<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 SEPTEMBER 27, 1998

                         Commission File Number 0-20684



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


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

                              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 October 30, 1998, 44,984,419 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 22.

<PAGE>   2

                            AUREAL SEMICONDUCTOR INC.


                                    FORM 10-Q

                                Table of Contents

<TABLE>
<CAPTION>
                                                                                               Page
                                                                                               ----
<S>      <C>                                                                                   <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

PART II. OTHER INFORMATION
         Item 1.  Legal Proceedings..........................................................   20
         Item 6.  Exhibits and Reports on Form 8-K...........................................   21

</TABLE>

                                       2

<PAGE>   3

                          PART I. FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS




                            AUREAL SEMICONDUCTOR INC.

               INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

                                   (Unaudited)

     Our Interim Condensed Consolidated Financial Statements have been prepared
by us, 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 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 December 28, 1997 and the notes included in our 1997 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 September 27, 1998 are not necessarily indicative of the results
that may be expected for any subsequent quarter or the entire fiscal year ending
January 3, 1999.

                                       3
<PAGE>   4

AUREAL SEMICONDUCTOR INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                               September 27,      December 28,
                                                                                   1998               1997
                                                                               -------------      ------------
                                                                                (Unaudited)
<S>                                                                            <C>                <C>
ASSETS:
   Current assets:
       Cash and cash equivalents                                               $     290          $     135
       Restricted cash                                                                 7                109
       Accounts receivable                                                         5,631                 21
       Inventories                                                                 3,501                511
       Deferred fair value of debt-related warrants                                  924              3,000
       Prepaid expenses and other current assets                                     738                462
                                                                              ----------          ---------
           Total current assets                                                   11,091              4,238
   Property and equipment:
       Machinery and equipment                                                     3,992              3,785
       Furniture, fixtures and improvements                                          645                599
                                                                              ----------          ---------
                                                                                   4,637              4,384
       Accumulated depreciation and amortization                                  (2,435)            (3,170)
                                                                              ----------          ---------
           Net property and equipment                                              2,202              1,214

   Long-term portion of fair value of debt-related warrants and other assets       1,008                898
                                                                              ----------           --------
           Total assets                                                        $  14,301           $  6,350
                                                                              ==========           ========

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT):
   Current liabilities:
       Line of credit                                                          $   3,394           $     --
       Accounts payable                                                            3,538              1,523
       Accrued compensation and benefits                                           1,451              1,115
       Other accrued liabilities                                                   1,044              1,365
       Current portion of pre-petition claims                                        913                880
                                                                              ----------           --------
           Total current liabilities                                              10,340              4,883

   Line of credit                                                                     --             21,975
   Long-term portion of pre-petition claims and deferred obligations               1,776              3,641
                                                                              ----------           --------
           Total liabilities                                                      12,116             30,499
                                                                              ----------           --------

   Stockholders' equity (deficit):
       Preferred stock, $0.001 par value, Authorized Shares - 5,000,000:
           Series A: Authorized shares - 500; Issued and outstanding
           Shares - 360 in 1998                                                       --                 --
           Series B: Authorized shares - 60,000; Issued and outstanding
           Shares - 40,163 in 1998                                                    --                 --
           Series C: Authorized shares - 1,500; Issued and outstanding
           Shares - 600 in 1998                                                       --                 --
       Additional paid-in capital                                                 51,357                 --
       Common stock, $0.001 par value:
           Authorized shares - 100,000,000; Issued and outstanding
           shares - 44,556,151 in 1998 and 41,850,205  in 1997                        45                 42
       Additional paid-in capital                                                118,358            114,352
       Accumulated deficit                                                      (167,575)          (138,543)
                                                                              ----------           --------
           Total stockholders' equity (deficit)                                    2,185            (24,149)
                                                                              ----------           --------

           Total liabilities and stockholders' equity (deficit)                $  14,301           $  6,350
                                                                              ==========           ========

</TABLE>
                             See accompanying notes.

                                       4

<PAGE>   5



AUREAL SEMICONDUCTOR INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)



<TABLE>
<CAPTION>
                                                        Quarter Ended                    Three Quarters Ended
                                                        -------------                    --------------------
                                               September 27,     September 28,      September 27,     September 28,
                                                   1998              1997               1998              1997
                                               -------------     -------------      -------------     -------------
                                                         (Unaudited)                          (Unaudited)
<S>                                             <C>               <C>                 <C>              <C>
Net sales                                       $   7,535         $     338           $ 14,553         $  1,460
Cost of sales                                       5,390                75             10,216              118
                                                ----------        ----------          ---------        ---------
Gross margin                                        2,145               263              4,337            1,342

Operating expenses:
Research and development                            3,014             1,862              8,548            4,861
Sales and marketing                                 1,511               880              4,495            2,554
General and administrative                          1,192               621              2,868            1,802
Amortization of reorganization asset                   --               625                 --            1,875
                                                ----------        ----------          ---------        ---------
     Total operating expenses                       5,717             3,988             15,911           11,092

Operating loss                                     (3,572)           (3,725)           (11,574)          (9,750)

Interest income                                        --                 4                 --               10
Amortization of debt-related warrants                (231)             (500)            (1,558)            (500)
Interest expense                                     (300)             (734)            (2,294)          (1,899)
Other income (expense)                                  5               186                396              384
                                                ----------        ----------          ---------        ---------
Loss from operations before income taxes           (4,098)           (4,769)           (15,030)         (11,755)

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

Net loss                                        $  (4,098)        $  (4,769)          $(15,030)        $(11,755)
                                                ==========        ==========          =========        =========

Accretion/dividends related to preferred stock  $  (1,891)               --           $(14,012)              --
                                                ==========        ==========          =========        =========

Net loss attributable to common stockholders    $  (5,989)        $  (4,769)          $(29,042)        $(11,755)
                                                ==========        ==========          =========        =========

Basic and diluted loss per share                $   (0.14)        $   (0.12)          $  (0.69)        $  (0.29)
                                                ==========        ==========          =========        =========

Shares used in calculating per share amounts       42,685            41,366             42,263           40,376
                                                ==========         =========          =========        =========
</TABLE>


                            See accompanying notes.

                                       5
<PAGE>   6

AUREAL SEMICONDUCTOR INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                      Three Quarters Ended
                                                                      --------------------
                                                               September 27,       September 28,
                                                                    1998               1997
                                                               -------------       -------------
                                                                           (Unaudited)
<S>                                                            <C>                 <C>
OPERATING ACTIVITIES
Net loss                                                       $  (15,030)          $ (11,755)
Adjustments to reconcile net loss to net cash
  used in operating activities:
     Depreciation and amortization                                  2,709               2,891
     Changes in operating assets and liabilities:
         Restricted cash                                              102                (106)
         Accounts receivable                                       (5,610)                  4
         Inventories                                               (3,741)               (242)
         Prepaid expenses and other current assets                   (613)               (328)
         Other assets                                                (465)                 --
         Accounts payable                                           1,995                (294)
         Accrued compensation and benefits, and
           other accrued liabilities                                 (342)                (79)
                                                               -----------           ---------
Net cash used in operating activities                             (20,995)             (9,909)
                                                               -----------           ---------

INVESTING ACTIVITIES
Acquisition of property and equipment                              (1,676)               (418)
                                                               -----------           ---------
Net cash used in investing activities                              (1,676)               (418)
                                                               -----------           ---------

FINANCING ACTIVITIES
Proceeds from Lines of credit                                      28,465              10,670
Repayment on Lines of credit                                      (15,546)             (3,890)
Principal payments on pre-petition claims                            (911)               (684)
Proceeds from issuance of preferred and common
  stock, net of issuance costs                                     10,818               4,233
                                                               -----------           ---------
Net cash provided by financing activities                          22,826              10,329
                                                               -----------           ---------

Net increase in cash and cash equivalents                             155                   2
Cash and cash equivalents at beginning of period                      135                  18
                                                               -----------           ---------
Cash and cash equivalents at end of period                     $      290            $     20
                                                               ===========           =========

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Interest paid                                                  $    2,739            $  1,491
SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES
Conversion of Line of credit balance to Preferred stock        $   28,685                  --
Accretion / dividends on Preferred Stock                       $   14,012                  --
Valuation of debt-related warrants issued                      $    1,848            $  5,000

</TABLE>


                             See accompanying notes.

                                       6

<PAGE>   7



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


1.   AUREAL SEMICONDUCTOR AND RECENT FINANCIAL EVENTS

     Aureal Semiconductor Inc., together with our subsidiaries Crystal River
Engineering, Inc. and Aureal Semiconductor Limited (combined, the "Company")
specialize in the design and marketing of audio semiconductor technologies for
use in both the PC and consumer electronics markets. Crystal River Engineering,
Inc. ("CRE"), founded in 1987 and acquired by us in 1996, has been a pioneer in
the development of 3D audio technologies. Aureal Semiconductor Limited, located
in Hong Kong, was established in the first quarter of 1998 as a sales, technical
support and field engineering office. Our business involves both the development
and sale of audio processing semiconductor chips and cards, as well as the
licensing of technology which is designed to define and develop advanced audio
standards in the marketplace. Our stock symbol on the OTC Bulletin Board is
AURL.

     During March 1998, we completed the sale of $5 million of Aureal Series A
Preferred Stock.

     On June 5, 1998 we completed three financing transactions, which had the
combined effect of increasing our borrowing capacity and providing additional
equity. The transactions included the following:

o    The sale of $5 million of our Series C Preferred Stock to DDJ Capital
     Management, LLC. Approximately $3.66 million of the offering was used to
     pay down the outstanding balance on the existing Line of Credit. The
     remaining $1.34 million was utilized for working capital purposes.

o    The remaining balance of $31.5 million on the existing Line of Credit was
     exchanged for 39, 375 shares of our Series B Preferred Stock.

o    A new $40 Million Revolving Credit Facility was established with Goldman
     Sachs Credit Partners LP ("Goldman Sachs") and the Technology Finance
     Division of Transamerica Business Credit Corporation ("Transamerica").

     In addition to the above financing transactions, on June 26, 1998, we
completed the sale of $1 million of our Series C Preferred Stock. The proceeds
of the offering were utilized to pay down outstanding borrowings under the
Credit Facility. Additional details of the ownership position of the original
preferred stock offerings (as of October 30, 1998) are provided below, in
thousands:

<TABLE>
<CAPTION>
     CLASS OF STOCK                                       SERIES A           SERIES B           SERIES C
     --------------                                       --------           --------           --------
     <S>                                                  <C>                <C>                <C>
     Original value issued                                $ 5,000            $ 39,375           $ 6,000
     Remaining stock value outstanding
      (at original issue value)                           $ 3,365            $ 39,375           $ 6,000
     Remaining stock value outstanding
       held by affiliates (at original issue value)       $ 1,320            $ 39,375           $ 5,000
     % outstanding held by affiliates                         39%                100%               83%
</TABLE>

2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     Basis of Presentation

     We have prepared the 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 December 28, 1997 and the notes included in our 1997 Annual Report
on Form 10-K.

     In our opinion, the interim Condensed Consolidated Financial Statements
reflect 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 and three quarters ended September 27, 1998 are not necessarily
indicative of the results that may be expected for any subsequent quarter or the
entire fiscal year ending January 3, 1999.

                                       7

<PAGE>   8

     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.

     Inventories

     Inventories are stated at the lower-of-cost-or-market value on a
weighted-average costing method. We do not consider any inventory to be raw
material since our point of purchase is for fabricated silicon wafers or
finished silicon dies. Net inventories at September 27, 1998 and December 28,
1997 consist of the following, in thousands:

<TABLE>
<CAPTION>
                                      September 27,       December 28,
                                         1998                1997
                                         ----                ----
       <S>                             <C>                 <C>
       Work in process                 $ 3,387             $   243
       Finished goods                      114                 268
                                       -------             -------
         Total Inventories             $ 3,501             $   511
                                       =======             =======
</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). Fixed assets with approximately $1.4 million in gross value and zero net
book value were retired during the first quarter of 1998 as they were determined
to no longer be in use.

     Revenue Recognition

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

     Concentration of Financial Instrument and Credit Risks

     Financial instruments, which potentially subject us to concentration of
market risk, consist primarily of our Line of Credit. This market risk on the
Line of Credit relates to changes in the prime lending rate, as the Line of
Credit bears interest rates which fluctuate with changes in the prime lending
rate.

     Our credit risk consists primarily of trade receivables. Many of our trade
receivables are the result of sales to foreign companies. Concentration of
credit risk is limited by the use of commercial letters of credit for many of
these international customers. Additionally, we have established an allowance
for doubtful accounts based on the credit risks of the business in general.

     Valuation of Warrants

     In June 1998, we issued 1,350,000 warrants ("Credit Facility Warrants") to
purchase our Common Stock to the lenders under our new Credit Facility (see Note
5). The fair value of the Credit Facility Warrants was estimated to be $1.8
million. Amortization of the $1.8 million asset, as additional interest expense
over the two-year life of the Credit Facility commenced in June 1998 at the rate
of $0.23 million per complete fiscal quarter.

     In 1997, we recorded the estimated fair value of warrants issued to related
parties in association with both the amendment of the Line of Credit ("Debt
Warrants"), and the sale of common stock ("Equity Warrants"). The fair value of
the Debt Warrants and the Equity Warrants was estimated to be $5.0 million and
$1.5 million, respectively. Amortization of the $5.0 million asset, as
additional interest expense over the life of the loan, commenced in August 1997
at the rate of $0.75 million per quarter. With the conversion of the loan in
June 1998, into our preferred stock, the remaining balance of the Debt Warrant
valuation was eliminated as part of the net book value of the debt. 

                                       8

<PAGE>   9

     Loss Per Share

     SFAS No. 128 "Earnings per Share" requires that the calculation for basic
earnings per share ("EPS") exclude the dilutive effect of common stock
equivalents. Diluted EPS under SFAS No. 128 is calculated using the weighted
average number of common shares and common stock equivalent shares outstanding
during the period. Common equivalent shares are computed using the treasury
stock method for outstanding warrants and stock options. Common equivalent
shares are excluded from the diluted EPS 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 the net loss position, any affect would
be anti-dilutive.

     Amortization of Intangibles

     At December 31, 1994, upon emergence from Chapter 11 Bankruptcy Protection,
our reorganization value in excess of our net assets generated a $44.1 million
intangible value that we classified as a reorganization asset in our
consolidated balance sheet ("Reorganization Asset"). The value of the
Reorganization Asset was reduced in the second quarter of 1995 when we left the
retail products business. The net remaining Reorganization Asset was amortized
at the rate of $625,000 per quarter through 1997, and was completely amortized
by December 28, 1997.

3.   RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

     In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS
130"), which we adopted in fiscal 1998. SFAS No. 130 requires companies to
disclose in financial statement format, all non-owner changes in equity. Such
changes include, for example, cumulative foreign currency translation
adjustments and unrealized gains and losses on available-for-sale securities.
The adoption of SFAS 130 has not had a material impact on our financial
statements.

     Also in June of 1997, "Disclosures about Segments of an Enterprise and
Related Information" (SFAS 131") was issued. This statement establishes
standards for reporting information about operating segments in annual financial
statements and interim financial reports. It also establishes standards for
related disclosures about products and services, geographic areas and major
customers. As defined in SFAS 131, operating segments are components of an
enterprise about which separate financial information is available that is
evaluated regularly by the chief operating decision-maker in deciding how to
allocate resources and in assessing performance. Generally, financial
information is required to be reported on the basis that is used internally for
evaluating segment performance and deciding how to allocate resources to
segments. We will adopt SFAS 131 in fiscal 1998, but as we operate in one
segment we do not expect its adoption to have a material effect on our financial
statements.

4.   ELIMINATION/CONVERSION OF PREVIOUS LINE OF CREDIT WITH RELATED PARTIES

     On June 5, 1998, we completed two transactions with the combined effect of
fully paying down the entire outstanding balance and eliminating our previous
Line of Credit with related parties.

     The sale of 500 shares of our Series C Preferred Stock (the "Series C
Preferred") for $5.0 million was made to DDJ Capital Management, LLC. $3.66
million of the proceeds from the sale were used to pay down the outstanding
balance under our Line of Credit. The Series C Preferred Stock carries an 8%
accretion rate over its three-year term, and provides for conversion to our
Common Stock or redemption at our option. It is convertible at the lesser of a
fixed value of $2.50 per Common share or a discount from the then-current market
price for our Common Stock at the date of conversion.

     The remaining $31.5 million balance of the Line of Credit was exchanged for
39,375 shares of Aureal 8% Series B Preferred Stock (the "Series B Preferred"),
with a face value of $39,375,000, and the Line of Credit was terminated. The
lenders under the Line of Credit released their lien on all of our assets as
part of the termination of the Line of Credit agreement. The Series B Preferred
Stock provides for conversion to our Common Stock at the rate of one share of
Common Stock for every $2.50 face value of Series B Preferred. The 8% annual
dividend, payable

                                       9

<PAGE>   10

quarterly may be paid in cash or in additional shares of Series B Preferred, at
our option. We have the option to redeem the Series B Preferred at its face
value at any time during its five-year term.

5.   NEW CREDIT FACILITY

     On June 5, 1998, in conjunction with the conversion and elimination of the
previous Line of Credit, we entered into a new $40 million Revolving Credit
Facility with Goldman Sachs and Transamerica. Terms of the new Credit Facility
provide for up to $32.5 million borrowing availability related to specific
accounts receivable, ("Tranche A"), with an additional $7.5 million of
availability unrelated to specific collateral requirements ("Tranche B").
Interest on borrowings under the two-year agreement is at the rates of Prime
plus three percent for Tranche A borrowings and Prime plus five percent for
Tranche B borrowings. We are subject to certain covenant restrictions under the
Credit Facility and have paid a $600,000 fee to the lenders in connection with
the initiation of the Credit Facility.

     Also in conjunction with the establishment of the new Credit Facility, we
issued warrants to purchase 1.35 million shares or our Common Stock to the
lenders under the Credit Facility. These warrants are exercisable at any time
over their five-year life at the exercise price of $2.156 per share of Common
Stock.

     At the end of the third quarter of the year, two of our financial ratios
were out of compliance with third quarter financial covenant requirements for
our Credit Facility. As of September 27, 1998 we had secured a waiver of
compliance for these specific covenant requirements.

6.   PREFERRED STOCK

     During the first half of 1998, we issued three series of preferred stock.
The net proceeds from all the preferred stock issuances were used to reduce our
outstanding debt and for working capital purposes. In March, we issued $5
million of Series A Preferred Stock (the "Series A Preferred"). The Series A
Preferred shares include conversion rights to our Common Stock at the lesser of
a $2.50 fixed conversion rate or a variable conversion pricing dependent upon
the underlying price of the Common Stock at the time of conversion. The Series A
Preferred shares bear accretion at an 8% annual rate over their three-year term.

     On June 5, 1998, we sold $5 million of Series C Preferred to DDJ Capital
Management, LLC ("DDJ"). The terms of the Series C Preferred are virtually
identical to the Series A Preferred. On June 26, 1998, we sold an additional $1
million of Series C Preferred to non-affiliates.

     Also on June 5, 1998, we exchanged 39,375 shares of Series B Preferred for
the entire $31.5 million outstanding balance of our previous Line of Credit. The
Series B Preferred bear a face value of $1,000 per share and an 8% annual
dividend rate. The dividends may be paid in cash or in additional Series B
Preferred shares, at our option. The $10.7 million difference between the fair
market value of the Series B Preferred shares and the net book value of the
exchanged debt (less associated unamortized fees) was charged directly to
accumulated deficit at the time of the transaction.

     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 $1.9 million in the third quarter of
1998.

7.   INCOME TAXES

     We were not required to provide for income taxes in the first three
quarters of 1998 or 1997 due to our net operating losses. No tax benefit has
been recorded for the losses due to the uncertainty of their realizability.

At December 28, 1997, we had available net operating loss carryforwards
("NOL's") of approximately $285 million to reduce future taxable income. The
NOL's expire on various dates through 2012. In connection with the adoption of
fresh start accounting, any tax benefit resulting from the use of the NOL's
generated prior to the bankruptcy plan confirmation in 1994 will be applied as a
direct addition to stockholders' equity.

                                       10

<PAGE>   11

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

     THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE UNAUDITED
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS INCLUDED ELSEWHERE HEREIN AND THE
AUDITED CONSOLIDATED FINANCIAL STATEMENTS AND NOTES AND MANAGEMENT'S DISCUSSION
AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR THE YEAR ENDED
DECEMBER 28, 1997, CONTAINED IN FORM 10-K FILED WITH THE SECURITIES AND EXCHANGE
COMMISSION.

     WE MAKE ANY FORWARD-LOOKING STATEMENTS IN THIS REPORT PURSUANT TO THE SAFE
HARBOR PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. YOU
ARE CAUTIONED THAT SUCH FORWARD-LOOKING STATEMENTS INVOLVE RISKS AND
UNCERTAINTIES, INCLUDING, BUT NOT LIMITED TO, DEPENDENCE ON THE PC AND CONSUMER
ELECTRONICS INDUSTRIES AND ON PRODUCT LINES BASED ON NEW TECHNOLOGIES; FOUNDRY
CAPACITY, AVAILABILITY AND RELIABILITY; COMPETITION AND PRICING PRESSURES; AND
OTHER RISKS DETAILED BELOW AND FROM TIME TO TIME IN OUR FILINGS WITH THE
SECURITIES AND EXCHANGE COMMISSION.

OVERVIEW

     Our objective is to be a leading supplier of high quality, advanced audio
solutions to both the PC and consumer electronics marketplaces. Our operating
strategy combines the development and sale of audio processing semiconductor
chips and cards with the licensing of technology to strategic partners in order
to define and develop advanced audio standards in the marketplace. Our strategy
encompasses the following primary elements:

o    Create value in the Aureal and A3D logos - Aureal is working to establish
     consumer association between the Aureal and A3D brand names and high
     quality, innovative audio. This high quality branding strategy can be
     utilized on multiple peripherals on an entire audio solution in the PC
     arena.

o    Offer low-cost PC audio acceleration - Aureal continues to develop and
     offer high-feature audio accelerator chips at prices competitive with
     lower-featured offerings from other manufacturers.

o    Expand our PC product offerings in response to the evolving market for
     audio and audio communications components. Audio cards are being
     distributed and audio communications combination cards are being developed
     for distribution. This expansion of our business model allows us to
     approach the PC market with a wide spectrum of audio products targeted
     to provide solutions at various feature / price points in the market.

o    Provide integrated audio components to the consumer market - we are
     developing devices targeted to the consumer electronics marketplace which
     are intended to provide lower system cost through integration of digital,
     analog and other audio system functions.

     During October of 1998, we made the following public announcements
regarding progress in our business model to provide comprehensive audio
solutions for the PC market:

o    A strategic alliance with Motorola Internet and Networking Group - this
     alliance provides for the integration of Motorola's unique Soft Modem
     technology with our award-winning Vortex 3D audio accelerators and A3D
     positional audio algorithms in a series of enhanced audio/communications
     solutions for the PC marketplace.

o    Packard Bell (Europe)'s incorporation of Vortex based PCI sound cards using
     A3D positional audio into their Platinum and Pulsar desktop computer lines.

o    Xitel, Australia's leading developer of premium audio boards for the PC
     introduced their new Storm Platinum sound accelerator using our
     Vortex 2.0 chip and A3D 2.0 audio technology.

o    Issuance of U.S. Patent Number 5,802,180 for a "Method and Apparatus for
     Efficient Presentation of High-Quality, Three-Dimensional Audio, Including
     Ambient Effects" - this patent enhances our intellectual property position 
     with respect to audio.

     In September, 1998, we announced the availability of A3D Pro Plug-In for
Pro Tools. A3D Pro allows game developers and professional editors and studios
to complement complex visuals with realistic audio environments. Recording
artists can construct custom venues that place the listener directly in the
desired environment. A3D Pro combines proprietary compressed Head-Related
Transfer Functions (HRTFs) with patent-pending acoustic environment rendering
techniques resulting in a totally immersive, three-dimensional sound field.

     In August, 1998, we announced the availability of our new Vortex 2 PCI
audio processor. Vortex 2 provides hardware support for Aureal's next generation
A3D 2.0 positional 3D audio technology. Vortex 2 is PC '98 compliant and more
than doubles the performance characteristics of the original Vortex chip
introduced one year ago. Subsequently, Diamond

                                       11

<PAGE>   12

Multimedia Systems, Inc. ("Diamond") announced that they will be featuring
Vortex 2 on their new MX300 sound card and our Vortex 1 chip on their Sonic 
Impact S90 audio accelerator boards.

     In July, 1998, we jointly announced with Diamond that we had entered into a
strategic alliance to develop and market next-generation audio solutions for the
PC marketplace. Under this agreement, Diamond will utilize our Vortex and A3D
audio technologies exclusively for products sold under Diamond's award-winning
"Monster Sound" PCI audio accelerator brand.

     In June, 1998, we announced that Compaq Computer Corporation, the world's
leading personal computer company, would begin featuring our A3D Interactive 3D
audio technology on their new line of Presario desktop computers. Compaq's
marketing materials, including point-of-sale displays in retail stores and
web-site presentation have begun to actively support Aureal's A3D technology.

     In April 1998, we introduced A3D 2.0, a significant enhancement to the
existing version of A3D that was originally introduced in September 1996. A3D
2.0, which is being incorporated in a number of PC game titles, is backward
compatible with the original A3D technology. A3D is currently incorporated into
a number of major PCs (including computer lines from Dell Computer Corporation,
Compaq and Packard Bell Europe), as well as a number of PC add-in audio cards
under various brand names. The new A3D 2.0 includes Aureal Wavetracing
Technology (which enables real-time acoustic reflections, reverb and occlusion
rendering features), more 3D sources, a higher sample rate and larger
Head-Related Transfer Function (HRTF) filters. Together, all of these feature
enhancements provide for improved three-dimensional rendering of audio for
interactive applications which was only available as early as two years ago on 
audio server products costing over $10,000.

     Early 1998 marked our first shipments of audio semiconductor chips after
two years of development work in the digital audio design area. Many of the
audio sound card applications utilizing the Vortex AU8820 chip are based on our
card reference design and have received numerous awards from various PC
publications. In addition, Aureal's A3D Interactive audio technology has been
widely recognized as the industry standard for three-dimensional sound
presentation. Our Vortex AU8820 PCI-based digital audio processor chip is a
feature-rich audio solution designed for the PC. In conjunction with our A3D
three-dimensional audio technology, we are offering an audio solution for the PC
that takes advantage of the benefits of PCI technology. We believe that the
market for PCI audio is expanding rapidly, and will be a significant market by
year-end 1998. Contributing to the move from ISA-based to PCI-based audio
systems for PCs are the requirements put forth by both Microsoft Corporation and
Intel Corporation relative to Windows qualifications.

     With announced "design-wins" including Dell Computer Corp. (utilizing sound
cards incorporating the AU8820 chip), Compaq Computer Corporation (A3D
implementation on the Presario line of desktop PCs) and Packard Bell (Europe)
(incorporation of A3D into Platinum and Pulsar lines), our technology has begun
to appear in market-leading PCs. The AU8820 is currently implemented in sound
cards utilized or marketed by Dell Computer Corporation, Turtle Beach Systems,
Diamond, Aztech Systems Ltd. and TerraTec Electronic GmbH. These customers, in
addition to Compaq, are actively promoting our A3D technology. Our A3D
technology is also gaining acceptance from PC game developers, and is currently
supported by a number of major game developers including Activision, Lucas Arts,
Interplay, GT Interactive, Broderbund, Electronic Arts, Sierra On-Line and Ubi
Soft. Many of these developers, as well as PC hardware manufacturers are working
with us to support A3D and Aureal brand recognition through use of the Aureal
and A3D logos on packages and advertisements.

RESULTS OF OPERATIONS

     Net Sales

     Net sales for the third quarter of 1998 were $7.5 million, compared to $3.4
million in the previous quarter and $0.3 million in the third quarter of 1997.
Year-to-date revenues for 1998 of $14.6 million represent the sale of over a
million AU8820 chips, the introduction of 8820 sound cards and the new AU8830
chip along with minor revenues from technology licensing.

     With the July 1998 announcement of the strategic alliance between Aureal
and Diamond, we commenced audio board sales during the third quarter of the
year. This alliance allows us to offer both chip and board level products to
customers in the PC market.

                                       12

<PAGE>   13

     Gross Margin

     Gross margin for the third quarter of 28.5% was a decline from the prior
quarter's margin of 41% due to manufacturing variances associated with initial
lower yields and higher testing costs in connection with new products. Gross
margin percentages in the prior year were significantly higher, although on
limited revenues, as the majority of such revenues were technology licensing
based. We do not anticipate that license revenues will be a significant portion
of overall revenues in the future. We believe that gross margin percentages
could vary as future volumes move between chips and cards depending upon market
demand.

     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 look to continue to bring new and
improved products to the audio forefront. In the third quarter, expenses
increased to $3 million from $2.9 million in the second quarter. Development of
new semiconductor products continued to be the focus during the third quarter of
the year. In addition, we have continued to increase the staffing in the
research and development area, both with employees and some specific project
contract work. Year-to-date expenditures in this area increased from $4.9
million in 1997 to $8.5 million in 1998, and have generally increased each
quarter over the last two years as development efforts on both software and
hardware based technology have expanded. We expect that the level of spending on
research and development will fluctuate but do not expect it to decline
significantly in absolute dollars in future periods.

     Selling and Marketing

     Selling and marketing expenses for the third quarter of 1998 were $1.5
million, flat with the level of spending in the prior quarter. For the year,
expenses increased to $4.5 million in 1998 from $2.6 million in 1997. This
increase was primarily attributable to costs, including selling commissions,
related to the commencement of AU8820 sales in 1998. Also incurred in 1998 were
costs associated with the design and launch of an advertising campaign designed
to increase the visibility of A3D to the end-user.

     General and Administrative

     General and administrative expenses for the third quarter were $1.2
million, an increase of $0.4 million from the second quarter and $0.6 million
from the prior year's quarter. Year-to-date expenses of $2.9 million were an
increase over $1.8 million for 1997. This increase was due mainly to headcount
increases and management and financial consulting fees.

     Amortization of Reorganization Asset

     The Reorganization Asset originated pursuant to our valuation upon exit
from bankruptcy protection in December 1994, whereby our fair value exceeded our
net assets by $44.1 million. The Reorganization Asset value was fully amortized
at year-end 1997 (at the rate of $625,000 per fiscal quarter, during 1997).

     Interest Expense

     Interest expense for the third quarter of 1998 and 1997 consisted primarily
of interest on the Lines of Credit at the rate of prime plus 3% and 5%,
respectively. Interest expense of $2.3 million year-to-date and $.3 million for
the quarter compare to prior year's expense of $1.9 million and $.7 million,
respectively. During 1997 and 1998 to-date, the Line of Credit has been a major
source of working capital for us. Proceeds from the sale of equity capital
during that time period were utilized periodically to pay down the balance of
the debt.

     With the pay down and elimination of the TCW Line of Credit in June 1998 in
connection with the exchange for our Series B Preferred Stock, interest expense
declined in the third quarter. The new Credit Facility with Goldman Sachs and
Transamerica carries a lower interest rate than the prior line to the extent
borrowings are based on eligible accounts receivable borrowing availability.

                                       13

<PAGE>   14

     Amortization of Debt-Related Warrants

     In August 1997, in conjunction with the expansion and extension of the TCW
Line of Credit, we issued warrants to purchase 3.15 million shares of our Common
Stock to the lenders. Utilizing 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 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.

     In connection with the new Credit Facility, 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, and is being amortized over the two-year term of the Credit Facility.

     Other Income

     We recognized other income of $0.4 million and $0.4 million year-to-date in
1998 and 1997, respectively. The income recognized in all quarters shown was
primarily due to various receipts and credits resulting from favorable
resolutions to previously recorded liabilities.

     Income Taxes

     We were not required to provide income taxes in the first three quarters of
either 1998 or 1997 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.

                                       14

<PAGE>   15

LIQUIDITY AND CAPITAL RESOURCES

     At September 27, 1998, we had working capital of $0.7 million and
stockholders' equity of $2.2 million. In quarterly financial statements since
1995, we have generally shown negative working capital amounts and stockholders'
deficit amounts. Our current revolving Line of Credit has been classified as a
short term asset due to the fact that we are required to use all available cash
receipts to repay any outstanding balances. Stockholder equity of $2.2 million
is largely the result of the issuance of preferred stock in the first half of
1998, both for cash and in exchange for the $31.5 million Line of Credit
balance. These transactions have resulted in significant Paid-in Capital
increases, however we continue to maintain a substantial accumulated deficit
developed as losses have been recorded over the last three years. We recognized
a net loss of $4.1 million in the third quarter of 1998 ($15 million
year-to-date) as well as year-to-date direct charges to accumulated deficit of
$14 million ($1.9 million in the third quarter) related to dividends and
accretion on preferred stock. Of that amount, $10.7 million is a one-time charge
related to the difference between the conversion/redemption value of the Series
B Preferred Stock ($39.4 million) and the net carrying value of the debt for
which it was exchanged ($28.7 million). Other dividends and value accretion
related to the Series A, B and C Preferred Stock resulted in an additional
charge of $1.9 million in the third quarter and $1.4 million in the second
quarter.

     Working capital used to support operating activities was $1.8 million in
the third quarter of 1998, an average of $0.6 million per month compared to the
$3.2 million per month used during the first two quarters of the year. This
decrease was due to the monitization of inventory through increased sales and
the decrease in the rate of operating loss per month (also due to increased
sales). On a year-to-date basis, we have used $21.0 million of working capital
to support operations in 1998, averaging roughly $2.33 million per month.
Working capital has been used to finance accounts receivable, inventory and
operating losses. We believe that we will move closer to generating cash flow
from operations as revenues are expected to grow in subsequent quarters. Such
revenue growth is dependent upon our success in promoting both the Vortex
semiconductor design and A3D audio technology as valuable components to a PC's
audio system. The acceptance of PCI audio (the underlying data-bus technology
utilized for both Vortex and A3D) as the standard for the PC is also key to our
immediate growth plans. To the extent such PCI acceptance and utilization does
not materialize or does not materialize as rapidly as expected, our growth could
be significantly impacted.

     Capital expenditures of $1.7 million during the first three quarters of
1998 consisted primarily of hardware and software tools utilized in our research
and development activities. Moderate increases in capital expenditures are
anticipated during the balance of 1998.

     We are continuing to assess "Year 2000" compliance (as explained in Risk
Factors). Based on the information currently available, we do not anticipate
that "Year 2000" compliance will have a material effect on our financial
statements or on our liquidity. Based on the information we have received from
the suppliers of our mission critical software systems, our systems appear to be
in compliance, and we have minimal financial exposure. We have initiated formal
communication with key suppliers and major customers to obtain "Year 2000"
compliance certificates. Should it become apparent that any our key suppliers or
customers are not fully "Year 2000" compliant, there can be no assurance that
such non-compliance would not have a material adverse effect on our liquidity.

     We believe that the $40 million Credit Facility, of which $3.4 million was
drawn as of September 27, 1998, will provide adequate financial resources to
sustain business for at least the next year. We may be required to seek
additional financing to expand our business, and there can be no assurance that
we will be able to generate positive cash flows in the future or to obtain
financing on favorable terms, if at all.

                                       15

<PAGE>   16

RISK FACTORS

     In evaluating our business, certain factors, including those discussed
below and those included in documents previously filed with the Securities and
Exchange Commission, should be considered in addition to the other information
in this Form 10-Q.

     History of Losses and Accumulated Deficit; Expectation of Future Losses

     We emerged from Chapter 11 Reorganization in December 1994. Since that time
we have incurred losses, in the aggregate amount of $168 million, from:

o    operating and eliminating our previous retail products business in 1995,

o    research and development of our advanced audio technologies business
     operations in 1996 and 1997 and

o    the initial stages of advanced audio products sales in the first three
     quarters of 1998.

While the majority of our revenues in 1996 and 1997 were generated through
technology licensing transactions, we anticipate that the majority of our
revenues will come from the sale of audio products in 1998 and future years.
There can be no assurance that we will be able to sell significant volumes of
our products in the future, and our ability to attain profitability or generate
positive cash flows is dependent upon generating these sales.

     New Technologies and Products Developed with New Technologies

     Our success depends on our ability to develop and market new technologies
aimed at advancing the level of audio quality in the PC and consumer electronics
devices. With respect to the PC market, audio technology is shifting from
utilization of the ISA bus to utilization of the more advanced (higher
bandwidth) PCI bus. This change enables advanced digital audio functionality
including positional 3D audio, streaming audio and higher quality presentation.
We can give no assurance that the shift from ISA-based audio to PCI-based audio
will occur in a timeframe for us to benefit from our PCI-based products and
technologies. As new technologies are developed, there can be no assurance that
markets will develop or will develop on a timely basis for us to benefit there
from.

     The success of new products depends on a number of factors, including
timely completion of product development, market acceptance of our and our
customer's new products and our ability to offer new products at competitive
prices. Incorporating our new products into our OEM customers' new product
designs requires the anticipation of market trends and performance and
functionality requirements of OEMs and the production of products that can be
available in a timely manner consistent with the OEMs' development and
production schedules. A failure in any of these areas could have a material
adverse effect on our results of operations.

     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 the need or preference for
our products could be diminished or eliminated. Conversely, each new generation
of technology, including digital audio technology, generally requires increased
processing power. In this regard, Intel Corporation has created the MMX
functionality with its Pentium line of processors and is promoting the
processing power of MMX for data and signal intensive functions such as graphics
and audio processing. We believe that advanced audio processing, done in
conjunction with either video or graphics processing is best performed with a
separate accelerator chip in addition to the host processor. There can be no
assurance that the increased capabilities of microprocessors in the future will
not adversely affect demand for our products.

     Product Concentration and Expansion of Business Model

     Substantially all of our revenues are related to advanced audio solutions
for the PC and consumer electronics markets, and we expect this to continue for
the foreseeable future. We are just embarking on an expansion of our
semiconductor business model to provide for an increased number of audio related
products including audio cards and audio communications combination cards. This
expansion may require additional working capital funds to provide for

                                       16

<PAGE>   17

incremental inventory as well as broader marketing programs. Several events
could have a material adverse effect on our operating results:

o    the failure of this market to continue to grow,

o    any reduction in demand as a result of increased competition in this
     market,

o    technological change,

o    failure by us to introduce new versions of products acceptable to the
     marketplace or

o    other similar factors

     Competition and Pricing Pressures

     The markets in which we compete are intensely competitive and are
characterized by evolving industry standards resulting in relatively short
product life cycles, significant pricing and performance improvement pressures,
and frequent new product introductions. We expect competition to increase in the
future from existing competitors and from other companies that may enter the
markets with products that may be less costly or provide higher performance or
additional features. We are unable to predict the timing and nature of any such
competitive product offerings. In general, product prices in the semiconductor
industry have decreased 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 such customers. As the markets for our products mature and
competition increases, we anticipate that prices for its products will generally
decline over time. If we are unable to reduce our costs sufficiently to offset
declines in product prices or are unable to introduce new, higher performance
products with higher product prices, our results of operations could be
materially adversely affected.

     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. In addition, some of those firms may have greater
intellectual property rights, broader product lines and longer-standing
relationships with customers than us. Our competitors may also include a number
of emerging companies.

     Dependence on Credit Facility

     Because we have not been profitable to date, we have funded our losses
through a combination of equity and debt financing. In June 1998, we entered
into a Credit Facility with Goldman Sachs and Transamerica, which provides for
an aggregate maximum borrowing line of $40 million. Terms of the new Credit
Facility provide for up to $32.5 million borrowing availability related to
specific accounts receivable, ("Tranche A"), with an additional $7.5 million of
availability unrelated to specific collateral requirements ("Tranche B"). The
interest rate on this Credit Facility is generally the prime rate plus 3% to 5%.
Accordingly, while the Credit Facility provides for working capital, the high
cost of servicing any borrowings thereunder could negatively effect our
liquidity. While in the past we have failed to comply with certain of the
financial covenants of our Credit Facility and have obtained a waiver from
Goldman Sachs and Transamerica, there can be no assurance that in future periods
we will be able to comply with all of the financial covenants of our Credit
Facility or that, should we fail to comply with all of these covenants, we
would be able to obtain a waiver of compliance from Goldman Sachs and
Transamerica. In the event we were out of compliance and not able to obtain a
waiver, we would be in default on our Credit Facility and this could have a
material adverse effect on our business, financial condition and results of
operations. There can be no assurance that the Credit Facility will provide
sufficient funding to meet our future needs. In the event we are required to
secure additional capital, there can be no assurance that such capital will be
available on acceptable terms or at all. Our inability to secure such potential
future financing, if necessary, would have a material adverse effect on our
business, financial condition and results of operations.

     Factors Inhibiting Takeover

     We are subject to the provisions of Section 203 of the Delaware General
Corporation Law, which imposes certain restrictions on the ability of a third
party to effect an unsolicited change in control. In addition, our Amended and
Restated Certificate of Incorporation does not provide for cumulative voting in
the election of directors, and certain provisions of our Amended and Restated
Certificate of Incorporation and Bylaws, including the provision which divides
the Board of Directors into three separate classes, may have the effect of
delaying or preventing changes in control or management.

     Trading in the Non-NASDAQ Over-the-Counter Market; Disclosure Relating to
Low Priced Stock

     Our Common Stock trades only on the OTC Bulletin. We do not currently meet
the requirements of the NASDAQ National Market or other national stock
exchanges. There can be no assurance that we will, in the future, meet such
listing requirements or that we will be accepted for trading on any such
national exchange.

                                       17

<PAGE>   18

     Because our Common Stock trades on the Non-NASDAQ Over-the-Counter market,
an investor may find it more difficult to dispose of, or to obtain accurate
quotations as to the market value of, our Common Stock. In addition, because our
securities are not listed on NASDAQ, trading in our Common Stock is also subject
to certain rules promulgated under the Securities Exchange Act of 1934, which
require additional disclosure by broker-dealers in connection with any trades
involving a stock defined as a penny stock (generally, a non-NASDAQ 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 effecting transactions in our
Common Stock, and severely limit the market liquidity of our Common Stock and
the ability of purchasers of our Common Stock to resell such securities in the
secondary market.

     Risk of Additional Shares Sold in the Public Market

     Because the holders of the Series A Preferred and Series C Preferred shares
may convert such shares into shares of our Common Stock at variable conversion
prices, the exact number of shares of Common Stock which we may issue upon
conversion of Series A Preferred and Series C Preferred shares is not presently
known, and may fluctuate based on the market value of our Common Stock. Because
of the variable conversion price feature of the Series A Preferred and Series C
Preferred shares, holders of such shares may have incentive to take certain
actions, including shorting our Common Stock, to decrease the market price of
such Common Stock. Upon a decrease in the market price of our Common Stock,
holders of the Series A Preferred and Series C Preferred shares may elect to
convert such shares at the variable conversion price and thereby receive a
greater number of shares of our Common Stock. Short selling is illegal if used
to manipulate the price of a company's securities for profit, and we has no
knowledge that any holders of Series A Preferred or Series C Preferred shares
intends to take any action which may cause the price of our Common Stock to
fall. However, there can be no assurance that holders of our Series A Preferred
or Series C Preferred shares will not short our Common Stock or take such other
actions, the effect of which may be to drive down the market price of our Common
Stock.

     Concentration of Stock Ownership

     Currently, three parties control approximately 75% of our outstanding
Common Stock, each of whom control at least 10% individually. There can be no
assurance that the liquidity of the market for our Common Stock will be
maintained at or increase over its current levels, and the trading price for our
Common Stock may be influenced by the volume and liquidity of the market for our
Common Stock. Sales of a large percentage of our total outstanding Common Stock
may have an adverse effect on its market price.

     Dependence on Foundries

     We are a "fabless" semiconductor firm, and depend on outside manufacturing
resources for production of all of our semiconductor products. Currently we
utilize two foundries, one domestic and one foreign for production of our
existing products. Both of these foundries have indicated to us that they have
the manufacturing availability to provide for our planned production of each of
its products for the next twelve months; however our production relationship
with each foundry is based only upon purchase orders and there is no assurance
that either foundry will continue to provide adequate manufacturing capacity to
us at our current level of production or any potential increases in production
levels. In the event either or both foundries cease to manufacture our
semiconductor products, we would have to contract with alternative foundries.
There can be no assurance that we would be able to contract with alternative
foundries in a timely manner or at all. The failure to do so would have a
material adverse effect on our business, 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 silicon wafers, difficulties in the
fabrication process or other factors can cause a substantial percentage of
wafers to be rejected or a significant number of die on each wafer to be
non-functional. Many of these yield problems are difficult to diagnose, and
potentially time-consuming or expensive to remedy. There can be no assurance
that our foundries will not experience irregularities or adverse yield
fluctuations in the manufacturing process of our products in the future. This
could have a material adverse effect on our business, financial condition and
results of operations.

                                       18

<PAGE>   19



     Dependence on Key Personnel

     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 have developed
compensation programs, including stock option plans for the granting of options
to all employees, designed to retain our employees. Competition for such
employees is intense, and the loss of the services of such employees could have
a material adverse effect on our business, financial condition and results of
operations.

     Dependence on Proprietary Technology

     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
secret, copyright and trademark laws, nondisclosure agreements and other
contractual provisions and technical measures to protect our proprietary rights.
There can also be no assurance that such measures will be adequate or safeguard
the proprietary technology underlying our products, or that our agreements with
employees, consultants and others who participate in the development of our
products will not be breached, that we will have adequate remedies for any
breach or that our proprietary information or trade secrets will not otherwise
become known. Moreover, notwithstanding our efforts to protect its intellectual
property, there can be no assurance that competitors will not be able to develop
products which are equal or superior to our products without infringing any of
our intellectual property rights. In addition, effective protection of
intellectual property rights may be unavailable or limited in certain countries.
Accordingly, there can be no assurance that our means of protecting its
intellectual property will be adequate or that our competitors will not
independently develop similar technologies or products.

     Although we do not believe that our products infringe the proprietary
rights of any third parties, there can be no assurance that infringement or
invalidity claims (or claims for indemnification resulting from infringement
claims) will not be asserted against us or that any such assertions will not
materially adversely affect our business, financial condition or results of
operations. Irrespective of the validity or the successful assertion of such
claims, we could incur significant legal costs in defending ourselves which
could have a material adverse effect on our business, financial condition or
results of operations.

     In February 1998, we were served with a suit for patent infringement filed
by Creative Technology Ltd., a Singapore corporation ("Creative"), and its
subsidiary, E-MU Systems, Inc., a California corporation ("E-MU") in the U.S.
District Court, Northern District of California. The suit alleges that our
Vortex AU8820 Digital Audio Processor 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 continuing acts of infringement by us and an accounting of
damages plus interest. In response, we filed a motion for summary judgement. In
October of 1998, the court issued its first ruling in this case and denied the
Creative motion for an injunction. The court also denied our motion for a
preliminary summary judgment and set further hearings for spring of 1999. We
believe that the action brought by Creative and E-MU is without merit and will
continue to vigorously defend ourselves.

     In the future, litigation may be necessary to resolve the claims asserted
by third parties related to infringe or invalidity or to enforce and protect our
intellectual property rights. There can be no assurance that we will prevail in
any such litigation, and any such 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, which could have a material adverse effect on 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 licensing our technology, any of which could have a material
adverse effect on our business, financial condition and results of operations.

     Year 2000 Compliance

     We use a number of computer software programs and operating systems in our
internal operations, including applications used in financial systems and
various administrative 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 possibly replacement of
such applications could be necessary. Given the current information about our
systems, it is not anticipated that such "Year 2000" costs will have a material
impact upon us. We have requested and obtained information regarding "Year 2000"
compliance from the suppliers/providers of all of our mission critical

                                       19

<PAGE>   20

software systems. Based on the information we currently have, all mission
critical systems appear to be "Year 2000" compliant. We are currently contacting
our major vendors and customers to obtain "Year 2000" compliance certificates.
Should it become apparent that any of its key suppliers or customers are not
fully "Year 2000" compliant, there can be no assurance that such non-compliance
would not have a material adverse effect on our business, financial condition or
results of operations.


PART II.  OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

     In February 1998, we were served with a suit for patent infringement filed
by Creative Technology Ltd., a Singapore corporation ("Creative"), and its
subsidiary, E-MU Systems, Inc., a California corporation ("E-MU") in the U.S.
District Court, Northern District of California. The suit alleges that our
Vortex AU8820 Digital Audio Processor 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 continuing acts of infringement by us and an accounting of
damages plus interest. In response, we filed a motion for summary judgement. In
October of 1998, the court issued its first ruling in this case denying the
Creative Technology Ltd. motion for a preliminary injunction. The court also
denied our motion for a summary judgment. Further hearings were set for spring
of 1999. We believe that the actions brought by Creative and E-MU are without
merit and will continue to vigorously defend our position.

     In October 1998, Creative Labs, the U.S. based subsidiary of Creative
Technology Ltd., filed a second lawsuit against us. This new lawsuit claims
"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.


                                       20

<PAGE>   21

     ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

     (a)  Exhibit index at page 22. 
     (b)  Reports on Form 8-K:

          On July 8, 1998, we filed a Form 8-K with the Securities and Exchange
          Commission ("SEC") disclosing the completion of disclosing the sale of
          $1 million of Aureal Series C Preferred Stock.



                                       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 SEMICONDUCTOR INC.

Date:   November 11, 1998              By: /s/ Kenneth A. Kokinakis
                                           -------------------------
                                           Kenneth A. Kokinakis
                                           President and Chief Executive Officer


Date:   November 11, 1998               By: /s/ David J. Domeier
                                            ------------------------
                                            David J. Domeier
                                            Vice President of Finance and
                                            Chief Financial Officer


                                       21

<PAGE>   22

                                  EXHIBIT INDEX

<TABLE>
<CAPTION>
Exhibit No.                              Description of Document
-----------                              -----------------------
<S>               <C>
2.1               Agreement and Plan of Reorganization among the Company, Aureal Acquisition
                  Corporation, a wholly-owned subsidiary of the Company 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 the Company dated May
                  8, 1996 (2)

3.2               Restated Bylaws of Aureal Semiconductor Inc. (6)

4.1               Common Stock Purchase Agreement by and among the Company and certain beneficial owners
                  of 5% or more of the Company's Common Stock, as amended  (3)

4.2               Common Stock Purchase Agreement by and among the Company and certain entities and
                  individuals dated June 10, 1996 (5)

4.3               Common Stock Purchase Agreement by and among the Company and certain entities and
                  individuals dated August 6, 1997 (8)

4.4               Preferred Stock Regulation D Subscription Agreement (10)

4.5               Certificate of Designation of Series A Preferred Stock of Aureal Semiconductor Inc.
                  (10)

4.6               Preferred Stock Registration Rights Agreement (Common Stock underlying Series A
                  Preferred Stock) (10)

4.7               Aureal Semiconductor Inc. Regulation D Subscription Agreement for Series C
                  Preferred Stock (11)

4.8               Certificate of Designation of Series C Preferred Stock of Aureal Semiconductor Inc.
                  (11)

4.9               Registration Rights Agreement (Common Stock underlying Series C Preferred Stock)
                  (11)

4.10              Loan and Security Agreement (Goldman and TBCC Credit Facility) (11)

4.11              Form of Warrant (Goldman and TBCC Warrants) (11)

4.12              8% Series B Convertible Preferred Stock Purchase Agreement (11)

4.13              Certificate of Designation of 8% Series B Convertible Preferred Stock for Aureal
                  Semiconductor Inc. (11)

4.14              Amendment Number 4 to Registration Rights Agreement (11)

10.1              Second Amended and Restated Loan Agreement between TCW
                  Special Credits and the Company dated August 6, 1997
                  increasing the loan commitment from $20 million to $31.5
                  million (9)

10.2              1995 Stock Option Plan (3)

</TABLE>

                                       22

<PAGE>   23
<TABLE>
<CAPTION>
Exhibit No.                              Description of Document
-----------                              -----------------------
<S>               <C>
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 (6)

10.8              1996 Outside Directors Stock Option Plan (7)

10.9              Manufacturing, Purchase and Distribution Agreement between Diamond Multimedia
                  Systems, Inc. and Aureal dated July 3, 1998 (13)

11.1              Computation of Earnings (Loss) Per Share (See pages 5 and 9)

27.1              Financial Data Schedule (Edgar Only)

</TABLE>

(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 S-3 (Registration
     number 333-3870) filed June 26, 1996.
(6)  Incorporated by reference to the exhibits filed with Form 10-Q for the
     quarter ended September 29, 1996.
(7)  Incorporated by reference to the exhibits filed with Form 10-K for the year
     ended December 29, 1996.
(8)  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.
(9)  Incorporated by reference to the exhibits filed with Form 10-Q for the
     quarter ended September 28, 1997.
(10) Incorporated by reference to the exhibits filed with Form 8-K dated March
     16, 1998.
(11) Incorporated by reference to the exhibits filed with Form 8-K dated June
     15, 1998.
(12) Incorporated by reference to the exhibits filed with Form 8-K dated July 8,
     1998.
(13) Incorporated by reference to the exhibits filed with Form 10-Q for the
     quarter ended June 28, 1998.

                                       23