**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**
| **(Mark One)**                                       | ** **                                                                                              |
|------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
| **x**                                                | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
| **For the fiscal year ended December 31, 2004** |
| **or**                                               |
| **o**                                                | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**Forthe transition period from               to               **

**CommissionFile Number: 0-21123**

****

**SRS LABS, INC.**

(Exact name of registrantas specified in its charter)
| **Delaware******(State or other jurisdiction of  incorporation or organization) | **33-0714264******(I.R.S. Employer  Identification No.) |
|---------------------------------------------------------------------------------|---------------------------------------------------------|

 

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

(Address of principalexecutive offices) (Zip Code)

**(949) 442-1070**

(Registrant’s telephonenumber, including area code)

Securities registeredpursuant to Section 12(b) of the Act: **None**

Securities registered pursuant to Section 12(g) ofthe Act:

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

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

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

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

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

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

**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of the registrant’sProxy Statement prepared in connection with the Annual Meeting of Stockholdersto be held in 2005 are incorporated by reference in Part III of this Form 10-K.

 

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**SRS LABS, INC.**

**ANNUAL REPORT ON FORM 10-K**

**Table of Contents**

|                   | ** ** | ** **                                                                                                          | ** ** | **Page** | ** ** |
|-------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| **PART I**   |
| Item 1.           |       | Business                                                                                                            |       | 5        |       |
| Item 1A.          |       | Executive Officers of the  Registrant                                                                               |       | 20       |       |
| Item 2.           |       | Properties                                                                                                          |       | 21       |       |
| Item 3.           |       | Legal Proceedings                                                                                                   |       | 22       |       |
| Item 4.           |       | Submission of Matters to a  Vote of Security Holders                                                                |       | 22       |       |
| **PART II**  |
| Item  5.          |       | Market for Registrant’s  Common Equity, Related Stockholder Matters and Issuer Purchases of Equity  Securities |       | 23       |       |
| Item 6.           |       | Selected Financial Data                                                                                             |       | 25       |       |
| Item 7.           |       | Management’s Discussion and  Analysis of Financial Condition and Results of Operation                          |       | 26       |       |
| Item 7A.     |       | Quantitative and Qualitative  Disclosures About Market Risk                                                         |       | 42       |       |
| Item 8.           |       | Financial Statements and  Supplementary Data                                                                        |       | 43       |       |
| Item 9.           |       | Changes in and Disagreements  With Accountants on Accounting and Financial Disclosure                          |       | 43       |       |
| Item 9A.     |       | Controls and Procedures                                                                                             |       | 43       |       |
| Item 9B.          |       | Other Information                                                                                                   |       | 44       |       |
| **PART III** |
| Item  10.         |       | Directors and Executive  Officers of the Registrant                                                                 |       | 45       |       |
| Item 11.          |       | Executive Compensation                                                                                              |       | 45       |       |
| Item 12.          |       | Security Ownership of  Certain Beneficial Owners and Management                                                     |       | 45       |       |
| Item 13.          |       | Certain Relationships and  Related Transactions                                                                     |       | 45       |       |
| Item 14.          |       | Principal Accountant Fees  and Services                                                                             |       | 45       |       |
| **PART IV**  |
| Item  15.         |       | Exhibits, Financial  Statement Schedules                                                                            |       | 46       |       |
| Signatures        |       | 50                                                                                                                  |       |

 

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

**SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS**

On one or more occasions, we may make statementsregarding our assumptions, projections, expectations, targets, intentions orbeliefs about future events. All statements other than statements of historicalfacts included in this Annual Report on Form 10-K relating toexpectation of future financial performance, continued growth, changes ineconomic conditions or capital markets and changes in customer usage patternsand preferences, are forward-looking statements.

Words or phrases such as “anticipates,” “believes,” “estimates,”“expects,” “intends,” “plans,” “predicts,” “projects,” “targets,” “will likelyresult,” “will continue,” “may,” “could” or similar expressions identifyforward-looking statements. Forward-looking statements involverisks and uncertainties which could cause actual results or outcomes to differmaterially from those expressed. We caution that while we make such statementsin good faith and we believe such statements are based on reasonableassumptions, including without limitation, management’s examination ofhistorical operating trends, data contained in records and other data availablefrom third parties, we cannot assure you that our expectations will berealized.

As moreparticularly discussed under the caption “Factors That May Affect FutureResults” in Item 7 of Management’s Discussion and Analysis of FinancialCondition and Results of Operations in this Annual Report on Form 10-K,some important factors that could cause actual results or outcomes for SRS Labsor our subsidiaries to differ materially from those discussed in forward-lookingstatements include:

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

·       ourability to build and strengthen our brand;

·       ourability to sustain historical margins as each of our industries develop;

·       increasedcompetition;

·       pricingpressures on consumer electronics manufacturers;

·       increasedcosts;

·       exposureto risks in our licensing business related to product and customerconcentration;

·       exposureto risks of international operations, particularly Asia and the People’sRepublic of China;

·       relianceon revenue contributed from our ASIC and standard IC business;

·       risksin our Valence business related to fabrication outsourcing to third parties;

·       cyclicalityin the semiconductor business;

·       relianceon intellectual property;

·       ourability to retain key members of management;

·       adversestate, federal or foreign legislation or regulation or adverse determinationsby regulators; and

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·       otherfactors identified from time to time in our filings with the Securities andExchange Commission.

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

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**PART I**

**Item1.**                        Business

**Overview**

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

We operate in the following two business segments:

*Semiconductors:  *ThroughSRS Labs, Inc.’s wholly-owned subsidiary, ValenceTech Limited, andValenceTech Limited’s wholly-owned subsidiaries (collectively “Valence”), weoperate a fabless semiconductor business which develops, designs and marketsstandard and custom analog ICs, digital signal processors, or DSPs, and mixedsignal integrated circuits primarily to original equipment manufacturers, orOEMs, and original design manufacturers , or ODMs, in the Asia Pacific region.

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

As used herein, the “Company,” “SRS Labs,” “we,” “us,”or “our” means SRS Labs, Inc. and its wholly owned subsidiaries, includingValence and SRSWOWcast.com Inc.

In2003, we reported our revenues in the following five segments: licensing,semiconductors, component distribution, product sales and Internet andbroadcast. In 2004, we decided to reduce our segments to licensing andsemiconductors because of the materiality of the revenues attributable to theother three segments. Revenue from the component distribution segment is nowreported in the semiconductor segment and revenues from product sales andInternet and broadcast segments are now reported in the licensing segment. Segmentinformation for prior years has been restated to conform to the current yearpresentation. The following table shows our revenues, cost of sales and grossmargin by product segment for the last three fiscal years:
| ** **          | ** ** | **Years ended December 31,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Semiconductors:** |       |                                        |       |   |   |   |   |
| Total revenues      |       | $                                           | 10,770,684 |   | $ | 10,712,382 |   | $ | 10,777,569 |   |
| Cost of sales       |       | 3,725,062                                   |       | 3,953,100 |   | 4,600,388 |   |
| Gross margin        |       | $                                           | 7,045,622  |   | $ | 6,759,282 |   | $ | 6,177,181 |   |
| **Licensing:**      |       |                                        |       |   |   |   |   |
| Total revenues      |       | $                                           | 10,831,704 |   | $ | 9,101,399 |   | $ | 8,224,224 |   |
| Cost of sales       |       | 228,147                                     |       | 102,979 |   | 153,857 |   |
| Gross margin        |       | $                                           | 10,603,557 |   | $ | 8,998,420 |   | $ | 8,070,367 |   |
| **Total:**          |       |                                        |       |   |   |   |   |
| Total revenues      |       | $                                           | 21,602,388 |   | $ | 19,813,781 |   | $ | 19,001,793 |   |
| Cost of sales       |       | 3,953,209                                   |       | 4,056,079 |   | 4,754,245 |   |
| Gross margin        |       | $                                           | 17,649,179 |   | $ | 15,757,702 |   | $ | 14,247,548 |   |

 

Further financial information for business segments,geographic areas and customer concentration is included in this Annual Reporton Form 10-K under “Item 8. Financial Statements and Supplemental 

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

SRS Labs was incorporatedin the State of California on June 23, 1993 and reincorporated in theState of Delaware on June 28, 1996. Our executive offices are located at2909 Daimler Street, Santa Ana, California 92705. Our telephone number is (949) 442-1070.

**Our Products and Technologies**

*Semiconductors*

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

As of the end of 2004, approximately 35 engineers supported our IC designcapabilities, which for the past six years have been awarded one of the HongKong Industry’s (HKITCC) Technology Achievement Awards. We outsource themanufacturing of these ASICs to a network of fabrication partners throughoutAsia Pacific, including Chartered Semiconductor, Samsung and TowerSemiconductor Limited in Israel.

In addition to performingcontract design work, we also design, develop and market standard ICs for the AsiaPacific manufacturing market under the ASP brand name. The products created arebased upon management’s analysis of trends in the market, knowledge gained fromlong standing relationships with customers and overall business experience. Thegeneral purpose integrated circuits offered include micro-controllers for DVDPlayers, set-top box receivers and audio/video equipment; ICs fortelecommunication and game equipment; small signal transistors and ICs usedmainly in the manufacture of consumer products such as television sets, radios,telephones, computer mother boards, add-on boards and audio hi-fi systems. Manyof these products are developed by utilizing our custom design libraries,advanced mixed signal design technologies, system level expertise, softwareknowledge and understanding of customer requirements. Many of these chipsinclude SRS audio technologies and by the end of 2004, 40% of the ASP productline included SRS audio chips.

*Licensing*

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

·       *Audio Enhancement*—Our audio enhancement technologies providenumerous enhancements to the audio listening experience, including improvingthe spatial imaging (width and height of the sound image field) and bassresponse from traditional multimedia speakers and headphones, positioning audiosounds in both the horizontal and vertical planes, repositioning the audio imagefor non-optimally located speakers and enhancing bass for speakers andheadphone systems that delivers bass up to an octave below the physicalcapabilities of the speaker’s driver. Our audio 

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

·       *Voice Processing*—Thesetechnologies, which include our VIPTMand Noise ReductionTM technologies, dramaticallyreduce noise to produce much clearer and crisper dialog over wirelesscommunication devices and improve the intelligibility of the human voice in avariety of listening situations, including high ambient backgroundenvironments.

·       *Surround Sound*—Our core surround sound technology, CircleSurround®, is a complete encoding and decoding format. Circle Surround *encoding*enables the distribution of up to 6.1 channels ofdiscrete audio over existing two-channel carriers such as broadcast television,FM radio, CDs and VHS tapes. Circle Surround *decoding*either**decodes Circle Surround encoded material for multi-channelplayback or creates up to 6.1 channels of audio from older formats of material,including mono, stereo, 4-channel surround or other matrix surround formats.Circle Surround decoding is available in three formats: Circle Surround, CircleSurround IITM and Circle Surround AutomotiveTM.

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

**Our Customers and Markets**

Wesell our semiconductors and license our technologies throughout the WesternHemisphere, the Asia Pacific region and in Europe. The following table presentsour revenue by geographic area. For product sales, revenue is allocated basedon the country to which product was shipped. For licensing-relatedrevenue, the allocation is based on the location of the licensee’s corporateheadquarters. The Americas region includes North, Central and South America.
| ** **                      | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------|------------|---------------------------------------------|------------|
| ** **                      | ** ** | **2004**                                    | ** ** | **%** | ** ** | **2003** | ** ** | **%** | ** ** | **2002** | ** ** | **%** | ** ** |
| ***Geographic  Area Revenue:*** |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Hong Kong                       |       | $                                           | 9,975,904  |   | 46 | % | $ | 9,235,976 |   | 47 | % | $ | 9,848,123 |   | 52 | % |
| Japan                           |       | 4,906,343                                   |       | 23 | % | 5,402,565 |   | 27 | % | 5,383,728 |   | 28 | % |
| Americas                        |       | 2,354,668                                   |       | 11 | % | 875,461 |   | 5 | % | 1,027,252 |   | 6 | % |
| China                           |       | 2,028,224                                   |       | 9 | % | 2,193,863 |   | 11 | % | 1,771,486 |   | 9 | % |
| Other Asia Pacific              |       | 1,661,880                                   |       | 8 | % | 1,226,945 |   | 6 | % | 151,649 |   | 1 | % |
| Europe                          |       | 675,369                                     |       | 3 | % | 878,971 |   | 4 | % | 819,555 |   | 4 | % |
| Total                           |       | $                                           | 21,602,388 |   | 100 | % | $ | 19,813,781 |   | 100 | % | $ | 19,001,793 |   | 100 | % |

 

*Semiconductors*

Our custom ASIC customers include the Asia-basedmanufacturing facilities for consumer electronics, telecommunications andpersonal computer manufacturers headquartered in North America, Europe and AsiaPacific.

We believe our expertise in design work allows us tooffer our customers a shorter development cycle, smaller die size and fasterturnaround time for final production, which strengthens our relationships withour customers and helps us retain our competitive advantage in the Asia Pacificregion.

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Our target customers for Standard ICs are the ODMs andOEMs of a variety of television applications, including LCD, projection, CRTand plasma televisions, as well as personal telecommunications, automotive,portable audio and personal computer equipment.

Our six largest customersaccounted for approximately 60% of our semiconductor revenues in 2004, and twocustomers, Cantronic Industries Limited and Fook Tin Technologies Limited,accounted for approximately 20% and 11% of our semiconductor revenues,respectively.

*Licensing*

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

 

**Home Entertainment**

Home entertainment products represent the largestcurrent market for our technologies and have historically been the largest revenuecontributor to our licensing business. Manufacturers in this market utilize ourtechnologies to differentiate their products from their competitors and improvefunctionality and product performance. In many instances, manufacturers licensemultiple technologies from us for multiple product lines and divisions. Productcategories within this market, include televisions, advanced displays, such asprojection, plasma and LCD, set-top boxes, DVD players, audio/video receiversand complete home-theater-in-a-box system.

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

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

*DVD Players & Set-top Boxes.  *Aprimary challenge for DVD player, recorder and set-top box manufacturers isthat the average household uses a two-speaker audio system, while most of thecontent played over these devices is encoded in multichannel audio. We havedeveloped a technology that creates a virtual surround sound experience overany existing two-speaker systems, including the internal speakers of atelevision. Our technology also creates a virtual surround experience fromstereo material. In 2004, we announced a cooperative agreement with STMicroelectronics for exclusive worldwide sales and marketing of TruSurround XTfor digital set-top box applications. As well, our technologies continue to beincluded in set-top boxes from Hughes for DirecTV and Motorola. In the DVDmarket, we have seen a continued slowdown of licensing royalties as a result ofincreasing pricing pressure on stand-alone DVD playback devices and ongoingtransition to new DVD recorder devices.

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

**PersonalTelecommunications**

Personal telecommunications, which include mobilephones, are becoming a true convergent product as many of the newest generationhandsets and wireless products are quickly becoming complete personalentertainment devices. We first penetrated the mobile phone market in 2001 withour VIP technology, the first patented voice technology for mobile phones thatprovides significant spoken-word comprehension to handset users throughreal-time digital signal analysis and processing. With the advent of multimediafunctionality, including digital music playback, ring tones, streaming video,two-way video conferencing, gaming, digital video recording and TV viewing, wecontinue to work with many of the leading mobile phone and voice communicationscompanies to implement our voice technology solutions in communicationsproducts.

Due to simple physical constraints, handset makersface the difficult challenge of achieving high-quality audio during playback ofthese multimedia applications. Most often, headphones or ear buds are selectedfor their cost, convenient small size and aesthetics, rather than for theiraudio performance. For handsets with integrated external speakers, the devicesize limits the speaker size, the spacing and even the separation between twospeakers if they can fit in the device at all. Various popular audiocompression schemes and codecs can also adversely affect the quality ofreproduced audio due to the compression methodologies. To address theseproblems, in 2003 we developed WOW XTTM for Mobile, the industry’s firstcomplete audio enhancement solution designed to improve the quality of anyaudio played on mobile devices. This advanced technology suite contains stereoaudio, psychoacoustic bass enhancements, noise 

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

Whether the device has one speaker, two closely spacedspeakers, or relies on headphone or ear bud playback, our audio and voicesolutions can be customized for any handset maker or OEM’s specificrequirements and handset design. We also have enabling and utility technologiesto help overcome the physical limitations of the small speaker drivers andheadphones of mobile devices to produce a more natural, realistic and immersiveaudio experience. Some of these technologies include the ability to preservethe original music source’s stereo instrumentation during stereo-to-mono mixdown, the ability to manage the output level of multiple audio sources toprevent clipping, and many other breakthrough solutions that help handsetmakers increase their market share by providing cost-effective audioenhancement solutions that help mobile carriers attract and keep morecustomers. For the newer stereo speaker-enabled mobile phones, WOW XTprovides the industry’s most extreme stereo width from polyphonic ring tonesand digitally compressed music formats such as MP3, WMA and AAC.

These solutions for mobilephones are primarily implemented using software. The key benefit of adding SRSsoftware technologies is that hardware design changes aren’t needed to quicklyachieve fuller, more dynamic audio. The WOW XT Audio Enhancement Suite, VoiceProcessing Suite, Audio Management Utility Suite and SRS 3D PositionalAudio technology are either available now or in development for a wide varietyof popular mobile software solutions, platforms and processors. During 2004,companies including Fangtek, NEC, Sharp and Samsung either signed a newlicensing agreement with SRS, or expanded their use of SRS technologies fortheir latest personal telecommunications devices.

**Portable Media**

The use of portable media players, such as MP3 andportable listening devices, is widespread around the world, reflecting demandfrom consumers to take their music and soon their video with them. While thedemand for more entertainment features increases, the size of the devices aredecreasing and because of simple physical design constraints, the quality ofthe audio experience cannot always be maintained. The small footprint of thesedevices limits speaker size, speaker spacing and the quality of headphonelistening is variable since headphones are often selected for their small size andaesthetics rather than their audio performance. In addition to physicalconsiderations, the various audio compression algorithms in common use, such asMP3, AAC and WMA, can adversely affect the quality of the reproduced audiodepending on factors such as encoded bit rate and encoder quality level.

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

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**Personal Computers**

Advances in computer technology and flat-panel LCDmonitors with speakers have transformed personal computers into home theatermedia hubs. Through PCs, users can now enjoy and manage collections of musicand movies, as well as satellite and cable TV programs; and can distribute thismultimedia content throughout the home using popular networking protocols.

With computer functionality growing every day, and theform factor of these devices shrinking and flattening, gone are the days oflarge CRT monitors or PC towers under the desk. Most traditional “desktop” PCmakers have now focused their product lines into notebook and tabletcomputers—from ultra portable to widescreen portable home theaters.

We have developed specific technology solutions that deliverhome-theater sound from small and closely spaced speakers, as well as fromheadphones. Our technologies enhance the audio experience from any content andany application.

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

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

**Automotive**

In 2003, we developed SRS Circle Surround AutomotiveTM,a special version of our Circle Surround technology that can be customized bycar manufacturers for the specific audio requirements of any vehicle. CircleSurround delivers up to 6.1 channels of full-bandwidth surround sound from anyaudio source, including the radio, CDs and even MP3 files burned onto a CD.

Rear seat passengers are increasingly using DVDsystems for entertainment. Our TruSurround technology, which is widely used bytraditional DVD player manufacturers, provides a realistic virtual surroundsound experience over traditional headphones. In addition, our SRS AutomotiveTMtechnology, which is a suite of audio enhancement and processing technologiesthat can be optimized for two or more speaker systems, or headphone playbackprovides remarkable improvement in the width, height and depth of any mono orstereo audio source, as well as provides deep, rich bass enhancement.

While little revenue was generated from this marketsegment during 2004, we think this market holds significant long-termopportunities for the license of our technologies. In 2004, we achieved severaldesign wins with leading manufacturers and automakers, including JohnsonControls, Honda, Toyota and Fujitsu Ten.

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Thefollowing table identifies a few of our largest licensing customers and themarket or markets for which such licensees are licensing****ourtechnologies, as of December 31, 2004:
| **OEM Name**             | ** ** | ** ** | ** ** | **Home  Entertainment** | ** ** | **Personal  Telecom** | ** ** | **Portable  Media  Devices** | ** ** | **Personal  Computer** | ** ** | **Automotive** | ** ** |
|-------------------------------|------------|------------|------------|-------------------------|------------|-----------------------|------------|------------------------------|------------|------------------------|------------|----------------|------------|
| Amtran                        |       |       | ·     |                    |       |                  |       |                         |       |                   |       |           |       |   | · |   |   |   |   |
| BenQ                          |       |       | ·     |                    |       |                  |       |                         |       |                   |       |           |       |   |   |   |   |   |   |
| Cantronic                     |       |       |       |                    |       |                  |       |                         |       |                   | ·     |           |       |   |   |   |   |   |   |
| Changhong                     |       |       | ·     |                    |       |                  |       |                         |       |                   |       |           |       |   |   |   |   |   |   |
| Hitachi Ltd.                  |       |       | ·     |                    |       |                  |       |                         |       |                   |       |           |       |   |   |   |   |   |   |
| Hughes Network System         |       |       | ·     |                    |       |                  |       |                         |       |                   |       |           |       |   |   |   |   |   |   |
| Kenwood Corporation           |       |       | ·     |                    |       |                  |       |                         |       |                   |       |           |       |   |   |   |   | · |   |
| LG Electronics                |       |       | ·     |                    |       |                  |       |                         |       |                   | ·     |           |       |   |   |   |   |   |   |
| Marantz Corporation           |       |       | ·     |                    |       |                  |       |                         |       |                   |       |           |       |   |   |   |   |   |   |
| Motorola BCS                  |       |       | ·     |                    |       |                  |       |                         |       |                   |       |           |       |   |   |   |   |   |   |
| NEC Corporation               |       |       |       |                    |       |                  | ·     |                         |       |                   |       |           |       |   |   |   |   |   |   |
| Philips Consumer  Electronics |       |       | ·     |                    |       |                  |       |                         |       |                   |       |           |       |   |   |   |   |   |   |
| Pioneer Corporation           |       |       | ·     |                    |       |                  |       |                         |       |                   |       |           |       |   |   |   |   |   |   |
| Reigncom/iRiver               |       |       |       |                    |       |                  |       |                         |       |                   | ·     |           |       |   |   |   |   |   |   |
| Samsung Electronics           |       |       | ·     |                    |       |                  | ·     |                         |       |                   | ·     |           |       |   |   |   |   |   |   |
| Sharp Corporation             |       |       |       |                    |       |                  | ·     |                         |       |                   |       |           |       |   |   |   |   |   |   |
| Skyworth                      |       |       | ·     |                    |       |                  |       |                         |       |                   |       |           |       |   |   |   |   |   |   |
| Sony Corporation              |       |       | ·     |                    |       |                  |       |                         |       |                   | ·     |           |       |   | · |   |   |   |   |
| ST Microelectronics           |       |       | ·     |                    |       |                  |       |                         |       |                   |       |           |       |   |   |   |   |   |   |
| Toshiba Corporation           |       |       | ·     |                    |       |                  |       |                         |       |                   |       |           |       |   | · |   |   |   |   |

 

Our six largest customersaccounted for more than 50% of our licensing revenues in 2004, and onecustomer, ST Microelectronics, accounted for approximately 11% of our licensingrevenues.

**OurStrategy**

*Semiconductors*

Our strategy in oursemiconductor business is to integrate our SRS technologies into our ICs and toleverage our technology to create added value for our semiconductor customers. Manufacturersof electronic products are under increasing pressure to bring their products tomarket rapidly, at lower cost and with differentiated features. We believe thatour audio technologies provide a compelling differentiable feature. In 2003, weleveraged our expertise in the design of integrated circuits and begandevelopment of a series of semiconductor products that included SRS technology.In 2004 mass production began on many of these products and by the end of 2004,40% of the ASP product line included SRS technology chips. These chips includea wide variety of stand-alone analog solutions for SRS technologies, includingSRS WOW, SRS TruBass, SRS 3D, SRS FOCUS and SRS Dialog Clarity that aremarketed to the high-growth and high-volume product categories manufactured inthe Asia Pacific region, such as portable audio systems, televisions, LCDmonitors, portable audio devices and computers. In 2004, we also launchedseveral universal audio processors that combined our audio technologies withstandard audio functions such as volume, tone and level; as well as the firstASP-branded DSP processors with SRS technology.

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*Licensing*

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

The mission of our licensing platform strategy is toachieve comprehensive and strategic coverage for our technology solutionswithin all of our targeted vertical product markets in order to expand salesand licensing opportunities. By developing strong relationships with theleading software and semiconductor companies, our audio technologies can bedelivered to customers worldwide across high growth and high volume productapplications.

Our licensing model most often employs a systemwhereby our licensees or prospective licensees request that SRS technologiesare enabled on key industry platforms from leading semiconductor manufacturersand middleware or firmware software providers (Platform Partners). Oftentimes,the request is first made goes to the platform provider. In othercircumstances, we may proactively target a new emerging platform in one of ourfive market segments.

We work together with our Platform Partners to provideour mutual customers with the technology which best fits their needs. We alsotogether solicit other customers who use the platform.

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

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*OEM Marketing Programs.  *Over600 million consumer electronics hardware or software products have beenshipped or downloaded that feature SRS technologies. Our logo is eitherprominently displayed on the product itself or, in the case of softwareproducts and mobile phones, featured in the graphical user interface. Thisconsistent logo exposure is considered a key tool in reaching consumersworldwide. In addition, we work with our OEM customers as they launch newproducts that feature SRS technologies. We supply complete SRS corporate andtechnology tool kits with a wide array of material, including SRS logos,illustrations, technology explanations and suggested demonstration material. In2004, we worked with Toshiba as well as Sony PC in the creation ofpoint-of-purchase videos that are used on display PCs in leading retail outletsaround the United States. These videos included information on SRS technologyas well as displayed our logo, thereby reinforcing the consumer’s awareness ofthe SRS feature inside their product purchase.

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

We also market hardware and software products forconsumers that feature our audio technologies*.*These products are sold exclusively online through our e-commercesite, *www.wowthing.com*.

The WOW ThingTM is a small processor that can beinstalled between speakers or headphones and the sound card or CPU of mostpersonal computer systems. It enhances the sound quality of CDs as well asdigitally compressed audio, which is downloaded or streamed over the Internet.The CS II Plug-in for the Windows Media Player delivers a full 5.1 surroundsound experience for stereo and mono music, videos and streaming audio. In2004, we created a consumer plug-in version of our latest stereo enhancementtechnology, WOW XT, for the Windows Media Player platform. Revenue from thesale of these products is insignificant, but gives us a valuable demonstrationplatform to showcase our audio technologies.

*Use of SRS Technology by Content and BroadcastProfessionals.  *Wedevelop, license and sell professional hardware and software products andconsumer software plug-ins primarily as a means of enabling contentcompanies, broadcasters and music publishers to encode their material in ourCircle Surround, or CS, technology. When CS is professionally used, the logo isdisplayed within the content itself, on the packaging material, or in the caseof radio an announcement that the broadcast is being delivered in SRS CircleSurround is played. We have concentrated on three key market segments in thepro audio space: television, radio and music, and have developed a full line ofhardware and software products to supportthese markets. These products are sold directly to professional customers andare also available from selected dealers and distributors servicing theprofessional audio and broadcast communities. We did not generate significantrevenue from the sale of professional hardware equipment in 2004 and theoutlook for significant revenue generation remains unproven, but we believethere is great value in continuing to pursue this market as a key element ofour branding strategy. Top television broadcasters in the United Statesand abroad, who have transmitted Circle Surround-encoded programs include ABC,CBS, NBC, ESPN, ESPN 2, ESPN HD, FOX, FX, TNT, PBS for dozens of programsincluding the 55th Annual Prime Time Emmy Awards, X Games, NFL and NBAbroadcasts, and more.

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

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of theagreement expires on July 9, 2006 and is automatically renewable forsuccessive one-year terms. Under the terms of this agreement, the brandingopportunities on each DVD released by CHS through the terms of the agreementinclude: (a) a short video of the SRS logo displayed prior to reaching themenu on the DVD; and (b) an instructional video on setting up a CircleSurround home theater system, which is available in the special features menu.For those DVDS encoded in Circle Surround, the CS logo will be prominentlydisplayed on the packaging of the DVD as well as in promotional material usedby distributors worldwide.

**Sales and Marketing**

We have two types of revenue collection systems withour licensees—bundled or non-bundled. Under a bundled agreement, royaltyrevenue may be collected by our Platform Partner at the time the solution issold to the OEM or ODM. Most often, however, we collect revenue directly fromour licensees. These licensing arrangements with OEMs or ODMs authorize them todesign, build and sell products containing our technology. Under this licensingmethod, OEM product licensees are free to choose a semiconductor solution fromthe Platform Partner that best suits their technical and cost-of-goods-soldrequirements. We receive royalties directly from the licensed OEM or ODM forthe use of our technologies in licensed products manufactured and shipped bythe OEM or ODM. Many major OEMs have licenses or purchase products manufacturedby a licensed ODM for the use of one or more of our technologies and for theuse and display of our trademarks. In the case of the Platform Partner whobundles our royalty within their solution, the cost of the solution includesour royalty at the time it is sold. The Platform Partner remits that royaltydirectly back to us on behalf of the licensee, thus streamlining the royaltycollection process of royalty reporting.

Our process for selecting particular Platform Partnersfor distributing our technology is based on several criteria including: (a) segmentleadership—we target chip partners that hold preeminent positions in marketsegments characterized by high growth, volume and/or margins; (b) volume—platformswhich will maximize exposure of our technologies to a large number of potentialOEMs; (c) synergy—platforms which serve to position our technologies alongwith compatible and additive technologies for integrated delivery; and (d) convergencepotential—which enable us to establish a presence on platforms that intersectmerging functional features. An example of this would be the platforms for newpersonal multifunctional devices that include mobile phone, personal digitalassistant, or PDA, and MP3 capabilities.

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Thefollowing table identifies a few of our chip partners who have entered intolicensing agreements with us and a few of our software partners who havedeveloped software formats and operating systems for which our technologysolutions are implemented, and the market or markets for which such licenseesor partners are marketing our technologies as of December 31, 2004:
| **Chip/Software Partner Name**        | ** ** | ** ** | ** ** | **Home  Entertainment** | ** ** | **Personal  Telecom** | ** ** | **Portable  Media Devices** | ** ** | **Personal  Computer** | ** ** | **Automotive** | ** ** |
|-------------------------------------------------|------------|------------|------------|-------------------------|------------|-----------------------|------------|----------------------------------|------------|------------------------|------------|----------------|------------|
| Analog Devices                                  |       |       | ·     |                    |       |                  | ·     |                             |       |                   | ·     |           |       |   | · |   |   |   | · |   |   |
| ARM                                             |       |       |       |                    |       |                  | ·     |                             |       |                   | ·     |           |       |   |   |   |   |   |   |   |   |
| ASP Microelectronics                            |       |       | ·     |                    |       |                  |       |                             |       |                   | ·     |           |       |   | · |   |   |   |   |   |   |
| Cirrus Logic                                    |       |       | ·     |                    |       |                  |       |                             |       |                   | ·     |           |       |   |   |   |   |   |   |   |   |
| Freescale                                       |       |       | ·     |                    |       |                  | ·     |                             |       |                   | ·     |           |       |   |   |   |   |   | · |   |   |
| Micronas                                        |       |       | ·     |                    |       |                  |       |                             |       |                   |       |           |       |   |   |   |   |   |   |   |   |
| New Japan Radio  Corporation (“NJRC”) |       |       | ·     |                    |       |                  |       |                             |       |                   | ·     |           |       |   | · |   |   |   | · |   |   |
| Philips Semiconductor                           |       |       | ·     |                    |       |                  |       |                             |       |                   | ·     |           |       |   |   |   |   |   | · |   |   |
| Sigmatel                                        |       |       |       |                    |       |                  |       |                             |       |                   | ·     |           |       |   | · |   |   |   |   |   |   |
| ST Microelectronics                             |       |       | ·     |                    |       |                  |       |                             |       |                   | ·     |           |       |   |   |   |   |   |   |   |   |
| Texas Instruments                               |       |       | ·     |                    |       |                  | ·     |                             |       |                   | ·     |           |       |   |   |   |   |   | · |   |   |

 

To implement our licensing sales strategy within ouridentified vertical markets, we have established a direct sales force and aworldwide network of independent sales agents. In North America, we employ adirect sales force to market our portfolio of audio and voice technologies tothe OEM community. Internationally, we maintain support offices in the CzechRepublic, Japan, Hong Kong and Korea to support our multi-national OEMcustomers. We actively promote the use of our trademarks and logos and directcustomers to prominently display the appropriate SRS technology logo onproducts, packaging and in advertising. We work closely with our licensees toenhance their success in selling finished products and semiconductor productsthat incorporate our technologies through a variety of licensee supportprograms. These programs include engineering support, sales training, tradeshowsupport, press support, customized marketing materials and corporatecommunications. Our corporate communications program includes press releases,advertising, speaking engagements and industry conferences. We use the Internetto provide easy-to-use audio technology demonstrations for those technologiesthat can be appropriately demonstrated on the World Wide Web. We conductin-person technology demonstrations or presentations for the press and othercompanies to promote our technologies and products.

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

**Backlog**

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

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**Research and Development**

Our customers compete in markets that arecharacterized by rapidly changing technology and continuous improvement inproducts and services. Our research and development expenditures in 2004, 2003and 2002 were approximately 30.0%, 28.9% and 30.6% of total operating expensesrespectively. These expenses consist of salaries and related costs of employeesand consultants engaged in ongoing research, design and development activitiesand costs for engineering materials and supplies.

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

**Competition**

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

*Semiconductors*

The Asia Pacific semiconductor industry is dominatedby several major suppliers, such as Motorola, National Semiconductor and TexasInstruments. These established semiconductor companies usually do not offercustom design services to manufacturers and will only do so if the number ofsemiconductors required by such manufacturers is very large. Instead, theysupply standard IC products to their customers. We occasionally compete withsmaller design houses in Japan, Taiwan or Korea, such as Sunplus, but most ofthese design houses are focused on standard semiconductor chip categories, suchas random access memory, micro-controller and other non-proprietaryfunctional processes.

We believe that our ASIC team is more flexible in itsstrategy of designing new products, as well as more responsive in the serviceprovided to clients. With 19 years of experience in the Asia Pacificsemiconductor market, our large accumulated design IP library can be reused fordifferent designs and can support a shorter chip development cycle and a lowerchip cost. Using our proprietary software, many of our designs can bere-targeted for different foundries and processes, which allows us to reducerisk and cost. We have strong in-house testing capabilities, usingstate-of-the-art software and hardware development tools. We also believe thatour expertise in local business practices and a strong franchise ofrelationships with clients gives us a competitive advantage over newcomers tothe industry and large multi-national firms.

Our ability to develop standard ICs that incorporateour audio technologies has opened up new chip sales opportunities, but could inthe future cause channel conflict with our network of SRS technologysemiconductor partners. Our objective is to minimize this conflict by concentratingour design and sales efforts on chip products for markets and productapplications that are underserved by our existing semiconductor partners.

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

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*Licensing*

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

In the field of 3D audio enhancement, we competedirectly with other audio providers, including QSound, Spatializer, Aureal andBBE Sound. Our newly launched 3D positional audio technology directly competeswith technologies from QSound and Synoptic. We believe that our bassenhancement technology, TruBass, competes directly with several technologies,including MaxxBass from Waves, Ltd, Vi.B.E from Spatializer, andnon-proprietary bass systems, such as Bass Boost, that are included on avariety of electronics products, including televisions, portable stereos andspeaker products. Because our audio enhancement techniques work with any existingrecorded material, whether mono, stereo or surround sound, most of our audioenhancement technologies, including SRS 3D Sound, SRS FOCUS, SRS TruBass andSRS Dialog Clarity, can be used either as an alternative or as a complement andenhancement to almost any competing audio technology.

Many companies in the wireless and telecommunicationsindustry are investigating methods to increase the quality of a voice signal;but we believe that their development work focuses on techniques to reducenoise and provide echo cancellation. We are not aware of any direct competingtechnologies to our voice technology, VIP, which processes the actual voicesignal to improve intelligibility and works on the formants of the human speechpattern. VIP is compatible to these other noise cancellation techniques.

Several technologies within our surround soundportfolio, including TruSurround, TruSurround XT, Circle Surround and CircleSurround II, compete directly with a variety of technologies from Spatializer,QSound, Dolby Laboratories and DTS®, Inc. These competing processesinclude: Dolby ProLogicTM and ProLogic II, which are analog, surround soundsystems that can encode surround content as well as decode up to 5.1 channelsof surround sound from mono or stereo; Dolby Digital (AC-3) and Dolby DigitalEX, that encode a six channel digital sound track on a movie print and decodesix channels of digital audio in a consumer electronics device; Dolby VirtualSpeaker, which processes the multichannels of Dolby Digital or Dolby Surroundover just two channels, creating a virtual surround sound experience; DTS,which uses CDs to reproduce six channels of digital sound synchronized with amovie print and decodes the six channels of sound in a consumer electronicsdevice; DTS NEO 6, which decodes up to 6.1 channels of surround sound frommono or stereo; and N-2-2TM from Spatializer, which processes the multichannelsof surround sound over two speakers.

Many of the companies referenced above have, or mayhave, substantially greater resources than us to devote to further technologiesand new product developments. We believe that we compete based primarily on thequality and performance of our proprietary technologies, brand name awareness,the ease and cost of implementing our technologies, the ability to meet OEMs’needs to differentiate their products, and the strength of our licenseerelationships. However, there can be no assurance that based on these factors,we will continue to be competitive with existing or future products ortechnologies of our competitors.

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

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**IntellectualProperty Rights and Proprietary Information**

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

In order to protect the underlying technologyconcepts, we have filed and/or obtained patents for all of our marketedtechnologies including technologies marketed under the trademarks SRS,TruSurround, TruSurround XT, FOCUS, Circle Surround, Circle Surround II, WOW,VIP and TruBass. In addition, we have numerous issued patents and patentspending for speaker and other acoustic reproduction technologies. We pursue ageneral practice of filing patent applications for our technologies in theUnited States and various foreign countries where our licensees manufacture,distribute or sell licensed products. We continually update and add newapplications to our patent portfolio to address changing worldwide marketconditions and our new technological innovations. The range of expiration datesfor our patents extend between the years 2005 to 2020. We have multiple patentscovering unique aspects and improvements for many of our technologies.Accordingly, the expiration of any single patent is not likely to significantlyaffect our intellectual property position or the ability to generate licensingrevenue.

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

**Seasonality**

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

**Employees**

As of December 31,2004 we employed 105 persons, 24 in finance and administration; 49 in researchand development, engineering and product development; and 32 in sales andmarketing. Of the 105 employees, 66 are employed in our semiconductor businessand are located overseas. None of our employees are covered by a collectivebargaining agreement or are presently represented by a labor union. We have notexperienced any labor problems or a work stoppage and believe we have goodrelations with our employees.

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**Available Information**

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

**Item 1A.**                Executive Officersof the Registrant

Thefollowing table sets forth the executive officers of SRS Labs, Inc., theirages as of March 1, 2005, and the positions currently held by each person:
| **Name**             | ** ** | ** ** | ** ** | **Age**                                            | ** ** | **Position** |
|----------------------|------------|------------|------------|----------------------------------------------------|------------|--------------|
| Thomas C.K. Yuen     |       | 53         |       | Chairman, Chief Executive Officer and President    |
| Janet M. Biski       |       | 49         |       | Chief Financial Officer, Treasurer and Secretary   |
| Alan D. Kraemer      |       | 54         |       | Executive Vice President, Chief Technology Officer |
| Philip Wong          |       | 48         |       | President, ValenceTech, Limited                    |
| Jennifer A. Drescher |       | 40         |       | Vice President, Corporate Communications           |
| Michael S. Oswald    |       | 49         |       | Vice President, General Counsel                    |

 

The Chief Executive Officer, President and ChiefFinancial Officer are elected annually by the Board of Directors at its firstmeeting following the annual meeting of stockholders. Other executive officersmay be appointed by the Board of Directors at such meeting or at any othermeeting. All executive officers serve at the pleasure of the Board ofDirectors.

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

**Janet M. Biski** hasserved as Chief Financial Officer and Treasurer of SRS Labs since December 2002.Ms. Biski has also served as Secretary of SRS Labs since November 2004.Previously, she was a founder and served as Chief Financial Officer and VicePresident of Operations for AccentCare, Inc., a home-care company, from April 1999to December 2002. During that time, AccentCare successfully completed 15acquisitions and grew revenues to approximately $100M. Previous to joiningAccentCare, Ms. Biski served as Vice President, Chief Financial Officer,Secretary and Treasurer of SRS Labs from 1994 to 1999. Ms. Biski was partof the management team in its early start-up phase which successfully led theCompany through the completion of its initial public offering. Ms. Biskialso participated in SRS Labs’ acquisition of Valence as well as several of theCompany’s acquisitions of 

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technology. Early in hercareer, Ms. Biski was a regional controller for Fujitsu Business Systems,and held various financial management positions at IBM/ROLM.  Ms. Biski has a BS in Accounting from theState University of New York.

**Alan D. Kraemer**has served as Chief Technology Officer of SRS Labs since January 2005. Hehas also served as Executive Vice President,Technology and Business Development since June 2004. Prior thereto,he served as Vice President, Engineering of the Company since April 2000and Director of Engineering since February 1994. In addition, Mr. Kraemerserved as President of Sierra Digital Productions, Inc., a compact discproduction and recording company, since August 1989. Prior to joining SRSLabs, Mr. Kraemer served as President of Engineering of De LaRue Printrak,a manufacturer of automatic fingerprint identification systems, Vice Presidentof Engineering for AST Research, a personal computer manufacturer, VicePresident of Engineering with Point4 Data Corporation, and as****Director of Software Engineering of Northrop Electronics.

**Philip Wong**hasserved as the President of ValenceTech Limited and Valence Technologies Limitedsince March 2004. Mr. Wong brings to Valence Tech and Valencesignificant technology experience, extensive high-level industry and governmentrelationships and a deep knowledge of the Asia Pacific market. From 1998 to March 2004,Wong served as managing partner of the China Key Partnership Group, an advisoryfirm that assists multinational companies in establishing a presence in the PRC.From 1987 to 1994, he held a variety of executive positions at AST Computers,culminating in the position as General Manager of Far East Sales workingdirectly under SRS Labs Chairman and Chief Executive Officer, Thomas Yuen, whoat the time was co-chairman and chief operating officer of AST. By 1994, ASThad established itself as the number one brand name of personal computers inthe Hong Kong and China markets with a 70% market share with revenues of $300million.

**Jennifer A. Drescher**has served as Vice President of Corporate Communications since December 2002and Vice President of Marketing for SRS Labs from December 2001. Shepreviously served as Vice President of Marketing for the company’s Internet andbroadcast subsidiary, SRSWOWcast Technologies from December 1999 through November 2001.Ms. Drescher was the Company’s first employee in 1993 working as Directorof Marketing until the formation of SRSWOWcast Technologies. Prior to joiningSRS Labs, Ms. Drescher’s career has held various senior level marketing,public relations and operational positions with audio technology licensing andproducts companies.

**Michael S. Oswald** has served as VicePresident and General Counsel of the Company since November 2004. He servedfrom 2001 to 2004 as Vice President and General Counsel of Lantronix, Inc.,a publicly traded provider of computer networking technologies. Prior to hispublic company experience, Mr. Oswald was a key management team member attwo successive start-up technology companies. Mr. Oswald was GeneralCounsel and Chief Administrative Officer at NowDocs, Inc. from 1999 to2001, where he managed Purchasing, Facilities, Human Resources and LegalAffairs and from 1996 to 1999 he was General Counsel at Acuity Corp. At Acuity,he was a member of the management team that negotiated Acuity’s acquisition byQuintus Corporation and co-led the transition team. He also served on Quintus’IPO team. Mr. Oswald earned a Juris Doctor degree from Santa ClaraUniversity School of Law, and a Bachelor of Arts degree from the University ofCalifornia at Riverside. He is an Adjunct Professor of Law at Western StateUniversity College of Law, where he teaches business law courses. Mr. Oswaldalso serves on the Board of Directors of the Southern California Chapter of theAmerican Corporate Counsel Association (ACCA).

**Item 2.**                        Properties

Our worldwide headquarters are located in Santa Ana,California, in a 23,400 square foot facility consisting of office and warehousespace. The lease is for a term of three years scheduled to expire on May 31,2005. At that time, we will have an option to renew the lease, under similarterms and conditions, 

21

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

Valence’s principal executive offices and research anddevelopment facility are located in Kwun Tong, Kowloon, Hong Kong  in a 16,600 square foot facility under twolease agreements which expire in November 2006, at which time we cannegotiate renewal agreements. To the extent that management is unable to reachsuch agreements, it believes that it will be able to secure comparable space atreasonable rates. Pursuant to these leases, we paid rent of $148,349 during2004, $330,826 during 2003 and $256,542 during 2002.

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

**Item 3.**                        LegalProceedings

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

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

None.

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**PART II**

**Item 5.**                        Market forRegistrant’s Common Equity, Related Stockholder Matters and Issuer Purchases ofEquity Securities

**Market for Common Stock**

Ourcommon stock trades on the Nasdaq National Market under the symbol SRSL. Thetable below reflects the high and low sales prices of the common stock asreported by The Nasdaq Stock Market, Inc. for the periods indicated.
| ** **      | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------|------------|----------|------------|---------|------------|
| **Fiscal 2004** |       |     |       |    |       |
| First Quarter   |       | $        | 12.00      |    | $          | 5.76 |   |
| Second Quarter  |       | $        | 7.85       |    | $          | 3.98 |   |
| Third Quarter   |       | $        | 6.77       |    | $          | 3.81 |   |
| Fourth Quarter  |       | $        | 7.45       |    | $          | 5.21 |   |
| **Fiscal 2003** |       |     |       |    |       |
| First Quarter   |       | $        | 3.23       |    | $          | 2.05 |   |
| Second Quarter  |       | $        | 4.92       |    | $          | 2.10 |   |
| Third Quarter   |       | $        | 6.19       |    | $          | 3.60 |   |
| Fourth Quarter  |       | $        | 11.00      |    | $          | 5.20 |   |

 

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

**Holders**

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

**Dividend Policy**

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

**SecuritiesAuthorized for Issuance Under Equity Compensation Plans**

The following equity compensation plans have beenapproved by our stockholders: the SRS Labs, Inc. Stock Option,Nonqualified Stock Option and Restricted Stock Purchase Plan (the “1993 Plan”),the SRS Labs, Inc. Amended and Restated 1996 Long-Term Incentive Plan (the“1996 Plan”), and the SRS Labs, Inc. Amended and Restated 1996Non-employee Directors’ Stock Option Plan (the “Non-employee Directors Plan”).A description of the material features of each of these plans is included inNote 10 to the Notes to Consolidated Financial Statements under the caption “StockAward/Option Plans/Warrants.” We do not have any equity compensation plansother than those approved by our stockholders.

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Thefollowing table sets forth information regarding the number of shares of ourcommon stock that may be issued pursuant to our equity compensation plans orarrangements as of the end of fiscal 2004.

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

----

(1)          Represents shares ofcommon stock that may be issued pursuant to outstanding options granted underthe following plans: 115,370 shares under the 1993 Plan, 4,491,171 shares underthe 1996 Plan and 115,000 shares under the Non-employee Directors Plan.

(2)          Represents shares ofcommon stock that may be issued pursuant to options available for future grantsunder the following plans: 2,250,436 shares under the 1996 Plan and 385,000shares under the Non-employee Directors Plan.

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

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

On June 30, 2003, theBoard of Directors adopted a stock repurchase program authorizing the purchaseof shares of up to $3,000,000 of its common stock for a period of six monthscommencing on July 1, 2004 and ending on December 31, 2004. Total purchasesunder the program since inception were 216,575 at an average purchase price of$5.66 per unit. The following table sets forth the purchases by the Company bymonth during the fourth quarter ended December 31, 2004.

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

 

**Item 6.**                        SelectedFinancial Data

Thefollowing selected financial information as of and for the dates and periodsindicated have been derived from our audited consolidated financial statements.The information set forth below is not necessarily indicative of results offuture operations, and should be read in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” in Part II,

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

 

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

**Overview**

SRS Labs is a leading developer and provider ofapplication specific integrated circuits (“ASICs”), standard integratedcircuits (“ICs”) and audio and voice technology solutions for the homeentertainment, portable media device, personal telecommunications, personalcomputer, automotive, and broadcast markets. We operate in the following twobusiness segments:

*Semiconductor:  *ThroughSRS Labs, Inc.’s wholly-owned subsidiary, ValenceTech Limited, andValenceTech Limited’s wholly-owned subsidiaries (collectively “Valence”), weoperate a fabless semiconductor company which develops, designs and marketsstandard and custom, analog, digital signal processors (“DSPs”), and mixedsignal, integrated circuits primarily to original equipment manufacturers (“OEMs”)and original design manufacturers (“ODMs”) in the Asia Pacific region.

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

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

**Critical Accounting Policies**

Our discussion and analysis of our results ofoperations and liquidity and capital resources are based on our consolidatedfinancial statements which have been prepared in accordance with accountingprinciples generally accepted in the United States.

The preparation of these financial statements requiresus to make estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and disclosure of contingent assets andliabilities. We base our estimates on historical and anticipated results andtrends and on various other assumptions that we believe are reasonable underthe circumstances, including assumptions as to future events. These estimatesform the basis for making judgments about the carrying value of assets andliabilities that are not readily apparent from other sources. By their nature,estimates are subject to an inherent degree of uncertainty. Actual results maydiffer from our estimates.

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

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recognition;however, these policies do not meet the definition of critical accountingestimates, because they do not generally require us to make estimates orjudgments that are difficult or subjective.

*Accounts Receivable*

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

*Inventory*

Inventory is stated at thelower of cost or net realizable value. We periodically assess our inventory forpotential obsolescence and lower-of-cost-or-market issues. We make estimates ofinventory obsolescence, providing reserves when necessary, based on, amongother factors, demand for inventory based on backlog, product pricing, theability to liquidate or sell older inventory, and the impact of introducing newproducts. If actual market conditions or our customer’s product demands areless favorable than those projected, additional provisions may be required.

*Intangible Assets &Capitalization of Software*

In accordance with Statement of Financial AccountingStandards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets”, weassess potential impairments to intangible assets when there is evidence thatevents or changes in circumstances indicate that the carrying amount of anasset may not be recovered. Our judgments regarding the existence of impairmentindicators and future cash flows related to intangible assets are based onoperational performance of our acquired businesses, market conditions and otherfactors. If the carrying value of a reporting unit exceeds its fair value,goodwill is considered impaired and a second test is performed to measure theamount of impairment loss, if any. For fiscal 2004, an independent valuation ofgoodwill and other intangibles was performed. To date, we have not recognizedany impairment of our goodwill and other intangible assets in connection withour adoption of SFAS 142. However, no assurances can be given that futureevaluation of goodwill will not result in charges as a result of futureimpairment.

In accordance with Statement of Financial AccountingStandards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets,” all of our intangible assets that have definite lives arebeing amortized on a straight-line basis over their estimated useful lives. Costspaid by us related to the establishment and transfer of patents, primarilylegal costs, are capitalized and amortized over periods ranging from five toten years, depending on the estimated life of the technology patented.Consideration for the purchase of assets in excess of the fair market value ofspecifically identified tangible assets has been capitalized as intangible andis being amortized over periods ranging from three to 11 years depending on theuseful life of the asset. We annually evaluate the recoverability of ourpatents and intangible assets based on the estimated future undiscounted cashflows. Should the carrying value of patents or intangible assets exceed theestimated future undiscounted cash flows for the expected periods of benefit,such assets will be written down to fair value. Based upon its most recentassessment, we have determined that there was impairment of $43,266 as of December 31,2004.

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

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technologicalfeasibility is established. Under Statement of Financial Accounting Standards (“SFAS”)No. 86, “Accounting for the Costs of Computer Software to be Sold, Leasedor Otherwise Marketed,” we capitalize software purchased from third parties ifthe related software product under development has reached technologicalfeasibility or if there are alternative future uses for the purchased software,provided that capitalized amounts will be realized over a period not exceedingfive years. Costs incurred prior to the establishment of technologicalfeasibility are charged to research and development expense. The establishmentof technological feasibility and ongoing assessment of recoverability ofcapitalized software development costs require considerable judgment bymanagement with respect to certain external factors, including, but not limitedto, anticipated future revenues, estimated economic life and changes insoftware and hardware technologies. Under SFAS No. 86, annual amortizationof software development costs should be the greater of the amount computedusing (a) the ratio that current gross revenues for a product bear to thetotal of current and anticipated future gross revenues for that product or (b) thestraight-line method over the remaining estimated economic life of the productincluding the period being reported on. After considering the two methods, weare using the straight-line method of amortization as the software can be usedfor many products and the estimates required to be made under the ratio thatcurrent gross revenues for products bear to the total of the current andanticipated future gross revenues for that product could result in underreporting of expense. Upon the general release of the software product tocustomers, capitalization ceases and such costs are amortized to cost of salesusing the straight-line method on a product-by-product basis over the estimatedlife, which is generally three years. To the extent that amounts capitalizedfor software development costs become impaired due to a decline in demand orthe introduction of new technology, such amounts will be written-off. All otherresearch and development expenditures are charged to research and developmentexpense in the period incurred.

*Income Taxes*

In preparing our consolidated financial statements, weestimate our income taxes in each of the countries in which we operate. Theprocess used to make these estimates includes an assessment of the current taxexpense, the results from tax examinations and the effects of temporarydifferences resulting from the different treatment of transactions for tax andfinancial accounting purposes. These differences result in deferred tax assetsand liabilities, which are included in our consolidated balance sheet. Weaccount for income taxes in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 109, “Accounting for Income Taxes,” which requiresthat deferred tax assets and liabilities be recognized using enacted tax ratesfor the effect of temporary differences between the book and tax bases ofrecorded assets and liabilities. SFAS 109 also requires that deferred taxassets be reduced by a valuation allowance if it is more likely than not thatsome portion or all of the deferred tax asset will not be realized. We evaluatethe reliability of our deferred tax assets by assessing our valuation allowanceand by adjusting the amount of such allowance, if necessary. At December 31,2004, we had net deferred tax assets primarily resulting from temporarydifferences between the book and tax bases of assets and liabilities, and lossand credit carry forwards. We continue to provide a valuation allowance oncertain deferred tax assets based on an assessment of the likelihood of theirrealization. In reaching our conclusion, we evaluated certain relevant criteriaincluding deferred tax liabilities that can be used to offset deferred taxassets, estimates of future taxable income of appropriate character within thecarry-forward period available under the tax law, and tax planning strategies.Our judgments regarding future taxable income may change due to marketconditions, changes in U.S. or international tax laws, and other factors. Thesechanges, if any, may require material adjustments to these deferred tax assets,resulting either in a tax benefit, if it is estimated that future taxableincome is likely, or a reduction in the value of the deferred tax assets, if itis determined that their value is impaired, resulting in a reduction in netincome or an increase in net loss in the period when such determinations aremade.

Our income tax provisionis based on calculations and assumptions that will be subject to examination bythe taxing authorities in the jurisdictions in which we operate. Should theactual results differ from our 

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estimates,we would have to adjust the income tax provision in the period in which thefacts and circumstances that give rise to the revision become known. Tax lawand rate changes are reflected in the income tax provision in the period inwhich such changes are enacted.

**Results of Operations**

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

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

 

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

*Revenues*

Total revenues for fiscal 2004 were $21,602,388compared to $19,813,781 in fiscal 2003, an increase of $1,788,607 or 9.0%.Semiconductor revenues were $10,770,684 in fiscal 2004 compared to $10,712,382in fiscal 2003, an increase of $58,302 or 0.5%. In 2004, semiconductor revenuegrowth was affected by management changes, foundry capacity constraints andcompetitive pressure related to its customers’ products. Semiconductor revenuesare composed of both ASIC and ASP. ASIC accounted for $7,752,537 or 72.0% infiscal 2004 compared to $8,168,751 or 76.3% in fiscal 2003, a decrease of$416,214 or 5.1%. ASP chips accounted for $3,018,147 or 28.0% in fiscal 2004compared to $2,543,631 or 23.7% in fiscal 2003, an increase of $474,516 or18.7%, of which SRS technology chips accounted for 60.8% of ASP growth. Thegrowth in ASP is attributable to new design wins with new chip offeringsincluding SRS chips.

Licensingrevenues were $10,831,704 in fiscal 2004, compared to $9,101,399 in fiscal2003, an increase of $1,730,305 or 19.0%. This increase is attributable to ourdiversification strategy which generated revenues in new product categoriessuch as mobile phones, portable audio devices, and PCs and increased 

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penetration in the Company’s key home theater market,including set-top boxes and televisions, which incorporate SRS Labs’ technologies.The following table presents the Company’s Licensing revenues mix by marketsegment, excluding product sales and Internet and broadcast segments:
| ** **                                                | ** ** | **Years Ended  December 31,** | ** ** |
|-----------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                | ** ** | **2004**                                | ** ** | **2003** | ** ** |
| Home  Entertainment (TV, Set-Top Box, A/V Receiver, DVD)  |       | 67                                      | %          | 81 | % |
| Portable Media  Devices (Digital Media Player, Headphone) |       | 12                                      | %          | 7 | % |
| PC (Software,  Hardware)                                  |       | 10                                      | %          | 5 | % |
| Personal  Telecommunications (Mobile phone, PDA)          |       | 10                                      | %          | 6 | % |
| Automotive                                                |       | 1                                       | %          | 1 | % |
|                                                      |       | 100                                     | %          | 100 | % |

 

*Gross Margin*

Costof sales consists primarily of fabrication costs, assembly and test costs, andthe cost of materials and overhead from operations. Gross margins are dependenton the mix of products sold, services provided and royalties earned. Thefollowing table presents the Company’s gross margin percentages for fiscal year2004 compared fiscal year 2003:
| ** **                                                    | ** ** | **Years Ended December 31,**                                      | ** ** |
|---------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                    | ** ** | **      2004      ** | ** ** | **      2003      ** | ** ** |
| **Semiconductor**                                             | ** ** |                                                                             | ** ** | ** ** |   |   | ** ** | ** ** |   |
| ASIC revenue as a percentage of total semiconductor  revenue  |       |                                                                             | 72.0       | % |   |   | 76.3 | % |   |
| ASIC gross margin                                             |       |                                                                             | 65.1       | % |   |   | 63.2 | % |   |
| ASP revenue as a percentage of total semiconductor  revenue   |       |                                                                             | 28.0       | % |   |   | 23.7 | % |   |
| ASP gross margin                                              |       |                                                                             | 66.3       | % |   |   | 62.8 | % |   |
| Total semiconductor revenue as a percentage of total  revenue |       |                                                                             | 49.9       | % |   |   | 54.1 | % |   |
| Total semiconductor gross margin                              |       |                                                                             | 65.4       | % |   |   | 63.1 | % |   |
| **Licensing**                                                 | ** ** |                                                                             | ** ** |   |   |   | ** ** |   |   |
| Licensing revenue as a percentage of total revenue            |       |                                                                             | 50.1       | % |   |   | 45.9 | % |   |
| Licensing gross margin                                        |       |                                                                             | 97.9       | % |   |   | 98.9 | % |   |
| **Total  Gross Margin**                                       |       |                                                                             | 81.7       | % |   |   | 79.5 | % |   |

 

*Sales and Marketing*

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

*Research andDevelopment*

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

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associatedwith personnel and expenses associated with supporting the Company’s customersin its five key markets. We expect thatresearch and development will continue to be critical to our business as weintroduce new products, but such expenses will fluctuate as a percentage ofrevenue due to change in sales volume. As a percentage of totalrevenues, research and development expenses increased from 21.5% for fiscalyear 2003, to 22.1% for fiscal year 2004.

*General andAdministrative*

General and administrativeexpenses consist primarily of employee-related expenses, legal costs associatedwith the administration of intellectual property and other professional fees.G&A expenses were $5,675,294 for fiscal year 2004 compared to $5,053,387for fiscal year 2003, an increase of $621,907 or 12.3%. The increase wasprimarily attributable to increased professional fees, public company expenses,including costs incurred for Sarbanes-Oxley 404 compliance and increasedamortization associated with the increased capitalization of patents andpurchased technology. As a percentage of total revenues, G&A expensesincreased from 25.5% for fiscal year 2003, to 26.3% for fiscal year 2004.

*Equity in Income ofInvestee*

Equity in income ofinvestee represents the Company’s proportionate share of profit from the LLCentered into with Coming Home Studios. On September 23, 2004, the Companyentered into a strategic alliance with Coming Home Studios LLC (“CHS”) toproduce and sell concert DVDs which include the Company’s Circle Surroundtechnology. The Operating Agreement governs CHS/SRS, LLC, which is a jointventure between CHS and the Company formed to complete and distribute concertvideos featuring Duran Duran, Boz Scaggs, Godsmack and All Access. Profits fromthe distribution of the concert videos and related assets will be allocated anddistributed equally until CHS and the Company have both received 1.75 timestheir original capital contributions, after which profits will be allocated anddistributed 90% to CHS and 10% to SRS Labs. The joint venture is accounted forusing the equity method and profits are recognized following the guidance forequity method accounting. We recognize and accrue profits as we get salesand/or royalty reports. For fiscal 2004, the profit recognized under theagreement was $32,358.

*Other Income, Net*

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

*Minority Interest*

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

*Provision forIncome Taxes*

The income tax provision for fiscal 2004 was $810,416compared to $1,038,463 for fiscal 2003 a decrease of $228,047 or 22.0%. Theprovision consists primarily of taxes paid on licensing revenues sourced fromcountries requiring foreign tax withholdings and taxes paid on profits in HongKong at the rate of 17.5%. The lower tax expense in fiscal 2004 resulted fromdecreased taxable income in our foreign 

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

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

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

*Revenues*

Total revenues for fiscal 2003 were $19,813,781compared to $19,001,793 in fiscal 2002, an increase of $811,988 or 4.3%.Semiconductor revenues were $10,712,382 in fiscal 2003 compared to $10,777,569in fiscal 2002, a decrease of $65,187 or 0.6%. Semiconductor revenues arecomprised of both ASIC and ASP revenues. ASIC accounted for $8,168,751 or 76.3%in fiscal 2003 compared to $9,435,258 or 87.5% in fiscal 2002, a decrease of$1,266,507 or 13.4%. The decrease was primarily attributable to the Company’sdecision to de-emphasize lower margin activities in component distributionrevenues and increased focus on ASP standard product development, as well asdecreased semiconductor business from existing semiconductor customers. ASPchips accounted for $2,543,631 or 23.7% in fiscal 2003 compared to $1,342,311or 12.5% in fiscal 2002, an increase of $1,201,320 or 89.5%, of which SRStechnology chips accounted for 75.1% of ASP growth. The growth in ASP wasattributable to new design wins with new chip offerings including SRS chips.

Licensingrevenues were $9,101,399 in fiscal 2003, compared to $8,224,224 in fiscal 2002,an increase of $877,175 or 10.7%. The increase was attributable to the salesgrowth of home entertainment products such as DVD players and portable productssuch as mobile phones and MP3 players that incorporate our technologies. Thefollowing table presents the Company’s licensing revenues mix by marketsegment, excluding product sales and Internet and broadcast segments:
| ** **                                                | ** ** | **Years Ended  December 31,** | ** ** |
|-----------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                | ** ** | ** 2003 **                    | ** ** | ** 2002 ** | ** ** |
| Home  Entertainment (TV, Set-Top Box, A/V Receiver, DVD)  |       |                                    | 81         | % |   |   | 94 | % |   |
| Portable Media  Devices (Digital Media Player, Headphone) |       |                                    | 7          | % |   |   | 1 | % |   |
| PC (Software,  Hardware)                                  |       |                                    | 5          | % |   |   | 2 | % |   |
| Personal  Telecommunications (Mobile phone, PDA)          |       |                                    | 6          | % |   |   | 2 | % |   |
| Automotive                                                |       |                                    | 1          | % |   |   | 1 | % |   |
|                                                      |       |                                    | 100        | % |   |   | 100 | % |   |

 

*Gross Margin*

Cost of sales consists primarily of fabrication costs,assembly and test costs, and the cost of materials and overhead fromoperations. Gross margins are dependent on the mix of products sold, servicesprovided and royalties earned. The improvement in gross margin from 75.0% in2002 to 79.5% in 2003 was primarily due to an increase in semiconductor gross margin,which resulted from the mix in revenues as we shifted the business away fromthe lower margin component distribution business and focused on higher marginsemiconductor sales. Since revenues from component distribution are included inASIC, it experienced an increase in gross margin as component distributionrevenues decreased. ASP gross margins improved as a result of the increase insales of new chip offerings with higher margins, of which many included SRStechnology.

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

 

*Sales and Marketing*

Sales and marketingexpenses consist primarily of employee salaries, sales consultants’ fees andrelated expenses, sales commissions and product promotion costs. Sales andmarketing expenses were $5,487,159 for fiscal year 2003 compared to $4,625,833**for fiscal year 2002, an increase of$861,326 or 18.6%. The increase wasattributable primarily to (a) investments in branding and promotion of ourtechnologies and products in new markets designed to increase future revenues; (b) co-promotionalactivities with our licensees; and (c) relocation of our sales andmarketing offices in Hong Kong. As a percentage of total revenues, salesand marketing expenses increased from 24.3% for fiscal year 2002, to 27.7% forfiscal year 2003.

*Research andDevelopment*

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

*General andAdministrative*

General and administrativeexpenses consist primarily of employee-related expenses, legal costs associatedwith the administration of intellectual property and other professional fees.G&A expenses were $5,053,387 for fiscal year 2003 compared to $4,889,484for fiscal year 2002, an increase of $163,903 or 3.4%. The increase was primarily attributable to additions to infrastructureand personnel for management of our foreign operations, increased professionalfees and public company expenses. As a percentage of total revenues,G&A expenses decreased from 25.7% for fiscal year 2002, to 25.5% for fiscalyear 2003.

*Other Income, Net*

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

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higher in fiscal 2002 due to realized gains on sales ofinvestments and higher interest income earned on investment balances.

*Minority Interest*

Minority interestrepresents the minority shareholders’ proportionate share of losses in SRSWOWcast.For fiscal 2003, minority interest was $5,430 compared to $77,708 in fiscal2002, a decrease of $72,278 or 93.0%. In February 2003, SRS Labs completedan exchange offer with the minority shareholders of SRSWOWcast, pursuant towhich SRS Labs acquired all 3,000,000 outstanding shares of SRSWOWcast Series AConvertible Preferred Stock in exchange for the issuance of 332,184 shares ofour common stock. As a result of the exchange offer, an intangible in theamount of $640,071 was recorded and SRSWOWcast became a wholly-ownedsubsidiary of SRS Labs.

*Provision forIncome Taxes*

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

**SelectedQuarterly Operating Results (Unaudited)**

Thefollowing table sets forth certain quarterly summary financial data for theeight quarters in the period ended December 31, 2004. The quarterlyinformation is based upon unaudited financial statements prepared by us on abasis consistent with our audited consolidated financial statements and, inmanagement’s opinion, includes all adjustments, consisting only of normalrecurring adjustments necessary for a fair presentation of the information forthe periods presented. This information should be read in conjunction with ouraudited consolidated financial statements and notes thereto appearing elsewherein this Report. Our quarterly operating results have varied significantly inthe past and are expected to vary significantly in the future. Due to roundingdifferences, the quarters in a given year may not add precisely to the annualnumbers for that year.
| ** **                   | ** ** | **Three Months Ended**                                     | ** ** |
|------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                   | ** ** | **Mar 31,  2004**                                               | ** ** | **June 30,  2004** | ** ** | **Sep 30,  2004** | ** ** | **Dec 31,  2004** | ** ** | **Mar 31,  2003** | ** ** | **June 30,  2003** | ** ** | **Sep 30,  2003** | ** ** | **Dec 31,  2003** | ** ** |
| ** **                   | ** ** | **(In thousands except per share amounts)** | ** ** |
| Revenues:                    |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Semiconductor                |       | $                                                                    | 2,416      |   | $ | 2,932 |   | $ | 3,644 |   | $ | 1,778 |   | $ | 1,764 |   | $ | 2,513 |   | $ | 2,967 |   | $ | 3,468 |   |
| Licensing                    |       | 2,927                                                                |       | 2,485 |   | 2,728 |   | 2,691 |   | 2,706 |   | 2,013 |   | 1,919 |   | 2,463 |   |
| Total revenues               |       | 5,343                                                                |       | 5,417 |   | 6,372 |   | 4,469 |   | 4,470 |   | 4,526 |   | 4,886 |   | 5,931 |   |
| Gross margin                 |       | 4,434                                                                |       | 4,331 |   | 4,951 |   | 3,933 |   | 3,801 |   | 3,625 |   | 3,644 |   | 4,688 |   |
| Operating expenses           |       | 4,299                                                                |       | 3,871 |   | 4,091 |   | 3,627 |   | 3,748 |   | 3,451 |   | 3,393 |   | 4,212 |   |
| Income from operations       |       | 135                                                                  |       | 460 |   | 860 |   | 306 |   | 53 |   | 174 |   | 251 |   | 476 |   |
| Net (loss) income            |       | $                                                                    | 135        |   | $ | 248 |   | $ | 737 |   | $ | 458 |   | $ | 43 |   | $ | (34 | ) | $ | 119 |   | $ | 331 |   |
| Net income per common share: |       |                                                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                        |       | $                                                                    | 0.01       |   | $ | 0.02 |   | $ | 0.05 |   | $ | 0.03 |   | $ | 0.00 |   | $ | 0.00 |   | $ | 0.01 |   | $ | 0.03 |   |
| Diluted                      |       | $                                                                    | 0.01       |   | $ | 0.02 |   | $ | 0.05 |   | $ | 0.02 |   | $ | 0.00 |   | $ | 0.00 |   | $ | 0.01 |   | $ | 0.02 |   |

 

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**Liquidity and Capital Resources**

At December 31, 2004 cash, cash equivalents andlong-term investments were $24,273,179 compared to $23,285,830 as of December 31,2003, an increase of $987,349. Of that, $7,011,912 was held in cash and cashequivalents, a decrease of $5,783,708 from cash and cash equivalents of$12,795,620 held at December 31, 2003 primarily resulting from thepurchase of long-term government securities classified as Investments AvailableFor Sale. Cash and cash equivalents generally consist of cash, money marketfunds and other money market instruments with original maturities of threemonths or less. We held $17,261,267 in investments available for sale at December 31,2004, as compared to $10,490,210 at December 31, 2003 an increase of $6,771,057.Investments consist of U.S. government securities rated AAA. In fiscal 2004,2003 and 2002, operations were funded primarily from cash from operations.

Net cash provided by operating activities was$2,567,568, $787,860 and $3,912,749 for fiscal 2004, 2003 and 2002,respectively. The $1,779,708 increase in net cash provided by operatingactivities in fiscal year 2004, compared to fiscal year 2003, was primarily aresult of net income of $1,578,521 further adjusted for non-cash itemsincluding depreciation and amortization of $1,322,544, deferred stock optioncompensation of $92,585 and impairment of intangibles of $43,266. Accountsreceivable increased 7% during fiscal 2004 primarily due to increases inlicensing revenues. The total days sales outstanding on a consolidated basiswere 22 days at December 31, 2004 compared to 23 days at December 31,2003. Our inventory, net of allowances, decreased $181,740 in fiscal 2004 dueprimarily to the sell off of backlog which built up in the second quarter of fiscal2004 due to foundry capacity constraints and the sale of component inventory,which was previously reserved for in our provision for slow moving and obsoleteinventory. The reversal of the provision provided a benefit of $198,467 forfiscal 2004, which was offset by increases in the reserve of $156,816associated with our periodic assessment of inventory to arrive at a net benefitof $41,651. Prepaid expenses and other current assets increased $263,810 infiscal 2004 due to the advance payment of promotional costs, which providefuture benefits and are associated with our branding strategy. In fiscal 2004,accounts payable decreased $519,046 primarily due to decreases in our inventorythat was partially offset by increases in deferred revenues of $417,424 due toincreased prepayment of license fees and increases in accrued expenses of$54,131.

Our net cash used in investing activities was$10,837,473 and $5,137,609 and $7,068,533 for fiscal 2004, 2003 and 2002,respectively. The increase in cash used for investing activities in fiscal 2004is due primarily to increased treasury investing activities of $6,611,038. As aresult of increasing interest rates, management elected to commit funds tolonger-term instruments. During fiscal 2004, we entered into a strategicalliance with Coming Home Studios LLC, which used cash of $2,596,090. Additionalinvesting activities, which used cash, were purchases of capital equipment andexpenditures related to patents and intangible assets totaling $1,630,345.

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

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

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**ContractualCash Obligations and Contingent Liabilities and Commitments**

Wehave contractual obligations and commitments with regards to operating leasearrangements. The following table quantifies our expected contractualobligations and commitments subsequent to December 31, 2004:
| ** **                       | ** ** | **Payments due by period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **More than 3  years** | ** ** |
| Operating lease  obligations     |       | $                                         | 432,669    |   | $ | 245,869 |   | $ | 186,800 |   |   | — |   |   |
| Total                            |       | $                                         | 432,669    |   | $ | 245,869 |   | $ | 186,800 |   |   | — |   |   |
|                                  |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Recent Accounting Pronouncements**

In December 2003, the FASB issued FIN 46-R,“Consolidation of Variable Interest Entities - an interpretation ofARB 51 (revised December 2003)”, which replaces FIN 46. FIN 46-Rincorporates certain modifications to FIN 46 adopted by the FASB subsequent tothe issuance of FIN 46, including modifications of the scope ofFIN 46. For all non-special purpose entities (“SPE”) created prior to February 1,2003, public entities will be required to adopt FIN 46-R at the end ofthe first interim or annual reporting period ending after March 15, 2004. Forall entities (regardless of whether the entity is an SPE) that were createdsubsequent to January 31, 2003, public entities are already required toapply the provisions of FIN 46, and should continue doing so unless they electto adopt the provisions of Fin 46-R early as of the first interim orannual reporting period ending after December 15, 2003. If they do notelect to adopt FIN 46-R early, public entities would be required toapply FIN 46-R to those post-January 31, 2003 entities as ofthe end of the first interim or annual reporting period ending after March 15,2004. The adoption of FIN 46-R for non-SPEs did not have a materialimpact on the Company’s financial position, results of operations or cash.

In June 2004, the Financial Accounting StandardsBoard FASB issued EITF Issue No. 02-14, “Whether an Investor ShouldApply the Equity Method of Accounting to Investments Other Than Common Stock.”EITF Issue No. 02-14 addresses whether the equity method ofaccounting applies when an investor does not have an investment in votingcommon stock of an investee but exercises significant influence through othermeans. EITF Issue No. 02-14 states that an investor should onlyapply the equity method of accounting when it has investments in either commonstock or in-substance common stock of a corporation, provided that the investorhas the ability to exercise significant influence over the operating andfinancial policies of the investee. The accounting provisions of EITF Issue No. 02-14are effective for the first quarter of fiscal 2005. We are in the process ofdetermining the effect, if any, the adoption of EITF Issue No. 02-14will have on our financial statements.

In September 2004, the Financial AccountingStandards Board (FASB) issued FASB Staff Position (FSP) Emerging Issues TaskForce (EITF) Issue 03-1-1, Effective Date of Paragraphs 10–20 ofEITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairmentand Its Application to Certain Investments,” which delays the effective datefor the recognition and measurement guidance in EITF Issue No. 03-1.In addition, the FASB has issued a proposed FSP to consider whether furtherapplication guidance is necessary for securities analyzed for impairment underEITF Issue No. 03-1. We continue to assess the potential impact thatthe adoption of the proposed FSP could have on our financial statements.

In November 2004, the Financial AccountingStandards Board issued SFAS No. 151, “Inventory costs, an amendment of ARBNo. 43 Chapter 4.” This Statement amends the guidance in ARB No. 43,Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormalamounts of idle facility expense, freight, handling costs, and wasted material(spoilage). It requires that those items be recognized as current-periodcharges regardless of whether they meet the criterion of “so abnormal.” Inaddition, this Statement requires that allocation of fixed production overheadsto the costs of conversion be based on the 

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

In December 2004, the FASB issued SFAS No. 123(R),“Share-Based Payment” (“SFAS No. 123(R)”). This statement replaces SFAS No. 123,“Accounting for Stock-Based Compensation” and supersedes APB No. 25, “Accountingfor Stock Issued to Employees” SFAS 123(R) requires all stock-basedcompensation to be recognized as an expense in the financial statements andthat such cost be measured according to the fair value of stock options. SFAS123(R) will be effective for quarterly periods beginning after June 15,2005. While we currently provide the pro forma disclosures required by SFAS No. 148,“Accounting for Stock-Based Compensation - Transition and Disclosure,” on aquarterly basis (see “Note 2—Stock-BasedCompensation”), we are currently evaluating the impact that this statement willhave on our consolidated financial statements.

On December 21, 2004,the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS109-1, “Application of FASB Statement No. 109, Accounting for IncomeTaxes, to the Tax Deduction on Qualified Production Activities Provided by theAmerican Jobs Creation Act of 2004” (“FSP No. 109-1”), and FASBStaff Position No. FAS 109-2, “Accounting and Disclosure Guidancefor the Foreign Earnings Repatriation Provision within the American JobsCreation Act of 2004” (“FSP No. 109-2”). These staff positionsprovide accounting guidance on how companies should account for the effects ofthe American Jobs Creation Act of 2004 (“AJCA”) that was signed into law on October 22,2004. FSP No. 109-1 states that the tax relief (special taxdeduction for domestic manufacturing) from this legislation should be accountedfor as a “special deduction” instead of a tax rate reduction. FSP No. 109-2gives a company additional time to evaluate the effects of the legislation onany plan for reinvestment or repatriation of foreign earnings for purposes ofapplying FASB Statement No. 109. We are investigating the repatriationprovision to determine whether we might repatriate extraordinary dividends, asdefined in the AJCA and the actual income tax impact to us will becomedeterminable once further technical guidance has been issued.

**FactorsThat May Affect Future Results**

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

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

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

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

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products,short product life cycles and significant price competition. The dynamic natureof this market limits our, as well as our customers’, ability to accurately forecastquarterly and annual sales. If we, or our customers, are unable to manageproduct transitions, our business and results of operations could be negativelyaffected.

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

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

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

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

*Our quarterlyresults may fluctuate*

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

*We are subject tothe highly cyclical nature of the semiconductor industry*

The semiconductor industryis highly cyclical. The industry has experienced significant downturns, oftenin connection with, or in anticipation of, maturing product cycles (of bothsemiconductor companies’ and their customers’ products) and declines in generaleconomic conditions. These downturns have been characterized by productionovercapacity, high inventory levels and accelerated erosion of average sellingprices. Any future downturns could significantly harm our sales or reduce ourprofitability for a prolonged period of time. From time to time, thesemiconductor industry also has experienced periods of increased 

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demandand production capacity constraints. We may experience substantial changes infuture operating results due to general semiconductor industry conditions,general economic conditions and other factors.

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

We derive a significant amount of our revenue fromValence’s ASIC business. Valence’s engineering team focuses on the design ofcustom ASICs to meet specific customers’ requirements and outsources theproduction of the design to mask houses, foundries and packaging houses locatedprimarily in Asia. The operations of Valence could be affected by a variety offactors, including the timing of customer orders, the timing of developmentrevenue, changes in the mix of products distributed and the mix of distributionchannels employed, the emergence of a new industry standard, productobsolescence and changes in pricing policies by us, our competitors or oursuppliers.

Business revenue from ASICs is concentrated in alimited number of customers in the areas of consumer electronics,communications products, computers and computer peripherals. The businessgenerated from any one customer may be for a fixed length or quantity. As such,it is customary in our ASIC business to have a certain amount of customerturnover as new ASIC projects are obtained for different customers. However, itis possible that the loss of any particular customer or any bad debt arisingfrom such customer may have a materially adverse impact on our financialcondition and results of operation.

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

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

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

*We are exposed torisks in our Valence business related to product fabrication outsourcing tothird parties*

Valence is a “fabless”semiconductor company meaning that Valence designs, develops and markets ourselection of custom and standard integrated circuits but we rely on third-partycontractors to manufacture, assemble and test our products. From time to timethere can be foundry capacity issues due to global demands that affect the semiconductorindustry. Although we believe our relationships are generally good, we do nothave long-term supply agreements with our third-party vendors and they are notobligated to perform services or supply products to us for any particularperiod or in any particular quantities, except as provided in each separatepurchase order accepted by them. The increased demand for our products coupledwith the demand for foundry services, is, and will continue to be for theforeseeable future, a challenge for us. In times of high demand, there aresignificant risks associated with our reliance on third-party vendorsincluding: reallocation of capacity to other foundry customers, potential priceincreases, delays and interruptions in order deliveries, reduced control overproduct quality and increased risk of misappropriation of intellectualproperty.

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*We conductoperations in a number of countries and are subject to risks of internationaloperations, particularly in Asia and the*People’s Republic of China

We have significant operations in Hong Kong, thePeople’s Republic of China (PRC) and other parts of Asia that requirerefinement to adapt to the changing market conditions in those regions. Ouroperations in Asia, and international operations in general, are subject torisks of unexpected changes in, or impositions of, legislative or regulatoryrequirements.

Our customers geographically located in the AsiaPacific markets accounted for approximately 86%, 93% and 90% of total Companysales in 2004, 2003 and 2002, respectively and are expected to continue toaccount for a substantial percentage of sales in the future. The economicclimate in Asia continues to be impacted by increases in unemployment, declinesin consumer spending, currency devaluation and bank failures. Any of thesefactors, should they continue, could significantly reduce the demand for theend user goods in which our products and technologies are used.

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

Hong Kong is a Special Administrative Region of thePRC with its own government and legislature. Hong Kong enjoys a high degree ofautonomy from the PRC under the principle of “one country, two systems.” We cangive no assurance that Hong Kong will continue to enjoy autonomy from the PRC.

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

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

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

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

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

*We are subject tocompetitive pressures*

Our existing and potentialcompetitors include both large and emerging domestic and internationalcompanies that have substantially greater financial, manufacturing, technical,marketing, distribution and other resources. Present or future competitors maybe able to develop products and technologies comparable or superior to ours,and to adapt more quickly than us to new technologies or evolving market needs.We believe that the competitive factors affecting the market for our productsand technologies include product performance, price and quality; productfunctionality and features; the ease of integration; and implementation of theproducts and technologies with other hardware and software components in theOEM’s products. In addition, the markets in which we compete are intenselycompetitive and are characterized by rapid technological changes, decliningaverage sales prices and rapid product obsolescence. Accordingly, there can beno assurance that we will be able to continue to compete effectively in itsrespective markets, that competition will not intensify or that futurecompetition will not have a material adverse effect on our business, operatingresults, cash flows and financial condition.

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

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

*We strongly rely onour intellectual property*

Our ability to compete maybe affected by our ability to protect our proprietary information. We havefiled numerous U.S. and foreign patent applications and to date have a numberof issued U.S. and foreign patents covering various aspects of ourtechnologies. There can be no assurance that the steps taken by us to protectour intellectual property will be adequate to prevent misappropriation of ourtechnology or that our competitors will not independently develop technologiesthat are substantially equivalent or superior to our technology. In addition,the laws of certain foreign countries may not protect our intellectual propertyrights to the same extent, as do the laws of the U.S. The semiconductorindustry is characterized by frequent claims and litigation regarding patentand other property rights. We are not currently a party to any claims of thisnature. There can be no assurances that third parties will not assert claims orinitiate litigation against us or our customers with respect to existing orfuture products. In addition, we may initiate claims or litigation againstthird parties for infringement of our proprietary rights or to determine thescope and validity of our proprietary rights.

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*We depend on ourkey personnel*

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

*The market price ofour common stock is volatile*

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

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

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

**Item 7A.**                Quantitative andQualitative Disclosures About Market Risk

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

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**Foreign Currency**

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

**Interest Rates**

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

**Item 8.**                        FinancialStatements and Supplementary Data

The financial statementinformation, including the Report of Independent Registered Public AccountingFirm, required by this Item 8 is set forth on pages F-1 to F-27of this Annual Report on Form 10-K and is hereby incorporated intothis Item 8 by reference. The Quarterly Financial Information required bythis Item 8 is set forth in Item 7 of this Annual Report on Form 10-Kand is hereby incorporated into this Item 8 by reference.

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

None.

**Item 9A.**                Controls andProcedures

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

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*Changesin Internal Controls.  *There have been no changes in ourinternal controls over financial reporting that occurred during our fourthquarter ended December 31, 2004 that have materially affected, or arereasonably likely to materially affect, our internal controls over financialreporting.

**Item 9B.**               Other Information

None.

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**PART III**

**Item 10.**                 Directors andExecutive Officers of the Registrant

Information regarding ourexecutive officers is included in Item 1A of Part I of this AnnualReport on Form 10-K and is hereby incorporated into thisItem 10 by reference. The information set forth under the captions “Electionof Directors,” “Information About the Board of Directors and Committees of theBoard” and “Transactions with Management and Others—Section 16(a) BeneficialOwnership Reporting Compliance” in our definitive proxy statement (the “ProxyStatement”) for the Annual Meeting of Stockholders that is scheduled to occurin June 2005, is incorporated herein by reference. The Proxy Statementwill be filed with the SEC not later than 120 days after the close offiscal 2004.

**Item 11.**                 ExecutiveCompensation

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

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

Information regarding security ownership of certainbeneficial owners and management is incorporated by reference to theinformation set forth under the caption “Security Ownership of CertainBeneficial Owners and Management” in the Proxy Statement. The Proxy Statementwill be filed with the SEC not later than 120 days after the close offiscal 2004.

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

**Item 13.**                 CertainRelationships and Related Transactions

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

**Item 14.**                 PrincipalAccountant Fees and Services

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

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**PART IV**

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

**(a)   DocumentsFiled as Part of This Report:**

**(1)   Financial Statements**
|                                                                                                                                           | **Page** |
|-------------------------------------------------------------------------------------------------------------------------------------------|----------|
| Report of Independent  Registered Public Accounting Firm—BDO Seidman, LLP                                                            | F-1      |   |
| Consolidated Balance Sheets as of  December 31, 2004 and 2003                                                                        | F-2      |   |
| Consolidated Statements of  Operations for the years ended December 31, 2004, 2003 and 2002                                          | F-3      |   |
| Consolidated Statements of Stockholders’  Equity and Comprehensive Income for the years ended December 31, 2004,  2003 and 2002 | F-4      |   |
| Consolidated Statements of Cash  Flows for the years ended December 31, 2004, 2003 and 2002                                          | F-5      |   |
| Notes to Consolidated Financial  Statements                                                                                               | F-6      |   |

 

**(2)   FinancialStatement Schedules**
|                                                                                                                             | **Page** |
|-----------------------------------------------------------------------------------------------------------------------------|----------|
| Schedule II—Valuation  and Qualifying Accounts and Reserves for the years ended December 31,  2004, 2003 and 2002 | F-27     |   |

 

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

**(3)   Exhibits**

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

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

48

----

 
| 10.23 | Tenancy Agreement  commencing November 16, 2003, by and between Jugada Company Limited and  Valence Semiconductor Design Limited relating to the premises located at  Workshops Nos. 1 through 10 and on the 19th Floor of APEC Plaza,  No. 49 Hoi Yuen Road, Kwun Tong, Hong Kong, previously filed with the  Commission as Exhibit 10.21 to the Form 10-K for the fiscal year  ended December 31, 2003, filed with the Commission on March 30,  2004, which is incorporated herein by reference. |
|-------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.24 | Stock Divestment  Agreement dated July 1, 1996, between the Company, Thomas C.K. Yuen,  Stephen V. Sedmak and Walter W. Cruttenden III, previously filed with the  Commission as Exhibit 10.17 to the Registration Statement Amendment  No. 2, which is incorporated herein by reference.                                                                                                                                                                                                                         |
| 10.25 | Strategic Alliance with  Coming Home Studios, dated September 23, 2004 filed with the Commission  as Exhibit 10.1 through 10-4 to the Form 8-K, previously filed with  the Commission on September 28, 2004, which is incorporated herein by  reference.                                                                                                                                                                                                                                                     |
| 14    | SRS Labs, Inc. Code  of Business Conduct and Ethics adopted by the Board of Directors Nov. 6,  2002, previously filed with the Commission as Exhibit 14 to the  Form 10-K for the fiscal year ended December 31, 2003, filed with  the Commission on March 30, 2004, which is incorporated herein by  reference.                                                                                                                                                                                   |
| 21    | Subsidiaries of the  Registrant, previously filed with the Commission as Exhibit 21 to the Form 10-K  for the fiscal year ended December 31, 2003, filed with the Commission  on March 30, 2004, which is incorporated herein by reference.                                                                                                                                                                                                                                                                       |
| 23.1  | Consent of Independent  Registered Public Accounting Firm, BDO Seidman LLP, dated March 31,  2005.                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 31.1  | Certification of the  Chief Executive Officer of SRS Labs, Inc., pursuant to 18 U.S.C  Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                                                                                                                                                       |
| 31.2  | Certification of the  Chief Financial Officer of SRS Labs, Inc., pursuant to 18 U.S.C  Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                                                                                                                                                       |
| 32.1  | Certification of Chief  Executive Officer of SRS Labs, Inc., pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                                                                                                                                                          |
| 32.2  | Certification of Chief  Financial Officer of SRS Labs, Inc., pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                                                                                                                                                          |

 

 

49

----

 

**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
| Dated: March 30, 2005 |   | By:    | /s/ THOMAS C.K. YUEN                                  |
|----------------------------|--------|--------|-------------------------------------------------------|
| * *                   |   |   | *Chairman  of the Board and  Chief Executive Officer* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.
|                         | **Name** | ** **                                           | ** ** | ** **          | **Capacity** | ** ** | ** ** | ** ** | **Date** | ** ** |
|-------------------------|----------|------------------------------------------------------|------------|---------------------|--------------|------------|------------|------------|----------|------------|
| /s/  THOMAS C.K. YUEN   |     | Director, Chairman of  the Board and Chief Executive |       | March 30, 2005 |
| Thomas C.K. Yuen        |     | Officer (Principal Executive Officer)                |       |                |
| /s/  JANET M. BISKI     |     | Chief Financial Officer  (Principal Financial and    |       | March 30, 2005 |
| Janet M. Biski          |     | Accounting Officer)                                  |       |                |
| /s/  DAVID R. DUKES     |     | Director                                             |       | March 30, 2005 |
| David R. Dukes          |     |                                                 |       |                |
| /s/  WINSTON E. HICKMAN |     | Director                                             |       | March 30, 2005 |
| Winston E.  Hickman     |     |                                                 |       |                |
| /s/  CAROL L MILTNER    |     | Director                                             |       | March 30, 2005 |
| Carol L. Miltner        |     |                                                 |       |                |
| /s/  STEPHEN V. SEDMAK  |     | Director                                             |       | March 30, 2005 |
| Stephen V. Sedmak       |     |                                                 |       |                |
| /s/  SAM YAU            |     | Director                                             |       | March 30, 2005 |
| Sam Yau                 |     |                                                 |       |                |

 

 

50

----

 

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

Tothe Board of Directors and Stockholders of

SRSLabs, Inc.

Santa Ana, California

We have audited the consolidated balance sheets of SRSLabs, Inc. and Subsidiaries as of December 31, 2004 and 2003, and therelated consolidated statements of operations, stockholders’ equity andcomprehensive income and cash flows for each of the three years in the periodended December 31, 2004. We have also audited the schedules listed in theaccompanying index. These financial statements and schedules are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these consolidated financial statements and schedules based on ouraudits.

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

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

Also,in our opinion, the schedules present fairly, in all material respects, theinformation set forth therein.
| **/s/ BDO SEIDMAN, LLP** | ** ** |
|--------------------------|------------|
| BDO Seidman, LLP         | ** ** |

 

CostaMesa, California

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

F-1

----

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

 

See accompanying notes to consolidated financial statements

F-2

----

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

 

See accompanying notes to consolidated financial statements

F-3

----

 

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

 

See accompanying notes to consolidated financial statements

F-4

----

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

 

See accompanying notes to consolidated financial statements

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**SRS LABS, INC.NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**1.   Organizationand Significant Accounting Policies**

*Organization*

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

We operate in thefollowing two business segments:

*Semiconductors:  *ThroughSRS Labs, Inc.’s wholly-owned subsidiary, ValenceTech Limited, andValenceTech Limited’s wholly-owned subsidiaries (collectively “Valence”), weoperate a fabless semiconductor business which develops, designs and marketsstandard and custom, analog, digital signal processors, or DSPs, and mixedsignal, integrated circuits primarily to original equipment manufacturers, orOEMs, and original design manufacturers , or ODMs, in the Asia Pacific region.

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

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

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

*Basis of Presentation*

The consolidated financialstatements have been prepared in accordance with accounting principlesgenerally accepted in the United States of America and include the Company andits wholly- and majority-owned subsidiaries, Valence andSRSWOWcast, after elimination of all intercompany accounts and transactions.The net loss attributable to minority shareholders is shown separately in theconsolidated statements of operations.

*Cash Equivalents*

Cash and cash equivalentsgenerally consist of cash, money market funds and other money marketinstruments with original or remaining maturities of three months or less atthe date of purchase. The Company maintains cash and cash equivalents,investments, and certain other financial instruments with various majorfinancial institutions. The Company performs periodic evaluations of therelative credit standing of these financial institutions.

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*Investments*

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

*Inventories*

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

*Furniture, Fixtures and Equipment*

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

*Intangible Assets*

Costs paid by the Companyrelated to the establishment and transfer of patents, primarily legal costs, arecapitalized and amortized, depending on the estimated life of the technologypatented. These assets are being amortized over periods ranging from three toeleven years depending on the useful life of the asset.

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

*Capitalization of software development costs*

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

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andchanges in software and hardware technologies. Under SFAS No. 86, annualamortization of software development costs should be the greater of the amountcomputed using (a) the ratio that current gross revenues for a productbear to the total of current and anticipated future gross revenues for thatproduct or (b) the straight-line method over the remaining estimatedeconomic life of the product including the period being reported on. TheCompany, after considering the two methods, is using the straight-line methodof amortization as the software can be used for many products and the estimatesrequired to be made under (a) could result in under reporting of expense.Upon the general release of the software product to customers, capitalizationceases and such costs are amortized to cost of sales using the straight-linemethod on a product-by-product basis over the estimated life, which isgenerally three years. To the extent that amounts capitalized for softwaredevelopment costs become impaired due to a decline in demand or theintroduction of new technology, such amounts will be written-off. All otherresearch and development expenditures are charged to research and developmentexpense in the period incurred.

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

 

TheCompany recorded amortization expense of $106,826, $28,401 and $24,000 for eachof the years ended December 31, 2004, 2003 and 2002 respectively. As of December 31,2004, the weighted average useful life of the Company’s capitalized software isapproximately 2.4 years. The following table shows the estimatedamortization expense for those assets for each of the five succeeding fiscalyears.
| **Year ending December 31,** | ** ** | ** ** | ** ** | **Estimated  Expense** | ** ** |
|---------------------------------------------|------------|------------|------------|------------------------|------------|
| 2005                                        |       | $          | 102,239    |                   |
| 2006                                        |       | 97,971     |       |
| 2007                                        |       | 45,688     |       |
| 2008                                        |       | 21,609     |       |
| 2009                                        |       | 4,058      |       |
|                                             |            |            |            |                        |            |  |

 

*Impairment of long-lived assets*

The Company evaluates therecoverability of long-lived assets with finite lives in accordance withStatement of Financial Accounting Standards SFAS 144, “Accounting for theImpairment of Long-Lived Assets.” The Company assesses potential impairments toits long-lived assets when there is evidence that events or changes incircumstances indicate that the carrying amount of an asset may not berecovered. An impairment loss is recognized when the carrying amount of thelong-lived asset is not recoverable and exceeds its fair value. The carryingamount of a long-lived asset is not recoverable if it exceeds the sum of theundiscounted cash flows expected to result from the use and eventualdisposition of the asset. Any required impairment loss is measured as theamount by which the carrying amount of a long-lived asset exceeds its fairvalue and is recorded as a reduction in the carrying value of the related assetand a charge to operating results. Based upon our most recent assessment as of December31, 2004, we have determined there was no impairment.

*Goodwill*

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

F-8

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andOther Intangible Assets,” which, among other things, establishes new standardsfor goodwill acquired in a business combination, eliminates the amortization ofgoodwill and requires the carrying value of goodwill and identifiableintangibles to be evaluated for impairment on an annual basis. Starting infiscal 2002, the Company no longer records goodwill amortization. In accordancewith SFAS No. 142, all of our intangible assets that have definite livesare being amortized on a straight-line basis over their estimated useful livesand goodwill is tested annually for impairment. Based upon our most recentassessment as of December 31, 2004, we have determined there was noimpairment.

*Minority Interest in Consolidated Subsidiary*

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

*Use of Estimates*

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

*Revenue Recognition*

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

*Research and Development*

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

*Advertising Expense*

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

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*Income Taxes*

The Company accounts forincome taxes in accordance with Statement of Financial Accounting Standard No. 109(SFAS 109), “Accounting for Income Taxes.” Deferred taxes on income result fromtemporary differences between the reporting of income for financial statementand tax reporting purposes. A valuation allowance related to a deferred taxasset is recorded when it is more likely than not that some portion or all ofthe deferred tax asset will not be realized.

*Foreign Currency Translation*

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

*Net Income Per Common Share*

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

Basicand diluted net income per share computed in accordance with SFAS 128 forthe years ended December 31 are as follows:
| ** **                                               | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|----------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| BASIC EPS                                                |       |       |       |       |       |       |       |
| Net income                                               |       | $          | 1,578,521  |       | $          | 458,719    |       | $ | 806,352 |   |
| Denominator: weighted  average common shares outstanding |       | 13,950,457 |       | 13,033,002 |       | 12,648,373 |       |
| Net income per  share—basic                         |       | $          | 0.11       |       | $          | 0.04       |       | $ | 0.06 |   |
| DILUTED EPS                                              |       |       |       |       |       |       |       |
| Net income                                               |       | $          | 1,578,521  |       | $          | 458,719    |       | $ | 806,352 |   |
| Denominator: weighted  average common shares outstanding |       | 13,950,457 |       | 13,033,002 |       | 12,648,373 |       |
| Common equivalent shares  outstanding:                   |       |       |       |       |       |       |       |
| Options                                                  |       | 1,830,749  |       | 1,387,808  |       | 213,826    |       |
| Total shares                                             |       | 15,781,206 |       | 14,420,810 |       | 12,862,199 |       |
| Net income per share—diluted                        |       | $          | 0.10       |       | $          | 0.03       |       | $ | 0.06 |   |

 

There were 164,000,1,816,276, and 3,664,580 potentially dilutive options outstanding at December 31,2004, 2003 and 2002, respectively, that were not included above because theywould be anti-dilutive.

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*Stock-BasedCompensation*

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

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

Thefollowing table illustrates the effect on net income and income per share ifthe Company’s had applied the fair value recognition provisions of SFAS No. 123,as amended by SFAS No. 148, to stock-based employee compensation:
| ** **                                                                                              | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Net income (attributable  to common  shareholder)—as reported                                      |       | $          | 1,578,521  |       | $          | 458,719    |       | $ | 806,352 |   |
| Add: stock based  employee compensation expense included in reported net income, net of 40% tax  effect |       | 55,550     |       | 43,768     |       | 53,235     |       |
| Less fair value of stock-based  employee compensation expense                                           |       | (1,594,917 | )          | (2,277,304 | )          | (2,160,997 | )          |
| Net income (loss)  (attributable to common shareholder)—pro forma                                  |       | 39,154     |       | (1,774,817 | )          | (1,301,410 | )          |
| Net income (loss) per share:                                                                            |       |       |       |       |       |       |       |
| Basic, as reported                                                                                      |       | $          | 0.11       |       | $          | 0.04       |       | $ | 0.06 |   |
| Basic, pro forma                                                                                        |       | $          | 0.00       |       | $          | (0.14      | )          | $ | (0.10 | ) |
| Diluted, as reported                                                                                    |       | $          | 0.10       |       | $          | 0.03       |       | $ | 0.06 |   |
| Diluted, pro forma                                                                                      |       | $          | 0.00       |       | $          | (0.12      | )          | $ | (0.10 | ) |

 

Thefair value of each option grant was estimated on the date of grant using the Black-Scholesoption-pricing model with the following weighted average assumptions used forgrants during the years ended December 31 with expected option lives offive years and a dividend rate of zero:
| ** **              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk free interest rate |       | 3.5      | %          | 2.9      | %          | 3.6      | %          |
| Expected volatility     |       | 75       | %          | 75       | %          | 87       | %          |

 

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

*Fair Value ofFinancial Instruments*

Management believes the carrying amounts of cash andcash equivalents, accounts receivable and accounts payable approximate fairvalue due to the short period of time between origination of the instrumentsand their expected realization. The carrying amounts of investments availablefor sale are reported at fair value based on quoted market prices(Note 2).

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*CustomerConcentration*

For the fiscal year ended December 31,2004 one customer accounted for approximately 10% of revenues. During thefiscal year ended December 31, 2003, one customer accounted forapproximately 11% of revenues. During the fiscal year ended December 31,2002 two customers accounted for approximately 13% and 11% of revenues,respectively. At December 31, 2004, five customers accounted forapproximately 22%, 21%, 12%, 11% and 11% of total receivables respectively. At December 31,2003 three customers accounted for 29%, 19% and 12% of total receivables,respectively. Given the significant amount of revenues derived from thesecustomers, the loss of any such customer or the uncollectibility of relatedreceivables could have a material adverse effect on the Company’s financialcondition and results of operations.

*Concentrations ofCredit Risk*

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

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

*Geographic Risk*

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

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

**Recent Accounting Pronouncements**

In December 2003, the Financial AccountingStandards Board (FASB) issued FIN 46-R, “Consolidation of VariableInterest Entities—aninterpretation of ARB 51 (revised December 2003)”, whichreplaces FIN 46. FIN 46-R incorporates certain modifications to FIN46 adopted by the FASB subsequent to the issuance of FIN 46, includingmodifications of the scope of FIN 46. For all non-special purpose entities(“SPE”) created prior to February 1, 2003, public entities will berequired to adopt FIN 46-R at the end of the first interim or annual reportingperiod ending after March 15, 2004. For all entities (regardless ofwhether the entity is an SPE) that were created subsequent to January 31,2003, public entities are already required to apply the provisions of FIN 46,and should continue doing so unless they elect to adopt the provisions of Fin46-R early as of the first interim or annual reporting period ending 

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

In June 2004, the Financial Accounting StandardsBoard (FASB) issued EITF Issue No. 02-14, “Whether an Investor ShouldApply the Equity Method of Accounting to Investments Other Than Common Stock.”EITF Issue No. 02-14 addresses whether the equity method of accountingapplies when an investor does not have an investment in voting common stock ofan investee but exercises significant influence through other means. EITF IssueNo. 02-14 states that an investor should only apply the equity method ofaccounting when it has investments in either common stock or in-substancecommon stock of a corporation, provided that the investor has the ability toexercise significant influence over the operating and financial policies of theinvestee. The accounting provisions of EITF Issue No. 02-14 are effectivefor the first quarter of fiscal 2005. The Company is in the process ofdetermining the effect, if any, the adoption of EITF Issue No. 02-14 willhave on its financial statements.

In September 2004, the Financial AccountingStandards Board (FASB) issued FASB Staff Position (FSP) Emerging Issues TaskForce (EITF) Issue 03-1-1, Effective Date of Paragraphs 10 - 20 of EITF Issue No. 03-1,“The Meaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments,” which delays the effective date for the recognition andmeasurement guidance in EITF Issue No. 03-1. In addition, the FASB hasissued a proposed FSP to consider whether further application guidance isnecessary for securities analyzed for impairment under EITF Issue No. 03-1.We continue to assess the potential impact that the adoption of the proposedFSP could have on our financial statements.

On December 21, 2004,the Financial Accounting Standards Board (FASB) issued FASB Staff Position No. FAS109-1, “Application of FASB Statement No. 109, Accounting for IncomeTaxes, to the Tax Deduction on Qualified Production Activities Provided by theAmerican Jobs Creation Act of 2004” (“FSP No. 109-1”), and FASB StaffPosition No. FAS 109-2, “Accounting and Disclosure Guidance for theForeign Earnings Repatriation Provision within the American Jobs Creation Actof 2004” (“FSP No. 109-2”). These staff positions provide accountingguidance on how companies should account for the effects of the American JobsCreation Act of 2004 (“AJCA”) that was signed into law on October 22,2004. FSP No. 109-1 states that the tax relief (special tax deduction fordomestic manufacturing) from this legislation should be accounted for as a “specialdeduction” instead of a tax rate reduction. FSP No. 109-2 gives a companyadditional time to evaluate the effects of the legislation on any plan forreinvestment or repatriation of foreign earnings for purposes of applying FASBStatement No. 109. The Company is investigating the repatriation provisionto determine whether it might repatriate extraordinary dividends, as defined inthe AJCA and the actual income tax impact to the Company will becomedeterminable once further technical guidance has been issued.

**Future Accounting Requirements**

In November 2004, the Financial AccountingStandards Board (FASB) issued SFAS No. 151, “Inventory costs, an amendmentof ARB No. 43 Chapter 4.” This Statement amends the guidance in ARB No. 43,Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amountsof idle facility expense, freight, handling costs, and wasted material(spoilage). It requires that those items be recognized as current-periodcharges regardless of whether they meet the criterion of “so abnormal.” Inaddition, this Statement requires that allocation of fixed production overheadsto the costs of conversion be based on the normal capacity of the productionfacilities. The provisions of this statement shall be applied prospectively forinventory costs incurred during fiscal years beginning after June 15,2005. We do not expect the adoption of this statement would have a materialimpact on our results of operations or financial position.

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

*Reclassifications*

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

**2.   InvestmentSecurities Available for Sale**

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

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

 

Thecontractual maturities of investments are shown below. Actual maturities maydiffer from contractual maturities.
| ** **                                    | ** ** | **December 31, 2004** | ** ** | **December 31, 2003** | ** ** |
|-----------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **Cost**                        | ** ** | **Estimated  Fair Value**  | ** ** | **Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| US Government securities  available for sale: |       |                            |       |                            |       |   |   |   |   |
| Due in one year or less                       |       | $                               | —     |                            | $          | — |   | $ | — |   | $ | — |   |
| Due in one to five years                      |       | 17,489,688                      |       | 17,261,267                      |       | 10,745,254 |   | 10,490,210 |   |
|                                          |       | $17,489,688                     |       | $                               | 17,261,267 |   | $ | 10,745,254 |   | $ | 10,490,210 |   |
|                                               |            |                                 |            |                                 |            |  |  |  |  |  |  |  |  |

 

Thefollowing table summarizes sales of available for sale securities for the yearsended December 31, 2004, 2003 and 2002. Specific identification was usedto determine costs in computing realized gains or losses.
| ** **          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| Proceeds from  sale |       | $                                           | 5,375,000  |   | $ | 16,862,523 |   | $ | 9,986,909 |   |
| Realized gains      |       | $                                           | 139,375    |   | $ | 36,739 |   | $ | 98,224 |   |
| Realized losses     |       | $                                           | —     |   | $ | (16,713 | ) | $ | — |   |

 

F-14

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**3.   Investment in LLC**

On September 23, 2004, the Company entered into astrategic alliance with Coming Home Studios LLC (“CHS”) to produce and sellconcert DVD’s which include the Company’s Circle Surround technology.  In connection with the strategic alliance, SRSand CHS entered into four agreements:  a Strategic Alliance Agreement, theCHS/SRS LLC Operating Agreement, a Warrant Agreement and a Production ServicesAgreement.

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

The Operating Agreement governs CHS/SRS, LLC, which isa joint venture between CHS and SRS formed to complete and distribute concertvideos featuring Duran Duran, Boz Scaggs, Godsmack and All Access.

Pursuant to the Operating Agreement each of CHS andSRS contributed capital with a value of $2,346,621. CHS is the managing memberof the joint venture and is entitled to receive a 5% management fee of all netrevenues received. CHS’ capital contribution to CHS/SRS, LLC consists of theartist agreements and related contracts pursuant to which CHS/SRS, LLC will produceand distribute the above-referenced concert videos. SRS’ capital contributionis an aggregate of $2,346,621, consisting of a $700,000 bridge loan that SRSextended to CHS on July 9, 2004 in anticipation of the strategic alliance,plus $1,646,621 in new cash. In addition, the Company capitalized $177,111consisting of costs associated with the formation of the LLC and co-promotionalprojects. CHS’ capital contribution consisted of the artist agreements withDuran Duran, Boz Scaggs, Godsmack and All Access pursuant to which the concertvideos are filmed, produced and distributed. CHS/SRS, LLC contracted with CHSto complete production of the concert videos pursuant to the ProductionServices Agreement. Profits from the distribution of the concert videos andrelated assets will be allocated and distributed equally until SRS and CHS haveboth received 1.75 times their original capital contributions, after whichprofits will be allocated and distributed 90% to CHS and 10% to SRS. The jointventure is accounted for using the equity method and profits are recognizedfollowing the guidance for equity method accounting. We recognize and accrueprofits as we get sales and/or royalty reports. As of December 31, 2004,two of the concert videos, Boz Scaggs and Godsmack have been released. Profitsof $32,358 generated from these videos have been recognized and included in “Equityin Income of Investee” in the Consolidated Statements of Operations.

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

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

F-15

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**4.   Furniture,Fixtures and Equipment**

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

 

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

**5.   Acquisitionof Minority Interest in SRSWOWcast**

On February 28, 2003, the Company purchased theminority interest of the shareholders of SRSWOWcast, also known as WOWcast, inwhich SRS Labs acquired all 3,000,000 shares of Series A ConvertiblePreferred Stock in exchange for the issuance of 332,184 shares of SRS Labscommon stock trading at $2.89 per share at the close of day on the transactiondate. The acquisition resulted in a purchase price of $960,012.

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

Thefollowing table summarizes the stated values of the assets acquired andliabilities assumed at the date of acquisition:
| Current Assets                 |   | $       | 324,002 |   |
|--------------------------------|--------|---------|---------|--------|
| Property &  Equipment |   | 3,774   |    |
| Current  Liabilities           |   | (7,835  | )       |
| Intangible Assets              |   | 640,071 |    |
| Purchase Price                 |   | $       | 960,012 |   |

 

Current assets primarilyconsisted of cash, accounts receivable and prepaid expenses and currentliabilities were valued at stated value. Property and equipment was valued atnet book value. The $640,071 of acquired intangible assets was assigned to alicense agreement between SRS Labs, Inc and SRSWOWcast, which is beingamortized over 10 years.

**6.   Goodwill and Intangible Assets**

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

F-16

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In accordance with SFAS No. 142, all of ourintangible assets that have definite lives are being amortized on astraight-line basis over their estimated useful lives and goodwill is evaluatedto determine if fair value of the asset has decreased below its carrying value.At December 31, 2004 and December 31, 2003, we evaluated goodwill anddetermined that no adjustment to impair goodwill was necessary.

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

 

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

 

F-17

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As of December 31,2004, the weighted average useful life of the Company’s patents and intangibleassets is approximately 3.6 years. The following table shows the estimatedamortization expense for those assets for each of the five succeeding fiscalyears.
| **Year ending December 31,** | ** ** | ** ** | ** ** | **Estimated expense** | ** ** |
|---------------------------------------------|------------|------------|------------|----------------------------|------------|
| 2005                                        |       |       | $          | 601,862                    |       |   |
| 2006                                        |       |       | 591,068    |                       |       |
| 2007                                        |       |       | 511,955    |                       |       |
| 2008                                        |       |       | 271,842    |                       |       |
| 2009                                        |       |       | 160,499    |                       |       |
| Thereafter                                  |       |       | 523,729    |                       |       |

 

**7.   Financing Arrangements**

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

**8.   Commitments and Contingencies**

The Company leases office space and certain equipmentunder non-cancelable operating leases expiring through 2008. The Company leasesits corporate office and storage facilities located in Santa Ana, California,under a lease agreement with a partnership that is affiliated with a principalstockholder and executive officer of the Company. The lease is for a term ofthree years, commencing June 1, 2002, with an option to extend the termfor an additional three years thereafter. Additionally, the Company leasesoffice and warehouse facilities in Hong Kong from unrelated parties. Total rentexpense was $370,788, $550,854, and $482,057 for the years ended December 31,2004, 2003, and 2002, respectively, of which $210,600, $208,260, and $198,900was paid to related parties, respectively.

Futureannual minimum lease payments under non-cancelable operating leases at December 31,2004, are as follows:
| **Year ending December 31,** | ** ** | ** ** | ** ** | **Facility** | ** ** | **Facility-Related  Party** | ** ** | **Office  Equipment** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|------------|------------|--------------|------------|-----------------------------|------------|-----------------------|------------|-----------|------------|
| 2005                                        |       | $          | 145,250    |         |       | $                           | 87,750     |                  |       |      | $          | 12,869 |   |   | $ | 245,869 |   |
| 2006                                        |       | 159,083    |       |         | —     |                        |       |                  | 12,869     |      |       | 171,952 |   |
| 2007                                        |       | —     |       |         | —     |                        |       |                  | 11,824     |      |       | 11,824 |   |
| 2008                                        |       | —     |       |         | —     |                        |       |                  | 3,024      |      |       | 3,024 |   |
| 2009                                        |       | —     |       |         | —     |                        |       |                  | —     |      |       | — |   |
| Total                                       |       | $          | 304,333    |         |       | $                           | 87,750     |                  |       |      | $          | 40,586 |   |   | $ | 432,669 |   |

 

*Litigation*

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

F-18

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*Indemnifications*

The Company enters into standard license agreements inits ordinary course of business. Pursuant to these agreements, the Companyagrees to indemnify its customers for losses suffered or incurred by them as aresult of any patent, copyright, or other intellectual property infringementclaim by any third party with respect to the Company’s products. Theseagreements generally have perpetual terms. The maximum amount ofindemnification the Company could be required to make under these agreements isgenerally limited to the license fees received by the Company. The Companyestimates the fair value of its indemnification obligation as insignificant,based upon its history of litigation concerning product and patent infringementclaims. Accordingly, the Company has no liabilities recorded forindemnification under these agreements as of December 31, 2004.

The Company has agreementswhereby our officers and directors are indemnified for certain events oroccurrences while the officer or director is, or was serving, at our request insuch capacity. The maximum potential amount of future payments we could berequired to make under these indemnification agreements is unlimited; however,we have a directors and officers insurance policy that reduces our exposure andenables us to recover a portion of any future amounts paid. As a result of ourinsurance policy coverage, we believe the estimated fair value of theseindemnification agreements is minimal. Currently, we have no liabilitiesrecorded for these agreements as of December 31, 2004.

*Warranties*

The Company offers itscustomers a warranty that its software products will substantially conform totheir functional specifications. To date, there have been no payments ormaterial costs incurred related to fulfilling these warranty obligations.Accordingly, the Company has no liabilities recorded for these warranties as ofDecember 31, 2004. The Company assesses the need for a warranty reserve ona quarterly basis. There can be no guarantee that a warranty reserve will notbecome necessary in the future.

*EmploymentContracts*

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

**9.   Income Taxes**

Thecomponents of income (loss) from continuing operations before income taxes areas follows:
| ** ** | ** ** | **Years ended December 31,** | ** ** |
|------------|------------|---------------------------------------------|------------|
| ** ** | ** ** | **2004**                                    | ** ** | **2003** | ** ** | **2002** | ** ** |
| U.S.       |       | $                                           | 615,196    |   | $ | (562,239 | ) | $ | (1,044,099 | ) |
| Foreign    |       | 1,773,741                                   |       | 2,059,421 |   | 2,438,784 |   |
| Total      |       | $                                           | 2,388,937  |   | $ | 1,497,182 |   | $ | 1,394,685 |   |

 

F-19

----

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

 

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

 

Deferredincome taxes reflect the net tax effects of temporary differences between thecarrying amounts of assets and liabilities for financial reporting purposes andthe amounts used for income tax purposes. Significant components of the Company’sdeferred tax assets and liabilities are as follows:
| ** **                       | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Deferred tax assets:             |       |                  |       |   |   |
| Depreciation and amortization    |       | $                     | 1,204,088  |   | $ | 1,507,181 |   |
| Accruals                         |       | 558,198               |       | 382,510 |   |
| Net operating loss carryforwards |       | 8,095,361             |       | 7,394,662 |   |
| Tax credit carryforwards         |       | 1,231,090             |       | 598,001 |   |
| Other                            |       | (211,102              | )          | (211,106 | ) |
| Foreign income taxes             |       | (170,256              | )          | (169,872 | ) |
| Valuation allowance              |       | (10,491,223           | )          | (9,284,836 | ) |
| Total net  deferred tax assets   |       | $                     | 216,156    |   | $ | 216,540 |   |

 

The Company has federal and state net operating losscarryforwards at December 31, 2004, of approximately $21,555,000 and$13,141,000 respectively. These net operating loss carryforwards began to 

F-20

----

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

As of December 31, 2004, a valuation allowance of$10,491,223 has been provided based on the Company’s assessment of the futurerealizability of certain deferred tax assets. The valuation allowance ondeferred tax assets relates to future deductible temporary differences, capitalloss carry forwards, foreign credit carryforwards and net operating losscarryforwards for which the Company has concluded it is more likely than notthat these items will not be realized in the ordinary course of operations.Management periodically evaluates the recoverability of the deferred tax assetsand recognizes the tax benefit only as reassessment demonstrates they arerealizable. At such time it is determined that it is more likely than not thatthe deferred tax assets are realizable, the valuation allowance is adjusted.This assessment is based on projections of future taxable income, which isimpacted in future periods, by income before taxes and stock option exercises.The amount of the net deferred tax assets considered realizable, however, couldbe reduced in the near term if actual future earnings are lower than estimated,or if there are differences in the timing or amount of future reversals ofexisting taxable temporary differences. For the period ended December 31,2004, the release of the valuation allowance disclosed in the tax RateReconciliation was due to the use of net operating losses that were fullyreserved with a valuation allowance. The overall increase in the valuationallowance, as disclosed in the table above for the Deferred Assets andLiabilities, is due to additional net operating losses attributable to theexercise of non-qualified stock options. The effect of the valuation allowancerelated to these stock options has been reported in equity.

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

The use of loss carryforwards and tax credit carryforwards may become limited in the event of an ownership change as definedunder I.R.C. code section 382.

On December 21, 2004,the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS109-1, “Application of FASB Statement No. 109, Accounting for IncomeTaxes, to the Tax Deduction on Qualified Production Activities Provided by theAmerican Jobs Creation Act of 2004” (“FSP No. 109-1”), and FASB StaffPosition No. FAS 109-2, “Accounting and Disclosure Guidance for theForeign Earnings Repatriation Provision within the American Jobs Creation Actof 2004” (“FSP No. 109-2”). These staff positions provideaccounting guidance on how companies should account for the effects of theAmerican Jobs Creation Act of 2004 (“AJCA”) that was signed into law on October 22,2004. FSP No. 109-1 states that the tax relief (special tax deduction fordomestic manufacturing) from this legislation should be accounted for as a “specialdeduction” instead of a tax rate reduction. FSP No. 109-2 gives a companyadditional time to evaluate the effects of the legislation on any plan forreinvestment or repatriation of foreign earnings for purposes of applying FASBStatement No. 109. The Company is investigating the repatriation provisionand expects, on or before the fourth quarter of 2005, to make the determinationas to whether it will repatriate extraordinary dividends, as defined in theAJCA and the actual income tax impact to the Company of such a repatriation,should it be made.

F-21

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**10.   Stockholders’ Equity**

*Stock Repurchases*

Duringthe fiscal year ended December 31, 1998, the Company’s Board of Directorsauthorized the repurchase of up to 500,000 of the outstanding shares of theCompany’s common stock for a period from December 23, 1998 to December 31,1999 (the “1998 Repurchase Program”). Under the 1998 Repurchase Program, 71,100shares 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 ofthe 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 2001Repurchase Program. On May 9, 2002, the Company’s Board of Directorsauthorized the repurchase of up to 500,000 of the outstanding shares of theCompany’s common stock for a period from May 10, 2002 to November 10,2002 (the “2002 Repurchase Program”). As of December 31, 2002, 100,400shares had been purchased at a cost of $266,607 under the 2002 RepurchaseProgram. All repurchased shares under the 1998, 2001 and 2002 RepurchasePrograms are reflected as treasury stock in the accompanying consolidatedbalance sheets. On June 30, 2004, the Company’s Board of Directorsauthorized a stock repurchase of up to $3,000,000 of its outstanding commonstock for a period of six months from July 1, 2004 to December 31,2004. The following table shows activity under the 2004 Repurchase Program forthe year ending December 31, 2004:

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

 

*Stock Award/OptionPlans/Warrants*

On December 10, 1993, the Company’s Board ofDirectors and shareholders adopted an Incentive Stock Option, NonqualifiedStock Option and Restricted Stock Purchase Plan (the “1993 Plan”). Under the1993 Plan, 801,971 shares of the Company’s common stock are reserved forissuance to executives, employees and non-employee directors of the Company atthe discretion of the Board of Directors or the committee administering the1993 Plan. The Compensation Committee of the Board or, in the absence of aCompensation Committee, the Board, has been appointed to administer the 1993Plan. Options issued under the 1993 Plan vest in the manner prescribed by theCompensation Committee or the Board, as applicable. As of December 31,2004, options to purchase 115,370 shares of the Company’s common stock wereoutstanding under the 1993 Plan.

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

F-22

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In June 1997, the Company’s Board of Directorsadopted and the Company’s stockholders approved the Amended and Restated 1996Long-Term Incentive Plan (the “1996 Plan”), for which 2,000,000 shares of theCompany’s common stock were reserved for issuance to officers, employees andconsultants of the Company. If any award granted under the 1996 Plan expires,terminates or is forfeited before the exercise thereof or the payment in fullthereof, the shares covered by the unexercised or unpaid portion will becomeavailable for new grants under the 1996 Plan. In June 1998, the Company’sBoard of Directors adopted and the Company’s stockholders approved an amendmentto the 1996 Plan to increase the number of shares in the plan by 2,500,000.Also in June 1998, in a separate amendment, the Company’s Board ofDirectors and the Company’s stockholders approved an amendment to allow alldirectors of the Company and any subsidiary of the Company to participate inthe 1996 Plan. In June 2000, the Company’s Board of Directors adopted andthe Company’s stockholders approved an amendment to the 1996 Plan to increasethe number of shares in the plan by 2,500,000. In June 2003, the Company’sBoard of Directors adopted and the Company’s shareholders approved an amendmentto the 1996 Plan to increase the number of shares in the plan by 1,500,000. TheCompensation Committee or, in the absence of a Compensation Committee, theBoard of Directors, has been appointed to administer the 1996 Plan. Optionsissued under the 1996 Plan vest in the manner prescribed by the CompensationCommittee or the Board, as applicable. As of December 31, 2004, options topurchase 4,491,171 shares of the Company’s common stock were outstanding underthe 1996 Plan.

In July 1996, the Company’s Board of Directorsadopted and the Company’s stockholders approved the 1996 Non-employee DirectorsStock Option Plan (the “Non-employee Directors Plan”), a non-discretionaryformula plan for which 120,000 shares of the Company’s common stock arereserved for issuance to the Company’s non-employee directors. A committeeconsisting of all directors who are not eligible to participate in theNon-employee Directors Plan administers the Non-employee Directors Plan. Withthe exception of the initial option granted to a non-employee director, whichvests immediately, options granted under the Non-employee Directors Plan vestover a three-year period, the first installment vesting on the date of grant.In June 1999, the shareholders approved the Amended and Restated 1996Non-employee Directors’ Stock Option Plan (the “Amended Non-employee DirectorsPlan”). Among the changes set forth in the Amended Non-employee Directors Planwas to increase by 130,000 the number of shares of common stock that may beissued. In June 2001, the Company’s Board of Directors adopted and theCompany’s stockholders approved an amendment to the Amended Non-employeeDirectors Plan to increase the number of shares in the plan by 250,000. As of December 31,2004, options to purchase 115,000 shares of common stock were outstanding underthe Amended Non-employee Directors Plan.

In connection with the Microsoft Transaction,Microsoft had a three-year warrant to purchase 100,000 shares of common stockof the Company at an exercise price per share of $17.21. The Company’ssubsidiary, SRSWOWcast, also issued to Microsoft a three-year warrant topurchase 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 PurchaseWarrant Agreement dated March 8, 2000 (the “SRSWOWcast Warrant”). The fairvalue of these warrants, totaling $2,555,783, was recorded as non-cash stockissuance cost by the Company during fiscal 2000. Fair value was calculatedusing the Black-Scholes option-pricing model with the followingweighted average assumptions: expected life—36 months; stockvolatility—96%; and risk-free interest rate—6.54%. During the term of bothwarrant agreements, no shares were purchased and as of December 31, 2003,the warrants had expired.

F-23

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Thefollowing table summarizes stock option activity under the Company’s stockoption and warrant plans for the periods indicated:
| ** **                             | ** ** | **Options   Outstanding ** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|--------------------------------------------|------------|
| Outstanding at  January 1, 2002   |       |                                 | 5,402,328  |                                       |       |   | $ | 4.44 |   |   |
| Granted                                |       |                                 | 1,631,400  |                                       |       |   | $ | 2.85 |   |   |
| Stock options exercised                |       |                                 | (86,670    | )                                          |       |   | $ | 1.52 |   |   |
| Forfeited                              |       |                                 | (922,116   | )                                          |       |   | $ | 4.09 |   |   |
| Outstanding at  December 31, 2002 |       |                                 | 6,024,942  |                                       |       |   | $ | 4.11 |   |   |
| Granted                                |       |                                 | 561,400    |                                       |       |   | $ | 4.17 |   |   |
| Stock options exercised                |       |                                 | (473,784   | )                                          |       |   | $ | 3.01 |   |   |
| Forfeited                              |       |                                 | (654,723   | )                                          |       |   | $ | 5.97 |   |   |
| Outstanding at  December 31, 2003 |       |                                 | 5,457,835  |                                       |       |   | $ | 3.99 |   |   |
| Granted                                |       |                                 | 1,199,000  |                                       |       |   | $ | 6.34 |   |   |
| Stock options exercised                |       |                                 | (989,134   | )                                          |       |   | $ | 3.75 |   |   |
| Forfeited                              |       |                                 | (946,160   | )                                          |       |   | $ | 5.23 |   |   |
| Outstanding at  December 31, 2004 |       |                                 | 4,721,541  |                                       |       |   | $ | 4.38 |   |   |

 

The weighted average fair value of options grantedduring 2004, 2003 and 2002 was $6.49, $4.15, and $2.77 respectively. Optionsgranted during 2004 generally vest over terms ranging from three years to fiveyears and the options generally expire in 10 years.

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

 

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

F-24

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**11.   Sale of Stock by Subsidiary**

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

**12.   Segment Information**

TheCompany operates two business segments—semiconductors and licensing. In 2003,the Company reported its revenues in the following five segments: licensing,semiconductors, component distribution, product sales, and Internet andbroadcast. In 2004, the Company decided to reduce its segments to licensing andsemiconductor because the revenue attributable to the discontinued segmentswere not material compared to revenues relating to semiconductors and licensing.Segment information for the 2003 segments has been restated to conform to thecurrent year presentation. Revenue from the component distribution segment isnow reported in the semiconductor segment and revenues from product sales andInternet and broadcast segments are now reported in the licensing segment.
| ** **      | ** ** | **Valence   Semiconductor ** | ** ** | **SRS Labs  Licensing** | ** ** | **Total** | ** ** |
|-----------------|------------|----------------------------------------|------------|------------------------------|------------|-----------|------------|
| **Fiscal 2004** |       |                                   |       |                         |       |      |       |   |   |
| Total revenues  |       |                                   | $          | 10,770,684                   |       |      | $          | 10,831,704 |   | $ | 21,602,388 |   |
| Cost of sales   |       |                                   | 3,725,062  |                         |       | 228,147   |       | 3,953,209 |   |
| Gross margin    |       |                                   | $          | 7,045,622                    |       |      | $          | 10,603,557 |   | $ | 17,649,179 |   |
| **Fiscal 2003** |       |                                   |       |                         |       |      |       |   |   |
| Total revenues  |       |                                   | $          | 10,712,382                   |       |      | $          | 9,101,399 |   | $ | 19,813,781 |   |
| Cost of sales   |       |                                   | 3,953,100  |                         |       | 102,979   |       | 4,056,079 |   |
| Gross margin    |       |                                   | $          | 6,759,282                    |       |      | $          | 8,998,420 |   | $ | 15,757,702 |   |
| **Fiscal 2002** |       |                                   |       |                         |       |      |       |   |   |
| Total revenues  |       |                                   | $          | 10,777,569                   |       |      | $          | 8,224,224 |   | $ | 19,001,793 |   |
| Cost of sales   |       |                                   | 4,600,388  |                         |       | 153,857   |       | 4,754,245 |   |
| Gross margin    |       |                                   | $          | 6,177,181                    |       |      | $          | 8,070,367 |   | $ | 14,247,548 |   |

 

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

F-25

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Thefollowing schedule presents the Company’s revenue by geographic area. Forproduct sales, revenue is allocated based on the country to which product wasshipped. For licensing-related revenue, the allocation is based on thelocation of the licensee’s corporate headquarters. The Americas region includesNorth, Central and South America.
| ** **                     | ** ** | **Years ended December 31,** | ** ** |
|--------------------------------|------------|---------------------------------------------|------------|
| ** **                     | ** ** | **2004**                                    | ** ** | **%** | ** ** | **2003** | ** ** | **%** | ** ** | **2002** | ** ** | **%** | ** ** |
| ***Geographic Area Revenue:*** |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| Hong Kong                      |       | $                                           | 9,975,904  |   | 46 | % | $ | 9,235,976 |   | 47 | % | $ | 9,848,123 |   | 52 | % |
| Japan                          |       | 4,906,343                                   |       | 23 | % | 5,402,565 |   | 27 | % | 5,383,728 |   | 28 | % |
| Americas                       |       | 2,354,668                                   |       | 11 | % | 875,461 |   | 5 | % | 1,027,252 |   | 6 | % |
| China                          |       | 2,028,224                                   |       | 9 | % | 2,193,863 |   | 11 | % | 1,771,486 |   | 9 | % |
| Other Asia Pacific             |       | 1,661,880                                   |       | 8 | % | 1,226,945 |   | 6 | % | 151,649 |   | 1 | % |
| Europe                         |       | 675,369                                     |       | 3 | % | 878,971 |   | 4 | % | 819,555 |   | 4 | % |
| Total                          |       | $                                           | 21,602,388 |   | 100 | % | $ | 19,813,781 |   | 100 | % | $ | 19,001,793 |   | 100 | % |

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

 

**13.   Related-Party Transactions**

The Company leases its corporate office and storagefacilities located in Santa Ana, California, under a lease agreement with apartnership that is affiliated with a stockholder and officer of the Company.The lease has a term of three years (expiring May 2005), with an option toextend the term for an additional three years thereafter through May 31,2008. We paid the partnership rent of $210,600 during 2004, $208,260 during2003, and $198,900 during 2002. See Note 8.

As described in Note 11, certain shareholders,directors and an executive officer of the Company purchased preferred sharesissued by a subsidiary of the Company. See Note 1.

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

**14.   Employee Benefit Plan**

The Company’s employees based in the United States mayparticipate in a salary deferral plan (the “401(k) Plan”) in whicheligible employees can contribute up to 75% of their eligible compensation. TheCompany also may contribute on a discretionary basis. During the years ended December 31,2004, 2003, and 2002, the Company contributed approximately $99,800, $81,800,and $67,200, respectively to the 401(k) Plan.

F-26

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**SCHEDULEII**

**VALUATION AND QUALIFYING ACCOUNTS AND RESERVES**

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

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(a)           The reduction relatesto the scrapping of component inventory that was fully reserved for and wasoffset by a credit to the corresponding inventory account.

F-27

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