##### Table of Contents



---

---

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



---



FORM 10-K



---

|                                        |       |  |  |                                                                                          |  |  |  | 
|--------------------------------------- | ----- |  |  | ---------------------------------------------------------------------------------------- |  |  |  | 
|(Mark One)                             
|                                        |       | 
|                                        | [X]   |  |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934     |  |  |  | 
|                                        |       | 
|For the period ended: December 31, 2002
|                                        |       | 
|OR                                     
|                                        |       | 
|                                        | [   ] |  |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 33-90532

SPATIALIZER AUDIO LABORATORIES,
INC.(Exact name of registrant as specified in its charter)

|                                                                        |  |                                                
|----------------------------------------------------------------------- |  | -----------------------------------------------
|Delaware
(State or other jurisdiction of
incorporation or organization) |  | 95-4484725
(I.R.S. Employer
Identification No.)

920 Hampshire Road, Suite A-34
Westlake Village, California 91361
(Address of principal executive offices)

900 Lafayette Street, Suite 710
Santa Clara, California 95050
(Address of principal corporate offices)

Telephone Number:
(408) 296-0600
(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  [X]    No  [   ]

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

Indicate by check
mark whether the registrant is an accelerated filer (as defined in
Rule 12b-2 of the Act).   Yes  [   ]    No  [X]

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 29, 2002) was
approximately $3,880,000 and at March 5, 2003 was approximately
$1,944,000. In addition, affiliates held non-voting preferred stock valued at $879,670, plus
accrued dividends, at both June 29, 2002 and March 5, 2003.

As of March 5, 2003, there were 47,406,939 shares of the Registrants
Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the
definitive proxy statement for the 2003 Annual Meeting are
incorporated by reference into Part III hereof.



---

---





---

TABLE OF CONTENTS



|             |                                                                                                |  |  |  |  |  |  | 
|------------ | ---------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I      
|             | Item 1.  Business                                                                             
|             | Item 2.  Properties                                                                           
|             | Item 4.  Submission of Matters to a Vote of Security Holders                                  
|             | Item 5.  Market for Registrants Common Equity and Related Stockholder Matters                
|             | Item 6.  Selected Consolidated Financial Data                                                 
|             | Item 7.  Managements Discussion and Analysis of Financial Condition and Results of Operations
|             | Item 8. Financial Statements                                                                  
|             | Item 9.  Change in and Disagreements with Accountants on Accounting and Financial Disclosure  
|PART III    
|             | Item 10.  Directors and Executive Officers of the Registrant                                  
|             | Item 11.  Executive Compensation                                                              
|             | Item 12.  Security Ownership of Certain Beneficial Owners and Management                      
|             | Item 13.  Certain Relationships and Related Transactions                                      
|             | Item 14.  Controls and Procedures                                                             
|PART IV     
|             | Item 15.  Exhibits, Financial Statement Schedules and Reports on Form 8-K                     
|SIGNATURES  
|EXHIBIT 3.5 
|EXHIBIT 3.6 
|EXHIBIT 3.7 
|EXHIBIT 4.31
|Exhibit 21.1
|EXHIBIT 99.1



---



##### Table of Contents






PART I




Item 1.Business

Overview

Spatializer Audio Laboratories, Inc. (Company or we) is a developer,
licensor and marketer of next generation technologies for the consumer
electronics, personal computing, enterprise computing and entertainment
industries. Our position as a developer of next generation technologies is
based on our business relationships with brand leaders, such as Apple, Toshiba
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
emerging digital audio marketplace specifically for consumer products like
Digital Versatile Disc (DVD) players, portable mp3 players, digital
televisions and digital home, portable and auto entertainment devices. As of
December 31, 2002, more than 40 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 including in consumer electronics, Toshiba, Panasonic, JVC,
Samsung, Sanyo, and Sharp, in the PC multimedia
marketplace by Apple Computer, among others, and on the Internet through our
VSP-11 universal sound processor and in software plug-ins for the WinAmp and
Linux-based XMMS MP3 players. 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.

Our other wholly owned subsidiary, MultiDisc Technologies, Inc., (MDT)
formed in June 1996 when we acquired development stage optical disc storage and
robotics assets and technologies from Home Theater Products International,
Inc., a debtor in possession, is now inactive. In September 1998, we announced
our plan to refocus our business on the exploitation of our core audio
technologies, suspend research and development at MDT and to properly position
the MDT assets for sale. Therefore, MDT has been accounted for as a
discontinued operation. Since 1998, we have been unsuccessful in identifying a
purchaser for the MDT assets or technology. Our repositioning in 1998
recognized that the capital investment required to properly commercialize the
MDT technology was beyond our capacity. We believe this strategy provides a
better opportunity to further solidify our position as a provider of virtual
audio solutions, based on our available capital resources.

We were
incorporated in the State of Delaware in February, 1994. Our corporate office and research center is located at 900 Lafayette
Street, Suite 710, Santa Clara, California 95050, Telephone (408) 296-0600. We
also maintain offices at 920 Hampshire Road, Suite A-34, 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 of interest to our stockholders are available
on our website promptly after filing or distribution.

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.

2



---



##### Table of Contents



|                                                                                  |  |                                                                                                                                                                                                       |  |                                                                                                                                                             
|--------------------------------------------------------------------------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                  |  |                                                                                                                                                                                                       |  | Virtual Audio                                                                                                                                               
|Category of Technology                                                            |  | Product Categories                                                                                                                                                                                    |  | Enhancement                                                                                                                                                 
|                                                                                  |  |                                                                                                                                                                                                       |  |                                                                                                                                                             
|3-D Stereo(Spatializer® 3-D Stereo)
SpatializerVirtualSurround
VBX               |  | Consumer electronics products providing
stereo playback  DVDPlayers, Stereo TVs,
VCRs, Stereo Components and Systems, Car
Audio, Laptop and Desktop Multimedia
Computers, Set-top Boxes            |  | Surround Sound enhancement
from an ordinary
stereo(two-channel) signal                                                                                      
|                                                                                  |  |                                                                                                                                                                                                       |  |                                                                                                                                                             
|Two-SpeakerVirtualization(Spatializer N-2-2,
Spatializer N-2-2Ultra)            |  | Products incorporating multi-channel audio
sources likeDolby Digital® (AC-3),
DolbyProLogic® or MPEG-2. Home Theater,
DVD-Video, Multimedia                                                           |  | Creation of spatially
accurate multi-speaker
cinematic audioexperience
from two speakers, and
headphones utilizing
discrete multi-channel
audio information.
|                                                                                  |  |                                                                                                                                                                                                       |  |                                                                                                                                                             
|Digital Virtual
Surround Sound                                                    |  | Computers utilizing DVD/MPEG and decoding.                                                                                                                                                            |  |                                                                                                                                                             
|                                                                                  |  |                                                                                                                                                                                                       |  |                                                                                                                                                             
|Bass Enhancement
(Vi.B.E.)                                                       |  | Consumer electronics products providing
stereo playback  DVD Players, Stereo TVs,
VCRs, Stereo Components and Systems, Car
Audio, Laptop and Desktop Multimedia
Computers and Speakers             |  | Simulation of lower
frequency response from
speakers with relatively
high low frequency
capability                                                          
|                                                                                  |  |                                                                                                                                                                                                       |  |                                                                                                                                                             
|Internet Audio Enhancement(Spatializer®VSP-11,
StreamFX)                         |  | Laptop and Desktop Multimedia Computers and
portable musicdevices running digital media
player Software                                                                                               |  | Surround Sound
and bass enhancement to playback of
ordinary internet audio
files                                                                            
|                                                                                  |  |                                                                                                                                                                                                       |  |                                                                                                                                                             
|Headphone Virtualization(Spatializer Natural
Headphone)
Digital Virtual Surround |  | Products incorporating multi-channel audio
sources likeDolby Digital® (AC-3), Dolby
ProLogic®, MPEG-2 or stereo. Home Theater,
DVD-Video, Multimedia Computers utilizing
DVD/MPEG Decoding or stereo. |  | Creation of spatially
accurate multi- speaker
cinematic audioexperience
from headphones utilizing
discrete multi-channel
audio information.                 
|                                                                                  |  |                                                                                                                                                                                                       |  |                                                                                                                                                             
|Phase Corrected Equalization
(Spatializer PCE)                                   |  | All audio products with one or more speakers                                                                                                                                                          |  | Creation of more
recognizable and cleaner
music or dialog from
broadcast media sources                                                                    
|                                                                                  |  |                                                                                                                                                                                                       |  |                                                                                                                                                             
|Matrixed Surround Sound
(Spatializer enCompass AV)                               |  | All audio products with five or more speakers                                                                                                                                                         |  | Creation of actual
surround sound (5.1 or
more channels) from mono
or stereo sources                                                                        

Licensed Products

Our current technology product applications are directed to (1)
two-speaker and headphone virtualization of multi-channel audio for DVD players
and home theater applications, (2) stereo and bass enhancement in consumer
electronics products and multimedia PCs, and (3) downloadable software,
purchased directly by consumers, delivering audio enhancement applications for
PCs.



| | 1. |  | Spatializer® 3D Stereo.Based upon proprietary and patented methods
of stereo signal processing, the Companys Spatializer® 3-D Stereo
technology is designed to create a vivid and expansive three-
dimensional surround sound listening experience from any stereo source
input using only two ordinary speakers. Along with professional audio
quality and coherent stable sonic imaging, the technology includes the
Companys unique DDP (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
| | -- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

3



---



##### Table of Contents





| |    |  | 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 four chip foundries (Matsushita, ESS Technologies, Inc.,
OnChip Systems and Luxsonor) 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | 2. |  | Spatializer® N-2-2Digital Virtual Surround. In September 1996, DPI
introduced Spatializer N-2-2,which the Company considers a core, and
enabling technology for DVD 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. Through outstanding
performance and continuous enhancement, Spatializer N-2-2 has emerged as
the de facto standard for branded virtual surround sound as measured
by most brand adoptions, cumulative shipments and market share of such
brands in the DVD player market. DVD is considered by many to be the
single most important and fastest adopted consumer audio/computer
technology ever introduced. The audio standards for DVD (based upon
geographic region) are multi-channel audio formats (Dolby Digital®
(AC-3) and MPEG-2) which carry six (or more) discrete (independent)
channels of audio  the front left and right channels, a center channel
(for vocal tracks), two rear surround channels and a Low Frequency
Effects (LFE or sub-woofer) channel for sound effects. The Spatializer
N-2-2software- 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-2-2runs in real-time on general
purpose Digital Signal Processing (DSP) hardware platforms like those
offered by LSI, Acer Labs, Inc., Motorola, VM Labs 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-2-2has 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-2-2process 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.
|
| | 3. |  | Spatializer® Vi.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. |  | Spatializer® VSP-11. First 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s proprietary psychoacoustic
techniques to allow consumers to enjoy the benefits of the renowned
Spatializer audio enhancement technologies on all leading media players,
soft DVD players and file sharing programs. This means that Spatializer
VSP-11 is truly 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. |  | Spatializer® Natural Headphone Spatializer 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. |  | Spatializer® PCE Spatializer PCE, 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                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

4



---



##### Table of Contents





| |    |  | 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.. Spatializer
PCE can be custom tailored for two or an array of speaker
configurations. Indeed, the technology, without a surround sound effect,
can enhance single speaker applications as well.
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | 7. |  | Spatializer® enCompass AV Spatializer 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.                                                                                                                                                                                                                                                                          

In addition to these technologies, we offer a series of products
introduced by DPI under the Spatializer DigitalFX brand, first introduced in
early 2000. The Spatializer DigitalFX series is a comprehensive audio
enhancement software solution based on the Companys Spatializer N-2-2 virtual
surround sound technology, Spatializer Vi.B.E and Spatializer PCE, combined
with additional audio effects tailored and optimized for specific product
applications. This powerful combination of technologies in a single product
targeted for specific product applications provides a highly efficient and cost
effective solution for the television, portable digital music, PDA, AV
Receiver, PC and car audio markets.

Spatializer Digital TVFX is a customized application of Spatializer
technology optimized for digital and analog televisions with an on board
digital signal processor. Spatializer integrates its original, patented 3D
Stereo and N-2-2 technologies with speaker-compensation and Vi.B.E. bass
enhancement algorithms. The digital processing of the stereo signal provides a
striking and immersive audio experience while the virtual bass enhancement
creates apparently deeper bass response from the small speakers utilized by
most televisions. Optional reverb and equalizer features further enhance the
audio experience. The result is a dramatic improvement to the overall audio
sound field provided by the television. Spatializer Digital TVFX is 100%
digital, and applicable to any TV system with an embedded DSP.

Spatializer Digital OntheGoFX is targeted specifically for portable
digital music players and Personal Data Assistants (PDAs). According to
industry analysts, the portable digital player market is expected to grow
significantly once the music industry establishes economically feasible, secure
and convenient modes of electronic music distribution. Spatializer Digital
OntheGoFX shares the same core 3D stereo technology as other members of the
Spatializer DigitalFX series, but includes a highly effective headphone
algorithm which produces an expanded headphone audio experience. In addition,
the included Vi.B.E technology is particularly effective in improving the
limited bass response of inexpensive lightweight stereo headphones often
incorporated into these devices. The algorithms are highly efficient, utilizing
a minimal amount of MIPS any standard embedded DSP.

Spatializer Digital PCFX combines the entire suite of respected
Spatializer audio technologies into a single, comprehensive and cost effective
software audio solution for the Wintel platform. Since the product runs on the
host CPU, with minimal CPU utilization, no discrete chip is required.
Spatializer Digital PCFX provides Spatializer 3-D stereo, Spatializer N-2-2
virtual surround sound for DVD playback, Vi.B.E virtual bass enhancement and
enCompass , Spatializers positional audio technology for computer games
utilizing the Microsoft DirectX API. Apple Computer began utilizing
Spatializer technology across their product platforms in October 1999.

Spatializer Digital AVFX is tailored for AV Receivers equipped with a
Dolby Digital decoder. Spatializer Digital AVFX provides Spatializer 3-D
stereo, Spatializer N-2-2 virtual surround sound for DVD audio or video
playback, Vi.B.E virtual bass enhancement and in the future, extensive room
modeling and customized effects.

Spatializer Digital AutoFX enhances the audio performance of DSP-based
car stereo systems by delivering Spatializers 3-D stereo, bass
enhancement, equalizer and reverb technology in a single solution. Optional
positional audio voice cues for on board GPS and navigation systems, virtual
surround sound for on board DVD player systems and space modeling will be
offered on an optional and customized basis based on specific customer need.

5



---



##### Table of Contents



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.

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.

In early 2001, we reached an agreement with C-Cube Semiconductor II (now
LSI Logic Corporation) to unbundle the royalty on their DSPs in order to
facilitate the licensing of multiple technologies to OEM manufacturers and to
help ensure that their products remained highly competitive in the market. As
such, effective April 1, 2001, C-Cubes customers using Spatializer technology
have entered into direct licenses with us.

We are currently negotiating new IC/DSP Foundry 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 DigitalFX series.

IC/DSP Foundry Licenses

In 2000 and early 2001, VM Labs, Inc., MIPS Technologies, New Japan Radio
Corporation (NJRC), Tvia, Inc. and Link Up Systems entered into Foundry
License or Distribution Agreements for Spatializer N-2-2 and or DigitalFX. All
but the NJRC agreements were non-royalty bearing distribution agreements, with
per unit royalties to be paid by the OEM customer.

In 2001, we entered into license or distribution agreements with Texas
Instruments, Cirrus Logic, Sanyo, Sharp and Kenwood, among others.

In 2002, we entered into Distribution agreements with Mediatech, Amlogic,
LSI Logic and Samsung Semiconductor for the porting and distribution of our
technologies to OEM manufacturers. These Distribution agreements grant the
right to port and or distribute our technology only to licensed customers of
Spatializer, who then pay a royalty for the use of such technologies.

As of December 31, 2002, we have entered into thirteen non-exclusive
Foundry Licenses for our Virtual Audio Signal Processing technologies with
Matsushita Electronics Corporation (MEC), ESS Technology, Inc. (ESS),
OnChip Systems, Inc. (OnChip), C-Cube Technologies, Inc. (C-Cube), Acer
Labs, Inc. (Ali), Luxsonor, VM Labs, Inc., MIPS Technologies, NJRC, Tvia,
Inc., Texas Instruments, Cirrus Logic and Link Up Systems. 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, 2002, more than 40 million ICs and DSPs incorporating
Spatializer audio signal processing technology had been manufactured and sold.

6



---



##### Table of Contents



OEM Licensees and Customers

As of December 31, 2002, our technology has been incorporated in products
offered by more than 100 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 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, car stereo systems, direct view TVs, wide
screen and projection TVs, VCRs, powered speakers, portable audio systems
(Boomboxes), HiFi stereo systems and components, computer sound cards and
graphics accelerator cards, multimedia desktop personal computers, notebook
computers, LCD projectors, multimedia computer monitors, and arcade pinball and
video games.

In 2002, four major customers, not presented in order of importance, each
accounted for 10% or more of our total revenues: Apple Computer, Inc., JVC,
Samsung and Toshiba Corporation, each of whom accounted for greater than 10% of
our total 2002 revenues. One OEM accounted for 33%, another accounted for 25%,
another accounted for 17% and one accounted for 10% of our royalty revenues
during 2002. One other account comprised 9% of total 2002 revenues. All other
OEMs accounted for less than 5% of royalty revenues
individually. During 2003 we anticipate a significant reduction in
the revenues from Apple as it completes its migration to its newest
operating system.

The following table is a partial list of the OEM Licensees and authorized
customers as of December 31, 2002:

|                                           |  |                                                                      
|------------------------------------------ |  | ---------------------------------------------------------------------
|Partial List of OEM Licensees or Customers |  |                                                                      
|                                           |  |                                                                      
|Amlogic                                    |  | NEC                                                                  
|Apple Computer Inc.                        |  | Panasonic TV & VCR (Matsushita Kotobuki
Electronics Industries, Ltd.)
|Cirrus Logic                               |  | Panasonic Car Audio (Matsushita Communications
Industrial Co., Ltd.) 
|Emerson                                    |  | Proton Electronic Industrial Co., Ltd.                               
|Fujitsu Computer Corp.                     |  | Samsung                                                              
|Hewlett Packard                            |  | Seiko Epson Corp.                                                    
|Hitachi, Ltd.                              |  | Sanyo Corp.                                                          
|Iiyama Electric Co., Ltd.                  |  | Sharp Corp.                                                          
|Gateway Computer Corp.                     |  | Toshiba DVD                                                          
|Golden Regent                              |  | Toshiba TV                                                           
|LG Electronics                             |  | Taisei Electric, Inc.                                                
|JVC                                        |  | Taiyo Electric Company, Ltd.                                         
|Labtec Enterprises, Inc.                   |  | Texas Instruments                                                    
|Mag Monitors                               |  | Theta Digital                                                        
|Marantz                                    |  | VM Labs, Inc.                                                        
|Mediatech                                  |  | Zenith                                                               
|Mitsubishi Image and Information Works     |  |                                                                      

As is evident from
the above list we have extensive relationships with OEM licensees and
customers outside the United States and, in fact, Japanese and Korean
based entities accounted for 50% and 17%, 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.

Hardware Products



| |  |  | MultiDisc Technologies, Inc.  Network Based Modular, Scaleable Compact
Disc/DVD Servers
| |  |  | ----------------------------------------------------------------------------------------

As its first effort to broaden our technology portfolio and capitalize on
our strong relationships with manufacturers of consumer electronics and
personal computer peripheral products, we acquired certain developmental stage
technologies and assets from Home Theatre Products (HTP), for approximately
$1,062,000 in June 1996 and formed a subsidiary, MDT. The MDT transaction,
which was implemented through a court-approved sale in the HTP bankruptcy
proceeding, included an array of compact disc server robotics and software
technologies in various stages of completion. The MDT transaction was intended
to position us for long term growth in a significant new market. Our intention
was to license this technology or enter into third party manufacturing
arrangements for sale of MDT CD/DVD changer products to OEMs.

The MDT transaction brought a combination of proprietary electromechanical
designs, robotics, operating software, firmware, intellectual property, and
engineering know-how and five patent applications acquired in the asset
acquisition. MDT added

7



---



##### Table of Contents



an additional forty-seven patent applications filed with
the United States Patent & Trademark Office (USPTO) to bring the total to
fifty-two patent applications filed.

On September 25, 1998, we announced our plan to refocus our business on
the exploitation of our core audio technologies and to properly position the
MDT assets for sale. The repositioning strategy recognized that the capital
investment required to properly commercialize the MDT technology was beyond the
Companys capacity. As a result, all operations, including research and
development activities, were suspended and the Company has accounted for MDT as
a discontinued operation. The Company has explored the sale of the business or
the patent portfolio with interested parties, but to date, no transaction has
been consummated.

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. The Companys
revenues, which totaled $1,856,000 in 2002, 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 products and
have eliminated our hardware product operations. Licensing operations have been
managed internally by our personnel and through use of an international sales
rep force.

As noted above, in 2002, four major customers, not presented in order of
importance, each accounted for 10% or more of our total revenues: Apple
Computer, Inc., JVC, Samsung and Toshiba Corporation, each of whom accounted
for greater than 10% of our total 2002 revenues. One OEM accounted for 33%,
another accounted for 25%, another accounted for 17% and one accounted for 10%
of our royalty revenues during 2002. One other account comprised 9% of total
2002 revenues. All other OEMs accounted for less than 5% of royalty revenues
individually.

The Company achieved profitable operating results in 2000 and 2002 as a
result of overhead reductions combined with the strong growth of DVD-related
revenues. In 2001, we began expanding our headcount, primarily in the
engineering area in anticipation of continued growth. At midyear, in light of a
weakening in market conditions and lower than anticipated royalties from a key
Asian account, expenditures were once again curtailed in order to bring
overhead levels more in line with current revenues. Declining revenues were
experienced from three major customers resulting from sluggish sales of their
products and the cessation of use of our products by the smaller of these
customers. In addition, while overhead reductions were implemented at mid-year,
profitability was further impacted by either the delay or cancellation of
anticipated products using our technology in light of weak market conditions.
As a result, we were not profitable in 2001. With the acquisition of new
accounts and to a lesser degree, growth of existing accounts, we were able to
increase revenues and reduce expenses, which returned the company to
profitability.

Competition

Virtual Audio Signal Processing Marketplace

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.
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.
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 the Company.

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

8



---



##### Table of Contents



internally. We also have developed new products that address our
customers need for a low cost solution. 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.

Patents, Trademarks and Copyrights

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 on our
enCompass V 2.0 technology with the USPTO covering the Companys 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. Much of our intellectual property consists of trade secrets. 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.

The MDT transaction brought a combination of proprietary electromechanical
designs, robotics, operating software, firmware, intellectual property, and
engineering know-how and five patent applications acquired in the asset
acquisition. MDT added an additional forty-seven patent applications filed with
the USPTO to bring the total to fifty-two patent applications filed. However,
due to the absence of working capital and suspension of all operating
activities of MDT, MDT cannot pursue these applications and some applications
have lapsed. The core MDT data storage technology is covered by U.S. patents
5,774,431, 5,822,283, 5,886,960 and 5,886,974. MDT has either obtained or
applied for U.S. trademark protection for its principal product names and logo
marks.

On September 25, 1998, we announced our plan to refocus our business on
the exploitation of our core audio technologies and to properly position the
MultiDisc assets for sale. The repositioning strategy recognized that the
capital investment required to properly commercialize the MDT technology was
beyond our capacity. As a result, operations, including all research and
development activities were suspended and we have accounted for MDT as a
discontinued operation.

Employees

We began 2002 with five full-time and nine part-time employees and sales
representatives and decreased our staff to four full time and eight part-time
employees, consultants and sales representatives by December 31, 2002. At
year-end, there were three full-time employees and three consultants engaged in
research and development. We employ the services of outside professional
consultants, particularly in the engineering area, due to the 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 Santa Clara, CA, is the
primary location for our audio technology division, (DPI). We occupy
approximately 2,700 square feet with an annual rent on a full service basis of
approximately $79,000. The lease expired on November 30, 2002 and is renewed on
a month to month basis.

In Westlake Village, California we occupy approximately 300 square feet
with an annual rent of approximately $9,600. The lease term on this space
expired in April 2002 and is renewed on a month to month basis. 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 Santa Clara, CA for use by the chief executive
officer when away from the executive office. The annual rent on this apartment
is $18,840. The lease expires on March 30, 2003 and will be renewed for another
six months on the same terms.

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, considered adequate and are being
utilized for their intended purposes.

9



---



##### Table of Contents



LEGAL PROCEEDINGS

In connection with the downsizing of the Company in 1998, a number of
employees were terminated and have filed, on various dates, employment and
compensation related claims with the California State labor authorities. All
but two of these claims have been settled. Two former officers and employees
of MDT filed labor and employment termination related claims before the Labor
Commissioner in 2000 seeking approximately $400,000 each which was allegedly
due under each of their respective employment agreements, which claims, if
resolved in favor of the claimants, could be material to the financial
statements of the Company. The Labor Commissioner postponed those
proceedings while other litigation proceeded in the Superior Court, Orange County seeking declaratory
relief to bar the labor claims, as well as return of intellectual property and
unspecified damages for breaches of the former officers and employees
employment agreements. These employees, however, filed for personal
bankruptcy and, as a result, the state court proceeding was postponed and then dismissed
primarily because of the bankruptcies. The claims became inactive.
While bankruptcy for one employee has been dismissed, the claims
have not been reactivated. 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.




Item 4.Submission of Matters to a Vote of Security Holders

There were no matters submitted to a vote of the security holders of the
Company either through solicitation of proxies or otherwise in the fourth
quarter of the fiscal year ended December 31, 2002.




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 sales price of our Common Stock on its principal market for
fiscal years 2000, 2001 and 2002:

|        |                |               |   |              |  |  |   |      | 
|------- | -------------- | ------------- | - | ------------ |  |  | - | ---- | 
|Period: |                | High (U.S. $) |   | Low (U.S. $)
|        |                |               |   |             
|2000    |                |               |   |              |  |  |   |     
|        | First Quarter  |               | $ | 2.56         |  |  | $ | 0.94 | 
|        | Second Quarter |               | $ | 1.56         |  |  | $ | 0.44 | 
|        | Third Quarter  |               | $ | 1.06         |  |  | $ | 0.50 | 
|        | Fourth Quarter |               | $ | 0.69         |  |  | $ | 0.19 | 
|2001    |                |               |   |              |  |  |   |     
|        | First Quarter  |               | $ | 0.56         |  |  | $ | 0.25 | 
|        | Second Quarter |               | $ | 0.38         |  |  | $ | 0.23 | 
|        | Third Quarter  |               | $ | 0.31         |  |  | $ | 0.15 | 
|        | Fourth Quarter |               | $ | 0.21         |  |  | $ | 0.11 | 
|2002    |                |               |   |              |  |  |   |     
|        | First Quarter  |               | $ | 0.22         |  |  | $ | 0.12 | 
|        | Second Quarter |               | $ | 0.14         |  |  | $ | 0.09 | 
|        | Third Quarter  |               | $ | 0.13         |  |  | $ | 0.06 | 
|        | Fourth Quarter |               | $ | 0.09         |  |  | $ | 0.06 | 

On March 5, 2003, the closing price reported by the OTC was U.S. $0.05.
Stockholders are urged to obtain current market prices for our Common Stock.
Beginning April 1, 1997, Computershare Investor Services, through its purchase
of the transfer agent business in 2000 of Harris Trust Company of California
has been our transfer agent.

Record Holders

To our knowledge
there were approximately 192 holders of record of the
stock of the Company as of March 5, 2003. However, our transfer agent has
indicated that beneficial ownership is in excess of 6,000 stockholders.

10



---



##### Table of Contents



Dividends

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.

However, holders of our Series B Preferred Stock are entitled to a
cumulative dividend, payable only out of assets legally available for such
payments. Holders of our Series B Preferred Stock are entitled to dividends
prior to any holders of our Common Stock or any subsequent series of preferred
stock which we may issue.




Item 6.Selected Consolidated Financial Data

The following selected consolidated financial data should be read in
conjunction with the Companys Consolidated Financial Statements and related
Notes and with Managements Discussion and Analysis of Financial Condition and
Results of Operations, included in Item 7. The selected financial data for the
years ended December 31, 2002, 2001, 2000, 1999 and 1998 are derived from the
Companys 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 year ended December 31, 2002 and the report
thereon are included elsewhere in this Report.

|                                           |  |                   |            |              |  |              |            |              |  |              |            |   |  |   |            |   |  |   |            |  
|------------------------------------------ |  | ----------------- | ---------- | ------------ |  | ------------ | ---------- | ------------ |  | ------------ | ---------- | - |  | - | ---------- | - |  | - | ---------- | -
|                                           |  | Fiscal Year Ended
|                                           |  |                  
|                                           |  | December 31,      |            | December 31, |  | December 31, |            | December 31, |  | December 31,
|                                           |  | 1998              |            | 1999         |  | 2000         |            | 2001         |  | 2002        
|                                           |  |                   |            |              |  |              |            |              |  |             
|Consolidated Statement of
Operations Data: |  |                   |            |              |  |              |            |              |  |              |            |   |  |   |            |   |  |   |            |  
|Revenues                                   |  | $                 | 1,680      |              |  | $            | 1,660      |              |  | $            | 2,202      |   |  | $ | 1,604      |   |  | $ | 1,856      |  
|Cost Of Revenues                           |  |                   | (134       | )            |  |              | (49        | )            |  |              | (248       | ) |  |   | (97        | ) |  |   | (131       | )
|                                           |  |                   |            |              |  |              |            |              |  |              |            |   |  |   |            |   |  |   |            |  
|Gross Profit                               |  |                   | 1,546      |              |  |              | 1,611      |              |  |              | 1,954      |   |  |   | 1,507      |   |  |   | 1,725      |  
|Total Operating Expenses                   |  |                   | (3,490     | )            |  |              | (1,156     | )            |  |              | (1,596     | ) |  |   | (1,823     | ) |  |   | (1,711     | )
|Other Income (Expense), Net                |  |                   | (108       | )            |  |              | (94        | )            |  |              | 34         |   |  |   | 73         |   |  |   | (2         | )
|Loss from Discontinued Operations          |  |                   | (3,702     | )            |  |              |            |              |  |              |            |   |  |   |            |   |  |   |            |  
|Income taxes                               |  |                   | (38        | )            |  |              | (6         | )            |  |              | (10        | ) |  |   | 3          |   |  |   | (6         | )
|                                           |  |                   |            |              |  |              |            |              |  |              |            |   |  |   |            |   |  |   |            |  
|Net Income (Loss)                          |  | $                 | (5,792     | )            |  | $            | 355        |              |  | $            | 382        |   |  | $ | (240       | ) |  | $ | 18         |  
|                                           |  |                   |            |              |  |              |            |              |  |              |            |   |  |   |            |   |  |   |            |  
|Basic Income (Loss) Per Share(5)           |  | $                 | (0.29      | )            |  | $            | 0.01       |              |  | $            | 0.01       |   |  | $ | (0.01      | ) |  | $ | 0.00       |  
|                                           |  |                   |            |              |  |              |            |              |  |              |            |   |  |   |            |   |  |   |            |  
|Diluted Income (Loss) Per Share(5)         |  | $                 | (0.29      | )            |  | $            | 0.01       |              |  | $            | 0.01       |   |  | $ | (0.01      | ) |  | $ | 0.00       |  
|                                           |  |                   |            |              |  |              |            |              |  |              |            |   |  |   |            |   |  |   |            |  
|Weighted Average Common Shares             |  |                   | 22,180,180 |              |  |              | 33,805,512 |              |  |              | 46,736,224 |   |  |   | 47,388,235 |   |  |   | 47,406,939 |  
|                                           |  |                   |            |              |  |              |            |              |  |              |            |   |  |   |            |   |  |   |            |  
|Consolidated Balance Sheet Data            |  |                   |            |              |  |              |            |              |  |              |            |   |  |   |            |   |  |   |            |  
|Cash and Cash Equivalents                  |  | $                 | 264        |              |  | $            | 1,022      |              |  | $            | 1,468      |   |  | $ | 869        |   |  | $ | 859        |  
|Working Capital (Deficit)                  |  |                   | (1,975     | )            |  |              | 395        |              |  |              | 1,195      |   |  |   | 1,124      |   |  |   | 1,125      |  
|Total Assets                               |  |                   | 893        |              |  |              | 2,118      |              |  |              | 2,457      |   |  |   | 1,753      |   |  |   | 1,746      |  
|Advances From Related Parties              |  |                   | 857        |              |  |              | 337        |              |  |              | 337        |   |  |   | 113        |   |  |   | 113        |  
|Total Shareholders Equity (Deficit)       |  | $                 | (1,553     | )            |  | $            | 768        |              |  | $            | 1,651      |   |  | $ | 1,411      |   |  | $ | 1,429      |  




Item 7.Managements Discussion and Analysis of Financial Condition and Results of Operations

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. In consultation with our Board of
Directors and Audit Committee, we have identified three accounting policies
that we believe are key 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.

11



---



##### Table of Contents



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, consisting primarily of legal and filing
fees, and amortize such costs over the remaining life of the patent (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.

The fourth critical accounting policy relates to the existence of an Audit
Committee of our Board of Directors.

Audit Committee

This committee is directed to review the scope, cost and results of the independent audit
of the Companys books and records, the results of the annual audit with Management and the
internal auditors and the adequacy of the Companys accounting, financial, and operating
controls; to recommend annually to the Board of Directors the selection of the
independent auditors; to consider proposals made by the Companys 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

The Compensation and Stock Option Committee of the Company (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 senior officers and employees of the
Company. 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 the Companys 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.

The following discussion and analysis relates to the financial condition
and results of operations of the Company and our subsidiaries for the year
ended December 31, 2002 compared to the year ended December 31, 2001, and the
year ended December 31, 2001 compared to the year ended December 31, 2000.

Results of Operations

For the Year Ended December 31, 2002, Compared to the Year Ended December 31, 2001

Revenues

Revenues increased to $1,856,000 for the year ended December 31, 2002
compared to $1,604,000 for the year ended December 31, 2001, an increase of
16%. Revenues are almost entirely comprised royalties pertaining to the
licensing of Spatializer® audio signal processing algorithms.

The increase in revenues is attributed primarily to the addition of two
new accounts which generated in excess of 10% of total revenue each, partially
offset by declining royalties on declining analog chip sales from another
account.

Gross Profit

Gross profit increased to $1,725,000 for the year ended December 31, 2002
compared to $1,507,000 in the comparable period last year, an increase of 14%.
Gross margin decreased to 93% of revenue in the year ended December 31, 2002
compared with 94% of revenue for the comparable period last year. The increase
in gross profit results from higher revenues in the current year, partially
offset by slightly lower gross margin. This decrease in the gross margin
percentage reflects a slight change in mix to commissionable foreign royalty
revenue compared to non-commissionable U.S. sourced revenue. The Company
maintains 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 the Companys independent representatives that solicit and oversee the particular accounts.

Operating Expenses

Operating expenses for the year ended December 31, 2002 decreased to
$1,711,000 (92% of sales) from $1,823,000 (114% of sales) for the year ended
December 31, 2001, a decrease of 6%. The decrease in operating expenses results
primarily from completion of various outside engineering consulting projects in
2001 for which we paid outside engineering fees. In 2002, a much greater level
of applications engineering projects were either done in house or by our
licensed distributors and the fees incurred for such work was significantly
reduced over the prior year. However, levels of pure R&D were unchanged between
the two years, as reflected by the level of new product introductions.

General and Administrative

General and
administrative costs increased to $766,000 for the year ended
December 31, 2002 from $707,000 for the year ended December 31, 2001, an
increase of 9%. The increase is primarily due to increased legal expenses
related to public filings and increased travel by the CEO. General operating
costs include rent, telephone, legal, public filing, office supplies and
stationery, postage, depreciation and similar costs.

12



---



##### Table of Contents



Research and Development

Research and
Development costs decreased to $433,000 for the year ended
December 31, 2002, compared to $639,000 for the year ended December 31, 2001, a
decrease of 32%. The decrease in research and development expense was due
completion of various outside engineering consulting projects in 2001 for which
we paid outside engineering fees. In 2002, a much greater level of applications
engineering projects were either done in house or by our licensed distributors
and as such, the fees incurred for such work were significantly reduced over
the prior year. However, levels of pure R&D were unchanged between the two
years, as reflected by the level of new product introductions.

The Company continued efforts to identify, validate, and develop new
product ideas at DPI. Specific engineering efforts were directed toward the
launch of encompass AV , development of Spatializer Audio Alchemy, refinement
of Spatializer Natural Headphone and applications engineering to port the
Companys technology to leading processor platforms.

Sales and Marketing

Sales and Marketing costs increased to $513,000 for the year ended
December 31, 2002, compared to $476,000 for the year ended December 31, 2001,
an increase of 8%. Spending was increase in the area of foreign travel, where
the Asian customer visitation frequency was doubled in the second half of 2002.

Net Income (Loss)

Net Income was $18,000 for the year ended December 31, 2002, compared to
net loss of $240,000 for the year ended December 31, 2001. Net Income for the
current period is primarily the result of higher revenues and improved overhead
management.

For the Year Ended December 31, 2001, Compared to the Year Ended December 31,
2000

Revenues

Revenues decreased to $1,604,000 for the year ended December 31, 2001
compared to $2,202,000 for the year ended December 31, 2000, a decrease of 27%.
Revenues include license issuance fees and royalties pertaining to the
licensing of Spatializer® audio signal processing designs and non-recurring
engineering fees.

The decrease in revenues is attributed primarily to (i) decreased
royalties from one account resulting from lower unit sales compared to the
prior year, (ii) lower royalties from another account due to a timing
difference between 2000 and 2001 created when royalty reporting shifted from
the DSP foundry (on shipment of DSP) to OEM customer (shipment of DVD player),
(iii) loss of an account in mid 2001 which had comprised less than 10% of sales
in the prior year and (iv) decreases in per unit Spatializer N-2-2 royalties
due to a volume-based sliding scale pricing structure with DSP foundries which
did not stabilize until the beginning of the third quarter of 2000.

Gross profit decreased to $1,507,000 for the year ended December 31, 2001
compared to $1,954,000 in the comparable period last year. Gross margin
increased to 95% of revenue in the year ended December 31, 2001 compared with
89% of revenue for the comparable period last year. The decrease in gross
profit results from lower revenues in the current year, partially offset by
higher gross margin. This increase in the gross margin percentage reflects the
realignment of our Asian sales rep network which included the implementation of
lower commission rates. The Company maintains a high margin since revenues are
from licensing and royalty activities, which have little or no associated
direct manufacturing or selling costs.

Operating Expenses

Operating expenses for the year ended December 31, 2001 increased to
$1,823,000 (114% of sales) from $1,595,000 (72% of sales) for the year ended
December 31, 2000, a increase of 11%. The increase in operating expenses
results from expansion of the Companys research and development efforts and
higher general and administrative expenses relating to legal and public company
expenses. The Company undertook an expansion of headcount in early 2001. When
it became clear in mid 2001 that anticipated revenue growth was not occurring,
the Company began to curtail the scope of its initiatives in order to bring
spending levels back in line with reported revenue streams.

13



---



##### Table of Contents



General and Administrative

General and administrative costs increased to $707,000 for the year ended
December 31, 2001 from $599,000 for the year ended December 31, 2000, an
increase of 18%. The increase is primarily due to increased legal expenses
related to public filings 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 $640,000 for the year ended
December 31, 2001, compared to $540,000 for the year ended December 31, 2000,
an increase of 19%. The increase in research and development expense was due to
the additions to headcount early in the year, search fees paid for certain
engineers hired by the Company and expanded use of engineering consultants for
specialized projects.

In addition, the Company continued efforts to identify, validate, and
develop new product ideas at DPI. Specific engineering efforts were directed
toward the launch of Spatializer N-2-2 Ultra , development of Spatializer
PCE, refinement of Spatializer Natural Headphone and applications engineering
to port the Companys technology to leading processor platforms.

Sales and Marketing

Sales and Marketing costs increased to $476,000 for the year ended
December 31, 2001, compared to $456,000 for the year ended December 31, 2000,
an increase of less than one percent. Spending was maintained at the prior
years level in order to continue the development of markets for existing
products.

Interest Income

Interest income on short-term investments decreased $23,499 from 2000 to
2001 due to lower cash investments combined with lower interest rates.

Interest Expense

Interest expense decreased $22,862 due to repayment of $225,242 of Notes
Payable to Related Parties in 2001.

Other Income (Expense), Net

Other income (expense) includes approximately $35,000 in gains on
settlements of claims relating to its discontinued operation, MDT.

Net Income (Loss)

Net loss was $240,000 for the year ended December 31, 2001, compared to
net income of $382,000 for the year ended December 31, 2000. The net loss for
the current period is primarily the result of lower revenues and higher
overhead, partially offset by improved gross margin.

Liquidity and Capital Resources

At December 31,
2002, we had $859,000 in cash and cash equivalents as
compared to $869,000 at December 31, 2001. The decrease in cash and cash
equivalents is attributed to modest increases in fixed assets and patent filing
expenditures. We had working capital of $1,125,000 at December 31, 2002 as
compared with working capital of $1,124,000 at December 31, 2001. Our future
cash flow will come primarily from the audio signal processing licensing,
Original Equipment Manufacturers (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 should generate additional cash flow without imposing any substantial
costs on the Company. We anticipate that there will be a wind down of
our licensing program in early 2003 with a large computer account as
that entity completes its migration to its latest operating system.
We added or expanded our relationships with JVC, Sanyo, Orion and
Mediatech this past year. We believe that growth from these and other
licensing arrangements including some that are pending but not
announced or in negotiation, will substantially offset any revenue
shortfalls from the computer account by the third quarter of fiscal
2003. Mediatech, in particular, has been successful in penetrating
the DVD market and our relationship with them positions us well as the
audio solutions provider of choice in these new accounts for 2003 and
2004. Further, by the second half of 2003, we expect to begin
generating revenues from the Company's new products that were
introduced in 2002.

Like other operating enterprises, the events of September 11, 2001 in the
United States brought a degree of uncertainty to our operations and hindered
our ability to plan and meet with our contractual partners outside the United
States in this dynamic environment. The operations of our business, and those
of our competitors, may also be impacted by the continued trend in the

14



---



##### Table of Contents



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,
the Company 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. The Company has responded by offering additional products targeted to
each price/quality segment of the market and continues to aggressively pursue
new opportunities in emerging product categories and complements to 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 the Company, and its rational commercial competitors,
to enhance their operating results.

To the extent the
Company maintains or exceeds its projected revenues and is not
required to fund contingencies, it expects to continue to
retain its current cash reserves and therefore, maintain its
liquidity position at a consistent level both on a short-term and
long-term basis. To the extent that the Company does not achieve
current operating levels or is required to fund contingencies, it
will be required to use some of its cash reserves and this could
impact its 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. To address
these objectives, we retained Neveric
Capital, a San Francisco based investment banking firm, to identify
and evaluate strategic opportunities and to explore
alternatives to enhance stockholder value and support the Company's
growth and overall strategy.

In December 1999, we completed a set of financial transactions (the
1999 Transactions) with certain existing holders of our equity and debt
and with new institutional investors. The 1999 Transactions included the
private placement of 1,884,254 additional shares of our Common Stock ($1.05
million in new capital or $0.56 per share), the issuance of warrants to acquire
2,100,000 shares of Common Stock exercisable for three years at an exercise
price of $.67 per share), the cancellation of 500,000 warrants to acquire
Common Stock issued in an earlier financing, the conversion of $1 million of
short term debt into a new Series B Redeemable Convertible Preferred Stock
(Series B Preferred Stock) and the conversion of $225,000 of secured debt
into secured convertible debt.

In the 1999 Transactions, $895,000 in short term loan advances from
officers, directors and their affiliates and certain other securities holders,
and accrued interest of $134,647, were restructured into the $1,000,000 in new
Series B Preferred Stock. The Series B Preferred Stock, and
any dividends therefrom not converted into cash, were convertible commencing in 2001 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 Company had an option
to redeem with cash any Series B Preferred
Stock not converted before the end of 2002 and to pay
Series B Preferred Stock accrued and declared cumulative dividends of 10%. In November
2002, the Board of Directors and the holders of the
Series B Preferred Stock, agreed to exchange the Series B
Preferred Stock for a new Series B-1 Preferred Stock which had terms
substantially the same as the Series B Preferred Stock, except
that the conversion date was deferred to December 2005, no future
dividends will accrue and dividends for prior periods on the
Series B Preferred Stock were reset and recalculated to the LIBOR rate
in effect on the first business day of each of 2000, 2001 and 2002,
respectively and were paid through the issuance of the appropriate
number of shares of Series B-1 Preferred Stock.
The exchange was completed in December 2002. The 500,000 warrants issued in the 1999 Transactions
expired, without exercise 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.

As noted above, in
the 1999 Transactions, $225,000 of secured debt, including accrued
interest, was converted into secured long term convertible debt. The long term
debt was repaid with interest in 2001. We currently have a related
party obligation of $112,500 which bears interest of 10% per annum, which we pay on a current basis. The debt is due on demand.

We eliminated Net Liabilities of Discontinued Operation since the statute
of limitations for claims has been exceeded. We continue to maintain an accrual
for unasserted claims or settlement costs related to the discontinuation of MDT
in 1999. We do not expect any final liability to be in excess of this balance.

Funds generated by these financing activities as well as cash generated
from our existing operations and customer base is expected to be sufficient for
us to meet our operating obligations and the anticipated additional research
and development for our audio technology business. The Company 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 the Company on terms that enhance shareholder value and
support the Companys business strategy.

To the extent the Company maintains or exceeds its projected revenues and
is not required to fund significant contingencies, it expects to continue to
retain its current cash reserves and therefore, maintain its liquidity position
at a consistent level both on a short-term and long-term basis. To the extent
that the Company does not achieve current operating levels or is required to
fund contingencies, it will be required to use some of its cash reserves and
this could impact its longer term liquidity.

15



---



##### Table of Contents



Net Operating Loss Carry forwards

At December 31, 2002, the Company had net operating loss carry forwards
for Federal income tax purposes of approximately $26,000,000 which are
available to offset future Federal taxable income, if any, through 2013.
Approximately $21,700,000 of these net operating loss carry forwards are
subject to an annual limitation of approximately $1,000,000.

Inflation

We believe that the moderate inflation rate of the last several years has
not impacted our operations.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In July 2001, the FASB issued SFAS No. 141, Business Combinations, which
establishes financial accounting and reporting for business combinations and
supersedes APB Opinion No. 16, Business Combinations, and FASB statement No.
38, Accounting for Preacquisition Contingencies of Purchased Enterprises.
SFAS No. 141 requires that all business combinations be accounted for using one
method, the purchase method. The provisions apply to all business combinations
initiated after June 30, 2001.

In July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible
Assets, which establishes financial accounting and reporting for acquired
goodwill and other intangible assets and supersedes APB Opinion No. 17,
Intangible Assets. SFAS No. 142 addresses how intangible assets that are
acquired individually or with a group of other assets (but not those acquired
in a business combination) should be accounted for in financial statements upon
their acquisition, and after they have been initially recognized in the
financial statements. The provisions of SFAS no. 142 were effective for fiscal
years beginning after December 15, 2001. We adopted SFAS No. 142 during the
first quarter of fiscal 2002, and the adoption of SFAS No. 142 had no material
impact on our financial reporting and related disclosures.

In August 2001, the FASB issued SFAS No. 143, Accounting for Asset
Retirement Obligations, which is effective for us beginning fiscal 2003. SFAS
No. 143 requires that the fair value of a liability for an asset retirement
obligation be recognized in the period in which it is incurred if a reasonable
estimate of fair value can be made, with the associated asset retirement costs
capitalized as part of the carrying amount of the long-lived assets. We do not
expect the adoption of SFAS No. 143 to have a material impact on our financial
position and results of operations.

In October 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, which is effective for fiscal
years beginning after December 15, 2001 and interim periods within those fiscal
periods. SFAS No. 144 supersedes FASB Statement No. 121 and parts of APB
Opinion No. 30, Reporting the Results of Operations  Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions Relating to Extraordinary
Items. However, SFAS No. 144 retains the requirement of APB Opinion No. 30 to
report discontinued operations separately from continuing operations and
extends that reporting to a component of an entity that either has been
disposed of (by sale, by abandonment or in a distribution to owners) or is
classified as held for sale. SFAS No. 144 addresses financial accounting and
reporting for the impairment of certain long-lived assets and for long-lived
assets to be disposed of. We do not expect the adoption of SFAS No. 144 to
have a material impact on our financial position and results of operations.

In June 2002, the
FASB issued SFAS 146, Accounting for Costs Associated with
Exit or Disposal Activities, which nullifies EITF Issue 94-3.
SFAS 146 is effective for exit and disposal activities that are
initiated after December 31, 2002 and requires that a liability
for a cost associated with an exit or disposal activity be recognized
when the liability is incurred in contrast to the date of an entity's
commitment to an exit plan, as required by EITF Issue 94-3. We do not
expect the adoption of SFAS No. 146 to have a material impact on
our financial position and results of operations.

In December 2002, the
FASB issued SFAS 148 Accounting for Stock-Based
Compensation an amendment to SFAS 123. SFAS 148
provides alternative methods of transition for a voluntary change to
the fair value based method of accounting for stock-based employee
compensation. In addition, this Statement amends the disclosure
requirements of Statement 123 to require prominent disclosures in
both annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect of
the method used on reported results. This statement is effective for
fiscal years ending after December 15, 2002 for transition
guidance and annual disclosure provisions; for financial reports
containing financial statements for interim periods beginning after
December 15, 2002 for interim disclosure provisions. The
adoption of SFAS No. 148 did not have a material impact on our
financial position and results of operations.

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, 2002. 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.

16



---



##### Table of Contents



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, 2002 and 2001 and the related consolidated statements of
operations, shareholders equity, and cash flows for the years ended December 31,
2002, 2001 and 2000. 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 auditing
standards generally accepted in the 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,
2002 and 2001, and
the results of its operations and its cash flows for the years ended December 31,
2002, 2001 and 2000 in conformity with generally accepted accounting
policies in the United States of America.

/s/   FARBER & HASS LLP

Oxnard, California
March 18, 2003

17



---



##### Table of Contents






Item 8.Financial Statements

SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

ASSETS

|                                                                                                                                                                                                    |                                           |                           |                                                                                                                                                                   |                            |           |              |           |              |           |             |           | 
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------- | ------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | --------- | ------------ | --------- | ------------ | --------- | ----------- | --------- | 
|                                                                                                                                                                                                    |                                           |                           |                                                                                                                                                                   |                            |           | December 31, |           | December 31,
|                                                                                                                                                                                                    |                                           |                           |                                                                                                                                                                   |                            |           | 2002         |           | 2001        
|                                                                                                                                                                                                    |                                           |                           |                                                                                                                                                                   |                            |           |              |           |             
|Current Assets:                                                                                                                                                                                     |                                           |                           |                                                                                                                                                                   |                            |           |              |           |             
|                                                                                                                                                                                                    | Cash and Cash Equivalents                 |                           | $                                                                                                                                                                 | 858,725                    |           |              | $         | 869,478      |          
|                                                                                                                                                                                                    | Accounts Receivable                       |                           |                                                                                                                                                                   | 499,023                    |           |              |           | 442,555      |          
|                                                                                                                                                                                                    | Prepaid
Expenses and Other Current Assets |                           |                                                                                                                                                                   | 82,920                     |           |              |           | 133,251      |          
|                                                                                                                                                                                                    |                                           |                           |                                                                                                                                                                   |                            |           |              |           |             
|                                                                                                                                                                                                    |                                           | Total Current Assets      |                                                                                                                                                                   |                            | 1,440,668 |              |           |              | 1,465,284 |            
|Property and Equipment, Net                                                                                                                                                                         |                                           |                           | 70,842                                                                                                                                                            |                            |           |              | 50,586    |             
|Intangible Assets, Net                                                                                                                                                                              |                                           |                           | 225,859                                                                                                                                                           |                            |           |              | 255,726   |             
|Other Assets                                                                                                                                                                                        |                                           |                           | 8,471                                                                                                                                                             |                            |           |              | 1,510     |             
|                                                                                                                                                                                                    |                                           |                           |                                                                                                                                                                   |                            |           |              |           |             
|                                                                                                                                                                                                    |                                           | $                         | 1,745,840                                                                                                                                                         |                            |           | $            | 1,753,106 |             
|                                                                                                                                                                                                    |                                           |                           |                                                                                                                                                                   |                            |           |              |           |             
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                               
|Current Liabilities:                                                                                                                                                                                |                                           |                           |                                                                                                                                                                   |                            |           |              |           |             
|                                                                                                                                                                                                    | Notes Payable to Related Party            |                           |                                                                                                                                                                   | 112,500                    |           |              |           | 112,500      |          
|                                                                                                                                                                                                    | Accounts Payable                          |                           |                                                                                                                                                                   | 39,027                     |           |              |           | 14,872       |          
|                                                                                                                                                                                                    | Accrued Wages and Benefits                |                           |                                                                                                                                                                   | 108,771                    |           |              |           | 72,969       |          
|                                                                                                                                                                                                    | Accrued Expenses                          |                           |                                                                                                                                                                   | 55,682                     |           |              |           | 41,197       |          
|                                                                                                                                                                                                    | Net Liabilities of Discontinued Operation |                           |                                                                                                                                                                   |                           |           |              |           | 100,000      |          
|                                                                                                                                                                                                    |                                           |                           |                                                                                                                                                                   |                            |           |              |           |             
|                                                                                                                                                                                                    |                                           | Total Current Liabilities |                                                                                                                                                                   |                            | 315,980   |              |           |              | 341,538   |            
|                                                                                                                                                                                                    |                                           |                           |                                                                                                                                                                   |                            |           |              |           |             
|Commitments and Contingencies                                                                                                                                                                       |                                           |                           |                                                                                                                                                                   |                            |           |              |           |             
|                                                                                                                                                                                                   
|                                                                                                                                                                                                   
|                                                                                                                                                                                                   
|                                                                                                                                                                                                   
|                                                                                                                                                                                                   
|                                                                                                                                                                                                   
|                                                                                                                                                                                                   
|                                                                                                                                                                                                   
|Series B-1 Redeemable Convertible Preferred Shares, $0.01 par
value:
1,000,000 shares authorized;
102,762 shares issued and outstanding at December 31, 2002 (liquidation preference of $1,027,620) |                                           |                           | 1,028                                                                                                                                                             |                            |           |              |           |             
|Stockholders Equity (Deficit):                                                                                                                                                                     |                                           |                           |                                                                                                                                                                   |                            |           |              |           |             
|                                                                                                                                                                                                    |                                           |                           | 10% Series B Convertible Preferred Shares $0.01 par value 1,000,000 shares authorized;
87,967 converted to Series B-1                                             |                            |           |              |           |              |           | 880         |          
|                                                                                                                                                                                                    |                                           |                           | Common shares, $0.01 par value; 65,000,000 shares
authorized; 47,406,939 and 47,406,939 shares
issued
and outstanding at December 31, 2002 and 2001,
respectively |                            |           | 474,070      |           |              |           | 474,070     |          
|                                                                                                                                                                                                    |                                           |                           | Additional Paid-In Capital                                                                                                                                        |                            |           | 46,402,704   |           |              |           | 46,402,852  |          
|                                                                                                                                                                                                    |                                           |                           | Accumulated Deficit                                                                                                                                               |                            |           | (45,447,942  | )         |              |           | (45,466,234 | )        
|                                                                                                                                                                                                    |                                           |                           |                                                                                                                                                                   |                            |           |              |           |             
|                                                                                                                                                                                                    |                                           |                           |                                                                                                                                                                   | Total Shareholders Equity |           |              | 1,428,832 |              |           |             | 1,411,568 | 
|                                                                                                                                                                                                    |                                           |                           |                                                                                                                                                                   |                            |           |              |           |             
|                                                                                                                                                                                                    |                                           | $                         | 1,745,840                                                                                                                                                         |                            |           | $            | 1,753,106 |             
|                                                                                                                                                                                                    |                                           |                           |                                                                                                                                                                   |                            |           |              |           |             

See accompanying notes to consolidated financial statements

18



---



##### Table of Contents



SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

|                            |                            |                                            |                                     |           |                         |            |           |           |          |            |           |           |         |            | 
|--------------------------- | -------------------------- | ------------------------------------------ | ----------------------------------- | --------- | ----------------------- | ---------- | --------- | --------- | -------- | ---------- | --------- | --------- | ------- | ---------- | 
|                            |                            |                                            |                                     |           | Year Ended December 31,
|                            |                            |                                            |                                     |           |                        
|                            |                            |                                            |                                     |           | 2002                    |            | 2001      |           | 2000    
|                            |                            |                                            |                                     |           |                         |            |           |           |         
|Revenues:                   |                            |                                            |                                     |           |                         |            |           |           |          |            |           |          
|                            | Product Revenues, Net      |                                            |                                     |           |                         |            |           |           |          |            |           |           |        
|                            | Licensing Revenues         |                                            |                                     |           |                         |            |           |           |          |            |           |           |        
|                            | Royalty Revenues           |                                            | $                                   | 1,855,934 |                         |            | $         | 1,603,782 |          |            | $         | 2,201,812 |        
|                            |                            |                                            |                                     |           |                         |            |           |           |          |            |           |          
|                            |                            |                                            | 1,855,934                           |           |                         |            | 1,603,782 |           |          |            | 2,201,812 |          
|                            |                            | Cost of Revenues                           |                                     |           | 130,516                 |            |           |           | 96,783   |            |           |           | 248,217 |           
|                            |                            |                                            |                                     |           |                         |            |           |           |          |            |           |          
|                            |                            |                                            | 1,725,418                           |           |                         |            | 1,506,999 |           |          |            | 1,953,595 |          
|                            |                            |                                            |                                     |           |                         |            |           |           |          |            |           |          
|Operating Expenses:         |                            |                                            |                                     |           |                         |            |           |           |          |            |           |          
|                            | General and Administrative |                                            |                                     | 765,637   |                         |            |           | 707,115   |          |            |           | 599,291   |        
|                            | Research and Development   |                                            |                                     | 432,826   |                         |            |           | 639,223   |          |            |           | 540,269   |        
|                            | Sales and Marketing        |                                            |                                     | 512,727   |                         |            |           | 476,432   |          |            |           | 455,901   |        
|                            |                            |                                            |                                     |           |                         |            |           |           |          |            |           |          
|                            |                            |                                            | 1,711,190                           |           |                         |            | 1,822,770 |           |          |            | 1,595,461 |          
|                            |                            |                                            |                                     |           |                         |            |           |           |          |            |           |          
|                            |                            | Operating Income (Loss)                    |                                     |           | 14,228                  |            |           |           | (315,771 | )          |           |           | 358,134 |           
|                            |                            |                                            |                                     |           |                         |            |           |           |          |            |           |          
|Interest Income             |                            |                                            | 12,432                              |           |                         |            | 41,358    |           |          |            | 64,857    |          
|Interest Expense            |                            |                                            | (14,493                             | )         |                         |            | (11,250   | )         |          |            | (34,112   | )        
|Other Income (Expense), Net |                            |                                            | 25                                  |           |                         |            | 42,691    |           |          |            | 3,140     |          
|                            |                            |                                            |                                     |           |                         |            |           |           |          |            |           |          
|                            |                            |                                            | (2,036                              | )         |                         |            | 72,799    |           |          |            | 33,885    |          
|                            |                            |                                            |                                     |           |                         |            |           |           |          |            |           |          
|                            |                            | Income (Loss) Before Income Taxes          |                                     |           | 12,192                  |            |           |           | (242,972 | )          |           |           | 392,019 |           
|                            |                            | Income Taxes                               |                                     |           | (6,100                  | )          |           |           | 2,865    |            |           |           | (10,000 | )         
|                            |                            |                                            |                                     |           |                         |            |           |           |          |            |           |          
|                            |                            | Net Income (Loss)                          |                                     | $         | 18,292                  |            |           | $         | (240,107 | )          |           | $         | 382,019 |           
|                            |                            |                                            |                                     |           |                         |            |           |           |          |            |           |          
|                            |                            | Basic and Diluted Income (Loss)
per Share: |                                     | $         | .00                     |            |           | $         | (.01     | )          |           | $         | .01     |           
|                            |                            |                                            |                                     |           |                         |            |           |           |          |            |           |          
|                            |                            |                                            | Weighted-Average Shares Outstanding |           |                         | 47,406,939 |           |           |          | 47,247,455 |           |           |         | 46,736,224 | 
|                            |                            |                                            |                                     |           |                         |            |           |           |          |            |           |          

See accompanying notes to consolidated financial statements

19



---



##### Table of Contents



SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

|                                                  |                                                                                                 |                                        |         |                         |          |      |           |          |          |   |           |         |          |  
|------------------------------------------------- | ----------------------------------------------------------------------------------------------- | -------------------------------------- | ------- | ----------------------- | -------- | ---- | --------- | -------- | -------- | - | --------- | ------- | -------- | -
|                                                  |                                                                                                 |                                        |         | Year Ended December 31,
|                                                  |                                                                                                 |                                        |         |                        
|                                                  |                                                                                                 |                                        |         | 2002                    |          | 2001 |           | 2000    
|                                                  |                                                                                                 |                                        |         |                         |          |      |           |         
|Cash Flows from Operating Activities:             |                                                                                                 |                                        |         |                         |          |      |           |          |          |   |           |        
|                                                  | Net Income (Loss)                                                                               |                                        | $       | 18,292                  |          |      | $         | (240,107 | )        |   | $         | 382,019 |         
|                                                  | Adjustments to Reconcile Net Income (Loss) to Net Cash
Provided (Used) by Operating Activities: |                                        |         |                         |          |      |           |          |          |   |           |         |         
|                                                  |                                                                                                 | Depreciation                           |         |                         | 54,737   |      |           |          | 77,785   |   |           |         | 64,730   |  
|                                                  |                                                                                                 | Amortization                           |         |                         | 50,766   |      |           |          | 61,345   |   |           |         | 21,239   |  
|                                                  |                                                                                                 | Stock and Options Issued for Services  |         |                         |          |      |           |          |          |   |           |         | 30,000   |  
|                                                  | Net Change in Assets and Liabilities:                                                           |                                        |         |                         |          |      |           |          |          |   |           |         |         
|                                                  |                                                                                                 | Accounts Receivable                    |         |                         | (56,460  | )    |           |          | 64,003   |   |           |         | 181,037  |  
|                                                  |                                                                                                 | Prepaid Expenses and Deposits          |         |                         | 43,370   |      |           |          | (63,132  | ) |           |         | (3,818   | )
|                                                  |                                                                                                 | Accounts Payable                       |         |                         | 24,155   |      |           |          | (36,910  | ) |           |         | (182,335 | )
|                                                  |                                                                                                 | Accrued Expenses and Other Liabilities |         |                         | 50,286   |      |           |          | (46,819  | ) |           |         | (183,268 | )
|                                                  |                                                                                                 | Discontinued Operations                |         |                         | (100,000 | )    |           |          | (155,840 | ) |           |         | (163,760 | )
|                                                  |                                                                                                 |                                        |         |                         |          |      |           |          |          |   |           |        
|Net Cash Provided (Used) by Operating Activities  |                                                                                                 |                                        | 85,138  |                         |          |      | (339,675  | )        |          |   | 145,844   |        
|                                                  |                                                                                                 |                                        |         |                         |          |      |           |          |          |   |           |        
|Cash Flows from Investing Activities:             |                                                                                                 |                                        |         |                         |          |      |           |          |          |   |           |        
|                                                  |                                                                                                 | Purchase of Property and Equipment     |         |                         | (74,993  | )    |           |          | (20,311  | ) |           |         | (40,489  | )
|                                                  |                                                                                                 | Proceeds from Disposal                 |         |                         |          |      |           |          |          |   |           |         | 500      |  
|                                                  |                                                                                                 | Intangible Assets                      |         |                         | (20,898  | )    |           |          | (14,282  | ) |           |         | (116,235 | )
|                                                  |                                                                                                 |                                        |         |                         |          |      |           |          |          |   |           |        
|Net Cash Used by Investing Activities             |                                                                                                 |                                        | (95,891 | )                       |          |      | (34,593   | )        |          |   | (156,224  | )      
|                                                  |                                                                                                 |                                        |         |                         |          |      |           |          |          |   |           |        
|Cash Flows from Financing Activities:             |                                                                                                 |                                        |         |                         |          |      |           |          |          |   |           |        
|                                                  | Exercise of Options and Warrants                                                                |                                        |         |                         |          |      |           | 1,000    |          |   |           | 470,519 |         
|                                                  | Notes and Amounts Due to (from) Related Parties                                                 |                                        |         |                         |          |      |           | (225,242 | )        |   |           |         |         
|                                                  | Repayments/Termination of Notes Payable                                                         |                                        |         |                         |          |      |           |          |          |   |           | (14,149 | )       
|                                                  |                                                                                                 |                                        |         |                         |          |      |           |          |          |   |           |        
|Net Cash Provided by Financing Activities         |                                                                                                 |                                        |         |                         |          |      | (224,242  | )        |          |   | 456,370   |        
|                                                  |                                                                                                 |                                        |         |                         |          |      |           |          |          |   |           |        
|Increase (Decrease) in Cash and Cash Equivalents  |                                                                                                 |                                        | (10,753 | )                       |          |      | (598,510  | )        |          |   | 445,990   |        
|Cash and Cash Equivalents, Beginning of Year      |                                                                                                 |                                        | 869,478 |                         |          |      | 1,467,988 |          |          |   | 1,021,998 |        
|                                                  |                                                                                                 |                                        |         |                         |          |      |           |          |          |   |           |        
|Cash and Cash Equivalents, End of Year            |                                                                                                 | $                                      | 858,725 |                         |          | $    | 869,478   |          |          | $ | 1,467,988 |        
|                                                  |                                                                                                 |                                        |         |                         |          |      |           |          |          |   |           |        
|Supplemental Disclosure of Cash Flow Information: |                                                                                                 |                                        |         |                         |          |      |           |          |          |   |           |        
|                                                  | Cash Paid During the Year for:                                                                  |                                        |         |                         |          |      |           |          |          |   |           |         |         
|                                                  |                                                                                                 | Interest                               |         | $                       | 14,493   |      |           | $        | 11,250   |   |           | $       | 11,250   |  
|                                                  |                                                                                                 | Income Taxes                           |         | $                       | 2,400    |      |           | $        | 3,237    |   |           | $       | 2,569    |  

See accompanying notes to consolidated financial statements

20



---



##### Table of Contents



SPATIALIZER AUDIO LABORATORIES, INC.
AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT)

|                                                    |  |                          |         |        |  |               |       |       |  |          |            |             |  |               |         |  |  |            |            |   |  |   |             |       |  |   |           |  
|--------------------------------------------------- |  | ------------------------ | ------- | ------ |  | ------------- | ----- | ----- |  | -------- | ---------- | ----------- |  | ------------- | ------- |  |  | ---------- | ---------- | - |  | - | ----------- | ----- |  | - | --------- | -
|                                                    |  | 10%
Series B Convertible |         | Common |  |               |       |       |  |          |            |             |  |               |         |  |  |            |            |  
|                                                    |  | Preferred Shares         |         | Shares |  | Common Shares |       |       |  |          |            |             |  |              
|                                                    |  |                          |         |        |  |               |       |       |  |          |            |             |  |              
|                                                    |  |                          |         |        |  |               |       |       |  |          |            |             |  |               |         |  |  | Additional |            |   |  |   |             | Total
|                                                    |  | Number of                |         | Par    |  | Number of     |       | Par   |  | Paid-In- |            | Accumulated |  | Shareholders'
|                                                    |  | Shares                   |         | Value  |  | Shares        |       | Value |  | Capital  |            | Deficit     |  | Equity       
|                                                    |  |                          |         |        |  |               |       |       |  |          |            |             |  |              
|Balance, December 31, 1999                          |  |                          | 102,967 |        |  | $             | 1,030 |       |  |          | 46,174,970 |             |  | $             | 461,750 |  |  | $          | 45,913,503 |   |  | $ | (45,608,146 | )     |  | $ | 768,137   |  
|Options Exercised                                   |  |                          |         |        |  |               |       |       |  |          | 648,001    |             |  |               | 6,480   |  |  |            | 438,839    |   |  |   |             |       |  |   | 445,319   |  
|Warrants Exercised                                  |  |                          |         |        |  |               |       |       |  |          | 210,000    |             |  |               | 2,100   |  |  |            | 23,100     |   |  |   |             |       |  |   | 25,200    |  
|Stock Issued for Services                           |  |                          |         |        |  |               |       |       |  |          | 55,000     |             |  |               | 550     |  |  |            | 29,450     |   |  |   |             |       |  |   | 30,000    |  
|Net Income                                          |  |                          |         |        |  |               |       |       |  |          |            |             |  |               |         |  |  |            |            |   |  |   | 382,019     |       |  |   | 382,019   |  
|Balance, December 31, 2000                          |  |                          | 102,967 |        |  | $             | 1,030 |       |  |          | 47,087,971 |             |  | $             | 470,880 |  |  | $          | 46,404,892 |   |  | $ | (45,226,127 | )     |  | $ | 1,650,675 |  
|                                                    |  |                          |         |        |  |               |       |       |  |          |            |             |  |               |         |  |  |            |            |   |  |   |             |       |  |   |           |  
|Conv. of Pfd. Shares, net                           |  |                          | (15,000 | )      |  |               | (150  | )     |  |          | 313,968    |             |  |               | 3,140   |  |  |            | (2,990     | ) |  |   |             |       |  |   |           |  
|Options Exercised Warrants Exercised                |  |                          |         |        |  |               |       |       |  |          | 5,000      |             |  |               | 50      |  |  |            | 950        |   |  |   |             |       |  |   | 1,000     |  
|Net Loss                                            |  |                          |         |        |  |               |       |       |  |          |            |             |  |               |         |  |  |            |            |   |  |   | (240,107    | )     |  |   | (240,107  | )
|Balance, December 31, 2001                          |  |                          | 87,967  |        |  | $             | 880   |       |  |          | 47,406,939 |             |  | $             | 474,070 |  |  | $          | 46,402,852 |   |  | $ | (45,466,234 | )     |  | $ | 1,411,568 |  
|                                                    |  |                          |         |        |  |               |       |       |  |          |            |             |  |               |         |  |  |            |            |   |  |   |             |       |  |   |           |  
|Conversion
of 10% Series B to Redeemable Series B-1 |  |                          | (87,867 | )      |  |               | (880  | )     |  |          |            |             |  |               |         |  |  |            |            |   |  |   |             |       |  |   | (880      | )
|Series B Pfd. Share dividend                        |  |                          |         |        |  |               |       |       |  |          |            |             |  |               |         |  |  |            | (148       | ) |  |   |             |       |  |   | (148      | )
|Net Income                                          |  |                          |         |        |  |               |       |       |  |          |            |             |  |               |         |  |  |            |            |   |  |   | 18,292      |       |  |   | 18,292    |  
|Balance, December 31, 2002                          |  |                          | -0-     |        |  | $             | -0-   |       |  |          | 47,406,939 |             |  | $             | 474,070 |  |  | $          | 46,402,704 |   |  | $ | (45,447,942 | )     |  | $ | 1,428,832 |  
|                                                    |  |                          |         |        |  |               |       |       |  |          |            |             |  |               |         |  |  |            |            |   |  |   |             |       |  |   |           |  

See accompanying notes to consolidated financial statements

21



---



##### Table of Contents



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 Santa
Clara, California.

The Companys wholly-owned subsidiary, Desper Products, Inc. (DPI), is
in the business of developing proprietary advanced audio signal processing
technologies and products for consumer electronics, entertainment, and
multimedia computing. All Company revenues are generated from this subsidiary.

The Companys wholly-owned subsidiary, MultiDisc Technologies, Inc.
(MDT), was in the business of developing scaleable, modular compact disc and
digital versatile disc (DVD) server technologies associated with a network
based compact disc/DVD server for internet and intranet applications.
Operations of MDT were discontinued in the fourth quarter of 1998 and the
assets have been marketed for sale (see Note 11).



|(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. MultiDisc Technologies, Inc. has been
presented as a discontinued operation (see Note 11). All significant
intercompany balances and transactions have been eliminated in consolidation.
Corporate administration is not allocated to subsidiaries.

Revenue Recognition The Company recognizes revenue from product sales
upon shipment to the customer. License revenues are recognized when earned, in
accordance with the contractual provisions. Royalty revenues are recognized
upon shipment of products incorporating the related technology by the original
equipment manufacturers (OEMs) and foundries.

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,
2002
substantially all cash and cash equivalents were on deposit at two financial
institutions.

At December 31, 2002, four major customers, not presented in
order of importance, each accounted for 10% or more of our total
accounts receivable:
Apple Computer, Inc., JVC, Samsung and Toshiba Corporation, each of whom
accounted for greater than 10% of our total 2002 accounts receivable. One OEM accounted
for 28.0%, another accounted for 22.4%, another accounted for 22.0% and one accounted
for 14.6% of our total accounts receivable at December 31, 2002.

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 67%, 59% and 60%
of total sales in the years ended December 31, 2002 and 2001 and
2000, respectively.

Major Customers
During the year ended December 31, 2002, three customers
accounted for 33%, 25%, and 17%, respectively, of the Companys net sales.

22



---



##### Table of Contents



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 $27,645,
$20,568 and $2,968 in 2002, 2001 and 2000, 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 On December 31, 1997, the Company retroactively
adopted the provisions of Statement of Financial Accounting Standards No. 128,
Earnings Per Share(SFAS 128) which replaces the presentation of primary and
fully diluted earnings (loss) per share with a presentation of basic and
diluted earnings (loss) per share. Basic earnings (loss) per share is computed
by dividing net income (loss) available to common shareholders by the weighted
average number of common shares outstanding during the period. Diluted earnings
(loss) per share reflects the potential dilution that could occur if securities
or other contracts to issue common stock were exercised or converted into
common stock or resulted in the issuance of common stock that then shared in
the earnings of the entity. Diluted earnings (loss) per share is computed
similarly to fully diluted earnings (loss) per share pursuant to the Accounting
Principles Board (APB) Opinion No. 15.

Since the Company generated a net loss in 2001, 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,
|                                                                                                                |  |                        
|                                                                                                                |  | 2002                   
|                                                                                                                |  |                        
|BASIC:                                                                                                          |  |                         |            | 
|Net Income (Loss) Available to Common Shareholders                                                              |  | $                       | 18,292     | 
|Weighted Average Shares Outstanding                                                                             |  |                         | 47,406,939 | 
|Basic Earnings(Loss)per Share                                                                                   |  | $                       | 0.00       | 
|DILUTED:                                                                                                        |  |                         |            | 
|Net Income (Loss) Available to Common Shareholders                                                              |  | $                       | 18,292     | 
|Weighted Average Shares Outstanding                                                                             |  |                         | 47,406,939 | 
|Net Effect of Dilutive Stock Options and Warrants Based on the
Treasury Stock Method Using Average Market Price |  |                         |            | 
|Total Shares                                                                                                    |  |                         | 47,406,939 | 
|Diluted Earnings per Share                                                                                      |  | $                       | 0.0000     | 
|Average Market Price of Common Stock                                                                            |  | $                       | .1234      | 
|Ending 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 2001 were not included in the computation of
diluted loss per share because the impact would have been anti-dilutive:

|         |  |      |           | 
|-------- |  | ---- | --------- | 
|         |  | 2002
|         |  |     
|Options  |  |      | 2,671,500 | 
|Warrants |  |      | -0-       | 
|         |  |      |           | 
|Total    |  |      | 2,671,500 | 
|         |  |      |           | 

Stock Option Plan Prior to January 1, 1996 the Company accounted for its
stock option plan in accordance with the provisions of APB Opinion No. 25,
Accounting for Stock Issued to Employees,and related interpretations. As such,
compensation expense would be recorded on the date of grant only if the current
market price of the underlying stock exceeded the exercise price. On January 1,
1996, the Company adopted SFAS No. 123, Accounting for Stock-Based
Compensation,which permits entities to recognize as expense using the
fair-value-based method over the vesting period the fair value of all employee
stock-based awards on the date of grant. Alternatively, SFAS No. 123 allows
entities to continue to apply the provisions of APB Opinion No. 25 and provide
pro forma

23



---



##### Table of Contents



net income (loss) and pro forma earnings (loss) per share disclosures
for employee stock option grants made in 1995 and future years as if the
fair-value-based method defined in SFAS No. 123 has been applied. The Company
has elected to continue to apply the provisions of APB Opinion No. 25 and
provide the pro forma disclosure provisions of SFAS No. 123 (Note 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 Financial Accounting Standards Board issued
Statement No. 131, Disclosures about Segments of an Enterprise and Related
Information(SFAS No. 131), in June 1997. SFAS No. 131 establishes standards
for the way public business enterprises are to report information about
operating segments in annual financial statements and requires enterprises to
report selected information about operating segments in interim financial
reports issued to shareholders. It also establishes standards for related
disclosures about products and services, geographic areas, and major customers.
It replaces the industry segment concept of SFAS No. 14, Financial Reporting
for Segments of a Business Enterprise,with a management approach concept as
to basis for identifying reportable segments. SFAS 131 is effective for
financial statements for fiscal years beginning after December 15, 1997. The
Company adopted SFAS 131 in December 1997. MDT is considered a discontinued
operation as of September 1998. As of December 31, 2002, the Company has only
one operating segment, DPI, the Companys Audio Signal
Processing business. Approximately 67% of total revenues in 2002 were
to companies located in Asia.

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- The FASB recently issued the following statements:
FASB 146 - Accounting for Costs Associated with Exit or Disposal
Activities, FASB 147 - Acquisitions of Certain Financial
Institutions, FASB 148 - Accounting for Stock-Based
Compensation. These FASB statements did not, or are not expected to,
have a material impact on the Company's financial position and
results of operations.

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

Fair Value of Financial Instruments- The fair and carrying values of cash
equivalents, accounts receivable, accounts payable, short-term debt to a
related party and accrued liabilities and those potentially subject to
valuation risk at December 31, 2002 and 2001 approximated fair value due to
their short maturity or nature.

The fair values of notes payable to a related party at December 31, 2002
and 2001 are materially consistent with the related carrying values based on
current rates offered to the Company for instruments with similar maturities.

Discontinued Operation- In September 1998, the Board of Directors
approved a plan to refocus corporate activities on the Companys core audio
business, Desper Products, Inc. In conjunction to this strategic refocusing,
the Company permanently suspended operations of MDT and placed the business and
its related patent portfolio up for sale. The Company is accounting for the
on-going operating and termination expenses of MDT as a discontinued operation
(see Note 11).



|(3) |  | Property and Equipment
|--- |  | ----------------------

Property and equipment, as of December 31, 2002 and 2001, consists of the
following, net of a reserve for impairment loss in 1998 in accordance with
application of SFAS 121:

|                                                    |  |      |         |      |  |   |         | 
|--------------------------------------------------- |  | ---- | ------- | ---- |  | - | ------- | 
|                                                    |  | 2002 |         | 2001
|                                                    |  |      |         |     
|Office Computers, Software, Equipment and Furniture |  | $    | 307,973 |      |  | $ | 304,127 | 
|Test Equipment                                      |  |      | 73,300  |      |  |   | 73,300  | 
|Tooling Equipment                                   |  |      | 45,539  |      |  |   | 45,539  | 
|Trade Show Booth and Demonstration Equipment        |  |      | 171,301 |      |  |   | 100,155 | 

24



---



##### Table of Contents



|                                               |  |      |         |      |  |   |         | 
|---------------------------------------------- |  | ---- | ------- | ---- |  | - | ------- | 
|                                               |  | 2002 |         | 2001
|                                               |  |      |         |     
|Automobiles                                    |  |      | 7,000   |      |  |   | 7,000   | 
|Leasehold Improvements                         |  |      | 0       |      |  |   | 22,122  | 
|                                               |  |      |         |      |  |   |         | 
|Total Property and Equipment                   |  |      | 605,113 |      |  |   | 552,243 | 
|Less Accumulated Depreciation and Amortization |  |      | 534,271 |      |  |   | 501,657 | 
|                                               |  |      |         |      |  |   |         | 
|Property and Equipment, Net                    |  | $    | 70,842  |      |  | $ | 50,586  | 
|                                               |  |      |         |      |  |   |         | 



|(4) |  | Intangible Assets
|--- |  | -----------------

Intangible assets, as of December 31, 2002 and 2001 consist of the
following:

|                                                    |  |      |         |      |  |   |         | 
|--------------------------------------------------- |  | ---- | ------- | ---- |  | - | ------- | 
|                                                    |  | 2002 |         | 2001
|                                                    |  |      |         |     
|Capitalized Patent, Trademarks and Technology Costs |  | $    | 486,549 |      |  | $ | 465,650 | 
|Less Accumulated Amortization                       |  |      | 260,690 |      |  |   | 209,924 | 
|                                                    |  |      |         |      |  |   |         | 
|Intangible Assets, Net                              |  | $    | 225,859 |      |  | $ | 255,726 | 
|                                                    |  |      |         |      |  |   |         | 

Estimated
amortization is as follows:

|           |  |   |         | 
|---------- |  | - | ------- | 
|2003       |  | $ | 50,765  | 
|2004       |  | $ | 43,794  | 
|2005       |  | $ | 25,733  | 
|2006       |  | $ | 16,702  | 
|2007       |  | $ | 16,702  | 
|Thereafter |  | $ | 72,163  | 
|           |  |   |         | 
|           |  |   | 225,859 | 



|(5) |  | Notes Payable to Related Parties
|--- |  | --------------------------------

The Company was indebted to the Desper Family Trust, a related party, in
the amount of $112,500 at December 31, 2002. This amount bears interest at a
fixed rate of 10% annually and is due on demand.



|(6) |  | Shareholders Equity
|--- |  | --------------------

During the year ended December 31, 2002, no shares were issued or
converted.

During the year ended December 31, 2001, shares were issued or converted
as follows:

In 2001, the Company converted 15,000 shares of Series B Convertible
Preferred Shares into 313,968 shares of common stock as per the terms of the
1999 Transactions. In addition, warrants to purchase 5,000 shares of common
stock were exercised in 2001, increasing shareholders equity by $1,000.

Capitalization

Series A Preferred Stock: On
December 26, 2002 the Company filed a Certificate of Elimination
with the Delaware Secretary of State stating that no shares of the
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 exist on or after January 1,
2003 to convert the Series B-1 Preferred Stock to common at a certain formula.
At December 29, 2005 certain mandatory conversion requirements
exist subject to a certain formula. The Series B-1 Preferred Stock has no voting
power. Certain restrictions on trading exist based on date sensitive
events. 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.



|(7) |  | Escrowed Performance Shares
|--- |  | ---------------------------

In December 1996, the Company accepted the terms outlined by the British
Columbia Securities Commissions (BCSC) for the release of the Companys
5,776,700 escrowed Performance Shares from Canadian Escrow into a new escrow
arrangement with the Company. The overall modification was approved by the
Companys shareholders in August 1996. Under the revised arrangement, the
performance shares were released automatically as follows: 20% on June 22,
2000; 30% on June 22, 2001; and 30% on June 22, 2002. Under the revised
escrow arrangement, the performance shares vested,
provided the individual had not voluntarily terminated his/her relationship
with the Company prior to applicable vesting dates.

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

All of the performance shares are included in the issued and outstanding
shares for the years ended December 31, 2002, 2001 and 2000. However, the
shares were not reflected in the calculation of loss per common share until
earned by and released to the holders on December 30, 1996, the date on which
the Company and the BCSC accepted and entered into the terms of the current
escrowed agreement as discussed above. As of December 31, 2002, all performance
shares under the escrow arrangement have been released.



|(8) |  | 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, 4,740,694 as of December 31, 2002. Stock
options are

25



---



##### Table of Contents



granted with an exercise price equal to the stocks fair market
value at the date of grant. Stock options have five-year terms and vest and
become fully exercisable up to three years from the date of grant.

At December 31, 2002, there were 2,069,194 additional shares available for
grant under the Plan. The per share weighted-average fair value of stock
options granted during 2002, 2001 and 2000 was $0.11, $0.29 and $0.19, and,
respectively, on the date of grant using the Black-Scholes option-pricing model
with the following weighted-average assumptions: 2002: expected
dividend yield 0%, risk-free interest rate of 6%, expected volatility
of 427% and expected life of 5 years; 2001 expected dividend yield
0%, risk-free interest rate of 9.0%, expected volatility of 332% and an
expected life of 5 years; 2000- expected dividend yield 0%, risk-free interest
rate of 9.0%, expected volatility of 654% and an 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 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:

|                        |  |      |          |      |  |      |          |   |  |   |         | 
|----------------------- |  | ---- | -------- | ---- |  | ---- | -------- | - |  | - | ------- | 
|                        |  | 2002 |          | 2001 |  | 2000
|                        |  |      |          |      |  |     
|NET INCOME (LOSS):      |  |      |          |      |  |      |          |   |  |   |         | 
|As Reported             |  | $    | 18,292   |      |  | $    | (240,107 | ) |  | $ | 382,019 | 
|Pro Forma               |  | $    | (136,498 | )    |  | $    | (344,853 | ) |  | $ | 292,169 | 
|BASIC AND DILUTED LOSS: |  |      |          |      |  |      |          |   |  |   |         | 
|As Reported             |  | $    | 0.01     |      |  | $    | (0.01    | ) |  | $ | 0.01    | 
|Pro Forma               |  | $    | (0.01    | )    |  | $    | (0.01    | ) |  | $ | 0.01    | 

Pro forma net income (loss) reflects only options granted since December 31,
1994. Therefore, the full impact of calculating compensation cost for stock
options under SFAS No. 123 is not reflected in the pro forma net loss amounts
presented above because compensation cost is reflected over the options
vesting period and compensation cost for options granted prior to January 1,
1995 is not considered.

Stock option activity during the periods indicated is as follows:

|                                         |  |        |           |                |  |                  |       | 
|---------------------------------------- |  | ------ | --------- | -------------- |  | ---------------- | ----- | 
|                                         |  |        |           |                |  | Weighted-Average
|                                         |  | Number |           | Exercise Price
|                                         |  |        |           |               
|Options outstanding at December 31, 1999 |  |        | 2,859,467 |                |  | $                | 1.271 | 
|                                         |  |        |           |                |  |                  |       | 
|Options granted                          |  |        | 400,000   |                |  | $                | 0.19  | 
|Options exercised                        |  |        | (648,001  | )              |  | $                | 0.69  | 
|Options forfeited                        |  |        | (399,167  | )              |  | $                | 1.92  | 
|                                         |  |        |           |                |  |                  |       | 
|Options outstanding at December 31, 2000 |  |        | 2,212,299 |                |  | $                | 1.13  | 
|                                         |  |        |           |                |  |                  |       | 
|Options granted                          |  |        | 410,000   |                |  | $                | 0.29  | 
|Options exercised                        |  |        | (0        | )              |  | $                | 0.00  | 
|Options forfeited                        |  |        | (750,000  | )              |  | $                | 0.83  | 
|                                         |  |        |           |                |  |                  |       | 
|Options outstanding at December 31, 2001 |  |        | 1,872,299 |                |  | $                | 0.45  | 
|                                         |  |        |           |                |  |                  |       | 
|Options granted                          |  |        | 1,300,000 |                |  | $                | 0.11  | 
|Options exercised                        |  |        | (0        | )              |  | $                | 0.00  | 
|Options forfeited                        |  |        | (500,799  | )              |  | $                | 2.29  | 
|                                         |  |        |           |                |  |                  |       | 
|Options
outstanding at December 31, 2002 |  |        | 2,671,500 |                |  |                  |       | 

At December 31,
2002, the number of options exercisable was 2,668,332 and
the weighted-average exercise price of those options was $0.24.

26



---



##### Table of Contents





|(9) |  | Warrants
|--- |  | --------

Warrant activity for the periods indicated below is as follows:

|                                          |  |          |            |               |  |   |      | 
|----------------------------------------- |  | -------- | ---------- | ------------- |  | - | ---- | 
|                                          |  | Warrants |            | Warrant Price
|                                          |  |          |            |              
|Warrants outstanding at December 31, 1999 |  |          | 2,730,000  |               |  | $ | 0.67 | 
|Warrants issued                           |  |          | 0          |               |  | $ | 0.00 | 
|Warrants exercised                        |  |          | (210,000   | )             |  | $ | 0.12 | 
|Warrants expired                          |  |          | 0          |               |  | $ | 0.00 | 
|                                          |  |          |            |               |  |   |      | 
|Warrants outstanding at December 31, 2000 |  |          | 2,520,000  |               |  | $ | 0.72 | 
|                                          |  |          |            |               |  |   |      | 
|Warrants issued                           |  |          | 0          |               |  | $ | 0.00 | 
|Warrants exercised                        |  |          | (5,000     | )             |  | $ | 0.20 | 
|Warrants expired                          |  |          | (415,000   | )             |  | $ | 1.16 | 
|                                          |  |          |            |               |  |   |      | 
|Warrants outstanding at December 31, 2001 |  |          | 2,100,000  |               |  | $ | 0.65 | 
|                                          |  |          |            |               |  |   |      | 
|Warrants issued                           |  |          | 0          |               |  | $ | 0.00 | 
|Warrants exercised                        |  |          | 0          |               |  | $ | 0.00 | 
|Warrants expired                          |  |          | (2,100,000 | )             |  | $ | 0.65 | 
|                                          |  |          |            |               |  |   |      | 
|Warrants outstanding at December 31, 2002 |  |          | 0          |               |  |   |      | 
|                                          |  |          |            |               |  |   |      | 

All of the warrants granted in 1999 were issued in connection with private
placements. At December 31, 2002, all such warrants had expired,
without exercise.



|(10) |  | Income Taxes
|---- |  | ------------

The Company files a consolidated return for U.S. income tax purposes.
Income tax expense for the years ended December 31, 2002, 2001 and 2000
consisted of the following:

|                    |  |      |       |      |  |      |       |   |  |   |        | 
|------------------- |  | ---- | ----- | ---- |  | ---- | ----- | - |  | - | ------ | 
|                    |  | 2002 |       | 2001 |  | 2000
|                    |  |      |       |      |  |     
|State franchise tax |  | $    | 2,400 |      |  | $    | 2,864 |   |  | $ | 800    | 
|Federal taxes       |  |      | (0    | )    |  |      | (0    | ) |  |   | 9,200  | 
|                    |  |      |       |      |  |      |       |   |  |   |        | 
|Total               |  | $    | 2,400 |      |  | $    | 2,864 |   |  | $ | 10,000 | 
|                    |  |      |       |      |  |      |       |   |  |   |        | 

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 foreign revenue.

Income tax expense for the years ended December 31, 2002, 2001 and 2000
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 carryforwards 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, 2001 is composed primarily
of the net loss carryforwards. The net change in the total valuation allowance
for the year ended December 31, 2001 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, 2002. 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, 2002, the Company had net operating loss carryforwards for
Federal income tax purposes of approximately $26,000,000 which are available to
offset future Federal taxable income, if any, through 2013. Approximately
$21,700,000 of these net operating loss carryforwards are subject to an annual
limitation of approximately $1,000,000.

27



---



##### Table of Contents





|(11) |  | Discontinued Operation
|---- |  | ----------------------

On September 25, 1998, the Board of Directors determined that it would be
unable to raise the necessary capital required to properly commercialize the
MDT technology. Therefore, the Company ceased funding the operations of MDT and
is actively seeking to sell the assets and technology. All employees of MDT
have been terminated and the Company has vacated the MDT facilities.

Based on this action, the Company is treating MDT as a discontinued
operation. Accordingly, the balance sheet and statement of operations of MDT
are not consolidated in the continuing operations of the Company, but rather
are disclosed as Net Liabilities of Discontinued Operation and Loss From
Discontinued Operation, respectively. At December 31, 2002, after four years of
inactivity and inability to sell the assets, the remaining balance of $71,045
was eliminated.



|(12) |  | Commitments and Contingencies
|---- |  | -----------------------------

In connection with the downsizing of the Company in 1998, a number of
employees were terminated and have filed, on various dates, employment and
compensation related claims with the California State labor authorities. All
but two of these claims have been settled. Two former officers and employees
of MDT filed labor and employment termination related claims before the Labor
Commissioner in 2000 seeking approximately $400,000 each which was allegedly
due under each of their respective employment agreements, which claims, if
resolved in favor of the claimants, could be material to the financial
statements of the Company. The Labor Commissioner postponed those
proceedings while other litigation proceeded in the Superior Court, Orange County seeking declaratory
relief to bar the labor claims, as well as return of intellectual property and
unspecified damages for breaches of the former officers and employees
employment agreements. These employees, however, filed for personal
bankruptcy and as a result, the state court proceeding was postponed and then dismissed
primarily because of the bankruptcies. The claims became inactive. While
bankruptcy for one employee has been dismissed the claims have not been
reactivated. 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
$77,000 through November 2002. Rent expense amounted to approximately $78,000,
$ 78,000 and $115,000 for the years ended December 31, 2002, 2001 and 2000,
respectively.



|(13) |  | 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 2002, 2001 and 2000 was approximately $2,000 per annum.

28



---



##### Table of Contents






Item 9.Change in and Disagreements with Accountants on Accounting and Financial Disclosure

None.




PART III




Item 10.Directors and Executive Officers of the Registrant

Information required for this item incorporated by reference to the
Definitive Proxy to be filed on or before April 30, 2003.




Item 11.Executive Compensation

Information required for this item incorporated by reference to the
Definitive Proxy to be filed on or before April 30, 2003.




Item 12.Security Ownership of Certain Beneficial Owners and Management

Equity Compensation Plan Information

|                                                           |       |                     |                      |                     |                      |                          |                           |   |                         |  |                      |   | 
|---------------------------------------------------------- | ----- | ------------------- | -------------------- | ------------------- | -------------------- | ------------------------ | ------------------------- | - | ----------------------- |  | -------------------- | - | 
|                                                           |       |                     |                      |                     |                      |                          |                           |   |                         |  | Number of securities
|                                                           |       |                     | Number of securities |                     |                      |                          |                           |   | remaining available for
|                                                           |       |                     | to be issued         |                     | Weighted-average     |                          | future issuance under    
|                                                           |       |                     | upon exercise of     |                     | exercise price of    |                          | equity compensation plans
|                                                           |       |                     | outstanding options, |                     | outstanding options, |                          | (excluding securities    
|Plan category                                              |       | warrants and rights |                      | warrants and rights |                      | reflected in column (a))
|                                                           |       |                     |                      |                     |                      |                         
|                                                           |       |                     | (a)                  |                     | (b)                  |                          | (c)                      
|Equity compensation
plans approved by
security holders     |       |                     | 2,671,500            | 1                   |                      | $                        | 0.24                      | 1 |                         |  |                      | 2
|Equity compensation
plans not approved
by security holders |       |                     | 0                    |                     |                      |                          | 0                         |   |                         |  | 0                    |  
|                                                           | Total |                     |                      |                     |                      |                          |                           |   |                         |  |                      |   | 



---

|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, 4,740,694 as of December 31, 2002.
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.
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| 
| 
| 
| 
|2 |  | In December 1996, the Company accepted the terms outlined by the British Columbia
Securities Commissions for the release of the Companys 5,776,700 escrowed
Performance Shares from Canadian Escrow into a new escrow arrangement with the
Company. The overall modification was approved by the Companys stockholders in
August 1996. Under the revised arrangements, the final release date was June 22, 2002. Since all
the Performance Shares were included in the issued and outstanding shares as of 1996
and thereafter, the Performance Shares have no dilutive effect on the Companys equity.                                                                                                                                                                                                                                                                                                                              

The remaining
information is required for this item is incorporated by reference to the
Definitive Proxy to be filed on or before April 30, 2003.




Item 13.Certain Relationships and Related Transactions

Information required for this item incorporated by reference to the
Definitive Proxy to be filed on or before April 30, 2003.




Item 14.Controls and Procedures

Within
90 days prior to the filing of this report, the Company carried
out an evaluation, under the supervision and with the participation
of the Companys management, including the Companys Chief
Executive Officer and Chief Financial Officer of the effectiveness of the design and operation of the
Companys disclosure controls and procedures. Consistent with
the Companys policies adopted to accommodate a single person holding both designations, the
evaluation was undertaken in consultation with the Companys audit committee and accounting
personnel. Based on that
evaluation, the Chief Executive Officer and Chief Financial Officer
concluded that the Companys disclosure controls and procedures
are effective to ensure that information required to be disclosed by
the Company in the 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 the Securities and
Exchange Commissions rules and forms.

There
were no significant changes in the Companys internal controls
or in other factors that could significantly affect internal controls
subsequent to the date of their evaluation.




PART IV




Item 15.Exhibits, Financial Statement Schedules and Reports on Form 8-K

|        |      |             |  |                                                                                                                                                                                                                                                                                                                                                          
|------- | ---- | ----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit
|Number  |      | Description
|        |      |            
|        | 2.1* |             |  | Desper-Spatializer Reorganization Agreement dated January 29, 1992. (Incorporated by reference to the
Companys Registration Statement on Form S-1, Registration No. 33-90532, effective August 21, 1995.)                                                                                                                                               
|        |      |            
|        | 2.2* |             |  | Arrangement Agreement dated as of March 4, 1994 among Spatializer-Yukon, DPI and Spatializer-Delaware
(Incorporated by reference to the Companys Registration Statement on Form S-1, Registration No
33-90532, effective August 21, 1995.)                                                                                                              
|        |      |            
|        | 3.1* |             |  | Certificate of Incorporation of Spatializer-Delaware as filed February 28, 1994. (Incorporated by
reference to the Companys Registration Statement on Form S-1, Registration No. 33-90532, effective
August 21, 1995.)                                                                                                                                  
|        |      |            
|        | 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                                                                                                                                                                                                                              
|        |      |            
|        | 3.4* |             |  | Certificate of Amendment of Certificate of Incorporation of the Company as filed on February 25, 2000                                                                                                                                                                                                                                                    
|        |      |            
|        | 3.5  |             |  | Certificate of Designation of Series B-1
Redeemable Convertible Preferred Stock as filed December 20, 2002                                                                                                                                                                                                                                               
|        |      |            
|        | 3.6  |             |  | Certificate of Elimination of Series A
Preferred Stock as filed December 26, 2002                                                                                                                                                                                                                                                                        
|        |      |            
|        | 3.7  |             |  | Certificate of Elimination of Series B
Preferred Stock as filed December  26,2002                                                                                                                                                                                                                                                                        
|        |      |            
|        | 4.1* |             |  | Form of Subscription Agreement for August 1994 Private Placement. (Incorporated by reference to the
Companys Registration Statement on Form S-1, Registration No. 33-90532, effective August 21, 1995.)                                                                                                                                                 
|        |      |            
|        | 4.2* |             |  | Form of Subscription Agreement for November 1994 Private Placement. (Incorporated by reference to the
Companys Registration Statement on Form S-1.)                                                                                                                                                                                                     
|        |      |            
|        | 4.3* |             |  | Form S-1, Registration No. 33-90532, effective August 21, 1995.) Form of Spatializer-Yukon Incentive
Stock Option Agreement. (Incorporated by reference to the Companys Registration Statement on Form S-1,
Registration No. 33-90532, effective August 21, 1995.)                                                                                      
|        |      |            
|        | 4.4* |             |  | Spatializer-Delaware Incentive Stock Option Plan (1995 Plan). (Incorporated by reference to the
Companys Registration Statement on Form S-1, Registration No. 33-90532, effective August 21, 1995.)                                                                                                                                                     
|        |      |            
|        | 4.5* |             |  | Performance Share Escrow Agreements dated June 22, 1992 among Montreal Trust Company of Canada,
Spatializer-Yukon and certain shareholders with respect to escrow of 2,181,048 common shares of
Spatializer-Yukon. (Incorporated by reference to the Companys Registration Statement on Form S-1,
Registration No. 33-90532, effective August 21, 1995.)

29



---



##### Table of Contents



|        |       |             |  |                                                                                                                                                                                                                                                                
|------- | ----- | ----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit
|Number  |       | Description
|        |       |            
|        | 4.6*  |             |  | Spatializer-Delaware 1996 Incentive Plan. (Incorporated by reference to the Companys Proxy Statement
dated June 25, 1996 and previously filed with the Commission.)                                                                                           
|        |       |            
|        | 4.7*  |             |  | Form of Subscription Agreement for 1995 Private Placements. (Incorporated by reference to the Companys
Registration Statement on Form S-1, Registration No. 33-90532, effective August 21, 1995.)                                                             
|        |       |            
|        | 4.8*  |             |  | Form of Subscription Agreement and Warrant Agreement for March 7, 1997 Private Placement. (Incorporated
by reference to the Companys Annual Report on Form 10-K for the year ended December 31, 1997.)                                                        
|        |       |            
|        | 4.9*  |             |  | 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.)                                                                  
|        |       |            
|        | 4.10* |             |  | Subscription Agreement for April 1998 Private Placement. (Incorporated by reference to the Companys
Registration Statement on Form S-3, Registrations No. 333-52863, filed May 15, 1998.)                                                                     
|        |       |            
|        | 4.11* |             |  | Common Stock Purchase Agreement dated as of December 29, 1999 among the Company, CPR (USA) Inc.,
LibertyView Funds, L.P., LibertyView Fund, LLC                                                                                                                
|        |       |            
|        | 4.12* |             |  | Stock Purchase Warrant, dated as of December 29, 1999 issued by the Company to CPR (USA) Inc.                                                                                                                                                                  
|        |       |            
|        | 4.13* |             |  | Stock Purchase Warrant, dated as of December 29, 1999 issued by the Company to LibertyView Funds, L.P.                                                                                                                                                         
|        |       |            
|        | 4.14* |             |  | Stock Purchase Warrant, dated as of December 29, 1999 issued by the Company to LibertyView Fund, LLC                                                                                                                                                           
|        |       |            
|        | 4.15* |             |  | Registration Rights Agreement dated as of December 29, 1999 among the Company and CPR (USA) Inc.,
LibertyView Funds, L.P. and LibertyView Fund, LLC                                                                                                            
|        |       |            
|        | 4.16* |             |  | Secured Non-Negotiable Convertible Promissory Note dated as of December 29, 1999 issued by the Company
to CPR (USA) Inc.                                                                                                                                       
|        |       |            
|        | 4.17* |             |  | Secured Non-Negotiable Convertible Promissory Note dated as of December 29, 1999 issued by the Company
to LibertyView Funds, L.P.                                                                                                                              
|        |       |            
|        | 4.18* |             |  | Secured Non-Negotiable Convertible Promissory Note dated as of December 29, 1999 issued by the Company
to LibertyView Fund LLC                                                                                                                                 
|        |       |            
|        | 4.19* |             |  | Registration Rights Agreement dated as of December 29, 1999 among the Company and CPR (USA) Inc.,
LibertyView Funds, L.P. and LibertyView Fund, LLC                                                                                                            
|        |       |            
|        | 4.20* |             |  | Agreement Regarding Cancellation of Warrants, dated as of December 29, 1999 among CPR (USA), Inc.,
LibertyView Funds, L.P. and LibertyView Fund, LLC                                                                                                           
|        |       |            
|        | 4.21* |             |  | Common Stock Subscription Agreement dated as of December 29, 1999 between the Company and Lufeng
Investments (as assignee of Arab Commerce Bank)                                                                                                               
|        |       |            
|        | 4.22* |             |  | Stock Purchase Warrant, dated as of December 29, 1999 issued by the Company to Lufeng Investments (as
assignee of Arab Commerce Bank)                                                                                                                          
|        |       |            
|        | 4.23* |             |  | Registration Rights Agreement dated as of December 29, 1999 between the Company and Lufeng Investments
(as assignee of Arab Commerce Bank)                                                                                                                     
|        |       |            
|        | 4.24* |             |  | Common Stock Subscription Agreement dated as of December 29, 1999 between the Company and Bank Insinger
de Beaufort                                                                                                                                            
|        |       |            
|        | 4.25* |             |  | Stock Purchase Warrant, dated as of December 29, 1999 issued by the Company to Bank Insinger de Beaufort                                                                                                                                                       
|        |       |            
|        | 4.26* |             |  | Registration Rights Agreement dated as of December 29, 1999 between the Company and Bank Insinger de
Beaufort                                                                                                                                                  
|        |       |            
|        | 4.27* |             |  | Common Stock Subscription Agreement dated as of December 29, 1999 between the Company and Romofin, A.G                                                                                                                                                         
|        |       |            
|        | 4.28* |             |  | Stock Purchase Warrant, dated as of December 29, 1999 issued by the Company to Romofin, A.G                                                                                                                                                                    
|        |       |            
|        | 4.29* |             |  | Registration Rights Agreement dated as of December 29, 1999 between the Company and Romofin, A.G                                                                                                                                                               
|        |       |            
|        | 4.30* |             |  | 10% Convertible Preferred Stock Subscription Agreement dated as of December 29, 1999 between the Company
and Clarion Finanz, A.G. Carlo Civelli, Henry R. Mandell, James D. Pace, Jerold H. Rubinstein, Gilbert
N. Segel, Aton Select Fund Ltd. and Romofin A.G
|        |       |            
|        | 4.31  |             |  | 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                                                                                  
|        |       |            
|        | 10.1* |             |  | 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.)                                                              

30



---



##### Table of Contents



|        |       |             |  |                                                                                                                                                                                                         
|------- | ----- | ----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit
|Number  |       | Description
|        |       |            
|        | 10.2* |             |  | License Agreement dated November 11, 1994 between DPI and ESS. (Incorporated by reference to the
Companys Registration Statement on Form S-1, Registration No. 33-90532, effective August 21, 1995.)   
|        |       |            
|        | 10.3* |             |  | License Agreement dated June 10, 1994 between Joel Cohen and DPI. (Incorporated by reference to the
Companys Registration Statement on Form S-1, Registration No. 33-90532, effective August 21, 1995.)
|        |       |            
|        | 10.4* |             |  | Agreement Regarding Indebtedness dated as of December 29, 1999 among the Company and CPR (USA) Inc.,
LibertyView Funds, L.P. and LibertyView Fund, LLC                                                  
|        |       |            
|        | 10.5* |             |  | Security Agreement dated as of December 29, 1999 among the Company and CPR (USA) Inc., LibertyView
Funds, L.P. and LibertyView Fund, LLC                                                                
|        |       |            
|        | 10.6* |             |  | Finders Fee Agreement dated as of December 27, 1999 between the Company and Bristol Capital, L.L.C                                                                                                     
|        |       |            
|        | 21.1  |             |  | Schedule of Subsidiaries of the Company                                                                                                                                                                 
|        |       |            
|        | 99.1  |             |  | Certification of Chief Executive Officer and
Chief Financial Officer                                                                                                                                    



---

|* |  | Previously filed.
|- |  | -----------------

Financial Statements See pages 17 and following.

Reports on 8-K None

31



---



##### 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 26, 2003 |  | SPATIALIZER AUDIO LABORATORIES, INC.
(Registrant)                                       
|                     
|                      |  | /s/   Henry R. Mandell
Henry 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
Carlo Civelli       |  | Director |  | March 26, 2003  
|                                       
|Stephen W. Desper                       |  | Director |  | March     , 2003
|                                       
|/s/   James D. Pace

James D. Pace      |  | Director |  | March 26, 2003  
|                                       
|/s/  Gilbert N. Segel

Gilbert N. Segel |  | Director |  | March 26, 2003  
|                                       
|/s/  Henry R. Mandell

Henry R. Mandell |  | Director |  | March 26, 2003  

32