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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
   FORM 10-Q
 
 (Mark One) ü
    
    Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934For the period ended: September 30, 2004ORo
    
    Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 Commission File Number: 000-26460 SPATIALIZER AUDIO LABORATORIES, INC.  Delaware
    
    95-4484725(State or other jurisdiction of
    
    (IRS Employerincorporation or organization)
    
    Identification No.)
 2625 Townsgate Road, Suite 330
Westlake Village, California 91361 (Address of principal executive offices) 1754 Technology Drive, Suite 125
San Jose, California 95110 (Address of principal corporate offices) Telephone Number: (408) 453-4180 (Registrants telephone number, including area code) 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 ü                                                                                               No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act): Yes o                                                                                               No ü As of October 28, 2004, there were 46,975,365 shares of the Registrants Common
Stock outstanding.




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TABLE OF CONTENTS  CONSOLIDATED BALANCE SHEETSCONSOLIDATED STATEMENTS OF OPERATIONSCONSOLIDATED STATEMENT OF CASH FLOWSCONSOLIDATED STATEMENT OF SHAREHOLDERS EQUITYNotes to Consolidated Financial StatementsItem 2. Managements Discussion and Analysis of Financial Condition and Results of OperationsItem 3. Quantitative and Qualitative Disclosures About Market RiskItem 4. Controls and ProceduresPART II. OTHER INFORMATIONITEM 1. LEGAL PROCEEDINGSITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDSITEM 3. DEFAULTS UPON SENIOR SECURITIESITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERSITEM 5. OTHER INFORMATIONITEM 6. EXHIBITS AND REPORTS ON FORM 8-KSIGNATURESExhibit 10.5Exhibit 31.1Exhibit 32.1    Table of Contents  SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES 
 CONSOLIDATED BALANCE SHEETS September 30,
    
    December 31,2004
    
    2003(unaudited)ASSETSCurrent Assets:Cash and Cash Equivalents
    
    $
    920,047
    
    
    $
    589,797Accounts Receivable, net
    
    
    208,029
    
    
    
    345,411Prepaid Expenses and Deposits
    
    
    95,074
    
    
    
    35,430Total Current Assets
    
    
    1,223,150
    
    
    
    970,638Property and Equipment, net
    
    
    33,868
    
    
    
    42,022Intangible Assets, net
    
    
    167,650
    
    
    
    192,485Total Assets
    
    $
    1,424,668
    
    
    $
    1,205,145LIABILITIES AND SHAREHOLDERS EQUITYCurrent Liabilities:Notes Payable to Related Party, Short Term
    
    
    37,500
    
    
    
    37,500Note Payable
    
    
    36,745
    
    
    
    Accounts Payable
    
    
    17,221
    
    
    
    21,466Accrued Wages and Benefits
    
    
    39,898
    
    
    
    36,973Accrued Professional Fees
    
    
    15,000
    
    
    
    20,000Accrued Commissions
    
    
    38,548
    
    
    
    33,856Accrued Expenses
    
    
    32,196
    
    
    
    28,197Deferred Income
    
    
    547,953
    
    
    
    Total
Current Liabilities
    
    
    765,061
    
    
    
    177,992Notes Payable to Related Party, Long Term
    
    
    30,831
    
    
    
    70,746Commitments and ContingenciesSeries B-1, Redeemable Convertible Preferred shares, $.01 par
value, 1,000,000 shares authorized, 102,762
shares issued and outstanding at September 30, 2004
and December 31, 2003.
    
    
    1,028
    
    
    
    1,028Shareholders Equity:Common shares, $.01 par value, 65,000,000 shares
authorized, 46,975,365 shares
issued and outstanding at September 30, 2004 and
December 31, 2003.
    
    
    469,754
    
    
    
    470,159Additional Paid-In Capital
    
    
    46,429,020
    
    
    
    46,428,615Accumulated Deficit
    
    
    (46,271,026
    )
    
    
    (45,943,395
    )Total Shareholders Equity
    
    
    627,748
    
    
    
    955,379$
    1,424,668
    
    
    $
    1,205,145




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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited) For the Three Month Period Ended
    
    For the Nine Month
Period EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenues :License Revenues
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Royalty Revenues
    
    
    205,324
    
    
    
    341,339
    
    
    
    610,863
    
    
    
    924,619Product Revenues
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    205,324
    
    
    
    341,339
    
    
    
    610,863
    
    
    
    924,619Cost of Revenues
    
    
    26,114
    
    
    
    35,147
    
    
    
    61,252
    
    
    
    93,586Gross Profit
    
    
    179,210
    
    
    
    306,192
    
    
    
    549,611
    
    
    
    831,033Operating Expenses:General and Administrative
    
    
    155,268
    
    
    
    193,293
    
    
    
    528,181
    
    
    
    585,830Research and Development
    
    
    93,842
    
    
    
    122,145
    
    
    
    295,630
    
    
    
    333,289Sales and Marketing
    
    
    11,484
    
    
    
    93,488
    
    
    
    46,962
    
    
    
    295,180260,594
    
    
    
    408,926
    
    
    
    870,773
    
    
    
    1,214,299Operating (Loss)
    
    
    (81,384
    )
    
    
    (102,734
    )
    
    
    (321,162
    )
    
    
    (383,266
    )Interest and Other Income
    
    
    744
    
    
    
    1,444
    
    
    
    2,633
    
    
    
    5,908Interest and Other Expense
    
    
    (1,936
    )
    
    
    (2,812
    )
    
    
    (8,702
    )
    
    
    (10,634
    )(1,192
    )
    
    
    (1,368
    )
    
    
    (6,069
    )
    
    
    (4,726
    )(Loss) Before Income Taxes
    
    
    (82,576
    )
    
    
    (104,102
    )
    
    
    (327,231
    )
    
    
    (387,992
    )Income Taxes
    
    
    2,000
    
    
    
    (2,400
    )
    
    
    (400
    )
    
    
    (5,420
    )Net (Loss)
    
    $
    (80,576
    )
    
    $
    (106,502
    )
    
    $
    (327,631
    )
    
    $
    (393,412
    )Basic and Diluted(Loss) Per Share
    
    $
    (0.00
    )
    
    $
    (0.00
    )
    
    $
    (0.01
    )
    
    $
    (0.01
    )Weighted Average Shares
Outstanding
    
    
    46,975,365
    
    
    
    47,406,939
    
    
    
    46,975,365
    
    
    
    47,406,939




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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES 
 CONSOLIDATED STATEMENT OF CASH FLOWS
(unaudited)
 Nine Months EndedSeptember 30,2004
    
    2003Cash Flows from Operating Activities:Net (Loss)
    
    $
    (327,631
    )
    
    $
    (393,412
    )Adjustments to reconcile net (loss) to net cash
provided by (used in) operating activities:Depreciation and Amortization
    
    
    52,816
    
    
    
    65,980Net Change in Assets and Liabilities:Accounts Receivable and Employee Advances
    
    
    137,382
    
    
    
    172,079Prepaid Expenses and Deposits
    
    
    (59,644
    )
    
    
    (14,854
    )Note Payable
    
    
    
    
    
    
    36,745Accounts Payable
    
    
    (4,245
    )
    
    
    1,711Accrued Wages and Benefits
    
    
    2,925
    
    
    
    Accrued Professional Fees
    
    
    (5,000
    )
    
    
    Accrued Commissions
    
    
    4,692
    
    
    
    Accrued Expenses
    
    
    3,999
    
    
    
    (28,528
    )Deferred Income
    
    
    547,953
    
    
    
    Net Cash Provided By (Used In) Operating Activities
    
    
    389,992
    
    
    
    (197,024
    )Cash Flows from Investing Activities:Purchase/Disp of Property and Equipment
    
    
    (3,247
    )
    
    
    (3,680
    )Increase in Capitalized Patent and Technology Costs
    
    
    (16,580
    )
    
    
    (1,030
    )Net Cash Provided By (Used in) Investing Activities
    
    
    (19,827
    )
    
    
    (4,710
    )Cash flows from Financing Activities:Repayment of Notes Payable
    
    
    (39,915
    )
    
    
    Net Cash Provided by Financing Activities
    
    
    (39,915
    )
    
    
    Increase (Decrease) in Cash and Cash Equivalents
    
    
    330,250
    
    
    
    (201,734
    )Cash and Cash Equivalents, Beginning of Period
    
    
    589,797
    
    
    
    858,725Cash and Cash Equivalents, End of Period
    
    $
    920,047
    
    
    $
    656,991Supplemental Disclosure of Cash Flow Information:Cash paid during the period for:Interest
    
    $
    10,149
    
    
    $
    10,632Income Taxes
    
    
    400
    
    
    
    5,420




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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES 
 CONSOLIDATED STATEMENT OF SHAREHOLDERS EQUITY
(unaudited)
 Common Shares
    
    
    
    
    
    
    
    
    
    TotalNumber of
    
    
    
    
    
    Additional
    
    Accumulated
    
    Shareholdersshares
    
    Par value
    
    paid-in-capital
    
    Deficit
    
    EquityBalance, December 31, 2003
    
    
    47,015,865
    
    
    $
    470,159
    
    
    $
    46,428,615
    
    
    $
    (45,943,395
    )
    
    $
    955,379Issuance of Preferred Shares, Net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Options Exercised
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Warrants Exercised
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Options Issued for Services
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Conversion of Preferred Shares, Net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net (Loss)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (123,796
    )
    
    
    (123,796
    )Balance, March 31, 2004
    
    
    47,015,865
    
    
    $
    470,159
    
    
    $
    46,428,615
    
    
    $
    (46,067,191
    )
    
    $
    831,583Net (Loss)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (123,259
    )
    
    $
    (123,259
    )Cancellation of Unissued Performance Shares
    
    
    -40,500
    
    
    
    -405
    
    
    
    405Balance, June 30, 2004
    
    
    46,975,365
    
    
    
    469,754
    
    
    
    46,429,020
    
    
    
    (46,190,450
    )
    
    
    708,324Net (Loss)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (80,576
    )
    
    
    (80,576
    )Balance, September 30, 2004
    
    
    46,975,365
    
    
    
    469,754
    
    
    
    46,429,020
    
    
    
    (46,271,026
    )
    
    
    627,748




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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES 
 Notes to Consolidated Financial Statements (1) Nature of Business Spatializer Audio Laboratories, Inc. and subsidiaries (the Company) is
in the business of developing and licensing technology. The Companys sales,
research and subsidiary administration are conducted out of facilities in San
Jose, California. The Companys wholly-owned subsidiary, Desper Products, Inc. (DPI), is
in the business of developing proprietary advanced audio signal processing
technologies and products for consumer electronics, entertainment, and
multimedia computing. All Company revenues are generated from this subsidiary. The foregoing interim financial information is unaudited and has been
prepared from the books and records of the Company. The financial information
reflects all adjustments necessary for a fair presentation of the financial
condition, results of operations and cash flows of the Company in conformity
with generally accepted accounting principles. All such adjustments were of a
normal recurring nature for interim financial reporting. Operating results for
the three and nine months ended September 30, 2004 are not necessarily
indicative of the results that may be expected for the year ending December 31,
2004. Accordingly, your attention is directed to footnote disclosures found in
the December 31, 2003 Annual Report and particularly to Note 1, which includes
a summary of significant accounting policies. (2) Significant Accounting Policies Basis of Consolidation The consolidated financial statements include the
accounts of Spatializer Audio Laboratories, Inc. and its wholly-owned
subsidiary, Desper Products, Inc. All significant intercompany balances and
transactions have been eliminated in consolidation. Corporate administration
expenses are not allocated to subsidiaries. Revenue Recognition The Company recognizes revenue from product sales
upon shipment to the customer. License revenues are recognized when earned, in
accordance with the contractual provisions. Royalty revenues are recognized
upon shipment of products incorporating the related technology by the original
equipment manufacturers (OEMs) and foundries. Deferred Revenue The Company receives License Fee advances from certain
customers in accordance with contract terms. The Company does not require
advances from all customers. Advances are negotiated on a per contract basis.
Cash received in advance of revenue earned from a contract is recorded as
deferred revenue until the related contract revenue is earned under the
Companys revenue recognition policy. Concentration of Credit Risk Financial instruments, which potentially
subject the Company to concentrations of credit risk, consist principally of
cash, cash equivalents and trade accounts receivable. The Company places its
temporary cash investments in certificates of deposit in excess of FDIC
insurance limits, principally at CitiBank FSB. At September 30, 2004
substantially all cash and cash equivalents were on deposit at two financial
institutions. At September 30, 2004, four major customers, not presented in order of
importance, each accounted for 10% or more of our total accounts receivable:
Matsushita, Toshiba, InterVideo




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and Sharp, each of whom accounted for greater than 10% of our total 2004
accounts receivable. One OEM accounted for 38%, another accounted for 17%,
another accounted for 16% and one accounted for 15% of our total accounts
receivable at September 30, 2004. The Company performs ongoing credit evaluations of its customers and
normally does not require collateral to support accounts receivable. Due to the
contractual nature of sales agreements and historical trends, no allowance for
doubtful accounts has been provided. The Company does not apply interest charges to past due accounts
receivable. Cash and Cash Equivalents Cash equivalents consist of highly liquid
investments with original maturities of three months or less. Customers Outside of the U.S. Sales to foreign customers were 88% and
100% of total sales in the year to date periods ended September 30, 2004 and
2003, respectively. Approximately 54% and 42% of sales were generated in Japan
and Korea, respectively. Major Customers During the quarter ended September 30, 2004, four
customers accounted for 42%, 19%, 13% and 12%, respectively, of the Companys
net sales. Research and Development Costs The Company expenses research and
development costs as incurred, which is presented as a separate line on the
statement of operations. Property and Equipment Property and equipment are stated at cost. Major
renewals and improvements are charged to the asset accounts while replacements,
maintenance and repairs, which do not improve or extend the lives of the
respective assets, are expensed. At the time property and equipment are retired
or otherwise disposed of, the asset and related accumulated depreciation
accounts are relieved of the applicable amounts. Gains or losses from
retirements or sales are credited or charged to income. Property and equipment
are depreciated over the useful lives of the asset ranging from 3 years to 5
years under the straight line method. Intangible Assets Intangible assets consist of patent costs and
trademarks which are amortized on a straight-line basis over the estimated
useful lives of the patents which range from five to twenty years. The weighted
average useful life of patents was approximately 12 years. Earnings Per Share Basic earnings (loss) per share is computed by
dividing net income (loss) available to common shareholders by the weighted
average number of common shares outstanding during the period. Diluted earnings
(loss) per share reflects the potential dilution that could occur if securities
or other contracts to issue common stock were exercised or converted into
common stock or resulted in the issuance of common stock that then shared in
the earnings of the entity. The following table presents contingently issuable
shares, options and warrants to purchase shares of common stock that were
outstanding during the three month periods ended September 30, 2004 and 2003
which were not included in the computation of diluted loss per share because
the impact would have been antidilutive or less than $0.01 per share:




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2004
    
    2003Options
    
    
    3,135,000
    
    
    
    2,771,500Warrants
    
    
    0
    
    
    
    03,135,000
    
    
    
    2,771,500
 During the three months ended September 30, 2004, no options to purchase shares
of the Companys common stock were granted. Impairment of Long-Lived Assets and Assets to be Disposed of- The Company
adopted the provisions of SFAS No. 1, Accounting for the Impairment of
Long-Lived Assetson January 1,
2002. This Statement requires that long-lived assets and certain identifiable
intangibles be reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future net cash flows expected
to be generated by the asset. If such assets are considered to be impaired, the
impairment to be recognized is measured as the amount by which the carrying
amounts of the assets exceed the fair value of the assets. Segment Reporting- The Financial Accounting Standards Board issued
Statement No. 131, Disclosures about Segments of an Enterprise and Related
Information(SFAS No. 131), in June 1997. SFAS No. 131 establishes standards
for the way public business enterprises are to report information about
operating segments in annual financial statements and requires enterprises to
report selected information about operating segments in interim financial
reports issued to shareholders. It also establishes standards for related
disclosures about products and services, geographic areas, and major customers.
It replaces the industry segment concept of SFAS No. 14, Financial Reporting
for Segments of a Business Enterprise,with a management approach concept as
to basis for identifying reportable segments. SFAS 131 is effective for
financial statements for fiscal years beginning after December 15, 1997. The
Company adopted SFAS 131 in December 1997. MDT is considered a discontinued
operation as of September 1998. As of September 30, 2004, the Company has only
one operating segment, DPI, the Companys Audio Signal Processing business. Income Taxes- Income taxes are accounted for under the asset and
liability method. Deferred tax assets and liabilities are recognized for the
future tax consequences attributable to differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases and operating loss and tax credit carry forwards. Deferred
tax assets and liabilities are measured using enacted tax rates expected to
apply to taxable income in the years in which those temporary differences are
expected to be recovered or settled. The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in income in the period that
includes the enactment date.




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Recent Accounting Pronouncements- The FASB recently issued the following
statements: FASB 146  Accounting for Costs Associated with Exit or Disposal
Activities, FASB 147  Acquisitions of Certain Financial Institutions, FASB 148
- Accounting for Stock-Based Compensation, FASB 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity and
FASB Interpretation 46 Consolidation of Variable Interest Entities, an
interpretation of ARB No. 51. These FASB statements did not, or are not
expected to, have a material impact on the Companys financial position and
results of operations. Use of Estimates- Management of the Company has made a number of
estimates and assumptions relating to the reporting of assets and liabilities
and the disclosure of contingent assets and liabilities to prepare these
financial statements in conformity with generally accepted accounting
principles. Actual results could differ from those estimates. Fair Value of Financial Instruments- The fair and carrying values of cash
equivalents, accounts receivable, accounts payable, short-term debt to a
related party and accrued liabilities and those potentially subject to
valuation risk at December 31, 2003 and September 30, 2004 approximated fair
value due to their short maturity or nature. The fair values of notes payable to a related party at December 31, 2003
and September 30, 2004 are materially consistent with the related carrying
values based on current rates offered to the Company for instruments with
similar maturities. (3) Property and Equipment Property and equipment, as of December 31, 2003 and September 30, 2004,
consists of the following, net of a reserve for impairment loss in 1998 in
accordance with application of SFAS 121: September 30, 2004
    
    December 31, 2003Office Computers, Software, Equipment and Furniture
    
    $
    331,866
    
    
    $
    309,744Test Equipment
    
    
    73,300
    
    
    
    73,300Tooling Equipment
    
    
    45,539
    
    
    
    45,539Trade Show Booth and Demonstration Equipment
    
    
    174,548
    
    
    
    171,301Automobiles
    
    
    7,000
    
    
    
    7,000Total Property and Equipment
    
    
    632,253
    
    
    
    606,884Less Accumulated Depreciation and Amortization
    
    
    598,385
    
    
    
    564,862Property and Equipment, Net
    
    $
    33,868
    
    
    $
    42,022




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(4) Intangible Assets Intangible assets, as of December 31, 2003 and September 30, 2004 consist
of the following: September 30, 2004
    
    December 31, 2003Capitalized Patent, Trademarks and Technology Costs
    
    $
    522,068
    
    
    $
    505,487Less Accumulated Amortization
    
    
    354,418
    
    
    
    313,002Intangible Assets, Net
    
    $
    167,650
    
    
    $
    192,485
 Estimated amortization is as follows: 2004
    
    $
    29,5632005
    
    $
    25,7332006
    
    $
    16,7022007
    
    $
    16,702Thereafter
    
    $
    78,950167,650
 (5) Notes Payable to Related Parties The Company was indebted to the Desper Family Trust, a related party, in
the amount of $68,331 at September 30, 2004. The Desper Family
Trusts principle beneficiary is the mother of a former Director of the Company. In the fourth quarter of 2003, in
response to the calling of the Note by the holder, we negotiated and completed
the conversion of the original $112,500 related party 10% demand note to a
three- year 10% term note. This amount bears interest at a fixed rate of 10%
annually, is paid in monthly installments of $5,191 that commenced on December
1, 2003 and continues for twenty-four months until the entire balance of
principal and interest is paid in full. (6) Note Payable The Company was indebted to the Premium Finance, Inc., an unrelated
insurance premium finance company, in the amount of $36,745 at September 30,
2004. This note finances the Companys annual Directors and Officers
Liability Insurance. This amount bears interest at a fixed rate of 8%
annually, is paid in monthly installments of $5,191 that commenced on June 1,
2004 and continues for nine months until the entire balance of principal and
interest is paid in full.




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(7) Shareholders Equity During the quarter ended September 30, 2004, no shares were issued,
cancelled or converted. During the year ended December 31, 2003, shares were issued or converted
as follows: An employee exercised options to purchase 166,666 shares of common stock in
2003, increasing shareholders equity by $10,000. Capitalization Series A Preferred Stock:On December 26, 2002 the Company filed a Certificate
of Elimination with the Delaware Secretary of State stating that no shares of
the Companys Series A Preferred Stock are outstanding and that no shares of
the Series A Preferred Stock will be issued. Series B Preferred Stock:On December 26, 2002 the Company filed a Certificate
of Elimination with the Delaware Secretary of State stating that no shares of
the Companys Series B Preferred Stock are outstanding and that no shares of
the Series B Preferred Stock will be issued. Series B-1 Redeemable Convertible Preferred Stock:On November 6, 2002 the
Board of Directors designated a Series B-1 Preferred Stock. The series has a
par value of $0.01 and a stated value of $10.00 per share which is designated
as a liquidation preference. The stock ranks prior to the Companys common
stock. No dividends will be paid on the Series B-1 Preferred Stock. Conversion
rights exist on or after January 1, 2003 to convert the Series B-1 Preferred
Stock to common at a certain formula. At December 29, 2005 certain mandatory
conversion requirements exist subject to a certain formula. The Series B-1
Preferred Stock has no voting power. Certain restrictions on trading exist
based on date sensitive events. In December 2002, 87,967 shares of Series B-1
Preferred Stock were issued in exchange for the Series B Preferred Stock and
14,795 shares were issued in lieu of the adjusted accrued dividends on the
Series B Preferred Stock. (8) Escrowed Performance Shares In December 1996, the Company accepted the terms outlined by the British
Columbia Securities Commission (BCSC) for the release of the Companys
5,776,700 escrowed Performance Shares from Canadian Escrow into a new escrow
arrangement with the Company. The overall modification was approved by the
Companys stockholders in August 1996. Under the revised arrangement, the
performance shares were released automatically as follows: 20% prior to June
22, 2000, 20% on June 22, 2000; 30% on June 22, 2001; and 30% on June 22, 2002.
Under the revised escrow arrangement, the performance shares vested, provided
the individual had not voluntarily terminated his/her relationship with the
Company prior to applicable vesting dates. Based on the revised escrow arrangement, which primarily converted the escrow
shares




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release from performance criteria to a time-based criterion, the Company
recorded as compensation expense the excess of the fair market value of the
5,776,700 performance shares on the date the Company accepted the terms of the
new escrow arrangement over the purchase price of such escrow shares. All of the performance shares are included in the issued and outstanding shares
for the years ended December 31, 2003, 2002 and 2001. However, the shares were
not reflected in the calculation of loss per common share until earned by and
released to the holders on December 30, 1996, the date on which the Company and
the BCSC accepted and entered into the terms of the current escrowed agreement
as discussed above. As of December 31, 2002, all performance shares under the
escrow arrangement have been released. In December 2003 and June 2004, 557,740
and 40,500 shares, respectively, of former employees or participants, who lost
entitlement to such shares under the terms of the escrow arrangement, were
cancelled. (9) Stock Options In 1995, the Company adopted a stock option plan (the Plan) pursuant to
which the Companys Board of Directors may grant stock options to directors,
officers and employees. The Plan which was approved by the stockholders
authorizes grants of options to purchase authorized but unissued common stock
up to 10% of total common shares outstanding at each calendar quarter,
4,697,537 as of September 30, 2004. Stock options are granted with an exercise
price equal to the stocks fair market value at the date of grant. Stock
options have five-year terms and vest and become fully exercisable up to three
years from the date of grant. At September 30, 2004, there were 1,562,537 additional shares available
for grant under the Plan. There were 200,000 options granted in the quarter ended September 30, 2004
to board members for board compensation and 100,000 shares granted to board
members in 1999 expired. The Company applies APB Opinion No. 25 in accounting for its Plan and,
accordingly, no compensation cost has been recognized for the fair value of its
stock options in the consolidated financial statements. Had the Company
determined compensation cost based on the fair value at the grant date for its
stock options under SFAS No. 123, the Companys net income (loss) would have
been increased to the pro forma amounts indicated below: 2004NET INCOME (LOSS):As Reported
    
    $
    (327,631
    )Pro Forma
    
    $
    (327,631
    )BASIC AND DILUTED LOSS:As Reported
    
    $
    (0.01
    )Pro Forma
    
    $
    (0.01
    )




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At September 30, 2004, the number of options exercisable was 3,135,000 and
the weighted-average exercise price of those options was $0.178. There were no warrants outstanding at December 31, 2003 and September 30,
2004. (10) Commitments and Contingencies We also anticipate that, from time to time, we may be named as a party to
legal proceedings that may arise in the ordinary course of our business. Operating Lease Commitments The Company is obligated under several non-cancelable operating leases.
Future minimum rental payments at September 30, 2004 for all operating leases
were approximately $5,400 through December 2004. Rent expense amounted to
approximately $5,400 and $21,000 for the quarters ended September 30, 2004 and
2003, respectively. (11) Profit Sharing Plan The Company has a 401(k) profit sharing plan covering substantially all
employees, subject to certain participation and vesting requirements. The
Company may elect to make discretionary contributions to the Plan, but has
never done so over the life of the Plan.




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Item 2. Managements Discussion and Analysis of Financial Condition and Results
of Operations This information should be read in conjunction with Managements
Discussion and Analysis of Financial Condition and Results of Operations
contained in the Companys Annual Report on Form 10-K for the year ended
December 31, 2003, the audited consolidated financial statements and the notes
thereto included in the Form 10-K and the unaudited interim consolidated
financial statements and notes thereto included in this report. Approach to MD&A The purpose of MD&A is to provide our shareholders and other interested
parties with information necessary to gain an understanding of our financial
condition, changes in financial condition and results of operations. As such,
we seek to satisfy three principal objectives:  
    
    to provide a narrative explanation of a Companys financial
statements that enables investors to see the company through the eyes of
management;
    
    to enhance the overall financial disclosure and provide the
context within which financial information should be analyzed; and
    
    to provide information about the quality of, and potential
variability of, a companys earnings and cash flow, so that investors
can ascertain the likelihood that past performance is indicative of
future performance. We believe the best way to achieve this is to give the reader:  
    
    An understanding of our operating environment
    
    An outline of critical accounting policies
    
    A review of the key components of the financial statements and our
cash position and capital resources
    
    Disclosure on our internal controls and procedures Operating Environment We operate in a very competitive business environment. This environment
impacts us in the following ways, further discussed in greater detail under
Risk Factors:  
    
    Our Operating Results Fluctuate and If We Are Unable to Achieve or
Sustain Profitability in the Future or Obtain Future Financing Our
Business Operations May Fail.
    
    Because The Market In Which We Operate Is Highly Competitive, We
Face Significant Pricing Pressure and Competition.




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
    
    We Rely on the Schedules and Cooperation of Chip Makers or Other
Third Parties to Deliver Our Technology in Consumer Products. These
Third parties Have Their Own Priorities and Alliances that May Delay or
Thwart our Sales Efforts to Potential Customers.
    
    If New Product Development Is Delayed, We Will Experience Delays In
Revenues And Competitive Products May Reach The Market Before Our
Products.
    
    If We Are Unable To Attract And Retain Our Key Personnel, We May
Not Be Able To Successfully Operate Our Business. The fluid, competitive and dynamic nature of the market continues a degree of
uncertainty to our operations. The operations of our business, and those of our
competitors, may also be impacted by the continued trend in the semiconductor
industry to offer free, but minimal audio solutions to certain product classes
to maintain and attract market share. This challenges our ability to convert
business opportunities to licensing agreements in those segments that allow us
to maintain or rapidly increase revenue. As a result, we must develop and
license our products and software solutions in a market that treats some audio
products, including those of our competitors, on a commodity basis in those
cases where the OEM product is considered a commodity product. While our
software applications deliver what we and most manufacturers who listen to it
believe is a significantly superior audio experience, the competitive market
forces that pressure manufacturers to reduce their costs may create some
resistance to new technology adoption or use. In addition, certain of our
competitors appear to be pursuing a business plan that disregards commercially
reasonable pricing to achieve a larger market penetration even if the
penetration will not provide for viable margins or returns. We have responded
by offering additional products targeted to each price/quality segment of the
market and continue to aggressively pursue new opportunities in emerging
product categories such as cellular phones and notebook computers that
complements our existing core business. In addition, our products have been
positioned as a means for manufacturers to save money while delivering an
enhanced audio experience. Nevertheless, these market conditions and
competitive forces make it more challenging for us, and our rational commercial
competitors, to enhance their operating results. The personal computer (PC) and consumer electronics markets are under intense
pressure, primarily from retailers, to reduce selling prices, with resultant
pressure to reduce costs. Cost reductions are driven by lower cost sourcing,
often in China, design simplification and reduction in features. While we
present a value proposition that stresses the cost reducing capabilities of our
audio solutions through improved performance from lower cost components as well
as product differentiation that Spatializer technology can deliver, all such
features are closely scrutinized by potential customers product marketing and
engineering. This makes it more challenging to secure new design wins,
particularly in product categories that have become commoditized, such as
became the case with DVD players. It also may result in the elimination of
features, including ours, if cost is of paramount importance. When this occurs,
we receive very short notice and revenues from such an account will typically
begin a steep decline in the subsequent quarter, resulting in period-to-period
fluctuation. Our response has been to strengthen our value proposition, more
aggressively price and feature enrich our products and enter new segments, such
as cell phones, with different competitive pressure. Manufacturers design-in cycles for our technology range from four to twelve
months, from




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the decision to adopt our technology to actual cash flow to us. These schedules
are also prone to delays at the manufacturer level and in some cases,
manufacturers new products may be cancelled due to market testing or resource
allocation. Since these events are beyond our control, it is difficult to
absolutely project when new deals will begin generating revenues or if signed
deals will generate financial results. For this reason, we do not typically
announce new deals until the target product is being introduced. Spatializer does not develop or market semiconductors. That is why we carry no
inventory or have order backlogs that typically are good indicators of near
term performance. Rather, we develop audio algorithms that are embedded on
third party processors or semiconductors used by our customers. While our
algorithms are implemented on a wide array of processors, often times a
customer uses a processor where there is no such implementation, or where a
competing solution has been implemented. In this case, our customers request
that our algorithm be implemented. While these requests are typically honored,
processor manufacturers must schedule such implementation as their resources or
corporate strategies allow. Therefore, the supply-chain is often quite long and
complicated, which potentially can result in delays or deadlines that may not
always coincide with our customers requirements and which are beyond the
control of our company. Therefore, when reviewing the operating results or drawing conclusions with
regard to future performance, these competitive forces and uncertainties must
be taken into consideration. Without absolute long-term visibility, it is
difficult to draw such conclusions in absolute terms. Further, the dynamic
nature of the business environment creates the potential for both positive and

negative fluctuations in near and long term operating performance. While
management strives to mitigate these risks, as outlined in Risk Factors,it is
not possible to be fully immune from such dynamics.




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Critical Accounting Policies Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated statements, which have been prepared
in accordance with accounting principles generally accepted in the United
States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses based on historical experience and various
other factors that are believed to be reasonable under the circumstances.
Actual results may differ from these estimates under different assumptions or
conditions. In consultation with our Board of Directors and Audit Committee, we
have identified three accounting policies that we believe are critical to an
understanding of our financial statements. These are important accounting
policies that require managements most difficult, subjective judgments. The first critical accounting policy relates to revenue recognition. We
recognize revenue from product sales upon shipment to the customer. License
revenues are recognized when earned, in accordance with the contractual
provisions. Royalty revenues are recognized upon shipment of products
incorporating the related technology by the original equipment manufacturers
(OEMs) and foundries. The second critical accounting policy relates to research and development
expenses. We expense all research and development expenses as incurred. Costs
incurred to establish the technological feasibility of our algorithms (which is
the primary component of our licensing) is expensed as incurred and included in
Research and Development expenses. Such algorithms are refined based on
customer requirements and licensed for inclusion in the customers specific
product. There are no production costs to capitalize as defined in Statement on
Financial Accounting Standards No. 86. The third critical accounting policy relates to intangible assets. Our
intangible assets consist primarily of patents. We capitalize all costs
directly attributable to patents, consisting primarily of legal and filing
fees, and amortize such costs over the remaining life of the patent (which
range from 3 to 20 years) using the straight-line method. In accordance with
SFAS 142, Goodwill and Other Intangible Assets, only intangible assets with
definite lives are amortized. Non-amortized intangible assets are instead
subject to annual impairment testing. Audit Committee This committee is directed to review the scope, cost and results of the
independent audit of our books and records, the results of the annual audit
with management and the internal auditors and the adequacy of our accounting,
financial, and operating controls; to recommend annually to the Board of
Directors the selection of the independent auditors; to approve proposals made
by our independent auditors for consulting work; and to report to the Board of
Directors, when so requested, on any accounting of financial matters.




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Additionally, following the completion of the audit, the committee meets with
the independent accountants to review with the independent accountants any
problems or difficulties the accountants may have encountered in connection
with the audit, the adequacy of the internal accounting controls, the financial
and accounting personnel and any management letter provided by the independent
accountants and the Companys response to that letter. The committee also
discusses with the independent accountants any matters that are required to be
discussed under applicable rules, including without limitation those matters
required to be discussed by Statement on Auditing Standards No. 61 relating to
the conduct of the audit. Compensation and Stock Committee Our Compensation and Stock Option Committee (the Compensation Committee)
currently consists of Messrs. Pace and Segel, each of whom is a non-employee
director of the Company and a disinterested person with respect to the plans
administered by such committee, as such term is defined in Rule 16b-3 adopted
under the Securities Exchange Act of 1934, as amended, and the rules and
regulations thereunder (collectively, the Exchange Act). The Compensation
Committee reviews and approves annual salaries, bonuses and other forms and
items of compensation for our senior officers and employees. Except for plans
that are, in accordance with their terms or as required by law, administered by
the Board of Directors or another particularly designated group, the
Compensation Committee also administers and implements all of our stock option
and other stock-based and equity-based benefit plans (including
performance-based plans), recommends changes or additions to those plans or
awards under the plans. Special Committee In November of 2002, the Board of Directors created a Special Committee to
review certain strategic opportunities as they arise and to obtain additional
information regarding such opportunities for consideration and evaluation by
the Board of Directors. Results of Operations This report contains forward-looking statements, within the meaning of the
Private Securities Reform Act of 1995, which are subject to a variety of risks
and uncertainties. Our actual results, performance, or achievements may differ
significantly from the results, performance, or achievements expressed or
implied in such forward-looking statements. Revenues Revenues for the three months ended September 30, 2004 were $205,000,
compared to revenues of $341,000 in the comparable period last year, a decrease
of 40%. Revenues in the three months ended September 30, 2004 were lower due to
a DVD OEM account with one manufacturer in 2003 for which there was no
comparable account in the current period. Revenues in the nine months ended
September 30, 2004 were $611,000, compared to revenues of $925,000 in the
comparable period last year, a decrease of 34%.The decline in revenue resulted
from the expiration of a licensing agreement with a major computer account in
January 2003 ($125,000 reduction) and the inability to replace a prior year DVD
OEM account in the current nine month period This was partially offset by an
increase in revenues from cell phone accounts.




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Gross Profit Gross profit for the three months ended September 30, 2004 was $179,000
(87% of revenue) compared to gross profit of $306,000 (90% of revenue) in the
comparable period last year, a decrease of 42%. Gross profit for the nine
months ended September 30, 2004 were $550,000 (90% of revenue) compared to
$831,000 (90% of revenue) in the comparable period last year. Gross profit in
the three and nine-month periods decreased primarily due to the decrease in
revenue. Gross margin decline in the current three month period resulted from
a portion of royalty paid and expensed on deferred revenue. Operating Expenses Operating expenses in the three months ended September 30, 2004 were
$261,000 (127% of revenue) compared to operating expenses of $409,000 (120% of
revenue) in the comparable period last year, a decrease of 36%. Operating
expenses in the nine months ended September 30, 2004 were $871,000 (143% of
revenue) compared to $1,214,000 (131% of revenue) in the comparable nine-month
period last year. The decrease in operating expenses for the three and nine
months ended September 30, 2004 resulted primarily from reductions in occupancy
and headcount effected in the fourth quarter of 2003. General and Administrative General and administrative expenses in the three months ended September
30, 2004 were $155,000 (76% of revenue) compared to general and
administrative expenses of $193,000 (57% of revenue) in the comparable period
last year, a decrease of 20%. General and administrative expenses in the
nine-months ended September 30, 2004 were $528,000 (86% of revenue) compared
to $586,000 (63% of revenue) in the comparable nine-month period last year.
The decrease in general and administrative expense for the three and nine
month periods resulted primarily from reductions in occupancy and support
services, partially offset by higher legal and accounting expenses arising
from new regulatory public company requirements and higher executive overseas
travel by the chief executive to secure additional contracts with
manufacturers and to maintain existing relationships with our customers. Research and Development Research and Development expenses in the three months ended September
30, 2004 were $94,000 (46% of revenue) compared to research and development
expenses of $122,000 (36% of revenue) in the comparable period last year, a
decrease of 23%. Research and Development expenses for the nine months ended
September 30, 2004 were $296,000 (48% of revenue) compared to $333,000 (36%
of revenue) in the comparable nine-month period last year. The decrease in
three and nine-month research and development expenses resulted from lower
cost Silicon Valley facilities, and greater use of lower cost off-shore
applications engineering, rather than domestic contracting compared with the
prior period. Sales and Marketing Sales and Marketing expenses in the three months ended September 30,
2004 were $11,000 (5% of revenue) compared to sales and marketing expenses of
$93,000 (27% of




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revenue) in the comparable period last year, a decrease of 88%. Sales
and Marketing expenses for the nine months ended September 30, 2004 were
$47,000 (8% of revenue) compared to $295,000 (32% of revenue) in the
comparable nine-month period last year. The decrease in sales and marketing
expense in the three and nine-month periods resulted primarily from the
elimination of a senior sales executive position ($50,000/$150,000),
transition of Japan sales to a commission only structure ($20,000/$60,000 and
lower cost Silicon Valley facilities ($12,000/$40,000). Net (Loss) Net loss in the three months ended September 30, 2004 was ($81,000), ($0.00)
basic per share, compared with net loss of ($107,000), ($0.00) basic per share in
the comparable period last year. Net loss in the nine months ended September
30, 2004 was ($328,000), ($0.01) basic per share, compared with net loss of
($393,000), ($0.01) basic per share in the comparable period last year. The net
loss resulted from decreased revenues, partially offset by lower operating
expenses. Liquidity and Capital Resources At September 30, 2004, we had $920,000 in cash and cash equivalents as
compared to $590,000 at December 31, 2003. The increase in cash and cash
equivalents results from a royalty advance received in the third quarter,
partially offset by the net loss. We had working capital of $458,000 at
September 30, 2004 as compared with working capital of $792,000 at December 31,
2003. In the fourth quarter of 2003, we negotiated and completed the conversion
of a $112,500 related party 10% demand note to a three-year 10% term note.
Principal and interest of $5,191 is paid monthly, which we pay on a current
basis. Installments due in more than twelve months are classified as Notes
Payable to Related Parties-long-term. We continue to maintain an accrual for unasserted claims or settlement
costs of approximately $28,000. We do not expect any final liability to be in
excess of this balance. We currently believe our future cash flow will come primarily from the
audio signal processing licensing, original equipment manufacturers (OEM)
royalties and from possible common stock issuances including warrants and
options. We are actively engaged in negotiations for additional audio signal
processing licensing arrangements which we believe should generate additional
cash flow without imposing any substantial costs on us. We announced two new
licensing arrangements in the cellular phone market and expect this category to
expand in 2004. We are also targeting other markets where the cost pressure is
not as acute and which might be more receptive to licensing our products. We anticipated that there would be a wind down of our licensing program in
2003 with a large computer account and reductions in licensing to DVD accounts
that are under extreme pressure to reduce costs. We anticipate that there may
continue to be dislocations of individual licensing programs due to continuing
pressure to reduce costs, particularly in the DVD player segment. We believe that growth from other licensing arrangements, which include
new markets such as cellular phones, and other arrangements that are pending
but not announced or in negotiation, will substantially offset any revenue
shortfalls from market dynamics or




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transitioning platforms. Further, we anticipate that our cost reduction
initiative implemented in the fourth quarter of 2003 will lower the revenues
needed to reach the break-even point. To the extent we maintain or exceed our projected revenues and are not
required to fund significant contingencies, we expect to continue to retain our
current cash reserves and therefore, maintain our liquidity position at a
consistent level both on at least a short-term basis. However, to the extent
that we do not achieve current projected operating levels, fail to close deals
in process timely or are required to fund contingencies, we will be required to
use our cash reserves and this will negatively impact our longer term
liquidity. We believe our current cash reserves and cash generated from our
existing operations and customer base are at a minimal level for us to meet our
operating obligations and the anticipated additional research and development
for our audio technology business for the short term. This constrained working
capital currently limits our ability to capitalize fully on market
opportunities and to compete as rigorously as we would like. Indeed, a
continued deterioration in our cash position will, absent new financing or
licensing arrangements, impair our ability to operate as a going concern. If
we do not achieve current projected operating levels, our current cash reserves
may be depleted within    months. In such case, we may have to rely on the
sale of equity, debt or convertible debt financings in the future, which may
have a dilutive effect on our existing shareholders. Further, we cannot assure
you that debt or equity financing will be available as required and if not
available, we would have to further scale down operations or even cease
operations. We will continue to consider and evaluate capital investment or business
arrangements with financial or strategic participants or investors as such
opportunities become available to us on terms that enhance shareholder value
and support our business strategy. Net Operating Loss Carry Forwards At December 31, 2003, we had net operating loss carry forwards for Federal
income tax purposes of approximately $27,000,000 which are available to offset
future Federal taxable income, if any, through 2023. Approximately $17,000,000
of these net operating loss carry forwards are subject to an annual limitation
of approximately $1,000,000. Risk Factors Certain information in this report includes forward-looking statements.
Forward-looking statements include statements regarding our expectations,
beliefs, intentions, plans, objectives, goals, strategies, future events or
performance and underlying assumptions and other statements that are other than
statements of historical fact. When used in this report the words shall,
should, forecast, all of, projected, believes, anticipates,
expects, and similar expressions are intended to identify these
forward-looking statements. In addition, we may from time to time make oral
forward-looking statements. We wish to caution readers that a number of
important factors could cause actual results to differ materially from those in
the forward-looking statements. Factors that could cause or contribute to such
differences include those discussed below, as well as those discussed above in
Managements Discussion and Analysis of Financial Condition and Results of
Operations, elsewhere in this report or from time to time described in our
other filings with the Securities and Exchange Commission.




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Our Operating Results Fluctuate and If We Are Unable to Achieve or Sustain
Profitability in the Future or Obtain Future Financing Our Business Operations
May Fail We continue to experience operating losses. While our objective and full
effort is on managing a profitable business, due to the market conditions and
factors outlined above and below and their impact on fluctuations in operating
expenses and revenues, we cannot provide assurance that we will be able to
generate a positive profit position in any given future period. We cannot
guarantee that we will increase sales of our products and technologies, or that
we will successfully develop and market any additional products. We may not be
able to re-establish or sustain future profitability. We may have to rely on
the sale of equity, debt or convertible debt financings in the future, which
may have a dilutive effect on our existing shareholders. Further, we cannot
assure you that debt or equity financing will be available as required and if
not available, we would have to further scale down operations or even cease
operations. Because The Market In Which We Operate Is Highly Competitive, We Face
Significant Pricing Pressure and Competition. We operate in a technology environment which is competitive and rapidly
changing. While our software applications deliver what we, and most
manufacturers who listen to it, believe is a significantly superior audio
experience, the competitive market forces that pressure manufacturers to reduce
their costs may create some resistance to new technology adoption or use. Our
future success is dependent on establishing and maintaining the technological
superiority of our products over those of competitors, our ability to
successfully identify and bring other compatible technologies and products to
market and a recognition by the market of product value. We compete with a
number of entities that produce various stereo audio enhancement processes,
technologies and products in both traditional two-speaker environments such as
consumer electronics and multimedia computing, and in multi-channel,
multi-speaker applications such as Home Theater. In the field of 3-D or
virtual audio, our principal competitors are SRS Labs, Inc., QSound Labs,
Inc. and Dolby Laboratories or technologies and products developed by other
companies, including entities that have business relationships with us. Many
of our competitors have greater financial, technical, sales and marketing
resources, better name recognition and a larger customer base than ours. In
addition, some of our large competitors may offer customers a broader product
line, which may provide a more comprehensive solution than our current
offerings. In addition, certain of our competitors appear to be pursuing a business
plan that disregards commercially reasonable pricing to achieve a larger market
penetration even if the penetration will not provide for viable margins or
returns. We have responded by offering additional products targeted to each
price and quality segment of the market and continue to aggressively pursue new
opportunities in emerging product categories and complements to our existing
core business. We believe our products have been positioned as a means for
manufacturers to save money while delivering an enhanced audio experience.
Nevertheless, these market conditions and competitive forces make it more
challenging for us, and our rational commercial competitors, to enhance their
operating results. There is no assurance that our present or contemplated
future products will achieve or maintain sufficient commercial acceptance, or
if they do, that functionally equivalent products will not be developed by
current or future competitors who had access to significantly greater resources
or which are willing to give away their products.




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We Rely on the Schedules and Cooperation of Chip Makers or Other Third Parties
to Deliver Our Technology in Consumer Products. These Third Parties Have Their
Own Priorities and Alliances that May Delay or Thwart our Sales Efforts to
Potential Customers. Spatializer does not develop or market semiconductors. That is why we carry no
inventory or have order backlogs that typically are good indicators of near
term performance. Rather, we develop audio algorithms that are embedded on
third party processors or semiconductors used by our customers. While our
algorithms are implemented on a wide array of processors, often times a
customer uses a processor where there is no such implementation, or where a
competing solution has been implemented. In this case, our customers request
that our algorithm be implemented. While these requests are typically honored,
processor manufacturers must schedule such implementation as their resources or
corporate strategies allow. Therefore, the supply-chain is often quite long and
complicated, which potentially can result in delays or deadlines that may not
always coincide with our customers requirements and which are beyond the
control of our company. If New Product Development Is Delayed, We Will Experience Delays In Revenues
And Competitive Products May Reach The Market Before Our Products. Since our inception, we have experienced delays in bringing new products
to market and commercial application as a result of delays inherent in
technology development, financial resource limits and industry responses and
maturity. These delays have resulted in delays in the timing of revenues and
product introduction. In the future, delays in new product development or
technology introduction on behalf of us, our original equipment manufacturers
of consumer electronics and multimedia computer products (OEMs), integrated
circuit (IC) foundries or our software producers and marketers could result in
further delays in revenues and could allow competitors to reach the market with
products before us. In view of the emerging nature of the technology involved,
and the rapidly changing character of the entire media, internet and computer
markets, our expansion into other technology areas, such as cellular
telephones, and the uncertainties concerning the ability of our current
products and new products to achieve meaningful commercial acceptance in the
new technology areas, there can be no assurance of when or if we will achieve
or sustain profitability. Manufacturers design-in cycles for our technology range from four to
twelve months, from the decision to adopt our technology to actual cash flow to
us. These schedules are also prone to delays at the manufacturer level and in
some cases, manufacturers new products may be cancelled due to market testing
or resource allocation. Since these events are beyond our control, it is
difficult to absolutely project when new deals will begin generating revenues
or if signed deals will generate financial results. For this reason, we do not
typically announce new deals until the target product is being introduced. We expect that we will continue to be dependent upon a limited number of
OEMs for a significant portion of our net sales in future periods, although no
OEM is presently obligated either to purchase a specified amount of products or
to provide us with binding forecasts of product purchases for any period. Our
four largest customers as of September 30, 2004 accounted for 42%, 19%, 13%
and 12% of our net sales in the third quarter. The loss of any one of our major
customers or licensees would significantly reduce our revenues and harm our
ability to achieve or sustain acceptable levels of operating results. The loss,
or signing of




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a similarly sized account or accounts would have a material short term
impact on our operations and there is no assurance that we will not lose all or
some of the revenues from one or more of these accounts. While we are working
to broaden the sources of our royalty streams, there can be no assurance that
we will be successful in retaining or attracting such key accounts and
broadening such revenue stream sources. Our products are typically one of many related products used by consumer
electronic users. Demand for our products is therefore subject to many risks
beyond our control, including, among others:  
    
    competition faced by our OEM customers in their particular end
markets;
    
    the technical, sales and marketing and management capabilities of
our OEM customers; and
    
    the pressure faced by our OEM customers to reduce cost There can be no assurance that we will not lose sales in the future as a
result of the pressure to reduce costs faced by our customers. The reduction of
orders from our significant OEM customers, or the discontinuance of our
products by our end users may subject us to potential adverse revenue
fluctuations. If We Are Unable To Attract And Retain Our Key Personnel, We May Not Be Able To
Successfully Operate Our Business. Our future success primarily depends on the abilities and efforts of a
small number of individuals, with particular management obligations and
technical expertise. Loss of the services of any of these persons could
adversely affect our business prospects. There is no assurance that we will be
able to retain this group or successfully recruit other personnel, as needed.
We compete with other enterprises with stronger financial resources and larger
staffs that may offer employment opportunities to our staff which are more
desirable than those which we are able to offer. Failure to maintain skilled
personnel with the software and engineering skills critical to our business
could have an adverse impact upon our business, the results of our operations
and our prospects. Currently, we have an employment agreement with Henry R.
Mandell with a term expiring in November 2005. 
 Item 3.Quantitative and Qualitative Disclosures About Market Risk We have not been exposed to material future earnings or cash flow
fluctuations from changes in interest rates on our short-term investments at
September 30, 2004. A hypothetical decrease of 100 basis points in interest
rate (ten percent of our overall earnings rate) would not result in a material
fluctuation in future earnings or cash flow. We have not entered into any
derivative financial instruments to manage interest rate risk or for
speculative purposes and we are not currently evaluating the future use of such
financial instruments. 
 Item 4.Controls and Procedures




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The Company carried out an evaluation of the effectiveness of the
Companys disclosure controls and procedures, as defined in Rules 13a-15(e) and
15d-15(e) of the Securities and Exchange Act of 1934. Based on that evaluation,
the Chief Executive Officer and Chief Financial Officer had concluded that the
Companys disclosure controls and procedures as of September 30, 2004 were
effective to ensure that information required to be disclosed by the Company in
reports that it files or submits under the Securities Exchange Act of 1934 is
recorded, processed, summarized and reported within the time periods specified
in Securities and Exchange Commissions rules and forms. There were no changes
in the Companys internal control over financial reporting that occurred during
the quarter ended September 30, 2004 that have materially affected, or are
reasonably likely to materially affect, the Companys internal control over
financial reporting.




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PART II. OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS From time to time we may be involved in various disputes and litigation
matters arising in the normal course of business. As of November 8, 2004, we
are not involved in any legal proceedings that are expected to have a material
adverse effect on our consolidated financial position, results of operations or
cash flows. However, litigation is subject to inherent uncertainties. Were an
unfavorable ruling to occur, there exists the possibility of a material adverse
impact on our results of operations of the period in which the ruling occurs.
Our estimate of the potential impact on our financial position or overall
results of operations for new legal proceedings could change in the future. 
 ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS None 
 ITEM 3. DEFAULTS UPON SENIOR SECURITIES None 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None 
 ITEM 5. OTHER INFORMATION None 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 10.5

    License Agreement between Spatializer Audio Laboratories, Inc.,
Desper Products, Inc. and Samsung Electronics, effective August 22,
2004.*31.1

    Certificate of Chief Executive Officer and Chief Financial Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 200232.1

    Certificate of Chief Executive Officer and Chief Financial Officer
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.**




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*

    Confidential treatment requested. Confidential portions of this exhibit
have been redacted and filed separately with the Securities and Exchange
Commission.**

    Certification will not be deemed filed for purposes of Section 18 of
the Securities Exchange Act of 1934.
 (b) Reports on Form 8-K: On August 10, 2004, we filed a Current Report on Form 8-K regarding a
press release issued with earnings information for the quarter ended June 30,
2004. The information furnished in the report shall not be deemed to be filed
for purposes of Section 18 of the Securities Exchange Act of 1934. On August 26, 2004, we filed a Current Report on Form 8-K regarding a
press release issued with information on the License Agreement between
Spatializer Audio Laboratories, Inc., Desper Products, Inc. and Samsung
Electronics. The information furnished in the report shall not be deemed to be
filed for purposes of Section 18 of the Securities Exchange Act of 1934.




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SIGNATURES Pursuant to the requirements 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. Dated: November 10, 2004 SPATIALIZER AUDIO LABORATORIES, INC.(Registrant)/s/ Henry R. MandellHenry R. MandellChairman of the Board, Chief Executive OfficerChief Financial Officer and Secretary