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

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

                                   FORM 10-K
                            ------------------------

(MARK ONE)

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

                    FOR THE PERIOD ENDED: DECEMBER 31, 1996

                                       OR

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

                        COMMISSION FILE NUMBER: 33-90532

                      SPATIALIZER AUDIO LABORATORIES, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

<TABLE>
<S>                                           <C>
                   DELAWARE                                     95-4484725
       (STATE OR OTHER JURISDICTION OF                       (I.R.S. EMPLOYER
        INCORPORATION OR ORGANIZATION)                     IDENTIFICATION NO.)
</TABLE>

                       20700 VENTURA BOULEVARD, SUITE 134
                     WOODLAND HILLS, CALIFORNIA 91364-2357
                    (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

                        TELEPHONE NUMBER: (818) 227-3370
              (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days:
                       YES [X]                      No [ ]

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

     The aggregate market value of the voting stock held by non-affiliates of
the registrant at March 13, 1997 was approximately $27,399,000.

     As of March 13, 1997, there were 20,795,929 shares of the Registrant's
Common Stock outstanding.
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<PAGE>   2

                                     PART I

ITEM 1.  BUSINESS

OVERVIEW

     Spatializer Audio Laboratories, Inc. (the "Company") is a leading
developer, licenser and marketer of next generation technologies for the
consumer electronics, personal computing and entertainment industries. The
Company has two operating business units (100% wholly owned subsidiaries),
Desper Products, Inc. ("DPI") and MultiDisc Technologies, Inc. ("MDT"), both of
which are in the business of technology development and licensing. DPI has
developed a full complement of patented and proprietary 3-D audio signal
processing technologies directed to the consumer electronics and multimedia PC
markets. New product offerings introduced in the fall of 1996 include
technologies for next generation consumer products like Digital Versatile Disc
(DVD) for personal computers and home entertainment; and interactive positional
audio for PC gaming on the Windows 95/97(TM) platforms. DPI's 3-D audio signal
processing technologies have been incorporated in nearly 200 products offered by
global brand leaders including Texas Instruments, Compaq, Hewlett-Packard,
Panasonic, JVC, Hitachi and Sharp, among others. In addition to continuing the
Company's objective of broadening recognition for the Spatializer brand name
through association with these and other globally recognized consumer
electronics and multimedia computer brand leaders, the Company has also placed a
high priority on broadening its technology base to position itself for continued
growth.

     MultiDisc Technologies, Inc. was formed in June 1996 when the Company
acquired development stage optical disc storage and robotics assets and
technologies from Home Theater Products International, Inc. ("HTP"), a debtor in
possession (the "MultiDisc Transaction"). MDT is currently a development stage
enterprise creating a new product category of 12 cm CD/DVD based scaleable
optical disc storage devices uniquely designed to combine the speed and
performance of CD server arrays, the flexibility and capacity of CD Jukebox
designs and next generation high speed, high volume robotics (the "MultiDisc(TM)
Technology"). The target markets for the MDT technology currently include
business networking and the Internet, backup/ archiving, and specialized
vertical market applications including medical information technology, data
warehousing and video-on-demand.

     The Company's executive offices are located at 20700 Ventura Boulevard,
Suite 134, Woodland Hills, California 91364, Telephone (818) 227-3370. World
Wide WEB site (http://www.spatializer.com).

DESPER PRODUCTS, INC. -- 3-D AUDIO SIGNAL PROCESSING TECHNOLOGIES

     DPI has developed a suite of proprietary advanced audio signal processing
technologies for the entire spectrum of applications falling under the general
category of "3-D" audio. The objective in each product category is to create or
simulate the effect of a multi-speaker sonic environment using two ordinary
speakers for playback. The market for 3-D audio is segmented into three broad
categories of technology as identified in the chart below. Each of these
technologies utilizes different underlying scientific principles in
accomplishing its design objectives is targeted to a specific class of consumer
electronics or multimedia product depending on the intended product use and
functional capability of the product.

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

<TABLE>
<CAPTION>
    CATEGORY OF TECHNOLOGY             PRODUCT CATEGORIES               3-D AUDIO ENHANCEMENT
---------------------------------------------------------------------------------------------------
<S>                             <C>                               <C>
 3-D Stereo                      Consumer electronics products     Surround Sound enhancement from
 (Spatializer(R) 3-D Stereo)     providing stereo playback -- DVD  an ordinary stereo signal.
                                 Players, Stereo TV's, VCR's,
                                 Stereo Components and Systems,
                                 Car Audio, Laptop and Desktop
                                 Multimedia Computers, Set-top
                                 Boxes.
---------------------------------------------------------------------------------------------------
 Positional Audio                Interactive Gaming for            Simulation of immersive,
 (Spatializer 3-D MAP(TM))       Multimedia Computers under        interactive sonic environments
 (Spatializer enCompass(TM))     Windows '95/'97, Virtual Reality  including sound objects that
                                 Applications.                     move in real time with related
                                                                   graphics objects or changes in
                                                                   game player position or
                                                                   perspective.
---------------------------------------------------------------------------------------------------
 Two-Speaker Virtualization      Products incorporating multi-     Creation of spatially accurate
 (Spatializer N-2-2(TM))         channel audio sources like Dolby  multi-speaker cinematic audio
 Digital Virtual Surround        Digital(R) (AC-3), Dolby          experience from two speakers,
                                 ProLogic(R) or MPEG-2. Home       utilizing discrete multi-channel
                                 Theater, DVD-Video, Multimedia    audio information.
                                 Computers utilizing DVD/MPEG and
                                 decoding.
---------------------------------------------------------------------------------------------------
</TABLE>

LICENSED PRODUCTS

     The Company's current technology product applications are directed to (1)
stereo enhancement in consumer electronics products and multimedia PCs, (2)
interactive positional audio for PC gaming, and (3) two-speaker virtualization
of multi-channel audio for DVD based multimedia computer and home theater
applications.

     1. SPATIALIZER(R) 3D STEREO.  Based upon proprietary and patented methods
        of stereo signal processing, the Company's Spatializer(R) 3-D Stereo
        technology is designed to create a vivid and expansive three-dimensional
        surround sound listening experience from any stereo source input using
        only two ordinary speakers. Along with professional audio quality and
        coherent stable sonic imaging, the technology includes the Company's
        unique DDP(TM) (Double Detect and Protect(TM)) algorithm which
        continuously monitors the underlying stereo signal and dynamically
        optimizes spatial processing avoiding deleterious sonic artifacts common
        in other systems and "set and forget" ease of use for consumers. First
        introduced in July, 1994, in the form of a 20 pin analog integrated
        circuit (IC) from Matsushita Electronics Corporation ("MEC"), the
        technology is now incorporated into low-cost, standard process ICs by
        three chip foundries (Matsushita, ESS Technologies, Inc., and OnChip
        Systems) for easy and inexpensive implementation in any consumer
        electronics or computer product utilizing stereo audio. A fourth IC
        Foundry, Lux Sonor, Inc., has recently been licensed. Matsushita and ESS
        are readying new Spatializer IC designs for introduction in 1997. In
        addition, the Company has developed cost reduced and improved
        performance analog and DSP software designs which it introduced during
        the first quarter of 1997.

     2. SPATIALIZER(R) 3-D MAP(TM) AND SPATIALIZER(R) ENCOMPASS(TM).  In 1996,
        the Company introduced Spatializer 3-D MAP(TM) (Multimedia Audio
        Positioning) , the first in its family of positional audio enhancements
        for PC gaming applications on the Windows 95(TM) platform which work in
        conjunction with DirectSound 2.0 and Spatializer 3-D Stereo hardware or
        software. There are currently 13 PC game developers licensed to use 3-D
        MAP. In February 1997, the Company introduced Spatializer(R)
        enCOMPASS(TM), a real-time software-only positional 3-D audio engine
        based upon the Company's proprietary implementation of HRTF (head
        related transfer functions) algorithms, and Interaural Intensity and
        Interaural Time differences. Spatializer enCOMPASS permits PC game
        developers to

                                        2
<PAGE>   4

        easily create immersive and interactive audio environments under the
        Windows '95 DirectSound 3-D audio API where sound objects move in real
        time in response to changes in the location or the perspective of the
        player in the game. The system supports playback over speakers or
        through headphones. Microsoft recently announced its support for 3-D
        audio and will provide an industry standard open API in DirectSound 5.0
        scheduled for release summer 1997.

     3. SPATIALIZER(R) N-2-2(TM) DIGITAL VIRTUAL SURROUND.  In September 1996,
        DPI introduced Spatializer N-2-2(TM) which the Company considers a
        "core" and "enabling" technology for DVD based personal computer and
        home theater products. DVD is considered by many to be the single most
        important and potentially most widely adopted consumer audio/computer
        technology to ever be introduced. The audio standards for DVD (based
        upon geographic region) are multi-channel audio formats (Dolby
        Digital(R) (AC-3) and MPEG-2) which carry six (or more) discrete
        (independent) channels of audio -- the front left and right channels, a
        center channel (for vocal tracks), two rear surround channels and a Low
        Frequency Effects (LFE or "sub-woofer") channel for sound effects. The
        Spatializer N-2-2 software-based algorithms permit spatially accurate
        reproduction of this multi-channel audio over any ordinary stereo system
        using two rather than the five or six speakers normally required in
        traditional home theater setups. Spatializer N-2-2 runs in real-time on
        general purpose DSP hardware platforms like those offered by Motorola
        and Zoran, may be integrated with host based software-only MPEG-2 or DVD
        decoders (like those offered by CompCore Multimedia and Mediamatics for
        the Intel(R) Pentium(R) microprocessor), and can be ported to any of the
        principal audio codecs or media processor/accelerator platforms
        performing Dolby Digital (AC-3) or MPEG-2 audio decoding. N-2-2 has been
        approved by Dolby Laboratories and qualifies Spatializer Licensees to
        use the newly created Dolby Digital VIRTUAL(TM) trademark on products
        incorporating the technology. The Company believes its Spatializer N-2-2
        process will serve to widen and accelerate the market for DVD
        acceptance, because it delivers the full cinematic audio experience to
        ordinary consumers without the additional expense and complication of
        multi-speaker home theater playback systems.

LICENSING ACTIVITIES

     The Company has traditionally licensed its technologies through
semiconductor manufacturing and distribution licenses ("Foundry Licenses") with
semiconductor foundries ("Foundries"). In turn, these Foundries manufacture and
distribute integrated circuits (ICs) incorporating Spatializer technology to
manufacturers of consumer electronics, and multimedia computer products
("OEMs").

     The terms of the Foundry Licenses are negotiated on an individual basis
requiring the payment of a per unit running royalty according to sliding scales
based upon cumulative volume. In addition, certain of the licenses call for the
payment of an up-front license issuance fee in addition to the running royalty.
Royalties are payable in the quarter following shipment from the Foundry to the
OEM.

     OEMs who desire to incorporate these ICs into their products are required
to enter into a license ("OEM Licenses") with the Company before they may
purchase the ICs in quantity. Foundry Licenses generally have limited the sale
of Spatializer ICs to OEMs who have entered into an OEM License with the
Company. OEM licenses generally provide for the payment of a further per unit
royalty by the OEM for OEM products incorporating a Spatializer IC ("Licensed
Products") payable in the quarter following shipment by the OEM of its Licensed
Products.

     In mid-1996, the Company modified its licensing program to ease the
licensing process and accelerate cash flow by offering Foundries an alternative
"Bundled Royalty" arrangement which permits the IC foundry to make a traditional
component IC sale to an OEM without requiring the OEM to negotiate a separate
royalty bearing license agreement with the Company. In these situations, the IC
Foundry is authorized to sell Spatializer ICs to OEMs which enter into a
simplified Logo Usage Agreement ("LUA") in consideration for a higher
("bundled") per unit royalty from the IC Foundry. This new alternative license
structure has relieved much of the licensing burden from the IC foundries and
has resulted in an increase in License signings.

                                        3
<PAGE>   5

     Because the Spatializer N-2-2 technology may be fully implemented in
software to run in host based (Intel Pentium) or general purpose DSP (Motorola
and Zoran) environments no IC Foundry may be involved. In these situations, the
Company will enter into royalty bearing licenses directly with the OEM.

     The Company is currently negotiating new IC Foundry and OEM licenses for
its N-2-2, enCOMPASS, and 3-D stereo technologies.

  IC Foundry Licenses

     As of December 31, 1996, the Company has entered into three non-exclusive
Foundry Licenses for its 3-D Stereo technology with Matsushita Electronics
Corporation ("MEC"), ESS Technology, Inc. ("ESS"), and OnChip Systems, Inc.
("OnChip"). Foundry Licenses require the payment of per unit running royalties
based upon a sliding scale computed on the number of Spatializer ICs sold.

     MEC currently manufactures and sells three 3-D Stereo IC's incorporating
Spatializer audio signal processing and has several more ICs in design. ESS
currently manufactures and sells the ES938 Spatializer(R) IC, which is primarily
for multimedia and notebook applications, and has designed Spatializer 3-D
stereo technology in two of its highest volume multifunction AudioDrive(R) ICs
for introduction in early 1997. OnChip currently manufacturers two versions of
the 3-D Stereo Spatializer(R) IC.

     As of December 31, 1996, more than 5.5 million ICs incorporating
Spatializer 3-D Stereo audio signal processing technology had been manufactured
and sold.

  OEM Licenses

     As of December 31, 1996, the Company had entered into 48 separate OEM
Licenses on various economic and business terms. Some of these OEM Licenses
required a license issuance fee and/or a separate per unit royalty, while others
were licensed under the LUA under bundled royalty licenses with the IC
foundries. The OEMs license a wide range of products, which include direct view
TVs, wide screen and projection TVs, VCRs, powered speakers, portable audio
systems ("Boomboxes"), HiFi stereo systems and components, computer sound cards
and graphics accelerator cards, multimedia desktop personal computers, notebook
computers, LCD projectors, multimedia computer monitors, car stereo systems, and
arcade pinball and video games.

     The following table is a list of the OEMs as of December 31, 1996 with whom
the Company has entered into OEM and/or LUA agreements:

<TABLE>
<S>                                                  <C>
 OEM                                                 OEM LISTING -- CONTINUED
--------------------------------------------------   ---------------------------------------------------
 4D Sound, Corp.                                      Matsushita Communications Industrial
 Ad Lib Multimedia, Inc.                              Matsushita Kotobuki Electronics, Inc.
 Anam Electronics Co., Ltd.                           MediaForte
 Bung Enterprises Ltd.                                Multimedia Labs, Inc.
 Canopus Corporation                                  Multiwave Innovation, Inc.
 Compaq Computer Corp.                                Orchid Technology
 CrystaLake Multimedia                                Panasonic (Matsushita Electric Industrial Co.,
 Digital Equipment Corp.                              LTD)
 Digital Technology Systems Of California, Inc.       Proside Corp.
 Everex Systems, Inc.                                 Proton Electronic Industrial Co., Ltd.
 Grandtec Electronic Corp.                            Samsung Information Systems, America
 Hewlett-Packard                                      Seiko Epson Corp.
 Hitachi, Ltd.                                        Sharp Corp.
 Iiyama Electric Co., Ltd.                            Sigma Electronics Design
 International Jensen Inc.                            Sound Vision Product, Inc.
 JK Micro (S) Pte., Ltd.                              Sowah
 JVC                                                  STB Systems, Inc.
 Kyushu Matsushita Electric                           Tae Kwang Industrial
 Kodi Chengdu                                         Taisei Electric, Inc.
 Konami Co., Ltd.                                     Taiyo Electric Company, Ltd.
 Labtec Enterprises, Inc.                             Texas Instruments
 Lotte Electronics                                    Tiva Microcomputer Corp.
 Mag Monitors                                         TXC Corporation
 Maseco                                               Vikosing Pte., Ltd.
                                                      Winner Products (USA), Inc.
</TABLE>

                                        4
<PAGE>   6

HARDWARE PRODUCTS

     Sales of the Company's professional and consumer hardware products to date
have not generated significant revenues and the Company does not plan to
manufacture these products in the future. The Company is focusing its attention
on licensing these product designs to third parties and concentrating on
software-only products and "plug-ins" for the principal of digital audio
workstation ("DAW") providers on both the MacIntosh(TM) and PC platforms.

  Professional Recording, Film and Broadcast Products

     The Company's PRO Spatializer(R), is a microprocessor-based audio
production system designed for professional recording, film and broadcast
applications. It offers a multi-track real-time processor that permits spatial
expansion, 360 degree dynamic sound movement, and localization of monophonic and
stereo sources utilizing conventional two-speaker stereo playback. It may be
used in any phase of the recording process and is fully compatible with all
standard stereo playback systems. The PRO Spatializer(R) is an expandable system
which offers from sixteen to twenty-four channels with a Manufacturer's
Suggested Retail Price ("MSRP") of $7,500. The Company also markets
Spatializer-8(TM), a non-expandable version of the PRO Spatializer(R) which
limits operator control to eight simultaneous recording channels with an MSRP of
$6,000; and DIGITAL Spatializer(R), a product designed for two-channel
professional record mastering providing full control over all spatial audio
parameters entirely within the digital domain.

     In December 1996, the Company introduced Spatializer(R) RETRO(TM), a rack
mount two-channel analog 3-D audio processor for project studios and live
performance with an MSRP of $649. The Company does not intend to further
manufacture of this product and is currently negotiating for the license of its
design.

     The Company's professional products have, however, served as a proving
ground and established credibility of the Company's technologies, gained a
strong measure of acceptance, and created strong brand recognition for the
Spatializer name in the professional recording, film and broadcast markets as
reflected by the following partial list of credits:

     - Soundtrack for the motion picture "EVITA" featuring Madonna

     - Live Broadcast of the 1996 SUMMER OLYMPICS in Atlanta

     - Twentieth Century Fox's film "BROKEN ARROW"

     - Paramount's "CRIMSON TIDE"

     - Disney's "THE LION KING"

     - The Eagles "HELL FREEZES OVER" CD

     - Bonnie Raitt's Grammy Award winning "LONGING IN THEIR HEARTS"

     - Barbra Streisand's live concert album "BARBRA -- THE CONCERT"

     - Michael Jackson's "HISTORY" CD

     - Warner Bros. animated TV series, including "ANIMANIACS"; "BATMAN: THE
       ANIMATED SERIES"; "TAZMANIA"; and "TINY TOON ADVENTURES"

     - GRAMMY(R) AWARDS live telecasts for the past four years.

     Capitalizing upon that name recognition, the Company has sought to expand
the market for its technology and products into computer games and multimedia
title production environments, particularly well suited to "3-D" sound
enhancement.

  Consumer Audio Products

     In January 1996, the Company introduced its first Spatializer(R) brand
product for consumers, the HTMS 2510(TM) Stereo Surround Sound System. The
device is an easy to install add-on, about the size of a VCR, that

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converts any two speaker or multiple speaker home stereo into a state-of-the-art
home theater system. The suggested retail price for the HTMS 2510 is $249. At
the Winter Consumer Electronics Show in January, 1996, the HTMS 2510 won a
prestigious "Innovations Awards" for excellence in product design and
innovation, as did eight other products which feature Spatializer(R) audio
technology from Panasonic, Proton and Labtec. The product received several
favorable reviews in respected consumer audio industry publications Audio
Magazine (June, 1996), Audio Adventure (June, 1996) and Sound on Sound (October,
1996).

     Consistent with its plans to concentrate on licensing and software-only
products, the Company does not intend to manufacture additional units, but is
considering licensing of the product designs and trademarks for manufacture and
distribution in selected geographic regions throughout the world.

SOFTWARE PRODUCTS

     Focusing on high margin, lower risk software products, and leveraging its
reputation and brand name recognition in the professional recording industry,
the Company introduced Spatializer(R) PT3D(TM), a software plug-in for the
industry leader Digidesign(R) digital audio workstation platform in November
1996. Priced at an MSRP of $399, PT3D provides Spatializer(R) 3-D sound imaging
and enhancement for the editing and production of audio for music, films and
computer games. The product is currently distributed through PRO Audio dealers
around the country. PT3D(TM) has received favorable reviews in leading industry
publications including Recording magazine (December 1996).

     The Company is currently developing additional software "plug-ins" for the
principal vendors of DAW software on both the MacIntosh and PC platform which it
expects to introduce in 1997.

MULTIDISC TECHNOLOGIES, INC. -- NETWORK BASED MODULAR, SCALEABLE COMPACT
DISC/DVD SERVERS

     As its first effort to broaden the Company's technology portfolio and
capitalize on the Company's strong relationships with manufacturers of consumer
electronics and personal computer peripheral products, the Company acquired
certain technologies and assets from HTP for $1,062,000 in June 1996 to form its
subsidiary, MultiDisc Technologies, Inc. The transaction, which was implemented
through a court-approved sale in the HTP bankruptcy proceeding, included an
array of development stage compact disc server robotics and software
technologies. The transaction was undertaken to position the Company for long
term growth in a significant new market.

     The MultiDisc Transaction brings to the Company a unique combination of
proprietary electromechanical designs, robotics, operating software, firmware,
intellectual property, and engineering talent. The core intellectual property is
reflected in five patent applications acquired by the Company in the asset
acquisition. When completed, the technology is expected to feature a flexible
modular design, which will allow extremely high-density and expandable disc
storage, and support all current and future 12cm CD and DVD formats. Since the
MultiDisc Technology is expected to be fully configurable, scaleable, and drive
independent, any new improvements in 12cm CD or DVD drive speed, format, optics
or media capacity can be easily accommodated. The net result is expected to be a
new class of devices significantly faster, smaller and more capable than
existing solutions at a fraction of their current cost. Devices built on the
technology are expected to have applications in numerous global markets where
on-line, near real-time data access, storage, archiving and retrieval are
required.

     Since the incorporation of MDT, the Company has concentrated on finalizing
the principal proof of concept designs and initial prototypes which it expects
to complete by the end of the second quarter of 1997. In addition, eight new
patent applications have been submitted to the United States Patent and
Trademark Office bringing the total patent applications to thirteen. An
additional seventeen patents applications have been identified, which are
currently in process and are expected to be filed in the near future.

     The principal competitive advantages of the MultiDisc technology are
extremely high disc storage density, passive expandability, and unlimited
scaleability of the system -- all at very small incremental hardware costs. As a
result, MDT CD/DVD servers could allow easy accessibility to hundreds or even
thousands of CDs into a single low cost device -- literally permitting terabytes
of data storage on a desktop.

                                        6
<PAGE>   8

The chief design goal behind the MultiDisc Technology is "on-line" accessibility
at "off-line" costs. With the forecasted growth in business networking, Internet
and Intranet servers, and on-line access to an ever growing data storage market,
the demand for network-capable scaleable compact disc-based storage and
archiving technologies is expected to rise markedly beyond the turn of the
century.

     MDT devices should have application in on-line or networked applications on
the Internet particularly as more audio, graphic and full motion video data
types become more prominent as these data-rich applications require tremendous
storage capacity. Within the wide range of possible markets, the Company plans
to focus its initial efforts on the development of general purpose, modular,
scaleable systems which have the widest possible vertical and horizontal
commercial application.

     Large vertical applications include patient medical records management and
medical image storage and retrieval (PACS -- Picture Archival and Compression
Systems). In health care, the trend to on-line systems is expected to continue
as pressures on medical cost reduction and quality assurance increase. In these
health information systems environments, an MDT data server can provide storage
for thousands of digital diagnostic images and patient information for access
and distribution within a hospital or medical center or for access by consulting
professionals at remote sites.

     There are numerous other vertical market applications, including
video-on-demand systems for hotels or cable systems, check image storage in
banks, on-line resources and retrieval in libraries and similar archives,
on-line instruction in schools and industry, real estate and banking, and in
government and industry where large volumes of paper are being reduced to
digital data.

     The major development milestones leading to MDT's market viability will be:

          1. Proof of concept for principal electro-mechanical designs

          2. Initial prototyping

          3. Software integration of user interface, motion control and data
     transfer functions

          4. Completion of the principal patent applications, and

          5. Formation of key strategic manufacturing, distribution and
     licensing relationships

     The Company expects to complete the principal proof of concept designs,
initial prototyping and filing of all key patents by the end of the second
quarter of 1997. Operating software and user interface designs are currently
underway initially targeting the Windows NT(R) and NOVELL(R) network platforms.
The Company is currently in discussions with potential manufacturing and
distribution partners as well as principal software providers for the CD
Jukebox/Changer marketplace.

REVENUES AND EXPENSES

     The Company generates revenues from royalties pursuant to its Foundry, OEM,
and other licenses, and from the sale and distribution of its consumer and
professional hardware products. The Company's revenues, which totaled $2,024,000
in 1996, were derived substantially from Foundry and OEM License royalties.

     The Company limits its inventory, capital cost, personnel and overhead cost
exposure in connection with its hardware products by entering into third-party
manufacturing and distribution arrangements. The Company is seeking to maximize
return on its intellectual property base by concentrating its efforts in very
high margin licensing and software products and eliminating its hardware product
operations. Licensing operations have been managed internally by Company
personnel. Sales of professional audio products are accomplished through a
worldwide network of professional audio dealers and managed by Company
personnel.

     The Company had four major customers in 1996, each of whom accounted for
greater than 10% of the Company's 1996 revenues. One OEM accounted for 24% of
the Company's total licensing revenues during 1996. All other OEM's accounted
for less than 10% individually. Royalties from each of the three Foundry
Licensees accounted for 25%, 14%, and 12% of total licensing revenues,
respectively.

                                        7
<PAGE>   9

     In June 1996, the Company acquired the MultiDisc development stage CD/DVD
server technologies in a transaction for $1,062,000 in an effort to
significantly broaden the Company's technology portfolio and capitalize on its
strong manufacturing and OEM relationships.

     In August 1996, the Company prevailed in a 22-month legal battle over its
3-D Stereo intellectual property when the U.S. District Court granted the
Company's motion for summary judgment against a competitor's assertions of
patent infringement (See ITEM 3 -- LEGAL PROCEEDINGS, Page 11, for further
detail). Following the ruling in its favor, the Company signed 17 new OEM
licensees in the third and fourth quarters, including such global market leaders
as JVC and Texas Instruments. The uncertainties caused by the patent litigation
severely hindered the performance of the Company for the last two years,
particularly since licensing revenue depends upon OEM unit shipments, which
follow three to four quarter production cycles.

     During 1996, the Company recorded three one-time (non recurring) expenses
aggregating $21,147,000 or ($1.67) per share which represented approximately 83%
of the operating loss reported for the year. These charges were:

          a) The Company recorded a one-time non-cash financial statement charge
     to earnings of $20,218,000 in the fourth quarter upon final consent by the
     British Columbia Securities Commission ("BCSC") and the Company's
     acceptance to the modification of the Company's performance share escrow
     arrangement as approved by the Company's shareholders in August, 1996.
     Under the revised arrangement the Company's 5,776,700 "Performance Shares"
     (representing approximately 24 percent of fully diluted shares outstanding
     at December 31, 1996) became subject to a new escrow arrangement under
     which the shares will be released over a six year period of time.

          b) The Company recorded a one-time charge to earnings in June 1996, in
     the amount of $680,000 as "In Process Research & Development" in connection
     with its MultiDisc Technologies CD/DVD robotics system technology
     acquisition.

          c) In connection with the liquidation of its Canadian predecessor, the
     Company incurred and paid Canadian income taxes in the amount of $249,000.

     During the last quarter of 1996, the Company completed the first phase of
re-organization of its Desper Products, Inc. audio signal processing business by
relocating the East Coast engineering facilities from Boston, Massachusetts to
Mountain View, California. The Company also closed its Southern California
research facility. In addition, the Company has implemented other cost cutting
measures during the first quarter of 1997 in an effort to reduce 1997 operating
costs from 1996 levels.

COMPETITION

3-D AUDIO SIGNAL PROCESSING MARKETPLACE

     The Company competes with a number of entities that produce various audio
enhancement processes, technologies and products, some utilizing traditional
two-speaker playback, others utilizing multiple speakers, and others restricted
to headphone listening. These include the consumer versions of multiple speaker,
matrix and discrete digital technologies developed for theatrical motion picture
exhibition (like Dolby Digital(R), Dolby ProLogic(R), and DTS(R)), as well as
other technologies designed to create an enhanced stereo image from two or more
speakers.

     The Company's principal competitors in the field of 3-D audio are QSound
Labs, Inc. ("QSound"), SRS Labs, Inc., Aureal Semi-conductor, Inc. and Harman
International. Only QSound competes with the Company in all three 3-D audio
market segments. In the future, the Company's products and technologies also may
compete with audio technologies and product applications developed by other
companies including entities that have business relationships with the Company.

     The Company believes that it will favorably compete in this market because
it offers a single source, complete suite of patented and proprietary
technologies, and because of its superior engineering and OEM support, the
strength of its IC Foundry and OEM relationships, and the Spatializer brand name
recognition in the industry.

                                        8
<PAGE>   10

COMPACT DISC SERVER/JUKEBOX MARKETPLACE

     The multiple disc server and CD-ROM changer industry is emerging and is
currently characterized by a single market leader NSM, a German based entity
which is adapting its audio "jukebox" expertise to CD-ROM applications and by a
number of small companies and specialty groups in large and established
enterprises which are seeking to enter the market. NSM sells products under its
own label and as an OEM for other manufactures such as Kodak. NSM offers only
hardware and is dependent on third parties for control and interface software,
and on system integrators and value added resellers (VARs) to implement the
hardware for individual solutions. The other entities generally offer either
large capacity free-standing disc changers (like the NSM products) for network
environments or small capacity changers (for ten or fewer discs) for personal
computer markets. The NSM products require a substantial end-user investment of
approximately $20,000 for a fully configured solution. Large capacity systems
are currently offered by DISC, Kubik, Dynatek, Boffin, Denon and Kodak: small
capacity systems are available from Mountain Data Systems (Nakamichi), NEC,
Sanyo, TeleVideo and JVC. Only Pioneer and Smart & Friendly offer both larger
and small capacity changers.

     The Company believes that if the MultiDisc technology is proven and reaches
market, it will compete in both large and small capacity markets principally
because of its flexible and configurable technology and its ability to integrate
the technology in turnkey solutions for the end-user. Currently, the Company
intends to enter the market through licensing, OEM relationships and other
strategic arrangements rather than as a direct manufacturer.

PATENTS, TRADEMARKS AND COPYRIGHTS

     The Company's core Spatializer audio signal processing technology is
covered by its U.S. patent 5,412,731, issued May 2, 1995. In addition, the
Company has acquired two related audio signal processing patents covering its
technology. Additional patent applications for the Company's reduced cost/higher
performance 3-D Stereo designs, and for its enCompass and N-2-2 technologies are
currently in process. Much of the Company's intellectual property consists of
trade secrets. The Company possesses copyright protection for its principal
software applications and has U.S. and foreign trademark protection for its key
product names and logo marks.

     As of December 31, 1996, MDT had five core patent applications on file with
the USPTO. To date an additional eight patent applications have been filed
covering software, mechanical techniques, implementations and mixed technology
designs bringing the total to thirteen. An additional seventeen patent
applications have been identified and are currently in process. The Company has
applied for U.S. trademark protection for its principal product names and logo
marks.

EMPLOYEES

     The Company began 1996 with twenty-nine full-time and two part-time
employees and grew to thirty-nine full-time and one part-time employees by
December 31, 1996. At year end, there were sixteen employees engaged in research
and development with seven of those employees involved with the development
effort at the Company's new subsidiary MDT. The Company's sales and marketing
department ended the year with nine full-time employees and the finance and
administrative department ended the year with fourteen full-time and one
part-time employees. From time to time the Company also employs the services of
outside professional consultants. None of the Company's employees is represented
by a labor union or is subject to a collective bargaining agreement. The Company
considers its relations with its employees and consultants to be excellent.

     In February 1997 the Company reduced its workforce by seven full-time
employees. This restructure reduced the staff count to thirty-two full-time
employees and one part-time employee. The Company now has fifteen full-time
employees in research and development, six full-time employees in sales and
marketing, and eleven full-time and one part-time employee in finance and
administrative.

                                        9
<PAGE>   11

                                    PART II

ITEM 2.  PROPERTIES

     In 1996, the Company's executive office was located in Woodland Hills,
California where it occupies approximately 4,340 square feet at an annual rent
of approximately $83,000. The Company's regional offices in Natick,
Massachusetts, Mountain View, California, and Newbury Park, California are also
in leased premises. The Natick lease covered approximately 2,200 square feet and
had an annual rent of approximately $26,200 in 1996. The Natick facility staff
were relocated to the Mountain View facility in January 1997 and the Natick
premises were closed on January 31, 1997. In the first quarter of 1996 the
Company relocated its Mountain View location to a larger facility in Mountain
View. The facility occupies approximately 4,200 square feet and the annual rent
for these premises is approximately $50,400. In 1996 the Company rented a sound
lab and technical support facility in Tujunga, California on a month-to-month
basis at a rent of approximately $14,100 per year. In the Company's effort to
consolidate, the technical support facility was also closed in January 1997. The
Company incurred no lease termination costs in connection with the closing of
various offices.

     The Company leases its space at rental rates and on terms which management
believes are consistent with those available for similar space in the applicable
local area. The Company's properties are well maintained, considered adequate
and are being utilized for their intended purposes.

ITEM 3.  LEGAL PROCEEDINGS

     In the Fall of 1994, QSound Labs, Inc. ("QSound") advised MEC that, in its
view, the Spatializer(R) technology infringed certain U.S. patents held by
QSound. Based on its belief that its technology does not infringe QSound's
patents, in October 1994 DPI initiated Desper Products, Inc. and Spatializer
Audio Laboratories, Inc. v. QSound Labs, Inc., Case No. 94-7276WDK(Bx).

     On August 29, 1996 the Court granted the Company's summary judgment motion
of non-infringment in its entirety and denied the motion by QSound in the
pending patent infringement litigation between the Company and QSound.

     In granting the Company's summary judgment motion, the Court found that the
Company's IC (Integrated Circuit) does not infringe the QSound patent and denied
QSound's motion with respect to infringement. The Company's claim that the
QSound patent is invalid was not decided and, since the issues which the Court
would need to consider on the patent invalidity claim are similar to certain
issues considered in the infringement claim, QSound was granted the right to
immediately appeal the denial of its motion and trial on the invalidity issue
was deferred until after that appeal. In substance, the Court's finding confirms
the Company's position that there is no infringement by the Company's IC of any
patent held by QSound and that the claims by QSound were without merit. If the
appeal is denied and the Court's decision is confirmed on appeal, the Company
intends to pursue the remaining claims for damages and for a decision that the
QSound patent is invalid. If the appeal is granted and the Court's decision on
the motion is overruled, a trial on the merits would follow at which time the
Company will again assert its current position, which already was adopted in the
grant of the Company's summary judgment motion, and will assert its remaining
claims against QSound.

     QSound has appealed and the appeal is pending. The Company expects that it
will ultimately prevail in this case, and therefore, the disposition of this
matter is not expected to have a material effect on the financial position or
results of operations of the Company. However, the outcome of all litigation is
to some extent unpredictable.

     The Company is not currently a party to any other legal actions and is not
aware of any other pending claims. The Company anticipates, however, that from
time to time it may be named as a party to legal actions in the ordinary course
of business.

                                       10
<PAGE>   12

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

     There were no matters submitted to a vote of the security holders of the
Company either through solicitation of proxies or otherwise in the fourth
quarter of the fiscal year ended December 31, 1996.

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

     The Company's Common Stock was listed and commenced trading on the small
capital market of NASDAQ on August 21, 1995 under the symbol "SPAZ". From July
14, 1992 to October 10, 1995, the Company's Common Stock traded on the Vancouver
Stock Exchange ("VSE") in Canadian dollars under the symbol "SLB.V". Beginning
October 10, 1995, the stock traded on the VSE in U.S. dollars under the symbol
"SLB.U". On February 12, 1997 the Company delisted from the VSE and subsequent
to such date has been trading only on NASDAQ. The following table sets forth the
high and low sales price of the Company's Common Stock on its principal market
for fiscal years 1995 and 1996:

<TABLE>
<CAPTION>
                                                           HIGH (CDN. $)(1)     LOW (CDN. $)(1)
                                                           ----------------     ---------------
    <S>                                                    <C>                  <C>
    PERIOD:
    1995
      First Quarter......................................       $4.15                $2.65
      Second Quarter.....................................       $5.63                $3.60
      Third Quarter(2)...................................       $7.25                $4.80
                                                            HIGH (U.S. $)        LOW (U.S. $)
                                                             ------------        ------------
      Third Quarter(3)...................................       $6.16                $4.31
      Fourth Quarter.....................................       $5.50                $3.38
    1996                                                    HIGH (U.S. $)        LOW (U.S. $)
                                                             ------------        ------------
      First Quarter......................................       $5.00                $3.75
      Second Quarter.....................................       $5.41                $4.00
      Third Quarter......................................       $5.06                $3.19
      Fourth Quarter.....................................       $3.88                $2.88
</TABLE>

---------------
(1) Trading is in shares of the Company as listed on the Vancouver Stock
    Exchange ("VSE") expressed in Canadian dollars.

(2) The Company became active on NASDAQ on August 21, 1995. Prior to that date,
    shares were still traded on the VSE and expressed in Canadian dollars (July
    1, 1995 to August 18, 1995).

(3) August 21, 1995 to September 30, 1995 are expressed in US Dollars as traded
    on NASDAQ.

     On March 13, 1997, the closing price reported by NASDAQ was U.S. $2.13.
Stockholders are urged to obtain current market prices for the Company's Common
Stock. Montreal Trust Company of Canada, Vancouver, B.C., was the transfer agent
and registrar for the Company's Common Stock for the 1996 fiscal year. Beginning
April 1, 1997, Harris Trust Company of California will become the new transfer
agent.

RECORD HOLDERS

     To the Company's knowledge there were approximately 150 holders of record
of the stock of the Company as of March 13, 1997. However, the Company's
transfer agent has indicated that beneficial ownership is in excess of 1,600
shareholders.

DIVIDENDS

     The Company has not paid any cash dividends on its Common Stock and has no
present intention of paying any dividends. The current policy of the Company is
to retain earnings, if any, for use in operations and in the development of its
business. The future dividend policy of the Company will be determined from time
to time by the Board of Directors.

                                       11
<PAGE>   13

ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA

     The following selected consolidated financial data should be read in
conjunction with the Company's Consolidated Financial Statements and related
Notes and with "Management's Discussion and Analysis of Financial Condition and
Results of Operations", included in Item 7. The selected data presented below
under the headings "Consolidated Statement of Operations Data" and "Consolidated
Balance Sheet Data" as of and for the years ended December 31, 1996 and 1995, as
of and for four-month period ended December 31, 1994, and the years ended August
31, 1994, are derived from the consolidated financial statements of Spatializer
Audio Laboratories, Inc. and subsidiaries, which consolidated financial
statements have been audited by KPMG Peat Marwick LLP, independent certified
public accountants. The consolidated financial statements as of December 31,
1996 and 1995, and the related consolidated statements of operations,
shareholders' equity, and cash flows for the years ended December 31, 1996 and
1995, the four-month period ended December 31, 1994, and the year ended August
31, 1994, and the report thereon, are included elsewhere in this Report.

<TABLE>
<CAPTION>
                                                                                                          FISCAL YEAR
                                                                                    FOUR MONTH               ENDED
                                                 FISCAL YEAR ENDED AUGUST 31,      PERIOD ENDED   ---------------------------
                                               ---------------------------------   DECEMBER 31,   DECEMBER 31,   DECEMBER 31,
                                                 1992        1993       1994(1)    1994(1 & 2)      1995(1)          1996
                                               ---------   ---------   ---------   ------------   ------------   ------------
                                                              (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                            <C>         <C>         <C>         <C>            <C>            <C>
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenues.....................................  $      --   $      97   $     140    $      187     $    1,230     $    2,024
Cost Of Revenues.............................         --         (55)        (61)          (25)           (79)          (186)
                                               ---------   ---------   ---------     ---------     ----------     ----------
Gross Profit.................................         --          42          79           162          1,151          1,838
Total Operating Expenses.....................     (1,039)     (2,120)     (1,808)       (1,339)        (4,403)       (27,042)(3)
Interest Income (Expense), Net...............        (29)        (25)        (79)          (16)            74            119
Income taxes.................................         --          --          --            --            (63)          (310)(4)
                                               ---------   ---------   ---------     ---------     ----------     ----------
Loss For The Period..........................  $  (1,068)  $  (2,103)  $  (1,808)   $   (1,193)    $   (3,241)    $  (25,395)
                                               ---------   ---------   ---------     ---------     ----------     ----------
Loss Per Common Share........................  $   (0.42)  $   (0.37)  $   (0.26)   $    (0.14)    $    (0.32)    $    (2.01)
                                               =========   =========   =========     =========     ==========     ==========
Weighted Average Common Shares(5)............  2,518,373   5,740,298   6,891,546     8,552,535     10,156,816     12,644,751
                                               =========   =========   =========     =========     ==========     ==========
CONSOLIDATED BALANCE SHEET DATA:
Cash and Cash Equivalents....................  $     669   $     500   $   1,779    $    1,540     $    3,113     $    1,587
Working Capital..............................        278         (66)          6           982          3,159          2,092
Total Assets.................................        764         932       2,676         2,318          4,420          4,141
Advances From Related Parties................        332         433         539           517            325            113
Shareholders's Note Payable..................         --         292          --            --             --             --
Total Shareholders' Equity...................  $     361   $      69   $     288    $    1,367     $    3,697     $    3,268
</TABLE>

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

(1) A Plan of Arrangement was completed on July 27, 1994 whereby the situs of
    the Company was moved to Delaware. Spatializer Audio Laboratories, Inc., a
    Delaware corporation, became the parent company for Spatializer-Yukon and
    DPI. The financial statements for this fiscal year reflect the consolidation
    of all three entities.

(2) Not comparative.

(3) Includes two one-time significant items. The first significant item is a
    Compensation Expense of $20,218,450 associated with the transfer of the
    Company's performance shares from Canadian Escrow into a new escrow
    arrangement which will provide for the release of the performance shares
    over the next six years. Based on the revised escrow arrangement, which
    primarily converts the escrow shares release from performance criteria to
    time-based criteria, the Company recorded compensation expense on the date
    the new escrow arrangement terms were accepted by the Company. The second
    significant item is an In-Process Research & Development ("IPR&D") expense
    of $680,000 related to the allocation of costs incurred as a result of the
    MultiDisc Technologies, Inc. ("MDT") subsidiary's asset acquisition in June
    1996.

(4) The Company incurred and paid Canadian income taxes in the amount of
    $249,000 during the year associated with the liquidation of
    Spatializer-Yukon, the Company's Canadian predecessor.

(5) Loss per share has been calculated based on the weighted average number of
    common shares outstanding including escrowed performance shares, which are
    factored into the calculation as of December 30, 1996, the date on which the
    British Columbia Securities Commission ("BCSC") issued its consent to the
    Company's revised escrow arrangement. Common stock equivalents have not been
    included in the calculation of primary loss per share for all periods as the
    effect of including such securities would be antidilutive.

                                       12
<PAGE>   14

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

FOR THE YEAR ENDED DECEMBER 31, 1996, COMPARED TO THE YEAR ENDED DECEMBER 31,
1995

     The following discussion and analysis relates to the financial condition
and results of operations of Spatializer Audio Laboratories, Inc. (the
"Company") for the year ended December 31, 1996, compared with the year ended
December 31, 1995, the year ended December 31, 1995, compared with the year
ended December 31, 1994 and for the four-month period ended December 31, 1994
compared with the four-month period ended December 31, 1993.

RESULTS OF OPERATIONS

REVENUES

     The Company reported increased revenues of 65% or $794,000, reaching
$2,024,000 for the year ended December 31, 1996, compared to $1,230,000 for the
year ended December 31, 1995. Revenues include sales of professional recording
systems, consumer products, license issuance fees and royalties pertaining to
the Spatializer(R) analog integrated circuit ("IC").

     The growth in revenues reflect the Company's transition to recurring
running royalties. In 1995 the majority of the Company's licensing revenues were
derived from one-time, up-front license issuance fees. In contrast, a
substantial portion of the licensing revenues for 1996 are derived primarily
from running royalties based on usage and include revenues from four major
customers. In 1996 these major customers represent 25%, 24%, 14% and 12%,
respectively. The full impact of the increase in recurring royalties was not
felt during 1996, as a portion of the revenue stream was offset by
non-refundable advanced royalties reported in 1995. As of December 31, 1996, the
majority of these advance royalties had been offset, resulting in the future
recognition of revenue on a basis concurrent with unit shipments.

     During the year, the Company offered a new streamlined "bundled" royalty
agreement with its foundries. The bundled royalty agreement is designed to
accelerate revenues and to simplify the selling process of the Spatializer(R)
IC. Foundries will continue to pay a royalty as the IC is manufactured and
shipped to Original Equipment Manufacturers (OEM's), however, the new agreement
makes it easier for foundries to sell the ICs to OEMs by eliminating the need to
negotiate a separate royalty with the OEMs. In this new bundled agreement the
OEM royalty is "bundled" in the chip price and paid directly by the IC Foundry
thus accelerating the receipt of such royalties to the Company. OEMs sign a
simplified Logo Usage Agreement

                                       13
<PAGE>   15

("LUA") in order to promote the usage of the Spatializer(R) IC. Twenty-four new
licensees were added during the year, bringing the total to fifty-one Foundry
and OEM licensees.

     The new licensees were a result of a combination of the new "bundled"
licensing agreement, introduction of the Company's N22(TM) -- Digital Virtual
Surround(TM) technologies for multi-channel discrete digital audio systems for
DVD/DVD-ROM, Spatializer 3-D Map(TM) positional audio enhancement software for
Windows(R) 95 ("PT-3D(TM)"), and a favorable ruling by the Court in the
intellectual property litigation with QSound Labs, Inc.

     The Company increased product sales through sales of its first consumer
product, the HTMS-2510(TM). Product sales for the year ended December 31, 1996,
represent approximately 17% of revenues compared with only 5% for the same
period in 1995. Due to unsatisfactory sales performance, the Company plans to
move away from such hardware products and to concentrate on the higher-margin
software products such as PT-3D(TM). The Company expects the majority of
revenues to continue to come from licensing activities.

     Gross profit for the year ended December 31, 1996, was approximately 91% as
compared with 94% for same period in 1995. Profit margins are high as the
majority of revenues are derived from licensing activities which carry low
direct costs. The reduction in gross profit is due to the above referenced
increase in product sales during 1996 since the margin on product sales is lower
than licensing margins.

OPERATING EXPENSES

     The Operating expenses for the year ended December 31, 1996 reflect two
significant non-recurring items which occurred in 1996. The first significant
item is for a Compensation expense of $20,218,450 associated with the transfer
of the Company's performance shares from Canadian Escrow into a new escrow
arrangement which will provide for the release of the performance shares for a
period up to six years. The second significant item is for In-Process Research &
Development ("IPR&D") of $680,000 related to the allocation of costs incurred as
a result of the MultiDisc Technologies, Inc. ("MDT") subsidiary's asset
acquisition in June 1996.

     After adjusting for the two one-time items listed above, operating expenses
for the year ended December 31, 1996, increased by approximately 40% or
$1,740,000, for a total of $6,144,000 compared to $4,404,000 for the same year
in 1995. This increase can be attributed primarily to the added costs of
operations related to the Company's new MDT subsidiary, increased efforts of
Sales and Marketing including
the launch of an aggressive advertising campaign for the HTMS-2510, as well as
the effects of a fully staffed operation at the Desper Products, Inc. ("DPI").

GENERAL AND ADMINISTRATIVE

     General and administrative costs remained relatively flat with a minor
decrease of approximately 2% or $51,000, to $2,329,000 for the year ended
December 31, 1996 as compared with $2,380,000 for the same period in 1995. The
change is primarily the result of increased payroll and payroll related costs
and financial reporting costs, offset by savings in travel, external accounting
fees, and consulting and temporary help.

     Payroll and Payroll Related

          Payroll and payroll related costs increased approximately 22%, or
     $151,000, to $831,000 for the year ended December 31, 1996 as compared with
     $680,000 for the same period in 1995. The increase is attributed to the
     increase in staff from ten full-time staff in 1995 to eleven full-time
     staff and one part-time staff in 1996. The increase in staff count is
     related primarily to additional workloads due to regulatory reporting
     requirements, the support of pursuing new product launches, and the support
     requirements of the Company's newest subsidiary, MDT. The increase is also
     reflective of a transition from temporary staff and consultants to
     permanent employees.

     Financial Reporting

          Financial reporting costs relate to regulatory filing requirements of
     the SEC and NASDAQ as well as printing of such materials for investor
     relations, financial analysts, and sales and marketing purposes.

                                       14
<PAGE>   16

     The costs for the Company's first Annual Report and Form 10-K along with
     quarterly Form 10-Q financial reportings were $150,000 for the year ended
     December 31, 1996. No similar documents were produced for marketing
     purposes in the prior year and therefore, there are no comparable costs in
     1995.

     Travel and Travel Related

          Travel and travel related costs decreased by approximately 38% or
     $50,000, to $81,000 for the year ended December 31, 1996 as compared with
     $131,000 for the same period in 1995. The decrease in travel and travel
     related costs are directly associated with travel during 1995 to Europe and
     the Pacific Rim to report on the Company and its products in those areas.

     Consulting Fees and Temporary Help

          Consulting fees and temporary help decreased by approximately 43%, or
     $101,000, for a total of $135,000 for the year ended December 31, 1996,
     compared to $236,000 for the same year in 1995. The reduction in costs
     relates to the completion of multiple consulting projects in 1995 including
     the analysis of technologies for potential acquisition and the permanent
     hire or elimination of temporary staff in the 1996 period. In addition, the
     three-month period ended December 31, 1995 included a third party patent
     analysis conducted in connection with the patent infringement lawsuit which
     was decided in the Company's favor in August 1996.

     Legal Fees

          Legal fees decreased approximately 37%, or $193,000, for a total of
     $331,000 for the twelve month period ended December 31, 1996, compared to
     $524,000 for the same twelve month period in 1995. This decrease is
     primarily the result of reduced litigation related fees and costs after
     August 1996 when the Court granted the Company's motion for summary
     judgment against a competitor's assertions of patent infringement. The
     competitor has appealed, therefore, additional litigation fees and costs
     will be incurred by the Company in connection with this matter.

     General Operating

          General operating costs were approximately $800,000 for both of the
     years ended December 31, 1996 and 1995. These costs include rent,
     telephone, office supplies and stationery, postage, depreciation and
     similar costs. The lack of increase is the direct result of internal cost
     controls and cost savings measures taken by the Company including the
     streamlining of agreements with outside service companies to reduce such
     costs.

RESEARCH AND DEVELOPMENT

     The research and development activity grew substantially in 1996 with the
added operations of the Company's new subsidiary, MDT commencing in June. In
addition, the Company continued efforts to identify, validate, and develop new
product ideas through DPI and introduced both the Spatializer 3-D Map(TM)
positional audio enhancement software for Windows(R) 95 and N22(TM) -- Digital
Virtual Surround technologies for multi-channel discrete audio systems in
DVD/DVD-ROM and Home Theater products during the year. All research and
development activities and related costs continue to be expensed in the period
incurred.

     To support these efforts research and development costs increased by
approximately 199% or $1,238,000, to $1,860,000 for the year ended December 31,
1996, compared to $622,000 for the same year in 1995. The increase relates
primarily to expenses incurred of $843,000 related to the Company's newly formed
subsidiary MDT which began operating in June 1996, along with a fully-staffed
operation at DPI.

     Payroll and Payroll Related

          Payroll and payroll related costs for the Research and Development
     Department increased approximately 118% or $636,000, to $1,174,000 for the
     year ended December 31, 1996 as compared with

                                       15
<PAGE>   17

     $538,000 for the same period in 1995. The increase is attributed to the
     increase in staff to fifteen in 1996. The increase in staff includes seven
     staff members involved in the MDT research and development efforts as well
     as additional staff costs of DPI which is now operating with employees
     rather than outside contractors.

          The Company's new subsidiary, MDT, which began operations on June 24,
     1996, represented approximately 43% or $505,000 of the department's payroll
     and payroll related costs for the year ended December 31, 1996.

     Technology and Product -- Engineering and Development

          Research & engineering costs, other than payroll and payroll related,
     increased substantially to approximately $686,000 for the year ended
     December 31, 1996 compared to $84,000 for the same period in 1995. The
     increase is primarily related to the six-months of operations of the
     Company's new subsidiary, MDT. Costs during future periods are expected to
     increase as the activities of MDT proceed towards the development of its
     network based compact disc/DVD server technologies.

SALES AND MARKETING

     Sales and marketing costs increased approximately 40%, or $554,000, for a
total of $1,955,000 for the year ended December 31, 1996, compared to $1,401,000
for the same year in 1995. The increase is attributed to payroll and payroll
related costs and advertising costs related to a continued advertising and
promotional campaign directed at the consumer and computer marketplaces.

     Payroll and Payroll Related

          Payroll and payroll related costs for the Sales and Marketing
     Department increased approximately 67% or $284,000, to $706,000 for the
     year ended December 31, 1996 as compared with $422,000 for the same period
     in 1995. The increase is attributed to the increase in staff from ten in
     1995 to twelve in 1996, increases in medical insurance due to new hires
     with family coverage, and timing issues with staffing changes.

     Advertising and Trade Show Related

          Advertising which includes publicity, public relations, and press
     release costs and trade show related costs increased approximately 104%, or
     $210,000, for a total of $411,000 for the year ended December 31, 1996,
     compared to $201,000 for the same year in 1995. The increase is attributed
     to supporting the introduction of the first Spatializer brand consumer
     hardware product, the HTMS-2510(TM) into the consumer market place as well
     to public relations and publicity related to the development of an
     organized advertising and promotional campaign directed at the consumer and
     computer marketplaces to achieve name brand recognition. In addition, the
     increase in trade show costs is related primarily to a larger presence at
     Winter Consumer Electronic Show ("CES") '96 where the Company introduced
     the HTMS-2510(TM).

     Other Sales and Marketing

          Other costs including travel and entertainment, brochure and
     promotional literature, outside services and general operating costs
     increased approximately 8% or $60,000, for a total of $838,000 for the year
     ended December 31, 1996, compared to $778,000 for the same year in 1995.
     These areas all increased to support the overall increased sales effort for
     both the Company's licensing and product activities.

                                       16
<PAGE>   18

NET LOSS

     The Company incurred the following significant, non-recurring items in 1996
which aggregated $21,147,000. Including these non-recurring items the Company
reported a net loss for fiscal year 1996 of $25,395,000.

     - The Company recorded a one-time non-cash financial statement charge to
       earnings of $20,218,000 in the fourth quarter upon final consent by the
       BCSC to the modification of the Company's performance share escrow
       arrangement. Under the revised arrangement the Company's 5,776,700
       "Performance Shares" (representing approximately 24 percent of fully
       diluted shares outstanding at December 31, 1996) became subject to a new
       escrow arrangement under which the shares will be released under a six
       year passage of time.

       The overall modification was approved by the Company's shareholders in
       August 1996. Under the revised arrangement, the performance shares will
       be released automatically as follows: 5% on June 22, 1997; 5% on June 22,
       1998; 10% on June 22, 1999; 20% on June 22, 2000; 30% on June 22, 2001;
       and 30% on June 22, 2002. In addition to the automatic releases,
       performance shares can be released based on the cash flow release
       criteria contained in the original June 22, 1992 escrow agreement
       although, to maintain a stable market in the Company's stock, in any year
       not more than 30% of the shares will be released, based on the cash flow
       criteria.

       Under the revised escrow arrangement, the performance shares will vest
       provided the individual has not voluntarily terminated his/her service to
       the Company prior to applicable vesting dates. Any individual who is
       involuntarily terminated by the Company has his/her unvested performance
       shares automatically accelerated to them. The Board, in its discretion,
       may allow an individual who has voluntarily terminated his/her service to
       keep a portion or all of his/her unvested performance shares.

       Based on the revised escrow arrangement, which modifies the escrow shares
       release from performance criteria to include a time-based criteria as
       well, the Company recorded as compensation expense the excess of the fair
       market value of the 5,776,700 performance shares on the date the Company
       accepted the terms of the new escrow arrangement over the purchase price
       of such escrow shares.

       All of the performance shares are included in the issued and outstanding
       shares for the twelve-month periods ended December 31, 1996, and 1995.

       For financial reporting purposes, such shares were treated as issued and
       outstanding but were not reflected in the calculation of loss per common
       share until earned by and released to the holders as they would be
       antidilutive. At December 31, 1995, no performance shares had been earned
       out. At December 31, 1996 these shares are included in the calculation of
       loss per common share beginning December 30, 1996, the date on which the
       Company and the BCSC accepted and entered into the terms of the current
       escrowed arrangement as discussed above.

     - The Company recorded a one-time charge to earnings in June 1996, in the
       amount of $680,000 as "In Process Research & Development" in connection
       with its MultiDisc Technologies CD/DVD robotics system technology
       acquisition.

     - Lastly, in connection with the liquidation of its Canadian predecessor,
       the Company incurred and paid Canadian income taxes in the amount of
       $249,000.

     After adjusting for the above referenced one-time items, the net loss for
the year ended December 31, 1996, totaled $4,248,000, compared to a net loss of
$3,241,000 in 1995, an approximate increase of 31%, or $1,007,000. The increased
loss includes operating expenses incurred of $843,000 related to the Company's
newly formed subsidiary MDT which began operating in June 1996.

     During the last quarter of 1996, the Company completed the first phase of
re-organization of its Desper Products, Inc. audio signal processing business by
relocating the East Coast engineering facilities from Boston, Massachusetts to
Mountain View, California. The Company also closed its southern California
research

                                       17
<PAGE>   19

facility. In addition, the Company has implemented other cost cutting measures
during the first quarter of 1997. In an effort to reduce 1997 operating costs
from 1996 levels.

FOR THE YEAR ENDED DECEMBER 31, 1995, COMPARED TO THE YEAR ENDED DECEMBER 31,
1994

     The following discussion and analysis relates to the financial condition
and results of operations of Spatializer Audio Laboratories, Inc. (the
"Company") for the year ended December 31, 1995, compared with the year ended
December 31, 1994, for the four-month period ended December 31, 1994 compared
with the four-month period ended December 31, 1993, and the fiscal year ended
August 31, 1994 compared with the fiscal year ended August 31, 1993.

     On December 13, 1994, the Board of Directors approved a change in the
Company's year from a fiscal year end of August 31 to a fiscal year end of
December 31 resulting in a four-month transition period which is stated in the
financials. For comparative purposes of discussion and analysis the financial
results of both twelve-month periods ended December 31, 1994 and 1995 are listed
in the table below:

<TABLE>
<CAPTION>
                                                                DECEMBER 31,     DECEMBER 31,
                                                                    1995             1994
                                                                ------------     ------------
                                                                                 (UNAUDITED)
    <S>                                                         <C>              <C>
    REVENUES:
      Product Revenues........................................  $     63,507     $     93,480
      Licensing Revenues......................................     1,166,713          220,090
                                                                 -----------      -----------
                                                                   1,230,220          313,570
              Cost of Revenues................................        78,854           81,806
                                                                 -----------      -----------
      Gross Profit............................................     1,151,366          231,764
                                                                 -----------      -----------
    OPERATING EXPENSES:
      General and Administrative..............................     2,443,379        1,304,415
      Research and Development................................       622,484          434,347
      Sales and Marketing.....................................     1,400,794          840,734
                                                                 -----------      -----------
                                                                   4,466,657        2,579,496
              Operating Loss..................................    (3,315,291       (2,347,732)
      Interest Income.........................................       113,701           22,979
      Interest Expense........................................       (39,695)        (113,642)
                                                                 -----------      -----------
              Net Loss........................................  $ (3,241,285)    $ (2,438,395)
                                                                 ===========      ===========
              Net Loss Per Common Share.......................  $      (0.32)    $      (0.32)
                                                                 ===========      ===========
      Weighted Average Common Shares..........................    10,156,816        7,618,925
                                                                 ===========      ===========
</TABLE>

RESULTS OF OPERATIONS

REVENUES

     The Company showed a substantial increase in revenues of 292% or $916,650,
reaching $1,230,220 for the year ended December 31, 1995, compared to $313,570
for the twelve month period ended December 31, 1994. Revenues include sales of
professional recording systems, license issuance fees and royalties pertaining
to the analog IC. This growth occurred as the Company emerged from the
development stage during the third quarter of 1995 with a total of three Foundry
and twenty-four OEM license agreements as of the end of 1995. The increase in
revenues is substantially from license issuance fees and running royalties
associated with the increased number of Foundry and OEM license agreements for
the Company's IC. The gross profit was approximately 94% of revenues as the
majority of sales are associated with license and royalty revenues which have
little or no direct costs associated with them. A significant portion of the
Company's ongoing revenue will be derived from royalties payable by the OEMs as
IC's are incorporated into existing or new products manufactured and sold by the
OEMs. As a result, the Company will continue to earn royalty revenues from

                                       18
<PAGE>   20

IC's shipped by the foundries in 1995 as these IC units are incorporated into
products sold in 1996 by the OEM's

OPERATING EXPENSES

     Operating expenses for the twelve month period ended December 31, 1995,
totaled $4,466,657 compared to $2,579,496 for the same twelve month period in
1994. The increase of approximately 73% or $1,887,161, can be attributed
primarily to increased payroll costs for personnel brought on to sustain the
growth of the Company as it emerged out of the development stage and to support
the increased demands of its current licensing and product operations.

     Payroll and Payroll Related Costs

          Payroll and payroll related costs showed increases throughout the
     Company as growth was experienced in all three departments (General &
     Administrative, Sales & Marketing and Research & Development). Salary and
     direct salary related costs increased by approximately 72% or $680,034, for
     a total of $1,623,790 for the twelve month period ended December 31, 1995,
     compared to $943,756 for the same twelve month period in 1994. At December
     31, 1994, the Company had 20 employees. By December 31, 1995, the staff
     size had grown to 29 employees.

          Of the three departments, Sales & Marketing had the largest increase
     of approximately 194% or $422,771, for a total of $640,854 for the twelve
     month period ended December 31, 1995, compared to $218,083 for the same
     twelve month period in 1994. The increase in Sales & Marketing can be
     attributed to the first full year of operations at the Mountain View, CA
     office which was leased in late 1994 and included the hiring of the Vice
     President of Sales and Marketing as well as additional sales staff. At
     December 31, 1994, this department had 5 employees. By December 31, 1995,
     this department had grown to 10 employees.

          General & Administrative increased approximately 48% or $211,205, for
     a total of $653,941 for the twelve month period ended December 31, 1995,
     compared to $442,736 for the same twelve month period in 1994. The increase
     in General & Administrative can be attributed to additional regulatory
     reporting requirements as well as administrative support for additional
     personnel throughout the Company. At December 31, 1994, there were 3
     employees in the Finance and Accounting department and 4 employees in the
     Administration and Investor Relations department for a total General and
     Administrative staff size of 7 employees. By December 31, 1995, both
     departments had grown to 5 employees for a total General and Administrative
     staff size of 10 employees.

          Research & Development had an increase of approximately 16% or
     $46,058, for a total of $328,995 for the twelve month period ended December
     31, 1995, compared to $282,937 for the same twelve month period in 1994.
     The increase can be attributed to a full year of operation at the Company's
     East Coast office which opened in late 1994 with an engineering staff hired
     to pursue research and development ideas aimed at improving existing
     products and creating new products and product concepts. At December 31,
     1994, this department had 8 employees. By December 31, 1995, this
     department had grown to 9 employees.

GENERAL AND ADMINISTRATIVE

     General and administrative expenses (less payroll and payroll related costs
discussed above, of $653,941 and $442,736 for the year ended December 31, 1995
and 1994 respectively) consisting primarily of professional and consulting fees,
investor relations, and other operating costs, increased by approximately 108%
or $927,759, for a total of $1,789,438 for the twelve month period ended
December 31, 1995, compared to $861,679 for the same twelve month period in
1994. The majority of this increase can be attributed to the expanding focus on
investor relations and legal fees incurred in connection with the registration
with the Securities and Exchange Commission ("SEC"), the NASDAQ listing, the
liquidation of Spatializer Audio Laboratories, Inc. -- Yukon and with patent
litigation costs.

                                       19
<PAGE>   21

     Professional Fees

          Legal fees increased approximately 94%, or $254,422, for a total of
     $523,773 for the twelve month period ended December 31, 1995, compared to
     $269,351 for the same twelve month period in 1994. This increase is
     attributed to fees incurred in connection with the following: the patent
     litigation filed in October 1994; filing requirements for the SEC related
     to the Company's August 1995 registration with the SEC and NASDAQ listing;
     fees incurred with private placements; trademark research; licensing
     negotiations; and the liquidation of Spatializer Audio Laboratories,
     Inc. -- Yukon.

     Outside Services and Consulting

          Outside services and consulting fees increased 448%, or $193,215, for
     a total of $236,327 for the twelve month period ended December 31, 1995,
     compared to $43,112 for the same twelve month period in 1994. These costs
     consist of personnel search fees associated with the hiring of additional
     employees, consulting fees associated with expanded corporate finance
     activities and payments to consultants and other personnel working on a
     part-time or special-project basis.

     Investor Relations Costs

          Investor relations costs increased approximately 58%, or $101,381, for
     a total of $275,443 for the twelve month period ended December 31, 1995,
     compared to $174,062 for the same twelve month period in 1994. The
     increased costs were incurred to accommodate increased interest in the
     Company and to keep the investment community informed of corporate
     developments.

     Other Operating Costs

          Other operating costs including rents, office supplies, travel and
     telephone increased by approximately 101%, or $378,741, for a total of
     $753,895 for the twelve month period ended December 31, 1995, compared to
     $375,154 for the same twelve month period in 1994. These costs reflect the
     increased costs of additional personnel and new office space leased in
     Woodland Hills, CA, during 1995.

RESEARCH AND DEVELOPMENT COSTS

     The Company incurs costs in the identification, validation and development
of new product ideas, and all such costs are expensed in the period incurred.
During the twelve month period ended December 31, 1995, Research & Development
expenditures increased as the Company had resources to allocate to this effort
and its understanding of market and product needs matured. These increased
efforts resulted in the design of three additional IC's which will be available
through foundries in the first quarter of 1996. In addition, several consumer
products were designed and will be brought to market over the first and second
quarters of 1996.

     Research and development expenses (less payroll and payroll related costs
discussed above, of $328,995 and $282,937 for the year ended December 31, 1995
and 1994 respectively) increased approximately 94%, or $142,079, for a total of
$293,489 for the twelve month period ended December 31, 1995, compared to
$151,410 for the same twelve month period in 1994. The increase can be
attributed to engineering costs incurred in research and prototype development
for new hardware and software products as well as the completion of development
on the Company's first consumer product, the HTMS-2510(TM), which was introduced
during the first quarter of 1996.

SALES AND MARKETING EXPENSES

     Sales and marketing expenses (less payroll and payroll related costs
discussed above, of $640,854 and $218,083 for the year ended December 31, 1995
and 1994 respectively) increased approximately 22%, or $137,289, for a total of
$759,940 for the twelve month period ended December 31, 1995, compared to
$622,651 for the same twelve month period in 1994. The increase is attributed to
public relations and publicity related to the development of an organized
advertising and promotional campaign directed at the consumer and computer
marketplaces. Efforts to achieve name brand recognition increased greatly in
1995 when the

                                       20
<PAGE>   22

first OEM products, incorporating the Spatializer IC, were introduced to US
markets. In addition, company and product information became available on the
Company's web site (http://www.spatializer.com).

NET LOSS

     The net loss for the twelve month period ended December 31, 1995, totaled
$3,241,285 or $(0.32) per share, compared to a net loss of $2,438,395 or $(0.32)
per share in the same twelve month period in 1994. The increase in the net loss
is attributed to the growth of the Company necessary to implement its current
licensing and product operations primarily related to added personnel and office
locations along with associated overhead. The increase in net loss can also be
attributed to research and development of new products, an expanding focus on
investor relations, legal fees and an organized advertising and promotional
campaign.

FOR THE FOUR-MONTH PERIODS ENDED DECEMBER 31, 1994 AND 1993

REVENUES

     Revenues include sales of professional recording systems and license issue
fees and royalties pertaining to the analog IC. Revenues of approximately
$187,000 for the four-month period ended December 31, 1994 reflect a substantial
increase over revenues of approximately $9,000 for the similar period in the
prior year. This increase can be primarily attributed to licensing revenues
derived from the IC which was first introduced in July 1994 and for which
revenues were first recorded in fiscal year ended August 31, 1994. Sales of the
professional systems to date have not varied by season. Licensing revenues to
date for the analog IC have not been sufficient to establish any pattern that
would determine seasonality in sales results.

OPERATING EXPENSES

GENERAL AND ADMINISTRATIVE

     General and administrative expenses, which consisted substantially of
professional and consulting fees, investor relations and payroll costs,
increased approximately 157%, or $374,000, from $238,000 for the four-month
period ended December 31, 1993 to $612,000 for the four-month period ended
December 31, 1994. This increase can be attributed to the hiring of additional
personnel, an expanding focus on investor relations and legal fees incurred in
connection with patent prosecution.

     General and Administrative Payroll

          Payroll costs rose approximately 58%, or $57,000, from $99,000 for the
     four-month period ended December 31, 1993 to $156,000 for the four-month
     period ended December 31, 1994. The increase can be attributed to the
     addition of administrative and finance personnel in late 1994 to assist
     with increased workload, to organize new product launches and to pursue new
     product ideas.

     Professional and Consulting Fees

          Legal fees increased approximately 198%, or $97,000, from $49,000 for
     the four-month period ended December 31, 1993 to $146,000 for the
     four-month period ended December 31, 1994. This increase can be attributed
     to fees incurred in late 1994 for private placement transactions, fees
     incurred in a patent infringement lawsuit filed in October 1994 and
     developing standard licensing agreements and finalizing terms of various
     licensing arrangements for the IC.

     Investor Relations Costs

          Investor relations costs increased $155,000 from $20,000 for the
     four-month period ended December 31, 1993 to $175,000 for the four-month
     period ended December 31, 1994. These costs were incurred to accommodate
     increased interest in the Company and to keep the investment community
     informed of corporate developments.

                                       21
<PAGE>   23

RESEARCH AND DEVELOPMENT

     The Company incurs costs in the identification, validation and development
of new product ideas, and all such costs are expensed in the period incurred.
Historically, research and development expenditures by the Company have been
limited by the lack of sufficient resources. The market for products is
characterized by continuing technological change. Management expects research
and development expenditures to increase in the future as resources permit.

     Research and development expenses increased approximately 58%, or $67,000,
from $116,000 for the four-month period ended December 31, 1993 to $183,000 for
the four-month period ended December 31, 1994. The increase can be attributed to
engineering costs incurred in the evaluation of development alternatives and
costs incurred in developing prototypes as the Company pursued the development
of several new products expected to be launched during 1995.

     Research and Development Payroll

          Payroll costs increased 36%, or $27,000, from $75,000 for the
     four-month period ended December 31, 1993 to $102,000 for the four-month
     period ended December 31, 1994. During the latter period, the Company
     opened a Licensing and Technical Support office on the East Coast and
     engineers were hired at this office to pursue research and development
     ideas aimed at improving existing products and creating prospects for new
     products.

     Prototyping Costs

          Prototyping costs increased approximately 258%, or $31,000, from
     $12,000 for the four-month period ended December 31, 1993 to $43,000 for
     the four-month period ended December 31, 1994. During the period ended
     December 1993, the Company's focus was on marketing the newly-introduced
     PRO Spatializer(R). During the period ended December 1994, the Company was
     focused on the evaluation of development alternatives and costs were
     incurred in developing prototypes of potential new products.

SALES AND MARKETING

     Sales and marketing expenses increased approximately 213%, or $370,000,
from $174,000 for the four-month period ended December 31, 1993 to $544,000 for
the four-month period ended December 31, 1994. In 1994, the Company increased
its sales and licensing efforts in anticipation of the commercial availability
of the MEC IC and in anticipation of the introduction of OEM products
incorporating the MEC IC. Costs included those associated with the opening of a
sales office in the Silicon Valley area, attendance at trade shows and a new
advertising campaign.

     Sales and Marketing Payroll

          Payroll costs for sales and marketing increased approximately 163%, or
     $83,000, from $51,000 for the four-month period ended December 31, 1993 to
     $134,000 for the four-month period ended December 31, 1994. The increase
     was attributable to the opening of the sales office in the Silicon Valley,
     a growing sales effort and personnel costs, and the hiring of a Vice
     President of Sales and Marketing.

     Advertising and Promotional Costs

          Costs of sales and marketing increased substantially from $7,000 for
     the four-month period ended December 31, 1993 to $65,000 for the four-month
     period ended December 31, 1994. The increase can be attributed to the
     development of a significant advertising and promotional campaign directed
     at the consumer and computer marketplaces, including retaining an
     advertising agency specializing in these markets.

                                       22
<PAGE>   24

     Trade Show Costs

          Trade show costs increased significantly from $16,000 for the
     four-month period ended December 31, 1993 to $207,000 for the four-month
     period ended December 31, 1994 and were applied principally to marketing
     the IC, particularly at trade shows directed to the computer and consumer
     electronics marketplaces.

LIQUIDITY AND CAPITAL RESOURCES

     At December 31, 1996, the Company had $1,587,000 in cash and cash
equivalents as compared to $3,113,000 at December 31, 1995. The decrease in cash
and cash equivalents is attributed to cash used for the MDT acquisition of
assets, cash used in operating activities, the purchase of fixed assets and the
retirement of a portion of the related party advances offset by cash received
from operations and common stock issuances, including private placements,
warrant and option exercises. The Company had working capital of $2,092,000 at
December 31, 1996 as compared with $3,159,000 at December 31, 1995. The
Company's future cash flow from operations will come primarily from Foundry and
OEM royalties. At December 31, 1996 the Company had three Foundry licensees and
forty-eight OEM Licensees as compared with three Foundry Licensees and
twenty-four OEM Licensees at December 31, 1995.

     The Company continues to have no long-term debt and has no present
commitments or agreements which would require any long-term debt to be incurred.
The Company owed $112,500 to related parties as of December 31, 1996 as compared
to $325,061 at December 31, 1995.

     During the first quarter 1997, the Company raised $2,000,000 through a
private placement of 1,600,000 units in the Company consisting of a share of
common stock and one-half of one non-transferable share purchase warrant. The
proceeds of the financing is currently expected to be utilized to finance the
Company's research and development activities in its MultiDisc Technologies
("MDT") business unit and for working capital reserves. However, such proceeds
may be used at the Company's discretion to fund working capital needs or other
obligations as they come due. In addition, the Company has the ability to
curtail certain activities including, but not limited to, MDT related research
and development, if necessary in order to meet its commitments. The Company also
agreed to modify certain outstanding one year warrants to purchase 155,000
shares of stock issued in May and June, 1996 by adjusting the exercise price to
an amount consistent with the current market price of the Company's stock ($1.75
US) and by adjusting the shares under warrant to 310,000 shares. Funds generated
by these financing activities as well as cash generated from operations is
expected to be sufficient for the Company to meet its obligations during the
next twelve months. However, additional sources of financing including debt,
equity or strategic investments may be required to fund capital expenditures,
acquisitions, research and development and marketing costs related to such
activities.

NET OPERATING LOSSES

     At December 31, 1996, the Company had $35,100,000 in net operating loss
carryforwards for financial reporting purposes and $15,400,000 for income tax
purposes. The Company's ability to utilize approximately $900,000 of these tax
losses which accrued during 1994 against future income may be restricted as a
result of the change in year-ends to December 31, 1994. The net operating loss
carryforwards expire through 2011.

INFLATION

     The Company believes that the moderate inflation rate of the 1990's has not
impacted its operations.

                                       23
<PAGE>   25

ITEM 8.  FINANCIAL STATEMENTS

                          INDEPENDENT AUDITORS' REPORT

The Board of Directors and Stockholders
Spatializer Audio Laboratories, Inc.:

     We have audited the consolidated balance sheets of Spatializer Audio
Laboratories, Inc. and subsidiaries as of December 31, 1996 and 1995, and the
related consolidated statements of operations, shareholders' equity, and cash
flows for the years ended December 31, 1996 and 1995, the four-month period
ended December 31, 1994, and the year ended August 31, 1994. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.

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

     In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Spatializer
Audio Laboratories, Inc. and subsidiaries as of December 31, 1996 and 1995, and
the results of their operations and their cash flows for the years ended
December 31, 1996 and 1995, the four-month period ended December 31, 1994 and
the year ended August 31, 1994, in conformity with generally accepted accounting
principles.

                                          KPMG PEAT MARWICK LLP

Los Angeles, California
February 21, 1997, except for Note 15,
which is as of March 7, 1997

                                       24
<PAGE>   26

                      SPATIALIZER AUDIO LABORATORIES, INC.
                                AND SUBSIDIARIES

                          CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                  DECEMBER 31,     DECEMBER 31,
                                                                      1996             1995
                                                                  ------------     ------------
<S>                                                               <C>              <C>
ASSETS
Current Assets:
  Cash and Cash Equivalents.....................................  $  1,587,395     $  3,113,057
  Accounts Receivables, net of allowance for doubtful accounts
     of $90,000 at December 31, 1996............................       820,856          412,010
  Inventory.....................................................       296,539          262,131
  Prepaid Expenses and Deposits.................................       260,984           94,068
                                                                   -----------      -----------
          Total Current Assets..................................     2,965,774        3,881,266
Fixed Assets, Net (Note 3)......................................       622,856          294,803
Intangible Assets, Net (Note 4).................................       451,733          243,532
Other Assets....................................................       100,832               --
                                                                   -----------      -----------
                                                                  $  4,141,195     $  4,419,601
                                                                   ===========      ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities:
  Accounts Payable..............................................  $    403,870     $    180,046
  Accrued Liabilities...........................................       333,152          203,530
  Advances from Related Parties (Note 5)........................       112,500          325,061
  Notes Payable.................................................        23,800           13,493
                                                                   -----------      -----------
          Total Current Liabilities.............................       873,322          722,130
                                                                   -----------      -----------
Shareholders' Equity:
  Preferred shares, $.01 par value, 1,000,000 shares authorized,
     no shares issued or outstanding............................            --               --
  Common shares, $.01 par value, 50,000,000 shares authorized,
     19,115,429 and 17,457,531 shares issued and outstanding at
     December 31, 1996 and 1995 respectively (Note 7)...........       191,154          174,575
  Additional Paid-In Capital....................................    38,527,775       13,578,782
  Accumulated Deficit...........................................   (35,451,056)     (10,055,886)
                                                                   -----------      -----------
          Total Shareholders' Equity............................     3,267,873        3,697,471
                                                                   -----------      -----------
                                                                  $  4,141,195     $  4,419,601
                                                                   ===========      ===========
</TABLE>

          See accompanying notes to consolidated financial statements

                                       25
<PAGE>   27

                      SPATIALIZER AUDIO LABORATORIES, INC.
                                AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                YEAR ENDED               FOUR MONTH
                                       ----------------------------      TRANSITION
                                                         DECEMBER       PERIOD ENDED     YEAR ENDED
                                       DECEMBER 31,         31,         DECEMBER 31,     AUGUST 31,
                                           1996            1995             1994            1994
                                       ------------     -----------     ------------     -----------
<S>                                    <C>              <C>             <C>              <C>
Revenues:
  Product Revenues...................  $    336,849     $    63,507     $     37,403     $    64,741
  Licensing Revenues.................     1,687,338       1,166,713          150,005          75,584
                                       ------------     -----------      -----------     -----------
                                          2,024,187       1,230,220          187,408         140,325
  Cost of Revenues...................       185,540          78,854           25,196          61,433
                                       ------------     -----------      -----------     -----------
                                          1,838,647       1,151,366          162,212          78,892
                                       ------------     -----------      -----------     -----------
Operating Expenses:
  General and Administrative.........     2,329,333       2,380,472          612,226         968,090
  Research and Development...........     1,860,400         622,484          182,557         363,257
  Sales and Marketing................     1,954,527       1,400,794          544,264         476,391
  Compensation Expense (Note 8)......    20,218,450              --               --              --
  In-Process Research & Development
     (Note 9)........................       679,684              --               --              --
                                       ------------     -----------      -----------     -----------
                                         27,042,394       4,403,750        1,339,047       1,807,738
                                       ------------     -----------      -----------     -----------
     Operating Loss..................   (25,203,747)     (3,252,384)      (1,176,835)     (1,728,846)
Interest Income......................       132,883         113,701           20,192           7,647
Interest Expense.....................       (13,769)        (39,695)         (36,618)        (87,188)
                                       ------------     -----------      -----------     -----------
                                            119,114          74,006          (16,426)        (79,541)
                                       ------------     -----------      -----------     -----------
Loss Before Income Taxes.............   (25,084,633)     (3,178,378)      (1,193,261)     (1,808,387)
Income Taxes (Note 10)...............      (310,537)        (62,907)              --              --
                                       ------------     -----------      -----------     -----------
     Net Loss........................  $(25,395,170)    $(3,241,285)    $ (1,193,261)    $(1,808,387)
                                       ============     ===========      ===========     ===========
     Net Loss Per Common Share.......  $      (2.01)    $     (0.32)    $      (0.14)    $     (0.26)
                                       ============     ===========      ===========     ===========
Weighted Average Common Shares
  Outstanding........................    12,644,751      10,156,816        8,552,535       6,891,546
                                       ============     ===========      ===========     ===========
</TABLE>

          See accompanying notes to consolidated financial statements

                                       26
<PAGE>   28

                      SPATIALIZER AUDIO LABORATORIES, INC.
                                AND SUBSIDIARIES

                     CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                                   FOUR MONTH
                                                         YEAR ENDED                TRANSITION
                                                -----------------------------        PERIOD        YEAR ENDED
                                                DECEMBER 31,     DECEMBER 31,     DECEMBER 31,     AUGUST 31,
                                                    1996             1995             1994            1994
                                                ------------     ------------     ------------     -----------
<S>                                             <C>              <C>              <C>              <C>
Cash Flows from Operating Activities:
  Net Loss....................................  $(25,395,170)    $ (3,241,285)    $ (1,193,261)    $(1,808,387)
  Adjustments to reconcile net income to net
     cash provided by operating activities:
     Depreciation and Amortization............       130,057           79,719           20,201          73,600
     Compensation Expense (Note 8)............    20,218,450               --               --              --
     In-Process Research and Development (Note
       9).....................................       679,684               --               --              --
  Net Change in Assets and Liabilities:
     Accounts Receivable......................      (408,846)        (319,604)         240,442        (307,184)
     Inventory................................       (34,408)         (22,419)          16,487         (61,164)
     Prepaid Expenses and Deposits............      (166,916)         (31,814)         (36,661)        (20,066)
     Accounts Payable.........................       223,824          (73,885)          44,472          74,323
     Accrued Liabilities......................       129,622           35,305           92,094          72,696
     Other Assets.............................      (100,832)              --               --              --
                                                ------------      -----------      -----------     -----------
Net Cash Used in Operating Activities.........    (4,724,535)      (3,573,983)        (816,226)     (1,976,182)
                                                ------------      -----------      -----------     -----------
Cash Flows from Financing Activities:
  Issuance of Common Shares...................     4,747,122        5,572,142        1,493,725       2,008,386
  Subscriptions Advance.......................            --               --               --       1,556,000
  Repayment of Subscription Loan..............            --               --         (778,000)             --
  Due to Related Parties......................      (212,561)        (192,221)         (21,818)        106,306
  Issuance of Notes Payable...................        26,213               --            5,105           7,751
  Repayments of Notes Payable.................       (15,907)             972             (198)       (291,958)
                                                ------------      -----------      -----------     -----------
Net Cash Provided by Financing Activities.....     4,544,867        5,380,893          698,814       3,386,485
                                                ------------      -----------      -----------     -----------
Cash Flows from Investing Activities:
  Purchase of Fixed Assets....................      (240,720)        (164,175)        (116,998)        (33,327)
  Increase in Intangible Assets...............       (43,118)         (69,544)          (5,200)       (116,044)
  MDT Asset Acquisition (Note 9)..............    (1,062,156)              --               --              --
                                                ------------      -----------      -----------     -----------
Net Cash Used in Investing Activities.........    (1,345,994)        (233,719)        (122,198)       (149,371)
                                                ------------      -----------      -----------     -----------
Foreign Exchange Adjustment...................            --               98               --          18,946
                                                ------------      -----------      -----------     -----------
Increase (Decrease) in Cash and Cash
  Equivalents.................................    (1,525,662)       1,573,289         (239,610)      1,279,878
Cash and Cash Equivalents, Beginning of
  Period......................................     3,113,057        1,539,768        1,779,378         499,500
                                                ------------      -----------      -----------     -----------
Cash and Cash Equivalents, End of Period......  $  1,587,395     $  3,113,057     $  1,539,768     $ 1,779,378
                                                ============      ===========      ===========     ===========
Supplemental Disclosure of Cash Flow
  Information:
  Cash paid during the period for:
     Interest.................................  $      1,639     $     39,695     $     34,564     $    67,463
     Income Taxes (Note 10)...................  $    310,729     $        800     $        800     $       800
</TABLE>

          See accompanying notes to consolidated financial statements

                                       27
<PAGE>   29

                      SPATIALIZER AUDIO LABORATORIES, INC.
                                AND SUBSIDIARIES

                 CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                               COMMON SHARES
                                  ----------------------------------------                      TOTAL
                                  NUMBER OF                  ADDITIONAL      ACCUMULATED    SHAREHOLDERS'
                                    SHARES     PAR VALUE   PAID-IN-CAPITAL     DEFICIT         EQUITY
                                  ----------   ---------   ---------------   ------------   -------------
<S>                               <C>          <C>         <C>               <C>            <C>
Balance, August 31, 1993........  11,378,674   $ 113,787     $ 3,787,317     $ (3,831,997)  $      69,107
Issuance of Shares in Connection
  with an Acquisition of
  Technology....................   1,000,000      10,000          44,890               --          54,890
Extension of Loan...............      16,405         164          19,561               --          19,725
Options Exercised (Note 12).....      40,000         400          40,236               --          40,636
Warrants Exercised (Note 12)....     942,917       9,429       1,205,469               --       1,214,898
Private Placements, Net (Note
  7)............................     600,000       6,000         672,237               --         678,237
Net Loss........................          --          --              --       (1,789,441)     (1,789,441)
                                  ----------    --------     -----------     ------------    ------------
Balance, August 31, 1994........  13,977,996     139,780       5,769,710       (5,621,438)        288,052
Options Exercised (Note 12).....      25,000         250          23,028               --          23,278
Warrants Exercised (Note 12)....      25,000         250          38,149               --          38,399
Private Placements, Net (Note
  7)............................     950,000       9,500       2,200,548               --       2,210,048
Net Loss........................          --          --              --       (1,193,261)     (1,193,261)
                                  ----------    --------     -----------     ------------    ------------
Balance, December 31, 1994......  14,977,996     149,780       8,031,435       (6,814,699)      1,366,516
Issuance of Shares for Debt.....      10,000         100           8,483               --           8,583
Options Exercised (Note 12).....     220,500       2,205         258,360               --         260,565
Warrants Exercised (Note 12)....     197,500       1,975         477,092               --         479,067
Private Placements, Net (Note
  7)............................   2,051,535      20,515       4,803,412               --       4,823,927
Net Loss........................          --          --              --       (3,241,187)     (3,241,187)
                                  ----------    --------     -----------     ------------    ------------
Balance, December 31, 1995......  17,457,531     174,575      13,578,782      (10,055,886)      3,697,471
Options Exercised (Note 12).....     363,033       3,630         383,905               --         387,535
Warrants Exercised (Note 12)....     646,000       6,460       1,704,127               --       1,710,587
Private Placements, Net (Note
  7)............................     648,865       6,489       2,642,511               --       2,649,000
Performance Shares (Note 8).....          --          --      20,218,450               --      20,218,450
Net Loss........................          --          --              --      (25,395,170)    (25,395,170)
                                  ----------    --------     -----------     ------------    ------------
Balance, December 31, 1996......  19,115,429   $ 191,154     $38,527,775     $(35,451,056)  $   3,267,873
                                  ==========    ========     ===========     ============    ============
</TABLE>

          See accompanying notes to consolidated financial statements

                                       28
<PAGE>   30

                      SPATIALIZER AUDIO LABORATORIES, INC.
                                AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(1) NATURE OF BUSINESS

     Spatializer Audio Laboratories, Inc. and subsidiaries (the "Company") is in
the business of technology development and licensing.

     The Company's wholly owned subsidiary Desper Products, Inc. ("DPI") is in
the business of developing proprietary advanced audio signal processing
technologies and products for consumer electronics, entertainment, and
multimedia computing.

     The Company's wholly owned subsidiary, MultiDisc Technologies, Inc. ("MDT")
is in the business of developing scaleable, modular compact disc/DVD server
technologies for licensing. Currently the development focus is on technologies
associated with a network based compact disc/DVD server for internet and
intranet applications.

     On December 5, 1995 the Board of Directors of the Company authorized the
liquidation of Spatializer Audio Laboratories, Inc. -- Yukon pursuant to S.213
of the Business Corporations Act (Yukon). This action was taken to minimize the
tax consequences to the Company. The liquidation was completed during the first
quarter of 1996.

(2) SIGNIFICANT ACCOUNTING POLICIES

  Basis of Presentation

     These consolidated financial statements are prepared in accordance with
generally accepted accounting principles in the United States.

     During the third quarter of 1995 the Company emerged from a development
stage enterprise.

  Change in Fiscal Year

     On December 13, 1994, the Board of Directors approved a change in the
Company's year from a fiscal year end of August 31 to a fiscal year end of
December 31. The consolidated financial statements include presentation of the
transition period beginning on September 1, 1994, and ending on December 31,
1994.

  Basis of Consolidation

     The consolidated financial statements include the accounts of Spatializer
Audio Laboratories, Inc. and its wholly owned subsidiaries, Desper Products,
Inc. and MultiDisc Technologies, Inc. All material inter-company transactions
have been eliminated.

  Revenue Recognition

     The Company recognizes revenue from product sales upon shipment to the
customer. The Company recognizes revenue from licensing agreements when earned,
in accordance with the contractual arrangements.

  Currency

     The operations of the Company take place primarily in the United States and
all financial reporting is in U.S. Dollars.

  Cash and Cash Equivalents

     Cash equivalents consist of highly liquid investments with original
maturities of three months or less.

                                       29
<PAGE>   31

                      SPATIALIZER AUDIO LABORATORIES, INC.
                                AND SUBSIDIARIES

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

  Inventory

     Inventory, which consists primarily of finished goods, is stated at the
lower of cost (first-in, first-out) or market.

  Research and Development Expenditures

     The Company expenses research and development expenditures as incurred.

  Fixed Assets

     Fixed assets are carried at cost and are depreciated over five to seven
years using accelerated-depreciation methods, which approximates 150% declining
balance. Leasehold improvements are amortized over the shorter of the useful
life or lease term.

  Intangible Assets

     Intangible assets consist of patent costs which are amortized on a
straight-line basis over the estimated useful lives of the patents which range
from five to ten years.

  Loss per Share

     Loss per share has been calculated based on the weighted average number of
common shares outstanding including escrowed performance shares, which are
factored into the calculation as of December 30, 1996 (Note 8). Common stock
equivalents have not been included in the calculation of primary loss per share
for all periods as the effect of including such securities would be
antidilutive.

  Stock Option Plan

     Prior to January 1, 1996 the Company accounted for its stock option plan in
accordance with the provisions of Accounting Principles Board ("APB") Opinion
No. 25, Accounting for Stock Issued to Employees, and related interpretations.
As such, compensation expense would be recorded on the date of grant only if the
current market price of the underlying stock exceeded the exercise price. On
January 1, 1996, the Company adopted SFAS No. 123, Accounting for Stock-Based
Compensation, which permits entities to recognize as expense over the vesting
period the fair value of all employee stock-based awards on the date of grant.
Alternatively, SFAS No. 123 also allows entities to continue to apply the
provisions of APB Opinion No. 25 and provide pro forma net income (loss) and pro
forma earnings (loss) per share disclosures for employee stock option grants
made in 1996 and future years as if the fair-value-based method defined in SFAS
No. 123 has been applied. The Company has elected to continue to apply the
provisions of APB Opinion No. 25 and provide the pro forma disclosure provisions
of SFAS No. 123 (Note 14).

  Impairment of Long-Lived Assets and Assets to be Disposed of

     The Company adopted the provisions of SFAS No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, on
January 1, 1996. This Statement requires that long-lived assets and certain
identifiable intangibles be reviewed for impairment whenever events or changes
in circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future net cash flows expected
to be generated by the asset. If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount by which the carrying
amount of the assets exceed the fair value of the assets. Assets to be disposed
of are reported at the lower of the carrying amount or fair value less costs to
sell.

                                       30
<PAGE>   32

                      SPATIALIZER AUDIO LABORATORIES, INC.
                                AND SUBSIDIARIES

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Adoption of this Statement did not have a material impact on the Company's
financial position, results of operations, or liquidity.

  Use of Estimates

     Management of the Company has made a number of estimates and assumptions
relating to the reporting of assets and liabilities and the disclosure of
contingent assets and liabilities to prepare these financial statements in
conformity with generally accepted accounting principles. Actual results could
differ from those estimates.

  Reclassifications

     Certain amounts have been reclassified to conform with 1996 presentation.

(3) FIXED ASSETS

     Fixed assets, at cost, as of December 31, 1996 and 1995 consist of the
following:

<TABLE>
<CAPTION>
                                                                       1996         1995
                                                                     --------     --------
    <S>                                                              <C>          <C>
    Office Computers, Software, Equipment and Furniture............  $595,993     $237,287
    Test Equipment.................................................    97,928       60,895
    Tooling Equipment..............................................    44,136       25,000
    Trade Show Booth and Demonstration Equipment...................   130,846      144,369
    Leasehold Improvements.........................................    45,756       23,916
                                                                     --------     --------
                                                                      914,659      491,467
    Less Accumulated Depreciation and Amortization.................   291,803      196,664
                                                                     --------     --------
                                                                     $622,856     $294,803
                                                                     ========     ========
</TABLE>

(4) INTANGIBLE ASSETS

     Intangible assets, as of December 31, 1996 and 1995 consist of the
following:

<TABLE>
<CAPTION>
                                                                       1996         1995
                                                                     --------     --------
    <S>                                                              <C>          <C>
    Capitalized patent and technology costs........................  $309,222     $266,104
    Capitalized patent costs in association with MDT Asset
      Acquisition (Note 9).........................................   200,000           --
                                                                     --------     --------
                                                                      509,222      266,104
    Less Accumulated Amortization..................................    57,489       22,572
                                                                     --------     --------
                                                                     $451,733     $243,532
                                                                     ========     ========
</TABLE>

(5) ADVANCES FROM RELATED PARTIES

     The Company was indebted to certain related parties for amounts totaling
$112,500 and $325,061 at December 31, 1996 and 1995, respectively, which
includes accrued interest. Amounts bear interest at rates ranging from a fixed
10% annually to prime plus 2% and are due on demand.

                                       31
<PAGE>   33

                      SPATIALIZER AUDIO LABORATORIES, INC.
                                AND SUBSIDIARIES

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

(6) FINANCIAL INSTRUMENTS

     The carrying values of cash and cash equivalents, accounts receivable,
prepaid expenses and deposits, accounts payable and accrued liabilities at
December 31, 1996 and 1995 approximated fair value due to the short maturity of
those investments.

     The fair values of the advances from related parties could not be estimated
due to the nature of the investments.

     The fair values of notes payable at December 31, 1996 and 1995 are
materially consistent with the related carrying values based on current rates
offered to the Company for instruments with similar maturities.

(7) SHAREHOLDERS' EQUITY

  During the year ended August 31, 1994, shares were issued or converted as
follows:

     In November of 1993, the Company exercised the put option granted to it in
1992 and issued 1,000,000 escrowed performance common shares (upon receipt of
par value Cdn. $.01 per share) in exchange for all of the outstanding Class C
common shares of DPI, originally issued in exchange for certain technology
rights.

     In November of 1993, all holders of outstanding escrowed performance
non-voting shares elected to exercise their rights provided in the Articles of
Incorporation/Continuance to convert such shares into an equal number of
escrowed performance common shares.

     In January 1994, the Company completed a private placement of 100,000 units
at a price of Cdn. $1.83 per unit, each unit comprised of one common share and
one-half of one non-transferable share purchase warrant. One warrant entitles
the holder to purchase one additional share at a price of Cdn. $2.15 per share
on or before January 4, 1995. These warrants were exercised during the year
ended August 31, 1994. Additional warrants for the purchase of 25,000 shares at
a price of Cdn. $2.15 per share were accrued ratably over a five month period,
ending November 17, 1994, pending the implementation of a shareholder offering
under a contemplated SMF committed to by the Company in connection with this
placement. These additional warrants, which were to expire on January 4, 1995,
were exercised and issued in December, 1994.

     During the year ended August 31, 1994, the Company issued 16,405 shares as
compensation for the extension of the maturity date on an amount borrowed from a
shareholder in March of 1994 and repaid during the year ended August 31, 1994.

     In April 1994, the Company completed a private placement of 500,000 units
at a price of Cdn. $1.50 per unit, each unit comprised of one common share and
one non-transferable share purchase warrant. One warrant entitles the holder to
purchase one additional share at a price of Cdn. $1.60 per share on or before
April 20, 1995. These warrants were exercised during the year ended August 31,
1994.

     During the four-month period ended December 31, 1994, shares were issued or
converted as follows:

     In November 1994, the Company completed a private placement of 650,000
units at a price of Cdn. $3.20 per unit, each unit comprised of one common share
and one-half of one non-transferable share purchase warrant. One warrant
entitles the holder to purchase one additional common share at a price of Cdn.
$3.20 on or before November 2, 1995 and after that date at a price of Cdn. $3.70
on or before November 2, 1996.

     In December 1994, the Company completed a private placement of 300,000
units at a price of Cdn. $3.60 per unit, each unit comprised of one common share
and 55% of one non-transferable share purchase warrant. One warrant entitles the
holder to purchase one additional common share at a price of Cdn. $3.60 on or
before August 5, 1995, and after that date at a price of Cdn. $4.15 on or before
August 5, 1996.

                                       32
<PAGE>   34

                      SPATIALIZER AUDIO LABORATORIES, INC.
                                AND SUBSIDIARIES

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     During the year ended December 31, 1995, shares were issued or converted as
follows:

     In August 1995, the Company completed a private placement of 100,000 units
at a price of Cdn. $3.25 (US $2.33) per unit, each unit comprised of one common
share and one-quarter of one non-transferable share purchase warrant. The
Company received Cdn. $325,000 (US $232,772) upon completion of this placement.
One warrant entitles the holder to purchase one additional share at a price of
Cdn. $3.25 (US $2.33) on or before May 2, 1996, and after that date at a price
of Cdn. $3.75 (US $2.69) on or before May 2, 1997.

     In August 1995, the Company completed a private placement of 1,200,000
units at a price of Cdn. $3.30 (US $2.40) per unit, each unit comprised of one
common share and one-quarter of one non-transferable share purchase warrant. The
Company received Cdn. $3,960,000 (US $2,876,101) upon completion of this
placement. One warrant entitles the holder to purchase one additional share at a
price of Cdn. $3.30 (US $2.40) on or before May 19, 1996, and after that date at
a price of Cdn. $3.80 (US $2.76) on or before May 19, 1997.

     In August 1995, the Company completed a private placement of 350,000 units
at a price of Cdn. $3.45 (US $2.50) per unit, each unit comprised of one common
share and one-quarter of one non-transferable share purchase warrant. The
Company received Cdn. $1,207,500 (US $876,405) upon completion of this
placement. One warrant entitles the holder to purchase one additional share at a
price of Cdn. $3.45 (US $2.50) on or before June 9, 1996, and after that date at
a price of Cdn. $4.00 (US $2.90) on or before June 9, 1997.

     Also in August 1995, the Company completed a private placement of 300,000
units at a price of Cdn. $3.85 (US $2.80) per unit, each unit comprised of one
common share and one-quarter of one non-transferable share purchase warrant. The
Company received Cdn. $1,155,000 (US $838,649) upon completion of this
placement. One warrant entitles the holder to purchase one additional share at a
price of Cdn. $3.85 (US $2.80) on or before June 23, 1996 and after that date at
a price of Cdn. $4.50 (US $3.27) on or before June 23, 1997.

     In relation to the private placements of the Company's stock during 1995,
finders fees for such placements were paid through the issuance of 101,535
shares of stock.

     During the year ended December 31, 1996, shares were issued or converted as
follows:

     In May 1996, the Company completed a private placement of 200,000 units at
a price of $4.25 U.S. per unit, each unit comprised of one common share and
one-quarter of one non-transferable share purchase warrant. One warrant entitles
the holder to purchase one additional share at a price of $4.75 U.S. on or
before May 9, 1997. Regulatory approval was received in July 1996 from the
Vancouver Stock Exchange ("VSE").

     Also in May 1996, the Company completed a private placement of 280,000
units at a price of $4.25 U.S. per unit, each unit comprised of one common share
and one-quarter of one non-transferable share purchase warrant. One warrant
entitles the holder to purchase one additional share at a price of $4.75 U.S. on
or before May 31, 1997. Regulatory approval was received in July 1996 from the
VSE.

     In June 1996, the Company completed a private placement of 140,000 units at
a price of $4.35 U.S. per unit, each unit comprised of one common share and
one-quarter of one non-transferable share purchase warrant. One warrant entitles
the holder to purchase one additional share at a price of $5.12 U.S. on or
before June 17, 1997. Regulatory approval was received in August 1996 from the
VSE.

     For the year ended December 31, 1996, funds related to private placements
totaling $2,649,000 had been received by the Company and included in cash and
cash equivalents.

                                       33
<PAGE>   35

                      SPATIALIZER AUDIO LABORATORIES, INC.
                                AND SUBSIDIARIES

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     In relation to the private placements of the Company's stock during 1996,
finders fees for such placements were paid through the issuance of 28,865 shares
of stock.

(8) ESCROW PERFORMANCE SHARES

     In December 1996, the Company accepted the terms outlined by the British
Columbia Securities Commissions ("BCSC") for the release of the Company's
5,776,700 escrowed "Performance Shares" from Canadian Escrow into a new escrow
arrangement with the Company. The overall modification was approved by the
Company's shareholders in August 1996. Under the revised arrangement, the
performance shares will be released automatically as follows: 5% on June 22,
1997; 5% on June 22, 1998; 10% on June 22, 1999; 20% on June 22, 2000; 30% on
June 22, 2001; and 30% on June 22, 2002. In addition to the automatic releases,
performance shares can be released based on the cash flow release criteria
contained in the original June 22, 1992 escrow agreement although, to maintain a
stable market in the Company's stock, in any year not more than 30% of the
shares will be released, based on the cash flow criteria.

     Under the revised escrow arrangement, the performance shares will vest
provided the individual has not voluntarily terminated his/her relationship with
the Company prior to applicable vesting dates.

     Based on the revised escrow arrangement, which primarily converts the
escrow shares release from performance criteria to a time-based criteria, the
Company recorded as compensation expense the excess of the fair market value of
the 5,776,700 performance shares on the date the Company accepted the terms of
the new escrow arrangement over the purchase price of such escrow shares.

     All of the performance shares are included in the issued and outstanding
shares for the twelve-month periods ended December 31, 1996, and 1995.

     For financial reporting purposes, such shares were treated as issued and
outstanding but were not reflected in the calculation of loss per common share
until earned by and released to the holders as they would be antidilutive. At
December 31, 1995, no performance shares had been earned out. At December 31,
1996 these shares are included in the calculation of loss per common share
beginning December 30, 1996, the date on which the Company and the BCSC accepted
and entered into the terms of the current escrowed agreement as discussed above.

(9) ASSET ACQUISITION

     In June 1996, the Company purchased certain assets from Home Theater
Products International, Inc. ("HTP"), a debtor in possession, for $1,062,156,
including acquisition costs. Of the purchase price, $679,684 was allocated to
In-Process Research & Development ("IPR&D") and expensed at the Closing. IPR&D
is defined as those research and development efforts that, as of the acquisition
date, June 24, 1996, have not yet generated commercializable products and thus
the revenue generating capability of the products is uncertain. At the date of
acquisition there were no existing products acquired. IPR&D represents 64% of
the total acquisition costs. The remaining 36% was allocated as follows:
approximately $200,000 to intangible assets, primarily representing acquired
patent applications, and approximately $182,000 to fixed assets, including
computers, office equipment, and furniture. The Company had not begun amortizing
the intangible assets purchased since the patents had not been approved as of
December 31, 1996.

                                       34
<PAGE>   36

                      SPATIALIZER AUDIO LABORATORIES, INC.
                                AND SUBSIDIARIES

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

(10) INCOME TAXES

     Spatializer Audio Laboratories, Inc. and subsidiaries (the "Company") file
on a consolidated basis for U.S. income tax purposes. As of December 31, 1996,
the Company had net operating loss carryforwards of approximately $35,100,000
for financial reporting and $15,400,000 for federal income tax purposes. The
Company's ability to utilize approximately $900,000 of the tax losses accrued
during 1994 against future income may be restricted as a result of a change in
year-end to December 31, 1994. The difference between the financial reporting
and the federal income tax net operating loss carryforwards result from the
recognition of certain expense items, primarily from compensation expense for
escrowed performance shares (see Note 8) and from the exercise of non-qualified
stock options, in different periods for financial and tax reporting purposes. In
addition, the Company has foreign tax and general business credit carryforwards
of $121,000 and $87,000, respectively. The net operating loss carryforwards
expire through 2011.

     Any deferred tax asset relating to the operating loss and credit
carryforwards or any other deferred tax asset has been fully offset by a
valuation allowance. Accordingly, no income tax benefit has been recorded.

     Based upon the level of historical losses incurred by the Company,
management believes that it is more likely than not that the Company will not
realize the benefits of the deferred tax assets. Thus, any deferred tax asset
relating to the non-capital tax losses, operating loss carryforwards, or any
other deferred tax asset, has been fully reserved by a valuation allowance.
Accordingly, no income tax benefit has been recorded.

     The Company completed the liquidation of Spatializer-Yukon, a Canadian
subsidiary in early 1996. The liquidation resulted in a Canadian tax liability
of approximately $249,000. In addition, the Company recognized approximately
$3,000 in minimum tax for state purposes.

     Revenues received from customers in foreign countries are sometimes subject
to withholding taxes that are deducted from outgoing funds at time of payment.
These taxes range from approximately 8.5% to 15% and are recorded as Foreign Tax
Expense at the time of deduction from the Company's cash receipts.

(11) MAJOR CUSTOMERS

     The revenues for the year ended December 31, 1996 include revenues from
four major customers each of whom represent 25%, 24%, 14%, and 12%,
respectively, of total revenues. The revenues for the year ended December 31,
1995 include revenues from three major customers each of whom represent 29%,
13%, and 12%, respectively, of total revenues.

(12) OPTIONS AND WARRANTS

     The Company has issued options to purchase common stock to certain
directors, officers and employees under various stock option plans. The option
and warrant exercise prices represent fair market values at the dates of grant.

                                       35
<PAGE>   37

                      SPATIALIZER AUDIO LABORATORIES, INC.
                                AND SUBSIDIARIES

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     Transactions in the stock options under these plans are summarized as
follows:

<TABLE>
<CAPTION>
            STOCK OPTIONS                  SHARES                    OPTION PRICE
--------------------------------------    ---------     --------------------------------------
<S>                                       <C>           <C>
Options Issued During the Year Ended
  and Outstanding at August 31,
  1993................................    1,050,000     Cdn. $1.20 - Cdn. $2.02 (U.S.
                                                        $.86 - U.S. $1.44) per Share expiring
                                                        various dates July 1997 to July 1998
Options Exercised.....................      (40,000)    Cdn. $1.20 - Cdn. $2.02 (U.S.
                                                        $.87 - U.S. $1.46) per Share
                                          ---------
Options Outstanding at August 31,
  1994................................    1,010,000     Cdn. $1.20 - Cdn. $2.02 (U.S.
                                                        $.87 - U.S. $1.20) per Share expiring
                                                        on various dates, July 1997 to July
                                                        1998
Options Issued........................       85,000     Cdn. $3.10 (US $2.25) per Share
Options Exercised.....................      (25,000)    Cdn. $1.20 (US $.93) per Share
                                          ---------
Options Outstanding at December 31,
  1994................................    1,070,000     Cdn. $1.20 - Cdn. $3.10 (U.S.
                                                        $.87 - U.S. $2.21) per Share expiring
                                                        on various dates, July 1997 to
                                                        November 1999
Options Issued........................      576,932     Cdn. $2.95 - Cdn. $5.84 (U.S. $2.20 -
                                                        U.S. $4.30) per Share
Options Exercised.....................     (220,500)    Cdn. $1.20 - Cdn. $4.28 (U.S.
                                                        $.87 - U.S. $3.17) per Share
                                          ---------
Options Outstanding at December 31,
  1995................................    1,426,432     Cdn. $1.20 - Cdn. $5.84 (U.S.
                                                        $.87 - U.S. $4.30) per Share expiring
                                                        on various dates, July 1997 to
                                                        November 2000
Options Issued........................      638,333     Cdn. $4.44 - Cdn. $6.56 (U.S. $3.26 -
                                                        U.S. $4.73) per Share
Options Exercised.....................     (363,033)    Cdn. $1.20 - Cdn. $4.28 (U.S. $.87 -
                                                        U.S. $3.17) per Share
                                          ---------
Options Outstanding at December 31,
  1996................................    1,701,732     Cdn. $1.20 - Cdn. $6.56 (U.S.
                                                        $.87 - U.S. $4.73) per Share expiring
                                                        on various dates, July 1997 to
                                                        November 2001
                                          =========
</TABLE>

The number of outstanding options exercisable at December 31, 1996 was
1,125,901.

                                       36
<PAGE>   38

                      SPATIALIZER AUDIO LABORATORIES, INC.
                                AND SUBSIDIARIES

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

     The following table summarizes the activity relating to warrants and common
shares issuable upon exercise of such warrants:

<TABLE>
<CAPTION>
                                                   COMMON
                                                  ISSUABLE
                                    WARRANTS       SHARES                WARRANT PRICE
                                   ----------     --------     ---------------------------------
<S>                                <C>            <C>          <C>
Warrants Outstanding at August                                 Cdn. $1.68 - Cdn. $2.00 (U.S.
  31, 1993.......................     522,917       72,917     $1.20 - U.S. $1.43) per Share
                                                               expiring on various dates, August
                                                               1994 to June 1995
Warrants Issued..................     800,000      675,000     Cdn. $1.60 - Cdn. $2.15 (U.S.
                                                               $1.14 - U.S. $1.53) per Share
Warrants Exercised...............  (1,312,917)    (942,917)    Cdn. $1.60 - Cdn. $2.15 (U.S.
                                                               $1.15 - U.S. $1.55) per Share
Warrants Expired.................     (10,000)      (5,000)    Cdn. $2.00 (U.S. $1.43) per Share
                                   ----------     --------
Warrants Outstanding at August
  31, 1994.......................          --           --
Warrants Issued..................     515,000      515,000     Cdn. $2.15 - Cdn. $4.15 (U.S.
                                                               $1.53 - U.S. $2.96) per Share
Warrants Exercised...............     (25,000)     (25,000)    Cdn. $2.15 (U.S. $1.54) per Share
                                   ----------     --------
Warrants Outstanding at December                               Cdn. $3.20 - Cdn. $4.15 (U.S.
  31, 1994.......................     490,000      490,000     $2.28 - U.S. $2.96) per Share
                                                               expiring on various dates, August
                                                               1996 to November 1996
Warrants Issued..................     487,500      487,500     Cdn. $3.25 - Cdn. $4.50 (U.S.
                                                               $2.42 - U.S. $3.35) per Share
Warrants Exercised...............    (197,500)    (197,500)    Cdn. $3.20 - Cdn. $3.30 (U.S.
                                                               $2.33 - U.S. $2.47) per Share
                                   ----------     --------
Warrants Outstanding at December                               Cdn. $3.20 - Cdn. $4.50 (U.S.
  31, 1995.......................     780,000      780,000     $2.33 - U.S. $3.35) per Share
                                                               expiring on various dates, August
                                                               1996 to June 1997
Warrants Issued..................     155,000      155,000     Cdn. $6.46 - Cdn. $6.97 (U.S.
                                                               $4.75 - U.S. $5.12) per Share
Warrants Exercised...............    (646,000)    (646,000)    Cdn. $3.20 - Cdn. $4.15 (U.S.
                                                               $2.33 - U.S. $3.05) per Share
Warrants Expired.................    (115,000)    (115,000)    Cdn. $3.70 (U.S. $2.69) per Share
                                   ----------     --------
Warrants Outstanding at December                               Cdn. $3.30 - Cdn. $6.97 (U.S.
  31, 1996.......................     174,000      174,000     $2.40 - U.S. $5.12) per Share
                                                               expiring on various dates, May
                                                               1997 to June 1997
                                   ==========     ========
</TABLE>

     The number of outstanding warrants exercisable at December 31, 1996 was
174,000.

NOTE:  Options and Warrants issued and exercised have been converted to US
       dollars using the exchange rate on the issue or exercise date.

     Based upon the results of calculation of fair value utilizing the
Black-Scholes methodology for option valuations the effect of applying SFAS No.
123's fair value method to the Company's stock-based awards, the net loss and
loss per share amounts are not materially different from amounts reported.

                                       37
<PAGE>   39

                      SPATIALIZER AUDIO LABORATORIES, INC.
                                AND SUBSIDIARIES

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

(13) COMMITMENTS AND CONTINGENCIES

  Legal

     On August 29, 1996 the Court granted the Company's summary judgment motion
in its entirety and denied the motion by QSound in the pending patent
infringement litigation between the Company and QSound. In granting the
Company's summary judgment motion, the Court found that the Company's IC
(Integrated Circuit) does not infringe the QSound patent and denied QSound's
motion with respect to infringement. The Company's claim that the QSound patent
in invalid was not decided and, since the issues which the Court would need to
consider on the patent invalidity claim are similar to certain issues considered
in the infringement claim, QSound was granted the right to immediately appeal
the denial of its motion and trial on the invalidity issue was deferred until
after that appeal. In substance, the Court's finding confirms the Company's
position that there is no infringement by the Company's IC of any patent held by
QSound and that the claims by QSound were without merit. If the appeal is denied
and the Court's decision is confirmed on appeal, the Company intends to pursue
the remaining claims for damages and for a decision that the QSound patent is
invalid. If the appeal is granted and the Court's decision on the motion is
overruled, a trial on the merits would follow at which time the Company will
again assert its current position, which already was adopted in the grant of the
Company's summary judgment motion, and will assert its remaining claims against
QSound. QSound has appealed and the appeal is pending.

  Lease Commitments

     The Company is obligated for future minimum rental payments for all
operating leases of approximately $193,000, $220,000, 104,969, and $2,053 during
the years ended December 31, 1997, 1998, 1999, and 2000, respectively. Rent
expense amounted to approximately $197,000, 132,000, $28,000, and $48,000 for
years ended December 31, 1996 and 1995, the four-month transition period ended
December 31, 1994, and the year ended August 31, 1994 respectively.

(14) VALUATION AND QUALIFYING RESERVES

     The Company had reserves for doubtful accounts recorded in the accompanying
consolidated financial statements which are summarized as follows:

<TABLE>
<CAPTION>
                                                          ALLOWANCE FOR
                                                        DOUBTFUL ACCOUNTS
                                                        -----------------
        <S>                                             <C>
        Balance at August 31, 1993....................     $  --
          Charges to expenses.........................        --
          Deductions..................................        --
                                                        -----------------
        Balance at August 31, 1994....................        --
          Charges to expenses.........................        --
          Deductions..................................        --
                                                        -----------------
        Balance at December 31, 1994..................        --
          Charges to expenses.........................        --
          Deductions..................................        --
        Balance at December 31, 1995..................        --
          Charges to expenses.........................      90,000
          Deductions..................................        --
                                                        -----------------
        Balance at December 31, 1996..................     $90,000
                                                        =================
</TABLE>

                                       38
<PAGE>   40

                      SPATIALIZER AUDIO LABORATORIES, INC.
                                AND SUBSIDIARIES

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

(15) SUBSEQUENT EVENT

  Private Placement

     On March 7, 1997, the Company raised $2,000,000 through a private placement
of 1,600,000 units in the Company consisting of a share of common stock and
one-half of one non-transferable share purchase warrant. The proceeds of the
financing will be utilized to finance the Company's research and development
activities in its MultiDisc Technologies business unit and for working capital
reserves. The Company also agreed to modify certain outstanding one year
warrants to purchase 155,000 shares of stock issued in May and June, 1996 by
adjusting the exercise price to an amount consistent with the current market
price of the Company's stock ($1.75 US) and by adjusting the shares under
warrant to 310,000 shares. Funds from these financing activities as well as cash
generated from operations is expected to be sufficient for the Company to meet
its obligations during the next twelve months.

  Vancouver Stock Exchange ("VSE") Delisting

     On February 12, 1997 the Company's common shares were delisted from the
VSE. The Company's common shares will continue to be quoted on NASDAQ small cap
markets.

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

     None.

                                       39
<PAGE>   41

                                    PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     This information is incorporated by reference to the Company's definitive
proxy statement relating to its annual meeting expected to be held on or about
June 5, 1997.

ITEM 11.  EXECUTIVE COMPENSATION

     This information is incorporated by reference to the Company's definitive
proxy statement relating to its annual meeting expected to be held on or about
June 5, 1997.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     This information is incorporated by reference to the Company's definitive
proxy statement elating to its annual meeting expected to be held on or about
June 5, 1997.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     This information is incorporated by reference to the Company's definitive
proxy statement relating to its annual meeting expected to be held on or about
June 5, 1997.

                                    PART IV

ITEM 14.  EXHIBITS

                                       40
<PAGE>   42

                                   SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

Dated: March 26, 1997

                                          SPATIALIZER AUDIO LABORATORIES, INC.
                                          (Registrant)

                                          /s/ STEVEN D. GERSHICK
                                          --------------------------------------
                                          Steven D. Gershick
                                          President & Chief Executive Officer

                                          /s/ KATHY PARTCH
                                          --------------------------------------
                                          Kathy Partch
                                          Chief Financial Officer

     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated

<TABLE>
<C>                                         <S>                  <C>

/s/ CARLO CIVELLI
----------------------------------------    Director             March 26, 1997
             Carlo Civelli

/s/ STEPHEN W. DESPER                       Director             March 26, 1997
----------------------------------------
           Stephen W. Desper

/s/ DAVID FOSTER                            Director             March 26, 1997
----------------------------------------
              David Foster

/s/ JAMES D. PACE                           Director             March 26, 1997
----------------------------------------
             James D. Pace

/s/ JEROLD H. RUBINSTEIN                    Director             March 26, 1997
----------------------------------------
          Jerold H. Rubinstein

/s/ GILBERT N. SEGEL                        Director             March 26, 1997
----------------------------------------
            Gilbert N. Segel
</TABLE>

                                       41
<PAGE>   43
                                    PART IV


ITEM 14.         EXHIBITS

2.1*     Desper-Spatializer Reorganization Agreement dated January 29, 1992.
         (Incorporated by reference to the Registrant's Registration Statement
         on Form S-1, Registration No. 33-90532, effective August 21, 1995.)

2.2*     Arrangement Agreement dated as of March 4, 1994 among
         Spatializer-Yukon, DPI and Spatializer-Delaware.  (Incorporated by
         reference to the Registrant's Registration Statement on Form S-1,
         Registration No. 33-90532, effective August 21, 1995.)

3.1*     Certificate of Incorporation of Spatializer-Delaware as filed February
         28, 1994.  (Incorporated by reference to the Registrant's Registration
         Statement on Form S-1, Registration No. 33-90532, effective August 21,
         1995.)

3.2*     Amended and Restated Bylaws of Spatializer-Delaware.  (Incorporated by
         reference to the Registrant's Registration Statement on Form S- 1,
         Registration No. 33-90532, effective August 21, 1995.)

4.1*     Form of Subscription Agreement for August 1994 Private Placement.
         (Incorporated by reference to the Registrant's Registration Statement
         on Form S-1, Registration No. 33-90532, effective August 21, 1995.)

4.2*     Form of Subscription Agreement for November 1994 Private Placement.
         (Incorporated by reference to the Registrant's Registration Statement
         on Form S-1, Registration No. 33-90532, effective August 21, 1995.)

4.3*     Form of Spatializer-Yukon Incentive Stock Option Agreement.
         (Incorporated by reference to the Registrant's Registration Statement
         on Form S-1, Registration No. 33-90532, effective August 21, 1995.)

4.4*     Spatializer-Delaware Incentive Stock Option Plan (1995 Plan).
         (Incorporated by reference to the Registrant's Registration Statement
         on Form S-1, Registration No. 33-90532, effective August 21, 1995.)

4.5*     Performance Share Escrow Agreements dated June 22, 1992 among Montreal
         Trust Company of Canada, Spatializer-Yukon and certain shareholders
         with respect to escrow of 2,181,048 common shares of
         Spatializer-Yukon. (Incorporated by reference to the Registrant's
         Registration Statement on Form S-1, Registration No. 33-90532,
         effective August 21, 1995.)

4.6*     Spatializer-Delaware 1996 Incentive Plan (Incorporated by reference to
         the Registrant's Proxy Statement dated June 25, 1996 and previously
         filed with the Commission.)

4.7*     Form of Subscription Agreement for 1995 Private Placements.

4.8      Form of Subscription Agreement and Warrant Agreement for March 7, 1997
         Private Placement.

4.9      Modification Agreement for Escrowed Performance Shares.

5.1*     Opinion of Brand Farrar Dziubla Freilich & Kolstad, LLP concerning
         legality of unissued securities subject to registration.

10.1***  License Agreement dated June 29, 1994 between DPI and MEC.
         (Incorporated by
<PAGE>   44
         reference to the Registrant's Registration Statement on Form S-1,
         Registration No. 33-90532, effective August 21, 1995.)

10.2***  License Agreement dated November 11, 1994 between DPI and ESS.
         (Incorporated by reference to the Registrant's Registration Statement
         on Form S-1, Registration No. 33-90532, effective August 21, 1995.)

10.3*    License Agreement dated June 10, 1994 between Joel Cohen and DPI.
         (Incorporated by reference to the Registrant's Registration Statement
         on Form S-1, Registration No. 33-90532, effective August 21, 1995.)

10.4*    Real Property Lease for executive offices in Woodland Hills,
         California (effective April 7, 1995).  (Incorporated by reference to
         the Registrant's Registration Statement on Form S-1, Registration No.
         33-90532, effective August 21, 1995.)

10.5*    Employment Agreement between DPI and Stephen Desper dated December 16,
         1991.  (Incorporated by reference to the Registrant's Registration
         Statement on Form S-1, Registration No. 33-90532, effective August 21,
         1995.)

10.6*    Employment Agreement between DPI and Steven Gershick dated December
         16, 1991.  (Incorporated by reference to the Registrant's Registration
         Statement on Form S-1, Registration No. 33-90532, effective August 21,
         1995.)

10.7*    Employment Agreement between MDT and Irwin Zucker dated June 24, 1996.
         (Incorporated by reference to the Registrant's Report on Form 8-K for
         the event occurring on June 24, 1996.)

11.1     Computation of Loss Per Common Share.

21.1     Schedule of Subsidiaries of the Company.

23.1     Consent of KPMG Peat Marwick LLP, independent certified public
         accountants.

__________________

*        Previously filed.
**       To be filed by amendment.
***      Portions subject to request for confidential treatment.  The
         confidential portions omitted have been filed separately with the
         Commission.

         [All other schedules have been omitted because they are not
         applicable, not required, or the information is included elsewhere in
         the statements or notes thereto.  The Registrant filed no reports on
         Form 8-K for the fiscal quarter ending ending December 31, 1996.]