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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-K



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|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------------

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005

OR



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

For the transition period from              to

Commission File No. 000-30335



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SONIC INNOVATIONS, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 87-0494518                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|2795 East Cottonwood Parkway, Suite 660 Salt Lake City, UT     |  | 84121-7036                          
|(Address of principal executive offices)                       |  | (Zip Code)                          

(801) 365-2800

(Registrants telephone number, including area code)



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Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock ($.001 Par Value)

Preferred Stock Purchase Rights

(Title of class)



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Indicate by check mark if the
registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act of 1933. ̈Yes    x  No

Indicate by check mark if the
registrant is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act of 1934. ̈Yes    x  No

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.    x  Yes ̈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 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 a large accelerated filer, an
accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).

Large accelerated
filer ̈Accelerated filer  x                    Non-accelerated filer ̈

Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Securities Exchange Act of 1934). ̈Yes    x  No

The aggregate market value of the common stock held by non-affiliates of the registrant as of
June 30, 2005 was approximately $102.1 million. For purposes of this calculation, all executive officers and directors of the registrant and all beneficial owners of more than ten percent or more of the registrants common stock were
considered affiliates.

As of March 1, 2006, the registrant had outstanding 21,909,187 shares of common stock.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrants Proxy Statement for the 2006 Annual Meeting of Stockholders are incorporated by reference in Part III of this Form 10-K.



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PART I

This Form 10-K contains forward-looking statements that involve risks and uncertainties. These statements refer to our future results, plans, objectives, expectations and intentions and are identified in detail in
the section titled Forward-Looking Statements included in Item 7 of this Form 10-K. Our actual results could differ materially and adversely from those anticipated in such forward-looking statements. Factors that could contribute to
these differences are discussed in detail in the section titled Factors That May Affect Future Performance included in Item 1-A of this Form 10-K. Investors should understand that it is not possible to predict or identify all such
factors that could cause actual results to differ from expectations, and we are under no obligation to update these factors. Investors are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date made.

ITEM 1. BUSINESS

Our Company

Sonic Innovations, Inc. is a hearing healthcare company. We design, develop, manufacture and market advanced digital hearing aids
intended to provide the highest levels of satisfaction for hearing impaired consumers and proprietary auditory testing equipment that automates the four most commonly performed hearing tests. We have developed patented digital signal processing
(DSP) technologies based on what we believe is an advanced understanding of human hearing. In countries where we have direct (owned) operations, we sell our products to hearing care professionals or directly to hearing impaired
consumers. In other parts of the world where we do not have direct operations, we sell principally to distributors. From our inception, we have focused all our efforts on the therapeutic side of hearing care by developing high-performance digital
hearing aids. In December 2004, we acquired Tympany, Inc. (Tympany) and now offer diagnostic equipment to further help hearing impaired individuals. Our mission is to improve the quality of life of the hearing impaired.

Our Innova, Applause, Natura 3, Natura 2, Altair, Tribute and Quartet hearing aid product lines, all of which incorporate our DSP platform, can be
purchased in the six common models for hearing aids: behind-the-ear (BTE); in-the-ear (ITE); half-shell (HS); in-the-canal (ITC); mini-canal (MC); and completely-in-the-canal
(CIC). Our Otogram product enables automated diagnostic auditory testing, including air and bone conduction; speech reception threshold and speech discrimination; tympanometry and acoustic reflex; and otoacoustic emissions.

We have four reportable operating segments. Our three hearing aid operating segments include North America, which includes owned operations in the
U.S. and Canada; Europe, which includes owned operations in Germany, Denmark, the Netherlands, Austria, Switzerland and England; and Rest-of-world, which includes an owned operation in Australia. In addition, we have an auditory testing equipment
operating segment, Tympany. (See Note 16 to our consolidated financial statements).

Registered trademarks of Sonic Innovations, Inc. are:
Ion, Innova, Applause, Natura, Altair, Tribute, Quartet, Expressfit,Directionalplus,Directionalfocus, Personalized Noise Reduction, Otogram and Sonic Innovations. Our Company was originally organized as a Utah corporation in
1991 under the name Sonix Technologies. We reincorporated in Delaware and changed our name to Sonic Innovations, Inc. in 1997.

Industry Background

The Hearing Aid Market

The market for hearing aids is very large and has substantial unmet needs. Industry researchers estimate that approximately 10% of the population suffers from hearing loss, but only about 2% actually use hearing aids.
There is no one source of worldwide hearing aid market and sales data, but U.S. data is maintained by the Hearing Industry Association and is generally adapted and used by the industry as a proxy for worldwide data. As depicted in the following
chart, less than 24% of the U.S. total population that could benefit from a hearing aid actually owns a hearing aid:

Hearing Aid Market



|                           |  |                                     |   |  |                                                   |   |  |                                                                 |  
|-------------------------- |  | ----------------------------------- | - |  | ------------------------------------------------- | - |  | --------------------------------------------------------------- | -
|Type of hearing impairment |  | Hearing impaired percentage by type |   |  | Percentage of hearing aid owners within each type |   |  | Percentage of total hearing impaired who are
hearing aid owners |  
|Mild                       |  | 7                                   | % |  | 8                                                 | % |  | 0.6                                                             | %
|Moderate                   |  | 51                                  |   |  | 17                                                |   |  | 8.7                                                             |  
|Severe                     |  | 38                                  |   |  | 34                                                |   |  | 13.0                                                            |  
|Profound                   |  | 4                                   |   |  | 37                                                |   |  | 1.5                                                             |  
|                           |  |                                     |   |  |                                                   |   |  |                                                                 |  
|Total                      |  | 100                                 | % |  |                                                   |   |  | 23.8                                                            | %
|                           |  |                                     |   |  |                                                   |   |  |                                                                 |  



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As seen in the above chart, the use of hearing aids is particularly low in the mild and moderate segments
of the hearing impaired population. Hearing impaired people in these segments, which comprise almost 60% of the hearing impaired population, often do not purchase hearing aids for a variety of reasons, including their belief that their hearing loss
is not significant enough to warrant a hearing aid, their concern regarding the stigma associated with wearing a hearing aid and their perception that existing hearing aids are uncomfortable, do not perform well, cannot solve specific hearing
problems and are too expensive.

Despite this low level of market penetration, annual worldwide retail sales of hearing aids are estimated
to be over $5 billion and wholesale sales are estimated to be over $2 billion. We anticipate that demographic trends, such as the aging of the developed worlds population, will accelerate the growth in the size of the hearing impaired
population, which should result in increasing hearing aid sales over time.

The hearing aid market can be categorized into two main types
 analog and digital. Digital hearing aids were first introduced in 1996 and in 2005 represented 89% of U.S. hearing aid sales, up from 83% in 2004 and 66% in 2003. Digital hearing aids have continued to gain market share at the expense of
older analog technology. This is particularly true as digital hearing aids have become more affordable and closer in price to analog hearing aids. For the past three years, we estimate that the overall U.S. hearing aid market grew by mid-single
digits annually based on data provided by the Hearing Industry Association.

Hearing Impairment

The major causes of hearing loss are aging, noise exposure, disease and injury. Hearing loss is usually gradual and develops slowly. In most cases it goes
unnoticed by the hearing impaired individual until the coping mechanisms they have developed (turning up the volume on the TV, moving closer in proximity to the speaker, etc.) are no longer effective. The impact of hearing loss on a persons
lifestyle can be dramatic. For adults, it can result in isolation from family and friends and a reluctance to participate in social events. In children, it can negatively affect the ability to learn, the development of communication skills and the
ability to interact with others.

Approximately 90% of all permanent hearing impairments are characterized as sensorineural losses, and the
remaining 10% are characterized as conductive losses. Sensorineural losses, which stem from deterioration of or damage to the cochlea, typically cannot be corrected by medical or surgical means. Hearing aids offer the most effective means of
rehabilitation for sensorineural losses. Conductive losses, which can be temporary or permanent, are generally corrected by medicine or surgery, and we do not compete in this market.

In the case of sensorineural hearing loss, all sounds are not affected equally. Typically, higher frequencies are more difficult to hear than lower
frequencies. Accordingly, the first sounds to disappear are those that have the highest pitches, such as the voices of women and children. Furthermore, speech becomes much more difficult to comprehend since it is the softer,
higher-pitched consonants that provide essential information to facilitate discrimination among words. Consider the following word list: cat, hat, fat, sat. Without the ability to clearly hear the first letter of each of these words, a person is
rendered helpless to comprehend what is being said. As a result, people with hearing losses often complain that they can hear others talking but do not understand what is being said.

Obtaining a Hearing Aid

An
individual who seeks help for a sensorineural hearing loss is generally motivated by a family member or may be referred by a primary care physician or an ear-nose-throat physician to a hearing care professionalan audiologist or a hearing
instrument specialist. The majority of hearing aids sold in the U.S. are custom-made to each individuals ear canal, particularly for users who have a mild to moderate hearing impairment. The hearing care professional first performs an
audiologic examination before taking an impression of the persons ear canals with a liquid silicone material that hardens to the approximate shape of the canal. This impression is sent to the hearing aid manufacturer who then builds a hearing
aid enclosed in a custom shell that matches the impression. This process usually requires about one week. There is considerable art and craftsmanship associated with creating custom hearing aids that fit comfortably. A great deal of judgment is
involved in shaping the final shell. If the aid does not fit the patient properly, the hearing care professional may make small modifications to the shell or send the hearing aid back to the manufacturer for a remake. It is not uncommon for a new
hearing aid to require remaking, which often requires an additional week.



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Hearing Aids

Sensorineural hearing loss results from damage to the hair cells in the inner ear (cochlea). This damage produces both frequency-specific hearing loss and frequency-specific loudness recruitment. The recruitment
problem associated with sensorineural loss is characterized by little or no sensitivity to low-level signals, mild loss of sensitivity to mid-level signals and normal sensitivity to high-level signals.

Early generation hearing aids focused on simply amplifying previously inaudible sounds to an audible level, which addressed the overall loss of hearing
sensitivity, but not loss of sensitivity at individual frequencies or pitches. The result was under-amplification of certain sounds and over-amplification of other sounds. This problem severely limited improvements in speech intelligibility; so
hearing was, in reality, only partially improved.

In the mid 1980s, hearing aids emerged that amplified sounds at different
frequencies by predetermined amounts providing frequency shaping for the loss of hearing sensitivity. This allowed little to no amplification at pitches where there was no hearing loss and greater amplification at pitches where there was
a hearing loss. However, these devices did nothing to address the recruitment problem and continued to allow many soft sounds to be inaudible and loud sounds to be intolerable. The wearer was forced to constantly adjust the hearing aid volume
control in an attempt to find an acceptable balance between making soft sounds audible and loud sounds tolerable. Although hearing aids employing this technology helped, these hearing aids generally did not improve speech intelligibility to a level
that satisfied users.

In the late 1980s, multi-band wide dynamic range compression (WDRC) was introduced into hearing
aids. This technology enabled the hearing aid to automatically adjust the output of individual frequency bands based on the input levels to those bands, allowing the hearing aid to apply more amplification to low-level sounds than to high-level
sounds by frequency band. The result was a hearing aid that more closely modeled the operation of the cochlea. Many hearing aid companies now utilize multi-band WDRC circuits that improve speech recognition from previous levels.

By the late 1990s, technological advances based on DSP led to the first digital hearing aids. DSP hearing aids allow more effective sound
processing algorithms to be built into smaller integrated circuits that consume less power. These circuits accomplish processing tasks that are impossible for analog systems and greatly enhance a hearing aids ability to adjust the incoming
signal to match the acoustic needs of the hearing impaired individual.

In recent years, DSP algorithms have greatly improved the ability
of hearing aids to meet specific needs of the listener. Examples include:



| |  |  | Adaptive directionality microphones that suppress sounds coming from behind the listener thereby improving speech understanding in background noise.
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| |  |  | Digital noise reduction algorithms that provide listening comfort in many noisy environments and in some situations can also improve speech understanding in background noise.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Feedback suppression algorithms that minimize, and sometimes eliminate, the annoying acoustic squeal of a hearing aid resulting from feedback.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------

Diagnostic Equipment

The most
common types of diagnostic equipment used to diagnose hearing loss and ear disease are clinical audiometers, tympanometers and otoacoustic emission equipment. Tympanometers and otoacoustic emission devices have been automated for a number of years.
Our Otogram automates audiometry, which is the most important and useful of all the hearing and ear related tests. The Otogram applies miniaturization, automation and artificial intelligence to enable patients to largely self administer four key
audiometric tests. These audiometric tests include (i) air and bone conduction with masking; (ii) speech reception threshold and speech discrimination with masking; (iii) tympanometry and acoustic reflex; and (iv) otoacoustic
emissions. These tests take about the same amount of time to complete in both automated and manual modes, which is about 30 minutes. The Otogram collects thousands of data points regarding a patients hearing health and organizes and summarizes
this data onto a one page report. The output and report provided by the Otogram meets the American Medical Associations requirements for Current Procedure Terminology (CPT) reimbursement for four CPT codes that enable reimbursement
depending on the type of tests completed.



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Our Technology

Hearing Aids

Our hearing aid technology strategy is to combine a number of distinct
technologies, supported by 46 patents and patent applications in process to date, to produce premium performing digital hearing aids. We seek to protect our intellectual property through patents, licenses, trade secrets and non-disclosure
agreements. We hold 37 U.S. patents, and we are the exclusive licensee for hearing aid and hearing protection applications under two patents held by Brigham Young University. We have 9 U.S. patent applications pending. We seek foreign patent
protection for our more significant patents in our more significant markets. At the core of our technology are proprietary DSP platforms that contain patented algorithms that are based on what we believe is an advanced understanding of human
hearing. These algorithms pre-process the incoming sound and present it to the impaired cochlea in a way that helps restore natural loudness perception and preserves the cues necessary for speech understanding. In addition, our DSP platforms process
sound at a faster rate than most competitive digital hearing aids.

Diagnostic Equipment

Our Otogram is proprietary, and we hold one U.S. patent and have 13 patent applications in process. The Otogram is the only device on the market that
combines all four of the core audiometric tests commonly performed when testing hearing. Additionally, the Otogram is also the only device that enables a patient to take an automated, comprehensive and diagnostic audiogram.

Our Products

Hearing Aids

We have packaged our proprietary technologies into a broad line of digital hearing aids that we believe offer superior sound quality, smaller size,
enhanced personalization and increased reliability at competitive prices. All of our products incorporate our proprietary DSP platforms and are programmable to address the hearing loss of the individual user. We currently sell our hearing aid
products both as completed hearing aids and as hearing aid kits, or faceplates, to others who then market finished hearing aids generally under our brand names.

Our Innova and Applause product lines incorporate our newest generation of DSP. This proprietary spectral enhancement technology offers a unique design that utilizes 16 channels/ 9 handles WDRC with very-fast acting
time constants. The combination of multi-channel narrow-band compression and very-fast acting time constants plays a crucial role in preserving the naturalness of sound, and results in what we believe is an exceptional sounding hearing
aid.

Our Natura 3, Natura 2, Altair, Tribute and Quartet product lines incorporate our second generation of DSP and continue to be among
the smallest custom and behind-the-ear products available today. These hearing aids provide advanced, customized sound processing through our patented core digital signal processing, speech weighted expansion, proprietary Personalized Noise
Reduction technology and Directionalplus system.

All of our hearing aids can be purchased in the six common models for hearing
aids: BTE; ITE; HS; ITC; MC and CIC. These products offer the latest in advanced DSP algorithms and include: automatic noise reduction, adaptive directionality and feedback management. These features are described in more detail below.

 Automatic Noise Reduction

Our automatic noise reduction system actively seeks out steady-state background noise and adds the ability to adapt the amount of noise reduction based on the input level of the noise. Competitive noise reduction algorithms only allow for a
fixed configuration that may or may not have optional levels for varying degrees of noise. This leaves hearing aid users challenged to locate the correct setting when their listening environment suddenly changes. In contrast, automatic noise
reduction removes the guess work for the hearing aid user by automatically adjusting the amount of noise reduction applied based on the level of the noise detected. No switches or adjustments are required.

 Adaptive Directionality

Directionalfocus is a patent-pending adaptive directional technology that offers a unique directional approach through a focused, adaptive gain manipulation based on the direction of sound. Sounds in front of
the listener are considered to be desirable; sounds originating from the sides and back of the listener are considered to be background noise and are therefore attenuated. The Directionalfocus system varies the amount of attenuation based on
the location of the sound, with more attenuation applied as the sound moves out of focus.

 Feedback
Management

Phase cancellation is the latest in feedback management technology and is designed to remove feedback before it becomes
audible. The result is squeal-free operation for the hearing aid user without having to sacrifice gain/amplification. Also available is an automatic gain adjuster which searches for feedback in each of the hearing aids channels and adjusts the



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gain automatically and appropriately so that feedback is removed. In addition, our feedback management technology can be engaged by the hearing aid user via
the push button on the hearing aid, allowing the user to train the feedback canceller should feedback occur.

Expressfit

In order to ensure that our advanced digital hearing aids are properly programmed to the individual needs
of the hearing aid wearer, we have developed a proprietary programming system, Expressfit, which runs on standard personal computers and enables our hearing aids to be easily configured by the hearing care professional to the unique needs of
each wearer.

Diagnostic Equipment

Our Otogram is a turnkey, closed system diagnostic device. This device includes the software and hardware necessary for diagnostic audiometric testing. The Otogram is a single purpose device, and we do not sell the
Otogram software separately from the device.

Improving Speech Understanding in Noise

The number one enhancement sought by hearing aid wearers is improved speech understanding in noise. Our products have been clinically proven to enhance
speech understanding in the presence of noise, offering hearing aid wearers a solution to the problem that challenges them the most. Clinically proven outcomes include:



| |  |  | Our Innova, Applause, Natura and Altair products improve speech understanding in noise and do so in one of the most adverse conditionswhere speech and noise originate from the
same source in front of the user.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Our noise reduction algorithm, available on our Innova, Applause and Natura products, provides additional hearing benefit in understanding speech in noise.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Our advanced directional systems, available on our Innova, Applause and Natura products, provide additional hearing benefit in understanding speech in noise.
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Manufacturing

Our
principal manufacturing facility is in Eagan, Minnesota (near Minneapolis), and we also have smaller manufacturing facilities in Copenhagen, Denmark; Copthorne, England (near London); Montreal, Canada; and Parkside, South Australia (near Adelaide).
Our principal manufacturing facility was established in Eagan because the presence of many major medical device companies, including hearing aid manufacturers, has created a skilled labor pool in that area. Our manufacturing operations consist of
the following activities:



| |  |  | overseeing the production of the DSP platforms used in our products;
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| |  |  | assembling and testing electronic subsystems and non-custom hearing aid products;
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| |  |  | fabricating custom hearing aid shells;
| | - |  | --------------------------------------



| |  |  | integrating the electronic components into the hearing aid shells;
| | - |  | ------------------------------------------------------------------



| |  |  | testing and calibrating finished hearing aids; and
| | - |  | --------------------------------------------------



| |  |  | repairing and servicing our products.
| | - |  | -------------------------------------

We assemble our
custom products (CIC, MC, HS, ITC and ITE) according to specifications received from hearing care professionals. We receive an impression of the wearers ear canal and programming requirements of the hearing aid from the hearing care
professional, from which we produce a custom hearing aid. Our BTE products are assembled using a standard plastic housing and are not custom-molded for a wearers ear because they are placed on the back of the ear.

A number of critical components used in our products are currently available from only a single or limited number of suppliers. For example, each of our
two proprietary digital signal processing chips is manufactured by a single supplier. Our relationship with these suppliers is critical to our business because our proprietary DSP chips are integral to our products and because only a small number of
suppliers would be able or willing to produce our chips in the relatively small quantities and with the exacting specifications we require. The receivers and microphones used in all our products are available from only



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two suppliers. We also rely on a limited number of contractors for certain development projects and assembly operations and are, therefore, subject to their
performance, over which we have little control. Our Otogram is manufactured to our specifications by a third-party contract manufacturer, who also performs major repairs.

Product Returns, Remakes and Repairs

The hearing aid industry experiences high levels of product
returns, remakes and repairs due to factors such as statutorily required liberal return policies and product performance that is inconsistent with hearing impaired consumers expectations. Our actual sales returns were $13.7 million in 2005,
$13.3 million in 2004 and $15.9 million in 2003. Our actual warranty (remake and repair) costs were $4.6 million in 2005, $4.7 million in 2004 and $3.4 million in 2003.

Sales and Marketing

Hearing Aids

Hearing aids have traditionally been dispensed (sold to the consumer) by hearing care professionals (audiologists and hearing instrument specialists) who
are often referred to as hearing aid retailers or dispensers. Due to the hearing care professionals influence over a consumers choice of a hearing aid brand, we believe that developing and maintaining strong relationships with hearing
care professionals is a critical aspect of our sales and marketing strategy. As a result, we aim to deliver superior customer service and support to hearing care professionals.

There are more than 12,000 hearing care professionals in the U.S., of which over 8,000 sell hearing aids. Our direct sales force targets select hearing
care professionals who are capable of and interested in dispensing advanced digital hearing aids. In addition to our direct sales force, we have an inside sales force and direct trainers. We also make extensive use of contract trainers, who both
influence and train hearing care professionals in order to differentiate our products and to ensure proficiency with our hearing aid programming and fitting. We also advertise our products to hearing care professionals through promotional materials,
trade publications and conventions. Our sales force is responsible for implementing loyalty and cooperative advertising programs with specific customers to generate demand for our products.

In Canada, England, Denmark, Austria and the Netherlands, we principally sell to hearing aid retailers and also sell directly to the hearing impaired
consumer to a limited extent. In Australia and Switzerland, we principally sell directly to the hearing impaired consumer through retail clinics and also sell on a wholesale basis to other hearing aid retailers to a limited extent. In Germany, we
principally sell directly to the hearing impaired consumer and pay the ear-nose-throat (ENT) doctor to perform the hearing aid fitting on the consumer and also sell on a wholesale basis to a limited extent. Elsewhere in the world, we
principally sell through a network of established distributors, who in turn sell to hearing care professionals.

To further our marketing
efforts, we occasionally use advertising, public relations and market research agencies. These agencies work in tandem with our internal marketing team to communicate our brands advantages to customers.

Diagnostic Equipment

We
distribute the Otogram directly to primary care physicians, ear-nose-throat doctors, audiologists, hearing instrument specialists and other hearing care professionals in the U.S. We also use independent sales representatives and distributors to sell
the Otogram.

Customers

We sell our
hearing aid products principally to hearing care professionals or directly to hearing impaired consumers. We also sell our hearing aids to distributors. In many developed countries outside the U.S., there are varying degrees of public reimbursement
for the purchase of hearing aids. While such reimbursement likely results in more hearing aids being sold, it also results in hearing impaired consumers buying lower priced hearing aids that are covered by reimbursement. We market our Otogram
product principally to primary care physicians, ear-nose-throat doctors, audiologists and hearing instrument specialists. Our goal is to reduce the barriers to diagnosing and treating hearing loss and ear disorders by expanding hearing healthcare
access to undiagnosed, misdiagnosed or untreated hearing impaired individuals. We hope to fulfill the desire of many hearing care organizations to engage physicians in their patients hearing health and to help partner physicians with hearing
care professionals.

Our net sales in 2005 of $105.0 million by operating segment were as follows: North America$37.4 million;
Europe$43.3 million; Rest-of-world$18.4 million; auditory testing equipment$5.9 million. Our customers are not generally contractually obligated to purchase any fixed quantities of products, and they may stop placing orders with us
at



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any time. We may be unable to retain our current customers, and we may be unable to recruit replacement or additional customers. We are selling hearing aids
to a number of retail chains that have a large number of owned or franchised locations and buying groups that have a large number of locations under contract. We are subject to the risk of losing these customers, incurring significant reductions in
sales to these customers, reducing prices in response to demands from these customers or incurring substantial marketing expenses in order to maintain their business. In addition, we are subject to the risk of being unable to collect receivable
balances from these customers. None of our customers account for more than 10% of net sales.

Research and Development

We continue to work on both product improvements and new product development, and we expect to continue both activities in the future. We intend to use
product improvements and new product development to enhance our competitive position in the market. Research and development includes audiology research, clinical testing, project management, integrated circuit design and engineering, software
engineering, mechanical engineering and materials science. Our integrated circuit design and development efforts are augmented by an outside contractor. Research and development expense was $8.8 million in 2005, $9.7 million in 2004 and $9.8 million
in 2003.

Competition

Hearing
Aids

We encounter aggressive competition from a number of hearing aid competitors worldwide. We compete principally with six larger
companiesSiemens GmbH, Starkey Laboratories, Inc., Widex A/S, William Demant Holdings A/S, Phonak S.A. and Great Nordic A/Sall of which have greater financial, sales, marketing, manufacturing and development resources than we currently
possess. We may not be able to compete effectively with these companies. The number of hearing aid companies who have a manufacturing and marketing presence in the hearing aid industry is approximately one-half of what it was in 1990. Consolidation
in the hearing aid industry has occurred at the wholesale and retail levels in the past number of years, as evidenced by the acquisitions of Interton, Beltone, Dahlberg/Miracle Ear, ReSound, Philips, Unitron and Sonus, and further consolidation
could produce stronger competitors.

The digital segment of the hearing aid industry is characterized by increasing competition and new
product introductions. The proliferation of digital hearing aids has lead to increasing price pressure and intense marketing campaigns as each company tries to differentiate its products and services from the others. We compete primarily on the
basis of sound quality, features, cosmetics, quality, price, ease of fitting the hearing aid, marketing and sales support, customer service, and education and training. We believe we can currently compete effectively on each of these factors, but if
we fail to compete effectively, our net sales and operating results will suffer.

Diagnostic Equipment

While many companies sell diagnostic hearing testing equipment, none has a device with the capabilities and features of the Otogram. The three leading
diagnostic equipment companies in the audiometric testing market are GN Otometrics (owned by Great Nordic A/S), Interacoustic/Maico/Tremetrics (owned by William Demant Holdings A/S) and Grason & Stadler (owned by Viasys). These three
companies have about two-thirds of the diagnostic hearing testing equipment market.

Patents, Licenses and Trade Secrets

We currently hold 38 U.S. patents and are the exclusive licensee for hearing aid and hearing protection applications under two patents held by Brigham
Young University (BYU). We also have 22 U.S. patent applications pending.

Under one of our license agreements with BYU, we
have an exclusive worldwide license to utilize certain patents and patents pending involving hearing aid signal processing, audio signal processing and hearing compression, including the fundamental sound processing algorithm incorporated into our
DSP platform. This agreement expires in 2013 or the expiration of the last claim of the patents. Under another license agreement with BYU, we have the perpetual right to use specified noise suppression technologies owned by BYU. We have
exclusive worldwide rights to use these technologies in hearing aid and hearing protection applications and a non-exclusive right to use them for other applications.

In addition to the above, we have the following licensing arrangements:



| |  |  | A fully paid-up license agreement with a Danish partnership that owns approximately 200 patents considered essential for the sale of programmable hearing aids.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | A license agreement that provides us with an exclusive worldwide right to utilize patents involving directional signal processing.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------



| |  |  | A license agreement that provides us with the technology to produce hearing aid shells using an automated process.
| | - |  | ------------------------------------------------------------------------------------------------------------------



| |  |  | A license agreement that provides us with the technology to make an ear-tube for our open-ear product.
| | - |  | ------------------------------------------------------------------------------------------------------



| |  |  | A license agreement covering aspects of our programming system.
| | - |  | ---------------------------------------------------------------

Our success depends in large part on our proprietary technology. We rely on a combination of patents, copyrights, trademarks, trade secrets, confidentiality procedures and licensing arrangements to establish and protect our proprietary
technology. If we fail to successfully enforce our intellectual property rights, our competitive position will suffer. We also rely on trade secret information, technical know-how and innovation to expand our proprietary position. We maintain a
policy of requiring certain of our employees and consultants to execute non-disclosure and assignment of inventions agreements upon commencement of their employment or engagement.

We may be required to spend significant resources to monitor and police our intellectual property rights. We may not be able to detect infringement and
may lose our competitive position in the market before we do so. In addition, competitors may design around our proprietary technology or develop competing technologies. Intellectual property rights may also be unavailable or limited in some foreign
countries. Our pending patent and trademark registration applications may not be allowed or competitors may challenge the validity or scope of these registrations. In addition, our patents may not provide us with a significant competitive advantage.

Government Regulation

Our products
are subject to regulation in the U.S. by the FDA, which may hamper the timing of our product introductions or subject us to costly penalties in the event we fail to comply. Generally, medical devices must either receive pre-market clearance from the
FDA through the 510(k) process or be an exempt product. Our hearing aid products are exempt from the 510(k) process. The Otogram has received 510(k) clearance. We must comply with facility registration and product listing requirements of the FDA and
adhere to its Quality System Regulations (QSR). If we or any third-party contract manufacturers of our products do not conform to the QSR, we will be required to find alternative manufacturers that do conform, which could be a long and
costly process. Noncompliance with applicable FDA requirements can result in fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production or criminal prosecution.

Sales of our products outside the U.S. are subject to foreign regulatory requirements that vary widely from country to country. The time required to
obtain approvals required by other countries may negatively affect our ability to sell products in those countries. In order to market our products in the member countries of the European Union (EU), we are required to obtain the
EUs CE mark certification, which we have accomplished for our hearing aid products by meeting the requirements of ISO 13485. Any failure to maintain our ISO 13485 certification or CE mark for our hearing aid products could significantly reduce
our net sales and operating results. We are seeking to obtain a CE mark for the Otogram to enable export sales of the Otogram.

We must
also maintain compliance with federal, state and foreign laws regarding sales incentives, techniques, referrals and other programs.

Employees

As of December 31, 2005, we had 346 employees in North America, 159 employees in Europe and 129 employees in Australia. The
majority of employees outside the U.S. are in operations and sales and marketing. None of our employees are represented by a labor union. We have never experienced any work stoppages and we consider relations with our employees to be good.



9



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Executive Officers of the Registrant

The following table sets forth our officers and their ages as of December 31, 2005:



|                     |  |     |  |                                                      
|-------------------- |  | --- |  | -----------------------------------------------------
|Name                 |  | Age |  | Position                                             
|Andrew G. Raguskus   |  | 60  |  | Executive Chairman of the Board                      
|                     |  |    
|Samuel L. Westover   |  | 50  |  | President and Chief Executive Officer                
|                     |  |    
|Stephen L. Wilson    |  | 52  |  | Senior Vice President and Chief Financial Officer    
|                     |  |    
|Michael A. James     |  | 57  |  | Senior Vice President Worldwide Commercial Operations
|                     |  |    
|Victor H. Bray, Jr.  |  | 51  |  | Vice President Quality Systems                       
|                     |  |    
|Jerry L. DaBell      |  | 59  |  | Vice President Research and Development              
|                     |  |    
|Jeffrey R. Geigel    |  | 32  |  | Vice President North American Sales                  
|                     |  |    
|Christie R. Mitchell |  | 46  |  | Vice President Manufacturing Operations              
|                     |  |    
|Michael M. Halloran  |  | 45  |  | Vice President and Corporate Controller              
|                     |  |    
|Brent H. Shimada     |  | 45  |  | Vice President Administration and General Counsel    

Andrew G. Raguskus was appointed Executive Chairman of the Board and resigned as President and
Chief Executive Officer in October 2005. He has been a Board member since 1996 and had been the Companys President and Chief Executive Officer since 1996. He was Chief Operating Officer of Sonic Solutions, Inc., a maker of digital audio
workstations, during 1996. He was Senior Vice President Operations of ReSound Corporation, a hearing aid company, from 1991 to 1995. Prior to that, he held management positions at Sun Microsystems, Inc. and General Electrics Medical Systems
division. He has served on the board of the Hearing Industry Association. Mr. Raguskus earned a bachelors degree in electrical engineering from Rensselaer Polytechnic Institute.

Samuel L. Westover was appointed President and Chief Executive Officer of the Company in October 2005. He has been a director since 2002 and served as
Chairman of the Audit Committee and a member of the Compensation and Governance and Nominating Committees until his appointment as President and Chief Executive Officer. From 2002 to 2004, Mr. Westover was President and CEO of CIGNA Dental and
President of CIGNA HealthCares Small Business Segment. Mr. Westover was CEO of two public companies and was the founding Chief Financial Officer of WellPoint, the largest health insurer in the U.S. In connection with the Salt Lake City
2002 Winter Olympics, Mr. Westover was Special Assistant to the Governor of Utah and established an independent economic development task force. He also received a gubernatorial appointment to serve as Chairman of the Public Education Job
Enhancement Committee, providing scholarships and financial assistance to facilitate advanced education of high school teachers in math and science. Mr. Westover earned a bachelors degree in accounting from Brigham Young University.

Stephen L. Wilson joined Sonic Innovations in 1999 as Vice President and Chief Financial Officer and became Senior Vice President and
Chief Financial Officer in 2003. From 1997 to 1999, Mr. Wilson was Executive Vice President and Chief Financial Officer of Computer Motion, Inc., a medical robotics company. From 1990 to 1997, he was Vice President Finance and Chief Financial
Officer of St. Jude Medical, Inc., a cardiovascular medical device company. He earned a bachelors degree in accounting from University of Connecticut and is a Certified Public Accountant.

Michael A. James joined Sonic Innovations in 2002 as Vice President Worldwide Field Operations and became Senior Vice President Worldwide Commercial
Operations in 2003. From 2000 through 2002, Mr. James was Vice President Commercial Operations of the Life Sciences division of Motorola, Inc. From 1996 to 2000, he was employed by Medtronic, Inc., a medical device company, most recently as
Vice President Marketing of the Perfusion Systems business. Mr. James previous experience included positions at Abbott Laboratories, Inc., Dart & Kraft, Inc. and Baxter Healthcare Corporation. He earned a bachelors degree
in English from Wichita State University and an M.B.A. from University of Chicago. Mr. James resigned from the Company in February 2006.

Victor H. Bray, Jr., Ph.D., joined Sonic Innovations in 1997 as Vice President Auditory Research and became Vice President Quality Systems in 2004. From 1993 to 1997, he was employed by ReSound Corporation, a hearing aid company, most
recently as Director of Clinical Research. From 1986 to 1993, Dr. Bray was Director of Audiology and Clinical Audiologist at the Austin Ear Clinic. He earned a bachelors degree in biochemistry from the University of Georgia, a
masters degree in audiology from Auburn University and a Ph.D. in speech and hearing science from University of Texas.

Jerry L.
DaBell joined Sonic Innovations in 2000 as Vice President Business Development and became Vice President Product Development in 2002 and Vice President Research and Development in July 2005. He was Senior Vice President Business Development of IMP,
Inc., a semi-conductor manufacturer, where he was employed from 1988 to 2000. He earned a bachelors degree and a masters degree in electrical engineering from Brigham Young University.

Jeffrey R. Geigel has been General Manager of the Companys Canadian operations since 2002 and became Vice President North American Sales in
December 2005, with responsibility for the U.S. sales organization and Canadian operations. From 2001 to 2002, Mr. Geigel was a business development consultant for the Company. From 1998 to 2001, he was Executive Vice President of Helix Hearing
Care of America Corporation, a North American operator of hearing healthcare clinics. He earned his bachelors degree in social sciences from the University of Ottawa.



10



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Christie R. Mitchell joined Sonic Innovations in 2000 as Materials Manager and became Director of
Material Logistics in 2003 and Vice President Manufacturing Operations in December 2005. From 1981 to 2000, she was employed by Baker Hughes Company, a provider of drilling products and services to the worldwide oil and gas industry, most recently
as Director of Worldwide Materials.

Michael M. Halloran joined Sonic Innovations in 1999 as Corporate Controller and became Vice President
and Corporate Controller in 2003. From 1994 to 1999, he served in various financial capacities for C.R. Bard, Inc., a medical products company. He earned a bachelors degree in accounting from State University of New York and is a Certified
Public Accountant.

Brent H. Shimada joined Sonic Innovations in October 2004 as Vice President Human Resources and Administration and
became Vice President Administration and General Counsel in December 2005. From 1999 to October 2004, he was Human Resources Director for American Express Global Travelers Cheque Operations Group. Mr. Shimada served as Senior Corporate
Counsel at American Stores Company, a grocery and drug retail chain, from 1996 to 1999. Prior to that, he was Legal Counsel for Alliant Techsystems, Inc., a government contractor. He earned a bachelors degree in finance, an MBA and a Juris
Doctor degree from the University of Utah.

Officers are elected by the board of directors and serve until their successors have been duly
elected and qualified. There are no family relationships among any of our directors or officers.

Availability of SEC Reports

We maintain an internet website at www.sonici.com, where we make available our annual reports on Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K, and amendments to those reports, each of which is filed or furnished pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after such reports are
electronically filed with, or furnished to, the SEC. The information contained on our website is not incorporated by reference in this Form 10-K and should not be considered a part of this report.

ITEM 1-A. FACTORS THAT MAY AFFECT FUTURE PERFORMANCE

Our future results, plans, objectives, expectations and intentions could be negatively affected by any of the following risk factors. Investors should understand that it is not possible to predict or identify all such factors,
and we are under no obligation to update these factors. Investors should not consider the factors listed as a complete statement of all potential risks and uncertainties.

We have a history of losses and negative cash flow.

We have a history of losses and negative cash
flow and a significant accumulated deficit and have yet to become consistently profitable. We may incur net losses and negative cash flow in the future. Whether or not we achieve consistent profitability will depend in significant part on increasing
our net sales, maintaining or improving our gross margin and maintaining or limiting increases in our operating expenses. Consequently, it is possible that we will not achieve consistent profitability on a quarterly or annual basis in the future.

We face aggressive competition in our business, and if we do not compete effectively our net sales and operating results will suffer.

We encounter aggressive competition from a number of competitors worldwide, six of which have far greater sales and more extensive financial and
business resources than we have. We may not choose to, or be able to, match the type or the volume of incentives that our competitors provide to hearing aid retailers, which could put us at a competitive disadvantage. In addition, some competitors
have purchased or established their own network of owned or franchised retail hearing aid operations or are adding to those networks, which could cause us to lose existing customers and make it difficult to recruit new customers. If we fail to
compete effectively, our net sales and operating results will suffer.

Our financial results may fluctuate significantly, which may cause our stock
price to decline.

Our financial results have fluctuated significantly in the past and may fluctuate significantly in the future. These
fluctuations could cause our stock price to vary significantly or decline. Factors that may cause fluctuations in our operating results include the following: general economic conditions; hearing aid market conditions; the competitive performance of
our products; delays or problems completing or introducing new products; expenses associated with increasing our sales, marketing or distribution capabilities; difficulties in integrating and managing acquired operations that could result in poor



11



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performance, additional expenses or write-downs of acquired intangible assets; changes in government healthcare systems and reductions in reimbursement
levels for hearing aids or diagnostic hearing testing; competitive pressures resulting in lower selling prices or significant promotional costs; difficulties in relationships with our customers; demand for and market acceptance of our products,
particularly new products where eventual market acceptance may not follow early indications; reductions in orders from larger customers; high levels of returns, remakes and repairs; changes in our product or customer mix; regulatory requirements;
difficulties in managing international operations; the effect of future acquisitions, if any; the effect of international conflicts and threats; inability to forecast revenue accurately; nonpayment of receivables; the announcement or introduction of
new products or services by our competitors; manufacturing problems; component availability and pricing; and other business factors beyond our control.

If net sales for a particular period were below our expectations, it is highly unlikely that we could proportionately reduce our operating expenses for that period. Therefore, any revenue shortfall would have a
disproportionately negative effect on our operating results for the period. You should not rely on our results for any one quarter as an indication of our future performance. In future quarters, our operating results may be below the expectations of
public market analysts or investors. If this occurs, our stock price would very likely decrease.

We have made a number of acquisitions and could make
additional acquisitions, which could be difficult to integrate, disrupt our business, dilute the equity of our shareholders and harm our operating results.

We may not be able to meet performance expectations for, or successfully integrate, businesses we have acquired or may acquire on a timely basis or at all. For example, it is too soon to evaluate whether Tympany,
Inc., which was acquired in December 2004 and which is currently generating significant losses, will achieve our expectations and positively affect our overall business. In the event Tympany fails to meet our expectations, fails to reach earn-out
thresholds desired by the formers owners, or fails to achieve market acceptance and meet our strategic objectives, litigation over this acquisition could result, which would be expensive and time consuming. In 2005, we incurred asset impairment
charges of $7.5 million related to the intangible assets of our Tympany and England operations.

As part of our business strategy, we may
continue to make acquisitions that complement or expand our existing business. Acquisitions involve risks, including (i) the inability to successfully integrate acquired businesses or to realize anticipated synergies, economies of scale or
other expected value; (ii) difficulties in managing and coordinating operations at new sites; (iii) the loss or termination of key employees of acquired businesses; (iv) the loss of key customers of acquired businesses;
(v) performance of acquired products; (vi) unanticipated expenses in connection with refining and improving acquired products; (vii) diversion of managements attention from other business concerns; and (vii) risks of
entering businesses and markets in which we have no direct or limited prior experience. Acquisitions may result in the utilization of cash and marketable securities, dilutive issuances of equity securities and the incurrence of debt, any of which
would weaken our financial position. In addition, acquisitions may result in the creation of (i) certain definite-lived intangible assets that increase amortization expense, (ii) goodwill and other indefinite-lived intangible assets that
subsequently may result in large write-downs should these assets become impaired and (iii) earn-out or other payments that may need to be expensed rather than recorded as additional goodwill.

If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results or prevent fraud. As a result, current
and potential stockholders could lose confidence in our financial reporting, which could harm our business and the trading price of our common stock.

Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. We have in the past discovered, and may in the future discover, areas of our internal controls that
need improvement. Although we have implemented enhanced procedures to properly prepare our financial statements, we cannot be certain that these measures will ensure that we will maintain adequate controls over our financial processes and reporting
in the future. In addition, Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate and report on our internal controls over financial reporting and have our independent registered public accounting firm annually attest to our
evaluation, as well as issue their own opinion on our internal control over financial reporting. We prepared for compliance with Section 404 by strengthening, assessing and testing our system of internal controls to provide the basis for our
report. However, the continuous process of strengthening our internal controls and complying with Section 404 is expensive and time consuming and requires significant management attention. We cannot be certain that these measures will ensure
that we will maintain adequate controls over our financial processes and reporting in the future. Failure to implement required new or improved controls, or difficulties encountered in their implementation, could harm our operating results or cause
us to fail to meet our reporting obligations. If we or our auditors discover a material weakness, the disclosure of that fact, even if quickly remedied, could reduce the markets confidence in our financial statements and harm our stock price.
In addition, future non-compliance with Section 404 could subject us to a variety of administrative sanctions, including the suspension or delisting of our common stock from the Nasdaq National Market and the inability of registered
broker-dealers to make a market in our common stock, which would further reduce our stock price.



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The loss of any large customer or a reduction in orders from any large customer could reduce our net sales and harm
our operating results.

We anticipate that our operating results in any given period will depend in part upon revenues from a number of
larger customers. Our customers are not generally contractually obligated to purchase any fixed quantities of products, and they may stop placing orders with us at any time. We may be unable to retain our current customers, and we may be unable to
recruit replacement or additional customers. We are selling hearing aids to a number of retail chains that have a large number of owned or franchised locations and buying groups that have a large number of locations under contract. We are subject to
the risk of losing large customers, incurring significant reductions in sales to these customers, reducing prices in response to demands from these customers or incurring substantial marketing expenses in order to maintain their business. In
addition, we are subject to the risk of being unable to collect receivable balances from these customers.

We rely on several suppliers and contractors,
and our business will be seriously harmed if these suppliers and contractors are not able to meet our requirements.

Certain critical
components used in our products are currently available only from a single or limited number of suppliers. For example, each of our proprietary digital signal processing chips is manufactured by a single supplier. These suppliers may not be willing
or able to satisfy our requirements. We also rely on a limited number of contractors for certain hearing aid component assemblies, Otogram assembly and advanced integrated circuitry development and are therefore subject to their performance, over
which we have little control. We may lose the services of these key suppliers or contractors. Finding a substitute part, process, supplier or contractor may be expensive and time-consuming, or may prove impossible in the near-term.

We have high levels of product returns, remakes and repairs, and our net sales and operating results will be lower if these levels increase.

We generally offer a minimum 60-day return policy and various warranties on our hearing aids. In general, the hearing aid industry has high levels of
returns, remakes and repairs, and our level of returns, remakes and repairs is comparable to that of the industry. We may not be able to attain lower levels of returns, remakes and repairs and, in fact, these levels may increase, which could reduce
our net sales and operating results.

If we fail to develop new and innovative products, our competitive position will suffer, and if our new products
are not well accepted, our net sales and operating results will suffer.

In order to be successful, we must develop new products and be
a leader in the commercialization of new technology innovations in the hearing aid market. Technological innovation is expensive and unpredictable and among other things, requires hiring (i) expert personnel who are difficult to find and
attract, or (ii) external contractors to perform complex tasks. Without the timely introduction of new products, our existing products are likely to become technologically obsolete over time, which would harm our business. We may not have the
technical capabilities necessary to develop further technologically innovative products. In addition, any enhancements to, or new generations of, our products, even if successfully developed, may not generate significant revenues. Moreover, if we
are unable to continue to introduce new products on a periodic basis, the overall average selling price of our products may decline, negatively impacting our gross margin. Our products may be rendered obsolete by changing consumer preferences or the
introduction of products embodying new technologies or features by us or our competitors. Obsolescence of our products, a breakthrough new method of addressing hearing loss or the introduction of technologically superior products by new
or existing competitors could cause us a rapid loss of sales or market share, which would have a significant adverse effect on our net sales, operating results and stock price.

Because of the complexity of our products, there may be undiscovered errors or defects that could harm our business or reputation.

Our products are complex and may contain undetected defects, errors or failures. Our customers may discover errors after new products have been introduced and sold. The occurrence of any defects, errors or failures
could result in the loss of or delay in market acceptance of our new products, product returns and warranty expenses, any of which could harm our reputation and business and adversely affect our net sales and operating results.



13



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If we are subject to litigation and infringement claims, they could be costly and disrupt our business.

There may be patents or patent applications in the U.S. or other countries that are pertinent to our business of which we are not
aware. The technology that we incorporate into and use to develop and manufacture our current and future products may be subject to claims that they infringe the patents or proprietary rights of others. The success of our technology efforts will
also depend on our ability to develop new technologies without infringing or misappropriating the proprietary rights of others.

We have in
the past and may in the future receive notices from third parties alleging patent, trademark or copyright infringement. Whether or not we actually infringe a third partys rights, receipt of these notices could result in significant costs and
diversion of the attention of management from our business. If a successful claim were brought against us, we would have to attempt to license the intellectual property right from the claimant or spend time and money to design around or avoid the
intellectual property. Any such license may not be available on reasonable terms, or at all. We may be involved in future lawsuits, arbitrations or other legal proceedings alleging patent infringement or other intellectual property rights
violations. In addition, litigation, arbitration or other legal proceedings may be necessary to:



| |  |  | assert claims of infringement of or otherwise enforce our intellectual property rights;
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | protect our trade secrets or know-how; or
| | - |  | -----------------------------------------



| |  |  | determine the enforceability, scope and validity of our intellectual property rights or those of others.
| | - |  | --------------------------------------------------------------------------------------------------------

We may be unsuccessful in defending or pursuing these lawsuits or claims. Regardless of the outcome, litigation can be very costly and can divert
managements attention. An adverse determination may subject us to significant liabilities or require us to seek licenses to other parties intellectual property rights. We may also be restricted or prevented from developing,
manufacturing, marketing or selling a new product that we develop. Further, we may not be able to obtain any necessary licenses on acceptable terms, if at all.

In addition, we may have to participate in proceedings before the U.S. Patent and Trademark office, or before foreign patent and trademark offices, with respect to our patents and patent applications or those of
others. These actions may result in substantial costs to us as well as a diversion of management attention. Furthermore, these actions could place our patents, trademarks and other intellectual property rights at risk and could result in the loss of
patent, trademark or other intellectual property rights protection for the products and services on which our business strategy depends.

We may be
unable to adequately protect or enforce our proprietary technology, which may result in its unauthorized use or reduced sales or otherwise reduce our ability to compete.

Our business and competitive position depend upon our ability to protect our proprietary technology. Despite our efforts to protect this information,
unauthorized parties may attempt to obtain and use information that we regard as proprietary. Any patents issued in connection with our efforts to develop new technology for our products may not be broad enough to protect all of the potential uses
of the technology.

In addition, when we do not control the prosecution, maintenance and enforcement of certain important intellectual
property, such as a technology in-licensed to us, the protection of the intellectual property rights may not be in our hands. If the entity that controls the intellectual property rights does not adequately protect those rights, our rights may be
impaired, which may affect our ability to develop, market and commercialize the related products. Our means of protecting our proprietary rights may not be adequate, and our competitors may:



| |  |  | independently develop substantially equivalent proprietary information, products and techniques;
| | - |  | ------------------------------------------------------------------------------------------------



| |  |  | otherwise gain access to our proprietary information; or
| | - |  | --------------------------------------------------------



| |  |  | design around our patents or other intellectual property.
| | - |  | ---------------------------------------------------------

We pursue a policy of having our employees, consultants and advisors execute proprietary information and invention agreements when they begin working for us. However, these agreements may not provide meaningful protection for our trade
secrets or other proprietary information in the event of unauthorized use or disclosure.

We are dependent on international operations, which exposes us
to a variety of risks that could result in lower sales and operating results.

International sales, particularly in Germany and
Australia, account for a material portion of our net sales. Our reliance on international operations exposes us to related risks and uncertainties, which, if realized, could cause our sales and operating results to decrease. There is significant
government or public hearing aid reimbursement in a number of countries outside the U.S., which if reduced or eliminated would likely have a negative effect on our sales. For example, reimbursement levels are trending downward in Germany, which has
negatively affected our sales in that country. Other



14



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changes in the healthcare systems of countries outside the U.S., such as instituting co-payments or co-insurance, would likely have negative effects on our
sales. In order to market our products in the EU, we are required to have the EUs CE mark certification. Any failure to maintain our CE mark certification would significantly reduce our net sales and operating results. We work under different
legal, regulatory and governmental regimes in various countries, which could delay our ability to sell products or cause us additional expense in determining how to comply, and taking any actions necessary to comply, with local legal, regulatory and
governmental requirements. In addition, we may need to adapt local practices to satisfy requirements applicable in the U.S. We face foreign currency risks primarily as a result of the revenues we derive from sales made outside the U.S., expenses
incurred outside the U.S. and intercompany account balances between our U.S. parent company and our non-U.S. subsidiary companies. Fluctuations in the exchange rates between the U.S. dollar and other currencies could negatively affect the sales
price of our products in international markets or lead to currency exchange losses. In general, our net sales and operating results benefit from a weakening U.S. dollar. If the U.S. dollar were to strengthen materially from current levels, our net
sales and operating results would suffer.

Accounting for stock-based compensation will negatively affect our results.

New accounting rules will require us to expense the value of stock awards beginning January 1, 2006. This will result in lower reported earnings per
share as compared to current accounting practice and may lead us to seek alternative means of providing incentive compensation, which could be less effective at attracting, retaining and motivating key employees or have other negative consequences.

Complications may result from hearing aid use, and we may incur significant expense if we are sued for product liability.

Although we have not experienced any significant product liability issues to date, we may be held liable if any product we develop causes injury or is
found otherwise unsuitable. If we are sued for an injury caused by our products, the resulting liability could result in significant expense beyond our products liability insurance limits, which would harm our operating results.

If we fail to comply with food and drug administration regulations or various sales-related laws, we may suffer fines, injunctions or other penalties.

Our products are subject to regulation in the U.S. by the FDA and similar entities in other countries. We must comply with facility registration and
product listing requirements of the FDA and similar entities and adhere to the FDAs Quality System Regulations. Noncompliance with applicable FDA and similar entities requirements can result in fines, injunctions, civil penalties, recall
or seizure of products, total or partial suspension of production or criminal prosecution. We must also maintain compliance with federal, state and foreign laws regarding sales incentives, techniques, referrals and other programs, some of which are
unclear or may be read broadly enough to prohibit standard sales programs such as discounts, free training or frequent buyer awards. While we intend to comply with the law in each of these jurisdictions, if our practices, or those of a
competitor, were to attract unfavorable press or governmental attention, our sales could be adversely affected or we could be subject to fines or governmental injunctions.

There may be sales of our stock by our directors and officers, and these sales could cause our stock price to fall.

Sales of our stock by our directors and officers, or the perception that such sales will occur, could adversely affect the market price of our stock. Some of our officers have adopted trading plans under SEC Rule
10b5-1 in order to dispose of a portion of their stock in an orderly manner. Other officers or directors may adopt such a trading plan in the future.

Provisions in our charter documents, our shareholders rights plan and Delaware law may deter takeover efforts that shareholders feel would be beneficial to shareholder value.

Our certificate of incorporation and bylaws, shareholder rights plan and Delaware law contain provisions that could make it harder for a third party to
acquire us without the consent of our board of directors. While we believe these provisions provide for an opportunity to receive a higher bid by requiring potential acquirers to negotiate with our board of directors, these provisions apply even if
the offer may be considered beneficial by some shareholders, and a takeover bid otherwise favored by a majority of our shareholders might be rejected by our board of directors.

ITEM 1-B. UNRESOLVED STAFF COMMENTS

Not applicable.



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ITEM 2. PROPERTIES

We lease manufacturing and office space in support of our business. Total leased space as of December 31, 2005 was 163,186 square feet as follows:



|                             |  |                |  |                              
|---------------------------- |  | -------------- |  | -----------------------------
|Location                     |  | Square Footage |  | Lease Expiration             
|Salt Lake City, Utah         |  | 39,815         |  | August 2009                  
|                             |  |               
|Eagan, Minnesota             |  | 22,748         |  | September 2011               
|                             |  |               
|Houston, Texas               |  | 5,400          |  | July 2008                    
|                             |  |               
|Copenhagen, Denmark          |  | 8,374          |  | May 2008                     
|                             |  |               
|London, England              |  | 6,440          |  | Various through April 2009   
|                             |  |               
|Adelaide, Australia          |  | 10,596         |  | December 2007                
|                             |  |               
|Australia retail locations   |  | 31,328         |  | Various through August 2010  
|                             |  |               
|Birr-Lupfig, Switzerland     |  | 2,583          |  | September 2007               
|                             |  |               
|Switzerland retail locations |  | 5,240          |  | Various through March 2010   
|                             |  |               
|Leibnitz, Austria            |  | 1,636          |  | June 2006                    
|                             |  |               
|Zwolle, Netherlands          |  | 5,199          |  | July 2008                    
|                             |  |               
|Montreal, Canada             |  | 7,475          |  | October 2009                 
|                             |  |               
|Hamburg, Germany             |  | 12,035         |  | Various through December 2010
|                             |  |               
|Germany retail locations     |  | 4,317          |  | Various through June 2011    
|                             |  |                |  |                              
|Total                        |  | 163,186        |  |                              
|                             |  |                |  |                              

We believe we have sufficient manufacturing capacity to satisfy current and forecasted demand for
at least the next 12 months.

ITEM 3. LEGAL PROCEEDINGS

In June 2005, Energy Transportation Group, Inc. (ETG) filed a patent infringement lawsuit in the United States District Court for the District of Delaware against fourteen defendants, including Sonic
Innovations. ETG claims the defendants have infringed upon U.S. Patent No. 4,731,850 entitled Programmable Digital Hearing Aid System and U.S. Patent No. 4,879,749 entitled Host Controller for Programmable Digital Hearing
Aid System. ETG is seeking damages resulting from defendants unauthorized manufacture, use, sale, offer to sell and/or importation into the U.S. products, methods, processes, services and/or systems that infringe the above-named patents.
We have filed our answer denying all allegations. Discovery has not begun and no trial date has been set.

In February 2006, the former
owners of Sanomed Handelsgesellschaft mbH (Sanomed), which we acquired in May 2003, filed a lawsuit in German civil court claiming that certain deductions made by us against accounts receivable amounts that were deemed uncollectible
prior to the acquisition but which have been collected and are due the former owners were improper. The former owners seek damages in the amount of $1,587. We will file our statement of defense in March 2006.

We strongly deny the allegations contained in the ETG and the Sanomed lawsuits and we intend to defend ourselves vigorously, however, litigation is
inherently uncertain and an unfavorable result could have a material adverse effect on us.

From time to time we are subject to legal
proceedings, claims and litigation arising in the ordinary course of our business. Most of these legal actions are brought against us by others and, when we feel it is necessary, we may bring legal actions ourselves. Actions can stem from disputes
regarding the ownership of intellectual property, customer claims regarding the function or performance of our products, government regulation or employment issues, among other sources. Litigation is inherently uncertain, and therefore we cannot
predict the eventual outcome of any such lawsuits. However, we do not expect that the ultimate resolution of any known legal action, other than as identified above, will have a material adverse effect on our results of operations and financial
position.

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

No matters were submitted to a vote of our stockholders during the quarter ended December 31, 2005.



16



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PART II

ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market
Information

Our common stock trades on the Nasdaq Stock Exchange, under the symbol SNCI. The high and low sales prices of
our common stock, as reported by the Nasdaq Stock Exchange, are set forth below for the periods indicated.



|               |  |             |      |     |   |     
|-------------- |  | ----------- | ---- | --- | - | ----
|               |  | Price Range
|2005           |  | High        |      | Low
|First quarter  |  | $           | 5.90 |     | $ | 3.95
|Second quarter |  |             | 5.72 |     |   | 4.00
|Third quarter  |  |             | 5.26 |     |   | 4.30
|Fourth quarter |  |             | 4.44 |     |   | 2.93



|               |  |      |       |     |   |     
|-------------- |  | ---- | ----- | --- | - | ----
|2004           |  | High |       | Low
|First quarter  |  | $    | 12.40 |     | $ | 5.49
|Second quarter |  |      | 12.54 |     |   | 5.42
|Third quarter  |  |      | 5.75  |     |   | 4.02
|Fourth quarter |  |      | 4.61  |     |   | 3.31

The closing price of our common stock as reported by the Nasdaq Stock Exchange on March 1,
2006 was $4.50 per share. As of March 1, 2006, there were approximately 3,600 holders of record of our common stock.

Dividends

We have never declared or paid cash dividends on our stock, and our board of directors has no present intention to declare or pay cash dividends.

Securities Authorized for Issuance under Equity Compensation Plans

The following table provides certain information concerning our equity compensation plans as of December 31, 2005:



|                                                           |     |                                                                                             |     |                                                                             |      |                                                                                                                                             |          
|---------------------------------------------------------- | --- | ------------------------------------------------------------------------------------------- | --- | --------------------------------------------------------------------------- | ---- | ------------------------------------------------------------------------------------------------------------------------------------------- | ---------
|Plan category                                              |     | Number of securities to be issued upon exercise of
outstanding options, warrants and rights |     | Weighted-average exercise price of outstanding options, warrants and rights |      | Number of securities remaining available for future issuance under
equity compensation plans (excluding securities reflected in column (a))
|                                                           | (a) |                                                                                             | (b) |                                                                             | (c) 
|Equity compensation plans approved by security holders     |     | 4,638,783                                                                                   |     | $                                                                           | 4.64 |                                                                                                                                             | 1,365,606
|Equity compensation plans not approved by security holders |     |                                                                                            |     |                                                                             |     |                                                                                                                                             |         
|                                                           |     |                                                                                             |     |                                                                             |      |                                                                                                                                             |          
|Total                                                      |     | 4,638,783                                                                                   |     | $                                                                           | 4.64 |                                                                                                                                             | 1,365,606
|                                                           |     |                                                                                             |     |                                                                             |      |                                                                                                                                             |          



17



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ITEM 6. SELECTED FINANCIAL DATA(in thousands, except per share and other data)

Selected Five Year Data:



|                                                   |  |      |         |   |      |   |         |      |  |   |         |   |  |      |        |   |  |   |        |  
|-------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | - |  | ---- | ------ | - |  | - | ------ | -
|                                                   |  | 2005 |         |   | 2004 |   |         | 2003 |  |   | 2002    |   |  | 2001 |       
|Statements of Operations:                          |  |      |         |   |      |   |         |      |  |   |         |   |  |      |        |   |  |   |        |  
|Net sales                                          |  | $    | 105,041 |   |      | $ | 98,534  |      |  | $ | 87,690  |   |  | $    | 68,018 |   |  | $ | 57,267 |  
|Gross profit                                       |  | $    | 56,227  |   |      | $ | 53,529  |      |  | $ | 46,364  |   |  | $    | 35,405 |   |  | $ | 25,985 |  
|Percent of net sales                               |  |      | 53.5    | % |      |   | 54.3    | %    |  |   | 52.9    | % |  |      | 52.1   | % |  |   | 45.4   | %
|Operating expenses                                 |  | $    | 77,110  |   |      | $ | 53,078  |      |  | $ | 46,708  |   |  | $    | 36,783 |   |  | $ | 33,713 |  
|Percent of net sales                               |  |      | 73.4    | % |      |   | 53.9    | %    |  |   | 53.3    | % |  |      | 54.1   | % |  |   | 58.9   | %
|Operating profit (loss)                            |  | $    | (20,883 | ) |      | $ | 451     |      |  | $ | (344    | ) |  | $    | (1,378 | ) |  | $ | (7,728 | )
|Net income (loss)                                  |  | $    | (19,608 | ) |      | $ | 411     |      |  | $ | 376     |   |  | $    | 32     |   |  | $ | (5,635 | )
|Earnings (loss) per common sharebasic             |  | $    | (0.92   | ) |      | $ | 0.02    |      |  | $ | 0.02    |   |  | $    | 0.00   |   |  | $ | (0.28  | )
|Earnings (loss) per common sharediluted           |  | $    | (0.92   | ) |      | $ | 0.02    |      |  | $ | 0.02    |   |  | $    | 0.00   |   |  | $ | (0.28  | )
|Weighted average common shares outstandingbasic   |  |      | 21,382  |   |      |   | 20,733  |      |  |   | 19,941  |   |  |      | 19,595 |   |  |   | 19,822 |  
|Weighted average common shares outstandingdiluted |  |      | 21,382  |   |      |   | 22,152  |      |  |   | 20,971  |   |  |      | 20,869 |   |  |   | 19,822 |  
|Balance Sheets:                                    |  |      |         |   |      |   |         |      |  |   |         |   |  |      |        |   |  |   |        |  
|Cash and marketable securitiesunrestricted        |  | $    | 7,865   |   |      | $ | 21,024  |      |  | $ | 21,360  |   |  | $    | 35,561 |   |  | $ | 45,806 |  
|Cash and marketable securitiesrestricted          |  |      | 8,384   |   |      |   | 11,325  |      |  |   | 11,852  |   |  |      |       |   |  |   |       |  
|Total assets                                       |  |      | 86,764  |   |      |   | 115,286 |      |  |   | 106,996 |   |  |      | 74,746 |   |  |   | 70,856 |  
|Long-term obligations                              |  |      | 5,033   |   |      |   | 7,161   |      |  |   | 7,845   |   |  |      |       |   |  |   | 102    |  
|Total liabilities                                  |  |      | 36,993  |   |      |   | 44,183  |      |  |   | 41,943  |   |  |      | 14,901 |   |  |   | 13,692 |  
|Shareholders equity                               |  |      | 49,771  |   |      |   | 71,103  |      |  |   | 65,053  |   |  |      | 59,845 |   |  |   | 57,164 |  
|Other:                                             |  |      |         |   |      |   |         |      |  |   |         |   |  |      |        |   |  |   |        |  
|Countries with direct operations                   |  |      | 9       |   |      |   | 9       |      |  |   | 9       |   |  |      | 8      |   |  |   | 3      |  
|Number of employees                                |  |      | 634     |   |      |   | 637     |      |  |   | 586     |   |  |      | 531    |   |  |   | 430    |  

In 2005, we recorded an asset impairment charge of $694 to cost of sales and $6,817 to selling,
general and administrative expense and a restructuring charge of $3,991 as more fully discussed in Notes 6 and 9 to the consolidated financial statements.



18



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Unaudited Quarterly Results of Operations:



|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|-------------------------------------------------- |  | ----- | ------ | - | ------ | - | ------ | ----- |  | - | ------ | - |  | - | ------ | -
|                                                   |  | First |        |   | Second |   |        | Third |  |   | Fourth |  
|2005:                                              |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Net sales                                          |  | $     | 25,891 |   |        | $ | 30,185 |       |  | $ | 24,353 |   |  | $ | 24,612 |  
|Cost of sales                                      |  |       | 12,034 |   |        |   | 13,419 |       |  |   | 11,718 |   |  |   | 11,643 |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Gross profit                                       |  |       | 13,857 |   |        |   | 16,766 |       |  |   | 12,635 |   |  |   | 12,969 |  
|Operating expenses                                 |  |       | 17,206 |   |        |   | 16,796 |       |  |   | 21,187 |   |  |   | 21,921 |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Operating loss                                     |  |       | (3,349 | ) |        |   | (30    | )     |  |   | (8,552 | ) |  |   | (8,952 | )
|Other income (expense)                             |  |       | (40    | ) |        |   | 128    |       |  |   | 96     |   |  |   | 32     |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Income (loss) before income taxes                  |  |       | (3,389 | ) |        |   | 98     |       |  |   | (8,456 | ) |  |   | (8,920 | )
|Income tax provision (benefit)                     |  |       | 88     |   |        |   | (165   | )     |  |   | (1,166 | ) |  |   | 184    |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Net income (loss)                                  |  | $     | (3,477 | ) |        | $ | 263    |       |  | $ | (7,290 | ) |  | $ | (9,104 | )
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Earnings (loss) per common sharebasic             |  | $     | (0.16  | ) |        | $ | 0.01   |       |  | $ | (0.34  | ) |  | $ | (0.42  | )
|Earnings (loss) per common sharediluted           |  | $     | (0.16  | ) |        | $ | 0.01   |       |  | $ | (0.34  | ) |  | $ | (0.42  | )
|Weighted average common shares outstandingbasic   |  |       | 21,215 |   |        |   | 21,289 |       |  |   | 21,488 |   |  |   | 21,530 |  
|Weighted average common shares outstandingdiluted |  |       | 21,215 |   |        |   | 21,984 |       |  |   | 21,488 |   |  |   | 21,530 |  
|                                                   |  |       |        |  
|2004:                                              |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Net sales                                          |  | $     | 26,306 |   |        | $ | 24,338 |       |  | $ | 22,456 |   |  | $ | 25,434 |  
|Cost of sales                                      |  |       | 11,729 |   |        |   | 10,663 |       |  |   | 10,456 |   |  |   | 12,157 |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Gross profit                                       |  |       | 14,577 |   |        |   | 13,675 |       |  |   | 12,000 |   |  |   | 13,277 |  
|Operating expenses                                 |  |       | 12,598 |   |        |   | 12,908 |       |  |   | 12,723 |   |  |   | 14,849 |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Operating profit (loss)                            |  |       | 1,979  |   |        |   | 767    |       |  |   | (723   | ) |  |   | (1,572 | )
|Other income (expense)                             |  |       | (49    | ) |        |   | (29    | )     |  |   | (6     | ) |  |   | 122    |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Income (loss) before income taxes                  |  |       | 1,930  |   |        |   | 738    |       |  |   | (729   | ) |  |   | (1,450 | )
|Income tax provision (benefit)                     |  |       | 342    |   |        |   | 114    |       |  |   | (69    | ) |  |   | (309   | )
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Net income (loss)                                  |  | $     | 1,588  |   |        | $ | 624    |       |  | $ | (660   | ) |  | $ | (1,141 | )
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Earnings (loss) per common sharebasic             |  | $     | 0.08   |   |        | $ | 0.03   |       |  | $ | (0.03  | ) |  | $ | (0.05  | )
|Earnings (loss) per common sharediluted           |  | $     | 0.07   |   |        | $ | 0.03   |       |  | $ | (0.03  | ) |  | $ | (0.05  | )
|Weighted average common shares outstandingbasic   |  |       | 20,408 |   |        |   | 20,682 |       |  |   | 20,860 |   |  |   | 20,975 |  
|Weighted average common shares outstandingdiluted |  |       | 22,790 |   |        |   | 22,775 |       |  |   | 20,860 |   |  |   | 20,975 |  

In the third quarter 2005, we recorded an asset impairment charge of $694 to cost of sales and
$5,061 to selling, general and administrative expense related to our Tympany operation and a restructuring charge of $1,186. In the fourth quarter 2005, we recorded an asset impairment charge of $1,756 related to our Tympany and England operations
and a restructuring charge of $2,805. Also in the fourth quarter 2005, we determined that it was more likely than not that we would not be able to realize the future benefit of the deferred income tax asset of our Australian subsidiary and,
accordingly, we recorded a valuation allowance of $1,179, which was charged to income taxes.



19



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ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(in
thousands, except share data)

OVERVIEW

Sonic Innovations Inc. is a hearing healthcare company. We design, develop, manufacture and market advanced digital hearing aids intended to provide the highest levels of satisfaction for hearing impaired consumers and proprietary auditory
testing equipment that automates the four most commonly performed hearing tests. We have developed patented DSP technologies based on what we believe is an advanced understanding of human hearing. In those countries where we have direct (owned)
operations, we sell our products to hearing care professionals or directly to hearing impaired consumers. In other parts of the world where we do not have direct operations, we sell principally to distributors. From our inception, we have focused on
the therapeutic side of hearing care by developing high-performance digital hearing aids. In December 2004, we acquired Tympany, Inc. (Tympany) and now offer hearing diagnostic equipment to further help hearing impaired individuals. Our
mission is to improve the quality of life of the hearing impaired.

Market

The hearing aid market is large at both the wholesale (manufacturing) level (over $2.0 billion) and the retail level (over $5.0 billion). There is no one
source of worldwide hearing aid market and sales data, but U.S. data is maintained by the HIA and is generally adapted and used by the industry as a proxy for worldwide data. The HIA data indicates that hearing aid sales increased on an annual
percentage basis in 2003, 2004 and 2005 by mid-single digits. While we expect similar growth in the near term, we believe the long-term growth potential in this market is significantly better. It is estimated less than 24% of those who could benefit
from a hearing aid actually own one. There are many factors that cause this low market penetration rate, such as the high cost of hearing aids, the stigma associated with wearing hearing aids, and the discomfort of wearing hearing aids. We believe
that these negative factors will decrease in importance in the future because we expect prices to decline and the stigma aspect to decrease as improvements in technology make the devices smaller, less conspicuous and more comfortable and as hearing
loss becomes more prevalent in society. Therefore, in the future, we expect that more people who could benefit from hearing aids will buy them, and we believe that the growth rate of the hearing impaired population will be significant, particularly
as the developed worlds population ages. As a result, we believe the market for hearing aids will increase significantly in the future. However, the following conditions in our market are impacting us in a negative way currently:



| |  |  | Competition is intense and new product offerings by our competitors are coming to market more quickly than in the past.
| | - |  | -----------------------------------------------------------------------------------------------------------------------



| |  |  | The performance, features and quality of lower-priced products continues to improve, which attracts more customers to these lower-priced products resulting in a lower average
selling price.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The rate of transition from analog to digital hearing aids has slowed considerably because digital devices now represent a very significant percentage in most developed markets. For
example, in the United States digital hearing aids now represent 89% of the market.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Economic conditions worldwide, particularly for the elderly, continue to cause people to defer the purchase of a new hearing aid.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



| |  |  | Many consumers feel that hearing aids are simply too expensive and cannot justify purchase on a cost-benefit basis.
| | - |  | -------------------------------------------------------------------------------------------------------------------



| |  |  | The available market continues to shrink as our competitors implement vertical integration strategies and buying groups limit the number of manufacturers with whom they do business.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

As the number of companies offering digital products proliferated and as the digital offerings from our competitors became
more competitive, our sales have suffered. In addition, our larger competitors have been able to use their greater marketing and distribution capabilities to more aggressively sell their products. The mindshare of the hearing aid dispenser is what
we need to win to be successful.



20



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Product Developments

In 2005, we introduced our Innova product family of hearing aids based on a new technology platform that improved upon our two strongest existing features  noise reduction and directionality. Noise reduction
allows the hearing aid to reduce background noise so that speech sounds are clearer. We have the only omni-directional hearing aid that has been clinically proven to improve speech intelligibility with background noise present. Directionality allows
the hearing aid wearer to better understand speech sounds through the use of directional microphones in the device. We launched Innova in the second quarter 2005 in English speaking countries and by the end of 2005 in non-English speaking countries.
Innova improved on our noise reduction algorithms, offered the features that had already been marketed by a number of our competitors, and had superior directionality capabilities. In addition, the Innova platform technology provides us the
opportunity to develop a broad product line of full-featured hearing aids that can allow us to compete effectively at more price points of the hearing aid market. In 2006, we will be introducing our first open-ear product, Ion, which
will be based on this technology platform. Open-ear products generally eliminate the effect of occlusion because there is no ear-mold involved, rather these products have an ear-bud that allows air into the ear. The market for open-ear products,
which have been in the market more than a year, is growing very rapidly. We believe that Ion will provide us a significant opportunity to increase our net sales.

Distribution Developments

We are competing in an industry that includes six much larger competitors who have significantly
more resources and have established relationships and reputations. Their product offerings are broad and their infrastructure and marketing and distribution capabilities are well established, and they continue to vertically integrate. This makes it
difficult for us to compete in the traditional distribution fashion. For this reason, we are interested in non-traditional distribution methods. We believe we are making progress with this strategy in several countries. In Germany, we sell direct to
the consumer and use the ear-nose-throat (ENT) doctor to perform the hearing aid fitting. In Australia and Switzerland, we sell direct to the consumer through retail stores. In Austria, our largest customer is a chain of electronics
stores that also sell hearing aids. In the Netherlands, our largest customer is a chain of optical stores that also sell hearing aids. As a result of our purchase of Tympany in December 2004, we sell a hearing testing device, the Otogram, to primary
care physicians, ENT doctors, audiologists and hearing instrument specialists. We are currently focusing on developing synergies between our diagnostic and therapeutic businesses in order to make both businesses successful.

Financial Results

Our financial results in 2005 were
negatively affected by the following items:



| |  |  | Large losses in our Tympany operation, which was acquired in December 2004. We are changing our selling strategy to a more conventional equipment distribution approach.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Write-downs of our investment in our Tympany operation of $6.3 million and England operation of $1.2 million, which reflected impairments in asset value.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | A restructuring charge of $4.0 million, which was mainly related to severance for personnel reductions and eliminating excess facilities.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Establishment of a valuation allowance against deferred income tax assets of our Australian subsidiary of $1.2 million, which resulted from Australias lack of sustained
profitability.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Lack of a competitive high-end product. This was partially solved by the introduction of our Innova product family in the U.S. early in the second quarter 2005. However,
Innova was not introduced worldwide until late in the fourth quarter of the year.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Lack of a competitive mid-range product. This was partially solved by the introduction of our Applause product family. However, Applause was launched in November 2005
and, therefore, had little financial impact in 2005.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The Innova product family did not drive incremental sales in 2005 to the extent we had anticipated.
| | - |  | ---------------------------------------------------------------------------------------------------



| |  |  | Lack of a product in the open-ear segment of the market, which has been growing rapidly since the first open-ear product appeared in the marketplace more than a year ago, and which
now comprises as much as 20% of some markets in the world.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Increased spending on sales and marketing initiatives in the U.S., Australia and Germany.
| | - |  | -----------------------------------------------------------------------------------------



21



---

Our operating loss of $20.9 million in 2005 was a direct result of the items listed above. In particular,
losses pertaining to our Tympany operation totaled $12.7 million, of which $7.4 million was due to asset impairment and restructuring charges.

As we enter 2006, we are optimistic about our ability to significantly improve our financial performance for the following reasons:



| |  |  | We have restructured our Tympany operation. While we continue to incur operating losses, we expect unit sales to improve as we change our focus from placing Otograms with the PCP to
selling Otograms to the PCP, the ENT doctor, the audiologist and the hearing instrument specialist. It is difficult to sell the Otogram to the primary care physician who has limited experience dealing with hearing loss. The ENT doctor, audiologist
and hearing instrument specialist are the experts in hearing, and we believe they will see the value of the Otogram. We are hopeful that this change in selling strategy will result in improved financial performance of our Tympany operation.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We have reorganized our executive management team and removed a layer of executive overhead.
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | We have a business plan focused on enhancing our profitability.
| | - |  | ---------------------------------------------------------------



| |  |  | We have replaced general or sales management in each of our three major geographies  the U.S., Germany and Australia.
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | We have adjusted our business by country such that we are planning to improve our profitability in each country in which we have a direct operation.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We will be introducing an open-ear product, Ion, by the start of the second quarter 2006. This will be a new product category for us, so we believe that sales of this product will
be largely incremental. In addition, the open-ear segment of the market is the only growing segment of the hearing aid market. Some customers estimate that open-ear products now comprise (after a little more than a year on the market) some 20% plus
of their total sales. This product is particularly helpful for first time hearing aid wearers who experience a high-frequency hearing loss, and Ion is targeted to aging baby-boomers. We believe Ion will be smaller, lighter and yet more powerful than
competing open-ear products.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We have increased our management and operational focus of our product distribution channels compared to our focus on technology. In addition, we are increasing our efforts to become
more customer-centric. Our goal is to be the hearing healthcare provider of choice to customers who value unparalleled levels of service and quality, great products and competitive pricing.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

RESULTS OF OPERATIONS

Net Sales. Net sales
consist of product sales less a provision for sales returns, which is made at the time of sale. Net sales by reportable operating segment by year were as follows:



|                           |  |      |         |      |   |        |  |     |      |  |        |        |  |     |   
|-------------------------- |  | ---- | ------- | ---- | - | ------ |  | --- | ---- |  | ------ | ------ |  | --- | --
|                           |  | 2005 |         | 2004 |   | Change |  |     | 2003 |  | Change |       
|Hearing aids:              |  |      |         |      |   |        |  |     |      |  |        |        |  |     |   
|North America              |  | $    | 37,394  |      | $ | 35,907 |  | 4   | %    |  | $      | 40,834 |  | (12 | )%
|Europe                     |  |      | 43,300  |      |   | 45,004 |  | (4  | )    |  |        | 31,695 |  | 42  |   
|Rest-of-world              |  |      | 18,432  |      |   | 16,777 |  | 10  |      |  |        | 15,161 |  | 11  |   
|                           |  |      |         |      |   |        |  |     |      |  |        |        |  |     |   
|                           |  |      | 99,126  |      |   | 97,688 |  | 1   |      |  |        | 87,690 |  | 11  |   
|Auditory testing equipment |  |      | 5,915   |      |   | 846    |  | 599 |      |  |        |       |  |    |   
|                           |  |      |         |      |   |        |  |     |      |  |        |        |  |     |   
|Net sales                  |  | $    | 105,041 |      | $ | 98,534 |  | 7   |      |  | $      | 87,690 |  | 12  |   
|                           |  |      |         |      |   |        |  |     |      |  |        |        |  |     |   

2005 Compared with 2004

Net sales of $105,041 in 2005 increased 7% from net sales of $98,534 in 2004 reflecting a full year of operations of our auditory testing equipment
business (Tympany), which was acquired in December 2004, and increased sales in Australia, which is categorized above in Rest-of-world.



22



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North American sales of $37,394 in 2005 increased 4% from 2004 sales of $35,907 as U.S. sales increased
only slightly (1%), but Canadian sales increased significantly (37%). U.S. sales continued to be effected by pressures from competitors new products, pricing concessions and aggressive dealer incentives. Our new high-end Innova product family,
which was introduced early in the second quarter 2005, sold well in the second quarter 2005, but Innova thereafter did not drive incremental sales to the extent we were anticipating. Canadian sales increased in 2005 from 2004 levels mainly as a
result of the introduction of Innova, aggressive marketing programs and a larger sales force. We expect U.S. sales in the first quarter 2006 to be modest; however, we anticipate significant improvement beginning in the second quarter 2006 with the
introduction of our new Ion product. In addition, we introduced our Applause product family late in 2005 and anticipate introducing another new product family, Natura Pro, in the second quarter 2006.

European sales of $43,300 in 2005 decreased 4% from 2004 sales of $45,004 mainly due to a 24% decrease in sales from our Denmark operation, which was a
combination of lower sales in Denmark and reduced export sales to certain distributors, particularly our distributor in France. Germany, which comprises over 60% of European sales, experienced a 1% decrease in sales from 2004 to 2005. Sales in
England, Austria and Switzerland were each up over 16% from 2004 to 2005, although the increase in Switzerland was favorably affected by a full year of sales of a retail operation acquired in the second quarter 2004. Sales in the Netherlands were
down 6% mainly as a result of difficulties in making a transition to new management. We expect European sales to increase in 2006 and such growth to be enhanced by the Innova product family and Applause product family, both of which were introduced
in non-English speaking European countries late in 2005, as well as the introduction of Ion and Natura Pro, both scheduled for the second quarter 2006.

Rest-of-world sales of $18,432 in 2005 increased 10% from 2004 sales of $16,777 as a result of increased sales in Australia, which mainly resulted from the introduction of Innova and aggressive marketing programs.
Sales in Australia, which comprises almost all of our Rest-of-world business, have increased since our acquisition of a business there in 2001. We expect Rest-of-world sales to continue to increase in 2006 and to benefit from the Applause product
family introduction late in 2005 and the anticipated introduction of Ion and Natura Pro in the second quarter 2006.

Auditory testing
equipment sales of $5,915 increased from 2004 sales of $846 as a result of a full year of operations in 2005 versus one month of operation in 2004. Auditory testing equipment sales in 2005 were disappointing and did not exhibit the growth we
anticipated when we bought Tympany in December 2004 due to the aforementioned issues.

We sell almost exclusively high-end 100% digital
hearing aids. We believe it is important to have a number of product families to provide our customers with pricing flexibility in selling to the hearing impaired consumer. In 2004 and 2003, we had five product families  Natura 3, Natura 2,
Altair, Tribute and Quartet. In 2005, we added our Innova and Applause product families, both of which are based on the Innova chipset, our latest and best technology. Prices for all existing products continued to decline in 2005, which offset the
higher pricing of our new products resulting in a small decrease in our overall average selling price. Our goal is to introduce new products at a fast enough rate to keep our overall average selling price from declining. We expect our overall
average selling price to increase during 2006 because we have incented our sales force to focus on average selling price, and we will be introducing new higher-priced products.

We generally have a 60-day return policy for hearing aid sales. Provisions for sales returns were $14,388, or 12.7% of gross hearing aid sales, and
$12,595, or 11.4% of gross hearing aid sales, in 2005 and 2004, respectively. The increase is a result of product mix and a shift to non-custom products in the U.S in 2005 as compared to 2004. We believe that the hearing aid industry, particularly
in the U.S., experiences a high level of product returns due to factors such as statutorily required liberal return policies and product performance that is inconsistent with hearing impaired consumers expectations. In Germany, Australia,
Switzerland and a portion of the Netherlands, sales are at the retail level and are recognized upon customer acceptance, and therefore, sales returns in these countries are considerably lower than in the balance of our business.



23



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2004 Compared with 2003

Net sales of $98,534 in 2004 increased 12% from net sales of $87,690 in 2003 as increased sales in Europe and Rest-of-world more than offset decreased
sales in North America.

North American sales of $35,907 in 2004 decreased from 2003 sales of $40,834 principally due to lower U.S. sales.
U.S. sales decreased 14% from 2003 to 2004 mainly due to competitive pressures from new products, pricing concessions and aggressive dealer incentives. In addition, our products lacked certain features embodied in various competitors hearing
aids. Our low-priced Quartet product family, which was introduced in the second quarter 2004, sold well in the fast growing low-priced digital segment of the U.S. market, but those sales were cannibalistic rather than incremental. Canadian sales
increased 15% from 2003 to 2004 mainly as a result of a restructured operation and sales force and the favorable effects of foreign currency translation.

European sales of $45,004 in 2004 increased 42% from 2003 sales of $31,695 primarily as a result of a full year effect of sales in Germany, where we acquired a business in the second quarter 2003, as well as sales
growth of this business. Also contributing to the year-over-year growth were increased sales in Austria and the Netherlands where our largest customer in each of those markets increased its level of business with us, the favorable effects of foreign
currency translation and the acquisition of several retail stores in Switzerland in the second quarter 2004. Currency translation alone increased 2004 European sales by approximately $3,200, representing 10% of the total 42% increase from 2003 sales
levels. While sales in Germany in 2004 were adversely affected by the lingering impact of changes in the German healthcare system made in late 2003, we saw a rebound in German order activity starting in September 2004 that carried over into the
fourth quarter 2004.

Rest-of-world sales of $16,777 in 2004 increased 11.4% from 2003 sales of $15,161 mainly as a result of increased
sales in Australia, all of which resulted from favorable effects of foreign currency translation.

Auditory testing equipment sales in 2004
included one month of operations of Tympany, Inc., which was acquired in December 2004.

In 2004 and 2003, we had five product families
 Natura 3, Natura 2SE, Altair, Tribute and Quartet. Our lower priced product families, Quartet and Tribute, were increasingly important to our sales effort as consumers continued to seek lower-priced digital hearing aids. The shift to
lower-priced products reduced our overall average selling price, which in combination with competitive pricing put pressure on gross margin.

Provisions for sales returns were $12,595, or 11% of gross hearing aid sales, and $16,782, or 16.1% of gross hearing aid sales, in 2004 and 2003, respectively. We experienced declining return rates for a number of reasons:



| |  |  | We had a higher percentage of net sales outside the U.S. in 2004 and return rates were considerably lower outside the U.S.
| | - |  | --------------------------------------------------------------------------------------------------------------------------



| |  |  | In Germany, Australia and Switzerland, sales are at the retail level and are recognized upon customer acceptance, and therefore, sales returns in these countries are considerably
lower than in the balance of our business. Accordingly, sales return rates were favorably affected by a full year of operations in Germany and retail operations in Switzerland and increased sales in Australia.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Our lower-priced Altair, Tribute and Quartet product families experienced a lower return rate than our higher priced Natura 3 and Natura 2 families. Generally, in the hearing aid
business, the higher the price of the hearing aid, the greater the rate at which it is returned.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Gross Profit.Cost
of sales primarily consists of manufacturing costs, royalty expenses, quality costs and costs associated with product remakes and repairs (warranty). Our gross profit and gross margin by reportable operating segment by year were as follows:



|                           |  |      |        |  |      |   |  |      |        |  |      |   |  |   |        |  |      |  
|-------------------------- |  | ---- | ------ |  | ---- | - |  | ---- | ------ |  | ---- | - |  | - | ------ |  | ---- | -
|                           |  | 2005 |        |  | 2004 |   |  | 2003 |       
|Hearing aids:              |  |      |        |  |      |   |  |      |        |  |      |   |  |   |        |  |      |  
|North America              |  | $    | 20,433 |  | 54.6 | % |  | $    | 20,280 |  | 56.5 | % |  | $ | 23,103 |  | 56.6 | %
|Europe                     |  |      | 22,478 |  | 51.9 |   |  |      | 21,659 |  | 48.1 |   |  |   | 13,880 |  | 43.8 |  
|Rest-of-world              |  |      | 12,214 |  | 66.3 |   |  |      | 11,179 |  | 66.6 |   |  |   | 9,381  |  | 61.9 |  
|                           |  |      |        |  |      |   |  |      |        |  |      |   |  |   |        |  |      |  
|                           |  |      | 55,125 |  | 55.6 |   |  |      | 53,118 |  | 54.4 |   |  |   | 46,364 |  | 52.9 |  
|Auditory testing equipment |  |      | 1,102  |  | 18.6 |   |  |      | 411    |  | 48.6 |   |  |   |       |  |     |  
|                           |  |      |        |  |      |   |  |      |        |  |      |   |  |   |        |  |      |  
|Total                      |  | $    | 56,227 |  | 53.5 |   |  | $    | 53,529 |  | 54.3 |   |  | $ | 46,364 |  | 52.9 |  
|                           |  |      |        |  |      |   |  |      |        |  |      |   |  |   |        |  |      |  



24



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2005 Compared With 2004

Gross profit of $56,227 in 2005 was up 5% from last years level of $53,529 mainly as a result of increased net sales, which were up 7% year-over-year, but gross margin declined slightly to 53.5% in 2005 from
54.3% in 2004. The gross margin decline principally resulted from an asset impairment charge in 2005 of $694 pertaining to the write-down of intellectual property, which had been recorded upon the acquisition of our Tympany operation in December
2004. In addition, gross margin in our auditory testing equipment segment was adversely affected by our recognition of deferred revenue that existed at the acquisition date, which added approximately $1.8 million of very low margin revenue in 2005,
product issues, supplier issues, warranty issues and inventory write-offs. North American gross margin decreased due to lower average selling prices, despite higher-priced Innova sales, as prices of our legacy products decreased and the incentives
and rebates on most products increased. European gross margin improved largely due to the continuing shift from custom to standard products. The cost of a custom device is higher than the cost of a standard device while selling prices are generally
similar. Provisions for warranty decreased to $4,990 in 2005 from $5,136 in 2004, principally as a result of product improvements related to improved wax protection systems that have reduced the frequency at which hearing aids are returned for
repair but which have resulted in an increase in the unit cost per repair. From 2004 to 2005, the number of hearing aids returned for repair decreased by more than 10%.

We expect that competitive pricing will continue to put pressure on our selling prices and gross margin. We were able to limit the reduction in our overall average selling price in the U.S. in 2005 because of the
second quarter introduction of the Innova product family, which, as a top-of-the-line product, had higher pricing. If we are able to continue to introduce new products on a periodic basis, we are hopeful that we can maintain or improve our overall
average selling price and positively impact our gross margin. We expect to increase our unit volume in 2006, and we believe that little additional overhead will be required by manufacturing operations to support increasing volume. This, in
combination with expected reduced purchased component and assembly costs, lower sales return rates and more off-shore outsourcing, should result in our gross margin improving beginning by the second quarter 2006. In addition, Tympany gross margin
should improve significantly in 2006 as a result of the elimination of low-margin deferred revenue recorded upon the acquisition, improved design and manufacturing, and a more reliable product.

2004 Compared With 2003

Gross profit of $53,529 in
2004 was up 15% from the 2003 level of $46,364 mainly as a result of increased net sales, which were up 12% year-over-year, but also due to a small improvement in gross margin. Gross margin improved to 54.3% in 2004 from 52.9% in 2003; however,
gross margin deteriorated in the second half of 2004 primarily as a result of lower average selling prices and geographic mix, mainly as a result of decreased U.S. prices and volume. This was reflected in the slightly decreased year-over-year North
American gross margin. Gross margin in 2004 also benefited from favorable foreign currency exchange rates due to the weaker U.S. dollar as the majority of our product costs were denominated in U.S. dollars, while a significant portion of our sales
were denominated in foreign currencies. This was reflected in improving gross margins for Europe and Rest-of-world. Provisions for warranty increased to $5,136 in 2004 from $3,924 in 2003 principally as a result of the increase in the number of
hearing aids covered under warranty and, to a lesser extent, to an increase in warranty costs per unit. The increase in warranty costs per unit was principally the result of using higher-cost, higher-performance earwax protection components in
performing repairs.

Selling, General and Administrative. Selling, general and administrative expense primarily consists of wages
and benefits for sales and marketing personnel, sales commissions, promotions and advertising, marketing support, distribution and administrative expenses.

Selling, general and administrative expense in dollars and as a percent of sales by reportable operating segment by year was as follows:



|                           |  |      |        |  |       |   |  |      |        |  |      |   |  |   |        |  |      |  
|-------------------------- |  | ---- | ------ |  | ----- | - |  | ---- | ------ |  | ---- | - |  | - | ------ |  | ---- | -
|                           |  | 2005 |        |  | 2004  |   |  | 2003 |       
|Hearing aids:              |  |      |        |  |       |   |  |      |        |  |      |   |  |   |        |  |      |  
|North America              |  | $    | 22,133 |  | 59.2  | % |  | $    | 17,816 |  | 49.6 | % |  | $ | 17,850 |  | 43.7 | %
|Europe                     |  |      | 17,446 |  | 40.3  |   |  |      | 15,494 |  | 34.4 |   |  |   | 10,724 |  | 33.8 |  
|Rest-of-world              |  |      | 11,838 |  | 64.2  |   |  |      | 9,650  |  | 57.5 |   |  |   | 8,367  |  | 55.2 |  
|                           |  |      |        |  |       |   |  |      |        |  |      |   |  |   |        |  |      |  
|                           |  |      | 51,417 |  | 51.9  |   |  |      | 42,960 |  | 44.0 |   |  |   | 36,941 |  | 42.1 |  
|Auditory testing equipment |  |      | 6,065  |  | 102.5 |   |  |      | 408    |  | 48.2 |   |  |   |       |  |     |  
|                           |  |      |        |  |       |   |  |      |        |  |      |   |  |   |        |  |      |  
|Total                      |  | $    | 57,482 |  | 54.7  |   |  | $    | 43,368 |  | 44.0 |   |  | $ | 36,941 |  | 42.1 |  
|                           |  |      |        |  |       |   |  |      |        |  |      |   |  |   |        |  |      |  



25



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2005 Compared with 2004

Selling, general and administrative expense was $57,482, or 54.7% of net sales, in 2005, an increase of $14,114, or 33%, from selling, general and
administrative expense of $43,368, or 44.0% of net sales, in 2004. This increase was mainly the result of the full year effect in 2005 of the acquisition of Tympany made in December 2004 and significant increases in U.S., Germany and Australia sales
and marketing expenses as we sought to strengthen our position in these three important markets, and, to a lesser extent, the full year affect in 2005 of the acquisition of a small Switzerland-based retail chain in the second quarter 2004. In
addition, we established accruals for potential settlements of various legal and other disputes in 2005. The increasingly competitive nature of our business was reflected in increased selling, general and administrative expenses as a percent of net
sales in each geography from 2004 to 2005. The increase as a percent of net sales was exacerbated by a decrease in sales in Europe. A portion of the increased sales and marketing costs in 2005 related to the introduction of the Innova product
family, which particularly affected 2005 North American selling, general and administrative expenses. In addition, Australia added significantly to its sales and marketing infrastructure, developed a number of new marketing programs and completed an
enterprise resource planning system implementation in 2005.

We expect selling, general and administrative expense to decrease modestly in
dollars, but significantly as a percentage of net sales, in 2006 as we have reorganized and reduced our management, restructured certain of our hearing aid operations, restructured our Tympany business, eliminated excess facilities and instituted a
clear focus on profitability.

2004 Compared with 2003

Selling, general and administrative expense was $43,368, or 44.0% of net sales, in 2004, an increase of $6,427, or 17%, from selling, general and administrative expense of $36,941, or 42.1% of net sales, in 2003. This
increase was mainly the result of the full year effect in 2004 of the acquisition of a German business in the second quarter 2003 and, to a lesser extent, the acquisition of a small Switzerland-based retail chain in the second quarter 2004. In
addition, foreign currency translation due to a weaker U.S. dollar resulted in an increase in 2004 selling, general and administrative expense of approximately $2,200 over 2003 levels. Also contributing to the year-over-year increase were
significant marketing costs connected with the anticipated 2005 introduction of our Innova product family; our acquisition of Tympany, Inc. in December 2004; increased costs in Australia related to a new branding strategy; information systems
development outside the U.S.; and Sarbanes-Oxley compliance related costs. The competitive nature of our business was reflected in increased selling, general and administrative expenses as a percent of net sales in each geography from 2003 to 2004.
This was exacerbated in North America due to declining sales and mitigated in Europe by significantly increased sales.

Research and
Development. Research and development expense primarily consists of wages and benefits for research and development, engineering, regulatory and clinical personnel and also includes consulting, intellectual property, clinical studies and
engineering support costs.

2005 Compared with 2004

Research and development expense of $8,820, or 8.4% of net sales, in 2005 decreased $890 (9%) from research and development expense of $9,710, or 9.9% of net sales, in 2004 despite incremental research and
development expense of $992 related to the Tympany business, which was acquired in December 2004. The decrease in research and development expense from 2004 to 2005 was mainly the result of the completion of the development of the Innova product
family early in 2005. Significant spending with third party contractors on Innova in 2004 did not recur in 2005. We expect research and development expense to increase in dollars, but to decrease as a percentage of sales, in 2006 as we complete our
new Ion product and prepare for the introduction of two new products.

2004 Compared with 2003

Research and development expense was $9,710, or 9.9% of net sales, in 2004, a decrease from research and development expense of $9,767, or 11.1% of net
sales, in 2003. Research and development expense was basically flat from 2004 to 2003 as increased costs relating to the development of the Innova product family in 2004 offset costs associated with the design, development and introduction of the
Natura 3 product family in 2003.



26



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Asset Impairment.During the third quarter 2005, the lack of progress toward profitability, a
changing business model and the termination and departure of the management team at Tympany, resulted in us performing an impairment analysis of the Tympany operation (auditory testing equipment segment). This analysis resulted in asset impairments
of $4,227 related to goodwill and $1,528 related to definite-lived intangibles, which caused goodwill to be completely written-off and definite-lived intangibles to be reduced to their estimated fair value of $1,495. Additionally, as a result of
this impairment and Tympanys operating results not meeting financial objectives in the fourth quarter 2005, we recorded an additional impairment charge of $500 related to the fourth quarter 2005 earn-out. We expect to continue to expense these
earn-outs until such time as expected cash flows from the business can support additional valuation. If that were to occur, we would capitalize these earn-outs as additional purchase price.

During the fourth quarter 2005, the Company discontinued doing business with two large customers of its England operation due to lack of current and
foreseeable profitability regarding these two customers, and, accordingly, we performed an impairment analysis of the England operation. This analysis resulted in an asset impairment of $1,256, which caused goodwill to be reduced to its estimated
fair value of $604.

We utilized a third-party valuation firm to assist with our evaluation of the value of our reporting units. Impairment
tests involved the use of both estimates of market value of our operating units as well as discounted cash flow analysis based on market rates. There were no asset impairments in 2004.

Restructuring Charge.In 2005, we took actions to improve our profitability, including reducing layers of management, restructuring certain
operations and eliminating excess facilities. In the third quarter 2005, we recorded $1,186 mainly related to termination of the management of Tympany and elimination of excess facilities. In the fourth quarter 2005, we recorded $2,805 mainly
related to executive severance packages, employee terminations and elimination of excess facilities.

Other Income. Other income
primarily consists of foreign currency gains and losses and interest income and interest expense.

2005 Compared with 2004

Other income was $216 in 2005 compared to $38 in 2004. The increase was principally a result of a number of small other income items
recognized in 2005 that not occur in 2004. Interest income basically offset the sum of interest expense and foreign currency exchange losses. We expect other income/expense to be relatively minimal per quarter in 2006.

2004 Compared with 2003

Other income
was $38 in 2004 compared to $1,537 in 2003. The decrease was principally a result of net foreign currency exchange losses of $182 in 2004 compared to net foreign currency gains of $1,220 in 2003. The shift in foreign currency exchange between the
two years resulted mainly from hedging the effect of a weakening U.S. dollar on the intercompany balances between our U.S. parent company and our non-U.S. subsidiaries in 2004 and the related costs of hedging. In addition, interest expense increased
from $165 in 2003 to $325 in 2004 due to the full year effect in 2004 of interest expense on our long-term loan.

Income Taxes Provision
(Benefit).Provision (benefit) is made for taxes on pre-tax income (loss). In some jurisdictions net operating loss carryforwards reduce or offset tax provisions.

2005 Compared with 2004

We had a tax benefit of $1,059 in 2005 as a result of a significant pre-tax
loss compared to a tax provision of $78 in 2004 as a result of a small pre-tax profit. The effective income tax rate in 2005 was 5.1% as the majority of our asset impairment and restructuring and other charges were in the U.S., where we are already
in a net operating loss carryforward position and cannot record a tax benefit for our losses because we have a valuation allowance established against our deferred income tax assets. We also benefited from legal entity losses in Germany and the
elimination of a tax contingency of $686 in a foreign location upon the closing of certain tax years by the tax authorities. In the fourth quarter 2005, we determined that it was more likely than not that we would not be able to realize the future
benefit of the deferred income tax asset of our Australian subsidiary due to continuing losses at that subsidiary and, accordingly, we recorded a valuation allowance of $1,179, which decreased the tax benefit. Income taxes in the U.S. and various
foreign locations have been largely negated by our net operating loss carryforwards. The U.S. tax provisions in 2005 and 2004 resulted from the alternate minimum tax and state taxes. Net operating loss carryforwards available to offset future
taxable income as of December 31, 2005 were $32,768 in the U.S. and $10,166 outside the U.S. We have maintained a full valuation allowance on our U.S. and all of our non-U.S. deferred income tax assets with the exception of Germany, and we
periodically assess the realization of these deferred income tax assets in that country.



27



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2004 Compared with 2003

The effective income tax rate was 16.0% in 2004 compared to 68.5% in 2003. We were profitable in certain foreign locations and provided income taxes
accordingly. Income taxes on U.S. profits were largely negated by our net operating loss carryforwards. The U.S. tax provisions in 2004 and 2003 resulted from the alternate minimum tax and state taxes. We maintained a full valuation allowance on our
U.S. and the majority of our non-U.S. deferred income tax assets.

LIQUIDITY AND CAPITAL RESOURCES

Net cash used in operating activities was $5,854 in 2005. Negative cash flow resulted from a net loss of $19,608, as positively affected by certain
non-cash expenses including depreciation and amortization of $5,383, stock-based compensation of $336, foreign currency losses of $700, deferred income taxes of $263 and asset impairment charges of $7,511. Negative cash flow also resulted from an
increase in accounts receivable of $259 and an increase in inventory of $1,217. The increase in inventory was primarily the result of an inventory build for new product launches. These negative cash flow items were partially offset by cash provided
by increases in accounts payable, accrued expenses and deferred revenue of $982 and a decrease in other assets of $55. The increase in accounts payable, accrued expenses and deferred revenue was primarily the result of the net accrued earn-out to
the former owners of Tympany.

Net cash provided by operating activities was $3,349 in 2004. Positive cash flow resulted from net income of
$411, as positively affected by certain non-cash expenses including depreciation and amortization of $3,558, stock-based compensation of $28 and deferred income taxes of $1,898, and negatively by non-cash foreign currency gains of $570. In addition,
cash was provided by decreases in accounts receivable of $1,788, inventories of $840 and other assets of $491. These net positive cash flow items were partially offset by cash used to reduce accounts payable and accrued expenses and less cash
received for items accounted for as deferred revenue totaling $5,095. The decrease in accounts receivable from December 31, 2003 to December 31, 2004 related mainly to lower U.S. sales in the fourth quarter 2004 compared to the fourth
quarter 2003 and to the sales mix variation throughout the world (as customers in certain geographies pay faster than others).

Net cash
used in operating activities was $2,048 in 2003. Positive cash flow resulted from net income of $376, as positively affected by non-cash expenses including depreciation and amortization of $2,812, stock-based compensation of $118 and deferred income
taxes of $290, and negatively by non-cash foreign currency gains of $1,610. These positive cash flow items were offset by (i) cash used to reduce accounts payable and accrued expenses and less cash received for items accounted for as deferred
revenue totaling $1,106; and (ii) cash used to increase accounts receivable by $2,378, inventory by $340 and other assets by $210 principally as a result of European working capital growth.

Net cash provided by investing activities of $8,758 in 2005 resulted from proceeds from the maturity of marketable securities of $12,803 and repayments
of customer investments and advances of $1,573. These cash inflows were offset somewhat by cash paid for (i) contingent consideration in the form of earn-out payments relating to prior years acquisitions of $2,333; the purchase of technology
licenses of $375; and (ii) purchases of property and equipment of $2,910.

Net cash used in investing activities of $11,300 in 2004
resulted from cash paid for (i) the acquisitions of Tympany and several foreign retail stores (net of all cash acquired) of $3,551; (ii) contingent consideration in the form of earn-out payments relating to prior year acquisitions made in
Germany and Denmark of $1,807; (iii) the purchase of assets related to a product line of $198; (iv) purchases of property and equipment of $5,773; and (v) the net purchase of marketable securities of $73. These cash outflows were
offset slightly by prepayments of customer advances of $102.

Net cash used in investing activities of $11,142 in 2003 resulted from cash
paid for (i) the acquisition of a German distribution business of $13,414, less cash received of $5,768; (ii) other acquisition activity of $635; (iii) purchases of property and equipment of $2,292; and (iv) the net purchase of
marketable securities of $815. These cash outflows were offset slightly by repayments of customer advances of $246.



28



---

Net cash used in financing activities of $2,597 in 2005 resulted from payments to the former owners of
our German business of amounts collected on certain accounts receivable that were written-off prior to the acquisition of $5,136 and loan principal payments of $1,247. These negative cash flow items were offset somewhat by stock option exercises and
shares issued under our employee stock purchase plan of $845 and net proceeds from restricted cash, cash equivalents and marketable securities no longer needed to collateralize a letter of credit of net $2,941.

Net cash provided by financing activities of $7,063 in 2004 resulted from proceeds from (i) the collection of certain accounts receivable that were
written-off prior to the acquisition and which are payable to the former owners of our German business of $5,136; (ii) stock option exercises and shares issued under our employee stock purchase plan of $2,643; and (iii) a decrease in
restricted cash, cash equivalents and marketable securities of $526. These positive cash flow items were partially offset by loan principal payments of $1,242.

Net cash provided by financing activities of $7,403 in 2003 resulted from proceeds from (i) a long-term loan to fund the acquisition of a German distribution business of $8,445 and (ii) stock option
exercises and shares issued under our employee stock purchase plan of $1,253. This was offset, in part, by repayment of long-term principal obligations of $399 and the transfer of a portion of our cash and cash equivalents to collateralize a letter
of credit of $1,896.

Our cash and marketable securities, including restricted amounts, totaled $16,249 as of December 31, 2005. In
2006, we have a number of items that will negatively affect our cash balance. The more significant items follow:



| |  |  | We will incur a net loss in the first quarter.
| | - |  | ----------------------------------------------



| |  |  | We will make cash payments for restructuring charges accrued in 2005.
| | - |  | ---------------------------------------------------------------------



| |  |  | We will make payments on our long-term loan.
| | - |  | --------------------------------------------



| |  |  | We will make earn-out payments in connection with previous acquisitions.
| | - |  | ------------------------------------------------------------------------

In addition, we may use cash to fund acquisitions of complementary businesses and technologies and to make customer loans. We believe that our cash and marketable securities balance will be adequate to meet our
operating, working capital and investment requirements for 2006.

Commitments.Our contractual obligations as of December 31,
2005 were as follows:



|                                                |  |       |        |                                   |   |             |  |             |       |            |   |       |  |   |    
|----------------------------------------------- |  | ----- | ------ | --------------------------------- | - | ----------- |  | ----------- | ----- | ---------- | - | ----- |  | - | ---
|                                                |  |       |        | For the years ending December 31,
|                                                |  | Total |        | 2006                              |   | 2007  2008 |  | 2009  2010 |       | After 2010
|Long-term debt including interest               |  | $     | 6,865  |                                   | $ | 1,406       |  | $           | 2,673 |            | $ | 2,484 |  | $ | 302
|Operating leases                                |  |       | 10,194 |                                   |   | 3,235       |  |             | 5,082 |            |   | 1,661 |  |   | 216
|Purchase commitments                            |  |       | 4,318  |                                   |   | 4,318       |  |             |      |            |   |      |  |   |   
|Acquisition related earn-out payments (maximum) |  |       | 1,776  |                                   |   | 1,776       |  |             |      |            |   |      |  |   |   
|Minimum royalty payments                        |  |       | 320    |                                   |   | 160         |  |             | 160   |            |   |      |  |   |   
|                                                |  |       |        |                                   |   |             |  |             |       |            |   |       |  |   |    
|Total                                           |  | $     | 23,473 |                                   | $ | 10,895      |  | $           | 7,915 |            | $ | 4,145 |  | $ | 518
|                                                |  |       |        |                                   |   |             |  |             |       |            |   |       |  |   |    

In addition to the commitments listed above, we will make earn-out payments in connection with our
acquisition of Tympany according to the following schedule: 2006  35% of net product revenue, plus 10% of net hearing aid sales in excess of 105% of a base amount; and 2007  20% of the lower of 2007 or 2006 net product revenue, plus 35%
of any excess of 2007 net product revenue over 2006 net product revenue, plus 10% of 2006 net hearing aid sales in excess of 110% of a base amount. Payments will be made semi-annually in a combination of cash (60%) and our common stock (40%).
The 2005 earn-out is in dispute and has not been paid, but has been accrued in the amount of $1,843 as of December 31, 2005. We anticipate resolving this dispute in 2006.



29



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Recent Accounting Pronouncements.In December 2004, the Financial Accounting Standards Board
(FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123R, Share-Based Payment, which revised SFAS No. 123, Accounting for Stock-Based Compensation, and superseded Accounting
Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the
financial statements based on their fair values. The pro forma disclosures previously permitted under SFAS No. 123 will no longer be an alternative to financial statement recognition. The new standard may be adopted using either the modified
prospective method or the modified retrospective method. In March 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment, which clarified the
SECs expectations with regard to the assumptions underlying the fair value estimates of options. We will no longer be permitted to follow the intrinsic value accounting method of APB No. 25. APB No. 25 resulted in no expense being
recorded for stock option grants for which the strike price was equal to the fair value of the underlying stock on the date of grant, which has been the situation for the Company prior to 2006. SFAS No. 123R became effective for us in the first
quarter of 2006. We will determine the fair value of share-based equity instruments issued to employees subsequent to January 1, 2006 using the Black-Scholes option-pricing model for stock options to calculate the amount of compensation cost
that must be recognized in the financial statements as a result of adopting SFAS No. 123R. The dividend yield, volatility and risk-free interest rate assumptions will be estimated in a manner consistent with the methodology disclosed in Note 14
to the consolidated financial statements. We estimate that the financial effect of adopting SFAS No. 123R will be to decrease 2006 earnings by approximately $0.02 to $0.03 per share.

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, which replaces APB Opinion No. 20,
Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements, and requires that a voluntary change in accounting principle be applied retrospectively to all prior period financial
statements presented, unless it is impracticable to do so. SFAS No. 154 also provides that a change in method of depreciating or amortizing a long-lived non-financial asset be accounted for as a change in estimate effected by a change in
accounting principle, and also provides that correction of errors in previously issued financial statements should be termed a restatement. SFAS No. 154 is effective for fiscal years beginning after December 15, 2005. We do not
believe the adoption of SFAS No. 154 will have a material effect on our results of operations and financial position.

In November
2005, the FASB issued FASB Staff Position No. FAS 115-1 (FAS 115-1) The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. FAS 115-1 provides accounting guidance for determining and
measuring other-than-temporary impairments of debt and equity securities, and confirms the disclosure requirements for investments in unrealized loss positions as outlined in Emerging Issues Task Force Issue 03-01, The Meaning of
Other-Than-Temporary Impairments and its Application to Certain Investments. The accounting requirements of FAS 115-1 are effective for us on January 1, 2006, and will not have a material effect on our results of operations and financial
position.

CRITICAL ACCOUNTING POLICIES

The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the results we report in our consolidated financial statements. The SEC has defined the most
critical accounting policies as the ones that are most important to the portrayal of our operating results and financial condition and which require us to make our most difficult and subjective judgments, often based on matters that are highly
uncertain at the time of estimation. Based on this definition, our most critical policies include: revenue recognition (including sales returns), warranty accruals, valuation of intangible assets and income taxes. Below, we discuss these policies
further, as well as the estimates and judgments involved. We also have other key accounting policies and accounting estimates relating to uncollectible accounts receivable and valuation of inventory. We believe that these other key accounting
policies and other accounting estimates either do not generally require us to make estimates and judgments that are as difficult or as subjective, or it is less likely that they would have a material impact on our results of operations and financial
condition for a given period.



30



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Revenue Recognition

Sales of hearing aids are recognized when (i) products are shipped, except for retail hearing aid sales, which are recognized upon acceptance by the consumer, (ii) persuasive evidence of an arrangement
exists, (iii) title and risk of loss has transferred, (iv) the price is fixed and determinable, (v) contractual obligations have been satisfied, and (vi) collectibility is reasonably assured. We apply the provisions of Statement
of Position (SOP) 97-02, Software Revenue Recognition, as amended by SOP 98-09 to our auditory testing equipment operating segment. SOP 97-02, as amended, generally requires revenue earned on software arrangements involving
multiple elements to be split between the elements such as software products and technical support. The fair value of an element must be based on vendor-specific objective evidence, which we establish based on the price charged when the same element
is sold separately. Net sales consist of product sales less provisions for sales returns, which are made at the time of sale. We analyze the rate of historical returns by geography, by product family and by model, as appropriate, when evaluating the
adequacy of the provision for sales returns. If actual sales returns for any particular product or in any particular geography differ from our estimates, revisions to the sales returns and allowance reserve will be required. Revenues related to
sales of separately priced extended service contracts are deferred and recognized on a straight-line basis over the contractual periods.

Warranty
Accruals

Our products are sold with warranties that require us to remedy deficiencies in quality or performance over specified periods
of time. We analyze the amount of historical warranty by geography, by product family, by model and by customer, as appropriate, when evaluating the adequacy of the accrual. Warranty costs are mainly affected by product failure rates, the cost of
material and labor necessary to service the product and the cost of shipping the product to and from our customers. If actual product failure rates or repair and remake costs differ from our estimates, revisions to the warranty accrual will be
required.

Valuation of Intangible Assets

We evaluate our goodwill and indefinite-lived intangible asset (arrangement with the Australian government to supply hearing aids) on an annual basis in the fourth quarter of each year or whenever a triggering event occurs, which may be an
indicator of impairment. In conducting the evaluation, we apply various techniques to estimate fair values. These techniques are inherently subjective and the resulting values are not necessarily representative of the values we might obtain in a
sale of a reporting unit or our indefinite-lived intangible asset to a willing third party. If this evaluation indicates that the value of the goodwill and indefinite-lived intangible asset may be impaired, we make an assessment of the amount of the
impairment. Any such impairment charge could be significant and could have a material adverse effect on our results of operations and financial position. In addition, we evaluate the indefinite-lived intangible asset to determine if the life
continues to be indefinite.

We evaluate our definite-lived intangible assets for indications of impairment whenever events or
changes in circumstances indicate that the carrying value may not be recoverable. Definite-lived intangible assets include technology, brand names, distribution agreements, customer relationships and databases, trademarks, trade-names and covenants
not to compete. Factors that could trigger an impairment review include significant under-performance relative to expected historical or projected future operating results, significant changes in the manner of our use of the acquired assets or the
strategy for our overall business, or significant negative industry or economic trends. If this evaluation indicates that the value of an asset may be impaired, we make an assessment of the recoverability of the net carrying value of the asset over
its remaining useful life. If the asset is not recoverable based on the estimated undiscounted future cash flows of the acquired entity or technology over the remaining amortization period, we will reduce the carrying value of the related asset to
fair value and may adjust the remaining amortization period. Any such impairment charge could be significant and could have a material adverse effect on our results of operations and financial position.

Income Taxes

The relative proportions of our domestic and foreign
income directly affect our effective income tax rate. We are also subject to changing tax laws in the multiple jurisdictions in which we operate. As of December 31, 2005, we had a valuation allowance against certain deferred income tax assets
of $20,982 and a net deferred income tax liability totaling $339. We currently do not believe it is more likely than not that our results of future operations will generate sufficient taxable income to utilize our net deferred income tax assets in
various tax jurisdictions. We consider future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for any valuation allowance, and if we determine we would be able to realize all or part of our net deferred
income tax assets in the future, we would adjust the valuation allowance in the period we make that determination. We do not provide for U.S. income taxes on the earnings of our foreign subsidiaries because they are considered permanently invested
outside of the U.S.

FORWARDLOOKING STATEMENTS

This Form 10-K, which should be read in conjunction with the consolidated financial statements and related notes, contains forward-looking statements that involve risks and uncertainties. These statements refer to our
future results, plans, objectives, expectations and intentions including statements regarding: our mission to improve the quality of life of the hearing impaired; reducing the barriers to diagnosing and treating hearing loss and ear disorders with
the Otogram; engaging physicians in their patients hearing health with the Otogram; demographic trends accelerating the growth in the size of the hearing impaired population; the long-term growth potential of the hearing aid market being
significantly better



31



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than the current growth rate; negative factors impacting hearing aid market growth rates today to decrease in importance in the future; hearing aid prices
decreasing in the future; hearing aids becoming smaller, less conspicuous and more comfortable through improvements in technology; more people who could benefit from hearing aids actually buying hearing aids in the future; significant growth of the
hearing impaired population, particularly as the developed worlds population ages; the market for hearing aids increasing significantly; developing the Innova platform technology into a broad product line of full-featured hearing aids;
introducing our first open-ear product, Ion, in 2006; Ion providing a significant opportunity to increase net sales; the Companys financial performance significantly improving; Tympanys financial performance improving; improved
profitability in each country in which we have a direct operation; sales of Ion being largely incremental; Ion being particularly helpful for first time hearing aid wearers; Ion being smaller, lighter and more powerful than competing open-ear
products; becoming more customer-centric; to be the hearing healthcare provider of choice; U.S. sales in the first quarter 2006 to be modest but to significantly improve beginning in the second quarter 2006 with the introduction of Ion; introducing
Natura Pro in the second quarter 2006; European and Rest-of-world sales increasing in 2006 and benefiting from the Innova, Applause, Natura Pro and Ion introductions; introducing new products at a fast enough rate to keep our overall average selling
price from declining and improve our gross margin; our overall average selling price to increase in 2006; unit volume increasing and resulting in better overhead absorption because little incremental overhead will be required to support increased
volume; gross margin improvement beginning in the second quarter 2006 depending on overhead absorption, purchased component and assembly costs, sales return rates and more off-shore outsourcing; Tympany gross margin improving significantly in 2006;
selling, general and administrative expense decreasing modestly in dollars, but significantly as a percentage of net sales, in 2006; research and development expense increasing in dollars but decreasing as a percentage of net sales in 2006;
expensing of Tympany earn-out payments until expected cash flows support additional valuation, at which time earn-out payments would be capitalized; other income/expense being relatively minimal per quarter in 2006; financial impact in 2006 of
adopting SFAS 123R; use of tax credits; financial instrument and customer credit risks; and sufficiency of cash to fund our operations in 2006. Our actual results could differ materially and adversely from those anticipated in such forward-looking
statements.

Factors that could contribute to these differences include, but are not limited to, the following risks: we have a history of
losses and negative cash flow; we face aggressive competition in our business, mainly from six substantially larger competitors; our financial results and stock price have fluctuated in the past and may fluctuate in the future; acquisitions could be
difficult to integrate, disrupt our business, result in litigation, dilute the equity of our shareholders and subject us to amortization expense and/or write-down of intangible assets; our internal control over financial reporting may not be
considered effective; we may lose a large customer or suffer a reduction in orders from a large customer and may be unable to collect significant receivable balances; we rely on several suppliers and contractors who may be unwilling or unable to
meet our product, service or contracting requirements; we have high rates of returns, remakes and repairs; we must have innovative, technologically superior products to compete effectively and gain market share; our products, due to their
complexity, may contain errors or defects that are discovered by our customers, thus harming our reputation and business; we may have issues with infringing on others intellectual property; we may have issues protecting our proprietary
technology; we are dependent on international operations, particularly in Germany and Australia, which exposes us to a variety of risks that could result in lower international sales; new accounting rules relating to stock-based compensation will
negatively affect our results beginning in 2006; we could be sued for product liability; we could suffer penalties, injunctions or fines if we fail to comply with U.S. Food and Drug Administration regulations or various sales related laws; our stock
price could suffer due to sales of stock by our directors and officers; and provisions in our charter documents, shareholder rights plan and Delaware law could deter any takeover of the Company. These factors are discussed in detail in the section
titled, Factors That May Affect Future Performance included in Item 1 of this Form 10-K. Investors should understand that it is not possible to predict or identify all such factors that could cause actual results to differ from
expectations, and we are under no obligation to update these factors.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (in
thousands)

Interest Rate Risk.We generally invest our cash in money market funds and corporate debt securities that are subject
to minimal credit and market risk considering that they are short-term (expected maturities of 18 months or less from date of purchase) and provided that we hold them to maturity, which is our intention. As of December 31, 2005, we had $3,058
held in investments in U.S. government obligations that carry an effective fixed interest rate of 2.6% and long-term debt which carries an interest rate of 1% above the EURIBOR rate (3.42% as of December 31, 2005). A hypothetical one percentage
point change in interest rates would not have had a material effect on our results of operations and financial position. The interest rates on our customer advances approximates the market rates for comparable instruments and are fixed. Given
current interest rates, we believe the market risks associated with these financial instruments are minimal.

Derivative
Instruments. We may enter into readily marketable forward contracts with financial institutions to minimize the short-term impact of foreign currency fluctuations on certain intercompany balances. We do not enter into these contracts for trading
or speculation purposes. Gains and losses on the contracts are included in the results of operations and offset foreign exchange gains or losses recognized on the revaluation of certain intercompany balances. Our foreign exchange forward contracts
generally mature one to three months from the contract date.



32



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Foreign Currency Risk. We face foreign currency risks primarily as a result of the revenues we
derive from sales made outside the U.S., expenses incurred outside the U.S., and from intercompany account balances between our U.S. parent and our non-U.S. subsidiaries. In 2005, approximately 63% of our net sales and 43% of our operating expenses
were denominated in currencies other than the U.S. dollar. Inventory purchases were transacted in U.S. dollars. The local currency of each foreign subsidiary is considered the functional currency, and revenue and expenses are translated at average
exchange rates for the reported periods. Therefore, our foreign sales and expenses will be higher in a period in which there is a weakening of the U.S. dollar and will be lower in a period in which there is a strengthening of the U.S. dollar. The
Australian dollar, Euro, and Danish kroner are our most significant foreign currencies. Given the uncertainty of exchange rate fluctuations and the varying performance of our foreign subsidiaries, we cannot estimate the affect of these fluctuations
on our future business, results of operations and financial condition. Fluctuations in the exchange rates between the U.S. dollar and other currencies could effectively increase or decrease the selling prices of our products in international markets
where the prices of our products are denominated in U.S. dollars. We regularly monitor our foreign currency risks and may take measures to reduce the impact of foreign exchange fluctuations on our operating results. To date, we have not used
derivative financial instruments for hedging, trading or speculating on foreign currency exchange, except to hedge intercompany balances. Average currency exchange rates to convert one U.S. dollar into each local currency for which we had sales of
over $5,000 in 2005 were as follows:



|                  |  |      |  |      |  |     
|----------------- |  | ---- |  | ---- |  | ----
|                  |  | 2005 |  | 2004 |  | 2003
|Australian dollar |  | 1.31 |  | 1.36 |  | 1.54
|Euro              |  | 0.80 |  | 0.81 |  | 0.89
|Danish kroner     |  | 6.00 |  | 5.99 |  | 6.58

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Financial statement information is set forth in Item 15 of this Form 10-K. Supplementary data is set forth in Item 6 of this Form 10-K.

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

There have been no changes in and disagreements with accountants on accounting and financial disclosure.

ITEM 9A. CONTROLS AND PROCEDURES.

We maintain
disclosure controls and procedures within the meaning of Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the Exchange Act). Our disclosure controls and procedures are designed to ensure that information
required to be disclosed by the Company in our reports filed under the Exchange Act, such as this Form 10-K, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commissions
(SECs) rules and forms. Our disclosure controls and procedures are also designed to ensure that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer,
to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating and implementing possible controls and procedures.

Evaluation of Disclosure Controls and Procedures. As of December 31, 2005, we evaluated the effectiveness of the design and operation of the
Companys disclosure controls and procedures, which was done under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer. Exhibits 31.1 and 31.2 of this Form 10-K are
certifications of our Chief Executive Officer and Chief Financial Officer, which are required in accordance with Rule 13a-14(a) and Rule 15d-14(a) of the Exchange Act. This Controls and Procedures section includes the information concerning the
controls evaluation referred to in the certifications and it should be read in conjunction with the certifications for a more complete understanding of the topics presented. Based on the controls evaluation, our Chief Executive Officer and Chief
Financial Officer have concluded that, as of the date of their evaluation, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is
made known to management, including our Chief Executive Officer and Chief Financial Officer, and that such information is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms.



33



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Change in Internal Control over Financial Reporting. There were no significant changes in our
internal control over financial reporting during our most recent fiscal quarter that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Managements Report on Internal Control over Financial Reporting. Our management is responsible for establishing and maintaining adequate
internal control over financial reporting. Our system of internal control over financial reporting within the meaning of Rules 13a-15(f) and 15d-15(f) of the Exchange Act is designed to provide reasonable assurance to our management and board of
directors regarding the preparation and fair presentation of our published financial statements in accordance with U.S. generally accepted accounting principles. All internal control systems, no matter how well designed, have inherent limitations.
Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

Our management assessed the effectiveness of our system of internal control over financial reporting as of December 31, 2005. In making this assessment, we used the criteria set forth by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on our assessment we believe that, as of December 31, 2005, our system of internal control over financial reporting was effective to
provide reasonable assurance regarding the reliability of our financial reporting and the preparation of our published financial statements in accordance with U.S. generally accepted accounting principles.

Attestation Report of the Independent Registered Public Accounting Firm. KPMG LLPs report on managements assessment of the
effectiveness of our system internal control over financial reporting as of December 31, 2005 is included on page F-2 of this Form 10-K.

ITEM 9B. OTHER INFORMATION.

None.



34



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PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by this item regarding
Section 16(a) compliance, the Audit Committee, the Companys Code of Ethics for Principal Executive and Senior Financial Officers and background of the directors set forth under the captions Share Ownership by Certain Beneficial
Owners and Management, Governance of the Company, Election of Directors and Section 16(a) Beneficial Ownership Reporting Compliance of the Companys definitive Proxy Statement for the May 12, 2006
Annual Meeting of Stockholders to be filed within 120 days after our fiscal year end of December 31, 2005 (Proxy Statement) is hereby incorporated by reference. Information concerning our executive officers is set forth in Part I,
Item 1 of this Form 10-K.

ITEM 11. EXECUTIVE COMPENSATION

The information required by this item set forth under the captions Executive Compensation and Other Information and Director Compensation of the Proxy Statement is incorporated herein by
reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by this item set forth under the caption Share Ownership by Certain Beneficial Owners and Management of the Proxy
Statement is incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

The information required by this item set forth under the caption Certain Relationships and Related Party Transactions of the Proxy Statement
is incorporated herein by reference.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this item set forth under the caption Ratification of Appointment of the Independent Auditors of the Proxy
Statement is incorporated herein by reference.

PART IV

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES



|(a) | LIST OF DOCUMENTS FILED AS PART OF THIS REPORT
|--- | ----------------------------------------------



| | 1. | FINANCIAL STATEMENTS
| | -- | --------------------

The following
consolidated financial statements and reports of the independent registered public accounting firm are included herein as a separate section beginning on page F-1 of this report:



|                                                                                                                                     |  |         
|------------------------------------------------------------------------------------------------------------------------------------ |  | --------
|                                                                                                                                     |  | Page No.
|Reports of Independent Registered Public Accounting Firm                                                                             |  | F-1     
|                                                                                                                                     | 
|Consolidated Balance Sheets as of December 31, 2005 and 2004                                                                         |  | F-3     
|                                                                                                                                     | 
|Consolidated Statements of Operations for the years ended December 31, 2005, 2004 and 2003                                           |  | F-4     
|                                                                                                                                     | 
|Consolidated Statements of Shareholders Equity and Comprehensive Income (Loss) for the years ended December 31, 2005, 2004 and 2003 |  | F-5     
|                                                                                                                                     | 
|Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004 and 2003                                           |  | F-6     
|                                                                                                                                     | 
|Notes to Consolidated Financial Statements                                                                                           |  | F-7     



35



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| | 2. | FINANCIAL STATEMENT SCHEDULE
| | -- | ----------------------------

The
following financial statement schedule is filed as part of this Form 10-K:



|                |  |                                   |  |            
|--------------- |  | --------------------------------- |  | -----------
|SCHEDULE NUMBER |  | DESCRIPTION                       |  | PAGE NUMBER
|II              |  | Valuation and Qualifying Accounts |  | 38         

The report of independent registered public accounting firm with respect to the Companys
financial statement schedule is on page 39. All other financial statement schedules not listed have been omitted because the required information is included in the consolidated financial statements or notes thereto, or is not applicable.



| | 3. | EXHIBITS
| | -- | --------



|               |  |                                                                                                                                                                                                                      
|-------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Exhibit Description                                                                                                                                                                                                  
|2.1(7)         |  | Sale and Purchase Agreement Between the Selling Shareholders of Sanomed Handelsgesellschaft mbH and PALME Verwaltungsgesellschaft mbH and the registrant.                                                            
|               | 
|2.2(8)         |  | Agreement and Plan of Reorganization By and Among the registrant, Saxophone Merger Sub, Inc., Saxophone Acquisition Corporation, Tympany, Inc., the Shareholders of Tympany, Inc. and the
Shareholder Representative.
|               | 
|3.2(1)         |  | Amended and Restated Bylaws and Articles of Incorporation of the registrant.                                                                                                                                         
|               | 
|10.1(1)        |  | Form of indemnification agreement entered into by the registrant with its directors and executive officers.                                                                                                          
|               | 
|10.2(9)#       |  | Form of management continuity agreement entered into by the registrant with its executive officers.                                                                                                                  
|               | 
|10.3(5)#       |  | 2000 Stock Plan and form of agreements thereunder.                                                                                                                                                                   
|               | 
|10.4(4)#       |  | 2000 Employee Stock Purchase Plan.                                                                                                                                                                                   
|               | 
|10.5(3)        |  | Preferred Stock Rights Agreement dated as of March 27, 2001 between the registrant and American Stock Transfer & Trust Company.                                                                                      
|               | 
|10.6(1)        |  | Amended and Restated License Agreement dated March 21, 2000 between the registrant and Brigham Young University.                                                                                                     
|               | 
|10.7(1)        |  | Amended and Restated Exclusive License Agreement dated March 21, 2000 between the registrant and Brigham Young University.                                                                                           
|               | 
|10.8(2)        |  | Subscription Agreement between K/S HIMPP and the registrant dated September 13, 2000.                                                                                                                                
|               | 
|10.9(2)        |  | Patent License Agreement between K/S HIMPP and the registrant dated September 13, 2000.                                                                                                                              
|               | 
|10.10(1)       |  | Lease Agreement dated April 28, 1999 between the registrant and 2795 E. Cottonwood Parkway, L.C.                                                                                                                     
|               | 
|10.11(6)       |  | Amendment to Lease Agreement dated April 28, 1999 between the registrant and 2795 E. Cottonwood Parkway, L.C.                                                                                                        
|               | 
|10.12(1)#      |  | Letter Agreement dated September 24, 1999 between the registrant and Stephen L. Wilson.                                                                                                                              
|               | 
|10.13(11) #    |  | Employment Agreement dated as of November 1, 2005 between the registrant and Andrew G. Raguskus.                                                                                                                     
|               | 
|10.14(11) #    |  | Employment Agreement dated as of October 27, 2005 between the registrant and Samuel L. Westover                                                                                                                      
|               | 
|10.15#         |  | Letter Agreement dated July 6, 2000 between the registrant and Jerry L. DaBell                                                                                                                                       
|               | 
|10.16#         |  | Management Bonus Program for 2006.                                                                                                                                                                                   
|               | 
|21.1           |  | Subsidiaries of the registrant.                                                                                                                                                                                      



36



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|               |  |                                                                                                                                                                       
|-------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Exhibit Description                                                                                                                                                   
|23.1           |  | Consent of independent registered public accounting firm.                                                                                                             
|               | 
|31.1           |  | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.                                    
|               | 
|31.2           |  | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act, as amended.                                    
|               | 
|32             |  | Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

---

|(1) | Incorporated by reference from the registrants Registration Statement on Form S-1 (file
no. 333-30566), as amended.
|--- | --------------------------------------------------------------------------------------------------------------------

|(2) | Incorporated by reference from the registrants Annual Report on Form 10-K for the year
ended December 31, 2000.
|--- | ----------------------------------------------------------------------------------------------------------------

|(3) | Incorporated by reference from the registrants Registration Statement on Form 8-A filed
on April 16, 2001.
|--- | -----------------------------------------------------------------------------------------------------------

|(4) | Incorporated by reference from the registrants Registration Statement on Form S-8 filed
on August 16, 2002.
|--- | ------------------------------------------------------------------------------------------------------------

|(5) | Incorporated by reference from the registrants Registration Statement on Form S-8 filed
on August 30, 2002.
|--- | ------------------------------------------------------------------------------------------------------------

|(6) | Incorporated by reference from the registrants Quarterly Report on Form 10-Q for the
quarter ended June 20, 2004
|--- | -----------------------------------------------------------------------------------------------------------------

|(7) | Incorporated by reference from the registrants Form 8-K current report filed on
May 29, 2003.
|--- | ----------------------------------------------------------------------------------------------

|(8) | Incorporated by reference from the registrants Form 8-K Current Report filed on
December 10, 2004.
|--- | ---------------------------------------------------------------------------------------------------

|(9) | Incorporated by reference from the registrants Annual Report on Form 10-K for the year
ended December 31, 2003.
|--- | ----------------------------------------------------------------------------------------------------------------

|(10) | Incorporated by reference from the registrants Quarterly Report on Form 10-Q for the
quarter ended March 31, 2004.
|---- | -------------------------------------------------------------------------------------------------------------------

|(11) | Incorporated by reference from the registrants Form 8-K Current Report filed on
November 2, 2005.
|---- | --------------------------------------------------------------------------------------------------

|# | Designates a management contract or compensatory plan or arrangement required to be filed as an exhibit.
|- | --------------------------------------------------------------------------------------------------------



|(b) | EXHIBITS
|--- | --------

See Item 15(a) 3.



|(c) | FINANCIAL STATEMENT SCHEDULE
|--- | ----------------------------

See
Item 15(a) 2.



37



---

Sonic Innovations, Inc.

Schedule IIValuation and Qualifying Accounts

(in thousands)



|                                              |  |      |  |                   |        |           |   |            |  |                |        |  |   |       
|--------------------------------------------- |  | ---- |  | ----------------- | ------ | --------- | - | ---------- |  | -------------- | ------ |  | - | ------
|                                              |  | Year |  | Beginning balance |        | Additions |   | Deductions |  | Ending balance
|Allowance for sales returns                   |  | 2005 |  | $                 | 2,815  |           | $ | 14,388     |  | $              | 13,735 |  | $ | 3,468 
|                                              |  | 2004 |  |                   | 3,487  |           |   | 12,595     |  |                | 13,267 |  |   | 2,815 
|                                              |  | 2003 |  |                   | 2,629  |           |   | 16,782     |  |                | 15,924 |  |   | 3,487 
|Allowance for doubtful accounts               |  | 2005 |  |                   | 1,617  |           |   | 214        |  |                | 226    |  |   | 1,605 
|                                              |  | 2004 |  |                   | 1,545  |           |   | 383        |  |                | 311    |  |   | 1,617 
|                                              |  | 2003 |  |                   | 930    |           |   | 652        |  |                | 37     |  |   | 1,545 
|Accrued restructuring                         |  | 2005 |  |                   |       |           |   | 3,991      |  |                | 1,434  |  |   | 2,557 
|Accrued warranty                              |  | 2005 |  |                   | 4,526  |           |   | 4,990      |  |                | 4,594  |  |   | 4,922 
|                                              |  | 2004 |  |                   | 4,115  |           |   | 5,136      |  |                | 4,725  |  |   | 4,526 
|                                              |  | 2003 |  |                   | 3,613  |           |   | 3,924      |  |                | 3,422  |  |   | 4,115 
|Inventory reserves(1)                         |  | 2005 |  |                   | 1,553  |           |   | 1,431      |  |                | 1,510  |  |   | 1,474 
|                                              |  | 2004 |  |                   | 1,864  |           |   | 1,400      |  |                | 1,711  |  |   | 1,553 
|                                              |  | 2003 |  |                   | 1,111  |           |   | 1,133      |  |                | 380    |  |   | 1,864 
|Deferred income tax asset valuation allowance |  | 2005 |  |                   | 16,078 |           |   | 5,705      |  |                | 801    |  |   | 20,982
|                                              |  | 2004 |  |                   | 14,348 |           |   | 3,648      |  |                | 1,918  |  |   | 16,078
|                                              |  | 2003 |  |                   | 15,102 |           |   | 1,470      |  |                | 2,224  |  |   | 14,348

---

|(1) | Includes reserves for excess and obsolete inventory and for product (inventory) returns.
Provision is made to (i) reduce excess and obsolete inventories to their estimated net realizable values and (ii) for estimated product (inventory) returns in those countries that sell hearing aids on a retail basis and recognize a sale
only upon acceptance by the consumer.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



38



---

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Sonic Innovations, Inc.:

Under date of March 15, 2006, we reported on the consolidated balance sheets of Sonic Innovations, Inc. and subsidiaries as of December 31,
2005 and 2004, and the related consolidated statements of operations, shareholders equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2005, which are included in the Sonic
Innovations, Inc. Annual Report on Form 10-K. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedule in the Annual Report on Form 10-K. This
financial statement schedule is the responsibility of the Companys management. Our responsibility is to express an opinion on this financial statement schedule based on our audits.

In our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents
fairly, in all material respects, the information set forth therein.

Salt Lake City, Utah

March 16, 2006



39



---

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.



|                     |  |                         |  |                                                                                                                
|-------------------- |  | ----------------------- |  | ---------------------------------------------------------------------------------------------------------------
|                     |  | SONIC INNOVATIONS, INC.
|                     |  |                        
|Date: March 16, 2006 |  | By:                     |  | /S/    SAMUEL L. WESTOVER                                                                                      
|                     |  |                         |  | Samuel L. Westover President and Chief Executive Officer (Principal Executive Officer)                         
|                     |  |                        
|                     |  | By:                     |  | /S/    STEPHEN L. WILSON                                                                                       
|                     |  |                         |  | Stephen L. Wilson Senior Vice President and Chief Financial Officer and Secretary (Principal Financial
Officer)
|                     |  |                        
|                     |  | By:                     |  | /S/    MICHAEL M. HALLORAN                                                                                     
|                     |  |                         |  | Michael M. Halloran Vice President and Corporate Controller (Principal Accounting Officer)                     

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed
below by the following directors and officers on behalf of the registrant on March 15, 2006.



|    |  |                                                                                  
|--- |  | ---------------------------------------------------------------------------------
|By: |  | /S/    SAMUEL L. WESTOVER                                                        
|    |  | Samuel L. Westover President and Chief Executive Officer and Director            
|    | 
|By: |  | /S/    STEPHEN L. WILSON                                                         
|    |  | Stephen L. Wilson Senior Vice President and Chief Financial Officer and Secretary
|    | 
|By: |  | /S/    MICHAEL M. HALLORAN                                                       
|    |  | Michael M. Halloran Vice President and Corporate Controller                      
|    | 
|By: |  | /S/    JAMES M. CALLAHAN                                                         
|    |  | James M. Callahan, Director                                                      
|    | 
|By: |  | /S/    LEWIS S. EDELHEIT                                                         
|    |  | Lewis S. Edelheit, Director                                                      
|    | 
|By: |  | /S/    CRAIG L.
MCKNIGHT                                                         
|    |  | Craig L. McKnight, Director                                                      
|    | 
|By: |  | /S/    ANDREW G. RAGUSKUS                                                        
|    |  | Andrew G. Raguskus, Director                                                     
|    | 
|By: |  | /S/    KEVIN J. RYAN                                                             
|    |  | Kevin J. Ryan, Director                                                          
|    | 
|By: |  | /S/    LAWRENCE C. WARD                                                          
|    |  | Lawrence C. Ward, Director                                                       



40



---

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Sonic Innovations, Inc.:

We have audited the accompanying
consolidated balance sheets of Sonic Innovations, Inc and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, shareholders equity and comprehensive income (loss), and cash flows for each of the
years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements based on
our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all
material respects, the financial position of Sonic Innovations, Inc. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005,
in conformity with U.S. generally accepted accounting principles.

We have also audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the effectiveness of Sonic Innovations, Inc.s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal ControlIntegrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 16, 2006, expressed an unqualified opinion on managements assessment of, and the effective operation of, internal control over
financial reporting.

Salt Lake City, Utah

March 16, 2006



F-1



---

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Sonic Innovations, Inc.:

We have audited managements assessment, included in the accompanying
Managements Report on Internal Control over Financial Reporting appearing under Item 9A, that Sonic Innovations, Inc. maintained effective internal control over financial reporting as of December 31, 2005, based on criteria
established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Sonic Innovations, Inc.s management is responsible for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on managements assessment and an opinion on the effectiveness of the Companys
internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.
Our audit included obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other
procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A
companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with
generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect
the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting
principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our
opinion, managements assessment that Sonic Innovations, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal
ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Sonic Innovations, Inc. maintained, in all material respects, effective internal control over financial
reporting as of December 31, 2005, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets
of Sonic Innovations, Inc. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, shareholders equity and comprehensive income (loss), and cash flows for each of the years in the
three-year period ended December 31, 2005, and our report dated March 16, 2006, expressed an unqualified opinion on those consolidated financial statements.



|                    
|--------------------
|                    
|Salt Lake City, Utah
|March 16, 2006      



F-2



---

SONIC INNOVATIONS, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)



|                                                                                                        |  |              |         |   |      |   |         |  
|------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | - | ---- | - | ------- | -
|                                                                                                        |  | December 31, |        
|                                                                                                        |  | 2005         |         |   | 2004 |  
|ASSETS                                                                                                  |  |              |         |   |      |   |         |  
|Current assets:                                                                                         |  |              |         |   |      |   |         |  
|Cash and cash equivalents                                                                               |  | $            | 7,865   |   |      | $ | 8,221   |  
|Marketable securities                                                                                   |  |              |        |   |      |   | 10,482  |  
|Restricted cash, cash equivalents and marketable securities                                             |  |              | 8,384   |   |      |   | 10,571  |  
|Accounts receivable, net                                                                                |  |              | 14,870  |   |      |   | 16,092  |  
|Inventories                                                                                             |  |              | 10,234  |   |      |   | 9,799   |  
|Prepaid expenses and other                                                                              |  |              | 2,168   |   |      |   | 2,969   |  
|                                                                                                        |  |              |         |   |      |   |         |  
|Total current assets                                                                                    |  |              | 43,521  |   |      |   | 58,134  |  
|Long-term marketable securities                                                                         |  |              |        |   |      |   | 2,321   |  
|Restricted long-term marketable securities                                                              |  |              |        |   |      |   | 754     |  
|Property and equipment, net                                                                             |  |              | 8,772   |   |      |   | 10,086  |  
|Definite-lived intangible assets, net                                                                   |  |              | 4,311   |   |      |   | 7,328   |  
|Indefinite-lived intangible assets                                                                      |  |              | 7,245   |   |      |   | 7,646   |  
|Goodwill                                                                                                |  |              | 22,269  |   |      |   | 27,326  |  
|Other assets                                                                                            |  |              | 646     |   |      |   | 1,691   |  
|                                                                                                        |  |              |         |   |      |   |         |  
|Total assets                                                                                            |  | $            | 86,764  |   |      | $ | 115,286 |  
|                                                                                                        |  |              |         |   |      |   |         |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                    |  |              |         |   |      |   |         |  
|Current liabilities:                                                                                    |  |              |         |   |      |   |         |  
|Current portion of long-term loan                                                                       |  | $            | 1,184   |   |      | $ | 1,364   |  
|Payable to former owners of acquired businesses                                                         |  |              | 1,843   |   |      |   | 3,627   |  
|Accounts payable                                                                                        |  |              | 7,346   |   |      |   | 8,315   |  
|Accrued payroll and related expenses                                                                    |  |              | 3,221   |   |      |   | 3,085   |  
|Accrued restructuring                                                                                   |  |              | 2,557   |   |      |   |        |  
|Accrued warranty                                                                                        |  |              | 4,922   |   |      |   | 4,526   |  
|Deferred revenue                                                                                        |  |              | 3,288   |   |      |   | 5,455   |  
|Other accrued liabilities                                                                               |  |              | 3,283   |   |      |   | 5,419   |  
|                                                                                                        |  |              |         |   |      |   |         |  
|Total current liabilities                                                                               |  |              | 27,644  |   |      |   | 31,791  |  
|Long-term loan, net of current portion                                                                  |  |              | 5,033   |   |      |   | 7,161   |  
|Deferred revenue, net of current portion                                                                |  |              | 3,969   |   |      |   | 4,444   |  
|Other liabilities                                                                                       |  |              | 347     |   |      |   | 787     |  
|                                                                                                        |  |              |         |   |      |   |         |  
|Total liabilities                                                                                       |  |              | 36,993  |   |      |   | 44,183  |  
|                                                                                                        |  |              |         |   |      |   |         |  
|Commitments and contingencies (Notes 2, 5 and 12)                                                       |  |              |         |   |      |   |         |  
|Shareholders equity:                                                                                   |  |              |         |   |      |   |         |  
|Common stock, $0.001 par value; 70,000 shares authorized; 22,464 and 22,178 shares issued, respectively |  |              | 22      |   |      |   | 22      |  
|Additional paid-in capital                                                                              |  |              | 120,578 |   |      |   | 118,135 |  
|Deferred stock-based compensation                                                                       |  |              | (1,270  | ) |      |   | (8      | )
|Accumulated deficit                                                                                     |  |              | (70,405 | ) |      |   | (50,797 | )
|Accumulated other comprehensive income                                                                  |  |              | 4,619   |   |      |   | 7,524   |  
|Treasury stock; 974 shares at cost                                                                      |  |              | (3,773  | ) |      |   | (3,773  | )
|                                                                                                        |  |              |         |   |      |   |         |  
|Total shareholders equity                                                                              |  |              | 49,771  |   |      |   | 71,103  |  
|                                                                                                        |  |              |         |   |      |   |         |  
|Total liabilities and shareholders equity                                                              |  | $            | 86,764  |   |      | $ | 115,286 |  
|                                                                                                        |  |              |         |   |      |   |         |  

See accompanying notes to consolidated financial statements.



F-3



---

SONIC INNOVATIONS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)



|                                                      |  |                                  |         |   |      |   |        |  |   |        |  
|----------------------------------------------------- |  | -------------------------------- | ------- | - | ---- | - | ------ |  | - | ------ | -
|                                                      |  | For the years ended December 31, |        
|                                                      |  | 2005                             |         |   | 2004 |   | 2003   | 
|Net sales                                             |  | $                                | 105,041 |   |      | $ | 98,534 |  | $ | 87,690 |  
|Cost of sales                                         |  |                                  | 48,120  |   |      |   | 45,005 |  |   | 41,326 |  
|Asset impairment charge                               |  |                                  | 694     |   |      |   |       |  |   |       |  
|                                                      |  |                                  |         |   |      |   |        |  |   |        |  
|Gross profit                                          |  |                                  | 56,227  |   |      |   | 53,529 |  |   | 46,364 |  
|Selling, general and administrative expense           |  |                                  | 57,482  |   |      |   | 43,368 |  |   | 36,941 |  
|Research and development expense                      |  |                                  | 8,820   |   |      |   | 9,710  |  |   | 9,767  |  
|Asset impairment charge                               |  |                                  | 6,817   |   |      |   |       |  |   |       |  
|Restructuring charge                                  |  |                                  | 3,991   |   |      |   |       |  |   |       |  
|                                                      |  |                                  |         |   |      |   |        |  |   |        |  
|Operating profit (loss)                               |  |                                  | (20,883 | ) |      |   | 451    |  |   | (344   | )
|Other income, net                                     |  |                                  | 216     |   |      |   | 38     |  |   | 1,537  |  
|                                                      |  |                                  |         |   |      |   |        |  |   |        |  
|Income (loss) before income taxes                     |  |                                  | (20,667 | ) |      |   | 489    |  |   | 1,193  |  
|Income tax provision (benefit)                        |  |                                  | (1,059  | ) |      |   | 78     |  |   | 817    |  
|                                                      |  |                                  |         |   |      |   |        |  |   |        |  
|Net income (loss)                                     |  | $                                | (19,608 | ) |      | $ | 411    |  | $ | 376    |  
|                                                      |  |                                  |         |   |      |   |        |  |   |        |  
|Basic and diluted earnings (loss) per common share:   |  |                                  |         |   |      |   |        |  |   |        |  
|Basic                                                 |  | $                                | (0.92   | ) |      | $ | 0.02   |  | $ | 0.02   |  
|                                                      |  |                                  |         |   |      |   |        |  |   |        |  
|Diluted                                               |  | $                                | (0.92   | ) |      | $ | 0.02   |  | $ | 0.02   |  
|                                                      |  |                                  |         |   |      |   |        |  |   |        |  
|Weighted average number of common shares outstanding: |  |                                  |         |   |      |   |        |  |   |        |  
|Basic                                                 |  |                                  | 21,382  |   |      |   | 20,733 |  |   | 19,941 |  
|                                                      |  |                                  |         |   |      |   |        |  |   |        |  
|Diluted                                               |  |                                  | 21,382  |   |      |   | 22,152 |  |   | 20,971 |  
|                                                      |  |                                  |         |   |      |   |        |  |   |        |  

See accompanying notes to consolidated financial statements.



F-4



---

SONIC INNOVATIONS, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY

AND COMPREHENSIVE INCOME (LOSS)

(in
thousands)



|                                                                     |  |              |  |                            |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |        |   |  |   |        |   |  |   |         |  
|-------------------------------------------------------------------- |  | ------------ |  | -------------------------- | -- |  | ------------------------------- | ------- | - | ------------------ | - | ------ | ------------------------------------------ |  | - | ------------- | - |  | ------------------------ | ------ | - |  | - | ------ | - |  | - | ------- | -
|                                                                     |  | Common
Stock |  | Additional Paid-in Capital |    |  | DeferredStock-basedCompensation |         |   | AccumulatedDeficit |   |        | AccumulatedOtherComprehensiveIncome (Loss) |  |   | TreasuryStock |   |  | TotalShareholdersEquity |       
|                                                                     |  | Shares       |  | Amount                     |    |  |                                 |         |   |                   
|Balance, December 31, 2002                                           |  | 20,686       |  | $                          | 21 |  | $                               | 113,434 |   |                    | $ | (156   | )                                          |  | $ | (51,584       | ) |  | $                        | 1,533  |   |  | $ | (3,403 | ) |  | $ | 59,845  |  
|Comprehensive income:                                                |  |              |  |                            |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |        |   |  |   |        |   |  |   |         |  
|Net income                                                           |  |             |  |                            |   |  |                                 |        |   |                    |   |       |                                            |  |   | 376           |   |  |                          |       |   |  |   |       |   |  |   | 376     |  
|Foreign currency translation adjustment                              |  |             |  |                            |   |  |                                 |        |   |                    |   |       |                                            |  |   |              |   |  |                          | 3,831  |   |  |   |       |   |  |   | 3,831   |  
|                                                                     |  |              |  |                            |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |        |   |  |   |        |   |  |   |         |  
|Comprehensive income                                                 |  |              |  |                            |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |        |   |  |   |        |   |  |   | 4,207   |  
|Exercise of stock options and employee stock purchase plan issuances |  | 484          |  |                            |   |  |                                 | 1,253   |   |                    |   |       |                                            |  |   |              |   |  |                          |       |   |  |   |       |   |  |   | 1,253   |  
|Treasury stock acquired in acquisition, 100 shares                   |  |             |  |                            |   |  |                                 |        |   |                    |   |       |                                            |  |   |              |   |  |                          |       |   |  |   | (370   | ) |  |   | (370    | )
|Stock-based compensation                                             |  |             |  |                            |   |  |                                 | (2      | ) |                    |   | 120    |                                            |  |   |              |   |  |                          |       |   |  |   |       |   |  |   | 118     |  
|                                                                     |  |              |  |                            |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |        |   |  |   |        |   |  |   |         |  
|Balance, December 31, 2003                                           |  | 21,170       |  |                            | 21 |  |                                 | 114,685 |   |                    |   | (36    | )                                          |  |   | (51,208       | ) |  |                          | 5,364  |   |  |   | (3,773 | ) |  |   | 65,053  |  
|Comprehensive income:                                                |  |              |  |                            |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |        |   |  |   |        |   |  |   |         |  
|Net income                                                           |  |             |  |                            |   |  |                                 |        |   |                    |   |       |                                            |  |   | 411           |   |  |                          |       |   |  |   |       |   |  |   | 411     |  
|Foreign currency translation adjustment                              |  |             |  |                            |   |  |                                 |        |   |                    |   |       |                                            |  |   |              |   |  |                          | 2,160  |   |  |   |       |   |  |   | 2,160   |  
|                                                                     |  |              |  |                            |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |        |   |  |   |        |   |  |   |         |  
|Comprehensive income                                                 |  |              |  |                            |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |        |   |  |   |        |   |  |   | 2,571   |  
|Exercise of stock options and employee stock purchase plan issuances |  | 812          |  |                            | 1  |  |                                 | 2,642   |   |                    |   |       |                                            |  |   |              |   |  |                          |       |   |  |   |       |   |  |   | 2,643   |  
|Issuance of common stock in connection with an acquisition           |  | 196          |  |                            |   |  |                                 | 808     |   |                    |   |       |                                            |  |   |              |   |  |                          |       |   |  |   |       |   |  |   | 808     |  
|Stock-based compensation                                             |  |             |  |                            |   |  |                                 |        |   |                    |   | 28     |                                            |  |   |              |   |  |                          |       |   |  |   |       |   |  |   | 28      |  
|                                                                     |  |              |  |                            |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |        |   |  |   |        |   |  |   |         |  
|Balance, December 31, 2004                                           |  | 22,178       |  |                            | 22 |  |                                 | 118,135 |   |                    |   | (8     | )                                          |  |   | (50,797       | ) |  |                          | 7,524  |   |  |   | (3,773 | ) |  |   | 71,103  |  
|Comprehensive loss:                                                  |  |              |  |                            |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |        |   |  |   |        |   |  |   |         |  
|Net loss                                                             |  |             |  |                            |   |  |                                 |        |   |                    |   |       |                                            |  |   | (19,608       | ) |  |                          |       |   |  |   |       |   |  |   | (19,608 | )
|Foreign currency translation adjustment                              |  |             |  |                            |   |  |                                 |        |   |                    |   |       |                                            |  |   |              |   |  |                          | (2,905 | ) |  |   |       |   |  |   | (2,905  | )
|                                                                     |  |              |  |                            |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |        |   |  |   |        |   |  |   |         |  
|Comprehensive loss                                                   |  |              |  |                            |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |        |   |  |   |        |   |  |   | (22,513 | )
|Exercise of stock options and employee stock purchase plan issuances |  | 286          |  |                            |   |  |                                 | 845     |   |                    |   |       |                                            |  |   |              |   |  |                          |       |   |  |   |       |   |  |   | 845     |  
|Restricted stock awards, net of forfeitures                          |  |             |  |                            |   |  |                                 | 1,598   |   |                    |   | (1,598 | )                                          |  |   |              |   |  |                          |       |   |  |   |       |   |  |   |        |  
|Stock-based compensation                                             |  |             |  |                            |   |  |                                 |        |   |                    |   | 336    |                                            |  |   |              |   |  |                          |       |   |  |   |       |   |  |   | 336     |  
|                                                                     |  |              |  |                            |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |        |   |  |   |        |   |  |   |         |  
|Balance, December 31, 2005                                           |  | 22,464       |  | $                          | 22 |  | $                               | 120,578 |   |                    | $ | (1,270 | )                                          |  | $ | (70,405       | ) |  | $                        | 4,619  |   |  | $ | (3,773 | ) |  | $ | 49,771  |  
|                                                                     |  |              |  |                            |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |        |   |  |   |        |   |  |   |         |  

See accompanying notes to consolidated financial statements.



F-5



---

SONIC INNOVATIONS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                                          |  |                                  |         |   |      |   |         |      |  |   |         |  
|--------------------------------------------------------------------------------------------------------- |  | -------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                          |  | For the years ended December 31, |        
|                                                                                                          |  | 2005                             |         |   | 2004 |   |         | 2003 | 
|Cash flows from operating activities:                                                                     |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net income (loss)                                                                                         |  | $                                | (19,608 | ) |      | $ | 411     |      |  | $ | 376     |  
|Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:        |  |                                  |         |   |      |   |         |      |  |   |         |  
|Depreciation and amortization                                                                             |  |                                  | 5,383   |   |      |   | 3,558   |      |  |   | 2,812   |  
|Stock-based compensation                                                                                  |  |                                  | 336     |   |      |   | 28      |      |  |   | 118     |  
|Foreign currency losses (gains), net                                                                      |  |                                  | 700     |   |      |   | (570    | )    |  |   | (1,610  | )
|Deferred income taxes                                                                                     |  |                                  | 263     |   |      |   | 1,898   |      |  |   | 290     |  
|Asset impairment                                                                                          |  |                                  | 7,511   |   |      |   |        |      |  |   |        |  
|Changes in assets and liabilities, net of effect of acquisitions:                                         |  |                                  |         |   |      |   |         |      |  |   |         |  
|Accounts receivable                                                                                       |  |                                  | (259    | ) |      |   | 1,788   |      |  |   | (2,378  | )
|Inventories                                                                                               |  |                                  | (1,217  | ) |      |   | 840     |      |  |   | (340    | )
|Other assets                                                                                              |  |                                  | 55      |   |      |   | 491     |      |  |   | (210    | )
|Accounts payable, accrued expenses and deferred revenue                                                   |  |                                  | 982     |   |      |   | (5,095  | )    |  |   | (1,106  | )
|                                                                                                          |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net cash provided by (used in) operating activities                                                       |  |                                  | (5,854  | ) |      |   | 3,349   |      |  |   | (2,048  | )
|Cash flows from investing activities:                                                                     |  |                                  |         |   |      |   |         |      |  |   |         |  
|Acquisitions of businesses and contingent consideration, net of cash acquired                             |  |                                  | (2,333  | ) |      |   | (5,556  | )    |  |   | (8,281  | )
|Purchase of property and equipment                                                                        |  |                                  | (2,910  | ) |      |   | (5,773  | )    |  |   | (2,292  | )
|Payments for technology licenses                                                                          |  |                                  | (375    | ) |      |   |        |      |  |   |        |  
|Investments and advances, net                                                                             |  |                                  | 1,573   |   |      |   | 102     |      |  |   | 246     |  
|Purchase of marketable securities                                                                         |  |                                  |        |   |      |   | (15,054 | )    |  |   | (27,281 | )
|Proceeds from maturity of marketable securities                                                           |  |                                  | 12,803  |   |      |   | 14,981  |      |  |   | 26,466  |  
|                                                                                                          |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net cash provided by (used in) investing activities                                                       |  |                                  | 8,758   |   |      |   | (11,300 | )    |  |   | (11,142 | )
|Cash flows from financing activities:                                                                     |  |                                  |         |   |      |   |         |      |  |   |         |  
|Proceeds from exercise of stock options and employee stock purchase plan issuances                        |  |                                  | 845     |   |      |   | 2,643   |      |  |   | 1,253   |  
|Collection of (payments for) pre-acquisition receivables payable to former owners of an acquired business |  |                                  | (5,136  | ) |      |   | 5,136   |      |  |   |        |  
|Purchase of restricted marketable securities used to collateralize letter of credit                       |  |                                  | (11,032 | ) |      |   | (15,849 | )    |  |   | (1,896  | )
|Proceeds from maturity of restricted marketable securities used to collateralize letter of credit         |  |                                  | 13,973  |   |      |   | 16,375  |      |  |   |        |  
|Proceeds from short-term loan                                                                             |  |                                  |        |   |      |   |        |      |  |   | 13,000  |  
|Principal payment on short-term loan                                                                      |  |                                  |        |   |      |   |        |      |  |   | (13,000 | )
|Proceeds from long-term loan                                                                              |  |                                  |        |   |      |   |        |      |  |   | 8,445   |  
|Principal payments on long-term loan                                                                      |  |                                  | (1,247  | ) |      |   | (1,242  | )    |  |   | (399    | )
|                                                                                                          |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net cash provided by (used in) financing activities                                                       |  |                                  | (2,597  | ) |      |   | 7,063   |      |  |   | 7,403   |  
|Effect of exchange rate changes on cash and cash equivalents                                              |  |                                  | (663    | ) |      |   | 479     |      |  |   | 727     |  
|                                                                                                          |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net decrease in cash and cash equivalents                                                                 |  |                                  | (356    | ) |      |   | (409    | )    |  |   | (5,060  | )
|Cash and cash equivalents, beginning of the year                                                          |  |                                  | 8,221   |   |      |   | 8,630   |      |  |   | 13,690  |  
|                                                                                                          |  |                                  |         |   |      |   |         |      |  |   |         |  
|Cash and cash equivalents, end of the year                                                                |  | $                                | 7,865   |   |      | $ | 8,221   |      |  | $ | 8,630   |  
|                                                                                                          |  |                                  |         |   |      |   |         |      |  |   |         |  
|Supplemental cash flow information:                                                                       |  |                                  |         |   |      |   |         |      |  |   |         |  
|Cash paid during the year for interest                                                                    |  | $                                | 286     |   |      | $ | 353     |      |  | $ | 92      |  
|Cash paid during the year for income taxes                                                                |  |                                  | 3,490   |   |      |   | 2,480   |      |  |   | 65      |  
|Supplemental disclosure of acquisition related activity:                                                  |  |                                  |         |   |      |   |         |      |  |   |         |  
|Fair value of assets acquired                                                                             |  | $                                | 63      |   |      | $ | 11,039  |      |  | $ | 22,857  |  
|Liabilities assumed                                                                                       |  |                                  |        |   |      |   | (5,521  | )    |  |   | (9,443  | )
|                                                                                                          |  |                                  |         |   |      |   |         |      |  |   |         |  
|Purchase consideration                                                                                    |  |                                  | 63      |   |      |   | 5,518   |      |  |   | 13,414  |  
|Additional purchase consideration due to achievement of milestones                                        |  |                                  | 3,672   |   |      |   | 2,339   |      |  |   | 635     |  
|Less: Common stock issued and accrued consideration, net                                                  |  |                                  | (1,402  | ) |      |   | (1,414  | )    |  |   |        |  
|Cash acquired in acquisitions                                                                             |  |                                  |        |   |      |   | (887    | )    |  |   | (5,768  | )
|                                                                                                          |  |                                  |         |   |      |   |         |      |  |   |         |  
|Acquisitions and contingent consideration, net of cash acquired                                           |  | $                                | 2,333   |   |      | $ | 5,556   |      |  | $ | 8,281   |  
|                                                                                                          |  |                                  |         |   |      |   |         |      |  |   |         |  

See accompanying notes to consolidated financial statements.



F-6



---

SONIC INNOVATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(dollars in thousands, except per share amounts)



NOTE 1. NATURE OF OPERATIONS

Sonic Innovations, Inc. (the Company) is a hearing healthcare company. The Company designs, develops, manufactures and markets advanced
digital hearing aids intended to provide the highest levels of satisfaction for hearing impaired consumers and proprietary auditory testing equipment that automates the four most commonly performed hearing tests. The Company has developed patented
processing (DSP) technologies based on what it believes is an advanced understanding of human hearing. In countries where the Company has direct (owned) operations, it sells to hearing care professionals or directly to hearing impaired
consumers. In other parts of the world where the Company does not have direct operations, it sells principally to distributors. From the Companys inception, it has focused all its efforts on the therapeutic side of hearing care by developing
high-performance digital hearing aids. In December 2004, the Company acquired Tympany, Inc. (Tympany) and now offers hearing diagnostic equipment.

NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation.The consolidated financial
statements include the accounts of Sonic Innovations, Inc. and its wholly owned subsidiaries. All intercompany balances and transactions are eliminated in consolidation.

Use of Estimates.The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts
of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates affecting the
financial statements are those related to allowance for doubtful accounts, sales returns, inventory obsolescence, long-lived asset impairment, warranty accruals, legal contingency accruals and deferred income tax asset valuation allowances. Actual
results could differ from those estimates.

Revenue Recognition and Concentrations of Credit Risk.Sales of hearing aids are
recognized when (i) products are shipped, except for hearing aid retail sales, which are recognized upon acceptance by the consumer, (ii) persuasive evidence of an arrangement exists, (iii) title and risk of loss has transferred,
(iv) the price is fixed and determinable, (v) contractual obligations have been satisfied, and (vi) collectibility is reasonably assured. The Company applies the provisions of Statement of Position (SOP) 97-02,
Software Revenue Recognition, as amended by SOP 98-09 to its auditory testing equipment operating segment. SOP 97-02, as amended, generally requires revenue earned on software arrangements involving multiple elements to be split between
the elements such as software products and technical support. The fair value of an element must be based on vendor-specific objective evidence, which the Company establishes based on the price charged when the same element is sold separately. Net
sales consist of product sales less provisions for sales returns, which are made at the time of sale. The Company generally has a 60-day return policy for hearing aid sales, and allowances for sales returns are reflected as a reduction of sales and
accounts receivable. If actual sales returns differ from the Companys estimates, revisions to the allowance for sales returns will be required. Allowances for sales returns were as follows:



|                            |  |      |         |   |      |   |         |      |  |   |         |  
|--------------------------- |  | ---- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                            |  | 2005 |         |   | 2004 |   |         | 2003 | 
|Balance, beginning of year  |  | $    | 2,815   |   |      | $ | 3,487   |      |  | $ | 2,629   |  
|Provisions and acquisitions |  |      | 14,388  |   |      |   | 12,595  |      |  |   | 16,782  |  
|Returns processed           |  |      | (13,735 | ) |      |   | (13,267 | )    |  |   | (15,924 | )
|                            |  |      |         |   |      |   |         |      |  |   |         |  
|Balance, end of year        |  | $    | 3,468   |   |      | $ | 2,815   |      |  | $ | 3,487   |  
|                            |  |      |         |   |      |   |         |      |  |   |         |  

The Company performs ongoing credit evaluations of its customers and provides for doubtful
accounts. As of December 31, 2005 and 2004, allowances for doubtful accounts were $1,605 and $1,617, respectively. No single customer comprised more than 10% of (i) net sales in 2005, 2004 and 2003 or (ii) accounts receivable as of
December 31, 2005 and 2004.

Revenues related to sales of separately priced extended service contracts are deferred and recognized on
a straight-line basis over the contractual periods.

Warranty Costs.The Company provides for the cost of remaking and repairing
products under warranty at the time of sale. These costs are included in cost of sales. When evaluating the adequacy of the warranty reserve, the Company analyzes the amount of historical and expected warranty costs by geography, by product family,
by model and by warranty period as appropriate. If actual product failure rates or repair and remake costs differ from the Companys estimates, revisions to the warranty accrual will be required.



F-7



---

SONIC INNOVATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(dollars in
thousands, except per share amounts)



Accrued warranty costs were as follows:



|                            |  |      |        |   |      |   |        |      |  |   |        |  
|--------------------------- |  | ---- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                            |  | 2005 |        |   | 2004 |   |        | 2003 | 
|Balance, beginning of year  |  | $    | 4,526  |   |      | $ | 4,115  |      |  | $ | 3,613  |  
|Provisions and acquisitions |  |      | 4,990  |   |      |   | 5,136  |      |  |   | 3,924  |  
|Costs incurred              |  |      | (4,594 | ) |      |   | (4,725 | )    |  |   | (3,422 | )
|                            |  |      |        |   |      |   |        |      |  |   |        |  
|Balance, end of year        |  | $    | 4,922  |   |      | $ | 4,526  |      |  | $ | 4,115  |  
|                            |  |      |        |   |      |   |        |      |  |   |        |  

Cash Equivalents.The Company considers all short-term investments purchased with an
original maturity of three months or less to be cash equivalents. As of December 31, 2005 and 2004, cash equivalents consisted of certificates of deposit and money market funds totaling $8,213 and $5,854, respectively. As of December 31,
2005, the Company had pledged $8,384 of cash, cash equivalents and marketable securities as security for a long-term loan (see Note 8).

Marketable Securities.The Company designates the classification of its marketable securities at the time of purchase and re-evaluates this designation as of each balance sheet date. The Companys marketable securities consisted
of U.S. government obligations as of December 31, 2005 and corporate debt securities and U.S. government and municipal obligations as of December 31, 2004. Marketable securities are classified as held-to-maturity and presented at amortized
cost, which approximated market value. The amortized cost of U.S. government obligations, corporate debt securities and municipal obligations is adjusted for amortization of premiums and accretion of discounts to maturity. A decline in the market
value below cost that is deemed other than temporary is charged to results of operations resulting in the establishment of a new cost basis. In 2005, 2004 and 2003, the Company did not experience any declines in market value, which were deemed other
than temporary. The Companys investment policy is to purchase debt securities with (i) maturity dates of 18 months or less from the date of purchase and (ii) minimum ratings of A-1 from Standard & Poors and P-1 from
Moodys.

Inventories.Inventories are stated at the lower of cost or market using the first-in, first-out method. The Company
includes material, labor and manufacturing overhead in the cost of inventories. Provision is made (i) to reduce excess and obsolete inventories to their estimated net realizable values and (ii) for estimated product (inventory) returns in
those countries that sell on a retail basis and recognize a sale only upon acceptance by the consumer. Inventories as of December 31 consisted of the following:



|                             |  |      |        |      |   |      
|---------------------------- |  | ---- | ------ | ---- | - | -----
|                             |  | 2005 |        | 2004
|Raw materials and components |  | $    | 6,029  |      | $ | 4,823
|Work in progress             |  |      | 101    |      |   | 117  
|Finished goods               |  |      | 4,104  |      |   | 4,859
|                             |  |      |        |      |   |      
|Total                        |  | $    | 10,234 |      | $ | 9,799
|                             |  |      |        |      |   |      

As of December 31, 2005 and 2004, inventory reserves were $1,474 and $1,553, respectively.

Purchase Commitments and Supplier Concentrations.The Company reviews its firm purchase commitments at each reporting date to
determine if commitments are at prices in excess of net realizable value. To the extent such commitments exceed net realizable value, the Companys policy is to recognize a loss in the period in which an impairment in value becomes evident.
There were no such losses recognized in 2005, 2004 and 2003.

The Company purchases all of its integrated circuits from two manufacturers.
Should these manufacturers be unable to provide such integrated circuits, the Companys ability to produce its products would be materially impaired.

Property and Equipment.Property and equipment are stated at cost. Depreciation is calculated using the straight-line method over the estimated useful lives, which are generally 7 years for furniture and
fixtures and 3 to 5 years for machinery and equipment. Leasehold improvements are amortized over the shorter of the estimated useful lives or the lease term. Upon the retirement or other disposition of property and equipment, the cost and related
accumulated depreciation or amortization are removed from the accounts. The resulting gain or loss is included in net income. Major renewals and betterments are capitalized while minor expenditures for maintenance and repairs are charged to expense
as incurred.



F-8



---

SONIC INNOVATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(dollars in
thousands, except per share amounts)



Goodwill and Other Intangible Assets.Goodwill represents the excess of costs over fair
value of assets of businesses acquired. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead tested for impairment at least annually in accordance
with the provisions of Statement of Financial Accounting Standards Board (SFAS) No.142, Goodwill and Other Intangible Assets. Intangible assets with estimable useful lives are amortized over their respective estimated useful
lives to their estimated residual values and reviewed for impairment in accordance with SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets.

Impairment of Long-lived Assets. In accordance with SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets, long-lived assets
such as property, plant, and equipment, and purchased intangible assets subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be
recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset or asset group to estimated undiscounted future cash flows expected to be generated by the asset or asset group. If the carrying
amount of an asset or asset group exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset or asset group. In 2005, the Company recorded
an asset impairment pertaining to purchased intangible assets of $1,528 (see Note 6). There were no such losses recognized in 2004 and 2003.

Goodwill and intangible assets that have indefinite useful lives are tested annually for impairment, and are tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is
recognized to the extent that the carrying amount exceeds the assets fair value. For goodwill, the impairment determination is made at the reporting unit level and consists of two steps. First, the Company determines the fair value of a
reporting unit and compares it to its carrying amount. Second, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting units goodwill over the
implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation, in accordance with SFAS No. 141, Business
Combinations. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. In 2005, based on impairment tests performed on each of the Companys reporting units, the Company recorded asset
impairments pertaining to goodwill totaling $5,983 (see Note 6). There was no impairment of goodwill or indefinite-lived intangible assets in 2004 and 2003.

Shipping and Handling. Shipping and handling revenues are included in net sales and costs are included in cost of sales.

Research and Development.Research and development costs, which include basic research, development of useful ideas into new products, continuing support and enhancement of existing products and regulatory and
clinical activities, are expensed as incurred.

Patents. In 2005, 2004 and 2003, the Company expensed direct costs associated with
obtaining and filing patents of $219, $294 and $256, respectively.

Advertising.Advertising costs are expensed as incurred and were
$4,211, $2,928 and $2,209 in 2005, 2004 and 2003, respectively.

Derivative Instruments.The Company may enter into readily
marketable forward contracts with financial institutions to minimize the short-term impact of foreign currency fluctuations on certain intercompany balances. The Company does not enter into these contracts for trading or speculation purposes. Gains
and losses on the contracts are included in the results of operations and offset foreign exchange gains or losses recognized on the revaluation of certain intercompany balances. The Companys foreign exchange forward contracts generally mature
in three months or less from the contract date. There were no contracts outstanding as of December 31, 2005.

Income Taxes. All
income tax amounts reflect the use of the asset and liability method. Under this method, deferred income tax assets and liabilities are determined based on the expected future income tax consequences of temporary differences between the carrying
amounts of assets and liabilities for financial and income tax reporting purposes. A valuation allowance is provided to offset deferred income tax assets if, based upon the available evidence, it is more likely than not that some or all of the
deferred income tax assets will not be realized.

Earnings (Loss) Per Common Share.Basic earnings (loss) per common share is
calculated based upon the weighted average number of shares of common stock outstanding during the period. In the 2005 basic loss per share calculation, the Company included 174,131 issuable shares related to amounts due to the former shareholders
of Tympany as contingent consideration. Diluted earnings (loss) per common share is calculated based upon the weighted average number of shares of common stock outstanding, plus the dilutive effect of common stock equivalents calculated using the
treasury stock method. Dilutive common stock equivalents in 2004 consisted of 1,395,991 shares pertaining to 3,198,670 stock options and 22,803 shares related to an accrued earn-out in connection with the Tympany acquisition. Dilutive common stock
equivalents in 2003 consisted of 1,030,412 shares pertaining to 2,855,110 stock options. Antidilutive common stock equivalents, consisting of stock options and restricted stock, of 4,996,483, 1,302,738 and 1,920,081 in 2005, 2004 and 2003,
respectively were excluded from diluted earnings per share calculations.

Fair Value of Financial Instruments.The Companys
financial instruments consist primarily of cash equivalents, marketable securities, foreign exchange forward contracts, customer advances and long-term debt. The carrying values of the financial instruments approximate their fair values based on
current interest rates and available market information.

Foreign Currency Translation.The accounts of the Companys
subsidiaries are translated into U.S dollars using the exchange rate at the balance sheet date for assets and liabilities and the weighted average exchange rate for the period for revenues, expenses, gains and losses. Translation adjustments are
recorded as a separate component of comprehensive income (loss). Gains or losses resulting from foreign currency transactions are included in other income (expense).



F-9



---

SONIC INNOVATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(dollars in
thousands, except per share amounts)



Employee Stock Option Plans.The Company has stock-based compensation plans for employees and
directors, which are described more fully in Note 14. The Company accounts for these plans under the recognition and measurement principles of Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to
Employees, and related interpretations. Under the intrinsic value method of APB No. 25, no compensation expense is recognized in the results of operations when the exercise price of the Companys employee stock options equals the
market price of the underlying stock on the date of grant.

If the Company elected to adopt the optional fair value recognition provisions
of SFAS No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation  Transition and Disclosure, for its stock plans, net income (loss) and per share
amounts as reported would have been adjusted to the pro forma amounts indicated below:



|                                                                                         |  |      |         |   |      |   |        |      |  |   |        |  
|---------------------------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                                                         |  | 2005 |         |   | 2004 |   |        | 2003 | 
|Net income (loss):                                                                       |  |      |         |   |      |   |        |      |  |   |        |  
|As reported                                                                              |  | $    | (19,608 | ) |      | $ | 411    |      |  | $ | 376    |  
|Add: Stock-based employee compensation included in reported net income (loss)            |  |      | 336     |   |      |   | 28     |      |  |   | 118    |  
|Deduct: Stock-based employee compensation expense determined under the fair value method |  |      | (1,525  | ) |      |   | (7,342 | )    |  |   | (3,280 | )
|                                                                                         |  |      |         |   |      |   |        |      |  |   |        |  
|Pro forma                                                                                |  | $    | (20,797 | ) |      | $ | (6,903 | )    |  | $ | (2,786 | )
|                                                                                         |  |      |         |   |      |   |        |      |  |   |        |  
|Basic earnings (loss) per share:                                                         |  |      |         |   |      |   |        |      |  |   |        |  
|As reported                                                                              |  | $    | (0.92   | ) |      | $ | 0.02   |      |  | $ | 0.02   |  
|                                                                                         |  |      |         |   |      |   |        |      |  |   |        |  
|Pro forma                                                                                |  | $    | (0.97   | ) |      | $ | (0.33  | )    |  | $ | (0.14  | )
|                                                                                         |  |      |         |   |      |   |        |      |  |   |        |  
|Diluted earnings (loss) per share:                                                       |  |      |         |   |      |   |        |      |  |   |        |  
|As reported                                                                              |  | $    | (0.92   | ) |      | $ | 0.02   |      |  | $ | 0.02   |  
|                                                                                         |  |      |         |   |      |   |        |      |  |   |        |  
|Pro forma                                                                                |  | $    | (0.97   | ) |      | $ | (0.33  | )    |  | $ | (0.14  | )
|                                                                                         |  |      |         |   |      |   |        |      |  |   |        |  

No income tax effects were included in the determination of the pro forma amounts because the
deferred income tax asset resulting from stock-based compensation would be offset by a valuation allowance.

The Company accelerated the
exercisability of 1,009,221 previously awarded stock options with exercise prices greater than the closing price of its common stock as of December 23, 2004 of $4.18 per share. This resulted in an acceleration of $3,510 of stock-based
compensation expense as determined under the fair value method in the 2004 pro forma amounts disclosed above. The exercise prices and number of shares subject to the accelerated vesting were unchanged. In 2005, the Company granted stock options to
purchase 525,000 shares of common stock, of which 250,000 shares became fully vested and exercisable on the date of grant and stock-based compensation expense of $528 relating to these shares has been recognized in the 2005 pro forma amounts above.

In determining the pro forma amounts in the table above, the fair value of each option was estimated on the date of grant using the
Black-Scholes option-pricing model based on the following weighted average assumptions:



|                         |  |               |   |  |                              |   |  |         |   |  |         |   |  |         |   |  |         |  
|------------------------ |  | ------------- | - |  | ---------------------------- | - |  | ------- | - |  | ------- | - |  | ------- | - |  | ------- | -
|                         |  | Stock Options |   |  | Employee Stock Purchase Plan |  
|                         |  | 2005          |   |  | 2004                         |   |  | 2003    |   |  | 2005    |   |  | 2004    |   |  | 2003    |  
|Risk free rate of return |  | 3.8           | % |  | 3.4                          | % |  | 3.1     | % |  | 2.7     | % |  | 2.0     | % |  | 1.8     | %
|Expected dividend yield  |  | 0.0           | % |  | 0.0                          | % |  | 0.0     | % |  | 0.0     | % |  | 0.0     | % |  | 0.0     | %
|Volatility               |  | 74            | % |  | 83                           | % |  | 87      | % |  | 73      | % |  | 74      | % |  | 73      | %
|Expected life            |  | 5 years       |   |  | 5 years                      |   |  | 5 years |   |  | 2 years |   |  | 2 years |   |  | 2 years |  

Comprehensive Income (Loss).Other comprehensive income (loss) includes net income (loss)
plus the results of certain changes in shareholders equity that are not reflected in the results of operations. The Companys comprehensive income (loss) consisted of changes in foreign currency translation adjustments, which were not
adjusted for income taxes as they related to specific indefinite investments in foreign subsidiaries.



F-10



---

SONIC INNOVATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(dollars in
thousands, except per share amounts)



New Accounting Pronouncements.In December 2004, the Financial Accounting Standards Board
(FASB) issued SFAS No. 123R, Share-Based Payment, which revised SFAS No. 123, Accounting for Stock-Based Compensation and superseded APB Opinion No. 25, Accounting for Stock Issued to
Employees. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. The pro forma disclosures previously permitted
under SFAS No. 123 will no longer be an alternative to financial statement recognition. The new standard may be adopted using either the modified prospective method or the modified retrospective method. In March 2005, the Securities and
Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment, which clarified the SECs expectations with regard to the assumptions underlying the fair value estimates of
options. The Company will no longer be permitted to follow the intrinsic value accounting method of APB No. 25. APB No. 25 resulted in no expense being recorded for stock option grants for which the strike price was equal to the fair value
of the underlying stock on the date of grant, which has been the situation for the Company prior to 2006. SFAS No. 123R became effective for the Company on January 1, 2006. The Company will determine the fair value of share-based equity
instruments issued to employees using the Black-Scholes option-pricing model for stock options to calculate the amount of compensation cost that must be recognized in the financial statements as a result of adopting SFAS No. 123R. The dividend
yield, volatility and risk-free interest rate assumptions will be estimated in a manner consistent with the methodology disclosed above. The Company estimates that the financial effect of adopting SFAS No. 123R will be to decrease 2006 earnings
by approximately $0.02 to $0.03 per share (unaudited).

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error
Corrections, which replaces APB Opinion No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements, and requires that a voluntary change in accounting principle be
applied retrospectively to all prior period financial statements presented, unless it is impracticable to do so. SFAS No. 154 also provides that a change in method of depreciating or amortizing a long-lived non-financial asset be accounted for
as a change in estimate effected by a change in accounting principle, and also provides that correction of errors in previously issued financial statements should be termed a restatement. SFAS No. 154 is effective for fiscal years
beginning after December 15, 2005. The Company does not believe the adoption of SFAS No. 154 will have a material effect on its results of operations and financial position.

In November 2005, the FASB issued FASB Staff Position No. FAS 115-1 (FAS 115-1), The Meaning of Other-Than-Temporary Impairment and its
Application to Certain Investments. FAS 115-1 provides accounting guidance for determining and measuring other-than-temporary impairments of debt and equity securities, and confirms the disclosure requirements for investments in unrealized loss
positions as outlined in Emerging Issues Task Force Issue No. 03-01, The Meaning of Other-Than-Temporary Impairments and its Application to Certain Investments. The accounting requirements of FAS 115-1 are effective as of
January 1, 2006 and will not have a material effect on the Companys results of operations and financial position.

NOTE 3. MARKETABLE
SECURITIES

Marketable securities as of December 31 consisted of the following:



|                      |  |                |       |                        |   |                         |  |   |            |   |                |   |                        |  |                         |        |  |            |   |  |   |     |   |  |   |       
|--------------------- |  | -------------- | ----- | ---------------------- | - | ----------------------- |  | - | ---------- | - | -------------- | - | ---------------------- |  | ----------------------- | ------ |  | ---------- | - |  | - | --- | - |  | - | ------
|                      |  | 2005           |       | 2004                  
|                      |  | Amortized Cost |       | Gross Unrealized Gains |   | Gross Unrealized Losses |  |   | Fair Value |   | Amortized Cost |   | Gross Unrealized Gains |  | Gross Unrealized Losses |        |  | Fair Value
|Corporate             |  | $              |      |                        | $ |                        |  | $ |           |   |                | $ |                       |  | $                       | 17,850 |  | $          |  |  | $ | (86 | ) |  | $ | 17,764
|U.S. government       |  |                | 3,058 |                        |   |                        |  |   | (6         | ) |                |   | 3,052                  |  |                         | 483    |  |            |  |  |   | (1  | ) |  |   | 482   
|Municipal obligations |  |                |      |                        |   |                        |  |   |           |   |                |   |                       |  |                         | 2,823  |  |            |  |  |   | (9  | ) |  |   | 2,814 
|                      |  |                |       |                        |   |                         |  |   |            |   |                |   |                        |  |                         |        |  |            |   |  |   |     |   |  |   |       
|Total                 |  | $              | 3,058 |                        | $ |                        |  | $ | (6         | ) |                | $ | 3,052                  |  | $                       | 21,156 |  | $          |  |  | $ | (96 | ) |  | $ | 21,060
|                      |  |                |       |                        |   |                         |  |   |            |   |                |   |                        |  |                         |        |  |            |   |  |   |     |   |  |   |       

Restricted marketable securities as of December 31, 2005 and 2004 were $3,058 and $8,353,
respectively.



F-11



---

SONIC INNOVATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(dollars in
thousands, except per share amounts)



All securities in an unrealized loss position as of December 31, 2005 are held-to-maturity debt
securities. These securities were not impaired at acquisition and the decline in fair value is due solely to interest rate fluctuations.

NOTE
4. PROPERTY AND EQUIPMENT

Property and equipment as of December 31 consisted of the following:



|                                               |  |      |         |   |      |   |         |  
|---------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                               |  | 2005 |         |   | 2004 |  
|Machinery and equipment                        |  | $    | 10,993  |   |      | $ | 10,146  |  
|Computer equipment and software                |  |      | 6,040   |   |      |   | 6,470   |  
|Furniture and office equipment                 |  |      | 6,671   |   |      |   | 5,598   |  
|Leasehold improvements                         |  |      | 1,030   |   |      |   | 969     |  
|                                               |  |      |         |   |      |   |         |  
|                                               |  |      | 24,734  |   |      |   | 23,183  |  
|Less accumulated depreciation and amortization |  |      | (15,962 | ) |      |   | (13,097 | )
|                                               |  |      |         |   |      |   |         |  
|Total                                          |  | $    | 8,772   |   |      | $ | 10,086  |  
|                                               |  |      |         |   |      |   |         |  

NOTE 5. ACQUISITIONS

In 2004, the Company acquired Tympany, Inc. (Tympany) and a foreign hearing aid retail chain. In 2003, the Company acquired Sanomed Handelsgesellschaft mbH (Sanomed).

Tympany. In December 2004, the Company acquired 100% of the stock of Tympany, the developer of the Otogram, a machine that automates the four most
commonly performed tests for diagnosing hearing loss. The initial purchase price of $2,191, including expenses of $183, consisted of $1,200 in cash and 196,115 shares of the Companys common stock valued at $808 based on the average closing
price of the common stock for the period beginning two days before and ending two days after the closing of the transaction. In addition, a $500 loan made by the Company to Tympany prior to the acquisition was recorded as additional consideration.
Contingent consideration in the form of an earn-out will be paid based on the following schedule: 2005  35% of net 2005 Tympany (Otogram) revenue, plus 10% of net 2005 hearing aid sales less a base amount; 2006  35% of net 2006 Tympany
revenue, plus 10% of net 2006 hearing aid sales less 105% of a base amount; and 2007  20% of the lesser of 2007 or 2006 net Tympany revenue, plus 35% of any excess of 2007 net Tympany revenue over 2006 net Tympany revenue, plus 10% of net 2007
hearing aid sales less 110% of a base amount. Payment will be made in a combination of cash (60%) and Company common stock (40%). As of December 31, 2005, the Company accrued $1,843 pertaining to payments due the former shareholders
of Tympany. The amount payable is currently in dispute with the former owners of Tympany and is expected to be resolved in 2006. Definite-lived intangible assets acquired included technology ($2,085), brand names ($529), non-compete agreements and
other ($391) and customer databases ($445). Goodwill in connection with the transaction will not be deductible for tax purposes.

The
results of operations of Tympany are included in the results of operations of the Company from December 1, 2004. The following table sets forth summary unaudited pro forma consolidated financial information as if the acquisition had taken place
at the beginning of the periods presented:



|                                                                       |  |      |         |   |      |   |        |  
|---------------------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------ | -
|                                                                       |  | 2004 |         |   | 2003 |  
|Net sales                                                              |  | $    | 101,334 |   |      | $ | 88,763 |  
|Operating loss                                                         |  |      | (5,109  | ) |      |   | (3,734 | )
|Net loss                                                               |  |      | (5,230  | ) |      |   | (3,034 | )
|Basic and diluted loss per common share                                |  | $    | (0.25   | ) |      | $ | (0.15  | )
|                                                                       |  |      |         |   |      |   |        |  
|Basic and diluted weighted average number of common shares outstanding |  |      | 20,929  |   |      |   | 20,137 |  
|                                                                       |  |      |         |   |      |   |        |  

Sanomed. In May 2003, the Company acquired 100% of the stock of Sanomed, a distribution
company that markets hearing aids directly to German hearing impaired customers through ear-nose-throat doctors. Under the terms of the purchase agreement, contingent consideration in the form of an earn-out has been paid in the amounts of $1,507
and $1,556 based on targeted sales performance for the one year periods ended May 31, 2005 and 2004, respectively. Additional contingent



F-12



---

SONIC INNOVATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(dollars in
thousands, except per share amounts)



consideration may be payable based on achieving targeted sales performance for the one year period ending May 31, 2006. Under the terms of the purchase
agreement, the Company is required to remit to the former owners of Sanomed any money collected on certain accounts receivable that were deemed uncollectible prior to the acquisition. As of December 31, 2005, the Company had collected $9,094 of
such accounts receivable, and the net after tax amount of $5,136 was remitted to the former owners in 2005.

The results of operations of
Sanomed are included in the results of operations of the Company from May 1, 2003. The following table sets forth summary unaudited pro forma consolidated financial information as if the acquisition had taken place as of January 1, 2003:



|                                                      |  |      |       
|----------------------------------------------------- |  | ---- | ------
|                                                      |  | 2003
|Net sales                                             |  | $    | 94,163
|Operating profit                                      |  |      | 1,287 
|Net income                                            |  |      | 1,306 
|Earnings per common share:                            |  |      |       
|Basic                                                 |  | $    | 0.07  
|                                                      |  |      |       
|Diluted                                               |  | $    | 0.06  
|                                                      |  |      |       
|Weighted average number of common shares outstanding: |  |      |       
|Basic                                                 |  |      | 19,908
|                                                      |  |      |       
|Diluted                                               |  |      | 20,938
|                                                      |  |      |       

Foreign Retail Chain.In May 2004, the Company acquired 100% of the stock of a
Switzerland-based hearing aid retail chain. Contingent consideration in the form of an earn-out of 225 CHF ($175) was paid in the second quarter 2005 based on targeted sales performance for the one year period ended April 30, 2005.

Purchase Price Allocation.The purchase prices of the acquired companies have been allocated to the tangible and intangible assets acquired and
liabilities assumed based on their estimated fair values. Goodwill represents the excess of purchase price over the net identifiable assets acquired. Allocations have required management judgment and have been supported with appraisals from
independent valuation companies especially with respect to the valuation of intangible assets. Critical estimates in valuing certain intangible assets included, but were not limited to, future expected cash flows from customer databases,
distribution agreements, purchased technology and technology licenses, non-compete agreements, software and brand names, as well as the time period over which the intangible assets will continue to have value. Managements estimates of fair
value have been based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable.

The following
table sets forth the initial allocation of the aggregate purchase price of the acquired businesses:



|                                                |  |      |        |   |      |   |        |  
|----------------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | -
|                                                |  | 2004 |        |   | 2003 |  
|Current assets                                  |  | $    | 2,964  |   |      | $ | 10,576 |  
|Property and equipment and other assets         |  |      | 395    |   |      |   | 401    |  
|Goodwill and indefinite-lived intangible assets |  |      | 3,363  |   |      |   | 9,834  |  
|Definite-lived intangible assets                |  |      | 4,317  |   |      |   | 2,046  |  
|Current liabilities                             |  |      | (3,436 | ) |      |   | (2,480 | )
|Deferred revenue                                |  |      | (2,085 | ) |      |   | (3,543 | )
|Deferred taxes and other liabilities            |  |      |       |   |      |   | (3,420 | )
|                                                |  |      |        |   |      |   |        |  
|Total                                           |  | $    | 5,518  |   |      | $ | 13,414 |  
|                                                |  |      |        |   |      |   |        |  

Under the terms of the Tympany purchase agreement, the Company was required to pay the first $250
of any losses incurred in connection with a lawsuit filed by Tympanys former contract manufacturer, and any losses in excess of $250 would be shared equally between the Company and Tympanys former owners. During the second quarter 2005,
the lawsuit was settled for $875, of which Tympanys former owners were responsible for $312. In 2005, the Company recorded an additional $63 of goodwill pertaining to this settlement.



F-13



---

SONIC INNOVATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(dollars in
thousands, except per share amounts)



Contingent Consideration.During the years ended December 31, 2005, 2004 and 2003, the
Company recorded $3,672, $2,339 and $635, respectively of contingent consideration in accordance with contractually established earn-out provisions. The earn-out amounts in 2005 related to Sanomed ($1,507), Tympany ($1,990) and a Switzerland-based
hearing aid retail chain ($175). The earn-out amounts in 2004 related to Sanomed ($1,556), a 2002 acquisition in the Netherlands ($546) and Tympany ($237). The earn-out amounts in 2003 related to 2002 acquisitions in Denmark ($350) and England
($285).

NOTE 6. INTANGIBLE ASSETS

Definite-lived intangible assets as of December 31 consisted of the following:



|                                  |  |              |  |                      |       |                          |   |                      |  |                          |       |  |   |      
|--------------------------------- |  | ------------ |  | -------------------- | ----- | ------------------------ | - | -------------------- |  | ------------------------ | ----- |  | - | -----
|                                  |  |              |  | 2005                 |       | 2004                    
|                                  |  | Useful Lives |  | Gross Carrying Value |       | Accumulated Amortization |   | Gross Carrying Value |  | Accumulated Amortization
|Purchased technology and licenses |  | 3-13 years   |  | $                    | 3,066 |                          | $ | 1,068                |  | $                        | 3,633 |  | $ | 570  
|Brand names                       |  | 3-15 years   |  |                      | 2,787 |                          |   | 887                  |  |                          | 3,373 |  |   | 624  
|Non-compete agreements            |  | 5 years      |  |                      | 403   |                          |   | 210                  |  |                          | 843   |  |   | 153  
|Customer databases                |  | 2-5 years    |  |                      | 326   |                          |   | 196                  |  |                          | 769   |  |   | 131  
|Distribution agreements           |  | 2-5 years    |  |                      | 310   |                          |   | 284                  |  |                          | 357   |  |   | 274  
|Software and other intangibles    |  | 1-5 years    |  |                      | 222   |                          |   | 158                  |  |                          | 227   |  |   | 122  
|                                  |  |              |  |                      |       |                          |   |                      |  |                          |       |  |   |      
|Total                             |  |              |  | $                    | 7,114 |                          | $ | 2,803                |  | $                        | 9,202 |  | $ | 1,874
|                                  |  |              |  |                      |       |                          |   |                      |  |                          |       |  |   |      

Amortization of definite-lived intangible assets is calculated using the straight-line method over
the estimated useful lives of the assets. Estimated annual amortization expense for the years 2006 through 2010 is as follows: 2006$783; 2007$724; 2008$609; 2009$541; and 2010$531.

Goodwill and indefinite-lived intangible assets in 2005 and 2004 were as follows:



|                                             |  |      |        |   |      |   |       
|-------------------------------------------- |  | ---- | ------ | - | ---- | - | ------
|                                             |  | 2005 |        |   | 2004
|Balance, beginning of year                   |  | $    | 34,972 |   |      | $ | 26,972
|Acquisitions                                 |  |      | 63     |   |      |   | 3,363 
|Contingent consideration (earn-out payments) |  |      | 3,672  |   |      |   | 2,339 
|Asset impairments                            |  |      | (5,983 | ) |      |   |      
|Effect of exchange rate changes              |  |      | (3,210 | ) |      |   | 2,298 
|                                             |  |      |        |   |      |   |       
|Balance, end of year                         |  | $    | 29,514 |   |      | $ | 34,972
|                                             |  |      |        |   |      |   |       

During the third quarter 2005, the lack of progress toward profitability, a changing business
model and the termination and departure of the management team at Tympany resulted in the Company performing an impairment analysis of the Tympany operation (auditory testing equipment segment). This analysis resulted in asset impairments of $4,227
related to goodwill and $1,528 related to definite-lived intangibles, which caused goodwill at this reporting unit to be completely written-off and definite-lived intangibles to be reduced to an estimated fair value of $1,495. Additionally, as a
result of this impairment and Tympanys operating results not meeting financial objectives in the fourth quarter 2005, the Company recorded an additional impairment charge of $500 related to the fourth quarter 2005 earn-out. The Company expects
to continue to expense these earn-outs until such time as expected cash flows from the business can support additional valuation. If that were to occur, the Company would capitalize these earn-outs as additional purchase price.

During the fourth quarter 2005, the Company discontinued doing business with two large customers of its England operation due to lack of current and
foreseeable profitability regarding these two customers and accordingly, the Company performed an impairment analysis of the England operation. This analysis resulted in a goodwill impairment charge of $1,256 related to this reporting unit.



F-14



---

SONIC INNOVATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(dollars in
thousands, except per share amounts)



The Company utilized a third-party valuation firm to assist with its evaluation of the value of its
reporting units. Impairment tests involved the use of both estimates of market value of the Companys reporting units as well as discounted cash flow analysis based on market rates.

NOTE 7. OTHER ASSETS

Other assets as of December 31 consisted of the following:



|                  |  |      |     |      |   |      
|----------------- |  | ---- | --- | ---- | - | -----
|                  |  | 2005 |     | 2004
|Customer advances |  | $    | 459 |      | $ | 1,232
|Other assets      |  |      | 187 |      |   | 459  
|                  |  |      |     |      |   |      
|Total             |  | $    | 646 |      | $ | 1,691
|                  |  |      |     |      |   |      

The Company makes customer advances on a limited basis after reviewing and assessing the credit
quality of the borrower. Customer advances are generally secured by the assets of the business and personal guarantees, generally bear market interest rates, are evidenced by promissory notes, and have maximum terms of four years. The Company
discontinues the accrual of interest income when an advance is determined to be non-performing.

NOTE 8. LONG-TERM LOAN

The Company negotiated a long-term loan with a German bank to support its acquisition of Sanomed in 2003. As of December 31, 2005, the balance of the
long-term loan was 5,250 Euro ($6,217). The interest rate applicable to the loan is 1.0% above the EURIBOR rate (3.42% as of December 31, 2005). The loan is collateralized by a letter of credit from a U.S. bank, and the Company pledged certain
amounts of its cash, cash equivalents and marketable securities as security to obtain a reduced interest rate of 0.6% on this letter of credit. The loan payments are 250 Euro ($294 as of December 31, 2005) per quarter. The effective
interest rates on this loan in 2005, 2004 and 2003 were 3.95%, 3.88% and 3.78%, respectively.

NOTE 9. ACCRUED RESTRUCTURING

In 2005, the Company took actions to improve its profitability, including reducing layers of management, restructuring certain operations and eliminating
excess facilities. The total number of employees impacted was 37. In the third quarter 2005, the Company recorded a restructuring charge of $1,186 mainly related to termination of the management of Tympany and elimination of excess facilities. In
the fourth quarter 2005, the Company recorded a restructuring charge of $2,805 mainly related to executive severance packages, employee terminations and elimination of excess facilities. Accrued restructuring in 2005 consisted of the following:



|                                |  |                 |        |   |                  |   |     |       |  |   |        |  
|------------------------------- |  | --------------- | ------ | - | ---------------- | - | --- | ----- |  | - | ------ | -
|                                |  | EmployeeRelated |        |   | ExcessFacilities |   |     | Total | 
|Restructuring charge            |  | $               | 3,637  |   |                  | $ | 354 |       |  | $ | 3,991  |  
|Payments                        |  |                 | (1,374 | ) |                  |   | (60 | )     |  |   | (1,434 | )
|                                |  |                 |        |   |                  |   |     |       |  |   |        |  
|Balance as of December 31, 2005 |  | $               | 2,263  |   |                  | $ | 294 |       |  | $ | 2,557  |  
|                                |  |                 |        |   |                  |   |     |       |  |   |        |  

Restructuring initiatives undertaken in 2005 required management to make a number of estimates and
assumptions concerning termination benefits, losses on excess facilities vacated or consolidated, ability to sublet vacated facilities and sublease terms. Management will continue to evaluate the adequacy of the related accruals and adjust the
balances based on changes in estimates and assumptions. Accordingly, the Company may incur future charges for changes in estimates of amounts previously recorded.

NOTE 10. CAPITAL STOCK

Preferred Stock.The Companys certificate of incorporation authorizes the issuance
of 5,000,000 shares of preferred stock with terms and preferences designated therein. As of December 31, 2005 and 2004, no preferred shares were outstanding.

Shareholder Rights Plan.The Company has a shareholder rights plan pursuant to which it declared a dividend of one preferred share purchase right for each outstanding share of common stock. Each right entitles
the holder, under certain circumstances, to purchase common stock of the Company with a value of twice the exercise price of the right. The rights are redeemable by the Company and expire in 2011.



F-15



---

SONIC INNOVATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(dollars in
thousands, except per share amounts)



NOTE 11. OTHER INCOME

Other income consisted of the following:



|                                      |  |      |      |   |      |   |      |      |  |   |       |  
|------------------------------------- |  | ---- | ---- | - | ---- | - | ---- | ---- |  | - | ----- | -
|                                      |  | 2005 |      |   | 2004 |   |      | 2003 | 
|Interest income                       |  | $    | 504  |   |      | $ | 548  |      |  | $ | 490   |  
|Interest expense                      |  |      | (292 | ) |      |   | (325 | )    |  |   | (165  | )
|Foreign currency exchange gain (loss) |  |      | (134 | ) |      |   | (182 | )    |  |   | 1,220 |  
|Other                                 |  |      | 138  |   |      |   | (3   | )    |  |   | (8    | )
|                                      |  |      |      |   |      |   |      |      |  |   |       |  
|Total                                 |  | $    | 216  |   |      | $ | 38   |      |  | $ | 1,537 |  
|                                      |  |      |      |   |      |   |      |      |  |   |       |  

NOTE 12. COMMITMENTS AND CONTINGENCIES

Operating Leases.The Company leases various equipment and office space under noncancelable operating leases that expire at various dates through
2011. Rental expense was $3,654, $3,438 and $3,545 in 2005, 2004 and 2003, respectively. Future minimum lease payments under noncancelable leases for the next five years and thereafter as of December 31, 2005 totaled $10,194 and are due as
follows: 2006$3,235; 2007$2,873; 2008$2,209; 2009$1,274; 2010$387; and thereafter$216. Sublease revenue of $19, $100 and $118 in 2005, 2004 and 2003, respectively was netted against rental expense.

Brigham Young University Technology License Agreements.The Company has a paid-up license with Brigham Young University (BYU) to
utilize certain patents involving hearing aid signal processing, audio signal processing and hearing compression. The agreement remains in effect until the expiration of the last patent right in 2013 and can be terminated by BYU in the event of
circumstances outlined in the agreement. During the term of the agreement, the Company is responsible for the payment of all fees and costs associated with filing and maintaining patent rights.

The Company also has a license agreement with BYU to utilize certain noise suppression technologies owned by BYU. The agreement remains in
effect indefinitely, unless terminated by BYU in the event of circumstances outlined in the agreement. Under the terms of this agreement, the Company is required to make royalty payments to BYU in the amount of 0.5% of the adjusted gross sales of
the licensed products sold or otherwise transferred to an end user for as long as the Company uses this technology. This agreement may be terminated without cancellation fees. Royalty expense pertaining to this license was $225, $193 and $129 in
2005, 2004 and 2003, respectively.

K/S HIMPP License Agreement.The Company has a paid-up license agreement with K/S HIMPP, a
Danish partnership, to use technology covered by approximately 200 patents owned by K/S HIMPP that are considered essential for the sale of programmable hearing aids. The paid-up license is being amortized over the life of the technology through
2013. Amortization expense pertaining to this license was $99 in each of the three years ended December 31, 2005, 2004 and 2003.

Ear Tube License Agreement.The Company has a license agreement with a competitor that provides the Company with a worldwide license to utilize patents involving ear tube technology for its open-ear product. Under the terms of this
agreement, the Company paid an up-front royalty of $125 and must pay a small royalty on each item sold if it manufacturers the item, or no royalty if it buys the item from the licensor. This agreement remains in effect for seven years from the first
product sale. Amortization of the up-front payment will begin when the product is introduced to the market and will continue over a five year period.

Programming System License Agreement.The Company has a license agreement with a competitor that provides the Company with a worldwide license to utilize patents involving programming a hearing aid. Under the
terms of this agreement, the Company paid an up-front royalty of $250 and must pay a per-unit royalty fee on each item shipped after a set minimum. This agreement remains in effect until the expiration of the patents in 2012. Royalty expense
pertaining to this license was $124 and $85, in 2005 and 2004, respectively.

Manufacturing License Agreement.The Company has a
license agreement with a competitor that provides the Company with the technology to produce hearing aid shells using an automated process. Under the terms of this agreement, the Company is obligated to pay a per-unit royalty for using such
technology. Royalty expense pertaining to this license was $4 in 2005.



F-16



---

SONIC INNOVATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(dollars in
thousands, except per share amounts)



Digital License Agreement.The Company has a license agreement with another company that
provides the Company an exclusive worldwide license to utilize patents involving directional signal processing. Under the terms of this agreement, the Company is required to pay a royalty equal to 0.5% of net sales of hearing aid products utilizing
the technology or a minimum quarterly fee, whichever is greater. This agreement remains in effect until the expiration of the patents in 2020. Royalty expense pertaining to this license was $110, $80 and $40 in 2005, 2004 and 2003, respectively.

Legal Matters.The Companys wholly owned subsidiary, Tympany, filed a declaratory judgment action in March 2004 against
BioCell and International Biophysics Corp. (collectively, IBC) stemming from a dispute regarding manufacturing services performed by IBC for Tympany. IBC counterclaimed and sought, among other claims, lost profits and punitive damages.
The Company settled this lawsuit in the second quarter 2005 by paying IBC $875, of which $312 will be reimbursed to the Company by the former owners of Tympany.

In June 2005, Energy Transportation Group, Inc. (ETG) filed a patent infringement lawsuit in the United States District Court for the District of Delaware against fourteen defendants, including the
Company. ETG claims the defendants have infringed upon U.S. Patent No. 4,731,850 entitled Programmable Digital Hearing Aid System and U.S. Patent No. 4,879,749 entitled Host Controller for Programmable Digital Hearing Aid
System. ETG is seeking damages resulting from defendants unauthorized manufacture, use, sale, offer to sell and/or importation into the U.S. products, methods, processes, services and/or systems that infringe the above-named patents. The
Company has filed its answer denying all allegations. Discovery has not begun and no trial date has been set.

In February 2006, the former
owners of Sanomed, which the Company acquired in May 2003, filed a lawsuit in German civil court claiming that certain deductions made by the Company against accounts receivable amounts that were deemed uncollectible prior to the acquisition but
which have been collected and are due the former owners were improper. The former owners seek damages in the amount of $1,587. The Company will file its statement of defense in March 2006.

The Company strongly denies the allegations contained in the ETG and the Sanomed lawsuits and the Company intends to defend itself vigorously, however,
litigation is inherently uncertain and an unfavorable result could have a material adverse effect on the Company.

From time to time the
Company is subject to legal proceedings, claims and litigation arising in the ordinary course of its business. Most of these legal actions are brought against the Company by others and, when the Company feels it is necessary, it may bring legal
actions itself. Actions can stem from disputes regarding the ownership of intellectual property, customer claims regarding the function or performance of the Companys products, government regulation or employment issues, among other sources.
Litigation is inherently uncertain, and therefore the Company cannot predict the eventual outcome of any such lawsuits. However, the Company does not expect that the ultimate resolution of any known legal action, other than as identified above, will
have a material adverse effect on its results of operations and financial position.

NOTE 13. INCOME TAXES

Income (loss) before income taxes consisted of the following:



|         |  |      |         |   |      |   |        |      |  |   |        |  
|-------- |  | ---- | ------- | - | ---- | - | ------ | ---- |  | - | ------ | -
|         |  | 2005 |         |   | 2004 |   |        | 2003 | 
|Domestic |  | $    | (11,218 | ) |      | $ | 3,130  |      |  | $ | 3,495  |  
|Foreign  |  |      | (9,449  | ) |      |   | (2,641 | )    |  |   | (2,302 | )
|         |  |      |         |   |      |   |        |      |  |   |        |  
|Total    |  | $    | (20,667 | ) |      | $ | 489    |      |  | $ | 1,193  |  
|         |  |      |         |   |      |   |        |      |  |   |        |  



F-17



---

SONIC INNOVATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(dollars in
thousands, except per share amounts)



Income tax provision (benefit) consisted of the following:



|          |  |      |        |   |      |   |        |      |  |   |    
|--------- |  | ---- | ------ | - | ---- | - | ------ | ---- |  | - | ---
|          |  | 2005 |        |   | 2004 |   |        | 2003
|Domestic: |  |      |        |   |      |   |        |      |  |   |    
|Current   |  | $    | 75     |   |      | $ | 201    |      |  | $ | 119
|Deferred  |  |      |       |   |      |   |       |      |  |   |   
|          |  |      |        |   |      |   |        |      |  |   |    
|          |  |      | 75     |   |      |   | 201    |      |  |   | 119
|Foreign:  |  |      |        |   |      |   |        |      |  |   |    
|Current   |  |      | (1,397 | ) |      |   | 1,980  |      |  |   | 408
|Deferred  |  |      | 263    |   |      |   | (2,103 | )    |  |   | 290
|          |  |      |        |   |      |   |        |      |  |   |    
|          |  |      | (1,134 | ) |      |   | (123   | )    |  |   | 698
|          |  |      |        |   |      |   |        |      |  |   |    
|Total     |  | $    | (1,059 | ) |      | $ | 78     |      |  | $ | 817
|          |  |      |        |   |      |   |        |      |  |   |    

The following table presents the principal reasons for the difference between the actual effective
income tax rate and the U.S. federal statutory income tax rate:



|                                                        |  |       |   |  |        |   |  |        |  
|------------------------------------------------------- |  | ----- | - |  | ------ | - |  | ------ | -
|                                                        |  | 2005  |   |  | 2004   |   |  | 2003   |  
|U.S. federal statutory income tax rate                  |  | 34.0  | % |  | 34.0   | % |  | 34.0   | %
|State income tax rate, net of federal income tax effect |  | (0.2  | ) |  | 8.7    |   |  | 1.5    |  
|Foreign earnings taxed at different rates               |  | (0.1  | ) |  | 31.2   |   |  | 124.1  |  
|Non-deductible items and other                          |  | 0.3   |   |  | 79.8   |   |  | 11.1   |  
|Asset impairments                                       |  | (9.8  | ) |  |       |   |  |       |  
|Change in valuation allowance                           |  | (19.1 | ) |  | (137.7 | ) |  | (102.2 | )
|                                                        |  |       |   |  |        |   |  |        |  
|Effective income tax rate                               |  | 5.1   | % |  | 16.0   | % |  | 68.5   | %
|                                                        |  |       |   |  |        |   |  |        |  

Deferred income taxes are determined based on the differences between the financial reporting and
income tax bases of assets and liabilities using enacted income tax rates expected to apply when the differences are expected to be settled or realized. Significant components of the net deferred income tax liability consisted of the following as of
December 31:



|                                                  |  |      |         |   |      |   |         |  
|------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                                  |  | 2005 |         |   | 2004 |  
|Deferred income tax assets:                       |  |      |         |   |      |   |         |  
|Net operating loss carryforwards                  |  | $    | 15,460  |   |      | $ | 12,953  |  
|Allowance for sales returns and doubtful accounts |  |      | 1,604   |   |      |   | 1,404   |  
|Inventory allowances and warranty accruals        |  |      | 1,790   |   |      |   | 1,504   |  
|Deferred revenue                                  |  |      | 788     |   |      |   | 1,614   |  
|Accumulated research and development credits      |  |      | 1,559   |   |      |   | 889     |  
|Other                                             |  |      | 2,781   |   |      |   | 1,533   |  
|                                                  |  |      |         |   |      |   |         |  
|Sub-total                                         |  |      | 23,982  |   |      |   | 19,897  |  
|Valuation allowance                               |  |      | (20,982 | ) |      |   | (16,078 | )
|                                                  |  |      |         |   |      |   |         |  
|Deferred income tax assets                        |  |      | 3,000   |   |      |   | 3,819   |  
|Deferred income tax liabilities:                  |  |      |         |   |      |   |         |  
|Inventory                                         |  |      | (7      | ) |      |   | (82     | )
|Depreciation                                      |  |      | (395    | ) |      |   | (662    | )
|Acquired intangible assets                        |  |      | (1,325  | ) |      |   | (2,218  | )
|Other                                             |  |      | (1,612  | ) |      |   | (933    | )
|                                                  |  |      |         |   |      |   |         |  
|Deferred income tax liabilities                   |  |      | (3,339  | ) |      |   | (3,895  | )
|                                                  |  |      |         |   |      |   |         |  
|Net deferred income tax liabilities               |  | $    | (339    | ) |      | $ | (76     | )
|                                                  |  |      |         |   |      |   |         |  



F-18



---

SONIC INNOVATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(dollars in
thousands, except per share amounts)



Deferred income tax assets and liabilities were netted by income tax jurisdiction and were reported
in the consolidated balance sheets as of December 31 as follows:



|                                            |  |                            |  |      |      |   |      |   |      |  
|------------------------------------------- |  | -------------------------- |  | ---- | ---- | - | ---- | - | ---- | -
|                                            |  | Reported In                |  | 2005 |      |   | 2004 |  
|Current deferred income tax assets          |  | Prepaid expenses and other |  | $    | 15   |   |      | $ | 591  |  
|Non-current deferred income tax assets      |  | Other assets               |  |      |     |   |      |   | 202  |  
|Current deferred income tax liabilities     |  | Other accrued liabilities  |  |      | (7   | ) |      |   | (82  | )
|Non-current deferred income tax liabilities |  | Other liabilities          |  |      | (347 | ) |      |   | (787 | )
|                                            |  |                            |  |      |      |   |      |   |      |  
|Net deferred income tax liabilities         |  |                            |  | $    | (339 | ) |      | $ | (76  | )
|                                            |  |                            |  |      |      |   |      |   |      |  

The Company has not provided for U.S. deferred income taxes or foreign withholding taxes on the
undistributed earnings of its non-U.S. subsidiaries since these earnings are intended to be reinvested indefinitely and therefore, the foreign currency translation adjustment included in other comprehensive income has not been tax effected. It is
not practical to estimate the amount of additional taxes that might be payable on such undistributed earnings.

Through 2004, the Company
had a valuation allowance on all its deferred income tax assets in every tax jurisdiction with the exception of Australia and Germany. The realization of deferred income tax assets depends upon the existence of sufficient taxable income within the
carryback or carryforward periods under the tax laws of each tax jurisdiction. The Company has considered the following possible sources of taxable income when assuming the realization of the deferred income tax assets: future taxable income
exclusive of reversing temporary differences and carryforwards; future reversals of existing taxable temporary differences; taxable income in prior carryback years; and tax planning strategies. In assessing net deferred income tax assets in
Australia in 2005, the Company determined that due to continuing losses, it was more likely than not that the net deferred income tax assets would not be realized. As a result, the Company established a valuation allowance of $1,179. In 2005, the
Company eliminated a tax contingency of $686 in a foreign location upon the closing of certain tax years by the tax authorities.

As of
December 31, 2005, the Company had net operating loss carryforwards for U.S. federal income tax reporting purposes totaling $32,768 that will begin to expire in 2018 if not utilized. Approximately $7,376 of the U.S. net operating loss
carryforward will be subject to annual limitations under Section 382 of the Internal Revenue Code due to the change in ownership on the acquisition of Tympany. The annual limitation may result in the expiration of net operating loss
carryforwards before utilization. The Company has various state net operating loss carryforwards, which expire depending on the rules of the various states to which the net operating loss is allocated. NonU.S. net operating loss carryforwards
of $10,166 will begin to expire in 2006. Approximately $3,483 of net operating loss carryforwards as of December 31, 2005 were attributable to deductions associated with the exercise of Company stock options, the benefit of which will be
credited to additional paid-in capital when realized.

The Company has federal research and development tax credit carryforwards of
approximately $1,229 that begin to expire in 2009 and state research and development tax credit carryforwards of $330 that begin to expire in 2015. The Company also has alternate minimum tax credit carryforwards of approximately $110 that have no
expiration date.

NOTE 14. STOCKBASED COMPENSATION

Stock Plan.The Companys 2000 Stock Plan provides for the issuance of a maximum of 8,997,196 shares of common stock. The plan allows for the grant of incentive or nonqualified stock options, stock
purchase rights and restricted stock and is administered by the Board of Directors who determines the type, quantity, terms and conditions of any award, including any vesting conditions. The plan contains an evergreen provision that allows the Board
to annually increase the number of shares available by the lesser of (i) 5% of the total outstanding shares, (ii) 789,474 shares, or (iii) a lesser amount as determined by the Board. As of December 31, 2005, 1,365,606 shares were
available for grant under the plan and, effective January 1, 2006, an additional 784,474 shares were added by the Board under the evergreen provision.

Stock Options.Stock options have a maximum term of ten years and generally vest over a four-year period from the grant date. In connection with the grant of certain stock options prior to the Companys
initial public offering in 2000, the Company recorded deferred stock-based compensation of $4,638, representing the difference between the exercise price and the deemed fair value of the Companys common stock on the date of grant for stock
options granted in the one-year period preceding the initial filing of the Companys initial public offering. Amortization of this deferred stock-based compensation was completed in 2005. The Companys stock option activity was as follows:



F-19



---

SONIC INNOVATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(dollars in
thousands, except per share amounts)



|                                 |  |               |   |  |                                 |     
|-------------------------------- |  | ------------- | - |  | ------------------------------- | ----
|                                 |  | Option shares |   |  | Weighted average exercise price
|Outstanding at December 31, 2002 |  | 4,527,134     |   |  | $                               | 4.72
|Granted                          |  | 1,521,250     |   |  |                                 | 4.75
|Exercised                        |  | (279,858      | ) |  |                                 | 2.01
|Forfeited or expired             |  | (876,324      | ) |  |                                 | 5.55
|                                 |  |               |   |  |                                 |     
|Outstanding at December 31, 2003 |  | 4,892,202     |   |  |                                 | 4.73
|Granted                          |  | 418,550       |   |  |                                 | 4.57
|Exercised                        |  | (516,231      | ) |  |                                 | 3.26
|Forfeited or expired             |  | (124,031      | ) |  |                                 | 8.30
|                                 |  |               |   |  |                                 |     
|Outstanding at December 31, 2004 |  | 4,670,490     |   |  |                                 | 4.78
|Granted                          |  | 525,000       |   |  |                                 | 3.39
|Exercised                        |  | (80,120       | ) |  |                                 | 2.40
|Forfeited or expired             |  | (476,587      | ) |  |                                 | 5.00
|                                 |  |               |   |  |                                 |     
|Outstanding at December 31, 2005 |  | 4,638,783     |   |  |                                 | 4.64
|                                 |  |               |   |  |                                 |     

The Company accelerated the exercisability of 1,009,221 previously awarded stock options with
exercise prices greater than the closing price of its common stock as of December 23, 2004 of $4.18 per share. The exercise prices and number of shares subject to the acceleration were unchanged. In 2005, the Company granted stock options to
purchase 525,000 shares of common stock, of which 250,000 shares became fully vested and exercisable on the date of grant.

As of
December 31, 2005, 2004 and 2003, there were stock options exercisable for 4,161,109, 3,911,507 and 2,546,903 shares of common stock at weighted average exercise prices of $4.78, $4.99 and $4.54 per share, respectively. Stock options
outstanding and exercisable as of December 31, 2005 were as follows:



|                         |        |                     |                                 |                     |                                         |  |        |  |                                 |  |   |      
|------------------------ | ------ | ------------------- | ------------------------------- | ------------------- | --------------------------------------- |  | ------ |  | ------------------------------- |  | - | -----
|Range of exercise prices |        | Options Outstanding |                                 | Options Exercisable
|                         | Shares |                     | Weighted average exercise price |                     | Weighted average remaining life (years) |  | Shares |  | Weighted average exercise price
|$0.27  $2.86            |        | 752,831             |                                 | $                   | 2.08                                    |  | 4.9    |  | 665,229                         |  | $ | 1.98 
|3.36  3.49              |        | 771,461             |                                 |                     | 3.41                                    |  | 8.4    |  | 521,461                         |  |   | 3.43 
|3.56  4.20              |        | 831,643             |                                 |                     | 3.97                                    |  | 5.8    |  | 711,571                         |  |   | 3.98 
|4.36  5.35              |        | 738,791             |                                 |                     | 4.66                                    |  | 7.0    |  | 718,791                         |  |   | 4.66 
|5.40  6.13              |        | 685,773             |                                 |                     | 5.87                                    |  | 6.1    |  | 685,773                         |  |   | 5.87 
|6.16  7.50              |        | 675,084             |                                 |                     | 6.75                                    |  | 6.7    |  | 675,084                         |  |   | 6.75 
|7.60  18.00             |        | 183,200             |                                 |                     | 11.06                                   |  | 5.3    |  | 183,200                         |  |   | 11.06
|                         |        |                     |                                 |                     |                                         |  |        |  |                                 |  |   |      
|Total                    |        | 4,638,783           |                                 |                     | 4.64                                    |  | 6.5    |  | 4,161,109                       |  |   | 4.78 
|                         |        |                     |                                 |                     |                                         |  |        |  |                                 |  |   |      

Restricted Stock. Restricted stock is issued on the date of grant and entitles the holders
to dividends and the right to vote their shares. Restrictions limit the sale or transfer of shares during the vesting period. In 2005, the Company granted 434,700 shares of restricted stock to employees and directors, of which 357,700 shares
remained restricted as of December 31, 2005. The fair market value of restricted stock on the date of grant is amortized to expense evenly over the restriction period, which generally is four years. The Company recorded compensation expense
related to restricted stock of $328 in 2005. Unamortized deferred stock-based compensation was $1,270 as of December 31, 2005.

NOTE
15. EMPLOYEE BENEFIT PLANS

The Company has an employee savings and retirement plan that is a salary deferral plan under
Section 401(k) of the Internal Revenue Code. The plan allows for matching contributions at the discretion of the Company. During 2005, the Company matched 25% of each employees first 4% of salary deferral. The match was increased to 50%
of each employees first 4% of salary deferral effective as of the first payroll in 2006. The Company expensed $123, $114 and $109 in matching contributions in 2005, 2004 and 2003, respectively.



F-20



---

SONIC INNOVATIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(dollars in
thousands, except per share amounts)



The Company has an employee stock purchase plan that allows participating employees to purchase,
through employee payroll deductions, shares of the Companys unissued common stock at 85% of the fair market value on specified dates. Employees purchased 205,664, 295,967 and 204,556 shares of common stock in 2005, 2004 and 2003, respectively
under the plan. As of December 31, 2005, 51,698 shares of common stock were reserved for issuance under the plan. The plan contains an evergreen provision that allows the Board to annually increase the number of shares available under the plan
by the lesser of (i) 2% of the total outstanding shares, (ii) 200,000 shares, or (iii) a lesser amount as determined by the Board. In December 2005, the Board of Directors made a decision to temporarily suspend share purchases under
the employee stock purchase plan.

NOTE 16. SEGMENT INFORMATION

The Company has four operating segments for which separate financial information is available and evaluated regularly by management in deciding how to allocate resources and assess performance. The Company
evaluates performance based on net sales and operating profit, among other things.

The Companys four operating segments include
three hearing aid operations (North America, Europe and Rest-of- world) and an auditory testing equipment operation. Inter-segment sales are eliminated in consolidation. This information is used by the chief operating decision maker to
assess the segments performance and in allocating the Companys resources. The Company does not allocate hearing aid research and development expenses to its hearing aid operating segments. In 2005, the Company determined that the
auditory testing equipment operation constituted a separate segment under SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, and has revised the segment information for prior periods to conform to the
current period presentation.



|                                                |  |                        |        |                           |        |   |               |  |   |        |  |   |         |   |  |   |        |   |  |   |         |  
|----------------------------------------------- |  | ---------------------- | ------ | ------------------------- | ------ | - | ------------- |  | - | ------ |  | - | ------- | - |  | - | ------ | - |  | - | ------- | -
|                                                |  | Hearing Aid Operations |        | Auditory TestingEquipment |        |   | Unallocated   |  |   | Total  | 
|                                                |  | North America          |        |                           | Europe |   | Rest-of-world |  |   |       
|2005                                            |  |                        |        |                           |        |   |               |  |   |        |  |   |         |   |  |   |        |   |  |   |         |  
|Net sales to external customers                 |  | $                      | 37,394 |                           |        | $ | 43,300        |  | $ | 18,432 |  | $ | 5,915   |   |  | $ |       |   |  | $ | 105,041 |  
|Asset impairment                                |  |                        |       |                           |        |   | 1,256         |  |   |       |  |   | 6,255   |   |  |   |       |   |  |   | 7,511   |  
|Restructuring                                   |  |                        | 1,894  |                           |        |   | 621           |  |   | 313    |  |   | 1,163   |   |  |   |       |   |  |   | 3,991   |  
|Operating profit (loss)                         |  |                        | (3,594 | )                         |        |   | 3,155         |  |   | 63     |  |   | (12,722 | ) |  |   | (7,785 | ) |  |   | (20,883 | )
|Identifiable segment assets                     |  |                        | 31,771 |                           |        |   | 37,694        |  |   | 13,312 |  |   | 3,987   |   |  |   |       |   |  |   | 86,764  |  
|Goodwill and indefinite-lived intangible assets |  |                        | 2,238  |                           |        |   | 20,031        |  |   | 7,245  |  |   |        |   |  |   |       |   |  |   | 29,514  |  
|Long-lived assets                               |  |                        | 7,294  |                           |        |   | 23,000        |  |   | 10,078 |  |   | 2,225   |   |  |   |       |   |  |   | 42,597  |  
|                                                |  |                        |        |                           |        |  
|2004                                            |  |                        |        |                           |        |   |               |  |   |        |  |   |         |   |  |   |        |   |  |   |         |  
|Net sales to external customers                 |  | $                      | 35,907 |                           |        | $ | 45,004        |  | $ | 16,777 |  | $ | 846     |   |  | $ |       |   |  | $ | 98,534  |  
|Operating profit (loss)                         |  |                        | 2,464  |                           |        |   | 6,165         |  |   | 1,529  |  |   | (42     | ) |  |   | (9,665 | ) |  |   | 451     |  
|Identifiable segment assets                     |  |                        | 46,241 |                           |        |   | 46,243        |  |   | 15,014 |  |   | 7,788   |   |  |   |       |   |  |   | 115,286 |  
|Goodwill and indefinite-lived intangible assets |  |                        | 4,357  |                           |        |   | 22,564        |  |   | 7,646  |  |   | 405     |   |  |   |       |   |  |   | 34,972  |  
|Long-lived assets                               |  |                        | 10,798 |                           |        |   | 26,826        |  |   | 10,544 |  |   | 4,218   |   |  |   |       |   |  |   | 52,386  |  
|                                                |  |                        |        |                           |        |  
|2003                                            |  |                        |        |                           |        |   |               |  |   |        |  |   |         |   |  |   |        |   |  |   |         |  
|Net sales to external customers                 |  | $                      | 40,834 |                           |        | $ | 31,695        |  | $ | 15,161 |  | $ |        |   |  | $ |       |   |  | $ | 87,690  |  
|Operating profit (loss)                         |  |                        | 5,253  |                           |        |   | 3,156         |  |   | 1,014  |  |   |        |   |  |   | (9,767 | ) |  |   | (344    | )
|Identifiable segment assets                     |  |                        | 55,824 |                           |        |   | 38,154        |  |   | 13,018 |  |   |        |   |  |   |       |   |  |   | 106,996 |  
|Goodwill and indefinite-lived intangible assets |  |                        | 2,016  |                           |        |   | 17,894        |  |   | 7,062  |  |   |        |   |  |   |       |   |  |   | 26,972  |  
|Long-lived assets                               |  |                        | 7,558  |                           |        |   | 20,398        |  |   | 9,038  |  |   |        |   |  |   |       |   |  |   | 36,994  |  

Long-lived assets consist of property and equipment, definite-lived and indefinite-lived
intangible assets and goodwill. The majority of the Companys assets as of December 31, 2005, 2004 and 2003 were attributable to its U.S. operations. In addition to the U.S., the Company operates in two countries, Germany and Australia, in
which assets and sales were in excess of 10% of consolidated amounts.



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