##### Table of Contents

---




UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-K





---




(Mark One)


| | x |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
| | - |  | ------------------------------------------------------------------------------------




For the fiscal year ended December 31, 2001





or





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




For the transition period from  to





Commission File Number 0-21123





SRS LABS, INC.


(Exact name of registrant as specified in its charter)





---




Delaware (State or other jurisdiction of incorporation or organization)

33-0714264 (I.R.S. Employer Identification No.)





2909 Daimler Street, Santa Ana, California 92705


(Address of principal executive offices) (Zip Code)





(949) 442-1070


(Registrants telephone number, including area code)





Securities registered pursuant to Section 12(b) of the Act:  None





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


Common Stock, Par Value $0.001 Per Share





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





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





The aggregate market value of the registrants voting Common Stock held by non-affiliates of the registrant was approximately $23,523,229 (computed
using the closing price of $3.05 per share of Common Stock on March 15, 2002, as reported by the Nasdaq Stock Market).





There
were 12,667,619 shares of the registrants Common Stock, par value $0.001 per share, outstanding on March 15, 2002. Of that amount, 124,900 shares were held as treasury shares.





DOCUMENTS INCORPORATED BY REFERENCE





Portions of the
registrants Proxy Statement prepared in connection with the Annual Meeting of Stockholders to be held in 2002 are incorporated by reference in Part III of this Form 10-K.





---



---

##### Table of Contents

SRS LABS, INC.





TABLE OF CONTENTS





PagePART IItem 1.

Business

3Item 2.

Properties

19Item 3.

Legal Proceedings

19Item 4.

Submission of Matters to a Vote of Security Holders

19PART IIItem 5.

Market for Registrants Common Equity and Related Stockholder Matters

20Item 6.

Selected Consolidated Financial Data

21Item 7.

Managements Discussion and Analysis of Financial Condition and Results of Operations

22Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

36Item 8.

Financial Statements and Supplementary Data

37Item 9.

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

60PART IIIItem 10.

Directors and Executive Officers of the Registrant

60Item 11.

Executive Compensation

60Item 12.

Security Ownership of Certain Beneficial Owners and Management

60Item 13.

Certain Relationships and Related Transactions

60PART IVItem 14.

Exhibits, Financial Statement Schedules, and Reports on Form 8-K

61Signatures

67





CAUTIONARY STATEMENT FOR PURPOSES OF THE SAFE HARBOR PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995





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




2




---

##### Table of Contents

PART I





Item 1.    
Business





Overview





SRS Labs, Inc. (SRS Labs or SRS) was incorporated in the State of California on June 23, 1993 and reincorporated in the State of Delaware on June 28, 1996. The Companys executive offices
are located at 2909 Daimler Street, Santa Ana, California 92705. The Companys telephone number is (949) 442-1070.





SRS Labs, Inc. conducts its business activities through the following three operating business units: SRS Labs, the parent company; its majority-owned subsidiary, SRSWOWcast.com, Inc., doing business as SRSWOWcast Technologies
(SRSWOWcast); and its wholly-owned subsidiary, ValenceTech Limited and ValenceTech Limiteds wholly-owned subsidiaries (collectively Valence). SRS Labs and its majority-owned and wholly-owned subsidiaries together are
hereby collectively referred to as the Company.





The Company is a developer and provider of application specific
integrated circuits, (ASICs), standard integrated circuits (ICs) and audio and voice technology solutions for the consumer electronics, home theater, DVD, portable audio, wireless device, computer, game, broadcast, Internet
and telecommunications markets. The Company operates in the following five business segments:





| |  |  | SRS Labs
| | - |  | --------




| |  |  | Licensing: SRS Labs develops and licenses audio and voice technologies to original equipment manufacturers (OEMs) and semiconductor manufacturers around the
world.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | Products: SRS Labs sells consumer products which incorporate its proprietary technologies.
| | - |  | ------------------------------------------------------------------------------------------




| |  |  | SRSWOWcast
| | - |  | ----------




| |  |  | Internet and Broadcast: SRSWOWcast develops and licenses software and hardware audio enhancement technology solutions for the Internet and broadcast markets.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | Valence
| | - |  | -------




| |  |  | ASICs: Valence develops and markets technology solutions in the form of analog and digital signal processor (DSP) ASIC semiconductors or other imbedded
custom semiconductor designs to OEMs.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | Component Distribution: Valence is an authorized, non-exclusive distributor of semiconductor components, subassemblies and finished goods for selected OEM customers. The
Company expects this business segment will be completely phased out by the end of 2002.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




A narrative
description of the Companys business activities by industry segment and geographic area follows. The financial information for business segments, geographic areas and customer concentration is included in this Annual Report on Form 10-K under
Item 8. Financial Statements and Supplemental Data in Notes 1 and 10 to the Notes to Consolidated Financial Statements. Revenues for each of our business segments as a percentage of consolidated revenues and additional discussion
relating to the Companys revenues are presented under Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations. Reference also is made to Item 7. Managements Discussion and
Analysis of Financial Condition and Results of Operations  Factors That May Affect Future Results for a discussion relating to certain business risks relating to the business of the Company.





Company History





The Company was formed in 1993
by purchasing all rights and assets of various audio and speaker technologies from the Hughes Aircraft Company (Hughes). The Company successfully completed its initial public offering in August 1996, raising approximately $22 million.
From its inception in 1993 until February 1998, the Company derived substantially all of its revenues from audio technology licensing activities for the consumer electronics, computer and game markets.




3




---

##### Table of Contents




On March 2, 1998, the Company acquired 100% of the outstanding stock of Valence Technology Inc.
(a British Virgin Islands holding company ultimately succeeded by Valence), which had its principal business operations and office locations in Hong Kong and the Peoples Republic of China (the PRC). This acquisition significantly
expanded the Companys business activities from the original licensing model to include the design, manufacture and marketing of custom ASICs, standard ICs, components and products.





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





During the fiscal year ended December 31, 2000 (Fiscal 2000), the Company launched its internet-based business. Initially, SRSWOWcasts business plan was focused on
developing and acquiring audio based content to generate and retain visitor traffic to its website in order to sell advertising and e-commerce products. In the fiscal year ended December 31, 2001 (Fiscal 2001), the Company changed its
Internet strategy and the corporate direction of SRSWOWcast to focus on the licensing of the Companys audio and voice enhancement technology solutions for use in the broadcast of any material, whether over the Internet or traditional broadcast
means, such as traditional television, cable or satellite.





SRS Labs  Technology, Licensing and Products





Description of Business





SRS Labs technology licensing strategy continues to be the development, acquisition and licensing of audio, voice and speaker technologies to product and semiconductor manufacturers in the consumer electronics, home theater, gaming,
computer, Internet, wireless and telecommunications markets around the world. Its strategy is to identify high growth markets, develop needed technology solutions and features, and work with semiconductor and platform partners to make these
technologies widely available and easy to implement. SRS Labs believes that it will strengthen its market position as a world leader in audio and voice technology by employing a strategy of providing a continuous stream of patented audio and voice
technologies, enhancing relationships with existing licensees and creating strong brand awareness in order to attract new licensees.





SRS Labs technologies may be implemented in a variety of methods, including discrete analog components, chip modules, analog semiconductors, DSPs and software. These various implementation options offer customers significant
flexibility when incorporating SRS Labs technologies into products.





License agreements for SRS Labs technologies
typically have multi-year terms and either require per-unit royalty payments for all products implementing SRS Labs technologies or provide for a fixed annual or quarterly royalty payment. License agreements also specify the use of SRS
Labs trademarks and logos on the product, within the packaging and in the users manual. Agreements also require product review and approval by SRS Labs to guarantee the quality of the technology implementation and the display of SRS Labs
logos and trademark verbiage. We believe these terms (a) ensure the quality and consistency of the technology and (b) elevate the Companys brand awareness in the marketplace. Most agreements do not have volume requirements and may be
terminated by the licensees or SRS Labs without substantial financial penalty.





Platform Strategy





SRS Labs licensing platform strategy is to achieve strategic coverage for its technology solutions within all of its targeted vertical
product markets in order to expand sales and licensing opportunities. By developing strong relationships with the leading software and semiconductor companies, SRS audio technologies can be delivered to customers worldwide across high growth and
high volume product applications.




4




---

##### Table of Contents




SRS Labs licensing model often employs a two-tiered system whereby semiconductor
manufacturers are licensed to build and sell semiconductor implementations involving SRS Labs technology solutions (the SRS Chip Partners). Under this two-tiered system, revenue is not received directly from the SRS Chip Partners.
OEMs also enter into licensing arrangements with SRS Labs for the use of our technology solutions in consumer and other products manufactured by the OEM. The SRS Chip Partners sell these semiconductor technology solutions directly to the licensed
OEMs. Under this two-tiered licensing method, OEM product licensees are free to choose a semiconductor solution from the SRS Chip Partner that best suits their requirements and matches their price expectations. SRS Labs receives royalties directly
from the licensed OEM under the two-tiered system for the use of its technologies in licensed products manufactured by the OEM. Many major OEMs have licenses for the use of one or more of SRS Labs technologies and for the use and display of
SRS Labs trademarks.





The two-tiered methodology is not well established in the computer multimedia industry or in certain
geographic regions such as the PRC consumer electronics marketplace. To address these market conditions, SRS Labs implements an alternate royalty collection method, whereby the royalty is bundled into the cost of the semiconductor
product and remitted directly to SRS Labs from the SRS Chip Partner when the semiconductor product is sold to the OEM. This methodology simplifies the business process for the OEM, the SRS Chip Partner and SRS Labs. SRS Labs determines which
licensing model to follow based on factors involving mutual discussions with the SRS Chip Partner and consumer product manufacturer, the particular market segment involved, the particular region where the products are manufactured and sold and other
factors.





The following table identifies the SRS Chip Partners who have entered into licensing agreements with SRS Labs as of
December 31, 2001 or who have software or digital platforms, which offer our technologies to licensed OEMs:





AKM Semiconductor

New Japan Radio Corporation (NJRC)Analog Devices

Philips SemiconductorBroadcom Corporation

SamsungCirrus Logic

ST MicroelectronicsFujitsu Semiconductor

Texas InstrumentsMitsubishi Electric Corporation

Toshiba CorporationMotorola

Zoran





Portfolio of Audio and Voice Technologies





The portfolio of technologies developed or acquired by SRS Labs includes a wide range of technology for mono and stereo audio enhancement, voice
processing, multi-channel surround sound and speaker design applications. The technologies, described in detail below, include Circle Surround ® , Circle Surround II  (CSII), FOCUS ® , NuVoice  ,
SRS ® , SRS Headphone  , TruBass ® , TruSurround ® , TruSurround XT  ,
VIP  , WOW  and WOW Voice  .





SRS, SRS Headphone, TruSurround, VIP, Circle Surround, TruBass, FOCUS and WOW are currently the subject of numerous license agreements and are actively marketed by SRS Labs. TruSurround
XT, CS II, NuVoice and WOW Voice were developed during Fiscal 2000 and Fiscal 2001 and the Company expects these technologies will contribute to revenue during the fiscal year ended December 31, 2002 (Fiscal 2002). Baser ® and ORB ® , speaker design applications that were included in the original technology acquisition from Hughes, and AVT  have not been actively promoted.





Mono and Stereo Audio Enhancement





| |  |  | SRS®3D
Sound
| | - |  | ------------




SRS 3D Sound is one of the worlds leading 3D audio enhancement technologies. The patented
technology broadens any mono or stereo audio signal and creates a realistic 3D sound image from just two standard stereo




5




---

##### Table of Contents

speakers. SRS is based on the fundamentals of the human hearing system and recreates the multitude of spatial cues that are present in a live listening environment but are lost in recording and
playback. SRS dramatically widens the sweet spot associated with traditional stereo; it therefore does not require the listener to be positioned in a specific location to experience the immersive 3D sound image.





SRS was originally developed by Hughes, which spent significant resources to develop and patent SRS and related audio technologies. Since acquiring the
SRS technology from Hughes in June 1993, SRS Labs has improved the performance of SRS, reduced the cost for OEMs to implement the technology, secured licensing relationships with various SRS Chip Partners who offer the technology in various analog
and DSP options and introduced the technology to a wider variety of consumer applications.





SRS can be applied to any consumer
electronics product that includes mono or stereo audio playback through two speakers or headphones, including televisions, computers, audio receivers, car products, musical instruments, gaming products, powered speakers, portable and wireless audio
products and mobile phones with audio playback.





| |  |  | SRS Headphone
| | - |  | --------------




Introduced in early 1998, the patented SRS Headphone technology optimizes
the core SRS 3D sound technology for use with a standard pair of headphones or ear buds. The process repositions the sound image from inside the listeners head to outside the listeners ears, creating a more natural listening situation.





| |  |  | WOW
| | - |  | ----




WOW is SRS Labs next generation 3D audio enhancement for speakers and headphones and was
introduced to the marketplace in November 1998. It delivers an incredibly large, immersive sound experience, from any stereo or mono source. WOW dramatically enlarges the sound image field creating a wider sweet spot, improves performance from
stereo speakers or headphones and, with SRS Labs patented TruBass technology, creates low bass frequencies up to an octave lower than the frequency limitation of the physical speakers. Product applications for WOW include any playback
environment using two speakers or a pair of headphones, including televisions, computers, boom boxes, automotive and portable audio devices, such as MP3 players, personal data assistants (PDAs) or voice recorders. WOW can also be
included in computer software products.





In March 2000, Microsoft Corporation (Microsoft) and SRS Labs entered into
a strategic alliance relating to its WOW technology. In connection with this alliance, Microsoft received licensing rights to include WOW in any of its products for a three year term. In Fiscal 2000, Microsoft embedded the WOW technology into its
Windows Media Player 7 and placed the SRS Logo and WOW controls directly on the Media Player interface. The WOW technology is prominently featured with a Media Player 7 Interface in the form of the SRS Labs logo that hyperlinks to the Companys
technology page in the SRSWOWcast website. In Fiscal 2001, Microsoft introduced the XP Version of the media player, which continues to feature the WOW technology and the hyperlink to the Companys technology page.





| |  |  | FOCUS®
| | - |  | ------




In many audio environments, speakers are not placed in an ideal location directly in front of a
listener. This makes it difficult to achieve a realistic sound experience from speakers that are below the plane of the listeners ear. SRS Labs developed FOCUS as a technology solution for this problem. Originally designed for use in
automobiles where front speakers are often placed under the dashboard or facing each other in the door panels, the patented FOCUS technology electronically repositions the sound image to create the appropriate perception of image height. In addition
to automobiles, FOCUS is ideally suited for any product application where speakers cannot be placed in optimal locations for either space or aesthetic reasons, such as big screen or projection TVs, home in-wall speakers and commercial applications
such as drive-through restaurant communications.




6




---

##### Table of Contents




| |  |  | TruBass®
| | - |  | --------




In 1998, SRS Labs introduced TruBass, a psychoacoustic process that creates the perception of
dramatically increased bass performance in smaller speaker systems and headphones far beyond the physical capabilities of the speakers themselves. It is a dynamic technology that actively monitors the low-frequency content of an audio signal and
optimizes the frequency and amplitude spectrum of the output signal to enhance bass perception. It effectively creates the impression of a subwoofer in smaller speaker systems and when used with a subwoofer, further increases the efficiency and
overall performance of the bass response.





Applications for this technology include any product with small and medium sized
speakers or headphones, such as those found in televisions, radios, portable audio devices, boom boxes, games and smaller hand-held devices. TruBass is an important part of the feature-set for several of SRS Labs technology solutions,
including WOW, CSII and TruSurround XT. In November 2001, SRS Labs was granted a United States patent for the TruBass technology.





Voice Processing





| |  |  | VIP
| | - |  | ----




VIP is a patented audio processing technology that improves the intelligibility of the spoken voice
especially in noisy environments or in text-to-speech applications. VIP selectively processes only those spectral portions of the speech signal that the brain uses for cognition, without requiring an increase in gain or volume. SRS inventor Arnold
Klayman, who is now the principal audio scientist at SRS Labs, originally developed the VIP technology at Hughes. During a divestiture in 1994, Hughes sold the VIP technology to a third party that further developed and marketed the VIP technology
along with a stand-alone signal processor for use in the professional sound reinforcement industry. As mentioned previously, SRS Labs acquired the VIP technology in 1998.





The market opportunities for VIP include cellular phones, wireless products, text-to-speech applications, hearing aids, public address and emergency warning systems, talking toys,
hand-free devices, Voice over Internet Protocol (VoIP), traditional and Internet broadcasting and other voice-related applications. SRS Labs directly offers both software and hardware implementation options for VIP. VIP technology is
available as digital code that may be ported to DSP platforms used by manufacturers of cellular phones, paging systems, digital televisions, sound reinforcement equipment and hearing aids. VIP is also available in software and can run on client or
server-side applications.





| |  |  | WOWVoiceand NuVoice
| | - |  | ---------------------




In Fiscal 2000, SRS Labs introduced two new technologies, WOWVoice and NuVoice, based on SRS Labs VIP technology and specifically designed for
telephone voice quality and intelligibility and text-to-speech enhancement applications. VIP alone increases the intelligibility of voice, particularly in noisy listening environments and dramatically improves the quality and clarity of synthesized
speech in text-to-speech applications (see VIP description above for more details). NuVoice adds warmth to voice and speech restoring the lower bass-frequencies oftentimes cut-off or lost in the transmission or compression of the telephony
bandwidth. It overcomes the physical limitations of small transducers found in cellular and traditional telephones by producing lower bass tones using psycho-acoustics and harmonic principles to make the speech sound more realistic, closer to the
original human speech before it was sent over the telephony equipment. NuVoice also improves the quality of text-to-speech engines making synthesized voices sound more natural. When NuVoice is added to VIP, the resulting suite of voice technology is
called WOWVoice. SRS Labs began actively marketing these technologies in the third and fourth quarter of 2000. In Fiscal 2001, Mitsubishi Electric Corporation signed a license agreement with SRS Labs for the use of the WOWVoice
technology in digital phones marketed in Japan under the NTT DoCoMo brand.




7




---

##### Table of Contents




Multi-Channel Audio





SRS Labs markets a complete technology portfolio for home entertainment systems, including virtual surround sound for playback of multi-channel audio material over two speakers, and an
encode/decode surround sound matrix technology that allows for the encoding of up to 5.1 channels of audio and the decoding of up to 6.1 channels of audio.





| |  |  | TruSurround®
| | - |  | ------------




TruSurround was specifically engineered to present 5.1 multi-channel
content using only two speakers, retaining all of the original audio information and giving listeners the perception that additional phantom speakers surround them. This technology is important in the home theater market for televisions,
set top boxes and DVD players as DVD audio and much of the satellite and cable programming are encoded or broadcast in multi-channel formats yet only a small fraction of households own multi-speaker home theater systems. TruSurround accepts all such
surround encoded audio sources and delivers a powerful, home theater experience through any two-speaker system, including the internal television speakers, DVD laptop speakers or any traditional pair of headphones. TruSurround is also backward
compatible with non surround-encoded audio and delivers an immersive SRS 3D audio experience from standard stereo sources. TruSurround carries Dolby   ® certification.





SRS Labs has already been granted a key U.S. Patent with 48 claims for TruSurround. The European Patent Office has recently issued a notice of allowance for SRS Labs TruSurround
technology. The patent is expected to issue in the coming months and will provide protection within the major economies of Europe including the United Kingdom, France, Italy, Germany, Austria, Belgium, Ireland, Netherlands, Spain, Sweden and
Switzerland.





| |  |  | TruSurround XT
| | - |  | ---------------




In November 2001, SRS Labs announced TruSurround XT, a premium version of
TruSurround that included significant new audio features. Based upon its patented predecessor and namesake, TruSurround XT also solves the problem of playing 5.1 multi-channel content over two speakers or headphones but also utilizes proprietary
algorithms for dialog clarity and bass enhancement.





Playback of dialog in home theater environments often suffers due to
competing signals from other speakers. In addition, feature film content is mixed specifically for cinema playback. When translated through home systems, dialog may become unintelligible. SRS Labs patented algorithm for dialog clarity enhances
voice clarity to address these problems, thus improving dialog intelligibility from all such source material. The patented TruBass technology is also included in TruSurround XT.





Similar to the original TruSurround, TruSurround XT is also backward compatible with stereo material. Unlike TruSurround, which enables SRS for stereo, TruSurround XT enables WOW for an
even more immersive and compelling stereo experience.





| |  |  | Circle Surround®
| | - |  | ----------------




Circle Surround is SRS Labs patented multi-channel encode/decode audio solution. It encodes five discrete channels of audio into two channels (the same space required for stereo) and
then decodes the two channels back into five for playback over a stereo, computer, gaming device or home theater system equipped for multi-channel playback. Circle Surround is unique to other multi-channel audio technologies in that it allows the
delivery of surround sound audio over a stereo format, so it can be broadcast over Internet, television, radio or cable infrastructures without requiring the bandwidth or equipment traditionally needed for 5.1 surround sound recording and playback.
In addition to the five channels for surround sound playback, there is also a low frequency output for the operation of a subwoofer.




8




---

##### Table of Contents




An additional unique feature of Circle Surround is that it produces up to 5.1 channels from any
mono or stereo material. As a result, consumers who own multi-speaker home theater speaker systems can enjoy 5.1 surround sound with standard stereo television programming, VHS movies or music CDs. Circle Surround is also backward compatible with
Dolby surround encoded material. Circle Surround can be used in the recording process for music or movies or in the development of games for computers or video game consoles and then implemented in a decoding playback device, such as a home audio
receiver, multi-media speakers, DVD player or car audio products.





In Fiscal 2001, SRS Labs demonstrated Circle Surrounds
game encoding capabilities and is pursuing game encoding relationships to further the technologys use in the game market.





| |  |  | Circle Surround II
| | - |  | -------------------




In November 2001, SRS Labs introduced CSII, a premium version of Circle Surround with powerful new audio
features. Based upon its patented predecessor and namesake, CSII is also an encode/decode surround matrix technology but also utilizes proprietary algorithms for dialog clarity and bass enrichment.





Playback of dialog in home theater environments often suffers due to competing signals from other speakers. In addition, feature film content is mixed
specifically for cinema playback. When translated through home systems, dialog may become unintelligible. SRS Labs patented algorithm for dialog clarity enhances voice clarity to address these problems, thus improving dialog intelligibility
from all such source material. SRS Labs patented TruBass technology is also included in CSII, providing deep bass to the front channels and subwoofer. Similar to the original Circle Surround, CSII is also backward compatible with non-encoded
surround material. Unlike Circle Surround, which creates up to 5.1 channels of audio from only a stereo source, CSII can create up to 6.1 channels from a stereo or mono audio source, making it the most flexible and feature rich surround sound
technology available on the market today.





CSII has been introduced to the network of SRS Chip Partners and SRS Labs anticipates
that it will announce semiconductor solutions and licensed products during Fiscal 2002.





Vertical Markets and OEM products





SRS Labs markets its patented technologies in the following vertical product segments: home theater and consumer audio;
computer multimedia and Internet products; gaming; portable and wireless audio; and voice communications.





Home Theater and
Consumer Audio





Home theater and consumer audio represents the largest current market for SRS Labs technologies and
has historically been the largest revenue contributor to the licensing segment. Audio enhancement, virtual surround sound and multi-channel technologies are becoming increasingly significant in televisions, stereo components, DVD players,
audio/video receivers and other home entertainment products. The markets for consumer electronics products are highly competitive and generally dominated by large manufacturers. SRS Labs provides its technology solutions to these manufacturers who
differentiate their products by continually adding new features and increasing product performance. SRS technologies applicable to these types of products include SRS, WOW, TruSurround, TruSurround XT, TruBass, FOCUS, Circle Surround and CSII.





SRS Labs has successfully signed licensing agreements with many of the leading consumer electronics manufacturers. One of SRS
Labs key strategies is to expand the use of its technologies into the various product lines of each OEM. For example, SRS technology was first licensed to Sony Corporation for use in televisions and over the last few years, Sony has expanded their
use of SRS technologies to portable DVD players, set-top boxes and portable audio devices.




9




---

##### Table of Contents




Computer Multimedia and Internet Products





Consumers are increasingly using computers and the Internet for more than just word processing or business functions. The majority of desktop computers
and laptops incorporate a CD-ROM drive and speakers and typically support high-resolution graphics, sound and voice communications. The demand for these capabilities has been driven by the proliferation of multi-media based entertainment and video
games, as well as the widespread use of the Internet. The personal computer and Internet software and appliance market is characterized by intense pricing competition and as a result the hardware market is difficult to penetrate. While no
significant licensing revenue was generated in this market during Fiscal 2001, SRS Labs believes that its technology solutions for voice communications, multi-channel sound for Internet and PC-based gaming and the playback of DVD movies through a
laptop will open up new licensing opportunities for this highly competitive and volatile market.





Gaming





Various SRS technologies can be implemented inside a variety of hardware gaming applications, including; video and arcade games, portable
game systems, accessory products and console game machines. In addition, SRS technology can be encoded directly into the game software thereby enhancing the quality of the audio track or providing multi-channel audio playback. SRS Labs has not
derived significant licensing revenue from these market segments, but believes that its Circle Surround and TruSurround technologies are well suited for use by gaming developers and gaming product manufacturers, including consoles and portable
devices, to enhance the overall sound quality of the game or offer multi-speaker surround sound or virtual surround sound through two speakers.





Portable and Wireless Audio





Portable audio product use is widespread reflecting demand
from consumers to take their music and video with them. The use of boom boxes, headphone products and digital audio players, such as MP3 and portable CD players are growing at a strong rate. Industry reports indicate this trend will continue. SRS
Labs believes that several of its technologies, such as WOW, TruBass and SRS Headphone, are ideally suited to improve the sound quality of small speakers or headphones that are traditionally used in this market segment. Consumers are also showing an
interest in migrating the home entertainment experience to the road through rear-seat video systems in automobiles using monitors built into headrests, the backs of driver seats, consoles and ceilings and through DVD players incorporated inside
laptops. This phenomenon is driving aftermarket suppliers to develop more entry-level DVD systems for use in the automotive and computer markets and provides a significant opportunity for SRS Labs virtual surround sound technologies, TruSurround and
TruSurround XT.





Voice Communications





Voice Communications present a serious challenge for intelligibility due to limited bandwidth and the dynamic range of the speakers and headphones used in mobile phones and other voice
devices. Additionally, when voice is compressed for transmission in the digital domain, quality is further degraded. As described above, many mobile phones throughout the world are increasingly incorporating music and audio playback functionality.
The combination of SRS voice technologies, VIP, WOW Voice and NuVoice, with audio technologies, WOW and SRS Headphone, provide a complete audio and voice enhancement solution for a variety of product applications, including cellular phones, wireless
products, text-to-speech applications, hearing aids, public address and emergency warning systems, talking toys, hand-free devices, traditional and Internet broadcasting and other voice-related applications.





Overall Licensee Sales Support





To implement its licensing sales strategy within its identified vertical markets, SRS Labs has established a direct sales force and a worldwide network of independent sales agents. In North America, SRS Labs employs a




10




---

##### Table of Contents

direct sales force to market our portfolio of audio and voice technologies to the OEM community. Internationally, SRS Labs maintains support offices in India, the Czech Republic, Japan, Hong Kong
and Korea to support its multi-national OEM customers. The Company actively promotes the use of its trademarks and logos and directs customers to prominently display the appropriate SRS technology logo on products, packaging and in advertising. The
Company works closely with its licensees to enhance their success in selling finished products and semiconductor products that incorporate SRS Labs technologies through a variety of licensee support programs. These programs include engineering
support, sales training, tradeshow support, press support, customized marketing materials and corporate communications. The Companys corporate communications program includes press releases and corporate newsletter dissemination to its
customers around the world, primarily through e-mail. The Company began to use the Internet to provide easy-to-use audio technology demonstrations for those technologies that can be appropriately demonstrated on the World Wide Web. The Company
conducts in-person technology demonstrations or presentations for the press and other companies to promote the Companys technologies and products.





The Company regularly participates in tradeshows and conferences to increase awareness of its technologies and to market its technologies and products. The Company also works closely with its licensees and SRS Chip
Partners to actively explore additional opportunities to utilize the Companys technologies in new products and/or markets.




11




---

##### Table of Contents




OEM Licensees





The following table identifies many of the Companys OEM licensees and the market or markets in which such licensees are participating or are planning to participate, as of December
31, 2001:





Home Theater and Consumer Audio

Computer Multimedia and Internet productsAiwa

Amtran TechnologyBangalore Audio Labs

Colortac TechnologyCasil Ele Products

Cyberlink CorporationDaewoo

Microsoft CorporationDiva Laboratories

Minebea OnkyoFujitsu Ten Corporation

NEWQ SystemFunai Electric

Sony CorporationHitachi Ltd.HiSense Corporation

Portable and Wireless AudioHughes Network Systems

Bright Headphone ElectronicsKenwood Corporation

Etronics CorporationKonka Group

Gamma Inc.Loewe OPTA GmbH

MPMan.comMarantz Japan Inc.

Olympus OpticalMinebea Onkyo

SAEC CommerceMitsubishi Electric Corporation

Sejin ElectronicsPhilips Consumer Electronics

Sennheiser ElectronicPioneer Corporation

Sony CorporationThomson Multimedia

Telean TechnologySalora International

Uni-Art Precise ProductsSamsung Electronics

Victor Company of JapanSharp Manufacturing Company of AmericaSherwood America, Inc.

Voice CommunicationsSkyworth Digital R&D Institute

Mitsubishi Electric CorporationSony Corporation

Olympus OpticalToshiba Corporation

Samsung ElectronicsVideocon International

Sharp CorporationYamaha Corporation





Products





In September 1999, the Company introduced the WOW Thing  family of software and hardware products. The WOW Thing family of software and hardware products enhances the sound quality of music downloaded over the Internet as well as the audio performance of computer and home
entertainment products and speakers. The Company currently markets two models: WOW Thing for Computers and WOW Thing for Game Consoles to consumers through the Companys Internet website, www.wowthing.com. The revenue
from this activity has not been significant; however, this product group helps elevate awareness of the technology as well as create brand awareness with the Companys customers and consumers.





During Fiscal 2001, SRS Labs developed a new line of proprietary, flat panel speakers and previewed design samples at the Consumer Electronics
Conference in January 2002. Plans have been developed to market these speakers under the SRS brand name to the U.S. consumer electronics retail industry beginning mid year




12




---

##### Table of Contents

2002. Recognizing that this is an extremely mature and competitive market, SRS Labs has adopted a very conservative strategy, which includes a plan to outsource the manufacturing of the speakers
and to target the high volume mass retailers. In this way, SRS Labs will be in a position to take advantage of the significant market opportunities while at the same time minimizing its cash expenditures.





SRSWOWcast Technologies





Description of
Business





SRSWOWcast focuses on developing and licensing hardware and software applications involving SRS technology for
the Internet and broadcast markets. Formed during the fiscal year ended December 31, 1999 (Fiscal 1999), SRSWOWcast was originally established as an entertainment portal with original Internet programming, syndicated programming and a
demonstration platform for SRS audio technologies. By the end of Fiscal 2000, it became apparent that the cost to produce original programming was increasing and the advertising revenue model would not be viable for SRSWOWcast.





In February 2001, SRSWOWcast revised its Internet strategy in order to focus on the licensing of the Companys audio and voice
enhancement technology solutions for Internet audio, online radio and traditional broadcast applications, such as television, radio, cable and satellite. SRSWOWcast has established a direct sales force to market the technology solutions and a line
of hardware and software products. Consistent with the licensing trademark policy, SRSWOWcast will actively promote the use of the SRS Labs trademarks and logos and will direct its customers to display the appropriate SRS technology logo.





Internet Market





Hardware and Software products developed by SRSWOWcast during Fiscal 2001 for the Internet market include SRS-APC Solo Software, SRS Surround Software, the SRS-APC System and the WOWCaster  Internet Radio Audio Processor.





SRS-APC Solo Software is a complete software system that acts as a processing station to provide all SRS audio enhancement technologies prior to compression or web casting. The software analyzes and processes an audio
signal of any content type, including voice, stereo and surround sound. The software is available in three configurations depending on the type of content that is to be processed. The SRS-APC Solo Software includes mono, stereo and voice enhancement
technologies from SRS Labs and is marketed to Internet radio stations, live event websites, encoding and service providers and other companies who deal with voice material and mono or stereo audio.





SRS Surround Software includes SRS-APC Solo Software with the addition of TruSurround technology, which creates virtual surround sound from any
multi-channel audio source. This version is marketed to websites and music companies whose content source was originally encoded in 5.1 or 6.1 audio, such as movie clips and live concerts.





The SRS-APC System includes SRS software configured on a rack mount personal computer bundled with a multi-channel management hardware device that enables processing of up to eight
channels simultaneously. This configuration provides a completely self-contained, rack mount processing station that can process any analog or digital input and is ideal for encoding companies, large content publishers, content delivery networks and
other production houses that process, stream or host a large amount of content simultaneously.





The WOWCaster Internet Radio
Audio Processor is a small hardware device that includes SRS WOW audio enhancement technology and is marketed to Internet radio stations and online music portals that prefer a hardware solution. The WOWCaster is installed directly between the source
of the audio before compression and transmission over the Internet occurs.




13




---

##### Table of Contents




Broadcast Market





In December 2001, SRSWOWcast signed a technology licensing agreement with National Mobile Television (NMT), the worlds leading provider of mobile television production
equipment for outside broadcast sports, entertainment and corporate productions. NMT provides mobile facilities to support more than 6,000 worldwide live events annually from major broadcast networks, cable networks and independent producers
including ABC Sports, CBS Sports, ESPN, Fox News, Fox Sports, Automatic Productions, WNET/Thirteen and The Madison Square Garden Network. The agreement marks SRSWOWcasts entry into the traditional broadcast market. Under the terms of the
agreement, SRSWOWcast will initially license its new Broadcast Phase Protector (BPP) and Broadcast Sports Processor (BSP) hardware products exclusively for NMTs sports broadcasting use in their entire fleet of 46 mobile
production units. The agreement requires (a) a per-event fee for events that are broadcast using the BSP and (b) SRS logo credit and on screen credits for the broadcast event.





The BSP includes a combination of SRS audio technologies specifically designed to enhance the announcers voice in a sports audio mix and improve the quality and clarity of mono,
stereo or surround sound broadcasts. The BPP allows for accurate stereo reproduction from a stereo broadcast by immunizing the stereo audio signal from common inadvertent phase reversals along the distribution path, including those originating at
the cable headend or from an improperly wired home audio system. Production units of both processors are expected to be available in selected NMT production units during the second quarter of 2002 with full deployment by the end of 2002. Under terms
of the agreement, NMT can also distribute the BPP and BSP processors to the entire broadcast industry.





ABC Sports successfully
used a prototype BSP production unit during their telecast of the 2002 Tournament of Roses Parade and the 2002 Rose Bowl Game.





Valence





Description of Business





Valence, a Hong Kong based, fabless semiconductor supplier, designs and sells a variety of custom ASICs and standard ICs which include analog, digital, mixed signal and DSP semiconductor
products that address a wide range of applications in the consumer electronics, telecommunications, game and personal computer markets.





Valence operates primarily in two areas, the design and sale of custom ASIC and standard IC semiconductor solutions and the distribution of semiconductors and components. Consistent with SRS Labs strategy to focus on high margin
business opportunities, Valence has been gradually phasing out the component distribution area of their business, which historically has provided significant top line revenue but very low margins. Concentrating sales, engineering and marketing
efforts on the high margin custom semiconductor design and semiconductor sales business should contribute to improved financial performance.





Design and Sale of Semiconductor Solutions





Valence has over sixteen years of
experience in the design and sale of ASICs and markets these products in two categories (a) custom ASICs for specific OEM customers and (b) standard ICs marketed under their own brand name, ASP Microelectronics (ASP). Based in Hong Kong,
approximately 30 engineers support Valences ASIC design capabilities with state of the art design libraries, equipment and software. Valence sells these custom ASICs and standard ICs to its contracted customers, outsourcing the manufacturing
to a network of fabrication partners throughout Asia Pacific, including Chartered Semiconductor, Samsung and Tower Semiconductor Limited in Israel.





Valences custom ASIC customers include industry leading, Asia-based manufacturing facilities for consumer electronics, telecommunications, game and personal computer manufacturers headquartered in North




14




---

##### Table of Contents

America, Europe and the Asia Pacific region. Due to nondisclosure agreements, specific customers cannot be disclosed. Under many of the design contracts, Valence negotiates to retain ownership of
the specific designs resulting in significant cost advantages. These designs form a significant library of intellectual property that can be utilized in future projects.





In addition to performing contract design work, Valence designs, produces and sells ICs to OEMs of consumer electronics, game, telecommunication and personal computer equipment in Asia
Pacific under the ASP brand name. Product offerings include a universal serial bus (USB) controller, a programmable USB end point device, a single chip PDA reduced instruction set computer (RISC) processor, a digital tuning
system, an electronic shock protection controller, a digital compact disk (CD) servo motor controller, a liquid crystal display (LCD) driver module as well as 4, 8 and 16 bit micro-controllers for applications in DVD players,
set-top box receivers, audio/video equipment, telecommunication and game equipment, MP3 players, televisions and mini and micro stereo hi-fi systems. The products created are based upon managements analysis of trends in the market, knowledge
gained from long standing relationships with customers and overall business experience. Many of these products are developed by capitalizing upon Valences extensive custom design libraries, advanced mixed signal design technologies, system
level expertise, software knowledge and a deep understanding of customer requirements.





The world is fast becoming digital, and
DSPs are the heart of this digital revolution. Valence has developed powerful 16 and 24 bit high speed DSPs with low power consumption and low cost performance features using deep sub-micron technology down to 0.18 microns. This DSP core technology
will enable the Company to optimize solutions for various applications including SRS audio and voice technologies such as TruSurround, TruSurround XT, WOW and Circle Surround. In addition, Valence has started to develop low power analog audio
processor ICs based on SRS audio and voice technologies targeting the mass volume consumer electronics markets for products such as boom boxes, televisions, LCD monitors and Surround Headphones. These products will be sold under the ASP brand name.
Low power analog ICs incorporating TruBass and WOW technologies are expected to be available in the first half of 2002.





Components





Valence is an authorized, non-exclusive distributor in Hong Kong and/or the PRC for
semiconductor products from Philips Hong Kong Ltd., Molex Hong Kong / China, Tripath Technology, Inc., Silicon Wave and Portalplayer Inc. as well as its own ASP brand. Access to multiple suppliers of similar ICs provides value to customers by
insuring an adequate supply of components and just in time delivery of goods to meet their production schedules.





In
the normal course of business, Valence carries inventory quantities of selected products that it distributes to meet rapid delivery requirements of customers. Valence provides a normal and customary merchandise return policy and generally does not
provide payment terms. Due to low margins and significant inventory risks within the component business, Valence will continue to phase out of the distribution side of its business and anticipates exiting the business by the end of Fiscal 2002.





Backlog





Sales at
Valence are primarily made pursuant to standard purchase orders for the delivery of ASIC, IC and component products. Order quantities and delivery schedules are frequently changed to reflect product availability, scheduling at our fabrication
partner facilities or changes in our customers needs. Customer orders can be canceled or rescheduled without significant penalty to the customer. Accordingly, our backlog at any particular date is not representative of actual sales for any
succeeding period, and we therefore believe that backlog is not generally a good indicator of future revenue. As of December 2001 and 2000, the backlog of orders for ASIC design work to non-affiliated parties was $647,267 and $738,841, respectively.
As of December 2001 and 2000, the backlog of orders for components was $84,801 and $5,777,740, respectively. The




15




---

##### Table of Contents

Company expects that all or substantially all of the current backlog of orders for 2001 will be completed in Fiscal 2002. Backlog is applicable only to the Companys Valence operating unit.





Research and Development





The Company has spent approximately 27.0%, 17.3% and 25.5% of total operating expenses on research and development (R&D) in Fiscal 2001, 2000 and 1999, respectively. These expenses consist of salaries and related costs of
employees and consultants engaged in ongoing research, design and development activities and costs for engineering materials and supplies





The Companys R&D group includes 44 software, hardware and application engineers who focus on developing intellectual property, technology solutions and consumer products. Nine engineers are based in the U.S.
with the remainder based in Hong Kong.





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





Through Valence, the Company operates one of
the largest independent IC design houses in Hong Kong, whose activities are primarily engaged in working on custom design ASIC projects for clients in the consumer electronics, game and telecommunications industries. These clients range from local
producers to large, multi-national manufacturers around the world. For five consecutive years since 1997, Valence has won the Hong Kong Industry Awards HKITCC Certificate of Merit in Technology Achievement award.





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





Competition





SRS Labs competes in each of its business segments with a number of companies that produce a variety of audio and voice
enhancement technologies, processes and products. These technologies, processes and products include: THX   ® , a certification program that indicates if a movie theater or particular piece of audio equipment meets certain specifications;
Dolby ® A-type, B-type and C-type noise reduction; Dolby SR ® , which provides noise reduction and encodes analog sound using four sound channels; ProLogic  and ProLogicII, surround sound systems incorporating an active center channel; DolbySRD ® , which encodes a six channel digital sound track on a movie print; DTS ® , which uses CDs to reproduce six channels of digital sound synchronized with a movie print; Dolby Digital, (AC-3) and Dolby Digital EX, which encodes a six channel digital sound track on a
movie print and decodes six channels of digital audio in a consumer electronics device; and SDDS ® , which encodes six
or eight channels of digital sound on both sides of a movie print. Because SRS works with any existing recorded material whether mono, stereo, surround sound or other encoding process, SRS can be used either as an alternative or as a complement and
enhancement to almost any competing audio technology. As a multi-channel encode/decode technology, Circle Surround competes more directly with the various surround sound technologies listed above.





SRS Labs also directly competes in the field of 3D audio and bass enhancement with other audio providers, including QSound Labs, Inc., Spatializer,
MaxxBass and Sensaura. The Company is not aware of any direct competing technologies to its voice intelligibility technology, VIP.




16




---

##### Table of Contents




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





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





Valence competitors are primarily fabless semiconductor design houses and manufacturers located in Taiwan, Japan and Korea. Most of the fabless semiconductor design houses in Taiwan and
Korea focus on the design of dynamic random access memory, static random access memory and semiconductors for personal computer applications. These fabless semiconductor design houses focus less on semiconductors for consumer electronics such as
home audio and video products, communications equipment and electronic game players.





Although the Asian Pacific semiconductor
industry is dominated by several major suppliers, such as Motorola, National Semiconductor and Texas Instruments, within every major market there is need for local, niche participants, such as Valence. Generally speaking, established semiconductor
companies do not offer semiconductor design services to manufacturers and will only do so if the number of semiconductors required by such manufacturers is very large. Instead, they supply standard semiconductors to such manufacturers. These
standard semiconductors may not be the most suitable components for the manufacturers as they may require additional semiconductor components to perform the designed functions required in their products. In such cases, these semiconductors will be
bulkier, heavier and more expensive compared to one custom-designed system-on-a-chip ASIC. Valences ASIC team is more flexible in its strategy of designing new products, as well as more responsive and flexible in the service provided to
clients. With sixteen years of experience in the Asian Pacific semiconductor market, Valences personnel has expertise in local business practices and a strong franchise of relationships with clients that the Company believes gives it a
competitive advantage over newcomers to the industry or the large multi-national firms.





DVD and MP3 have become and will
continue to be the standard audio and video formats and have received global mass-market adoption. Through its strategic partnerships with various technology providers, combined with ASP ICs and ASIC technologies, Valence designs, develops and
markets complete system turnkey solutions for mass consumer audio and video OEM manufacturers of DVD players, home theater systems, MP3 Discman with PLL, MP3 recorders and players and MP3 Hard Disk Jukeboxes. Although the overall consumer
electronics market in the PRC is vast, it is highly competitive with many large manufacturers competing in the same market segment. Price erosion and technology change will rapidly reduce product life cycles.





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




17




---

##### Table of Contents




Intellectual Property Rights and Proprietary Information





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





In order to protect the underlying technology concepts, the Company has filed and/or obtained patents for all of its marketed technologies including technologies marketed under the
trademarks SRS, TruSurround, FOCUS, Circle Surround, WOW, VIP and TruBass. In addition, the Company has numerous issued patents and patents pending for speaker and other acoustic reproduction technologies. The Company pursues a general practice of
filing patent applications for its technologies in the United States and various foreign countries where its licensees manufacture, distribute or sell licensed products. The Company continually updates and adds new applications to its patent
portfolio to address changing worldwide market conditions and new technological innovations of the Company. The range of expiration dates for the Companys patents extend between the year 2005 to 2018. The Company has multiple patents covering
unique aspects and improvements for many of its technologies. Accordingly, the expiration of any single patent is not likely to affect the Companys intellectual property position or the ability to generate licensing revenue.





The Companys strategy for protection of its trademarks identifying the various Company technology solutions is commensurate with its
strategy for obtaining patent protection. Specifically, the Company routinely files U.S. federal and foreign trademark applications for the various word names and logos used to market its technology solutions to licensees and the general public. The
duration of the U.S. and foreign registered trademarks can typically be maintained indefinitely, provided proper maintenance fees are paid and trademarks are continually used or licensed by the Company.





Seasonality





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





Employees





The Company employed 100 persons as of December 31, 2001: 23 in finance and administration, 46 in R&D, engineering and product development and 31 in
sales and marketing. Of the aggregate number of employees, 65 are employed by Valence and are located overseas. None of the Companys employees are covered by a collective bargaining agreement or are presently represented by a labor union. The
Company has not experienced any work stoppages and considers its employee relations to be good.




18




---

##### Table of Contents




Item 2.    
Properties





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





Pursuant to the Companys lease agreement with the Partnership, the Company leases all 23,400 square feet of space at the
above-referenced facility. The lease is for a term of two years which commenced June 1, 2000 and is scheduled to expire on May 31, 2002. At the time of expiration, the Company will have an option to renew the lease, under similar terms and
conditions, for two additional years commencing on June 1, 2002 and terminating on May 31, 2004. The Company paid the Partnership rent of $182,520 during Fiscal 2001, $175,500 during Fiscal 2000 and $165,672 during Fiscal 1999.





The Company, through Valence and its subsidiaries, leases office and warehouse facilities in Hong Kong. Valences principal operations
are conducted at two leased facilities located in Hong Kong. The principal executive offices of Valence are located in Kowloon Tong, Hong Kong, in a 5,887 square foot office facility under a lease, which expires in August 2003. Valences other
principal office is located in Kwun Tong, Kowloon, Hong Kong, in a 9,918 square foot office facility under a lease, which expires in December 2003. Pursuant to these leases, the Company paid rent of $301,686 during Fiscal 2001, $413,569 during
Fiscal 2000 and $429,672 during Fiscal 1999.





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





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





Item 3.    
Legal Proceedings





From time to time the Company may be involved in various disputes and litigation
matters arising in the normal course of business. As of the date of this Annual Report on Form 10-K, the Company is not involved in any legal proceedings that are expected to have a material adverse effect on the Companys consolidated
financial position, results of operations or cash flows.





Item 4.    
Submission of Matters to a Vote of Security Holders





No matters were submitted to a vote of the
Companys stockholders during the fourth quarter of 2001.




19




---

##### Table of Contents

PART II





Item
5.    
Market for Registrants Common Equity and Related Stockholder Matters





Market for Common Stock





The common stock of the Company, par value $0.001 per share (the Common Stock), trades on the Nasdaq Stock Market as a National
Market System Security under the symbol SRSL. The table below reflects the high and low sales prices of the Common Stock as reported by The Nasdaq Stock Market, Inc. for the periods indicated.





High

LowFISCAL 2001First Quarter

4.75

2.00Second Quarter

6.00

2.00Third Quarter

5.40

2.71Fourth Quarter

4.10

2.10FISCAL 2000First Quarter

47.00

5.75Second Quarter

24.94

8.38Third Quarter

11.63

7.06Fourth Quarter

8.50

1.75





At March 15, 2002, the last sale price of the Common Stock was $3.05 per share.





Holders





At March 15,
2002, there were 417 stockholders of record.





Dividend Policy





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




20




---

##### Table of Contents

Item 6.    
Selected Consolidated Financial Data





The following table sets forth selected financial data of the
Company for the fiscal years ended December 31, 2001, 2000, 1999, 1998 and 1997 which has been derived from the Companys consolidated audited financial statements. The following information should be read in conjunction with Item 7.
Managements Discussion and Analysis and Results of Operations  Liquidity and Capital Resources and the Consolidated Financial Statements and Notes thereto included elsewhere in this Report.





Fiscal Year Ended December 31,2001


2000


1999


1998


1997(in thousands except per share data)Revenues:Semiconductor revenue

$
5,647


$
10,168


$
15,247


$
10,295


$
Licensing revenue


4,973



2,930



3,378



5,467



10,081Component distribution revenue


4,603



14,718



17,123



28,963



Product revenue


190



101



48







Internet and broadcast revenue


18



55











Total revenues


15,431



27,972



35,796



44,725



10,081Cost of sales


6,704



16,611



22,003



29,819



210Gross margin


8,727



11,361



13,793



14,906



9,871Operating costs and expenses Sales and marketing


4,475



6,355



5,148



6,846



2,112Research and development


3,576



4,151



4,142



2,555



596General and administrative


5,167



10,357



6,932



5,531



2,615Non-cash stock issuance cost






3,112











Acquired in-process research and development














18,510



Total operating costs and expenses


13,218



23,975



16,222



33,442



5,323(Loss) income from operations


(4,491
)


(12,614
)


(2,429
)


(18,536
)


4,548Other income, net


797



1,180



735



705



1,088Minority interest


193



250











(Loss) income before income tax expense (benefit)


(3,501
)


(11,184
)


(1,694
)


(17,831
)


5,636Income tax expense (benefit)


377



325



50



(273
)


1,863Net (loss) income

$
(3,878
)

$
(11,509
)

$
(1,744
)

$
(17,558
)

$
3,773Net (loss) income per common share:Basic

$
(0.31
)

$
(0.93
)

$
(0.15
)

$
(1.54
)

$
0.39Diluted

$
(0.31
)

$
(0.93
)

$
(0.15
)

$
(1.54
)

$
0.35Weighted average number of shares used in the calculation of net (loss) income per common share:Basic


12,630



12,379



11,696



11,410



9,556Diluted


12,630



12,379



11,696



11,410



10,852Balance sheet data:Working capital

$
19,615


$
21,914


$
10,953


$
7,644


$
9,075Total assets


28,263



41,569



39,101



45,535



31,542Short-term debt and current portion of long-term obligations






8,000



8,000



8,000



82Stockholders equity


24,536



28,303



25,040



26,072



29,420




21




---

##### Table of Contents




Item 7.    
Managements Discussion and Analysis of Financial Condition and Results of Operations





The
following discussion should be read in conjunction with Item 6. Selected Consolidated Financial Data included in this Annual Report on Form 10-K and Item 8. Financial Statements and Supplemental Data including the Notes to
Consolidated Financial Statements. The forward-looking statements in this discussion regarding the markets in which the Company operates, our expectations regarding our future performance, liquidity and capital resources and other non-historical
statements in this discussion include numerous risks and uncertainties, as described in Factors That May Affect Future Results in this Item 7 of this Report. Our actual results may differ materially from those contained in any
forward-looking statements.





Overview





SRS Labs, Inc. conducts its business activities through the following three operating business units: SRS Labs, the parent company; its majority-owned subsidiary, SRSWOWcast; and its wholly-owned subsidiary, Valence.





The Company is a developer and provider of ASICs, ICs and audio and voice technology solutions for the consumer electronics,
home theater, DVD, portable audio, wireless device, computer, game, broadcast, Internet and telecommunications markets. The Company operates in the following five business segments:





| |  |  | SRS Labs
| | - |  | --------




| |  |  | Licensing:  SRS Labs develops and licenses audio and voice technologies to OEMs and semiconductor manufacturers around the world.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------




| |  |  | Products:  SRS Labs sells consumer products which incorporate its proprietary technologies.
| | - |  | -------------------------------------------------------------------------------------------




| |  |  | SRSWOWcast
| | - |  | ----------




| |  |  | Internet and Broadcast:  SRSWOWcast develops and licenses software and hardware audio enhancement technology solutions for the Internet and broadcast markets.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | Valence
| | - |  | -------

| |  |  | ASICs:  Valence develops and markets technology solutions in the form of analog and DSP ASIC semiconductors or other imbedded custom semiconductor designs to
OEMs.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | Component Distribution:  Valence is an authorized, non-exclusive distributor of semiconductor components, subassemblies and finished goods for selected OEM
customers. The Company expects this business segment will be completely phased out by the end of 2002.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




From
the Companys inception in 1993 until February 1998, the Company derived substantially all of its revenue from royalties received from technology licenses. On March 2, 1998, the Company acquired all of the outstanding capital stock of Valence,
a British Virgin Islands holding company with its principal business operations in Hong Kong and the PRC for an aggregate purchase price, excluding non-compete agreements and acquisition costs, of $19,500,000 consisting of approximately $7,400,000
in cash and approximately 1,680,611 shares of the Companys common stock, $0.001 par value per share (the Common Stock). The acquisition was accounted for as a purchase with an effective date of February 1, 1998. The
acquisition of Valence had a material impact on the Companys financial statements subsequent to February 1998. Accordingly, current and future financial statements may not be directly comparable to the Companys historical financial
statements prior to 1998.





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




22




---

##### Table of Contents

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





Critical Accounting Policies





On December 12, 2001, the Securities and Exchange Commission (SEC) issued Financial Reporting Release (FRR) No. 60, Cautionary Advice Regarding Disclosure
About Critical Accounting Policies which, among other things, encourages discussion concerning the most critical accounting policies used in the preparation of the Companys financial statements. Critical accounting policies are defined
as those that are both very important to the portrayal of the Companys financial condition and results, and require managements most difficult, subjective or complex judgments. We are required to make certain estimates, judgments and
assumptions that we believe are reasonable based upon available information, historical experience and/or forecasts. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities at the date of the financial
statements and the reported revenues and expenses during the reporting periods. Actual results could differ from these estimates. The accounting policies which management believes are the most critical to aid in fully understanding and evaluating
our reported financial results include those relating to allowances for doubtful accounts for accounts receivable and inventory obsolescence reserves.





Allowance for Doubtful Accounts





The Companys trade receivables are derived from
sales to OEMs and distributors in the consumer electronics, home theater, computer, game, broadcast, Internet and telecommunications markets primarily in Asia, North America and Europe. The Company makes periodic evaluations of the creditworthiness
of its customers and manages its exposure to losses from bad debts by limiting the amount of credit extended whenever deemed necessary. The Company maintains an allowance for estimated uncollectible accounts receivable and such losses have
historically been within managements expectations. Any deterioration in the financial condition of our customers could result in an impairment of their ability to pay our accounts receivable in full which may require an increase in our
allowance for doubtful accounts.





Inventory Obsolescence Reserves





Inventories, which consist of finished goods, are stated at the lower of cost or net realizable value. Cost is calculated using the weighted average method and is comprised of
material costs and, where applicable, subcontracting and overhead costs that have been incurred in bringing the inventories to their present location and condition. Net realizable value represents the estimated selling price less costs to be
incurred in selling and distribution. We regularly review inventory quantities on hand and record a provision for excess and obsolete inventory based primarily on our estimates of product demand, current material costs and/or net realizable value.
Adverse changes in technology or market conditions could result in a decrease in demand for our products, which may require an increase to our inventory obsolescence reserves.




23




---

##### Table of Contents




Results of Operations





The following table sets forth certain consolidated operating data as a percentage of total revenues for the years ended December 31, 2001, 2000 and 1999:





Percentage of Total Revenue Years Ended December 31,2001


2000


1999Semiconductor revenue

37
%

36
%

43
%Licensing revenue

32


11


9Component distribution revenue

30


53


48Product revenue

1


0


0Internet and broadcast revenue

0


0


0Total revenue

100


100


100Cost of sales

43


59


61Gross margin

57


41


39Operating costs and expensesSales and marketing

29


23


14Research and development

23


15


12General and administrative

34


37


20Non-cash stock issuance cost

0


11


0Total operating expense

86


86


46Operating loss

(29
)

(45
)

(7
)Other income, net

5


4


2Minority interest

1


1


0Loss before income taxes

(23
)

(40
)

(5
)Income tax expense (benefit)

2


1


0Net loss

(25
)%

(41
)%

(5
)%





Year Ended December 31, 2001 Compared to Year Ended December 31, 2000





Revenues





The Company generates revenues in five business segments. Semiconductor revenue consists of design fees and sales of ASICs by Valence to OEM manufacturers and sales of general purpose ICs designed by the Company under
the brand name ASP. Licensing revenues are royalties generated primarily from the license of the Companys audio and voice technologies. License and royalty agreements generally provide for the license of technologies for a specified period of
time for either a single fee or a fee based on the number of units distributed by the licensee. Component distribution revenue consists of (a) the manufacture and sale of Valences own branded product line of VCD players, amplifiers and game
products and (b) the distribution of semiconductor products, manufacturing components and sub-assemblies to OEMs for the Hong Kong and the PRC markets. Product sales represent sales of consumer products incorporating one or more of SRS Labs
proprietary technologies. Internet and broadcast revenues consist of the sale of hardware and software applications involving the Internet and broadcast audio markets.





Total revenues for Fiscal 2001 were $15,430,930 compared to $27,972,694 in Fiscal 2000, a decrease of $12,541,764 or 44.8%. Semiconductor revenues were $5,646,724 in Fiscal 2001 compared
to $10,168,525 in Fiscal 2000 a decrease of $4,521,801 or 44.5%. This decrease was due to a continued general weakness in demand in worldwide markets for consumer electronics products which negatively impacted the sales of




24




---

##### Table of Contents

semiconductor ICs. Licensing revenues were $4,973,584 in Fiscal 2001 compared to $2,929,717 in Fiscal 2000 an increase of $2,043,867 or 69.8%. This increase was attributable to the sales growth
of home entertainment products such as DVD players and other products which incorporate our technologies. Component distribution revenues were $4,602,819 in Fiscal 2001 compared to $14,718,440 in Fiscal 2000 a decrease of $10,115,621 or 68.7%. This
decrease was due both to the continued general weakness in demand in worldwide markets for consumer electronics products as well as the Companys decision to focus on higher margin semiconductor and licensing revenues and de-emphasize certain
lower margin distribution activities. Product revenues and revenues generated by the Companys Internet and broadcast based business were $189,820 and $17,983, respectively in Fiscal 2001 and $101,148 and $54,864, respectively in Fiscal 2000.





Gross Margin





Cost of sales consists primarily of component costs, fabrication costs, assembly and test costs, and the cost of materials and overhead from operations. Gross margin for Fiscal 2001 increased to 56.6% as a percentage
of total revenue from 40.6% for Fiscal 2000. The increase resulted primarily from the Companys decision to focus the revenue base towards higher margin semiconductor and licensing revenues and away from lower margin component distribution.





Sales and Marketing





Sales and marketing expenses consist primarily of employee-related expenses, sales commissions and product promotion costs. Sales and marketing expenses were $4,474,575 in Fiscal 2001 compared to $6,355,742 in Fiscal
2000, a decrease of $1,881,167 or 29.6%. This decrease is attributable primarily to reductions in spending at Valence associated with the cutback in the component distribution business as well as reductions in the level of expenditures at SRSWOWcast
following Fiscal 2000s initial construction of the website and the creation of program content for the website. Effective February 21, 2001, SRSWOWcast discontinued efforts to develop program content to focus on utilizing the website to
promote the licensing of the Companys audio and voice technology solutions. Management believes sales and marketing expenditures will continue to be a significant component of operating costs in the future to increase brand awareness and
promote the adoption of the Companys technology in new and existing markets. As a percentage of total revenues, sales and marketing expenses increased to 29.0% in Fiscal 2001 from 22.7% in Fiscal 2000.





Research and Development





Research and development expenses consist of salaries and related costs of employees and consultants engaged in ongoing research, design and development activities and costs for engineering materials and supplies. Research and development
expenses were $3,576,170 in Fiscal 2001 compared to $4,151,064 in Fiscal 2000, a decrease of $574,894 or 13.9%. This decrease is primarily attributable to a reduction in staffing levels at Valence and SRSWOWcast. As a percentage of total revenues,
research and development expenses increased to 23.2% in Fiscal 2001 from 14.8% in Fiscal 2000.





Management believes that
research and development expenses will increase in the future as a result of a return to more normal demand for semiconductor ICs as well as the Companys ongoing product development efforts including activity related to the expansion of
consumer products incorporating the Companys audio and voice technologies.





General and Administrative





General and administrative expenses consist primarily of employee-related expenses, legal costs associated with the
administration of intellectual property, professional fees and various other administrative costs. General and administrative expenses were $5,167,396 in Fiscal 2001 compared to $10,357,001 in Fiscal 2000, a decrease of $5,189,605 or 50.1%. The
decrease is primarily due to elevated expenditures incurred during Fiscal 2000 resulting from severance costs incurred related to the resignation of an employee of Valence, the write-off of




25




---

##### Table of Contents

certain intellectual property incorporating obsolete or unpursued technologies, higher legal and employee related expenses associated with the launch of SRSWOWcast, expenses related to the
terminated Valence initial public offering (see below), plus higher salaries and benefits, legal, and other administrative expenses in the Companys core licensing business. The decrease was also attributable to a reduction in the level of
amortization expense related to intangible assets both from prior year write-offs as well as certain categories of intangibles becoming fully amortized during the period. As a percentage of total revenues, general and administrative expenses
decreased to 33.5% in Fiscal 2001 from 37.0% in Fiscal 2000.





On March 3, 2000, the Company filed an application to list the
common shares of Valence on the GEM, in order to sell a minority interest in Valence to the public. The initial public offering was targeted for completion in the second quarter of 2000. However, due to negative market conditions affecting equity
markets worldwide, including the GEM, the Company elected not to proceed with the offering. Offering costs incurred by the Company, comprised primarily of legal, accounting and underwriting fees, totaled $1,142,175 for Fiscal 2000. These costs are
included in general and administrative expense in the accompanying financial statements.





Non-cash Stock Issuance Cost





In March 2000, the Company entered into a technology and marketing alliance with Microsoft. In conjunction with this
transaction, Microsoft purchased shares of common stock of the Company and was issued warrants to purchase additional shares of common stock of the Company and of its subsidiary, SRSWOWcast (together referred to as the Microsoft
Transaction). As a result of the Microsoft Transaction, the Company recognized a one-time, non-cash charge totaling $3,111,859. See Note 9 of the Notes to Consolidated Financial Statements for more information concerning the Microsoft
Transaction.





Other Income, Net





Other income, net consists primarily of interest income, interest expense, realized gains and losses on the sale of investments and foreign currency transaction gains and losses at Valence. Net interest income was
$782,235 in Fiscal 2001 compared to $1,059,009 in Fiscal 2000, a decrease of 26.1%. The decrease is primarily attributable to lower average cash and investment balances during the current year as compared to the prior year as well as lower interest
rates earned on investment balances during Fiscal 2001.





Minority Interest





Minority interest represents the minority shareholders proportionate share of losses in SRSWOWcast. Losses in SRSWOWcast are expected to continue
as a result of expenditures exceeding revenues in an effort to support the expansion and growth of SRSWOWcast business operations. Should losses continue in SRSWOWcast, the minority interest adjustment in the consolidated statement of operations
will continue to reduce the Companys net losses by the minority shareholders proportionate share of SRSWOWcasts net losses to the extent of their investment.





Provision for Income Taxes





The income tax provision for
Fiscal 2001 was $377,519 compared to $324,981 for Fiscal 2000. The higher tax expense in Fiscal 2001 was primarily a result of higher levels of foreign tax on higher licensing revenues sourced from countries requiring foreign tax withholdings. The
Company had federal and state net operating loss carryforwards at December 31, 2001 of approximately $16,500,000 and $11,600,000, respectively. These net operating loss carryforwards will begin to expire in 2019 and 2003, respectively. In addition,
the Company has federal tax credit carryforwards of approximately $863,000. The portion related to the foreign tax credit is $178,000 which will begin to expire in 2003. The remainder of the tax credits will begin to expire in 2011. As of December
31, 2001, a valuation allowance of approximately $6,899,000 has been provided based on the Companys assessment of the future realizability of certain deferred tax assets. Approximately $1,417,000 of the valuation allowance is attributable to
the potential tax benefit of stock option transactions that will be credited directly to additional paid in capital, if realized.




26




---

##### Table of Contents




Year Ended December 31, 2000 Compared to Year Ended December 31, 1999





Revenues





Total revenues for Fiscal 2000 were $27,972,694 compared to $35,795,583 in Fiscal 1999, a decrease of $7,822,889 or 21.9%. Semiconductor revenues were $10,168,525 in Fiscal 2000 compared to $15,246,572 in Fiscal 1999 a decrease of
$5,078,047 or 33.3%. Licensing revenues were $2,929,717 in Fiscal 2000 compared to $3,377,649 in Fiscal 1999 a decrease of $447,932 or 13.3%. These decreases were due to a continued general weakness in the Asian markets leading to reduced demand for
consumer electronics products in the region which negatively impacted the sales of semiconductor ICs that include the Companys audio technologies and the trend by consumer electronic manufacturers to initially adopt the Companys new
technologies into higher end models resulting in limited volume potential for the short term. Component distribution revenues were $14,718,440 in Fiscal 2000 compared to $17,115,815 in Fiscal 1999 a decrease of $2,397,375 or 14.0%. This decrease was
primarily due to the Companys decision to focus on higher margin semiconductor and licensing revenues and de-emphasize certain lower margin distribution activities. Product revenues and revenues generated by the Companys Internet and
broadcast based business were $101,148 and $54,864, respectively in Fiscal 2000 and $55,547 and $0, respectively in Fiscal 1999.





Gross Margin





Gross margin for Fiscal 2000 increased to 40.6% as a percentage of total revenue from 38.5% for
Fiscal 1999. The increase resulted primarily from the Companys decision to focus its revenue base towards higher margin semiconductor and licensing revenues and away from lower margin component distribution.





Sales and Marketing





Sales and marketing expenses were $6,355,742 in Fiscal 2000 compared to $5,148,458 in Fiscal 1999, an increase of $1,207,284 or 23.5%. This increase is attributable primarily to spending associated with the development and promotion of the
SRSWOWcast website and creation of program content for the website. As a percentage of total revenues, sales and marketing expenses increased to 22.7% in Fiscal 2000 from 14.4% in Fiscal 1999.





Research and Development





Research and development
expenses were $4,151,064 in Fiscal 2000 compared to $4,141,571 in Fiscal 1999, an increase of $9,493 or 0.2%. This increase is primarily attributable to expenses related to SRSWOWcast, offset partially by a reduction in staffing levels at Valence.
As a percentage of total revenues, research and development expenses increased to 14.8% in Fiscal 2000 from 11.6% in Fiscal 1999.





General and Administrative





General and administrative expenses were $10,357,001 in Fiscal 2000 compared to
$6,932,397 in Fiscal 1999, an increase of $3,424,604 or 49.4%. The increase is primarily due to severance costs incurred related to the resignation of an employee of Valence, the write-off of certain intellectual property incorporating obsolete or
unpursued technologies, higher legal and employee related expenses associated with the launch of SRSWOWcast, expenses related to the terminated Valence initial public offering, plus higher salaries and benefits, legal, and other administrative
expenses in the Companys core licensing business. As a percentage of total revenues, general and administrative expenses increased to 37.0% in Fiscal 2000 from 19.4% in Fiscal 1999.





Non-cash Stock Issuance Cost





See the discussion above
concerning the non-cash stock issuance cost relating to the Microsoft Transaction.




27




---

##### Table of Contents




Other Income, Net





Net interest income was $1,059,009 in Fiscal 2000 compared to $448,117 in Fiscal 1999, an increase of 136.3%. The increase is primarily attributable to higher average cash and investment
balances during the current year as compared to the prior year due partly to the $5,000,000 received in the Microsoft Transaction.





Minority Interest





On September 29, 2000, the Company sold an equity interest in SRSWOWcast through a private
placement of SRSWOWcast Series A Convertible Preferred Stock (See Note 9 of the Notes to Consolidated Financial Statements for more information concerning this transaction). Minority interest represents the minority shareholders proportionate
share of losses in SRSWOWcast after September 29, 2000.





Provision for Income Taxes





The income tax provision for Fiscal 2000 was $324,981 compared to $49,662 for Fiscal 1999. The higher tax expense in Fiscal 2000 was primarily a result
of Valence fully utilizing tax loss carryforwards during Fiscal 2000 resulting in higher income tax expense and the Company recognizing a tax benefit in Fiscal 1999 primarily due to a taxable loss recognized for U.S. federal income tax purposes
related to domestic operations. In addition, the Company benefited from certain tax credits and statutory tax rates in the Asian countries where Valence has its principal business operations which are lower than United States statutory rates.




28




---

##### Table of Contents




Selected Quarterly Operating Results (Unaudited)





The following table sets forth certain quarterly summary financial data for the eight quarters in the period ended December 31, 2001. The quarterly information is based upon unaudited
financial statements prepared by the Company on a basis consistent with the Companys audited consolidated financial statements and, in managements opinion, includes all adjustments, consisting only of normal recurring adjustments
necessary for a fair presentation of the information for the periods presented. This information should be read in conjunction with the Companys audited Consolidated Financial Statements and Notes thereto appearing elsewhere in this Report.
The Companys quarterly operating results have varied significantly in the past and are expected to vary significantly in the future.





Three Months EndedMar 31, 2001


Jun 30, 2001


Sep 30, 2001


Dec 31, 2001


Mar 31, 2000


Jun 30, 2000


Sep 30, 2000


Dec 31, 2000(In thousands except per share amounts)Revenues:Semiconductor

$
1,084


$
1,500


$
1,574


$
1,489


$
2,312


$
2,394


$
3,047


$
2,415Licensing


1,164



1,625



1,304



880



567



466



825



1,072Component distribution


2,065



1,607



651



280



4,258



3,694



4,098



2,669Product


14



102



20



54



22



28



32



19Internet and broadcast


4



10







4



32



11



6



6Total revenues


4,331



4,844



3,549



2,707



7,191



6,593



8,008



6,181Gross margin


2,029



2,510



2,275



1,913



2,342



2,326



3,391



3,302Operating expenses (a) (b)


3,831



3,620



3,227



2,540



6,755



6,603



4,723



5,895Operating loss


(1,802
)


(1,110
)


(952
)


(627
)


(4,413
)


(4,277
)


(1,332
)


(2,593
)Net loss

$
(1,566
)

$
(980
)

$
(802
)

$
(531
)

$
(4,341
)

$
(4,107
)

$
(1,222
)

$
(1,839
)Net loss per Common share:Basic and diluted

$
(0.12
)

$
(0.08
)

$
(0.06
)

$
(0.05
)

$
(0.36
)

$
(0.33
)

$
(0.10
)

$
(0.14
)


---

|(a) |  | Operating expenses for the three month period ended March 31, 2000 included $3,112 related to non-cash stock issuance cost.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------




|(b) |  | Operating expenses for the three month period ended June 30, 2000 included $1,142 related to offering costs incurred on the terminated Valence initial public offering.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------




Liquidity and Capital Resources





The Company has primarily financed its operations from its inception through private sales of our equity securities, funds generated from operations, an initial public offering of 3,107,452 shares of Common Stock in
August 1996 resulting in net proceeds of approximately $22 million and from short-term borrowings under revolving credit facilities.





As of December 31, 2001, cash, cash equivalents and investments were $19,593,723 compared to $30,425,210 as of December 31, 2000, a decrease of $10,831,487. The Companys principal source of liquidity to fund ongoing operations for the
year ended December 31, 2001 was cash, cash equivalents and investments. The Company has adopted an investment guideline restricting the types and minimum quality of investments the Company is authorized to purchase. At December 31, 2001, the
Company had cash and cash equivalents of $19,011,167 and investments of $582,556. Cash and cash equivalents generally consist of cash, money market funds and other money market instruments with original or remaining maturities of three months or
less. Investments consist of municipal bonds rated a minimum of A1. Net cash used in operating activities during Fiscal 2001 was $2,205,497, attributable primarily to the net loss during the year as well as a net decrease in accounts payable and
accrued liabilities, offset somewhat by a decrease in inventories as well as certain adjustments to reconcile net loss to cash used in operating activities including depreciation and amortization. Net




29




---

##### Table of Contents

cash provided by investing activities of $5,091,868 resulted from proceeds received from sales of the Companys investments offset by purchases of furniture, fixtures and equipment and
expenditures related to intangible assets. Net cash used in financing activities of $8,003,684 was attributable to the repayment of the Companys line of credit and the purchase of treasury shares of the Company offset somewhat by the proceeds
from sale of common stock pursuant to exercise of employee stock options.





Inventories in Fiscal 2001 decreased from $3,068,478
at December 31, 2000 to $1,624,067 at December 31, 2001. This decrease was primarily related to the Companys decision to exit from the lower margin component distribution business in favor of the higher margin semiconductor and licensing
business segments. Accounts payable and accrued liabilities decreased from $1,603,401 and $1,974,357, respectively at December 31, 2000 to $822,698 and $1,357,105, respectively at December 31, 2001 primarily due to reduced activity and staffing
levels during the later stages of Fiscal 2001 compared to Fiscal 2000.





Net cash used in operating activities during Fiscal 2000
was $4,848,803 reflecting the net loss during the year and a net decrease in accounts payable, offset by a decrease in accounts receivable as well as certain adjustments to reconcile net loss to cash used in operating activities including
depreciation and amortization and non-cash stock issuance costs. Net cash provided by investing activities of $525,630 resulted from proceeds received from sales of the Companys investments offset by purchases of furniture, fixtures and
equipment and intangible assets. Net cash provided by financing activities of $12,481,975 resulted from proceeds from the Microsoft Transaction, proceeds from sale of stock of a subsidiary and proceeds from sale of common stock pursuant to exercise
of employee stock options.





In March 1998, the Company obtained a revolving line of credit and letter of credit facility with a
bank which was secured by certain of the Companys cash, cash equivalents and investments. This line of credit expired on April 1, 2001 and was fully repaid on April 2, 2001. The total availability under the line of credit was the lesser of
$10,000,000 or a percentage of the fair market value of the collateral. Interest on the line of credit was at the banks prime rate or LIBOR plus 0.75%. On April 1, 2001, the Company entered into a new revolving line of credit with the same
bank on substantially the same terms and conditions as the previous revolving line of credit except the total availability under the new line of credit was reduced to the lesser of $5,000,000 or a percentage of the fair market value of the
collateral. On October 11, 2001 the Company terminated the new revolving line of credit and letter of credit facility with the bank.





In November 1999, Valence obtained a credit facility with a bank that provided for availability under the line of credit aggregating approximately $5,000,000. In January 2001, the credit facility was renegotiated to reduce the amount of
availability to borrow under the credit facility and to provide for a variety of import/export trade instruments up to $2,000,000 at interest rates ranging from 1% over the Hong Kong Dollar prime rate to 1.75% over LIBOR. The facility was
collateralized by certain of Valences assets on deposit with the bank. The facility expired on October 31, 2001 and is currently being renegotiated. There can be no assurance that management will be successful in the renegotiation of a new
credit facility on terms favorable to the Company, or at all. At December 31, 2001 and 2000, there were no obligations outstanding under this credit facility.





The Company anticipates that its primary uses of working capital in future periods will be to acquire new technologies and to fund increased costs for additional sales, marketing and engineering headcounts and other
marketing activities associated with the introduction of new technologies and products into the market.





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




30




---

##### Table of Contents




Recent Accounting Pronouncements





On January 1, 2001, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities
as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities  an amendment of FASB Statement No. 133 which requires derivatives to be reported as assets or liabilities in the balance
sheet at fair value. The amendment included expanding the normal purchase and sale exemption for supply contracts, permitting the offsetting of certain intercompany foreign currency derivatives and thus reducing the number of third party
derivatives, permitting hedge accounting for foreign-currency denominated assets and liabilities and redefining interest rate risk to reduce sources of ineffectiveness. The adoption of SFAS No. 133, as amended by SFAS No. 138, did not have a
material impact on the Companys consolidated results of operations, financial position or cash flows.





In July 2001, the
Financial Accounting Standards Board (FASB) issued SFAS No. 141 Business Combinations, which, among other things, requires that the purchase method of accounting be used for all business combinations initiated after June 30,
2001, no longer permits the use of the pooling-of-interests method of accounting for business combinations and broadens the criteria for recording intangible assets separate from goodwill. The adoption of SFAS No. 141 during the third quarter of
2001 did not have a material impact on the Companys consolidated results of operations, financial position or cash flows.





In July 2001, FASB issued SFAS No. 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 of goodwill and identifiable intangibles to be evaluated for impairment on an annual basis. Identifiable intangible assets with a determinable useful life will continue to be amortized over that period. SFAS No. 142 is
effective for fiscal years beginning after December 15, 2001. Management does not believe the adoption of SFAS No. 142 will have a material impact on the Companys consolidated results of operations, financial position or cash flows.





In August 2001, FASB issued SFAS No. 143 Accounting for Asset Retirement Obligations, which addresses financial
accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated retirement costs. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002. Management does not believe the
adoption of SFAS No. 143 will have a material impact on the Companys consolidated results of operations, financial position or cash flows.





In October 2001, FASB issued SFAS No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets, which addresses financial accounting and reporting for the impairment of long-lived assets and for
long-lived assets to be disposed of either by sale or other than by sale. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. Management does not believe the adoption of SFAS No. 144 will have a material impact on the
Companys consolidated results of operations, financial position or cash flows.





Factors That May Affect Future Results





Quarterly Fluctuations





The Companys operating results may fluctuate from those in prior quarters and will continue to be subject to quarterly and other fluctuations due to a variety of factors, including the extent to which the
Companys licensees incorporate the Companys technologies into their products; the timing of orders from, and the shipments to, major customers; the timing of new product introductions by the Company; the gain or loss of significant
customers; competitive pressures on selling prices; the market acceptance of new or enhanced versions of the Companys technologies; the rate that the Companys semiconductor licensees manufacture and distribute semiconductors to product
manufacturers; and fluctuations in general economic conditions, particularly those affecting the consumer electronics market. Due to the Companys dependence on the consumer electronics market, the substantial seasonality of sales in the market
could impact the Companys revenues and net income. As a result, the Company believes that period-to-period comparisons of its results of operations are not




31




---

##### Table of Contents

necessarily meaningful and should not be relied upon as indications of future performance. The Company believes that there is seasonality relating to the Christmas season as well as the Chinese
New Year within the Asia region, which fall into the fourth and first quarters, respectively.





Valences Business





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





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





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





Internet Business





In Fiscal 1999, the Company launched its Internet business with the formation of SRSWOWcast. In Fiscal 2000, SRSWOWcast commenced operations with a business plan which focused on developing and acquiring audio based
content to attract visitor traffic to its website in order to sell advertising and e-commerce products. In 2001, the Company changed its Internet strategy to focus on the sale and licensing of software and hardware products incorporating the
Companys audio and voice enhancement technology solutions to the broadcast and Internet markets. There can be no assurance that this new business model will develop a sufficient customer base to be able to generate meaningful revenue.





Product Business





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




32




---

##### Table of Contents




In Fiscal 2000, the Company packaged the hardware and began to market two models: WOW
Thing for Computers and WOW Thing for Game Consoles to consumers and resellers. Although revenues from these products have not been significant, this product group helps elevate awareness of the technology as well as create brand
awareness with the Companys customers and consumers.





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





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





Economic Risks Associated with Doing Business in Asia





The Companys significant operations in Hong Kong, the PRC and other parts of Asia have required, and will continue to require, refinement to adapt
to the changing market conditions in the region. The Companys operations in Asia, and international operations in general, are subject to risks of unexpected changes in, or impositions of, legislative or regulatory requirements.





Customers geographically located in the Asia Pacific markets accounted for approximately 90%, 94% and 94% of total Company sales in 2001,
2000 and 1999, respectively and are expected to continue to account for a substantial percentage of sales in the future. The economic climate in Asia continues to be impacted by increases in unemployment, declines in consumer spending, currency
devaluation and bank failures. Any of these factors, should they continue, could significantly reduce the demand for the end user goods in which the Companys products and technologies are used.





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





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





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




33




---

##### Table of Contents




Currency Risk/Stability of Asian Markets





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





Competitive Pressures





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





Importance of Intellectual Property





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




34




---

##### Table of Contents




Dependence on Key Personnel





The Companys future success depends in part on the continued service of its key engineering, sales, marketing and executive personnel, including highly skilled semiconductor design
personnel. The Company anticipates that any future growth will require it to recruit and hire a number of new personnel in engineering, operations, finance, sales and marketing. Competition for such personnel during times of economic growth is
intense, and there can be no assurance that the Company can recruit and retain necessary personnel to operate its business and support future growth.





Marketability and Volatility of Stock Price





The trading price of the Common Stock has
been, and will likely continue to be, subject to wide fluctuations in response to quarterly variations in the Companys operating results, announcements of new products or technological innovations by the Company or its competitors, strategic
alliances between the Company and third parties, general market fluctuations and other events and factors. Changes in earnings estimates made by brokerage firms and industry analysts relating to the markets in which the Company does business, or
relating to the Company specifically, have in the past resulted in, and could in the future result in, an immediate and adverse effect on the market price of the Common Stock. Even though our stock is quoted on the Nasdaq Stock Market, our stock has
had and may continue to have low trading volume and high volatility. The historically low trading volume of our stock makes it more likely that a severe fluctuation in volume, either up or down, will significantly impact the stock price. Since our
shares are thinly traded, our shareholders may have difficulty selling our common stock.





Acquisitions





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




35




---

##### Table of Contents




Item 7A.    Quantitative and Qualitative Disclosures About Market Risk





The
Company is exposed to a variety of risks, including foreign currency fluctuations and changes in interest rates affecting investment earnings.





Foreign Currency





The Company has subsidiary operations in Hong Kong and customers in the PRC, and, accordingly,
the Company is exposed to transaction gains and losses that could result from changes in foreign currency exchange rates. The Company uses the local currency (Hong Kong dollars) as the functional currency for its Valence subsidiaries. Translation
adjustments resulting from the process of translating foreign currency financial statements into U.S. dollars were not significant in Fiscal 2001, 2000 and 1999 due to the fact that the value of the Hong Kong dollar is currently pegged to the U.S.
dollar, and the exchange rate remained relatively constant throughout such fiscal years. Cash balances maintained by Valence in excess of normal operating requirements are invested in U.S. denominated bank accounts further reducing balance sheet
exposure to changes in foreign currency exchange rates. Under the current circumstances, the Company believes that the foreign currency market risk is not material. The Company actively monitors its foreign exchange exposure and, should
circumstances change, intends to implement strategies to reduce its risk at such time that it determines that the benefits of such strategies outweigh the associated costs. There can be no assurance that managements efforts to reduce foreign
exchange exposure will be successful.





Interest Rates





The Companys exposure to market risk for changes in interest rates, relates primarily to our invested balances of cash, cash equivalents and investments. The Companys investment policy specifies excess
funds are to be invested in a manner that preserves capital, provides liquidity and generates the highest available after-tax return. To limit exposure to market risk, the Company places its cash in banks, cash equivalents in high quality,
short-term commercial paper and money market funds and investments consist of short-term municipal bonds. The Company does not invest in any derivative instruments. The fair value of the Companys cash, cash equivalents and investments or
related income would not be significantly impacted by either a 100 basis point increase or decrease in interest rates as most investments are at fixed rates and are relatively short term. All cash, cash equivalents and investments are carried at
fair value, which approximates cost.




36




---

##### Table of Contents




Item 8.    
Financial Statements and Supplementary Data





PageCONSOLIDATED FINANCIAL STATEMENTS:Independent Auditors Report

38Consolidated Balance Sheets as of December 31, 2001 and 2000

39Consolidated Statements of Operations for the years ended December 31, 2001, 2000 and 1999

40Consolidated Statements of Stockholders Equity and Comprehensive Loss for the years ended December 31, 2001, 2000 and
1999

41Consolidated Statements of Cash Flows for the years ended December 31, 2001, 2000 and 1999

42Notes to Consolidated Financial Statements

43FINANCIAL STATEMENT SCHEDULE:Schedule II  Valuation and Qualifying Accounts and Reserves for the years ended December 31, 2001, 2000 and 1999

59





The Quarterly Financial Information required by this Item 8 is set forth in Item
7 of this Annual Report on Form 10-K and is hereby incorporated into this Item 8.




37




---

##### Table of Contents




INDEPENDENT AUDITORS REPORT





To the Board of Directors


and Stockholders of


SRS Labs, Inc.:





We have audited the accompanying consolidated balance sheets of SRS Labs, Inc. and subsidiaries (the Company) as of December 31, 2001 and
2000, and the related consolidated statements of operations, stockholders equity and comprehensive loss and cash flows for each of the three years in the period ended December 31, 2001. Our audits also included the financial statement schedule
listed in the Index to Financial Statements at Item 14(a)(2). These financial statements and the financial statement schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial
statements and the financial statement schedule based on our audits.





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





In our opinion, such
consolidated financial statements present fairly, in all material respects, the financial position of SRS Labs, Inc. and subsidiaries as of December 31, 2001 and 2000, and the results of their operations and their cash flows for each of the three
years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the information set forth therein.





/s/    DELOITTE &
TOUCHE LLP





Costa Mesa, California


March 15, 2002




38




---

##### Table of Contents




SRS LABS, INC.





CONSOLIDATED BALANCE SHEETS





ASSETS





December 31, 2001


December 31, 2000Current AssetsCash and cash equivalents

$
19,011,167


$
24,128,480Investments available for sale


582,556



5,713,881Accounts receivable, net of allowance for doubtful accounts of $68,888 in 2001 and $995,599 in 2000


870,016



787,908Inventories, net of reserve of $679,052 in 2001 and $757,185 in 2000


1,624,067



3,068,478Prepaid expenses and other current assets, including other receivables of $22,191 in 2001 and $150,856 in 2000


631,844



847,953Deferred income taxes


219,429



38,116Total Current Assets


22,939,079



34,584,816Investments available for sale






582,849Furniture, fixtures and equipment, net


1,672,801



1,808,624Intangible assets, net


2,852,009



3,692,218Deferred income taxes


799,499



900,839Total Assets

$
28,263,388


$
41,569,346LIABILITIES AND STOCKHOLDERS EQUITYCurrent LiabilitiesAccounts payable

$
822,698


$
1,603,401Accrued liabilities


1,357,105



1,974,357Line of credit






8,000,000Income taxes payable


1,144,493



1,093,107Total Current Liabilities


3,324,296



12,670,865Minority interest


403,079



595,428Commitments and contingencies (Note 7)Stockholders EquityPreferred 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; 12,789,644 and 12,652,844 shares issued; and 12,664,744 and 12,581,744 outstanding for 2001 and 2000, respectively


12,790



12,653Additional paid-in capital


55,745,867



55,436,455Cumulative other comprehensive loss


(74,055
)


(64,950
)Accumulated deficit


(30,696,595
)


(26,817,824
)Treasury stock at cost, 124,900 and 71,100 shares at December 31, 2001 and 2000, respectively


(451,994
)


(263,281
)Total Stockholders Equity


24,536,013



28,303,053Total Liabilities And Stockholders Equity

$
28,263,388


$
41,569,346





See accompanying notes to consolidated financial statements




39




---

##### Table of Contents




SRS LABS, INC.





CONSOLIDATED STATEMENTS OF OPERATIONS





Years Ended December 31,2001


2000


1999Total revenues

$
15,430,930


$
27,972,694


$
35,795,583Cost of sales


6,703,550



16,611,290



22,002,817Gross margin


8,727,380



11,361,404



13,792,766ExpensesSales and marketing


4,474,575



6,355,742



5,148,458Research and development


3,576,170



4,151,064



4,141,571General and administrative


5,167,396



10,357,001



6,932,397Non-cash stock issuance cost






3,111,859



Total expenses


13,218,141



23,975,666



16,222,426Loss from operations


(4,490,761
)


(12,614,262
)


(2,429,660
)Other income, net


796,504



1,180,352



735,122Minority interest


193,005



249,577



Loss before income tax expense


(3,501,252
)


(11,184,333
)


(1,694,538
)Income tax expense


377,519



324,981



49,662Net loss

$
(3,878,771
)

$
(11,509,314
)

$
(1,744,200
)Net loss per common share:Basic and diluted

$
(0.31
)

$
(0.93
)

$
(0.15
)Weighted average shares used in the calculation of net loss per common share:Basic and diluted


12,630,199



12,379,281



11,696,272











See
accompanying notes to consolidated financial statements




40




---

##### Table of Contents




SRS LABS, INC.





CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY AND COMPREHENSIVE LOSS





Common Stock

Additional Paid-in Capital

Accumulative Other Comprehensive Income (Loss)


Accumulated Deficit


Treasury Stock


Total


Comprehensive Loss For The Years Ended December 31,Shares


AmountBALANCE, January 1, 1999

11,688,893


$
11,689

$
39,483,405

$
141,389


$
(13,564,310
)

$



$
26,072,173Proceeds from exercise of stock options

201,798



202


590,594














590,796Tax benefit associated with exercise of stock options








381,376














381,376Deferred stock option compensation








121,518














121,518Treasury stock

(71,100
)
















(263,281
)


(263,281
)Unrealized loss on investments available for sale, net of tax











(113,232
)










(113,232
)

$
(113,232
)Currency translation adjustment











(4,827
)










(4,827
)


(4,827
)Net loss















(1,744,200
)






(1,744,200
)


(1,744,200
)BALANCE, December 31, 1999

11,819,591



11,891


40,576,893


23,330



(15,308,510
)


(263,281
)


25,040,323


$
(1,862,259
)Proceeds from exercise of stock options

471,624



471


1,481,213














1,481,684Deferred stock option compensation








111,495














111,495Issuance of common stock and warrants

290,529



291


8,111,859














8,112,150Increase in additional paid-in capital from sale of stock by subsidiary








5,154,995














5,154,995Unrealized loss on investments available for sale, net of tax











(7,061
)










(7,061
)

$
(7,061
)Currency translation adjustment











(81,219
)










(81,219
)


(81,219
)Net loss















(11,509,314
)






(11,509,314
)


(11,509,314
)BALANCE, December 31, 2000

12,581,744



12,653


55,436,455


(64,950
)


(26,817,824
)


(263,281
)


28,303,053


$
(11,597,594
)Proceeds from exercise of stock options

136,800



137


184,892














185,029Deferred stock option compensation








124,520














124,520Issuance of common stock and warrants























Treasury stock

(53,800
)
















(188,713
)


(188,713
)Unrealized loss on investments available for sale, net of tax











(13,849
)










(13,849
)

$
(13,849
)Currency translation adjustment











4,744











4,744



4,744Net loss















(3,878,771
)






(3,878,771
)


(3,878,771
)BALANCE, December 31, 2001

12,664,744


$
12,790

$
55,745,867

$
(74,055
)

$
(30,696,595
)

$
(451,994
)

$
24,536,013


$
(3,887,876
)








See accompanying notes to consolidated financial
statements




41




---

##### Table of Contents




SRS LABS, INC.





CONSOLIDATED STATEMENTS OF CASH FLOWS





Years Ended December 31,2001


2000


1999Cash Flows From Operating Activities:Net loss

$
(3,878,771
)

$
(11,509,314
)

$
(1,744,200
)Adjustments to reconcile net loss to net cash (used in) provided by operating activities:Non-cash stock issuance cost






3,111,859



Minority interest


(193,005
)


(249,577
)


Provision for doubtful accounts


50,240



116,560



1,040,271Provision for obsolete inventory


113,920



132,341



628,006Depreciation and amortization


1,558,299



3,549,075



2,127,736Deferred income taxes


(79,973
)


(116,599
)


(836,140
)Amortization of premium on investments available for sale


15,701



34,035



54,964Stock option compensation expense


125,176



111,495



121,518Currency translation adjustment


4,744



(81,219
)


(4,827
)Loss on disposition of furniture, fixtures and equipment


865



16,483



1,594Changes in operating assets and liabilities, net of the effect of acquisitions:Accounts receivable


(132,348
)


1,590,689



1,785,258Inventories


1,330,491



(474,626
)


1,278,769Prepaid expenses and other assets


216,109



304,421



2,091,859Accounts payable


(780,703
)


(1,279,285
)


(7,749,819
)Accrued liabilities


(617,252
)


315,393



1,236,121Income taxes payable


61,010



(420,534
)


1,602,067Net cash (used in) provided by operating activities


(2,205,497
)


(4,848,803
)


1,633,177Cash Flows From Investing Activities:Purchase of furniture, fixtures and equipment


(509,183
)


(1,154,370
)


(464,037
)Proceeds from sales of investments available for sale


5,675,000



3,000,000



2,500,000Expenditures related to intangible assets


(73,949
)


(1,320,000
)


(368,219
)Net cash provided by investing activities


5,091,868



525,630



1,667,744Cash Flows From Financing Activities:Proceeds from sale of common stock






5,000,291



Proceeds from sale of stock by subsidiary






6,000,000



Principal payments on line of credit


(8,000,000
)






Exercise of stock options


185,029



1,481,684



590,796Purchase of treasury stock


(188,713
)






(263,281
)Net cash (used in) provided by financing activities


(8,003,684
)


12,481,975



327,515Net (decrease) increase in cash and cash equivalents


(5,117,313
)


8,158,802



3,628,436Cash and cash equivalents, beginning of period


24,128,480



15,969,678



12,341,242Cash and cash equivalents, end of period

$
19,011,167


$
24,128,480


$
15,969,678Supplemental Disclosures Of Cash Flow Information:Cash paid during the period for:Interest

$
151,667


$
586,722


$
179,194Income taxes

$
396,482


$
963,794


$
Supplemental Disclosures of Non-cash Investing and Financing Activities:Unrealized loss on investments, net

$
(13,849
)

$
(7,061
)

$
(113,232
)Tax benefit associated with exercise of stock options

$



$



$
381,376





See accompanying notes to consolidated financial statements




42




---

##### Table of Contents

SRS LABS, INC.





NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS


For the Years Ended December 31, 2001, 2000 and 1999





1.    Organization and Significant Accounting Policies





Organization





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





SRS Labs, Inc. conducts its
business activities through the following three operating business units: SRS Labs, the parent company; its majority-owned subsidiary, SRSWOWcast.com, Inc., doing business as SRSWOWcast Technologies (SRSWOWcast); and its wholly-owned
subsidiary, ValenceTech Limited and ValenceTech Limiteds wholly-owned subsidiaries (collectively Valence). SRS Labs and its majority-owned and wholly-owned subsidiaries together are hereby collectively referred to as the
Company.





The Company is a developer and provider of application specific integrated circuits, (ASICs),
standard integrated circuits (ICs) and audio and voice technology solutions for the consumer electronics, home theater, DVD, portable audio, wireless device, computer, game, broadcast, Internet and telecommunications markets. The Company
operates in the following five business segments:





| |  |  | SRS Labs
| | - |  | --------




| |  |  | Licensing: SRS Labs develops and licenses audio and voice technologies to original equipment manufacturers (OEMs) and semiconductor manufacturers around the
world.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | Products: SRS Labs sells consumer products which incorporate its proprietary technologies.
| | - |  | ------------------------------------------------------------------------------------------




| |  |  | SRSWOWcast
| | - |  | ----------




| |  |  | Internet and Broadcast: SRSWOWcast develops and licenses software and hardware audio enhancement technology solutions for the Internet and broadcast markets.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | Valence
| | - |  | -------




| |  |  | ASICs: Valence develops and markets technology solutions in the form of analog and digital signal processor (DSP) ASIC semiconductors or other imbedded
custom semiconductor designs to OEMs.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | Component Distribution: Valence is an authorized, non-exclusive distributor of semiconductor components, subassemblies and finished goods for selected OEM customers. The
Company expects this business segment will be completely phased out by the end of 2002.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




Basis of
Presentation





The consolidated financial statements have been prepared in accordance with accounting principles generally
accepted in the United States of America and include the Company and its wholly and majority owned subsidiaries, Valence and SRSWOWcast, after elimination of all intercompany accounts and transactions. The equity and net loss attributable to
minority shareholders are shown separately in the consolidated balance sheet and statement of operations, respectively.





Cash
Equivalents





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




43




---

##### Table of Contents



SRS LABS, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


For the Years Ended December 31, 2001, 2000 and 1999




maintains cash and cash equivalents, investments, and certain other financial instruments with various major financial institutions. The Company performs periodic evaluations of the relative
credit standing of these financial institutions and limits the amount of credit exposure with any one institution.





Investments





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





Inventories





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





Furniture, Fixtures and Equipment





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





Intangible Assets





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





Consideration for the purchase of assets in excess of the fair market value of specifically identified tangible assets has been capitalized as
intangible assets in the accompanying consolidated balance sheets. These assets are being amortized over periods ranging from three to eleven years depending on the useful life of the asset.





The Company annually evaluates the recoverability of its patents and intangible assets based on the estimated future undiscounted cash flows. Should the carrying value of patents or
intangible assets exceed the estimated future undiscounted cash flows for the expected periods of benefit, such assets would be written down to fair value. Based upon its most recent assessment, the Company has determined that there was no
impairment at December 31, 2001.





Long-Lived Assets





The Company accounts for the impairment and disposition of long-lived assets in accordance with SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of.




44




---

##### Table of Contents



SRS LABS, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


For the Years Ended December 31, 2001, 2000 and 1999




In accordance with SFAS No. 121, long-lived assets are reviewed for events or changes in circumstances that indicate that their carrying value may not be recoverable. The Company periodically
reviews the carrying value of long-lived assets to determine whether or not an impairment to such value has occurred and, based on its most recent assessment, has determined that there was no impairment at December 31, 2001.





Minority Interest in Consolidated Subsidiary





Minority interest in consolidated subsidiary represents the minority stockholders proportionate share of the equity of SRSWOWcast. At December 31, 2001 and 2000, the Company owned approximately 87% of the
capital stock of SRSWOWcast.





Use of Estimates





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





Revenue Recognition





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





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





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





Research and Development





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





Income Taxes





The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. Deferred
taxes on income result from temporary differences between the reporting of income for financial statement and tax reporting purposes. A valuation allowance related to a deferred tax asset is recorded when it is more likely than not that some portion
or all of the deferred tax asset will not be realized.




45




---

##### Table of Contents



SRS LABS, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


For the Years Ended December 31, 2001, 2000 and 1999







Foreign Currency Translation





The Companys reporting currency is the U.S. dollar, while the functional currency of Valence is the Hong Kong dollar. Assets and liabilities of
Valence are translated at the rate of exchange on the balance sheet date. Revenues and expenses are translated using the average exchange rate for the period. Translation adjustments resulting from the process of translating foreign currency
financial statements into U.S. dollars are included as a separate component of stockholders equity (accumulative other comprehensive income (loss)). Foreign currency translation gains (losses) were $4,744, ($81,219) and ($4,827) during the
years ended December 31, 2001, 2000 and 1999, respectively. Transaction (losses) gains arising on exchange of foreign currency are recognized as incurred in the statements of operations and aggregated ($3,261), $51,855 and $26,775 during the years
ended December 31, 2001, 2000 and 1999, respectively.





Net Loss Per Common Share





The Company applies SFAS No. 128, Earnings per Share, which requires the disclosure of basic and diluted net income or loss per share for
all current and prior periods. Basic net income or loss per common share is computed by dividing net income or loss available to common stockholders by the weighted average number of common shares outstanding during each year. Diluted net income or
loss per common share reflects the maximum dilution, based on the average price of the Companys common stock each period and is computed similar to basic income or loss per share except that the denominator is increased to include the number
of additional shares that would have been outstanding if potentially dilutive stock options and warrants had been exercised. Common stock equivalents have not been included in calculating diluted net loss per share for the years ended December 31,
2001, 2000 and 1999, respectively as their inclusion would be anti-dilutive.





Stock-Based Compensation





The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board
(APB) Opinion No. 25, Accounting for Stock Issued to Employees. The Company accounts for stock-based awards to non-employees using the fair value method in accordance with SFAS No. 123, Accounting for Stock-Based
Compensation.





Fair Value of Financial Instruments





Management believes the carrying amounts of cash and cash equivalents, accounts receivable and accounts payable approximate fair value due to the short period of time between origination
of the instruments and their expected realization. The carrying amounts of investments available for sale are reported at fair value based on quoted market prices (Note 3).





Customer Concentration





During the fiscal year ended
December 31, 2000 (Fiscal 2000) and the fiscal year ended December 31, 1999 (Fiscal 1999), one customer accounted for approximately 14% and 21% of revenues, respectively. Given the significant amount of revenues derived from
these customers, the loss of any such customer or the uncollectibility of related receivables could have a material adverse effect on the Companys financial condition and results of operations. For the fiscal year ended December 31, 2001
(Fiscal 2001), no single customer accounted for more than 10% of revenues.




46




---

##### Table of Contents



SRS LABS, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


For the Years Ended December 31, 2001, 2000 and 1999







Concentrations of Credit Risk





Financial instruments, which potentially subject the Company to concentrations of credit risk, consist primarily of cash equivalents, investments and
trade accounts receivable. The Company places its cash in banks and its cash equivalents in commercial paper and money market funds. Investments consist primarily of short- term municipal bonds. The Company has not experienced any significant losses
on its cash equivalents or investments.





The Companys trade receivables are derived from sales to OEMs and distributors in
the consumer electronics, home theater, computer, game, broadcast, Internet and telecommunications markets primarily in Asia, North America and Europe. The Company makes periodic evaluations of the creditworthiness of its customers and manages its
exposure to losses from bad debts by limiting the amount of credit extended whenever deemed necessary and generally does not require collateral. The Company maintains an allowance for estimated uncollectible accounts receivable and such losses have
historically been within managements expectations.





Geographic Risk





The Companys significant operations in Hong Kong, the Peoples Republic of China (PRC) and other parts of Asia have required, and will
continue to require, refinement to adapt to the changing market conditions in the region. The Companys operations in Asia, and international operations in general, are subject to risks of unexpected changes in, or impositions of legislative or
regulatory requirements.





Customers geographically located in the Asia Pacific markets accounted for approximately 90%, 94% and
94% of total Company sales in 2001, 2000 and 1999, respectively and are expected to continue to account for a substantial percentage of sales in the future. The economic climate in Asia continues to be impacted by increases in unemployment, declines
in consumer spending, currency devaluation and bank failures. Any of these factors, should they continue, could significantly reduce the demand for the end user goods in which the Companys products and technologies are used.





Recent Accounting Pronouncements





On January 1, 2001, the Company adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and
Certain Hedging Activities  an amendment of FASB Statement No. 133 which requires derivatives to be reported as assets or liabilities in the balance sheet at fair value. The amendment included expanding the normal purchase and
sale exemption for supply contracts, permitting the offsetting of certain intercompany foreign currency derivatives and thus reducing the number of third party derivatives, permitting hedge accounting for foreign-currency denominated assets and
liabilities and redefining interest rate risk to reduce sources of ineffectiveness. The adoption of SFAS No. 133, as amended by SFAS No. 138, did not have a material impact on the Companys consolidated results of operations, financial position
or cash flows.





In July 2001, FASB issued SFAS No. 141 Business Combinations, which, among other things, requires
the purchase method of accounting be used for all business combinations initiated after June 30, 2001, no longer permits the use of the pooling-of-interests method of accounting for business combinations and broadens the criteria for recording
intangible assets separate from goodwill. The adoption of SFAS No. 141 during the third quarter of 2001 did not have a material impact on the Companys consolidated results of operations, financial position or cash flows.




47




---

##### Table of Contents



SRS LABS, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


For the Years Ended December 31, 2001, 2000 and 1999







In July 2001, FASB issued SFAS No. 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 of goodwill and identifiable intangibles to be evaluated for
impairment on an annual basis. Identifiable intangible assets with a determinable useful life will continue to be amortized over that period. SFAS No. 142 is effective for fiscal years beginning after December 15, 2001. Management does not believe
the adoption of SFAS No. 142 will have a material impact on the Companys consolidated results of operations, financial position or cash flows.





In August 2001, FASB issued SFAS No. 143 Accounting for Asset Retirement Obligations, which addresses financial accounting and reporting for obligations associated with the retirement of tangible
long-lived assets and the associated retirement costs. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002. Management does not believe the adoption of SFAS No. 143 will have a material impact on the Companys consolidated
results of operations, financial position or cash flows.





In October 2001, FASB issued SFAS No. 144 Accounting for the
Impairment or Disposal of Long-Lived Assets, which addresses financial accounting and reporting for the impairment of long-lived assets and for long-lived assets to be disposed of either by sale or other than by sale. SFAS No. 144 is effective
for fiscal years beginning after December 15, 2001. Management does not believe the adoption of SFAS No. 144 will have a material impact on the Companys consolidated results of operations, financial position or cash flows.





Reclassifications





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





2.    Acquisitions





On March 2, 1998, the Company acquired (the Acquisition) all
of the outstanding shares of capital stock of Valence Technology Inc. (a British Virgin Islands holding company ultimately succeeded by Valence). The Acquisition was accounted for as a purchase having an effective date of February 1, 1998, and
accordingly, the total purchase price was allocated to the assets acquired and liabilities assumed at their estimated fair values in accordance with APB Opinion No. 16. The aggregate consideration, including acquisition costs and non-compete
agreements, was $21,879,033. Valence, which conducts its operations through its subsidiaries based in Hong Kong and the PRC, is engaged in the following business activities: (i) the development and marketing of technology in the form of ASICs and
ICs to OEMs and (ii) the sale of consumer electronic and telecommunications products and components.





On February 28, 1998, the
Company acquired certain rights to a proprietary technology, Voice Intelligibility Processor (VIP), from a third party. The aggregate consideration, including acquisition costs, was $1,138,710.





On May 21, 1998, the Company acquired certain rights to a proprietary technology, Circle Surround, from a third party. The aggregate consideration,
including acquisition costs, was $834,985.




48




---

##### Table of Contents



SRS LABS, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


For the Years Ended December 31, 2001, 2000 and 1999







3.    Investment Securities Available for Sale





The following table summarizes the Companys investment securities available for sale:





December 31,2001

2000Municipal bonds available for sale:Cost

$
570,274

$
6,260,975Unrealized gains


12,282


35,755Estimated fair value

$
582,556

$
6,296,730





The contractual maturities of investments are shown below. Actual maturities may
differ from contractual maturities.





December 31, 2001

December 31, 2000Cost

Estimated Fair Value

Cost

Estimated Fair ValueMunicipal bonds:Due in one year or less

$
570,274

$
582,556

$
5,684,486

$
5,713,881Due in one to five years








576,489


582,849$
570,274

$
582,556

$
6,260,975

$
6,296,730





4.    Furniture, Fixtures and Equipment





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





December 31,2001


2000Furniture, fixtures and equipment

$
1,257,855


$
1,207,731Computer equipment


2,951,673



2,508,403Leasehold improvements


283,566



290,1644,493,094



4,006,298Less accumulated depreciation and amortization


(2,820,293
)


(2,197,674
)$
1,672,801


$
1,808,624




49




---

##### Table of Contents



SRS LABS, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


For the Years Ended December 31, 2001, 2000 and 1999







5.    Intangible Assets





Intangible assets consist of the following:





December 31,2001


2000Goodwill

$
711,886


$
711,886Patents


1,216,602



1,142,654Developed technology


1,200,000



1,200,000Cell library


1,150,000



1,150,000Customer list


1,000,000



1,000,000Workforce


1,000,000



1,000,000Non-compete agreement


900,400



900,400Brand name


660,000



660,000Other purchased technology


120,000



120,0007,958,888



7,884,940Less accumulated amortization


(5,106,879
)


(4,192,722
)$
2,852,009


$
3,692,218





Amortization periods range from three to eleven years depending on the estimated
useful life of the asset. A review for impairment during Fiscal 2000 resulted in a write-down of intangible assets with a cost of $1,693,740 and a net book value of $1,116,000. Based upon its most recent assessment, the Company has determined that
there was no further impairment at December 31, 2001. In conjunction with the adoption of SFAS No. 142 Goodwill and Other Intangible Assets, the Company will cease the amortization of Goodwill effective January 1, 2002, the effect
of which will not be significant to the Companys consolidated financial position, results of operations or cash flows.





6.    Financing Arrangements





In March 1998, the Company obtained a revolving line of credit
and letter of credit facility with a bank which was secured by certain of the Companys cash, cash equivalents and investments. This line of credit expired on April 1, 2001 and was fully repaid on April 2, 2001. The total availability under the
line of credit was the lesser of $10,000,000 or a percentage of the fair market value of the collateral. Interest on the line of credit was at the banks prime rate or LIBOR plus 0.75%. On April 1, 2001, the Company entered into a new revolving
line of credit with the same bank on substantially the same terms and conditions as the previous revolving line of credit except the total availability under the new line of credit was reduced to the lesser of $5,000,000 or a percentage of the fair
market value of the collateral. At December 31, 2001, the Company had no borrowings outstanding under the new revolving line of credit and on October 11, 2001 the Company terminated the new revolving line of credit and letter of credit facility with
the bank. As of December 31, 2000, the Company had $8.0 million outstanding under the line of credit.





In November 1999, Valence
obtained a credit facility with a bank that provided for availability under the line of credit aggregating approximately $5,000,000. In January 2001, the credit facility was renegotiated to reduce the amount of availability to borrow under the
credit facility and to provide for a variety of import/export trade instruments up to $2,000,000 at interest rates ranging from 1% over the Hong Kong Dollar prime rate to 1.75% over LIBOR. The facility was collateralized by certain of Valences
assets on deposit with the bank. The facility expired on October 31, 2001 and is currently being renegotiated. There can be no assurance that management will be successful in the renegotiation of a new credit facility on terms favorable to the
Company, or at all. At December 31, 2001 and 2000, there were no obligations outstanding under this credit facility.




50




---

##### Table of Contents



SRS LABS, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


For the Years Ended December 31, 2001, 2000 and 1999







7.    Commitments and Contingencies





The Company leases office space and certain equipment under noncancelable operating leases expiring through 2003.





The Company leases its corporate office and storage facilities located in Santa Ana, California, under a lease agreement with a partnership which is
affiliated with a principal stockholder and executive officer of the Company. The lease is for a term of two years, commencing June 1, 2000, with an option to extend the term for an additional two years thereafter. Additionally, the Company leases
office and warehouse facilities in Hong Kong from unrelated parties. Total rent expense was $520,362, $615,847 and $604,198 for the years ended December 31, 2001, 2000, and 1999, respectively, of which $182,520, $175,500 and $165,672 was paid
to related parties, respectively. Future annual minimum lease payments under noncancelable operating leases at December 31, 2001, are as follows:





Year ending December 31,

Facility

Office Equipment

Total2002

$
355,633

$
5,495

$
361,1282003


243,154


2,290


245,444$
598,787

$
7,785

$
606,572





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





8.    Income Taxes





The provision for income taxes consists of the following:





December 31,2001


2000


1999Current:Federal

$
(69,183
)

$
(82,801
)

$
35,553State


150,756



(10,828
)


88,282Foreign


375,918



535,210



761,967457,491



441,581



885,802Deferred:Federal


(589,730
)


(4,352,139
)


(1,583,931
)State


(327,900
)


(626,850
)


(281,414
)Foreign






(44,812
)


(125,196
)Change in valuation allowance


837,658



4,907,201



1,154,401(79,972
)


(116,600
)


(836,140
)$
377,519


$
324,981


$
49,662




51




---

##### Table of Contents



SRS LABS, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


For the Years Ended December 31, 2001, 2000 and 1999







The reconciliation of the benefit for income taxes computed at U.S. federal
statutory rates to the provision for income taxes is as follows:





December 31,2001


2000


1999Tax at U.S. federal statutory rates

$
(1,225,438
)

$
(4,001,868
)

$
(593,088
)State income taxes, net of federal


(127,938
)


(420,868
)


(127,467
)Tax exempt interest


(31,667
)


70,179



(35,862
)Change in valuation allowance


837,658



4,907,201



1,154,401Impact of foreign dividend


396,021







Foreign withholding tax


328,785



220,875



184,528Other


200,098



(450,538
)


(532,850
)Total income tax expense

$
377,519


$
324,981


$
49,662





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





December 31,2001


2000Deferred tax assets (liabilities):State income taxes

$
(486,832
)

$
(362,895
)Depreciation and amortization


665,234



566,727Accruals


9,747



(20,205
)Net operating loss carryforwards


6,641,263



6,085,899Tax credit carryforwards


862,537



683,224Other


226,239



47,807Valuation allowance


(6,899,260
)


(6,061,602
)Total net deferred tax assets

$
1,018,928


$
938,955





The Company has federal and state net operating loss carryforwards at December
31, 2001, of approximately $16,500,000 and $11,600,000, respectively. These net operating loss carryforwards will begin to expire in 2019 and 2003, respectively. In addition, the Company has federal tax credit carryforwards of approximately $863,000
at December 31, 2001. The portion related to the foreign tax credit is $178,000 which will begin to expire in 2003. The remainder of the tax credits will begin to expire in 2011.





As of December 31, 2001, a valuation allowance of approximately $6,899,000 has been provided based on the Companys assessment of the future realizability of certain deferred tax
assets. Approximately $1,417,000 of the valuation allowance is attributable to the potential tax benefit of stock option transactions that will be credited directly to additional paid in capital, if realized.




52




---

##### Table of Contents



SRS LABS, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


For the Years Ended December 31, 2001, 2000 and 1999







9.    Stockholders Equity





Issuance of Common Stock





Stock Repurchases





During the fiscal year ended December 31, 1998 (Fiscal 1998), the Companys Board of Directors authorized
the repurchase of up to 500,000 of the outstanding shares of the Companys common stock for a period from December 23, 1998 to December 31, 1999 (the 1998 Repurchase Program). Under the 1998 Repurchase Program, 71,100 shares had
been repurchased at a cost of $263,281. On September 17, 2001, the Companys Board of Directors authorized the repurchase of up to 250,000 of the outstanding shares of the Companys common stock for a period from September 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. All repurchased shares under both the 1998 Repurchase Program and the 2001
Repurchase Program are reflected as treasury stock in the accompanying consolidated balance sheets.





Common Stock Issuances





During Fiscal 2000, the Company entered into a technology and marketing alliance with Microsoft Corporation
(Microsoft). In connection with this transaction, Microsoft purchased 290,529 shares of the Companys common stock for $17.21 per share or $5,000,000 in the aggregate (together referred to as the Microsoft Transaction).
The difference between the purchase price received and the fair value of the common stock on the date of purchase, totaling $556,076, was recorded as non-cash stock issuance cost by the Company during Fiscal 2000.





Stock Award/Option Plans/Warrants





On December 10, 1993, the Companys Board of Directors and shareholders adopted an Incentive Stock Option, Nonqualified Stock Option and Restricted Stock Purchase Plan (the 1993 Plan). Under the 1993
Plan, 801,971 shares of the Companys common stock are reserved for issuance to executives, employees and non-employee directors of the Company at the discretion of the Board of Directors or the committee administering the 1993 Plan. The
Compensation Committee of the Board or, in the absence of a Compensation Committee, the Board has been appointed to administer the 1993 Plan. Options issued under the 1993 Plan vest in the manner prescribed by the Compensation Committee or the
Board, as applicable. As of December 31, 2001, options to purchase 801,971 shares of the Companys common stock were granted under the 1993 Plan.





In June 1997, the Companys Board of Directors adopted and the Companys stockholders approved the Amended and Restated 1996 Long-Term Incentive Plan (the 1996 Plan), for which 2,000,000 shares
of the Companys common stock were reserved for issuance to officers, employees and consultants of the Company. If any award granted under the 1996 Plan expires, terminates or is forfeited before the exercise thereof or the payment in full
thereof, the shares covered by the unexercised or unpaid portion will become available for new grants under the 1996 Plan. In June 1998, the Companys Board of Directors adopted and the Companys stockholders approved an amendment to the
1996 Plan to increase the number of shares in the plan by 2,500,000. Also in June 1998, in a separate amendment, the Companys Board of Directors and the Companys stockholders approved an amendment to allow all directors of the Company
and any subsidiary of the Company to participate in the 1996 Plan. In June 2000, the Companys Board of Directors adopted and the Companys stockholders approved an amendment to the 1996 Plan to increase the number of shares in the plan by
2,500,000. The Compensation Committee or, in the absence of a Compensation Committee, the Board of Directors has been appointed to administer the 1996 Plan. Options issued under the 1996 Plan vest in the manner prescribed by the




53




---

##### Table of Contents



SRS LABS, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


For the Years Ended December 31, 2001, 2000 and 1999




Compensation Committee or the Board, as applicable. As of December 31, 2001, options to purchase 7,141,259 shares of the Companys common stock were granted under the 1996 Plan.





In July 1996, the Companys Board of Directors adopted and the Companys stockholders approved the 1996 Non-employee
Directors Stock Option Plan (the Non-employee Directors Plan), a non-discretionary formula plan for which 120,000 shares of the Companys common stock are reserved for issuance to the Companys non-employee directors. A
committee consisting of all directors who are not eligible to participate in the Non-employee Directors Plan administers the Non-employee Directors Plan. With the exception of the initial option granted to a non-employee director, which vests
immediately, options granted under the Non-employee Directors Plan vest over a three-year period, the first installment vesting on the date of grant. In June 1999, the shareholders approved the Amended and Restated 1996 Non-employee Directors
Stock Option Plan (the Amended Non-employee Directors Plan). Among the changes set forth in the Amended Non-employee Directors Plan was to increase by 130,000 the number of shares of common stock that may be issued. In June 2001, the
Companys Board of Directors adopted and the Companys stockholders approved an amendment to the Amended Non-employee Directors Plan to increase the number of shares in the plan by 250,000. As of December 31, 2001, options to purchase
160,000 shares of common stock were granted under the Amended Non-employee Directors Plan.





In connection with the Microsoft
Transaction, Microsoft has a three year warrant to purchase 100,000 shares of common stock of the Company at an exercise price per share of $17.21. The number of eligible shares to purchase under this warrant is subject to adjustment based upon the
occurrence of certain conditions as set forth in the SRS Labs, Inc. Common Stock Purchase Warrant Agreement dated March 8, 2000 (the SRS Warrant). The Companys majority-owned subsidiary, SRSWOWcast, also issued to Microsoft a
three-year warrant to purchase up to 2,500,000 shares of its common stock at an price per share of $2.00 as specified in the SRSWOWcast.com, Inc. Common Stock Purchase Warrant Agreement dated March 8, 2000 (the SRSWOWcast Warrant),
subject to certain conditions and adjustment as set forth in the SRSWOWcast Warrant. The fair value of these warrants, totaling $2,555,783, was recorded as non-cash stock issuance cost by the Company during Fiscal 2000. Fair value was calculated
using the Black-Scholes option-pricing model with the following weighted average assumptions: expected life  36 months; stock volatility  96%; and risk-free interest rate  6.54%.




54




---

##### Table of Contents



SRS LABS, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


For the Years Ended December 31, 2001, 2000 and 1999







The following table summarizes stock option activity under the Companys stock
option and warrant plans for the periods indicated:





Options Outstanding


Weighted Average Exercise PriceOutstanding at January 1, 1999

4,919,208


$
4.54Granted

1,255,875


$
3.39Stock options exercised

(201,798
)

$
2.93Forfeited

(888,742
)

$
5.17Outstanding at December 31, 1999

5,084,543


$
4.23Granted

578,814


$
11.20Stock options exercised

(471,624
)

$
3.03Forfeited

(194,319
)

$
7.88Outstanding at December 31, 2000

4,997,414


$
5.01Granted

1,573,000


$
2.93Stock options exercised

(136,800
)

$
1.35Forfeited

(1,031,286
)

$
5.30Outstanding at December 31, 2001

5,402,328


$
4.44





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





Range of Exercise Prices

Number of Options Outstanding

Weighted Average Remaining Contractual Life

Weighted Average Exercise Price

Exercisable As of 12/31/2001

Weighted Average Exercise PriceRange of exercise prices:$  0.00  $  1.90

95,807

2.3

$
0.3358

95,807

$
0.3358$  1.91  $  3.80

2,916,157

8.3

$
3.0461

987,850

$
3.0656$  3.81  $  5.70

1,785,809

4.9

$
5.2004

1,589,393

$
5.1814$  5.71  $  7.60

274,814

7.2

$
6.2296

235,189

$
6.1885$  7.61  $  9.50

137,500

8.0

$
8.5636

49,375

$
8.3924$  9.51  $11.40

42,241

6.6

$
10.5056

27,241

$
10.4743$11.41  $13.30

30,000

8.5

$
11.7500

20,000

$
11.7500$17.10  $19.00

120,000

2.4

$
17.5083

105,000

$
17.29525,402,328

6.9

$
4.4404

3,109,855

$
4.9848





On March 5, 1999, pursuant to a technology license agreement entered into by the
Company and a customer, options were granted to the customer to purchase up to 50,000 shares of common stock at an exercise price of $3.94 per share. The fair value of the grant is being recognized as compensation expense ratably over the vesting
period of the options. The Company recognized $13,548, $27,636 and $30,857 of compensation expense relating to these options in Fiscal 2001, 2000 and 1999, respectively. In addition to the 50,000 options granted in 1999, the Company has an
obligation to grant up to 200,000 additional options if the customer meets specified performance criteria as defined by the agreement. The exercise price of additional option grants will be the fair market value of the common stock at the date of
grant. In addition, during the years ended December 31, 2001,




55




---

##### Table of Contents



SRS LABS, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


For the Years Ended December 31, 2001, 2000 and 1999




2000 and 1999, the Company recorded $66,502, $83,859 and $83,355, respectively, of deferred compensation expense related to stock options granted to non-employee contractors.





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





December 31,2001


2000


1999Expected life

60 months


60 months


60 monthsStock volatility

97
%

105
%

65
%Risk-free interest rate

4.6
%

6.2
%

5.9
%





The Companys calculations are based on a single option valuation approach
and forfeitures are recognized as they occur. If the computed fair values of all applicable stock option awards had been amortized to expense over the vesting period of the awards, pro forma net loss would have been $6,198,699 or $.58 per share in
2001; $13,699,489 or $1.17 per share in 2000; and $3,392,244 or $.35 per share in 1999. However, the impact of outstanding nonvested stock options granted prior to 1995 has been excluded from the pro forma calculation; accordingly, the 1999 pro
forma adjustment is not indicative of future period pro forma adjustments, when the calculation applied to all applicable stock options.





Sale of
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 of 3,000,000
shares of SRSWOWcast Series A Convertible Preferred Stock (Preferred Stock) 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 a right to purchase one-tenth of a share of SRSWOWcasts common stock for each share of Preferred Stock purchased by such investor, exercisable at $2.50 per whole
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 a Subsidiary, the Company recorded $5,154,995 of additional paid-in capital associated with the
Private Placement.




56




---

##### Table of Contents



SRS LABS, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


For the Years Ended December 31, 2001, 2000 and 1999







10.    Segment Information





During 2001 the Company changed the composition of its segments to correspond with how management now assesses the performance of each operating segment. Segment information for
2000 and 1999, previously two segments, has been restated to conform to the current year presentation. The Company operates its three operating units in the following five business segments: (i) SRS Labs  the licensing of
technologies developed by the Company to OEMs and semiconductor manufacturers; (ii) SRS Labs the sale of consumer products incorporating SRS proprietary technologies; (iii) Valence  the development and marketing of
technology either in the form of ASICs or other imbedded custom semiconductor designs; (iv) Valence  the component distribution business; and (v) SRSWOWcast  the sale of hardware and software solutions to the Internet
and broadcast audio markets. The Company does not allocate corporate operating expenses or specific assets to these segments. Therefore, the segment information that follows includes only net revenues, cost of sales and gross margins of the
identified segments, revenue by geographic area and long-lived assets by geographic area:





Business SegmentsSRS Labs


Valence

SRSWOWcastLicensing

Products


ASIC

Components

Internet and Broadcast Sales

TotalFiscal 2001Net revenues

$
4,973,584

$
189,820


$
5,646,724

$
4,602,819

$
17,983

$
15,430,930Cost of sales


36,082


314,491



2,009,673


4,343,194


110


6,703,550Gross margin

$
4,937,502

$
(124,671
)

$
3,637,051

$
259,625

$
17,873

$
8,727,380Fiscal 2000Net revenues

$
2,929,717

$
101,148


$
10,168,525

$
14,718,440

$
54,864

$
27,972,694Cost of sales


13,867


67,918



3,699,245


12,806,565


23,695


16,611,290Gross margin

$
2,915,850

$
33,230


$
6,469,280

$
1,911,875

$
31,169

$
11,361,404Fiscal 1999Net revenues

$
3,377,649

$
55,547


$
15,246,572

$
17,115,815


N/A

$
35,795,583Cost of sales


109,946


51,725



5,985,251


15,855,895


N/A


22,002,817Gross margin

$
3,267,703

$
3,822


$
9,261,321

$
1,259,920


N/A

$
13,792,766





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





December 31,Geographic Area Revenue:

2001

2000

1999Asia Pacific

$
13,917,282

$
26,316,233

$
33,536,423Americas


608,952


1,104,210


1,268,918Europe


904,696


552,251


990,242Total

$
15,430,930

$
27,972,694

$
35,795,583




57




---

##### Table of Contents



SRS LABS, INC.





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


For the Years Ended December 31, 2001, 2000 and 1999







The following schedule presents the Companys long-lived assets by geographic
area:





Geographic Area Long-lived Assets:

December 31,2001

2000Asia Pacific

$
1,243,249

$
1,268,352United States


429,552


540,272Total

$
1,672,801

$
1,808,624





11.    Related-Party Transactions





The Company leases its corporate office and storage facilities located in Santa Ana, California, under a lease agreement with a partnership which is
affiliated with a stockholder and officer of the Company. The lease has a term of two years (expiring May 2002), with an option to extend the term for an additional two years thereafter.





During Fiscal 1999, total revenue from an affiliated company which is 100% owned by a Company officer/stockholder, amounted to $1,326. As of December 31, 2001 and 2000, there were no
amounts owing from or to this affiliated company.





As described in Note 9, certain shareholders, directors and an executive
officer of the Company purchased preferred shares issued by a subsidiary of the Company.





12.    Employee Benefit Plan





The Companys employees based in the United States may participate in a salary deferral plan (the 401(k)
Plan) in which eligible employees can contribute up to 15% of their eligible compensation. The Company also may contribute on a discretionary basis. During the years ended December 31, 2001, 2000 and 1999, the Company contributed $60,114,
$48,543 and $0, respectively to the 401(k) Plan.




58




---

##### Table of Contents




SCHEDULE II





VALUATION AND QUALIFYING ACCOUNTS AND RESERVES





Balance at Beginning of Period

Additions (Reductions) Charged to Costs and Expense

Deductions


Balance at End of PeriodFor the year ended December 31, 2001:Allowance for doubtful accounts

$
995,599

$
50,240

$
(976,951
)

$
68,888Inventory reserve

$
757,185

$
113,920

$
(192,053
)

$
679,052For the year ended December 31, 2000:Allowance for doubtful accounts

$
1,083,961

$
116,560

$
(204,922
)

$
995,599Inventory reserve

$
624,844

$
357,244

$
(224,903
)

$
757,185For the year ended December 31, 1999:Allowance for doubtful accounts

$
422,138

$
1,040,271

$
(378,448
)

$
1,083,961Inventory reserve

$
653,370

$
628,006

$
(656,532
)

$
624,844




59




---

##### Table of Contents




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





Not
Applicable.





PART III





Item
10.    
Directors and Executive Officers of the Registrant





The information set forth under the captions
ELECTION OF DIRECTORS and TRANSACTIONS WITH MANAGEMENT AND OTHERS  Section 16(a) Beneficial Ownership Reporting Compliance in the Companys definitive proxy statement (the Proxy Statement) for the
Annual Meeting of Stockholders scheduled to be held in June 2002, is incorporated herein by reference. The Proxy Statement will be filed with the U.S. Securities and Exchange Commission (the Commission) not later than 120 days after the
close of Fiscal 2001.





Item 11.    
Executive Compensation





Except as specifically provided, the information set forth under the
captions COMPENSATION OF EXECUTIVE OFFICERS and INFORMATION ABOUT THE BOARD OF DIRECTORS AND COMMITTEES OF THE BOARD  Compensation of Directors in the Proxy Statement is incorporated herein by reference. The Proxy
Statement will be filed with the Commission not later than 120 days after the close of Fiscal 2001. The Report on Executive Compensation and the Performance Graph set forth under the caption COMPENSATION OF EXECUTIVE OFFICERS in the
Proxy Statement shall not be deemed incorporated by reference herein and shall not otherwise be deemed filed as part of this Annual Report on Form 10-K.





Item 12.    
SecurityOwnership of Certain Beneficial Owners and Management





The information set forth under the
caption SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT in the Proxy Statement is incorporated herein by reference. The Proxy Statement will be filed with the Commission not later than 120 days after the close of Fiscal
2001.





Item 13.    
Certain Relationships and Related Transactions





The information set forth under the caption
TRANSACTIONS WITH MANAGEMENT AND OTHERS in the Proxy Statement is incorporated herein by reference. The Proxy Statement will be filed with the Commission not later than 120 days after the close of Fiscal 2001.




60




---

##### Table of Contents




PART IV





Item 14.    
Exhibits, Financial Statement Schedules and Reports on Form 8-K





(a)    Documents Filed as Part of This
Report:





(1)    Financial Statements





INDEX TO FINANCIAL STATEMENTS:


PageIndependent Auditors Report

38Consolidated Balance Sheets as of December 31, 2001 and 2000

39Consolidated Statements of Operations for the years ended December 31, 2001, 2000 and 1999

40Consolidated Statements of Stockholders Equity and Comprehensive Loss for the years ended December 31, 2001, 2000 and
1999

41Consolidated Statements of Cash Flows for the years ended December 31, 2001, 2000 and 1999

42Notes to Consolidated Financial Statements

43





(2)    Financial Statement Schedules





PageSchedule II  Valuation and Qualifying Accounts and Reserves for the years ended December 31, 2001, 2000 and
1999

59





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





(3)    Exhibits





The exhibits listed below are hereby filed with the Commission as part of this Annual Report on Form 10-K. The Company will furnish a copy of any exhibit upon request, but a reasonable fee will be charged to cover the Companys
expenses in furnishing such exhibit.





Exhibit Number

Description2.1

Purchase Agreement dated as of February 24, 1998, by and among the Company, Valence Technology Inc., Thomrose Holdings (BVI) Limited, Rayfa (BVI) Limited, Cape Spencer
International Limited, and Anki (BVI) Limited, previously filed with the Commission as Exhibit 2.1 to the Companys Current Report on Form 8-K filed with the Commission on March 13, 1998 (the Form 8-K), which is
incorporated herein by reference.2.2

Stock Purchase Agreement dated as of February 24, 1998, by between the Company and North 22 Capital Partners 2, Inc., previously filed with the Commission as Exhibit 2.2 to
the Form 8-K, which is incorporated herein by reference.2.3

Purchase Agreement dated as of January 28, 1998, between the Company and R.G.A. & Associates, Ltd. d/b/a ToteVision and VIP Labs®previously filed with the Commission as Exhibit 2.3 to the Companys Annual Report on Form 10-KSB for the fiscal year ended December 31, 1997
filed with the Commission on March 31, 1998 (the 1997 Annual Report), which is incorporated herein by reference.




61




---

##### Table of Contents

Exhibit Number

Description2.4

Asset Purchase Agreement dated as of May 21, 1998 by and between Rocktron Corporation and the Company, previously filed with the Commission as Exhibit 2.1 to the
Companys Quarterly Report on Form 10-Q for the period ended June 30, 1998 (the June 1998 10-Q), which is incorporated herein by reference.3.1

Certificate of Incorporation of the Company, previously filed with the Commission as Exhibit 3.1 to the Companys Registration Statement on Form SB-2, specifically
included in Amendment No. 1 to such Registration Statement filed with the Commission on July 3, 1996 (File No. 333-4974-LA) (the Registration Statement Amendment No. 1), which is incorporated herein by reference.3.2

Bylaws of the Company, previously filed with the Commission as Exhibit 3.1 to the Companys Quarterly Report on Form 10-Q for the period ended September 30, 1999, filed
with the Commission on November 12, 1999, which is incorporated herein by reference.Material Contracts Relating to Management Compensation Plans or Arrangements10.1

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, previously filed with the Commission as Appendix A to the Companys Definitive Proxy Statement dated
April 30, 1998, filed with the Commission on April 30, 1998, which is incorporated herein by reference.10.9

SRS Labs, Inc. 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.10.10

SRS Labs, Inc. 1996 Amended and Restated Nonemployee Directors Stock Option Plan, previously filed with the Commission as Appendix A to the Companys Definitive Proxy
Statement dated and filed with the Commission on April 29, 1999, which is incorporated herein by reference.




62




---

##### Table of Contents

Exhibit Number

Description10.11

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, 2001, which is incorporated herein by reference.10.12

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.10.13

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.10.14

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.10.15

Employment Agreement dated as of March 2, 1998, by and among the Company, Valence Technology Inc., and Thomas Wah Tong Wan, previously filed with the Commission as
Exhibit 10.16 to the 1997 Annual Report, which is incorporated herein by reference.10.16

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.10.17

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.10.18

Noncompetition Agreement dated as of March 2, 1998, by and among the Company, Thomrose Holdings (BVI) Limited, and Thomas Wah Tong Wan, previously filed with the Commission
as Exhibit 2.5 to the Companys Current Report on Form 8-K filed with the Commission on March 13, 1998 (the Form 8-K), which is incorporated herein by reference.10.19

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.10.20

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.10.21

Employment Agreement dated as of July 1, 1998 by and between the Company and John AuYeung, previously filed with the Commission as Exhibit 10.1 to the Companys
Quarterly Report on Form 10-Q for the period ended September 30, 1998, which is incorporated herein by reference.10.22

Severance Agreement, dated February 23, 1999, by and between the Company and Thomas P. Parkinson, previously filed as Exhibit 10.1 to the Companys Quarterly Report on
Form 10-Q for the period ended March 31, 1999, filed with the Commission on May 17, 1999, which is incorporated herein by reference.10.23

Employment Agreement dated August 27, 1999 by and between the Company and James F. Gardner.10.24

Settlement and Release Agreement by and among Thomas Wah Tong Wan, the Company and ValenceTech Limited dated July 27, 2000, previously filed with the Commission as Exhibit
10.1 to the September 2000 10-Q, which is incorporated herein by reference.




63




---

##### Table of Contents

Exhibit Number

DescriptionOther Material Contracts10.25

Shareholders Agreement dated as of January 27, 1994, between the Company and the Shareholders of the Company named therein, previously filed with the Commission as Exhibit
9.3 to the Companys Registration Statement on Form SB-2, specifically included in Amendment No. 2 to such Registration Statement filed with the Commission on August 2, 1996 (File No. 333-4974-LA) (the Registration Statement
Amendment No. 2), which is incorporated herein by reference.10.26

Shareholders Agreement II dated as of January 9, 1995, between the Company and the Shareholders of the Company named therein, previously filed with the Commission as Exhibit
9.1 to the Registration Statement, which is incorporated herein by reference.10.27

Shareholders Agreement III dated as of April 21, 1995, between the Company and the Shareholders of the Company named therein, previously filed with the Commission as Exhibit
9.2 to the Registration Statement, which is incorporated herein by reference.10.28

Asset Purchase Agreement dated as of June 30, 1993, between the Company and Hughes Aircraft, previously filed with the Commission as Exhibit 10.1 to the Registration
Statement, which is incorporated herein by reference.10.29

Stock Purchase Agreement dated as of January 9, 1995, between the Company and Packard Bell Electronics, Inc. d/b/a Packard Bell Corporation, previously filed with the
Commission as Exhibit 10.3 to the Registration Statement Amendment No. 2, which is incorporated herein by reference.10.30

Amended and Restated Stock Option Agreement dated as of January 9, 1995, between the Company and Packard Bell Electronics, Inc. d/b/a Packard Bell Corporation, previously
filed with the Commission as Exhibit 10.4 to the Registration Statement, which is incorporated herein by reference.10.31

License Agreement dated as of January 9, 1995, between the Company and Packard Bell Electronics, Inc. d/b/a Packard Bell Corporation, previously filed with the Commission as
Exhibit 10.5 to the Companys Registration Statement on Form SB-2, specifically included in Amendment No. 3 to such Registration Statement filed with the Commission on August 7, 1996 (File No. 333-4974-LA) (the Registration Statement
Amendment No. 3), which is incorporated herein by reference.10.32

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.10.33

Industrial Real Estate Lease dated May 30, 1997, between the Company and Daimler Commerce Partners, L.P., previously filed with the Commission as Exhibit 10.1 to the
Companys Form 10-QSB for the quarterly period ended June 30, 1997, filed with the Commission on August 13, 1997, which is incorporated herein by reference.10.34

Tenancy Agreement dated September 7, 1998, by and between Hong Kong Industrial Technology Centre Corporation and Valence Semiconductor Design Limited relating to the
premises located at Unit 413 on the Fourth Floor of the Hong Kong Industrial Technology Centre.10.35

Tenancy Agreement commencing January 1, 1998, by and between Jugada Company Limited and Valence Semiconductor Design Limited relating to the premises located at Workshops
Nos. 1, 2, 3, 4, 5, 6, 7 and 8 on the 19th Floor of APEC Plaza, No. 49 Hoi Yuen Road, Kwun Tong, Hong Kong, previously filed with the Commission as Exhibit 10.34 to the 1997 Annual Report, which is incorporated herein by reference.10.36

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.




64




---

##### Table of Contents

Exhibit Number

Description10.37

Services Agreement dated July 1, 1996, between the Company and Sierra Digital Productions, Inc., previously filed with the Commission as Exhibit 10.19 to the Registration
Statement Amendment No. 1, which is incorporated herein by reference.10.38

Registration Rights Agreement dated as of January 28, 1998, by and between the Company and R.G.A. & Associates, Ltd., d/b/a ToteVision and VIP Labs®and William S. Taraday, previously filed with the Commission as Exhibit 10.37 to the 1997 Annual Report, filed with the
Commission on March 31, 1998, which is incorporated herein by reference.10.39

Warrant to Purchase 94,000 Shares of Common Stock of the Company dated February 26, 1998, held by R.G.A. & Associates, Ltd., d/b/a ToteVision and VIP Labs®, previously filed with the Commission as Exhibit 10.38 to the 1997 Annual Report, which is incorporated herein by
reference.10.40

Warrant to Purchase 2,500 Shares of Common Stock of the Company dated February 26, 1998, held by Herbert H. Wax, previously filed with the Commission as Exhibit 10.39 to the
1997 Annual Report, which is incorporated herein by reference.10.41

Warrant to Purchase 2,500 Shares of Common Stock of the Company dated February 26, 1998, held by Steven E. Loyd, previously filed with the Commission as Exhibit 10.40 to the
1997 Annual Report, which is incorporated herein by reference.10.42

Warrant to Purchase 1,000 Shares of Common Stock of the Company dated February 26, 1998, held by the Van Valkenberg Furber Law Group, P.L.L.C., previously filed with the
Commission as Exhibit 10.41 to the 1997 Annual Report, which is incorporated herein by reference.10.43

Registration Rights Agreement dated as of May 21, 1998, previously filed with the Commission as Exhibit 10.1 to the June 1998 Form 10-Q, which is incorporated herein by
reference.10.44

Credit and Security Agreement dated as of July 6, 1999, by and between the Company and City National Bank.10.45

Securities Account Control Agreement dated as of July 6, 1999, by and among the Company, Investors Bank & Trust Company, Salomon Brothers Asset Management Inc. and City
National Bank.10.46

Revolving Credit Note dated July 6, 1999, by the Company in favor of City National Bank.10.47

First Amendment to Credit and Security Agreement dated as of April 1, 2001, by and between the Company and City National Bank previously filed with the Commission as Exhibit
10.1 to the March 2001 Form 10-Q, which is incorporated herein by reference.10.48

New Revolving Credit Note dated April 1, 2001, by the Company in favor of City National Bank previously filed with the Commission as Exhibit 10.2 to the March 2001 Form
10-Q, which is incorporated herein by reference.10.49

Common Stock Purchase Agreement dated as of March 8, 2000 by and among SRS Labs, Inc., SRSWOWcast.com, Inc. and Microsoft Corporation, previously filed with the Commission
as Exhibit 10.1 to the March 2000 10-Q, which is incorporated herein by reference.10.50

Common Stock Purchase Warrant dated March 8, 2000 granted to Microsoft Corporation by SRS Labs, Inc., previously filed with the Commission as Exhibit 10.2 to the March
2000 10-Q, which is incorporated herein by reference.10.51

Common Stock Purchase Warrant dated March 8, 2000 granted to Microsoft Corporation by SRSWOWcast.com, Inc., previously filed with the Commission as Exhibit 10.3 to the March
2000 10-Q, which is incorporated herein by reference.




65




---

##### Table of Contents

Exhibit Number

Description10.52

Series A Preferred Stock and Warrant Purchase Agreement dated September 29, 2000 between SRSWOWcast.com, Inc. and the Investors named on Schedule A to the Series A Preferred
Stock and Warrant Purchase Agreement, previously filed with the Commission as Exhibit 10.2 to the September 2000 10-Q, which is incorporated herein by reference.10.53

Investor Rights Agreement dated as of September 29, 2000 between SRSWOWcast.com, Inc. and the persons whose names appear on the Signature Page to the Investor Rights
Agreement, previously filed with the Commission as Exhibit 10.3 to the September 2000 10-Q, which is incorporated herein by reference.21

Subsidiaries.23

Consent of Deloitte & Touche LLP dated March 28, 2002.24

Power of attorney (included on page 67 of the Form 10-K).





(b)    Reports on Form 8-K.





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




66




---

##### Table of Contents




SIGNATURES





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





| | SR | S LABS, INC., a Delaware corporation
| | -- | ------------------------------------




Date:  March
29, 2002


By:

/s/    THOMAS C.K. YUENThomas C.K. Yuen Chairman of the Board and Chief Executive
Officer





POWER OF ATTORNEY





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





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





Name

Capacity

Date/s/    THOMAS C.K. YUEN Thomas C.K. Yuen

Director, Chairman of the Board and Chief Executive Officer (Principal Executive Officer)

March 29, 2002/s/    DARRELL E. BAKER Darrell E. Baker

Vice President  Finance, Secretary and acting Treasurer (Principal Financial and Accounting Officer)

March 29, 2002/s/    GARETH C.C. CHANG Gareth C.C. Chang

Director

March 29, 2002/s/    ROBERT PFANNKUCH Robert Pfannkuch

Director

March 29, 2002/s/    STEPHEN V. SEDMAK Stephen V. Sedmak

Director

March 29, 2002/s/    JEFFREY I. SCHEINROCK Jeffrey I. Scheinrock

Director

March 29, 2002/s/    JOHN TU John Tu

Director

March 29, 2002/s/    SAM YAU Sam Yau

Director

March 29, 2002




67




---

##### Table of Contents




EXHIBIT INDEX





Exhibit Number

Description2.1

Purchase Agreement dated as of February 24, 1998, by and among the Company, Valence Technology Inc., Thomrose Holdings (BVI) Limited, Rayfa (BVI) Limited, Cape Spencer
International Limited, and Anki (BVI) Limited, previously filed with the Commission as Exhibit 2.1 to the Companys Current Report on Form 8-K filed with the Commission on March 13, 1998 (the Form 8-K), which is incorporated herein
by reference.2.2

Stock Purchase Agreement dated as of February 24, 1998, by between the Company and North 22 Capital Partners 2, Inc., previously filed with the Commission as Exhibit 2.2 to
the Form 8-K, which is incorporated herein by reference.2.3

Purchase Agreement dated as of January 28, 1998, between the Company and R.G.A. & Associates, Ltd. d/b/a ToteVision and VIP Labs®previously filed with the Commission as Exhibit 2.3 to the Companys Annual Report on Form 10-KSB for the fiscal year ended December 31, 1997
filed with the Commission on March 31, 1998 (the 1997 Annual Report), which is incorporated herein by reference.2.4

Asset Purchase Agreement dated as of May 21, 1998 by and between Rocktron Corporation and the Company, previously filed with the Commission as Exhibit 2.1 to the
Companys Quarterly Report on Form 10-Q for the period ended June 30, 1998 (the June 1998 10-Q), which is incorporated herein by reference.3.1

Certificate of Incorporation of the Company, previously filed with the Commission as Exhibit 3.1 to the Companys Registration Statement on Form SB-2, specifically
included in Amendment No. 1 to such Registration Statement filed with the Commission on July 3, 1996 (File No. 333-4974-LA) (the Registration Statement Amendment No. 1), which is incorporated herein by reference.3.2

Bylaws of the Company, previously filed with the Commission as Exhibit 3.1 to the Companys Quarterly Report on Form 10-Q for the period ended September 30, 1999, filed
with the Commission on November 12, 1999, which is incorporated herein by reference.Material Contracts Relating to Management Compensation Plans or Arrangements10.1

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.




68




---

##### Table of Contents

Exhibit Number

Description10.6

SRS Labs, Inc. Incentive Stock Option, Nonqualified Stock Option and Restricted Purchase Plan  1993, as amended and restated, previously filed with the Commission as
Exhibit 10.12 to the Companys Registration Statement on Form SB-2 filed with the Commission on June 3, 1996 (File No. 333-4974-LA) (the Registration Statement), which is incorporated herein by reference.10.7

Stock Option Agreement dated January 19, 1994, between the Company and Stephen V. Sedmak, as amended, previously filed with the Commission as Exhibit 10.13 to the
Registration Statement, which is incorporated herein by reference.10.8

SRS Labs, Inc. Amended and Restated 1996 Long-Term Incentive Plan, previously filed with the Commission as Appendix A to the Companys Definitive Proxy Statement dated
April 30, 1998, filed with the Commission on April 30, 1998, which is incorporated herein by reference.10.9

SRS Labs, Inc. 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.10.10

SRS Labs, Inc. 1996 Amended and Restated Nonemployee Directors Stock Option Plan, previously filed with the Commission as Appendix A to the Companys Definitive Proxy
Statement dated and filed with the Commission on April 29, 1999, which is incorporated herein by reference.10.11

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, 2001, which is incorporated herein by reference.10.12

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.10.13

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.10.14

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.10.15

Employment Agreement dated as of March 2, 1998, by and among the Company, Valence Technology Inc., and Thomas Wah Tong Wan, previously filed with the Commission as
Exhibit 10.16 to the 1997 Annual Report, which is incorporated herein by reference.10.16

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.10.17

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.10.18

Noncompetition Agreement dated as of March 2, 1998, by and among the Company, Thomrose Holdings (BVI) Limited, and Thomas Wah Tong Wan, previously filed with the Commission
as Exhibit 2.5 to the Companys Current Report on Form 8-K filed with the Commission on March 13, 1998 (the Form 8-K), which is incorporated herein by reference.10.19

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.




69




---

##### Table of Contents

Exhibit Number

Description10.20

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.10.21

Employment Agreement dated as of July 1, 1998 by and between the Company and John AuYeung, previously filed with the Commission as Exhibit 10.1 to the Companys
Quarterly Report on Form 10-Q for the period ended September 30, 1998, which is incorporated herein by reference.10.22

Severance Agreement, dated February 23, 1999, by and between the Company and Thomas P. Parkinson, previously filed as Exhibit 10.1 to the Companys Quarterly Report on
Form 10-Q for the period ended March 31, 1999, filed with the Commission on May 17, 1999, which is incorporated herein by reference.10.23

Employment Agreement dated August 27, 1999 by and between the Company and James F. Gardner.10.24

Settlement and Release Agreement by and among Thomas Wah Tong Wan, the Company and ValenceTech Limited dated July 27, 2000, previously filed with the Commission as Exhibit
10.1 to the September 2000 10-Q, which is incorporated herein by reference.Other Material Contracts10.25

Shareholders Agreement dated as of January 27, 1994, between the Company and the Shareholders of the Company named therein, previously filed with the Commission as Exhibit
9.3 to the Companys Registration Statement on Form SB-2, specifically included in Amendment No. 2 to such Registration Statement filed with the Commission on August 2, 1996 (File No. 333-4974-LA) (the Registration Statement Amendment No.
2), which is incorporated herein by reference.10.26

Shareholders Agreement II dated as of January 9, 1995, between the Company and the Shareholders of the Company named therein, previously filed with the Commission as Exhibit
9.1 to the Registration Statement, which is incorporated herein by reference.10.27

Shareholders Agreement III dated as of April 21, 1995, between the Company and the Shareholders of the Company named therein, previously filed with the Commission as Exhibit
9.2 to the Registration Statement, which is incorporated herein by reference.10.28

Asset Purchase Agreement dated as of June 30, 1993, between the Company and Hughes Aircraft, previously filed with the Commission as Exhibit 10.1 to the Registration
Statement, which is incorporated herein by reference.10.29

Stock Purchase Agreement dated as of January 9, 1995, between the Company and Packard Bell Electronics, Inc. d/b/a Packard Bell Corporation, previously filed with the
Commission as Exhibit 10.3 to the Registration Statement Amendment No. 2, which is incorporated herein by reference.10.30

Amended and Restated Stock Option Agreement dated as of January 9, 1995, between the Company and Packard Bell Electronics, Inc. d/b/a Packard Bell Corporation, previously
filed with the Commission as Exhibit 10.4 to the Registration Statement, which is incorporated herein by reference.10.31

License Agreement dated as of January 9, 1995, between the Company and Packard Bell Electronics, Inc. d/b/a Packard Bell Corporation, previously filed with the Commission as
Exhibit 10.5 to the Companys Registration Statement on Form SB-2, specifically included in Amendment No. 3 to such Registration Statement filed with the Commission on August 7, 1996 (File No. 333-4974-LA) (the Registration Statement
Amendment No. 3), which is incorporated herein by reference.10.32

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.




70




---

##### Table of Contents

Exhibit Number

Description10.33

Industrial Real Estate Lease dated May 30, 1997, between the Company and Daimler Commerce Partners, L.P., previously filed with the Commission as Exhibit 10.1 to the
Companys Form 10-QSB for the quarterly period ended June 30, 1997, filed with the Commission on August 13, 1997, which is incorporated herein by reference.10.34

Tenancy Agreement dated September 7, 1998, by and between Hong Kong Industrial Technology Centre Corporation and Valence Semiconductor Design Limited relating to the
premises located at Unit 413 on the Fourth Floor of the Hong Kong Industrial Technology Centre.10.35

Tenancy Agreement commencing January 1, 1998, by and between Jugada Company Limited and Valence Semiconductor Design Limited relating to the premises located at Workshops
Nos. 1, 2, 3, 4, 5, 6, 7 and 8 on the 19th Floor of APEC Plaza, No. 49 Hoi Yuen Road, Kwun Tong, Hong Kong, previously filed with the Commission as Exhibit 10.34 to the 1997 Annual Report, which is incorporated herein by reference.10.36

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.10.37

Services Agreement dated July 1, 1996, between the Company and Sierra Digital Productions, Inc., previously filed with the Commission as Exhibit 10.19 to the Registration
Statement Amendment No. 1, which is incorporated herein by reference.10.38

Registration Rights Agreement dated as of January 28, 1998, by and between the Company and R.G.A. & Associates, Ltd., d/b/a ToteVision and VIP Labs®and William S. Taraday, previously filed with the Commission as Exhibit 10.37 to the 1997 Annual Report, filed with the
Commission on March 31, 1998, which is incorporated herein by reference.10.39

Warrant to Purchase 94,000 Shares of Common Stock of the Company dated February 26, 1998, held by R.G.A. & Associates, Ltd., d/b/a ToteVision and VIP Labs®, previously filed with the Commission as Exhibit 10.38 to the 1997 Annual Report, which is incorporated herein by
reference.10.40

Warrant to Purchase 2,500 Shares of Common Stock of the Company dated February 26, 1998, held by Herbert H. Wax, previously filed with the Commission as Exhibit 10.39 to the
1997 Annual Report, which is incorporated herein by reference.10.41

Warrant to Purchase 2,500 Shares of Common Stock of the Company dated February 26, 1998, held by Steven E. Loyd, previously filed with the Commission as Exhibit 10.40 to the
1997 Annual Report, which is incorporated herein by reference.10.42

Warrant to Purchase 1,000 Shares of Common Stock of the Company dated February 26, 1998, held by the Van Valkenberg Furber Law Group, P.L.L.C., previously filed with the
Commission as Exhibit 10.41 to the 1997 Annual Report, which is incorporated herein by reference.10.43

Registration Rights Agreement dated as of May 21, 1998, previously filed with the Commission as Exhibit 10.1 to the June 1998 Form 10-Q, which is incorporated herein by
reference.10.44

Credit and Security Agreement dated as of July 6, 1999, by and between the Company and City National Bank.10.45

Securities Account Control Agreement dated as of July 6, 1999, by and among the Company, Investors Bank & Trust Company, Salomon Brothers Asset Management Inc. and City
National Bank.10.46

Revolving Credit Note dated July 6, 1999, by the Company in favor of City National Bank.




71




---

##### Table of Contents

Exhibit Number

Description10.47

First Amendment to Credit and Security Agreement dated as of April 1, 2001, by and between the Company and City National Bank previously filed with the Commission as Exhibit
10.1 to the March 2001 Form 10-Q, which is incorporated herein by reference.10.48

New Revolving Credit Note dated April 1, 2001, by the Company in favor of City National Bank previously filed with the Commission as Exhibit 10.2 to the March 2001 Form
10-Q, which is incorporated herein by reference.10.49

Common Stock Purchase Agreement dated as of March 8, 2000 by and among SRS Labs, Inc., SRSWOWcast.com, Inc. and Microsoft Corporation, previously filed with the Commission
as Exhibit 10.1 to the March 2000 10-Q, which is incorporated herein by reference.10.50

Common Stock Purchase Warrant dated March 8, 2000 granted to Microsoft Corporation by SRS Labs, Inc., previously filed with the Commission as Exhibit 10.2 to the March
2000 10-Q, which is incorporated herein by reference.10.51

Common Stock Purchase Warrant dated March 8, 2000 granted to Microsoft Corporation by SRSWOWcast.com, Inc., previously filed with the Commission as Exhibit 10.3 to the March
2000 10-Q, which is incorporated herein by reference.10.52

Series A Preferred Stock and Warrant Purchase Agreement dated September 29, 2000 between SRSWOWcast.com, Inc. and the Investors named on Schedule A to the Series A Preferred
Stock and Warrant Purchase Agreement, previously filed with the Commission as Exhibit 10.2 to the September 2000 10-Q, which is incorporated herein by reference.10.53

Investor Rights Agreement dated as of September 29, 2000 between SRSWOWcast.com, Inc. and the persons whose names appear on the Signature Page to the Investor Rights
Agreement, previously filed with the Commission as Exhibit 10.3 to the September 2000 10-Q, which is incorporated herein by reference.21

Subsidiaries.23

Consent of Deloitte & Touche LLP dated March 28, 2002.24

Power of attorney (included on page 67 of the Form 10-K).




72