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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549   FORM 10-K   (Mark One) þ   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the period ended: December 31, 2004 OR  o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF
1934 Commission File Number: 000-26460 SPATIALIZER AUDIO LABORATORIES, INC. (Exact name of registrant as specified in its charter) Delaware
    
    95-4484725(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)
 2625 Townsgate Road, Suite 330
Westlake Village, California 91361
(Address of principal executive offices) 2025 Gateway Place, Suite 365
San Jose, California 95110
(Address of principal corporate offices) Telephone Number: (408) 453-4180
(Registrants telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act:
None Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.01 par value Indicate by check mark whether the registrant (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days: Yes þ No o




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TABLE OF CONTENTS  
 PART IItem 1. BusinessItem 2. PropertiesItem 3. Legal ProceedingsItem 4. Submission of Matters to a Vote of Security HoldersItem 5. Market for Registrants Common Equity and Related Stockholder MattersItem 6. Selected Consolidated Financial DataItem 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsItem 7A. Quantitative and Qualitative Disclosures About Market RiskItem 8. Financial Statements and Supplementary DataINDEPENDENT AUDITORS REPORTCONSOLIDATED BALANCE SHEETSCONSOLIDATED STATEMENTS OF OPERATIONSCONSOLIDATED STATEMENTS OF CASH FLOWSCONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT)NOTES TO CONSOLIDATED FINANCIAL STATEMENTSItem 9. Change in and Disagreements with Accountants on Accounting and Financial DisclosureItem 9A. Controls and ProceduresPART IIIItem 10. Directors and Executive Officers of the RegistrantItem 11. Executive CompensationItem 12. Security Ownership of Certain Beneficial Owners and ManagementItem 13. Certain Relationships and Related TransactionsItem 14. Principal Accounting Fees and ServicesPART IVItem 15. Exhibits, Financial Statement Schedules and Reports on Form 8-KSIGNATURESEX-23.1EX-31.1EX-32.1Exhibit 10.3Exhibit 10.5Exhibit 10.6Exhibit 10.7Exhibit 21.1Exhibit 23.1Exhibit 31.1Exhibit 32.1
  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. o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Act). Yes o No þ The aggregate market value of the voting stock held by non-affiliates of the registrant
computed by reference to the price at which the common equity was last sold as of the last business
of the registrants most recently completed second quarter (June 30, 2004) was approximately
$4,227,783 and at February 7, 2005 was approximately $2,818,522. In addition, affiliates held
non-voting preferred stock valued at $1,183,510 at both June 30, 2004 and
February 7, 2005. As of February 7, 2005, there were 46,975,363 shares of the Registrants Common Stock
outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive proxy statement for the 2004 Annual Meeting are incorporated by
reference into Part III hereof. 2




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CAUTIONARY STATEMENT REGARDING FORWARD LOOKING STATEMENTS This Annual Report on Form 10-K contains forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities
Act of 1933, as amended, reflecting managements current expectations. Examples of such
forward-looking statements include our expectations with respect to our strategy. Although we
believe that our expectations are based upon reasonable assumptions, there can be no assurances
that our financial goals will be realized. Such forward-looking statements involve known and
unknown risks, uncertainties and other factors that may cause our actual results, performance or
achievements, or industry results, to be materially different from any future results, performance
or achievements expressed or implied by such forward-looking statements. Numerous factors may
affect our actual results and may cause results to differ materially from those expressed in
forward-looking statements made by or on behalf of our company. For this purpose, any statements
contained herein that are not statements of historical fact may be deemed to be forward-looking
statements. Without limiting the foregoing, the words, believes, anticipates, plans,
expects and similar expressions are intended to identify forward-looking statements. The
important factors discussed under the caption Factors That May Affect Future Results in Item 7.
Managements Discussion and Analysis of Financial Condition and Results of Operations, herein,
among others, would cause actual results to differ materially from those indicated by
forward-looking statements made herein and represent managements current expectations and are
inherently uncertain. Investors are warned that actual results may differ from managements
expectations. We assume no obligation to update the forward-looking information to reflect actual
results or changes in the factors affecting such forward-looking information. 
 PART I 
 Item 1.Business Overview Spatializer Audio Laboratories, Inc. (Spatializer or Company) is a developer, licensor and
marketer of next generation technologies for the consumer electronics, personal computing,
entertainment and cellular telephone markets. Our technology is incorporated into products
offered by our licensees and customers on various economic and business terms. Our position as a
developer of next generation technologies is based on our business relationships with brand
leaders, such as Toshiba, Samsung, Sanyo and Matsushita. We conduct our audio business through our
parent company and our wholly owned subsidiary, Desper Products, Inc. (DPI). DPI has developed a
full complement of patented and proprietary 3-D or virtual audio signal processing technologies
directed to the consumer electronics and multimedia PC markets. We continue to expand our product
offerings to take advantage of the growing digital audio marketplace specifically for consumer
products like Digital Versatile Disc (DVD) players, portable mp3 players, digital televisions and
digital home, portable and cellular handset devices. As of December 31, 2004, more than 47 million
licensed units had been shipped covering all of these applications. DPIs virtual audio signal
processing technologies are currently incorporated in products offered by global brand leaders in
consumer electronics, PCs and cell phones including Toshiba, Matsushita, Samsung, Intervideo,
Sanyo, and Sharp. We are focused on broadening recognition of the Spatializer brand name through
association with these and other globally recognized consumer electronics and multimedia computer
brand leaders, and on broadening our audio technology and software base to position ourselves for
continued growth. We believe that with the accelerating growth in the digital audio/video
marketplace, the market for virtual audio technologies, and therefore for our products, is entering
a new phase of opportunity. We were incorporated in the State of Delaware in February, 1994 as the successor company in a
Plan of Arrangement pursuant to which the outstanding shares of Spatializer Audio Laboratories,
Inc., a publicly held Yukon, Canada corporation, were exchanged for an equal number of shares of
our common stock. Our corporate office and research center is located at 2025 Gateway Place, Suite
365, San Jose, California 95110, Telephone (408) 453-4180. We also maintain executive offices at
2625 Townsgate Road, Suite 330, Westlake Village, California 91361. We have a Website at
www.spatializer.com. Copies of this Annual Report, including our financial statements and our
quarterly reports on Form 10-Q as well as other corporate information, including press releases, of
interest to our stockholders are available on our website promptly after filing or distribution. As
used herein, Spatializer, the Company, we or our means Spatializer Audio Laboratories, Inc.
and its wholly-owned subsidiaries. 3




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Desper Products, Inc.  Virtual 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 virtual audio. The objective
in each product category is to create or simulate the effect of a multi-speaker sonic environment
using two ordinary speakers (or headphones) for playback. The market for virtual audio is segmented
into six broad categories of technology as identified in the listing below. Each of these
technologies utilizes different underlying scientific principles in accomplishing its design
objectives and is targeted to a specific class of consumer electronics or multimedia computer
depending on the intended product use and functional capability of the product. DPI currently has
other audio signal processing technologies under development which will serve to expand its market
scope and partner product capabilities. Category of Technology
    
    
    Product Categories
    
    
    Audio EnhancementStereo Surround Sound
    
    
    Consumer electronics products providing
stereo playback  DVD Players, Stereo
TVs, Stereo Components and Systems, Car
Audio, Laptop and Desktop Multimedia
Computers, Set-top Boxes
    
    
    Surround sound enhancement from an ordinary
stereo (two-channel) signalMicro-Speaker Virtualization
(Ring tones, music, multimedia)
    
    
    Cell Phones and Mobile Multimedia Players
    
    
    Widens sound stage
and improves stereo
separation from
Two-Channel Ring
tones, compressed
audio, FM and TV
broadcast and games
in small form
factor applications.Surround Sound Enhancement
    
    
    Products incorporating stereo audio
sources for playback through 5.1 or more
home theater systems: AV Receivers
    
    
    Creation of
spatially accurate
home theater
surround sound from
two channel sourcesMulti-Channel-Speaker
Virtualization
    
    
    Products incorporating multi-channel
audio sources like Dolby Digital®
(AC-3), DolbyProLogic® or MPEG-2. Home
Theater, DVD-Video, Multimedia
    
    
    Creation of
spatially accurate
multi-speaker
cinematic audio
experience from two
speakers utilizing
discrete
multi-channel audio
informationNoise Reduction
    
    
    Computers and Recordable DVD utilizing
DVD/MPEG and decoding. Cell phone
handsets.
    
    
    Static noise
reduction combined
with stabilization
of dynamic audio
rangeVirtual Bass Enhancement
    
    
    Consumer electronics products providing
stereo playback Mobile Multimedia
Players, Cell Phones, DVD
Players/Recorders, Stereo TVs, Stereo
Components and Systems, Car Audio,
Laptop and Desktop Multimedia Computers
and Speakers and Headphones.
    
    
    Simulation of lower
frequency response
from speakers with
relatively high low
frequency
capabilityDynamic Range Compression
    
    
    Laptop and Desktop Multimedia Computers,
Cell Phones and Portable Multimedia
Players running digital media player
software
    
    
    Prevents over-driving speakers, headphones or
ear buds while maximizing the dynamic audio
outputHeadphone Virtualization
    
    
    Any consumer, cell phone or mobile
application incorporating both stereo
and multi-channel audio sources like
Dolby Digital® (AC-3), Dolby ProLogic®,
MPEG-2 or stereo. DVD-Video, Multimedia
Computers utilizing DVD/MPEG Decoding or
stereo
    
    
    Creation of
spatially accurate
multi- speaker
cinematic audio
experience from
headphones
utilizing discrete
multi-channel audio
informationPhase Corrected Equalization
    
    
    All audio products with one or more
speakers
    
    
    Creation of more
recognizable and
cleaner music or
dialog from all
media sourcesVirtual Digital Theatre
    
    
    PCs and Notebooks
    
    
    Audio enhancement
to help ease the
transition of PCs
and Notebooks into
entertainment
platforms
 4




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Licensed Products Our current technology product applications are directed to (1) speaker enhancement, (2)
stereo surround sound enhancement, (3) mobile entertainment enhancement and (4) noise reduction.  1.
    Spatializer3D Stereo.Based upon proprietary and patented methods of stereo signal
processing, our Spatializer 3D Stereotechnology 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 our unique DDP (Double Detect and Protect)
algorithm. DDP continuously monitors the underlying stereo signal and dynamically optimizes
spatial processing, avoiding deleterious sonic artifacts common in other systems and
provides set and forget ease of use for consumers. First introduced in July 1994 by DPI,
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 products utilizing stereo
audio. The technology is currently available in both analog and digital formats. Matsushita
introduced a new Spatializer IC design in 1999, offering the Spatializer 3-D Stereoeffect
in a simplified, lower cost package. In early 2002, we introduced a new algorithm-based
technology which provides a virtual surround sound effect from a two channel input for
DSP-based environments. In 2003, we introduced Spatializer ((environ)), especially designed
for cellular phones with two, closely spaced speakers to enhance both ring tones and music.2.
    SpatializerN-2-2 Ultra Digital Virtual Surround. In September 1996, DPI introduced
Spatializer N-2-2,which we consider a core, and enabling technology for Dolby
Digital-based home theater products and personal computers. In mid-2001, DPI introduced
Spatializer N-2-2 Ultraas the latest generation of this core audio technology. The audio
standards for multi-channel digital audio(based upon geographic region) are multi-channel
audio formats (Dolby Digital® (AC-3) and MPEG-2) which carry up to eight (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-2-2Ultrasoftware- 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-2-2Ultraruns in real-time on general purpose Digital Signal
Processing (DSP) hardware platforms like those offered by LSI, Acer Labs, Inc., NEC,
Motorola, MediaTek and Zoran; may be integrated with host based software-only MPEG-2 or DVD
decoders (like WinDVD and PowerDVD, offered by InterVideo and Cyberlink, respectively, for
the Intel® Pentium® series of microprocessors); 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. Spatializer N-2-2Ultrahas been approved by Dolby Laboratories and
qualifies Spatializer licensees to use the newly created Dolby Digital VIRTUAL trademark on
products incorporating the technology. We believe our Spatializer N-2-2Ultra process has
helped 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. The Company holds a patent on
this technology.3.
    SpatializerVi.B.E.In early 1999, DPI introduced Spatializer Vi.B.E., a virtual bass
enhancement technology. Spatializer Vi.B.E. produces a dynamic bass response from even the
lowest-end speakers or headphones. This is particularly important in enhancing the audio of
all forms of portable digital audio devices. Spatializer Vi.B.E. uses proprietary technology
to generate the perception of realistic bass frequencies that are unaffected by actual
speaker system frequency response capability.4.
    SpatializerVSP-11First introduced by DPI in early 2002, Spatializer VSP-11 (Virtual
Sound Processor 11) is a stand-alone application program for Microsoft Windows 95, 98, ME,
2000 and XP platforms that utilizes Spatializer proprietary psychoacoustic techniques to
allow consumers to enjoy the benefits of the renowned Spatializer audio enhancement
technologies on leading media players, soft DVD players and file sharing programs. This
means that Spatializer VSP-11 is a universal audio enhancement software package that will
enhance output from the Microsoft®Media Player, Real Player®, Real Jukebox®, WinAmp®,
WinDVD®, PowerDVD®, among others, without any special modification. It will run in
conjunction with any sound card, as well as with USB audio. 5




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5.
    SpatializerNatural HeadphoneSpatializer Natural Headphone, introduced by DPI in March
2001, renders spatially accurate multiple speaker positions simulating the typical home
theater or stereo arrangement through a headphone. The headphone algorithm delivers a high
performance simulated surround sound experience, using a reasonable amount of processing
power at a reasonable cost. Thus, this solution is equally practical and effective for both
low-power portable devices and home theater applications. Unlike typical virtual surround
sound headphone solutions, which rely heavily on reverberation which can sound unnatural,
Spatializer Natural Headphone utilizes a combination of techniques to provide an expanded,
yet natural sound field.6.
    SpatializerPCE, introduced in October 2001, makes high frequencies clearer, crisper and
more brilliant while low frequencies are more dramatic, tighter and have more impact.
Spatializer® PCE gives the manufacturer an inexpensive way to dramatically improve the sound
of low-end loudspeakers, such as the kind found in televisions, boom boxes and computers.
Spatializer PCE is also ideal for improving the quality of Internet audio, which can sound
rather lackluster and dull due to compression or low bit rates. It can be applied prior to
encoding audio streams, and can just as easily enhance the playback of the decompressed
audio. It can improve the clarity, intelligibility and impact of both dialog and music.
Spatializer PCE works by both modifying and smoothing non-linear phase response and by
creating psycho-acoustic cues. Typical equalization techniques cause phase distortion
(non-zero group delay) due to non-linear phase response. Spatializer PCE has a nearly-linear
phase response, which results in a near-zero group delay. This improves the naturalness,
or transparency of the dialog or music by not adding to phase distortion already present in
many playback systems. This technology is patent pending. Spatializer PCE can be custom
tailored for two or an array of speaker configurations. The technology, without a surround
sound effect, can enhance single speaker applications as well.7.
    SpatializerenCompass AVSpatializer enCompass AV, launched in late 2002, is designed to
offer high quality, multi-channel audio, even from mono or stereo sources. This technology
allows owners of home theater systems with five or more speakers to hear a surround sound
effect, utilizing all of their speakers to deliver full system utility from CDs, cassettes
or VHS tape or records.8.
    SpatializerVirtuaLFEprocesses the sub-woofer channel with proprietary psycho-acoustic
techniques to virtualize, reinforce and enhance the effect for accurate reproduction through
two speaker home audio or on-board television speakers. The result is an emotive low
frequency effect that brings DVDs alive as if an actual sub-woofer speaker were employed.
The efficient algorithm architecture makes implementation feasible on a wide array of home
entertainment products.9.
    SpatializerAudio Alchemydynamically removes noise from up to six input channel
simultaneously. Utilizing state of the art noise removal and reduction techniques,
Spatializer Audio Alchemy dynamically adjusts to changing noise levels and environments.
Tailored for the human voice, Spatializer Audio Alchemy removes background noise such as
fans, motor hum, and tape hiss. Spatializer Audio Alchemy features an advanced equalization
processor to compensate for frequency response limitations in the audio recording hardware
and transducers. In addition, Spatializer Audio Alchemy also performs spatial reconstruction
to simulate the original acoustic environment, and normalizes the dynamic range of the
digital audio source to a level compatible with home theater environments. This technology
is patent pending. In addition, we offer three whole product solutions with multiple Spatializer technologies that
comprehensively address the unique audio delivery challenges inherent in each targeted platform.
The Spatializer HD Class is comprised of three new products specifically targeted at home audio,
cellular telephones and other mobile applications and personal computers. The Spatializer
technologies in each package operate in a complementary fashion, such that the concurrent
technologies deliver a more powerful and effective audio experience than that possible from a
single solution. Further, each technology has been optimized and customized for the targeted
application and is designed to overcome the audio challenges presented by small form factor,
transducer limitations and even cost constraints. Spatializer UltraMobile HD delivers higher definition digital audio to mobile audio systems
through the multiple and complementary use of Spatializer Natural Headphone, Spatializer Vi.B.E.
and Spatializer PCE. UltraMobile HD improves the performance of low cost headphones or ear buds, as
well as from compressed audio by opening up the sound field while improving bass performance. In
cellular telephone applications, Spatializer ((environ)) delivers maximum performance from
micro-speakers that are mounted closely together and helps compensate for the more limited dynamic
range as compared with standard size speakers. When applied to stereophonic ring tones, Spatializer
((environ)) creates a startling and expressive sound field when such speakers are utilized in
cellular handsets. 6




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Spatializer UltraTV HD delivers higher definition digital audio performance to digital
televisions, DVD players and DVD Recorders. HDTV signals can realistically be retrieved only in
limited ways, leading to customer disappointment. The Spatializer UltraTV HD processor is designed
to compensate for these shortcomings in digital home entertainment for the millions of households
without home theater systems. Realistic surround sound, near-sub-woofer effects and crisp dialog is
made possible through two speakers, rather than through expensive arrays of external speakers.
Another unique aspect of this product is that it is designed specifically for playback through
television speakers and can be custom tailored to the frequency aspects of a manufacturers speaker
set. Spatializer UltraPC HD helps ease the transition of the personal computer from business tool
to a comprehensive component of the digital home entertainment experience. Spatializer UltraPC HD
includes Spatializer N-2-2 Ultra that delivers surround sound through only two speakers,
Spatializer Natural Headphone for personal surround sound, Spatializer VirtuaLFE that processes
the sub-woofer channel for a low frequency effect through ordinary speakers and Spatializer PCE for
dialog clarity. Each of these technologies has been optimized for small speaker or headphone
playback and can be custom tuned to a manufacturers specific speaker set. Licensing Activities Until 2000, we licensed our technologies primarily through semiconductor manufacturing and
distribution licenses (Foundry Licenses) with semiconductor foundries. In turn, the foundries
manufacture and distribute integrated circuits ICs (integrated circuits) or DSPs (digital signal
processors) incorporating Spatializer technology to consumer electronics and multimedia computer
OEMs (original equipment manufacturers). In 2000, we began offering foundries the option of entering into a non-royalty bearing
distribution agreement with us. Under this business model, the foundry offers Spatializer
technology as an optional feature, promotes our technology in their sales materials and cooperates
with the Spatializer sales force in closing license agreements for Spatializer technology with the
OEM customer. This business model provides the foundry with an additional selling feature at no
additional cost to the foundry. The OEM can obtain use of the technology directly from Spatializer
without any additional mark-up from the foundry. The terms of all of our licenses are negotiated on an individual basis requiring the payment
of a per unit running royalty according to sliding scales based upon cumulative volume. Some of our
licenses call for the payment of an up-front license issuance fee either in lieu of, or in addition
to the running royalty. Other agreements require the OEM customer, rather than the foundry, to pay
the royalty. Per unit royalties are generally reportable and payable 45 days after the end of the
quarter following shipment from the foundry to the OEM or, in the case of a distribution agreement,
by the OEM to its accounts. OEMs who desire to incorporate these DSPs or ICs into their products are required to enter
into a license (OEM Licenses) with us before they may purchase the ICs in quantity. Foundry
Licenses generally have limited the sale of DSPs or ICs with Spatializer technology to OEMs who
have entered into an OEM License with us. 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. We are currently negotiating new IC/DSP Foundry Licenses and OEM Licenses with potential
customers for Spatializer N-2-2 Ultra, Spatializer Vi.B.E., Spatializer Natural Headphone ,
Spatializer PCE and combinations and optimizations of these technologies under the Spatializer
Ultra HD series. Currently, all new licenses are negotiated by our Chief Executive Officer. 7




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IC/DSP Foundry Licenses On August 26, 2004, the Company announced that , through its wholly-owned
subsidiary, Desper Products, Inc., it entered into a major multi-technology licensing agreement
with Samsung Electronics, Co. Ltd. on August 22, 2004. As of December 31, 2004, we have entered into non-exclusive Foundry Licenses for our Virtual
Audio Signal Processing technologies with Matsushita Electronics Corporation (MEC), Samsung
Electronics, Sigmatel, ESS Technology, Inc. (ESS), OnChip Systems, Inc. (OnChip), LSI Logic,
Inc. (LSI), Acer Labs, Inc. (Ali), MIPS Technologies, NJRC, Tvia, Inc., Texas Instruments,
Cirrus Logic and MediaTek. Foundry Licenses generally require the payment of per unit running
royalties based upon a sliding scale computed on the number of Spatializer ICs or DSPs sold. As of December 31, 2004, more than 47 million ICs, programmable processors and DSPs
incorporating Spatializer audio signal processing technology had been manufactured and sold. OEM Licensees and Customers As of December 31, 2004, our technology has been incorporated in products offered by more than
105 separate OEM Licensees and customers 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 Logo Usage Agreement (LUA) or were authorized customers under bundled royalty
licenses with the IC foundries. The OEM Licensees and customers offer a wide range of products,
which include DVD players and recorders, cellular phones, portable digital audio players,
programmable processors, multimedia desktop personal computers, notebook computers and digital
televisions. In 2004, four major customers, not presented in order of importance, each accounted for 10% or
more of our total revenues: Matsushita, Toshiba, Sharp and Samsung, each of whom accounted for
greater than 10% of our total 2003 revenues. One OEM accounted for 29%, one accounted for 25% each,
one accounted for 21% and one accounted for 13% of our royalty revenues during 2004. One other
account comprised more than 5%, but less than 10% of revenues. All other OEMs accounted for less
than 5% of royalty revenues individually. The following table is a partial list of the OEM
Licensees and authorized customers as of December 31, 2004:  
    Acer Labs
    Apple Computer
    Cirrus Logic
    InterVideo
    JVC
    LG Electronics
    Logitech
    LSI
    MediaTek
    Micronas
    Mitsubishi Image and Information Works
    Motorola
    NEC
    Panasonic Car Audio
    Panasonic TV
    Samsung
    Sanyo Corp.
    Sharp Corp.
    Sigmatel
    Texas Instruments
    Theta Digital
    Toshiba DVD
    Toshiba TV
    Zoran We have extensive relationships with OEM licensees and customers outside the United States.
Japanese and Korean based entities accounted for 70% and 25% of our total revenues, respectively in
2004, 71% and 20% of our total revenues, respectively in 2003, and 50% and 17% of our total
revenues, respectively in 2002. The products incorporating our technology are, in turn, sold
throughout the world, in market segments and amounts that are consistent with the overall general
world markets for consumer electronics and software. Customers, Revenues and Expenses We generate revenues in our audio business from royalties pursuant to our Foundry, OEM, and
other licenses, and from non-recurring engineering fees to port our technologies to specific
licensees applications. Our revenues, which totaled $1,106,000 in 2004, were derived almost
entirely from Foundry and OEM license fees and royalties. We seek to maximize return on our intellectual property base by concentrating our efforts in
higher margin licensing and software 8




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products and eliminated our hardware product operations. Licensing operations have been
managed internally by our personnel and through use of an international sales representative
force.In 2004, four major customers, not presented in order of importance, each accounted for 10%
or more of our total revenues: Matsushita, Toshiba, Sharp and Samsung, each of whom accounted for
greater than 10% of our total revenues. One OEM accounted for 29%, one accounted for 25% each, one
accounted for 21% and one accounted for 13% of our royalty revenues during 2004. One other account
comprised more than 5%, but less than 10% of revenues. All other OEMs accounted for less than 5%
of royalty revenues individually. In 2004, declining revenues were experienced from three major DVD customers resulting
primarily from the cessation of use of our products by these customers. In most of these cases, the
DVD player market, where we had a high concentration of accounts, became commoditized and resulted
in a steep decline in price and margins. Manufacturers were forced to strip out features, such as
those from our company, in order to compete. Another PC account migrated completely in 2003 to a
new operating system and chose not to include any audio software enhancements. In 2004, we expanded
our efforts to penetrate the DVD recorder, PC and cellular handset markets. While we achieved some
success in this regard, with 49% of 2004 revenue coming from these new sources, securing revenue
traction proved difficult since the accounts we lost represented approximately 56% of 2003 revenue.
Revenue from new or expanded relationships outside the DVD player category were insufficient to
totally offset these losses, resulting in a continued decline in revenue, although reductions in
overhead helped to significantly reduce the net loss compared to 2003. Competition We compete 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 speakers, matrix and discrete digital technologies developed for theatrical
motion picture exhibition (like Dolby Digital®, Dolby ProLogic®, and DTS®), as well as other
technologies designed to create an enhanced stereo image from two or more speakers. Our principal competitors in the field of virtual audio are SRS Labs, Inc., Dolby
Laboratories, Inc., Sonaptic. and Qsound Labs, Inc. In addition, some DSP foundries and
OEMs have proprietary virtual audio technologies that they regularly offer to OEMs at no cost.
These companies have, or may have, substantially greater resources than us to devote to further
technologies and new product developments. Pressure on OEMs to reduce their costs, particularly in the DVD market is intense. The
marketplace is also susceptible to undisciplined competitors who, from time to time, may offer
below market prices to generate short term revenue and larger market penetrations even if it does
not provide for viable margins. In the future, our products and technologies also may compete with
audio technologies and product applications developed by other companies including entities that
have business relationships with us. Factors that affect our ability to compete include product
quality, performance and features, conformance to existing and new standards, price, customer
support and marketing and distribution strategies. We believe that we will favorably compete in this market because we offer a single source,
complete suite of patented and proprietary 3D Stereo, interactive positional, virtual surround
sound, headphone and speaker virtualization technologies. By virtue of our specialized engineering
and OEM support, we can offer a turn-key audio solution to OEMs who do not possess this expertise
internally. We also have developed new products that address our customers need for a low cost
solution. We also focus intensely on customer support and have expanded our low-cost contract
engineering capabilities with the use of a consulting firm in India. In addition, the strength of
our IC Foundry and OEM relationships and the Spatializer brand name recognition in the industry are
other key differentiators between both our branded and unbranded competition. Lastly, we continue
to explore new and alternative business models that we believe serve the interests of both our
customers and our stockholders. Research and Development Our research and development expenditures in 2004, 2003 and 2002 were approximately 54%, 28%
and 25% of total operating expenses respectively. These expenses consist of salaries and related
costs of employees and consultants engaged in ongoing research, design and development activities
and costs for engineering materials and supplies As of December 31, 2004, we had three employees and consultants in our R&D group representing
38% of our total human resources. In addition and not included above, we have the availability of
three dedicated engineers at an outside consulting company in India for applications engineering.
Our software, hardware and application engineers focus on developing intellectual property, 9




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technology solutions and consumer products. In 2004, we established a relationship with an
engineering services firm in Bangalore, India for the substantial transfer of all applications
engineering work to this firm. In addition to substantially lower cost for consulting services as
compared to domestic contractors, project completion dates have been reliable and throughput
expanded due to their relatively large engineering staff. Thus, multiple projects can be completed
simultaneously and within budgeted cost and time parameters. Intellectual Property and Proprietary Information We rely on a variety of intellectual property protections for our products and services,
including patent, copyright, trademark and trade secret laws, and contractual obligations. Our core
signal processing technology is covered by U.S. patents 5,412,731, 5,896,456 and 6,307,941. On
March 20, 1998, we filed a patent application on our enCompass V 2.0 technology with the United
States Patent & Trademark Office (USPTO) covering our enCompass 2.0 positional audio gaming
technology. In June 2000, we filed an additional patent application for our reduced cost/higher
performance 3-D Stereo circuit design. In late 2002, we filed a patent application covering our
Spatializer PCE technology. In 2003, we filed a patent application for Spatializer Audio Alchemy.
Much of our intellectual property consists of trade secrets. In 2002, patent 6,307,941 was issued
by the USPTO covering our Spatializer N-2-2 technology. We possess copyright protection for its
principal software applications and has U.S. and foreign trademark protection for its key product
names and logo marks. There can be no assurance that these measures will be successful, or that competitors will not
be able to produce a non-infringing competitive product or service. In addition, the laws of
certain countries in which our products are or may be developed, manufactured or sold, including
various countries in Asia, may not protect our products and intellectual property rights to the
same extent as the laws of the United States, or at all. There can be no assurance that third
parties will not assert infringement claims against us, or that if required to obtain any third
party licenses as a result of an infringement dispute, we will be able to obtain such licenses. Seasonality Due to our dependence on the consumer electronics market, we experience seasonal fluctuation
is sales and earnings. In particular, we believe that there is seasonality relating to the
Christmas season in the third and fourth quarters, as well as the first quarter, which is generally
the weakest. We are moving toward diversifying our key market segments in the consumer electronics
industry in an effort to even out our seasonal fluctuation. Overall, seasonality does not have a
material effect on our business. Employees We began 2004 with four full-time and five part-time employees and sales representatives and
decreased our staff to three full time and five part-time employees, consultants and sales
representatives by December 31, 2004. At year-end, there were two full-time employees and one
consultant engaged in research and development. In addition, we utilize an engineering firm with
three dedicated engineers to our projects on an as-needed basis. We employ the services of outside
professional consultants, particularly in the audio engineering area, due to the costly and tight
labor market for such professionals in Silicon Valley as well as the need for specialized expertise
in the course of our business. None of our employees are represented by a labor union or are
subject to a collective bargaining agreement. We consider our relations with our employees and
consultants to be satisfactory. 
 Item 2. Properties Our corporate office and research center in San Jose, California, is the primary location for
our audio technology division, Desper Products, Inc. (DPI). We occupy approximately 1,300 square
feet with an annual rent on a full service basis of approximately $25,500 in calendar 2005 and
$26,275 in calendar 2006. The lease expires on December 30, 2006 and is renewable at market rates
thereafter . Our executive office is located in Westlake Village, California, where we occupy
approximately 100 square feet with an annual rent of approximately $5,300. The lease term on this
space expires on June 30, 2005 and is renewable on a month to month basis thereafter. This space in
the Los Angeles area is used to facilitate business and contacts with the entertainment community
as well as with our accountants, lawyers and directors. We lease an apartment in San Jose, California for use by the chief executive officer when away
from the executive office. The annual rent on this apartment is approximately $16,800. The lease is
on a month-to-month basis. 10




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We lease our space at rental rates and on terms which management believes are consistent with
those available for similar space in the applicable local area. Our properties are well maintained
and we believe they are adequate to support our current requirements. 
 Item 3.Legal Proceedings From time to time we may be involved in various disputes and litigation matters arising in the
normal course of business. As of the date of this Annual Report on Form 10-K, we are not involved
in any legal proceedings that are expected to have a material adverse effect on our consolidated
financial position, results of operations or cash flows. However, litigation is subject to inherent
uncertainties. Were an unfavorable ruling to occur, there exists the possibility of a material
adverse impact on our results of operations of the period in which the ruling occurs. Our estimate
of the potential impact on our financial position or overall results of operations for the above
legal proceedings could change in the future. 
 Item 4.Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of our security holders either through solicitation
of proxies or otherwise in the fourth quarter of the fiscal year ended December 31, 2004. 
 Item 5.Market for Registrants Common Equity and Related Stockholder Matters Our Common Stock was listed and commenced trading on the NASDAQ SmallCap market on August 21,
1995 under the symbol SPAZ. In January 1999, the Common Stock was delisted by the NASDAQ SmallCap
Market due to our inability to maintain listing requirements. Our Common Stock immediately
commenced trading on the OTC Bulletin Board under the same symbol. The following table sets forth
the high and low bid price of our Common Stock as reported on the OTC Bulletin Board for fiscal
years 2003 and 2004. The quotations listed below reflect interim dealer prices without retail
mark-up, mark-down or commission and may not represent actual transactions. Period:
    
    High (U.S. $)
    
    
    Low (U.S. $)2003First Quarter
    
    $
    0.08
    
    
    $
    0.04Second Quarter
    
    $
    0.07
    
    
    $
    0.04Third Quarter
    
    $
    0.06
    
    
    $
    0.04Fourth Quarter
    
    $
    0.19
    
    
    $
    0.042004First Quarter
    
    $
    0.22
    
    
    $
    0.11Second Quarter
    
    $
    0.14
    
    
    $
    0.06Third Quarter
    
    $
    0.10
    
    
    $
    0.05Fourth Quarter
    
    $
    0.09
    
    
    $
    0.05
 On February 7, 2005, the closing price reported by the OTC Bulletin Board was U.S. $0.06.
Stockholders are urged to obtain current market prices for our Common Stock. Computershare Investor
Services, LLC is our transfer agent and registrar. There were no sales of unregistered securities by the Company during the years ended December
31, 2002, 2003 and 2004. To our knowledge there were approximately 200 holders of record of the stock of the Company as
of February 7, 2005. Our transfer agent has indicated that beneficial ownership is in excess of
4,000 stockholders. We have not paid any cash dividends on its Common Stock and have no present intention of
paying any dividends. Our current policy is to retain earnings, if any, for use in operations and
in the development of its business. Our future dividend policy will be determined from time to time
by the Board of Directors. The Company has not repurchased any of its equity securities and as of the date hereof, has
not made any plans to do so. 11




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Item 6.Selected Consolidated Financial Data The following selected consolidated financial data should be read in conjunction with our
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 financial data
for the years ended December 31, 2003, 2002, 2001, 2000 and 1999 are derived from our consolidated
financial statements that have been audited by Farber & Hass LLP, independent certified public
accountants. The consolidated statements of operation and cash flows for the years ended December
31, 2002, 2003 and 2004 and the report thereon are included elsewhere in this Report. Fiscal
Year Ended(   , 000 Omitted)December 31, 2000
    
    
    December 31, 2001
    
    
    December 31, 2002
    
    
    December 31, 2003
    
    
    December 31, 2004Consolidated
Statement of Operations
Data:Revenues
    
    $
    2,202
    
    
    $
    1,604
    
    
    $
    1,856
    
    
    $
    1,269
    
    
    $
    1,106Cost Of Revenues
    
    
    (248
    )
    
    
    (97
    )
    
    
    (131
    )
    
    
    (122
    )
    
    
    (111
    )Gross Profit
    
    
    1,954
    
    
    
    1,507
    
    
    
    1,725
    
    
    
    1,147
    
    
    
    995Total Operating Expenses
    
    
    (1,596
    )
    
    
    (1,823
    )
    
    
    (1,711
    )
    
    
    (1,631
    )
    
    
    (1,146
    )Other Income (Expense),
Net
    
    
    34
    
    
    
    73
    
    
    
    (2
    )
    
    
    (6
    )
    
    
    (5
    )Loss from Discontinued
Operations
Income taxes
    
    
    (10
    )
    
    
    3
    
    
    
    (6
    )
    
    
    (5
    )
    
    
    (1
    )Net Income (Loss)
    
    $
    382
    
    
    $
    (240
    )
    
    $
    18
    
    
    $
    (495
    )
    
    $
    (157
    )Basic Income (Loss) Per
Share
    
    $
    0.01
    
    
    $
    (0.01
    )
    
    $
    0.00
    
    
    $
    (0.01
    )
    
    $
    (0.00
    )Diluted Income (Loss) Per
Share
    
    $
    0.01
    
    
    $
    (0.01
    )
    
    $
    0.00
    
    
    $
    (0.01
    )
    
    $
    (0.00
    )Weighted Average Common
Shares
    
    
    46,736,224
    
    
    
    47,388,235
    
    
    
    47,406,939
    
    
    
    47,309,171
    
    
    
    46,975,363Consolidated Balance
Sheet DataCash and Cash Equivalents
    
    $
    1,468
    
    
    $
    869
    
    
    $
    859
    
    
    $
    590
    
    
    $
    871Working Capital
    
    
    1,195
    
    
    
    1,124
    
    
    
    1,125
    
    
    
    793
    
    
    
    603Total Assets
    
    
    2,457
    
    
    
    1,753
    
    
    
    1,746
    
    
    
    1,205
    
    
    
    1,464Redeemable Preferred Stock
    
    
    
    
    
    
    
    
    
    
    1
    
    
    
    1
    
    
    
    1Advances From Related
Parties
    
    
    337
    
    
    
    113
    
    
    
    113
    
    
    
    108
    
    
    
    0Total Shareholders Equity
    
    $
    1,651
    
    
    $
    1,411
    
    
    $
    1,429
    
    
    $
    955
    
    
    $
    798
 12




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Item 7.Managements Discussion and Analysis of Financial Condition and Results of Operations Executive Overview Revenues decreased to $1,106,000 for the year ended December 31, 2004 compared to $1,269,000
for the year ended December 31, 2003, a decrease of 13%. Revenues are almost entirely comprised of
royalties pertaining to the licensing of Spatializer® audio signal processing algorithms. A key
issue discussed is the difficulty in obtaining revenue traction when traditional revenue sources
are eroding, while being replaced by new revenue sources at a lower rate. Net loss was $157,000 for the year ended December 31, 2004; ($0.00) basic per share, compared
to net loss of $495,000, ($0.01) per share basic and diluted, for the year ended December 31, 2003.
Net loss for the current period is primarily the result of lower revenue, partially offset by lower
overhead. A key issue discussed is managements efforts to reduce overhead is view of declining
revenue, while maintaining competitiveness. Net cash provided by operating activities was $343,939 for the year ended December 31, 2004,
as compared to net cash used in operating activities of $253,965 for the year ended December 31,
2003 and net cash provided by operating activities of $85,138 for the year ended December 31, 2002.
The increase in cash flows from operations for the year ended December 31, 2004 was primarily a
result of the increase in deferred income, a decrease in accounts receivable, partially offset by
the net loss. Deferred income increased due to the licensing prepayment and accounts receivable
decreased a portion of fourth quarter 2004 revenues being realized through the recognition of
deferred income. A key issue is the Companys ability to generate continued positive cash flow, or
if needed, raise additional capital to fund its business. The business environment in which we operate is highly competitive and is offers substantial
risk. These risks should be studied and understood, as outlined in Risk Factors later in this
document. Approach to MD&A An important demonstration of our commitment to our stockholders is a clear explanation of the
Companys operating results, risks and opportunities. The purpose of MD&A is to provide our
shareholders and other interested parties with information necessary to gain an understanding of
our financial condition, changes in financial condition and results of operations. As such, we seek
to satisfy three principal objectives:  
    to provide a narrative explanation of a companys financial statements in plain
English that enables the average investor to see the company through the eyes of
management;
    to enhance the overall financial disclosure and provide the context within which
financial information should be analyzed; and
    to provide information about the quality of, and potential variability of, a companys
earnings and cash flow, so that investors can ascertain the likelihood that and relationship
of past performance being indicative of future performance. We believe the best way to achieve this is to give the reader:  
    An understanding of our operating environment and its risks
    An outline of critical accounting policies
    A review of our corporate governance structure 13




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
    A review of the key components of the financial statements and our cash position and
capital resources
    A review of the important trends in the financial statements and our cash flow
    Disclosure on our internal controls and procedures Operating Environment We operate in a very competitive business environment. This environment impacts us in the
following ways, further discussed in greater detail under Risk Factors:  
    We Face Significant Pricing Pressure and Competition that can Result in Our Technology
Being Designed Out Within a Short Time Frame, or Impeding Efforts to Secure New Design Wins
    New Customer Product Development Can be Delayed. This Results in Delays In Revenues.
Further, Where our Products are Delayed, Competitive Products May Reach The Market Before,
or Replace Our Products.
    We Rely on the Schedules and Cooperation of Chip Makers or Other Third Parties to
Deliver Our Technology in Consumer Products. These Third parties Have Their Own Priorities
and Alliances that May Delay or Thwart our Sales Efforts to Potential Customers. The PC and consumer electronics markets are under intense pressure, primarily from retailers, to
reduce selling prices, with resultant pressure to reduce costs. In addition, pricing action by our
competitors may be very aggressive. Cost reductions are driven by lower cost sourcing, often in
China, design simplification and reduction in or substitution of features. While we present a value
proposition that stresses the cost reducing capabilities of our audio solutions through improved
performance from lower cost components as well as product differentiation that Spatializer
technology can deliver, all such features are closely scrutinized by potential customers product
marketing and engineering. This makes it more challenging to secure new design wins, particularly
in product categories that have become commoditized, such as the case with DVD players. It also may
result in the elimination of features, including ours, if cost is of paramount importance. When
this occurs, we receive very short notice and revenues from such an account will typically begin a
steep decline in the subsequent quarter, resulting in period-to-period fluctuation. This also
results limited visibility with regard to future revenues and their impact on our operating
results. Our response has been to strengthen our value proposition, more aggressively price and
include additional features in our products. We have also entered new segments, such as cell
phones, with different competitive pressure. We also emphasize to our overseas sales
representatives the need for close customer support, with the objective that both new opportunities
and possible difficulties are brought to light as soon as possible. Manufacturers design-in cycles for our technology range from four to twelve months, from the
decision to adopt our technology to actual cashflow. Many of our customers operate under very fluid
development schedules. These schedules are prone to delays at the manufacturer level and in some
cases, manufacturers new products may be cancelled due to market testing or resource allocation.
Since these events are beyond our control, it is difficult to absolutely project when new deals
will begin generating revenues or if signed deals will generate financial results. For this reason,
we do not typically announce new deals until the target product is being introduced. Spatializer does not develop or market semiconductors. That is why we carry no inventory or have
order backlogs that typically are good indicators of near term performance. Rather, we develop
audio algorithms that are embedded on third party processors or semiconductors used by our
customers. Whether such processors become an industry standard, or gain wide acceptance in the
market, is speculative. While our algorithms are implemented on a wide array of processors, often
times a customer uses a processor where there is no such implementation, or where a competing
solution has been implemented. In this case, our customers must request that our algorithm be
implemented. While these requests may be honored, processor manufacturers must schedule such
implementation as their resources or corporate strategies allow. Some chip makers, particularly in
the cell phone market, have already incorporated solutions from our competitors as a component of
the chip itself, making it costly and time consuming to implement alternate solutions like ours.
Therefore, the supply-chain is often quite long and complicated, which potentially can result in
delays or deadlines that may not always coincide with our customers requirements and which are
beyond the control of our company. Therefore, when reviewing the operating results or drawing conclusions with regard to future
performance, these competitive forces and uncertainties must be taken into consideration. Without
absolute long-term visibility, it is difficult to draw such conclusions in absolute terms. Further,
the dynamic nature of the business environment creates the potential for both positive and negative 14




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fluctuations in near and long term operating performance. While management strives to mitigate
these risks, as outlined in Risk Factors,it is not possible to be fully immune from such dynamics. Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations are based
upon our consolidated statements, which have been prepared in accordance with accounting principles
generally accepted in the United States. The preparation of these financial statements requires us
to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues
and expenses based on historical experience and various other factors that are believed to be
reasonable under the circumstances. Actual results may differ from these estimates under different
assumptions or conditions. In consultation with our Board of Directors and Audit Committee, we have
identified three accounting policies that we believe are critical to an understanding of our
financial statements. These are important accounting policies that require managements most
difficult, subjective judgments. The first critical accounting policy relates to revenue recognition. We recognize revenue from
product sales upon shipment to the customer. License revenues are recognized when earned, in
accordance with the contractual provisions. Royalty revenues are recognized upon shipment of
products incorporating the related technology by the original equipment manufacturers (OEMs) and
foundries. These revenues are reported to us by our Licensees in formal, written royalty reports,
which serve as the basis for our quarterly revenue accruals. Infrequently, certain written reports
are received after our required reporting deadlines, sometimes due to contractual requirements. In
such cases, management tries to obtain verbal reports or informal reports from the Licensee. In the
absence of such information, management may utilize conservative estimates based on information
received or historical trends. In such isolated cases, management strives to under-estimate such
revenues to err on the side of caution. In the event such estimates are used, the revenue for the
following quarter is adjusted based on receipt of the written report. In addition, any error in
Licensee reporting, which is very infrequent, is adjusted in the subsequent quarter when agreed by
both parties as correct. The second critical accounting policy relates to research and development expenses. We expense
all research and development expenses as incurred. Costs incurred to establish the technological
feasibility of our algorithms (which is the primary component of our licensing) is expensed as
incurred and included in Research and Development expenses. Such algorithms are refined based on
customer requirements and licensed for inclusion in the customers specific product. There are no
production costs to capitalize as defined in Statement on Financial Accounting Standards No. 86. The third critical accounting policy relates to intangible assets. Our intangible assets
consist primarily of patents. We capitalize all costs directly attributable to patents and
trademarks, consisting primarily of legal and filing fees, and amortize such costs over the
remaining life of the asset (which range from 3 to 20 years) using the straight-line method. In
accordance with SFAS 142, Goodwill and Other Intangible Assets, only intangible assets with
definite lives are amortized. Non-amortized intangible assets are instead subject to annual
impairment testing. Corporate Governance Audit Committee This committee, chaired by Mr. Gilbert Segel, is directed to review the scope, cost and
results of the independent audit of our books and records, the results of the annual audit with
management and the internal auditors and the adequacy of our accounting, financial, and operating
controls; to recommend annually to the Board of Directors the selection of the independent
auditors; to approve proposals made by our independent auditors for consulting work; and to report
to the Board of Directors, when so requested, on any accounting of financial matters. Compensation and Stock Committee Our Compensation and Stock Option Committee (the Compensation Committee) currently consists
of Messrs. Pace and Segel, each of whom is a non-employee director of the Company and a
disinterested person with respect to the plans administered by such committee, as such term is
defined in Rule 16b-3 adopted under the Securities Exchange Act of 1934, as amended, and the rules
and regulations thereunder (collectively, the Exchange Act). The Compensation Committee reviews
and approves annual salaries, bonuses and other forms and items of compensation for our senior
officers and employees. Except for plans that are, in accordance with their terms or as required by
law, administered by the Board of Directors or another particularly designated group, the
Compensation Committee also administers and implements all of our stock option and other
stock-based and equity-based benefit plans (including performance-based plans), recommends changes
or additions to those plans or awards under the plans. 15




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Our Audit Committee and Compensation and Stock Committee charters are available in print to any
stockholder upon request in writing to our principal executive office at 2625 Townsgate Road, Suite
330, Westlake Village, California 91361. Key Components of the Financial Statements and Important Trends The financial statements, including Balance Sheet, results of operations, cash flow and
Changes in Stockholders Equity should be read in conjunction with the Consolidated Financial
Statements and Notes thereto included elsewhere in this report. MD&A explains the key components of
each of these financial statements, key trends and reasons for reporting period-to-period
fluctuations. The Balance Sheet provides a snapshot view of our financial condition at the end of our fiscal
year. A balance sheet helps management and our stockholders understand the financial strength and
capabilities of our business. Balance sheets can help identify and analyze trends, particularly in
the area of receivables and payables. A review of cash compared to the comparable year and in
relation to ongoing profit or loss can show the ability of the Company to withstand business
variations. The relationship between Current Assets and Current Liabilities Working capital
(current assets less current liabilities) measures how much in liquid assets a company has
available to build its business . The presence of Deferred Revenue indicates cash received
on revenue to be earned over the next twelve months. Receivables that are substantially higher than
revenue for the quarter may indicate a slowdown of collections, with an impact on future cash
position. This is addressed further in MD&A under Liquidity and Capital Resources. The Consolidated Statement of Operations tells the reader whether the Company had a profit or
loss. It shows key sources of revenue and major expense categories. It is important to note
period-to-period comparisons of each line item of this statement, reasons for any fluctuation and
how costs are managed in relation to the overall revenue trend of the business. These statements
are prepared using accrual accounting under generally accepted accounting standards. This is
addressed further in MD&A under Revenues and Expenses. The Consolidated Statement of Cashflows explains the actual sources and uses of cash. Some
expenses of the Company, such as depreciation and amortization do not result in a cash outflow in
the current period, since the underlying patent expenditure or asset purchase was made years
earlier. New capital expenditures, on the other hand, resulted in a disbursement of cash, but will
be expensed in the Statement of Operations over its useful life. Fluctuations in Receivables and
payables also explain why the net change in cash is not equal to the loss reported on the Statement
of Operations. Therefore, it is possible that the impact of a net loss on cash is less or more than
the actual amount of the loss. This is discussed further in MD&A under Liquidity and Capital
Resources. The Consolidated Statement of Changes in Stockholders Equity shows the impact of the
operating results on the Companys equity. In addition, this statement shows new equity brought
into the Company through stock sales or stock option exercise. This is discussed further in MD&A
under Liquidity and Capital Resources. Results of Operations The following discussion and analysis relates to our financial condition and results of
operations for the year ended December 31, 2004 compared to the year ended December 31, 2003, and
the year ended December 31, 2003 compared to the year ended December 31, 2002. The following
discussion of the financial condition and results of operations should be read in conjunction with
the Consolidated Financial Statements and Notes thereto included elsewhere in this report. For the Year Ended December 31, 2004, Compared to the Year Ended December 31, 2003 Revenues Revenues decreased to $1,106,000 for the year ended December 31, 2004 compared to $1,269,000
for the year ended December 31, 2003, a decrease of 13%. Revenues are almost entirely comprised of
royalties pertaining to the licensing of Spatializer® audio signal processing algorithms. While the overall decrease was relatively modest, the revenue mix by licensee platform was
significantly different year over year. The decrease in revenues is attributed primarily to the
loss or reduction at three key DVD player accounts and one PC account which in aggregate, generated
approximately 56% of total fiscal 2003 revenue. In each case, these licensees decided to use no
licensed virtual surround solution or opted for a free solution from their chip supplier, driven
primarily by cost reduction pressure. These losses 16




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were partially offset by three new revenue sources in cellular phones, mobile audio semiconductors
and PCs, and the expansion of an existing license relating to recordable DVD. Gross Profit Gross profit decreased to $995,000 for the year ended December 31, 2004 compared to $1,147,000
in the comparable period last year, a decrease of 13%. Gross margin held steady at 90% of revenue
in the year ended December 31, 2004 compared with 90% of revenue for the comparable period last
year. The decrease in gross profit results from lower revenues in the current year We maintain a
high margin since revenues are from licensing and royalty activities, which have little or no
associated direct manufacturing or selling costs other than commissions paid to our independent
representatives that solicit and oversee the particular accounts. All development costs are
expensed as engineering and development expenses in the period they are incurred. Operating Expenses Operating expenses for the year ended December 31, 2004 decreased to $1,146,000 (105% of
sales) from $1,631,000 (128% of sales) for the year ended December 31, 2003, a decrease of 30%. The
decrease in operating expenses results primarily from reductions in general and administrative
expense and sales and marketing expense. General and Administrative expenses declined due to the
relocation to smaller and less expensive offices in December 2003 and lower occupancy-related
expenses. Sales and marketing expenses declined due to the elimination of a marketing and business
development executive position and related travel in the fourth quarter of 2003 and the
restructuring of our Japan sales operation. These responsibilities were transferred to another
executive and to a new commissioned representative firm in Japan. General and Administrative General and administrative expense decreased to $615,000 for the year ended December 31, 2004
from $811,000 for the year ended December 31, 2003, a decrease of 24%. The decrease is primarily
due to the relocation of our offices to smaller and lower cost facilities in December 2003, upon
expiration of an existing lease, lower occupancy related expenses, partially offset by increased
legal and accounting expenses related to public filings, in part in response to the additional
requirements imposed on public companies by the Sarbanes-Oxley Act and increased travel by the CEO.
General operating costs include rent, telephone, legal, public filing, office supplies and
stationery, postage, depreciation and similar costs. Research and Development Research and Development costs decreased to $393,000 for the year ended December 31, 2004,
compared to $459,000 for the year ended December 31, 2003, a decrease of 14%. The decrease in
research and development expense was due to the commencement of the use of lower cost specialist
consultants in India in the second half of 2004. We continued efforts to identify, validate, and develop new product ideas at DPI. Specific
engineering efforts were directed toward the launch of Spatializer Audio Alchemy, refinement of
Spatializer Natural Headphone, development of new cell phone solutions and applications engineering
to port our technology to leading processor platforms. Sales and Marketing Sales and Marketing costs decreased to $138,000 for the year ended December 31, 2004, compared
to $361,000 for the year ended December 31, 2003, a decrease of 62%. The reduction in such expenses
resulted from the elimination of a sales consultant position, the elimination of a sales executive
position in the third quarter of 2003 and fewer trade show participations. Net Income (Loss) Net loss was $157,000 for the year ended December 31, 2004; ($0.00) basic per share, compared
to net loss of $495,000, ($0.01) per share basic and diluted, for the year ended December 31, 2003.
Net loss for the current period is primarily the result of lower revenue, partially offset by lower
overhead. 17




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For the Year Ended December 31, 2003, Compared to the Year Ended December 31, 2002 Revenues Revenues decreased to $1,269,000 for the year ended December 31, 2003 compared to $1,856,000
for the year ended December 31, 2002, a decrease of 32%. Revenues are almost entirely comprised of
royalties pertaining to the licensing of Spatializer® audio signal processing algorithms. The decrease in revenues is attributed primarily to the loss or reduction at two key accounts
which generated in excess of 20% of total revenue each, partially offset by revenue from a new
account. The first lost account was in the PC market, which completed its migration to a new
operating system in which it chose not to include any software audio enhancements. The second
account was in the DVD player market, where it selected a lower cost solution for its low cost,
high volume DVD players. Gross Profit Gross profit decreased to $1,147,000 for the year ended December 31, 2003 compared to
$1,725,000 in the comparable period last year, a decrease of 34%. Gross margin decreased to 90% of
revenue in the year ended December 31, 2003 compared with 93% of revenue for the comparable period
last year. The decrease in gross profit results from lower revenues in the current year and from
lower gross margin. The decrease in the gross margin percentage reflects a change in mix to
commissionable foreign royalty revenue compared to non-commissionable U.S. sourced revenue. We
maintain a high margin since revenues are from licensing and royalty activities, which have little
or no associated direct manufacturing or selling costs other than commissions paid to our
independent representatives that solicit and oversee the particular accounts. Operating Expenses Operating expenses for the year ended December 31, 2003 decreased to $1,631,000 (128% of
sales) from $1,711,000 (92% of sales) for the year ended December 31, 2002, a decrease of 5%. The
decrease in operating expenses results primarily from reductions in sales and marketing due to the
elimination of a marketing and business development executive position and related travel in late
2003. These responsibilities were transferred to another executive and to a new representative firm
in Japan. In the fourth quarter of fiscal 2003, we implemented a cost reduction program that included
the elimination of an executive position, relocation of the corporate offices to smaller and lower
cost facilities, replacement of a stipended representative with a commissioned representative and
other overhead related cost savings. The annualized reduction to be provided by these initiatives
is expected to result in an overall overhead reduction of at least 20%. General and Administrative General and administrative costs increased to $811,000 for the year ended December 31, 2003
from $766,000 for the year ended December 31, 2002, an increase of 6%. The increase is primarily
due to increased legal expenses related to public filings, in part in response to the additional
requirements imposed on public companies by the Sarbanes-Oxley Act, and increased travel by the
CEO. General operating costs include rent, telephone, legal, public filing, office supplies and
stationery, postage, depreciation and similar costs. Research and Development Research and Development costs increased to $459,000 for the year ended December 31, 2003,
compared to $433,000 for the year ended December 31, 2002, an increase of 6%. The increase in
research and development expense was due to strategic use of outside specialist consultants, wage
increases and increased health insurance premiums for such personnel. We continued efforts to identify, validate, and develop new product ideas at DPI. Specific
engineering efforts were directed toward 18




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the launch of Spatializer Audio Alchemy, refinement of Spatializer Natural Headphone,
development of the HD Series of whole product solutions and applications engineering to port our
technology to leading processor platforms. Sales and Marketing Sales and Marketing costs decreased to $361,000 for the year ended December 31, 2003, compared
to $513,000 for the year ended December 31, 2002, a decrease of 30%. The reduction in such expenses
resulted from the elimination of a sales consultant position, the elimination of a sales executive
position in the third quarter of 2003 and fewer trade show participations. Net Income (Loss) Net loss was $495,000 for the year ended December 31, 2003; ($0.01) basic per share, compared
to net income of $18,000, ($0.00) per share basic and diluted, for the year ended December 31,
2002. Net loss for the current period is primarily the result of lower gross margin, partially
offset by lower overhead. Liquidity and Capital Resources At December 31, 2004, we had $871,000 in cash and cash equivalents as compared to $590,000 at
December 31, 2003. The increase in cash and cash equivalents is attributed to an increase in
deferred revenue resulting from prepayments on a licensing agreement of $391,395, partially offset
by the operating loss of $174,103. We had working capital of $586,000 at December 31, 2004 as
compared with working capital of $793,000 at December 31, 2003. Net cash provided by operating activities was $343,939 for the year ended December 31, 2004,
as compared to net cash used in operating activities of $253,965 for the year ended December 31,
2003 and net cash provided by operating activities of $85,138 for the year ended December 31, 2002.
The increase in cash flows from operations for the year ended December 31, 2004 was primarily a
result of the increase in deferred income, a decrease in accounts receivable, partially offset by
the net loss. Deferred income increased due to the licensing prepayment and accounts receivable
decreased a portion of fourth quarter 2004 revenues being realized through the recognition of
deferred income. We use cash in investing activities primarily to secure patent and trademark protection for
our proprietary technology and brand name, and to purchase short-term investments such as bank
certificates of deposit. Cash used in investing activities totaled $20,587, $20,709 and $95,891,
respectively, in the years ended December 31, 2004, 2003, and 2002. All expenditures for on-going
research and development are expenses and therefore included in the Net Loss. Net cash flows used in financing activities totaled $41,994 for the year ended December 31,
2004 and cash provided by financing activities totaled $5,746 and $0 for the years ended December
31, 2003 and 2002, respectively. In November 2002, the Board of Directors and the holders of our previously outstanding Series
B Preferred Stock agreed to exchange the Series B Preferred Stock for a new Series B-1 Preferred
Stock, which are convertible commencing in December 2005 into restricted Common Stock at a 10%
discount, based on the 10 day average closing bid price prior to the conversion, but subject to a
minimum conversion of $.56 per share and a maximum of $1.12 per share. The exchange was completed
in December 2002. In connection with the exchange the Series B-1 Preferred Stock, we withdrew the
Series A and Series B Preferred Stock and, therefore, currently the Series B-1 Preferred Stock is
our only authorized or outstanding class of preferred stock. In the fourth quarter of 2003, we negotiated and completed the conversion of a $112,500
related party 10% demand note to a three-year 10% term note. Principal and interest of $5,191 is
paid monthly, which we pay on a current basis. Since the director who was an indirect beneficiary
of the demand note retired from the Board of Directors in June 2003, the demand note is classified
as a note payable at December 31, 2004. There are no installments due in more than twelve months
as of December 31, 2004. We continue to maintain an accrual for unasserted claims or settlement costs of approximately
$28,000. We do not expect any final liability to be in excess of this balance. 19




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Future payments due under operating lease obligations as of December 31, 2004 are described
below: Payments due by periodLess than
    
    
    
    
    
    
    
    
    
    
    More thanContractual obligations
    
    Total
    
    
    1 year
    
    
    1-3 years
    
    
    3-5 years
    
    
    5 yearsLong-Term Debt ObligationsCapital Lease ObligationsOperating Lease Obligations
    
    $
    54,955
    
    
    $
    28,680
    
    
    $
    26,275Purchase ObligationsTotal
    
    $
    54,955
    
    
    $
    28,680
    
    
    $
    26,275
 Our future cash flow will come primarily from the audio signal processing licensing, OEM
royalties and from possible common stock issuances including warrants and options. We are actively
engaged in negotiations for additional audio signal processing licensing arrangements which we
believe should generate additional cash flow without imposing any substantial costs on us. We
anticipate that there may continue to be dislocations of individual licensing programs due to
continuing pressure to reduce costs, particularly in the DVD player segment. We currently believe
that growth from other licensing arrangements, which include new markets such as cellular phones,
and other arrangements that are pending but not announced or in negotiation, will substantially
offset any revenue shortfalls from market dynamics or transitioning platforms. The four new or
expanded licensing deals from such sources that generated approximately 60% of fiscal 2004 revenue
support this belief. Further, our cost reduction initiative implemented in the fourth quarter of
2003 has lowered the revenues needed to reach the break-even point. The fluid, competitive and dynamic nature of the market continues a degree of uncertainty to
our operations. The operations of our business, and those of our competitors, may also be impacted
by the continued trend in the semiconductor industry to offer free, but minimal audio solutions to
certain product classes to maintain and attract market share. This challenges our ability to
convert business opportunities to licensing agreements in those segments that allow us to maintain
or rapidly increase revenue. As a result, we must develop and license its products and software
solutions in a market that treats some audio products, including those of our competitors, on a
commodity basis in those cases where the OEM product is considered a commodity product. While our
software applications deliver what we and most manufacturers who listen to it believe is a
significantly superior audio experience, the competitive market forces that pressure manufacturers
to reduce their costs may create some resistance to new technology adoption or use. In addition,
certain of our competitors appear to be pursuing a business plan that disregards commercially
reasonable pricing to achieve a larger market penetration even if the penetration will not provide
for viable margins or returns. We have responded by offering additional products targeted to each
price/quality segment of the market and continue to aggressively pursue new opportunities in
emerging product categories such as cellular phones and notebook computers that complements our
existing core business. In addition, our products have been positioned as a means for manufacturers
to save money while delivering an enhanced audio experience. Nevertheless, these market conditions
and competitive forces make it more challenging for us, and our rational commercial competitors, to
enhance their operating results. To the extent we maintain or exceed our projected revenues and are not required to fund
significant contingencies, we expect to continue to retain our current cash reserves and therefore,
maintain our liquidity position at a consistent level both on a short-term and long-term basis. To
the extent that we do not achieve current operating levels or are required to fund contingencies,
we will be required to use some of our cash reserves and this could impact our longer term
liquidity. In addition, we wish to achieve accelerated growth and to take advantage of the dynamic
market forces in which we operate, rather than to be affected by them. We believe our current cash
reserves and cash generated from our existing operations and customer base are sufficient for us to
meet our operating obligations and the anticipated additional research and development for our
audio technology business for at least the next 12 months. We will also continue to consider and
evaluate capital investment or business arrangements with financial or strategic participants or
investors as such opportunities become available to us on terms that enhance shareholder value and
support our business strategy. Net Operating Loss Carry forwards At December 31, 2004, we had net operating loss carry forwards for Federal income tax purposes
of approximately $26,500,000 which are available to offset future Federal taxable income, if any,
through 2013. Approximately $21,700,000 of these net operating loss carry forwards is subject to an
annual limitation of approximately $1,000,000. 20




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In December 2003, the FASB issued SFAS 132R Employers Disclosures about Pensions and Other
Postretirement Benefitsan amendment of FASB Statements No. 87, 88, and 106. This Statement
revises employers disclosures about pension plans and other postretirement benefit plans. It does
not change the measurement or recognition of those plans required by FASB Statements No. 87,
EmployersAccounting for Pensions,No. 88, Employers Accounting for Settlements and Curtailments
of Defined Benefit Pension Plans and for Termination Benefits,and No. 106, Employers Accounting
for Postretirement Benefits Other Than Pensions.This Statement retains the disclosure requirements
contained in FASB Statement No. 132, Employers Disclosures about Pensions and Other Postretirement
Benefits,which it replaces. It requires additional disclosures to those in the original Statement
132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit
pension plans and other defined benefit postretirement plans. The Company will adopt the provisions
of SFAS 132R on January 1, 2004. The adoption of this pronouncement is not expected to have a
material effect on the Companys financial position, results from operations or cash flows. In November 2004, the FASB issued SFAS No. 151, Inventory Costs-an amendment of ARB. No. 43,
Chapter 4.This Statement amends the guidance in ARB No. 43, Chapter 4, Inventory Pricing, to
clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and
wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously stated that ... under some
circumstances, items such as idle facility expense, excessive spoilage, double freight, and
rehandling costs may be so abnormal as to require treatment as current period charges.... This
Statement requires that those items be recognized as current-period charges regardless of whether
they meet the criterion of so abnormal. In addition, this Statement requires that allocation of
fixed production overheads to the costs of conversion be based on the normal capacity of the
production facilities. In December 2004, the FASB issued SFAS No. 152, Accounting for Real Estate Time-Sharing
Transactions  an amendment of FASB statements no. 66 and 67. This Statement amends FASB Statement
No. 66, Accounting for Sales of Real Estate, to reference the financial accounting and reporting
guidance for real estate time-sharing transactions that is provided in AICPA Statement of Position
(SOP) 04-2, Accounting for Real Estate Time-Sharing Transactions.This Statement also amends FASB
Statement No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects, to
state that the guidance for (a) incidental operations and (b) costs incurred to sell real estate
projects does not apply to real estate time-sharing transactions. The accounting for those
operations and costs is subject to the guidance in SOP 04-2. In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary assets  an amendment of
APB Opinion No. 29.This Statement amends APB Opinion 29 to eliminate the exception for
nonmonetary exchanges of similar productive assets and replaces it with a general exception for
exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has
commercial substance if the future cash flows of the entity are expected to change significantly as
a result of the exchange. In December 2004, the FASB issued SFAS No. 123R, Share Based Payment. This Statement is a
revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. This Statement
supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees and its related
implementation guidance. This Statement establishes standards for the accounting for transactions
in which an entity exchanges its equity instruments for goods or services. It also addresses
transactions in which an entity incurs liabilities in exchange for goods or services that are based
on the fair value of the entitys equity instruments or that may be settled by the issuance of
those equity instruments. The Statement focuses primarily on accounting for transactions in which
an entity obtains employee services in share-based payment transactions. This Statement does not
change the accounting guidance for share-based payment transactions with parties other than
employees provided in Statement 123 as originally issued and EITF Issue No. 96-18, Accounting for
Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services.   This Statement does not address the accounting for employee share
ownership plans, which are subject to AICPA Statement of Position 93-6, Employers Accounting for
Employee Stock Ownership Plans. Factors That May Affect Future Results This Annual Report on Form 10-K contains forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities
Act of 1933, as amended, reflecting managements current expectations. Examples of such
forward-looking statements include our expectations with respect to our strategy. Although we
believe that our expectations are based upon reasonable assumptions, there can be no assurances
that our financial goals will be realized. Such forward-looking statements involve known and
unknown risks, uncertainties and other factors that may cause our actual results, performance or
achievements, or industry results, to be materially different from any future results, performance
or achievements expressed or implied by such forward-looking statements. Numerous factors may
affect our actual results and may cause results to differ materially from those expressed in
forward-looking statements made by or on behalf of our company. For this purpose, any statements
contained herein that are not statements of historical fact may be deemed to be forward-looking
statements. Without limiting the foregoing, the words, believes, anticipates, plans,
expects and similar expressions are intended to identify forward-looking statements. The
important factors discussed under the caption Factors That May Affect Future Results in Item 7.
Managements Discussion and Analysis of Financial Condition and Results of Operations, herein,
among others, would cause actual results to differ materially from those indicated by
forward-looking statements made herein and represent managements current expectations and are
inherently uncertain. Investors are warned that actual results may differ from managements
expectations. We assume no obligation to update the forward-looking information to reflect actual
results or changes in the factors affecting such forward-looking information. Our Operating Results Fluctuate and If We Are Unable to Achieve or Sustain Profitability in the
Future or Obtain Future Financing Our Business Operations May Fail We have experienced a loss from operations in three of the last four years. We experienced
declining losses in the second and third quarters of 2004, and a profit in the fourth quarter of
2004. While our objective and full effort is on managing a profitable business, due to the market
conditions and factors outlined above and below and their impact on fluctuations in operating
expenses and revenues,, we cannot provide assurance that we will be able to generate a positive
profit position in any given future period. We cannot guarantee that we will increase sales of our
products and technologies, or that we will successfully develop and market any additional products,
or achieve or sustain future profitability, and we may have to rely on the sale of shares or on
debt financings in the future, which may have a dilutive effect on our existing shareholders.
Further, we cannot assure you that debt or equity financing will be available as required and if
not available, we would have to further scale down operations or even cease operations. Because The Market In Which We Operate Is Highly Competitive, We Face Significant Pricing Pressure
and Competition. 22




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The PC and consumer electronics markets are under intense pressure, primarily from retailers,
to reduce selling prices, with resultant pressure to reduce costs. In addition, certain of our
competitors appear to be pursuing a business plan that disregards commercially reasonable pricing
to achieve a larger market penetration even if the penetration will not provide for viable margins
or returns. Cost reductions are driven by lower cost sourcing, often in China, design
simplification and reduction in or substitution of features. Therefore, we are seeking commercial
acceptance of our products in highly competitive markets. We have responded by offering additional
products targeted to each price and quality segment of the market, more aggressively price and
feature enrich our products and enter new segments, such as cell phones, with different competitive
pressure. While we present a value proposition that stresses the cost reducing capabilities of our
audio solutions through improved performance from lower cost components as well as product
differentiation that Spatializer technology can deliver, all such features are closely scrutinized
by potential customers product marketing and engineering. This makes it more challenging to secure
new design wins, particularly in product categories that have become commoditized, such as the case
with DVD players. It also may result in the elimination of features, including ours, if cost is of
paramount importance. There is no assurance that our present or contemplated future products will
achieve or maintain sufficient commercial acceptance, or if they do, that functionally equivalent
products will not be developed by current or future competitors who had access to significantly
greater resources or which are willing to give away their products. Because Our Relative Size and Power Is Small Compared To That of Our Customers, Our Business
Leverage With Some Customers Is Generally Weak and Communication Not Always Transparent We deal with some of the largest global consumer electronics makers in the world, the vast
majority of which are in Asia. Spatializer is a small company and there are other options for
manufacturers, including those from our competitors, their chip suppliers, or eliminating the use
of audio enhancement technology altogether. As such, our leverage with our customers is generally
weak. In addition, the culture in our local markets may not dictate clear, direct and transparent
communication of business plans or technology usage as is the culture in our home country. When
this occurs, we could receive very short notice of discontinued use of our technology and revenues
from such an account would typically begin a steep decline in the subsequent quarter, resulting in
period-to-period fluctuation. This also results in limited visibility with regard to future
revenues and its impact on our operating results. Our response has been to strengthen our business
relationships with more onsite visits, increase our understanding of cultural differences and focus
more intently on service. We also emphasize to our overseas sales representatives the need for
close customer support, with the objective that both new opportunities and possible difficulties
are brought to light as soon as possible. We Rely on the Schedules and Cooperation of Chip Makers or Other Third Parties to Deliver Our
Technology in Consumer Products. These Third Parties Have Their Own Priorities and Alliances That
May Delay or Thwart our Sales Efforts to Potential Customers. Spatializer does not develop or market semiconductors. That is why we carry no inventory or have
order backlogs that typically are good indicators of near term performance. Rather, we develop
audio algorithms that are embedded on third party processors or semiconductors used by our
customers. While our algorithms are implemented on a wide array of processors, often times a
customer uses a processor where there is no such implementation, or where a competing solution has
been implemented. In this case, our customers request that our algorithm be implemented. While
these requests are typically honored, processor manufacturers must schedule such implementation as
their resources or corporate strategies allow. Therefore, the supply-chain is often quite long and
complicated, which potentially can result in delays or deadlines that may not always coincide with
our customers requirements and which are beyond the control of our company.In addition, standards
may be adopted by cell phone system operators or manufacturers that may impede or prevent the
penetration of non-standard technology onto their platforms. While our efforts are focused on
promoting our technology to such potential customers, there is no assurance that we will be
successful in making our technology a standard. If New Product Development Is Delayed, We Will Experience Delays In Revenues And Competitive
Products May Reach The Market Before Our Products. Since our inception, we have experienced delays in bringing new products to market and
commercial application as a result of delays inherent in technology development, financial resource
limits and industry responses and maturity. These delays have resulted in delays in the timing of
revenues and product introduction. In the future, delays in new product development or technology
introduction on behalf of us, our original equipment manufacturers of consumer electronics and
multimedia computer products (OEMs), integrated circuit (IC) foundries or our software producers
and marketers could result in further delays in revenues and could allow competitors to reach the
market with products before us. In view of the emerging nature of the technology involved, and the
rapidly changing character of the entire media, internet and computer markets, our expansion into
other technology areas and the 23




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uncertainties concerning the ability of our current products and new products to achieve
meaningful commercial acceptance, there can be no assurance of when or if we will achieve or
sustain profitability. Manufacturers design-in cycles for our technology range from four to twelve months, from the
decision to adopt our technology to cashflow. These schedules are also prone to delays at the
manufacturer level and in some cases, manufacturers new products may be cancelled due to market
testing or resource allocation. Since these events are beyond our control, it is difficult to
absolutely project when new deals will begin generating revenues or if signed deals will generate
financial results. For this reason, we do not typically announce new deals until the target product
is being introduced. We Expect That We Will Continue to be Dependent upon a Limited Number of OEMs for a
Significant Portion of Our Net Sales in Future Periods Although no OEM is presently obligated either to purchase a specified amount of products or to
provide us with binding forecasts of product purchases for any period, we anticipate being
dependent upon a limited number of OEMs for a large port of our net sales. Our four largest
customers as of December 31, 2004 accounted for 30%, 25%, 21% and 13% of our net sales.. The loss
of any one of our major customers or licensees would significantly reduce our revenues and harm our
ability to achieve or sustain acceptable levels of operating results. The loss, or signing of a
similarly sized account or accounts would have a material short term impact on our operations and
there is no assurance that we will not lose all or some of the revenues from one or more of these
accounts. While we are working to broaden the sources of our royalty streams, there can be no
assurance that we will be successful in retaining or attracting such key accounts and broadening
such revenue stream sources. Demand for Our Products is Subject to Risks Beyond Our Control. Our products are typically one of many related products used by consumer electronic users. As
a result, demand for our products is therefore subject to many risks beyond our control, including,
among others:  
    competition faced by our OEM customers in their particular end markets;
    the technical, sales and marketing and management capabilities of our OEM customers;
    the pressure faced by our OEM customers to reduce cost There can be no assurance that we will not lose sales in the future as a result of the
pressure to reduce costs faced by our customers. The reduction of orders from our significant OEM
customers, or the discontinuance of our products by our end users may subject us to potential
adverse revenue fluctuations. Because The Technology Environment In Which We Operate Is Rapidly Changing, We May Not Be
Successful In Establishing And Maintaining The Technological Superiority Of Our Products Over Those
Of Our Competitors. We operate in a technology environment which is competitive and rapidly changing. While our
software applications deliver what we, and most manufacturers who listen to it, believe is a
significantly superior audio experience, the competitive market forces that pressure manufacturers
to reduce their costs may create some resistance to new technology adoption or use. Our future
success is dependent on establishing and maintaining the technological superiority of our products
over those of competitors, our ability to successfully identify and bring other compatible
technologies and products to market and a recognition by the market of product value. We compete
with a number of entities that produce various stereo audio enhancement processes, technologies and
products in both traditional two-speaker environments such as consumer electronics and multimedia
computing, and in multi-channel, multi-speaker applications such as Home Theater. In the field of
3-D or virtual audio, our principal competitors are SRS Labs, Inc., QSound Labs, Inc. and Dolby
Laboratories or technologies and products developed by other companies, including entities that
have business relationships with us. There can be no assurance that we will be able to favorably
compete in this market in the future. If We Are Unable To Attract And Retain Our Key Personnel, We May Not Be Able To Successfully
Operate Our Business. Our future success primarily depends on the abilities and efforts of a small number of
individuals, with particular management obligations and technical expertise. Loss of the services
of any of these persons could adversely affect our business prospects. There is no assurance that
we will be able to retain this group or successfully recruit other personnel, as needed. We compete
with other 24




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enterprises with stronger financial resources and larger staffs that may offer employment
opportunities to our staff which are more desirable than those which we are able to offer. Failure
to maintain skilled personnel with the software and engineering skills critical to our business
could have an adverse impact upon our business, the results of our operations and our prospects.
Currently, all new licenses are negotiated by Henry R. Mandell, our Chief Executive Officer, with
whom we have an employment agreement with a term expiring in November 2006. The Market For Our Stock May Be Not Remain Liquid And The Stock Price May Be Subject To Volatility Our stock is quoted on the OTC Bulletin Board, where low trading volume and high volatility is
often experienced. While a few firms make a market in our stock, the historically low trading
volume and relatively few market makers of our stock makes it more likely that a severe fluctuation
in volume, either up or down, will significantly impact the stock price. There can be no assurance
that these market makers will continue to quote our stock and a reduction in such market makers
would negatively impact trading liquidity. Further, with our constrained resources and increased
cost and time associated with implementation of Sarbanes-Oxley, it may not be possible for us to
remain listed on the OTC Bulletin Board in the future as a fully reporting company. This and the
existing limited market and volume in the trading of our stock, may result in our shareholders
having difficulty selling our common stock.The trading price of our Common Stock has been, and will
likely continue to be, subject to wide fluctuations in response to quarterly variations in our
operating results, announcements of new products or technological innovations by the Company or our
competitors, strategic alliances between us and third parties, general market fluctuations and
other events and factors, some of which may be beyond our control. 
 Item 7A.Quantitative and Qualitative Disclosures About Market Risk We have not been exposed to material future earnings or cash flow fluctuations from changes in
interest rates on our short-term investments at December 31, 2004. A hypothetical decrease of 100
basis points in interest rate (ten percent of our overall earnings rate) would not result in a
material fluctuation in future earnings or cash flow. We have not entered into any derivative
financial instruments to manage interest rate risk or for speculative purposes and we are not
currently evaluating the future use of such financial instruments. 25




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Item 8.Financial Statements and Supplementary Data 
 INDEPENDENT AUDITORS REPORT To the Board of Directors Of Spatializer Audio Laboratories, Inc.: We have audited the accompanying consolidated balance sheets of Spatializer Audio
Laboratories, Inc. and subsidiaries (The Company) as of December 31, 2004 and 2003 and the
related consolidated statements of operations, shareholders equity, and cash flows for the years
ended December 31, 2004, 2003 and 2002. 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 the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits 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, 2004 and 2003, and the results of its operations and its cash flows for the
years ended December 31, 2004, 2003 and 2002 in conformity with
accounting principles generally
accepted in the United States of America. /s/ FARBER & HASS LLP Camarillo, California
February 28, 2005 26




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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES 
 CONSOLIDATED BALANCE SHEETS December 31,
    
    
    December 31,2004
    
    
    2003ASSETSCurrent Assets:Cash and Cash Equivalents
    
    $
    871,155
    
    
    $
    589,797Accounts Receivable
    
    
    325,712
    
    
    
    345,411Prepaid Expenses and Other Current Assets
    
    
    70,940
    
    
    
    35,430Total Current Assets
    
    
    1,267,807
    
    
    
    970,638Property and Equipment, Net
    
    
    29,527
    
    
    
    42,022Intangible Assets, Net
    
    
    166,710
    
    
    
    192,485Other Assets
    
    
    
    
    
    
    $
    1,464,044
    
    
    $
    1,205,145LIABILITIES AND STOCKHOLDERS EQUITYCurrent Liabilities:Notes Payable
    
    
    66,252Notes Payable to Related Party, Short Term
    
    
    
    
    
    
    37,500Accounts Payable
    
    
    71,873
    
    
    
    21,466Accrued Wages and Benefits
    
    
    50,446
    
    
    
    36,973Accrued Professional Fees
    
    
    20,000
    
    
    
    20,000Accrued Commissions
    
    
    32,182
    
    
    
    33,856Accrued Expenses
    
    
    32,979
    
    
    
    28,197Deferred Income
    
    
    391,395Total Current Liabilities
    
    
    665,127
    
    
    
    177,992Notes Payable to Related Party, Long Term
    
    
    
    
    
    
    70,746Commitments and ContingenciesSeries B-1 Redeemable Convertible Preferred Shares, $0.01 par
value: 1,000,000 shares authorized; 118,351 shares issued and
outstanding at December 31, 2004 (liquidation preference
of $1,183,510)
    
    
    1,182
    
    
    
    1,182Stockholders Equity (Deficit):Common shares, $0.01 par value; 65,000,000 shares authorized;
46,975,363 and 47,015,865 shares issued and outstanding at
December 31, 2004 and 2003, respectively
    
    
    469,754
    
    
    
    470,159Additional Paid-In Capital
    
    
    46,428,866
    
    
    
    46,428,461Accumulated Deficit
    
    
    (46,100,885
    )
    
    
    (45,943,395
    )Total Shareholders Equity
    
    
    797,735
    
    
    
    955,225$
    1,464,044
    
    
    $
    1,205,145
 See accompanying notes to consolidated financial statements 27




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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF OPERATIONS Year Ended December 31,2004
    
    
    2003
    
    
    2002Revenues:Royalty Revenues
    
    $
    1,105,923
    
    
    $
    1,269,286
    
    
    $
    1,855,934Cost of Revenues
    
    
    111,395
    
    
    
    122,417
    
    
    
    130,516994,528
    
    
    
    1,146,869
    
    
    
    1,725,418Operating Expenses:General and Administrative
    
    
    615,412
    
    
    
    811,024
    
    
    
    765,637Research and Development
    
    
    393,004
    
    
    
    458,940
    
    
    
    432,826Sales and Marketing
    
    
    137,889
    
    
    
    360,692
    
    
    
    512,7271,146,305
    
    
    
    1,630,656
    
    
    
    1,711,190Operating Income (Loss)
    
    
    (151,777
    )
    
    
    (483,787
    )
    
    
    14,228Interest Income
    
    
    4,982
    
    
    
    7,201
    
    
    
    12,432Interest Expense
    
    
    (10,295
    )
    
    
    (13,447
    )
    
    
    (14,493
    )Other Income (Expense), Net
    
    
    0
    
    
    
    0
    
    
    
    25(5,313
    )
    
    
    (6,246
    )
    
    
    (2,036
    )Income (Loss) Before Income Taxes
    
    
    (157,090
    )
    
    
    (490,033
    )
    
    
    12,192Income Taxes
    
    
    (400
    )
    
    
    (5,420
    )
    
    
    (6,100
    )Net Income (Loss)
    
    $
    (157,490
    )
    
    $
    (495,453
    )
    
    $
    18,292Basic and Diluted Income (Loss) per Share:
    
    $
    (.00
    )
    
    $
    (.01
    )
    
    $
    .00Weighted-Average Shares Outstanding
    
    
    46,975,363
    
    
    
    47,309,171
    
    
    
    47,406,939
 See accompanying notes to consolidated financial statements 28




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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended December 31,2004
    
    
    2003
    
    
    2002Cash Flows from Operating Activities:Net Income (Loss)
    
    $
    (157,490
    )
    
    $
    (495,453
    )
    
    $
    18,292Adjustments to Reconcile Net Income (Loss) to
Net Cash Provided (Used) by Operating
Activities:Depreciation
    
    
    11,942
    
    
    
    30,591
    
    
    
    54,737Amortization
    
    
    46,915
    
    
    
    52,313
    
    
    
    50,766Stock and Options Issued for Services
    
    
    
    
    
    
    12,000Net Change in Assets and Liabilities:Accounts Receivable
    
    
    19,699
    
    
    
    153,612
    
    
    
    (56,460
    )Prepaid Expenses, Deposits and Other Assets
    
    
    (35,510
    )
    
    
    55,960
    
    
    
    43,370Accounts Payable
    
    
    50,407
    
    
    
    (17,561
    )
    
    
    24,155Accrued Expenses and Other Liabilities
    
    
    16,581
    
    
    
    (45,427
    )
    
    
    50,286Deferred Revenue
    
    
    391,395Discontinued Operations
    
    
    
    
    
    
    
    
    
    
    (100,000
    )Net Cash Provided (Used) by Operating Activities
    
    
    343,939
    
    
    
    (253,965
    )
    
    
    85,138Cash Flows from Investing Activities:Purchase of Property and Equipment
    
    
    (4,007
    )
    
    
    (1,771
    )
    
    
    (74,993
    )Intangible Assets
    
    
    (16,580
    )
    
    
    (18,938
    )
    
    
    (20,898
    )Net Cash Used by Investing Activities
    
    
    (20,587
    )
    
    
    (20,709
    )
    
    
    (95,891
    )Cash Flows from Financing Activities:Exercise of Options and Warrants
    
    
    
    
    
    
    10,000Notes Payable
    
    
    66,252Notes and Amounts Due to (from) Related Parties
    
    
    (108,246
    )
    
    
    108,246Repayments/Termination of Notes Payable
    
    
    
    
    
    
    (112,500
    )Net Cash Provided (Used) by Financing Activities.
    
    
    (41,994
    )
    
    
    5,746Increase (Decrease) in Cash and Cash Equivalents.
    
    
    281,358
    
    
    
    (268,928
    )
    
    
    (10,753
    )Cash and Cash Equivalents, Beginning of Year
    
    
    589,797
    
    
    
    858,725
    
    
    
    869,478Cash and Cash Equivalents, End of Year
    
    $
    871,155
    
    
    $
    589,797
    
    
    $
    858,725Supplemental Disclosure of Cash Flow Information:Cash Paid During the Year for:Interest
    
    $
    10,295
    
    
    $
    11,250
    
    
    $
    14,493Income Taxes
    
    $
    400
    
    
    $
    4,800
    
    
    $
    2,400
 See accompanying notes to consolidated financial statements 29




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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT) 10% Series B Convertible
    
    
    CommonPreferred Shares
    
    
    Shares
    
    
    Common SharesAdditional
    
    
    
    
    
    
    TotalNumber of
    
    
    Par
    
    
    Number of
    
    
    Par
    
    
    Paid-In-
    
    
    Accumulated
    
    
    ShareholdersShares
    
    
    Value
    
    
    Shares
    
    
    Value
    
    
    Capital
    
    
    Deficit
    
    
    EquityBalance, December 31, 2001
    
    
    87,967
    
    
    $
    880
    
    
    
    47,406,939
    
    
    $
    474,070
    
    
    $
    46,402,852
    
    
    $
    (45,466,234
    )
    
    $
    1,411,568Conversion of 10% Series B to
Redeemable Series B-1
    
    
    (87,867
    )
    
    
    (880
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (880
    )Series B Pfd. Share dividend
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (302
    )
    
    
    
    
    
    
    (302
    )Net Income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    18,292
    
    
    
    18,292Balance, December 31, 2002
    
    
    -0-
    
    
    $
    -0-
    
    
    
    47,406,939
    
    
    $
    474,070
    
    
    $
    46,402,550
    
    
    $
    (45,447,942
    )
    
    $
    1,428,678Options Exercised Warrants
Exercised
    
    
    
    
    
    
    
    
    
    
    166,666
    
    
    
    1,667
    
    
    
    8,333
    
    
    
    
    
    
    
    10,000Options Issued for Services
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    12,000
    
    
    
    
    
    
    
    12,000Cancellation of Unissued
Performance Shares
    
    
    
    
    
    
    
    
    
    
    (557,740
    )
    
    
    (5,578
    )
    
    
    5,578Net Loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (495,453
    )
    
    
    (495,453
    )Balance, December 31, 2003
    
    
    -0-
    
    
    $
    -0-
    
    
    
    47,015,865
    
    
    $
    470,159
    
    
    $
    46,428,461
    
    
    $
    (45,943,395
    )
    
    $
    955,225Cancellation of Unissued
Performance Shares
    
    
    
    
    
    
    
    
    
    
    (40,500
    )
    
    
    (405
    )
    
    
    405Net Loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (157,490
    )
    
    
    (157,490
    )Balance, December 31, 2004
    
    
    -0-
    
    
    $
    -0-
    
    
    
    46,975,365
    
    
    $
    469,754
    
    
    $
    46,428,866
    
    
    $
    (46,100,885
    )
    
    $
    797,735
 See accompanying notes to consolidated financial statements 30




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SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) Nature of Business Spatializer Audio Laboratories, Inc. and subsidiaries (the Company) is in the business of
developing and licensing technology. The Company sales, research and subsidiary administration are
conducted out of facilities in San Jose, California. The Companys wholly-owned subsidiary, Desper Products, Inc. (DPI), is in the business of
developing proprietary advanced audio signal processing technologies and products for consumer
electronics, entertainment, and multimedia computing. All Company revenues are generated from this
subsidiary. (2) Significant Accounting Policies Basis of Consolidation The consolidated financial statements include the accounts of
Spatializer Audio Laboratories, Inc. and its wholly-owned subsidiary, Desper Products, Inc. All
significant intercompany balances and transactions have been eliminated in consolidation. Corporate
administration expenses are not allocated to subsidiaries. Reclassification
Certain 2003 and 2002 amounts have been reclassified to
conform with the current year presentation. In that regard, the
Company has reflected the issuance of 15,384 shares of Class B-1 Convertible Preferred Stock that was originally recorded in Additional
Paid-in Capital. This resulted in a reclassification of $154 to Convertible Preferred Stock from APIC. Revenue Recognition The Company recognizes revenue from product sales upon shipment to the
customer. License revenues are recognized when earned, in accordance with the contractual
provisions. Royalty revenues are recognized upon shipment of products incorporating the related
technology by the original equipment manufacturers (OEMs) and foundries. The Company recognizes
revenue in accordance with SEC Staff Accounting Bulletin 101. Concentration of Credit Risk Financial instruments, which potentially subject the company to
concentrations of credit risk, consist principally of cash, cash equivalents and trade accounts
receivable. The Company places its temporary cash investments in certificates of deposit in excess
of FDIC insurance limits, principally at Citibank FSB. At December 31, 2004 and 2003, substantially
all cash and cash equivalents were on deposit at one financial institution. At December 31, 2004, three major customers, not presented in order of importance, each
accounted for 10% or more of our total accounts receivable: Matsushita, Sharp and Toshiba
Corporation, each of whom accounted for greater than 10% of our total 2004 accounts receivable. One
customer accounted for 31.0%, another accounted for 27% and one accounted for 18% of our total
accounts receivable at December 31, 2004. At December 31, 2003, one customer accounted for 42%, one
customer accounted for 23% and one customer accounted for 16%. The Company performs ongoing credit evaluations of its customers and normally does not require
collateral to support accounts receivable. Due to the contractual nature of sales agreements and
historical trends, no allowance for doubtful accounts has been provided. The Company does not apply interest charges to past due accounts receivable. Cash and Cash Equivalents Cash equivalents consist of highly liquid investments with
original maturities of three months or less. Customers Outside of the U.S.-Sales to foreign customers were 95%, 91% and 90% of total sales
in the years ended December 31, 2004 and 2003 and 2002, respectively. Major Customers During the year ended December 31, 2004, four customers accounted for 29%,
25%, 21% and 13%, respectively, of the Companys net sales. During the year ended December 31,
2003, three customers accounted for 34%, 20%, and 20%, respectively, of the Companys net sales. 31




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Research and Development Costs The Company expenses research and development costs as
incurred, which is presented as a separate line on the statement of operations. Advertising Costs Costs incurred for producing and communicating advertising are expensed
when incurred and included in selling, general and administrative expenses. Consolidated
advertising expense amounted to $4,289, $2,960 and $4,087 in 2004, 2003 and 2002, respectively. Property and Equipment Property and equipment are stated at cost. Major renewals and
improvements are charged to the asset accounts while replacements, maintenance and repairs, which
do not improve or extend the lives of the respective assets, are expensed. At the time property and
equipment are retired or otherwise disposed of, the asset and related accumulated depreciation
accounts are relieved of the applicable amounts. Gains or losses from retirements or sales are
credited or charged to income. Property and equipment are depreciated over the useful lives of the
asset ranging from 3 years to 5 years under the straight line method. Intangible Assets Intangible assets consist of patent costs and trademarks which are
amortized on a straight-line basis over the estimated useful lives of the patents which range from
five to twenty years. Earnings Per Share The Company determines earnings per share in accordance with Statement of
Financial Accounting Standards No. 128, Earnings Per Share(SFAS 128). Basic earnings (loss) per
share is computed by dividing net income (loss) available to common shareholders by the weighted
average number of common shares outstanding during the period. Diluted earnings (loss) per share
reflects the potential dilution that could occur if securities or other contracts to issue common
stock were exercised or converted into common stock or resulted in the issuance of common stock
that then shared in the earnings of the entity. Since the Company generated a net loss in 2004 and 2003, outstanding stock options and
warrants would have been anti-dilutive and are not applicable to this calculation. The impact of Statement 128 on the calculation of earnings per share is as follows: Year Ended December 31,2002BASIC:Net Income (Loss) Available to Common Shareholders
    
    $
    18,292Weighted Average Shares Outstanding
    
    
    47,406,939Basic Earnings(Loss) per Share
    
    $
    0.00DILUTED:Net Income (Loss) Available to Common Shareholders
    
    $
    18,292Weighted Average Shares Outstanding
    
    
    47,406,939Net Effect of Dilutive Stock Options and Warrants
Based on the Treasury Stock Method Using Average Market PriceTotal Shares
    
    
    47,406,939Diluted Earnings per Share
    
    $
    0.0000Average Market Price of Common Stock
    
    $
    .1234Ending Market Price of Common Stock
    
    $
    .06
 The following table presents contingently issuable shares, options and warrants to purchase
shares of common stock at December 31, 2002. Those that were outstanding during 2004 and 2003 were
not included in the computation of diluted loss per share because the impact would have been
anti-dilutive: 2002Options.
    
    
    2,671,500Warrants
    
    
    -0-Total
    
    
    2,671,500
 Stock Option Plan The Company determines the effect of stock based compensation in accordance
with SFAS No. 123, Accounting for Stock-Based Compensation, as amended which permits entities to recognize as
expense using the fair-value method over the 32




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vesting period of all employee stock-based awards on the date of grant. Alternatively, SFAS
No. 123 allows entities to continue to utilize the intrinsic value method for equity instruments
granted to employees and provide pro forma net income (loss) and pro forma earnings (loss) per
share disclosures for employee stock option grants after 1994 as if the fair-value-based method
defined in SFAS No. 123 has been applied. The Company has elected to continue to utilize the
intrinsic value method for employee stock option grants and provide the pro forma disclosure
provisions of SFAS No. 123 (Note 8). 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 as the amount by which the carrying amounts
of the assets exceed the fair value of the assets (see Notes 4). Assets to be disposed of are
reported at the lower of the carrying amount or fair value less costs to sell. Segment Reporting- The Company adopted SFAS 131, Disclosures about Segments of an Enterprise
and Related Information(SFAS No. 131), in December 1997. MDT has been considered a discontinued
operation since September 1998. As of December 31, 2002, the Company has only one operating
segment, DPI, the Companys Audio Signal Processing business. Income Taxes- Income taxes are accounted for under the asset and liability method. Deferred
tax assets and liabilities are recognized for the future tax consequences attributable to
differences between the financial statement carrying amounts of existing assets and liabilities and
their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets
and liabilities are measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or settled. The effect on
deferred tax assets and liabilities of a change in tax rates is recognized in income in the period
that includes the enactment date. Recent Accounting Pronouncements- In January 2003 the FASB issued Interpretation 46
Consolidation of Variable Interest Entities, an interpretation of ARB No. 51. This Interpretation
requires a Company to consolidate the financial statements of a Variable Interest Entity (VIE),
sometimes also known as a special purpose entity, even if the entity does not hold a majority
equity interest in the VIE. The Interpretation requires that if a business enterprise has a
controlling financial interest in a VIE, the assets, liabilities, and results of the activities
of the VIE should be included in consolidated financial statements with those of the business
enterprise, even if it holds a minority equity position. This Interpretation was effective
immediately for all VIEs created after January 31, 2003; for the first fiscal year or interim
period beginning after June 15, 2003 for VIEs in which a Company holds a variable interest that it
acquired before February 1, 2003. In May 2003 the FASB issued SFAS 150 Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity. This Statement establishes standards for how an
issuer of debt or equity classifies and measures certain financial instruments with characteristics
of both liabilities and equity. It requires that an issuer classify a financial instrument that is
within its scope as a liability (or an asset in some circumstances). Many of those instruments were
previously classified as equity. This Statement is effective for financial instruments entered into
or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim
period beginning after June 15, 2003. In December 2003, the FASB issued SFAS 132R Employers Disclosures about Pensions and Other
Postretirement Benefitsan amendment of FASB Statements No. 87, 88, and 106. This Statement
revises employers disclosures about pension plans and other postretirement benefit plans. It does
not change the measurement or recognition of those plans required by FASB Statements No. 87,
EmployersAccounting for Pensions,No. 88, Employers Accounting for Settlements and Curtailments
of Defined Benefit Pension Plans and for Termination Benefits,and No. 106, Employers Accounting
for Postretirement Benefits Other Than Pensions.This Statement retains the disclosure requirements
contained in FASB Statement No. 132, Employers Disclosures about Pensions and Other Postretirement
Benefits,which it replaces. It requires additional disclosures to those in the original Statement
132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit
pension plans and other defined benefit postretirement plans. The Company will adopt the provisions
of SFAS 132R on January 1, 2004. In November 2004, the FASB issued SFAS No. 151, Inventory Costs-an amendment of ARB. No. 43,
Chapter 4.This Statement amends the guidance in ARB No. 43, Chapter 4, Inventory Pricing, to
clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and
wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously stated that ... under some
circumstances, items such as idle facility expense, excessive spoilage, double freight, and
rehandling costs may be so abnormal as to require treatment as current period charges.... This
Statement requires that those items be recognized as current-period charges regardless of whether
they meet the criterion of so abnormal. In addition, this Statement requires that allocation of
fixed production overheads to the costs of conversion be based on the normal capacity of the
production facilities. In December 2004, the FASB issued SFAS No. 152, Accounting for Real Estate Time-Sharing
Transactions  an amendment of FASB statements no. 66 and 67. This Statement amends FASB Statement
No. 66, Accounting for Sales of Real Estate,to reference the financial accounting and reporting
guidance for real estate time-sharing transactions that is provided in AICPA Statement of Position
(SOP) 04-2, Accounting for Real Estate Time-Sharing Transactions.This Statement also amends FASB
Statement No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects,to
state that the guidance for (a) incidental operations and (b) costs incurred to sell real estate
projects does not apply to real estate time-sharing transactions. The accounting for those
operations and costs is subject to the guidance in SOP 04-2. In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary assets  an amendment of
APB Opinion No. 29.This Statement amends APB Opinion 29 to eliminate the exception for
nonmonetary exchanges of similar productive assets and replaces it with a general exception for
exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has
commercial substance if the future cash flows of the entity are expected to change significantly as
a result of the exchange. In December 2004, the FASB issued SFAS No. 123R, Share Based Payment. This Statement is a
revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. This Statement
supersedes APB Opinion No. 25, Accounting for Stock Issued to Employeesand its related
implementation guidance.This Statement establishes standards for the accounting for transactions
in which an entity exchanges its equity instruments for goods or services. It also addresses
transactions in which an entity incurs liabilities in exchange for goods or services that are based
on the fair value of the entitys equity instruments or that may be settled by the issuance of
those equity instruments. The Statement focuses primarily on accounting for transactions in which
an entity obtains employee services in share-based payment transactions. This Statement does not
change the accounting guidance for share-based payment transactions with parties other than
employees provided in Statement 123 as originally issued and EITF Issue No. 96-18, Accounting for
Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services.This Statement does not address the accounting for employee share
ownership plans, which are subject to AICPA Statement of Position 93-6, Employers Accounting for
Employee Stock Ownership Plans. The Company believes that the adoption of these pronouncements will not have a material effect
on the Companys financial position, results from operations or cash flows. Use of Estimates- Management of the Company has made a number of estimates and assumptions
relating to the reporting of 33




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assets and liabilities and the disclosure of contingent assets and liabilities to prepare
these financial statements in conformity with generally accepted accounting principles. Actual
results could differ from those estimates. Fair Value of Financial Instruments- The fair and carrying values of cash equivalents,
accounts receivable, accounts payable, short-term debt to a related party and accrued liabilities
and those potentially subject to valuation risk at December 31, 2004 and 2003 approximated fair
value due to their short maturity or nature. The fair values of notes payable at December 31, 2004 and notes payable to a related party
2003 are materially consistent with the related carrying values based on current rates offered to
the Company for instruments with similar maturities. (3) Property and Equipment Property and equipment, as of December 31, 2004 and 2003, consists of the following, net of a
reserve for impairment loss in 1998 in accordance with application of SFAS 121: 2004
    
    
    2003Office Computers, Software, Equipment and Furniture
    
    $
    331,867
    
    
    $
    309,744Test Equipment
    
    
    73,300
    
    
    
    73,300Tooling Equipment
    
    
    45,539
    
    
    
    45,539Trade Show Booth and Demonstration Equipment
    
    
    174,548
    
    
    
    171,301Automobiles
    
    
    7,000
    
    
    
    7,000Total Property and Equipment
    
    
    632,253
    
    
    
    606,884Less Accumulated Depreciation and Amortization
    
    
    602,727
    
    
    
    564,862Property and Equipment, Net
    
    $
    29,527
    
    
    $
    42,022
 (4) Intangible Assets Intangible assets, as of December 31, 2004 and 2003 consist of the following: 2004
    
    
    2003Capitalized Patent, Trademarks and Technology Costs
    
    $
    522,827
    
    
    $
    505,487Less Accumulated Amortization
    
    
    356,117
    
    
    
    313,002Intangible Assets, Net
    
    $
    166,710
    
    
    $
    192,485
 Estimated amortization is as follows: 2005
    
    $
    25,7332006
    
    $
    16,7022007
    
    $
    16,7022008
    
    $
    16,702Thereafter
    
    $
    90,871$
    166,710
 (5) Notes Payable to Related Parties The Company was indebted to the Desper Family Trust, a related party, in the amount of $54,349
at December 31, 2004. In the fourth quarter of 2003, in response to the calling of the Note by
the holder, we negotiated and completed the conversion of the $112,500 related party 10% demand
note to a three- year 10% term note. Principal and interest of $5,191 are due monthly, which we
pay on a current basis. Since the director who was an indirect beneficiary of the demand note
retired from the Board of Directors in June 2003, the demand note is classified as a note
payable at December 31, 2004. There are no installments due in more than twelve months as of
December 31, 2004 34




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##### Table of Contents



(6) Shareholders Equity During the year ended December 31, 2004, shares were issued or converted as follows:
Unissued Performance Shares held in escrow were cancelled. Options to purchase common shares in exchange for services were issued with a value of $1,000. During the year ended December 31, 2003, shares were issued or converted as follows: An employee exercised options to purchase 166,666 shares of common stock were exercised in 2003,
increasing shareholders equity by $10,000. Options to purchase common shares in exchange for services were issued with a value of $12,000. Capitalization Series A Preferred Stock:On December 26, 2002 the Company filed a Certificate of Elimination with
the Delaware Secretary of State stating that no shares of the Corporations Series A Preferred Stock
are outstanding and that no shares of the Series A Preferred Stock will be issued. Series B Preferred Stock:On December 26, 2002 the Company filed a Certificate of Elimination with
the Delaware Secretary of State stating that no shares of the Corporations Series B Preferred Stock
are outstanding and that no shares of the Series B Preferred Stock will be issued. Series B-1 Redeemable Convertible Preferred Stock:On November 6, 2002 the Board of Directors
Designated a Series B-1 Preferred Stock. The series has a par value of $0.01 and a stated value of
$10.00 per share US and is designated as a liquidation preference. The stock will rank prior to the
Companys common stock. No dividends will be paid on the Series B-1 Preferred Stock. Conversion
rights vested on January 1, 2003 to convert the Series B-1 Preferred Stock to common at a certain
formula based on an average closing share price, subject to a floor of $0.56 and a ceiling of
$1.12. At December 29, 2005 certain mandatory conversion requirements exist subject to the above
formula. The Series B-1 Preferred Stock has no voting power. Certain restrictions on trading exist
based on date sensitive events based on the Companys Insider Trading Policy. In December 2002,
87,967 shares of Series B-1 Preferred Stock were issued in exchange for the Series B Preferred
Stock and 14,795 shares were issued in lieu of the adjusted accrued dividends on the Series B
Preferred Stock. In 2004, the Company has reflected the issuance of
15,384 shares of Class B-1 Convertible Preferred Stock that was originally recorded in
Additional Paid-in Capital. This resulted in a reclassification of $154
to Convertible Preferred Stock from APIC. (7) Stock Options In 1995, the Company adopted a stock option plan (the Plan) pursuant to which the Companys
Board of Directors may grant stock options to directors, officers and employees. The Plan which was
approved by the stockholders authorizes grants of options to purchase authorized but unissued
common stock up to 10% of total common shares outstanding at each calendar quarter, 4,697,536 as
of December 31, 2004. Stock options are granted with an exercise price at the minimum equal to the
stocks fair market value at the date of grant. Stock options have five-year terms and vest and
become fully exercisable up to three years from the date of grant. At December 31, 2004, there were 2,062,536 additional shares available for grant under the
Plan. The per share weighted-average fair value of stock options granted during 2004, 2003 and 2002
was $0.09, $0.05 and $0.11, respectively, on the date of grant using the Black-Scholes
option-pricing model with the following weighted-average assumptions: 2004- expected dividend yield
0%, risk-free interest rate of 4.1%, expected volatility of 150% and an expected life of 5 years;
2003- expected dividend yield 0%, risk-free interest rate of 2.25%, expected volatility of 137% and
an expected life of 5 years; 2002  expected dividend yield 0%, risk-free interest rate of 6%,
expected volatility of 427% and expected life of 5 years The Company applies APB Opinion No. 25 in accounting for its Plan and, accordingly, no
compensation cost has been recognized for the fair value of its stock options in the consolidated
financial statements. Had the Company determined compensation cost based 35




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##### Table of Contents



on the fair value at the grant date for its stock options under SFAS No. 123, the Companys
net income (loss) would have been increased to the pro forma amounts indicated below: 2004
    
    
    2003
    
    
    2002NET INCOME (LOSS):As Reported
    
    $
    (157,490
    )
    
    $
    (495,453
    )
    
    $
    18,292Pro Forma
    
    $
    (172,770
    )
    
    $
    (538,368
    )
    
    $
    (136,498
    )BASIC AND DILUTED LOSS:As Reported
    
    $
    (0.00
    )
    
    $
    (0.01
    )
    
    $
    0.01Pro Forma
    
    $
    (0.00
    )
    
    $
    (0.01
    )
    
    $
    (0.01
    )
 Stock option activity during the periods indicated is as follows: Weighted-AverageExercisable
    
    Number
    
    
    Exercise PriceOptions outstanding at December 31, 2001
    
    
    1,529,132
    
    
    
    1,872,299
    
    
    $
    0.45Options granted
    
    
    
    
    
    
    1,300,000
    
    
    $
    0.11Options exercised
    
    
    
    
    
    
    (0
    )
    
    $
    0.00Options forfeited
    
    
    
    
    
    
    (500,799
    )
    
    $
    2.29Options outstanding at December 31, 2002
    
    
    2,668,332
    
    
    
    2,671,500Options granted
    
    
    
    
    
    
    1,200,000
    
    
    $
    0.05Options exercised
    
    
    
    
    
    
    (166,666
    )
    
    $
    0.06Options forfeited/expired
    
    
    
    
    
    
    (669,834
    )
    
    $
    0.18Options outstanding at December 31, 2003
    
    
    2,540,000
    
    
    
    3,035,000
    
    
    $
    0.18Options granted
    
    
    
    
    
    
    200,000
    
    
    $
    0.09Options exercised
    
    
    
    
    
    
    
    
    
    
    Options forfeited
    
    
    
    
    
    
    600,000
    
    
    $
    0.43Options outstanding at December 31, 2004
    
    
    2,381,666
    
    
    
    2,635,000
    
    
    $
    0.11
 (8) Warrants Warrant activity for the periods indicated below is as follows: Warrants
    
    
    Warrant PriceWarrants outstanding at December 31, 2001
    
    
    2,100,000
    
    
    $
    0.65Warrants issued
    
    
    0
    
    
    $
    0.00Warrants exercised
    
    
    0
    
    
    $
    0.00Warrants expired
    
    
    (2,100,000
    )
    
    $
    0.65Warrants outstanding at December 31, 2002
    
    
    0
    
    
    $
    0.00Warrants issued
    
    
    0
    
    
    $
    0.00Warrants exercised
    
    
    0
    
    
    $
    0.00Warrants expired
    
    
    0
    
    
    $
    0.00Warrants outstanding at December 31, 2003
    
    
    0
    
    
    $
    0.00Warrants issued
    
    
    0
    
    
    $
    0.00Warrants exercised
    
    
    0
    
    
    $
    0.00Warrants expired
    
    
    0
    
    
    $
    0.00Warrants outstanding at December 31, 2004
    
    
    0
    
    
    $
    0.00
 All of the warrants were granted in 1999 and were issued in connection with private
placements. At December 31, 2002, all such warrants had expired, without exercise. 36




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##### Table of Contents



(9) Income Taxes The Company files a consolidated return for U.S. income tax purposes. Income tax expense for
the years ended December 31, 2004, 2003 and 2002 consisted of the following: 2004
    
    
    2003
    
    
    2002State franchise tax
    
    $
    400
    
    
    $
    4,800
    
    
    $
    2,400Federal taxes
    
    
    (0
    )
    
    
    (0
    )
    
    
    (0
    )Total
    
    $
    400
    
    
    $
    4,800
    
    
    $
    2,400
 Certain revenues received from customers in foreign countries are subject to withholding taxes
that are deducted from outgoing funds at the time of payment. These taxes range from approximately
10% to 16.5% and are recorded as net royalty revenue. Income tax expense for the years ended December 31, 2004, 2003 and 2002 differed from the
amounts computed by applying the U.S. federal income tax rate of 34 percent to loss before income
taxes primarily due to the generation of additional net operating loss carry forwards for which no
tax benefit has been provided. The tax effects of temporary differences that give rise to significant portions of the
deferred tax assets at December 31, 2004 is composed primarily of the net loss carry forwards. The
net change in the total valuation allowance for the year ended December 31, 2004 was insignificant.
In assessing the realizability of deferred tax assets, management considers whether it is more
likely than not that some portion or all of the deferred tax assets will not be realized. The
ultimate realization of deferred tax assets is dependent upon the generation of future taxable
income during the periods in which those temporary differences become deductible. Management
considers projected future taxable income and tax planning strategies in making this assessment.
Based upon the level of historical taxable losses, management believes it is more likely than not
the Company will not realize the benefits of these deductible differences and has established a
valuation allowance to fully reserve the deferred tax assets at December 31, 2004. Additionally,
the ultimate realizability of net operating losses may be limited by change of control provisions
under Section 382 of the Internal Revenue Code. At
December 31, 2004 and 2003, deferred income tax assets were primarily
composed of: Federal at 15% tax rate: 2004
    
    
    2003Accrued Vacation
    
    
    
    (6,048
    )
    
    
    (4,338
    )Net
operating loss carryforward
    
    
    
    1,550,763
    
    
    
    1,533,605Accum
Amortization & depreciation
    
    
    
    6,189
    
    
    
    5,831State
deferred tax asset
    
    
    
    (62,021
    )
    
    
    (92,751
    )R & D
credit
    
    
    
    314,971
    
    
    
    288,450Foreign Tax
Credit
    
    
    
    35,838
    
    
    
    35,838Deferred tax Asset
    
    
    
    1,839,692
    
    
    
    1,766,635Less:
Valuation Allowance
    
    
    
    (1,839,692
    )
    
    
    (1,766,635
    )Net deferred
tax asset
    
    
    
    0
    
    
    
    0
 (10) Commitments and Contingencies We also anticipate that, from time to time, we may be named as a party to other legal
proceedings that may arise in the ordinary course of our business. Operating Lease Commitments The Company is obligated under several non-cancelable operating leases. Future minimum rental
payments for all operating leases of approximately $52,000 through December, 2006. Rent expense
amounted to approximately $23,000, $ 83,000 and $78,000 for the years ended December 31, 2004, 2003
and 2002, respectively. (11) Profit Sharing Plan The Company has a 401(k) profit sharing plan covering substantially all employees, subject to
certain participation and vesting requirements. The Company may elect to make discretionary
contributions to the Plan, but has never done so over the life of the Plan. The amount charged to
administrative expense for the Plan in 2004, 2003 and 2002 was approximately $2,000 per annum. 37




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##### Table of Contents



(12) Quarterly Financial Data (unaudited) The following is a summary of the quarterly results of operations for the years ended December
31, 2004 and 2003: Quarter Ended2004
    
    March 31
    
    
    June 30
    
    
    September 30
    
    
    December 31Net Revenues
    
    $
    170,679
    
    
    $
    234,860
    
    
    $
    205,324
    
    
    $
    495,060Gross Margin
    
    $
    153,675
    
    
    $
    216,727
    
    
    $
    179,210
    
    
    $
    444,916Net Income (Loss)
    
    $
    (123,796
    )
    
    $
    (123,259
    )
    
    $
    (80,576
    )
    
    $
    170,141Basic (Loss) Per Share
    
    $
    (0.00
    )
    
    $
    (0.00
    )
    
    $
    (0.00
    )
    
    $
    0.00
 Quarter Ended2003
    
    March 31
    
    
    June 30
    
    
    September 30
    
    
    December 31Net Revenues
    
    $
    332,378
    
    
    $
    250,902
    
    
    $
    341,339
    
    
    $
    344,667Gross Margin
    
    $
    296,436
    
    
    $
    228,405
    
    
    $
    306,192
    
    
    $
    315,836Net Income (Loss)
    
    $
    (74,449
    )
    
    $
    (212,461
    )
    
    $
    (106,502
    )
    
    $
    (102,041
    )Basic (Loss) Per Share
    
    $
    (0.00
    )
    
    $
    (0.00
    )
    
    $
    (0.00
    )
    
    $
    (0.01
    )
 38




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##### Table of Contents



Item 9.Change in and Disagreements with Accountants on Accounting and Financial Disclosure None. 
 Item 9A.Controls and Procedures We carried out an evaluation of the effectiveness of our disclosure controls and procedures,
as defined in Rules 13a-15(e) and 15d-15(e) of the Securities and Exchange Act of 1934. Based on
that evaluation, the Chief Executive Officer and Chief Financial Officer had concluded that our
disclosure controls and procedures as of the end of the period covered by this report were
effective to ensure that information required to be disclosed by the Company in reports that it
files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and
reported within the time periods specified in Securities and Exchange Commissions rules and forms.
There were no changes in our internal control over financial reporting that occurred during the
quarter ended December 31, 2004 that have materially affected, or are reasonably likely to
materially affect, our internal control over financial reporting. 
 PART III 
 Item 10.Directors and Executive Officers of the Registrant Information required for this item incorporated by reference to our Proxy Statement for the
2004 Annual Meeting of Stockholders. Code of Ethics We adopted a Code of Ethics that applies to all of our directors, officers and employees,
including our Chief Executive Officer, our Chief Financial Officer and other senior financial
officers. The Company will provide a copy of our code of ethics to any person, free of charge,
upon written request sent to our principal executive office at 2625 Townsgate Road, Suite 330,
Westlake Village, California 91361. 
 Item 11.Executive Compensation Information required for this item incorporated by reference to our Proxy Statement for the
2004 Annual Meeting of Stockholders. 
 Item 12.Security Ownership of Certain Beneficial Owners and Management Equity Compensation Plan Information Number of securitiesNumber of securities
    
    
    
    
    
    
    remaining available forto be issued
    
    
    Weighted-average
    
    
    future issuance underupon exercise of
    
    
    exercise price of
    
    
    equity compensation plansoutstanding options,
    
    
    outstanding options,
    
    
    (excluding securitiesPlan category
    
    warrants and rights
    
    
    warrants and rights
    
    
    reflected in column (a))(a)
    
    
    (b)
    
    
    (c)Equity
compensation plans
approved by security
holders
    
    
    2,635,000
    (1)
    
    $
    0.12
    (1)
    
    
    2,062,536Equity compensation
plans not approved by
security holders.
    
    
    0
    
    
    
    0
    
    
    
    0Total
    
    
    2,635,000
    
    
    
    
    
    
    
    2,062,536
 39




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##### Table of Contents



(1)
    
    Represents options to acquire the Companys Common Stock under the Companys 1995 Stock
Option Plan and 1996 Incentive Plan approved by the Companys stockholders in 1995 and 1996,
respectively. The 1995 Plan authorizes grants of options to purchase authorized but unissued
common stock in an amount of up to 10% of total common shares outstanding at each calendar
quarter or 4,697,536 as at December 31, 2004. Stock options are granted with an exercise price
equal to the stocks fair market value at the date of grant. Stock options have five-year
terms and vest and become fully exercisable as determined by the committee on date of grant.
The 1996 Plan supplements the 1995 Plan by allowing for stock appreciation, incentive shares
and similar accruals aggregating not more than the equivalent of 500,000 shares and the
regrant of any Performance Shares that become available for regrant. See Note 2. The remaining information is required for this item is incorporated by reference to our Proxy
Statement for the 2005 Annual Meeting of Stockholders. 
 Item 13.Certain Relationships and Related Transactions Information required for this item incorporated by reference to our Proxy Statement for the
2005 Annual Meeting of Stockholders. 
 Item 14.Principal Accounting Fees and Services Information required for this item incorporated by reference to our Proxy Statement for the
2005 Annual Meeting of Stockholders. 
 PART IV 
 Item 15.Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Financial Statements See Item 8. (c) Exhibits 40




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##### Table of Contents



The following Exhibits are filed as part of, or incorporated by reference into, this Report: ExhibitNumber
    
    Description2.1*
    
    Arrangement Agreement dated as of March 4, 1994 among Spatializer-Yukon, DPI and
Spatializer-Delaware (Incorporated by reference to the Companys Registration Statement on Form
S-1,Registration No 33-90532, effective August 21, 1995.)3.1*
    
    Certificate of Incorporation of
Spatializer-Delaware as filed February 28, 1994. (Incorporated
by reference to the CompanysRegistration 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 Companys
Registration Statement on Form S-1,Registration No. 33-90532, effective August 21, 1995.)3.3*
    
    Certificate of Designation of
Series B 10% Redeemable Convertible Preferred Stock of the Company
as filed December 27, 1999(Incorporated by reference to the Companys Annual Report on
Form10-K, for the period ended December 31, 1999.)3.4*
    
    Certificate of Amendment of Certificate of Incorporation of the Company as filed on February
25, 2000 (Incorporated by reference to the Companys Annual Report on Form 10-K, for the period
ended December 31, 1999.)3.5*
    
    Certificate of Designation of Series B-1 Redeemable Convertible Preferred Stock as filed
December 20, 2002 (Incorporated by reference to the Companys Annual Report on Form 10-K, for
the period ended December 31, 2002.)3.6*
    
    Certificate of Elimination of Series A Preferred Stock as filed December 26, 2002 (Incorporated
by reference to the Companys Annual Report on Form 10-K, for the period ended December
31,2002.)3.7*
    
    Certificate of Elimination of Series B Preferred Stock as filed December 26,2002 (Incorporated
by reference to the Companys Annual Report on Form 10-K, for the period ended December
31,2002.)4.1*
    
    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 Companys Registration Statement on Form
S-1, Registration No. 33-90532,effective August 21, 1995.)4.2*
    
    Modification Agreement for Escrowed Performance Shares. (Incorporated by reference to the
Companys Definitive Proxy Statement dated June 28, 1996 and previously filed with the
Commission.)4.3*
    
    Form of Exchange Agreement effective December 26, 2002 entered into by holders of Series B
Preferred Stock in connection with exchange of same for Series B-1 Preferred Stock
(Incorporated by reference to the Companys Annual Report on Form 10-K, for the period ended
December 31, 2002.)10.1*
    
    Spatializer-Delaware Incentive Stock Option Plan (1995 Plan). (Incorporated by reference to the
Companys Registration Statement on Form S-1, Registration No. 33-90532, effective August
21,1995.)10.2*
    
    Spatializer-Delaware 1996 Incentive Plan. (Incorporated by reference to the Companys Proxy
Statement dated June 25, 1996 and previously filed with the Commission.)10.3
    
    Form of Stock Option Agreement
 41




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##### Table of Contents



ExhibitNumber
    
    Description10.4*
    
    License Agreement dated June 29, 1994 between DPI and MEC. (Incorporated by reference to the
Companys Registration Statement on Form S-1, Registration No. 33-90532, effective August
21,1995.)10.5
    
    Employment Agreement dated November 12, 2004, between the Company and Henry Mandell, as amended.10.6
    
    Related Party Promissory Note to the Successor Trustee of the Ira A. Desper Marital Trust dated
November 1, 2003.10.7
    
    Lease for Office and Research Center in San Jose, CA.10.8
    
    License Agreement between Spatializer Audio Laboratories, Inc., Desper Products, Inc. and
Samsung Electronics, effective August 22, 2004. (Incorporated by reference to the Companys
Quarterly Report on Form 10-Q for the period ended September 30, 2004.)21.1
    
    Subsidiaries of the Company23.1
    
    Consent of Independent Auditors31.1
    
    Certificate of Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of
the Sarbanes-Oxley Act of 200232.1
    
    Certificate of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002 (Certification will not be deemed filed for purposes of
Section 18 of the Securities Exchange Act of 1934)
   *
    
    Previously filed. 42




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##### Table of Contents



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 22, 2005SPATIALIZER AUDIO LABORATORIES, INC.(Registrant)/s/ Henry R. MandellHenry R. MandellChief Executive Officer & 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. Signature
    
    Title
    
    Date/s/ Carlo Civelli
    
    Director
    
    March 22, 2005Carlo Civelli/s/ James D. Pace
    
    Director
    
    March 22, 2005James D. Pace/s/ Gilbert N. Segel
    
    Director
    
    March 22, 2005Gilbert N. Segel/s/ Henry R. Mandell
    
    Director
    
    March 22, 2005Henry R. Mandell
 43