**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-K/A**

 
| **(Mark One)**                                        | ** ** |
|-------------------------------------------------------|------------|
| **x**                                                 | ** ** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                  |
| **For the  fiscal year ended December 31, 2004** |
|                                                  |
| **or**                                                |
|                                                  |
| **o**                                                 | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition period from               to               **

 

**Commission File Number: 0-21123**

 

 

**SRS LABS, INC.**

(Exactname of registrant as specified in its charter)

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

 

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

(Addressof principal executive offices) (Zip Code)

 

**(949) 442-1070**

(Registrant’stelephone number, including area code)

 

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

 

Securitiesregistered pursuant to Section 12(g) of the Act:

**Common Stock, Par Value$0.001 Per Share**

** **

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 ý No o

 

Indicate by check markif disclosure 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-K orany amendment to this Form 10-K. o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Act). Yes o No ý

 

The aggregate marketvalue of the registrant’s voting Common Stock held by non-affiliates of theregistrant was approximately $58,508,303 (computed using the closing price of$5.49 per share of Common Stock on June 30, 2004, as reported by theNasdaq Stock Market).

 

As of March 15,2005, 14,689,028 shares of the registrant’s Common Stock, par value $0.001 pershare, were outstanding. Of that amount, 441,875 shares were held as treasuryshares.

 

**DOCUMENTS INCORPORATEDBY REFERENCE**

** **

Portions of theregistrant’s Proxy Statement prepared in connection with the Annual Meeting ofStockholders to be held in 2005 are incorporated by reference in Part IIIof this Form 10-K.

 

 

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**EXPLANATORY NOTE**

 

This Amendment to Form 10-K(“Amendment”) is being filed for the purpose of modifying certain disclosuresin the Annual Report on Form 10-K for the registrant’s fiscal year ended December 31,2004 originally filed on March 31, 2005 (the “Original Filing”).

 

On May 10,2005, management of SRS Labs, Inc. (the “Company”) was advised by BDOSeidman, LLP, its independent registered public accounting firm (“BDO Seidman”),of the conclusion reached by it regarding the Company’s interim accounting forsales and marketing expenses related to trade shows.  This conclusion was reached in connectionwith BDO Seidman’s financial statement review procedures relating to theCompany’s Quarterly Report on Form 10-Q for the first quarter of the yearending December 31, 2005 (“fiscal 2005”). Commencing in the first quarter of the fiscal year ended December 31, 2004 (“fiscal 2004”)**,** the Company began to capitalize and amortizetrade show expenses incurred in the fiscal year to reflect the future economicbenefits received during such fiscal year. Management discussed the issue with the Audit Committee of the Company’sBoard of Directors and BDO Seidman and was of the view that capitalization andamortization of trade show expenses was allowable.  As part of the first quarter review, BDOSeidman noted that trade show costs previously capitalized and amortized shouldhave been treated as period expenses in******fiscal 2004.**  As a result, BDO Seidman expressed its viewthat (a) trade show costs previously capitalized and amortized duringfiscal 2004 should have been treated as period expenses in fiscal 2004; (b) eachof the Company’s quarterly reports previously filed in fiscal 2004 should berestated; and (c) no reliance should be placed on the previously issuedfiscal 2004 quarterly financial statements.

 

Acting on therecommendation of BDO Seidman, the Company has restated its financialstatements for the quarterly periods ended March 31, 2004, June 30,2004 and September 30, 2004.  TheCompany is restating these unaudited quarterly financial statements principallyto reflect trade show expenses as period expenses that are expensed asincurred.  This amended Annual Report on Form 10-K/Aamends prior disclosure to restate previously reported unaudited quarterlyresults as a result of the change in accounting treatment for trade show expenses.  The restatement of our quarterly reports forfiscal 2004 has no impact on the Company’s consolidated net income for fiscal2004 and does not affect the Company’s historical cash flows.  Accordingly, the financial statementsincluded in the Annual Report have not changed.

 

**In addition, in the course ofBDO Seidman’s financial statement review procedures relating to the Company’sQuarterly Report on Form 10-Q for the first quarter of fiscal 2005, BDOSeidman advised the Company that the Company’s decision to capitalize andamortize tradeshow expenses during fiscal 2004 constituted a deficiency in theCompany’s internal controls and advised the Audit Committee that this internalcontrol deficiency constitutes a reportable condition and a material weakness asdefined in Statement on Auditing Standards No. 60. As a result of thisinternal control deficiency, the Company has implemented more formal proceduresregarding changes in accounting treatment and related communications with theAudit Committee and****the Company’s **independent registered public accounting firm.

 

**This Form 10-K/A has not been updated except asrequired to reflect the effects of the restatements to the Company’s unaudited quarterlyresults. This amendment includes changes to Part II, Items 7 and 9A and Part IV,Item 15. Except as identified in the prior sentence, no other item included inthe original Form 10-K has been amended, and such items shall remain ineffect as of the filing date of the original Form 10-K. Additionally, thisForm 10-K/A does not purport to provide an update or discussion of anyother developments at the Company subsequent to its original filing.**

 

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**SRSLABS, INC.**

**ANNUALREPORT ON FORM 10-K**

**Tableof Contents**

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

 

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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 a decision toinvest in our securities. The risks and uncertainties described below are notthe only ones facing our company. Additional risks and uncertainties notpresently known or that we currently believe to be less significant may alsoadversely affect us. Unless the context requires otherwise, references to “theCompany,” “we,” “us,” “our” and “SRS Labs” refer specifically to SRS Labs andits subsidiaries.

 

**SPECIALNOTE REGARDING FORWARD-LOOKING STATEMENTS**

 

On one or moreoccasions, we may make statements regarding our assumptions, projections,expectations, targets, intentions or beliefs about future events. Allstatements other than statements of historical facts included in this AnnualReport on Form 10-K relating to expectation of future financialperformance, continued growth, changes in economic conditions or capitalmarkets and changes in customer usage patterns and preferences, are forward-lookingstatements.

 

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

 

As more particularlydiscussed under the caption “Factors That May Affect Future Results” inItem 7 of Management’s Discussion and Analysis of Financial Condition andResults of Operations in this Annual Report on Form 10-K, some importantfactors that could cause actual results or outcomes for SRS Labs or oursubsidiaries to differ materially from those discussed in forward-lookingstatements include:

 

•  changes in general economic conditions in themarkets in which we may compete and fluctuations in demand in the soundtechnology licensing and semiconductor industries;

 

•  our ability to build and strengthen our brand;

 

•  our ability to sustain historical margins aseach of our industries develop;

 

•  increased competition;

 

•  pricing pressures on consumer electronicsmanufacturers;

 

•  increased costs;

 

•  exposure to risks in our licensing businessrelated to product and customer concentration;

 

•  exposure to risks of international operations,particularly Asia and the People’s Republic of China;

 

•  reliance on revenue contributed from our ASICand standard IC business;

 

•  risks in our Valence business related tofabrication outsourcing to third parties;

 

•  cyclicality in the semiconductor business;

 

•  reliance on intellectual property;

 

•  our ability to retain key members ofmanagement;

 

•  adverse state, federal or foreign legislationor regulation or adverse determinations by regulators; and

 

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•  other factors identified from time to time inour filings with the Securities and Exchange Commission.

 

Any forward-lookingstatement speaks only as of the date on which such statement is made, and,except as required by law, we undertake no obligation to update any forward-lookingstatement to reflect events or circumstances after the date on which suchstatement is made or to reflect the occurrence of unanticipated events. Newfactors emerge from time to time, and it is not possible for management topredict all such factors.

 

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**PART I**

** **

**Item1**.         Business

** **

**Overview**

** **

SRS Labs is a leadingdeveloper and provider of application specific integrated circuits, or ASICs,standard integrated circuits, or ICs, and audio and voice technology solutionsfor the home entertainment, portable media device, personal telecommunications,personal computer, automotive and broadcast markets.

 

We operate in thefollowing two business segments:

 

*Semiconductors:  *Through SRSLabs, Inc.’s wholly-owned subsidiary, ValenceTech Limited, and ValenceTechLimited’s wholly-owned subsidiaries (collectively “Valence”), we operate afabless semiconductor business which develops, designs and markets standard andcustom analog ICs, digital signal processors, or DSPs, and mixed signalintegrated circuits primarily to original equipment manufacturers, or OEMs, andoriginal design manufacturers , or ODMs, in the Asia Pacific region.

 

*Licensing:**  ***Through SRSLabs, the parent company, the licensing segment develops and licenses audio,voice and surround sound technology solutions to many of the world’s leadingOEMs, software providers and semiconductor companies, and licenses and marketshardware and software products for the Internet and professional audio markets.

 

As used herein, the “Company,”“SRS Labs,” “we,” “us,” or “our” means SRS Labs, Inc. and its wholly ownedsubsidiaries, including Valence and SRSWOWcast.com Inc.

 

In 2003, we reported ourrevenues in the following five segments: licensing, semiconductors, componentdistribution, product sales and Internet and broadcast. In 2004, we decided toreduce our segments to licensing and semiconductors because of the materialityof the revenues attributable to the other three segments. Revenue from thecomponent distribution segment is now reported in the semiconductor segment andrevenues from product sales and Internet and broadcast segments are nowreported in the licensing segment. Segment information for prior years has beenrestated to conform to the current year presentation. The following table showsour revenues, cost of sales and gross margin by product segment for the lastthree fiscal years:

 
| ** **          | ** ** | **Years ended December 31,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Semiconductors:** |       |                                        |       |   |   |   |   |
| Total revenues      |       | $                                           | 10,770,684 |   | $ | 10,712,382 |   | $ | 10,777,569 |   |
| Cost of sales       |       | 3,725,062                                   |       | 3,953,100 |   | 4,600,388 |   |
| Gross margin        |       | $                                           | 7,045,622  |   | $ | 6,759,282 |   | $ | 6,177,181 |   |
|                |       |                                        |       |   |   |   |   |
| **Licensing:**      |       |                                        |       |   |   |   |   |
| Total revenues      |       | $                                           | 10,831,704 |   | $ | 9,101,399 |   | $ | 8,224,224 |   |
| Cost of sales       |       | 228,147                                     |       | 102,979 |   | 153,857 |   |
| Gross margin        |       | $                                           | 10,603,557 |   | $ | 8,998,420 |   | $ | 8,070,367 |   |
|                |       |                                        |       |   |   |   |   |
| **Total:**          |       |                                        |       |   |   |   |   |
| Total revenues      |       | $                                           | 21,602,388 |   | $ | 19,813,781 |   | $ | 19,001,793 |   |
| Cost of sales       |       | 3,953,209                                   |       | 4,056,079 |   | 4,754,245 |   |
| Gross margin        |       | $                                           | 17,649,179 |   | $ | 15,757,702 |   | $ | 14,247,548 |   |

 

Further financialinformation for business segments, geographic areas and customer concentrationis included in this Annual Report on Form 10-K under “Item 8. FinancialStatements and Supplemental

 

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Data” and in Notes 1 and12 to the Notes to Consolidated Financial Statements. Revenues for each of ourbusiness segments as a percentage of consolidated revenues and additionaldiscussion relating to our revenues are presented under “Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations.”Reference also is made to “Item 7. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Factors That May AffectFuture Results” for a discussion relating to certain business risks relating toour business.

 

SRS Labs wasincorporated in the State of California on June 23, 1993 andreincorporated in the State of Delaware on June 28, 1996. Our executiveoffices are located at 2909 Daimler Street, Santa Ana, California 92705. Ourtelephone number is(949) 442-1070.

 

**OurProducts and Technologies**

** **

*Semiconductors*

* *

Our fablesssemiconductor business designs, develops and markets custom and proprietaryanalog, digital and mixed signal integrated circuits. These products address awide range of applications in the consumer electronics, home entertainment,telecommunications and personal computer markets. We market our semiconductorproducts in two categories: (a) custom ASICs for specific OEM customersprimarily in the Asia Pacific region, and (b) standard integrated circuitsmarketed under the brand name, ASP Microelectronics, or ASP, many of whichinclude our audio, voice and surround sound technologies.

 

As of the end of 2004,approximately 35 engineerssupported our IC design capabilities, which for the past six years have beenawarded one of the Hong Kong Industry’s (HKITCC) Technology Achievement Awards.We outsource the manufacturing of these ASICs to a network of fabricationpartners throughout Asia Pacific, including Chartered Semiconductor, Samsungand Tower Semiconductor Limited in Israel.

 

In addition toperforming contract design work, we also design, develop and market standardICs for the Asia Pacific manufacturing market under the ASP brand name. Theproducts created are based upon management’s analysis of trends in the market,knowledge gained from long standing relationships with customers and overallbusiness experience. The general purpose integrated circuits offered includemicro-controllers for DVD Players, set-top box receivers and audio/videoequipment; ICs for telecommunication and game equipment; small signaltransistors and ICs used mainly in the manufacture of consumer products such astelevision sets, radios, telephones, computer mother boards, add-on boards andaudio hi-fi systems. Many of these products are developed by utilizing ourcustom design libraries, advanced mixed signal design technologies, systemlevel expertise, software knowledge and understanding of customer requirements.Many of these chips include SRS audio technologies and by the end of 2004, 40%of the ASP product line included SRS audio chips.

 

*Licensing*

* *

Our licensing businessdevelops and markets audio enhancement, voice and surround sound technologiesto OEMs, ODMs, semiconductor manufacturers and software providers in the homeentertainment, portable media device, personal telecommunications, automotiveand personal computer markets. Our portfolio of licensabletechnologies includes a wide range of techniques for the enhancementand delivery of audio, voice and surround sound technologies, including thefollowing:

 

•  *Audio Enhancement*—Ouraudio enhancement technologies provide numerous enhancements to the audiolistening experience, including improving the spatial imaging (width and heightof the sound image field) and bass response from traditional multimediaspeakers and headphones, positioning audio sounds in both the horizontal and verticalplanes, repositioning the audio image for non-optimally located speakers andenhancing bass for speakers and headphone systems that delivers bass up to anoctave below the physical capabilities of the speaker’s driver. Our audio

 

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enhancement technologiesinclude: SRS 3D Positional AudioTM, WOWTM, WOW XTTM, TruBass®, FOCUS®, SRSHeadphoneTM, SRS DialogClarityTM,TruSurround XT®, SRS 3D® Sound and SRS AutoTM.

 

•  *Voice Processing*—Thesetechnologies, which include our VIPTM and Noise ReductionTM technologies,dramatically reduce noise to produce much clearer and crisper dialog overwireless communication devices and improve the intelligibility of the humanvoice in a variety of listening situations, including high ambient backgroundenvironments.

 

•  *Surround Sound*—Ourcore surround sound technology, Circle Surround®, is a complete encoding anddecoding format. Circle Surround *encoding*enablesthe distribution of up to 6.1 channels of discrete audio over existingtwo-channel carriers such as broadcast television, FM radio, CDs and VHS tapes.Circle Surround *decoding*either**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 surround formats.Circle Surround decoding is available in three formats: Circle Surround, CircleSurround IITM and Circle Surround AutomotiveTM.

 

Our portfolio oftechnologies can address a broad spectrum of product applications within the verticalmarkets that we have targeted. Our technologies may be implemented in a varietyof methods, including discrete analog components, chip modules, analogsemiconductors, DSPs and software. These various implementation options offercustomers significant flexibility when incorporating our technologies intoproducts.

 

**OurCustomers and Markets**

 

We sell oursemiconductors and license our technologies throughout the Western Hemisphere,the Asia Pacific region and in Europe. The following table presents our revenueby geographic area. For product sales, revenue is allocated based on thecountry to which product was shipped. For licensing-related revenue, theallocation is based on the location of the licensee’s corporate headquarters.The Americas region includes North, Central and South America.

 
| ** **                      | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **2004**                                    | ** ** | **%** | ** ** | **2003** | ** ** | **%** | ** ** | **2002** | ** ** | **%** | ** ** |
| ***Geographic  Area Revenue:*** |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Hong Kong                       |       | $                                           | 9,975,904  |   | 46 | % | $ | 9,235,976 |   | 47 | % | $ | 9,848,123 |   | 52 | % |
| Japan                           |       | 4,906,343                                   |       | 23 | % | 5,402,565 |   | 27 | % | 5,383,728 |   | 28 | % |
| Americas                        |       | 2,354,668                                   |       | 11 | % | 875,461 |   | 5 | % | 1,027,252 |   | 6 | % |
| China                           |       | 2,028,224                                   |       | 9 | % | 2,193,863 |   | 11 | % | 1,771,486 |   | 9 | % |
| Other Asia  Pacific             |       | 1,661,880                                   |       | 8 | % | 1,226,945 |   | 6 | % | 151,649 |   | 1 | % |
| Europe                          |       | 675,369                                     |       | 3 | % | 878,971 |   | 4 | % | 819,555 |   | 4 | % |
| Total                           |       | $                                           | 21,602,388 |   | 100 | % | $ | 19,813,781 |   | 100 | % | $ | 19,001,793 |   | 100 | % |
|                                 |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Semiconductors*

 

Our custom ASICcustomers include the Asia-based manufacturing facilities for consumerelectronics, telecommunications and personal computer manufacturersheadquartered in North America, Europe and Asia Pacific.

 

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

 

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Our target customers forStandard ICs are the ODMs and OEMs of a variety of television applications,including LCD, projection, CRT and plasma televisions, as well as personaltelecommunications, automotive, portable audio and personal computer equipment.

 

Our six largestcustomers accounted for approximately 60% of our semiconductor revenues in2004, and two customers, Cantronic Industries Limited and Fook Tin TechnologiesLimited, accounted for approximately 20% and 11% of our semiconductor revenues,respectively.

 

*Licensing*

* *

Through our licensingbusiness segment, we market our portfolio of technologies to the followingvertical markets: home entertainment; personal telecommunications; portablemedia; personal computers and automotive. Our license agreements typically havemulti-year or automatic renewal terms, and either require per-unit royaltypayments for all products implementing our technologies or provide for a fixedannual or quarterly royalty payment. License agreements also specify the use ofour trademarks and logos on the product, within the packaging and in the user’smanual. Agreements also require our product review and approval to guaranteethe quality of the technology implementation and the correct usage of our logosand trademarks. We believe these terms ensure the quality and consistency ofthe technology and elevate the awareness of the SRS brand in the marketplace.Most agreements do not have volume requirements and may be terminated by thelicensees or us without substantial financial penalty. The following chartshows the percentage of our licensing revenue we received in 2004 and 2003 fromeach of these markets. Commencing in 2003, we embarked on a strategy to furtherdiversify our concentration across markets.

 
| ***2004*** |   | ***2003*** | *** *** |
|------------|--------|------------|--------------|
|            |   |            |
|            |        |            |              |  |

 

**HomeEntertainment**

 

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

 

*Televisions*.   Ouraudio technologies are widely used by television manufacturers as not only adifferentiating feature, but also because they resolve a multitude of audiochallenges that manufacturers encounter. As the television market migrates frombulky tube models to thinner digital displays,

 

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manufacturers are finding that they haveless room for speakers, which in turn compromises the overall audio quality ofthe television. From bass enhancement and dialog clarity to virtual surroundsound, we provide manufacturers with patented solutions that deliveroutstanding audio quality, without the expense of additional equipment orlarger speakers. In 2004, we announced several new and expanded licensingrelationships in the TV segment, including Akai, Ben Q, Dell, LG Electronics,Hyundai Image Quest, Samsung and Metz. During the year we also announced acollaborative partnership with Chinese TV manufacturer Skyworth to developaudio technologies for the Chinese consumer electronics market. In 2004, ourtechnologies have increasingly been implemented in flat panel TVs and monitorssuch as LCDs, plasma and projection displays. The flat panel display market hasgrown significantly, and over the past year, our licensing royalties derivedfrom flat panels have increased as these advanced models are quickly replacingtraditional CRT (Cathode Ray Tube) televisions.

 

*DVDPlayers & Set-top Boxes.  *A primarychallenge for DVD player, recorder and set-top box manufacturers is that the averagehousehold uses a two-speaker audio system, while most of the content playedover these devices is encoded in multichannel audio. We have developed atechnology that creates a virtual surround sound experience over any existingtwo-speaker systems, including the internal speakers of a television. Ourtechnology also creates a virtual surround experience from stereo material. In2004, we announced a cooperative agreement with ST Microelectronics forexclusive worldwide sales and marketing of TruSurround XT for digital set-topbox applications. As well, our technologies continue to be included in set-topboxes from Hughes for DirecTV and Motorola. In the DVD market, we have seen acontinued slowdown of licensing royalties as a result of increasing pricingpressure on stand-alone DVD playback devices and ongoing transition to new DVDrecorder devices.

 

*A/VReceivers & Home-Theater-in-a-Box.  *The receiveris the central hub for a typical home theater system and is rapidly becomingintegrated into a “home-theater-in-a-box” system that comes complete with a DVDplayer, VCR, CD player, set-top box and 5.1 speakers. Our portfolio oftechnologies can address this rapidly growing market from bass enhancement tothe improvement of the center channel dialog or front speaker stereoenhancement to full 5.1 surround sound. In 2004, we announced new or expandedOEM relationships with companies including Marantz, Pioneer and Motorola fortheir latest home entertainment systems.

 

**PersonalTelecommunications**

** **

Personaltelecommunications, which include mobile phones, are becoming a true convergentproduct as many of the newest generation handsets and wireless products arequickly becoming complete personal entertainment devices. We first penetratedthe mobile phone market in 2001 with our VIP technology, the first patentedvoice technology for mobile phones that provides significant spoken-wordcomprehension to handset users through real-time digital signal analysis andprocessing. With the advent of multimedia functionality, including digitalmusic playback, ring tones, streaming video, two-way video conferencing,gaming, digital video recording and TV viewing, we continue to work with manyof the leading mobile phone and voice communications companies to implement ourvoice technology solutions in communications products.

 

Due to simple physicalconstraints, handset makers face the difficult challenge of achievinghigh-quality audio during playback of these multimedia applications. Mostoften, headphones or ear buds are selected for their cost, convenient smallsize and aesthetics, rather than for their audio performance. For handsets withintegrated external speakers, the device size limits the speaker size, thespacing and even the separation between two speakers if they can fit in thedevice at all. Various popular audio compression schemes and codecs can alsoadversely affect the quality of reproduced audio due to the compressionmethodologies. To address these problems, in 2003 we developed WOW XTTM forMobile, the industry’s first complete audio enhancement solution designed toimprove the quality of any audio played on mobile devices. This advancedtechnology suite contains stereo audio, psychoacoustic bass enhancements, noise

 

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reduction, voice clarityand voice quality enhancement technologies. Coupled with valuable audiomanagement utility techniques that manage the audio level, this solutionovercomes the physical limitations of small speaker drivers and headphones andimproves the audio and voice quality, ensuring the best possible userexperience for consumers. In 2004, we further enhanced our portfolio ofsolutions for wireless devices with the introduction of SRS 3D PositionalAudioTM, which is a psychoacoustic audio rendering engine that makes audio cuessound as if they have been placed in a three-dimensional area in the spacearound the listener’s head.

 

Whether the device hasone speaker, two closely spaced speakers, or relies on headphone or ear budplayback, our audio and voice solutions can be customized for any handset makeror OEM’s specific requirements and handset design. We also have enabling andutility technologies to help overcome the physical limitations of the smallspeaker drivers and headphones of mobile devices to produce a more natural,realistic and immersive audio experience. Some of these technologies includethe ability to preserve the original music source’s stereo instrumentationduring stereo-to-mono mix down, the ability to manage the output level ofmultiple audio sources to prevent clipping, and many other breakthroughsolutions that help handset makers increase their market share by providingcost-effective audio enhancement solutions that help mobile carriers attractand keep more customers. For the newer stereo speaker-enabled mobile phones,WOW XT provides the industry’s most extreme stereo width from polyphonic ringtones and digitally compressed music formats such as MP3, WMA and AAC.

 

These solutions formobile phones are primarily implemented using software. The key benefit ofadding SRS software technologies is that hardware design changes aren’t neededto quickly achieve fuller, more dynamic audio. The WOW XT Audio EnhancementSuite, Voice Processing Suite, Audio Management Utility Suite and SRS 3DPositional Audio technology are either available now or in development for awide variety of popular mobile software solutions, platforms and processors. During2004, companies including Fangtek, NEC, Sharp and Samsung either signed a newlicensing agreement with SRS, or expanded their use of SRS technologies fortheir latest personal telecommunications devices.

 

**PortableMedia**

 

The use of portablemedia players, such as MP3 and portable listening devices, is widespread aroundthe world, reflecting demand from consumers to take their music and soon theirvideo with them. While the demand for more entertainment features increases,the size of the devices are decreasing and because of simple physical designconstraints, the quality of the audio experience cannot always be maintained.The small footprint of these devices limits speaker size, speaker spacing andthe quality of headphone listening is variable since headphones are oftenselected for their small size and aesthetics rather than their audioperformance. In addition to physical considerations, the various audiocompression algorithms in common use, such as MP3, AAC and WMA, can adverselyaffect the quality of the reproduced audio depending on factors such as encodedbit rate and encoder quality level.

 

Manufacturers of thesedevices are looking for solutions to improve the listening experience withoutaffecting design change, increasing power consumption or adding additionalproduct components. Similar to the mobile phone market, our solutions forportable media devices are primarily implemented using software, which allowsmanufacturers to quickly and easily implement our technologies once they havebeen optimized for their specific software and hardware requirements. Theprimary technology solution for this market is SRS WOW, which is a suite ofpatented techniques designed to create a full, rich and wide audio image overone speaker, two speakers or headphones. As of the end of 2004, our SRS WOWtechnology libraries were available on a wide variety of the portable mediadevice market’s leading semiconductor and software platforms. In 2004, weannounced new or expanded licensing agreements with OEMs including LGElectronics, RIO (Japan) and Samsung.

 

10

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**PersonalComputers**

 

Advances in computertechnology and flat-panel LCD monitors with speakers have transformed personalcomputers into home theater media hubs. Through PCs, users can now enjoy andmanage collections of music and movies, as well as satellite and cable TVprograms; and can distribute this multimedia content throughout the home usingpopular networking protocols.

 

With computerfunctionality growing every day, and the form factor of these devices shrinkingand flattening, gone are the days of large CRT monitors or PC towers under thedesk. Most traditional “desktop” PC makers have now focused their product linesinto notebook and tablet computers—from ultra portable to widescreen portablehome theaters.

 

We have developedspecific technology solutions that deliver home-theater sound from small andclosely spaced speakers, as well as from headphones. Our technologies enhancethe audio experience from any content and any application.

 

In 2004, we achieved amajor milestone for the penetration of this market and introduced system-leveldrivers for ADI SoundMax, SigmaTel and Realtek audio codecs. Our drivers areWHQL tested by our audio codec partners and can be delivered as signed drivers.In addition, we can provide generic system level drivers that can be used bymanufacturers for custom integration into their graphical user interface. Thedesign premise behind these system level driver solutions is that by deliveringSRS technology on a low level within the audio path, any audio played throughthe computer, no matter the application or source, can be enhanced. The valuefor manufacturers is that their product’s overall sound quality is instantlyimproved through the use of SRS technologies and can be achieved costeffectively. Leading semiconductor companies also provide numerous analog audioprocessor chips that include our technology.

 

By the end of 2004, ourcustomers in this market included Sony, who incorporated our WOW technologyinto their VAIO desktops and Toshiba, who licensed our SRS TruSurround fortheir line of Satellite and Qosmio laptop computers. In addition, Micro-StarInternational licensed our 3D audio technology for its Mega PC product line.

 

**Automotive**

 

In 2003, we developedSRS Circle Surround AutomotiveTM, a special version of our Circle Surroundtechnology that can be customized by car manufacturers for the specific audiorequirements of any vehicle. Circle Surround delivers up to 6.1 channels offull-bandwidth surround sound from any audio source, including the radio, CDsand even MP3 files burned onto a CD.

 

Rear seat passengers areincreasingly using DVD systems for entertainment. Our TruSurround technology,which is widely used by traditional DVD player manufacturers, provides a realisticvirtual surround sound experience over traditional headphones. In addition, ourSRS AutomotiveTM technology, which is a suite of audio enhancement andprocessing technologies that can be optimized for two or more speaker systems,or headphone playback provides remarkable improvement in the width, height anddepth of any mono or stereo audio source, as well as provides deep, rich bassenhancement.

 

While little revenue wasgenerated from this market segment during 2004, we think this market holdssignificant long-term opportunities for the license of our technologies. In2004, we achieved several design wins with leading manufacturers andautomakers, including Johnson Controls, Honda, Toyota and Fujitsu Ten.

 

11

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The following tableidentifies a few of our largest licensing customers and the market or marketsfor which such licensees are licensing****ourtechnologies, as of December 31, 2004:

 
| **OEM Name**             | ** ** | **Home  Entertainment** | ** ** | **Personal  Telecom** | ** ** | **Portable  Media  Devices** | ** ** | **Personal  Computer** | ** ** | **Automotive** | ** ** |
|-------------------------------|------------|-------------------------|------------|-----------------------|------------|------------------------------|------------|------------------------|------------|----------------|------------|
| Amtran                        |       | •                  |       |                  |       |                         |       | •                 |       |           |       |
| BenQ                          |       | •                  |       |                  |       |                         |       |                   |       |           |       |
| Cantronic                     |       |                    |       |                  |       | •                       |       |                   |       |           |       |
| Changhong                     |       | •                  |       |                  |       |                         |       |                   |       |           |       |
| Hitachi Ltd.                  |       | •                  |       |                  |       |                         |       |                   |       |           |       |
| Hughes Network  System        |       | •                  |       |                  |       |                         |       |                   |       |           |       |
| Kenwood Corporation           |       | •                  |       |                  |       |                         |       |                   |       | •         |       |
| LG Electronics                |       | •                  |       |                  |       | •                       |       |                   |       |           |       |
| Marantz Corporation           |       | •                  |       |                  |       |                         |       |                   |       |           |       |
| Motorola BCS                  |       | •                  |       |                  |       |                         |       |                   |       |           |       |
| NEC Corporation               |       |                    |       | •                |       |                         |       |                   |       |           |       |
| Philips Consumer  Electronics |       | •                  |       |                  |       |                         |       |                   |       |           |       |
| Pioneer  Corporation          |       | •                  |       |                  |       |                         |       |                   |       |           |       |
| Reigncom/iRiver               |       |                    |       |                  |       | •                       |       |                   |       |           |       |
| Samsung  Electronics          |       | •                  |       | •                |       | •                       |       |                   |       |           |       |
| Sharp Corporation             |       |                    |       | •                |       |                         |       |                   |       |           |       |
| Skyworth                      |       | •                  |       |                  |       |                         |       |                   |       |           |       |
| Sony Corporation              |       | •                  |       |                  |       | •                       |       | •                 |       |           |       |
| ST  Microelectronics          |       | •                  |       |                  |       |                         |       |                   |       |           |       |
| Toshiba  Corporation          |       | •                  |       |                  |       |                         |       | •                 |       |           |       |

 

Our six largestcustomers accounted for more than 50% of our licensing revenues in 2004, andone customer, ST Microelectronics, accounted for approximately 11% of ourlicensing revenues.

 

**OurStrategy**

** **

*Semiconductors*

* *

Our strategy in oursemiconductor business is to integrate our SRS technologies into our ICs and toleverage our technology to create added value for our semiconductor customers.Manufacturers of electronic products are under increasing pressure to bringtheir products to market rapidly, at lower cost and with differentiatedfeatures. We believe that our audio technologies provide a compellingdifferentiable feature. In 2003, we leveraged our expertise in the design ofintegrated circuits and began development of a series of semiconductor productsthat included SRS technology. In 2004 mass production began on many of theseproducts and by the end of 2004, 40% of the ASP product line included SRStechnology chips. These chips include a wide variety of stand-alone analogsolutions for SRS technologies, including SRS WOW, SRS TruBass, SRS 3D, SRSFOCUS and SRS Dialog Clarity that are marketed to the high-growth andhigh-volume product categories manufactured in the Asia Pacific region, such asportable audio systems, televisions, LCD monitors, portable audio devices andcomputers. In 2004, we also launched several universal audio processors thatcombined our audio technologies with standard audio functions such as volume,tone and level; as well as the first ASP-branded DSP processors with SRStechnology.

 

12

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*Licensing*

 

Our sales strategy is toidentify high-growth markets, develop needed technology solutions and featuresand work with software and semiconductor platform partners to make thesetechnologies widely available and easy-to-implement by OEMs and ODMs. Webelieve that we will continue to strengthen our market position as a worldleader in audio and voice technology by employing the strategy of providing acontinuous stream of patented audio and voice technologies, penetrating newlicensing accounts, expanding relationships with existing licensees, creating abroad platform of software and semiconductor partners and developing strongbrand awareness of the SRS logo.

 

The mission of ourlicensing platform strategy is to achieve comprehensive and strategic coveragefor our technology solutions within all of our targeted vertical productmarkets in order to expand sales and licensing opportunities. By developingstrong relationships with the leading software and semiconductor companies, ouraudio technologies can be delivered to customers worldwide across high growthand high volume product applications.

 

Our licensing model mostoften employs a system whereby our licensees or prospective licensees requestthat SRS technologies are enabled on key industry platforms from leadingsemiconductor manufacturers and middleware or firmware software providers(Platform Partners). Oftentimes, the request is first made goes to the platformprovider. In other circumstances, we may proactively target a new emergingplatform in one of our five market segments.

 

We work together withour Platform Partners to provide our mutual customers with the technology whichbest fits their needs. We also together solicit other customers who use theplatform.

 

As a technologylicensing company, one of our greatest assets is the strength of our brand.Since brand recognition drives licensing sales, we have invested in strategiesthat increase consumer awareness of SRS Labs with the ultimate goal ofestablishing our brand with both product manufacturers and consumers around theworld as the symbol for high-quality audio. The three primary vehicles that weuse to further the proliferation of our brand are: (a) placement of theSRS logo by OEMS on products and in co-marketing programs; (b) onlinebranding programs; and (c) use, and recognition of use, of SRS technologyby content and broadcast professionals.

 

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*OEM Marketing Programs.  *Over 600million consumer electronics hardware or software products have been shipped ordownloaded that feature 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. This consistent logo exposureis considered a key tool in reaching consumers worldwide. In addition, we workwith 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 2004, we worked withToshiba as well as Sony PC in the creation of point-of-purchase videos that areused on display PCs in leading retail outlets around the United States. Thesevideos included information on SRS technology as well as displayed our logo,thereby reinforcing the consumer’s awareness of the SRS feature inside theirproduct purchase.

 

*Online Branding.  *Onlineexposure has also been an important part of our branding strategy. Asignificant component of our relationship with Microsoft is that the SRS logodisplayed in the audio control panel of Microsoft’s Windows® Media Player linksto an SRS technology page. As a result, over 15 million audio enthusiasts whouse their computers for music and entertainment playback visited our website in2004 and were further exposed to the SRS brand.

 

We also market hardwareand software products for consumers that feature our audio technologies*.*These products are sold exclusivelyonline through our e-commerce site, *www.wowthing.com*.

 

The WOW ThingTM is asmall processor that can be installed between speakers or headphones and thesound card or CPU of most personal computer systems. It enhances the soundquality of CDs as well as digitally compressed audio, which is downloaded orstreamed over the Internet. The CS II Plug-in for the Windows Media Playerdelivers a full 5.1 surround sound experience for stereo and mono music,videos and streaming audio. In 2004, we created a consumer plug-in version ofour latest stereo enhancement technology, WOW XT, for the Windows Media Playerplatform. Revenue from the sale of these products is insignificant, but givesus a valuable demonstration platform to showcase our audio technologies.

 

*Use of SRS Technology by Contentand Broadcast Professionals.  *We develop,license and sell professional hardware and software products and consumersoftware plug-ins primarily as a means of enabling content companies,broadcasters and music publishers to encode their material in our CircleSurround, or CS, technology. When CS is professionally used, the logo isdisplayed within the content itself, on the packaging material, or in the caseof radio an announcement that the broadcast is being delivered in SRS CircleSurround is played. We have concentrated on three key market segments in thepro audio space: television, radio and music, and have developed a full line ofhardware and software products to support these markets. These products aresold directly to professional customers and are also available from selecteddealers and distributors servicing the professional audio and broadcastcommunities. We did not generate significant revenue from the sale ofprofessional hardware equipment in 2004 and the outlook for significant revenuegeneration remains unproven, but we believe there is great value in continuingto pursue this market as a key element of our branding strategy. Top televisionbroadcasters in the United States and abroad, who have transmitted CircleSurround-encoded programs include ABC, CBS, NBC, ESPN, ESPN 2, ESPN HD, FOX,FX, TNT, PBS for dozens of programs including the 55th Annual Prime Time EmmyAwards, X Games, NFL and NBA broadcasts, and more.

 

In September 2004,we entered into a strategic alliance with Coming Home Studios LLC (“CHS”) toproduce and sell concert DVDs which include our Circle Surround technology. Inconnection with the strategic alliance, SRS Labs and CHS entered into fouragreements:  a Strategic AllianceAgreement, the CHS/SRS LLC Operating Agreement, a Warrant Agreement and a ProductionServices Agreement. In the Strategic Alliance Agreement, SRS Labs and CHS agreeto work together to identify and implement co-promotional opportunities,including trade shows, movie theaters, video streaming, concert DVDs, artistendorsements, bundling and premium deals, web-based promotional clips and roadshows. The initial term

 

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of the agreement expireson July 9, 2006 and is automatically renewable for successive one-yearterms. Under the terms of this agreement, the branding opportunities on eachDVD released by CHS through the terms of the agreement include: (a) ashort video of the SRS logo displayed prior to reaching the menu on the DVD;and (b) an instructional video on setting up a Circle Surround hometheater system, which is available in the special features menu. For those DVDSencoded in Circle Surround, the CS logo will be prominently displayed on thepackaging of the DVD as well as in promotional material used by distributorsworldwide.

 

**Salesand Marketing**

 

We have two types ofrevenue collection systems with our licensees—bundled or non-bundled. Under abundled agreement, royalty revenue may be collected by our Platform Partner atthe time the solution is sold to the OEM or ODM. Most often, however, wecollect revenue directly from our licensees. These licensing arrangements withOEMs or ODMs authorize them to design, build and sell products containing ourtechnology. Under this licensing method, OEM product licensees are free to choosea semiconductor solution from the Platform Partner that best suits theirtechnical and cost-of-goods-sold requirements. We receive royalties directlyfrom the licensed OEM or ODM for the use of our technologies in licensedproducts manufactured and shipped by the OEM or ODM. Many major OEMs havelicenses or purchase products manufactured by a licensed ODM for the use of oneor more of our technologies and for the use and display of our trademarks. Inthe case of the Platform Partner who bundles our royalty within their solution,the cost of the solution includes our royalty at the time it is sold. ThePlatform Partner remits that royalty directly back to us on behalf of thelicensee, thus streamlining the royalty collection process of royaltyreporting.

 

Our process forselecting particular Platform Partners for distributing our technology is basedon several criteria including: (a) segment leadership—we target chippartners that hold preeminent positions in market segments characterized byhigh growth, volume and/or margins; (b) volume—platforms which willmaximize exposure of our technologies to a large number of potential OEMs; (c) synergy—platformswhich serve to position our technologies along with compatible and additivetechnologies for integrated delivery; and (d) convergence potential—whichenable us to establish a presence on platforms that intersect mergingfunctional features. An example of this would be the platforms for new personalmultifunctional devices that include mobile phone, personal digital assistant,or PDA, and MP3 capabilities.

 

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The following tableidentifies a few of our chip partners who have entered into licensingagreements with us and a few of our software partners who have developedsoftware formats and operating systems for which our technology solutions areimplemented, and the market or markets for which such licensees or partners aremarketing our technologies as of December 31, 2004:

 
| **Chip/Software Partner Name**        | ** ** | **Home  Entertainment** | ** ** | **Personal  Telecom** | ** ** | **Portable  Media Devices** | ** ** | **Personal  Computer** | ** ** | **Automotive** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|-----------------------------|------------|------------------------|------------|----------------|------------|
| Analog Devices                                  |       | •                  |       | •                |       | •                      |       | •                 |       | •         |       |
| ARM                                             |       |                    |       | •                |       | •                      |       |                   |       |           |       |
| ASP  Microelectronics                           |       | •                  |       |                  |       | •                      |       | •                 |       |           |       |
| Cirrus Logic                                    |       | •                  |       |                  |       | •                      |       |                   |       |           |       |
| Freescale                                       |       | •                  |       | •                |       | •                      |       |                   |       | •         |       |
| Micronas                                        |       | •                  |       |                  |       |                        |       |                   |       |           |       |
| New Japan Radio  Corporation (“NJRC”) |       | •                  |       |                  |       | •                      |       | •                 |       | •         |       |
| Philips  Semiconductor                          |       | •                  |       |                  |       | •                      |       |                   |       | •         |       |
| Sigmatel                                        |       |                    |       |                  |       | •                      |       | •                 |       |           |       |
| ST  Microelectronics                            |       | •                  |       |                  |       | •                      |       |                   |       |           |       |
| Texas  Instruments                              |       | •                  |       | •                |       | •                      |       |                   |       | •         |       |

 

To implement ourlicensing sales strategy within our identified vertical markets, we haveestablished a direct sales force and a worldwide network of independent salesagents. In North America, we employ a direct sales force to market ourportfolio of audio and voice technologies to the OEM community.Internationally, we maintain support offices in the Czech Republic, Japan, HongKong and Korea to support our multi-national OEM customers. We actively promotethe use of our trademarks and logos and direct customers to prominently displaythe appropriate SRS technology logo on products, packaging and in advertising.We work closely with our licensees to enhance their success in selling finishedproducts and semiconductor products that incorporate our technologies through avariety of licensee support programs. These programs include engineeringsupport, sales training, tradeshow support, press support, customized marketingmaterials and corporate communications. Our corporate communications programincludes press releases, advertising, speaking engagements and industryconferences. We use the Internet to provide easy-to-use audio technologydemonstrations for those technologies that can be appropriately demonstrated onthe World Wide Web. We conduct in-person technology demonstrations or presentationsfor the press and other companies 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 with ourlicensees and Chip Partners to actively explore additional opportunities toplace our technologies in new products and/or markets.

 

**Backlog**

** **

Backlog is applicableonly to our semiconductor business. Sales of semiconductors are primarily madepursuant to standard purchase orders for the delivery of ASIC and IC products.Order quantities and delivery schedules are frequently changed to reflectproduct availability, scheduling at our fabrication partner facilities orchanges in our customers’ needs. Customer orders can be canceled or rescheduledwithout significant penalty to the customer. Accordingly, our backlog at anyparticular date is not representative of actual sales for any succeedingperiod. For this reason, we believe that backlog is not generally a goodindicator of future revenue. As of December 2004 and 2003, the backlog oforders for ASIC and IC products to non-affiliated parties was $1,539,567 and$2,219,301, respectively. We expect that all or substantially all of thecurrent backlog of orders for 2004 will be completed in 2005.

 

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**Researchand Development**

** **

Our customers compete inmarkets that are characterized by rapidly changing technology and continuousimprovement in products and services. Our research and development expendituresin 2004, 2003 and 2002 were approximately 30.0%, 28.9% and 30.6% of totaloperating expenses respectively. These expenses consist of salaries and relatedcosts of employees and consultants engaged in ongoing research, design anddevelopment activities and costs for engineering materials and supplies.

 

As of December 31,2004, we had 49 employees in our R&D group representing 47% of our totalhuman resources. Our software, hardware and application engineers focus ondeveloping intellectual property, technology solutions and consumer products.Fourteen engineers are based in the U.S. with the remainder based in Hong Kong.

 

**Competition**

** **

We compete in each ofour business segments with a number of different companies, which produce avariety of technologies, processes and products.

 

*Semiconductors*

* *

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

 

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

 

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

 

The markets in which wesell our products are also subject to extreme price competition. Accordingly,we expect to continue to experience declines in the selling prices of ourproducts over the life cycle of each product. In order to offset declines inthe selling prices of our products, we must continue to reduce the costs ofproducts through product design changes, manufacturing process changes, volumediscounts and other savings negotiated with our manufacturing subcontractors.Since we do not operate our own manufacturing facilities, we may not be able toreduce costs as rapidly as competitors who perform their own manufacturing. Ourability to design and introduce, in a timely manner, lower-cost versions ofexisting products or higher gross margin new products, or to successfullymanage our manufacturing subcontractor relationships, could have a materialadverse effect on our gross margins.

 

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*Licensing*

* *

Competition in theaudio, voice and surround sound technology licensing business includes otherlicensing companies who offer competing technologies as well as the internalengineering department of our licensees, who may develop audio enhancementtechniques for their own products.

 

In the field of 3D audioenhancement, we compete directly with other audio providers, including QSound,Spatializer, Aureal and BBE Sound. Our newly launched 3D positional audiotechnology directly competes with technologies from QSound and Synoptic. Webelieve that our bass enhancement technology, TruBass, competes directly withseveral technologies, including MaxxBass from Waves, Ltd, Vi.B.E fromSpatializer, and non-proprietary bass systems, such as Bass Boost, that areincluded on a variety of electronics products, including televisions, portablestereos and speaker products. Because our audio enhancement techniques workwith any existing recorded material, whether mono, stereo or surround sound,most of our audio enhancement technologies, including SRS 3D Sound, SRS FOCUS,SRS TruBass and SRS Dialog Clarity, can be used either as an alternative or asa complement and enhancement to almost any competing audio technology.

 

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

 

Several technologieswithin our surround sound portfolio, including TruSurround, TruSurround XT,Circle Surround and Circle Surround II, compete directly with a variety oftechnologies from Spatializer, QSound, Dolby Laboratories and DTS®, Inc.These competing processes include: Dolby ProLogicTM and ProLogic II, which areanalog, surround sound systems that can encode surround content as well asdecode up to 5.1 channels of surround sound from mono or stereo; Dolby Digital(AC-3) and Dolby Digital EX, that encode a six channel digital sound track on amovie print and decode six channels of digital audio in a consumer electronicsdevice; Dolby Virtual Speaker, which processes the multichannels of DolbyDigital or Dolby Surround over just two channels, creating a virtual surroundsound experience; DTS, which uses CDs to reproduce six channels of digitalsound synchronized with a movie print and decodes the six channels of sound ina consumer electronics device; DTS NEO 6, which decodes up to 6.1 channelsof surround sound from mono or stereo; and N-2-2TM from Spatializer, whichprocesses the multichannels of surround sound over two speakers.

 

Many of the companiesreferenced above have, or may have, substantially greater resources than us todevote to further technologies and new product developments. We believe that wecompete based primarily on the quality and performance of our proprietarytechnologies, brand name awareness, the ease and cost of implementing ourtechnologies, the ability to meet OEMs’ needs to differentiate their products,and the strength of our licensee relationships. However, there can be noassurance that based on these factors, we will continue to be competitive withexisting or future products or technologies of our competitors.

 

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

 

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**IntellectualProperty Rights and Proprietary Information**

** **

We operate in industrieswhere innovation, investment in new ideas and protection of intellectualproperty rights are important for success. We rely on a variety of intellectualproperty protections for our products and services, including patent,copyright, trademark and trade secret laws and contractual obligations. Wepursue a policy of enforcing such rights. There can be no assurance, however,that our intellectual property rights will be adequate to ensure ourcompetitive position, or that competitors will not be able to produce anon-infringing competitive product or service. There can be no assurance thatthird parties will not assert infringement claims against us, or that ifrequired to obtain any third party licenses as a result of an infringementdispute, we will be able to obtain such licenses. Although we believe that ourpatents and trademarks are important to each of our business segments, suchpatents and trademarks are especially important to the licensing businesssegments.

 

In order to protect theunderlying technology concepts, we have filed and/or obtained patents for allof our marketed technologies including technologies marketed under thetrademarks SRS, TruSurround, TruSurround XT, FOCUS, Circle Surround, CircleSurround II, WOW, VIP and TruBass. In addition, we have numerous issued patentsand patents pending for speaker and other acoustic reproduction technologies.We pursue a general practice of filing patent applications for our technologiesin the United States and various foreign countries where our licenseesmanufacture, distribute or sell licensed products. We continually update andadd new applications to our patent portfolio to address changing worldwidemarket conditions and our new technological innovations. The range ofexpiration dates for our patents extend between the years 2005 to 2020. We havemultiple patents covering unique aspects and improvements for many of ourtechnologies. Accordingly, the expiration of any single patent is not likely tosignificantly affect our intellectual property position or the ability togenerate licensing revenue.

 

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

 

**Seasonality**

** **

Due to our dependence onthe consumer electronics market, we experience seasonal fluctuation in salesand earnings. In particular, we believe that the licensing business experiencesseasonality relating to the Christmas season in the fourth quarter, and thesemiconductor business located in the Asia Pacific region experiencesseasonality related to the Chinese New Year in the first quarter. We have movedtoward diversifying our key market segments in the consumer electronicsindustry in an effort to even out our seasonal fluctuation.

 

**Employees**

** **

As of December 31,2004 we employed 105 persons, 24 in finance and administration; 49 in researchand development, engineering and product development; and 32 in sales andmarketing. Of the 105 employees, 66 are employed in our semiconductor businessand are located overseas. None of our employees are covered by a collectivebargaining agreement 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.

 

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**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, as soonas reasonably practicable after we electronically file such material with orfurnish it to the SEC. Our SEC reports can be accessed through the investorrelations section of our website. The information found on our website isnot part of this or any other report we file with or furnish to the SEC.

 

**Item1A**.      ExecutiveOfficers of the Registrant

** **

The following table setsforth the executive officers of SRS Labs, Inc., their ages as of March 1,2005, and the positions currently held by each person:

 
| **Name**              | ** ** | **Age** | ** ** | **Position**                                        |
|-----------------------|------------|---------|------------|-----------------------------------------------------|
| Thomas  C.K. Yuen     |       | 53      |       | Chairman,  Chief Executive Officer and President    |
| Janet  M. Biski       |       | 49      |       | Chief  Financial Officer, Treasurer and Secretary   |
| Alan  D. Kraemer      |       | 54      |       | Executive  Vice President, Chief Technology Officer |
| Philip  Wong          |       | 48      |       | President,  ValenceTech, Limited                    |
| Jennifer  A. Drescher |       | 40      |       | Vice  President, Corporate Communications           |
| Michael  S. Oswald    |       | 49      |       | Vice  President, General Counsel                    |

 

The Chief ExecutiveOfficer, President and Chief Financial Officer are elected annually by theBoard of Directors at its first meeting following the annual meeting ofstockholders. Other executive officers may be appointed by the Board ofDirectors at such meeting or at any other meeting. All executive officers serveat the pleasure of the Board of Directors.

 

**ThomasC.K. Yuen** has served as Chairman, Chief Executive Officer, Presidentand a director of SRS Labs since January 1994. Mr. Yuen also servesas Chairman of the Board and Chief Executive Officer and a Director ofValenceTech Limited, its wholly-owned subsidiary Valence Technologies Limited,and of SRS WOWcast, Inc.  Prior tojoining SRS Labs, Mr. Yuen co-founded Irvine-based AST Research, Inc.in 1981. He served as AST’s co-chairman and chief operating officer. Under hisleadership, AST became a Fortune 500 company in 1991 and its stock was namedthe Best Performing NASD Stock of 1991. Mr. Yuen departed AST in 1992 andfocused his efforts on investing in new projects. Before co-founding AST, heheld various engineering and project management positions with Hughes AircraftCompany, Sperry Univac and Computer Automation. Mr. Yuen was born inShanghai, China and raised in Hong Kong. He received his Bachelor of ScienceDegree in Electrical Engineering from University of California, Irvine in 1974with School Honors. He is also an Honorary Professor of China NationalityUniversity in Beijing. Mr. Yuen is the recipient of several awards fromUniversity of California, Irvine, including the UCI Medal in 1990; theoutstanding Engineering Alumni Award in 1987 and the Distinguished AlumnusAward in 1986. He was named one of the top 25 executives of the computerindustry by the Computer Reseller News Magazine in 1988 and 1991. In 1997, Mr. Yuenreceived the Director of the Year award from the Orange County Foundation ofCorporate Directors.

 

**JanetM. Biski** has served as Chief Financial Officer and Treasurer of SRSLabs since December 2002. Ms. Biski has also served as Secretary ofSRS Labs since November 2004. Previously, she was a founder and served asChief Financial Officer and Vice President of Operations for AccentCare, Inc.,a home-care company, from April 1999 to December 2002. During thattime, AccentCare successfully completed 15 acquisitions and grew revenues toapproximately $100M. Previous to joining AccentCare, Ms. Biski served asVice President, Chief Financial Officer, Secretary and Treasurer of SRS Labsfrom 1994 to 1999. Ms. Biski was part of the management team in its earlystart-up phase which successfully led the Company through the completion of itsinitial public offering. Ms. Biski also participated in SRS Labs’acquisition of Valence as well as several of the Company’s acquisitions of

 

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technology. Early in her career, Ms. Biskiwas a regional controller for Fujitsu Business Systems, and held variousfinancial management positions at IBM/ROLM. Ms. Biski has a BS in Accounting from the State University of NewYork.

 

**Alan D.Kraemer** has served as Chief Technology Officer of SRS Labs since January 2005.He has also served as Executive Vice President, Technology and BusinessDevelopment since June 2004. Prior thereto, he served as Vice President,Engineering of the Company since April 2000 and Director of Engineeringsince February 1994. In addition, Mr. Kraemer served as President ofSierra Digital Productions, Inc., a compact disc production and recordingcompany, since August 1989. Prior to joining SRS Labs, Mr. Kraemerserved as President of Engineering of De LaRue Printrak, a manufacturer ofautomatic fingerprint identification systems, Vice President of Engineering forAST Research, a personal computer manufacturer, Vice President of Engineeringwith Point4 Data Corporation, and as****Director ofSoftware Engineering of Northrop Electronics.

 

**PhilipWong**has served as the President of ValenceTech Limited andValence Technologies Limited since March 2004. Mr. Wong brings toValence Tech and Valence significant technology experience, extensivehigh-level industry and government relationships and a deep knowledge of theAsia Pacific market. From 1998 to March 2004, Wong served as managingpartner of the China Key Partnership Group, an advisory firm that assistsmultinational companies in establishing a presence in the PRC. From 1987 to1994, he held a variety of executive positions at AST Computers, culminating inthe position as General Manager of Far East Sales working directly under SRSLabs Chairman and Chief Executive Officer, Thomas Yuen, who at the time wasco-chairman and chief operating officer of AST. By 1994, AST had establisheditself as the number one brand name of personal computers in the Hong Kong andChina markets with a 70% market share with revenues of $300 million.

 

**JenniferA. Drescher** has served as Vice President of CorporateCommunications since December 2002 and Vice President of Marketing for SRSLabs from December 2001. She previously served as Vice President ofMarketing for the company’s Internet and broadcast subsidiary, SRSWOWcastTechnologies from December 1999 through November 2001. Ms. Drescherwas the Company’s first employee in 1993 working as Director of Marketing untilthe formation of SRSWOWcast Technologies. Prior to joining SRS Labs, Ms. Drescher’scareer has held various senior level marketing, public relations andoperational positions with audio technology licensing and products companies.

 

**MichaelS. Oswald** has served as Vice President and General Counsel of theCompany since November 2004. He served from 2001 to 2004 as Vice Presidentand General Counsel of Lantronix, Inc., a publicly traded provider ofcomputer networking technologies. Prior to his public company experience, Mr. Oswaldwas a key management team member at two successive start-up technologycompanies. Mr. Oswald was General Counsel and Chief Administrative Officerat NowDocs, Inc. from 1999 to 2001, where he managed Purchasing,Facilities, Human Resources and Legal Affairs and from 1996 to 1999 he wasGeneral Counsel at Acuity Corp. At Acuity, he was a member of the managementteam that negotiated Acuity’s acquisition by Quintus Corporation and co-led thetransition team. He also served on Quintus’ IPO team. Mr. Oswald earned aJuris Doctor degree from Santa Clara University School of Law, and a Bachelorof Arts degree from the University of California at Riverside. He is an AdjunctProfessor of Law at Western State University College of Law, where he teachesbusiness law courses. Mr. Oswald also serves on the Board of Directors ofthe Southern California Chapter of the American Corporate Counsel Association(ACCA).

 

**Item2**.         Properties

 

Our worldwideheadquarters are located in Santa Ana, California, in a 23,400 square footfacility consisting of office and warehouse space. The lease is for a term ofthree years scheduled to expire on May 31, 2005. At that time, we willhave an option to renew the lease, under similar terms and conditions,

 

21

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for three additionalyears through May 31, 2008. We lease this facility from Daimler CommercePartners, L.P., the general partner of which is Conifer Investments, Inc.The sole shareholders of Conifer are Thomas C.K. Yuen, our Chairman, ChiefExecutive Officer and President, and his spouse, Misako Yuen, as co-trustees ofthe Thomas Yuen Family Trust. Mr. and Mrs. Yuen also serve as theexecutive officers of Conifer. Mr. and Mrs. Yuen, as co-trustees ofthe Trust, beneficially own a significant amount of our outstanding shares ofcommon stock. We paid the Daimler Commerce Partners rent of $210,600, $208,260 $198,900in 2004, 2003 and 2002, respectively. The terms and conditions of the lease arecompetitive based on a review of similar properties in the area with similarterms and conditions.

 

Valence’s principalexecutive offices and research and development facility are located in KwunTong, Kowloon, Hong Kong  in a 16,600square foot facility under two lease agreements which expire in November 2006,at which time we can negotiate renewal agreements. To the extent thatmanagement is unable to reach such agreements, it believes that it will be ableto secure comparable space at reasonable rates. Pursuant to these leases, wepaid rent of $148,349 during 2004, $330,826 during 2003 and $256,542 during2002.

 

Our worldwideheadquarters house personnel responsible for the development of ourtechnologies and the administration of the licensing business. The Valencefacilities are used in connection with the design and marketing of ASICs, ICsand the sale of consumer electronic products and components. We believe that ourcurrent facilities are adequate to support our current requirements.

 

**Item3**.         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.

 

**Item4**.         Submission ofMatters to a Vote of Security Holders

** **

None.

 

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**PART II**

** **

**Item5**.         Market forRegistrant’s Common Equity, Related Stockholder Matters and Issuer Purchases ofEquity Securities

** **

**Marketfor Common Stock**

** **

Our common stock tradeson the Nasdaq National Market under the symbol SRSL. The table below reflectsthe high and low sales prices of the common stock as reported by The NasdaqStock Market, Inc. for the periods indicated.

 

| ** **       | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------|------------|----------|------------|---------|------------|
| **Fiscal  2004** |       |     |       |    |       |
| First Quarter    |       | $        | 12.00      |    | $          | 5.76 |   |
| Second Quarter   |       | $        | 7.85       |    | $          | 3.98 |   |
| Third Quarter    |       | $        | 6.77       |    | $          | 3.81 |   |
| Fourth Quarter   |       | $        | 7.45       |    | $          | 5.21 |   |
| **Fiscal  2003** |       |     |       |    |       |
| First Quarter    |       | $        | 3.23       |    | $          | 2.05 |   |
| Second Quarter   |       | $        | 4.92       |    | $          | 2.10 |   |
| Third Quarter    |       | $        | 6.19       |    | $          | 3.60 |   |
| Fourth Quarter   |       | $        | 11.00      |    | $          | 5.20 |   |

 

At March 15, 2005,the last sale price of the Common Stock was $4.26 per share.

 

**Holders**

** **

At March 15, 2005,there were 425 stockholders of record.

 

**DividendPolicy**

** **

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

 

**SecuritiesAuthorized for Issuance Under Equity Compensation Plans**

** **

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

 

23

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The following table setsforth information regarding the number of shares of our common stock that maybe issued pursuant to our equity compensation plans or arrangements as of theend of fiscal 2004.

 

**EquityCompensation Plan Information**

 
| ** **                                              | ** ** | **(a)**                                                                                                                                          | ** ** | **(b)**                                                                                                     | ** ** | **(c)**                                                                                                                                                                                                        | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Plan category**                                  | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities remaining  available for future issuance  under equity compensation plans  (excluding securities  reflected in column(a))** | ** ** |
| Equity  compensation plans approved by security holders |       | 4,721,541                                                                                                                                        | (1)(3)     | $                                                                                                           | 4.38       |                                                                                                                                                                                                           | 2,635,436  | (2) |
|                                                         |            |                                                                                                                                                  |            |                                                                                                             |            |                                                                                                                                                                                                                |            |  |

 

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(1)    Represents shares of common stock that maybe issued pursuant to outstanding options granted under the following plans:115,370 shares under the 1993 Plan, 4,491,171 shares under the 1996 Plan and115,000 shares under the Non-employee Directors Plan.

 

(2)    Represents shares of common stock that maybe issued pursuant to options available for future grants under the followingplans: 2,250,436 shares under the 1996 Plan and 385,000 shares under theNon-employee Directors Plan.

 

(3)    No options have been granted under the 1993plan since June 7, 1996. The 1993 plan expired on December 10, 2003.

 

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

 

On June 30, 2003,the Board of Directors adopted a stock repurchase program authorizing thepurchase of shares of up to $3,000,000 of its common stock for a period of sixmonths commencing on July 1, 2004 and ending on December 31, 2004.Total purchases under the program since inception were 216,575 at an averagepurchase price of $5.66 per unit. The following table sets forth the purchasesby the Company by month during the fourth quarter ended December 31, 2004.

 

**ISSUERPURCHASES OF EQUITY SECURITIES**

 
| ** **     | ** ** | **(a)**                                                       | ** ** | **(b)**                                                      | ** ** | **(c)**                                                                                                                                       | ** ** | **(d)**                                                                                                                                                                                        | ** ** |
|----------------|------------|---------------------------------------------------------------|------------|--------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Period**     | ** ** | **Total  Number of  Shares  (or Units)  Purchased** | ** ** | **Average  Price Paid  per Share  (or Unit)** | ** ** | **Total Number  of Shares  (or Units)  Purchased as  Part of Publicly  Announced Plans  or Programs** | ** ** | **Maximum  Number  (or Approximate  Dollar Value)  of Shares (or Units)  that May Yet Be  Purchased Under  the Plans or Programs** | ** ** |
| Nov 1-30, 2004 |       | 134,550                                                       |       | $                                                            | 5.75       |                                                                                                                                          | 134,550    |                                                                                                                                                                                           | $          | 2,062,449 |   |
| Dec 1-31, 2004 |       | 48,368                                                        |       | $                                                            | 5.95       |                                                                                                                                          | 48,368     |                                                                                                                                                                                           | $          | 0 |   |
| Total          |       | 182,916                                                       |       | $                                                            | 5.80       |                                                                                                                                          | 182,918    |                                                                                                                                                                                           | $          | 0 |   |

 

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**Item6**.         SelectedFinancial Data

 

The following selectedfinancial information as of and for the dates and periods indicated have beenderived from our audited consolidated financial statements. The information setforth below is not necessarily indicative of results of future operations, andshould be read in conjunction with “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” in Part II, Item 7 of thisAnnual Report on Form 10-K and our consolidated financial statements andrelated notes included elsewhere in this Report.

 
| ** **                                                                                         | ** ** | **Years Ended December 31,**                       | ** ** |
|----------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                                                         | ** ** | **2004**                                                          | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                                                         | ** ** | **(In thousands except per share data)** | ** ** |
| Revenues:                                                                                          |       |                                                              |       |   |   |   |   |   |   |   |   |
| Semiconductor                                                                                      |       | $                                                                 | 10,770     |   | $ | 10,712 |   | $ | 10,778 |   | $ | 10,250 |   | $ | 24,887 |   |
| Licensing                                                                                          |       | 10,832                                                            |       | 9,102 |   | 8,224 |   | 5,181 |   | 3,085 |   |
| Total revenues                                                                                     |       | 21,602                                                            |       | 19,814 |   | 19,002 |   | 15,431 |   | 27,972 |   |
| Cost of sales:                                                                                     |       |                                                              |       |   |   |   |   |   |   |   |   |
| Semiconductor                                                                                      |       | 3,725                                                             |       | 3,953 |   | 4,600 |   | 6,289 |   | 16,505 |   |
| Licensing                                                                                          |       | 228                                                               |       | 103 |   | 154 |   | 415 |   | 106 |   |
| Total cost of  sales                                                                               |       | 3,953                                                             |       | 4,056 |   | 4,754 |   | 6,704 |   | 16,611 |   |
| Gross margin                                                                                       |       | 17,649                                                            |       | 15,758 |   | 14,248 |   | 8,727 |   | 11,361 |   |
| Operating  expenses:                                                                               |       |                                                              |       |   |   |   |   |   |   |   |   |
| Sales and  marketing                                                                               |       | 5,445                                                             |       | 5,487 |   | 4,626 |   | 4,475 |   | 6,355 |   |
| Research and  development                                                                          |       | 4,767                                                             |       | 4,264 |   | 4,189 |   | 3,576 |   | 4,151 |   |
| General and administrative                                                                         |       | 5,675                                                             |       | 5,053 |   | 4,890 |   | 5,167 |   | 10,357 |   |
| Non-cash stock  issuance cost                                                                      |       | —                                                            |       | — |   | — |   | — |   | 3,112 |   |
| Total operating  expenses                                                                          |       | 15,887                                                            |       | 14,804 |   | 13,705 |   | 13,218 |   | 23,975 |   |
| Income (loss)  from operations                                                                     |       | 1,762                                                             |       | 954 |   | 543 |   | (4,491 | ) | (12,614 | ) |
| Equity in income  of investee                                                                      |       | 32                                                                |       | — |   | — |   | — |   | — |   |
| Other income,  net                                                                                 |       | 595                                                               |       | 538 |   | 774 |   | 797 |   | 1,180 |   |
| Minority  interest                                                                                 |       | —                                                            |       | 5 |   | 78 |   | 193 |   | 250 |   |
| Income (loss)  before income tax expense                                                           |       | 2,389                                                             |       | 1,497 |   | 1,395 |   | (3,501 | ) | (11,184 | ) |
| Income tax  expense                                                                                |       | 810                                                               |       | 1,038 |   | 589 |   | 377 |   | 325 |   |
| Net income  (loss)                                                                                 |       | $                                                                 | 1,579      |   | $ | 459 |   | $ | 806 |   | $ | (3,878 | ) | $ | (11,509 | ) |
| Net income  (loss) per common share:                                                               |       |                                                              |       |   |   |   |   |   |   |   |   |
| Basic                                                                                              |       | $                                                                 | 0.11       |   | $ | 0.04 |   | $ | 0.06 |   | $ | (0.31 | ) | $ | (0.93 | ) |
| Diluted                                                                                            |       | $                                                                 | 0.10       |   | $ | 0.03 |   | $ | 0.06 |   | $ | (0.31 | ) | $ | (0.93 | ) |
| Weighted average  number of shares used in the calculation of net income (loss) per common  share: |       |                                                              |       |   |   |   |   |   |   |   |   |
| Basic                                                                                              |       | 13,950                                                            |       | 13,033 |   | 12,648 |   | 12,630 |   | 12,379 |   |
| Diluted                                                                                            |       | 15,781                                                            |       | 14,421 |   | 12,862 |   | 12,630 |   | 12,379 |   |
| Balance sheet  data:                                                                               |       |                                                              |       |   |   |   |   |   |   |   |   |
| Working capital                                                                                    |       | $                                                                 | 7,192      |   | $ | 12,335 |   | $ | 14,401 |   | $ | 19,615 |   | $ | 21,914 |   |
| Total assets                                                                                       |       | 35,502                                                            |       | 31,491 |   | 29,307 |   | 28,263 |   | 41,569 |   |
| Short-term debt  and current portion of long-term obligations                                      |       | —                                                            |       | — |   | — |   | — |   | 8,000 |   |
| Stockholders’  equity                                                                         |       | 32,431                                                            |       | 27,950 |   | 25,282 |   | 24,536 |   | 28,303 |   |

 

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**Item 7.         Management’sDiscussion and Analysis of Financial Condition and Results of Operation**

 

**Overview**

 

SRS Labs is a leadingdeveloper and provider of application specific integrated circuits (“ASICs”),standard integrated circuits (“ICs”) and audio and voice technology solutionsfor the home entertainment, portable media device, personal telecommunications,personal computer, automotive, and broadcast markets. We operate in thefollowing two business segments:

 

*Semiconductor:  *Through SRSLabs, Inc.’s wholly-owned subsidiary, ValenceTech Limited, and ValenceTechLimited’s wholly-owned subsidiaries (collectively “Valence”), we operate afabless semiconductor company which develops, designs and markets standard andcustom, analog, digital signal processors (“DSPs”), and mixed signal,integrated circuits primarily to original equipment manufacturers (“OEMs”) andoriginal design manufacturers (“ODMs”) in the Asia Pacific region.

 

*Licensing**:  ***Through SRSLabs, the parent company, and its wholly-owned subsidiary, SRSWOWcast.com, Inc.,doing business as SRSWOWcast Technologies (“SRSWOWcast”), the licensing segmentdevelops and licenses audio and voice technology solutions to many of the world’sleading OEMs, software providers and semiconductor companies, and licenses andmarkets hardware and software products for the Internet and professional audiomarkets.

 

In 2003, we reported ourrevenues in the following five segments: licensing, semiconductors, componentdistribution, product sales, and Internet and broadcast. In 2004, we decided toreduce our segments to licensing and semiconductors because of the materialityof the revenues attributable to the other three segments. Revenue from thecomponent distribution segment is now reported in the semiconductor segment andrevenues from product sales and Internet and broadcast segments are nowreported in the licensing segment. As used herein, the “Company,” “SRS Labs,” “we,”“us,” or “our” means SRS Labs, Inc. and its wholly owned subsidiaries,including Valence and SRSWOWcast.

 

**Critical AccountingPolicies**

** **

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 representsa summary of our critical accounting policies, defined as those policies thatwe believe are: (a) the most important to the portrayal of our financialcondition and results of operations, and (b) that require management’smost difficult, subjective or complex judgments, often as a result of the needto make estimates about the matters that are inherently uncertain. Our mostcritical accounting estimates include valuation of accounts receivable, whichimpacts operating expenses; valuation of inventory, which impacts gross margin;valuation of intangible assets and capitalization of software, which primarilyimpacts operating expenses when we impair assets or accelerate theirdepreciation; and recognition and measurement of current and deferred incometax assets and liabilities, which impacts our tax provision. We discuss each ofthese policies below, as well as the estimates and judgments involved. We alsohave other policies that we consider key accounting policies, such as ourpolicies for revenue 

 

26

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recognition; however,these policies do not meet the definition of critical accounting estimates,because they do not generally require us to make estimates or judgments thatare difficult or subjective.

 

*Accounts Receivable*

* *

We perform ongoingcredit evaluations 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 the liquidityor financial position of our customers may require additional provisions fordoubtful accounts.

 

*Inventory*

* *

Inventory is stated atthe lower of cost or net realizable value. We periodically assess our inventoryfor potential obsolescence and lower-of-cost-or-market issues. We makeestimates of inventory obsolescence, providing reserves when necessary, basedon, among other factors, demand for inventory based on backlog, productpricing, the ability to liquidate or sell older inventory, and the impact ofintroducing new products. If actual market conditions or our customer’s productdemands are less favorable than those projected, additional provisions may berequired.

 

*Intangible Assets &Capitalization of Software*

* *

In accordance withStatement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwilland Other Intangible Assets”, we assess potential impairments to intangibleassets when there is evidence that events or changes in circumstances indicatethat the carrying amount of an asset may not be recovered. Our judgmentsregarding the existence of impairment indicators and future cash flows relatedto intangible assets are based on operational performance of our acquiredbusinesses, market conditions and other factors. If the carrying value of areporting unit exceeds its fair value, goodwill is considered impaired and asecond test is performed to measure the amount of impairment loss, if any. Forfiscal 2004, an independent valuation of goodwill and other intangibles wasperformed. To date, we have not recognized any impairment of our goodwill andother intangible assets in connection with our adoption of SFAS 142.However, no assurances can be given that future evaluation of goodwill will notresult in charges as a result of future impairment.

 

In accordance withStatement of Financial Accounting Standards (“SFAS”) No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets,” all of our intangibleassets that have definite lives are being amortized on a straight-line basisover their estimated useful lives. Costs paid by us related to theestablishment and transfer of patents, primarily legal costs, are capitalizedand amortized over periods ranging from five to ten years, depending on theestimated life of the technology patented. Consideration for the purchase ofassets in excess of the fair market value of specifically identified tangibleassets has been capitalized as intangible and is being amortized over periodsranging from three to 11 years depending on the useful life of the asset. Weannually evaluate the recoverability of our patents and intangible assets basedon the estimated future undiscounted cash flows. Should the carrying value ofpatents or intangible assets exceed the estimated future undiscounted cashflows for the expected periods of benefit, such assets will be written down tofair value. Based upon its most recent assessment, we have determined thatthere was impairment of $43,266 as of December 31, 2004.

 

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 Statement of Financial Accounting Standards (“SFAS”)No. 86, “Accounting for the Costs of Computer Software to be Sold, Leasedor Otherwise Marketed,” we capitalize software purchased from third parties ifthe related 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 not exceedingfive years. Costs incurred prior to the establishment of technological feasibilityare charged to research and development expense. The establishment oftechnological feasibility and ongoing assessment of recoverability ofcapitalized 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 should be the greater of the amount computedusing (a) the ratio that current gross revenues for a product bear to thetotal of current and anticipated 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. After considering the two methods, weare using the straight-line method of amortization as the software can be usedfor many products and the estimates required to be made under the ratio thatcurrent gross revenues for products bear to the total of the current andanticipated future gross revenues for that product could result in underreporting of expense. Upon the general release of the software product tocustomers, capitalization ceases and such costs are amortized to cost of salesusing the straight-line method on a product-by-product basis over the estimatedlife, which is generally three years. To the extent that amounts capitalizedfor software development costs become impaired due to a decline in demand orthe introduction of new technology, such amounts will be written-off. All otherresearch and development expenditures are charged to research and developmentexpense in the period incurred.

 

*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 current tax expense, the results from taxexaminations and the effects of temporary differences resulting from thedifferent treatment of transactions for tax and financial accounting purposes.These differences result in deferred tax assets and liabilities, which areincluded in our consolidated balance sheet. We account for income taxes inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 109,“Accounting for Income Taxes,” which requires that deferred tax assets andliabilities be recognized using enacted tax rates for the effect of temporarydifferences between the book and tax bases of recorded assets and liabilities.SFAS 109 also requires that deferred tax assets be reduced by a valuationallowance if it is more likely than not that some portion or all of thedeferred tax asset will not be realized. We evaluate the reliability of ourdeferred tax assets by assessing our valuation allowance and by adjusting theamount of such allowance, if necessary. At December 31, 2004, we had netdeferred tax assets primarily resulting from temporary differences between thebook and tax bases of assets and liabilities, and loss and credit carryforwards. We continue to provide a valuation allowance on certain deferred taxassets based on an assessment of the likelihood of their realization. Inreaching our conclusion, we evaluated certain relevant criteria including deferredtax liabilities that can be used to offset deferred tax assets, estimates offuture taxable income of appropriate character within the carry-forward periodavailable under the tax law, and tax planning strategies. Our judgmentsregarding future taxable income may change due to market conditions, changes inU.S. or international tax laws, and other factors. These changes, if any, mayrequire material adjustments to these deferred tax assets, resulting either ina tax benefit, if it is estimated that future taxable income is likely, or areduction in the value of the deferred tax assets, if it is determined thattheir value is impaired, resulting in a reduction in net income or an increasein net loss in the period when such determinations are made.

 

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 

 

28

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estimates, we would haveto adjust the income tax provision in the period in which the facts andcircumstances that give rise to the revision become known. Tax law and ratechanges are reflected in the income tax provision in the period in which suchchanges are enacted.

 

**Results of Operations**

** **

The following table setsforth certain consolidated operating data as a percentage of total revenue forthe years ended December 31, 2004, 2003, and 2002:

 

**Percentageof Total Revenue**

 
| ** **                    | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------|------------|---------------------------------------------|------------|
| **Revenues:**                 | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Semiconductor                 |       | 50                                          | %          | 54 | % | 57 | % |
| Licensing                     |       | 50                                          |       | 46 |   | 43 |   |
| Total  revenues               |       | 100                                         |       | 100 |   | 100 |   |
|                          |       |                                        |       |   |   |   |   |
| Cost  of sales:               |       |                                        |       |   |   |   |   |
| Semiconductor                 |       | 17                                          |       | 20 |   | 24 |   |
| Licensing                     |       | 1                                           |       | 0 |   | 1 |   |
| Total  cost of sales          |       | 18                                          |       | 20 |   | 25 |   |
| Gross  margin                 |       | 82                                          |       | 80 |   | 75 |   |
| Operating  expenses           |       |                                        |       |   |   |   |   |
| Sales  and marketing          |       | 26                                          |       | 28 |   | 24 |   |
| Research  and development     |       | 22                                          |       | 22 |   | 22 |   |
| General  and administrative   |       | 26                                          |       | 25 |   | 26 |   |
| Total  operating expenses     |       | 74                                          |       | 75 |   | 72 |   |
| Operating  income             |       | 8                                           |       | 5 |   | 3 |   |
| Equity  in income of investee |       | 0                                           |       | 0 |   | 0 |   |
| Other  income, net            |       | 3                                           |       | 3 |   | 4 |   |
| Minority  interest            |       | 0                                           |       | 0 |   | 0 |   |
| Income  before income taxes   |       | 11                                          |       | 8 |   | 7 |   |
| Income  tax expense           |       | 4                                           |       | 6 |   | 3 |   |
| Net  income                   |       | 7                                           | %          | 2 | % | 4 | % |

 

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

** **

*Revenues*

* *

Total revenues forfiscal 2004 were $21,602,388 compared to $19,813,781 in fiscal 2003, anincrease of $1,788,607 or 9.0%. Semiconductor revenues were $10,770,684 infiscal 2004 compared to $10,712,382 in fiscal 2003, an increase of $58,302 or0.5%. In 2004, semiconductor revenue growth was affected by management changes,foundry capacity constraints and competitive pressure related to its customers’products. Semiconductor revenues are composed of both ASIC and ASP. ASIC accountedfor $7,752,537 or 72.0% in fiscal 2004 compared to $8,168,751 or 76.3% infiscal 2003, a decrease of $416,214 or 5.1%. ASP chips accounted for $3,018,147or 28.0% in fiscal 2004 compared to $2,543,631 or 23.7% in fiscal 2003, anincrease of $474,516 or 18.7%, of which SRS technology chips accounted for60.8% of ASP growth. The growth in ASP is attributable to new design wins withnew chip offerings including SRS chips.

 

Licensing revenues were$10,831,704 in fiscal 2004, compared to $9,101,399 in fiscal 2003, an increaseof $1,730,305 or 19.0%. This increase is attributable to our diversificationstrategy which generated revenues in new product categories such as mobilephones, portable audio devices, and PCs and increased 

 

29

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penetration in theCompany’s key home theater market, including set-top boxes and televisions,which incorporate SRS Labs’ technologies. The following table presents theCompany’s Licensing revenues mix by market segment, excluding product sales andInternet and broadcast segments:

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

 

*Gross Margin*

* *

Cost of sales consistsprimarily of fabrication costs, assembly and test costs, and the cost ofmaterials and overhead from operations. Gross margins are dependent on the mixof products sold, services provided and royalties earned. The following tablepresents the Company’s gross margin percentages for fiscal year 2004 comparedfiscal year 2003:

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

 

*Sales and Marketing*

* *

Sales and marketingexpenses consist primarily of employee salaries, sales consultants’ fees andrelated expenses, sales commissions and product promotion costs. Sales andmarketing expenses were $5,445,224 for fiscal year 2004 compared to $5,487,159**for fiscal year 2003, a decrease of$41,935 or 0.8%. Sales and marketing expenses were higher in fiscal 2003 due tostrong consumer advertising campaigns to market the SRS Labs’ speaker productsand to brand the SRS logo to consumers worldwide. As a percentage of totalrevenues, sales and marketing expenses decreased from 27.7% for fiscal year2003, to 25.2% for fiscal year 2004.

 

*Research and Development*

* *

Research and developmentexpenses consist of salaries and related costs of employees engaged in ongoingresearch, design and development activities and costs for engineering materialsand supplies. Research and development expenses were $4,767,004 for fiscal year2004 compared to $4,263,682 for fiscal year 2003, an increase of $503,322 or11.8%. The increase is primarily attributable to increased costs 

 

30

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associated withpersonnel and expenses associated with supporting the Company’s customers inits five key markets. We expect that research and development will continue tobe critical to our business as we introduce new products, but such expenseswill fluctuate as a percentage of revenue due to change in sales volume. As apercentage of total revenues, research and development expenses increased from21.5% for fiscal year 2003, to 22.1% for fiscal year 2004.

 

*General andAdministrative*

* *

General andadministrative expenses consist primarily of employee-related expenses, legalcosts associated with the administration of intellectual property and otherprofessional fees. G&A expenses were $5,675,294 for fiscal year 2004compared to $5,053,387 for fiscal year 2003, an increase of $621,907 or 12.3%.The increase was primarily attributable to increased professional fees, publiccompany expenses, including costs incurred for Sarbanes-Oxley 404 complianceand increased amortization associated with the increased capitalization ofpatents and purchased technology. As a percentage of total revenues, G&Aexpenses increased from 25.5% for fiscal year 2003, to 26.3% for fiscal year2004.

 

*Equity in Income ofInvestee*

* *

Equity in income ofinvestee represents the Company’s proportionate share of profit from the LLCentered into with Coming Home Studios. On September 23, 2004, the Company enteredinto a strategic alliance with Coming Home Studios LLC (“CHS”) to produce andsell concert DVDs which include the Company’s Circle Surround technology. TheOperating Agreement governs CHS/SRS, LLC, which is a joint venture between CHSand the Company formed to complete and distribute concert videos featuringDuran Duran, Boz Scaggs, Godsmack and All Access. Profits from the distributionof the concert videos and related assets will be allocated and distributedequally until CHS and the Company have both received 1.75 times their originalcapital contributions, after which profits will be allocated and distributed90% to CHS and 10% to SRS Labs. The joint venture is accounted for using theequity method and profits are recognized following the guidance for equitymethod accounting. We recognize and accrue profits as we get sales and/orroyalty reports. For fiscal 2004, the profit recognized under the agreement was$32,358.

 

*Other Income, Net*

* *

Other income, net,consists primarily of interest income, gain or (loss) on sale of securities,interest expense and foreign currency transaction gains and losses. Otherincome, net, was $594,922 for fiscal year 2004, compared to $538,278 for fiscalyear 2003, an increase of $56,644 or 10.5%. The increase is primarilyattributable to investment gains from sales of U.S. Treasury in 2004.

 

*Minority Interest*

* *

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

 

*Provision for IncomeTaxes*

* *

The income tax provisionfor fiscal 2004 was $810,416 compared to $1,038,463 for fiscal 2003 a decreaseof $228,047 or 22.0%. The provision consists primarily of taxes paid onlicensing revenues sourced from countries requiring foreign tax withholdingsand taxes paid on profits in Hong Kong at the rate of 17.5%. The lower taxexpense in fiscal 2004 resulted from decreased taxable income in our foreign 

 

31

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subsidiary and highertaxable income from our U.S. operations for which we apply net operating losscarry-forwards to offset taxable income. Additionally, in 2004, we benefitedfrom the U.S. Japan tax treaty, which eliminated source-country withholdings onroyalties. That treaty became effective on July 1, 2004.

 

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

 

**Year Ended December 31,2003 Compared to Year Ended December 31, 2002**

** **

*Revenues*

* *

Total revenues forfiscal 2003 were $19,813,781 compared to $19,001,793 in fiscal 2002, anincrease of $811,988 or 4.3%. Semiconductor revenues were $10,712,382 in fiscal2003 compared to $10,777,569 in fiscal 2002, a decrease of $65,187 or 0.6%. Semiconductorrevenues are comprised of both ASIC and ASP revenues. ASIC accounted for$8,168,751 or 76.3% in fiscal 2003 compared to $9,435,258 or 87.5% in fiscal2002, a decrease of $1,266,507 or 13.4%. The decrease was primarilyattributable to the Company’s decision to de-emphasize lower margin activitiesin component distribution revenues and increased focus on ASP standard productdevelopment, as well as decreased semiconductor business from existingsemiconductor customers. ASP chips accounted for $2,543,631 or 23.7% in fiscal2003 compared to $1,342,311 or 12.5% in fiscal 2002, an increase of $1,201,320or 89.5%, of which SRS technology chips accounted for 75.1% of ASP growth. Thegrowth in ASP was attributable to new design wins with new chip offeringsincluding SRS chips.

 

Licensing revenues were$9,101,399 in fiscal 2003, compared to $8,224,224 in fiscal 2002, an increaseof $877,175 or 10.7%. The increase was attributable to the sales growth of homeentertainment products such as DVD players and portable products such as mobilephones and MP3 players that incorporate our technologies. The following tablepresents the Company’s licensing revenues mix by market segment, excludingproduct sales and Internet and broadcast segments:

 
| ** **                                                | ** ** | **Years Ended  December 31,** | ** ** |
|-----------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                | ** ** | **2003**                                | ** ** | **2002** | ** ** |
| Home  Entertainment (TV, Set-Top Box, A/V Receiver, DVD)  |       | 81                                      | %          | 94 | % |
| Portable  Media Devices (Digital Media Player, Headphone) |       | 7                                       | %          | 1 | % |
| PC  (Software, Hardware)                                  |       | 5                                       | %          | 2 | % |
| Personal  Telecommunications (Mobile phone, PDA)          |       | 6                                       | %          | 2 | % |
| Automotive                                                |       | 1                                       | %          | 1 | % |
|                                                      |       | 100                                     | %          | 100 | % |

 

*Gross Margin*

 

Cost of sales consistsprimarily of fabrication costs, assembly and test costs, and the cost ofmaterials and overhead from operations. Gross margins are dependent on the mixof products sold, services provided and royalties earned. The improvement ingross margin from 75.0% in 2002 to 79.5% in 2003 was primarily due to anincrease in semiconductor gross margin, which resulted from the mix in revenuesas we shifted the business away from the lower margin component distributionbusiness and focused on higher margin semiconductor sales. Since revenues fromcomponent distribution are included in ASIC, it experienced an increase ingross margin as component distribution revenues decreased. ASP gross marginsimproved as a result of the increase in sales of new chip offerings with highermargins, of which many included SRS technology.

 

32

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The following tablepresents our gross margin percentages for fiscal year 2003 compared fiscal year2002:

 
| ** **                                                    | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                    | ** ** | **2003**                                    | ** ** | **2002** | ** ** |
| **Semiconductor**                                             |       |                                        |       |   |   |
| ASIC  revenue as a percentage of total semiconductor revenue  |       | 76.3                                        | %          | 87.5 | % |
| ASIC  gross margin                                            |       | 63.2                                        | %          | 58.1 | % |
| ASP  revenue as a percentage of total semiconductor revenue   |       | 23.7                                        | %          | 12.5 | % |
| ASP  gross margin                                             |       | 62.8                                        | %          | 51.7 | % |
| Total  semiconductor revenue as a percentage of total revenue |       | 54.1                                        | %          | 56.7 | % |
| Total  semiconductor gross margin                             |       | 63.1                                        | %          | 57.3 | % |
| **Licensing**                                                 |       |                                        |       |   |   |
| Licensing  revenue as a percentage of total revenue           |       | 45.9                                        | %          | 43.3 | % |
| Licensing  gross margin                                       |       | 98.9                                        | %          | 98.2 | % |
| **Total Gross Margin**                                        |       | 79.5                                        | %          | 75.0 | % |

 

*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 $5,487,159 for fiscal year 2003 compared to $4,625,833**for fiscal year 2002, an increase of$861,326 or 18.6%. The increase was attributable primarily to (a) investmentsin branding and promotion of our technologies and products in new marketsdesigned to increase future revenues; (b) co-promotional activities withour licensees; and (c) relocation of our sales and marketing offices inHong Kong. As a percentage of total revenues, sales and marketing expensesincreased from 24.3% for fiscal year 2002, to 27.7% for fiscal year 2003.

 

*Research and Development*

* *

Research and developmentexpenses consist of salaries and related costs of employees engaged in ongoingresearch, design and development activities and costs for engineering materialsand supplies. Research and development expenses were $4,263,682 for fiscal year2003 compared to $4,189,379 for fiscal year 2002, an increase of $74,303 or1.8%. The increase was primarily attributable to the addition of research anddevelopment personnel in the last quarter of 2003. As a percentage of totalrevenues, research and development expenses decreased from 22.0% for fiscalyear 2002, to 21.5% for fiscal year 2003.

 

*General andAdministrative*

* *

General andadministrative expenses consist primarily of employee-related expenses, legalcosts associated with the administration of intellectual property and otherprofessional fees. G&A expenses were $5,053,387 for fiscal year 2003compared to $4,889,484 for fiscal year 2002, an increase of $163,903 or 3.4%.The increase was primarily attributable to additions to infrastructure andpersonnel for management of our foreign operations, increased professional feesand public company expenses. As a percentage of total revenues, G&A expensesdecreased from 25.7% for fiscal year 2002, to 25.5% for fiscal year 2003.

 

*Other Income, Net*

* *

Other income, net,consists primarily of interest income, gain or (loss) on sale of securities,interest expense and foreign currency transaction gains and losses. Otherincome, net, was $538,278 for fiscal year 2003, compared to $774,125 for fiscalyear 2002, a decrease of $235,847 or 30.5%. Other income, net was 

 

33

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higher in fiscal 2002due to realized gains on sales of investments and higher interest income earnedon investment balances.

 

*Minority Interest*

* *

Minority interestrepresents the minority shareholders’ proportionate share of losses inSRSWOWcast. For fiscal 2003, minority interest was $5,430 compared to $77,708in fiscal 2002, a decrease of $72,278 or 93.0%. In February 2003, SRS Labscompleted an exchange offer with the minority shareholders of SRSWOWcast,pursuant to which SRS Labs acquired all 3,000,000 outstanding shares ofSRSWOWcast Series A Convertible Preferred Stock in exchange for theissuance of 332,184 shares of our common stock. As a result of the exchangeoffer, an intangible in the amount of $640,071 was recorded and SRSWOWcastbecame a wholly-owned subsidiary of SRS Labs.

 

*Provision for IncomeTaxes*

* *

The income tax provisionfor fiscal 2003 was $1,038,463 compared to $588,333 for fiscal 2002. The highertax expense in fiscal 2003 resulted almost entirely from taxes paid on earningsin our Hong Kong subsidiary at the tax rate of 17.5% and higher levels offoreign tax paid on licensing revenues sourced from countries requiring foreigntax withholdings. Additionally, in 2002 we revised our estimates related toincome tax payables resulting in a benefit of $882,717 in the 2002 currentincome tax provision. We had federal and state net operating losscarry-forwards at December 31, 2003 of approximately $19,778,000 and$11,487,000 respectively. The net operating loss carry-forwards began expiringin 2003 and will continue through 2019. In addition, we had federal tax creditcarry-forwards of approximately $362,000, which begin to expire in 2011. As of December 31,2003, a valuation allowance of $9,284,836 had been provided based on ourassessment of our future ability to realize certain deferred tax assets.

 

**Selected QuarterlyOperating Results (Unaudited)**

 

The following table setsforth certain quarterly summary financial data for the eight quarters in theperiod ended December 31, 2004. The quarterly information is based uponunaudited financial statements prepared by us on a basis consistent with ouraudited consolidated financial statements and, in management’s opinion,includes all adjustments, consisting only of normal recurring adjustmentsnecessary for a fair presentation of the information for the periods presented.This information should be read in conjunction with our audited consolidatedfinancial statements and notes thereto appearing elsewhere in this Report. Ourquarterly operating results have varied significantly in the past and areexpected to vary significantly in the future. Due to rounding differences, thequarters in a given year may not add precisely to the annual numbers for thatyear.

 
| ** **                     | ** ** | **Three Months Ended**                                     | ** ** |
|--------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                     | ** ** | **Mar 31,  2004***                                              | ** ** | **June 30,  2004*** | ** ** | **Sep 30,  2004*** | ** ** | **Dec 31,  2004*** | ** ** | **Mar 31,  2003** | ** ** | **June 30,  2003** | ** ** | **Sep 30,  2003** | ** ** | **Dec 31,  2003** | ** ** |
| ** **                     | ** ** | **(In thousands except per share amounts)** | ** ** |
| Revenues:                      |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Semiconductor                  |       | $                                                                    | 2,416      |   | $ | 2,932 |   | $ | 3,644 |   | $ | 1,778 |   | $ | 1,764 |   | $ | 2,513 |   | $ | 2,967 |   | $ | 3,468 |   |
| Licensing                      |       | 2,927                                                                |       | 2,485 |   | 2,728 |   | 2,691 |   | 2,706 |   | 2,013 |   | 1,919 |   | 2,463 |   |
| Total revenues                 |       | 5,343                                                                |       | 5,417 |   | 6,372 |   | 4,469 |   | 4,470 |   | 4,526 |   | 4,886 |   | 5,931 |   |
| Gross margin                   |       | 4,434                                                                |       | 4,331 |   | 4,951 |   | 3,933 |   | 3,801 |   | 3,625 |   | 3,644 |   | 4,688 |   |
| Operating expenses             |       | 4,458                                                                |       | 3,889 |   | 4,024 |   | 3,516 |   | 3,748 |   | 3,451 |   | 3,393 |   | 4,212 |   |
| Income (loss) from  operations |       | (24                                                                  | )          | 442 |   | 927 |   | 417 |   | 53 |   | 174 |   | 251 |   | 476 |   |
| Net income (loss)              |       | $                                                                    | (25        | ) | $ | 230 |   | $ | 804 |   | $ | 569 |   | $ | 43 |   | $ | (34 | ) | $ | 119 |   | $ | 331 |   |
| Net income per common  share:  |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                          |       | $                                                                    | 0.00       |   | $ | 0.02 |   | $ | 0.06 |   | $ | 0.04 |   | $ | 0.00 |   | $ | 0.00 |   | $ | 0.01 |   | $ | 0.03 |   |
| Diluted                        |       | $                                                                    | 0.00       |   | $ | 0.01 |   | $ | 0.05 |   | $ | 0.04 |   | $ | 0.00 |   | $ | 0.00 |   | $ | 0.01 |   | $ | 0.02 |   |

 

----

*2004 operating expenses, income (loss) from operations, net income (loss), andbasic and diluted earnings per share have been restated.  See the Explanatory Note to this Form 10-K/A.

 

34

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**Liquidity and CapitalResources**

** **

At December 31,2004 cash, cash equivalents and long-term investments were $24,273,179 comparedto $23,285,830 as of December 31, 2003, an increase of $987,349. Of that,$7,011,912 was held in cash and cash equivalents, a decrease of $5,783,708 fromcash and cash equivalents of $12,795,620 held at December 31, 2003 primarilyresulting from the purchase of long-term government securities classified asInvestments Available For Sale. Cash and cash equivalents generally consist ofcash, money market funds and other money market instruments with originalmaturities of three months or less. We held $17,261,267 in investmentsavailable for sale at December 31, 2004, as compared to $10,490,210 atDecember 31, 2003 an increase of $6,771,057. Investments consist of U.S.government securities rated AAA. In fiscal 2004, 2003 and 2002, operations werefunded primarily from cash from operations.

 

Net cash provided byoperating activities was $2,567,568, $787,860 and $3,912,749 for fiscal 2004,2003 and 2002, respectively. The $1,779,708 increase in net cash provided byoperating activities in fiscal year 2004, compared to fiscal year 2003, wasprimarily a result of net income of $1,578,521 further adjusted for non-cashitems including depreciation and amortization of $1,322,544, deferred stockoption compensation of $92,585 and impairment of intangibles of $43,266.Accounts receivable increased 7% during fiscal 2004 primarily due to increasesin licensing revenues. The total days sales outstanding on a consolidated basiswere 22 days at December 31, 2004 compared to 23 days at December 31,2003. Our inventory, net of allowances, decreased $181,740 in fiscal 2004 dueprimarily to the sell off of backlog which built up in the second quarter offiscal 2004 due to foundry capacity constraints and the sale of componentinventory, which was previously reserved for in our provision for slow movingand obsolete inventory. The reversal of the provision provided a benefit of$198,467 for fiscal 2004, which was offset by increases in the reserve of$156,816 associated with our periodic assessment of inventory to arrive at anet benefit of $41,651. Prepaid expenses and other current assets increased$263,810 in fiscal 2004 due to the advance payment of promotional costs, whichprovide future benefits and are associated with our branding strategy. Infiscal 2004, accounts payable decreased $519,046 primarily due to decreases inour inventory that was partially offset by increases in deferred revenues of$417,424 due to increased prepayment of license fees and increases in accruedexpenses of $54,131.

 

Our net cash used ininvesting activities was $10,837,473 and $5,137,609 and $7,068,533 for fiscal2004, 2003 and 2002, respectively. The increase in cash used for investingactivities in fiscal 2004 is due primarily to increased treasury investingactivities of $6,611,038. As a result of increasing interest rates, managementelected to commit funds to longer-term instruments. During fiscal 2004, weentered into a strategic alliance with Coming Home Studios LLC, which used cashof $2,596,090. Additional investing activities, which used cash, were purchasesof capital equipment and expenditures related to patents and intangible assetstotaling $1,630,345.

 

Our net financingactivities provided cash of $2,486,197 and $1,424,509 during fiscal year 2004and 2003, respectively and used cash of $134,523 during fiscal 2002. Ourfinancing activities during 2004 primarily consisted of proceeds from theexercise of employee stock options of $3,711,451, partially offset by thepurchase of treasury shares for $1,225,254.

 

We believe our existingcash balances and investments together with cash generated from operatingactivities will be sufficient to meet our anticipated cash needs for at leastthe next twelve months. Our future capital requirements will depend on manyfactors, including our level of revenues, the timing and extent of spending tosupport product development efforts, the expansion of sales and marketingactivities, the timing of introductions of new products, the costs to ensureaccess to adequate manufacturing capacity, and the continuing market acceptanceof our products. We could be required, or could elect, to seek additionalfunding through public or private equity or debt financing. No assurance can begiven that such additional funds will be available on terms acceptable to us orat all.

 

35

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**Contractual CashObligations and Contingent Liabilities and Commitments**

** **

We have contractualobligations and commitments with regards to operating lease arrangements. Thefollowing table quantifies our expected contractual obligations and commitmentssubsequent to December 31, 2004:

 
| ** **                       | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | **Total**                                 | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **More than 3  years** | ** ** |
| Operating  lease obligations     |       | $                                         | 432,669    |   | $ | 245,869 |   | $ | 186,800 |   | — |   |
| Total                            |       | $                                         | 432,669    |   | $ | 245,869 |   | $ | 186,800 |   | — |   |

 

**Recent AccountingPronouncements**

** **

In December 2003,the FASB issued FIN 46-R, “Consolidation of Variable Interest Entities -an interpretation of ARB 51 (revised December 2003)”, whichreplaces FIN 46. FIN 46-R incorporates certain modifications to FIN46 adopted by the FASB subsequent to the issuance of FIN 46, includingmodifications of the scope of FIN 46. For all non-special purpose entities(“SPE”) created prior to February 1, 2003, public entities will berequired to adopt FIN 46-R at the end of the first interim or annual reportingperiod ending after March 15, 2004. For all entities (regardless ofwhether the entity is an SPE) that were created subsequent to January 31,2003, public entities are already required to apply the provisions of FIN 46,and should continue doing so unless they elect to adopt the provisions of Fin46-R early as of the first interim or annual reporting period ending afterDecember 15, 2003. If they do not elect to adopt FIN 46-R early,public entities would be required to apply FIN 46-R to thosepost-January 31, 2003 entities as of the end of the first interim orannual reporting period ending after March 15, 2004. The adoption of FIN46-R for non-SPEs did not have a material impact on the Company’s financialposition, results of operations or cash.

 

In June 2004, theFinancial Accounting Standards Board FASB issued EITF Issue No. 02-14, “Whetheran Investor Should Apply the Equity Method of Accounting to Investments OtherThan Common Stock.” EITF Issue No. 02-14 addresses whether the equitymethod of accounting applies when an investor does not have an investment invoting common stock of an investee but exercises significant influence throughother means. EITF Issue No. 02-14 states that an investor should onlyapply the equity method of accounting when it has investments in either commonstock or in-substance common stock of a corporation, provided that the investorhas the ability to exercise significant influence over the operating andfinancial policies of the investee. The accounting provisions of EITF IssueNo. 02-14 are effective for the first quarter of fiscal 2005. We are inthe process of determining the effect, if any, the adoption of EITF IssueNo. 02-14 will have on our financial statements.

 

In September 2004,the Financial Accounting Standards Board (FASB) issued FASB Staff Position(FSP) Emerging Issues Task Force (EITF) Issue 03-1-1, Effective Date ofParagraphs 10–20 of EITF Issue No. 03-1, “The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments,”which delays the effective date for the recognition and measurement guidance inEITF Issue No. 03-1. In addition, the FASB has issued a proposed FSP toconsider whether further application guidance is necessary for securitiesanalyzed for impairment under EITF Issue No. 03-1. We continue to assessthe potential impact that the adoption of the proposed FSP could have on ourfinancial statements.

 

In November 2004,the Financial Accounting Standards Board issued SFAS No. 151, “Inventorycosts, an amendment of ARB No. 43 Chapter 4.” This Statement amends theguidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarifythe accounting for abnormal amounts of idle facility expense, freight, handlingcosts, and wasted material (spoilage). It requires that those items berecognized as current-period charges regardless of whether they meet thecriterion of “so abnormal.” In addition, this Statement requires that allocationof fixed production overheads to the costs of conversion be based on the 

 

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normal capacity of theproduction facilities. The provisions of this statement shall be appliedprospectively for inventory costs incurred during fiscal years beginning afterJune 15, 2005. We do not expect the adoption of this statement would havea material impact on our results of operations or financial position.

 

In December 2004,the FASB issued SFAS No. 123(R), “Share-Based Payment” (“SFASNo. 123(R)”). This statement replaces SFAS No. 123, “Accounting forStock-Based Compensation” and supersedes APB No. 25, “Accounting for StockIssued to Employees” SFAS 123(R) requires all stock-based compensation tobe recognized as an expense in the financial statements and that such cost bemeasured according to the fair value of stock options. SFAS 123(R) will beeffective for quarterly periods beginning after June 15, 2005. While wecurrently provide the pro forma disclosures required by SFAS No. 148, “Accountingfor Stock-Based Compensation - Transition and Disclosure,” on a quarterly basis(see “Note 2—Stock-Based Compensation”), we are currently evaluating the impactthat this statement will have on our consolidated financial statements.

 

On December 21,2004, the Financial Accounting Standards Board (“FASB”) issued FASB StaffPosition No. FAS 109-1, “Application of FASB Statement No. 109,Accounting for Income Taxes, to the Tax Deduction on Qualified ProductionActivities Provided by the American Jobs Creation Act of 2004” (“FSPNo. 109-1”), and FASB Staff Position No. FAS 109-2, “Accounting andDisclosure Guidance for the Foreign Earnings Repatriation Provision within theAmerican Jobs Creation Act of 2004” (“FSPNo. 109-2”). These staff positions provide accounting guidance on howcompanies should account for the effects of the American Jobs Creation Act of2004 (“AJCA”) that was signed into law on October 22, 2004. FSPNo. 109-1 states that the tax relief (special tax deduction for domesticmanufacturing) from this legislation should be accounted for as a “specialdeduction” instead of a tax rate reduction. FSP No. 109-2 gives a companyadditional time to evaluate the effects of the legislation on any plan forreinvestment or repatriation of foreign earnings for purposes of applying FASBStatement No. 109. We are investigating the repatriation provision todetermine whether we might repatriate extraordinary dividends, as defined inthe AJCA and the actual income tax impact to us will become determinable oncefurther technical guidance has been issued.

 

**Factors ThatMay Affect Future Results**

** **

*We are exposed to risksin our licensing business related to product and customer concentration*

* *

Currently, our licensingrevenue is concentrated in the home theater market with the majority of revenuegenerated from the inclusion of SRS technology inside televisions, DVD playersand set-top boxes. We expect that the consumer home entertainment market willcontinue to account for a significant portion of our licensing revenues for theforeseeable future. While consumer spending in general on consumer electronicproducts has increased, retail prices for certain consumer electronics productsthat include our audio technology, such as DVD players, have decreasedsignificantly. Indications are that this trend will continue for theforeseeable future. From time to time, certain of our original equipmentmanufacturer and semiconductor manufacturer customers may account for asignificant portion of revenue from a particular product application, such asDVD players, set-top boxes or televisions. Consumer electronics productsmanufacturers could decide to exclude our audio enhancement technology fromtheir home theater products altogether in an effort to reduce cost. The loss ofany such customer could have a material adverse affect on our financialcondition and results of operations.

 

*Our business is highlydependent on the consumer electronics market, which is characterized by shortproduct life cycles, fluctuations in demand and seasonality, and subject torisks 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 productlife cycles and significant price competition. The dynamic nature of thismarket limits our, as well as our customers’, ability to accurately forecastquarterly and annual sales. If we, or our customers, are unable to manageproduct transitions, our business and results of operations could be negativelyaffected.

 

*Pricing pressures on theconsumer electronics product manufacturers who incorporate our technologiesinto their products could limit the licensing fees we charge for ourtechnologies, which could adversely affect our revenues*

* *

The markets for theconsumer electronics products in which our technologies are incorporated areintensely competitive and price sensitive. Retail prices for consumerelectronics products that include our technologies, such as DVD players andhome theater systems, have decreased significantly, and we expect prices tocontinue to decrease for the foreseeable future. In response, manufacturershave sought to reduce their product costs, which can result in downwardpressure on the licensing fees we charge our customers who incorporate ourtechnologies. A decline in the licensing fees we charge could materially andadversely affect our operating results.

 

*Our business andprospects depend on the strength of our brand, and if we do not maintain andstrengthen our brand, our business will be materially harmed*

* *

Maintaining andstrengthening the “SRS” brand is critical to maintaining and expanding both ourproducts and services business and our technology licensing business, as wellas to our ability to enter new markets for our audio and other technologies.Our continued success is due, in part, to our reputation for providing highquality products, services and technologies across multiple consumerelectronics product segments. If we fail to effectively promote and maintainthe SRS brand, our business and prospects will suffer.

 

*Our quarterly resultsmay fluctuate*

* *

Our operating resultsmay fluctuate from those in prior quarters and will continue to be subject toquarterly and other fluctuations due to a variety of factors, including theextent to which our licensees incorporate our technologies into their products;the timing of orders from, and the shipments to, major customers; the timing ofnew product introductions; the gain or loss of significant customers;competitive pressures on selling prices; the market acceptance of new orenhanced versions of our technologies; the rate that our semiconductorlicensees manufacture and distribute chips to product manufacturers; andfluctuations in general economic conditions, particularly those affecting theconsumer electronics market. Due to our dependence on the consumer electronicsmarket, the substantial seasonality of sales in the market could impact ourrevenues and net income. In particular, we believe that there is seasonalityrelating to the Christmas season generally and the Chinese New Year within theAsia region, which fall into the fourth and first quarters respectively. As aresult, we believe that period-to-period comparisons of our results ofoperations are not necessarily meaningful and should not be relied on asindications of future performance.

 

*We are subject to thehighly cyclical nature of the semiconductor industry*

* *

The semiconductorindustry is highly cyclical. The industry has experienced significantdownturns, often in connection with, or in anticipation of, maturing productcycles (of both semiconductor companies’ and their customers’ products) anddeclines in general economic conditions. These downturns have beencharacterized by production overcapacity, high inventory levels and acceleratederosion of average selling prices. Any future downturns could significantlyharm our sales or reduce our profitability for a prolonged period of time. Fromtime to time, the semiconductor industry also has experienced periods ofincreased 

 

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demand and productioncapacity constraints. We may experience substantial changes in future operatingresults due to general semiconductor industry conditions, general economicconditions and other factors.

 

*We rely on revenuecontribution from our ASIC and standard IC business*

* *

We derive a significantamount of our revenue from Valence’s ASIC business. Valence’s engineering teamfocuses on the design of custom ASICs to meet specific customers’ requirementsand outsources the production of the design to mask houses, foundries andpackaging houses located primarily in Asia. The operations of Valence could beaffected by a variety of factors, including the timing of customer orders, thetiming of development revenue, changes in the mix of products distributed andthe mix of distribution channels employed, the emergence of a new industrystandard, product obsolescence and changes in pricing policies by us, ourcompetitors or our suppliers.

 

Business revenue fromASICs is concentrated in a limited number of customers in the areas of consumerelectronics, communications products, computers and computer peripherals. Thebusiness generated from any one customer may be for a fixed length or quantity.As such, it is customary in our ASIC business to have a certain amount ofcustomer turnover as new ASIC projects are obtained for different customers.However, it is possible that the loss of any particular customer or any baddebt arising from such customer may have a materially adverse impact on ourfinancial condition and results of operation.

 

Valence adds significantdiversity to our overall business structure and opportunities. We recognizethat in the presence of such corporate diversity, and in particular with regardto the semiconductor industry, there will always exist a potential for conflictamong sales channels between us and our technology licensees. Although theoperations of our licensing business and those of Valence are generallycomplementary, there can be no assurances that sales channel conflicts will notarise. If such potential conflicts do materialize, we may or may not be able tomitigate the effect of such perceived conflicts, which, if not resolved, mayimpact the results of operations.

 

*Potential channelconflict with existing semiconductor partners could cause us to lose futurebusiness*

* *

As we bring out more andmore Valence semiconductors with SRS audio technologies embedded in them, ourcurrent semiconductor partners may perceive those new devices as threats totheir own products. The semiconductor partners may respond by reducing oreliminating the volumes of business they presently do with us, which would havean adverse effect on our licensing revenue.

 

*We are exposed to risksin our Valence business related to product fabrication outsourcing to thirdparties*

* *

Valence is a “fabless”semiconductor company meaning that Valence designs, develops and markets ourselection of custom and standard integrated circuits but we rely on third-partycontractors to manufacture, assemble and test our products. From time to timethere can be foundry capacity issues due to global demands that affect thesemiconductor industry. Although we believe our relationships are generallygood, we do not have long-term supply agreements with our third-party vendorsand they are not obligated to perform services or supply products to us for anyparticular period or in any particular quantities, except as provided in eachseparate purchase order accepted by them. The increased demand for our productscoupled with the demand for foundry services, is, and will continue to be forthe foreseeable future, a challenge for us. In times of high demand, there aresignificant risks associated with our reliance on third-party vendorsincluding: reallocation of capacity to other foundry customers, potential priceincreases, delays and interruptions in order deliveries, reduced control overproduct quality and increased risk of misappropriation of intellectualproperty.

 

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*We conduct operations ina number of countries and are subject to risks of international operations,particularly in Asia and the*People’sRepublic of China

* *

We have significantoperations in Hong Kong, the People’s Republic of China (PRC) and other partsof Asia that require refinement to adapt to the changing market conditions inthose regions. Our operations in Asia, and international operations in general,are subject to risks of unexpected changes in, or impositions of, legislativeor regulatory requirements.

 

Our customersgeographically located in the Asia Pacific markets accounted for approximately86%, 93% and 90% of total Company sales in 2004, 2003 and 2002, respectivelyand are expected to continue to account for a substantial percentage of salesin the future. The economic climate in Asia continues to be impacted byincreases in unemployment, declines in consumer spending, currency devaluationand bank failures. Any of these factors, should they continue, couldsignificantly reduce the demand for the end user goods in which our productsand technologies are used.

 

The PRC economy hasexperienced significant growth in the past decade; but such growth has beenuneven across geographic and economic sectors. There can be no assurance thatsuch growth will continue or that any potential currency devaluation in theregion will not have a negative effect on our business, including Valence. ThePRC economy has also experienced deflation in the past, which may continue inthe future. The current economic situation may adversely affect ourprofitability over time as expenditures for consumer electronics products andinformation technology may decrease due to the results of slowing domesticdemand and deflation.

 

Hong Kong is a SpecialAdministrative Region of the PRC with its own government and legislature. HongKong enjoys a high degree of autonomy from the PRC under the principle of “onecountry, two systems.” We can give no assurance that Hong Kong will continue toenjoy autonomy from the PRC.

 

The Hong Kong dollar hasremained relatively constant due to the U.S. dollar peg and currency boardsystem that has been in effect in Hong Kong since 1983. Since mid-1997,interest rates in Hong Kong have fluctuated significantly and real estate andretail sales have declined. We can give no assurance that the Hong Kong economywill not worsen or that the historical currency peg of the Hong Kong dollar tothe U.S. dollar will be maintained. Continued declining consumer spending inHong Kong, deflation or the discontinuation of the currency peg could adverselyaffect our business.

 

*We are exposed tocurrency fluctuations and instability in the Asian markets*

* *

We expect thatinternational sales will continue to represent a significant portion of ourtotal revenues. To date, all of our licensing revenues have been denominated inU.S. dollars and most costs have been incurred in U.S. dollars. It is ourexpectation that licensing revenues will continue to be denominated in U.S.dollars for the foreseeable future. Because Valence’s business is primarilyfocused in Asia and because of our anticipated expansion of business in the PRCand other parts of Asia, our consolidated results of operations and financialposition could be significantly affected by risks associated with internationalactivities, including economic and labor conditions, political instability, taxlaws (including U.S. taxes on foreign subsidiaries) and changes in the value ofthe U.S. dollar versus the local currency in which the products are sold. Inaddition, our valuation of assets recorded as a result of the Valenceacquisition may also be adversely impacted by the currency fluctuationsrelative to the U.S. dollar. We intend to actively monitor our****foreign exchange exposure and to implementstrategies to reduce our foreign exchange risk at such time that we determinethe benefits of such strategies outweigh the associated costs. However, thereis no guarantee that we will take steps to insure against such risks, andshould such risks occur, there is no guarantee that we will not besignificantly impacted.

 

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*If the sale of consumerelectronics products incorporating our technologies does not grow in emergingmarkets, our ability to increase our licensing revenue may be limited*

* *

We also expect thatgrowth in our licensing revenue will depend, in part, upon the growth of salesof consumer electronics products incorporating our technologies in othercountries, including China and India, as consumers in these markets have moredisposable income and are increasingly purchasing entertainment products withsurround sound capabilities. However, if our licensing revenue from the use ofour technologies in these new markets or geographic areas does not expand, ourprospects could be adversely affected.

 

*We are subject tocompetitive pressures*

* *

Our existing andpotential competitors include both large and emerging domestic andinternational companies that have substantially greater financial,manufacturing, technical, marketing, distribution and other resources. Presentor future competitors may be able to develop products and technologiescomparable or superior to ours, and to adapt more quickly than us to newtechnologies or evolving market needs. We believe that the competitive factorsaffecting the market for our products and technologies include productperformance, price and quality; product functionality and features; the ease ofintegration; and implementation of the products and technologies with otherhardware and software components in the OEM’s products. In addition, themarkets in which we compete are intensely competitive and are characterized byrapid technological changes, declining average sales prices and rapid productobsolescence. Accordingly, there can be no assurance that we will be able tocontinue to compete effectively in its respective markets, that competitionwill not intensify or that future competition will not have a material adverseeffect on our business, operating results, cash flows and financial condition.

 

*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 and to negotiate a sale. For example, ittypically takes six to nine months after our first contact with a prospectivecustomer before we start licensing our technology to that customer. Inaddition, purchase of our products is usually made in connection with newdesign starts, the timing of which is outside of our control. Accordingly, wemay be unable to predict accurately the timing of any significant future salesof our products. We may also spend substantial time and management attention onpotential license agreements that are not consummated, thereby foregoing otheropportunities.

 

*We strongly rely on ourintellectual property*

* *

Our ability to competemay be 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. The semiconductorindustry is characterized by frequent claims and litigation regarding patentand other property rights. We are not currently a party to any claims of thisnature. There can be no assurances that third parties will not assert claims orinitiate litigation against us or our customers with respect to existing orfuture products. In addition, we may initiate claims or litigation againstthird parties for infringement of our proprietary rights or to determine thescope and validity of our proprietary rights.

 

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*We depend on our keypersonnel*

* *

Our future successdepends to a large extent upon the continued service of key personnel, includingengineering, sales and marketing staff, and highly skilled semiconductor designstaff. We anticipate that any future growth will require us to recruit and hirea number of new personnel in engineering, operations, finance, sales andmarketing. Competition for such personnel can be intense, and there can be noassurance that we can recruit and retain necessary personnel to operate ourbusiness and support future growth.

 

*The market price of ourcommon stock is volatile*

* *

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

 

*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 of incorporation,our bylaws and Delaware law contain provisions that might enable our managementto discourage, delay or prevent change in control. In addition, theseprovisions could limit the price that investors would be willing to pay in thefuture for shares of our common stock.

 

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

** **

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

 

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**Foreign Currency**

** **

International salesrepresent a significant portion of our total revenues. To date, all of ourlicensing revenues have been denominated in U.S. dollars and most costshave been incurred in U.S. dollars. We have subsidiary operations in HongKong and customers in the PRC, and, accordingly, we are exposed to transactiongains and losses that could result from changes in foreign currency exchangerates. We use the local currency (Hong Kong dollars) as the functional currencyfor our Valence subsidiaries. The Hong Kong dollar has remained relativelyconstant due to the U.S. dollar peg and currency board system that hasbeen in effect in Hong Kong since 1983. To date, most of our semiconductorrevenue and expenses incurred have been denominated in Hong Kong dollars.Translation adjustments resulting from the process of translating foreigncurrency financial statements into U.S. dollars were not significant infiscal 2004, 2003, and 2002. Cash balances maintained by Valence in excess ofnormal operating requirements are invested in U.S. denominated bankaccounts further reducing balance sheet exposure to changes in foreign currencyexchange rates. Under the current circumstances, we believe that the foreigncurrency market risk is not material, however, we can give no assurance thatthe Hong Kong economy will not worsen or that the historical currency peg ofthe Hong Kong dollar to the U.S. dollar will be maintained. We activelymonitor our foreign exchange exposure and, should circumstances change, intendto implement strategies to reduce our risk at such time that it determines thatthe benefits of such strategies outweigh the associated costs. There can be noassurance that management’s efforts to reduce foreign exchange exposure will besuccessful.

 

**Interest Rates**

** **

Our exposure to marketrisk includes changes in interest rates, which relates primarily to ourinvested balances of cash, cash equivalents and investments. Our investmentpolicy specifies excess funds are to be invested in a manner that preservescapital, provides liquidity and generates the highest available after-taxreturn. To limit exposure to market risk, we place our cash in banks, cashequivalents in high quality, short-term commercial paper and money market fundsand investments consisting of U.S. government securities and U.Sgovernment-backed securities. We do not invest in any derivative instruments.All cash, cash equivalents and investments are carried at fair value, whichapproximates 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 F-1 to F-27 ofthis Annual 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**

** **

None.

 

**Item 9A.     Controlsand Procedures**

 

*Restatements*

 

OnMay 10, 2005, management of the Company was advised by BDO Seidman, LLP, itsindependent registered public accounting firm (“BDO Seidman”), of theconclusion reached by it regarding the Company’s interim accounting for salesand marketing expenses related to trade shows. This conclusion was reached in connection with BDO Seidman’s financialstatement review procedures relating to the Company’s Quarterly Report on Form10-Q for the first quarter of the year ending December 31, 2005 (“fiscal2005”).  Commencing in the first quarterof the fiscal year ended December 31, 2004 (“fiscal 2004”), the Company beganto capitalize and amortize trade show expenses incurred in the fiscal year toreflect the future economic benefits received during such fiscal year.  Management discussed the issue with the AuditCommittee of the Company’s Board of Directors and BDO Seidman and was of theview that capitalization and amortization of trade show expenses wasallowable.  As part of the first quarterreview, BDO Seidman noted that trade show costs previously capitalized andamortized should have been treated as period expenses in fiscal 2004.  As a result, BDO Seidman expressed its viewthat (a) trade show costs previously capitalized and amortized during fiscal2004 should have been treated as period expenses in fiscal 2004; (b) each ofthe Company’s quarterly reports previously filed in fiscal 2004 should beamended; and (c) no reliance should be placed on the previously issued fiscal2004 quarterly financial statements.  Werestated our financial results for the quarters ended March 31, June 30, andSeptember 30, 2004 to reflect adjustments to our previously reported financialinformation.  In addition, this annualreport on Form 10-K for fiscal 2004 is being amended to reflect such restatedquarterly results including the quarter ended December 31, 2004.

 

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*Evaluationof Disclosure Controls and Procedures*

 

TheCompany conducted an evaluation of the effectiveness of the design andoperation of our disclosure controls and procedures (as defined inRules 13a-15(e) and 15d-15(e) under the Securities Exchange Actof 1934, as amended (the “Exchange Act”)) as of the end of the period coveredby this Annual Report in connection with the filing of its initial AnnualReport on Form 10-K based upon the information available at that time andconcluded that the Company’s disclosure controls and procedures were effective.The controls evaluation was done under the supervision and with theparticipation of management, including our Chief Executive Officer and ChiefFinancial Officer.

 

Subsequentto that evaluation, in connection with the restatements described above, underthe direction of our Chief Executive Officer and Chief Financial Officer, wereevaluated our disclosure controls and procedures. In the course of BDOSeidman’s financial statement review procedures relating to the Company’sQuarterly Report on Form 10-Q for the quarterly period ended March 31, 2005, ourChief Executive Officer and Chief Financial Officer were advised by BDO Seidmanthat the Company’s improper interpretation of accounting literature with respectto interim accounting for sales and marketing expenses related to trade showexpenses described above constituted a material weakness in our internalcontrol over financial reporting.  Solelyas a result of this material weakness, we concluded that our disclosurecontrols and procedures were not effective as of the end of the period coveredby this Annual Report.

 

Inconnection with this amended Annual Report on Form 10-K/A, under the directionof our Chief Executive Officer and Chief Financial Officer, we havere-evaluated our disclosure controls and procedures as currently in effect,including the changes in internal controls over financial reporting describedbelow, and we have concluded that, as of the date of this amended Annual Reporton Form 10-K/A, our disclosure controls and procedures are effective.

 

*Changesin Internal Controls*

 

Inthe course of BDO Seidman’s financial statement review procedures relating tothe Company’s Quarterly Report on Form 10-Q for the quarterly period endedMarch 31, 2005, BDO Seidman advised the Company that the Company’s improperinterpretation of accounting literature with respect to interim accounting forsales and marketing expenses related to trade show expenses described aboveconstituted a deficiency in the Company’s internal controls and advised theAudit Committee that this internal control deficiency constitutes a reportablecondition and a material weakness as defined in Statement on Auditing StandardsNo. 60.  As a result of this internalcontrol deficiency, the Company has implemented more formal proceduresregarding changes in accounting treatment and related communications with theAudit Committee and the Company’s independent registered public accountingfirm.

 

TheCompany believes that these corrective actions, taken as a whole, willremediate the control deficiency identified above, but the Company willcontinue to monitor the effectiveness of these actions and will make any otherchanges or take such other actions as management determines to be appropriate.

 

Aspreviously reported, there was no change in our internal control over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)during the fourth quarter of fiscal 2004, that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting. However, subsequent to March 31, 2005, we took the remedial actionsdescribed above.

 

**Item9B.      Other Information**

 

None.

 

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**PART III**

** **

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

** **

Information regardingour executive officers is included in Item 1A of Part I of thisAnnual Report on Form 10-K and is hereby incorporated into thisItem 10 by reference. The information set forth under the captions “Electionof Directors,” “Information About the Board of Directors and Committees of theBoard” and “Transactions with Management 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 2005, is incorporatedherein by reference. The Proxy Statement will be filed with the SEC not laterthan 120 days after the close of fiscal 2004.

 

**Item11.      Executive Compensation**

** **

Except as specificallyprovided, the information set forth under the captions “Compensation ofExecutive Officers” and “Information About the Board of Directors andCommittees of the Board—Compensation of Directors” in the Proxy Statement isincorporated herein by reference. The Proxy Statement will be filed with theSEC not later than 120 days after the close of fiscal 2004. The Report onExecutive Compensation and the Performance Graph set forth under the caption “Compensationof Executive Officers” in the Proxy Statement shall not be deemed incorporatedby reference herein and shall not otherwise be deemed “filed” as part of thisAnnual Report on Form 10-K.

 

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

** **

Information regardingsecurity ownership of certain beneficial owners and management is incorporatedby reference to the information set forth under the caption “Security Ownershipof Certain Beneficial Owners and Management” in the Proxy Statement. The ProxyStatement will be filed with the SEC not later than 120 days after theclose of fiscal 2004.

 

Information regardingequity compensation plans required by this Item 12 is included inItem 5 of Part II of this report and is incorporated into this Itemby reference.

 

**Item 13.      CertainRelationships and Related Transactions**

** **

The information setforth under the caption “Transactions with Management and Others” in the ProxyStatement is incorporated herein by reference. The Proxy Statement will befiled with the Commission not later than 120 days after the close offiscal 2004.

 

**Item 14.      PrincipalAccountant Fees and Services**

** **

Information regardingprincipal accountant fees and services is incorporated by reference to theinformation set forth under the caption “Relationship of the Company withIndependent Auditors” in the Proxy Statement. The Proxy Statement will be filedwith the SEC not later than 120 days after the close of fiscal 2004.

 

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**PART IV**

** **

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

** **

**(a)  Documents Filed as Part of This Report:**

 

**(1)         Financial Statements**

 
| Report  of Independent Registered Public Accounting Firm—BDO Seidman, LLP                                                            |   |
|-------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Consolidated Balance Sheets  as of December 31, 2004 and 2003                                                                        |   |
| Consolidated  Statements of Operations for the years ended December 31, 2004, 2003 and  2002                                         |   |
| Consolidated Statements of  Stockholders’ Equity and Comprehensive Income for the years ended  December 31, 2004, 2003 and 2002 |   |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2004, 2003 and  2002                                         |   |
| Notes to  Consolidated Financial Statements                                                                                               |   |

 

**(2)         Financial Statement Schedules**

 
| Schedule  II—Valuation and Qualifying Accounts and Reserves for the years ended  December 31, 2004, 2003 and 2002 |   |
|-----------------------------------------------------------------------------------------------------------------------------|--------|

 

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The financial statementschedule included in Part II, Item 8 herein is filed as part of thisAnnual Report on Form 10-K. All other schedules are omitted as therequired information is inapplicable or the information is presented in theconsolidated financial statements or related notes.

 

**(3)         Exhibits**

 

The exhibits listedbelow are hereby filed with the SEC as part of this Annual Report onForm 10-K. The Company will furnish a copy of any exhibit upon request,but a reasonable fee will be charged to cover our expenses in furnishing suchexhibit.

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                               |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | Certificate of  Incorporation of the Company, previously filed with the Commission as  Exhibit 3.1 to the Company’s Registration Statement on Form SB-2,  specifically included in Amendment No. 1 to such Registration Statement  filed with the Commission on July 3, 1996 (File No. 333-4974-LA)  (the “Registration Statement Amendment No. 1”), which is incorporated  herein by reference. |
| 3.2                 |       | Bylaws of the Company,  previously filed with the Commission as Exhibit 3.1 to the Company’s  Quarterly Report on Form 10-Q for the period ended September 30,  1999, filed with the Commission on November 12, 1999, which is  incorporated herein by reference.                                                                                                                                                    |
|                |       | **Material  Contracts Relating to Management Compensation Plans or Arrangements**                                                                                                                                                                                                                                                                                                                                                             |
| 10.1                |       | Employment Agreement  dated July 1, 1996, between the Company and Thomas C.K. Yuen, previously  filed with the Commission as Exhibit 10.8 to the Registration Statement  Amendment No. 1, which is incorporated herein by reference.                                                                                                                                                                                           |
| 10.2                |       | Amendment to Employment  Agreement dated as of March 14, 1997, between the Company and Thomas  C.K. Yuen, previously filed with the Commission as Exhibit 10.2 to the  Company’s Annual Report on Form 10-KSB for the fiscal year ended  December 31, 1996, filed with the Commission on March 31, 1997 (the  “1996 Annual Report”), which is incorporated herein by reference.                       |
| 10.3                |       | Employment Agreement  dated July 1, 1996, between the Company and Arnold I. Klayman,  previously filed with the Commission as Exhibit 10.10 to the  Registration Statement Amendment No. 1, which is incorporated herein by  reference.                                                                                                                                                                                        |
| 10.4                |       | Amendment to Employment  Agreement dated as of March 14, 1997, between the Company and Arnold I.  Klayman, previously filed as Exhibit 10.5 to the 1996 Annual Report,  which is incorporated herein by reference.                                                                                                                                                                                                                  |
| 10.5                |       | Employment Agreement  dated July 1, 1996, between the Company and Alan D. Kraemer, previously  filed with the Commission as Exhibit 10.11 to the Registration Statement  Amendment No. 1, which is incorporated herein by reference.                                                                                                                                                                                           |
| 10.6                |       | SRS Labs, Inc.  Incentive Stock Option, Nonqualified Stock Option and Restricted Purchase  Plan-1993, as amended and restated, previously filed with the Commission as  Exhibit 10.12 to the Company’s Registration Statement on Form SB-2  filed with the Commission on June 3, 1996 (File No. 333-4974-LA) (the  “Registration Statement”), which is incorporated herein by reference.              |
| 10.7                |       | Stock Option Agreement  dated January 19, 1994, between the Company and Stephen V. Sedmak, as  amended, previously filed with the Commission as Exhibit 10.13 to the  Registration Statement, which is incorporated herein by reference.                                                                                                                                                                                            |
| 10.8                |       | SRS Labs, Inc.  Amended and Restated 1996 Long-Term Incentive Plan, as amended, previously  filed with the Commission as Appendix A to the Company’s Definitive Proxy  Statement dated and filed with the Commission on April 26, 2000, which  is incorporated herein by reference.                                                                                                                                            |

 

47

----

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.9                |       | SRS Labs, Inc.  Amended and Restated 1996 Non-employee Directors Stock Option Plan, as amended,  previously filed with the Commission as Appendix B to the Company’s  Definitive Proxy Statement dated and filed with the Commission on  April 30, 2003, which is incorporated herein by reference.                                                                                                                                                                                 |
| 10.10               |       | Annual Incentive Bonus  Plan, previously filed with the Commission as Exhibit 10.18 to the  Registration Statement Amendment No. 1, which is incorporated herein by  reference.                                                                                                                                                                                                                                                                                                               |
| 10.11               |       | SRS Labs, Inc.  Supplemental Executive Incentive Bonus Plan, previously filed with the  Commission as Exhibit 10.14 to the 1996 Annual Report, which is  incorporated herein by reference.                                                                                                                                                                                                                                                                                                    |
| 10.12               |       | Form of  Indemnification Agreement, previously filed with the Commission as  Exhibit 10.20 to the Registration Statement Amendment No. 1, which  is incorporated herein by reference.                                                                                                                                                                                                                                                                                                    |
| 10.13               |       | Employment Agreement  dated as of March 2, 1998, by and among the Company, Valence  Semiconductor Design Limited, and Choi Yat Ming, previously filed with the  Commission as Exhibit 10.17 to the 1997 Annual Report, which is  incorporated herein by reference.                                                                                                                                                                                                                            |
| 10.14               |       | Employment Agreement  dated as of March 2, 1998, by and among the Company, LEC Electronic  Components Limited, and Wong Yin Bun, previously filed with the Commission as  Exhibit 10.18 to the 1997 Annual Report, which is incorporated herein by  reference.                                                                                                                                                                                                                                |
| 10.15               |       | Noncompetition  Agreement dated as of March 2, 1998, by and among the Company, Cape  Spencer International Limited and Wong Yin Bun, previously filed with the  Commission as Exhibit 2.6 to the Form 8-K, which is incorporated  herein by reference.                                                                                                                                                                                                                                   |
| 10.16               |       | Noncompetition  Agreement dated as of March 2, 1998, by and among the Company, Rayfa  (BVI) Limited and Choi Yat Ming, previously filed with the Commission as  Exhibit 2.7 to the Form 8-K, which is incorporated herein by  reference.                                                                                                                                                                                                                                                 |
| 10.17               |       | Employment Agreement  dated August 27, 1999 by and between the Company and James F. Gardner,  previously filed with the Commission as Exhibit 10.23 to the Company’s  Annual Report on Form 10-K for the year ended December 31, 2001,  filed with the Commission on March 29, 2002, which is incorporated  herein by reference.                                                                                                                                          |
| 10.18               |       | Employment Letter with  Michael Oswald, Vice President and General Counsel, dated November 9,  2004, previously filed with the Commission as Exhibit 10.1 to the  Form 8-K filed with the Commission on February 3, 2005, which is  incorporated herein by reference.                                                                                                                                                                                                               |
| 10.19               |       | Non-employee Director  Compensation Policy adopted by the Company’s Board of Directors on  January 28, 2005, previously filed with the Commission as  Exhibit 10.5 to the Form 8-K filed with the Commission on  February 3, 2005, which is incorporated herein by reference.                                                                                                                                                                                                  |
|                |       | **Other  Material Contracts**                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.20               |       | License Agreement dated  as of June 27, 1988, between Hughes Aircraft and Sony Corporation, as  amended and assigned to the Company, previously filed with the Commission as  Exhibit 10.6 to the Registration Statement Amendment No. 3, which  is incorporated herein by reference.                                                                                                                                                                                                    |
| 10.21               |       | Industrial Real Estate  Lease dated May 30, 1997, between the Company and Daimler Commerce  Partners, L.P., previously filed with the Commission as Exhibit 10.1 to  the Company’s Form 10-Q for the quarterly period ended June 30,  1997, filed with the Commission on August 13, 1997, which is  incorporated herein by reference.                                                                                                                                     |
| 10.22               |       | Tenancy Agreement  commencing Nov. 16, 2003 by and between Jugada Company Limited and  Valence Technology Limited relating to premises located at workshop No 01-07  on the 20th floor of APEC Plaza, No. 49 Hoi Yuen Road, Kwun  Tong, Kowloon Hong Kong, previously filed with the Commission as  Exhibit 10.20 to the Form 10-K for the fiscal year ended  December 31, 2003, filed with the Commission on March 30, 2004,  which is incorporated herein by reference. |

 

48

----

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.23               |       | Tenancy Agreement commencing  November 16, 2003, by and between Jugada Company Limited and Valence  Semiconductor Design Limited relating to the premises located at Workshops  Nos. 1 through 10 and on the 19th Floor of APEC Plaza, No. 49  Hoi Yuen Road, Kwun Tong, Hong Kong, previously filed with the Commission as  Exhibit 10.21 to the Form 10-K for the fiscal year ended  December 31, 2003, filed with the Commission on March 30, 2004,  which is incorporated herein by reference. |
| 10.24               |       | Stock Divestment  Agreement dated July 1, 1996, between the Company, Thomas C.K. Yuen,  Stephen V. Sedmak and Walter W. Cruttenden III, previously filed with the  Commission as Exhibit 10.17 to the Registration Statement Amendment  No. 2, which is incorporated herein by reference.                                                                                                                                                                                                                         |
| 10.25               |       | Strategic Alliance with  Coming Home Studios, dated September 23, 2004 filed with the Commission  as Exhibit 10.1 through 10-4 to the Form 8-K, previously filed with  the Commission on September 28, 2004, which is incorporated herein by  reference.                                                                                                                                                                                                                                                     |
| 14                  |       | SRS Labs, Inc.  Code of Business Conduct and Ethics adopted by the Board of Directors  Nov. 6, 2002, previously filed with the Commission as Exhibit 14 to  the Form 10-K for the fiscal year ended December 31, 2003, filed  with the Commission on March 30, 2004, which is incorporated herein by  reference.                                                                                                                                                                                   |
| 21                  |       | Subsidiaries of the  Registrant, previously filed with the Commission as Exhibit 21 to the  Form 10-K for the fiscal year ended December 31, 2003, filed with  the Commission on March 30, 2004, which is incorporated herein by  reference.                                                                                                                                                                                                                                                                      |
| 23.1                |       | Consent of Independent  Registered Public Accounting Firm, BDO Seidman LLP.                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| 31.1                |       | Certification of the  Chief Executive Officer of SRS Labs, Inc., pursuant to 18 U.S.C  Section 1350, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                       |
| 31.2                |       | Certification of the  Chief Financial Officer of SRS Labs, Inc., pursuant to 18 U.S.C  Section 1350, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                       |
| 32.1                |       | Certification of Chief  Executive Officer of SRS Labs, Inc., pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                          |
| 32.2                |       | Certification of Chief  Financial Officer of SRS Labs, Inc., pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                          |

 

49

----

 

**SIGNATURES**

** **

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this annual report on Form 10-K/A to besigned on its behalf by the undersigned, thereunto duly authorized.

 
| Dated: May 17, 2005 |   | By:      | /s/ THOMAS C.K.  YUEN                                 |   |
|---------------------|--------|----------|-------------------------------------------------------|--------|
| * *            |   | * * | *Chairman  of the Board and  Chief Executive Officer* |   |

 

 

50

----

 

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

** **

To the Board ofDirectors and Stockholders of

SRS Labs, Inc.

Santa Ana, California

 

We have audited theconsolidated balance sheets of SRS Labs, Inc. and Subsidiaries as ofDecember 31, 2004 and 2003, and the related consolidated statements ofoperations, stockholders’ equity and comprehensive income and cash flows foreach of the three years in the period ended December 31, 2004. We havealso audited the schedules listed in the accompanying index. These financialstatements and schedules are the responsibility of the Company’s management.Our responsibility is to express an opinion on these consolidated financialstatements and schedules based on our audits.

 

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements andthe schedules are free of material misstatement. The Company is not required tohave, nor are we engaged to perform, an audit of its internal control overfinancial reporting. Our audits 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 schedules, assessing the accounting principlesused and significant estimates made by management, as well as evaluating theoverall presentation of the financial statements and schedules. We believe thatour audits provide a reasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of SRS Labs, Inc.and Subsidiaries as of December 31, 2004 and 2003, and the results of itsoperations and its cash flows for each of the three years in the period endedDecember 31, 2004, in conformity with accounting principles generallyaccepted in the United States of America.

 

Also, in our opinion,the schedules present fairly, in all material respects, the information setforth therein.

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

 

 

Costa Mesa, California

February 18, 2005,except as to Note 1, paragraphs 16 and 17, which are as of March 17, 2005

 

F-1

----

 

**SRSLABS, INC.**

 

**CONSOLIDATED BALANCESHEETS**

 
| ** **                                                                                                                                                                          | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                          |       |                        |       |                        |       |
| **Current  Assets**                                                                                                                                                                 |       |                        |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                          |       | $                           | 7,011,912  |                        | $          | 12,795,620 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $32,962 in 2004 and  $87,628 in 2003                                                                                |       | 1,318,665                   |       | 1,230,423                   |       |
| Inventories, net  of reserve of $240,824 in 2004 and $867,923 in 2003                                                                                                               |       | 571,280                     |       | 753,020                     |       |
| Prepaid expenses  and other current assets, including other receivables of $9,004 in 2004 and  $4,033 in 2003                                                                       |       | 1,337,506                   |       | 1,073,696                   |       |
| Deferred income  taxes                                                                                                                                                              |       | 23,406                      |       | 23,406                      |       |
| **Total  Current Assets**                                                                                                                                                           |       | 10,262,769                  |       | 15,876,165                  |       |
| Investments  available for sale                                                                                                                                                     |       | 17,261,267                  |       | 10,490,210                  |       |
| Investment in  LLC                                                                                                                                                                  |       | 2,596,090                   |       | —                      |       |
| Furniture,  fixtures and equipment, net                                                                                                                                             |       | 1,995,579                   |       | 1,661,980                   |       |
| Intangible  assets, net                                                                                                                                                             |       | 2,660,955                   |       | 2,736,810                   |       |
| Goodwill                                                                                                                                                                            |       | 533,031                     |       | 533,031                     |       |
| Deferred income  taxes                                                                                                                                                              |       | 192,750                     |       | 193,134                     |       |
| **Total  Assets**                                                                                                                                                                   |       | $                           | 35,502,441 |                        | $          | 31,491,330 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                       |       |                        |       |                        |       |
| **Current  Liabilities**                                                                                                                                                            |       |                        |       |                        |       |
| Accounts payable                                                                                                                                                                    |       | $                           | 984,805    |                        | $          | 1,503,851 |   |
| Accrued  liabilities                                                                                                                                                                |       | 1,640,714                   |       | 1,586,583                   |       |
| Deferred revenue                                                                                                                                                                    |       | 436,910                     |       | 19,486                      |       |
| Income taxes  payable                                                                                                                                                               |       | 8,628                       |       | 430,949                     |       |
| **Total  Current Liabilities**                                                                                                                                                      |       | 3,071,057                   |       | 3,540,869                   |       |
| Commitments and  contingencies (Note 8)                                                                                                                                             |       |                        |       |                        |       |
| **Stockholders’  Equity**                                                                                                                                                      |       |                        |       |                        |       |
| Preferred  stock—$0.001 par value; 2,000,000 shares authorized; no shares issued and  outstanding                                                                              |       | —                      |       | —                      |       |
| Common  stock—$0.001 par value; 56,000,000 shares authorized; 14,671,416 and  13,682,282 shares issued; 14,229,541 and 13,456,982 outstanding for 2004 and  2003, respectively |       | 14,672                      |       | 13,683                      |       |
| Additional  paid-in capital                                                                                                                                                         |       | 62,523,292                  |       | 58,423,249                  |       |
| Accumulated  other comprehensive loss                                                                                                                                               |       | (309,722                    | )          | (336,346                    | )          |
| Accumulated  deficit                                                                                                                                                                |       | (27,853,003                 | )          | (29,431,524                 | )          |
| Treasury stock  at cost 441,875 and 225,300 shares at December 31, 2004 and 2003,  respectively                                                                                |       | (1,943,855                  | )          | (718,601                    | )          |
| **Total  Stockholders’ Equity**                                                                                                                                                |       | 32,431,384                  |       | 27,950,461                  |       |
| **Total  Liabilities And Stockholders’ Equity**                                                                                                                                |       | $                           | 35,502,441 |                        | $          | 31,491,330 |   |

 

See accompanying notes toconsolidated financial statements

 

F-2

----

 

**SRSLABS, INC.CONSOLIDATED STATEMENTS OFOPERATIONS**

 
| ** **                                                                       | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                       | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Revenue:                                                                         |       |                                        |       |   |   |   |   |
| Semiconductor                                                                    |       | $                                           | 10,770,684 |   | $ | 10,712,382 |   | $ | 10,777,569 |   |
| Licensing                                                                        |       | 10,831,704                                  |       | 9,101,399 |   | 8,224,224 |   |
| Total revenues                                                                   |       | 21,602,388                                  |       | 19,813,781 |   | 19,001,793 |   |
| Cost of sales:                                                                   |       |                                        |       |   |   |   |   |
| Semiconductor                                                                    |       | 3,725,062                                   |       | 3,953,100 |   | 4,600,388 |   |
| Licensing                                                                        |       | 228,147                                     |       | 102,979 |   | 153,857 |   |
| Total cost of  sales                                                             |       | 3,953,209                                   |       | 4,056,079 |   | 4,754,245 |   |
| Gross margin                                                                     |       | 17,649,179                                  |       | 15,757,702 |   | 14,247,548 |   |
| Operating  expenses                                                              |       |                                        |       |   |   |   |   |
| Sales and  marketing                                                             |       | 5,445,224                                   |       | 5,487,159 |   | 4,625,833 |   |
| Research and  development                                                        |       | 4,767,004                                   |       | 4,263,682 |   | 4,189,379 |   |
| General and  administrative                                                      |       | 5,675,294                                   |       | 5,053,387 |   | 4,889,484 |   |
| Total operating  expenses                                                        |       | 15,887,522                                  |       | 14,804,228 |   | 13,704,696 |   |
| Income from  operations                                                          |       | 1,761,657                                   |       | 953,474 |   | 542,852 |   |
| Equity in income  of investee                                                    |       | 32,358                                      |       | — |   | — |   |
| Other income,  net                                                               |       | 594,922                                     |       | 538,278 |   | 774,125 |   |
| Minority  interest                                                               |       | —                                      |       | 5,430 |   | 77,708 |   |
| Income before  income tax expense                                                |       | 2,388,937                                   |       | 1,497,182 |   | 1,394,685 |   |
| Income tax  expense                                                              |       | 810,416                                     |       | 1,038,463 |   | 588,333 |   |
| Net income                                                                       |       | $                                           | 1,578,521  |   | $ | 458,719 |   | $ | 806,352 |   |
| Net income per  common share:                                                    |       |                                        |       |   |   |   |   |
| Basic                                                                            |       | $                                           | 0.11       |   | $ | 0.04 |   | $ | 0.06 |   |
| Diluted                                                                          |       | $                                           | 0.10       |   | $ | 0.03 |   | $ | 0.06 |   |
| Weighted average  shares used in the calculation of net income per common share: |       |                                        |       |   |   |   |   |
| Basic                                                                            |       | 13,950,457                                  |       | 13,033,002 |   | 12,648,373 |   |
| Diluted                                                                          |       | 15,781,206                                  |       | 14,420,810 |   | 12,862,199 |   |

 

See accompanying notes toconsolidated financial statements

 

F-3

----

 

**SRS LABS, INC.**

 

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY ANDCOMPREHENSIVE INCOME**

 
| ** **                                                     | ** ** | ** **            | ** ** | ** **  | ** ** | ** **        | ** ** | ** **      | ** ** | ** **   | ** ** | ** ** | ** ** | ** **           | ** ** | **Comprehensive**     | ** ** |
|----------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-------------------|------------|-----------------|------------|--------------|------------|------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                                     | ** ** | ** **            | ** ** | ** **  | ** ** | ** **        | ** ** | **Accumulated** | ** ** | ** **   | ** ** | ** ** | ** ** | ** **           | ** ** | **Income**            | ** ** |
| ** **                                                     | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**    | ** ** | **Other**       | ** ** | ** **   | ** ** | ** ** | ** ** | ** **           | ** ** | **for the**      | ** ** |
| ** **                                                     | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Comprehensive** | ** ** | **Accumulated** | ** ** | **Treasury** | ** ** | ** ** | ** ** | **Years Ended** | ** ** |
| ** **                                                     | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**       | ** ** | **Loss**        | ** ** | **Deficit**  | ** ** | **Stock**  | ** ** | **Total**            | ** ** | **December 31,** | ** ** |
| BALANCE, Jan 1,  2002                                          |       | 12,664,744            |       | $           | 12,790     |              | $          | 55,745,867      |       | $            | (74,055    | )          | $          | (30,696,595          | )          | $                     | (451,994   | ) | $ | 24,536,013 |   |   |   |
| Proceeds from  exercise of stock options                       |       | 86,670                |       | 87          |       | 131,997           |       | —          |       | —       |       | —     |       | 132,084              |       |                  |       |
| Deferred stock  option compensation                            |       | —                |       | —      |       | 88,725            |       | —          |       | —       |       | —     |       | 88,725               |       |                  |       |
| Treasury Stock                                                 |       | (100,400              | )          | —      |       | —            |       | —          |       | —       |       | (266,607   | )          | (266,607             | )          |                  |       |
| Unrealized loss  on investments available for sale, net of tax |       | —                |       | —      |       | —            |       | (14,509         | )          | —       |       | —     |       | (14,509              | )          | (14,509               | )          |
| Net income                                                     |       | —                |       | —      |       | —            |       | —          |       | 806,352      |       | —     |       | 806,352              |       | 806,352               |       |
| BALANCE,  Dec 31, 2002                                    |       | 12,651,014            |       | 12,877      |       | 55,966,589        |       | (88,564         | )          | (29,890,243  | )          | (718,601   | )          | 25,282,058           |       | $                     | 791,843    |   |
| Proceeds from  exercise of stock options                       |       | 473,784               |       | 474         |       | 1,424,035         |       | —          |       | —       |       | —     |       | 1,424,509            |       |                  |       |
| Deferred stock  option compensation                            |       | —                |       | —      |       | 72,945            |       | —          |       | —       |       | —     |       | 72,945               |       |                  |       |
| Issuance of  Common Stock                                      |       | 332,184               |       | 332         |       | 959,680           |       | —          |       | —       |       | —     |       | 960,012              |       |                  |       |
| Unrealized loss  on investments available for sale, net of tax |       | —                |       | —      |       | —            |       | (247,782        | )          | —       |       | —     |       | (247,782             | )          | (247,782              | )          |
| Net income                                                     |       | —                |       | —      |       | —            |       | —          |       | 458,719      |       | —     |       | 458,719              |       | 458,719               |       |
| BALANCE,  Dec 31, 2003                                    |       | 13,456,982            |       | 13,683      |       | 58,423,249        |       | (336,346        | )          | (29,431,524  | )          | (718,601   | )          | 27,950,461           |       | $                     | 210,937    |   |
| Proceeds from  exercise of stock options                       |       | 989,134               |       | 989         |       | 3,710,462         |       | —          |       | —       |       | —     |       | 3,711,451            |       |                  |       |
| Tax benefit from  exercise of stock options                    |       | —                |       | —      |       | 296,996           |       | —          |       | —       |       | —     |       | 296,996              |       |                  |       |
| Deferred stock  option compensation                            |       | —                |       | —      |       | 92,585            |       | —          |       | —       |       | —     |       | 92,585               |       |                  |       |
| Issuance of  Common Stock                                      |       | —                |       | —      |       | —            |       | —          |       | —       |       | —     |       | —               |       |                  |       |
| Treasury Stock                                                 |       | (216,575              | )          | —      |       | —            |       | —          |       | —       |       | (1,225,254 | )          | (1,225,254           | )          |                  |       |
| Unrealized gain  on investments available for sale, net of tax |       | —                |       | —      |       | —            |       | 26,624          |       | —       |       | —     |       | 26,624               |       | 26,624                |       |
| Net income                                                     |       | —                |       | —      |       | —            |       | —          |       | 1,578,521    |       | —     |       | 1,578,521            |       | 1,578,521             |       |
| BALANCE,  Dec 31, 2004                                    |       | 14,229,541            |       | $           | 14,672     |              | $          | 62,523,292      |       | $            | (309,722   | )          | $          | (27,853,003          | )          | $                     | (1,943,855 | ) | $ | 32,431,384 |   | $ | 1,605,145 |   |

 

See accompanying notes toconsolidated financial statements

 

F-4

----

 

**SRS LABS, INC.**

 

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
| ** **                                                                         | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Cash  Flows From Operating Activities:**                                         | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                                           | 1,578,521  |   | $ | 458,719 |   | $ | 806,352 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                        |       |   |   |   |   |
| Depreciation and  amortization                                                     |       | 1,322,544                                   |       | 1,167,825 |   | 1,198,922 |   |
| Minority  interest                                                                 |       | —                                      |       | (5,430 | ) | (77,708 | ) |
| Provision for  doubtful accounts                                                   |       | 58,508                                      |       | 38,839 |   | 22,220 |   |
| (Benefit)  Provision for obsolete inventory                                        |       | (41,651                                     | )          | 48,686 |   | 490,666 |   |
| Deferred taxes                                                                     |       | 384                                         |       | (30,898 | ) | 833,283 |   |
| Amortization of  premium on investments available for sale                         |       | 5,980                                       |       | 6,394 |   | — |   |
| Net realized  gain on investments available for sale                               |       | (139,375                                    | )          | (20,026 | ) | (98,224 | ) |
| Increase in  deferred stock option compensation                                    |       | 92,585                                      |       | 72,945 |   | 88,725 |   |
| Loss on  disposition of furniture, fixtures and equipment                          |       | 6,791                                       |       | 10,257 |   | 4,107 |   |
| Impairment on  intangible assets                                                   |       | 43,266                                      |       | — |   | — |   |
| Changes in  operating assets and liabilities:                                      |       |                                        |       |   |   |   |   |
| Accounts  receivable                                                               |       | (146,750                                    | )          | (194,842 | ) | (226,625 | ) |
| Inventories                                                                        |       | 223,391                                     |       | 5,676 |   | 326,019 |   |
| Prepaid expenses  and other current assets                                         |       | (263,810                                    | )          | (625,742 | ) | 169,402 |   |
| Accounts payable                                                                   |       | (519,046                                    | )          | 492,819 |   | 188,334 |   |
| Accrued  liabilities                                                               |       | 54,131                                      |       | (650,545 | ) | 867,289 |   |
| Deferred revenue                                                                   |       | 417,424                                     |       | (103,822 | ) | 123,308 |   |
| Income taxes  payable                                                              |       | (125,325                                    | )          | 117,005 |   | (803,321 | ) |
| Net cash  provided by operating activities                                         |       | 2,567,568                                   |       | 787,860 |   | 3,912,749 |   |
| **Cash  Flows From Investing Activities:**                                         |       |                                        |       |   |   |   |   |
| Purchase of  furniture, fixtures and equipment                                     |       | (1,116,889                                  | )          | (505,084 | ) | (922,070 | ) |
| Proceeds from  sales of furniture, fixtures and equipment                          |       | 550                                         |       | — |   | — |   |
| Purchase of  investments available for sale                                        |       | (11,986,038                                 | )          | (20,956,112 | ) | (15,951,409 | ) |
| Proceeds from  sale of investments available for sale                              |       | 5,375,000                                   |       | 16,862,523 |   | 9,986,909 |   |
| Investment in  LLC                                                                 |       | (2,596,090                                  | )          | — |   | — |   |
| Expenditures  related to patents and intangible assets                             |       | (514,006                                    | )          | (538,936 | ) | (181,963 | ) |
| Net cash used in  investing activities                                             |       | (10,837,473                                 | )          | (5,137,609 | ) | (7,068,533 | ) |
| **Cash  Flows From Financing Activities:**                                         |       |                                        |       |   |   |   |   |
| Purchase of  treasury stock                                                        |       | (1,225,254                                  | )          | — |   | (266,607 | ) |
| Proceeds from  exercise of stock options                                           |       | 3,711,451                                   |       | 1,424,509 |   | 132,084 |   |
| Net cash  provided by (used in) financing activities                               |       | 2,486,197                                   |       | 1,424,509 |   | (134,523 | ) |
| **Net  Decrease in Cash and Cash Equivalents**                                     |       | (5,783,708                                  | )          | (2,925,240 | ) | (3,290,307 | ) |
| **Cash  and Cash Equivalents, Beginning of Period**                                |       | 12,795,620                                  |       | 15,720,860 |   | 19,011,167 |   |
| **Cash  and Cash Equivalents, End of Period**                                      |       | $                                           | 7,011,912  |   | $ | 12,795,620 |   | $ | 15,720,860 |   |
| **Supplemental  Disclosures of Cash Flow Information:**                            |       |                                        |       |   |   |   |   |
| Cash paid during  the period for:                                                  |       |                                        |       |   |   |   |   |
| Income taxes                                                                       |       | $                                           | 1,047,624  |   | $ | 1,129,334 |   | $ | 623,919 |   |
| **Supplemental  Disclosure of Non-Cash Investing and Financing Activities:**       |       |                                        |       |   |   |   |   |
| Unrealized  gain/(loss) on investments, net                                        |       | $                                           | 26,624     |   | $ | (247,782 | ) | $ | (14,509 | ) |
| Issuance of  Common stock for minority interest                                    |       | —                                      |       | $ | 960,012 |   | — |   |
| Tax benefit on  employee stock plans                                               |       | $                                           | 296,996    |   | $ | — |   | $ | — |   |

 

See accompanying notes toconsolidated financial statements

 

F-5

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**SRS LABS, INC.**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

** **

**1.   Organizationand Significant Accounting Policies**

** **

*Organization*

* *

SRS Labs is a leadingdeveloper and provider of application specific integrated circuits, or ASICs,standard integrated circuits, or ICs, and audio and voice technology solutionsfor the home entertainment, portable media device, personal telecommunications,personal computer, automotive and broadcast markets.

 

We operate in thefollowing two business segments:

 

*Semiconductors:  *Through SRSLabs, Inc.’s wholly-owned subsidiary, ValenceTech Limited, and ValenceTechLimited’s wholly-owned subsidiaries (collectively “Valence”), we operate afabless semiconductor business which develops, designs and markets standard andcustom, analog, digital signal processors, or DSPs, and mixed signal,integrated circuits primarily to original equipment manufacturers, or OEMs, andoriginal design manufacturers , or ODMs, in the Asia Pacific region.

 

*Licensing:**  ***Through SRSLabs, the parent company, the licensing segment develops and licenses audio andvoice technology solutions to many of the world’s leading OEMs, softwareproviders and semiconductor companies, and licenses and markets hardware andsoftware products for the Internet and professional audio markets.

 

As used herein, the “Company,”“SRS Labs,” “we,” “us,” or “our” means SRS Labs, Inc. and its wholly ownedsubsidiaries, including Valence and SRSWOWcast.com Inc.

 

In 2003, we reported ourrevenues in the following five segments: licensing, semiconductors, componentdistribution, product sales and Internet and broadcast. In 2004, we decided toreduce our segments to licensing and semiconductors because of the materialityof the revenues attributable to the other three segments. Revenue from thecomponent distribution segment is now reported in the semiconductor segment andrevenues from product sales and Internet and broadcast segments are nowreported in the licensing segment. Segment information for prior years has beenrestated to conform to the current year presentation.

 

*Basisof Presentation*

* *

The consolidatedfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America and include theCompany and its wholly- and majority-owned subsidiaries, Valence andSRSWOWcast, after elimination of all intercompany accounts and transactions.The net loss attributable to minority shareholders is shown separately in theconsolidated statements of operations.

 

*CashEquivalents*

* *

Cash and cashequivalents generally consist of cash, money market funds and other moneymarket instruments with original or remaining maturities of three months orless at the date of purchase. The Company maintains cash and cash equivalents,investments, and certain other financial instruments with various majorfinancial institutions. The Company performs periodic evaluations of therelative credit standing of these financial institutions.

 

F-6

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*Investments*

* *

The Company accounts forinvestments in accordance with Statement of Financial Accounting StandardsSFAS 115, “Accounting for Certain Investments in Debt and EquitySecurities.” Investments, consisting primarily of U.S. government securities,have been classified as available for sale and are reported at fair value,based on quoted market prices, in the accompanying consolidated balance sheets.Those securities with a maturation date of one year or less have beenclassified as current assets. Unrealized gains and losses, net of applicableincome taxes, are reported as a separate component of stockholders’ equity.

 

*Inventories*

* *

Inventories, whichconsist of finished goods, are stated at the lower of cost or net realizablevalue. Cost is calculated using the weighted average method and is comprised ofmaterial costs and, where applicable, subcontracting and overhead costs thathave been incurred in bringing the inventories to their present location andcondition. Net realizable value represents the estimated selling price lesscosts to be incurred in selling and distribution. Market is determined bycomparison with recent purchases or net realizable value. Net realizable valueis based on forecasts for sales of the Company’s products in the ensuing years.Should demand for the Company’s products prove to be significantly less thananticipated, the ultimate realizable value of the Company’s inventories couldbe substantially less than the amount shown on the accompanying consolidatedbalance sheets.

 

*Furniture,Fixtures and Equipment*

* *

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

 

*IntangibleAssets*

* *

Costs paid by theCompany related to the establishment and transfer of patents, primarily legalcosts, are capitalized and amortized, depending on the estimated life of thetechnology patented. These assets are being amortized over periods ranging fromthree to eleven years depending on the useful life of the asset.

 

The Company annuallyevaluates the recoverability of its patents and intangible assets based on theestimated future undiscounted cash flows. Should the carrying value of patentsor intangible assets exceed the estimated future undiscounted cash flows forthe expected periods of benefit, such assets would be written down to fairvalue. Based upon its most recent assessment, the Company has determined thatthere was impairment of $43,266 as of December 31, 2004, which is includedin G&A expenses.

 

*Capitalizationof 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 technological feasibility is established. UnderStatement of Financial Accounting Standards (“SFAS”) No. 86, “Accountingfor the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,”the company capitalizes software purchased from third parties if the relatedsoftware product under development has reached technological feasibility or ifthere are alternative future uses for the purchased software, provided thatcapitalized amounts will be realized over a period not exceeding five years.Costs incurred prior to the establishment of technological feasibility are chargedto research and development expense. The establishment of technologicalfeasibility and ongoing assessment of recoverability of capitalized softwaredevelopment costs require considerable judgment by management with respect tocertain external factors, including, but not limited to, anticipated futurerevenues, estimated economic life 

 

F-7

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and changes in softwareand hardware technologies. Under SFAS No. 86, annual amortization ofsoftware development costs should be the greater of the amount computed using(a) the ratio that current gross revenues for a product bear to the totalof current and anticipated future gross revenues for that product or(b) the straight-line method over the remaining estimated economic life ofthe product including the period being reported on. The Company, afterconsidering the two methods, is using the straight-line method of amortizationas the software can be used for many products and the estimates required to bemade under (a) could result in under reporting of expense. Upon thegeneral release of the software product to customers, capitalization ceases andsuch costs 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 and developmentexpenditures are charged to research and development expense in the periodincurred.

 

Capitalized software asof December 31, 2004 and 2003 is as follows:

 
| ** **                 | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Capitalized  software      |       | $                     | 464,568    |   | $ | 342,760 |   |
| Accumulated amortization   |       | (193,003              | )          | (96,401 | ) |
| Capitalized  software, net |       | $                     | 271,565    |   | $ | 246,359 |   |

 

The Company recordedamortization expense of $106,826, $28,401 and $24,000 for each of the yearsended December 31, 2004, 2003 and 2002 respectively. As ofDecember 31, 2004, the weighted average useful life of the Company’scapitalized software is approximately 2.4 years. The following table showsthe estimated amortization expense for those assets for each of the fivesucceeding fiscal years.

 
| **Year ending December 31,** | ** ** | **Estimated  Expense** | ** ** |
|---------------------------------------------|------------|------------------------|------------|
| 2005                                        |       | $                      | 102,239    |   |
| 2006                                        |       | 97,971                 |       |
| 2007                                        |       | 45,688                 |       |
| 2008                                        |       | 21,609                 |       |
| 2009                                        |       | 4,058                  |       |
|                                             |            |                        |            |  |

 

*Impairmentof long-lived assets*

* *

The Company evaluatesthe recoverability of long-lived assets with finite lives in accordance withStatement of Financial Accounting Standards SFAS 144, “Accounting for theImpairment of Long-Lived Assets.” The Company assesses potential impairments toits long-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 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 our most recent assessment as ofDecember 31, 2004, we have determined there was no impairment.

 

*Goodwill*

* *

Goodwill represents theexcess of purchase price and related costs over the value assigned to the nettangible and identifiable intangible assets of businesses acquired. Effectiveas of the beginning of fiscal 2002, the Company adopted Statement of FinancialAccounting Standards No. 142 (SFAS 142), “Goodwill 

 

F-8

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and Other IntangibleAssets,” which, among other things, establishes new standards for goodwillacquired in a business combination, eliminates the amortization of goodwill andrequires the carrying value of goodwill and identifiable intangibles to beevaluated for impairment on an annual basis. Starting in fiscal 2002, theCompany no longer records goodwill amortization. In accordance with SFASNo. 142, all of our intangible assets that have definite lives are beingamortized on a straight-line basis over their estimated useful lives andgoodwill is tested annually for impairment. Based upon our most recentassessment as of December 31, 2004, we have determined there was noimpairment.

 

*MinorityInterest in Consolidated Subsidiary*

* *

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

 

*Useof Estimates*

* *

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America necessarily requires management tomake estimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported revenues and expenses during thereporting periods. Actual results could materially differ from these estimates.

 

*RevenueRecognition*

* *

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. Commission income derived from our distribution activities is recognizedon an accrual basis in the period when earned.

 

*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.

 

*AdvertisingExpense*

* *

Advertising costs arecharged to expense as incurred. The company expensed $67,112, $505,514, and$297,769 for the years ended December 31, 2004, 2003 and 2002,respectively. Prepaid expenses includes advertising costs of $46,471 and $0 foryears ended December 31, 2004 and 2003, respectively.

 

F-9

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*IncomeTaxes*

* *

The Company accounts forincome taxes in accordance with Statement of Financial Accounting StandardNo. 109 (SFAS 109), “Accounting for Income Taxes.” Deferred taxes onincome result from temporary differences between the reporting of income forfinancial statement and tax reporting purposes. A valuation allowance relatedto a deferred tax asset is recorded when it is more likely than not that someportion or all of the deferred tax asset will not be realized.

 

*ForeignCurrency Translation*

* *

Our reporting currencyis the U.S. dollar, while the functional currency of Valence is the Hong Kongdollar. Assets and liabilities of Valence are translated at the rate ofexchange on the balance sheet date. Revenues and expenses are translated usingthe average exchange rate for the period. Translation adjustments resultingfrom the process of translating foreign currency financial statements into U.S.dollars are included as a separate component of stockholders’ equity(accumulated other comprehensive income). Foreign currency translation gainswere $0 during the years ended December 31, 2004, 2003 and 2002respectively. Transaction losses arising on exchange of foreign currency arerecognized as incurred in the statements of operations and aggregated $4,676,$6,689, and $468 during the years ended December 31, 2004, 2003 and 2002,respectively.

 

*NetIncome Per Common Share*

* *

The Company appliesStatement of Financial Accounting Standard No. 128 (SFAS 128), “Earningsper Share,” which requires the disclosure of basic and diluted net income orloss per share for all current and prior periods. Basic net income or loss percommon share is computed by dividing net income or loss available to commonstockholders by the weighted average number of common shares outstanding duringeach year. Diluted net income or loss per common share reflects the maximumdilution, based on the average price of our common stock each period and iscomputed similar to basic income or loss per share except that the denominatoris increased to include the number of additional shares that would have beenoutstanding if potentially dilutive stock options and warrants had beenexercised.

 

Basic and diluted netincome per share computed in accordance with SFAS 128 for the years endedDecember 31 are as follows:

 
| ** **                                               | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|----------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| BASIC EPS                                                |       |       |       |       |       |       |       |
| Net income                                               |       | $          | 1,578,521  |       | $          | 458,719    |       | $ | 806,352 |   |
| Denominator:  weighted average common shares outstanding |       | 13,950,457 |       | 13,033,002 |       | 12,648,373 |       |
| Net income per  share—basic                         |       | $          | 0.11       |       | $          | 0.04       |       | $ | 0.06 |   |
| DILUTED EPS                                              |       |       |       |       |       |       |       |
| Net income                                               |       | $          | 1,578,521  |       | $          | 458,719    |       | $ | 806,352 |   |
| Denominator:  weighted average common shares outstanding |       | 13,950,457 |       | 13,033,002 |       | 12,648,373 |       |
| Common  equivalent shares outstanding:                   |       |       |       |       |       |       |       |
| Options                                                  |       | 1,830,749  |       | 1,387,808  |       | 213,826    |       |
| Total shares                                             |       | 15,781,206 |       | 14,420,810 |       | 12,862,199 |       |
| Net income per  share—diluted                       |       | $          | 0.10       |       | $          | 0.03       |       | $ | 0.06 |   |
|                                                          |            |            |            |            |            |            |            |  |  |  |  |

 

There were 164,000,1,816,276, and 3,664,580 potentially dilutive options outstanding atDecember 31, 2004, 2003 and 2002, respectively, that were not includedabove because they would be anti-dilutive.

 

F-10

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*Stock-BasedCompensation*

* *

The Company accounts forstock-based employee compensation arrangements in accordance with theprovisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accountingfor Stock Issued to Employees,” Financial Accounting Standards BoardInterpretation No. 44 (“FIN 44”) “Accounting for Certain TransactionsInvolving Stock Compensation—an Interpretation of APB 25,” and complies withthe disclosure provisions of SFAS No. 148, “Accounting for Stock-BasedCompensation, Transition and Disclosure.” Under APB No. 25, compensationexpense is based on the difference, if any, on the date of the grant, betweenthe fair value of the Company’s stock and the exercise price. The Companyaccounts for stock issued to non-employees in accordance with the provisions ofSFAS No. 148 and the EITF Issue No. 96-18, “Accounting for EquityInstruments that are Issued to other than Employees for Acquiring, or inConjunction with Selling Goods or Services.”

 

The Company amortizesstock-based compensation using the straight-line method over the remainingvesting periods of the related options, which is generally four years. Proforma information regarding net loss and earnings per share is required to bedetermined as if we had accounted for employee stock options under the fairvalue method of SFAS No. 123, as amended by SFAS No. 148.

 

The following tableillustrates the effect on net income and income per share if the Company’s hadapplied the fair value recognition provisions of SFAS No. 123, as amendedby SFAS No. 148, to stock-based employee compensation:

 
| ** **                                                                                              | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Net income  (attributable to common shareholder)—as reported                                       |       | $          | 1,578,521  |       | $          | 458,719    |       | $ | 806,352 |   |
| Add: stock based  employee compensation expense included in reported net income, net of 40% tax  effect |       | 55,550     |       | 43,768     |       | 53,235     |       |
| Less fair value  of stock-based employee compensation expense                                           |       | (1,594,917 | )          | (2,277,304 | )          | (2,160,997 | )          |
| Net income  (loss) (attributable to common shareholder)—pro forma                                  |       | 39,154     |       | (1,774,817 | )          | (1,301,410 | )          |
| Net income  (loss) per share:                                                                           |       |       |       |       |       |       |       |
| Basic, as  reported                                                                                     |       | $          | 0.11       |       | $          | 0.04       |       | $ | 0.06 |   |
| Basic, pro forma                                                                                        |       | $          | 0.00       |       | $          | (0.14      | )          | $ | (0.10 | ) |
| Diluted, as  reported                                                                                   |       | $          | 0.10       |       | $          | 0.03       |       | $ | 0.06 |   |
| Diluted, pro  forma                                                                                     |       | $          | 0.00       |       | $          | (0.12      | )          | $ | (0.10 | ) |

 

The fair value of eachoption grant was estimated on the date of grant using the Black-Scholesoption-pricing model with the following weighted average assumptions used forgrants during the years ended December 31 with expected option lives offive years and a dividend rate of zero:

 
| ** **               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk free  interest rate |       | 3.5      | %          | 2.9      | %          | 3.6      | %          |
| Expected  volatility     |       | 75       | %          | 75       | %          | 87       | %          |

 

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

 

*FairValue of Financial Instruments*

* *

Management believes thecarrying amounts of cash and cash equivalents, accounts receivable and accountspayable approximate fair value due to the short period of time betweenorigination of the instruments and their expected realization. The carryingamounts of investments available for sale are reported at fair value based onquoted market prices (Note 2).

 

F-11

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*CustomerConcentration*

* *

For the fiscal yearended December 31, 2004 one customer accounted for approximately 10% ofrevenues. During the fiscal year ended December 31, 2003, one customeraccounted for approximately 11% of revenues. During the fiscal year endedDecember 31, 2002 two customers accounted for approximately 13% and 11% ofrevenues, respectively. At December 31, 2004, five customers accounted forapproximately 22%, 21%, 12%, 11% and 11% of total receivables respectively. AtDecember 31, 2003 three customers accounted for 29%, 19% and 12% of totalreceivables, respectively. Given the significant amount of revenues derivedfrom these customers, the loss of any such customer or the uncollectibility ofrelated receivables could have a material adverse effect on the Company’sfinancial condition and results of operations.

 

*Concentrationsof Credit Risk*

* *

Financial instruments,which potentially subject the Company to concentrations of credit risk, consistprimarily of cash equivalents, investments and trade accounts receivable. TheCompany places its cash in banks and its cash equivalents in commercial paperand money market funds at certain financial institutions in excess of amountsinsured by federal agencies. The Company does not believe that as a result ofthis concentration we are subject to any unusual financial risk beyond thenormal risk associated with commercial banking relationships. The Companyperforms periodic evaluations of the relative credit standing of thesefinancial institutions. Investments consist of U.S. government securities ratedAAA. The Company has not experienced any significant losses on its cashequivalents or investments.

 

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

 

*GeographicRisk*

* *

The Company’ssignificant operations in Hong Kong, the People’s Republic of China (“PRC”) andother parts of Asia have required, and will continue to require, refinement toadapt to the changing market conditions in the region. The Company’s operationsin Asia, and international operations in general, are subject to risks ofunexpected changes in, or impositions of legislative or regulatoryrequirements.

 

Customers geographicallylocated in the Asia Pacific markets accounted for approximately 86%, 93%, and90% of total Company sales in 2004, 2003 and 2002, respectively and areexpected to continue to account for a substantial percentage of sales in thefuture.

 

**RecentAccounting Pronouncements**

** **

In December 2003,the Financial Accounting Standards Board (FASB) issued FIN 46-R, “Consolidationof Variable Interest Entities—an interpretation of ARB 51 (revisedDecember 2003)”, which replaces FIN 46. FIN 46-R incorporatescertain modifications to FIN 46 adopted by the FASB subsequent to the issuanceof FIN 46, including modifications of the scope of FIN 46. For allnon-special purpose entities (“SPE”) created prior to February 1, 2003,public entities will be required to adopt FIN 46-R at the end of the firstinterim or annual reporting period ending after March 15, 2004. For allentities (regardless of whether the entity is an SPE) that were createdsubsequent to January 31, 2003, public entities are already required toapply the provisions of FIN 46, and should continue doing so unless they electto adopt the provisions of Fin 46-R early as of the first interim or annualreporting period ending 

 

F-12

----

 

after December 15,2003. If they do not elect to adopt FIN 46-R early, public entities wouldbe required to apply FIN 46-R to those post-January 31, 2003 entitiesas of the end of the first interim or annual reporting period ending afterMarch 15, 2004. The adoption of FIN 46-R for non-SPEs did not have amaterial impact on the Company’s financial position, results of operations orcash.

 

In June 2004, theFinancial Accounting Standards Board (FASB) issued EITF Issue No. 02-14, “Whetheran Investor Should Apply the Equity Method of Accounting to Investments OtherThan Common Stock.” EITF Issue No. 02-14 addresses whether the equitymethod of accounting applies when an investor does not have an investment invoting common stock of an investee but exercises significant influence throughother means. EITF Issue No. 02-14 states that an investor should onlyapply the equity method of accounting when it has investments in either commonstock or in-substance common stock of a corporation, provided that the investorhas the ability to exercise significant influence over the operating andfinancial policies of the investee. The accounting provisions of EITF IssueNo. 02-14 are effective for the first quarter of fiscal 2005. The Companyis in the process of determining the effect, if any, the adoption of EITF IssueNo. 02-14 will have on its financial statements.

 

In September 2004,the Financial Accounting Standards Board (FASB) issued FASB Staff Position(FSP) Emerging Issues Task Force (EITF) Issue 03-1-1, Effective Date ofParagraphs 10 - 20 of EITF Issue No. 03-1, “The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments,”which delays the effective date for the recognition and measurement guidance inEITF Issue No. 03-1. In addition, the FASB has issued a proposed FSP toconsider whether further application guidance is necessary for securitiesanalyzed for impairment under EITF Issue No. 03-1. We continue to assessthe potential impact that the adoption of the proposed FSP could have on ourfinancial statements.

 

On December 21,2004, the Financial Accounting Standards Board (FASB) issued FASB StaffPosition No. FAS 109-1, “Application of FASB Statement No. 109,Accounting for Income Taxes, to the Tax Deduction on Qualified ProductionActivities Provided by the American Jobs Creation Act of 2004” (“FSPNo. 109-1”), and FASB Staff Position No. FAS 109-2, “Accounting andDisclosure Guidance for the Foreign Earnings Repatriation Provision within theAmerican Jobs Creation Act of 2004” (“FSP No. 109-2”). These staffpositions provide accounting guidance on how companies should account for theeffects of the American Jobs Creation Act of 2004 (“AJCA”) that was signed intolaw on October 22, 2004. FSP No. 109-1 states that the tax relief(special tax deduction for domestic manufacturing) from this legislation shouldbe accounted for as a “special deduction” instead of a tax rate reduction. FSPNo. 109-2 gives a company additional time to evaluate the effects of thelegislation on any plan for reinvestment or repatriation of foreign earningsfor purposes of applying FASB Statement No. 109. The Company isinvestigating the repatriation provision to determine whether it mightrepatriate extraordinary dividends, as defined in the AJCA and the actualincome tax impact to the Company will become determinable once furthertechnical guidance has been issued.

 

**FutureAccounting Requirements**

** **

In November 2004,the Financial Accounting Standards Board (FASB) issued SFAS No. 151, “Inventorycosts, an amendment of ARB No. 43 Chapter 4.” This Statement amends theguidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify theaccounting for abnormal amounts of idle facility expense, freight, handlingcosts, and wasted material (spoilage). It requires that those items berecognized as current-period charges regardless of whether they meet thecriterion of “so abnormal.” In addition, this Statement requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities. The provisions of thisstatement shall be applied prospectively for inventory costs incurred duringfiscal years beginning after June 15, 2005. We do not expect the adoptionof this statement would have a material impact on our results of operations orfinancial position.

 

F-13

----

 

In December 2004,the Financial Accounting Standards Board (FASB) issued SFAS No. 123(R), “Share-BasedPayment” (“SFAS No. 123(R)”). This statement replaces SFAS No. 123, “Accountingfor Stock-Based Compensation” and supersedes APB No. 25, “Accounting forStock Issued to Employees*”* SFAS123(R) requires all stock-based compensation to be recognized as anexpense in the financial statements and that such cost be measured according tothe fair value of stock options. SFAS 123(R) will be effective forquarterly periods beginning after June 15, 2005. While the Companycurrently provides the pro forma disclosures required by SFAS No. 148, “Accountingfor Stock-Based Compensation—Transition and Disclosure,” on a quarterly basis(see “Note 2—Stock-Based Compensation”), it is currently evaluating the impactthis statement will have on its consolidated financial statements.

 

*Reclassifications*

* *

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

 

**2.   InvestmentSecurities Available for Sale**

** **

Investments withmaturities greater than one year from the balance sheet date are classified aslong-term investments. The Company invests its excess cash in US Treasury andAgency securities, and tax-exempt securities with approved financialinstitutions with a minimum investment grade of “A1.” The investments availablefor sale consist mainly of bonds and include only marketable securities withsecondary or resale markets to ensure portfolio liquidity.

 

The following tablesummarizes the Company’s investment securities available for sale: 

 
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2004**              | ** ** | **2003** | ** ** |
| U.S. Government  securities available for sale: |       |                  |       |   |   |
| Cost                                            |       | $                     | 17,489,688 |   | $ | 10,745,254 |   |
| Unrealized  losses                              |       | (228,421              | )          | (255,044 | ) |
| Estimated fair  value                           |       | $                     | 17,261,267 |   | $ | 10,490,210 |   |

 

The contractualmaturities of investments are shown below. Actual maturities may differ fromcontractual maturities.

 
| ** **                                    | ** ** | **December 31, 2004** | ** ** | **December 31, 2003** | ** ** |
|-----------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **Cost**                        | ** ** | **Estimated  Fair Value**  | ** ** | **Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| US Government  securities available for sale: |       |                            |       |                            |       |   |   |   |   |
| Due in one year  or less                      |       | $                               | —     |                            | $          | — |   | $ | — |   | $ | — |   |
| Due in one to  five years                     |       | 17,489,688                      |       | 17,261,267                      |       | 10,745,254 |   | 10,490,210 |   |
|                                          |       | $                               | 17,489,688 |                            | $          | 17,261,267 |   | $ | 10,745,254 |   | $ | 10,490,210 |   |
|                                               |            |                                 |            |                                 |            |  |  |  |  |  |  |  |  |  |

 

The following tablesummarizes sales of available for sale securities for the years endedDecember 31, 2004, 2003 and 2002. Specific identification was used todetermine costs in computing realized gains or losses.

 
| ** **          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Proceeds from  sale |       | $                                           | 5,375,000  |   | $ | 16,862,523 |   | $ | 9,986,909 |   |
| Realized gains      |       | $                                           | 139,375    |   | $ | 36,739 |   | $ | 98,224 |   |
| Realized losses     |       | $                                           | —     |   | $ | (16,713 | ) | $ | — |   |
|                     |            |                                             |            |  |  |  |  |  |  |  |  |

 

F-14

----

 

**3.   Investmentin LLC**

** **

On September 23,2004, the Company entered into a strategic alliance with Coming Home StudiosLLC (“CHS”) to produce and sell concert DVD’s which include the Company’sCircle Surround technology.  Inconnection with the strategic alliance, SRS and CHS entered into fouragreements:  a Strategic Alliance Agreement, the CHS/SRS LLC OperatingAgreement, a Warrant Agreement and a Production Services Agreement.

 

In the StrategicAlliance Agreement, CHS and SRS agree to work together to identify andimplement co-promotional opportunities, including trade shows, movie theaters,video streaming, concert DVDs, artist endorsements, bundling and premium deals,web-based promotional clips and road shows. The initial term of the agreementexpires on July 9, 2006 and is automatically renewable for successiveone-year terms.

 

The Operating Agreementgoverns CHS/SRS, LLC, which is a joint venture between CHS and SRS formed tocomplete and distribute concert videos featuring Duran Duran, Boz Scaggs,Godsmack and All Access.

 

Pursuant to theOperating Agreement each of CHS and SRS contributed capital with a value of$2,346,621. CHS is the managing member of the joint venture and is entitled toreceive a 5% management fee of all net revenues received. CHS’ capitalcontribution to CHS/SRS, LLC consists of the artist agreements and relatedcontracts pursuant to which CHS/SRS, LLC will produce and distribute theabove-referenced concert videos. SRS’ capital contribution is an aggregate of$2,346,621, consisting of a $700,000 bridge loan that SRS extended to CHS onJuly 9, 2004 in anticipation of the strategic alliance, plus $1,646,621 innew cash. In addition, the Company capitalized $177,111 consisting of costsassociated with the formation of the LLC and co-promotional projects. CHS’capital contribution consisted of the artist agreements with Duran Duran, BozScaggs, Godsmack and All Access pursuant to which the concert videos arefilmed, produced and distributed. CHS/SRS, LLC contracted with CHS to completeproduction of the concert videos pursuant to the Production Services Agreement.Profits from the distribution of the concert videos and related assets will beallocated and distributed equally until SRS and CHS have both received 1.75times their original capital contributions, after which profits will beallocated and distributed 90% to CHS and 10% to SRS. The joint venture isaccounted for using the equity method and profits are recognized following theguidance for equity method accounting. We recognize and accrue profits as weget sales and/or royalty reports. As of December 31, 2004, two of theconcert videos, Boz Scaggs and Godsmack have been released. Profits of $32,358generated from these videos have been recognized and included in “Equity inIncome of Investee” in the Consolidated Statements of Operations.

 

Under the WarrantAgreement, SRS paid CHS $40,000 to acquire a warrant to purchase up to 122,000units of Class A membership interests in CHS, which representsapproximately 10% of the equity of CHS, for an exercise price of $9.836 perunit, subject to adjustment based on valuation of CHS at the time of anadditional funding. The warrant is immediately vested and exercisable for up totwo years. It is transferable and contains customary antidilution and priceprotection provisions for warrants of this type.

 

Under the ProductionServices Agreement, CHS/SRS, LLC contracted with CHS as an independentcontractor to perform all production services and to provide all otherservices, personnel, materials and elements for the production, completion anddelivery of the concert videos. CHS, as the independent contractor, shallreceive an aggregate of $365,000 in production fees for all of its servicesunder the Production Services Agreement. CHS is responsible for payment of allcosts and expenses in connection with the production and completion of theconcert videos.

 

F-15

----

 

**4.   Furniture,Fixtures and Equipment**

** **

Furniture, fixtures andequipment, net, consist of the following:

 
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Furniture,  fixtures and equipment              |       | $                     | 1,664,129  |   | $ | 1,458,537 |   |
| Computer  equipment                             |       | 4,827,317             |       | 4,105,798 |   |
| Leasehold  improvements                         |       | 387,806               |       | 277,005 |   |
|                                            |       | 6,879,252             |       | 5,841,340 |   |
| Less accumulated  depreciation and amortization |       | (4,883,673            | )          | (4,179,360 | ) |
|                                            |       | $                     | 1,995,579  |   | $ | 1,661,980 |   |

 

Depreciation expense isreflected in operating expenses totaling $775,949, $703,727, and $655,340 forthe years ended December 31, 2004, 2003 and 2002, respectively in theaccompanying financial statements based on applicable asset use.

 

**5.   Acquisitionof Minority Interest in SRSWOWcast**

** **

On February 28,2003, the Company purchased the minority interest of the shareholders ofSRSWOWcast, also known as WOWcast, in which SRS Labs acquired all3,000,000 shares of Series A Convertible Preferred Stock in exchange forthe issuance of 332,184 shares of SRS Labs common stock trading at $2.89per share at the close of day on the transaction date. The acquisition resultedin a purchase price of $960,012.

 

SRSWOWcast develops andmarkets professional software and hardware products and consumer softwareplugins that incorporate proprietary audio enhancement, voice and surroundsound technologies. SRS Labs, as the majority shareholder has consistentlyincluded the results of SRS WOWcast in all previously reported consolidatedfinancial statements. The acquisition was a strategic initiative, which allowsthe Company to own 100% of the rights to the license of the Circle Surroundtechnology. Full ownership of the technology license will aid in the deploymentand marketing of such and will help the Company to compete more effectively.

 

The following tablesummarizes the stated values of the assets acquired and liabilities assumed atthe date of acquisition:

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

 

Current assets primarilyconsisted of cash, accounts receivable and prepaid expenses and current liabilitieswere valued at stated value. Property and equipment was valued at net bookvalue. The $640,071 of acquired intangible assets was assigned to a licenseagreement between SRS Labs, Inc and SRSWOWcast, which is being amortizedover 10 years.

 

**6.   Goodwilland Intangible Assets**

** **

On January 1, 2002the Company adopted Statement of Financial Accounting Standard No. 142(SFAS 142) “Goodwill and Other Intangible Assets,” which, among other things,establishes new standards for goodwill acquired in a business combination,eliminates the amortization of goodwill and requires the carrying value ofgoodwill and identifiable intangibles to be evaluated for impairment on anannual basis.

 

F-16

----

 

In accordance with SFASNo. 142, all of our intangible assets that have definite lives are beingamortized on a straight-line basis over their estimated useful lives andgoodwill is evaluated to determine if fair value of the asset has decreasedbelow its carrying value. At December 31, 2004 and December 31, 2003,we evaluated goodwill and determined that no adjustment to impair goodwill wasnecessary.

 

Goodwill and intangibleassets consist of the following:

 
| ** **                                                                                                                                                                      | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                      | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Goodwill                                                                                                                                                                        |       | $                     | 533,031    |   | $ | 533,031 |   |
| Patents                                                                                                                                                                         |       | $                     | 2,038,582  |   | $ | 1,760,236 |   |
| Accumulated  amortization                                                                                                                                                       |       | (891,178              | )          | (739,792 | ) |
| Patents, net                                                                                                                                                                    |       | 1,147,404             |       | 1,020,444 |   |
| Other  Intangibles:                                                                                                                                                             |       |                  |       |   |   |
| Assets acquired  in the purchase of our subsidiary Valence Technology in 1998: Covenant not to  compete, Developed Technology, ASP brand name, Cell Library, and Customer  List |       | 4,910,400             |       | 4,910,400 |   |
| Asset acquired  in purchase of our subsidiary SRSWOWcast in February 2003                                                                                                  |       | 640,071               |       | 640,071 |   |
| Poly Planar  purchased technology for speaker products                                                                                                                          |       | 120,000               |       | 120,000 |   |
| Capitalized  software and hardware for several technologies                                                                                                                     |       | 394,840               |       | 222,758 |   |
| Total of Other  Intangibles                                                                                                                                                     |       | 6,065,311             |       | 5,893,229 |   |
| Accumulated  amortization, other intangibles                                                                                                                                    |       | (4,551,760            | )          | (4,176,863 | ) |
| Other  intangibles, net                                                                                                                                                         |       | 1,513,551             |       | 1,716,366 |   |
| Intangible  assets, net                                                                                                                                                         |       | $                     | 2,660,955  |   | $ | 2,736,810 |   |

 

Amortization periodsrange from three to eleven years depending on the estimated useful life of theasset. Amortization expense consists of the following:

 
| ** **                                                                                     | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Patents                                                                                        |       | $                                          | 161,475    |   | $ | 149,427 |   | $ | 133,594 |   |
| Other  intangibles:                                                                            |       |                                       |       |   |   |   |   |
| Covenant not to  compete, developed technology, ASP brand name, cell library and customer list |       | 211,158                                    |       | 214,506 |   | 385,988 |   |
| Asset acquired  in purchase of our subsidiary SRSWOWcast in February                           |       | 64,007                                     |       | 53,339 |   | — |   |
| Poly Planar  purchased technology                                                              |       | 24,000                                     |       | 24,000 |   | 24,000 |   |
| Capitalized  software and hardware                                                             |       | 85,955                                     |       | 3,776 |   | — |   |
| Total intangible  amortization expense                                                         |       | $                                          | 546,595    |   | $ | 445,048 |   | $ | 543,582 |   |
|                                                                                                |            |                                            |            |  |  |  |  |  |  |  |  |

 

F-17

----

 

As of December 31,2004, the weighted average useful life of the Company’s patents and intangibleassets is approximately 3.6 years. The following table shows the estimatedamortization expense for those assets for each of the five succeeding fiscalyears.

 
| **Year ending December 31,** | ** ** | **Estimated expense** | ** ** |
|---------------------------------------------|------------|----------------------------|------------|
| 2005                                        |       | $                          | 601,862    |   |
| 2006                                        |       | 591,068                    |       |
| 2007                                        |       | 511,955                    |       |
| 2008                                        |       | 271,842                    |       |
| 2009                                        |       | 160,499                    |       |
| Thereafter                                  |       | 523,729                    |       |
|                                             |            |                            |            |  |

 

**7.   FinancingArrangements**

** **

In November 1999,Valence obtained a credit facility and access to import/export tradeinstruments with a bank that was secured by certain assets of Valence ondeposit. Total availability during the life of the facility ranged from$2,000,000 to $5,000,000, depending on the type of instrument provided for. Theline of credit was not renewed as of December 31, 2003, the associatedcollateral was released, and as of December 31, 2003 and 2002, there wereno outstanding obligations under this credit facility.

 

**8.   Commitmentsand Contingencies**

** **

The Company leasesoffice space and certain equipment under non-cancelable operating leasesexpiring through 2008. The Company leases its corporate office and storagefacilities located in Santa Ana, California, under a lease agreement with apartnership that is affiliated with a principal stockholder and executiveofficer of the Company. The lease is for a term of three years, commencingJune 1, 2002, with an option to extend the term for an additional threeyears thereafter. Additionally, the Company leases office and warehousefacilities in Hong Kong from unrelated parties. Total rent expense was$370,788, $550,854, and $482,057 for the years ended December 31, 2004,2003, and 2002, respectively, of which $210,600, $208,260, and $198,900 waspaid to related parties, respectively.

 

Future annual minimumlease payments under non-cancelable operating leases at December 31, 2004,are as follows:

 
| **Year ending December 31,** | ** ** | **Facility** | ** ** | **Facility-Related  Party** | ** ** | **Office  Equipment** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|--------------|------------|-----------------------------|------------|-----------------------|------------|-----------|------------|
| 2005                                        |       | $            | 145,250    |                        | $          | 87,750                |       | $         | 12,869     |   | $ | 245,869 |   |
| 2006                                        |       | 159,083      |       | —                      |       | 12,869                |       | 171,952   |       |
| 2007                                        |       | —       |       | —                      |       | 11,824                |       | 11,824    |       |
| 2008                                        |       | —       |       | —                      |       | 3,024                 |       | 3,024     |       |
| 2009                                        |       | —       |       | —                      |       | —                |       | —    |       |
| Total                                       |       | $            | 304,333    |                        | $          | 87,750                |       | $         | 40,586     |   | $ | 432,669 |   |

 

*Litigation*

* *

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

 

F-18

----

 

*Indemnifications*

* *

The Company enters intostandard license agreements in its ordinary course of business. Pursuant tothese agreements, the Company agrees to indemnify its customers for lossessuffered or incurred by them as a result of any patent, copyright, or otherintellectual property infringement claim by any third party with respect to theCompany’s products. These agreements generally have perpetual terms. Themaximum amount of indemnification the Company could be required to make underthese agreements is generally limited to the license fees received by theCompany. The Company estimates the fair value of its indemnification obligationas insignificant, based upon its history of litigation concerning product andpatent infringement claims. Accordingly, the Company has no liabilitiesrecorded for indemnification under these agreements as of December 31,2004.

 

The Company hasagreements whereby our officers and directors are indemnified for certainevents or occurrences while the officer or director is, or was serving, at ourrequest in such capacity. The maximum potential amount of future payments wecould be required to make under these indemnification agreements is unlimited;however, we have a directors and officers insurance policy that reduces ourexposure and enables us to recover a portion of any future amounts paid. As aresult of our insurance policy coverage, we believe the estimated fair value ofthese indemnification agreements is minimal. Currently, we have no liabilitiesrecorded for these agreements as of December 31, 2004.

 

*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, 2004. The Company assesses the need for a warranty reserve ona quarterly basis. There can be no guarantee that a warranty reserve will notbecome necessary in the future.

 

*EmploymentContracts*

* *

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

 

**9.   IncomeTaxes**

** **

The components of income(loss) from continuing operations before income taxes are as follows:

 
| ** ** | ** ** | **Years ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| U.S.       |       | $                                           | 615,196    |   | $ | (562,239 | ) | $ | (1,044,099 | ) |
| Foreign    |       | 1,773,741                                   |       | 2,059,421 |   | 2,438,784 |   |
| Total      |       | $                                           | 2,388,937  |   | $ | 1,497,182 |   | $ | 1,394,685 |   |

 

 

F-19

----

 

 

The provision for incometaxes consists of the following:

 
| ** **                          | ** ** | **Years ended December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------------|------------|
| ** **                          | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Current:                            |       |                                        |       |   |   |   |   |
| Federal                             |       | $                                           | 23,356     |   | $ | — |   | $ | (140,141 | ) |
| State                               |       | 7,873                                       |       | 1,600 |   | (99,455 | ) |
| Foreign                             |       | 778,803                                     |       | 1,067,761 |   | (5,354 | ) |
| Total                               |       | 810,032                                     |       | 1,069,361 |   | (244,950 | ) |
| Deferred:                           |       |                                        |       |   |   |   |   |
| Federal                             |       | 106,117                                     |       | (292,145 | ) | (215,388 | ) |
| State                               |       | 46,699                                      |       | (113,085 | ) | (9,840 | ) |
| Foreign                             |       | 384                                         |       | (30,897 | ) | (130,007 | ) |
| Change in  valuation allowance, net |       | (152,816                                    | )          | 405,229 |   | 1,188,518 |   |
| Total                               |       | 384                                         |       | (30,898 | ) | 833,283 |   |
| Total income tax  provision         |       | $                                           | 810,416    |   | $ | 1,038,463 |   | $ | 588,333 |   |

 

The reconciliation ofthe income tax expense (benefit) computed at U.S. federal statutory rates tothe provision for income taxes is as follows:

 
| ** **                               | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------|------------|---------------------------------------------|------------|
| ** **                               | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Tax at U.S.  federal statutory rates     |       | $                                           | 812,239    |   | $ | 509,042 |   | $ | 474,193 |   |
| State income  taxes, net of federal      |       | 37,583                                      |       | (16,690 | ) | 81,372 |   |
| Tax exempt  interest                     |       | —                                      |       | — |   | (88,155 | ) |
| Change in  valuation allowance, net      |       | (152,816                                    | )          | 405,229 |   | 1,188,518 |   |
| Foreign  withholding tax                 |       | 489,498                                     |       | 415,423 |   | 338,644 |   |
| Change in tax  credits                   |       | —                                      |       | — |   | (480,388 | ) |
| Change in  estimated payable amounts     |       | —                                      |       | — |   | (882,717 | ) |
| Foreign tax rate  differential and other |       | (376,088                                    | )          | (274,541 | ) | (43,134 | ) |
| Total income tax  expense                |       | $                                           | 810,416    |   | $ | 1,038,463 |   | $ | 588,333 |   |

 

Deferred income taxesreflect the net tax effects of temporary differences between the carryingamounts of assets and liabilities for financial reporting purposes and theamounts used for income tax purposes. Significant components of the Company’sdeferred tax assets and liabilities are as follows:

 
| ** **                        | ** ** | **December 31,** | ** ** |
|-----------------------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Deferred tax  assets:             |       |                  |       |   |   |
| Depreciation and  amortization    |       | $                     | 1,204,088  |   | $ | 1,507,181 |   |
| Accruals                          |       | 558,198               |       | 382,510 |   |
| Net operating  loss carryforwards |       | 8,095,361             |       | 7,394,662 |   |
| Tax credit  carryforwards         |       | 1,231,090             |       | 598,001 |   |
| Other                             |       | (211,102              | )          | (211,106 | ) |
| Foreign income  taxes             |       | (170,256              | )          | (169,872 | ) |
| Valuation  allowance              |       | (10,491,223           | )          | (9,284,836 | ) |
| Total net  deferred tax assets    |       | $                     | 216,156    |   | $ | 216,540 |   |

 

The Company has federaland state net operating loss carryforwards at December 31, 2004, ofapproximately $21,555,000 and $13,141,000 respectively. These net operatingloss carryforwards began to

 

F-20

----

 

expire in 2003 and willcontinue to expire through 2024. In addition, the Company has federal taxcredit carryforwards of approximately $1,150,733 at December 31, 2004,which will begin to expire in 2011.

 

As of December 31,2004, a valuation allowance of $10,491,223 has been provided based on theCompany’s assessment of the future realizability of certain deferred taxassets. The valuation allowance on deferred tax assets relates to futuredeductible temporary differences, capital loss carry forwards, foreign creditcarryforwards and net operating loss carryforwards for which the Company hasconcluded it is more likely than not that these items will not be realized inthe ordinary course of operations. Management periodically evaluates therecoverability of the deferred tax assets and recognizes the tax benefit onlyas reassessment demonstrates they are realizable. At such time it is determinedthat it is more likely than not that the deferred tax assets are realizable,the valuation allowance is adjusted. This assessment is based on projections offuture taxable income, which is impacted in future periods, by income beforetaxes and stock option exercises. The amount of the net deferred tax assetsconsidered realizable, however, could be reduced in the near term if actualfuture earnings are lower than estimated, or if there are differences in thetiming or amount of future reversals of existing taxable temporary differences.For the period ended December 31, 2004, the release of the valuationallowance disclosed in the tax Rate Reconciliation was due to the use of netoperating losses that were fully reserved with a valuation allowance. Theoverall increase in the valuation allowance, as disclosed in the table abovefor the Deferred Assets and Liabilities, is due to additional net operatinglosses attributable to the exercise of non-qualified stock options. The effectof the valuation allowance related to these stock options has been reported inequity.

 

Undistributed earningsof the Company’s foreign subsidiaries are considered to be indefinitelyreinvested and, accordingly, no provision for U.S. federal and state incometaxes has been provided thereon. Upon distribution of those earnings in theform of dividends or otherwise, the Company would be subject to U.S. incometaxes and possibly withholding taxes payable to the foreign countries, but maybe able to offset unrecognized foreign tax credit carryforwards. Determinationof the amount of unrecognized deferred income tax liability is not practicablebecause of the complexities associated with its hypothetical calculation.

 

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

 

On December 21,2004, the Financial Accounting Standards Board (“FASB”) issued FASB StaffPosition No. FAS 109-1, “Application of FASB Statement No. 109,Accounting for Income Taxes, to the Tax Deduction on Qualified ProductionActivities Provided by the American Jobs Creation Act of 2004” (“FSPNo. 109-1”), and FASB Staff Position No. FAS 109-2, “Accounting andDisclosure Guidance for the Foreign Earnings Repatriation Provision within theAmerican Jobs Creation Act of 2004” (“FSP No. 109-2”). These staffpositions provide accounting guidance on how companies should account for theeffects of the American Jobs Creation Act of 2004 (“AJCA”) that was signed intolaw on October 22, 2004. FSP No. 109-1 states that the tax relief(special tax deduction for domestic manufacturing) from this legislation shouldbe accounted for as a “special deduction” instead of a tax rate reduction. FSPNo. 109-2 gives a company additional time to evaluate the effects of thelegislation on any plan for reinvestment or repatriation of foreign earningsfor purposes of applying FASB Statement No. 109. The Company isinvestigating the repatriation provision and expects, on or before the fourthquarter of 2005, to make the determination as to whether it will repatriateextraordinary dividends, as defined in the AJCA and the actual income taximpact to the Company of such a repatriation, should it be made.

 

F-21

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**10.   Stockholders’Equity**

** **

*StockRepurchases*

* *

During the fiscal yearended December 31, 1998, the Company’s Board of Directors authorized therepurchase of up to 500,000 of the outstanding shares of the Company’s commonstock for a period from December 23, 1998 to December 31, 1999 (the “1998Repurchase Program”). Under the 1998 Repurchase Program, 71,100 shares had beenrepurchased at a cost of $263,281. On September 17, 2001, the Company’sBoard of Directors authorized the repurchase of up to 250,000 of theoutstanding shares of the Company’s common stock for a period fromSeptember 17, 2001 to March 17, 2002 (the “2001 Repurchase Program”).As of December 31, 2001, 53,800 shares had been repurchased at a cost of$188,713 under the 2001 Repurchase Program. On May 9, 2002, the Company’sBoard of Directors authorized the repurchase of up to 500,000 of theoutstanding shares of the Company’s common stock for a period from May 10,2002 to November 10, 2002 (the “2002 Repurchase Program”). As ofDecember 31, 2002, 100,400 shares had been purchased at a cost of $266,607under the 2002 Repurchase Program. All repurchased shares under the 1998, 2001and 2002 Repurchase Programs are reflected as treasury stock in theaccompanying consolidated balance sheets. On June 30, 2004, the Company’sBoard of Directors authorized a stock repurchase of up to $3,000,000 of itsoutstanding common stock for a period of six months from July 1, 2004 toDecember 31, 2004. The following table shows activity under the 2004Repurchase Program for the year ending December 31, 2004:

 

**ISSUERPURCHASES OF EQUITY SECURITIES**

 
| ** **              | ** ** | **(a)**                                      | ** ** | **(b)**                                      | ** ** | **(c)**                                                                                                   | ** ** | **(d)**                                                                                                                                                      | ** ** |
|-------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Period**              | ** ** | **Total  Number of  Shares  Purchased** | ** ** | **Average  Price Paid  per Share** | ** ** | **Total Number  of Shares  Purchased as  Part of Publicly  Announced Plan** | ** ** | **Approximate  Dollar Value of  Shares that May  Yet Be Purchased  Under the Plan as  of Period End** | ** ** |
| August 1-31,  2004 |       | 31,114                                       |       | $                                            | 4.87       |                                                                                                      | 31,114     |                                                                                                                                                         | $          | 2,848,330 |   |
| Sept 1-30, 2004         |       | 2,543                                        |       | $                                            | 5.03       |                                                                                                      | 2,543      |                                                                                                                                                         | $          | 2,835,539 |   |
| Nov 1-30, 2004          |       | 134,550                                      |       | $                                            | 5.75       |                                                                                                      | 134,550    |                                                                                                                                                         | $          | 2,062,449 |   |
| Dec 1-31, 2004          |       | 48,368                                       |       | $                                            | 5.95       |                                                                                                      | 48,368     |                                                                                                                                                         | $          | 0 |   |
| Total                   |       | 216,575                                      |       | $                                            | 5.66       |                                                                                                      | 216,575    |                                                                                                                                                         | $          | 0 |   |

 

*StockAward/Option Plans/Warrants*

* *

On December 10,1993, the Company’s Board of Directors and shareholders adopted an IncentiveStock Option, Nonqualified Stock Option and Restricted Stock Purchase Plan (the“1993 Plan”). Under the 1993 Plan, 801,971 shares of the Company’s common stockare reserved for issuance to executives, employees and non-employee directorsof the Company at the discretion of the Board of Directors or the committeeadministering the 1993 Plan. The Compensation Committee of the Board or, in theabsence of a Compensation Committee, the Board, has been appointed toadminister the 1993 Plan. Options issued under the 1993 Plan vest in the mannerprescribed by the Compensation Committee or the Board, as applicable. As ofDecember 31, 2004, options to purchase 115,370 shares of the Company’scommon stock were outstanding under the 1993 Plan.

 

In January 1994,the Company entered into stock option agreements with two Company officerswhereby options to purchase 181,032 shares of the Company’s common stock weregranted to each of the officers at an exercise price of $0.14 per share(collectively, the “Executive Option Agreements”). As of December 31,2004, there were no options outstanding under the Executive Option Agreements.

 

F-22

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In June 1997, theCompany’s Board of Directors adopted and the Company’s stockholders approvedthe Amended and Restated 1996 Long-Term Incentive Plan (the “1996 Plan”), forwhich 2,000,000 shares of the Company’s common stock were reserved for issuanceto officers, employees and consultants of the Company. If any award grantedunder the 1996 Plan expires, terminates or is forfeited before the exercisethereof or the payment in full thereof, the shares covered by the unexercisedor unpaid portion will become available for new grants under the 1996 Plan. InJune 1998, the Company’s Board of Directors adopted and the Company’sstockholders approved an amendment to the 1996 Plan to increase the number ofshares in the plan by 2,500,000. Also in June 1998, in a separateamendment, the Company’s Board of Directors and the Company’s stockholdersapproved an amendment to allow all directors of the Company and any subsidiaryof the Company to participate in the 1996 Plan. In June 2000, the Company’sBoard of Directors adopted and the Company’s stockholders approved an amendmentto the 1996 Plan to increase the number of shares in the plan by 2,500,000. InJune 2003, the Company’s Board of Directors adopted and the Company’sshareholders approved an amendment to the 1996 Plan to increase the number ofshares in the plan by 1,500,000. The Compensation Committee or, in the absenceof a Compensation Committee, the Board of Directors, has been appointed toadminister the 1996 Plan. Options issued under the 1996 Plan vest in the mannerprescribed by the Compensation Committee or the Board, as applicable. As ofDecember 31, 2004, options to purchase 4,491,171 shares of the Company’scommon stock were outstanding under the 1996 Plan.

 

In July 1996, theCompany’s Board of Directors adopted and the Company’s stockholders approvedthe 1996 Non-employee Directors Stock Option Plan (the “Non-employee DirectorsPlan”), a non-discretionary formula plan for which 120,000 shares of theCompany’s common stock are reserved for issuance to the Company’s non-employeedirectors. A committee consisting of all directors who are not eligible toparticipate in the Non-employee Directors Plan administers the Non-employeeDirectors Plan. With the exception of the initial option granted to a non-employeedirector, which vests immediately, options granted under the Non-employeeDirectors Plan vest over a three-year period, the first installment vesting onthe date of grant. In June 1999, the shareholders approved the Amended andRestated 1996 Non-employee Directors’ Stock Option Plan (the “AmendedNon-employee Directors Plan”). Among the changes set forth in the AmendedNon-employee Directors Plan was to increase by 130,000 the number of shares ofcommon stock that may be issued. In June 2001, the Company’s Board ofDirectors adopted and the Company’s stockholders approved an amendment to theAmended Non-employee Directors Plan to increase the number of shares in theplan by 250,000. As of December 31, 2004, options to purchase 115,000shares of common stock were outstanding under the Amended Non-employeeDirectors Plan.

 

In connection with theMicrosoft Transaction, Microsoft had a three-year warrant to purchase 100,000shares of common stock of the Company at an exercise price per share of $17.21.The Company’s subsidiary, SRSWOWcast, also issued to Microsoft a three-yearwarrant to purchase up to 2,500,000 shares of its common stock at an price pershare of $2.00 as specified in the SRSWOWcast.com, Inc. Common StockPurchase Warrant Agreement dated March 8, 2000 (the “SRSWOWcast Warrant”).The fair value of these warrants, totaling $2,555,783, was recorded as non-cashstock issuance cost by the Company during fiscal 2000. Fair value wascalculated using the Black-Scholes option-pricing model with the followingweighted average assumptions: expected life—36 months; stockvolatility—96%; and risk-free interest rate—6.54%. During the term of bothwarrant agreements, no shares were purchased and as of December 31, 2003,the warrants had expired.

 

F-23

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The following tablesummarizes stock option activity under the Company’s stock option and warrantplans for the periods indicated:

 
| ** **                             | ** ** | **Options  Outstanding** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|----------------------------------------|------------|--------------------------|------------|--------------------------------------------|------------|
| Outstanding at  January 1, 2002   |       | 5,402,328                |       | $                                          | 4.44       |   |
| Granted                                |       | 1,631,400                |       | $                                          | 2.85       |   |
| Stock options  exercised               |       | (86,670                  | )          | $                                          | 1.52       |   |
| Forfeited                              |       | (922,116                 | )          | $                                          | 4.09       |   |
| Outstanding at  December 31, 2002 |       | 6,024,942                |       | $                                          | 4.11       |   |
| Granted                                |       | 561,400                  |       | $                                          | 4.17       |   |
| Stock options  exercised               |       | (473,784                 | )          | $                                          | 3.01       |   |
| Forfeited                              |       | (654,723                 | )          | $                                          | 5.97       |   |
| Outstanding at  December 31, 2003 |       | 5,457,835                |       | $                                          | 3.99       |   |
| Granted                                |       | 1,199,000                |       | $                                          | 6.34       |   |
| Stock options  exercised               |       | (989,134                 | )          | $                                          | 3.75       |   |
| Forfeited                              |       | (946,160                 | )          | $                                          | 5.23       |   |
| Outstanding at  December 31, 2004 |       | 4,721,541                |       | $                                          | 4.38       |   |

 

The weighted averagefair value of options granted during 2004, 2003 and 2002 was $6.49, $4.15, and$2.77 respectively. Options granted during 2004 generally vest over termsranging from three years to five years and the options generally expire in10 years.

 

The following tablesummarizes information concerning currently outstanding and exercisable optionsand warrants:

 
| **Range of Exercise Prices** | ** ** | **Number of  Options  Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Exercisable  As of  12/31/2004** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|---------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------------------|------------|--------------------------------------------|------------|-----------------------------------------|------------|--------------------------------------------|------------|
| $0.00 - $1.90                               |       | 0                                        |       | 0.0                                                     |       | $                                          | 0.0000     |                                    | 0          |                                       | $          | 0.0000 |   |
| $1.91 - $3.80                               |       | 2,249,752                                |       | 6.2                                                     |       | $                                          | 2.9565     |                                    | 1,587,804  |                                       | $          | 3.0025 |   |
| $3.81 - $5.70                               |       | 1,460,789                                |       | 4.3                                                     |       | $                                          | 4.9529     |                                    | 1,129,452  |                                       | $          | 5.0149 |   |
| $5.71 - $7.60                               |       | 918,500                                  |       | 8.5                                                     |       | $                                          | 6.2700     |                                    | 130,875    |                                       | $          | 6.6034 |   |
| $7.61 - $9.50                               |       | 52,500                                   |       | 2.3                                                     |       | $                                          | 8.6190     |                                    | 52,500     |                                       | $          | 8.6190 |   |
| $9.51 - $11.40                              |       | 20,000                                   |       | 5.4                                                     |       | $                                          | 10.5625    |                                    | 20,000     |                                       | $          | 10.5625 |   |
| $17.10 - $19.00                             |       | 20,000                                   |       | 5.2                                                     |       | $                                          | 19.0000    |                                    | 20,000     |                                       | $          | 19.0000 |   |
|                                        |       | 4,721,541                                |       | 6.0                                                     |       | $                                          | 4.3819     |                                    | 2,940,631  |                                       | $          | 4.1962 |   |

 

On March 5, 1999,pursuant to a technology license agreement entered into by the Company and acustomer, options were granted to the customer to purchase up to 50,000 sharesof common stock at an exercise price of $3.94 per share. The fair value of thegrant is being recognized as compensation expense ratably over the vestingperiod of the options. The Company recognized $2,588 of compensation expenserelating to these options in fiscal 2002. In addition to the 50,000 optionsgranted in 1999, the Company has an obligation to grant up to 200,000additional options if the customer meets specified performance criteria asdefined by the agreement. All 250,000 options have expired under the terms ofthe license agreement, and none were ever exercised. In addition, during theyears ended December 31, 2004, 2003 and 2002, the Company recorded$92,585, $72,945, and $88,725 respectively, of deferred compensation expenserelated to stock options granted to non-employee contractors.

 

F-24

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**11.   Saleof Stock by Subsidiary**

** **

On September 29,2000, the Company’s wholly-owned subsidiary SRSWOWcast and certain investors,which included shareholders, directors and an executive officer of the Company,entered into a Series A Preferred Stock and Warrant Purchase Agreement(the “Private Placement Agreement”) relating to the purchase and sale of3,000,000 shares of SRSWOWcast Series A Convertible Preferred Stock (“PreferredStock”) for a purchase price of $2.00 per share or $6,000,000 in the aggregate(the “Private Placement”). Pursuant to the Private Placement Agreement,investors received an immediately exercisable, three year warrant evidencing aright to purchase one-tenth of a share of SRSWOWcast’s common stock for eachshare of Preferred Stock purchased by such investor, exercisable at $2.50 perwhole share. The fair value of the warrants was zero at the date of issuance.In accordance with SAB No. 51, “Accounting for Sales of Stock by aSubsidiary,” the Company recorded $5,154,995 of additional paid-in capitalassociated with the Private Placement. In February 2003, the Companycompleted an exchange offer with the minority shareholders of SRSWOWcast,pursuant to which SRS Labs acquired all 3,000,000 outstanding shares ofSRSWOWcast Series A Convertible Preferred Stock in exchange for theissuance of 332,184 shares of SRS Labs common stock. As a result of theexchange offer, an intangible asset in the amount of $640,071 was recorded andSRSWOWcast became a wholly owned subsidiary of SRS Labs.

 

**12.   SegmentInformation**

** **

The Company operates twobusiness segments—semiconductors and licensing. In 2003, the Company reportedits revenues in the following five segments: licensing, semiconductors,component distribution, product sales, and Internet and broadcast. In 2004, theCompany decided to reduce its segments to licensing and semiconductor becausethe revenue attributable to the discontinued segments were not materialcompared to revenues relating to semiconductors and licensing. Segmentinformation for the 2003 segments has been restated to conform to the currentyear presentation. Revenue from the component distribution segment is nowreported in the semiconductor segment and revenues from product sales andInternet and broadcast segments are now reported in the licensing segment.

 
| ** **       | ** ** | **Valence  Semiconductor** | ** ** | **SRS Labs  Licensing** | ** ** | **Total**  | ** ** |
|------------------|------------|----------------------------|------------|------------------------------|------------|------------|------------|
| **Fiscal  2004** |       |                       |       |                         |       |       |       |
| Total revenues   |       | $                          | 10,770,684 |                         | $          | 10,831,704 |       | $ | 21,602,388 |   |
| Cost of sales    |       | 3,725,062                  |       | 228,147                      |       | 3,953,209  |       |
| Gross margin     |       | $                          | 7,045,622  |                         | $          | 10,603,557 |       | $ | 17,649,179 |   |
| **Fiscal  2003** |       |                       |       |                         |       |       |       |
| Total revenues   |       | $                          | 10,712,382 |                         | $          | 9,101,399  |       | $ | 19,813,781 |   |
| Cost of sales    |       | 3,953,100                  |       | 102,979                      |       | 4,056,079  |       |
| Gross margin     |       | $                          | 6,759,282  |                         | $          | 8,998,420  |       | $ | 15,757,702 |   |
| **Fiscal  2002** |       |                       |       |                         |       |       |       |
| Total revenues   |       | $                          | 10,777,569 |                         | $          | 8,224,224  |       | $ | 19,001,793 |   |
| Cost of sales    |       | 4,600,388                  |       | 153,857                      |       | 4,754,245  |       |
| Gross margin     |       | $                          | 6,177,181  |                         | $          | 8,070,367  |       | $ | 14,247,548 |   |

 

For fiscal year 2004,one customer accounted for approximately 10% of revenues, or $2,180,065 in thesemiconductor segment. For fiscal year 2003, one customer accounted forapproximately 11% of revenues, or $2,107,790 in the semiconductor segment. Forfiscal year 2002, two customers accounted for approximately 13% and 11% ofrevenues or $2,449,779 in the semiconductor segment and $1,991,554 in thelicensing segment, respectively.

 

F-25

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The following schedulepresents the Company’s revenue by geographic area. For product sales, revenueis allocated based on the country to which product was shipped. Forlicensing-related revenue, the allocation is based on the location of thelicensee’s corporate headquarters. The Americas region includes North, Centraland South America.

 
| ** **                      | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **2004**                                    | ** ** | **%** | ** ** | **2003** | ** ** | **%** | ** ** | **2002** | ** ** | **%** | ** ** |
| ***Geographic  Area Revenue:*** |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Hong Kong                       |       | $                                           | 9,975,904  |   | 46 | % | $ | 9,235,976 |   | 47 | % | $ | 9,848,123 |   | 52 | % |
| Japan                           |       | 4,906,343                                   |       | 23 | % | 5,402,565 |   | 27 | % | 5,383,728 |   | 28 | % |
| Americas                        |       | 2,354,668                                   |       | 11 | % | 875,461 |   | 5 | % | 1,027,252 |   | 6 | % |
| China                           |       | 2,028,224                                   |       | 9 | % | 2,193,863 |   | 11 | % | 1,771,486 |   | 9 | % |
| Other Asia  Pacific             |       | 1,661,880                                   |       | 8 | % | 1,226,945 |   | 6 | % | 151,649 |   | 1 | % |
| Europe                          |       | 675,369                                     |       | 3 | % | 878,971 |   | 4 | % | 819,555 |   | 4 | % |
| Total                           |       | $                                           | 21,602,388 |   | 100 | % | $ | 19,813,781 |   | 100 | % | $ | 19,001,793 |   | 100 | % |

 
| ** **                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2004**              | ** ** | **2003** | ** ** |
| ***Geographic  Area Long-lived Assets:*** |       |                  |       |   |   |
| Asia Pacific                              |       | $                     | 2,028,787  |   | $ | 1,840,323 |   |
| United States                             |       | 499,823               |       | 354,687 |   |
| Total                                     |       | $                     | 2,528,610  |   | $ | 2,195,010 |   |

 

**13.   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 andofficer of the Company. The lease has a term of three years (expiringMay 2005), with an option to extend the term for an additional three yearsthereafter through May 31, 2008. We paid the partnership rent of $210,600during 2004, $208,260 during 2003, and $198,900 during 2002. See Note 8.

 

As described inNote 11, certain shareholders, directors and an executive officer of theCompany purchased preferred shares issued by a subsidiary of the Company. SeeNote 1.

 

The Company and SierraDigital Productions, Inc. (“Sierra Digital”) entered into a ConsultingAgreement dated August 23, 1994, pursuant to which Sierra Digital providesproduct definition, development and design services on a 100% time commitmentbasis to the Company in connection with the Company’s research and developmentof its sound technologies. The president and sole shareholder of Sierra Digitalis Alan D. Kraemer, the Company’s Chief Technology Officer. Pursuant to theConsulting Agreement, the Company paid to Sierra Digital a monthly retainer of$10,083 per month plus expenses. This agreement terminated on June 30,2003. The Company paid Sierra Digital $70,583 and $121,000 during Fiscal 2003and Fiscal 2002 respectively.

 

**14.   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. Duringthe years ended December 31, 2004, 2003, and 2002, the Company contributedapproximately $99,800, $81,800, and $67,200, respectively to the401(k) Plan.

 

F-26

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**SCHEDULEII**

**VALUATIONAND QUALIFYING ACCOUNTS AND RESERVES**

 
| ** **                                  | ** ** | **Balance at  Beginning  of Period** | ** ** | **Additions  (Reductions)  Charged to  Expense** | ** ** | **Deductions** | ** ** | **Balance  at End  of Period** | ** ** |
|---------------------------------------------|------------|------------------------------------------------|------------|-------------------------------------------------------|------------|----------------|------------|------------------------------------------|------------|
| For the year  ended December 31, 2004: |       |                                           |       |                                                  |       |           |       |                                     |       |
| Allowance for  doubtful accounts            |       | $                                              | 87,628     |                                                  | $          | 58,508         |       | $                                        | (113,174   | ) | $ | 32,962 |   |
| Inventory  reserve                          |       | $                                              | 867,923    |                                                  | $          | (41,651        | )          | $                                        | (585,447(a | ) | $ | 240,825 |   |
| For the year  ended December 31, 2003: |       |                                           |       |                                                  |       |           |       |                                     |       |
| Allowance for  doubtful accounts            |       | $                                              | 49,049     |                                                  | $          | 38,839         |       | $                                        | (260       | ) | $ | 87,628 |   |
| Inventory  reserve                          |       | $                                              | 857,986    |                                                  | $          | 48,686         |       | $                                        | (38,749    | ) | $ | 867,923 |   |
| For the year  ended December 31, 2002: |       |                                           |       |                                                  |       |           |       |                                     |       |
| Allowance for  doubtful accounts            |       | $                                              | 68,888     |                                                  | $          | 22,220         |       | $                                        | (42,059    | ) | $ | 49,049 |   |
| Inventory  reserve                          |       | $                                              | 679,052    |                                                  | $          | 490,666        |       | $                                        | (311,732   | ) | $ | 857,986 |   |

 

----

(a)             Thereduction relates to the scrapping of component inventory that was fullyreserved for and was offset by a credit to the corresponding inventory account.

 

F-27

----