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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
   FORM 10-Q
 
 (Mark One) þ
    
    Quarterly report pursuant to
Section 13 or 15(d) of the Securities Exchange Act of 1934For the period ended: March 31, 2005ORo
    
    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 330Westlake Village, California 91361  2025 Gateway Place, Suite 365San Jose, California 95110  Telephone Number: (408) 453-4180  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 þ
    
    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 þ
 As of May 2, 2005 there were 46,975,365 shares of the Registrants Common Stock outstanding.




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TABLE OF CONTENTS  PART I. FINANCIAL INFORMATIONITEM I. 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 8KSIGNATURESExhibit 31.1Exhibit 32.1    Table of Contents  
 PART I. FINANCIAL INFORMATION 
 ITEM I. FINANCIAL STATEMENTS SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS March 31,
    
    
    December 31,2005
    
    
    2004(unaudited)ASSETSCurrent Assets:Cash and Cash Equivalents
    
    $
    873,904
    
    
    $
    871,155Accounts Receivable, net
    
    
    170,610
    
    
    
    325,712Prepaid Expenses and Deposits
    
    
    36,464
    
    
    
    70,940Total Current Assets
    
    
    1,080,978
    
    
    
    1,267,807Property and Equipment, net
    
    
    29,321
    
    
    
    29,527Intangible Assets, net
    
    
    153,519
    
    
    
    166,710Total Assets
    
    $
    1,263,818
    
    
    $
    1,464,044LIABILITIES AND SHAREHOLDERS EQUITYCurrent Liabilities:Note Payable
    
    
    40,015
    
    
    
    66,252Accounts Payable
    
    
    79,238
    
    
    
    71,873Accrued Wages and Benefits
    
    
    46,786
    
    
    
    50,446Accrued Professional Fees
    
    
    
    
    
    
    20,000Accrued Commissions
    
    
    17,532
    
    
    
    32,182Accrued Expenses
    
    
    36,479
    
    
    
    32,979Deferred Income
    
    
    234,837
    
    
    
    391,395Total
Current Liabilities
    
    
    454,887
    
    
    
    665,127Commitments and ContingenciesSeries B-1, Redeemable Convertible
Preferred shares, $.01 par
value, 1,000,000 shares authorized,
118,351
shares issued and outstanding at
March 31, 2005
and December 31, 2004.
    
    
    1,182
    
    
    
    1,182Shareholders Equity:Common shares, $.01 par value, 65,000,000 shares
authorized, 46,975,365 shares
issued and outstanding at March 31, 2005 and
December 31, 2004.
    
    
    469,754
    
    
    
    469,754Additional Paid-In Capital
    
    
    46,428,866
    
    
    
    46,428,866Accumulated Deficit
    
    
    (46,090,871
    )
    
    
    (46,100,885
    )Total Shareholders Equity
    
    
    807,749
    
    
    
    797,735Total Liabilities and Equity
    
    $
    1,263,818
    
    
    $
    1,464,044




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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited) For the Three Month Period EndedMarch 31,
    
    
    March 31,2005
    
    
    2004Revenues:Royalty Revenues
    
    $
    331,950
    
    
    $
    170,679331,950
    
    
    
    170,679Cost of Revenues
    
    
    33,872
    
    
    
    17,004Gross Profit
    
    
    298,078
    
    
    
    153,675Operating Expenses:General and Administrative
    
    
    151,201
    
    
    
    166,630Research and Development
    
    
    99,290
    
    
    
    95,482Sales and Marketing
    
    
    39,253
    
    
    
    13,701Total Operating Expenses
    
    
    289,744
    
    
    
    275,813Operating Profit (Loss)
    
    
    8,334
    
    
    
    (122,138
    )Interest and Other Income
    
    
    2,920
    
    
    
    941Interest and Other Expense
    
    
    (1,240
    )
    
    
    (2,599
    )1,680
    
    
    
    (1,658
    )Income(Loss) Before Income Taxes
    
    
    10,014
    
    
    
    (123,796
    )Income Taxes
    
    
    
    
    
    
    Net Income(Loss)
    
    
    10,014
    
    
    
    (123,796
    )Basic and Diluted Earnings(Loss) Per Share
    
    $
    
    
    
    $
    Weighted Average Shares
Outstanding
    
    
    46,975,363
    
    
    
    47,015,865




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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS
(unaudited)
 Three Months EndedMarch 31,2005
    
    
    2004Cash Flows from Operating Activities:Net Income (Loss)
    
    $
    10,014
    
    
    $
    (123,796
    )Adjustments to reconcile net (loss) to net cash
provided by (used in) operating activities:Depreciation and Amortization
    
    
    17,262
    
    
    
    17,097Net Change in Assets and Liabilities:Accounts Receivable and Employee Advances
    
    
    155,102
    
    
    
    162,892Prepaid Expenses and Deposits
    
    
    34,476
    
    
    
    27,586Accounts Payable
    
    
    7,365
    
    
    
    18,780Accrued Wages and Benefits
    
    
    (3,660
    )
    
    
    7,518Accrued Professional Fees
    
    
    (20,000
    )
    
    
    (15,000
    )Accrued Commissions
    
    
    (14,650
    )
    
    
    (16,043
    )Accrued Expenses
    
    
    3,500
    
    
    
    1,000Deferred Income
    
    
    (156,558
    )
    
    
    Net Cash Provided By (Used In) Operating Activities
    
    
    32,851
    
    
    
    80,034Cash Flows from Investing Activities:Purchase/Disp of Property and Equipment
    
    
    (3,865
    )
    
    
    Increase in Capitalized Patent and Technology Costs
    
    
    
    
    
    
    (9,708
    )Net Cash Provided By (Used in) Investing Activities
    
    
    (3,865
    )
    
    
    (9,708
    )Cash flows from Financing Activities:Repayment of Notes Payable
    
    
    (26,237
    )
    
    
    (12,975
    )Net Cash Provided by Financing Activities
    
    
    (26,237
    )
    
    
    (12,975
    )Increase (Decrease) in Cash and Cash Equivalents
    
    
    2,749
    
    
    
    57,351Cash and Cash Equivalents, Beginning of Period
    
    
    871,155
    
    
    
    589,797Cash and Cash Equivalents, End of Period
    
    $
    873,904
    
    
    $
    647,148Supplemental Disclosure of Cash Flow Information:Cash paid during the period for:Interest
    
    $
    1,240
    
    
    $
    2,599Income Taxes
    
    
    
    
    
    
    




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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, 2004
    
    
    46,975,365
    
    
    $
    469,754
    
    
    $
    46,428,866
    
    
    $
    (46,100,885
    )
    
    $
    797,735Net Income (Loss)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,014
    
    
    
    10,014Balance, March 31, 2005
    
    
    46,975,365
    
    
    $
    469,754
    
    
    $
    46,428,866
    
    
    $
    (46,090,871
    )
    
    $
    807,749




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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 months ended
March 31, 2005 are not necessarily indicative of the results that may be expected for the year
ending December 31, 2005. Accordingly, your attention is directed to footnote disclosures found in
the December 31, 2004 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, DPI. 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. The Company recognizes
revenue in accordance with SEC Staff Accounting Bulletin 101. 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.




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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 March 31, 2005 substantially all cash and
cash equivalents were on deposit at two financial institutions, with these institutions FDIC or
SIPC insurance in excess of the amounts on deposit. At March 31, 2005, two major customers, not presented in order of importance, each accounted
for 10% or more of our total accounts receivable: Matsushita, Sharp, each of whom accounted for
greater than 10% of our total 2004 accounts receivable. One OEM accounted for 15% and one accounted
for 12% of our total accounts receivable at March 31, 2005. 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 100% and 100% of total sales
in the year to date periods ended March 31, 2005 and 2004, respectively. Approximately 46% and 47%
of sales were generated in Japan and Korea, respectively. Major Customers During the quarter ended March 31, 2005, three customers, Samsung, Sharp and
Matsushita, not presented in order of importance, accounted for 47%, 15% and 12% of the Companys
net sales in the quarter ended March 31, 2005. 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 11 years.




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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 March 31, 2005 and 2004
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: 2005
    
    
    2004Options
    
    
    3,135,000
    
    
    
    3,035,000Warrants
    
    
    0
    
    
    
    03,135,000
    
    
    
    3,035,000
 During the three months ended March 31, 2005, options to purchase 500,000 shares of the Companys
common stock were granted to Henry R. Mandell, at a price of $0.10 per share, as part of the
extension of his employment agreement. Stock Option Plan The Company determines the effect of stock based compensation in
accordance with SFAS No. 123, Accounting for Stock-Based Compensation, as amendedwhich permits
entities to recognize as expense using the fair-value method over the vesting period of all
employee stock-based awards on the date of grant. Alternatively, SFAS No. 123 allows entities to
continue to utilize the intrinsic value method for equity instruments granted to employees and
provide pro forma net income (loss) and pro forma earnings (loss) per share disclosures for
employee stock option grants after 1994 as if the fair-value-based method defined in SFAS No. 123
has been applied. 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 Assets,on 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.




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Segment Reporting- The Company adopted SFAS 131, Disclosures about Segments of an Enterprise
and Related Information(SFAS No. 131), in December 1997. MDT has been considered a discontinued
operation since September 1998. As of December 31, 2002, the Company has only one operating
segment, DPI, the Companys audio enhancement licensing 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. Recent Accounting Pronouncements- In January 2003 the FASB issued Interpretation 46
Consolidation of Variable Interest Entities, an interpretation of ARB No. 51. This Interpretation
requires a Company to consolidate the financial statements of a Variable Interest Entity (VIE),
sometimes also known as a special purpose entity, even if the entity does not hold a majority
equity interest in the VIE. The Interpretation requires that if a business enterprise has a
controlling financial interest in a VIE, the assets, liabilities, and results of the activities
of the VIE should be included in consolidated financial statements with those of the business
enterprise, even if it holds a minority equity position. This Interpretation was effective
immediately for all VIEs created after January 31, 2003; for the first fiscal year or interim
period beginning after June 15, 2003 for VIEs in which a Company holds a variable interest that it
acquired before February 1, 2003. In May 2003 the FASB issued SFAS 150 Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity. This Statement establishes standards for how an
issuer of debt or equity classifies and measures certain financial instruments with characteristics
of both liabilities and equity. It requires that an issuer classify a financial instrument that is
within its scope as a liability (or an asset in some circumstances). Many of those instruments were
previously classified as equity. This Statement is effective for financial instruments entered into
or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim
period beginning after June 15, 2003. In December 2003, the FASB issued SFAS 132R Employers Disclosures about Pensions and Other
Postretirement Benefitsan amendment of FASB Statements No. 87, 88, and 106. This Statement
revises employers disclosures about pension plans and other postretirement benefit plans. It does
not change the measurement or recognition of those plans required by FASB Statements No. 87,
EmployersAccounting for Pensions,No. 88, Employers Accounting for Settlements and Curtailments
of Defined Benefit Pension Plans and for Termination Benefits,and No. 106, Employers Accounting
for Postretirement Benefits Other Than Pensions.This Statement retains the disclosure requirements
contained in FASB Statement No. 132, Employers Disclosures about Pensions and Other Postretirement
Benefits,which it replaces. It requires additional disclosures to those in the original Statement
132 about the assets, obligations, cash




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flows, and net periodic benefit cost of defined benefit pension plans and other defined
benefit postretirement plans. The Company will adopt the provisions of SFAS 132R on January 1,
2004. In November 2004, the FASB issued SFAS No. 151, Inventory Costs-an amendment of ARB. No. 43,
Chapter 4.This Statement amends the guidance in ARB No. 43, Chapter 4, Inventory Pricing, to
clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and
wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously stated that ... under some
circumstances, items such as idle facility expense, excessive spoilage, double freight, and
rehandling costs may be so abnormal as to require treatment as current period charges.... This
Statement requires that those items be recognized as current-period charges regardless of whether
they meet the criterion of so abnormal. In addition, this Statement requires that allocation of
fixed production overheads to the costs of conversion be based on the normal capacity of the
production facilities. In December 2004, the FASB issued SFAS No. 152, Accounting for Real Estate Time-Sharing
Transactions  an amendment of FASB statements no. 66 and 67. This Statement amends FASB Statement
No. 66, Accounting for Sales of Real Estate,to reference the financial accounting and reporting
guidance for real estate time-sharing transactions that is provided in AICPA Statement of Position
(SOP) 04-2, Accounting for Real Estate Time-Sharing Transactions.This Statement also amends FASB
Statement No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects,to
state that the guidance for (a) incidental operations and (b) costs incurred to sell real estate
projects does not apply to real estate time-sharing transactions. The accounting for those
operations and costs is subject to the guidance in SOP 04-2. In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary assets  an
amendment of APB Opinion No. 29.This Statement amends APB Opinion 29 to eliminate the exception
for nonmonetary exchanges of similar productive assets and replaces it with a general exception for
exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has
commercial substance if the future cash flows of the entity are expected to change significantly as
a result of the exchange. In December 2004, the FASB issued SFAS No. 123R, Share Based Payment. This Statement is a
revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. This Statement
supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees and its related
implementation guidance. This Statement establishes standards for the accounting for transactions
in which an entity exchanges its equity instruments for goods or services. It also addresses
transactions in which an entity incurs liabilities in exchange for goods or services that are based
on the fair value of the entitys equity instruments or that may be settled by the issuance of
those equity instruments. The Statement focuses primarily on accounting for transactions in which
an entity obtains employee services in share-based payment transactions. This Statement does not
change the accounting guidance for share-based payment transactions with




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parties other than employees provided in Statement 123 as originally issued and EITF Issue No.
96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or
in Conjunction with Selling, Goods or Services. This Statement does not address the accounting for
employee share ownership plans, which are subject to AICPA Statement of Position 93-6, Employers
Accounting for Employee Stock Ownership Plans. The Company believes that the adoption of these pronouncements will not have a material effect
on the Companys financial position, results from operations or cash flows. 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, 2004 and March 31, 2005
approximated fair value due to their short maturity or nature. The fair values of notes payable to a related party at December 31, 2004 and March 31, 2005
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, 2004 and March 31, 2005, consists of the following,
net of a reserve for impairment loss in 1998 in accordance with application of SFAS 121: March 31,
    
    
    December 31,2005
    
    
    2004Office Computers, Software, Equipment and Furniture
    
    $
    335,731
    
    
    $
    331,867Test Equipment
    
    
    73,300
    
    
    
    73,300Tooling Equipment
    
    
    45,539
    
    
    
    45,539Trade Show Booth and Demonstration Equipment
    
    
    174,548
    
    
    
    174,548Automobiles
    
    
    7,000
    
    
    
    7,000Total Property and Equipment
    
    
    636,118
    
    
    
    632,253Less Accumulated Depreciation and Amortization
    
    
    606,797
    
    
    
    602,727Property and Equipment, Net
    
    $
    29,321
    
    
    $
    29,527




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(4) Intangible Assets Intangible assets, as of December 31, 2004 and March 31, 2005 consist of the following: March 31,
    
    
    December 31,2005
    
    
    2004Capitalized Patent, Trademarks and Technology Costs
    
    $
    522,068
    
    
    $
    522,827Less Accumulated Amortization
    
    
    368,549
    
    
    
    356,117Intangible Assets, Net
    
    $
    153,519
    
    
    $
    166,710
 Estimated amortization is as follows: 2005
    
    $
    25,7332006
    
    $
    16,7022007
    
    $
    16,7022008
    
    $
    16,702Thereafter
    
    $
    77,680
 (5) Notes Payable The Company was indebted to the Desper Family Trust, in the amount of $40,015 at March 31,
2005. The Desper Family Trusts principal beneficiary is the mother of a former member of the Board
of Directors of the Company. This directors term expired in June 2003 and as such, is not a
related party. This note 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. All remaining
installments are due in no more than twelve months from March 31, 2005. (6) Shareholders Equity During the quarter ended March 31, 2005, shares were issued, cancelled or converted as
follows: There were 500,000 options granted to the CEO related to the extension of his employment
agreement. These options vested half on issuance and half in November, 2005, if the executive is in
the employ of the Company. These options may be exercised at a price of $0.10 per share through
February, 2010. These options had no value at March 31, 2005. During the year ended December 31, 2004, shares were issued or converted as follows:




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Unissued Performance Shares held in escrow were cancelled. Options to purchase common shares in exchange for services were issued with a value of $1,000. 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 and is designated as a liquidation preference. The stock will rank prior to the
Companys common stock. No dividends will be paid on the Series B-1 Preferred Stock. Conversion
rights vested on January 1, 2003 to convert the Series B-1 Preferred Stock to common stock at a
certain formula based on an average closing share price, subject to a floor of $0.56 and a ceiling
of $1.12. At December 29, 2005 certain mandatory conversion requirements exist subject to the above
formula. The Series B-1 Preferred Stock has no voting power. Certain restrictions on trading exist
based on date sensitive events based on the Companys Insider Trading Policy. 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. In 2004, the Company reflected the issuance of 15,384 shares of Class B-1
Convertible Preferred Stock that was originally recorded in Additional Paid in Capital. This
resulted in a reclassification of $154 to Convertible Preferred Stock from APIC. (7) 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 March 31, 2005. 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 March 31, 2005, there were 1,562,537 additional shares available for grant under the Plan.




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There were 500,000 options granted in the quarter ended March 31, 2005 to the CEO related to
the extension of his employment agreement. These options vested half on issuance and half in
November, 2005, if the executive is in the employ of the Company. These options may be exercised at
a price of $0.10 per share through February, 2010. 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 would have been
reduced to the pro forma amounts indicated below: 2005
    
    
    2004NET INCOME (LOSS):As Reported
    
    $
    10,014
    
    
    $
    (124,000
    )Pro Forma
    
    $
    (5,266
    )
    
    $
    (125,000
    )BASIC AND DILUTED LOSS:As Reported
    
    $
    0.00
    
    
    $
    (0.00
    )Pro Forma
    
    $
    (0.00
    )
    
    $
    (0.00
    )
 At March 31, 2005, the number of options exercisable was 3,135,000 and the weighted-average
exercise price of those options was $0.10. There were no warrants outstanding at December 31, 2004 and March 31, 2005. (8) 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 March 31, 2005 for all operating leases were approximately $21,000 through December
2005. Rent expense amounted to approximately $8,000 and $5,400 for the quarters ended March 31,
2005 and 2004, respectively. (9) 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, 2004, 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. Executive Overview Revenues increased to $332,000 for the quarter ended March 31, 2005 compared to $171,000 for
the quarter ended March 31, 2004, an increase of 94%. Revenues are almost entirely comprised of
royalties pertaining to the licensing of Spatializer® audio signal processing algorithms. A key
issue discussed is our ability to obtain revenue traction when traditional revenue sources are
eroding, while being replaced by new revenue sources. Net income was $10,000 for the quarter ended March 31, 2005; $0.00 basic and diluted per
share, compared to net loss of $124,000, ($0.00) per share basic, for the quarter ended March 31,
2004. Net income for the current period is primarily the result of higher revenue, partially offset
by higher overhead. A key issue discussed is managements efforts to increase revenues while
managing overhead and maintaining competitiveness during revenue source transition to new markets
for the Company. Net cash provided by operating activities was $32,851 for the quarter ended March 31, 2005, as
compared to net cash provided by operating activities of $80,000 in the quarter ended March 31,
2004. The decrease in cash flows from operations for the quarter ended March 31, 2005, against the
comparable quarter last year was primarily a result of the decrease in deferred income, a decrease
in accruals and note payable, partially offset by the net income. Deferred income decreased due to
the licensing prepayment and accounts receivable decreased a portion of fourth quarter 2004
revenues being realized through the recognition of deferred income. A key issue is the Companys
ability to generate continued positive cash flow, or if needed, raise additional capital to fund
its business. The business environment in which we operate is highly competitive and as result, we face
substantial risk. These risks should be studied and understood, as outlined in Risk Factors later
in this document. Approach to MD&A An important demonstration of our commitment to our stockholders is a clear explanation of the
Companys operating results, risks and opportunities. 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:




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
    to provide a narrative explanation of a companys financial statements in plain
English that enables the average investor 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 and
relationship of past performance being indicative of future performance. We believe the best way to achieve this is to give the reader:  
    An understanding of our operating environment and its risks
    An outline of critical accounting policies
    A review of our corporate governance structure
    A review of the key components of the financial statements and our cash position and
capital resources
    A review of the important trends in the financial statements and our cash flow
    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:  
    We Face Significant Pricing Pressure and Competition that can Result in Our
Technology Being Designed Out Within a Short Time Frame, or Impeding Efforts to Secure New
Design Wins
    New Customer Product Development Can be Delayed. This Results in Delays In Revenues.
Further, Where our Products are Delayed, Competitive Products May Reach The Market Before,
or Replace Our Products.
    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. The PC and consumer electronics markets are under intense pressure, primarily from retailers, to
reduce selling prices, with resultant pressure to reduce costs. In addition, pricing action by our
competitors may be very aggressive. Cost reductions are driven by lower cost sourcing, often in
China, design simplification and reduction in or substitution of features. While we present a value
proposition that stresses the cost




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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 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. This also results limited visibility
with regard to future revenues and their impact on our operating results. Our response has been to
strengthen our value proposition, more aggressively price and include additional features in our
products. We have also entered new segments, such as cell phones, with different competitive
pressure. We also emphasize to our overseas sales representatives the need for close customer
support, with the objective that both new opportunities and possible difficulties are brought to
light as soon as possible. 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. Many of our customers operate under very
fluid development schedules. These schedules are 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. Whether such processors become an industry standard, or gain wide acceptance in the
market, is speculative. 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 must request that our algorithm be
implemented. While these requests may be honored, processor manufacturers must schedule such
implementation as their resources or corporate strategies allow. Some chip makers, particularly in
the cell phone market, have already incorporated solutions from our competitors as a component of
the chip itself, making it costly and time consuming to implement alternate solutions like ours.
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. These revenues are reported to us by our Licensees in formal, written royalty reports,
which serve as the basis for our quarterly revenue accruals. Infrequently, certain written reports
are received after our required reporting deadlines, sometimes due to contractual requirements. In
such cases, management tries to obtain verbal reports or informal reports from the Licensee. In the
absence of such information, management may utilize conservative estimates based on information
received or historical trends. In such isolated cases, management strives to under-estimate such
revenues to err on the side of caution. In the event such estimates are used, the revenue for the
following quarter is adjusted based on receipt of the written report. In addition, any error in
Licensee reporting, which is very infrequent, is adjusted in the subsequent quarter when agreed by
both parties as correct. 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 and
trademarks, consisting primarily of legal and filing fees, and amortize such costs over the
remaining life of the asset (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. Corporate Governance Audit Committee




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This committee, chaired by Mr. Gilbert Segel, 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. 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. Our Audit Committee and Compensation and Stock Committee charters are available in print to any
stockholder upon request in writing to our corporate office at 2025 Gateway Place, Suite 365, San
Jose, CA 95110. Key Components of the Financial Statements and Important Trends The financial statements, including Balance Sheet, results of operations, cash flow and
Changes in Stockholders Equity should be read in conjunction with the Consolidated Financial
Statements and Notes thereto included elsewhere in this report. MD&A explains the key components of
each of these financial statements, key trends and reasons for reporting period-to-period
fluctuations. The Balance Sheet provides a snapshot view of our financial condition at the end of our fiscal
year. A balance sheet helps management and our stockholders understand the financial strength and
capabilities of our business. Balance sheets can help identify and analyze trends, particularly in
the area of receivables and payables. A review of cash compared to the comparable year and in
relation to ongoing profit or loss can show the ability of the Company to withstand business
variations. The relationship between Current Assets and Current Liabilities Working capital
(current assets less current liabilities) measures how much in liquid assets a company has
available to build its business. The presence of Deferred Revenue indicates cash received on
revenue to be earned over the next twelve months. Receivables that are substantially higher than
revenue for the quarter may indicate a slowdown of collections, with an impact on future cash
position. This is addressed further in MD&A under Liquidity and Capital Resources.




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The Consolidated Statement of Operations tells the reader whether the Company had a profit or
loss. It shows key sources of revenue and major expense categories. It is important to note
period-to-period comparisons of each line item of this statement, reasons for any fluctuation and
how costs are managed in relation to the overall revenue trend of the business. These statements
are prepared using accrual accounting under generally accepted accounting standards. This is
addressed further in MD&A under Revenues and Expenses. The Consolidated Statement of Cash flows explains the actual sources and uses of cash. Some
expenses of the Company, such as depreciation and amortization do not result in a cash outflow in
the current period, since the underlying patent expenditure or asset purchase was made years
earlier. New capital expenditures, on the other hand, resulted in a disbursement of cash, but will
be expensed in the Statement of Operations over its useful life. Fluctuations in Receivables and
payables also explain why the net change in cash is not equal to the loss reported on the Statement
of Operations. Therefore, it is possible that the impact of a net loss on cash is less or more than
the actual amount of the loss. This is discussed further in MD&A under Liquidity and Capital
Resources. The Consolidated Statement of Changes in Stockholders Equity shows the impact of the
operating results on the Companys equity. In addition, this statement shows new equity brought
into the Company through stock sales or stock option exercise. This is discussed further in MD&A
under Liquidity and Capital Resources 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 March 31, 2005 were $332,000, compared to revenues of
$171,000 in the comparable period last year, an increase of 94%. Revenues in the three months ended
March 31, 2005 were higher due to continued recognition of prepaid royalties (25% of prepayment)
from a major customer, for which there was no such comparable customer last year. In addition a
loss of a DVD OEM account which comprised 44% of first quarter 2004 revenues was replaced by
revenue from another DVD OEM and two PC accounts for which there was no comparable revenue in the
first quarter of 2004. As such, approximately 67% of the revenue in the quarter ended March 31,
2005 were derived from new licensing agreements with new customers entered into subsequent to March
31, 2004.




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Gross Profit Gross profit for the three months ended March 31, 2005 was $298,000 (90% of revenue)
compared to gross profit of $154,000 (90% of revenue) in the comparable period last year, an
increase of 94%. Gross profit in the three month period increased due to the increase in
revenue. Operating Expenses Operating expenses in the three months ended March 31, 2005 were $290,000 (87% of revenue)
compared to operating expenses of $276,000 (161% of revenue) in the comparable period last year, an
increase of 5%. The increase in operating expenses for the three months ended March 31, 2005
resulted primarily from increased sales and marketing and slightly higher research and development
expense, partially offset by lower corporate expenses. General and Administrative General and administrative expenses in the three months ended March 31, 2005 were $151,000
(45% of revenue) compared to general and administrative expenses of $167,000 (50% of revenue) in
the comparable period last year, a decrease of 10%. The decrease in general and administrative
expense for the three month periods resulted primarily from the charging of sales related travel
for the CEO to sales and marketing expense, as opposed to general and administrative expense.
This was partially offset by slightly higher occupancy expense associated with the relocation of
the corporate offices to slightly larger space. Research and Development Research and Development expenses in the three months ended March 31, 2005 were $99,000
(30% of revenue) compared to research and development expenses of $95,000 (56% of revenue) in
the comparable period last year, an increase of 4%. The increase in three month research and
development expenses resulted from slightly more expensive Silicon Valley facilities, and
greater use of off-shore applications engineering to expand our technology availability on
various processors. Sales and Marketing Sales and Marketing expenses in the three months ended March 31, 2005 were $39,000 (12% of
revenue) compared to sales and marketing expenses of $14,000 (8% of revenue) in the comparable
period last year, an increase of 179%. The increase in sales and marketing expense in the three
and month period resulted primarily from the charging of CEO sales related travel to sales and
marketing instead of general and administrative expense, as was the practice last year,
increased travel and the addition of a part time marketing coordinator.




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Net Income (Loss) Net income in the three months ended March 31, 2005 was 10,000, $0.00 basic and diluted per
share, compared with net loss of ($124,000), ($0.00) basic per share in the comparable period last
year. The net income resulted from increased revenues, partially offset by higher operating
expenses. Liquidity and Capital Resources At March 31, 2005, we had $874,000 in cash and cash equivalents as compared to $871,000 at
December 31, 2004. The increase in cash and cash equivalents results from a decrease in accounts
receivable and current liabilities, partially offset by a decrease in deferred revenue. We had
working capital of $626,000 at March 31, 2005 as compared with working capital of $603,000 at
December 31, 2004. 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. Since the director who was an indirect beneficiary
of the demand note completed his term as director and did not stand for re-election to the Board of
Directors in June 2003, the demand note is classified as a note payable at March 31, 2005. There
are no installments due in more than twelve months as of March 31, 2005. Future payments due under operating lease obligations as of March 31, 2005 are described
below: Payments due by periodLess than
    
    
    
    
    
    
    
    
    
    
    More thanContractual obligations
    
    Total
    
    
    1 year
    
    
    1-3 years
    
    
    3-5 years
    
    
    5 yearsLong-Term Debt ObligationsCapital Lease ObligationsOperating Lease Obligations
    
    $
    54,955
    
    
    $
    28,680
    
    
    $
    26,275Purchase ObligationsTotal
    
    $
    54,955
    
    
    $
    28,680
    
    
    $
    26,275
 Our future cash flow will come primarily from the audio signal processing licensing, 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
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 currently 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 transitioning platforms. The four new or
expanded licensing deals from such sources that generated approximately 60% of fiscal 2004 revenue
support this belief. Further, our cost reduction initiative implemented in the fourth quarter of
2003 has lowered the revenues needed to reach the




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break-even point. The fluid, competitive and dynamic nature of the market continues to add 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 its 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. 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 a short-term and long-term basis. To
the extent that we do not achieve current operating levels or are required to fund contingencies,
we will be required to use some of our cash reserves and this could impact our longer term
liquidity. In addition, we wish to achieve accelerated growth and to take advantage of the dynamic
market forces in which we operate, rather than to be affected by them. We believe our current cash
reserves and cash generated from our existing operations and customer base are sufficient for us to
meet our operating obligations and the anticipated additional research and development for our
audio technology business for at least the next 12 months. We will also 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, 2004, we had net operating loss carry forwards for Federal income tax purposes
of approximately $26,500,000 which are available to offset future Federal taxable income, if any,
through 2013. Approximately $21,700,000 of these net operating loss carry forwards is subject to an
annual limitation of approximately $1,000,000.




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Recently Issued Accounting Pronouncements In November 2004, the FASB issued SFAS No. 151, Inventory Costs-an amendment of ARB. No. 43,
Chapter 4.This Statement amends the guidance in ARB No. 43, Chapter 4, Inventory Pricing, to
clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and
wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously stated that ... under some
circumstances, items such as idle facility expense, excessive spoilage, double freight, and
rehandling costs may be so abnormal as to require treatment as current period charges.... This
Statement requires that those items be recognized as current-period charges regardless of whether
they meet the criterion of so abnormal. In addition, this Statement requires that allocation of
fixed production overheads to the costs of conversion be based on the normal capacity of the
production facilities. In December 2004, the FASB issued SFAS No. 152, Accounting for Real Estate Time-Sharing
Transactions  an amendment of FASB statements no. 66 and 67. This Statement amends FASB Statement
No. 66, Accounting for Sales of Real Estate,to reference the financial accounting and reporting
guidance for real estate time-sharing transactions that is provided in AICPA Statement of Position
(SOP) 04-2, Accounting for Real Estate Time-Sharing Transactions.This Statement also amends FASB
Statement No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects,to
state that the guidance for (a) incidental operations and (b) costs incurred to sell real estate
projects does not apply to real estate time-sharing transactions. The accounting for those
operations and costs is subject to the guidance in SOP 04-2. In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary assets  an amendment of
APB Opinion No. 29.This Statement amends APB Opinion 29 to eliminate the exception for
nonmonetary exchanges of similar productive assets and replaces it with a general exception for
exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has
commercial substance if the future cash flows of the entity are expected to change significantly as
a result of the exchange. In December 2004, the FASB issued SFAS No. 123R, Share Based Payment. This Statement is a
revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. This Statement
supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees and its related
implementation guidance. This Statement establishes standards for the accounting for transactions
in which an entity exchanges its equity instruments for goods or services. It also addresses
transactions in which an entity incurs liabilities in exchange for goods or services that are based
on the fair value of the entitys equity instruments or that may be settled by the issuance of
those equity instruments. The Statement focuses primarily on accounting for transactions in which
an entity obtains employee services in share-based payment transactions. This Statement does not
change the accounting guidance for share-based payment transactions with parties other than
employees provided in Statement 123 as originally issued and EITF




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Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services. This Statement does not address the
accounting for employee share ownership plans, which are subject to AICPA Statement of Position
93-6, Employers Accounting for Employee Stock Ownership Plans. Factors That May Affect Future Results This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities
Act of 1933, as amended, reflecting managements current expectations. Examples of such
forward-looking statements include our expectations with respect to our strategy. Although we
believe that our expectations are based upon reasonable assumptions, there can be no assurances
that our financial goals will be realized. Such forward-looking statements involve known and
unknown risks, uncertainties and other factors that may cause our actual results, performance or
achievements, or industry results, to be materially different from any future results, performance
or achievements expressed or implied by such forward-looking statements. Numerous factors may
affect our actual results and may cause results to differ materially from those expressed in
forward-looking statements made by or on behalf of our company. For this purpose, any statements
contained herein that are not statements of historical fact may be deemed to be forward-looking
statements. Without limiting the foregoing, the words, believes, anticipates, plans,
expects and similar expressions are intended to identify forward-looking statements. The
important factors discussed under the caption Factors That May Affect Future Results in Item 7.
Managements Discussion and Analysis of Financial Condition and Results of Operations, herein,
among others, would cause actual results to differ materially from those indicated by
forward-looking statements made herein and represent managements current expectations and are
inherently uncertain. Investors are warned that actual results may differ from managements
expectations. We assume no obligation to update the forward-looking information to reflect actual
results or changes in the factors affecting such forward-looking information. 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 have experienced a loss from operations in three of the last four years. We experienced
declining losses in the second and third quarters of 2004, and a profit in the fourth quarter of
2004 and first quarter of 2005. 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, or achieve or sustain future profitability, and we may have to rely on the
sale of shares or on 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




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operations or even cease operations. Because The Market In Which We Operate Is Highly Competitive, We Face Significant Pricing Pressure
and Competition. The PC and consumer electronics markets are under intense pressure, primarily from retailers,
to reduce selling prices, with resultant pressure to reduce costs. 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. Cost reductions are driven by lower cost sourcing, often in China, design
simplification and reduction in or substitution of features. Therefore, we are seeking commercial
acceptance of our products in highly competitive markets. We have responded by offering additional
products targeted to each price and quality segment of the market, more aggressively price and
feature enrich our products and enter new segments, such as cell phones, with different competitive
pressure. 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 the case
with DVD players. It also may result in the elimination of features, including ours, if cost is of
paramount importance. 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. Because Our Relative Size and Power Is Small Compared To That of Our Customers, Our Business
Leverage With Some Customers Is Generally Weak and Communication Not Always Transparent We deal with some of the largest global consumer electronics makers in the world, the vast
majority of which are in Asia. Spatializer is a small company and there are other options for
manufacturers, including those from our competitors, their chip suppliers, or eliminating the use
of audio enhancement technology altogether. As such, our leverage with our customers is generally
weak. In addition, the culture in our local markets may not dictate clear, direct and transparent
communication of business plans or technology usage as is the culture in our home country. When
this occurs, we could receive very short notice of discontinued use of our technology and revenues
from such an account would typically begin a steep decline in the subsequent quarter, resulting in
period-to-period fluctuation. This also results in limited visibility with regard to future
revenues and its impact on our operating results. Our response has been to strengthen our business
relationships with more onsite visits, increase our understanding of cultural differences and focus
more intently on service. We also emphasize to our overseas sales representatives the need for
close customer support, with the objective that both new opportunities and possible difficulties
are brought to light as soon as possible.




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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.In addition, standards
may be adopted by cell phone system operators or manufacturers that may impede or prevent the
penetration of non-standard technology onto their platforms. While our efforts are focused on
promoting our technology to such potential customers, there is no assurance that we will be
successful in making our technology a standard. 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 and the uncertainties concerning the ability of our current products and new
products to achieve meaningful commercial acceptance, 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 cash flow. 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




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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, we anticipate being
dependent upon a limited number of OEMs for a large port of our net sales. Our three largest
customers as of March 31, 2005 accounted for 47%, 15% and 12% of our net sales.. 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 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. Demand for Our Products is Subject to Risks Beyond Our Control. Our products are typically one of many related products used by consumer electronic users. As
a result, 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;
    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. Because The Technology Environment In Which We Operate Is Rapidly Changing, We May Not Be
Successful In Establishing And Maintaining The Technological Superiority Of Our Products Over Those
Of Our Competitors. 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




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by other companies, including entities that have business relationships with us. There can be
no assurance that we will be able to favorably compete in this market in the future. 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, all new licenses are negotiated by Henry R. Mandell, our Chief Executive
Officer, with whom we have an employment agreement with a term expiring in November 2006. The Market For Our Stock May Be Not Remain Liquid And The Stock Price May Be Subject To Volatility Our stock is quoted on the OTC Bulletin Board, where low trading volume and high volatility is
often experienced. While a few firms make a market in our stock, the historically low trading
volume and relatively few market makers of our stock makes it more likely that a severe fluctuation
in volume, either up or down, will significantly impact the stock price. There can be no assurance
that these market makers will continue to quote our stock and a reduction in such market makers
would negatively impact trading liquidity. Further, with our constrained resources and increased
cost and time associated with implementation of Sarbanes-Oxley, it may not be possible for us to
remain listed on the OTC Bulletin Board in the future as a fully reporting company. This and the
existing limited market and volume in the trading of our stock, may result in our shareholders
having difficulty selling our common stock. The trading price of our Common Stock has been, and
will likely continue to be, subject to wide fluctuations in response to quarterly variations in our
operating results, announcements of new products or technological innovations by the Company or our
competitors, strategic alliances between us and third parties, general market fluctuations and
other events and factors, some of which may be beyond our control. 
 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 March 31, 2005. 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




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risk or for speculative purposes and we are not currently evaluating the future use of such
financial instruments. 
 Item 4.Controls and Procedures 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 March 31, 2005 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 March 31, 2005 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 May 2, 2005, 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 There were no unregistered sales of equity securities or repurchases during the period covered
by this report. 
 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 8K (a) Exhibits 2.1*
    
    Arrangement Agreement dated as of March 4, 1994 among
Spatializer-Yukon, DPI and Spatializer-Delaware (Incorporated by
reference to the Companys Registration Statement on Form
S-1,Registration No 33-90532, effective August 21, 1995.)3.1*
    
    Certificate of Incorporation of Spatializer-Delaware as filed
February 28, 1994. (Incorporated by reference to the Companys
Registration Statement on Form S-1, Registration No.
33-90532,effective August 21, 1995.)




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3.2*
    
    Amended and Restated Bylaws of Spatializer-Delaware. (Incorporated
by reference to the Companys Registration Statement on Form
S-1,Registration No. 33-90532, effective August 21, 1995.)3.3*
    
    Certificate of Designation of Series B 10% Redeemable Convertible
Preferred Stock of the Company as filed December 27,
1999(Incorporated by reference to the Companys Annual Report on
Form10-K, for the period ended December 31, 1999.)3.4*
    
    Certificate of Amendment of Certificate of Incorporation of the
Company as filed on February 25, 2000 (Incorporated by reference to
the Companys Annual Report on Form 10-K, for the period ended
December 31, 1999.)3.5*
    
    Certificate of Designation of Series B-1 Redeemable Convertible
Preferred Stock as filed December 20, 2002 (Incorporated by
reference to the Companys Annual Report on Form 10-K, for the
period ended December 31, 2002.)3.6*
    
    Certificate of Elimination of Series A Preferred Stock as filed
December 26, 2002 (Incorporated by reference to the Companys
Annual Report on Form 10-K, for the period ended December 31,2002.)3.7*
    
    Certificate of Elimination of Series B Preferred Stock as filed
December 26,2002 (Incorporated by reference to the Companys Annual
Report on Form 10-K, for the period ended December 31,2002.)10.1*
    
    Spatializer-Delaware Incentive Stock Option Plan (1995 Plan).
(Incorporated by reference to the Companys Registration Statement
on Form S-1, Registration No. 33-90532, effective August 21,1995.)10.2*
    
    Spatializer-Delaware 1996 Incentive Plan. (Incorporated by
reference to the Companys Proxy Statement dated June 25, 1996 and
previously filed with the Commission.)10.3*
    
    Form of Stock Option Agreement10.4*
    
    License Agreement dated June 29, 1994 between DPI and MEC.
(Incorporated by reference to the Companys Registration Statement
on Form S-1, Registration No. 33-90532, effective August 21,1995.)10.5*
    
    Employment Agreement dated November 12, 2004, between the Company
and Henry Mandell, as amended. (Incorporated by reference to the
Companys Annual Report on Form 10-K, for the period ended December
31, 2004.)10.6*
    
    Related Party Promissory Note to the Successor Trustee of the Ira
A. Desper Marital Trust dated November 1, 2003. (Incorporated by
reference to the Companys Annual Report on Form 10-K, for the
period ended December 31, 2004.)10.7*
    
    Lease for Office and Research Center in San Jose, CA. (Incorporated
by reference to the Companys Annual Report on Form 10-K, for the
period ended December 31, 2004.)10.8*
    
    License Agreement between Spatializer Audio Laboratories, Inc.,
Desper Products, Inc. and Samsung Electronics, effective August 22,
2004. (Incorporated by reference to the Companys Quarterly Report
on Form 10-Q for the period ended September 30, 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.
   *
    
    Previously filed **
    
    Certification will not be deemed 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: May 10, 2005 SPATIALIZER AUDIO LABORATORIES, INC.
(Registrant)/s/ Henry R. MandellHenry R. MandellChairman of the Board, Chief Executive Officer
Chief Financial Officer and Secretary