<PAGE>

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

                                    FORM 10-K

(Mark One)

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

     For the fiscal period ended September 30, 2002

                                       OR

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

     Commission File Number 1-14007

                               SONIC FOUNDRY, INC.
             (Exact name of registrant as specified in its charter)

                MARYLAND                               39-1783372
     State or other jurisdiction of                 (I.R.S. Employer
     incorporation or organization)                Identification No.)

 1617 Sherman Avenue, Madison, WI 53704              (608) 256-3133
(Address of principal executive offices)      (Issuer's telephone number)

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

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

                     Common stock par value $0.01 per share
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

                        Yes       [X]              No

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

                        Yes       [X]              No

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).

                        Yes       [X]              No

The aggregate market value of the voting stock held by non-affiliates
of the Registrant's was approximately $9,366,000 based on the last sale price on
December 18, 2002.

The number of shares outstanding of the issuer's common equity was 27,702,705 as
of December 18, 2002.

                       DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2003 Annual Meeting of Stockholders are
incorporated by reference into Part III. A definitive Proxy Statement pursuant
to Regulation 14A will be filed with the Commission no later than January 28,
2003.

<PAGE>

                                TABLE OF CONTENTS

<TABLE>
                                                                                          PAGE NO.

                                     PART I

<S>         <C>                                                                              <C>
Item 1.     Business.....................................................................     3
Item 2.     Properties...................................................................     9
Item 3.     Legal Proceedings............................................................     9
Item 4.     Submission of Matters to a Vote of Security Holders..........................    10

                                     PART II

Item 5.     Market for Registrant's Common Equity and Related
            Stockholder Matters..........................................................    11
Item 6.     Selected Financial Data......................................................    12
Item 7.     Management's Discussion and Analysis of Financial
            Condition and Results of Operations..........................................    13
Item 7A     Quantitative and Qualitative Disclosures About Market Risk...................    29
Item 8.     Financial Statements and Supplementary Data:
            Report of Ernst & Young LLP, Independent Auditors                                30
            Balance Sheets...............................................................    31
            Statements of Operations.....................................................    33
            Statements of Stockholders' Equity...........................................    34
            Statements of Cash Flows.....................................................    35
            Notes to Financial Statements................................................    36
Item 9.     Changes in and Disagreements with Accountants on
            Accounting and Financial Disclosure..........................................    51

                                    PART III

Item 10.    Directors and Executive Officers of the Registrant...........................    51
Item 11.    Executive Compensation.......................................................    51
Item 12.    Security Ownership of Certain Beneficial Owners and
            Management...................................................................    51
Item 13.    Certain Relationships and Related Transactions...............................    51
Item 14.    Controls and Procedures.....................................................     51

                                     PART IV

Item 15.    Exhibits, Financial Statement Schedules and Reports on Form 8-K..............    51
</TABLE>

                                       2

<PAGE>

                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


IN ADDITION TO HISTORICAL INFORMATION, THIS ANNUAL REPORT ON FORM 10-K CONTAINS
FORWARD-LOOKING STATEMENTS SUCH AS STATEMENTS OF THE COMPANY'S EXPECTATIONS,
PLANS, OBJECTIVES AND BELIEFS. THESE STATEMENTS USE SUCH WORDS AS "MAY," "WILL,"
"EXPECT," "ANTICIPATE," "BELIEVE," "PLAN" AND OTHER SIMILAR TERMINOLOGY. ACTUAL
RESULTS COULD DIFFER MATERIALLY DUE TO CHANGES IN THE MARKET ACCEPTANCE OF SONIC
FOUNDRY'S PRODUCTS OR SERVICES, MARKET INTRODUCTION OR PRODUCT DEVELOPMENT
DELAYS, GLOBAL AND LOCAL BUSINESS CONDITIONS, LEGISLATION AND GOVERNMENTAL
REGULATIONS, COMPETITION, THE COMPANY'S ABILITY TO EFFECTIVELY MAINTAIN AND
UPDATE ITS PRODUCT OR SERVICE PORTFOLIO, SHIFTS IN TECHNOLOGY, POLITICAL OR
ECONOMIC INSTABILITY IN LOCAL MARKETS AND CURRENCY AND EXCHANGE RATES.

                                     PART I

ITEM 1. BUSINESS

Sonic Foundry was founded in 1991, incorporated in Wisconsin in March 1994 and
merged into a Maryland corporation of the same name in October 1996. We
categorize our business into three separate operations: desktop software,
services and systems software. We conduct our desktop software operations
directly through Sonic Foundry, Inc. We conduct our services operations
primarily through two subsidiaries, Sonic Foundry Media Services, Inc. and
International Image Services Corporation, Inc. d/b/a Sonic Foundry Media
Services while our systems software operations are managed from Sonic Foundry
Systems Group, Inc. d/b/a Sonic Foundry Media Systems. Our executive offices are
located at 1617 Sherman Avenue, Madison, Wisconsin, 53704 and our telephone
number is (608) 256-3133. Our corporate website is http://www.sonicfoundry.com.
Electronic access to our SEC filings is available at the "Investor Information"
section of our website.

Since the early 90's, Sonic Foundry has been writing software code and
developing solutions for the creation, manipulation and delivery of digital
media. Our initial efforts, which resulted in a Windows-based editing tool for
sound, have grown into a full suite of desktop software products utilized by all
levels of consumers, from producers of music to consumers of music, from
corporate sales teams to web page developers, and from the world's top film and
broadcast entertainment companies to proud parents sharing videos with family
via the web. Our engineering and sales efforts have established Sonic Foundry as
a leading provider of digital media tools on the Microsoft Windows(R) platform.

In 1999, many entertainment and corporate users of our products began to request
digital media solutions beyond our commercially available technology. Like the
many companies who outgrew their initial off-the-shelf accounting program, these
entities desired more robust, automated digital media solutions. In many cases,
the parties looked to outsource the process in order to save time and resources.

To capitalize on the growing demand for advanced solutions, we first
established, in October 1999, media services operations to provide format
conversion and digital encoding solutions to content owners. The media services
operation incorporates our existing technology and a wide array of audio and
video signal processing algorithms, including our unreleased proprietary
automation tools. Primary services include translating analog or digital tapes,
CDs, films and other audio and video media into various compression and Internet
streaming file formats, including multiple compression rates. Add-on services
involve cleaning or filtering recordings for improved quality.

The acquisition of STV Communications, Inc. ("STV") in April 2000 accelerated
our media services efforts, especially to Internet related companies. STV
offered additional expertise in providing value-added services such as
broadcast, live event web casting, production, hosting and encoding of media
into various streaming formats.

Our August 2000 acquisition of International Image Services Corporation, Inc.
("II") enabled us to penetrate many of the high-end content producers. II, d/b/a
Sonic Foundry Media Services with offices in Hollywood and Toronto, is one of
North America's leading suppliers of technical services to the television
program distribution market. These services include a number of preprocessing
algorithms and technologies used for standards conversions as well as improving
analog to digital conversions. Through this subsidiary, we service many popular
series such as "The Simpsons" and "The Sopranos"; establishing a brand and
reputation that has attracted major studios such as Warner, MGM, 20th Century
Fox, Paramount and DreamWorks as well as leading independent production
companies including Alliance Atlantis, Carsey-Warner, Hallmark, Endemol, HBO and
MTV. In December 2000, the California operations of STV and II were consolidated
into Sonic Foundry Media Services, Inc.

                                       3

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


On October 15, 2001, our systems software operation was formed when our
wholly-owned subsidiary, Sonic Foundry Systems Group, Inc. acquired the assets
and assumed certain liabilities of MediaSite, Inc. ("MediaSite"), a global
pioneer in providing automated rich media publishing, management and access
solutions. MediaSite derived its core technology from a Carnegie Mellon
University research effort funded by leading government agencies and private
corporations. MediaSite's technology (hereafter, the "Media Systems technology")
provides for the indexing, searching and retrieving of digital media.

Our internally developed software code, coupled with our acquired systems
technology and entertainment relationships/reputation positioned us as a leading
media management solutions provider to major motion picture studios, television
networks, government agencies, educational institutions and other broadcasters
and producers.

Media Management Solutions

We have sought to be the leading single source of digital media solutions,
bringing value across the media supply chain through our unique breadth and
completeness of software technologies, professional knowledge, expertise and
service. To accomplish this goal requires:

     .  Developing software technology that: a) replaces traditional, and
        often more costly, hardware dependent processes; and b) creates new
        service opportunities to our current entertainment customers.
     .  Promoting brand recognition, brand loyalty and productive utilization
        of, and consumption of, digital media in various vertical software
        channels.

Capture, restore, digitize and encode existing content

In order to provide users with flexibility of use and distribution, content must
exist in a digital format. Our digital media capture technologies run the gamut
of capturing audio, video and mixed media signals. Digitization is an important
process that allows followon signal processing and signal enhancement to occur.
Once digitized and processed, content must be formatted or compressed into
various formats to enable delivery or storage. Such formats include MPEG, .WAV,
..AVI, MP3, RealNetwork's RealMedia and Microsoft Windows Media.

Many content owners currently have - by virtue of purchasing our desktop
software - the ability to capture, restore and encode media in a Windows
environment. See "Sonic Foundry's Reportable Seqments - 1. Desktop Software."
What they lack, however, is the in-house expertise and technology to perform
those functions efficiently, particularly on larger scales. Though our
automation and processing technology, including batching - the simultaneous
processing of multiple files that is used exclusively through our service
offering - we provide numerous competitive advantages to our clientele. Because
many content companies need to ingest large volumes of existing data quickly and
accurately in order to efficiently realize the advantages digitization offers,
we believe they will pay a premium for automation tools either in the form of
systems or services. See "Sonic Foundry's Reportable Segments - 2. Services" and
"3. Systems Software."

Store, index, search and retrieve content

Once digitized, content must be stored and retrieved in an efficient manner.
Existing search functions for video or audio can provide not only inaccurate
results, but also an unwieldy volume of search results, each of which must be
viewed or listened to from beginning to end. A true media management solution
must allow users to quickly and accurately find a reasonable number of results,
winnow such results down further based on specific criteria, and then find
specific sections of video or audio as easily as searching documents for words.

Our system technology offers a solutions suite that turns traditional video into
"Rich Media" - content that can be catalogued, indexed and searched. Likewise,
our technology offers a way to extract information from unstructured media. This
approach uses combined speech, language and image understanding technology to
transcribe, segment and index linear video. Innovations include rapid retrieval
of "video paragraphs," which satisfies an arbitrary subject query based on words
in the soundtrack, closed-captioning or other annotations and "video skimming,"
that enables an accelerated viewing of the key video and audio sequences without
the perceptual disturbance of simply speeding up the frame rate and audio. See
"Sonic Foundry's Reportable Segments - 3, Systems Software."

Deliver and publish the content

The final function of a media management system is to efficiently distribute the
content to users and consumers through numerous distribution methods. Content
will be available both live and on-demand. Some content may have embedded
marketing along with interactivity allowing for highly targeted programming and
data collection. Vertical markets such as the government, education and
corporate markets will benefit through targeted distribution. Sonic Foundry's
strategic mission is to facilitate this process.

                                       4

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


The Sonic Foundry solution is based on enabling an enterprise to capitalize on
digital media distribution techniques. In particular, the corporate, education
and government markets are key vertical market focus areas for our system and
service offerings. In government, archiving, searching and retrieving media,
both audio and video are becoming a crucial component of surveillance, counter
espionage and defense applications. The automated solutions developed through
our systems operation offer all of these capabilities and justifies migration to
a digital media management solution. Similarly, in the education markets, both
traditional and corporate, on-line learning has lacked a key component (the
effective indexing and cataloging of information for retrieval), which our
solution set specifically addresses. Finally, corporate customers have a need to
archive and organize large volumes of collected information varying from sales
and marketing information to convention presentations. Once collected, this
information needs to be viewable and accessible in order to create value.

The process of managing and automating the workings of the entertainment
industry is another focus. Various technologies have been developed that allow
for the tracking of media in a vault, automatically duplicating the content and
facilitating the distribution of that content to entertainment distributors. Our
solutions help improve the operating margins of entertainment customers who seek
out expanded forms of distribution at lower costs. In all markets, the Sonic
Foundry solution is concentrated on extracting value from media.

Promotion and Development of Traditional Software Tools

We believe we have established ourselves as a leader in the development of media
editing, production and encoding software. We have broadened our in-house
technology by supporting emerging streaming media standards, licensing a tool
for encoding streaming media to Microsoft and developing our own "loss less"
audio compression/decompression algorithm (a "codec"). We incorporated our
expertise in audio and digital editing into our first professional video-editing
product, Vegas(R) Video, in fiscal 2000. Leveraging the Vegas Video technology
and early professional acclaim, we introduced a scaled down consumer version,
VideoFactory(TM), in September 2000. See "Sonic Foundry's Reportable Seqments -
1. Desktop Software."

We believe a number of digital media savvy employees of our targeted media
management audience use our software offerings purchased through commercial and
direct channels, and therefore represents a marketing bridge to the media
management service and system offering.

In addition, our Acidplanet website and our affiliation with Sony Pictures
Digital Entertainment (Sony) promote digital media entertainment.

Current Customer's Analog Needs and Internal Media Services Operating
Efficiencies

The transition to a digital world will not be complete for many years. Over this
time period, new services and capabilities that keep our customers at the
forefront of the transition effort will be necessary. Our services' customers
still need to duplicate, convert and distribute analog content. In order to
maintain and build relationships with these content rich enterprises, our
traditional services as well as more cost effective and innovative long-term
solutions will be required. We believe that this will open larger market
opportunities for our products and services.

Our recent work for Metro-Goldwyn-Mayer Studios (MGM) is an example of
enhancement opportunities with existing clients. MGM has adopted our Media
Collective(TM) technology in managing their film and video re-mastering jobs.
Internet browser based technologies have been custom designed to provide job
tracking and inventory management of their important media assets. Media
Collective demonstrates how databases, web interfaces and report generation will
greatly improve operating margins. The objective of this offering and future
technologies is to: 1) provide content owners with easier access to and control
over their assets and 2) to ultimately expand distribution opportunities. Other
technologies currently being developed include automated restoration
technologies, software-based dubbing modules and improved on-line searching and
retrieval modules. See "Sonic Foundry's Reportable Seqments -2. services."

Sonic Foundry's Reportable Segments

In accordance with disclosure requirements for segment reporting, the SEC's
guidance has been to present financial information in a format that is used by
the Company's management to make decisions. We have two primary revenue centers
reported in our financial statements; software license fees and services. Within
the software license fee revenue center, we further break out our operations
into desktop and systems related software. We analyze these three segments,
along with their respective production costs, independently from each other.
However, because the majority of our operating expenses support both revenue
centers, we

                                       5

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


analyze all items below gross margin on a combined basis. We describe these
three segments as desktop software, services and systems software.

Please see footnote 11 for financial information regarding segments.

1.  Desktop Software

Our desktop software operation develops sophisticated software tools for the
creation, editing and publishing of digital multimedia. Production professionals
use our Sound Forge(R), ACID(TM) and Vegas(R) Video tools worldwide for
everything from music creation and mastering, to non-linear digital video
editing and streaming media development. We distribute our products through
retail, direct and OEM channels. Delivery into the direct channel includes both
boxed product and electronic download. Generally, software product ships the
same day. The production of our software products includes CD duplication,
component purchases (manuals, boxes and inserts) and final packaging. Third
parties produce, assemble and fulfill all domestic and international orders. We
satisfy OEM arrangements by providing the manufacturer with a single master CD
and list of serial numbers. We believe there are numerous sources and
alternatives to the existing production process. To date, we have not
experienced any material difficulties or delays in the manufacture and assembly
of our products, or material returns due to product defects.

We also provide customer sales and technical support in a number of different
formats; some of which we charge separately for and some of which are included
in the price of licensing the software. We provide phone support to assist all
our software customers with technical problems they may have installing the
software, normally within 30 days of sale. For buyers of our professional level
products we provide 60 days of technical support for installation as well as
other issues. We also answer technical questions directed to our support staff
in email form, provide a user forum on our website and offer paid support
through a 900 phone number and annual support plans.

Sales to one distributor, Navarre Corporation, totaled 13%, 18% and 16% of
software revenue for the fiscal years ended September 30, 2002, 2001 and 2000.

We categorize our desktop software offerings into the following three key
groups:

Creation Products

Creation products consist of the ACID product line, which includes ACID Pro,
ACID Style, Super Duper Music Looper(TM) and our catalog of over 100 loop
libraries. The ACID product line offers both musicians and non-musicians an easy
way to create and play back music via a computer in a multi-track format. ACID
allows users to mix and merge audio "loops," which are audio files of drums,
guitars, pianos, or any other audio information, into another audio file to
create music, all on a royalty-free basis to the end user. ACID allows the user
to change tempo, change keys, add new rhythms and add vocals by embedding
samples wherever desired, all in real-time. The user can then record finished
songs to a CD or encode into various compression formats for Internet delivery
or transfer to a portable MP3 device.

Editing Products

Vegas Video and VideoFactory are principally non-linear video editing ("NLE")
products with audio features, while Sound Forge and Sound Forge Studio focus on
audio NLE capabilities while including some video features. Vegas Video and
Sound Forge are generally used by professionals for a variety of digital audio
and video editing needs while VideoFactory and Sound Forge Studio are designed
with a simplified user interface and features for consumer users. Just as a
word-processor can store, edit and transfer textual data more effectively and
efficiently than a typewriter, our editors can store, edit, manipulate, and
transfer audio or video data more effectively and efficiently than traditional
analog editing tools such as a tape recorder. We also carry various products
complimentary to our NLE products such as Noise Reduction, a tool for restoring
and repairing audio recordings and Batch Converter which allows the user to
apply processes and effects across multiple files as well as various audio
effects products.

Delivery Products

In October 2002 we announced the reintroduction of our popular Red Book audio CD
burning application, CD Architect, to version 5.0 with significant new features
and enhancements. With CD Architect, users can extract audio from compact discs
or import supported files from their PC. Likewise, users can lay out a
professional master CD, ready for manufacturing replication.


                                       6

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


2.  Services

Our services operations provide digitization, management and delivery solutions
for various industries. Traditional fulfillment services consist of duplication,
conversion, reformatting and encoding of television, film and audio content for
multiple delivery platforms. We also offer MediaWorks, a suite of media asset
management tools, which will provide the infrastructure for storage, management
and delivery of digital media content.

Our traditional fulfillment services enable clients to meet the demands of
distributing audio, video and media content to global markets. Fulfillment
includes a detailed, comprehensive assessment of our client's original content
to determine its readiness for international distribution. Once this process is
complete, we optimize the content and perform international format conversions
for traditional broadcast distribution as well as MPEG-1 and -2 conversions for
broadband and video-on-demand distribution.

Our digital MediaWorks(TM) services include: MediaCenter - Provides online
access to videotape libraries and orders; MediaCollective - Project management
tool for internal and vendor/partner use; MediaQC - Enables online viewing of
technical evaluation reports and impairments; and MediaTaxi - Technology for
managing, distributing, accessing and storing advertising, sales, marketing and
publicity materials. MGM adopted MediaCollective to manage and coordinate their
film and video re-mastering initiatives. These media asset management efforts
may in the future include several additional tools to assist MGM and other media
content owners in the future.

In 2002, 85% of our services revenue related to traditional duplication,
conversion and reformatting of videotape while the remaining 15% related to
digital related services. Although our service operations rely on several major
studios, services revenues to the three largest media services customers were
15%, 14% and 12% of total media services revenues in 2002.

The traditional fulfillment services are seasonal and volume tends to mirror
that of the television industry with busier periods in the fall and January
through March. Normal seasonality is often affected by the impact outside events
have on television content or advertising such as the Summer Olympics in
September 2000 and the events of September 11, 2001.

Media service's traditional fulfillment services do not have significant
backlog. Jobs are often completed within a week of receiving master tapes. After
completing duplication, conversion or reformatting, the original master tapes
are either stored in our on-site vaults or returned to the studios. The
duplicated or repurposed tapes are either sent to the studios or distributed
around the globe to broadcasters.

3.  Systems Software

Our systems software business (formerly MediaSite) provides customized
development of automated rich-media applications and scalable solutions that
allow media and entertainment companies, as well as enterprises, educational and
government organizations, to deploy, manage and distribute video content on
IP-based networks. Primary products include:



MediaSite Live, a comprehensive solution that combines hardware, software and
server technology in one integrated system that allows customers to readily
capture, stream, deliver and archive synchronized audio, video and other
multimedia presentation collateral without expensive media production equipment
and with greater flexibility, convenience and speed than competitive products.

MediaSite Publisher, a product for creating accessible and searchable rich media
presentations by using meta-tagging tools to identify and extract audio, video,
and other textural cues. Publisher then allows the user to quickly and
accurately locate media files by keyword or topic. Users can view scores and
descriptive information to determine relevancy of their search results, and
watch the returned clips with Publisher's Highlights Indexing Module.

Our system products are typically sold direct or through system integrators and
our Live product is incorporated within a third party personal computer. The
production of our system software products is generally limited to CD
duplication and loading onto the third party hardware, which we do internally.
We believe there are numerous sources and alternatives to the existing
production process. To date, we have not experienced any material difficulties
or delays in the manufacture and assembly of our system products, or material
returns due to product defects. We also provide customer sales and technical
support through annual support plans.

                                       7

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


                                OTHER INFORMATION

Potential Sale of Assets

The Company recently determined that operations of our desktop software and
services business would not provide sufficient cash flow along with our existing
cash reserves to fund planned growth of the systems division and make remaining
subordinated debt payments. In response, the Company retained an advisor to
evaluate the sale of certain operating assets. As of the reporting date, the
Company has received multiple non-binding offers from qualified bidders and we
anticipate closing one or more transactions in early 2003. Such a transaction is
expected to provide the Company with sufficient resources to:

     .  Retire the remaining balance due subordinated debt holders;
     .  Retire the additional $1,000,000 bridge note;
     .  Restructure the Company and aggressively pursue a focused strategy of
        growing the remaining business.

There can be no assurances the Company will reach an agreement to sell certain
assets nor that any such agreement will be completed on terms favorable to the
Company or timely enough to avoid disruption of operations.

Competition

Numerous companies offer products or services competing directly or indirectly
with our services and software. However, none of these companies can
independently offer a matching product line competing one for one with our
product line.

Our primary competitors in the automated indexed media arena are Convera and
Virage. Our primary competitors in the services space are the leading
post-production houses and web-oriented encoding businesses such as Liberty
Livewire's Four Media Company, Deluxe, Technicolor and point.360. Our software
offerings compete against products from Adobe, Apple, Avid Technology,
Microsoft, Pinnacle Systems, RealNetworks and Roxio. Our competitors in the web
presentation market include E-studiolive, Polycom, Softv.net, Tegrity and
ViewCast.

The markets for our products and services are intensely competitive. Pricing
pressure, rapid development, feature upgrades and undefined new technologies
characterize the industry. Most of our competitors or potential competitors have
significantly greater financial, management, technical and marketing resources
than we do. We could also face future competition from other large companies
such as IBM, Oracle, Corel or Macromedia. Each of these potential competitors
has substantially greater resources than we do and could become a significant
competitor.

The primary factors on which we compete are quality, pricing, product features,
cross-platform file support, brand marketing and customer support. The relative
importance of each factor is dependent on the market and customer group
targeted. We believe we compete favorably with respect to these factors, but
there can be no assurance that we will continue to do so.

Intellectual Property

To protect our proprietary rights, we rely on a combination of trademark,
patent, copyright and trade secret laws, confidentiality agreements with our
employees and third parties and "shrink wrap" licenses.

Our products are generally licensed to end users on a "right to use" basis
pursuant to a license that is nontransferable and restricts the use of the
products to the customer's internal purposes on a designated number of
computers. We also rely on copyright laws and on "shrink wrap" and electronic
licenses that are not signed by the end user. The enforceability of "shrink
wrap" and electronic licenses has not been conclusively determined. We have
recently applied for several patents and have registered numerous copyrights,
trademarks, domain names, and logos in the United States and foreign countries.

Policing unauthorized use of computer software is difficult, and software piracy
is a persistent problem for the software industry. We employ third parties to
assist us in locating evidence of piracy of our products and aggressively pursue
offenders.

Research and Development

Rapid technological change in the personal computer hardware and software market
requires us to maintain high levels of expenditure on development of new
features for our existing products and services as well as the introduction of
new products

                                       8

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


and services. We primarily develop our software internally. We occasionally
acquire products developed by others by purchasing the stock or assets of the
business entity that held ownership rights to the technology. In other
instances, we have licensed or purchased the intellectual property ownership
rights of programs developed by others with license or technology transfer
agreements that may obligate us to pay royalties, typically based on a
percentage of the revenues generated by those programs.

During the fiscal years ended September 30, 2002, 2001 and 2000, we spent
$7.2 million, $8.0 million and $7.9 million on internal research and development
activities. These amounts represent 28%, 30%, and 30% of total revenues in each
of those years.

In October 2001 we acquired the assets of MediaSite which includes the
underlying technology of our current MediaSite Publisher and MediaSite Live
products for a total of $9.1 million. MediaSite derived its core technology from
a Carnegie Mellon University research effort funded by leading government
agencies and private corporations for which it obtained a license.
Simultaneously with the acquisition, we entered into a license agreement with
CMU for the core technology.

In February 2002 we acquired all the intellectual property rights to the Media
Taxi(TM) asset management system from Los Angeles based Digital Savant, Inc for
$0.7 million. Media Taxi is a widely deployed browser-based media asset
management system for distributing marketing and publicity materials which our
services business currently markets to our entertainment customers.

Employees

As of September 30, 2002, 2001 and 2000, we had 246, 239, and 445 full-time
employees, respectively. The December 2000 restructuring plan resulted in a
decline in employees from 2000 to 2001. The continued integration of STV and II
identified a number of duplicative positions as well as efforts not core to our
strategy. In response, we announced a layoff of approximately 200 employees
during the quarter ended December 2000. Our employees are not represented by a
labor union, nor are they subject to a collective bargaining agreement. We have
never experienced a work stoppage and believe that our employee relations are
satisfactory.

ITEM 2.  PROPERTIES

Our principal offices are located in Madison, WI in one leased facility of
approximately 45,000 square feet. The building serves as our corporate
headquarters, accommodating our desktop software operations as well as our G&A,
R&D and Sales and Marketing departments. In August 2002, we sublet approximately
6,000 square feet in one quarter of the building that was not being utilized. We
also lease a small software engineering office in Waterloo, Ontario.

We lease production facilities for our services operations in Santa Monica,
California and Toronto, Canada. In California, we sublet the space previously
occupied by the former STV and moved these operations into the 12,000 sq. ft. II
facility. An additional 7,000 square feet at this location is an undeveloped
warehouse, which we are currently seeking to sublet. The Toronto facility totals
approximately 19,000 square feet and is fully utilized.

Our enterprise software business is located in a 9,000 square foot leased
facility in Wexford Pennsylvania. In addition, we lease 7,000 square feet in
downtown Pittsburgh, Pennsylvania that we are attempting to sublet. We believe
these facilities are adequate and suitable for our needs.

ITEM 3.  LEGAL PROCEEDINGS

We are subject to routine legal proceedings, as well as demands, claims and
threatened litigation that arise in the normal course or our business. We
currently believe that the ultimate amount of liability, if any, for any pending
claims of any type (either alone or combined) will not materially effect our
financial position, results of operations or liquidity. However, the ultimate
outcome of any litigation is uncertain, and either unfavorable or favorable
outcomes could have a material negative impact. Regardless of outcome,
litigation can have an adverse impact on our business because of defense costs,
diversion of management resources and other factors.

                                       9

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


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

There were no matters submitted to a vote of security holders during the fourth
quarter ended September 30, 2002.

                                       10

<PAGE>

                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


                                     PART II

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

Our common stock was initially traded on the American Stock Exchange under the
symbol "SFO," beginning with our initial public offering in April of 1998. On
April 24, 2000, our common stock began trading on the NASDAQ National Market
under the symbol "SOFO." The following table sets forth, for the periods
indicated, the high and low sale prices per share of our common stock as
reported on the NASDAQ National Market.

<TABLE>
<CAPTION>
                                                         High       Low
          <S>                                          <C>        <C>
          Year Ended September 30, 2003:

          First Quarter (through December 18, 2002)    $ 0.90     $ 0.10

          Year Ended September 30, 2002:

          First Quarter                                  4.44       1.00
          Second Quarter                                 3.27       2.04
          Third Quarter                                  2.57       1.14
          Fourth Quarter                                 1.40       0.56

          Year Ended September 30, 2001:

          First Quarter                                  8.94       0.91
          Second Quarter                                 6.00       1.25
          Third Quarter                                  2.59       1.13
          Fourth Quarter                                 2.40       1.10
</TABLE>

Sine October 2001, our common stock has failed to maintain a minimum bid price
of $1.00 per share for at least 10 consecutive days, which caused our stock
price to fail to meet one of the minimum standards required by the Nasdaq stock
market for continued listing as a Nasdaq National Market Security. On
October 16, 2002 the company received a letter from Nasdaq indicating that it
needed to regain compliance by January 14, 2003 in order to remain on the Nasdaq
National Market.

The Company has not paid any cash dividends and does not intend to pay any cash
dividends in the foreseeable future.

At December 20, 2002 there were 484 common stockholders of record. Many shares
are held by brokers and other institutions on behalf of shareholders.

                      Equity Compensation Plan Information

<TABLE>
<CAPTION>
              Plan category                Number of securities to      Weighted average       Number of securities
                                           be issued upon exercise     exercise price of     remaining available for
                                           of outstanding options,    outstanding options,       future issuance
                                             warrants and rights      warrants and rights
--------------------------------------------------------------------------------------------------------------------
                                                      (a)                      (b)                      (c)
--------------------------------------------------------------------------------------------------------------------
<S>                                        <C>                        <C>                    <C>
   Equity compensation plans approved by           2,616,013                  $3.79                   506,120
   security holders
--------------------------------------------------------------------------------------------------------------------
   Equity compensation plans not approved          3,521,221                  $1.45                   278,779
   by security holders
--------------------------------------------------------------------------------------------------------------------
   Total                                           6,137,234                  $2.45                   784,899
--------------------------------------------------------------------------------------------------------------------
</TABLE>

                                       11

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


RECENT SALES OF UNREGISTERED SECURITIES

None.


ITEM 6. SELECTED FINANCIAL DATA

The selected financial and operating data as of and for the years ended
September 30, 2002, 2001, 2000, 1999 and 1998 were derived from our financial
statements that have been audited by Ernst & Young LLP, independent auditors.
The selected financial data set forth below is qualified in its entirety by, and
should be read in conjunction with, "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and our financial statements and
notes thereto appearing elsewhere in this annual report on Form 10-K.

<TABLE>
                                                                   Years Ended September 30,
                                                  ---------------------------------------------------------------
(in thousands except per share data)               2002           2001            2000          1999        1998
                                                   ----           ----            ----          ----        ----
<S>                                               <C>            <C>            <C>            <C>         <C>
Statement of Operations Data:
Total net revenues                                $26,156        $26,284        $ 26,307       $13,682     $7,470
Total cost of revenues                             10,585         12,920          10,670         3,390      2,028
Gross profit                                       15,571         13,364          15,637        10,292      5,442
Selling and marketing expenses                      8,803         12,554          19,822         9,336      3,231
General and administrative expenses                 6,979         10,153           9,982         4,253      1,878
Product development expenses                        7,231          7,986           7,868         2,875      1,046
Restructuring and impairment charge                    --          4,973              --            --         --
Amortization of goodwill                               --         27,478          14,300            --         --
Cumulative effect of change in
accounting principle                               44,732             --              --            --         --
Net loss                                          (56,737)       (49,860)        (34,922)       (5,997)      (632)

Pro forma loss per common share:
      Basic and diluted                           $ (2.12)       $ (2.25)       $  (1.89)      $ (1.06)    $ (.22)

Weighted average common shares                     26,812         22,129          18,503         5,687      2,713
</TABLE>


<TABLE>
                                                                         September 30,
                                                  ---------------------------------------------------------------
                                                   2002            2001            2000           1999     1998
                                                   ----            ----            ----           ----     ----
Balance Sheet Data:
<S>                                               <C>            <C>            <C>             <C>       <C>
Cash and cash equivalents                         $ 3,704        $ 7,809        $ 21,948       $ 5,889    $ 9,940
Working capital (deficit)                            (496)         4,421          22,153         8,843     11,156
Total assets                                       27,643         71,683         126,825        16,709     15,950
Total indebtedness                                  5,379          5,989           8,409         5,283        714
Stockholders' equity                               17,984         61,231         110,366         8,747     14,091
</TABLE>

                                       12

<PAGE>
                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


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

The financial and business analysis below provides information that the Company
believes is relevant to an assessment and understanding of the Company's
consolidated financial position and results of operations. This financial and
business analysis should be read in conjunction with the consolidated financial
statements and related notes.

In addition to historical information, this discussion contains forward-looking
statements such as statements of our expectations, plans, objectives and
beliefs. These statements use such words as "may," "will," "expect,"
"anticipate," "believe," "plan," and other similar terminology. Actual results
could differ materially due to changes in the market acceptance of our products
and services, market introduction or product development delays, our ability to
effectively integrate acquired businesses, global and local business conditions,
legislation and governmental regulations, competition, our ability to
effectively maintain and update our product portfolio, shifts in technology,
political or economic instability in local markets, and currency and exchange
rates. The Company also faces several risk factors, which are outlined below.

                                  RISK FACTORS

OUR AUDITORS HAVE ISSUED A "GOING CONCERN" OPINION

Our auditors have stated that due to our working capital deficiency, our
convertible debt obligations, and our lack of long-term credit availability,
there is "substantial doubt" about our ability to continue as a going concern.
Our plans in regard to these matters is to consider the sale of certain assets.
As of the reporting date, we have received multiple non-binding offers from
qualified bidders and we anticipate closing one or more transactions in early
2003. Such a transaction is expected to provide us with sufficient resources to:

     .  Retire the remaining balance due subordinated debt holders;

     .  Retire the additional $1,000,000 bridge note;

     .  Restructure the Company and aggressively pursue a focused strategy of
        growing the remaining business.

There can be no assurances we will reach an agreement to sell certain assets nor
that any such agreement will be completed on terms favorable to us or timely
enough to avoid disruption of operations.

IF WE ARE UNABLE TO COMPLY WITH NASDAQ'S CONTINUED LISTING REQUIREMENTS, OUR
COMMON STOCK COULD BE DELISTED FROM THE NASDAQ NATIONAL OR SMALLCAP MARKET.

Since October 2001, our common stock has failed to maintain a minimum bid price
of $1.00 per share for at least 10 consecutive days, which caused our stock
price to fail to meet one of the minimum standards required by the Nasdaq Stock
Market for continued listing as a Nasdaq National Market security. On October
16, 2002 we received a letter from Nasdaq indicating that we need to regain
compliance by January 14, 2003 in order to remain on the Nasdaq National Market.
In order to avoid delisting from Nasdaq entirely, we plan to voluntarily apply
to Nasdaq to have our listing transferred to the SmallCap Market prior to
January 14, 2003. The Nasdaq SmallCap Market also requires compliance with a
minimum bid price of $1.00 per share for at least 10 consecutive days, although
it affords an additional 90-day grace period, or until April 14, 2003. The
Company may also be eligible for an additional grace period (until October 13,
2003). We must be in compliance with this requirement at the expiration of any
available grace periods, or face delisting from Nasdaq.

There can be no assurance that we will be able to satisfy all requirements for
continued listing of our common stock on the Nasdaq SmallCap Market, including
the minimum bid price requirement and minimum tangible assets or stockholders'
equity requirements. If we are unable to meet Nasdaq's requirements in the
future, our stock will be subject to delisting, which may have a material
adverse effect on the price of our common stock and the levels of liquidity
currently available to our stockholders. Delisting would also make it more
difficult for us to raise capital in the future. If our common stock is removed
from the Nasdaq SmallCap Market, an investor could find it more difficult to
dispose of, or to obtain accurate quotations as to the market value of, our
common shares. Additionally, our stock may then be subject to "penny stock"
regulations.

                                       13

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


THE OVERALL ECONOMIC PROBLEMS IN THE TECHNOLOGY INDUSTRY HAVE WEAKENED OUR
ABILITY TO RAISE CAPITAL AND ACHIEVE PROFITABLE OPERATIONS.

     The technology industry has been in a severe economic recession since
mid-2000. Among other things, spending in the technology sector has shrunk, and
stock prices have dropped precipitously. This has impacted us in many ways,
including, most significantly, a drop in the demand for our products and
services and a steep plunge in the market price of our common stock. In
response, we have made significant cuts in our work force and in other areas,
incurring a restructuring charge of $3.8 million in December 2000 and $1.2
million in September 2001. The technology industry in general, and our company
in particular, has still not recovered from the economic recession. We lost
$56.7 million in fiscal 2002, including the cumulative effect of a change in
accounting principle, and we may continue to lose money for the foreseeable
future. Although we generated $500 thousand in cash from operating activities in
the fourth quarter of 2002, we may not achieve these results in the future and
have cash needs in excess of that amount including quarterly interest and
$330,000 per month principal payments on our convertible subordinated debt,
capital lease payments, purchases of equipment and working capital. Lenders
representing $4.75 million of original principal have agreed to defer
approximately $900 thousand of the principal payments that were or will become
due from September 2002 through January 2003, until the earlier of a transaction
contemplated in "Liquidity and Management's Plan" or January 20, 2003. In
addition, because of the extreme weakness in the price of our common stock, our
access to capital markets has been severely restricted.

OUR EVOLVING MIX OF BUSINESS MAKES IT DIFFICULT TO EVALUATE OUR COMPANY.

     We were incorporated in 1994 and became a public company in 1998. For the
first several years of our existence, we focused exclusively on selling software
products. In fiscal 2000, we began, primarily through acquisitions, to focus on
our media services group. In October 2001, we purchased MediaSite, Inc., thereby
adding a third business segment -systems software - to our company. Due to our
evolving business mix, an investor will have limited insight into trends that
may emerge and affect our business. In addition, the revenue and income
potential of the systems software business is unproven.

WE MAY CONTINUE TO INCUR NET LOSSES.

     We have incurred significant losses since our inception, $56.7 million in
2002; $49.9 million in 2001; $34.9 million in 2000; $6.0 million in 1999; and
$0.6 million in 1998, and we may never become profitable. As of September 30,
2002, we had an accumulated deficit of $149 million.

WE MAY NOT EARN REVENUES SUFFICIENT TO REMAIN IN BUSINESS.

     Our ability to become profitable depends on whether we can sell our
products, services and systems for more than it costs to produce and support
them. Our future sales also need to provide sufficient margin to support our
ongoing operating activities. The success of our revenue model will depend upon
many factors including:

     .  Our ability to develop and market our systems software operations; and

     .  The extent to which consumers and businesses use our products,
        services and systems.

Because of the recession in the technology market, the early stage of our
systems software business, and the evolving nature of our business, we cannot
predict whether our revenue model will prove to be viable, whether demand for
our products, services and systems will materialize at the prices we expect to
charge, or whether current or future pricing levels will be sustainable.

WE MUST CONTINUALLY DEVELOP NEW PRODUCTS, SERVICES AND SYSTEMS WHICH APPEAL TO
OUR CUSTOMERS.

     Our products, services and systems are subject to rapid obsolescence and
our future success will depend upon our ability to develop new products,
services and systems that meet changing customer and marketplace requirements.
There is no assurance that we will be able to successfully:

     .  Identify new product, service and system opportunities; or

                                       14

<PAGE>
                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


     .  Develop and introduce new products, services and systems to market in a
        timely manner.

     Even if we are able to identify new opportunities, our working capital
constraints limit our ability to pursue them. If we are unable to identify and
develop and introduce new products, services and systems on a timely basis,
demand for our products, services and systems will decline.

     We must identify and develop markets for our products, services and
systems. A suitable market for our products, services and systems may not
develop or, if it does develop, it may take years for the market to become large
enough to support significant business opportunities. Even if we are able to
successfully identify, develop, and introduce new products, services and
systems, there is no assurance that a suitable market for these products,
services and systems will materialize. The following factors could affect the
success of our products, services and systems and our ability to address
sustainable markets:

     .  The failure of our business plan to accurately predict the types of
        products, services and systems the future marketplace will demand;

     .  Our limited working capital may not allow us to commit the resources
        required to adequately support the introduction of new products,
        services and systems;

     .  The failure of our business plan to accurately predict the estimated
        sales cycle, price and acceptance of our products, services and
        systems; or

     .  The development by others of products, services and systems that makes
        our products, services and systems noncompetitive or obsolete.

CONTINUED COMMERCIAL FAILURE OF INTERNET-BASED BUSINESSES COULD REDUCE DEMAND
FOR OUR SERVICES AND SYSTEMS SOFTWARE.

     The substantial proportion of customers for our digital media services and
systems software have been Internet-based businesses and we expect that in the
future, a majority of our customers will be these types of businesses.

     Our business prospects and revenues would be harmed by the continued
commercial failure or diminished commercial prospects of these or like
customers. In addition, if such customers continue to have difficulty raising
additional capital to fund their operations, our business prospects and revenues
would be harmed.

THERE IS A GREAT DEAL OF COMPETITION IN THE MARKET FOR SYSTEMS SOFTWARE AND
SERVICES, WHICH COULD LOWER THE DEMAND FOR OUR SYSTEMS SOFTWARE AND SERVICES.

     The market for digital media services and systems is relatively new, and we
face competition from in-house digital services by potential customers, other
vendors that provide outsourced digital media services and other companies that
directly provide digital media applications. If we do not compete effectively or
if we experience reduced market share from increased competition, our business
will be harmed. In addition, the more successful we are in the emerging market
for Internet media services and systems, the more competitors are likely to
emerge including turnkey Internet media application and service providers;
streaming media platform developers; digital music infrastructure providers;
digital media applications service providers (including for digital musical
subscription) and video post production houses.

     The presence of these competitors could reduce the demand for our systems
and services, and we may not have the financial resources to compete
successfully.

OUR MEDIA SERVICES AND SYSTEMS SOFTWARE BUSINESS MODEL IS UNPROVEN, MAKING IT
DIFFICULT TO FORECAST OUR REVENUES AND OPERATING RESULTS.

     Our services and systems business model is based on the premise that
digital media content providers and developers will outsource a large percentage
of their digital service and content management needs. Our potential customers
may rely on internal resources for these needs. In addition, technological
advances may render an outsourced solution unnecessary, particularly as new
media content is created in a digital format. Market acceptance of our services
may depend in part on reductions in the cost of our services so that we may
offer a more cost effective solution than both our competitors and our

                                       15

<PAGE>

                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


customers doing the work internally. Our cost reduction efforts may not allow us
to keep pace with competitive pricing pressures and may not lead to improved
gross margins. In order to remain competitive, we expect to reduce the cost of
our services through design and engineering changes. We may not be successful in
reducing the costs of providing our services.

THE TECHNOLOGY UNDERLYING OUR PRODUCTS, SERVICES AND SYSTEMS IS COMPLEX AND MAY
CONTAIN UNKNOWN DEFECTS THAT COULD HARM OUR REPUTATION, RESULT IN PRODUCT
LIABILITY OR DECREASE MARKET ACCEPTANCE OF OUR PRODUCTS, SERVICES AND SYSTEMS.

     The technology underlying our digital media products, services and systems
is complex and includes software that is internally developed and software
licensed from third parties. These software products may contain errors or
defects, particularly when first introduced or when new versions or enhancements
are released. We may not discover software defects that affect our current or
new services and applications or enhancements until after they are sold.
Furthermore, because our digital media services and systems are designed to work
in conjunction with various platforms and applications, we are susceptible to
errors or defects in third-party applications that can result in a lower quality
product for our customers. Any defects in our products, services and systems
could:

     .  Damage our reputation;

     .  Cause our customers to initiate product liability suits against us;

     .  Increase our product development resources;

     .  Cause us to lose sales; and

     .  Delay market acceptance of our digital media services and systems.

     Our errors and omissions coverage may not be sufficient to cover our
complete liability exposure.

WE RELY ON STRATEGIC RELATIONSHIPS TO PROMOTE OUR SERVICES AND PRODUCTS; IF WE
FAIL TO MAINTAIN OR ENHANCE THESE RELATIONSHIPS, OUR ABILITY TO SERVE OUR
CUSTOMERS AND DEVELOP NEW SERVICES AND APPLICATIONS COULD BE HARMED.

     Our business depends, in part, upon relationships that we have with
strategic partners such as Microsoft, RealNetworks, Sony, Carnegie Mellon
University and Fraunhofer Institute. We rely, in party, on strategic
relationships to help us:

     .  Maximize the acceptance of our products by customers through
        distribution arrangements;

     .  Increase the amount and availability of compelling media content on
        the Internet to help boost demand for our products and services;

     .  Increase awareness of our Sonic Foundry and MediaSite brands; and

     .  Increase the performance and utility of our products and services.

     We would be unable to realize many of these goals without the cooperation
of these partners. We anticipate that the efforts of our strategic partners will
become more important as the availability and use of multimedia content on the
Internet increases. For example, we may become more reliant on strategic
partners to provide more secure and easy-to-use electronic commerce solutions
and build out the necessary infrastructure for media delivery. Due to the
evolving nature of the Internet media infrastructure market, we will need to
develop additional relationships to adapt to changing technologies and standards
and to work with newly emerging companies with whom we do not have pre-existing
relationships. The loss of our existing strategic relationships, the inability
to find other strategic partners or the failure of our existing relationships to
achieve meaningful positive results could make it difficult to strengthen our
technology development and to increase the adoption of our products and
services.

                                       16

<PAGE>

                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


IN OUR SOFTWARE SEGMENT, WE RELY UPON DISTRIBUTORS TO INCREASE OUR MARKET
PENETRATION SO THE LOSS OF ONE OR MORE DISTRIBUTORS, OR THE RETURN BY THE
DISTRIBUTORS OF A LARGE AMOUNT OF OUR PRODUCT, WOULD HARM OUR SALES.

     We have contracts with Navarre Corporation, and other U.S. companies, that
distribute our software products to various computer resellers, value-added
resellers, catalog distributors and smaller retail outlets. Navarre Corporation
accounted for 8% of total revenues and 13% of software revenues for fiscal 2002.
Our contract with Navarre requires us to accept the return of any of our
products that it does not sell and to credit it for the value of these products.
It also provides Navarre with protection for the value of their inventory in the
event that we lower our prices. If these distributors fail to continue to carry
our products, return large quantities of our products to us, or competitive
pressures require us to lower the prices of the products that we supply to them,
our business will suffer.

WE DEPEND ON A LIMITED NUMBER OF CUSTOMERS FOR A SIGNIFICANT PROPORTION OF OUR
REVENUES SO THE LOSS OF, OR DELAY IN PAYMENT FROM, ONE OR A SMALL NUMBER OF
CUSTOMERS COULD HARM OUR SALES.

     A limited number of customers have accounted for a majority of our revenues
in our media services segment and will continue to do so for the foreseeable
future. During the year ended September 30, 2002, three of our customers in that
segment accounted for approximately 41% of our media services revenue. We
believe that a small number of customers will likely continue to account for a
significant percentage of our media services revenues for the foreseeable
future. Due to high revenue concentration among a limited number of customers,
the cancellation, reduction or delay of a large customer order or our failure to
timely complete or deliver a project during a given quarter will reduce revenues
for the quarter. In addition, if any customer fails to pay amounts it owes us,
or if we lose a key customer, our sales will suffer.

DUE TO OUR LICENSE AGREEMENT WITH CARNEGIE MELLON UNIVERSITY, WE MAY FACE
COMPETITION IN OUR PUBLISHER(TM) PRODUCT AND WE MAY LOSE THE ABILITY TO SELL
THAT PRODUCT IN THE FUTURE.

     Our Publisher(TM) product is based in part on licensed technology from
Carnegie Mellon. As part of the MediaSite transaction we acquired a nonexclusive
license to use certain technology in that product and have recently negotiated
an exclusive license as to certain competitors. Because the exclusivity is
limited to a defined list of competitors, a risk exists that Carnegie Mellon
could license the technology to another party that is not currently a named
competitor, but could become competitive with us. Moreover, if the License
Agreement were to terminate before the underlying patents expired, we would lose
the ability to sell the products covered by the License Agreement.

WE MAY NOT BE SUCCESSFUL IN PROTECTING OUR INTELLECTUAL PROPERTY AND PROPRIETARY
RIGHTS.

     Our inability to protect our proprietary rights, and the costs of doing so,
could harm our business. Our success and ability to compete partly depends on
the superiority, uniqueness or value of our technology, including both
internally developed technology and technology licensed from third parties. To
protect our proprietary rights, we rely on a combination of trademark, patent,
copyright and trade secret laws, confidentiality agreements with our employees
and third parties and "shrink wrap" licenses. Recently, we have undertaken
additional efforts to identify which of our proprietary processes and algorithms
may be patentable, and we currently have several patent applications pending
with the U.S. Patent and Trademark Office. If patents are not issued as a result
of any of these applications, or if we cannot afford to enforce them, other
parties may infringe on our proprietary rights.

     Despite our efforts to protect our proprietary rights, unauthorized parties
may copy or infringe aspects of our technology, products, services or
trademarks, or obtain and use information we regard as proprietary. In addition,
others may independently develop technologies that are similar or superior to
ours, which could reduce the value of our intellectual property.

     Companies in the computer industry have frequently resorted to litigation
regarding intellectual property rights. We may have to litigate to enforce our
intellectual property rights or to determine the validity and scope of other
parties' proprietary rights.

     We face the risk that our customers might not have all necessary ownership
or license rights in the content for us to perform our encoding services. Any
alleged liability could harm our business by damaging our reputation, requiring
us to incur legal costs in defense, and exposing us to awards of damages and
costs and diverting management's attention.

                                       17

<PAGE>
                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002

     Because we host audio and video content on Web sites for customers and
provide services related to digital media content, we face potential liability
or alleged liability for negligence, infringement of copyright, patent, or
trademark rights, defamation, indecency and other claims based on the nature and
content of the materials we host.

     Third parties may claim infringement by us with respect to past, current,
or future technologies. If a third party's claim of intellectual property right
infringement were to prevail, we could be forced to pay damages, comply with
injunctions, or halt distribution of our products while we re-engineer them or
seek licenses to necessary technology, which might not be available on
reasonable terms. We could also be subject to claims for indemnification
resulting from infringement claims made against our customers and strategic
partners, which could increase our defense costs and potential damages. In
addition, we have agreed to indemnify certain distributors and original
equipment manufacturers, or OEMs, for infringement claims of other parties. If
these other parties sue the distributors or OEMs, we may be responsible for
defending the lawsuit and for paying any judgment that may result.

WE MAY BE UNABLE TO RETAIN TECHNOLOGY LICENSED OR OBTAINED FROM THIRD PARTIES
AND STRATEGIC PARTNERS.

     We rely upon licenses from third parties and strategic partners for some of
our technologies. These companies that license the technologies to us may decide
to discontinue the licenses at any time. If they do so, our business may suffer

WE MAY BE UNABLE TO OBTAIN THE EXPECTED BENEFITS OF OUR RECENT ACQUISITIONS.

         Our acquisition of certain assets of MediaSite, Inc., which was
completed in October 2001, will require devoting our resources to setting up a
new media systems segment. In addition, in February 2002, we acquired certain
assets of Digital Savant, Inc.

         We may not be able to successfully assimilate the personnel,
technology, operations and customers of these acquisitions into our business. In
addition, we may fail to achieve the anticipated synergy from these
acquisitions, including product, systems and software development, and other
operational synergies. The integration process of these businesses may further
strain our existing financial and managerial controls and reporting systems and
procedures. This may result in the diversion of management and financial
resources from our core business objectives.

         In addition, it is possible that an unforeseen liability may arise from
our acquisition of these companies and result in a claim against us.

OUR REVENUES FROM OUR FOREIGN CUSTOMERS ARE SUBJECT TO ADDITIONAL RISKS ARISING
FROM FOREIGN OPERATIONS.

         We maintain a media services facility in Toronto, Canada, which
provides services primarily to Canadian and other international customers and we
distribute our software products in approximately 30 countries through 30
international distributors. Net revenues from customers outside of North America
accounted for 15% of total net revenues for the year ended September 30, 2002.

         We are subject to the normal risks of doing business internationally.
These risks include:

     .    Unexpected changes in laws or regulatory requirements.

     .    Political instability.

     .    Export and import restrictions.

     .    Actions by third parties such as discount pricing and business
          techniques unique to foreign countries.

     .    Tariffs and trade barriers and limitations on fund transfers.

     .    Longer payment cycles and problems in collecting accounts receivable.


                                       18

<PAGE>
                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


     .  Potential adverse tax consequences.

     .  Exchange rate fluctuations.

     .  Economic conditions including inflation, high tariffs, or wage and
        price controls.

     .  Increased risk of piracy and limits on our ability to enforce our
        intellectual property rights.

WE MAY BE SUBJECT TO ASSESSMENT OF SALES AND OTHER TAXES FOR THE SALE OF OUR
PRODUCTS, LICENSE OF TECHNOLOGY OR PROVISION OF SERVICES.

     We may have to pay past sales or other taxes that we have not collected
from our customers. We do not currently collect sales or other taxes on the sale
of our products, license of technology or provision of services in states and
countries other than Wisconsin and California. The federal Internet Tax Freedom
Act, passed in 1998, imposes a three-year moratorium on discriminatory sales
taxes on electronic commerce, which was recently extended for 2 additional
years. We cannot assure you that this moratorium will be re-extended. Further,
foreign countries or, following the moratorium, one or more states, may seek to
impose sales or other tax obligations on companies that engage in such
activities within their jurisdictions. Our business would suffer if one or more
states or any foreign country were able to require us to collect sales or other
taxes from current or past sales of products, licenses of technology or
provision of services, particularly because we would be unable to go back to
customers to collect sales taxes for past sales and may have to pay such taxes
out of our own funds.

THE CONCENTRATION OF OWNERSHIP BY OUR AFFILIATED STOCKHOLDERS MAY DELAY OR
PREVENT ANY MERGER OR TAKEOVER OF THE COMPANY, WHICH MAY LIMIT THE AMOUNT OF
PREMIUM A STOCKHOLDER WOULD OTHERWISE OBTAIN ON HIS COMMON STOCK.

     Certain of our existing stockholders have significant influence over our
management and affairs, which they could exercise against your best interests.
As of September 30, 2002, our officers and directors, together with entities
that may be deemed affiliates of or related to such persons or entities,
beneficially owned nearly 30% of our outstanding common stock. As a result,
these stockholders, acting together, may be able to influence significantly our
management and affairs and matters requiring stockholder approval, including the
election of directors and approval of significant corporate transactions.
Accordingly, this concentration of ownership may have the effect of impeding a
merger, consolidation, takeover or other business consolidation involving us, or
discouraging a potential acquiror from making a tender offer for our shares.
This concentration of ownership could also adversely affect our stock's market
price or lessen any premium over market price that an acquiror might otherwise
pay.

PROVISIONS OF OUR CHARTER DOCUMENTS AND MARYLAND LAW COULD ALSO DISCOURAGE AN
ACQUISITION OF OUR COMPANY THAT WOULD BENEFIT OUR STOCKHOLDERS.

     Provisions of our articles of incorporation and by-laws may make it more
difficult for a third party to acquire control of our company, even if a change
in control would benefit our stockholders. Our articles of incorporation
authorize our board of directors, without stockholder approval, to issue one or
more series of preferred stock, which could have voting and conversion rights
that adversely affect or dilute the voting power of the holders of common stock.
Furthermore, our articles of incorporation provide for classified voting, which
means that our stockholders may vote upon the retention of only one or two of
our six directors each year. Moreover, Maryland corporate law restricts certain
business combination transactions with "interested stockholders."

Overview

In accordance with FAS 131 disclosure on segment reporting, the SEC's guidance
has been to present financial information in a format that is used by the
Company's management to make decisions. The Company is a leading provider of
professional rich media solutions with three primary revenue centers:

Desktop Software develops sophisticated software tools used by professionals and
hobbyists for the creation, editing and publishing of digital audio and video.
We currently focus our software efforts on the Sound Forge(R), ACID(TM), and
Vegas(R) Video platforms.

                                       19

<PAGE>
                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


Systems Software (formerly MediaSite) develops automated rich-media applications
and scalable solutions that allow media owners - including entertainment
companies, educational institutions, corporations and government organizations -
to deploy, manage, index and distribute video content on IP-based networks.

Services supplies media digitization, management and delivery solutions for
various industries, particularly the entertainment sector. These services
consist of conversion, reformatting and encoding of television, film and other
video content for multiple delivery platforms.

These three revenue centers, along with their respective production costs, are
analyzed independently from each other. However, because the majority of
operating expenses support all revenue centers, all items below gross margin are
analyzed on a combined basis.

Critical Accounting Policies

We have identified the following as critical accounting policies to our company
and have discussed the development, selection of estimates and the disclosure
regarding them with the audit committee of the board of directors: Revenue
recognition, sales returns, allowance for doubtful accounts and other credits;
Impairment of investments and Impairment of long-lived assets.

Revenue Recognition, Sales Returns, Allowance for Doubtful Accounts and Offer
Credits

We recognize revenue for licensing of software products upon shipment, net of
estimated returns, provided that collection is determined to be probable and no
significant obligations remain. Product revenue from distributors is subject to
agreements allowing limited rights of return, rebates, and price protection.
Accordingly, we reduce revenue recognized for estimated future returns, price
protection when given, and rebates at the time the related revenue is recorded
or promotion is offered. The estimates for returns are adjusted periodically
based upon historical rates of returns, inventory levels in the distribution
channel, and other related factors. The estimates and reserves for rebates and
price protection are based on historical rates. While management believes it can
make reliable estimates for these matters, nevertheless unsold products in these
distribution channels are exposed to rapid changes in consumer preferences or
technological obsolescence due to new operating environments, product updates or
competing products. Significant judgments and estimates must be made and used in
connection with establishing reserves for sales returns, price protection and
rebates in any accounting period. Material differences may result in the amount
and timing of our revenue for any period if we made different judgments or
utilized different estimates. During fiscal 2001, returns from software products
sold to consumer retail distributors were higher than historical rates incurred
in fiscal 2000 and 1999. In response to economic factors affecting the consumer
retail market, we began recording revenues to consumer retail distributors on a
consignment basis in September 2001.

Please refer to Note 1 of our Notes to Consolidated Financial Statements for
further information on our revenue recognition policies.

The preparation of our consolidated financial statements also requires us to
make estimates regarding the collectability of our accounts receivables. We
specifically analyze the age of accounts receivable and analyze historical bad
debts, customer concentrations, customer credit-worthiness and current economic
trends when evaluating the adequacy of the allowance for doubtful accounts.

Impairment of Investments

We periodically evaluate whether any estimated decline in the fair value of our
long-term investment is other-than-temporary. Significant judgments and
estimates must be made to assess the fair value of our investment and determine
whether an other-than-temporary decline in fair value of our investment has
occurred. This evaluation consists of a review of qualitative and quantitative
factors, review of publicly available information regarding the investee and
discussions with investee management. Since our investment is in a private
company with no quoted market price, we also consider the implied value from any
recent rounds of financing completed. Based upon an evaluation of the facts and
circumstances during the quarter ended June 30, 2002, we determined that our
investment had a significant decline in fair value and that we are unlikely to
recover most, if any, of our investment. Accordingly, we wrote off the entire
$514,000 balance.

                                       20

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


Impairment of long-lived assets

We assess the impairment of goodwill on an annual basis or whenever events or
changes in circumstances indicate that the fair value of the reporting unit to
which goodwill relates is less than the carrying value. Factors we consider
important which could trigger an impairment review include the following:

..  poor economic performance relative to historical or projected future
   operating results;

..  significant negative industry, economic or company specific trends;

..  changes in the manner of our use of the assets or the plans for our
   business; and

..  loss of key personnel

If we determine that the fair value of a reporting unit is less than its
carrying value including goodwill, based upon the annual test or the existence
of one or more of the above indicators of impairment, we would then measure
impairment based on a comparison of the implied fair value of reporting unit
goodwill with the carrying amount of goodwill. The implied fair value of
goodwill is determined by allocating the fair value of a reporting unit to its
assets (recognized and unrecognized) and liabilities in a manner similar to a
purchase price allocation. The residual fair value after this allocation is the
implied fair value of reporting unit goodwill. To the extent the carrying amount
of reporting unit goodwill is greater than the implied fair value of reporting
unit goodwill, we would record an impairment charge for the difference.

The Company evaluates all of its long-lived assets, including intangible assets
other than goodwill, for impairment in accordance with the provisions of SFAS
No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS
144 requires that long-lived assets and intangible assets other than goodwill be
evaluated for impairment whenever events or changes in circumstances indicate
that the carrying value of an asset may not be recoverable based on expected
undiscounted cash flows attributable to that asset. Should events indicate that
any of the Company's assets are impaired; the amount of such impairment will be
measured as the difference between the carrying value and the fair value of the
impaired asset and recorded in earnings during the period of such impairment.

RESULTS OF OPERATIONS

The following table has been presented to add clarification only and should be
read in conjunction with the audited financial statements. At the beginning of
fiscal 2001, the Company adopted EITF No. 00-14, "Accounting for Certain Sales
Incentives." For comparison purposes, cash rebates previously accounted for as a
marketing expense in 2000 have been reclassified as a reduction of software
license fees (See footnote 1, Accounting Pronouncements).

<TABLE>
<CAPTION>
                                                                      For the Years Ended September 30,
                                                    -------------------------------------------------------------------
                                                            2002                    2001                     2000
                                                            ----                    ----                     ----
<S>                                                 <C>          <C>         <C>           <C>        <C>          <C>
Desktop software license fees                       $15,898      100%        $15,550       100%       $21,455      100%
Cost of desktop software license fees                 2,991       19           5,187        33          5,493       26
                                                    -------      ---         -------       ---        -------      ---
Gross margin - desktop software license fees        $12,907       81%        $10,363        67%       $15,962       74%

Systems software license fees                          $859      100%              -         -              -        -
Cost of systems software license fees                   380       44               -         -              -        -
                                                    -------      ---         -------       ---        -------      ---
Gross margin - systems software license fees        $   479       56%              -         -              -        -


Media services                                      $ 9,399      100%        $10,734       100%       $ 4,852      100%
Cost of media services                                7,214       77           7,733        72          5,177      107
                                                    -------      ---         -------       ---        -------      ---
Gross margin - media services                       $ 2,185       23%        $ 3,001        28%       $  (325)      (7)%
                                                    -------                  -------                  -------
Total Net Revenue                                   $26,156                  $26,284                  $26,307
                                                    =======                  =======                  =======
</TABLE>


               Year ended September 30, 2002 ("2002") compared to
                   the year ended September 30, 2001 ("2001")

                                       21

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


Total net revenues decreased by $128 to $26,156 in 2002 from $26,284 in 2001.
Increased contributions from the traditional desktop segment of $348 and
contributions from the new systems software segment of $859 nearly offset a
decline in services revenues of ($1,335).

           2001 compared to the year ended September 30, 2000 ("2000")

Total net revenues remained relatively unchanged, decreasing by $23 to $26,284
in 2001 from $26,307 in 2000. Although total revenues remained flat, the
contribution from the two segments changed significantly. In 2000, sales from
desktop software license fees contributed 82% to total revenues while the media
services division contributed 18%. 2000 media services revenue, however, only
include revenue contributed from the former STV Communications, Inc. ("STV") and
International Image, Inc. ("II") since the effective dates of acquisition (See
footnote 12).

Revenue from Desktop Software License Fees

Software License Fees in the Statement of Operations include both desktop and
systems software.

Revenues from desktop software license fees consist of fees charged for the
licensing of Windows based software products. The Company's primary focus is on
the platforms of ACID(R), Sound Forge(R) and Vegas(R) Video. These software
products are marketed to both consumers and producers of digital media. We reach
both our domestic and international markets through traditional retail
distribution channels, our direct sales effort and OEM partnerships.

                              2002 Compared to 2001

Revenue from desktop software license fees increased $348 or 2%, from 2001 to
2002. The net change resulted from the following items:

     .  Sales of Vegas Video (version 3 released in November 2001) grew by
        $1.7 million in 2002. A new release of Vegas Video is due out in early
        2003.

     .  Acid and Acid Loop sales declined $694. The decline is primarily due
        to the timing of new releases. In 2001, Acid sales benefited from two
        strong quarters ($2.8 million) after the release of Acid 3.0. In
        August and September the newly released version 4.0 drove Acid sales
        to $2.2 million. We expect that version 4.0's strong performance will
        extend into 2003, and that, eventually, sales from version 4.0 will
        exceed those of version 3.0.

     .  Sound Forge and Sound Forge Studio approximated $5.0 million for both
        years. Sound Forge sales had little variance from year to year, while
        Studio revenues grew by $300k.

     .  An additional contributor to 2002 sales was an OEM bundling
        arrangement with Sony. This arrangement netted $400 in Q3-2002. The
        arrangement is not expected to net significant additional revenues in
        future periods.

     .  The remainder of the year-to-year change is attributable to Siren,
        Vegas Audio, and other products that were not actively promoted in
        2002.

                              2001 compared to 2000

Revenue from desktop software license fees decreased $5,905 or 28%, from 2000 to
2001. The net change resulted from the following items:

     .  Sales of Acid decreased nearly $4 million due to the expiration of a
        significant OEM arrangement with Hewlett Packard and withdrawal from
        consumer retail.

     .  Acid Loop sales increased $500 due to a strong load in to the
        professional retail channel.

     .  Sound Forge and Sound Forge Studio grew
        $1.5 million with the much anticipated release of version 5.0 o Siren
        sales decreased by $1.8 million due to withdrawal from consumer retail
        and the decision to cease development of further versions.

     .  Vegas Video and Vegas Audio sales declined by $1.1 million due to a
        reduced retail presence.

     .  Customized software engineering for Sony decreased by $500


Gross Margin from Desktop Software License Fees

                                       22

<PAGE>

                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002

                              2002 Compared to 2001

Included in costs of software license fees are product material costs, assembly
labor, freight, royalties on third party technology or intellectual content, and
amortization of previously capitalized product development and localization
costs.

Despite only slight growth in revenue, gross margin for desktop software
improved over $2.5 million in 2002. Gross margin for this segment equaled 81% of
software license fees in 2002 versus 67% in 2001. The following items
contributed to the marked improvement in desktop software gross margins:

     .    A reduction in material costs associated with an increase in the
          number of electronic downloads. Download sales were 26% of desktop
          software sales in 2002 and 22% in 2001.
     .    A reduction in obsolescence and scrap due to lower inventory levels.
          2001 had significant charges related to the exit from lower priced
          consumer products and the consumer channel.
     .    A shift toward higher priced professional products from lower (less
          than 50%) margin consumer products. Vegas Video, which was nearly 15%
          of desktop software revenues in 2002, has margins over 90%.

We anticipate that software margins will continue to exceed 80% in the
foreseeable future.

                              2001 compared to 2000

Gross margin for desktop software decreased from 74% in 2000 to 67% in 2001. The
two significant issue contributing to the decline were:

     .    Revenues from high margin OEM partners declined $4.0 million. The most
          significant OEM relationship was an agreement with Hewlett Packard
          that bundled Acid with CD-Roms. There are virtually no material or
          labor costs associated with OEM revenue.
     .    In early 2001, weak consumer sales and new product introductions
          resulted in increased obsolete and slow-moving inventory that was
          written off.

Revenue from Systems Software

Revenue from our Systems software division, established upon the acquisition of
MediaSite, consist of fees charged for the licensing of software products and
custom software development. The primary focus is on the platforms of MediaSite
Publisher(TM) and MediaSite Live(TM). These software products are marketed to
government agencies, educational institutions, and corporations who need to
deploy, manage, index and distribute video content on IP-based networks. We
reach both our domestic and international markets through reseller networks, a
direct sales effort and partnerships with system Integrators.

System software revenues in 2002 amounted to $859. The revenues can be segmented
as follows:

     .    MediaSite Publisher sales were $368 for 2002. Over half of the
          Publisher revenues represent what we believe to be the first stage of
          a relationship with a system integrator selling to a unit of the
          Federal Government, from which may generate additional license and
          support revenues in the future.
     .    MediaSite Live, which was completed in mid-June 2002, experienced
          sales of $206 in 2002.
     .    Custom development for a Federal agency accounted for $252 of revenue.
          This contract was completed in May 2002. Total Federal government
          system software revenue totaled $538 in 2002.

In Q4-2002, no revenues were recorded for either Publisher or custom
development. Although we continue to offer those products and services, we have
shifted most of this segment's focus to the Media Site Live product and expect
that product to drive future growth.

                       Gross Margin from Systems Software

The significant components of cost of systems include: o A 5% royalty on sales
of MediaSite Publisher's technology.

     .    Cost of hardware that is bundled with MediaSite Live. Live sales
          should typically result in gross margins of approximately 60% - 70%.
     .    Amortization of MediaSite acquisition amounts assigned to purchased
          technology and other identified intangibles. We

                                       23

<PAGE>

                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002

          will be amortizing approximately $100 per quarter over the next 5
          years for the identified intangibles of the MediaSite purchase.

Revenue from Media Services

Revenue from services includes tape duplication for broadcast distribution,
broadcast standard conversions, audio and video encoding, as well as fees for
consulting and development services.

                              2002 Compared to 2001

Revenue from services declined $1,335 or 12%, from 2001 to 2002. We believe a
decline in advertising income of entertainment companies led to decreased demand
for our traditional duplication and conversion services. Traditional services
declined approximately $1,800 while Digital Restoration and High Definition
services rose by $500. A decrease in encoding revenues of $375 also contributed
to the overall decline. The new Mediaworks offering (including the acquired
MediaTaxi technology) accounted for approximately $120 during 2002.

                              2001 Compared to 2000

Revenue from media services increased $5,882, or 121%, from 2000 to 2001.
However, 2000 media services revenue only includes revenue contributed from STV
since April 2000 and from II since June 2000. On a quarterly comparison, Q4-2001
revenues decreased $282 to $2,541 from $2,823 in Q4-2000. The collapse of the
dot.com encoding industry at the beginning of fiscal 2001 as well as revenue
from a one-time consulting arrangement in Q4-2000 contributed to the decrease.
Revenues from II's traditional conversion and duplication services increased 22%
from Q4-2000 to Q4-2001.

Gross Margin from Media Services

Costs of services include compensation, benefits and other expenses associated
with production personnel, videotape costs and an allocation for general and
administrative expenses such as facility costs. These costs have become
relatively stable and fixed in dollars since Q3-2001 and we do not anticipate
major changes in the near future. Future fluctuations in gross margin will
result primarily from changes in revenue because: 1) these costs should remain
relatively fixed going forward; and 2) newer offerings, such as MediaTaxi and
MediaDub, are lower cost procedures dependent on software code rather than
headcount.

Gross margin from services decreased from 28% in 2001 to 23% in 2002. The
decline relates to the revenue decreases discussed above and demonstrates the
fixed nature, primarily labor costs and equipment depreciation, of our cost of
services. 2002 also included $80 of amortization of MediaTaxi technology
acquired in February.

                              2001 Compared to 2000

Gross margin from media services improved significantly to 28% in 2001 from (7)%
in 2000. While revenue from media services increased 121% from 2000 to 2001,
costs of media services only increased 49%. The improvement in gross margin
resulted from the Q1-2001 elimination of duplicate positions, operational and
process improvements, a switch to a temporary labor force for encoding services
and a reduction in depreciation expense in Q3-2001 due to the write-off and
disposal of underutilized leased assets no longer needed for the business.

Operating Expenses

The following chart is provided to add clarification by presenting items as a
percentage of total revenues. This should be read in conjunction with the
audited financial statements.

                                       24

<PAGE>

                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


<TABLE>
<CAPTION>
                                                     For the years ended September 30,
                                                     ---------------------------------
                                                     2002          2001           2000
                                                     ----          ----           ----
<S>                                                  <C>           <C>            <C>
Total revenues                                        100%          100%           100%
Cost of revenues                                       40            49             41
                                                      ---           ---            ---
    Gross margin                                       60            51             59
Operating expenses
Selling and marketing expenses                         34            48             72
General and administrative expenses                    27            39             38
Product development expenses                           27            30             30
                                                      ---           ---            ---
                                                       88           117            140
Restructuring and other charges                         -            19              4
Amortization of goodwill and other purchase
  Intangibles                                           -           104             54
                                                        -           ---            ---
  Total operating expenses                             88           240            198
                                                      ---           ---            ---
  Loss from operations                                (28)%        (189)%         (138)%
                                                      ===           ===            ===
</TABLE>

Selling and Marketing Expenses

Selling and marketing expenses include: wages and commissions for sales,
marketing, business development and technical support personnel; our direct mail
catalog; print advertising and various promotional expenses for both our
software products and services. Timing of these costs may vary greatly depending
on introduction of new products and services or entrance into new markets.

                              2002 compared to 2001

Selling and marketing expenses decreased by $3,751, or 30%, to $8,803 in 2002
from $12,554 in 2001. This decrease is primarily the result of our December 2000
restructuring which included the following key actions:

     .    2001 $1.0 million write-off of prepaid advertising related to a 2000
          equity issuance
     .    Reduction in retail advertising ($2.0 million reduction in 2002)
     .    Significant staff reductions sales, services business development,
          marketing and customer service ($900 reduction in 2002)
     .    Decline in tradeshow expenses, outsourced customer service, and
          catalog expenses ($1.4 million reduction in 2002). Over the past year
          we have built a larger database of names and no longer have to rent as
          many lists for our catalog campaigns.

The above savings were offset by over $2.5 million of sales costs (primarily
salaries, travel, and public relation efforts) of the new systems division.

                              2001 compared to 2000

Selling and marketing expenses decreased by $7,268 or 37%, to $12,554 in 2001
from $19,822 in 2000. The decrease was the result of:

     .    Reductions in advertising, staff, and other expenses related to the
          December 2000 restructuring.
     .    A greater percentage of revenues coming from the media services
          division, which requires less expensive, more targeted forms of
          marketing.
     .    A reduced focus on more costly brand marketing such as tradeshows and
          media advertising.

General and Administrative Expenses ("G&A expenses")

General and administrative ("G&A") expenses consist of personnel and related
costs associated with the facilities, finance, legal, human resource and
information technology departments, as well as other expenses not fully
allocated to functional areas.

                              2002 compared to 2001

G&A expenses decreased by $3,174, or 31%, from $10,153 in 2001 to $6,979 in
2002. The reduction is due to the elimination of non-recurring, integration
related expenses and elements of the Q1-2001 restructuring plan which included
the removal of duplicate personnel functions and the consolidation of
facilities. $1.9 million of the year to year decrease occurred in Q1. In
addition, bad debt expense decreased by $800. Approximately $600 of the decline
related to a salary waiver program for executives that began in December 2001
(under the terms of the salary waiver program, certain executives waived salary
in exchange for stock options).

                                       25

<PAGE>

                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


                              2001 compared to 2000

G&A expenses increased slightly by $171, or 2%, to $10,153 in 2001 from $9,982
in 2000. The elimination of non-recurring, acquisition related expenses and
elements of the December 2000 restructuring plan, including removal of duplicate
functions through staff reductions and consolidation of facilities greatly
improved our efficiencies in 2001. The impact resulted in a decrease in Q1 G&A
from $3.9 million to $2.2 million in Q4 or 39%. These improvements partially
offset a $995 increase in bad debt expense. $780 of the increase is attributable
to the software division with 52% relating to the termination of a relationship
with one of our distributors. Bad debt expense from the media services division
comprised the remaining $213 with three customers contributing 51% of the
increase.

Product Development Expenses ("R&D expenses")

Product development expenses include salaries and wages of the software research
and development staff and an allocation of benefits, facility and administrative
expenses. Fluctuations in product development expenses correlate directly to
changes in headcount.

In accordance with SFAS Number 86, the Company capitalizes the cost of
development of software products that have reached technological feasibility. No
development costs for our core product line were capitalized during 2000, 2001
or 2002; however, portions of the MediaSite ($1.4 million in 2002, amortized
over 5 years), MediaTaxi ($240 in 2002, amortized over 2 years), and the Jedor
($240 in 2000) acquisitions were allocated to capitalized software development.

Going forward we believe software development costs qualifying for
capitalization will continue to be insignificant, and, as such, we expect that
we will expense most or all research and development costs as incurred.

                             2002 compared to 2001

R&D expenses decreased $755, or 9%, from $7,986 in 2001 to $7,231 in 2002. The
decrease resulting from the company-wide restructuring in December 2000 well
exceeded the 2002 addition of MediaSite developers. Headcount at the beginning
of the December 2000 quarter was over 100. Current headcount is just under 60.
As part of the restructuring, we eliminated low volume, niche products such as
Soft Encode as well as the engineering positions required to maintain these
products.

                              2001 compared to 2000

R&D expenses remained relatively unchanged, increasing $118, or 1%, from $7,868
in 2000 to $7,986 in 2001. As a percentage of total revenue, R&D expenses also
remained unchanged at 30% for both 2001 and 2000. Many of the positions
eliminated in December 2000 had been added in 2000.

Restructuring and Other Charges

As outlined in footnote 15 to the audited financial statements included in this
report, restructuring charges of $4,973 were recorded in 2001. Consistent with
management's plan to reduce costs in response to weak market conditions, the
restructuring charge primarily consisted of: 1) an accrual for 60 days of
severance and benefits for domestic employees terminated on December 20, 2000 as
well as severance and other expenses associated with closing our office in the
Netherlands; 2) an asset impairment charge related to the sale, disposal or
write-down of PCs, office equipment and other assets no longer required; 3)
operating and lease termination costs related to the consolidation of
facilities; and 4) miscellaneous charges such as forfeited tradeshow deposits.
The restructuring significantly reduced certain expenses as discussed in the
Gross Margin, Sales, G&A, and Product development sections above.

At September 30, 2002 the remaining balance in the restructuring accrual
-entirely related to rent - was $93. This balance includes a 2002 charge of $60
which anticipates future rent costs above and beyond the original accrual. The
lease related to the accrued rent expires in Feb 2003.

Other Income (Expense)

The increase in interest expense was due to the subordinated debt issuance in
February 2002. (See note 4 to the consolidated financial statements). In
addition, other expense included $535 of losses on asset disposals, a $514 loss
on the write-off of long-

                                       26

<PAGE>

                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


term investment, and a $238 gain on the settlement of debt.

Cumulative Effect of Changes in Accounting Principle, Amortization of Goodwill
and Other Purchase Intangibles

Effective October 2001, the Company adopted Financial Accounting Standards Board
("SFAS") No. 142, "Goodwill and Other Intangible Assets." Under the new rules,
the Company ceased the amortization of goodwill associated with the services
reporting unit, which included the acquisitions of STV Communications and
International Image. Implementation of the new rules also requires an assessment
of the carrying value of goodwill using a number of criteria, including the
value of the overall enterprise as of October 1, 2001. The Company retained an
independent appraisal firm to assist in the assessment, which resulted in a
$44,732 write off of the entire remaining value of goodwill associated with the
services reporting unit. Future impairment charges, if any, associated with
MediaSite or other acquisitions will be reflected as an operating expense in the
statement of operations.

The 2001 and 2000 amortization of goodwill and other purchase intangibles
consisted of expense associated with the purchases of STV and II. Total
purchased intangibles consisted of assembled workforce of $3,200, amortized over
one to five-years and goodwill of $82,900, amortized over a three to seven year
period. In the quarter ended December 31, 2000 we received a final appraisal of
II's fixed assets and, as a result, reclassified $1,200 of the purchase price
from goodwill to fixed assets. In April 2001, we paid $500 in full settlement of
a $700 note due the minority shareholders of II, which resulted in a reduction
of goodwill.

                                       27

<PAGE>

                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


LIQUIDITY AND CAPITAL RESOURCES

We have funded our operations to date primarily from public and private
placement offerings of equity securities, debt and cash flows from operations.
For the years ended September 30, 2002, 2001 and 2000, we had cash and cash
equivalents of $3,704, $7,809, and $21,948. The higher cash balance in 2000 was
due to proceeds of $53,995 raised from the exercise of common stock warrants and
the issuance of common stock through private placements.

                              2002 compared to 2001

Cash used in operating activities totaled $4,883 in 2002 compared to $10,197 in
2001. The change related to a $6,680 improvement in operating expenses,
excluding 2001 restructuring charges, amortization, and write-off of prepaid
Internet advertising. This improvement was offset slightly by payment of
liabilities assumed in the MediaSite transaction.

Cash used in investing activities totaled $1,693 in 2002 compared to $2,023 in
2001. Investing activities in both years relate to fixed asset and acquisition
related outflows. 2001 also included $1.2 million of proceeds from the sale of
underutilized assets.

In 2002, net cash provided by financing activities was $2,595 compared to net
cash used in 2001 financing activities of $2,025. The most significant
occurrences of 2002 were $6,535 of net proceeds from subordinated debt and
$2,357 of payments to settle the remaining $3.3 million of notes (plus accrued
interest) related to the II acquisition. The settlement also included 500,000
shares of stock valued at $660 thousand. The difference between the principal
and accrued interest balance and the settlement cost was recorded as a gain, net
of certain legal and settlement costs. In addition, in 2002, we also incurred
$248 of debt related to a one-time deferred compensation plan.

                              2001 compared to 2000

Cash used in operating activities totaled $10,197 in 2001 compared to $19,008 in
2000. Decreased use of operating cash of $8,811 from 2000 to 2001 consisted
primarily of operating cost reductions identified in the Q1-2001 restructuring.
The following items contributed to the decrease:

     .    Selling and marketing expenses declined $7,268 from 2000 to 2001. This
          decline is attributable to a reduction in personnel and a
          significantly lesser focus on expensive brand marketing such as
          tradeshows and media advertising. This reduction also helped drive the
          $2,860 reduction in accounts payable and accrued liabilities.

     .    Trade receivables declined $5,010 from 2000 to 2001. The entire
          decline is related to the software division and reflects the continued
          switch in channel mix away from retail, in which customers are granted
          terms, to the direct channel, in which credit card payments are
          processed within three days.

     .    Inventory balances declined $788 from 2000 to 2001. This decline is
          directly related to the increase in electronic delivery of our
          software products and the reduction in retail business.

Cash used in investing activities totaled $2,023 in 2001 compared to $18,125 in
2000. Investing activities in both years related to the acquisition of STV and
II, fixed asset purchases primarily for our media services division, and the
sale of underutilized assets. Also in 2000, we recognized a $600 gain on shares
we sold from an investment in a high speed networking company. The acquisition
activities in 2001 relate to legal, accounting and other professional fees
accrued in 2000 for the II acquisition and paid in 2001.

In 2001, cash used in financing activities was $2,025 compared to $53,192
provided by financing activities in 2000. The most significant change between
the two years was the $53,995 raised in 2000 from equity compared to only $317
in 2001. The majority of the $2,546 increase in debt and capital lease payments
from 2000 to 2001 relates to lease financing for media services equipment
obtained in the STV transaction. Also impacting 2001 was $436 in proceeds
received from a term loan from a bank in Toronto and a draw of $571 on our line
of credit from the same bank, which was subsequently paid back in October 2001.

                     Recent Developments Impacting Liquidity

In May 2002 we began making quarterly interest payments of approximately $175 on
the subordinated debt, which will continue on the then outstanding balance
through the date of maturity. Monthly principal payments of approximately $330
began in August 2002.

                                       28

<PAGE>

                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


In July of 2002, we initiated discussions with a majority of the debt holders to
amend the terms of their respective note agreements to reduce or defer the
amount of monthly principal payments required. In December 2002, the Company and
noteholders representing $4.75 million of the original $7.1 million of notes
agreed to defer a portion of previously due and unpaid principal payments as
well as future monthly note payments through January 20, 2003. In return, the
Company agreed, among other things, to provide the noteholders with a second
security interest in all assets of the Company and to increase the interest rate
from 10% to 12%.

In November 2002 the Company completed a bridge financing transaction of $1.0
million with the brother of Rimas Buinevicius, Chief Executive Officer. Mr.
Buinevicius abstained from board of director discussion regarding approval of
the transaction. The note is backed by substantially all the assets of the
company and is due, along with $250 thousand of interest, at the earlier of
March 2003 or upon completion of a transaction generating sufficient cash to
allow for payment.

The Company recently determined that operations of our desktop software and
services business would not provide sufficient cash flow along with our existing
cash reserves to fund planned growth of the systems division and make remaining
subordinated debt payments. In response, the Company retained an advisor to
evaluate the sale of certain operating assets. As of the reporting date, the
Company has received multiple non-binding offers from qualified bidders and we
anticipate closing one or more transactions in early 2003. Such a transaction is
expected to provide the Company with sufficient resources to:

     .    Retire the remaining balance due subordinated debt holders

     .    Retire the additional $1.0 million bridge note

     .    Restructure the Company and aggressively pursue a focused strategy of
          growing the remaining business.

There can be no assurances the Company will reach an agreement to sell certain
assets nor that any such agreement will be completed on terms favorable to the
Company or timely enough to avoid disruption of operations.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Derivative Financial Instruments

The Company is not party to any derivative financial instruments or other
financial instruments for which the fair value disclosure would be required
under SFAS No. 107, "Derivative Financial Instruments, Other Financial
Instruments and Derivative Commodity Instruments." The Company's cash
equivalents consist of overnight investments in money market funds that are
carried at fair value. Accordingly, we believe that the market risk of such
investments is minimal.

Interest Rate Risk

The Company's cash equivalents are subject to interest rate fluctuations,
however, we believe this risk is immaterial due to the short-term nature of
these investments.

Foreign Currency Exchange Rate Risk

All international sales of our software products are denominated in US dollars.
However, the majority of transactions for our media services division in Toronto
are denominated in Canadian dollars. Although these transactions are not
generally subject to significant foreign exchange rate gains and losses, they
are translated into US dollars as part of our consolidated financial statements
and therefore fluctuations in the exchange rate will affect our consolidated
financial statements. The Canadian dollar has been stable relative to the US
dollar and we have not engaged in any foreign currency hedging activities.

                                       29

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Report of Ernst & Young LLP, Independent Auditors

The Board of Directors and Stockholders Sonic Foundry, Inc.

We have audited the accompanying consolidated balance sheets of Sonic Foundry,
Inc. (the Company) as of September 30, 2002 and 2001, and the related
consolidated statements of operations, stockholders' equity and cash flows for
the years ended September 30, 2002, 2001, and 2000. Our audits also included the
financial statement schedule listed in the index at Item 14(a). The financial
statements and schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of the Company at
September 30, 2002 and 2001 and the consolidated results of its operations and
its cash flows for the years ended September 30, 2002, 2001, and 2000, in
conformity with accounting principles generally accepted in the United States.
Also, in our opinion, the related financial statement schedule, when considered
in relation to the basic financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.

The accompanying financial statements have been prepared assuming the Company
will continue as a going concern. As more fully described in Note 2, the Company
has a working capital deficiency. In addition, the Company's convertible debt is
a current obligation and the Company does not have long-term credit
availability. These conditions raise substantial doubt about the Company's
ability to continue as a going concern. Management's plans in regard to these
matters are also described in Note 2. The financial statements do not include
any adjustments to reflect the possible future effects on the recoverability and
classification of assets or the amounts and classification of liabilities that
may result from the outcome of this uncertainty.


                                ERNST & YOUNG LLP

Milwaukee, Wisconsin
November 9, 2002, except Note 4 and Note
16 as to which the date is December 17, 2002

                                       30

<PAGE>

                               Sonic Foundry, Inc.
                           Consolidated Balance Sheets
                      (in thousands except for share data)

<TABLE>
<CAPTION>
                                                                      September 30,
                                                                      -------------
                                                                    2002        2001
                                                                    ----        ----
<S>                                                               <C>         <C>
Assets
Current assets:
   Cash and cash equivalents                                      $ 3,704     $ 7,809
   Accounts receivable, net of allowances of $729 and $1,075        3,886       4,065
   Accounts receivable, other                                          89          26
   Inventories                                                        362       1,118
   Prepaid expenses and other current assets                          619       1,085
                                                                  -------     -------
      Total current assets                                          8,660      14,103

Property and equipment:
   Buildings and improvements                                       2,450       2,409
   Equipment                                                       13,263      13,823
   Furniture and fixtures                                             567         542
   Assets held for sale                                                            40
                                                                  -------     -------
     Total property and equipment                                  16,280      16,814
     Less accumulated depreciation                                  7,584       5,010
                                                                  -------     -------
        Net property and equipment                                  8,696      11,804
Other assets:
   Goodwill and other intangibles, net                              8,255      44,732
   Capitalized software development costs, net                      1,333          73
   Long-term investment                                                 -         514
   Debt issuance costs, net of $323 of amortization                   653           -
   Other assets                                                        46         457
                                                                 --------     -------
     Total other assets                                            10,287      45,776
                                                                 --------     -------
Total assets                                                     $ 27,643     $71,683
                                                                 ========     =======
</TABLE>

See accompanying notes


                                       31

<PAGE>

                               Sonic Foundry, Inc.
                           Consolidated Balance Sheets
                      (in thousands except for share data)


<TABLE>
<CAPTION>
                                                                                     September 30,
                                                                                   -----------------
                                                                                   2002         2001
                                                                                   ----         ----
<S>                                                                              <C>           <C>
Liabilities and stockholders' equity
Current liabilities:
   Accounts payable                                                              $ 3,035       $ 2,316
   Unearned revenue                                                                   62            83
   Accrued liabilities                                                             1,090         1,719
   Accrued restructuring charges                                                      93           345
   Current portion of long-term debt                                                 574         4,003
   Convertible debt, net of discount                                               3,482            --
   Current portion of capital lease obligations                                      820         1,216
                                                                                --------       -------
   Total current liabilities                                                       9,156         9,682

   Long-term obligations, net of current portion                                     323           217
   Capital lease obligations, net of current portion                                  64           525
   Other liabilities                                                                 116            28

Stockholders' equity:
   Preferred stock, $.01 par value, authorized 5,000,000
      shares; none issued and outstanding                                             --            --
   5% preferred stock, Series B, voting, cumulative,
      convertible, $.01 par value (liquidation preference at
      par), authorized 10,000,000 shares, none issued and
      outstanding                                                                     --            --
   Common stock, $.01 par value, authorized 100,000,000
      shares; 27,729,825 and 22,345,503 issued and 27,702,075 and 22,317,753
      outstanding at September 30, 2002 and 2001                                     277           223
   Common stock to be issued                                                          --         5,375
   Additional paid-in capital                                                    167,028       148,188
   Accumulated deficit                                                          (148,985)      (92,248)
   Receivable for common stock issued                                                (26)          (34)
   Cumulative foreign currency translations                                         (111)            7
   Unearned compensation                                                             (49)         (130)
   Treasury stock, at cost, 27,750 shares                                           (150)         (150)
                                                                                --------       -------
     Total stockholders' equity                                                   17,984        61,231
                                                                                --------       -------
Total liabilities and stockholders' equity                                      $ 27,643       $71,683
                                                                                ========       =======
</TABLE>

See accompanying notes

                                       32

<PAGE>
                               Sonic Foundry, Inc.
                      Consolidated Statements of Operations
                    (in thousands except for per share data)

<TABLE>
<CAPTION>
                                                                        Years Ended September 30,
                                                                        -------------------------
                                                                    2002           2001            2000
                                                                    ----           ----            ----
<S>                                                               <C>            <C>             <C>
Revenue:
Software license fees                                             $16,757        $ 15,550        $ 21,455
Media services                                                      9,399          10,734           4,852
                                                                  -------        --------        --------
     Total revenue                                                 26,156          26,284          26,307
Cost of revenue:

Cost of software license fees                                       3,371           5,187           5,493
Cost of media services                                              7,214           7,733           5,177
                                                                  -------        --------        --------
     Total cost of revenue                                         10,585          12,920          10,670
                                                                  -------        --------        --------

Gross margin                                                       15,571          13,364          15,637

Operating expenses:

Selling and marketing expenses                                      8,803          12,554          19,822
General and administrative expenses                                 6,979          10,153           9,982
Product development expenses                                        7,231           7,986           7,868
Restructuring charges                                                  --           4,973              --
Amortization of goodwill and
   other intangibles                                                   --          27,478          14,300
                                                                  -------         -------        --------
     Total operating expense                                       23,013          63,144          51,972
                                                                  -------         -------        --------
Loss from operations                                               (7,442)        (49,780)        (36,335)

Other income (expense):                                              (606)           (515)           (618)
Interest expense
Non-cash interest expense                                          (3,409)             --              --
Interest and other income                                            (536)            435           2,031
                                                                  -------         -------         -------
     Total other income (expense)
                                                                   (4,551)            (80)          1,413
                                                                  -------         -------         -------
Loss before income taxes and cumulative effect of change in
   accounting principle                                           (11,993)        (49,860)        (34,922)
Income Taxes                                                          (12)             --              --
                                                                  -------         -------         -------
Loss before cumulative effect of change in accounting principle   (12,005)        (49,860)        (34,922)

Cumulative effect of change in accounting principle               (44,732)             --              --
                                                                 --------        --------        --------
Net loss                                                         $(56,737)       $(49,860)       $(34,922)
                                                                 ========        ========        ========

Loss per common share:
Loss before cumulative effect of change in accounting principle  $   (.45)       $  (2.25)       $  (1.89)
Cumulative effect of change in accounting principle                 (1.67)             --              --
                                                                 --------        --------        --------
Net loss per common share -basic and diluted                     $  (2.12)       $  (2.25)       $  (1.89)
                                                                 ========        ========        ========
</TABLE>

See accompanying notes

                                       33

<PAGE>
                               Sonic Foundry, Inc.
                 Consolidated Statements of Stockholders' Equity
              For the Years Ended September 30, 2002, 2001 and 2000
                                 (in thousands)
<TABLE>
<CAPTION>
                                                                                                       Receiv-
                                                                                                        ables
                                                   Common               Addi-                            for
                               Preferred           stock                tional    Accumu-    Currency  common   Unearned
                               series B   Common   to be    Treasury   paid-in     lated     transla-   stock    compen-
                                 stock    stock    issued    stock     capital    deficit      tions   issued    sation     Total
-----------------------------------------------------------------------------------------------------------------------------------
<S>                            <C>        <C>     <C>       <C>       <C>        <C>         <C>       <C>      <C>       <C>
Balance, September 30, 1999        -        130         -        -      16,283      (7,466)       -        -       (200)     8,747
Issuance of common stock           -         18         -        -      41,164           -        -        -          -     41,182
Issuance of common stock
   warrants and options            -          -         -        -         830           -        -        -          -        830
Issuance of stock and stock
  options for acquisitions         -         22     5,579        -      74,079           -        -        -     (5,307)    74,373
Exercise of common stock
  warrants and options             -         39         -        -      15,374           -        -      (72)         -     15,341
Conversion of subordinated
  debt to common stock             -         10         -        -       4,208           -        -        -          -      4,218
Amortization of unearned
  compensation and
  adjustments related to
  employee terminations            -          -         -     (150)     (3,648)          -        -        -      4,258        460
Comprehensive loss:
  Net loss                         -          -         -                          (34,922)       -        -          -    (34,922)
  Foreign currency
     translation adjustments       -          -         -        -           -           -      137        -          -        137
-----------------------------------------------------------------------------------------------------------------------------------
Comprehensive loss                 -          -         -        -           -     (34,922)     137        -          -    (34,785)
-----------------------------------------------------------------------------------------------------------------------------------
Balance, September 30, 2000        -        219     5,579     (150)    148,290     (42,388)     137      (72)    (1,249)   110,366
Issuance of common stock           -          2         -        -         214           -        -        -          -        216
Issuance of common stock
  warrants and options             -          -         -        -         635           -        -        -       (616)        19
Exercise of common stock
  warrants and options             -          2         -        -          99           -        -        4          -        105
Conversion of exchangeable
  stock to common stock            -          -      (204)       -         204           -        -        -          -          -
Amortization of unearned
  compensation and
  adjustment related to
  employee terminations            -          -         -        -      (1,249)          -        -        -      1,735        486
Rescission of option exercise
  and subsequent reissuance        -          -         -        -          (5)          -        -       34          -         29
Comprehensive loss:
  Net loss                         -          -         -        -           -     (49,860)       -        -          -    (49,860)
  Foreign currency
     translation adjustments       -          -         -        -           -           -     (130)       -          -       (130)
-----------------------------------------------------------------------------------------------------------------------------------
Comprehensive loss                 -          -         -        -           -     (49,860)    (130)       -          -    (49,990)
-----------------------------------------------------------------------------------------------------------------------------------
Balance, September 30, 2001       $-       $223   $ 5,375    $(150)   $148,188   $ (92,248)   $   7     $(34)   $  (130)  $ 61,231
Issuance of common stock           -          6         -        -         808           -        -        -          -        814
Issuance of common stock
  warrants with convertible
  debt                             -          -         -        -       6,707           -        -        -          -      6,707
Issuance of common stock
  warrants and options             -          -         -        -         205           -        -        -        (98)       107
Issuance of stock, stock
  options and stock warrants
  for acquisitions                 -         42         -        -       5,640           -        -        -          -      5,682
Exercise of common stock
  warrants and options             -          1         -        -         110           -        -        8          -        119
Conversion of exchangeable
  stock to common stock            -          5    (5,375)       -       5,370           -        -        -          -          -
Amortization of unearned
  compensation                     -          -         -        -           -           -        -        -        179        179
Comprehensive loss:
  Net loss                         -          -         -        -           -     (56,737)       -        -          -    (56,737)
  Foreign currency
     translation adjustments       -          -         -        -           -           -     (118)       -          -       (118)
-----------------------------------------------------------------------------------------------------------------------------------
Comprehensive loss                 -          -         -        -           -     (56,737)    (118)       -          -    (56,855)
-----------------------------------------------------------------------------------------------------------------------------------
Balance, September 30, 2002       $-       $277   $     -    $(150)   $167,028   $(148,985)   $(111)    $(26)   $   (49)  $ 17,984
===================================================================================================================================
</TABLE>

                                       34

<PAGE>

                               Sonic Foundry, Inc.
                      Consolidated Statements of Cash Flows
                                 (in thousands)

<TABLE>
<CAPTION>
                                                                                          Years Ended September 30,
                                                                                         ---------------------------
                                                                                         2002        2001       2000
                                                                                         ----        ----       ----
<S>                                                                                    <C>         <C>        <C>
Operating activities

Net loss                                                                               $(56,737)   $(49,860)  $(34,922)
Adjustments to reconcile net loss to net cash used in operating activities:
  Cumulative effect of change in accounting principle                                    44,732          --         --
  Amortization of goodwill, other intangibles, and capitalized software development
    costs                                                                                   417      27,923     14,068
  Depreciation and amortization of property and equipment                                 3,614       3,726      2,684
  Amortization of debt discount and debt issuance costs                                   3,409          --        164
  Non-cash compensation charges and charges for stock warrants and options                  291         635      1,260
  Non-cash advertising charge                                                                --       1,000      1,500
  Non-cash imputed interest charge for acquisition                                           --          --        191
  (Gain) loss on sale of assets                                                             535       2,576       (545)
  Write-off of long-term investment                                                         514          --         --
  Gain on settlement of debt                                                               (238)         --         --
  Changes in operating assets and liabilities:
    Accounts receivable and revenues in excess of billings                                   79       5,444     (3,459)
    Inventories                                                                             756         788     (1,342)
    Prepaid expenses and other assets                                                       462         431       (392)
    Accounts payable and accrued liabilities                                             (2,717)     (2,860)     1,785
                                                                                       -------------------------------
Total adjustments                                                                        51,854      39,663     15,914
                                                                                       -------------------------------
Net cash used in operating activities                                                    (4,883)    (10,197)   (19,008)

Investing activities

Acquisitions, net of cash acquired                                                         (579)     (1,255)   (11,949)
Purchases of property and equipment                                                      (1,131)     (1,984)    (7,202)
Proceeds from disposals of assets                                                            17       1,216      1,026
                                                                                       -------------------------------
Net cash used in investing activities                                                    (1,693)     (2,023)   (18,125)

Financing activities

Proceeds from issuance of common stock, net of issuance costs                               263         317     53,995
Proceeds from debt issuances                                                              6,783         436         --
Payments on long-term debt and capital leases                                            (4,332)     (3,349)      (803)
Borrowings on line of credit, net                                                          (119)        571         --
                                                                                       -------------------------------
Net cash provided by (used in) financing activities                                       2,595      (2,025)    53,192

Effect of exchange rate changes on cash                                                    (124)        106         --
                                                                                       -------------------------------
Net increase (decrease) in cash                                                          (4,105)    (14,139)    16,059
Cash and cash equivalents at beginning of period                                          7,809      21,948      5,889
                                                                                       -------------------------------
Cash and cash equivalents at end of period                                             $  3,704    $  7,809   $ 21,948
                                                                                       ===============================
</TABLE>

                                       35

<PAGE>

                               Sonic Foundry, Inc.
                      Consolidated Statements of Cash Flows
                                 (in thousands)
<TABLE>
<CAPTION>

<S>                                                                                              <C>            <C>         <C>
Supplemental cash flow information:
   Interest paid                                                                                $  493         $  321      $   233
   Income taxes paid                                                                               259             --           --
Noncash transactions:
   Capital lease acquisitions                                                                       32            100        2,614
     Issuance of options for deferred compensation plan                                             98             --           --
   Conversion of exchangeable stock into common stock                                            5,375            204           --
   Common stock and stock options issued for MediaSite                                           5,016             --           --
   Common stock issued for Digital Savant                                                          541             --           --
   Common stock issued for liabilities assumed in MediaSite transaction                            125             --           --
   Common stock issued for debt settlement                                                         660             --           --
   Issuance of common stock in exchange for advertising                                             --             --        2,500
   Issuance of common stock for Jedor                                                               --             --          300
   Issuance of common stock and stock options for STV                                               --             --       72,480
   Common stock issued and issuable for International Image                                         --             --        6,900
   Note payable for acquisition of International Image                                              --             --        4,000
   Reclassification of goodwill to fixed assets upon final appraisal of International Image         --          1,281           --
   Reduction of goodwill upon settlement of notes due certain International Image
     Shareholders                                                                                   --            200           --
   Cancellation of unvested stock options classified as unearned compensation upon
     acquisition of STV                                                                             --          1,249           --
   Preferred stock dividend                                                                         --             --           --
   Issuance of warrants for consulting services                                                     49             19          830
   Receivables from employees for option exercises                                                  --             --           72
   Conversion of debt into common stock, net                                                        --             --        4,218
</TABLE>

See accompanying notes

1.   Basis of Presentation and Significant Accounting Policies

Business and Concentration of Credit Risk

Sonic Foundry, Inc. (the Company) is a media solutions provider developing and
offering: 1.) Windows-based software tools for the creation, editing,
presentation and publishing of digital multimedia; 2.) Services for the
conversion, reformatting and encoding of television, film and audio content into
multiple delivery platforms and 3.) Systems software for management and
distribution of media. The Company sells its software to music, video, broadcast
and Internet markets worldwide. The Company sells its services to primarily the
entertainment industry. All domestic and international sales are denominated in
either U.S. or Canadian dollars. The Company performs periodic credit
evaluations of its customers' financial condition and generally does not require
collateral.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of the
Company and its subsidiaries. All significant intercompany transactions and
balances have been eliminated. The functional currency of foreign owned
subsidiaries is the Canadian dollar; accordingly, assets and liabilities are
translated into United States dollars at the rate of exchange existing at the
end of the period. Income and expense amounts are translated at the average
exchange rates during the period. Adjustments resulting from translation are
classified as a separate component of comprehensive income within stockholders'
equity.

Cash and Cash Equivalents

For purposes of the statement of cash flows, the Company considers all highly
liquid investments purchased with a maturity of three months or less to be cash
equivalents.

Use of Estimates

                                       36

<PAGE>

                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002

The preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.

Revenue Recognition

Software License Fees

Revenues from software license fees consist of fees charged for the licensing of
Windows-based software products. Software license fees are recognized when
persuasive evidence of an arrangement exists, the software product has been
delivered and no significant obligations of the Company remain, the fee to the
Company is fixed and determinable, and collection of the resulting receivable is
deemed probable. Delivery occurs through the following methods:

     .    Direct Distribution: Direct revenues are recognized upon delivery to
          the end-user either via shipment of a boxed product from the Company's
          warehouse or electronic download. No returns are accepted.

     .    Retail Distribution: Retail revenues are recognized upon delivery to a
          third-party distributor, net of allowances for estimated returns.

     .    OEM: OEM revenues are generated through partnerships with hardware and
          software vendors who license the right to bundle one of the Company's
          products with the partner's products. Typically, this type of revenue
          is recognized as the partner sells through to the end-user.

     .    Consulting: Consulting revenues include fees recorded pursuant to
          long-term contracts, using the percentage of completion method of
          accounting, when significant customization or modification of a
          product is required.

     .    Consignment: Consignment revenues are recognized when a third-party
          reseller delivers the boxed product to their customer.

All desktop software products sold include free installation support and
professional software products sold include 60 days of free telephone support.
Costs associated with free support are accrued at the date of sale because the
free support is not significant. Customers that require additional post-contract
customer support ("PCS") are charged a separate fee either through a telephone
charge or annual subscription charge. Revenue and associated costs for PCS are
recognized as the services are performed or on a straight-line basis over the
contractual period.

Media Services

Revenues from services are typically recognized when persuasive evidence of a
contract exists, the service has been completed and no significant obligations
of the Company remain, the fee is fixed and determinable and collection of the
resulting receivable is deemed probable. The Company records revenue on a
percentage of completion method, generally by using the number of tapes
completed as a percentage of total tapes included in the contract, when
performing services of a duration of 30 days or more and all criteria for
recognition of service revenue are met other than completion.

We perform ongoing credit evaluations of our customers' financial condition and
generally do not require collateral. We maintain allowances for potential credit
losses and such losses have been within our expectations.

Inventory Valuation

Inventories are carried at the lower of cost or market with cost determined on a
first-in, first-out (FIFO) basis.

Inventory consists of the following (in thousands):
<TABLE>
<CAPTION>
                                                               September 30,
                                                              ---------------
                                                              2002      2001
                                                              ----     ------
           <S>                                                <C>      <C>
           Raw materials and supplies                         $216     $  390
           Work-in-process                                      10        112
           Finished goods                                      136        616
                                                              ----     ------
                                                              $362     $1,118
                                                              ====     ======
</TABLE>

                                       37

<PAGE>

                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002

Software Development Costs

The Company capitalizes the cost of development of software products that have
reached technological feasibility. Costs incurred prior to the establishment of
technological feasibility are charged to product development expense. When the
product is available for general release to customers, capitalization ceases and
such costs are amortized on a product-by-product basis computed as the greater
of (a) the ratio that current gross revenues for the product bear to the total
of current and anticipated future gross revenues or (b) the straight-line
amortization over the remaining estimated economic useful life (generally two
years) of the product. Capitalized software development costs are reported at
the lower of unamortized cost or net realizable value. In 2002, the company
capitalized $1,400,000 related to the MediaSite transaction (amortized over 5
years) and $240,000 related to the Media Taxi acquisitions (amortized over 2
years) (see note 12).

Capitalized software development costs at September 30, 2002 and 2001 are net of
accumulated amortization of $2,041,000 and $1,660,000.

Advertising Costs

Advertising costs are expensed at the time the advertising takes place.
Advertising costs, excluding the credits detailed below, were $1,830,000,
$4,161,000, and $6,657,000 for the years ended September 30, 2002, 2001, and
2000.

In March 2000, the Company received $1,500,000 of advertising credits from
Warner Brothers and $1,000,000 from Sony in exchange for common stock. The
$1,500,000 received from Warner Brothers was allocated to its Entertaindom
website and the $1,000,000 from Sony was allocated to its Screenblast website.
During fiscal 2000, the entire amount related to Warner Brothers was charged to
advertising expense. Following Sony's launch of the Screenblast website in
September 2001, the Company expensed the entire $1,000,000 to advertising
expense.

Property and Equipment

Property and equipment are recorded at cost and are depreciated using the
straight-line method for financial reporting purposes. The estimated useful
lives used to calculate depreciation are as follows:
<TABLE>
<CAPTION>
                                                       Years
                                                       -----
        <S>                                            <C>
        Building and improvements                      5 to 10 years
        Equipment and capital lease assets             3 to 5 years
        Furniture and fixtures                         7 years
</TABLE>

Impairment of Long-Lived Assets

Property and equipment, capitalized software development costs and goodwill and
other intangibles are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount may not be recoverable. If the
sum of the expected undiscounted cash flows is less than the carrying value of
the related asset or group of assets, a loss is recognized for the difference
between the fair value and carrying value of the asset or group of assets.

Income Taxes

Deferred income taxes are provided for temporary differences between financial
reporting and income tax basis of assets and liabilities, and are measured using
currently enacted tax rates and laws. Deferred income taxes also arise from the
future benefits of net operating loss carryforwards. For the US operations, a
valuation allowance equal to 100% of the net deferred tax assets has been
recognized due to uncertainty regarding future realization.

Fair Value of Financial Instruments

The Company's financial instruments consist primarily of cash and cash
equivalents, trade receivables, trade payables and debt instruments. The book
values of cash and cash equivalents, trade receivables, and trade payables are
considered to be representative of their respective fair values. None of the
Company's debt instruments that are outstanding at September 30, 2002, have
readily ascertainable market values; however, except for the convertible debt
which is reported net of an unamortized discount, the carrying values are
considered to approximate their respective fair values. See Note 4 for the terms
and carrying values of the Company's various debt instruments.

                                       38

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


Per Share Computation

The following table sets forth the computation of basic and diluted loss per
share:

<TABLE>
<CAPTION>
(in thousands except share and per share data)                        Years Ended September 30,
                                                                 2002          2001          2000
                                                                 ----          ----          ----
<S>                                                           <C>           <C>           <C>

Denominator

Denominator for basic and dilutive loss per share
  - weighted average common shares                            26,812,000    22,129,000    18,503,000
                                                              ==========    ==========    ==========

Securities that could potentially dilute
   earnings per share in the future that are not
   included in the computation of diluted loss
   per share as their impact is antidilutive
   (treasury stock method)
   Options and warrants                                        1,842,517       914,000     2,654,000
   Common stock to be issued                                          --       467,380       161,700
</TABLE>

Accounting Pronouncements

In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative
Instruments and Hedging Activities," as amended by SFAS No. 138, which
establishes accounting and reporting standards for derivative instruments and
hedging activities. SFAS No. 133 establishes a new model for accounting
standards and was effective for fiscal years beginning after June 15, 2000.
Adoption of SFAS 133 did not have any impact on the Company's consolidated
financial statements.

In June 2001, the Financial Accounting Standards Board issued SFAS No. 141,
"Business Combinations," and No. 142, "Goodwill and Other Intangible Assets."
SFAS No. 141 requires that the purchase method of accounting be used for all
business combinations initiated after June 30, 2001. Use of the
pooling-of-interests method is no longer permitted. SFAS No. 141 also includes
guidance on the initial recognition and measurement of goodwill and other
intangible assets acquired in a business combination that is completed after
June 30, 2001. SFAS No. 142 no longer permits the amortization of goodwill and
indefinite-lived intangible assets. Instead, these assets must be reviewed
annually (or more frequently under certain conditions) for impairment in
accordance with this Statement. This impairment test uses a fair value approach
rather than the undiscounted cash flows approach previously required by SFAS No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of." The amortization of goodwill associated with the
acquisitions of STV and II are no longer recorded upon adoption of the new
rules. Intangible assets that do not have indefinite lives continue to be
amortized over their useful lives and reviewed for impairment. The Company
adopted SFAS No. 142 on October 1, 2001. See Note 13 for the impact of adoption.

2.  Liquidity and Management's Plan

The Company recently determined that operations of our desktop software and
services business would not provide sufficient cash flow along with our existing
cash reserves to fund planned growth of the systems division and make remaining
subordinated debt payments. In response, the Company retained an advisor to
evaluate the sale of certain operating assets. As of the reporting date, the
Company has received multiple non-binding offers from qualified bidders and we
anticipate closing one or more transactions in early 2003. Such a transaction is
expected to provide the Company with sufficient resources to:

     .  Retire the remaining balance due subordinated debt holders

     .  Retire the additional $1,000,000 bridge note (see note 16)

     .  Restructure the Company and aggressively pursue a focused strategy of
        growing the remaining business.

Management believes the cash flows from the Company's operations in fiscal 2003
and the proceeds of the transaction discussed above, will fund its operations
and will provide the Company with the ability to meet its cash flow obligations.
Accordingly, the financial statements have been prepared on the basis of a going
concern, which contemplates realization of assets and satisfaction of
liabilities in the normal course of business.

3.  Long-Term Investment and Other Assets

Early in 1999, the Company guaranteed the operating lease of a company (the
entity) that develops high speed networking

                                       39

<PAGE>
                               Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                      For the Year Ended September 30, 2002


products for broadband access to and delivery of on-line media. The Company
received common stock of the entity, in exchange for a lease guarantee and also
invested $514,000 in common stock of the entity. The operating lease had a
five-year term. The Company believes it has no further commitment under the
lease as of September 30, 2002. The Company owned less than 20% of the entity;
accordingly, the investment was accounted for using the cost method.

In December 1999, the Company sold a portion of shares and recognized a $600,000
gain on the sale. In June 2002, the Company wrote off the remaining $514,000
investment based on an evaluation of qualitative and quantitative factors
including discussions with management and review of financial and other
materials.

In September 2001, the Company advanced $419,000 to MediaSite, Inc., which was
recorded as a non-current asset. This balance was accounted for as part of the
purchase price of MediaSite, Inc. in the first quarter of 2002.

4.      Long-Term Debt and Notes Payable

Long-term obligations consist of the following:

<TABLE>
<CAPTION>


(in thousands)                                                                        Years Ended September 30,
                                                                                          2002          2001
                                                                                          ----          ----
<S>                                                                                      <C>           <C>
Convertible debt interest rate of 10% per annum
  Net of unamortized discount of  $3,235                                                 $3,482        $   --
Subordinated note payable due to former owners of International Image                        --         3,300
Term loan to a bank, due May 2004, monthly payments of
  $16 Canadian dollars including interest at Canadian Prime plus 1.5%
  and secured by substantially all Canadian assets                                          216           340
Employee deferred compensation plan due January 1, 2004 through January 1, 2006,
  interest rate of 9% to 11% per annum                                                      230            --
Other bank loans due on demand                                                              451           580
                                                                                            ---        ------
Total                                                                                     4,379         4,220
Less amounts due within one year                                                          4,056         4,003
                                                                                         ------        ------
Long-term debt                                                                           $  323        $  217
                                                                                         ======        ======
</TABLE>

Maturities of long-term debt at September 30, 2002 are as follows:

(in thousands)

                  Fiscal
                  ------

                   2003                       4,056
                   2004                         132
                   2005                          42
                   2006                         149
                                             ------
                   Total                     $4,379
                                             ======

Convertible Note

In January and February 2002, the Company completed a $7,125,000 offering of
convertible subordinated debt with several investors. The promissory notes
("Notes") bear interest at 10% per annum and require the Company to repay
principal (if not converted) in monthly installments commencing on August 1,
2002. The aggregate amount of such monthly installments for all the Notes is
$330,000 with a final installment in the aggregate amount of $1,181,000 due on
the maturity date of February 1, 2004.

In December 2002, the Company reached an agreement with lenders totaling $4.75
million of original principal of the Notes to modify the original repayment
terms. The terms of the agreement defer approximately $900,000 of past due and
future principal payments until the earlier of January 20, 2003 or the
completion of the transaction contemplated in "Liquidity and Managements Plan",
the ("Transaction"). In return, the Company agreed to provide the lenders with a
second collateral position in all the assets of the Company and to increase the
rate of interest to 12% per annum. In addition, the Company agreed to accelerate
the date on which payment in full of the Notes would be due to the earlier of
June 1, 2003 or the completion of the Transaction with lenders of original
principal totaling $1.5 million.

The Notes may be converted into shares of our common stock, in whole or in part,
at any time. The conversion price is $2.45 per share, subject to potential
anti-dilution adjustments. The Investors also received 1,163,000 warrants to
purchase shares of common stock at an exercise price of $2.94.

The Notes include a covenant requiring the Company to have $2.5 million of
available cash at the end of each quarter. At September 30, 2002 the Company was
in full compliance with the covenant.

The Company also paid the placement agents $502,000 in commissions and issued
them 154,000 warrants to purchase common stock at an exercise price of $2.94.
The commissions and value of the warrants are classified as debt issuance costs
in the accompanying balance sheet.


                                       40

<PAGE>
                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


Warrants granted to the Investors and the placement agents expire in February
2006.

The value allocated to the warrants issued was measured at the date of grant
because the number of shares was fixed and determinable. The value was
determined based upon a Black-Scholes option pricing model with the following
assumptions: risk-free interest rate of 3%, dividend yield of 0%, expected
common stock market price volatility factor of 1.5 and the expected life of the
warrants. The valuation of the investor warrants reduced the carrying value of
the debt by $2.8 million and was recorded as a debt discount. The debt discount
recorded for the warrant valuation caused a beneficial embedded conversion
feature valued at $3.5 million which was recorded as an additional debt
discount.

The debt discount is being amortized using an effective interest method over the
two-year term of the debt. The unamortized balance of the debt discount at
September 30, 2002, was $3,235,000. The debt issuance costs are being amortized
using the straight-line method over the two-year term of the debt.

Subordinated Note

In early January 2001, the Company withheld payment on a $4 million note due to
the former shareholders of International Image pending the resolution of certain
disputed representations made during the acquisition. In January 2001 certain of
the note holders initiated litigation against the Company in Toronto for payment
of the note and in March 2001 the Company initiated a counter action for damages
incurred.

In April 2001, the Company paid certain shareholders $500,000 in full settlement
of $700,000 of the note plus accrued interest originally owed. Litigation with
the remaining shareholders continued.

In October 2001, pursuant to an agreement with the plaintiffs, the Company
deposited $1,000,000 with the Ontario Superior Court of Justice to be held in
trust until settlement of the suit. The transaction was recorded as restricted
cash.

In June 2002, the Company settled $2.8 million of the remaining $3.3 million
note balance plus accrued interest for $1.9 million in cash and 500,000 shares
of common stock valued at $660,000. The difference between the principal and
accrued interest balance and the settlement cost was recorded as a gain, net of
certain legal costs. The remaining note amounts were settled for similar
discounts to those above in August and September of 2002. As of September 30,
2002 no further obligations remained.

5.  Commitments

At September 30, 2002 the gross amount of capital leases and related accumulated
amortization was approximately $2,952,000 and $1,584,000, respectively. The
Company has a letter of credit in the amount of $100,000 which secures a
building lease. The Company leases certain facilities and equipment under
operating lease agreements expiring through May 31, 2010. Total rent expense on
all operating leases was approximately $1,545,000, $2,158,000, and $1,369,000
for the years ended September 30, 2002, 2001 and 2000. The following is a
schedule by year of future minimum lease payments under capital and operating
leases, excluding the anticipated receipt of sublease income of $107,000,
$112,000, and $96,000 in 2003, 2004 and 2005 respectively.

          Fiscal                                Capital      Operating
          ------                                -------      ---------
          2003                                   857          1,393
          2004                                    71          1,077
          2005                                     1            936
          2006                                    --            653
          2007                                    --            574
          Thereafter                              --          2,219
                                                 ---         ------
          Total                                  929         $6,851
                                                             ======
          Less amount representing interest       45
                                                ----
          Capital lease obligations             $884
                                                ====


6.  Common Stock Warrants

The Company has issued restricted common stock purchase warrants to various
consultants, underwriters, and debtors. Each warrant represents the right to
purchase one share of common stock. All warrants are currently exercisable.

                             Warrants Outstanding at

                                       41

<PAGE>
                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


            Exercise Prices        September 30, 2002       Expiration Date
            ---------------        ------------------       ---------------

             $0.09                        4,426                       2005
              1.09 to $1.64             405,000               2006 to 2007
              2.50 to 2.94            1,337,270               2003 to 2007
              4.00 to 6.19              709,400               2003 to 2005
              9.28 to 37.44             291,400               2003 to 2010
                                      ---------
                                      2,747,496
                                      =========

7.  Stock Options and Employee Stock Purchase Plan

The Company maintains an employee stock option plan under which the Company may
grant options to acquire up to 4,000,000 shares of common stock.

In 1999, the Company established an additional non-qualified plan under which
400,000 shares of common stock could be issued. The shares under this plan were
increased to 800,000 in fiscal 2001 and to 3,800,000 in December of 2001.

The Company also has a directors' stock option plan under which the Company may
grant options to acquire up to 600,000 shares of common stock to non-employee
directors. Each non-employee director, who is re-elected or who is continuing as
a member of the board of directors on the annual meeting date and on each
subsequent meeting of stockholders, is granted options to purchase 20,000 shares
of common stock.

Each option entitles the holder to purchase one share of common stock at the
specified option price. The exercise price of each option granted under the
plans was set at the market price of the Company's common stock at the
respective grant date. The exercise price of options assumed in the STV
acquisition was calculated using the exchange ratio. Options vest at various
intervals, as determined by the Board of Directors at the date of grant, and
expire at the earlier of termination of employment, discontinuance of service on
the board of directors, ten years from the grant date or at such times as are
set by the Company at the date of grant.

The number of shares available for grant under these plans at September 30, 2002
is as follows:

<TABLE>
<CAPTION>
                                                                   Employee      Non-Qualified      Director
                                                                Stock Option     Stock Option     Stock Option
                                                                    Plan             Plan             Plan
                                                                ------------     -------------    ------------
<S>                                                             <C>              <C>              <C>
Shares available for grant at September 30, 1999                    183,550                -          60,000
Amendment to increase shares available in plan                    2,000,000                -         420,000
Adoption of plan                                                          -          400,000               -
Options granted                                                    (397,132)        (365,159)        (60,000)
Options assumed in STV acquisition                                 (359,850)               -               -
Options forfeited                                                   206,541           43,000               -
                                                                 ----------       ----------         -------
Shares available for grant at September 30, 2000                  1,633,109           77,841         420,000
Amendment to increase shares available in plan                            -          400,000               -
Options granted                                                  (2,032,900)        (210,000)        (60,000)
Options forfeited                                                   693,451          111,000               -
                                                                 ----------       ----------         -------
Shares available for grant at September 30, 2001                    293,660          378,841         360,000
Amendment to increase shares available in plan                            -        3,000,000               -
Options granted                                                    (361,100)      (3,186,736)        (60,000)
Options forfeited                                                   273,560           86,674               -
                                                                 ----------       ----------         -------
Shares available for grant at September 30, 2002                    206,120          278,779         300,000
                                                                 ==========       ==========         =======
</TABLE>

                                       42

<PAGE>

                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


The following table summarizes information with respect to the stock option
plans.
<TABLE>
<CAPTION>
                                                                                Years Ended September 30,
                                                        -------------------------------------------------------------------------
                                                              2002                       2001                      2000
                                                        --------------------      --------------------     ----------------------
                                                                    Weighted                  Weighted                   Weighted
                                                                     Average                   Average                    Average
                                                                    Exercise                  Exercise                   Exercise
                                                         Options      Price        Options      Price       Options        Price
                                                        ---------   --------      ---------   --------     ---------     --------
<S>                                                     <C>         <C>           <C>         <C>          <C>           <C>
Outstanding at beginning of
  Year                                                  2,974,314     $3.88       1,720,469     $9.25      1,536,450      $ 1.69
Granted                                                 3,607,836      1.30       2,302,900      1.27        822,291       18.53
Assumed in acquisition                                         --        --              --        --        359,850        7.42
Exercised                                                 (84,682)     1.32        (244,604)     0.41       (748,581)       0.92
Forfeited                                                (360,234)     3.03        (804,451)     8.95       (249,541)      15.05
                                                        ---------      ----        --------     -----      ---------      ------
Outstanding at end of year                              6,137,234     $2.45       2,974,314     $3.88      1,720,469      $ 9.25
                                                        =========     =====       =========     =====      =========      ======
Exercisable at end of year                              3,742,181                 1,021,785                  605,907
                                                        =========                 =========                =========
Weighted average fair value of
  options granted during period                         $    0.96                 $    1.04                $   16.61
                                                        =========                 =========                =========
</TABLE>

The options outstanding at September 30, 2002 have been segregated into four
ranges for additional disclosure as follows:
<TABLE>
<CAPTION>

                                                   Options Outstanding                                Options Exercisable
                                 ------------------------------------------------------      -------------------------------------
                                     Options            Weighted
                                 Outstanding at         Average             Weighted              Options             Weighted
                                  September 30,        Remaining            Average            Exercisable at     Average Exercise
Exercise Prices                       2002          Contractual Life     Exercise Price      September 30, 2002        Price
---------------                  --------------     ----------------     --------------      ------------------   ----------------
<S>                              <C>                <C>                  <C>                 <C>                  <C>
$0.47 to $0.74                        61,968              7.63                $0.60                  40,573            $ 0.54
$1.01 to $1.36                     4,173,153              8.64                 1.10               2,858,261              1.11
$1.60 to $2.62                     1,261,916              8.48                 2.09                 392,315              2.19
$3.13 to $59.88                      640,197              6.84                12.15                 451,032             13.84
</TABLE>

As permitted by SFAS No. 123, "Accounting for Stock-Based Compensation," the
Company follows Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issued to Employees," in accounting for its stock option plans. Had the
Company accounted for its stock option plans based upon the fair value at the
grant date for options granted under the plan, based on the provisions of SFAS
123, the Company's pro forma net loss and pro forma net loss per share would
have been as follows (for purposes of pro forma disclosures, the estimated fair
value of the options is amortized to expense over the options' vesting period):
<TABLE>
<CAPTION>
                                                                    Years Ended September 30,
                                                           ----------------------------------------------
                                                             2002                2001              2000
                                                           --------            --------          --------
              <S>                                          <C>                 <C>               <C>
              Pro forma net loss (in thousands)            $(59,978)           $(52,567)         $(39,313)
              Pro forma net loss per share                    (2.24)              (2.37)            (2.12)
</TABLE>

Pro forma information regarding net loss and net loss per share is required by
SFAS No. 123, and has been determined as if the Company had accounted for its
employee stock options under the minimum value method of that Statement for
option grants made prior to the Company's initial public offering and the
Black-Scholes method for grants made subsequent to such offering. With the
exception of volatility (which is ignored in the case of the minimum value
method), the following weighted-average assumptions were used for all periods
presented: risk-free interest rates of 1.7% to 6%, dividend yields of 0%;
expected common stock market price volatility factors ranging from .50 to 1.38
and a weighted-average expected life of the option of one to five years.

                                       43

<PAGE>

                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002

In July of 2000, the Company began an Employee Stock Purchase Plan (Stock
Purchase Plan), which allows for the issuance of 1,000,000 shares of common
stock. There were no shares issued under the plan for the year ended September
30, 2000. There were 115,126 and 181,005 shares issued under the plan for the
years ended September 30, 2002 and 2001. All employees of the Company who have
completed three months of employment are eligible to participate in the Stock
Purchase Plan, provided the employee would not hold 5% or more of the total
combined voting power of the Company. Shares may be purchased at the end of a
specified period at the lower of 85% of the market value at the beginning or the
end of the specified period through accumulation of payroll deductions.

8.   Income Taxes

Income tax benefit in the statement of operations consists of the following (in
thousands):
<TABLE>
<CAPTION>
                                (in thousands)                                              Years Ended September 30,
                                                                                   -----------------------------------------
                                                                                     2002             2001             2000
                                                                                   -------          -------          -------
<S>                                                                                <C>              <C>              <C>
Deferred income tax benefit                                                        $(4,032)         $(8,503)         $(8,901)
Change in valuation allowance                                                        4,032            8,503            8,901
Canadian income tax expense                                                             12                0                0
                                                                                   -------          -------          -------
                                                                                   $    12          $    --          $    --
                                                                                   =======          =======          =======
</TABLE>

The reconciliation of income tax expense computed at the U.S. federal statutory
rate to income tax expense is (in thousands):
<TABLE>
<CAPTION>
                                                                                       Years Ended September 30,
                                                                               ----------------------------------------
                                                                                 2002            2001            2000
                                                                               --------        --------        --------
     <S>                                                                       <C>             <C>             <C>
     Tax benefit at U.S. statutory rate of 34%                                 $(19,291)       $(16,952)       $(11,873)
     Permanent differences, net                                                  15,354           8,577           3,372
     Other                                                                          (95)           (128)           (400)
     Canadian income tax expense                                                    (12)              -              --
     Change in valuation allowance                                                4,032           8,503           8,901
                                                                               --------        --------        --------
                                                                               $    (12)       $     --        $     --
                                                                               =========       ========        ========
</TABLE>

The significant components of the deferred tax accounts recognized for financial
reporting purposes were as follows (in thousands):
<TABLE>
<CAPTION>
                                                                                                      September 30,
                                                                                                  ---------------------
                                                                                                    2002          2001
                                                                                                  -------       -------
     <S>                                                                                          <C>           <C>
     Deferred tax assets:
     Net operating loss and other carryforwards                                                   $23,537       $18,351
     Common stock warrants                                                                            649           649
     Allowance for doubtful accounts                                                                  284           419
     Other                                                                                             11         1,030
                                                                                                  -------       -------
     Total deferred tax assets                                                                     24,481        20,449
     Valuation allowance                                                                          (24,481)      (20,449)
     Deferred tax liability - depreciation                                                           (116)           --
                                                                                                  -------       -------
     Net deferred tax liabilities                                                                 $  (116)      $    --
                                                                                                  =======       =======
</TABLE>

The net deferred tax liability at September 30, 2002, relates primarily to
differences in depreciation methods for Canadian assets.

At September 30, 2002, the Company had net operating loss carry forwards of
approximately $59 million for U.S. Federal and state tax purposes, which expire
beginning in 2011. In the event of a change in ownership greater than 50% in a
three-year period, utilization of the net operating losses may be subject to a
substantial annual limitation due to the ownership change limitations provided
by the Internal Revenue Code of 1986 and similar state provisions.

9.   Savings Plan

The Company's defined contribution 401(k) savings plan covers substantially all
employees meeting certain minimum eligibility requirements. Participating
employees can elect to defer a portion of their compensation and contribute it
to the plan on a pretax

                                       44

<PAGE>
                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


basis. The Company may also match certain amounts and/or provide additional
discretionary contributions, as defined. The Company made discretionary
contributions of $291,000, $286,000, and $268,000 during the years ended
September 30, 2002, 2001 and 2000.

10. Related-Party Transactions

The Company incurred fees of $192,000, $214,000 and $529,000 during the years
ended September 30, 2002, 2001, and 2000 to a law firm whose partner is a
director and stockholder of the Company.

For the years ended September 30, 2002 and 2001, the Company had loans
outstanding to certain executives totaling $58,000 and $25,000, respectively.
The largest outstanding balance was $25,000. In all cases, the loans are backed
by company stock.

In November 2002 the Company completed a bridge financing transaction of $1.0
million with the brother of Rimas Buinevicius, Chief Executive Officer. Mr.
Buinevicius abstained from board of director discussion regarding approval of
the transaction. The note is backed by substantially all assets of the Company
and is due, along with $250,000 of interest, at the earlier of March 2003 or
upon completion of a transaction generating sufficient cash to allow for
payment.

11. Segment Disclosure

Accounting principles generally accepted in the United States require the
Company to present financial information in a format that is used by the
Company's management to make decisions. Management views the Company in its
entirety as a digital media solutions provider with three primary revenue
centers: (i) a desktop software division, (ii) a services division, and (iii) a
systems division. The Company analyzes these three revenue centers, along with
their respective production costs, independently from each other. However,
because the majority of our operating expenses support both revenue centers, the
Company analyzes all items below gross margin on a combined basis.

Summarized financial information of the Company's continuing operations by
business segment for the fiscal years ended September 30, 2002, 2001 and 2000 is
as follows (in thousands):
<TABLE>
<CAPTION>

                                                                        Years Ended September 30,
                                                                        -------------------------
                                                              2002                   2001                  2000
                                                              ----                   ----                  ----
<S>                                                         <C>                    <C>                   <C>
          Revenues:
             Desktop Software                               $15,898                $15,550               $ 21,455
             Systems Software                                   859                     --                     --
             Services                                         9,399                 10,734                  4,852
                                                            -------                -------               --------
                                                            $26,156                $26,284               $ 26,307

          Gross margin:
             Desktop Software                               $12,907                $10,363               $ 15,962
             Systems Software                                   479                     --                     --
             Services                                         2,185                  3,001                   (325)
                                                            -------                -------               --------
                                                            $15,571                $13,364               $ 15,637

          Total assets (including intangibles
          and goodwill, see note below):

             Desktop Software                               $ 1,790                $ 2,795               $ 10,011
             Systems Software                                 9,519                     --                     --
             Services                                         8,814                 54,763                 85,003
             Unallocated                                      7,520                 14,125                 31,811
                                                            -------                -------               --------
                                                            $27,643                $71,683               $126,825
</TABLE>

Desktop software includes capitalized software development costs of $0, $73 and
$518 at September 30, 2002, 2001 and 2000. At September 30, 2002, Systems
software includes $8,498 of goodwill, intangibles and capitalized software
development costs. Services includes goodwill, intangibles and capitalized
software development costs of $639, $54,763, and $85,003 at September 30, 2002,
2001, and 2000.

Of the $27.6 million in total assets held by the Company, $2.7 million are held
in Canada.

                                       45

<PAGE>
                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002

Major Customers

Software revenues to the largest software customer were 13% and 18% of total
software revenues in 2002 and 2001. Software revenues to the largest two
software customers were 16% and 15% in 2000.

Media services revenues to the four largest media services customers were 15%,
14%, 12% and 10% of total media services revenues in 2002. Media services
revenues to the two largest media services customers were 13% and 10% of total
media services revenues in 2001. There were no individual media services
customers that exceeded 10% of media services revenues in 2000.

Percentage of revenues by continent were as follows:
<TABLE>
<CAPTION>

                                          Years ended September 30,
                                          -------------------------
                                2002               2001                 2000
                                ----               ----                 ----
<S>                             <C>                <C>                   <C>
          North America          85%                82%                   87%
          Europe                  9                  7                     6
          Asia                    4                  9                     6
          Other                   2                  2                     1
                                ---                ---                   ---
             Total              100%               100%                  100%
                                ===                ===                   ===
</TABLE>

12. Acquisitions

On October 15, 2001, the Company completed the asset purchase of MediaSite,
Inc., which provides automated rich media publishing, management and access
solutions. Under terms of the purchase agreement, a wholly-owned subsidiary of
the Company purchased the majority of the assets of MediaSite and assumed
certain of its liabilities in exchange for 3,880,000 shares of the Company's
common stock and 300,000 warrants valued at $1.20 per share. Also as part of the
purchase, the Company capitalized $490,000 in closing costs, $3,101,000 in
assumed liabilities and a $365,000 advance that was issued to MediaSite in
September 2001. The acquisition was accounted for as a purchase, and
accordingly, the results of operations were included in the consolidated
financial statements from the purchase date.

Approximately $9.1 million of intangible assets resulted from the purchase of
MediaSite. The Company obtained an independent appraisal, which resulted in an
allocation of $120,000 to the Carnegie Mellon University license agreement,
$130,000 to the MediaSite trade name and $1,400,000 to acquired technology. All
three were determined to have useful lives of 5 years and will be amortized to
cost of goods sold. The remaining balance of $7.5 million was assigned to
goodwill and, in accordance with SFAS No. 142, will not be amortized, but will
be reviewed annually for impairment. See note 13 for the results of the annual
impairment test.

On February 12, 2002 the Company's services division purchased all the
intellectual property rights to Media Taxi (TM) from Los Angeles based Digital
Savant, Inc. in exchange for $100,000 and 221,000 shares of the Company's common
stock. The acquisition was accounted for as a purchase, and accordingly, the
results of operations were included in the consolidated financial statements
from the purchase date.

Media Taxi is a widely deployed browser-based media asset management system
focused on streamlining the management and distribution of marketing and
publicity materials for the entertainment industry. A portion of the purchase
price, $240,000, was assigned to purchased technology and is being amortized to
cost of services over two years. The remaining portion of the acquisition price,
$479,000, was assigned to goodwill and, in accordance with SFAS No. 142, will
not be amortized, but will be reviewed annually for impairment.

On April 3, 2000, the Company completed its acquisition of STV, a media
convergence company offering webcasting, syndication and production, and
post-production services. Pursuant to the Merger Agreement, an aggregate of
$1.22 million in cash was paid and 2,107,096 shares of the Company's common
stock valued at $30.75 per share were issued in exchange for all of the issued
and outstanding capital stock of STV. In addition 485,584 options to purchase
shares of Sonic Foundry common stock were issued to replace existing STV options
and warrants. As part of the acquisition, the Company incurred $1.63 million of
direct transaction costs. The acquisition was accounted for as a purchase and,
accordingly, the results of operations were included in the consolidated
financial statements from April 3, 2000, the effective date of the acquisition.
The purchase price was allocated to the acquired assets and assumed liabilities
on the basis of their estimated fair values as of the date of the acquisition,
with intangible assets determined by an independent appraisal. Intangible assets
were classified as assembled workforce ($1 million with 1 year amortization
period) and goodwill ($70 million with 3 year amortization period). Unearned
compensation of $5.3

                                       46

<PAGE>

                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002

million resulted from the valuation of the assumed options and was being
amortized over the average remaining vesting period of 3.5 years. However, this
figure was reduced to account for adjustments for forfeited, unvested options of
employees terminated since the acquisition date and became fully amortized in
fiscal 2001. Effective October 1, 2001, all the aforementioned intangible assets
related to STV were written off upon adoption of FAS 142. See Footnote 13.

Effective June 1, 2000, the Company acquired all of the capital stock of
International Image, a leading developer and marketer of Internet software
tools, services, and systems. The purchase consideration consisted of 600,000
shares of the Company's common stock valued at $11.50 per share, $4 million of
short-term notes payable and approximately $8 million in cash and debt assumed.
Approximately 485,000 of the 600,000 common shares were issued in the form of
exchangeable shares pursuant to an Exchange Agreement whereby holders could
exchange such shares at their option into the Company's common shares. In 2001,
nearly 18,000 of the exchangeable shares were converted to common shares. The
remainder were converted in 2002. The acquisition was accounted for as a
purchase and, accordingly, the results of operations have been included in the
consolidated financial statements from June 1, 2000, the effective date of the
acquisition. The close of the acquisition occurred in August of 2000, following
approval of the transaction from Canadian securities authorities. The purchase
price was allocated to the acquired assets and assumed liabilities on the basis
of their estimated fair values as of the date of the acquisition, with
intangible assets determined by an independent appraisal. Intangible assets were
classified as assembled workforce ($2.2 million with 5 year amortization) and
goodwill ($14.1 million). Goodwill related to the video tape business operations
of the Company ($4.7 million) was being amortized over 7 years. Goodwill related
to the remaining business operations ($9.4 million) was being amortized over 3
years. Effective October 1, 2001, all the aforementioned intangible assets
related to International Image were written off upon adoption of FAS 142. See
Footnote 13.

Based on unaudited data, the following table presents selected financial
information for the Company on a pro forma basis, assuming International Image
and STV had been consolidated since October 1, 1999:
<TABLE>
<CAPTION>
               (in thousands except per share data)       2000
                                                        --------
               <S>                                      <C>
               Net revenues                             $ 35,558
               Net loss                                  (53,555)
               Net loss per share                       $  (2.66)
</TABLE>

The pro forma net loss includes the additional amortization of goodwill that
would have been expensed had the transaction taken place at the beginning of the
period being reported.

The pro forma results are not necessarily indicative of future operations or the
actual results that would have occurred had the acquisition been made as of the
beginning of the period being reported.

13.  Goodwill and Other Intangible Assets - Adoption of Statement No. 142

In July 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets", which established financial accounting and reporting for acquired
goodwill and other intangible assets and supersedes APB Opinion No. 17,
"Intangible Assets." The Company early adopted SFAS No. 142 on October 1, 2001,
the beginning of its fiscal year. SFAS No. 142 requires that goodwill and
intangible assets that have indefinite useful lives not be amortized but,
instead, tested at least annually for impairment. Accordingly, the Company
reclassified the net book value of assembled workforce to goodwill and ceased
amortization of all goodwill, on October 1, 2001. Intangible assets that have
finite useful lives, primarily developed technology and know-how, continue to be
amortized over their useful lives.

The standard also requires that goodwill be tested for impairment annually. In
the year of adoption, the standard required a transitional goodwill impairment
evaluation, which was a two-step process. The first step was a screen for
whether there was an indication that goodwill was impaired as of October 1,
2001. At this time, the Company had two reporting units - software and services.
The entire goodwill balance, which had resulted from the 2000 acquisitions of
STV Communications and International Image, related to the services unit. To
determine if the goodwill was impaired, the Company retained an independent
appraisal firm to perform a valuation of the services unit using the criteria
prescribed under FAS 142. During December 2001, the appraisers completed this
first step, which indicated that goodwill recorded during the 2000 acquisitions
mentioned above was impaired as of October 1, 2001.

For the second step, the Company used the services of the same independent
appraisal firm to compare the implied fair value of the affected reporting
unit's goodwill to its carrying value in order to measure the amount of
impairment. The fair value of goodwill was determined by allocating the
reporting unit's fair value to all of its assets and liabilities in a manner
similar to a

                                       47

<PAGE>

                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002

purchase price allocation in accordance with SFAS No. 141, "Business
Combinations." During December 2001, the appraisers concluded that goodwill was
100% impaired. Therefore, the Company recorded an impairment loss of $44.7
million as a cumulative effect of a change in accounting principle in its
statement of operations.

The circumstances leading to the goodwill impairment related to: 1) the
decreased demand for digital services such as encoding (especially from dot
coms); 2) significant reductions of STV's workforce; 3) the company's decreased
market capitalization; and 4) a history of cash flow and operating losses for
the services unit. These negative trends provided evidence that initial growth
expectations of STV and International Image did not materialize. The fair value
used to determine the impairment was based on a combination of discounted cash
flow valuation techniques, market transactions and the prices of publicly traded
comparable companies.

Subsequent impairment charges for MediaSite or other acquisitions, if any, will
be reflected as an operating expense in the income statement. As of July 1, 2002
an independent appraisal firm determined that goodwill was not impaired. Had the
Company been accounting for its goodwill under SFAS No. 142 for all periods
presented, the Company's net loss and loss per share would have been as follows:

<TABLE>
<CAPTION>
     (in thousands, except per share data)               Years ended September 30,
                                                   ------------------------------------
                                                     2002          2001          2000
                                                   --------      --------      --------
  <S>                                              <C>           <C>           <C>
  Reported net loss                                $(56,737)     $(49,860)     $(34,922)
  Add back cumulative effect of change in
    accounting principle                             44,732             -             -
  Add back goodwill amortization
                                                          -        27,478        14,300
                                                   --------      --------      --------
  Adjusted net loss                                $(12,005)     $(22,382)      (20,622)
                                                   ========      ========      ========

  Basic and diluted - net loss per share
  Reported net loss per share                      $  (2.12)     $  (2.25)     $  (1.89)
  Cumulative  effect of change in  accounting
    principle                                          1.67             -             -
  Goodwill amortization                                   -          1.24           .77
                                                   --------      --------      --------
  Adjusted net loss per share                      $   (.45)     $  (1.01)      $ (1.12)
                                                   ========      ========      ========
</TABLE>

The following tables present details of the Company's total purchased intangible
assets:
<TABLE>
<CAPTION>
            (in thousands)                           Year ended September 30, 2002
                                               ------------------------------------------
                                                 Life                Accumulated
                                               (Years)    Gross     Amortization     Net
                                               -------    ------    ------------    -----
  <S>                                          <C>        <C>       <C>             <C>
  Systems Segment
  Amortizable:
    License Agreement                             5       $  120        $24         $  96
    Trade Name                                    5          130         26           104
                                                          ------        ---         -----
                                                             250         50           200
  Non-amortizable goodwill                                 8,055          -         8,055
                                                          ------        ---         -----
  Total                                                    8,305         50         8,255
                                                          ======        ===         =====
</TABLE>

14.  Contingencies

The Company is involved in various claims brought about by certain parties that
are incidental to its operations. In the opinion of management, the outcome of
these matters will not have a material adverse impact on the Company's financial
position or results of operations.

15.  Restructuring and Other Charges

As a result of rapidly changing market conditions, in December 2000 the
Company's Board of Directors authorized management to make a 40% workforce
reduction affecting all divisions of the Company in order to reduce future cash
expenditures. The restructuring charges were determined based upon plans
submitted by the Company's management and approved by the Board of

                                       48

<PAGE>

                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


Directors using information available at the time. As a result of the workforce
reduction, the Company exited four leased facilities and disposed of fixed
assets (mainly computer equipment and trade show assets) that were no longer
necessary for future operations. Future lease obligations of facilities exited
were accrued net of estimated sub-lease income to be generated through the lease
term. Computer equipment and trade show assets no longer necessary for
operations were written down from a carrying amount of $3.1 million to their
anticipated net realizable value. As a result of the workforce reductions,
termination of leases and disposal of fixed assets, the Company recorded
restructuring charges of $3,782,000 during the first quarter of fiscal 2001. In
the fourth quarter of fiscal 2001, the Company refined the net realizable value
of equipment no longer necessary in operations that was identified in the
December 2000 restructuring plan, which resulted in an additional charge of
$1,191,000. The remaining balance will continue to decrease as lease obligations
are paid and sublease income is received.

<TABLE>
<CAPTION>
(in thousands)                                Severance and        Lease        Fixed asset
                                              Related Charges    Terminations    Disposals    Other    Total
                                              ----------------------------------------------------------------
<S>                                           <C>                <C>            <C>           <C>     <C>
Charge in December 2000                          $   1,470         $ 1,555        $   594     $ 163   $ 3,782
Charge in September 2001                                -               -           1,191        -      1,191
                                              ----------------------------------------------------------------
  Total charges                                      1,470           1,555          1,785       163     4,973
Adjustments to December 2000 charge                     -             (503)           503        -         -
Amount paid in fiscal 2001, net                     (1,470)           (707)            -         (2)   (2,179)
Non-cash charges                                        -               -          (2,288)     (161)   (2,449)
                                              ----------------------------------------------------------------
  Accrued liabilities at September 30, 2001             -              345             -         -        345
Adjustments to December 2000 Charge                     -              (61)           121        -         60
Amount paid in fiscal 2002, net                         -             (191)            -         -       (191)
Non-cash charges                                        -               -            (121)       -       (121)
                                              ----------------------------------------------------------------
  Accrued liabilities at September 30, 2002      $      -          $    93             -      $  -    $    93
                                              ----------------------------------------------------------------
</TABLE>

16.  Subsequent Events

In July 2002, we initiated discussions with a majority of the debt holders to
amend the terms of their respective note agreements to reduce or defer the
amount of monthly principal payments required. In December 2002, the Company and
noteholders representing $4.75 million of the original $7.1 million of notes
agreed to defer a portion of previously due and unpaid principal payments as
well as future monthly note payments through January 20, 2003. In return, the
Company agreed, among other things, to provide the noteholders with a second
security interest in all assets of the Company and to increase the interest rate
from 10% to 12%.

In November 2002 the Company completed a bridge financing transaction of
$1,000,000 with the brother of Rimas Buinevicius, Chief Executive Officer.
Mr. Buinevicius abstained from board of director discussion regarding approval
of the transaction. The note is backed by substantially all the assets of the
Company and is due, along with $250,000 of interest, at the earlier of March
2003 or upon completion of a transaction generating sufficient cash to allow for
payment.

                                       49

<PAGE>

                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


17.  Quarterly Financial Data (unaudited)

The following table sets forth selected quarterly financial and stock price
information for the years ended September 30, 2002 and 2001. The operating
results are not necessarily indicative of results for any future period.

<TABLE>
<CAPTION>
                                         Quarterly Financial Data (in thousands)

                     Q4-2002   Q3-2002   Q2-2002    Q1-2002    Q4-2001   Q3-2001    Q2-2001    Q1-2001
                     -------   -------   -------    -------    -------   -------    -------    -------
<S>                  <C>       <C>       <C>       <C>        <C>        <C>       <C>        <C>
Net revenues         $ 6,433   $ 7,234   $ 6,451   $  6,038   $  5,408   $ 7,094   $  7,264   $  6,518
Gross margin           3,926     4,699     3,684      3,262      2,936     4,130      3,517      2,781
Net loss              (3,971)   (2,504)   (2,912)   (47,350)   (11,374)   (8,536)   (10,277)   (19,673)

Net loss per share   $  (.14)  $  (.09)  $  (.11)  $  (1.84)  $   (.51)  $  (.39)  $  (.46)   $   (.90)
</TABLE>

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

Not applicable.

                                    PART III

ITEMS 10 - 13

A definitive proxy statement pursuant to Regulation 14A will be filed with the
Commission not later than January 28, 2003, which is 120 days after the close of
the Registrant's fiscal year. The proxy statement will be incorporated by
reference into Part III (Items 10 through 13) of Form 10-K.

ITEM 14. Controls And Procedures

Evaluation of Disclosure Controls and Procedures

Based on evaluations as of a date within 90 days of the filing date of this
report, our principal executive officer and principal financial officer, with
the participation of our management team, have concluded that our disclosure
controls and procedures (as defined in Rules 13a-14 (c) and 15d-14 (c) under the
Securities Exchange Act) are effective to ensure that information required to be
disclosed by us in reports that we file or submit under the Securities Exchange
Act is recorded, processed, summarized and reported within the time periods
specified in the rules and forms of the SEC.

Changes in Internal Controls

There were no significant changes in our internal controls or in other factors
that could significantly affect these internal controls subsequent to the date
of their most recent evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.

                                     PART IV

ITEM 15.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

     (a)  The following financial statements are filed as part of this report:

          1.   Financial Statements and Supplementary Data. Listed in the Table
               of Contents provided in response to Item 8.

          2.   Financial Statement Schedule. Financial Statement Schedule II of
               the Company is included in this Report. All other Financial
               Statement Schedules have been omitted since they are either not
               required, not applicable or the information is otherwise
               included.

          3.   Exhibits.

                                       50

<PAGE>
                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


2.1    Amendment No. 1 to the Purchase Agreement dated February 11, 2002 by
       and between Sonic Foundry, Inc. and Omicron Partners, L.P, filed as
       exhibit 2.1 to the registration statement on Form S-3 filed on April
       29, 2002, and hereby incorporated by reference.

2.2    Note - Exhibit A to Amendment No. 1 to the Purchase Agreement, filed
       as exhibit 2.2 to the registration statement on Form S-3 filed on
       April 29, 2002, and hereby incorporated by reference.

2.3    Warrant - Exhibit B to Amendment No. 1 to the Purchase Agreement,
       filed as exhibit 2.3 to the registration statement on Form S-3 filed
       on April 29, 2002, and hereby incorporated by reference.

2.4    Registration Rights Agreement - Exhibit C to Amendment No. 1 to the
       Purchase Agreement, filed as exhibit 2.4 to the registration statement
       on Form S-3 filed on April 29, 2002, and hereby incorporated by
       reference.

3.1    Amended and Restated Articles of Incorporation of the Registrant,
       filed as Exhibit No. 3.1 to the registration statement on amendment
       No. 2 to Form SB-2 dated April 3, 1998 (Reg. No. 333-46005) (the
       "Registration Statement"), and hereby incorporated by reference.

3.2    Amended and Restated By-Laws of the Registrant, filed as Exhibit No.
       3.2 to the Registration Statement, and hereby incorporated by
       reference.

10.1*  Registrant's 1995 Stock Option Plan, as amended, filed as Exhibit No.
       4.1 to the Registration Statement on Form S-8 on September 8, 2000,
       and hereby incorporated by reference.

10.2*  Registrant's Non-Employee Directors' Stock Option Plan, filed as
       Exhibit No. 10.2 to the Registration Statement, and hereby incorporated
       by reference.

10.3*  Employment Agreement between Registrant and Rimas Buinevicius dated as
       of January 1, 2001, filed as Exhibit 10.4 to the Quarterly Report on
       Form 10-Q for the quarter ended March 31, 2001, and hereby
       incorporated by reference.

10.4*  Employment Agreement between Registrant and Monty R. Schmidt dated as
       of January 1, 2001, filed as Exhibit 10.5 to the Quarterly Report on
       Form 10-Q for the quarter ended March 31, 2001, and hereby
       incorporated by reference.

10.5*  Employment Agreement between Registrant and Curtis J. Palmer
       dated as of January 1, 2001, filed as Exhibit 10.6 to the
       Quarterly Report on Form 10-Q for the quarter ended March 31,
       2001, and hereby incorporated by reference.

10.6   Digital Audio System License Agreement between Registrant and Dolby
       Laboratories Licensing Corporation dated July 28, 1997, filed as Exhibit
       No. 10.7 to the Registration Statement, and hereby incorporated by
       reference.

10.7   Digital Audio System License Agreement between Registrant and Dolby
       Laboratories Licensing Corporation dated July 28, 1997, filed as Exhibit
       No. 10.8 to the Registration Statement, and hereby incorporated by
       reference.

10.9   Convertible Debenture Purchase Agreement dated September 13, 1999 between
       Purchasers and the Registrant filed as Exhibit No. 10.17 to the Current
       Report on form 8-K filed on September 24, 1999, and hereby incorporated
       by reference.

10.10  Commercial Lease between Registrant and Tenney Place Development, LLC
       regarding 1617 Sherman Ave., Madison, Wisconsin dated October 1, 1999,
       filed as Exhibit No. 10.18 to the Annual Report on form 10-K for the
       period ended September 30, 1999, and hereby

                                       51

<PAGE>
                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


        incorporated by reference.

10.11   Commercial Lease between Registrant and Hargol Management Limited
        regarding 23 Prince Andrew Place, Don Mills, Ontario, Canada dated
        January 15, 1990, filed as Exhibit No. 10.20 to the Amended Annual
        Report on Form 10-K/A for the year ended September 30, 2000, and
        hereby incorporated by reference.

10.12   Commercial Lease between Registrant and the Richlar Partnership
        regarding 1703 Stewart St., Santa Monica, CA, dated August 10, 1995,
        filed as Exhibit No. 10.21 to the Amended Annual Report on Form 10-K/A
        for the year ended September 30, 2000, and hereby incorporated by
        reference.

10.13   Commercial Lease between Registrant and Thomas Seaman regarding 12233
        Olympic Blvd., Santa Monica, CA, dated January 23, 2000 filed as
        Exhibit No. 10.22 to the Amended Annual Report on Form 10-K/A for the
        year ended September 30, 2000, and hereby incorporated by reference.

10.14   Registration Rights Agreement, dated March 31, 2000, among the Company
        and Sony Pictures Entertainment Inc., filed as Exhibit 4.6 to the
        Registration Statement filed on Form S-3 on May 12, 2000, and hereby
        incorporated by reference.

10.15   Buyer Non-Voting Exchangeable Share Option Agreement, dated August 24,
        2000, among the Registrant, Dan McLellan, Curtis Staples, and Sonic
        Foundry (Nova Scotia), Inc., filed as Exhibit 4.3 to the Registration
        Statement filed on Form S-3 on November 7, 2000, and hereby
        incorporated by reference.

10.16   Support Agreement, dated August 24, 2000, between the Company and
        Sonic Foundry (Nova Scotia), Inc. filed as Exhibit 4.4 to the
        Registration Statement filed on Form S-3 on November 7, 2000 and
        hereby incorporated by reference.

10.17   Commercial Lease between Ewart Associates, L.P. and Sonic Foundry
        Systems Group, Inc. (now known as Sonic Foundry Media Systems, Inc.),
        regarding 925 Liberty Avenue, Pittsburgh, PA 15222, dated November 30,
        2001, filed as Exhibit No. 10.23 to the Quarterly Report on Form 10-Q
        for the quarter ended March 31, 2002, and hereby incorporated by
        reference.

10.18   Commercial Lease between Stonewood East and Sonic Foundry Media
        Systems, Inc. regarding 12300 Perry Highway, Wexford, PA, dated
        January 13, 2002 filed as Exhibit No. 10.24 to the Quarterly Report on
        Form 10-Q for the quarter ended March 31, 2002, and hereby
        incorporated by reference.

10.19   Asset Purchase Agreement and Plan of Asset Transfer and Reorganization
        dated September 6, 2001 by and among Sonic Foundry, Inc., Sonic
        Foundry Systems Group, Inc. (formerly known as MediaSite Acquisition,
        Inc.), and MediaSite, Inc., filed as Exhibit No. 2.1 to the Current
        Report on Form 8-K dated October 30, 2001, and hereby incorporated by
        reference.

10.20   Asset Purchase Agreement dated February 6, 2002 by and among Sonic
        Foundry Media Services, Inc. and Digital Savant, Inc, filed as Exhibit
        No. 10.26 to the Quarterly Report on Form 10-Q for the quarter ended
        March 31, 2002, and hereby incorporated by reference.

10.21*  Registrant's 2001 Deferred Compensation Plan, filed as Exhibit 4.4 to
        Form S-8 on November 21, 2001 and hereby incorporated by reference.

10.22   Stock Restriction and Registration Agreement between Sonic Foundry,
        Inc., Zero Stage Capital VI Limited Partnership, Saturn Capital, Inc.
        and Saturn Partners Limited Partnership dated October 15, 2001 filed
        as Exhibit 4.4 to Form S-3 filed on December 21, 2001, and hereby
        incorporated by reference.


                                       52

<PAGE>
                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


10.23* Registrant's Amended 1999 Non-Qualified Plan, filed as Exhibit 4.1 to
       Form S-8 on December 21, 2001, and hereby incorporated by reference.

10.24  Software License and Marketing Agreement effective as of March 25, 2002
       between Registrant and Broderbund Properties LLC filed as
       Exhibit No. 99.2 to the Registration Statement on Form S-3 filed on
       August 13, 2002 and hereby incorporated by reference.

10.25  Amended and Restated License Agreement effective October 15, 2001 between
       Carnegie Mellon University and MediaSite, Inc. filed as
       Exhibit No. 10.31 to the Quarterly Report on Form 10-Q for the quarter
       ended March 31, 2002 , and hereby incorporated by reference.

10.26  Warrant Agreement filed as Exhibit 10.1 to Registration  Statement
       No. 333-98795 on Form S-3 filed on August 27, 2002 and hereby
       incorporated by reference.

23     Consent of Ernst & Young LLP, Independent Auditors.

99.1   Section 906 Certification of Chief Executive Officer.

99.2   Section 906 Certification of Chief Financial Officer.


       * Compensatory Plan or Arrangement



(b) REPORTS ON FORM 8-K (none)

                                       53

<PAGE>
                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


SIGNATURES

Pursuant to the requirement of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized in the City of Madison,
State of Wisconsin, on December 27 , 2002.

                               Sonic Foundry, Inc.
                               -------------------
                                  (Registrant)

By:        /s/ Rimas P. Buinevicius
           ---------------------------------------
           Rimas P. Buinevicius
           Chairman and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed by the following persons in the capacities and on the dates
indicated.
<TABLE>
<CAPTION>

Signature                                      Title                                                     Date
---------                                      -----                                                     ----
<S>                                            <C>                                                       <C>

/s/ Rimas P. Buinevicius                       Chief Executive Officer and Chairman                      December     27, 2002
------------------------------------------

/s/ Monty R. Schmidt                           President and Director                                    December     27, 2002
------------------------------------------

/s/ Curtis J. Palmer                           Chief Technology Officer and Director                     December     27, 2002
------------------------------------------

/s/ Kenneth A. Minor                           Chief Financial Officer                                   December     27, 2002
------------------------------------------

/s/ Frederick H. Kopko, Jr.                    Secretary and Director                                    December     27, 2002
------------------------------------------

/s/ Arnold Pollard                             Director                                                  December     27, 2002
------------------------------------------

/s/ David C. Kleinman                          Director                                                  December     27, 2002
------------------------------------------
</TABLE>



                                       54

<PAGE>
                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


                                 CERTIFICATIONS

I, Rimas P. Buinevicius, certify that:

     1.   I have reviewed this annual report on Form 10-K of Sonic Foundry,
          Inc.;

     2.   Based on my knowledge, this annual report does not contain any untrue
          statement of a material fact or omit to state a material fact
          necessary to make the statements made, in light of the circumstances
          under which such statements were made, not misleading with respect to
          the period covered by this annual report;

     3.   Based on my knowledge, the financial statements, and other financial
          information included in this annual report, fairly present in all
          material respects the financial condition, results of operations and
          cash flows of the registrant as of, and for, the periods presented in
          this annual report;

     4.   The registrant's other certifying officers and I are responsible for
          establishing and maintaining disclosure controls and procedures (as
          defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
          and we have:

          a) designed such disclosure controls and procedures to ensure that
          material information relating to the registrant, including its
          consolidated subsidiaries, is made known to us by others within those
          entities, particularly during the period in which this report is
          being prepared;

          b) evaluated the effectiveness of the registrant's disclosure controls
          and procedures as of a date within 90 days prior to the filing date of
          this report (the "Evaluation Date"); and

          c) presented in this report our conclusions about the effectiveness
          of the disclosure controls and procedures based on our evaluation
          as of the Evaluation Date;

     5.   The registrant's other certifying officers and I have disclosed, based
          on our most recent evaluation, to the registrant's auditors and the
          audit committee of registrant's board of directors (or persons
          performing the equivalent function):

          a) all significant deficiencies in the design or operation of internal
          controls which could adversely affect the registrant's ability to
          record, process, summarize and report financial data and have
          identified for the registrant's auditors any material weaknesses in
          internal controls; and

          b) any fraud, whether or not material, that involves management or
          other employees who have a significant role in the registrant's
          internal controls; and

     6.   The registrant's other certifying officers and I have indicated in
          this report whether or not there were significant changes in internal
          controls or in other factors that could significantly affect internal
          controls subsequent to the date of our most recent evaluation,
          including any corrective actions with regard to significant
          deficiencies and material weaknesses.

Date:  December 27, 2002

              By: /s/ Rimas P. Buinevicius
                -----------------------------
              By:   Rimas P. Buinevicius
              Title: Chairman and CEO

                                       55

<PAGE>
                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


I, Kenneth A. Minor, certify that:

     1.   I have reviewed this annual report on Form 10-K of Sonic Foundry,
          Inc.;

     2.   Based on my knowledge, this annual report does not contain any untrue
          statement of a material fact or omit to state a material fact
          necessary to make the statements made, in light of the circumstances
          under which such statements were made, not misleading with respect to
          the period covered by this annual report;

     3.   Based on my knowledge, the financial statements, and other financial
          information included in this annual report, fairly present in all
          material respects the financial condition, results of operations and
          cash flows of the registrant as of, and for, the periods presented in
          this annual report;

     4.   The registrant's other certifying officers and I are responsible for
          establishing and maintaining disclosure controls and procedures (as
          defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
          and have:

          a) designed such disclosure controls and procedures to ensure that
          material information relating to the registrant, including its
          consolidated subsidiaries, is made known to us by others within those
          entities, particularly during the period in which this report is
          being prepared;

          b) evaluated the effectiveness of the registrant's disclosure controls
          and procedures as of a date within 90 days prior to the filing date of
          this report (the "Evaluation Date"); and

          c) presented in this report our conclusions about the effectiveness
          of the disclosure controls and procedures based on our evaluation
          as of the Evaluation Date;

     5.   The registrant's other certifying officers and I have disclosed, based
          on our most recent evaluation, to the registrant's auditors and the
          audit committee of registrant's board of directors (or persons
          performing the equivalent function):

          a) all significant deficiencies in the design or operation of internal
          controls which could adversely affect the registrant's ability to
          record, process, summarize and report financial data and have
          identified for the registrant's auditors any material weaknesses in
          internal controls; and

          b) any fraud, whether or not material, that involves management or
          other employees who have a significant role in the registrant's
          internal controls; and

     6.   The registrant's other certifying officers and I have indicated in
          this report whether or not there were significant changes in internal
          controls or in other factors that could significantly affect internal
          controls subsequent to the date of our most recent evaluation,
          including any corrective actions with regard to significant
          deficiencies and material weaknesses.


Date: December 27, 2002

              By: /s/ Kenneth A. Minor
                ----------------------------
              By:   Kenneth A. Minor
              Title: Chief Financial Officer and Secretary

                                       56

<PAGE>

                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


                               SONIC FOUNDRY, INC

                 SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
                                 (In thousands)
<TABLE>
<CAPTION>
                                                       Additions             Deductions
                                               ---------------------------------------------
                                 Balance at    Charged to  Charged to Other                    Balance at
                                Beginning of   Costs and       Accounts                          End of
                                   Period       Expenses     Describe/(1)/     Describe/(2)/     Period
                                ------------   ---------   ----------------    -------------   ----------
<S>                             <C>            <C>         <C>                 <C>             <C>
Year ended September 30, 2002
-----------------------------
Accounts receivable reserve        $1,075        $  321         $   --            $  667         $  729
                                   ======        ======         ======            ======         ======

Inventory reserve                  $  177        $   75         $   --            $  125         $  127
                                   ======        ======         ======            ======         ======

Year ended September 30, 2001
-----------------------------
Accounts receivable reserve        $1,209        $2,929         $   --            $3,063         $1,075
                                   ======        ======         ======            ======         ======

Inventory reserve                   $ 225        $   --         $   --            $   48         $  177
                                   ======        ======         ======            ======         ======

Year ended September 30, 2000
-----------------------------
Accounts receivable reserve        $1,315        $1,763         $  171            $2,040         $1,209
                                   ======        ======         ======            ======         ======

Inventory reserve                  $   --        $  225         $   --            $   --         $  225
                                   ======        ======         ======            ======         ======
</TABLE>

1.      Allowance upon acquisition of receivables of STV and II.

2.      The 2002 deduction for accounts receivable reserve includes $477 for
        uncollectible accounts written off and $190 for rebates. The 2001
        deduction for the accounts receivable reserve includes uncollectible
        accounts written off of $1,139 and actual rebates taken of $1,924. The
        deduction for the inventory reserve includes inventory written off.

                                       57



<PAGE>


                              Sonic Foundry, Inc.
                           Annual Report on Form 10-K
                     For the Year Ended September 30, 2002


EXHIBIT 23

               CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

We consent to the incorporation by reference in (i) the Registration Statement
(Form S-8 filed on March 26, 1999, amended on September 8, 2000) pertaining to
the Sonic Foundry, Inc. 1995 Stock Option Plan, the Sonic Foundry, Inc.
Non-Employee Directors Stock Option Plan and the Shareholder Relations
Consultant Warrants, (ii) the Registration Statement (Form S-3 filed on November
12, 1999) pertaining to shares of common stock issuable upon conversion of
debentures and exercise of certain warrants, (iii) the Registration Statement
(Form S-3 filed on October 25, 1999) pertaining to shares of common stock
issuable upon exercise of certain warrants, (iv) the Registration Statement
(Form S-8 filed on June 30, 2000) pertaining to the Sonic Foundry, Inc. Employee
Stock Purchase Plan, (v) the Registration Statement (Form S-8 filed on September
8, 2000) pertaining to the 1999 Non-Qualified Stock Option Plan, (vi) the
Registration Statement (Form S-3 filed on November 7, 2000, amended on February
16, 2001) pertaining to shares of common stock issuable upon conversion of
exchangeable shares and the exercise of exchangeable share options and warrants
(vii) the Registration Statement (Form S-3 filed on May 15, 2000) pertaining to
shares of common stock issuable upon the exercise of warrants, (viii) the
Registration Statement (Form S-8 filed on November 21, 2001) pertaining to the
Sonic Foundry, Inc. 2001 Deferred compensation Plan, (ix) the Registration
Statement (Form S-8 filed on December 21, 2001) pertaining to the MediaSite,
Inc. Employee Retention Plan, (x) the Registration Statement (Form S-8 amended
on December 21, 2001) pertaining to the amended 1999 Non-Qualified Stock Option
Plan, (xi) the Registration Statement (Form S-3 effective July 17, 2002)
pertaining to shares issued and issuable pursuant to the conversion of debt and
exercise of warrants, (xii) the Registration Statement (Form S-3 effective
August 16, 2002) pertaining to shares issued and issuable pursuant to the
exercise of warrants and (xiii) the Registration Statement (Form S-3 effective
September 13, 2002) pertaining to shares issued and issuable pursuant to the
exercise of warrants of our report dated November 9, 2002, except Note 4 and
Note 16 as to which the date is December 17, 2002, with respect to the financial
statements and schedule of Sonic Foundry, Inc. included in this Annual Report
(Form 10-K) for the year ended September 30, 2002.

                                       /s/ ERNST & YOUNG

Milwaukee, Wisconsin
December 23, 2002


                                       58