<PAGE>   1

                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-Q

             Quarterly Report Pursuant to Section 13 or 15(d) of the
                        Securities Exchange Act of 1934.


                   FOR THE QUARTERLY PERIOD ENDED JULY 4, 1999

                         Commission File Number 0-20684



                                   AUREAL INC.
             (Exact name of registrant as specified in its charter)

                  DELAWARE                                 94-3117385
 (State or other jurisdiction of                       (I.R.S. Employer
 incorporation or organization)                     Identification Number)

                              4245 TECHNOLOGY DRIVE
                                FREMONT, CA 94538
                    (Address of principal executive offices)
                            Telephone: (510) 252-4245

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

                                 Yes [X] No [ ]

Indicate by check mark whether the registrant has filed all documents required
to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934
subsequent to the distribution of securities under a plan confirmed by a court.

                                 Yes [X] No [ ]

At August 1, 1999, 9,961,165 shares of common stock, $0.001 par value, of the
registrant were outstanding.

This report on Form 10-Q contains 23 pages. The exhibit index is on page 23.


<PAGE>   2

                                   AUREAL INC


                                    FORM 10-Q

                                Table of Contents
<TABLE>
<CAPTION>


                                                                                                             PAGE

<S>                                                                                                          <C>
PART I.  FINANCIAL INFORMATION
           Item 1.  Financial Statements........................................................................3
           Item 2.  Management's Discussion and Analysis of Financial Condition and Results of
                      Operations...............................................................................11
           Item 3.  Qualitative and Quantitative Disclosure of Market Risks....................................20

PART II.  OTHER INFORMATION
           Item 1.   Legal Proceedings.........................................................................21
           Item 4.   Submission of Matters to a Vote of Security Holders.......................................21
           Item 5.   Other Information.........................................................................21
           Item 6.   Exhibits and Reports on Form 8-K..........................................................21

</TABLE>

                                       2
<PAGE>   3

                          PART I. FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

                                   AUREAL INC.

               INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

                                   (Unaudited)

       We have prepared the Interim Condensed Consolidated Financial Statements
of Aureal Inc. without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission. Certain information and footnote disclosures
normally included in financial statements prepared in accordance with generally
accepted accounting principals have been omitted pursuant to such rules and
regulations. The disclosures included in the Interim Condensed Consolidated
Financial Statements should be read in conjunction with our audited financial
statements at January 3, 1999 and the notes thereto included in our 1998 Annual
Report on Form 10-K.

      The preparation of financial statements in conformity with generally
accepted accounting principles and pursuant to the rules and regulations of the
Securities and Exchange Commission requires us to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.

      The Interim Condensed Consolidated Financial Statements reflect, in our
opinion, all adjustments (which include only normal recurring adjustments)
necessary for a fair presentation of financial position, results of operations
and cash flows for such periods. The results of operations for the fiscal
quarter ended July 4, 1999 are not necessarily indicative of the results that
may be expected for any subsequent quarter or the entire fiscal year ending
January 2, 2000.

                                       3
<PAGE>   4

AUREAL INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
                                                                                July 4, 1999     Jan. 3, 1999
                                                                                ------------     -------------
                                                                                 (Unaudited)
<S>                                                                             <C>              <C>
ASSETS:
      Current assets:
          Cash and cash equivalents                                               $   4,238          $      87
          Restricted cash                                                                --                  6
          Accounts receivable                                                         4,775              4,781
          Inventories                                                                 6,644              3,916
          Deferred fair value of debt related warrants                                   --                924
          Prepaid loan fees and other current assets                                    554                757
                                                                                  ---------          ---------
                Total current assets                                                 16,211             10,471
      Property and equipment:
          Machinery and equipment                                                     5,330              4,636
          Furniture, fixtures and improvements                                          686                639
                                                                                  ---------          ---------
                                                                                      6,016              5,275
          Accumulated depreciation and amortization                                  (3,601)            (2,795)
                                                                                  ---------          ---------
                Net property and equipment                                            2,415              2,480
      Other long-term assets                                                            161                687
                                                                                  ---------          ---------
                Total assets                                                      $  18,787          $  13,638
                                                                                  =========          =========

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT):
      Current liabilities:
          Line of credit                                                          $      --          $   4,329
          Accounts payable                                                            6,773              5,966
          Accrued compensation and benefits                                           1,799              1,765
          Other accrued liabilities                                                   1,343              1,061
          Current portion of pre-petition claims                                        982                936
                                                                                  ---------          ---------
                Total current liabilities                                            10,897             14,057
      Long-term portion of pre-petition claims and deferred obligations                 303                889
                                                                                  ---------          ---------
                Total liabilities                                                    11,200             14,946

      Stockholders' equity (deficit):
          Preferred stock, $0.001 par value, authorized shares-5,000,000:
                Series A: Authorized shares - 500; Issued and outstanding
                shares - 35 and 249,  respectively                                       --                 --
                Series B: Authorized shares - 60,000; 40,966 shares
                issued and outstanding in 1998                                           --                 --
                Series C: Authorized shares - 1,500; 600 shares
                issued and outstanding in 1998                                           --                 --
          Additional paid-in capital                                                    387             51,421
          Common stock, $0.001 par value:
                Authorized shares - 200,000,000; Issued and outstanding
                shares - 9,961,165 and 3,178,422, respectively                           10                 48
          Additional paid-in capital                                                192,203            119,790
          Accumulated deficit                                                      (185,013)          (172,567)
                                                                                  ---------          ---------
                Total stockholders' equity (deficit)                                  7,587             (1,308)
                                                                                  ---------          ---------
                Total liabilities and stockholders' equity (deficit)              $  18,787          $  13,638
                                                                                  =========          =========
</TABLE>

   The accompanying notes are an integral part of these financial statements.


                                       4
<PAGE>   5

AUREAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>

                                                               Quarter Ended                      Six Months Ended
                                                      -------------------------------     ---------------------------------
                                                         July 4,           June 28,          July 4,           June 28,
                                                           1999              1998              1999              1998
                                                               (Unaudited)                           (Unaudited)

<S>                                                    <C>               <C>               <C>               <C>
Net sales                                              $  8,063          $  3,436          $ 20,641          $  7,018
Cost of sales                                             5,013             2,033            13,334             4,826
                                                       --------          --------          --------          --------
Gross Margin                                              3,050             1,403             7,307             2,192

Operating expenses:
     Research and Development                             3,635             2,916             6,999             5,534
     Sales and Marketing                                  2,930             1,628             5,002             2,984
     General and Administrative                           2,620               816             3,787             1,676
                                                       --------          --------          --------          --------
         Total operating expenses                         9,185             5,360            15,788            10,194

                                                       --------          --------          --------          --------
Operating loss                                           (6,135)           (3,957)           (8,481)           (8,002)

     Amortization of debt related warrants               (1,078)             (577)           (1,309)           (1,327)
     Interest expense                                      (699)             (963)           (1,132)           (1,994)
     Other income (expense), net                            (30)               51               (40)              391
                                                       --------          --------          --------          --------
Loss from operations before income taxes                 (7,942)           (5,446)          (10,962)          (10,932)

Provision for income taxes                                   --                --                --                --
                                                       --------          --------          --------          --------

Net loss                                               $ (7,942)         $ (5,446)         $(10,962)         $(10,932)
                                                       ========          ========          ========          ========

Accretion/dividends related to preferred stock         $   (290)         $(12,121)         $ (1,484)         $(12,121)
                                                       ========          ========          ========          ========

Net loss attributable to common stockholders           $ (8,232)         $(17,567)         $(12,446)         $(23,053)
                                                       ========          ========          ========          ========

Net loss per share: basic and diluted                  $  (1.14)         $  (6.25)         $  (2.27)         $  (8.22)
                                                       --------          --------          --------          --------

Weighted average common shares outstanding                7,221             2,809             5,488             2,803
                                                       ========          ========          ========          ========
</TABLE>

   The accompanying notes are an integral part of these financial statements.

                                       5
<PAGE>   6
AUREAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>

                                                                                Six Months Ended
                                                                          --------------------------
                                                                            July 4,         June 28,
                                                                             1999            1998
                                                                                 (Unaudited)
<S>                                                                       <C>               <C>
OPERATING ACTIVITIES
Net loss from operations                                                  $(10,962)         $(10,932)
Adjustments to reconcile net loss from operations
 to net cash used in operating activities:
      Depreciation and amortization                                          2,979             2,026
      Changes in operating assets and liabilities:
            Restricted cash                                                      6               109
            Accounts receivable                                                  6            (3,432)
            Inventories                                                     (2,728)           (4,845)
            Prepaid expenses and other current assets                         (706)             (549)
            Other assets                                                       242              (465)
            Accounts payable                                                   688               (57)
            Accrued compensation and benefits, and
            other accrued liabilities                                          318              (315)
                                                                          --------          --------
Net cash used in operating activities                                      (10,157)          (18,460)
                                                                          --------          --------

INVESTING ACTIVITIES
Acquisition of property and equipment                                         (751)           (1,038)
                                                                          --------          --------
Net cash used in investing activities                                         (751)           (1,038)
                                                                          --------          --------

FINANCING ACTIVITIES
Proceeds from Line of Credit                                                27,180            18,984
Repayment on Line of Credit                                                (31,554)           (9,074)
Principal payments on pre-petition claims                                     (540)           (1,211)
Proceeds (expenses) from issuance of stock, net of issuance costs           19,973            10,780
                                                                          --------          --------
Net cash provided by financing activities                                   15,059            19,479
                                                                          --------          --------

Net increase/(decrease) in cash and cash equivalents                         4,151               (19)
Cash and cash equivalents at beginning of period                                87               135
                                                                          --------          --------
Cash and cash equivalents at end of period                                $  4,238          $    116
                                                                          ========          ========

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

Interest paid                                                             $    637          $  2,439

SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING
  ACTIVITIES

Conversion of Line of Credit balance to preferred stock                         --          $ 28,685
Accretion/dividends on preferred stock                                    $  1,484          $ 12,121
Valuation of debt-related warrants issued                                       --          $  1,848
</TABLE>

   The accompanying notes are an integral part of these financial statements.


                                       6

<PAGE>   7

AUREAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1.    THE COMPANY AND RECENT FINANCIAL EVENTS

      Aureal Inc., together with our subsidiaries Crystal River Engineering,
Inc. and Aureal Semiconductor Limited, is a producer of digital audio
semiconductor and board-level products and advanced digital audio technologies
for the personal computer and consumer electronics markets. Crystal River
Engineering, which was founded in 1987 and which we acquired in the second
quarter of 1996, has been a pioneer in the development of 3D audio technologies.
Aureal Semiconductor Limited, located in Hong Kong, was established in March
1998 as a sales, technical support and field engineering office. Our business
involves the development and sale of audio processing semiconductor chips and
audio-based add-in cards for use in PCs, as well as the licensing of technology
that is designed to define and develop advanced audio standards in the
marketplace. Our stock symbol on the OTC Bulletin Board is AURL.

      On April 5, 1999, we announced a capital restructuring plan which included
a subscription rights offering, the conversion of our outstanding series B
preferred stock to common stock and a one-for-fifteen reverse stock split. Under
the subscription rights offering, we offered for sale $20 million of our common
stock, at a price of $0.60 per share (pre-reverse split). Stockholders of our
common stock on April 22, 1999 were offered, on a pro-rata basis, the
opportunity to purchase new shares of our common stock. Our two largest
stockholders, Oaktree Capital Management LLC and TCW Special Credits, agreed to
purchase any unsubscribed shares of this rights offering up to a maximum amount
of $20 million. Oaktree and TCW, holders of all of our series B preferred stock,
converted their shares of series B preferred stock into 20.5 million shares of
common stock upon the closing of the rights offering. In consideration of this
conversion, we issued an additional 26.2 million shares of common stock to these
holders. We did not register these additional 26.2 million shares, but we
granted standard demand and piggyback registration rights to Oaktree and TCW. As
a result of these actions, most of our preferred stock converted to common
stock. We also announced a one-for-fifteen reverse stock split. The split was
effected as of June 10, 1999, at which point we had 9,960,577 shares outstanding
after the split.

2.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

      Basis of Presentation

      We, the management of Aureal Inc., have prepared the following Interim
Condensed Consolidated Financial Statements without audit, pursuant to the rules
and regulations of the Securities and Exchange Commission. Certain information
and footnote disclosures normally included in the financial statements prepared
in accordance with generally accepted accounting principles have been omitted
pursuant to such rules and regulations. The disclosures included in the Interim
Condensed Consolidated Financial Statements should be read in conjunction with
our audited financial statements at January 3, 1999 and the financial footnotes
included in our 1998 Annual Report on Form 10-K.

      The Interim Condensed Consolidated Financial Statements reflect, in the
opinion of management, all adjustments (which include only normal recurring
adjustments) necessary for a fair presentation of financial position, results of
operations and cash flows for such periods. The results of operations for the
fiscal quarter ended July 4, 1999 are not necessarily indicative of the results
that may be expected for any subsequent quarter or the entire fiscal year ending
January 2, 2000.

      Cash and Cash Equivalents and Short Term Investments

      We consider cash invested in highly liquid financial instruments with an
original maturity of three months or less to be cash equivalents. Cash
investments in highly liquid financial instruments with original maturities
greater than three months but not longer than fifteen months are classified as
short-term investments.

                                       7
<PAGE>   8

      Inventories

      Inventories are stated at the lower-of-cost-or-market value on a first-in
first-out basis. We do not consider any inventory to be raw material, since our
initial point of purchase is for fabricated silicon wafers. Net inventories at
July 4, 1999 and January 3, 1999 consisted of the following, in thousands:
<TABLE>
<CAPTION>

                               July 4, 1999      January 3, 1999
                               ------------      ---------------

<S>                           <C>                <C>
Work-In-Process ..............      $1,158         $2,460
Finished Goods ...............       5,486          1,456
                                    ------         ------
          Total Inventories ..      $6,644         $3,916
                                    ======         ======
</TABLE>

      Property and Equipment

      Property and equipment are stated at cost and depreciated utilizing the
straight-line method over their estimated useful lives (one and one-half to five
years). Leasehold improvements are amortized utilizing the straight-line method
over their estimated useful lives or the term of the lease whichever is shorter.
Maintenance and repairs are expensed as incurred.

      Revenue Recognition

      Our major sources of revenue consist of sales of proprietary design,
advanced audio semiconductor chips and boards, and licensing of related audio
technologies. Revenue is recognized upon shipment for product sales. Licensing
revenues are recognized upon delivery of licensed product if a non-cancelable
contract has been signed, the fees are fixed and determinable, collection of the
recognized fees is probable, and there are no remaining significant obligations.

      Comprehensive income

      Statement of Financial Accounting Standards No. 130 requires that we
disclose all non-owner changes in equity, such as cumulative foreign currency
translation adjustments, certain minimum pension liabilities and gains and
losses on available-for-sale securities. During the first half of both 1999 and
1998, we had no elements of comprehensive income.

      Concentration of Financial Instrument Risks and Credit Risks

      Financial instruments which potentially subject us to concentration of
market risk consist primarily of our line of credit. Concentration of market
risk on the line of credit is related to changes in the prime lending rate, as
the majority of our debt bears interest rates which fluctuate with changes in
the prime lending rate. Our credit risk consists primarily of trade receivables.
Some of these trade receivables are the result of sales to foreign companies. We
have established an allowance for doubtful accounts based on the credit risks of
the business in general.

      Valuation of Warrants

      In connection with the establishment of a credit facility in June 1998, we
issued warrants to purchase 1.35 million shares of our common stock. The fair
value of these warrants was estimated utilizing the Black-Scholes valuation
method as approximately $1.8 million. This value was being amortized over the
two-year term of the credit facility. These warrants were issued in
consideration of the Tranche B portion of this credit facility. When the Tranche
B portion of this credit facility was terminated in May 1999, the remaining
unamortized value of $0.9 million was expensed.

      Loss Per Share

      The Financial Accounting Standards Board has issued Statement of Financial
Accounting Standards No. 128, which is effective for financial statements for
periods ending after December 15, 1997. Statement of Financial Accounting
Standards No. 128 requires that the calculation for basic earnings per share
exclude the dilutive effect of common stock equivalents in the calculation for
basic net income (loss) per share. Diluted earnings per share under Statement of
Financial Accounting Standards No. 128, is calculated using the weighted average
number of common shares and common stock equivalent shares outstanding during
the period. Common equivalent shares

                                       8
<PAGE>   9

are computed using the treasury stock method for outstanding warrants and stock
options. Common equivalent shares are excluded from the diluted earnings per
share computation only if their effect is anti-dilutive. No common stock
equivalents were included in the calculations for any fiscal period presented
as, due to our net loss position, any affect would be anti-dilutive.

      Accretion related to the beneficial conversion features of the series A
preferred and the series C preferred, and the dividend / accretion rate of 8% on
all three series of preferred stock totaled $1.5 million during the first two
quarters of 1999. These charges were recorded directly to accumulated deficit
and are included as a component of net loss per share attributable to common
stockholders.

      Loss per share figures for prior periods have been restated to reflect the
effect of the one-for-fifteen reverse stock split effected June 10, 1999.

3.    CREDIT FACILITY

      In connection with our May 1999 capital restructuring, the outstanding
balance under our previous line of credit was re-paid and new terms were agreed
upon with Transamerica Business Credit Corporation. This new agreement is a
$12.2 million credit facility at an interest rate of prime plus 3%. We are
subject to certain covenant restrictions under this facility. This agreement is
in force until September 30, 1999. We are currently renegotiating the terms of
this agreement to include a reduction in the interest rate, an extension of the
term to two years and an increase in the total dollars available to borrow under
the line.

      Our previous line of credit was entered into on June 5, 1998 with
Transamerica Business Credit Corporation and Goldman Sachs Credit Partners L.P.
This was a two year $40 million revolving credit facility partially secured by
our assets. Terms of the credit facility provided for up to $32.5 million
borrowing availability related to specific accounts receivable, referred to as
Tranche A, with an additional $7.5 million of availability unrelated to specific
collateral requirements, referred to as Tranche B. Interest on borrowings under
the two-year agreement was at the rates of prime plus 3% for Tranche A
borrowings and prime plus 5% percent for Tranche B borrowings. We were subject
to certain covenant restrictions under the credit facility and paid a $600,000
fee to the lenders in connection with the initiation of this credit facility.

4.    EQUITY FUNDING

      On April 5, 1999, we announced a capital restructuring plan which included
a subscription rights offering, the conversion of our outstanding series B
preferred stock to common stock and a one-for-fifteen reverse stock split. Under
the subscription rights offering, we offered for sale $20 million of our common
stock, at a price of $0.60 per share (pre-reverse split). Stockholders of our
common stock on April 22, 1999 were offered, on a pro-rata basis, the
opportunity to purchase new shares of our common stock. Our two largest
stockholders, Oaktree Capital Management LLC and TCW Special Credits, agreed to
purchase any unsubscribed shares of this rights offering up to a maximum amount
of $20 million. Oaktree and TCW, holders of all of our series B preferred stock,
converted their shares of series B preferred stock into 20.5 million shares of
common stock upon the closing of the rights offering. In consideration of this
conversion, we issued an additional 26.2 million shares of common stock to these
holders. We did not register these additional 26.2 million shares, but we
granted standard demand and piggyback registration rights to Oaktree and TCW. As
a result of these actions, most of our preferred stock converted to common
stock. We also announced a one-for-fifteen reverse stock split. These actions
should make it possible for us to qualify for NASDAQ national market listing in
the near future.

      At our 1999 annual meeting of stockholders, our stockholders approved a
one-for-fifteen reverse stock split and an increase in the number of shares for
the stock option plan. The reverse split was effected on June 10, 1999, and
these actions have been reflected in the accompanying consolidated financial
statements.

5.    INCOME TAXES

      We were not required to provide for income taxes in the first two quarters
of 1999 or 1998 due to our net operating losses. No tax benefit has been
recorded for the losses due to the uncertainty as to the realizability. At
January 3, 1999, we had available net operating loss carryforwards of
approximately $308 million to reduce future taxable income.

                                       9
<PAGE>   10
INDUSTRY SEGMENTS AND MAJOR CUSTOMERS

      Aureal operates in a single segment which includes three product revenue
groups. During the second quarter of 1999 we generated $4.2 million in revenues
from the sale of chips, $3.6 million from the sale of board-level products and
$0.3 million in revenues from licensing agreements. During the same period in
1998, revenues from chips were $3.2 million and $0.2 million from licensing
agreements and miscellaneous audio revenues.


                                       10
<PAGE>   11

      ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
               RESULTS OF OPERATIONS

           THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF
SECTION 27A OF THE SECURITIES ACT OF 1933 AND SECTION 21E OF THE SECURITIES
EXCHANGE ACT OF 1934. ANY FORWARD-LOOKING STATEMENTS MADE HEREIN ARE MADE
PURSUANT TO THE SAFE HARBOR PROVISIONS OF THE PRIVATE SECURITIES LITIGATION ACT
OF 1995. INVESTORS ARE CAUTIONED THAT ACTUAL RESULTS MAY DIFFER MATERIALLY FROM
THOSE PROJECTED IN ANY FORWARD-LOOKING STATEMENTS DUE TO A NUMBER OF FACTORS
INCLUDING, BUT NOT LIMITED TO, OUR DEPENDENCE ON THE PERSONAL COMPUTER AND
CONSUMER ELECTRONICS INDUSTRIES AND ON PRODUCT LINES BASED ON NEW TECHNOLOGIES;
FOUNDRY AND FACTORY CAPACITY, AVAILABILITY AND RELIABILITY; COMPETITION AND
PRICING PRESSURES; OUR ABILITY TO SECURE ADDITIONAL FINANCING; AND OTHER RISKS
DETAILED BELOW AND FROM TIME TO TIME IN OUR FILINGS WITH THE SECURITIES AND
EXCHANGE COMMISSION. FOR A FURTHER DISCUSSION OF THE RISKS RELATING TO OUR
BUSINESS, SEE THE RISK FACTORS SECTION OF MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS.

OVERVIEW

           Aureal Inc., together with our subsidiaries Crystal River
Engineering, Inc. and Aureal Semiconductor Limited, is a producer of digital
audio semiconductor and board-level products and advanced digital audio
technologies for the personal computer and consumer electronics markets. We
contract with independent silicon manufacturers, which in the semiconductor
industry are called foundries, for production of our semiconductor products, and
thus we do not fabricate our own semiconductor products. The foundry that
manufactures the majority of our semiconductor products is one of the three
largest foundries in the world that manufactures products exclusively for
outside customers. Our objective is to be a leading provider of advanced digital
audio solutions for the personal computer and consumer electronics markets.

           During the first half of 1999, a number of significant events
occurred for us:

o   In June 1999, we completed a capital restructuring which included a $20
    million subscription rights offering of common stock, the conversion of all
    of our series B and C preferred stock and a one-for-fifteen reverse stock
    split.

o   In May 1999, our stockholders voted to change our name from Aureal
    Semiconductor Inc. to Aureal Inc. We believe our new name more accurately
    reflects our focus as a digital audio imaging hardware and software company.

o   Also in May 1999, we announced the introduction of the Vortex Advantage
    soundcard - a new, low-cost audio sub-system for systems integrators.

o   In April 1999, we announced that Sony Electronics had begun shipping two new
    VAIO brand PCs incorporating our Vortex2 audio processors. With the
    introduction of these machines, Sony became the first manufacturer to design
    Vortex2 audio processors directly onto a PC motherboard.

o   Also in April 1999, we announced the availability of a new digital audio
    accelerator for desktop and notebook PCs, the Vortex AU8810. This new chip
    is a low-cost, motherboard solution resulting from the integration of audio
    and modem capabilities.

o   March 1999, we released our A3D 2.0 software development kit, which enables
    the creation of interactive 3D audio content, to the general development
    community. This kit had previously only been available to selected game
    developers. We received an extremely positive response to the new kit, with
    demand for CDs and Internet downloads of the kit reaching into the
    thousands.

o   Also in March 1999, we announced the formation of a partnership with
    Flatland Online, Inc. As part of this partnership, we have integrated our
    A3D 2.0 standard into Flatland's tools and web browser extension software
    providing easy-to-use positional audio for the 3D web enhanced by our Aureal
    Wavetracing technology.

o   In February 1999, we received Computer Gaming World's prestigious Gaming
    Hardware of the Year award for our Vortex2 audio processor. This event was
    significant because it was the first time that the award was presented to an
    audio hardware company, signifying a shift in industry focus from graphics
    to audio. Also in February, we began web-based distribution of our A3D Pro
    sound design software. This marked our first foray into electronic commerce.

o   In January 1999, we began direct sales to systems integrators. We also
    announced an extension of our relationship with Compaq Computer Corporation,
    in which Compaq agreed to ship our Vortex sound card products in their new
    Presario 5600 desktop computer products.

      We are headquartered in Fremont, California and have offices in Austin,
Texas and Hong Kong. In June 1999 we leased a 100,000 square foot building in
Fremont, California. The move to this location will be


                                       11


<PAGE>   12

completed in August 1999 and will consolidate employees from two previously
occupied locations in Fremont and allow for future growth. Leases for two
smaller locations will expire over the next several months. As of July 4, 1999,
we employed 140 people. Of this total, 107 were engaged in engineering
functions, 20 were in sales and marketing activities, and 13 were engaged in
administrative support. In addition, we utilize the services of contractor
consultants to supplement our employee workforce.

           Aureal, Aureal 3D, A3D and the A3D logo are registered trademarks of
Aureal Inc. Other trademarks referred to in this document belong to their
respective owners.

RESULTS OF OPERATIONS

Second quarter and six months of 1999 compared to second quarter and six months
of 1998

           Net sales

           Net sales for the second quarter of 1999 were $8.1 million compared
to $3.4 million in the second quarter of 1998. This 138% increase in sales was
the result of the continued commercial success in the marketplace of our Vortex
and Vortex2 products. During the second quarter of 1999, we introduced new sound
cards based on our low-cost Vortex AU8810 chip. We also saw continued channel
growth from our AU8820 chips, AU8820 sound cards, AU8830 chips and AU8830 sound
cards. Year to date revenues in 1999 were $20.6 million compared to $7.0 million
in the prior year. Revenues from the year and second quarter of 1998 consisted
mainly of sales of our AU8820 chips. Licensing revenues in the second quarters
of 1999 and 1998 were $0.3 and $0.2 million, respectively.

           Gross margin

           Gross margin for the second quarter of 1999 was 38%. This was a 4
point or 12% increase in gross margin over the 34% reported in the first quarter
of 1999. This increase was attributable to lower materials costs for our AU8820
and AU8810 chips, favorable pricing agreements for testing and significantly
less startup costs for new products. Our gross margin in the second quarter of
1998 was 41% and reflected product cost reduction and one-time favorable
variances in product costs. Gross margin was positively affected in all quarters
by revenues from licensing. While we anticipate the continuation of revenues
from technology licensing agreements, we do not believe that they will be a
significant percentage of our total revenues in the future. We believe that our
gross margins could vary depending upon market demand for our various products,
new product introductions and the timing and volumes of licensing revenues.

           Research and development

           Expenditures for research and development continue to be significant
as resources are allocated to create future audio products for both the PC and
consumer electronics markets. Spending in this area yields both short-term and
long-term product developments as we continue to bring new and improved products
to the audio forefront. Research and development expenses increased from $2.9
million in the second quarter of 1998 to $3.6 million in the second quarter of
1999 but declined as a percentage of net sales from 85% to 45%, respectively.
Year-to-date research and development expenditures in 1999 were $7.0 million
compared to $5.5 million in 1998. This was a 27% increase in dollar expenditures
year-to-year. We expect research and development to continue to be a significant
area of investment for us as we develop new technologies and explore new audio
frontiers. We expect that the level of spending on research and development will
fluctuate as a percentage of net sales, but we do not expect it to decline
significantly in absolute dollars in the future.

           Sales and marketing

           During the second quarter of 1999, we continued our direct sales
efforts to expand our presence in the system integrator channel. To affect this
new distribution strategy, we increased selling and marketing headcount,
advertising expenses, trade-show participation and travel and commission
expenditures. This resulted in an 80% increase in spending in this area between
the second quarters of 1999 and 1998, respectively and a 68% increase between
1999 and 1998 on a year-to-date basis. While year-to-date sales and marketing
expenses increased in absolute dollar terms from $3.0 million in 1998 to $5.0
million in 1999, these costs decreased as a percentage of net

                                       12


<PAGE>   13

sales from 43% in 1998 to 24% in 1999. As we expand our distribution model, we
expect sales and marketing expenses will continue to increase in absolute
dollars in the future.

           General and administrative

           General and administrative expenses for the second quarter of 1999
increased to $2.6 million from $0.8 million in 1998. This increase was the
result of increased headcount and legal fees. For the second quarter of 1999,
legal fees were $1.5 million. These fees were primarily for services directly
related to a series of lawsuits between Creative Technology Ltd. and us. For
the six months 1999 compared to 1998, general and administrative expenses
increased to $3.8 million from $1.7 million but decreased as a percentage of net
sales from 24% in 1998 to 18% in 1999. We expect that general and administrative
expenses will increase in absolute dollar terms over the next several periods
due to headcount increases, the costs associated with providing expanded
infrastructure for our organization and continuing legal fees.

           Interest expense

           Interest expense for the second quarters of 1999 and 1998 decreased
to $0.7 million from $1.0 million, respectively. This decrease was primarily the
result of our recent capital restructuring. The $20.0 million capital infusion
in May 1999 allowed us to pay off our previous line of credit. Interest expense
for the second quarter of 1999 also included a non-recurring charge of $0.5
million in expensed loan fees that related to the previous credit facility. In
June 1998, we paid down and eliminated our previous line of credit in connection
with the exchange for our series B preferred stock. This resulted in the decline
of interest expense based on the lower outstanding balance of our borrowings. On
a year-to-date basis, interest expense declined from $2.0 million in 1998 to
$1.1 million in 1999.

           Amortization of debt-related warrants

           In connection with the establishment of a credit facility in June
1998, we issued warrants to purchase 1.35 million shares of our common stock.
The fair value of these warrants was estimated utilizing the Black-Scholes
valuation method as approximately $1.8 million. This value was being amortized
over the two-year term of the credit facility. These warrants were issued in
consideration of the Tranche B portion of this credit facility. When the Tranche
B portion of this credit facility was terminated in May 1999; the remaining
unamortized value of $0.9 million was expensed.

           In August 1997, in conjunction with the expansion and extension of
our prior line of credit, we issued warrants to purchase 3.15 million shares of
our common stock to our lenders. Using the Black-Scholes valuation method, the
estimated fair value of the warrants was determined to be $5.0 million. This
value was amortized over the estimated life of the line of credit at the rate of
$0.75 million per quarter. When the line of credit was converted to preferred
stock in June 1998, the remaining unamortized deferred costs related to the
warrants were netted against the outstanding loan balance and eliminated as a
reduction of the conversion value of the series B preferred shares.

           Income taxes

           We were not required to provide for income taxes in either the first
half of 1999 or 1998, respectively due to our net operating losses. No tax
benefit has been recorded for the net operating loss carryforwards due to the
uncertainty as to their realizability.

                                       13
<PAGE>   14
LIQUIDITY AND CAPITAL RESOURCES

           As of July 4, 1999, we had working capital of $5.3 million and
stockholders' equity of $7.6 million. The $10.2 million net cash used in
operations during the first half of 1999 was approximately $8.3 million less
than we used in the first half of 1998. This decrease was primarily due to lower
levels of inventory and accounts receivable build. Net cash used for investing
in equipment and software tools stayed constant at $0.2 million in the second
quarters of both 1999 and 1998. These capital expenditures consisted primarily
of purchases of hardware and software tools utilized in our research and
development activities. Capital expenditures are anticipated to increase
significantly during 1999, to an estimated level of approximately $3 million for
the year.

           Financing for second quarter of 1999 cash outlays was provided by our
previous line of credit and cash received from our rights offering. We expect
that in the next six months we will need additional cash to expand our business
and to finance additional inventory and accounts receivable. It is extremely
difficult to estimate the cash flows, and the timing of these cash flows, due to
our lack of significant sales and customer payment history. We can make no
assurance that we will be able to generate positive cash flows in the future.

           On April 5, 1999, we announced a capital restructuring plan which
included a subscription rights offering, the conversion of our outstanding
series B preferred stock to common stock and a one-for-fifteen reverse stock
split. Under the subscription rights offering, we offered for sale $20 million
of our common stock, at a price of $0.60 per share (pre-reverse split).
Stockholders of our common stock on April 22, 1999 were offered, on a pro-rata
basis, the opportunity to purchase new shares of our common stock. Our two
largest stockholders, Oaktree Capital Management LLC and TCW Special Credits,
agreed to purchase any unsubscribed shares of this rights offering up to a
maximum amount of $20 million. Oaktree and TCW, holders of all of our series B
preferred stock, converted their shares of series B preferred stock into 20.5
million shares of common stock upon the closing of the rights offering. In
consideration of this conversion, we issued an additional 26.2 million shares of
common stock to these holders. We did not register these additional 26.2 million
shares, but we granted standard demand and piggyback registration rights to
Oaktree and TCW. As a result of these actions, most of our preferred stock
converted to common stock. We also announced a one-for-fifteen reverse stock
split. These actions should make it possible for us to qualify for NASDAQ
national market listing in the near future.

           In connection with our May 1999 capital restructuring, the
outstanding balance under our previous line of credit was re-paid and new terms
were agreed upon with Transamerica Business Credit Corporation. This new
agreement is a $12.2 million credit facility at an interest rate of prime plus
3%. We are subject to certain covenant restrictions under this facility. This
agreement is in force until September 30, 1999. We are currently renegotiating
the terms this agreement to include a reduction in the interest rate, an
extension of the term to two years and an increase in the total dollars
available to borrow under the line.

           At July 4, 1999, we had no borrowings under our credit facility with
Transamerica. Our unused borrowing availability under the line was $4.0 million.
At quarter-end July 4, 1999, our financial ratios were out of compliance with
financial covenant requirements for the credit facility; however, at July 29, we
had secured a waiver of non-compliance for these specific covenants.

DISCLOSURE REGARDING THE YEAR 2000

           Year 2000 Readiness Disclosure: Some computer, software, and other
equipment include computer code in which calendar year data is abbreviated to
only two digits. As a result of this design protocol, some of these systems
could fail to operate or fail to produce correct results if the year "00" is
interpreted to mean 1900 instead of 2000. These problems are widely expected to
increase in frequency and severity as the year 2000 approaches and are commonly
referred to as the "year 2000 problem."

Assessment:
           The year 2000 problem affects some of the computers, software and
other equipment that we use, operate or maintain for our operations. We have
developed a year 2000 readiness plan to assess our exposure to the year 2000
problem, implement solutions and develop necessary contingency plans. This plan
has been reported to our board of directors and progress is reported to them on
a regular basis. To date we have obtained verification and validation from the
majority of our independent third party software and hardware suppliers of the
year 2000 compliance of their products.


                                       14

<PAGE>   15

Internal infrastructure:

           Of the systems we are currently using, the components of our mission
critical software are year 2000 compliant as are the majority of the software
packages we employ as engineering tools. Upon completion of the evaluation and
assessment of all of our software packages and hardware, we will commence the
process of modifying, upgrading and replacing the systems that have been
assessed as adversely affected. We expect to complete this process before the
occurrence of any material disruption of our business.

           In addition to computers and software packages, there are office
equipment such as fax machines, telephone switches, security systems and other
common devices which may be affected by the year 2000 problem. Of these pieces
of equipment, we have identified our voice mail system as needing replacement or
upgrade and this will be completed in August 1999.

Products and software programs:

           We have tested our products for year 2000 problems. This testing was
completed during the first quarter of 1999. Our engineering staff performed
compliance testing on all A3D drivers, utilities and supporting software using
testing methods and measurements that specifically addressed potential risks to
seamless integration into the year 2000 environment. Our A3D product passed both
functional and usage tests without errors due to year 2000 non-compliance.

           We estimate the cost of completing any required modifications,
upgrades or replacements of our internal systems to not be significant. All
systems that we have tested to date are year 2000 compliant, except for our
voice mail system which we will upgrade in August 1999. We believe that the
systems that we have not tested can be replaced or modified in the normal course
of business.

Suppliers:

           We are contacting our suppliers and checking the web sites of
third-party suppliers of components used in the manufacture of our products to
determine if these suppliers are certifying that the components they provide us
are year 2000 compliant. To date, we believe all critical components that we
obtain from third party suppliers are year 2000 compliant. We expect that we
will be able to resolve any significant year 2000 problems with any third-party
suppliers of components; however, there can be no assurance that these suppliers
will resolve any or all year 2000 problems before the occurrence of a material
disruption to the operation of our business. Any failure of these third parties
to timely resolve year 2000 problems with their systems could have a material
adverse effect on our business, operating results and financial condition.

Most likely consequences of year 2000 problems:

           We expect to identify and resolve all year 2000 problems before they
materially adversely affect our business operations; however, we believe that it
is not possible to determine with complete certainty that all year 2000 problems
affecting us have been identified or corrected. The number of devices that could
be affected and the interactions among these devices are simply too numerous. In
addition, no one can accurately predict how many year 2000 problem-related
failures will occur or the severity, duration, or financial consequences of
these perhaps inevitable failures. As a result, we believe that we could
experience a significant number of operational inconveniences and inefficiencies
for us, our contract manufacturers, and our customers that will divert
management's time and attention and financial and human resources from ordinary
business activities. We also believe that it is possible that there may be
business disputes alleging that we failed to comply with the delivery terms of
contracts.

Contingency plans:

           We will develop contingency plans to be implemented if our efforts to
correct identifiable year 2000 problems are not effective. Depending on the
systems identified as non-compliant, these plans could include: accelerated
replacement of affected equipment or software, short to medium-term use of
backup equipment and software; increased work hours for our personnel; and use
of contract personnel to correct on an accelerated schedule any year 2000
problems that arise or to provide manual workarounds for information systems.
Our implementation of any of these contingency plans could have a material
adverse effect on our business, operating results and financial condition.


                                       15
<PAGE>   16
Disclaimer:

           The discussion of our efforts and expectations relating to year 2000
compliance are forward-looking statements. Our ability to achieve year 2000
compliance and the level of incremental costs associated therewith, could be
adversely affected by, among other things, the availability and cost of
programming and testing resources, third party suppliers' ability to modify
proprietary software, and unanticipated problems identified in the ongoing
compliance review.

RISK FACTORS

           In addition to the other information in this report or incorporated
in this report by reference, you should consider carefully the following factors
in evaluating Aureal and our business:


WE HAVE COMPLETED A ONE-FOR-FIFTEEN REVERSE STOCK SPLIT AND THE MARKET PRICE OF
OUR COMMON STOCK MAY DECLINE

           Our stock price may decline as a result of the one-for-fifteen
reverse stock split we effected in June 1999. Many companies that have announced
and then effected reverse stock splits have seen their stock price fall, both
before and after the reverse split is effected. Our stockholders approved the
one-for-fifteen reverse split in our common stock in May 1999. While a reverse
stock split does not in any way affect the value of, or your investment in,
Aureal, the markets may react negatively to it which could cause our stock price
to decline further. We cannot assure you that, as a result of the reverse stock
split, our stock price will not decline to a price that is less than fifteen
times the price of our stock prior to the reverse stock split.

WE HAVE SUSTAINED LOSSES IN THE PAST AND WE EXPECT TO SUSTAIN LOSSES IN THE
FUTURE

           We emerged from bankruptcy protection in December 1994. Since that
time, we have recorded an accumulated deficit of $185 million as of July 4,
1999. This deficit is comprised of $168 million of incurred losses and $17
million of accretion and dividends on our preferred stock. We generated the
majority of our revenues in 1997 and 1996 through technology licensing
transactions. The majority of our revenues in 1998 and the first two quarters of
1999 came from the sale of advanced audio products. We expect that the majority
of our future revenues will be derived from the sale of advanced audio products.
However, we will not be profitable unless we sell significant volumes of our
advanced audio products in the future.

A DIRECTOR OF AUREAL HAS VOTING CONTROL OVER A SUBSTANTIAL AMOUNT OF OUR STOCK
AND MAY, THEREFORE, INFLUENCE OUR AFFAIRS

           As of July 4, 1999, Richard Masson, a director of Aureal, is deemed
to have voting control over approximately 77% of our common stock as a result of
his affiliations with Oaktree and TCW. As a result of the amount of our stock
deemed to be under the stockholder voting control of Mr. Masson, he may directly
and indirectly influence the affairs of Aureal requiring stockholders' approval.
Accordingly, Mr. Masson can be deemed to be able to control all matters
requiring approval by our stockholders, including the election of directors and
the approval of mergers or other business combinations.

INVESTORS MAY FIND IT DIFFICULT TO TRADE OUR COMMON STOCK ON THE
OVER-THE-COUNTER ELECTRONIC BULLETIN BOARD

           Our common stock trades only on the Over-the-Counter Electronic
Bulletin Board. In prior periods, we did not meet the requirements for listing
on the NASDAQ National Market or any national stock exchange. However, we
believe that our common stock will qualify for listing on the NASDAQ National
Market now that we have completed our $20 million rights offering and effected a
one-for-fifteen reverse stock split. Because our common stock trades on the
Bulletin Board, an investor may find it very difficult to sell or to obtain
accurate quotations as to the market value of our common stock. Furthermore,
because our common stock is not listed on the NASDAQ National Market, trading in
our common stock is also subject to certain rules promulgated by the SEC under
the Securities Exchange Act of 1934. These rules require additional disclosure
by broker-dealers in connection with any trades involving a stock defined as a
penny stock. Generally, a penny stock is any non-NASDAQ National Market listed
equity security that has a market price of less than $5.00 per share, subject to
certain exceptions. The additional burdens imposed upon broker-dealers by such
requirements may discourage broker-dealers from

                                       16


<PAGE>   17

affecting transactions in our common stock and may limit the ability of
purchasers of our common stock to resell our common stock in the secondary
market.

WE EXPECT THE AVERAGE SELLING PRICE OF OUR PRODUCTS TO DECREASE WHICH MAY REDUCE
GROSS MARGINS AND REVENUES

           Product prices in the audio technology industry generally decrease
over the life of a particular product. The willingness of prospective customers
to design our products into their products depends to a significant extent upon
our ability to price our products at levels that are cost-effective for these
customers. As the markets for our products mature and competition increases, we
anticipate that prices for our products will decline over time. If we are unable
to reduce our costs sufficiently to offset declines in our product prices, or if
we are unable to introduce new, higher performance products with higher product
prices, our gross margins and revenues could decline.

WE DEPEND ON A CREDIT FACILITY TO FUND OUR BUSINESS OPERATIONS

           Because we have not been profitable to date, we have had to fund our
losses through a combination of equity and debt financings. In June 1999, we
entered into a credit facility that provides for an aggregate maximum borrowing
of $12.2 million. The interest rate on the credit facility is generally the
prime rate plus 3.0%. Accordingly, while the credit facility provides us with
needed working capital, the high cost of servicing any borrowing under it could
negatively affect our liquidity. In addition, the credit facility may not be
sufficient to meet our working capital requirements. In the event we must secure
capital in addition to the line of credit, there can be no assurance that such
capital will be available on acceptable terms or at all. Our inability to secure
future financing, if necessary, would materially adversely affect our business,
financial condition and results of operations.

TO COMPETE EFFECTIVELY IN THE AUDIO TECHNOLOGY MARKET, WE NEED TO DEVELOP NEW
AUDIO TECHNOLOGIES THAT ARE WIDELY ACCEPTED BY OUR CUSTOMERS

           Our success depends on our ability to develop and market new audio
technologies aimed at advancing the level of audio quality in personal computers
and consumer electronics devices. To be successful, we must timely develop new
products that we can sell at competitive prices to our customers who will design
them into their products. In order for our customers to design our advanced
audio products into their personal computers and consumer electronic products,
we must:

           o          anticipate market trends;

           o          anticipate the performance and functionality requirements
                      of our current and potential customers;

           o          develop and produce products that meet the timing and
                      pricing requirements of our current and potential
                      customers; and

           o          produce products that can be available in a timely manner
                      consistent with our current and potential customers'
                      development and production schedules.

           We are expanding our business model to provide for an increased
number of audio-related products, including audio cards and audio communications
combination cards. We may require additional working capital funds for this
expansion to provide for incremental inventory and broader marketing programs. A
number of factors may limit the success of our expansion, and each could
negatively impact our business and results of operations. These factors include:

           o          the failure of the market for advanced audio products to
                      grow;

           o          reduced demand for our products as a result of increased
                      competition in this market; unforeseen technological
                      change; and

           o          our potential failure to introduce new versions of
                      products that our customers and the market accept.

           A failure to develop new audio technologies that will be accepted by
our customers could materially adversely affect our ability to generate
revenues.

NEW GENERATIONS OF MICROPROCESSORS AND OTHER NEW TECHNOLOGIES MAY DECREASE
DEMAND FOR OUR PRODUCTS

           We also face the risk that new generations of microprocessors that
are capable of performing the function of advanced audio products will greatly
reduce demand for our products. Each successive generation of microprocessors
has provided increased performance, which could, in the future, result in a
microprocessor capable of performing advanced audio functions to an extent that
diminishes or eliminates the need or preference for our products. In addition,
each new generation of technology, including digital audio technology, generally
requires

                                       17


<PAGE>   18

increased processing power. The increased capabilities of microprocessors in the
future may lower demand for our products which will materially adversely affect
our business, financial condition and results of operations.

INTENSE COMPETITION IN THE MARKET FOR AUDIO PRODUCTS AND ADVANCED AUDIO
TECHNOLOGIES COULD PREVENT AUREAL FROM INCREASING REVENUE AND PREVENT AUREAL
FROM ACHIEVING PROFITABILITY

           The markets for audio products and advanced audio technologies are
intensely competitive and are characterized by evolving industry standards that
result in:

           o          short product life cycles;

           o          significant pressure to improve price and performance; and

           o          frequent new product introductions.

           We expect competition to increase from existing competitors and from
other companies that may enter the markets for advanced audio products with
devices that may be less costly or provide higher performance or additional
features than the products we currently offer. However, we are unable to predict
the timing and nature of any such competitive product offerings.

           In addition, we anticipate that we will compete for the development
of new technologies and for the sale of semiconductor products with a number of
companies who have more extensive resources, including financial, manufacturing,
technical, marketing and distribution. Furthermore, some of these competitors
have greater intellectual property rights, broader product lines and
longer-standing relationships with their customers than we do. In addition to
our established competitors, we may also face competition from a number of
emerging companies. To remain competitive, we believe we must, among other
things, invest significant resources in developing new products and enhancing
our current products and maintaining customer satisfaction. If we fail to do so,
our products will not compete favorably with those of our competitors and our
revenue could be materially adversely affected.

WE MAY NOT HAVE AN ADEQUATE SUPPLY OF OUR PRODUCTS BECAUSE WE DEPEND ON
FOUNDRIES AND FACTORIES TO PRODUCE OUR PRODUCTS AND OUR PRODUCTS ARE DIFFICULT
TO MANUFACTURE

           We do not manufacture our own products, and we depend on outside
manufacturing resources for production of all of our products. Currently, we
utilize one foreign semiconductor foundry and one contract manufacturer for
production of our board level products. These facilities have indicated to us
that they have the manufacturing availability to provide for our planned levels
of production of each of our products for the next 12 months; however, our
production relationship with them is based only upon purchase orders.
Consequently, they may not continue to adequately provide manufacturing capacity
to us for our current level of production or any potential increases in our
production levels. In the event that they cease to manufacture our products, we
would have to contract with alternative facilities. However, we may not be able
to timely contract with alternative facilities or to contract with them at all.
Such a situation could materially adversely affect our ability to sell products
to our customers, which in turn would hurt our financial condition and results
of operations.

           The manufacture of semiconductor products is a highly complex and
precise process. Minute levels of contaminants in the manufacturing environment,
defects in the masks used to print circuits on wafers, difficulties in the
fabrication process and other factors can cause a substantial percentage of
wafers to be rejected or a significant number of die on each wafer not to
function. Many of these problems are difficult to diagnose and potentially
time-consuming or expensive to remedy. The foundries that we employ may, in the
future, experience irregularities or adverse yield fluctuations in the
manufacturing processes of our products. In such event, our business, financial
condition and results of operations may be materially adversely affected.

OUR CHARTER DOCUMENTS AND DELAWARE LAW MAY INHIBIT A TAKEOVER OF AUREAL

           Provisions in our amended and restated certificate of incorporation
and bylaws may have the effect of delaying or preventing a change of control or
changes in our management. These provisions include, among others:

           o          the division of the board of directors into three separate
                      classes;

           o          the right of the board to elect the director to fill a
                      space created by the expansion of the board;

           o          the ability of the board to alter our bylaws; and

           o          the requirement that at least 10% of the outstanding
                      shares are needed to call a special meeting of
                      stockholders.

                                       18
<PAGE>   19

           Furthermore, because we are incorporated in Delaware, we are subject
to the provisions of section 203 of the Delaware General Corporation Law. These
provisions prohibit certain large stockholders, in particular those owning 15%
or more of the outstanding voting stock, from consummating a merger or
combination with a corporation unless (1) 66 2/3% of the shares of voting stock
not owned by this large stockholder approve the merger or combination or (2) the
board of directors approves the merger or combination or the transaction which
resulted in the large stockholder owning 15% or more of our outstanding voting
stock.

WE MAY NOT BE ABLE TO RETAIN OUR KEY ENGINEERING, MARKETING, SALES AND
MANAGEMENT PERSONNEL THAT WE NEED TO SUCCESSFULLY MANAGE OUR BUSINESS

           Our success depends to a significant extent upon the continued
services of key engineering, marketing, sales and management personnel. Our
employees may voluntarily terminate their employment with us at any time. We
recognize the value of the contributions of each of our employees, and we have
developed compensation programs, including stock programs open to all employees,
designed to retain our employees. However, competition for these employees is
intense, particularly in Silicon Valley, and the loss of the services of any one
of these employees could materially adversely affect our business, financial
condition and results of operations.

OUR PRODUCTS EMPLOY PROPRIETARY TECHNOLOGY AND THIS TECHNOLOGY MAY INFRINGE ON
THE INTELLECTUAL PROPERTY RIGHTS OF THIRD PARTIES

           Our ability to compete successfully will depend, in part, on our
ability to protect our proprietary technology. We rely on a combination of
patents, trade secrets, copyright and trademark laws, nondisclosure agreements
and other contractual provisions and technical measures to protect our
proprietary rights. Nevertheless, such measures may not be adequate or safeguard
the proprietary technology underlying our advanced audio products. In addition,
employees, consultants and others who participate in the development of our
products may breach their agreements with us regarding our intellectual
property, and we may not have adequate remedies for any such breach. We also
realize that our proprietary information and trade secrets may become known
through other means not currently foreseen by us. Moreover, notwithstanding our
efforts to protect our intellectual property, our competitors may be able to
develop products that are equal or superior to our products without infringing
on any of our intellectual property rights. In addition, we may not be able to
effectively protect our intellectual property rights in certain countries. Our
failure to protect our proprietary technology may materially adversely affect
our financial condition and results of operations.

           Although we do not believe that our products infringe the proprietary
rights of any third parties, third parties may still assert infringement or
invalidity claims, or claims for indemnification resulting from infringement
claims, against us. The assertion of these claims could materially adversely
affect our business, financial condition and results of operations. In addition,
irrespective of the validity or the successful assertion of any claims, we could
incur significant costs in defending against these claims. In defending claims
of alleged infringement, we could incur significant expenses and waste resources
that could have a material adverse affect on our business, financial condition
and results of operations.

WE ARE INVOLVED IN LAWSUITS WITH CREATIVE AND E-MU WHICH COULD NEGATIVELY IMPACT
OUR BUSINESS

           In February 1998, Creative Technology Ltd. and its subsidiary, E-Mu
Systems, Inc., served us with a lawsuit for patent infringement that Creative
and E-Mu filed in the U.S. District Court, Northern District of California. The
lawsuit asserts that our original Vortex product infringes on a patent that
describes a specific implementation for an electronic musical instrument
designed by E-Mu. Creative and E-Mu seek, among other things, a preliminary and
permanent injunction against alleged continuing acts of infringement by us and
an accounting of damages plus interest. In response, we filed a motion for
summary judgment. In August 1998, E-Mu and Creative filed a motion for a
preliminary injunction with respect to our original Vortex and updated Vortex2
products. In October 1998, the court denied Creative's motion for preliminary
injunction. At that time, our motion for summary judgment was also denied. We
believe that the actions that Creative and E-Mu filed are without merit, and we
are vigorously defending against these actions. In December 1998, we filed a
lawsuit alleging patent infringement against Creative and E-Mu. We believe
that Creative and E-Mu have infringed on two of our patents, Patent No.
5,596,644 entitled "Method and Apparatus for Efficient Presentation of
Hi-Quality 3-Dimensional Audio" and Patent No. 5,802,180 entitled "Method and
Apparatus for Efficient Presentation of 3-Dimensional Audio Including Ambient
Effects."

                                       19
<PAGE>   20

           Additional litigation may be necessary to resolve the claims asserted
by Creative and E-Mu and to resolve our claims against Creative and E-Mu and any
other claims asserted in the future to defend against claims of infringement or
invalidity or to enforce and protect our intellectual property rights. We cannot
assure you that we will prevail in any litigation with either of them. Also, any
litigation, whether or not determined in our favor or settled by us, would be
costly and would divert the efforts and attention of our management and
technical personnel from normal business operations; this could materially
adversely affect our business, financial condition and results of operations.
Adverse determinations in litigation could result in the loss of our proprietary
rights, subject us to significant liabilities, require us to seek licenses from
third parties or prevent us from producing certain core products. Any of these
results could have a material adverse affect on our business, financial
condition and results of operations.

THE FAILURE OF OUR KEY SUPPLIERS AND CUSTOMERS TO BE YEAR 2000 COMPLIANT COULD
NEGATIVELY IMPACT OUR BUSINESS

           We use a number of computer software programs and operating systems
in our internal operations, including applications used in financial business
systems and various administration functions. To the extent that these software
applications contain source code that is unable to appropriately interpret the
upcoming calendar year 2000, some level of modification or even possible
replacement of such source code or applications could be necessary. Given the
current information, we currently do not anticipate that such year 2000 costs
will have a material impact upon us. We have requested and obtained information
regarding year 2000 compliance from suppliers and providers of all of our
mission critical software systems. Based on the information we currently have,
all mission critical systems appear to be year 2000 compliant. We are currently
contacting major vendors and customers to obtain year 2000 compliance
certificates. The failure of any of our key suppliers or customers to be year
2000 compliant could have a material adverse effect on our business, financial
condition and results of operations.

         ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURE OF MARKET RISKS

       There has not been a material change in our exposure to interest rate and
foreign currency risks since the date of the 1998 Form 10-K.

Interest Rate Risk. Our expose to market risk for changes in interest rate
relates primarily to our cash equivalents. We do not invest in derivative
financial instruments. Our cash equivalent investments are in money market
accounts with high-credit quality issuers. The table below presents principal
amounts and related interest rates for our cash equivalent investments at July
4, 1999. Our cash equivalent investments are held in fully liquid money market
accounts with no maturity dates.

Foreign Currency Exchange Risk. We transact business with customers and
suppliers located in foreign countries. All of these transactions are
denominated in US dollars and therefore, we have no significant cash flows that
are transacted in foreign currencies.

The table below presents our cash equivalents and related interest rates at July
4, 1999:
<TABLE>
<CAPTION>

                           Carrying                    Interest
                             amount                       rate
                          --------------               ---------
                          (In thousands)

<S>                       <C>                          <C>
Cash Equivalents               $3,701                    4.8%
</TABLE>


                                       20



<PAGE>   21
PART II.  OTHER INFORMATION

ITEM 1.    LEGAL PROCEEDINGS

       In February 1998, Creative Technology Ltd. and its subsidiary, E-Mu
Systems, Inc., served us with a lawsuit for patent infringement that Creative
and E-Mu filed in the U.S. District Court, Northern District of California. The
lawsuit asserts that our original Vortex product infringes on a patent that
describes a specific implementation for an electronic musical instrument
designed by E-Mu. Creative and E-Mu seek, among other things, a preliminary and
permanent injunction against alleged continuing acts of infringement by us and
an accounting of damages plus interest. In response, we filed a motion for
summary judgment. In August 1998, E-Mu and Creative filed a motion for a
preliminary injunction with respect to our original Vortex and updated Vortex2
products. In October 1998, the court denied Creative's motion for preliminary
injunction. At that time, our motion for summary judgment was also denied.
Creative appealed the denial of the preliminary injunction, and on May 6, 1999,
the Federal Court of Appeals affirmed the District Court's ruling denying the
preliminary injunction. A trial is currently scheduled for winter of 1999. We
believe that the actions that Creative and E-Mu filed are without merit, and we
are vigorously defending against these actions.

       In December 1998, we filed a lawsuit alleging patent infringement
against Creative and E-Mu. We believe that Creative and E-Mu have infringed on
two of our patents, Patent No. 5,596,644 entitled "Method and Apparatus for
Efficient Presentation of Hi-Quality 3-Dimensional Audio" and Patent No.
5,802,180 entitled "Method and Apparatus for Efficient Presentation of
3-Dimensional Audio Including Ambient Effects."

       In October 1998, Creative Labs, the U.S. based subsidiary of Creative,
filed a second lawsuit against us. This new lawsuit claims we have engaged in
"false advertising" and "unfair business practices." These complaints center
primarily on a comparison chart prepared by Aureal and published by third
parties on the world-wide-web. We believe that this action is without merit and
have commenced a vigorous defense of this action. We have filed a response
denying these allegations and filed counterclaims against Creative Labs.

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

       The Annual Meeting of Stockholders was held on May 19, 1999 at which the
stockholders voted on five proposals. Proposal number one was to re-elect
Kenneth A. Kokinakis as a director for a three-year period. Proposal number two
was to approve an amendment to our restated certificate of incorporation to
change our name from Aureal Semiconductor Inc. to Aureal Inc. Proposal number
three was to approve a one-for-fifteen reverse stock split. Proposal number four
was to approve an amendment to increase by 3,333,333 the maximum number of
shares that may be issued under the 1995 stock option plan and to increase the
employee grant limit from 80,000 shares to 500,000. Proposal number five was to
ratify the appointment of independent accountants. The results of the votes cast
by our stockholders are shown in the table below:
<TABLE>
<CAPTION>

                                                                            Non-Votes and
                      For                Against             Abstain      Broker Non-Votes
                      ---                -------             -------      ----------------
<S>                <C>                 <C>                  <C>           <C>
Proposal 1         65,859,782                  0            148,552                 --
Proposal 2         64,815,287          1,169,630             23,417                 --
Proposal 3         64,335,874            975,224             15,091            682,145
Proposal 4         52,247,709          3,549,173             52,289         10,159,163
Proposal 5         65,620,898             68,766            318,670                 --
</TABLE>

ITEM 5.         OTHER INFORMATION

       On August 6, 1999, Thomas K. Smith, Jr. resigned from our board of
directors concurrent with his separation from his employer Trust Company of the
West, a wholly owned subsidiary of the TCW Group, Inc.

ITEM 6.         EXHIBITS AND REPORTS ON FORM 8-K

       (a)    Exhibit index at page 23.

       (b)    Reports on Form 8-K: We filed no reports on Form 8-K during the
              second quarter ended July 4, 1999.

                                       21
<PAGE>   22

                                   SIGNATURES


       Pursuant to the requirements of the Securities and Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.


                                         AUREAL INC.



Date:      August 17, 1999               By:       /s/Kenneth A. Kokinakis
                                                   ---------------------------
                                         Kenneth A. Kokinakis
                                         President and Chief Executive Officer


Date:      August 17, 1999               By:       /s/David J. Domeier
                                                   ---------------------------
                                         David J. Domeier
                                         Senior Vice President of Finance
                                         Chief Financial Officer

                                        22
<PAGE>   23

                                         EXHIBIT INDEX

  Exhibit No.                       Description of Document
  -----------                       -----------------------

       2.1    Agreement and Plan of Reorganization among Aureal, Aureal
              Acquisition Corporation, a wholly-owned subsidiary of Aureal and
              Crystal River Engineering, Inc., dated as of May 7, 1996 (1)

       2.2    Second Amended Joint Plan of Reorganization dated November 10,
              1994 (4)

       3.1    Second Amended and Restated Certificate of Incorporation of Aureal
              dated May 8, 1996 (2)

       3.2    Restated Bylaws of Aureal Semiconductor Inc. (5)

       4.3    Common Stock Purchase Agreement by and among Aureal and certain
              entities and individuals dated August 6, 1997 (7)

       4.4    Preferred Stock Regulation D Subscription Agreement (Series A
              Preferred Stock) (8)

       4.5    Certificate of Designation of Series A Preferred Stock of Aureal
              Semiconductor Inc. (8)

       4.6    Preferred Stock Registration Rights Agreement (Common stock
              underlying series A preferred stock)(8)

       4.7    Aureal Semiconductor Inc. regulation D Subscription Agreement for
              Series C Preferred Stock (9)

       4.8    Certificate of Designation of Series C Preferred Stock of Aureal
              Semiconductor Inc. (9)

       4.9    Registration Rights Agreement ( Common Stock underlying Series C
              Preferred Stock) (9)

       4.10   Loan and Security Agreement (Goldman and TBCC Credit Facility) (9)

       4.11   Form of Warrant (Goldman and TBCC Warrants) (9)

       4.12   8% Series B Convertible Preferred Stock Purchase Agreement (9)

       4.13   Certificate of Designation of 8% Series B Convertible Preferred
              Stock for Aureal Semiconductor, Inc. (9)

       4.14   Amendment Number 4 to Registration Rights Agreement (9)

       4.20   Form of Registration Rights Agreement among Oaktree, TCW and
              Aureal Semiconductor, Inc. (11)

       10.2   1995 Stock Option Plan (3)

       10.3   Form of incentive option agreement and non-statutory stock option
              agreement used under 1995 Stock Option Plan (3)

       10.4   1994 Stock Option Plan (4)

       10.5   Form of incentive option agreement and non-statutory stock option
              agreement used under 1994 Stock Option Plan (4)

       10.6   Industrial space sublease with Chemical Waste Management, Inc.
              dated September 13, 1995 (3)

       10.7   Form of indemnity agreement for directors and officers (5)

       10.8   1996 Outside Directors Stock Option Plan (6)

       10.9   Manufacturing, Purchasing and Distribution Agreement between
              Diamond Multimedia Systems, Inc. and Aureal dated July 3, 1998
              (10)

       10.10  Industrial space sublease with Lam Research Corporation, dated
              June 7, 1999.

       27.1   Financial Data Schedule (Edgar Only)

--------------------

(1)    Incorporated by reference to the exhibits filed with Form 8-K dated May
       22, 1996

(2)    Incorporated by reference to the exhibits filed with Form S-8
       (Registration number 333-09531) filed August 2, 1996

(3)    Incorporated by reference to the exhibits filed with Form 10-K for the
       year ended December 31, 1995

(4)    Incorporated by reference to the exhibits filed with Form 10-K for the
       year ended December 31, 1994

(5)    Incorporated by reference to the exhibits filed with Form 10-Q for the
       quarter ended September 29, 1996

(6)    Incorporated by reference to the exhibits filed with Form 10-K for the
       year ended December 29, 1996.

(7)    Incorporated by reference to the exhibits filed with Form S-3 (As
       Post-Effective Amendment No. 1, Registration number 333-3870) filed
       September 12, 1997.

(8)    Incorporated by reference to the exhibits filed with Form 8-K dated March
       16, 1998

(9)    Incorporated by reference to the exhibits filed with Form 8-K dated June
       15, 1998.

(10)   Incorporated by reference to the exhibits filed with Form 10-Q for the
       quarter ended June 28,1998.

(11)   Incorporated by reference to exhibits filed with Form S-3 (Registration
       number 333-75631) filed April 2, 1999.

                                       23