — |   |
| Other                            |       | 625,047               |       | (217,129 | ) |
| Valuation allowance              |       | (15,089,937           | )          | (11,668,869 | ) |
| Total net  deferred tax assets   |       | $                     | 386,412    |   | $ | 380,386 |   |

 

The Company has deferred tax liabilities that areimmaterial. The Company has federal and state net operating loss carryforwardsat December 31, 2006 of approximately $17,621,730 and $7,992,523,respectively. These net operating loss carryforwards began to expire in 2003 andwill continue to expire through 2026. In addition, the Company has federal taxcredit carryforwards of approximately $2,865,936 at December 31, 2006,which will begin to expire in 2010. The Company also has federal and statecapital loss carryforwards at December 31, 2006 of $16,219,585, whichbegin to expire in 2011.

As of December 31, 2006, a valuation allowance of$15,089,937 has been provided based on the Company’s assessment of the futurerealizability of certain deferred tax assets. The valuation allowance ondeferred tax assets relates to future deductible temporary differences, capitalloss carryforwards, foreign credit carryforwards, research and developmentcredit carryforwards, and net operating loss carryforwards for which theCompany has concluded it is more likely than not that these items will not berealized in the ordinary course of operations. Management periodicallyevaluates the recoverability of the deferred tax assets and recognizes the taxbenefit only as reassessment demonstrates they are realizable. At such time itis determined that it is more likely than not that the deferred tax assets arerealizable, the valuation allowance is adjusted. This assessment is based onprojections of future taxable income, which is impacted in future periods byincome before taxes and stock option exercises. The amount of the net deferredtax assets considered realizable, however, could be reduced in the near term ifactual future earnings are lower than estimated, or if there are differences inthe timing or amount of future reversals of existing taxable temporarydifferences. As a result of SFAS No. 123R, the Company’s deferred taxassets at December 31, 2006 do not include approximately $2.4 million ofexcess tax benefits from employee stock option exercises that are a componentof the Company’s net operating loss carryovers. Equity will be increased byapproximately $2.4 million if and when such excess tax benefits are ultimatelyrealized.

The use of losscarryforwards and tax credit carry forwards may become limited in the event ofan ownership change as defined under Internal Revenue Code section 382.

**7.**                 Stockholders’Equity and Stock Based Compensation

*Stock Repurchases*

On June 30, 2004, the Board authorized therepurchase of up to $3,000,000 of its outstanding common stock for a periodfrom July 1, 2004 to December 31, 2004 (the “2004 Repurchase Program”).The Company repurchased 216,575 shares at a cost of $1,225,254 under the 2004Repurchase Program.

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On March 25, 2005, the Board authorized the repurchaseof up to $3,000,000 of the Company’s common stock for a period from April 17,2005 to March 31, 2006 (the “2005 Repurchase Program”). All sharesrepurchased under the 2004 and 2005 Repurchase Program are reflected astreasury stock in the accompanying consolidated balance sheets. The Companyrepurchased 232,223 shares at a cost of $1,059,590 under the 2005 RepurchaseProgram. There was no activity under the 2005 Repurchase Program during 2006,and the program expired on March 31, 2006.

On September 29,2006, the Company repurchased from the Management Buyers of Valence 357,625shares of SRS common stock, which were obtained by the Management Buyersthrough the exercise of vested employee stock options, for an aggregaterepurchase price of $2,114,586. Such shares were immediately canceled and aretherefore not outstanding as of December 31, 2006. The repurchase priceper share paid for such shares was equal to the average closing price of SRScommon stock for the seven trading days ending three days prior to the closingdate of the sale of Valence. See Note 11.

*Stock Award/OptionPlans/Warrants*

In July 1996, the Board adopted and the Company’sstockholders approved the 1996 Long-Term Incentive Plan (as amended andrestated, the “1996 Plan”), for which 1,000,000 shares of the Company’s commonstock were reserved for issuance to officers, employees and consultants of theCompany. If any award granted under the 1996 Plan expires, terminates or isforfeited before the exercise thereof or the payment in full thereof, theshares covered by the unexercised or unpaid portion will become available fornew grants under the 1996 Plan. In June 1997, the Board and the Company’sstockholders approved the amendment and restatement of the 1996 Plan, includingto increase the number of shares reserved for issuance under the plan by1,000,000. In June 1998, the Board and the Company’s stockholders approvedan amendment to the 1996 Plan to increase the number of shares reserved forissuance under the plan by 2,500,000. Also in June 1998, in a separateamendment, the Board and the Company’s stockholders approved an amendment toallow all directors of the Company and any subsidiary of the Company toparticipate in the 1996 Plan. In June 2000, the Board adopted and theCompany’s stockholders approved an amendment to the 1996 Plan to increase thenumber of shares reserved for issuance under the plan by 2,500,000. In June 2003,the Board and the Company’s stockholders approved an amendment to the 1996 Planto increase the number of shares reserved for issuance under the plan by1,500,000. The Compensation Committee or, in the absence of a CompensationCommittee, the Board, as a whole, has been appointed to administer the 1996Plan. Options issued under the 1996 Plan vest in the manner prescribed by theCompensation Committee or the Board, as applicable. As of December 31,2006, options to purchase 2,105,088 shares of the Company’s common stock wereoutstanding under the 1996 Plan. There are no options available for grant underthe 1996 Plan as of December 31, 2006.

In July 1996, the Board adopted and the Company’sstockholders approved the 1996 Non-employee Directors Stock Option Plan (the “Non-employeeDirectors Plan”), a non-discretionary formula plan for which 120,000 shares ofthe Company’s common stock were reserved for issuance to the Company’snon-employee directors. A committee consisting of all directors who are noteligible to participate in the Non-employee Directors Plan administers theNon-employee Directors Plan. With the exception of the initial option grantedto a non-employee director, which vests immediately, options granted under theNon-employee Directors Plan vest over a three-year period, the firstinstallment vesting on the date of grant. In June 1999, the Company’sstockholders approved the Amended and Restated 1996 Non-employee Directors’Stock Option Plan (the “Amended Non-employee Directors Plan”). Among thechanges set forth in the Amended Non-employee Directors Plan was to increase by130,000 the number of shares of common stock that may be issued under the plan.In June 2001, the Board adopted and the Company’s stockholders approved anamendment to the Amended Non-employee Directors Plan to increase the number ofshares reserved for issuance under the plan by 250,000. As of December 31,2006, options to purchase 130,000 shares of common stock were outstanding underthe Amended Non-employee Directors 

58

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Plan. There are 340,000options available for grant under the Non-employee Directors Plan as of December 31,2006.

On June 22, 2006, theBoard adopted and the Company’s stockholders approved the 2006 Stock IncentivePlan (the “2006 Plan”), for which 1,500,000 shares of the Company’s commonstock has been reserved for issuance under the plan provided that the Companyshall not make additional awards under the 1996 Plan. Either the Board or acommittee appointed by the Board (the “Committee”) will administer the 2006Plan. The Compensation Committee is currently acting as the Committee forpurposes of the 2006 Plan. Under the 2006 Plan, the Committee may grant optionsthat are intended to qualify as incentive stock options. Additionally, theCommittee may also grant share appreciation rights, restricted shares,restricted share units, unrestricted shares, deferred share units, andperformance awards. The vesting period is dependent on the type of awardgranted. As of December 31, 2006, options to purchase 125,000 shares ofcommon stock were outstanding under the 2006 Plan. There are 1,375,000 optionsavailable for grant under the 2006 Plan as of December 31, 2006.

*Stock BasedCompensation*

In December 2004, the FASB issued SFAS No. 123R.This Statement requires companies to expense the estimated fair value of stockoptions and similar equity instruments issued to employees over the requisiteservice period. SFAS 123R eliminates the alternative to use the intrinsicmethod of accounting provided for in APB 25, which generally resulted in animmaterial amount of compensation expense recorded in the financial statementsrelated to the grant of stock options to employees if certain conditions weremet. The pro forma impact from recognition of the estimated fair value of stockoptions granted to employees has been previously disclosed in the Company’sfootnotes as required under previous accounting rules.

Effective for the first quarter of fiscal 2006, theCompany adopted SFAS 123R using the modified prospective applicationmethod, which requires the Company to record compensation expense for allawards granted after the date of adoption, and for the unvested portion ofpreviously granted awards that remain outstanding at the date of adoption.Accordingly, prior period amounts presented herein have not been restated toreflect the adoption of SFAS 123R.

The fair value concepts were not changed significantlyin SFAS 123R; however, in adopting SFAS 123R, companies must chooseamong alternative valuation models and amortization assumptions. Afterassessing alternative valuation models and amortization assumptions, theCompany is continuing to use both the Black-Scholes-Merton (“BSM”)option-pricing formula and straight-line amortization of compensation expenseover the requisite service period of the grant. The Company will reconsider useof this model if additional information becomes available in the future thatindicates another model would be more appropriate, or if grants issued infuture periods have characteristics that cannot be reasonably estimated usingthis model. Under SFAS No. 123, the Company was not required to estimate forfeituresin its expense calculation for the stock compensation pro forma footnotedisclosure; however, SFAS No. 123R requires an estimate of forfeitures andupon adoption the Company changed its methodology to include an estimate offorfeitures. The adoption of SFAS No. 123R had no effect on cash flowsfrom financing activities.

59

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Thefollowing table illustrates the effect on net income and net income per shareas if the Company had applied the fair value recognition provisions of SFAS No. 123Rto periods prior to the Company’s actual date of adoption to options grantedunder the Company’s stock option plans. For purposes of this pro formadisclosure, the fair value of the options is estimated using a BSMoption-pricing formula and amortized on a straight-line basis to expense overthe options’ vesting period:

| ** **                                                                                                     | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                     | ** ** | **2005**                                    | ** ** | **2004** | ** ** |
| Net (loss) income  (attributable to common stockholder)—as reported                                       |       | $                                           | (1,424,385 | ) | $ | 1,578,521 |   |
| Add: stock based  employee compensation expense included in reported net (loss) income, net of  40% tax effect |       | 33,481                                      |       | 55,550 |   |
| Less : fair value  of stock-based employee compensation expense                                                |       | (1,136,471                                  | )          | (1,594,917 | ) |
| Net (loss) income  (attributable to common stockholder)—pro forma                                         |       | $                                           | (2,527,375 | ) | $ | 39,154 |   |
| Net (loss) income  per share:                                                                                  |       |                                        |       |   |   |
| Basic, as  reported                                                                                            |       | $                                           | (0.10      | ) | $ | 0.11 |   |
| Basic, pro forma                                                                                               |       | $                                           | (0.18      | ) | $ | 0.00 |   |
| Diluted, as  reported                                                                                          |       | $                                           | (0.10      | ) | $ | 0.10 |   |
| Diluted, pro forma                                                                                             |       | $                                           | (0.18      | ) | $ | 0.00 |   |

 

Option awards are generally granted with an exerciseprice equal to the market price of the Company’s stock at the date of grant.Option awards generally have a term of 10 years and vest and become exercisableover a four-year service period.

The fair value of eachshare-based award is estimated on the grant date using the BSM option-pricingformula. Expected volatilities are based on the historical volatility of theCompany’s stock price. The expected term of options granted subsequent to theadoption of SFAS 123R is derived using the simplified method as defined inthe SEC’s Staff Accounting Bulletin 107, *Implementation of FASB123R*. The risk-free rate for periods within the contractual life ofthe option is based on the U.S. Treasury interest rates in effect at the timeof grant. The fair value of options granted was estimated using the followingweighted-average assumptions:

| ** **                | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------|------------|---------------------------------------------|------------|
| ** **                | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Expected term (in  years) |       | 6.25                                        |       | 6.25 |   | 6.25 |   |
| Expected  volatility      |       | 57                                          | %          | 58 | % | 75 | % |
| Risk-free  interest rate  |       | 4.9                                         | %          | 4.1 | % | 3.5 | % |
| Dividend yield            |       | 0.00                                        | %          | 0.00 | % | 0.00 | % |

 

Totalcompensation cost recognized in fiscal 2006 is as follows:

| Continuing  Operations:                                        |   |    |      |
|----------------------------------------------------------------|--------|---------|-----------|
| Sales and marketing                                            |   | $       | 515,762   |   |
| Research and development                                       |   | 331,480 |      |
| General and administrative                                     |   | 512,525 |      |
| Total  compensation cost recognized in continuing operations   |   | $       | 1,359,767 |   |
| Total compensation cost recognized in discontinued  operations |   | $       | 101,143   |   |
| Total compensation cost  recognized                            |   | $       | 1,460,910 |   |

 

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Theremaining unrecognized compensation cost is $2,379,333 and the weighted averageperiod over which the expense will be recognized is 2.65 years.

Thefollowing table summarizes the weighted-average fair value of stock optionsgranted and the total intrinsic value of stock options exercised during theyears ended December 31, 2006, 2005 and 2004:

| ** **                                    | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted-average  fair value at date of grant |       | $                                           | 3.50       |   | $ | 3.25 |   | $ | 4.56 |   |
| Intrinsic value of  options exercised         |       | $                                           | 6,267,399  |   | $ | 575,008 |   | $ | 4,180,498 |   |

 

Asummary of option activity under the stock option plans and changes during theyear ended December 31, 2006 is presented below:

| ** **                                   | ** ** | ** ** | ** ** | **Weighted-Average** | ** ** | ** **                       | ** ** |
|----------------------------------------------|------------|------------|------------|----------------------|------------|----------------------------------|------------|
| ** **                                   | ** ** | **Shares** | ** ** | **Exercise  Price**  | ** ** | **Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
| Outstanding,  January 1, 2004           |       | 5,457,835  |       |                 | $          | 3.99                             |       |   |   |   |   |   |   |   |
| Granted                                      |       | 1,199,000  |       |                 | 6.34       |                             |       |   |   |   |   |   |   |
| Cancelled/Forfeited                          |       | (946,160   | )          |                 | 5.23       |                             |       |   |   |   |   |   |   |
| Exercised                                    |       | (989,134   | )          |                 | 3.75       |                             |       |   |   |   |   |   |   |
| Outstanding,  December 31, 2004         |       | 4,721,541  |       |                 | 4.38       |                             |       |   |   |   |   |   |   |
| Granted                                      |       | 588,775    |       |                 | 5.37       |                             |       |   |   |   |   |   |   |
| Cancelled/Forfeited                          |       | (583,788   | )          |                 | 5.62       |                             |       |   |   |   |   |   |   |
| Exercised                                    |       | (282,274   | )          |                 | 3.51       |                             |       |   |   |   |   |   |   |
| Outstanding,  December 31, 2005         |       | 4,444,254  |       |                 | 4.41       |                             |       |   |   |   |   |   |   |
| Granted                                      |       | 500,900    |       |                 | 5.81       |                             |       |   |   |   |   |   |   |
| Cancelled/Forfeited                          |       | (620,095   | )          |                 | 5.27       |                             |       |   |   |   |   |   |   |
| Exercised                                    |       | (1,964,971 | )          |                 | 3.90       |                             |       |   |   |   |   |   |   |
| Outstanding,  December 31, 2006         |       | 2,360,088  |       |                 | $          | 4.91                             |       |   |   | 6.1 |   |   | $ | 15,471,848 |   |
| Options exercisable,  December 31, 2006 |       | 1,538,920  |       |                 | $          | 4.46                             |       |   |   | 4.8 |   |   | $ | 9,951,755 |   |

 

The following tablesummarizes information concerning currently outstanding and exercisable optionsand warrants at December 31, 2006:

| **Range of Exercise Prices** | ** ** | ** ** | ** ** | **Number of  Options   Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual Life  (in Years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Exercisable  As of  12/31/2006** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|---------------------------------------------|------------|------------|------------|------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|-----------------------------------------|------------|--------------------------------------------|------------|
| $  1.91 -  $  3.80 |       |       | 742,073    |                                           |       |                                                                     | 4.3        |                                       |       |                                    | $          | 2.93                                       |       |   | 740,198 |   |   | $ | 2.93 |   |   |
| $  3.81 -  $  5.70 |       |       | 661,815    |                                           |       |                                                                     | 6.0        |                                       |       |                                    | 4.88       |                                       |       | 442,222 |   |   | 4.79 |   |   |
| $  5.71 -  $  7.60 |       |       | 898,700    |                                           |       |                                                                     | 7.9        |                                       |       |                                    | 6.04       |                                       |       | 299,000 |   |   | 6.13 |   |   |
| $  7.61 -  $  9.50 |       |       | 17,500     |                                           |       |                                                                     | 3.2        |                                       |       |                                    | 8.68       |                                       |       | 17,500 |   |   | 8.68 |   |   |
| $  9.51 -  $11.40            |       |       | 20,000     |                                           |       |                                                                     | 3.4        |                                       |       |                                    | 10.56      |                                       |       | 20,000 |   |   | 10.56 |   |   |
| $17.10 - $19.00                        |       |       | 20,000     |                                           |       |                                                                     | 3.2        |                                       |       |                                    | 19.00      |                                       |       | 20,000 |   |   | 19.00 |   |   |
|                                        |       |       | 2,360,088  |                                           |       |                                                                     | 6.1        |                                       |       |                                    | $          | 4.91                                       |       |   | 1,538,920 |   |   | $ | 4.46 |   |   |

 

The total shares subject to options exercisable as of December 31,2006, 2005 and 2004 were 1,538,920, 3,248,290 and 2,940,631, respectively, withweighted average exercise prices of $4.46, $4.16 and $4.20, respectively.

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**8.**                 SegmentInformation

The Company previously operated in two businesssegments—semiconductors and licensing. However, as a result of selling thesemiconductor business, the Company now has continuing operations in only onebusiness segment, licensing. The Company’s revenue from continuing operationsis solely derived from licensing related revenue.

Thefollowing schedule presents the Company’s revenue by geographic area. Forproduct sales, revenue is allocated based on the country to which product wasshipped. For licensing-related revenue, the allocation is based on thelocation of the licensee’s corporate headquarters. The Americas region includesNorth, Central and South America.
|                                 | ** **   | **Years Ended December 31,** | ** **   |
|---------------------------------|--------------|---------------------------------------------|--------------|
| ** **                      | ** **   | **2006**                                    | ** **   | **%** | ** ** | **2005** | ** ** | **%** | ** ** | **2004** | ** ** | **%** | ** ** |
| ***Geographic  Area Revenue:*** | *** *** | *** ***                                | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** |
| Japan                           |         | $                                           | 8,115,378    |   | 44 | % | $ | 5,564,809 |   | 38 | % | $ | 4,906,343 |   | 45 | % |
| Korea                           |         | 5,652,550                                   |         | 30 | % | 3,980,660 |   | 27 | % | 1,456,063 |   | 14 | % |
| Greater China                   |         | 3,165,572                                   |         | 17 | % | 2,763,646 |   | 19 | % | 1,625,564 |   | 15 | % |
| Americas                        |         | 1,534,421                                   |         | 8 | % | 2,024,269 |   | 14 | % | 2,318,359 |   | 21 | % |
| Europe                          |         | 79,608                                      |         | 1 | % | 275,094 |   | 2 | % | 525,375 |   | 5 | % |
| Total                           |         | $                                           | 18,547,529   |   | 100 | % | $ | 14,608,478 |   | 100 | % | $ | 10,831,704 |   | 100 | % |

 

**9.**                 Related-PartyTransactions

The Company leases itscorporate office and storage facilities located in Santa Ana, California undera lease agreement with a partnership that is affiliated with a stockholder,officer and director of the Company. The lease has a term of three years, andexpires on May 31, 2008. We paid the partnership rent of $230,256, $222,066and $210,600 during 2006, 2005 and 2004, respectively. See Note 5.

**10.**          EmployeeBenefit Plan

The Company’s employeesbased in the United States may participate in a salary deferral plan (the “401(k) Plan”)in which eligible employees can contribute up to 75% of their eligiblecompensation. The Company also may contribute on a discretionary basis. TheCompany’s matching contribution vests ratably over a four year period. Duringthe years ended December 31, 2006, 2005, and 2004, the Company contributedapproximately $114,372, $93,700 and $99,800, respectively, to the 401(k) Plan.

**11.**          DiscontinuedOperations

*Valence:*   Through itsformer subsidiary, ValenceTech Limited, the Company operated a fablesssemiconductor business which developed, designed and marketed standard andcustom analog ICs, digital signal processors, and mixed signal integratedcircuits primarily to OEMs and ODMs, in the Asia Pacific region.

On February 23, 2006, the Board of Directorsapproved a plan to sell Valence in order to focus management’s attention andthe Company’s financial resources on its licensing business. On July 14,2006, the Company entered into a definitive Sale and Purchase Agreement to sellValence to Noblehigh Enterprises Inc. Noblehigh is owned by Willas ArrayElectronics (Holding) Limited as well as certain members of management ofValence. The sale transaction was completed on September 29, 2006 and,accordingly, the results of the operations of Valence and its cash flowsthrough the date of sale are reported as discontinued operations in all periodspresented. The transaction did not require approval by SRS’s stockholders.

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Thesale to Noblehigh was effected through two simultaneous transactions: (1) therepurchase by Valence of approximately 74% of the outstanding shares of Valencefrom SRS using its existing cash and (2) the purchase by Noblehigh of theremaining outstanding shares of Valence from SRS for $4.3 million. The saleresulted in a gain on the disposal, which is reflected in the accompanyingconsolidated financial statement of operations for 2006, calculated as follows:

| Cash proceeds  from sale  |   | $          | 4,300,000 |   |
|---------------------------|--------|------------|-----------|--------|
| Less :  Transaction costs |   | (924,450   | )         |
| Net proceeds              |   | 3,375,550  |      |
| Net assets sold           |   | (3,137,925 | )         |
| Gain on sale of Valence   |   | $          | 237,625   |   |

 

Additionally, the Company repurchased from theManagement Buyers 357,625 shares of SRS common stock, which were obtained bythe Management Buyers through the exercise of vested employee stock options,for an aggregate repurchase price of $2,114,586. Such shares were immediatelycanceled and are therefore not outstanding as of December 31, 2006. Therepurchase price per share paid for such shares was equal to the averageclosing price of SRS common stock for the seven trading days ending three daysprior to the closing date of the sale of Valence.

*CHS/SRSLLC:**  *In September 2004,the Company entered into a strategic alliance with Coming Home Studios LLC, touse and promote SRS Labs’ technologies, to promote CHS productions and topromote each company’s respective brands. In connection with the strategicalliance, the Company and CHS established a joint venture, CHS/SRS, LLC (the “JointVenture”), to produce and distribute nine concert videos featuring SRS Labs’Circle Surround technology. Initially, CHS was the manager of the JointVenture; however, the Company became the manager of the Joint Venture in July 2005.As a result of becoming the manager of, and providing financial support to, theJoint Venture, the Company was required under Financial Accounting StandardsBoard Interpretation No. 46, *Consolidation of VariableInterest Entities,* to consolidate the financial statements of theJoint Venture into its consolidated financial statements commencing with thethird quarter of fiscal 2005. Previously, the Company accounted for its 50%equity ownership in the Joint Venture as an investment using the equity method.

The Company recorded an asset impairment charge of$3.3 million related to its investment in the Joint Venture in the fourthquarter of fiscal 2005 based on management’s estimate of the recoverability ofthe related assets. On February 23, 2006, the Board authorized managementto divest its entire equity interest in the Joint Venture. The transaction didnot require approval by SRS stockholders. As a result of its decision to sellits interest in the Joint Venture, the Company has accounted for the JointVenture as a discontinued operation in the consolidated financial statementsfor all periods presented. On June 30, 2006, the Company completed thesale of its interest in the Joint Venture to CHS in exchange for $200,000, therights to all cash assets of the Joint Venture, and a promissory note in theamount of $175,000. The Company recorded a gain on disposal of its interest inthe Joint Venture of $387,021 in the Company’s accompanying consolidatedstatement of operations for the year ended December 31, 2006.  Any amounts related to the promissory note andaccrued interest thereon will be recorded at the time the cash is received bySRS.

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Incomefrom discontinued operations consists of direct revenues and direct expenses ofValence and the Joint Venture. General corporate overhead costs have not beenallocated to discontinued operations. A summary of the operating results ofValence and the Joint Venture included in discontinued operations in theaccompanying consolidated statements of operation is as follows:
|                                                                   | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                        | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Valence:**                                                      | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues.                                                         | ** ** | $                                           | 7,682,931  |   | $ | 8,432,449 |   | $ | 10,770,684 |   |
| Cost of sales                                                     |       | 3,562,750                                   |       | 3,411,649 |   | 3,725,062 |   |
| Gross margin                                                      |       | 4,120,181                                   |       | 5,020,800 |   | 7,045,622 |   |
| Total operating expenses                                          |       | 3,193,519                                   |       | 5,056,831 |   | 4,454,013 |   |
| Income (loss)  from operations                                    |       | 926,662                                     |       | (36,031 | ) | 2,591,609 |   |
| Other income  (expense), net                                      |       | 31,669                                      |       | (3,302 | ) | — |   |
| Income (loss)  before income tax expense                          |       | 958,331                                     |       | (39,333 | ) | 2,591,609 |   |
| Income tax  expense (benefit)                                     |       | 33,632                                      |       | (175,026 | ) | 287,288 |   |
| **Net  income from Valence**                                      |       | 924,699                                     |       | 135,693 |   | 2,304,321 |   |
| **Net  income (loss) from Joint Venture**                         |       | 92,380                                      |       | (3,222,702 | ) | 32,358 |   |
| **Net  income (loss) from discontinued operations, net of taxes** |       | 1,017,079                                   |       | (3,087,009 | ) | 2,336,679 |   |
| **Gain on  disposal of discontinued operations**                  |       | 624,646                                     |       | — |   | — |   |
| **Total income (loss) from  discontinued operations**             |       | $                                           | 1,641,725  |   | $ | (3,087,009 | ) | $ | 2,336,679 |   |

 

Asummary of the assets and liabilities related to the discontinued operations ofValence and the Joint Venture classified as held for sale in the accompanying2005 consolidated balance sheet:

| Current assets held for  sale:                |   |      |      |
|-----------------------------------------------|--------|-----------|-----------|
| Accounts receivable, net                      |   | $         | 902,771   |   |
| Inventories, net                              |   | 534,226   |      |
| Prepaid expenses and other current assets     |   | 422,130   |      |
| Total                                         |   | $         | 1,859,127 |   |
| Long term assets  held for sale:              |   |      |      |
| Furniture, fixtures and equipment, net   |   | $         | 1,060,631 |   |
| Goodwill, net                                 |   | 533,031   |      |
| Intangibles, net                              |   | 471,461   |      |
| Total                                         |   | $         | 2,065,123 |   |
| Liabilities  related to assets held for sale: |   |      |      |
| Accounts payable                              |   | $         | 855,559   |   |
| Accrued liabilities                           |   | 1,315,142 |      |
| Total                                         |   | $         | 2,170,701 |   |

 

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**SCHEDULE IIVALUATION AND QUALIFYING ACCOUNTS AND RESERVES**

| ** **                                  | ** ** | **Balance at  Beginning  of Period** | ** ** | **Additions  Charged to  Expense** | ** ** | **Deductions** | ** ** | **Balance  at End  of Period** | ** ** |
|---------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------|------------|----------------|------------|------------------------------------------|------------|
| For the year ended  December 31, 2006: |       |                                           |       |                                    |       |           |       |                                     |       |   |   |   |   |
| Allowance for doubtful accounts             |       |                                           | $          | 38,011                                  |       |           |       | $                                        | 19,594     |   |   | $ | 18,349 |   | $ | 39,256 |   |
| For the year ended  December 31, 2005: |       |                                           |       |                                    |       |           |       |                                     |       |   |   |   |   |
| Allowance for doubtful accounts             |       |                                           | $          | —                                  |       |           |       | $                                        | 38,011     |   |   | $ | — |   | $ | 38,011 |   |
| For the year ended  December 31, 2004: |       |                                           |       |                                    |       |           |       |                                     |       |   |   |   |   |
| Allowance for  doubtful accounts            |       |                                           | $          | —                                  |       |           |       | $                                        | 113,174    |   |   | $ | (113,174 | ) | $ | — |   |

 

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**EXHIBITINDEX**
| Exhibit   Number | ** **      | **Description** | ** ** |
|------------------|-----------------|-----------------|------------|
|             |   3.1 |            |       | Certificate of  Incorporation of the Company, previously filed with the SEC as  Exhibit 3.1 to the Company’s Registration Statement on Form SB-2,  specifically included in Amendment No. 1 to such Registration Statement  filed with the SEC on July 3, 1996 (File No. 333-4974-LA)  (the “Registration Statement Amendment No. 1”), which is incorporated  herein by reference. |   |
|             |   3.2 |            |       | Bylaws of the  Company, previously filed with the SEC as Exhibit 3.1 to the Company’s  Quarterly Report on Form 10-Q for the period ended  September 30, 1999, filed with the SEC on November 12, 1999, which  is incorporated herein by reference. |   |
|             |            |            | ** ** | **Material Contracts Relating to Management Compensation  Plans or Arrangements** | ** ** |
|             | 10.1            |            |       | Employment  Agreement dated July 1, 1996, between the Company and Thomas C.K. Yuen,  previously filed with the SEC as Exhibit 10.8 to the Registration  Statement Amendment No. 1, which is incorporated herein by reference. |   |
|             | 10.2            |            |       | Amendment to  Employment Agreement dated as of March 14, 1997, between the Company and  Thomas C.K. Yuen, previously filed with the SEC as Exhibit 10.2 to the  Company’s Annual Report on Form 10-KSB for the fiscal year ended  December 31, 1996, filed with the SEC on March 31, 1997 (the “1996  Annual Report”), which is incorporated herein by reference. |   |
|             | 10.3            |            |       | Employment  Agreement dated July 1, 1996, between the Company and Alan D. Kraemer,  previously filed with the SEC as Exhibit 10.11 to the Registration  Statement Amendment No. 1, which is incorporated herein by reference. |   |
|             | 10.4            |            |       | SRS  Labs, Inc. Amended and Restated 1996 Non-employee Directors Stock  Option Plan, as amended, previously filed with the SEC as Appendix B to  the Company’s Definitive Proxy Statement dated and filed with the SEC on  April 30, 2003, which is incorporated herein by reference. |   |
|             | 10.5            |            |       | Form of  Indemnification Agreement, previously filed with the SEC as  Exhibit 10.20 to the Registration Statement Amendment No. 1, which  is incorporated herein by reference. |   |
|             | 10.6            |            |       | Non-employee  Director Compensation Policy adopted by the Company’s Board of Directors on  January 28, 2005, previously filed with the SEC as Exhibit 10.1 to  the Company’s Current Report on Form 8-K filed with the SEC on  February 3, 2005, which is incorporated herein by reference. |   |
|             | 10.7            |            |       | Form of  Non-Employee Director Stock Option Agreement under the SRS Labs, Inc.  Amended and Restated 1996 Non-Employee Directors’ Stock Option Plan (Initial  Appointment), previously filed with the SEC as Exhibit 10.2 to the  Company’s Current Report on Form 8-K file with the SEC on  February 3, 2005, which is incorporated herein by reference. |   |
|             | 10.8            |            |       | Form of  Non-Employee Director Stock Option Agreement under the SRS Labs, Inc.  Amended and Restated 1996 Non-Employee Directors’ Stock Option Plan  (Re-Election), previously filed with the SEC as Exhibit 10.3 to the  Company’s Current Report on Form 8-K file with the SEC on  February 3, 2005, which is incorporated herein by reference. |   |
|             | 10.9            |            |       | Form of  Non-Employee Director Stock Option Agreement under the SRS Labs, Inc.  Amended and Restated 1996 Long-Term Incentive Plan, previously filed with the  SEC as Exhibit 10.4 to the Company’s Current Report on Form 8-K  file with the SEC on February 3, 2005, which is incorporated herein by  reference. |   |

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|        | 10.10 |   |   | Form of  Nonqualified Stock Option Agreement under the SRS Labs, Inc. Amended and  Restated 1996 Long-Term Incentive Plan dated March 29, 2005 (With  Schedule of Optionees Attached—Thomas C.K. Yuen, Janet M. Biski, Alan D.  Kraemer, Philip Wong and Jennifer Drescher), previously filed with the SEC as  Exhibit 10.1 to the Company’s Current Report Form 8-K filed  with the SEC on April 4, 2005, which is incorporated herein by  reference. |   |
|--------|-------|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   | 10.11 |   |   | SRS Labs, Inc.  2005 Change in Control Protection Plan approved April 27, 2005,  previously filed with the SEC as Exhibit 10.1 to the Company’s Current  Report on Form 8-K filed with the SEC on May 3, 2005, which  is incorporated herein by reference.                                                                                                                                                                                                       |   |
|   | 10.12 |   |   | Form of  Participation Agreement under the SRS Labs, Inc. 2005 Change in Control  Protection Plan for Selected Executive Officers (With Schedule of Parties  Attached—Thomas C.K. Yuen, Janet M. Biski and Alan D. Kraemer) approved  April 27, 2005, previously filed with the SEC as Exhibit 10.2 to  the Company’s Current Report on Form 8-K filed with the SEC on  May 3, 2005, which is incorporated herein by reference.                        |   |
|   | 10.13 |   |   | SRS  Labs, Inc. Amended and Restated 1996 Long-Term Incentive Plan, as  amended, approved April 27, 2005, previously filed with the SEC as  Exhibit 10.5 to the Form 8-K filed with the SEC on  May 3, 2005, which is incorporated herein by reference.                                                                                                                                                                                                               |   |
|   | 10.14 |   |   | Employment Letter  Agreement dated June 24, 2005 by and between the Company and Michael  Franzi, previously filed with the SEC as Exhibit 10.1 to the Company’s  Current Report on Form 8-K filed with the SEC on August 18,  2005, which is incorporated herein by reference.                                                                                                                                                                                        |   |
|   | 10.15 |   |   | Stock Option  Agreement dated August 17, 2005 by and between the Company and Michael  Franzi, previously filed with the SEC as Exhibit 10.2 to the Company’s  Current Report on Form 8-K filed with the SEC on August 18,  2005, which is incorporated herein by reference.                                                                                                                                                                                           |   |
|   | 10.16 |   |   | Employment Letter  Agreement dated December 21, 2005 by and between the Company and Ulrich  E. Gottschling, previously filed with the SEC as Exhibit 99.1 to the  Company’s Current Report on Form 8-K filed with the SEC on  December 29, 2005, which is incorporated herein by reference.                                                                                                                                                                           |   |
|   | 10.17 |   |   | Participation  Agreement for Ulrich E. Gottschling under the SRS Labs, Inc. 2005 Change  in Control Protection Plan, dated January 12, 2006, previously filed  with the SEC as Exhibit 99.1 to the Company’s Current Report on  Form 8-K filed with the SEC on January 18, 2006, which is  incorporated herein by reference.                                                                                                                                     |   |
|   | 10.18 |   |   | Participation  Agreement for Michael Franzi under the SRS Labs, Inc. 2005 Change in  Control Protection Plan, dated January 12, 2005, previously filed with  the SEC as Exhibit 99.2 to the Company’s Current Report on Form 8-K  filed with the SEC on January 18, 2006, which is incorporated herein by  reference.                                                                                                                                            |   |
|   | 10.19 |   |   | Nonqualified  Stock Option Agreement by and between the Company and Ulrich E. Gottschling,  dated January 12, 2006, previously filed with the SEC as Exhibit 99.6  to the Company’s Current Report on Form 8-K filed with the SEC on  January 18, 2006, which is incorporated herein by reference.                                                                                                                                                                    |   |
|   | 10.20 |   |   | Nonqualified  Stock Option Agreement by and between the Company and Sarah Yang, dated  January 12, 2006, previously filed with the SEC as Exhibit 99.7 to  the Company’s Current Report on Form 8-K filed with the SEC on  January 18, 2006, which is incorporated herein by reference.                                                                                                                                                                               |   |

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|        | 10.21  |   |       | Form of  Nonqualified Stock Option Agreement under the SRS Labs, Inc. 1996 Amended  and Restated Long-Term Incentive Plan, as Amended, previously filed with the  SEC as Exhibit 99.8 to the Company’s Current Report on Form 8-K  filed with the SEC on January 18, 2006, which is incorporated herein by  reference.                                                                                                               |       |
|--------|--------|--------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|   | 10.22  |   |       | SRS  Labs, Inc. 2006 Profit Sharing and Bonus Plan approved on April 12,  2006, previously filed with the SEC as Exhibit 99.1 to the Company’s  Current Report on Form 8-K filed with the SEC on April 18,  2006, which is incorporated herein by reference.                                                                                                                                                                         |       |
|   | 10.23  |   |       | Salary adjustment  for Lionel Cheung, President of Valence Tech, Limited, and President of its  wholly-owned subsidiary Valence Technology Limited, as approved on  April 25, 2006, previously filed with the SEC on the Company’s Current  Report on Form 8-K filed with the SEC on April 28, 2006,  which is incorporated herein by reference.                                                                                               |       |
|   | 10.24  |   |       | SRS  Labs, Inc. 2006 Stock Incentive Plan, as approved by the Company’s  shareholders on June 22, 2006, previously filed with the SEC as  Exhibit 10.1 to the Company’s Current Report on Form 8-K  filed with the SEC on June 28, 2006, which is incorporated herein by  reference.                                                                                                                                            |       |
|   | 10.25  |   |       | Salary adjustment  and discretionary merit bonus for Ulrich E. Gottschling, Chief Financial  Officer of the Company, as approved on November 1, 2006, previously  filed with the SEC on the Company’s Current Report on Form 8-K  filed with the SEC on November 6, 2006, which is incorporated herein by  reference.                                                                                                                          |       |
|   | 10.26  |   |       | SRS  Labs, Inc. 2007 Profit Sharing and Bonus Plan approved on  December 12, 2006, previously filed with the SEC as Exhibit 10.1 to  the Company’s Current Report on Form 8-K filed with the SEC on  December 18, 2006, which is incorporated herein by reference.                                                                                                                                                                   |       |
|   | 10.27  |   |       | Salary adjustment  for Alan Kraemer, Executive Vice President, Chief Technology Officer, Sarah  Yang, Vice President, Software Engineering and Michael Franzi, Vice  President, Sales Licensing, as approved on February 8, 2007, previously  filed with the SEC on the Company’s Current Report on Form 8-K  filed with the SEC on February 13, 2007, which is incorporated herein by  reference.                                             |       |
|   |   |   | ** ** | **Other Material Contracts**                                                                                                                                                                                                                                                                                                                                                                                                                                       | ** ** |
|   | 10.28  |   |       | License Agreement  dated as of June 27, 1988, between Hughes Aircraft and Sony Corporation,  as amended and assigned to the Company, previously filed with the SEC as  Exhibit 10.6 to the Company’s Registration Statement on Form SB-2,  specifically included in Amendment No. 3 to such Registration Statement  filed with the SEC on August 7, 1996 (File No. 333-4974-LA),  which is incorporated herein by reference.    |       |
|   | 10.29  |   |       | Industrial Real  Estate Lease dated May 30, 1997, between the Company and Daimler  Commerce Partners, L.P., previously filed with the SEC as Exhibit 10.1  to the Company’s Quarterly Form 10-QSB for the quarterly period  ended June 30, 1997, filed with the SEC on August 13, 1997, which  is incorporated herein by reference.                                                                                                  |       |
|   | 10.30  |   |       | Stock Divestment  Agreement dated July 1, 1996, between the Company, Thomas C.K. Yuen,  Stephen V. Sedmak and Walter W. Cruttenden III, previously filed with the SEC  as Exhibit 10.17 to the Company’s Registration Statement on Form SB-2,  specifically included in Amendment No. 2 to such Registration Statement  file with the SEC on August 2, 1996 (File No. 333-4974-LA),  which is incorporated herein by reference. |       |

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|        | 10.31 |   |   | Transition Agreement and  General Release between the Company and Janet Biski, dated March 31,  2006, previously filed with the SEC as Exhibit 99.1 to the Company’s  Current Report on Form 8-K filed with the SEC on April 4,  2006, which is incorporated herein by reference.                                                                                                                                    |   |
|--------|-------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|   | 10.32 |   |   | The Company’s Patent  Reward Program previously filed with the SEC as Exhibit 10.2 to the  Company’s Current Report on Form 8-K filed with the SEC on  June 28, 2006, which is incorporated herein by reference.                                                                                                                                                                                                     |   |
|   | 10.33 |   |   | Promissory Note dated  June 30, 2006 between the Company and Coming Home Studios, LLC, as  previously filed with the SEC as Exhibit 10.2 to the Company’s Current  Report on Form 8-K filed with the SEC on July 7, 2006, which  is incorporated herein by reference.                                                                                                                                                |   |
|   | 10.34 |   |   | Security Agreement dated  June 30, 2006 between the Company and Coming Home Studios, LLC, as  previously filed with the SEC as Exhibit 10.3 to the Company’s Current  Report on Form 8-K filed with the SEC on July 7, 2006, which  is incorporated herein by reference.                                                                                                                                             |   |
|   | 10.35 |   |   | Assignment Agreement  dated June 30, 2006 between the Company and Coming Home Studios, LLC, as  previously filed with the SEC as Exhibit 10.4 to the Company’s Current  Report on Form 8-K filed with the SEC on July 7, 2006, which  is incorporated herein by reference.                                                                                                                                           |   |
|   | 10.36 |   |   | First Amendment to the  Strategic Alliance Agreement dated June 30, 2006 between the Company and  Coming Home Studios, LLC, as previously filed with the SEC as  Exhibit 10.5 to the Company’s Current Report on Form 8-K  filed with the SEC on July 7, 2006, which is incorporated herein by  reference.                                                                                                           |   |
|   | 10.37 |   |   | Separation Agreement and  General Release between the Company and David Frerichs dated July 12,  2006, as previously filed with the SEC as Exhibit 10.1 to the Company’s  Current Report on Form 8-K filed with the SEC on July 17,  2006, which is incorporated herein by reference.                                                                                                                                |   |
|   | 10.38 |   |   | Sale and Purchase  Agreement Relating to Ordinary Shares in the Issued Share Capital of Valence  Tech Ltd dated July 14, 2006 between the Company and Noblehigh  Enterprises, Inc. and Willas-Array Electronics (Holdings) Ltd., as  previously filed with the SEC as Exhibit 2.1 to the Company’s Current  Report on Form 8-K filed with the SEC on July 17, 2006, which  is incorporated herein by reference. |   |
|   | 10.39 |   |   | Deed of Indemnity between  the Company and Noblehigh Enterprises, Inc., as previously filed with  the SEC as Exhibit 2.2 to the Company’s Current Report on Form 8-K  filed with the SEC on July 17, 2006, which is incorporated herein by  reference.                                                                                                                                                               |   |
|   | 21    |   |   | Subsidiaries of the  Company.                                                                                                                                                                                                                                                                                                                                                                                                                 |   |
|   | 23.1  |   |   | Consent of Independent  Registered Public Accounting Firm, Squar, Milner, Peterson,  Miranda & Williamson, LLP, dated March 21, 2007.                                                                                                                                                                                                                                                                                           |   |
|   | 23.2  |   |   | Consent of Independent  Registered Public Accounting Firm, BDO Seidman LLP, dated March 21, 2007                                                                                                                                                                                                                                                                                                                                         |   |
|   | 31.1  |   |   | Certification of the  Chief Executive Officer of SRS Labs, Inc., pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                        |   |
|   | 31.2  |   |   | Certification of the  Chief Financial Officer of SRS Labs, Inc., pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                        |   |
|   | 32.1  |   |   | Certification of Chief  Executive Officer of SRS Labs, Inc., pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                                                                       |   |
|   | 32.2  |   |   | Certification of Chief  Financial Officer of SRS Labs, Inc., pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                                                                       |   |

 

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