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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-K



x ANNUAL REPORT PURSUANT TO
SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003



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)



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|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 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 an accelerated filer (as
defined in Rule 12b-2 of the Securities Exchange Act of 1934, as amended).  x



The aggregate market value of the voting, and non-voting common equity held by non-affiliates of the registrant as of March 8, 2004, computed by reference
to the closing sale price of the registrants common stock on the Nasdaq National Market on June 30, 2003 ($3.60) was approximately $72.6 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 (and their affiliates) were considered affiliates.



As of March 8, 2004, the registrant had outstanding 20,510,778 shares of common stock.



DOCUMENTS INCORPORATED BY REFERENCE



Portions of the registrants Proxy Statement for the 2004 Annual Meeting of Shareholders 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 Item 7 of this Form 10-K. Our actual results could differ materially and adversely from those anticipated in such forward-looking statements. Investors are cautioned not to
place undue reliance on such statements, which speak only as of the date made. 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 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 1. | BUSINESS
|------- | --------



Our Company



Sonic
Innovations, Inc. designs, develops, manufactures and markets advanced digital hearing aids designed to provide the highest levels of satisfaction for hearing impaired consumers. Capitalizing on what we believe is an advanced understanding of human
hearing, we have developed patented digital signal processing (DSP) technologies and embedded them in the smallest single-chip DSP platform ever installed in a hearing aid. In the United States (U.S.), Canada, Denmark, England, Switzerland, Austria
and the Netherlands, we sell finished hearing aids principally to hearing care professionals. In Germany and Australia, we sell hearing aids directly to hearing impaired consumers. In other parts of the world where we do not have a direct presence,
we sell finished hearing aids and hearing aid kits principally to distributors. We first began shipping product in the fourth quarter of 1998.



Our Natura 3, Natura 2 SE, Altair, Tribute and Quartet product lines, which incorporate our DSP platform, are among the smallest products available today
and can be purchased in the six common models for hearing aids: behind-the-ear; in-the-ear; half-shell; in-the-canal; mini-canal; and completely-in-the-canal. Our Adesso product, which also incorporates our DSP platform, is a programmable,
instant-fit, completely-in-the canal model that is the smallest digital hearing aid available today.



In May 2003, we acquired Sanomed Handelsgesellschaft mbH, a hearing aid retailer in Germany. This acquisition provided us with a measurable presence in
the worlds second largest hearing aid market. Traditionally, hearing aid manufacturers sell to a hearing aid retailer who then sells to the consumer. Sanomed is different in its distribution model than our major competitors, in that it sells
direct to the consumer, using the ear-nose-throat (ENT) physician to do the hearing aid fitting.



Industry Background



The 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. Said differently, of the total population that could
benefit from a hearing aid, only about 20% own a hearing aid. This is depicted in the following chart:



Hearing Aid Market by Segment



|                           |  |                                    |   |  |                                                |   |  |                                                               |  
|-------------------------- |  | ---------------------------------- | - |  | ---------------------------------------------- | - |  | ------------------------------------------------------------- | -
|Type of hearing impairment |  | Hearing impairedpercentage by type |   |  | Percentage ofhearing aidowners withineach type |   |  | Percentage of totalhearing impaired who are hearingaid owners |  
|Mild/moderate              |  | 81                                 | % |  | 14                                             | % |  | 11.0                                                          | %
|Severe                     |  | 15                                 |   |  | 50                                             |   |  | 7.5                                                           |  
|Profound                   |  | 4                                  |   |  | 37                                             |   |  | 1.5                                                           |  
|                           |  |                                    |   |  |                                                |   |  |                                                               |  
|Total                      |  | 100                                | % |  |                                                |   |  | 20.0                                                          | %
|                           |  |                                    |   |  |                                                |   |  |                                                               |  



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As seen in the above chart, the use of hearing aids is particularly low in the mild/moderate segment of
the hearing impaired population. Hearing impaired people in this segment, which comprises a very large percentage 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, worldwide retail sales of hearing aids are estimated to be approximately $5 billion and wholesale sales are estimated to be approximately $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 three segmentsnon-programmable analog, programmable analog and digital.
Digital hearing aids were first introduced in 1996 and in 2003 represent an estimated 66% of U.S. hearing aid sales, up from 45% in 2002. 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. In 2003, the overall U.S. hearing aid market grew by approximately 5% in units according to data provided by the Hearing Industry
Association. We believe that as companies like ours continue to take advantage of the full potential of the digital platform the percentage of sales from digital hearing aids will continue to increase. However, we believe the pace of digital
penetration will begin to slow. As a digital hearing aid company, we continue to benefit from the market trend from analog to digital.



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 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.



Hearing Aids



It is now well known that 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.



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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 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. Unfortunately, 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. The result was a hearing aid design 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 1996, technological advances based on digital signal processing (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.



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 aid dispenser. Most hearing aids in the U.S. are custom-made to each individuals ear canal, particularly for users in the mild to moderate loss
category. 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 manufacturer who then builds an aid with 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.



Our Technology



Our
technology strategy is to combine a number of distinct technologies, supported by 45 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 34 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 11 patent
applications pending. The core of our technology is our proprietary DSP platform, which is based on what we believe is a significant advancement in the understanding of human hearing. Using state-of-the-art chip design capabilities, we have embedded
our proprietary algorithms into the smallest single-chip DSP platform available in a hearing aid today. As a result, our products are among the smallest hearing aids available today.



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Digital Signal Processing Platform



Our proprietary DSP platform contains a patented set of algorithms that are
based on our 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 platform processes sound at a rate we believe to be faster than other digital hearing aids. Traditionally, hearing aids have not processed sounds quickly enough to allow a wearer to localize sounds, or ascertain
from which direction a sound emanates. We believe that our products are the first to solve this problem, thus providing a much more natural hearing experience by restoring lost localization and directionality of sound.



Single Chip Solution



Using state-of-the-art chip design capabilities, we have embedded our
proprietary DSP platform into a single chip that is the smallest, most sophisticated DSP chip available in a hearing aid today. We are not aware of any other hearing aid company that has introduced a single-chip DSP solution. This proprietary DSP
chip is an advanced, energy-efficient integrated circuit that powers frequency-specific, level-dependent, multi-channel features. The result of this convergence of advanced hearing science and leading edge digital technology is several families of
hearing aids that we believe deliver a more natural, lifelike listening and communication experience to the hearing impaired.



Our Products



We have packaged our proprietary technologies into a broad line of digital hearing aids that offer what we believe is superior sound quality, smaller
size, enhanced personalization and increased reliability at competitive prices. All of our products incorporate our proprietary DSP platform 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 Natura 3, Natura 2 SE, Altair, Tribute and Quartet product lines incorporate our DSP platform, and are among the smallest custom products available
today. They 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 Adesso product is an instant-fit hearing aid
that also contains our DSP platform and is the smallest digital hearing aid available.



Our 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. These features are described in more detail below.



Registered trademarks of Sonic Innovations, Inc. are: Natura, Altair, Tribute, Quartet, Conforma, Adesso, Expressfit,Directionalplus,Personalized Noise Reduction and Sonic Innovations, Inc.



Dynamic Speech Enhancement



Our patented core digital signal processing technology, which is offered in
all of our products, not only enhances speech understanding, but also provides a more natural communication experience. Our DSP platform processes frequencies within narrow bands similar to the cochlea and employs very fast-acting compression, which
produces virtually instantaneous volume adjustments to sounds. Consequently, our products respond to speech cues and other sounds in real timewithout a delay.



Speech Weighted Expansion



To address a common complaint with traditional wide dynamic range compression (WDRC) hearing aids, we have adapted a
technology called expansion from the professional audio field. Traditional WDRC hearing aids apply the highest level of gain (volume) to the softest sounds, including non-speech sounds. As a result,



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individuals often complain that non-speech soft sounds, such as fan noise, get too loud and become annoying. Our speech weighted expansion technology,
however, actually reduces the volume for low-intensity sounds and can be set to meet each individuals needs. As a result, our products are quiet without compromising volume for normal-intensity sounds.



Personalized Noise Reduction



Our Natura 3, Natura 2 SE and Adesso hearing aids offer our patented
Personalized Noise Reduction technology. This technology detects and reduces many background noises to provide the hearing impaired consumer with improved speech understanding in noise and a more comfortable listening and communication experience.
Personalized Noise Reduction reduces unwanted background noises and applies gain (volume) only to speech-like inputs in each of nine independent channels. This results in an improved signal-to-noise ratio because the amplitude (loudness)
of the noise is reduced without altering the amplitude of speech.



Directionalplus System



Typical
directional only microphone technology helps the user focus on sounds originating from the front by de-emphasizing sounds coming from behind. While such systems have been proven to be effective under certain listening conditions, these
systems rely on the assumption that speech is the sound arriving from in front of the user and noise is any sound originating from behind. Of course in the real world, noise is all around the typical user. Our approach to
this challenge is to utilize our sophisticated Directionalplus system that combines our patented Personalized Noise Reduction and switchable directionality. Available on our Natura 2 SE and Natura 3 models, these two technologies emphasize
sounds from the front and de-emphasize noise originating from all directions, thus improving the users ability to understand speech in the most challenging listening environments.



Expressfit Software



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 enables our hearing aids to be easily configured by the hearing care professional to the unique needs of each wearer. Expressfit, which runs on standard personal computers, is an
integral part of ensuring that our technologically advanced hearing aids meet the needs of each individual hearing aid wearer.



Improving Speech Understanding in Noise



The number one enhancement sought by hearing aid wearers is improved speech understanding in noise, with 95% of users requesting this improvement. Our
products have been clinically proven to enhance speech understanding in the presence of noise, offering hearing aid wearers a unique solution to the problem that challenges them the most. Clinically proven means that a two-site study in
the U.S., following Food and Drug Administration (FDA) guidelines for hearing aid research as recommended by the Hearing Industries Association (HIA), found a statistically significant benefit in speech intelligibility performance in noise when
comparing unaided to aided conditions. Specifically, there were three clinically proven outcomes from this study:



Sonic Innovations Natura (Natura 2 SE and Natura 3) and Altair hearing aids improve speech understanding in noise without the use of directional
microphones. Our 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. This was accomplished with
small-size, custom hearing aids proving that our core digital signal processing technology improves speech intelligibility in noise, using small-size, custom hearing aids without the burden of directional microphones.



Sonic Innovations Personalized Noise Reduction algorithm provides
additional benefit in understanding speech in noise.Our Personalized Noise Reduction algorithm, available on our Natura products, provides additional hearing benefit in understanding speech in noise.



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Sonic Innovations Natura hearing aids improve speech understanding in noise over analog hearing
aids. Our Natura products provide additional hearing benefit over analog-based hearing aids.



Manufacturing



Our
principal manufacturing facility is in Eagan, Minnesota (near Minneapolis), and we also have manufacturing facilities in Herlev, Denmark (near Copenhagen); 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 platform used in our products;
| | - | -------------------------------------------------------------------



| |  | assembling and testing the electronic subsystems and non-custom hearing aid products;
| | - | -------------------------------------------------------------------------------------



| |  | fabricating custom hearing aid shells;
| | - | --------------------------------------



| |  | integrating the electronic components into the hearing aid shell; and
| | - | ---------------------------------------------------------------------



| |  | testing and calibrating the finished hearing aid.
| | - | -------------------------------------------------



We assemble our custom (CIC, MC, HS, ITC and ITE) products 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. Similarly, Adesso is assembled using
standardized components, consisting of an electronic subsystem, a plastic housing and disposable foam tips that eliminate the need for a custom-molded shell.



A number of key components used in our products are currently available from only a single or limited number of suppliers. For example, our proprietary
digital signal processing chips are manufactured by a single supplier. Our relationship with this supplier is critical to our business because our proprietary DSP chip is integral to our products and because only a small number of suppliers would be
able or willing to produce our chip in the relatively small quantities and with the exacting specifications we require. Under our agreement with this supplier, we are required to make minimum annual purchases, which may be higher than our
requirements. The receivers and microphones used in all our products are available from only two suppliers. We also rely on contract manufacturers and are, therefore, subject to their performance, over which we have little control.



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 expections. Our actual sales returns were $15.9 million in 2003, $16.3 million in 2002
and $15.7 million in 2001. Our actual warranty (remake and repair) costs were $3.4 million in 2003, $3.1 million in 2002 and $2.7 million in 2001.



Sales and Marketing



Hearing aids have traditionally been dispensed (sold to the consumer) by hearing care professionals. 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 a high
level of customer service and support to hearing care professionals.



In the U.S., there are more than 12,000 hearing care professionals. However, only approximately 7,200 sell hearing aids. We position our products as premium-priced, premium-performance hearing aids and therefore, our direct sales force
targets select hearing care professionals who are capable of and interested in dispensing premium digital hearing aids. We have sold our products to over 3,300 hearing care professional accounts in the U.S.



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In addition to our direct sales force, we have an inside sales force and company 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 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.



Outside the U.S., we sell our products directly to hearing aid retailers in
Canada, England, Denmark, Switzerland, Austria and the Netherlands. In Australia, we sell directly to the hearing impaired consumer through more than 30 retail clinics and also sell on a wholesale basis to other hearing aid retailers. In Germany, we
sell directly to the hearing impaired consumer and pay the ENT physician to perform the hearing aid fitting on the consumer. Elsewhere in the world, we sell through a network of established distributors, who in turn sell to hearing care
professionals.



To further our marketing efforts, we sometimes
use advertising, public relations and market research agencies. These organizations work in tandem with our internal marketing team to communicate our brands advantages to customers. We may, in the future, implement direct-to-consumer
advertising and promotion campaigns that reflect our belief that consumers, as well as hearing care professionals, are important to the success of our products.



We believe that the evolution of the current distribution channel, combined with the characteristics of our hearing aids, particularly the ease of
fitting and opportunity for reduced hearing aid returns, remakes and repairs, will create new distribution opportunities. We are exploring alternative and emerging distribution channels, and we are currently selling to large hearing-care chains and
other chain-based retailers.



Customers



Our net sales in 2003 of $87.7 million by geography were as follows: North
America$40.8 million; Europe$31.7 million; and rest-of-world$15.2 million. 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.
If any of our larger customers were to stop or delay purchases, our net sales and operating results would be adversely affected. We may be unable to retain our current customers, and we may be unable to recruit replacement or additional customers.
We are selling an increasing number of hearing aids to several audiology clinic consolidators who have a large number of owned or franchised hearing aid clinics, as well as organized buying groups. As sales to larger customers and organized buying
groups increase, we are subject to the risk of losing these customers, incurring significant reductions in sales or granting price concessions to these customers. In addition, we are subject to the risk of collecting receivable balances from these
customers.



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. As of December 31, 2003, there were 44 employees actively
involved in research, development, clinical and regulatory activities. Their skills include 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 $9.8 million in 2003, $8.3 million in 2002 and $9.1 million in 2001.



Competition



We encounter aggressive competition from a number of hearing aid competitors worldwide. We compete principally with larger
companiesSiemens GmbH, Starkey Laboratories, Inc., Widex A/S, William Demant



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Holding A/S, Phonak S.A. and Great Nordic A/Sall of which have greater financial, sales and marketing, manufacturing and development resources than we
currently possess. Our competitors may develop products that are more effective in treating hearing loss than our own products, thus rendering our technologies and products obsolete or uncompetitive. We may not be able to compete effectively with
these competitors. The number of 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 in the last several
years, as evidenced by the acquisitions of Beltone, Dahlberg/Miracle Ear, ReSound, Philips, Unitron and Sonus, and further consolidation could produce stronger competitors. If we fail to compete effectively, our net sales and operating results will
suffer. For instance, we may have to reduce the prices of our products or offer additional customer incentives to stay competitive.



The digital segment of the hearing aid industry is characterized by increasing competition and new product introductions. The proliferation of digital
hearing aids is likely to lead to increasing price pressure and intense marketing campaigns as each company tries to differentiate its products from the others. We compete primarily on the basis of sound quality; technology; size, particularly in
CIC models; quality; comfort; reliability; price; ease of fitting the hearing aid; marketing, sales and distribution capabilities; and customer service, support and training. We believe we can currently compete effectively on each of these factors.



Patents, Licenses and Trade Secrets



We currently hold 34 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 11 patent applications pending.



Under our 1995 license agreement with BYU, as amended in 1996 and 2000, 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. Under this agreement, which expires in 2013 or the expiration
of the last claim of the patents, we are responsible for the payment of all fees and costs associated with filing and maintaining patent rights. As consideration for the license, we issued 105,567 shares of our common stock and paid $580,000 to BYU.



In 1997, we entered into another license agreement with BYU
giving us 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. We are required to make royalty payments to BYU equal to 0.5% of sales derived from products containing the licensed technologies.



In 2000, we paid $1.8 million to K/S HIMPP, a Danish partnership that owns approximately 200 patents considered essential for the sale of programmable
hearing aids, for a fully paid-up technology license.



In 1999,
in order to resolve a claim of patent infringement made by one of our competitors, we entered into a license agreement under which we agreed to pay a royalty of 1.5% on all net sales of hearing aids and components from October 1998 through September
2001.



In 2003, we entered into a license agreement with
another company that provides us with an exclusive worldwide license to utilize patents involving directional signal processing. Under the terms of this agreement, we are required to pay a royalty or a minimum quarterly fee, whichever is greater.



In 2003, we entered into a manufacturing license agreement
with a competitor that provides us with the technology to produce hearing aid shells using an automated process. Under the terms of this agreement, we are required to pay a royalty.



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



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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 require 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 considered to be medical devices and are subject to regulation in the U.S. by the Food and Drug Administration (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 premarket clearance from the FDA through the 510(k) process or be an exempt product. We believe
our hearing aids are exempt from the 510(k) process. We must comply with facility registration and product listing requirements of the FDA and adhere to its Quality System Regulations (QSR). The FDA enforces the QSR through periodic inspections,
which we have yet to undergo. 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 by meeting the requirements of ISO 13485. Any failure to maintain our ISO 13485 certification or CE Mark could significantly reduce our net sales and operating results.



Employees



As of December 31, 2003, we had 323 employees in North America, including 30
in administration, 74 in sales and marketing, 44 in research, development, clinical and regulatory and 175 in operations. Outside the U.S., we had 263 employees, including 122 in Australia and 141 in Europe. 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 not experienced any work stoppages and we consider relations with our employees to be good.



Executive Officers of the Registrant



The following table sets forth our officers and their ages as of December
31, 2003:



|                     |  |     |  |                                                     
|-------------------- |  | --- |  | ----------------------------------------------------
|Name                 |  | Age |  | Position                                            
|Andrew G. Raguskus   |  | 58  |  | President and Chief Executive Officer               
|Stephen L. Wilson    |  | 50  |  | Senior Vice President and Chief Financial Officer   
|Michael A. James     |  | 55  |  | SeniorVice President Worldwide Commercial Operations
|Jorgen Heide         |  | 65  |  | Senior Vice President Business Development          
|Gregory N. Koskowich |  | 43  |  | Vice President Research and Development             
|Victor H. Bray, Jr.  |  | 49  |  | Vice President Quality Systems                      
|Jerry L. DaBell      |  | 57  |  | Vice President Product Development                  
|Weston O. Ison       |  | 63  |  | Vice President Worldwide Manufacturing              
|Wayne C. Goebel      |  | 61  |  | Vice President U.S. Sales                           
|Michael M. Halloran  |  | 43  |  | Vice President and Corporate Controller             



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Andrew G. Raguskus joined Sonic Innovations in 1996 as President, Chief Executive Officer and director.
Mr. Raguskus 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 joining
ReSound, Mr. Raguskus held positions with various technology companies, including Sun Microsystems, Inc. and General Electrics Medical Systems Division. He serves on the board of the Hearing Industries Association. Mr. Raguskus earned a
bachelors degree in electrical engineering from Rensselaer Polytechnic Institute.



Stephen L. Wilson joined Sonic Innovations in October 1999 as Vice President and Chief Financial Officer and became Senior Vice President and Chief Financial Officer in February 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 October 2002 as Vice President Worldwide Field Operations and became Senior Vice President Worldwide
Commercial Operations in February 2003. From September 2000 through September 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.



Jorgen Heide joined Sonic Innovations in March 1997 as Vice President Operations, became Vice President International in February 1998 and Senior Vice
President Business Development in February 2003. From 1992 to 1997, Mr. Heide held three separate Vice President positions at ReSound Corporation, a hearing aid company. He earned a masters degree in electronic engineering from Frederiksberg
Tekniske Skole in Copenhagen, Denmark.



Gregory N. Koskowich,
Ph.D., joined Sonic Innovations in June 1997 as Vice President Research and Development. From 1995 to 1997, he was Vice President Product Development of IMP, Inc., a semi-conductor manufacturer. From 1992 to 1995, he was Manager of Microelectronics
Engineering at ReSound Corporation, a hearing aid company. He earned a bachelors degree and a masters degree in electrical engineering from University of Calgary and a Ph.D. in electrical engineering from University of Washington.



Victor H. Bray, Jr., Ph.D., joined Sonic Innovations in August
1997 as Vice President Auditory Research and became Vice President Quality Systems in January 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 at Austin.



Jerry L. DaBell joined Sonic Innovations in July 2000 as Vice President Business Development and became Vice President Product Development in January 2002. 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.



Weston O. Ison joined Sonic Innovations in October 1999 as Vice President Quality and Regulatory and became Vice President
Operations and Quality in June 2001 and Vice President Worldwide Manufacturing in January 2004. From 1992 to 1999, he served as Vice President of Quality, Customer Service and Operations Planning at American National Can, a packaging company. Mr.
Isons previous experience included positions at Case Corporation, Picker Medical and General Electric. He earned a bachelors degree in electrical engineering from University of Utah.



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Wayne C. Goebel joined Sonic Innovations in September 2003 as Vice President U.S. Sales. From 2001 to
September 2003, he was Vice President of Worldwide Sales of Corneal Science Corporation, an eye care company. From 1995 to 2001, he was Vice President of Sales and Marketing for North America, South America and Asia of Biocompatibles Inc., a contact
lens company. From 1989 to 1995, he was Vice President of Sales of Spectrascan Imaging Services Inc., a mammography and ultrasound service business. Mr. Goebels prior experience included 14 years with Bausch & Lomb, a contact lens company,
where he was Vice President of Sales for the Professional Products Division and General Manager of the Retail Optical Division. He earned a bachelors degree in political science from University of Massachusetts at Amherst.



Michael M. Halloran joined Sonic Innovations in April 1999 as Corporate
Controller and became Vice President and Corporate Controller in January 2003. From 1994 to 1999, he served in various financial capacities for C.R. Bard, Inc., a medical products company. Prior to that, Mr. Halloran spent eight years in public
accounting with Ernst & Young. He earned a bachelors degree in accounting from State University of New York at Oswego and is a Certified Public Accountant.



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(a) 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. These reports may be accessed through our websites
investor relations page. 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.



FACTORS THAT MAY AFFECT FUTURE PERFORMANCE



Our future results, plans, objectives, expectations and intentions could be 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 OPERATING CASH FLOWS



Although we reported net income of $1.4 million for the
quarter ended December 31, 2003, we have a history of losses and an accumulated deficit of $51.2 million at December 31, 2003. Cash and marketable securities decreased from $35.6 million at December 31, 2002 to $33.2 million at December 31, 2003. We
may incur net losses and negative operating cash flows in the future. Whether or not we maintain or increase profitability will depend in significant part on increasing our net sales, maintaining or improving our gross margin and limiting increases
to our operating expenses. Consequently, it is possible that we will not achieve or maintain profitability, or increase 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. Some of our competitors have invested in or advanced money, offered forgivable loans and provided other monetary incentives
to retail hearing aid operations. Although we have implemented similar programs on a limited basis, we may not choose to, or be



12



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able to, match these incentives, 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, which could cause us to lose existing 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 quarterly and annual operating results have
fluctuated in the past and may fluctuate significantly in the future. These fluctuations could cause our stock price to fluctuate significantly or decline. Factors that may cause fluctuations in our operating results include the following: general
economic conditions; the competitive performance of our products; government reimbursement levels for hearing aids; distribution of our products; difficulties in relationships with our customers; demand for and market acceptance of our products,
particularly our newer products where eventual market acceptance may not follow early indications; a reduction in orders from larger customers; manufacturing problems; high levels of returns, remakes and repairs; changes in our product or customer
mix; competitive pressures resulting in lower selling prices or significant promotional costs; unanticipated delays or problems in the introduction of new products; regulatory requirements; difficulties in managing international operations;
difficulties in integrating and managing acquired operations that could result in poor performance and write-downs of acquired intangible assets; the effect of future acquisitions, if any; component availability and pricing; the effect of
international conflicts and threats; inability to forecast revenue accurately; nonpayment of accounts and notes receivable; the announcement or introduction of new products or services by our competitors; and other business factors beyond our
control.



If net sales for a particular period were below our
expectations, it is 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. To manage the expansion of our operations and future growth, we will be required to (i) improve financial and management information controls and reporting systems and procedures; (ii) hire, train and manage additional qualified personnel;
(iii) expand our direct and indirect sales channels; and (iv) transition acquired businesses to sell more of our branded products.



As part of our business strategy, we may continue to make acquisitions that complement or expand our existing business. Our acquisition of businesses and
expansion of operations 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) loss of key employees of acquired businesses; (iv) loss of key customers of acquired businesses; (v) diversion of managements attention from other business concerns; and (vi) risks of entering markets in which we
have no direct or limited prior experience.



Acquisitions of
other businesses may result in the utilization of cash and marketable securities, dilutive issuances of equity securities and the incurrence of debt. In addition, acquisitions may result in the creation of (i) certain definite-lived intangible
assets that increase amortization expense, or (ii) goodwill and other indefinite-lived intangible assets that subsequently may result in large write-offs should these assets become impaired.



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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 continue to 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 several audiology clinic consolidators that have a large number of owned or
franchised retail hearing aid clinics. We are subject to the risk of losing our larger customers, incurring significant reductions in sales to these customers or reducing future prices in order to maintain our business. In addition, we are subject
to the risk of being unable to collect receivable balances from these customers.



WE ARE IN THE PROCESS OF SETTLING A CLASS ACTION LAWSUIT IN WHICH THE PLAINTIFF IS CLAIMING THAT WE AND CERTAIN OF OUR OFFICERS AND DIRECTORS VIOLATED FEDERAL SECURITIES LAWS



We are currently in the process of settling a lawsuit filed in October 2000
claiming that we and certain of our officers and directors violated federal securities laws by providing materially false and misleading information or concealing information about our relationship with Starkey Laboratories, Inc. The complaint
alleges that as a result of false statements or omissions, we were able to complete our initial public offering, artificially inflate our financial projections and results and have our stock trade at inflated levels. We continue to deny these
allegations. We have reached an agreement in principle to settle the securities class action lawsuits that have been consolidated under the caption Lynda Steinbeck, et al. v. Sonic Innovations, Inc., et al., in the United States District
Court for the District of Utah. The terms of the settlement call for a cash payment of $7.0 million, which will be funded by Sonic Innovations directors and officers liability insurance. The settlement is expected to have no impact on
our results of operations and financial condition. Final settlement is contingent on negotiation and execution of a formal settlement stipulation and court approvals of the settlement following notification to members of the class and an opportunity
for class members to object. Our directors and officers liability insurance premium, which renews in May 2004, will be substantially higher than in previous years.



WE RELY ON SEVERAL SOLE SOURCE OR LIMITED SOURCE SUPPLIERS AND CONTRACTORS, AND OUR BUSINESS WILL BE SERIOUSLY HARMED IF THESE SUPPLIERS
AND CONTRACTORS ARE NOT ABLE TO MEET OUR REQUIREMENTS AND ALTERNATIVE SOURCES ARE NOT AVAILABLE



Certain components used in our products are currently available only from a single or limited number of suppliers. For example, our proprietary digital
signal processing chips are manufactured by a single supplier. Our relationship with this supplier is critical to our business 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. This supplier may not be willing or able to satisfy our future advanced technology requirements. Under our agreement with this supplier, we are required to make minimum annual purchases, which may be
higher than our requirements. The receivers and microphones used in all our products are available from only two suppliers. We also rely on contractors for certain hearing aid component assembly and advanced integrated circuit design and development
and are therefore subject to their performance, over which we have little control. We may be forced to cease producing our products if we experience significant shortages of critical components from these key suppliers or lose the services of our
contractors. Finding a substitute part, process, supplier or contractor may be expensive, time-consuming or impossible.



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 60-day return policy and a minimum of a one-year
warranty on our hearing aids. Our actual sales returns were $15.9 million in 2003, $16.3 million in 2002 and $15.7 million in 2001. Our actual



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warranty costs for remakes and repairs were $3.4 million in 2003, $3.1 million in 2002 and $2.7 million in 2001. 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 DO NOT GAIN MARKET SHARE AS RAPIDLY AS WE ANTICIPATE,
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 may require hiring (i) expert personnel who
are difficult to find and attract or (ii) external vendors 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 revenues in excess of
the costs of development. 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. If our products do not gain market share as rapidly as
we anticipate, our net sales and operating results will suffer.



WE MAY BE
UNABLE TO EXPAND OUR MANUFACTURING CAPABILITIES SUFFICIENTLY OR TO FIND THIRD PARTIES TO MANUFACTURE OUR PRODUCTS, WHICH WOULD LIMIT OUR ABILITY TO DEVELOP AND DELIVER SUFFICIENT QUANTITIES OF PRODUCTS IN A TIMELY MANNER



To be successful, we must manufacture our products in commercial quantities
in compliance with regulatory requirements at acceptable costs. We may not be able to expand our manufacturing capabilities at acceptable costs or enter into agreements with third parties with respect to these activities. We would incur significant
expenses if we expanded our facilities and hired additional personnel.



THIRD PARTIES HAVE CLAIMED AND MAY CLAIM IN THE FUTURE THAT WE ARE INFRINGING THEIR INTELLECTUAL PROPERTY, AND WE COULD SUFFER SIGNIFICANT EXPENSE OR BE PREVENTED FROM SELLING PRODUCTS IF THESE CLAIMS ARE SUCCESSFUL



Third parties have claimed and may claim in the future that we are
infringing their intellectual property rights. In fact, we are currently suing a competitor in federal court to obtain a declaratory judgment that we do not infringe on this competitors technology. While we do not believe that any of our
products infringe the proprietary rights of third parties, we may be unaware of intellectual property rights of others that may cover some of our technology. Whether or not we actually infringe a third partys rights, any litigation regarding
patents or other intellectual property could be costly and time-consuming and divert our management and key personnel from our business operations. Claims of intellectual property infringement might also require us to enter into costly royalty or
license agreements.



BECAUSE OUR SUCCESS DEPENDS ON OUR PROPRIETARY
TECHNOLOGY, IF THIRD PARTIES INFRINGE OUR INTELLECTUAL PROPERTY, WE MAY BE FORCED TO EXPEND SIGNIFICANT RESOURCES ENFORCING OUR RIGHTS OR SUFFER COMPETITIVE INJURY



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. Additionally, some foreign laws do not protect our proprietary rights to the same extent as U.S. laws. If we fail
to successfully enforce our intellectual property rights, our competitive position will suffer.



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SELLING THROUGH NON-TRADITIONAL DISTRIBUTION CHANNELS COULD HARM OUR RELATIONSHIPS WITH EXISTING CUSTOMERS AND CAUSE
THEM TO PURCHASE FEWER OF OUR PRODUCTS, WHICH WOULD REDUCE OUR NET SALES AND OPERATING RESULTS



In Germany and Australia, we sell hearing aids direct to the hearing impaired consumer, and in some markets we are experimenting with selling our products
through non-traditional distribution channels, such as high volume general retail and electronics retail stores and the ear-nose-throat physician group. Our current initiatives or any future initiatives could alienate our traditional hearing care
professional customers. It is possible that our hearing care professional customers will react by reducing or discontinuing their purchases from us. In such a scenario, the resulting loss of revenue may not be offset by revenue from new distribution
channels, and we may choose not to continue using any of these new channels. Should hearing care professionals react unfavorably to such a strategy, they would likely purchase fewer of our products, which would reduce our net sales and operating
results and damage our competitive position.



WE ARE DEPENDENT ON
INTERNATIONAL OPERATIONS, WHICH EXPOSES US TO A VARIETY OF RISKS THAT COULD RESULT IN LOWER INTERNATIONAL 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 international sales and operating results to decrease. For example, there is significant government hearing aid reimbursement in a number of countries outside the
U.S., which if reduced or eliminated could have a negative effect on hearing aid sales. In addition, in order to market our products in the European Union (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. Furthermore, 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 the 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.



WE MAY NOT BE
ABLE TO MAINTAIN OR EXPAND OUR BUSINESS IF WE ARE UNABLE TO HIRE AND RETAIN SUFFICIENT TECHNICAL AND SALES PERSONNEL



Competition for qualified personnel in technology industries can be intense. If we are unable to hire and retain sufficient technical and sales personnel
our business and operating results may suffer.



IF OUR STOCK PRICE DOES NOT
INCREASE, WE MAY HAVE DIFFICULTY RETAINING KEY EMPLOYEES



Stock options are an important component of the compensation of our key personnel. If our stock price does not increase in the future, we may face difficulty retaining key employees and may need to exchange existing options for new options
or issue new options to motivate and retain our key employees, which would be dilutive to the equity of our shareholders. In addition, recently announced accounting rules will require us to expense the value of stock options vesting or granted after
January 1, 2005. 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



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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, WE MAY
SUFFER FINES, INJUNCTIONS OR OTHER PENALTIES



Our products
are considered to be medical devices and are, accordingly, subject to regulation in the U.S. by the Food and Drug Administration (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.



TECHNOLOGY STOCKS HAVE EXPERIENCED EXTREME VOLATILITY, AND OUR STOCK PRICE COULD BE EXTREMELY VOLATILE. CONSEQUENTLY, YOU MAY NOT BE ABLE TO RESELL YOUR SHARES AT OR ABOVE THE PRICE YOU PAID FOR THEM



The stock market in general and technology stocks in particular, have
experienced extreme volatility that has often been unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the market price of our stock.



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. Approximately 2.4 million of our outstanding shares of stock are beneficially owned by our directors and officers. 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 YOU 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.



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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, 2003 was 172,918 square feet as follows:



|                           |  |                |  |                              
|-------------------------- |  | -------------- |  | -----------------------------
|Location                   |  | Square Footage |  | Lease Expiration             
|Salt Lake City, Utah       |  | 55,000         |  | August 2004                  
|Eagan, Minnesota           |  | 22,748         |  | October 2006                 
|Copenhagen, Denmark        |  | 18,363         |  | August 2005                  
|London, England            |  | 6,462          |  | Various through April 2009   
|Adelaide, Australia        |  | 10,591         |  | December 2004                
|Australia retail locations |  | 28,202         |  | Various through November 2008
|Birr-Lupfig, Switzerland   |  | 2,580          |  | September 2007               
|Leibnitz, Austria          |  | 1,636          |  | June 2005                    
|Zwolle, Netherlands        |  | 8,536          |  | Various through August 2008  
|Montreal, Canada           |  | 7,700          |  | June 2005                    
|Hamburg, Germany           |  | 9,300          |  | June 2009                    
|Germany retail locations   |  | 1,800          |  | Various through June 2009    
|                           |  |                |  |                              
|Total                      |  | 172,918        |  |                              
|                           |  |                |  |                              



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



|ITEM 3. | LEGAL PROCEEDINGS
|------- | -----------------



We are currently in the process of settling a lawsuit filed in October 2000 claiming that we and certain of our officers and directors violated federal
securities laws by providing materially false and misleading information, or concealing information, about our relationship with Starkey Laboratories, Inc. This lawsuit, which is pending in the U.S. District Court for the District of Utah, is being
brought as a class action on behalf of all purchasers of our common stock from May 2, 2000 to October 24, 2000 and seeks damages in an unspecified amount. The complaint alleges that as a result of false statements or omissions, we were able to
complete our IPO, artificially inflate our financial projections and results and have our stock trade at inflated levels. We have reached an agreement in principle to settle the securities class action lawsuits that have been consolidated under the
caption Lynda Steinbeck, et al. v. Sonic Innovations, Inc., et al., in the United States District Court for the District of Utah. The terms of the settlement call for a cash payment of $7.0 million, which will be funded by Sonic
Innovations directors and officers liability insurance. The settlement is expected to have no impact on our results of operations and financial position. Final settlement is contingent on negotiation and execution of a formal settlement
stipulation and court approvals of the settlement following notification to members of the class and an opportunity for class members to object.



In addition, we are subject to legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters
cannot be predicted with certainty, we do not expect that the ultimate resolution of these matters 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 shareholders during the quarter ended December 31, 2003.



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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
|2003           |  | High        |      | Low
|               |  |            
|First quarter  |  | $           | 3.86 |     | $ | 1.94
|Second quarter |  |             | 4.69 |     |   | 2.18
|Third quarter  |  |             | 6.41 |     |   | 3.45
|Fourth quarter |  |             | 8.00 |     |   | 5.60
|               |  |            
|2002           |  | High        |      | Low
|               |  |            
|First quarter  |  | $           | 7.35 |     | $ | 4.11
|Second quarter |  |             | 7.44 |     |   | 4.61
|Third quarter  |  |             | 7.45 |     |   | 4.50
|Fourth quarter |  |             | 6.19 |     |   | 3.40



The closing price of
our common stock as reported by the Nasdaq Stock Exchange on March 8, 2004 was $10.60 per share. As of March 8, 2004, there were approximately 3,200 holders of record of our common stock.



Dividends



We have not historically declared or paid cash dividends on any class of stock. 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, 2003:



|                                                           |  |                                                                                            |  |                                                                            |      |                                                                                                                                          |        
|---------------------------------------------------------- |  | ------------------------------------------------------------------------------------------ |  | -------------------------------------------------------------------------- | ---- | ---------------------------------------------------------------------------------------------------------------------------------------- | -------
|Plan category                                              |  | Number of securities tobe issued upon exercise of outstanding options, warrants and rights |  | Weighted-average exerciseprice of outstanding options, warrants and rights |      | Number of securities remainingavailable for future issuance under equity compensation plans
(excludingsecurities reflected in column (a)
|                                                           |  | (a)                                                                                        |  | (b)                                                                        |      | (c)                                                                                                                                     
|Equity compensation plans approved by security holders     |  | 4,892,202                                                                                  |  | $                                                                          | 4.73 |                                                                                                                                          | 624,076
|Equity compensation plans not approved by security holders |  |                                                                                           |  |                                                                            |     |                                                                                                                                          |       
|                                                           |  |                                                                                            |  |                                                                            |      |                                                                                                                                          |        
|Total                                                      |  | 4,892,202                                                                                  |  | $                                                                          | 4.73 |                                                                                                                                          | 624,076
|                                                           |  |                                                                                            |  |                                                                            |      |                                                                                                                                          |        



19



---

|ITEM 6. | SELECTED FINANCIAL DATA(In thousands, except share and other data)
|------- | ------------------------------------------------------------------



|                                                   |  |      |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |         |  
|-------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------ | ---- |  | - | ------ | - |  | ---- | ------ | - |  | - | ------- | -
|                                                   |  | 2003 |         |   | 2002 |   |        | 2001 |  |   | 2000   |   |  | 1999 |       
|Statements of Operations:                          |  |      |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |         |  
|Net sales                                          |  | $    | 87,690  |   |      | $ | 68,018 |      |  | $ | 57,267 |   |  | $    | 51,660 |   |  | $ | 28,694  |  
|Gross profit                                       |  | $    | 46,370  |   |      | $ | 35,421 |      |  | $ | 26,018 |   |  | $    | 25,473 |   |  | $ | 11,632  |  
|Percent of net sales                               |  |      | 52.9    | % |      |   | 52.1   | %    |  |   | 45.4   | % |  |      | 49.3   | % |  |   | 40.5    | %
|Operating expenses                                 |  | $    | 46,714  |   |      | $ | 36,799 |      |  | $ | 33,746 |   |  | $    | 29,224 |   |  | $ | 25,383  |  
|Percent of net sales                               |  |      | 53.3    | % |      |   | 54.1   | %    |  |   | 58.9   | % |  |      | 56.6   | % |  |   | 88.5    | %
|Operating loss                                     |  | $    | (344    | ) |      | $ | (1,378 | )    |  | $ | (7,728 | ) |  | $    | (3,751 | ) |  | $ | (13,751 | )
|Net income (loss)                                  |  | $    | 376     |   |      | $ | 32     |      |  | $ | (5,635 | ) |  | $    | (4,204 | ) |  | $ | (17,337 | )
|Earnings (loss) per common sharebasic             |  | $    | 0.02    |   |      | $ | 0.00   |      |  | $ | (0.28  | ) |  | $    | (0.31  | ) |  | $ | (12.72  | )
|Earnings (loss) per common sharediluted           |  | $    | 0.02    |   |      | $ | 0.00   |      |  | $ | (0.28  | ) |  | $    | (0.31  | ) |  | $ | (12.72  | )
|Weighted average common shares outstandingbasic   |  |      | 19,941  |   |      |   | 19,595 |      |  |   | 19,822 |   |  |      | 13,479 |   |  |   | 1,363   |  
|Weighted average common shares outstandingdiluted |  |      | 20,971  |   |      |   | 20,869 |      |  |   | 19,822 |   |  |      | 13,479 |   |  |   | 1,363   |  
|Balance Sheets:                                    |  |      |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |         |  
|Cash and marketable securitiesunrestricted        |  | $    | 21,360  |   |      | $ | 35,561 |      |  | $ | 45,806 |   |  | $    | 52,210 |   |  | $ | 5,939   |  
|Cash and marketable securitiesrestricted          |  | $    | 11,852  |   |      | $ |       |      |  | $ |       |   |  | $    |       |   |  | $ |        |  
|Total assets                                       |  | $    | 106,996 |   |      | $ | 74,746 |      |  | $ | 70,856 |   |  | $    | 76,248 |   |  | $ | 18,462  |  
|Total liabilities                                  |  | $    | 41,943  |   |      | $ | 14,901 |      |  | $ | 13,692 |   |  | $    | 11,977 |   |  | $ | 21,134  |  
|Shareholders equity (deficit)                     |  | $    | 65,053  |   |      | $ | 59,845 |      |  | $ | 57,164 |   |  | $    | 64,271 |   |  | $ | (38,801 | )
|Other:                                             |  |      |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |         |  
|Countries with operations                          |  |      | 9       |   |      |   | 8      |      |  |   | 3      |   |  |      | 2      |   |  |   | 1       |  
|Number of employees                                |  |      | 586     |   |      |   | 531    |      |  |   | 430    |   |  |      | 342    |   |  |   | 211     |  



|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|-------------------------------------------------- |  | ----- | ------ | - | ------ | - | ------ | ----- |  | - | ------ | - |  | - | ------ | -
|                                                   |  | First |        |   | Second |   |        | Third |  |   | Fourth |  
|Unaudited quarterly results of operations:         |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|                                                   |  |       |        |  
|2003:                                              |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Net sales                                          |  | $     | 17,014 |   |        | $ | 21,887 |       |  | $ | 23,084 |   |  | $ | 25,705 |  
|Cost of sales                                      |  |       | 7,795  |   |        |   | 10,646 |       |  |   | 11,155 |   |  |   | 11,724 |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Gross profit                                       |  |       | 9,219  |   |        |   | 11,241 |       |  |   | 11,929 |   |  |   | 13,981 |  
|Operating expenses                                 |  |       | 10,498 |   |        |   | 11,325 |       |  |   | 12,219 |   |  |   | 12,672 |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Operating profit (loss)                            |  |       | (1,279 | ) |        |   | (84    | )     |  |   | (290   | ) |  |   | 1,309  |  
|Other income                                       |  |       | 557    |   |        |   | 589    |       |  |   | 44     |   |  |   | 347    |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Income (loss) before income taxes                  |  |       | (722   | ) |        |   | 505    |       |  |   | (246   | ) |  |   | 1,656  |  
|Provision for income taxes                         |  |       | 124    |   |        |   | 341    |       |  |   | 142    |   |  |   | 210    |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Net income (loss)                                  |  | $     | (846   | ) |        | $ | 164    |       |  | $ | (388   | ) |  | $ | 1,446  |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Basic and diluted earnings (loss) per common share |  | $     | (0.04  | ) |        | $ | 0.01   |       |  | $ | (0.02  | ) |  | $ | 0.07   |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|                                                   |  |       |        |  
|2002:                                              |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Net sales                                          |  | $     | 15,104 |   |        | $ | 17,351 |       |  | $ | 18,317 |   |  | $ | 17,246 |  
|Cost of sales                                      |  |       | 7,441  |   |        |   | 8,364  |       |  |   | 8,689  |   |  |   | 8,103  |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Gross profit                                       |  |       | 7,663  |   |        |   | 8,987  |       |  |   | 9,628  |   |  |   | 9,143  |  
|Operating expenses                                 |  |       | 8,471  |   |        |   | 9,281  |       |  |   | 9,397  |   |  |   | 9,650  |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Operating profit (loss)                            |  |       | (808   | ) |        |   | (294   | )     |  |   | 231    |   |  |   | (507   | )
|Other income                                       |  |       | 389    |   |        |   | 451    |       |  |   | 172    |   |  |   | 464    |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Income (loss) before income taxes                  |  |       | (419   | ) |        |   | 157    |       |  |   | 403    |   |  |   | (43    | )
|Provision for income taxes                         |  |       |       |   |        |   |       |       |  |   |       |   |  |   | 66     |  
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Net income (loss)                                  |  | $     | (419   | ) |        | $ | 157    |       |  | $ | 403    |   |  | $ | (109   | )
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  
|Basic and diluted earnings (loss) per common share |  | $     | (0.02  | ) |        | $ | 0.01   |       |  | $ | 0.02   |   |  | $ | (0.01  | )
|                                                   |  |       |        |   |        |   |        |       |  |   |        |   |  |   |        |  



20



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



FORWARDLOOKING STATEMENTS



This Form 10-K, including the following discussion, 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: significant growth of the hearing impaired population; demographic trends such as the aging of the developed worlds population accelerating the size of the hearing impaired population and resulting in increasing
hearing aid sales over time; our fourth quarter results being indicative of on-going quarterly results; the hearing aid market transitioning from analog to digital products and the continuing transition thereof; our benefiting from this transition
to digital products; strengthened international sales capability; expectations for Europe to be our fastest growth geography in 2004, led by the expansion of our German business; overall average selling price decreasing in 2004; gross margin
expansion in 2004 depending on overhead absorption, cost savings initiatives, product returns, repair costs per unit, overall average selling price and certain government reimbursement levels; selling, general and administrative expense and research
and development expense increasing in dollars, but not necessarily as a percentage of sales, in 2004; expansion of our direct selling capability, adding new customers, expanding our product offerings and promotional material, pursuing branding and
advertising campaigns and other additional costs related to the growth of our business; improvement in our effective income tax rate; continuance of product improvement and design and development of new products; the use of new products and product
improvements to improve our competitive position; contracting of certain advanced integrated circuit design and development to a third party; ability to compete effectively; exemption of future products and enhancements from the FDAs 501(k)
process; reductions in returns, rework and repairs; significance of large customers; amortization of deferred stock-based compensation; growth in operating expenses; capital expenditures to improve manufacturing and development capabilities; future
acquisitions; and sufficiency of cash to fund our operations in 2004. 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 operating cash flows; 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; any
acquisitions that we undertake could be difficult to integrate, disrupt our business and dilute our shareholders; 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; our shareholder lawsuit has been settled in principle, but is not yet final; we rely on several sole source or limited source suppliers and contractors who may be unable to meet our requirements; we have high rates of returns, remakes and
repairs; we must have innovative, technologically superior products to compete effectively and gain market share; we may be unable to expand our manufacturing capabilities; we may have issues with infringing on others intellectual property; we
may have issues protecting our proprietary technology; we may harm our relationships with our traditional customers by selling through non-traditional channels, such as to high volume general retail or electronics retail stores or to ear-nose-throat
physicians; 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; we may encounter difficulties in hiring and retaining sufficient
sales and technical personnel; we may have difficulty retaining key employees if our stock price does not increase because stock options are a significant component of compensation; we could be sued for product liability; we could suffer penalties
if we fail to comply with U.S. Food and Drug Administration regulations; our stock price could be volatile because we are a technology company; our stock price could suffer due to sales 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.



21



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OVERVIEW



We design, develop, manufacture and market advanced digital hearing aids designed to provide the highest levels of satisfaction for hearing impaired
consumers. Capitalizing on what we believe is an advanced understanding of human hearing, we have developed patented digital signal processing (DSP) technologies and embedded them in the smallest single-chip DSP platform ever installed in a hearing
aid. In the United States (U.S.), Canada, Denmark, England, Switzerland, Austria and the Netherlands, we sell finished hearing aids principally to hearing care professionals. In Germany and Australia, we sell hearing aids directly to hearing
impaired consumers. In other parts of the world where we do not have a direct presence, we sell finished hearing aids and hearing aid kits principally to distributors. We first began shipping product in the fourth quarter of 1998.



While we believe the number of hearing impaired people continues to grow
significantly on a worldwide basis, the sale of hearing aids has not exhibited significant growth. There is no worldwide sales data available for the hearing aid industry, so most industry followers utilize U.S. sales data provided by the Hearing
Industry Association (HIA) as a proxy for worldwide hearing aid sales data. After declines in U.S. hearing aid unit sales from 2000 to 2001 and from 2001 to 2002, as reported by the HIA, the market grew from 2002 to 2003.



Our net sales in 2003 of $87,690 increased 29% from 2002 net sales of
$68,018. Our 2003 results were favorably affected by acquisitions and foreign currency translation. In particular, our acquisition of a business in Germany in the second quarter 2003 significantly improved our overall business.



The fourth quarter 2003 was a break-out quarter for our business as we
achieved net sales of $25,705 and net income of $1,446, or $.07 per share. We believe our performance in that quarter is indicative of the results we are now capable of achieving.



There are several over-arching issues affecting our business currently:



| |  | The market has been transitioning from analog to digital hearing aids, which has resulted in the U.S. market now being 66% digital. We do not believe this encroachment will continue
at as rapid a pace as we have been experiencing.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Economic conditions worldwide have caused people to defer the purchase of a new hearing aid or to repair or recondition an existing hearing aid rather than purchase a new hearing
aid. We are hopeful that improving economic conditions will result in increasing hearing aid sales.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We have expanded our product offering to provide our customers with products that cover a broader pricing spectrum. This has resulted in a higher sales mix of lower priced products
as hearing impaired consumers seek out lower priced digital hearing aids.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We have been acquisitive over the past several years, having acquired one business in 2001, seven businesses in 2002 and one business in 2003. Six of these businesses were our
former distributors. All of these acquisitions were outside the U.S. and have considerably strengthened our international sales capability. We are now much more an international company as shown in this table of percentage of net sales by geography:
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|              |  |       |   |  |       |   |  |       |  
|------------- |  | ----- | - |  | ----- | - |  | ----- | -
|              |  | 2003  |   |  | 2002  |   |  | 2001  |  
|North America |  | 46.6  | % |  | 58.6  | % |  | 72.4  | %
|Europe        |  | 36.1  |   |  | 20.9  |   |  | 15.6  |  
|Rest-of-world |  | 17.3  |   |  | 20.5  |   |  | 12.0  |  
|              |  |       |   |  |       |   |  |       |  
|              |  | 100.0 | % |  | 100.0 | % |  | 100.0 | %
|              |  |       |   |  |       |   |  |       |  



Because of our
investments in European distribution (six of our nine acquisitions were in Europe), we look for Europe to be our fastest growth geography in 2004.



22



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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 financial condition and operating results 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, 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 reported results of operations for a given period.



Revenue Recognition



Sales are recognized when
(i) products are shipped, except for retail sales in Germany and Australia, which are recognized upon acceptance by the hearing impaired 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) collectability is reasonably assured. Net sales consist of product sales less provisions for sales returns, which are made at the time of sale. We
generally have a 60-day return policy. 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.



Revenues related to sales of separately priced extended service contracts are
deferred and recognized on a straight-line basis over the contracted periods, which range from one to five years.



Warranty Accruals



Our products are sold with warranties that require us to remedy deficiencies in quality or performance over specified periods of time, which range from
one to five years. We analyze the amount of historical warranty by geography, product family and model, 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 material, labor and shipping costs differ from our estimates, revisions to the warranty accrual would be
required.



Valuation of Intangible Assets



We evaluate our goodwill and indefinite-lived intangible assets on an annual
basis in the fourth quarter in accordance with Statement of Financial Accounting Standards No. 142 (SFAS 142), Goodwill and Other Intangible Assets. In conducting the evaluation, we apply various techniques to estimate the fair value of
our reporting units. These techniques are inherently subjective and the resulting values are not necessarily representative of the values we might obtain in a sale of our reporting units to a willing third party. If this evaluation indicates that
the value of the asset may be impaired, we make an assessment of the impairment of the asset using the two-step method prescribed by SFAS 142. Any such impairment charge could be significant and could have a material adverse effect on our results of
operations and financial position.



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 consist of contract rights, customer relationships,
trademarks and 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



23



---

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 revenue and 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, 2003, we had a valuation allowance against certain deferred income tax assets of $14,348 and a net deferred income tax liability totaling $1,973. We currently do not believe
it is more likely than not that our results of future operations will generate sufficient taxable income to utilize certain of our deferred income tax assets. 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.



RESULTS OF OPERATIONS2003 COMPARED WITH 2002



NetSales.Net sales consist of product sales less a provision for sales returns, which is made at the time of sale. Net sales by geography were as follows:



|              |  |      |        |      |   |        |  |     |  
|------------- |  | ---- | ------ | ---- | - | ------ |  | --- | -
|              |  | 2003 |        | 2002 |   | Change | 
|Net sales:    |  |      |        |      |   |        |  |     |  
|North America |  | $    | 40,834 |      | $ | 39,881 |  | 2   | %
|Europe        |  |      | 31,695 |      |   | 14,209 |  | 123 |  
|Rest-of-world |  |      | 15,161 |      |   | 13,928 |  | 9   |  
|              |  |      |        |      |   |        |  |     |  
|Net sales     |  | $    | 87,690 |      | $ | 68,018 |  | 29  | %
|              |  |      |        |      |   |        |  |     |  



Net sales increased
29% from $68,018 in 2002 to $87,690 in 2003. By geography, sales in North America of $40,834 in 2003 increased 2% from 2002 sales of $39,881 principally due to the full year effect of two companies that were acquired in Canada in the second quarter
2002. U.S. sales decreased 2% from 2003 to 2002 mainly due to decreased sales of our Adesso product resulting from the poor acceptance of the instant-fit paradigm in the U.S. market. European sales of $31,695 in 2003 increased 123% from
2002 sales of $14,209, and were aided by our 2003 acquisition of a distribution business in Germany and the full year effect of our 2002 acquisitions of distribution businesses in England, Switzerland, Austria and the Netherlands. These acquisitions
have allowed us to (i) move from distributor-based to direct-sale operations to gain better control over and improve our profitability in the local markets and (ii) expand our capabilities to deliver a full line of Sonic Innovations products
in these countries. Rest-of-world sales of $15,161 in 2003 increased 9% from 2002 sales of $13,928 as increased sales of our Australian business more than offset the loss of business in Japan resulting from the purchase of our distributor by a
competitor and in Brazil resulting from the termination of our distributor. In addition, the favorable effect of foreign currency translation due to the weaker U.S. dollar increased 2003 net sales by approximately $4,900 over 2002 levels.



With the introduction of our high-end Natura 3 product family
in the second quarter 2003, we now have a five-tiered product family strategy with our Natura 3, Natura 2 SE, Altair, Tribute and Quartet product families.



24



---

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. Our lower priced product families, Quartet and Tribute, have become increasingly important to our sales effort, as relatively weak economies continue to cause consumers to seek lower priced digital hearing aids. The shift to lower priced
products reduces our overall average selling price, which puts pressure on gross margin. Offsetting this somewhat are lower sales return rates experienced for our lower priced products. The introduction of Natura 3 and the reduction in sales of
Adesso helped our overall average selling price to remain consistent from 2002 to 2003; however, we now expect our overall average selling price to decrease until we introduce our next generation product line in 2005.



We generally have a 60-day return policy for our hearing aids. Our actual
sales returns were $15,924 and $16,300 in 2003 and 2002, respectively. Sales returns as a percentage of sales improved from 19.3% in 2002 to 15.4% in 2003 for a number of reasons:



| |  | We had a higher percentage of net sales outside the U.S. in 2003 and return rates are considerably lower outside the U.S.
| | - | -------------------------------------------------------------------------------------------------------------------------



| |  | Germany and Australia sales are at the retail level and are recognized upon customer acceptance. Therefore, returns in these two countries, both of which have significant sales, are
much lower.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  | We continue to implement improved manufacturing techniques and better programming software for fitting our hearing aids.
| | - | ------------------------------------------------------------------------------------------------------------------------



| |  | Customers have become more experienced with our products.
| | - | ---------------------------------------------------------



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.



Gross Profit.Our gross profit and gross margin in 2003 and 2002 were as follows:



|             |  |      |        |   |      |   |        |  
|------------ |  | ---- | ------ | - | ---- | - | ------ | -
|             |  | 2003 |        |   | 2002 |  
|Gross profit |  | $    | 46,370 |   |      | $ | 35,421 |  
|Gross margin |  |      | 52.9   | % |      |   | 52.1   | %



Increased gross margin
in 2003 principally resulted from reduced purchased component costs, improved labor utilization and manufacturing structure, and better absorption of overhead as a result of higher unit volume, as well as the incremental margin derived from the full
year impact of the acquisitions in 2002 of several of our distributors. This gross margin improvement in 2003 was partially offset by severance costs of $615 associated with a consolidation of manufacturing operations in the third quarter. Cost of
sales primarily consists of manufacturing costs, royalty expenses, quality costs and costs associated with product remakes and repairs (warranty). The warranty periods range from one to five years for hearing aids. Our actual warranty costs
increased from $3,115 in 2002 to $3,422 in 2003 as a result of the increase in the number of hearing aids covered under warranty, partially offset by a decrease in warranty costs per unit. The decrease in warranty costs per unit is a result of
reduced component costs and better overhead absorption resulting from higher volume in our repair facility. Further gross margin expansion in 2004 will only be possible if (i) no or little additional overhead is necessary to support increasing
volumes, (ii) cost saving initiatives and programs to reduce component costs and product repair costs are successful, (iii) product returns continue to trend down, (iv) per unit repair costs continue to trend down, (v) overall average selling price
does not deteriorate, (vi) foreign currency positions do not decline, and (vii) certain government-based reimbursement levels for hearing aids are not reduced.



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



25



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support, distribution and administrative expenses. Selling, general and administrative expense was $36,846, or 42.0% of net sales, in 2003, an increase of
$8,698 (31%) from selling, general and administrative expense of $28,148, or 41.4% of net sales, in 2002. This increase was mainly the result of an acquisition of a German business in the second quarter 2003 and, to a lesser extent, the full year
effect of acquisitions made during 2002 in Canada, Denmark, England, Switzerland, Austria and the Netherlands totaling approximately $6,400. In addition, foreign currency translation due to the weaker U.S. dollar resulted in an increase in 2003
selling, general and administrative expense of approximately $2,100 over 2002 levels. Excluding the effect of acquisitions and foreign currency translation, selling, general and administrative expense in 2003 increased by approximately $200, or
0.7%, from 2002 levels, reflecting our objective of gaining leverage from our existing infrastructure.



We expect selling, general and administrative expense to increase in 2004 as we incur a full year of operations of our German business acquired in 2003,
continue to expand our direct selling capability, add new customers, expand our product offerings and product and promotional materials, pursue branding and advertising campaigns and incur additional costs related to the anticipated growth of our
business. As a result, in 2004, we expect selling, general and administrative expense to increase in dollars, although not necessarily as a percentage of sales. Sales and marketing expenses may also vary considerably from quarter to quarter as a
result of the timing of our tradeshows and promotional and advertising campaigns.



Research and Development. Research and development expense primarily consists of wages and benefits for research, development, engineering, regulatory and clinical personnel, and also includes consulting,
intellectual property, clinical study and engineering support costs. Research and development expense was $9,750, or 11.1% of net sales, in 2003, an increase of $1,450 (17%) from research and development expense of $8,300, or 12.2% of net sales, in
2002. The increase in research and development expense was principally due to costs associated with the design, development and introduction of the Natura 3 product family and assistance in the design and development of advanced integrated circuitry
by a third-party contractor. We expect research and development expense to increase in dollars, although not necessarily as a percentage of sales, in 2004 as we design and develop new products and continue to contract certain advanced integrated
circuit design and development to a third-party contractor.



Stock-based Compensation.Deferred stock-based compensation represents the difference between the exercise price and the deemed fair value of our common stock on the grant date for stock options granted in the one-year period
preceding the initial filing of our initial public offering and is being amortized over the vesting periods of the individual stock options, periodically adjusted for employee separations. In 2003 and 2002, $118 and $351, respectively was amortized
as stock-based compensation expense. The unamortized balance of $36 as of December 31, 2003 is expected to be amortized as follows: 2004$26; and 2005$10. These amounts will decrease if any of the related stock options are forfeited prior
to vesting.



Other Income.Other income was $1,537 in
2003 compared to $1,476 in 2002. The increase was principally a result of foreign currency exchange gains of $1,220 in 2003 compared to $527 in 2002. Foreign currency exchange gains resulted from the effect of the weakening U.S. dollar on the
intercompany balances between our U.S. parent company and our non-U.S. subsidiaries. These gains were partially offset by a reduction in interest income and other from $982 in 2002 to $482 in 2003 mainly due to lower cash and marketable securities
balances and lower interest rates. In addition we incurred interest expense of $165 in 2003 associated with the debt incurred to fund the acquisition of our German business.



Provision for Income Taxes. The effective income tax rate in 2003 was 68.5% compared to 67.3% in 2002. We have been
profitable in certain foreign locations, for which tax provisions have been provided. The U.S. tax provision in 2003 was due to alternate minimum tax. Net operating loss carry-forwards available to offset future taxable income as of December 31,
2003 were $20,888 in the U.S. and $8,147 outside the U.S. Our effective



26



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income tax rate in 2004 and beyond should improve from the effective rates experienced in 2003 and 2002. We have maintained a full valuation allowance on our
U.S. and the majority of our non-U.S. deferred tax income assets. We continually assess the realization of these deferred income tax assets.



RESULTS OF OPERATIONS2002 COMPARED WITH 2001



NetSales.Net sales in 2002 and 2001 were comprised of:



|                            |  |      |        |      |   |          |  |     |  
|--------------------------- |  | ---- | ------ | ---- | - | -------- |  | --- | -
|                            |  | 2002 |        | 2001 |   | % Change | 
|Net hearing aid sales:      |  |      |        |      |   |          |  |     |  
|North America               |  | $    | 39,697 |      | $ | 37,556   |  | 6   | %
|Europe                      |  |      | 14,209 |      |   | 8,904    |  | 60  |  
|Rest-of-world               |  |      | 13,156 |      |   | 5,776    |  | 128 |  
|                            |  |      |        |      |   |          |  |     |  
|Total net hearing aid sales |  |      | 67,062 |      |   | 52,236   |  | 28  |  
|Net component sales         |  |      | 956    |      |   | 5,031    |  | (81 | )
|                            |  |      |        |      |   |          |  |     |  
|Total net sales             |  | $    | 68,018 |      | $ | 57,267   |  | 19  | %
|                            |  |      |        |      |   |          |  |     |  



Net sales increased
19% from $57,267 in 2001 to $68,018 in 2002. By geography, hearing aid sales in North America of $39,697 in 2002 increased 6% from 2001 sales of $37,556 principally due to sales of our lower priced Tribute product family and Adesso product, both of
which were introduced in the first quarter 2002, and the acquisition of two companies in Canada in the second quarter 2002. U.S. sales increased 3% from 2001 to 2002. European hearing aid sales of $14,209 in 2002 increased 60% from 2001 sales of
$8,904, and were aided by our 2002 acquisitions of distribution operations in Denmark, England, Switzerland, Austria and the Netherlands. Rest-of-world hearing aid sales of $13,156 in 2002 increased 128% from 2001 sales of $5,776 and included a full
year of our Australian business which was acquired in July 2001. In addition, Australian sales in 2002 benefited from the success of our lower-priced Quartet product family, which we introduced in late 2001 in that market.



In 2002, our lower priced product families, Quartet, which was introduced in
late 2001, and Tribute, which was introduced in the first quarter 2002, became increasingly important to our sales effort, as relatively weak economies caused consumers to seek lower priced hearing aids. The shift to lower priced products reduced
our overall average selling price, which put pressure on gross margin. Offsetting this somewhat were lower sales return rates experienced for our lower priced products.



Component sales were $956 in 2002, a decrease from $5,031 in 2001. The majority of the sales reduction resulted from
discontinuing sales to Starkey Laboratories, to which we had sales of $3,900 in 2001.



Actual sales returns were $16,300 and $15,726 in 2002 and 2001, respectively. Sales returns as a percentage of hearing aid sales improved from 21.5% in 2001 to 19.3% in 2002 for the following reasons:



| |  | We had a higher percentage of net sales outside the U.S. in 2002 and return rates were considerably lower outside the U.S.
| | - | --------------------------------------------------------------------------------------------------------------------------



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



| |  | We implemented improved manufacturing techniques and better programming software for fitting our hearing aids.
| | - | --------------------------------------------------------------------------------------------------------------



Gross Profit.Our gross profit and gross margin in 2002 and 2001 were
as follows:



|             |  |      |        |   |      |   |        |  
|------------ |  | ---- | ------ | - | ---- | - | ------ | -
|             |  | 2002 |        |   | 2001 |  
|Gross profit |  | $    | 35,421 |   |      | $ | 26,018 |  
|Gross margin |  |      | 52.1   | % |      |   | 45.4   | %



27



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Increased gross margin in 2002 principally resulted from reduced purchased component costs, reduced
outsourcing and contracting costs, expiration of a royalty license in late 2001, improved labor utilization and manufacturing structure and better absorption of overhead as a result of higher unit volume, as well as the incremental gross margin
derived from the acquisition of several of our distributors. This gross margin improvement was achieved in an environment of a declining overall average selling price due to product mix shift toward lower priced products and, to a lesser extent,
price competition. Warranty costs increased by 15% from $2,718 in 2001 to $3,115 in 2002, primarily as a result of our increased sales volume. Warranty costs per unit decreased in 2002 due to decreased component costs and better overhead absorption
due to higher volume in our repair facility.



Selling,
General and Administrative. Selling, general and administrative expense was $28,148, or 41.4% of net sales, in 2002, an increase of $4,186 (17%) from selling, general and administrative expense of $23,962, or 41.8% of net sales, in 2001. This
increase was mainly the result of acquisitions made during 2002 in Canada, Denmark, England, Switzerland, Austria and the Netherlands, and more importantly the effect of a full year of our Australian business, which we purchased in 2001 totaling
approximately $5,700. Excluding the effect of acquisitions, selling, general and administrative expense in 2002 decreased by approximately $1,500 from 2001 levels primarily as a result of fourth quarter 2001 cost reduction initiatives in the U.S.
and Europe.



Research and Development. Research and
development expense was $8,300, or 12.2% of net sales, in 2002, a decrease of $757 (8%) from research and development expense of $9,057, or 15.8% of net sales, in 2001. The decrease was mainly the result of a fourth quarter 2001 cost reduction
initiative mainly related to headcount reductions in the U.S.



Stock-based Compensation.Deferred stock-based compensation expense was $351 and $727 in 2002 and 2001, respectively.



Other Income.Other income was $1,476 in 2002 compared to $2,093 in 2001. The reduction principally resulted from a decrease in interest income
from $2,268 in 2001 to $982 in 2002 mainly due to lower cash and marketable securities balances and significantly lower interest rates. The decrease in interest income was offset somewhat by foreign currency exchange gains of $527 in 2002 versus
losses of $66 in 2001. Foreign currency exchange gains in 2002 resulted from the effect of the weakening U.S. dollar on the intercompany balances between our U.S. parent company and our non-U.S. subsidiaries.



Provision for Income Taxes. We recorded an income tax provision in
2002 of $66 based on our profitability in certain countries outside the U.S.



LIQUIDITY AND CAPITAL RESOURCES



Net cash used in operating activities was $2,048 in 2003. Positive cash flow items included net income of $376, as impacted by non-cash items, including depreciation and amortization of $2,812, stock-based compensation of $118 and deferred
income taxes of $290. These positive cash flow items were offset by cash used to reduce accounts payable and accrued expenses of $1,106; increases in accounts receivable of $2,378, inventory of $340 and prepaid expenses and other of $210 resulting
primarily from European working capital growth; and a foreign currency transaction gain of $1,610. Net cash provided by operating activities was $681 in 2002. Positive cash flow items included net income of $32, as impacted by non-cash items
including depreciation of amortization of $2,019, a decrease in accounts receivable mainly due to increased collections of $1,429 and a decrease in inventories of $801, mainly due to better inventory management. These positive cash flow items more
than offset cash used to reduce accounts payable and accrued expenses and less cash received from items accounted for as deferred revenue totaling $3,375. Net cash provided by operating activities of $3,437 in 2001 resulted principally from a
decrease in accounts receivable mainly due to increased collections of $3,208 and a decrease in inventories mainly due to better inventory management of $2,048. These positive cash flow changes more than offset the net loss of $5,635, as impacted by
$2,760 of non-cash expenses related to depreciation, amortization, stock-based compensation and foreign currency losses.



28



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Net cash used in investing activities of $11,142 in 2003 resulted from cash paid for (i) the acquisition
of a Germany business in May 2003 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 somewhat by a decrease in customer advances of $246. Net cash used in investing activities of $1,449 in 2002 resulted from cash paid for the acquisition of seven hearing aid businesses outside the U.S. of $7,511, purchases of property
and equipment of $2,146 and an increase in other assets pertaining mainly to customer advances of $1,798. These cash outflows were substantially offset by net proceeds from the maturity of marketable securities of $10,006. Net cash provided by
investing activities of $5,586 in 2001 resulted from net proceeds from the maturity of marketable securities of $13,021, offset in part by cash paid for the acquisition of our Australian business of $5,143, purchases of property and equipment of
$1,567 and investments and advances of $725.



Net cash provided
by financing activities of $7,403 in 2003 resulted from proceeds from (i) a long-term loan (payable over 7 years) to fund the Germany acquisition 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 our letter of credit of $1,896. Net cash provided by financing activities of
$140 in 2002 resulted from proceeds from stock option exercises and shares issued under our employee stock purchase plan of $1,147, substantially offset by repayment of long-term principal obligations of $349 and purchases of common stock for
treasury of $658. During 2002 and 2001, we repurchased a total of 874,000 shares of our common stock under a share repurchase program which authorized up to a total of 1,000,000 shares to be repurchased by March 31, 2002. Net cash used in financing
activities of $2,355 in 2001 resulted from purchases of common stock for treasury of $2,745 and repayment of long-term principal obligations of $377, offset, in part by, receipt of proceeds from stock option exercises and shares issued under our
employee stock purchase plan of $767.



Our cash and marketable
securities, including restricted amounts, totaled $33,212 as of December 31, 2003. We expect to experience growth in our operating expenses in order to execute our business plan. Accordingly, we expect that these increasing operating expenses,
together with capital expenditures necessary to improve our manufacturing and development capabilities, will constitute a significant use of our cash for at least the next twelve months. In addition, we may use cash to fund acquisitions of
complimentary businesses and technologies. We believe that our cash and marketable securities balance will be adequate to meet our operating, working capital and investment requirements in 2004.



Commitments.Our contractual obligations as of December 31, 2003 have
been summarized in the table below:



|                         |  |       |        |                                     |   |             |  |             |       |            |   |       |  |   |      
|------------------------ |  | ----- | ------ | ----------------------------------- | - | ----------- |  | ----------- | ----- | ---------- | - | ----- |  | - | -----
|                         |  |       |        | For the year(s) ending December 31,
|                         |  | Total |        | 2004                                |   | 2005  2006 |  | 2007  2008 |       | After 2008
|Long-term debt           |  | $     | 9,100  |                                     | $ | 1,255       |  | $           | 2,510 |            | $ | 2,510 |  | $ | 2,825
|Operating leases         |  |       | 6,981  |                                     |   | 3,046       |  |             | 2,819 |            |   | 1,046 |  |   | 70   
|Purchase commitment      |  |       | 2,043  |                                     |   | 2,043       |  |             |       |            |   |       |  |   |      
|Earn-out on acquisitions |  |       | 5,767  |                                     |   | 2,315       |  |             | 3,452 |            |   |       |  |   |      
|Minimum royalty payments |  |       | 520    |                                     |   | 80          |  |             | 280   |            |   | 160   |  |   |      
|                         |  |       |        |                                     |   |             |  |             |       |            |   |       |  |   |      
|Total                    |  | $     | 24,411 |                                     | $ | 8,739       |  | $           | 9,061 |            | $ | 3,716 |  | $ | 2,895
|                         |  |       |        |                                     |   |             |  |             |       |            |   |       |  |   |      



Recent Accounting
Pronouncements.Statement of Financial Accounting Standards (SFAS) No. 146, Accounting for Costs Associated with Exit or Disposal Activities, requires a liability to be recorded for costs associated with an exit or disposal activity
when that liability is incurred and can be measured at fair value. A liability is incurred when an event obligates the entity to transfer or use assets (i.e., when an event leaves the company little or no discretion to avoid transferring or using
the assets in the future). Under previous accounting rules, if a companys management approved an exit plan, the company generally could record the costs of that



29



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plan as a liability on the approval date, even if the company did not incur the costs until a later date. Under SFAS No. 146, some of those costs might
qualify for immediate recognition, while others might be recorded during one or more future periods. Our adoption of SFAS No. 146 did not have a material impact on our results of operations and financial position.



In November 2002, the Emerging Issues Task Force (EITF) reached a consensus
on Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. The EITF concluded that revenue arrangements with multiple elements should be divided into separate units of accounting if the deliverables in the
arrangement have value to the customer on a standalone basis, if there is objective and reliable evidence of the fair value of the undelivered elements, and as long as there are no rights of return or additional performance guarantees by the
company. The provisions of EITF Issue No. 00-21 are applicable to agreements entered into in fiscal periods beginning after June 15, 2003. Our adoption of EITF No. 00-21 had no effect on our results of operations and financial condition.



In November 2002, the Financial Accounting Standards Board (FASB), issued
Financial Interpretation No. 45 Guarantors Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others, (FIN 45), which expands previously issued accounting guidance and
disclosure requirements for certain guarantees. FIN 45 requires recognition of an initial liability for the fair value of an obligation assumed by issuing a guarantee. The provision for initial recognition and measurement of the liability will be
applied on a prospective basis to guarantees issued or modified after December 31, 2002. Our adoption of FIN 45 had no effect on our results of operations and financial position.



In January 2003, the FASB issued Financial Interpretation No. 46, Consolidation of Variable Interest Entities,
(FIN 46), which clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the
equity investors in the entity do not have the characteristics of a controlling financial interest or do not provide sufficient equity at risk for the entity to support its activities. FIN 46 is effective for all new variable interest entities
acquired or created after January 31, 2003. In December 2003, the FASB issued FIN 46R, a revision to FIN 46. Among other changes, the revisions of FIN 46R clarified some requirements of original FIN 46, eased some implementation problems and added
new scope exceptions. FIN 46R deferred the effective date to the end of the first reporting period ending after March 15, 2004. Under these guidelines, we will adopt FIN 46R in the first quarter of 2004. Our adoption of FIN 46R is expected to
have no effect on our financial condition and results of operations since we currently do not have any financial interests in variable interest entities.



In April 2003, the FASB issued SFAS No. 149, Amendments of Statement 133 on Derivative Instruments and Hedging Activities. This statement
amends and clarifies financial accounting and reporting for derivative instruments, including certain instruments embedded in other contracts and for hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities. This statement requires that contracts with comparable characteristics be accounted for similarly. In particular, this statement clarifies under what circumstances a contract with an initial net investment meets the characteristic
of a derivative, clarifies when a derivative contains a financing component, amends the definition of an underlying hedged risk to conform to language used in FIN 45 and amends certain other existing pronouncements. This statement, the provisions of
which are to be applied prospectively, is effective for contracts entered into or modified after June 30, 2003. Our adoption of SFAS No. 149 had no effect on our results of operations and financial position.



In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity. This statement establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics
of both liabilities and equity. SFAS No. 150 requires that a company classify a financial instrument that is within SFAS No. 150s scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation
of the company. Many of those instruments were previously classified as equity. SFAS No. 150



30



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requires a company to classify the following instruments as liabilities (or assets in some circumstances): mandatorily redeemable financial instruments;
obligations to repurchase company equity shares by transferring assets; and certain obligations to issue a variable number of company equity shares. SFAS No. 150 was effective for all financial instruments entered into or modified after May 31,
2003, and otherwise was effective at the beginning of the first interim period beginning after June 15, 2003. Our adoption of SFAS No. 150 had no effect on our results of operations and financial position.



|ITEM 7A. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
|-------- | ----------------------------------------------------------



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, 2003, we had $22.7 million held in investments in
debt securities that carry an effective fixed interest rate of 1.6%. A hypothetical one percentage point change in interest rates would not have had a material effect on our liquidity, financial condition or results of operations. 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 enter into readily marketable forward
contracts with financial institutions to minimize the short-term impact of foreign currency fluctuations on certain foreign currency receivables and payables primarily denominated in Australian and European currencies. These contracts create limited
earnings volatility because gains and losses associated with exchange rate movements are offset by the transaction gains and losses on certain foreign currency receivables and payables recognized in earnings. We had no derivative instruments
outstanding as of December 31, 2003.



We do not enter into
these agreements for trading or speculation purposes. Gains and losses on the contracts are included in other income in the statements of operations and offset foreign exchange gains or losses recognized on the revaluation of our intercompany
accounts. Our foreign exchange forward contracts generally range from one to three months in original maturity.



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 2003, approximately 55% of our net sales and 44% of our operating expenses were denominated in currencies other than the U.S.
dollar. Inventory purchases were transacted primarily 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, Canadian dollar,
British pound sterling 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



31



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intercompany payables and receivables. Average currency exchange rates to convert one U.S. dollar into each local currency for which we had sales of over
$3,000 in 2003 were as follows:



|                       |  |      |  |      |  |     
|---------------------- |  | ---- |  | ---- |  | ----
|                       |  | 2003 |  | 2002 |  | 2001
|Australian dollar      |  | 1.54 |  | 1.84 |  | 1.93
|Euro                   |  | 0.89 |  | 1.06 |  | 1.12
|Canadian dollar        |  | 1.40 |  | 1.57 |  | 1.55
|British pound sterling |  | 0.61 |  | 0.67 |  | 0.69
|Danish kroner          |  | 6.58 |  | 7.88 |  | 8.32



|ITEM 8. | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
|------- | -------------------------------------------



Financial statements 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
|------- | ------------------------------------------------------------------------------------



On July 1, 2003, our Board of Directors, upon recommendation of the Audit Committee, unanimously approved the dismissal of
Arthur Andersen LLP as our independent auditing firm and appointed KPMG LLP to serve as our new independent auditing firm.



Arthur Andersen LLPs report on our consolidated financial statements for the year ended December 31, 2001 did not contain an adverse opinion or
disclaimer of opinion, nor was it qualified or modified as to uncertainty, audit scope or accounting principles.



During the year ended December 31, 2001 and the period from January 1, 2002 through July 1, 2002, there was no disagreement between us and Arthur Andersen
LLP on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreement, if not resolved to Arthur Andersen LLPs satisfaction, would have caused Arthur Andersen LLP to make
reference to the subject matter of such disagreement in its reports on our consolidated financial statements for such years; and there occurred no reportable event as defined in Item 304(a)(1)(v) of Regulation S-K.



During the year ended December 31, 2001 and through July 1, 2002, we did not
consult with KPMG LLP regarding any of the matters or events set forth in Item 304(a)(2)(i) and (ii) of Regulation S-K.



In accordance with Item 304 of Regulation S-K, we submitted this disclosure to Arthur Andersen LLP and KPMG LLP and presented them with the opportunity to
include a statement if they believed the above statements were incorrect or incomplete.



|ITEM 9A. | CONTROLS AND PROCEDURES
|-------- | -----------------------



Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we
conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the securities Exchange Act of 1934, as amended, as of the end of the period
covered by this report (the Evaluation Date). Based on this evaluation, our principal executive officer and principal financial officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective such
that the information relating to the Company, including our consolidated subsidiaries, required to be disclosed in our Securities and Exchange Commission (SEC) reports (i) is recorded, processed, summarized and reported within the time
periods specified in SEC rules and forms, and (ii) is accumulated and communicated to the Companys management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding
required disclosure.



32



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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 and background of the
directors appearing under the captions Stock Ownership, Governance of the Company and Election of Directors in the Companys definitive Proxy Statement for the May 6, 2004 Annual Meeting of Shareholders to be
filed within 120 days after our fiscal year end of December 31, 2003 (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. The information set forth
under the caption Section 16(a) Beneficial Ownership Reporting Compliance in the Proxy Statement is incorporated herein by reference.



|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 Named Executive Officers of
the Proxy Statement is incorporated herein by reference. Other information required by this Item is submitted in a separate section of this Form 10-K. See Item 5 above.



|ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS
|-------- | ----------------------------------------------------



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



|ITEM 14. | PRINCIPAL ACCOUNTING FEES AND SERVICES
|-------- | --------------------------------------



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



PART IV



|ITEM 15. | EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
|-------- | ---------------------------------------------------------------



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



| | (1) | FINANCIAL STATEMENTS
| | --- | --------------------



The following consolidated financial statements and independent auditors reports are included herein as a separate section beginning
on page F-1 of this report:



|                                                                                                                                     |  |         
|------------------------------------------------------------------------------------------------------------------------------------ |  | --------
|                                                                                                                                     |  | Page No.
|                                                                                                                                     | 
|Independent Auditors Reports                                                                                                        |  | F-1     
|                                                                                                                                     | 
|Consolidated Balance Sheets as of December 31, 2003 and 2002                                                                         |  | F-2     
|                                                                                                                                     | 
|Consolidated Statements of Operations for the years ended December 31, 2003, 2002 and 2001                                           |  | F-3     
|                                                                                                                                     | 
|Consolidated Statements of Shareholders Equity and Comprehensive Income (Loss) for the years ended December 31, 2003, 2002 and 2001 |  | F-4     
|                                                                                                                                     | 
|Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002 and 2001                                           |  | F-5     
|                                                                                                                                     | 
|Notes to Consolidated Financial Statements                                                                                           |  | F-6     





33



---

| | (2) | FINANCIAL STATEMENT SCHEDULE
| | --- | ----------------------------



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



|                |  |                                   |  |           
|--------------- |  | --------------------------------- |  | ----------
|SCHEDULE NUMBER |  | DESCRIPTION                       |  | PAGENUMBER
|II              |  | Valuation and Qualifying Accounts |  | 36        



The independent
auditors reports with respect to the Companys financial statement schedule are on page 37. All other financial statements and 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



|              |  |                                                                                                                                                          
|------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Exhibit Description                                                                                                                                      
|              | 
|2.1(7)        |  | Sale and Purchase agreement between the selling shareholders of Sanomed Handelsgesellschaft mbH and PALME Verwaltungsgesellschaft mbH and the registrant.
|              | 
|3.2(1)        |  | Amended and Restated Bylaws of the registrant.                                                                                                           
|              | 
|10.1(1)       |  | Form of indemnification agreement entered into by the registrant with each of its directors and executive officers.                                      
|              | 
|10.2(1)#      |  | 1993 Stock Plan and form of agreements thereunder.                                                                                                       
|              | 
|10.3(5)#      |  | 2000 Stock Plan and form of agreements thereunder.                                                                                                       
|              | 
|10.4(4)#      |  | 2000 Employee Stock Purchase Plan.                                                                                                                       
|              | 
|10.5          |  | Form of management continuity agreement entered into by the registrant with its executive officers.                                                      
|              | 
|10.6(3)       |  | Preferred Stock Rights Agreement dated as of March 27, 2001 between the registrant and American Stock Transfer & Trust Company.                          
|              | 
|10.7(1)       |  | License and Manufacturing Agreement dated February 20, 1997 between the registrant and Atmel Corporation.                                                
|              | 
|10.8(6)*      |  | Amendment dated January 7, 2002 to License and Manufacturing Agreement between the registrant and Atmel Corporation.                                     
|              | 
|10.10(1)      |  | Amended and Restated License Agreement dated March 21, 2000 between the registrant and Brigham Young University.                                         
|              | 
|10.11(1)      |  | Amended and Restated Exclusive License Agreement dated March 21, 2000 between the registrant and Brigham Young University.                               
|              | 
|10.13(1)      |  | Lease Agreement dated April 28, 1999 between the registrant and 2795 E. Cottonwood Parkway, L.C.                                                         
|              | 
|10.14(1)#     |  | Letter Agreement dated February 8, 1998 between the registrant and Michael D. Monahan.                                                                   
|              | 
|10.15(1)#     |  | Letter Agreement dated May 4, 1997 between the registrant and Gregory N. Koskowich.                                                                      
|              | 
|10.16(1)#     |  | Letter Agreement dated September 24, 1999 between the registrant and Stephen L. Wilson.                                                                  
|              | 
|10.17(2)      |  | Subscription Agreement between K/S HIMPP and the registrant dated September 13, 2000.                                                                    
|              | 
|10.18(2)      |  | Patent License Agreement between K/S HIMPP and the registrant dated September 13, 2000.                                                                  
|              | 
|21.1          |  | Subsidiaries of the registrant.                                                                                                                          



34



---

|              |  |                                                                                                                                                                       
|------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Exhibit Description                                                                                                                                                   
|              | 
|23.1          |  | Consent of Independent Auditors.                                                                                                                                      
|              | 
|23.2          |  | Information regarding consent of Arthur Andersen LLP.                                                                                                                 
|              | 
|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 From S-8 filed on August 16, 2002.
|--- | ------------------------------------------------------------------------------------------------------------



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



|(6) | Incorporated by reference from the registrants Annual Report on Form 10-K for the year ended December 31, 2002.
|--- | ----------------------------------------------------------------------------------------------------------------



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



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



|* | Confidential treatment has been requested for portions of this exhibit.
|- | -----------------------------------------------------------------------



|(b) | REPORTS ON FORM 8-K
|--- | -------------------



There were no reports on Form 8-K filed during the quarter ended December 31, 2003.



|(c) | EXHIBITS
|--- | --------



See Item 15(a)(1).



|(d) | FINANCIAL STATEMENT SCHEDULE
|--- | ----------------------------



See Item 15(a)(2).



35



---

Sonic Innovations, Inc.

Schedule IIValuation and Qualifying Accounts

(in thousands)



|                                               |  |      |  |                  |        |           |   |            |  |               |        |  |   |       
|---------------------------------------------- |  | ---- |  | ---------------- | ------ | --------- | - | ---------- |  | ------------- | ------ |  | - | ------
|                                               |  | Year |  | Beginningbalance |        | Additions |   | Deductions |  | Endingbalance
|Allowance for sales returns                    |  | 2003 |  | $                | 2,629  |           | $ | 16,782     |  | $             | 15,924 |  | $ | 3,487 
|                                               |  | 2002 |  |                  | 2,925  |           |   | 16,004     |  |               | 16,300 |  |   | 2,629 
|                                               |  | 2001 |  |                  | 2,767  |           |   | 15,884     |  |               | 15,726 |  |   | 2,925 
|                                               |  |      |  |                  |       
|Allowance for doubtful accounts                |  | 2003 |  |                  | 930    |           |   | 652        |  |               | 37     |  |   | 1,545 
|                                               |  | 2002 |  |                  | 1,196  |           |   | 311        |  |               | 577    |  |   | 930   
|                                               |  | 2001 |  |                  | 676    |           |   | 676        |  |               | 156    |  |   | 1,196 
|                                               |  |      |  |                  |       
|Accrued warranty                               |  | 2003 |  |                  | 3,613  |           |   | 3,924      |  |               | 3,422  |  |   | 4,115 
|                                               |  | 2002 |  |                  | 2,347  |           |   | 4,381      |  |               | 3,115  |  |   | 3,613 
|                                               |  | 2001 |  |                  | 1,229  |           |   | 3,836      |  |               | 2,718  |  |   | 2,347 
|                                               |  |      |  |                  |       
|Inventory reserves                             |  | 2003 |  |                  | 1,111  |           |   | 1,133      |  |               | 380    |  |   | 1,864 
|                                               |  | 2002 |  |                  | 774    |           |   | 908        |  |               | 571    |  |   | 1,111 
|                                               |  | 2001 |  |                  | 1,107  |           |   | 2,080      |  |               | 2,413  |  |   | 774   
|                                               |  |      |  |                  |       
|Deferred income tax asset valuation allowances |  | 2003 |  |                  | 15,102 |           |   | 1,470      |  |               | 2,224  |  |   | 14,348
|                                               |  | 2002 |  |                  | 15,866 |           |   |           |  |               | 764    |  |   | 15,102
|                                               |  | 2001 |  |                  | 13,790 |           |   | 2,076      |  |               |       |  |   | 15,866



36



---

INDEPENDENT AUDITORS REPORTS ON

CONSOLIDATED FINANCIAL STATEMENT SCHEDULE



The Board of Directors and Shareholders

Sonic Innovations, Inc.:



Under date of January 24, 2004, we reported on the consolidated balance sheets of Sonic Innovations, Inc. and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of operations, shareholders equity
and comprehensive income (loss), and cash flows for the years then ended included in this Form 10-K. In connection with our audit of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement
schedule as it relates to the years ended December 31, 2003 and 2002 included in this Form 10-K. This consolidated financial statement schedule is the responsibility of the Companys management. Our responsibility is to express an opinion on
this consolidated financial statement schedule based on our audits.



In our opinion, the 2003 and 2002 information included in the consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects,
the information set forth therein.



/s/    KPMG LLP



Salt Lake City, Utah

January 24, 2004



The following is a copy of the audit report previously issued by Arthur Andersen LLP in connection with the
Companys financial statement schedule for 2001 referred to in Item 14(a)(2) of our annual report on Form 10-K for the year ended December 31, 2001. This audit report has not been reissued by Arthur Andersen LLP in connection with this schedule
because Arthur Andersen LLP has ceased operations.



To Sonic Innovations, Inc.:



We have audited in
accordance with auditing standards generally accepted in the United States, the consolidated financial statements included in Sonic Innovations, Inc.s Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued
our report thereon dated January 25, 2002. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule referred to in Item 14(a)(2) is the responsibility of the Companys management
and is presented for purposes of complying with the Securities and Exchange Commissions rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic
financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.



/s/    ARTHUR
ANDERSEN LLP



Salt Lake City,
Utah

January 25, 2002



37



---

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 15, 2004 |  |  |  | By:                     |  | /s/    ANDREW G.
RAGUSKUS
|                        |  |  |  |                         |  |                           |  | Andrew G. Raguskus 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, 2004.



|    |  |                                                                                                          
|--- |  | ---------------------------------------------------------------------------------------------------------
|By: |  | /s/    ANDREW G.
RAGUSKUS                                                                                
|    |  | Andrew G. Raguskus President and Chief Executive Officer                                                 
|    | 
|By: |  | /s/    STEPHEN L.
WILSONStephen L.
Wilson Senior Vice President and Chief Financial Officer and Secretary
|    | 
|By: |  | /s/    MICHAEL M.
HALLORANMichael M.
Halloran Vice President and Corporate Controller                    
|    | 
|By: |  | /s/    LEWIS S.
EDELHEIT                                                                                 
|    |  | Director                                                                                                 
|    | 
|By: |  | /s/    ANTHONY B.
EVNIN                                                                                  
|    |  | Director                                                                                                 
|    | 
|By: |  | /s/    KEVIN J.
RYAN                                                                                     
|    |  | Director                                                                                                 
|    | 
|By: |  | /s/    LAWRENCE C.
WARD                                                                                  
|    |  | Director                                                                                                 
|    | 
|By: |  | /s/    SAMUEL L.
WESTOVER                                                                                
|    |  | Director                                                                                                 



38



---

INDEPENDENT AUDITORS REPORTS



To the Board of Directors and Shareholders of Sonic Innovations, Inc.:



We have audited the accompanying consolidated balance sheets of Sonic Innovations, Inc. and subsidiaries as of December 31,
2003 and 2002, and the related consolidated statements of operations, shareholders equity and comprehensive income (loss), and cash flows for the years then ended. These consolidated financial statements are the responsibility of the
Companys management. Our responsibility is to express an opinion on these financial statements based on our audits. The accompanying consolidated statements of operations, shareholders equity and comprehensive income (loss), and cash
flows for the year ended December 31, 2001, were audited by other auditors who have ceased operations. Those auditors expressed an unqualified opinion on those financial statements in their report dated January 25, 2002.



We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. 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 2003 and 2002 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Sonic Innovations, Inc. and subsidiaries as of
December 31, 2003 and 2002, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.



/s/    KPMG LLP



Salt Lake City, Utah

January 24, 2004



The following is a copy of the audit report previously issued by Arthur Andersen LLP in connection with the Companys consolidated financial
statements as of December 31, 2001 and 2000 and for each of the years in the three-year period ended December 31, 2001. This audit report has not been reissued by Arthur Andersen LLP in connection with this annual report because Arthur Andersen LLP
has ceased operations.



To Sonic
Innovations, Inc.:



We have audited the accompanying
consolidated balance sheets of Sonic Innovations, Inc. (a Delaware corporation) and subsidiaries (the Company) as of December 31, 2001 and 2000, and the related consolidated statements of operations, shareholders equity and cash flows for each
of the three years in the period ended December 31, 2001. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits.



We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform the 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 consolidated financial position of Sonic Innovations, Inc. and subsidiaries as of December 31, 2001 and 2000, and the
results of their operations and their cash flows for each of the three years in the period ended December 31, 2001 in conformity with accounting principles generally accepted in the United States.



/s/    ARTHUR
ANDERSEN LLP



Salt Lake City,
Utah

January 25, 2002



F-1



---

SONIC INNOVATIONS, INC.

CONSOLIDATED BALANCE SHEETS

In thousands, except per share data



|                                                                                                        |  |              |         |   |      |   |         |  
|------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | - | ---- | - | ------- | -
|                                                                                                        |  | December 31, |        
|                                                                                                        |  | 2003         |         |   | 2002 |  
|ASSETS                                                                                                  |  |              |         |   |      |   |         |  
|Current assets:                                                                                         |  |              |         |   |      |   |         |  
|Cash and cash equivalents                                                                               |  | $            | 8,630   |   |      | $ | 13,690  |  
|Marketable securities                                                                                   |  |              | 8,565   |   |      |   | 16,255  |  
|Restricted cash, cash equivalents and marketable securities                                             |  |              | 5,989   |   |      |   |        |  
|Accounts receivable, net                                                                                |  |              | 16,232  |   |      |   | 8,208   |  
|Inventories                                                                                             |  |              | 9,361   |   |      |   | 6,485   |  
|Prepaid expenses and other                                                                              |  |              | 2,492   |   |      |   | 1,809   |  
|Receivable from insurance company                                                                       |  |              | 7,000   |   |      |   |        |  
|                                                                                                        |  |              |         |   |      |   |         |  
|Total current assets                                                                                    |  |              | 58,269  |   |      |   | 46,447  |  
|                                                                                                        |  |             
|Long-term marketable securities                                                                         |  |              | 4,165   |   |      |   | 5,616   |  
|Restricted long-term marketable securities                                                              |  |              | 5,863   |   |      |   |        |  
|Property and equipment, net                                                                             |  |              | 6,493   |   |      |   | 5,862   |  
|Goodwill and indefinite-lived intangible assets                                                         |  |              | 26,972  |   |      |   | 13,311  |  
|Definite-lived intangible assets, net                                                                   |  |              | 3,529   |   |      |   | 1,609   |  
|Other assets                                                                                            |  |              | 1,705   |   |      |   | 1,901   |  
|                                                                                                        |  |              |         |   |      |   |         |  
|Total assets                                                                                            |  | $            | 106,996 |   |      | $ | 74,746  |  
|                                                                                                        |  |              |         |   |      |   |         |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                    |  |              |         |   |      |   |         |  
|Current liabilities:                                                                                    |  |              |         |   |      |   |         |  
|Current portion of long-term obligations                                                                |  | $            | 1,255   |   |      | $ | 102     |  
|Payable for settlement of lawsuit                                                                       |  |              | 7,000   |   |      |   |        |  
|Accounts payable                                                                                        |  |              | 8,455   |   |      |   | 4,111   |  
|Accrued payroll and related expenses                                                                    |  |              | 3,166   |   |      |   | 2,890   |  
|Accrued warranty                                                                                        |  |              | 4,115   |   |      |   | 3,613   |  
|Deferred revenue                                                                                        |  |              | 2,773   |   |      |   | 1,809   |  
|Deferred income tax liabilities                                                                         |  |              | 1,459   |   |      |   |        |  
|Other accrued liabilities                                                                               |  |              | 1,700   |   |      |   | 2,376   |  
|                                                                                                        |  |              |         |   |      |   |         |  
|Total current liabilities                                                                               |  |              | 29,923  |   |      |   | 14,901  |  
|                                                                                                        |  |             
|Long-term obligations, net of current portion                                                           |  |              | 7,845   |   |      |   |        |  
|Deferred revenue, net of current portion                                                                |  |              | 3,058   |   |      |   |        |  
|Deferred income tax liabilities, net of current portion                                                 |  |              | 866     |   |      |   |        |  
|Other liabilities                                                                                       |  |              | 251     |   |      |   |        |  
|                                                                                                        |  |              |         |   |      |   |         |  
|Total liabilities                                                                                       |  |              | 41,943  |   |      |   | 14,901  |  
|                                                                                                        |  |             
|Commitments and contingencies (Notes 3, 6, 7 and 9)                                                     |  |              |         |   |      |   |         |  
|Shareholders equity:                                                                                   |  |              |         |   |      |   |         |  
|Common stock, $0.001 par value; 70,000 shares authorized; 21,170 and 20,686 shares issued, respectively |  |              | 21      |   |      |   | 21      |  
|Additional paid-in capital                                                                              |  |              | 114,685 |   |      |   | 113,434 |  
|Deferred stock-based compensation                                                                       |  |              | (36     | ) |      |   | (156    | )
|Accumulated deficit                                                                                     |  |              | (51,208 | ) |      |   | (51,584 | )
|Accumulated other comprehensive income                                                                  |  |              | 5,364   |   |      |   | 1,533   |  
|Treasury stock, at cost; 830 and 730 shares, respectively                                               |  |              | (3,773  | ) |      |   | (3,403  | )
|                                                                                                        |  |              |         |   |      |   |         |  
|Total shareholders equity                                                                              |  |              | 65,053  |   |      |   | 59,845  |  
|                                                                                                        |  |              |         |   |      |   |         |  
|Total liabilities and shareholders equity                                                              |  | $            | 106,996 |   |      | $ | 74,746  |  
|                                                                                                        |  |              |         |   |      |   |         |  



See accompanying
notes to consolidated financial statements.



F-2



---

SONIC INNOVATIONS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

In thousands, except per share data



|                                                            |  |                                  |        |   |      |   |        |      |  |   |        |  
|----------------------------------------------------------- |  | -------------------------------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                            |  | For the Years Ended December 31, |       
|                                                            |  | 2003                             |        |   | 2002 |   |        | 2001 | 
|Net sales                                                   |  | $                                | 87,690 |   |      | $ | 68,018 |      |  | $ | 57,267 |  
|Cost of sales                                               |  |                                  | 41,320 |   |      |   | 32,597 |      |  |   | 31,249 |  
|                                                            |  |                                  |        |   |      |   |        |      |  |   |        |  
|Gross profit                                                |  |                                  | 46,370 |   |      |   | 35,421 |      |  |   | 26,018 |  
|                                                            |  |                                  |       
|Selling, general and administrative expense                 |  |                                  | 36,846 |   |      |   | 28,148 |      |  |   | 23,962 |  
|Research and development expense                            |  |                                  | 9,750  |   |      |   | 8,300  |      |  |   | 9,057  |  
|Stock-based compensation expense                            |  |                                  | 118    |   |      |   | 351    |      |  |   | 727    |  
|                                                            |  |                                  |        |   |      |   |        |      |  |   |        |  
|Operating loss                                              |  |                                  | (344   | ) |      |   | (1,378 | )    |  |   | (7,728 | )
|Other income, net                                           |  |                                  | 1,537  |   |      |   | 1,476  |      |  |   | 2,093  |  
|                                                            |  |                                  |        |   |      |   |        |      |  |   |        |  
|Income (loss) before income taxes                           |  |                                  | 1,193  |   |      |   | 98     |      |  |   | (5,635 | )
|Provision for income taxes                                  |  |                                  | 817    |   |      |   | 66     |      |  |   |       |  
|                                                            |  |                                  |        |   |      |   |        |      |  |   |        |  
|Net income (loss)                                           |  | $                                | 376    |   |      | $ | 32     |      |  | $ | (5,635 | )
|                                                            |  |                                  |        |   |      |   |        |      |  |   |        |  
|Basic and diluted earnings (loss) per common share:         |  | $                                | 0.02   |   |      | $ | 0.00   |      |  | $ | (0.28  | )
|                                                            |  |                                  |        |   |      |   |        |      |  |   |        |  
|                                                            |  |                                  |       
|Weighted average number of common shares outstanding:       |  |                                  |        |   |      |   |        |      |  |   |        |  
|Basic                                                       |  |                                  | 19,941 |   |      |   | 19,595 |      |  |   | 19,822 |  
|                                                            |  |                                  |        |   |      |   |        |      |  |   |        |  
|Diluted                                                     |  |                                  | 20,971 |   |      |   | 20,869 |      |  |   | 19,822 |  
|                                                            |  |                                  |        |   |      |   |        |      |  |   |        |  
|                                                            |  |                                  |       
|Stock-based compensation expense allocable to each caption: |  |                                  |        |   |      |   |        |      |  |   |        |  
|Cost of sales                                               |  | $                                | 6      |   |      | $ | 16     |      |  | $ | 33     |  
|Selling, general and administrative expense                 |  |                                  | 95     |   |      |   | 287    |      |  |   | 595    |  
|Research and development expense                            |  |                                  | 17     |   |      |   | 48     |      |  |   | 99     |  
|                                                            |  |                                  |        |   |      |   |        |      |  |   |        |  
|Stock-based compensation expense                            |  | $                                | 118    |   |      | $ | 351    |      |  | $ | 727    |  
|                                                            |  |                                  |        |   |      |   |        |      |  |   |        |  





See accompanying notes to consolidated financial statements.



F-3



---

SONIC INNOVATIONS, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY

AND COMPREHENSIVE INCOME
(LOSS)

In thousands



|                                                                                 |  |              |  |                          |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |       |   |  |   |        |   |  |   |        |  
|-------------------------------------------------------------------------------- |  | ------------ |  | ------------------------ | -- |  | ------------------------------- | ------- | - | ------------------ | - | ------ | ------------------------------------------ |  | - | ------------- | - |  | ------------------------ | ----- | - |  | - | ------ | - |  | - | ------ | -
|                                                                                 |  | Common Stock |  | AdditionalPaid-inCapital |    |  | DeferredStock-basedCompensation |         |   | AccumulatedDeficit |   |        | AccumulatedOtherComprehensiveIncome (Loss) |  |   | TreasuryStock |   |  | TotalShareholdersEquity |      
|                                                                                 |  | Shares       |  | Amount                   |    |  |                                 |         |   |                   
|Balance, December 31, 2000                                                       |  | 19,812       |  | $                        | 20 |  | $                               | 111,633 |   |                    | $ | (1,346 | )                                          |  | $ | (45,981       | ) |  | $                        | (55   | ) |  | $ |       |   |  | $ | 64,271 |  
|Comprehensive loss:                                                              |  |              |  |                          |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |       |   |  |   |        |   |  |   |        |  
|Net loss                                                                         |  |             |  |                          |   |  |                                 |        |   |                    |   |       |                                            |  |   | (5,635        | ) |  |                          |      |   |  |   |       |   |  |   | (5,635 | )
|Foreign currency translation adjustment                                          |  |             |  |                          |   |  |                                 |        |   |                    |   |       |                                            |  |   |              |   |  |                          | (221  | ) |  |   |       |   |  |   | (221   | )
|                                                                                 |  |              |  |                          |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |       |   |  |   |        |   |  |   |        |  
|                                                                                 |  |              |  |                          |    |  |                                 |        
|Comprehensive loss                                                               |  |              |  |                          |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |       |   |  |   |        |   |  |   | (5,856 | )
|                                                                                 |  |              |  |                          |    |  |                                 |        
|Exercise of stock options and employee stock purchase plan issuances             |  | 309          |  |                          |   |  |                                 | 767     |   |                    |   |       |                                            |  |   |              |   |  |                          |      |   |  |   |       |   |  |   | 767    |  
|Treasury stock purchases, 730 shares                                             |  |             |  |                          |   |  |                                 |        |   |                    |   |       |                                            |  |   |              |   |  |                          |      |   |  |   | (2,745 | ) |  |   | (2,745 | )
|Stock-based compensation                                                         |  |             |  |                          |   |  |                                 | (112    | ) |                    |   | 839    |                                            |  |   |              |   |  |                          |      |   |  |   |       |   |  |   | 727    |  
|                                                                                 |  |              |  |                          |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |       |   |  |   |        |   |  |   |        |  
|                                                                                 |  |              |  |                          |    |  |                                 |        
|Balance, December 31, 2001                                                       |  | 20,121       |  |                          | 20 |  |                                 | 112,288 |   |                    |   | (507   | )                                          |  |   | (51,616       | ) |  |                          | (276  | ) |  |   | (2,745 | ) |  |   | 57,164 |  
|Comprehensive income:                                                            |  |              |  |                          |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |       |   |  |   |        |   |  |   |        |  
|Net income                                                                       |  |             |  |                          |   |  |                                 |        |   |                    |   |       |                                            |  |   | 32            |   |  |                          |      |   |  |   |       |   |  |   | 32     |  
|Foreign currency translation adjustment                                          |  |             |  |                          |   |  |                                 |        |   |                    |   |       |                                            |  |   |              |   |  |                          | 1,809 |   |  |   |       |   |  |   | 1,809  |  
|                                                                                 |  |              |  |                          |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |       |   |  |   |        |   |  |   |        |  
|                                                                                 |  |              |  |                          |    |  |                                 |        
|Comprehensive income                                                             |  |              |  |                          |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |       |   |  |   |        |   |  |   | 1,841  |  
|                                                                                 |  |              |  |                          |    |  |                                 |        
|Exercise of stock options and warrant and employee stock purchase plan issuances |  | 565          |  |                          | 1  |  |                                 | 1,146   |   |                    |   |       |                                            |  |   |              |   |  |                          |      |   |  |   |       |   |  |   | 1,147  |  
|Treasury stock purchases, 144 shares                                             |  |             |  |                          |   |  |                                 |        |   |                    |   |       |                                            |  |   |              |   |  |                          |      |   |  |   | (658   | ) |  |   | (658   | )
|Stock-based compensation                                                         |  |             |  |                          |   |  |                                 |        |   |                    |   | 351    |                                            |  |   |              |   |  |                          |      |   |  |   |       |   |  |   | 351    |  
|                                                                                 |  |              |  |                          |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |       |   |  |   |        |   |  |   |        |  
|                                                                                 |  |              |  |                          |    |  |                                 |        
|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 (Note 3)                      |  |             |  |                          |   |  |                                 |        |   |                    |   |       |                                            |  |   |              |   |  |                          |      |   |  |   | (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 |  
|                                                                                 |  |              |  |                          |    |  |                                 |         |   |                    |   |        |                                            |  |   |               |   |  |                          |       |   |  |   |        |   |  |   |        |  



See accompanying
notes to consolidated financial statements.



F-4



---

SONIC INNOVATIONS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)



|                                                                                                   |  |                                  |         |   |      |   |         |      |  |   |         |  
|-------------------------------------------------------------------------------------------------- |  | -------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                   |  | For the years ended December 31, |        
|                                                                                                   |  | 2003                             |         |   | 2002 |   |         | 2001 | 
|Cash flows from operating activities:                                                              |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net income (loss)                                                                                  |  | $                                | 376     |   |      | $ | 32      |      |  | $ | (5,635  | )
|Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |  |                                  |         |   |      |   |         |      |  |   |         |  
|Depreciation and amortization                                                                      |  |                                  | 2,812   |   |      |   | 2,019   |      |  |   | 1,967   |  
|Stock-based compensation                                                                           |  |                                  | 118     |   |      |   | 351     |      |  |   | 727     |  
|Foreign currency (gain) loss                                                                       |  |                                  | (1,610  | ) |      |   | (527    | )    |  |   | 66      |  
|Deferred income taxes                                                                              |  |                                  | 290     |   |      |   |        |      |  |   |        |  
|Changes in assets and liabilities, net of effect of acquisitions:                                  |  |                                  |         |   |      |   |         |      |  |   |         |  
|Accounts receivable, net                                                                           |  |                                  | (2,378  | ) |      |   | 1,429   |      |  |   | 3,208   |  
|Inventories                                                                                        |  |                                  | (340    | ) |      |   | 801     |      |  |   | 2,048   |  
|Prepaid expenses and other                                                                         |  |                                  | (442    | ) |      |   | 32      |      |  |   | (251    | )
|Other assets                                                                                       |  |                                  | 232     |   |      |   | (81     | )    |  |   | 638     |  
|Accounts payable, accrued expenses and deferred revenue                                            |  |                                  | (1,106  | ) |      |   | (3,375  | )    |  |   | 669     |  
|                                                                                                   |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net cash provided by (used in) operating activities                                                |  |                                  | (2,048  | ) |      |   | 681     |      |  |   | 3,437   |  
|                                                                                                   |  |                                  |        
|Cash flows from investing activities:                                                              |  |                                  |         |   |      |   |         |      |  |   |         |  
|Acquisitions, net of cash acquired                                                                 |  |                                  | (8,281  | ) |      |   | (7,511  | )    |  |   | (5,143  | )
|Purchase of property and equipment                                                                 |  |                                  | (2,292  | ) |      |   | (2,146  | )    |  |   | (1,567  | )
|Investments and advances, net                                                                      |  |                                  | 246     |   |      |   | (1,798  | )    |  |   | (725    | )
|Purchase of marketable securities                                                                  |  |                                  | (27,281 | ) |      |   | (70,301 | )    |  |   | (42,864 | )
|Proceeds from sale or maturity of marketable securities                                            |  |                                  | 26,466  |   |      |   | 80,307  |      |  |   | 55,885  |  
|                                                                                                   |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net cash provided by (used in) investing activities                                                |  |                                  | (11,142 | ) |      |   | (1,449  | )    |  |   | 5,586   |  
|                                                                                                   |  |                                  |        
|Cash flows from financing activities:                                                              |  |                                  |         |   |      |   |         |      |  |   |         |  
|Proceeds from exercise of stock options and employee stock purchase plan issuances                 |  |                                  | 1,253   |   |      |   | 1,147   |      |  |   | 767     |  
|Restricted cash deposit to collateralize letter of credit                                          |  |                                  | (1,896  | ) |      |   |        |      |  |   |        |  
|Proceeds from short-term loan                                                                      |  |                                  | 13,000  |   |      |   |        |      |  |   |        |  
|Principal payment on short-term loan                                                               |  |                                  | (13,000 | ) |      |   |        |      |  |   |        |  
|Proceeds from long-term obligation                                                                 |  |                                  | 8,445   |   |      |   |        |      |  |   |        |  
|Principal payments on long-term obligations                                                        |  |                                  | (399    | ) |      |   | (349    | )    |  |   | (377    | )
|Purchase of common stock for treasury                                                              |  |                                  |        |   |      |   | (658    | )    |  |   | (2,745  | )
|                                                                                                   |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net cash provided by (used in) financing activities                                                |  |                                  | 7,403   |   |      |   | 140     |      |  |   | (2,355  | )
|                                                                                                   |  |                                  |        
|Effect of exchange rate changes on cash and cash equivalents                                       |  |                                  | 727     |   |      |   | 389     |      |  |   | (51     | )
|                                                                                                   |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net increase (decrease) in cash and cash equivalents                                               |  |                                  | (5,060  | ) |      |   | (239    | )    |  |   | 6,617   |  
|Cash and cash equivalents, beginning of the year                                                   |  |                                  | 13,690  |   |      |   | 13,929  |      |  |   | 7,312   |  
|                                                                                                   |  |                                  |         |   |      |   |         |      |  |   |         |  
|Cash and cash equivalents, end of the year                                                         |  | $                                | 8,630   |   |      | $ | 13,690  |      |  | $ | 13,929  |  
|                                                                                                   |  |                                  |         |   |      |   |         |      |  |   |         |  
|                                                                                                   |  |                                  |        
|Supplemental cash flow information:                                                                |  |                                  |         |   |      |   |         |      |  |   |         |  
|Cash paid during the year for interest                                                             |  | $                                | 92      |   |      | $ | 35      |      |  | $ | 78      |  
|Cash paid during the year for income taxes                                                         |  |                                  | 65      |   |      |   |        |      |  |   |        |  
|                                                                                                   |  |                                  |        
|Supplemental disclosure of acquisition related activity:                                           |  |                                  |         |   |      |   |         |      |  |   |         |  
|Fair value of assets acquired                                                                      |  | $                                | 23,493  |   |      | $ | 13,411  |      |  | $ | 6,630   |  
|Liabilities assumed                                                                                |  |                                  | 9,444   |   |      |   | 4,695   |      |  |   | 1,478   |  
|                                                                                                   |  |                                  |         |   |      |   |         |      |  |   |         |  
|Net cash paid                                                                                      |  |                                  | 14,049  |   |      |   | 8,716   |      |  |   | 5,152   |  
|Cash acquired                                                                                      |  |                                  | 5,768   |   |      |   | 1,205   |      |  |   | 9       |  
|                                                                                                   |  |                                  |         |   |      |   |         |      |  |   |         |  
|Acquisitions, net of cash acquired                                                                 |  | $                                | 8,281   |   |      | $ | 7,511   |      |  | $ | 5,143   |  
|                                                                                                   |  |                                  |         |   |      |   |         |      |  |   |         |  



See accompanying
notes to consolidated financial statements.



F-5



---

SONIC INNOVATIONS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

In thousands, except share data



NOTE 1    NATURE OF OPERATIONS



Sonic Innovations, Inc. (the Company) designs, develops, manufacturers and markets advanced digital hearing aids that are intended to provide the highest levels of satisfaction for hearing impaired customers.
Capitalizing on what it believes is an advanced understanding of human hearing, the Company has developed patented digital signal processing (DSP) technologies and embedded them in the smallest single-chip DSP platform ever installed in a hearing
aid. In countries where the Company has a direct presence, the Company principally sells finished hearing aids to hearing care professionals, except in Australia and Germany where the Company principally sells hearing aids directly to hearing
impaired consumers. In countries where the Company does not have a direct presence, the Company sells finished hearing aids and hearing aid kits principally to distributors.



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 accounting principles generally accepted in the United States of
America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues
and expenses during the reporting period. Among the significant estimates affecting the financial statements are those related to allowance for doubtful accounts, sales returns, inventory obsolescence, long-lived asset impairment, warranty accruals
and deferred income tax asset valuation allowances. Actual results could differ from those estimates.



Revenue Recognition and Concentrations of Credit Risk.Sales are recognized when (i) products are shipped, except for retail sales in Germany and
Australia, which are recognized upon acceptance by the hearing impaired 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) collectability is reasonably assured. 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, and allowances for sales
returns are reflected as a reduction of sales. Allowances for sales returns were as follows:



|                            |  |      |         |   |      |   |         |      |  |   |         |  
|--------------------------- |  | ---- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                            |  | 2003 |         |   | 2002 |   |         | 2001 | 
|Balance, beginning of year  |  | $    | 2,629   |   |      | $ | 2,925   |      |  | $ | 2,767   |  
|Provisions and acquisitions |  |      | 16,782  |   |      |   | 16,004  |      |  |   | 15,884  |  
|Returns processed           |  |      | (15,924 | ) |      |   | (16,300 | )    |  |   | (15,726 | )
|                            |  |      |         |   |      |   |         |      |  |   |         |  
|Balance, end of year        |  | $    | 3,487   |   |      | $ | 2,629   |      |  | $ | 2,925   |  
|                            |  |      |         |   |      |   |         |      |  |   |         |  



The Company performs
ongoing credit evaluations of its customers and provides for doubtful accounts. As of December 31, 2003 and 2002, allowances for doubtful accounts were $1,545 and $930, respectively. No single customer comprised 10% or more of net sales in either
2003 or 2002. One customer comprised 10% of net sales in 2001.



Revenues related to sales of separately priced extended service contracts are deferred and recognized on a straight-line basis over the contractual periods, which range from one to five years.



F-6



---

SONIC INNOVATIONS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(In thousands, except share data)



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. Warranty periods range from one to five years. The Company analyzes the amount of historical warranty by geography, product family and model, as appropriate, when evaluating
the adequacy of the reserve. Because of the length of the warranty period, adjustments to the originally recorded provisions may be necessary from time to time. Accrued warranty was as follows:



|                            |  |      |        |   |      |   |        |      |  |   |        |  
|--------------------------- |  | ---- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                            |  | 2003 |        |   | 2002 |   |        | 2001 | 
|Balance, beginning of year  |  | $    | 3,613  |   |      | $ | 2,347  |      |  | $ | 1,229  |  
|Provisions and acquisitions |  |      | 3,924  |   |      |   | 4,381  |      |  |   | 3,836  |  
|Costs                       |  |      | (3,422 | ) |      |   | (3,115 | )    |  |   | (2,718 | )
|                            |  |      |        |   |      |   |        |      |  |   |        |  
|Balance, end of year        |  | $    | 4,115  |   |      | $ | 3,613  |      |  | $ | 2,347  |  
|                            |  |      |        |   |      |   |        |      |  |   |        |  



Derivative
Instruments. The Company enters into forward contracts with financial institutions to minimize the short-term impact of foreign currency fluctuations on certain intercompany account balances. The Company does not enter into these contracts for
trading or speculation purposes. Gains and losses on the contracts are included in net income (loss) and offset foreign exchange gains or losses recognized on the revaluation of intercompany accounts. The Companys foreign currency forward
contracts generally mature one to three months from the contract date. As of December 31, 2003, there were no hedging instruments outstanding.



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, 2003 and 2002, cash equivalents consisted of certificates of deposit and money market funds totaling $5,917 and $9,080, respectively. As of December 31, 2003, the Company had pledged $11,852 of cash, cash equivalents
and marketable securities to secure a long-term loan (see Note 6).



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. As of December 31, 2003 and 2002, the
Companys investment portfolio consisted of corporate debt securities classified as held-to-maturity and was presented at its amortized cost, which approximated market value. The amortized cost of corporate debt securities 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. The Companys
investment policy is to purchase debt securities with (i) anticipated 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.



F-7



---

SONIC INNOVATIONS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(In thousands, except share data)



The Companys investments as of December 31 consisted of the following:



|                      |  |                |        |                        |   |                         |  |   |            |   |  |   |       
|--------------------- |  | -------------- | ------ | ---------------------- | - | ----------------------- |  | - | ---------- | - |  | - | ------
|                      |  | 2003          
|                      |  | Amortized Cost |        | Gross Unrealized Gains |   | Gross Unrealized Losses |  |   | Fair Value
|Corporate             |  | $              | 11,584 |                        | $ | 6                       |  | $ | (6         | ) |  | $ | 11,584
|U.S. government       |  |                | 7,668  |                        |   | 8                       |  |   | (8         | ) |  |   | 7,668 
|Municipal obligations |  |                | 2,861  |                        |   |                        |  |   |           |   |  |   | 2,861 
|Other                 |  |                | 573    |                        |   |                        |  |   | (1         | ) |  |   | 572   
|                      |  |                |        |                        |   |                         |  |   |            |   |  |   |       
|Total                 |  | $              | 22,686 |                        | $ | 14                      |  | $ | (15        | ) |  | $ | 22,685
|                      |  |                |        |                        |   |                         |  |   |            |   |  |   |       
|                      | 
|                      |  | 2002          
|                      |  | Amortized Cost |        | Gross Unrealized Gains |   | Gross Unrealized Losses |  |   | Fair Value
|Corporate             |  | $              | 13,895 |                        | $ | 20                      |  | $ | (8         | ) |  | $ | 13,907
|U.S. government       |  |                | 6,393  |                        |   | 23                      |  |   | (3         | ) |  |   | 6,413 
|Municipal obligations |  |                | 1,377  |                        |   |                        |  |   |           |   |  |   | 1,377 
|Other                 |  |                | 206    |                        |   |                        |  |   | (3         | ) |  |   | 203   
|                      |  |                |        |                        |   |                         |  |   |            |   |  |   |       
|Total                 |  | $              | 21,871 |                        | $ | 43                      |  | $ | (14        | ) |  | $ | 21,900
|                      |  |                |        |                        |   |                         |  |   |            |   |  |   |       



Inventories.Inventories are stated at the lower of cost or market value using the first-in, first-out (FIFO) method. Inventories as of December 31 consisted of the following:



|                 |  |      |       |      |   |      
|---------------- |  | ---- | ----- | ---- | - | -----
|                 |  | 2003 |       | 2002
|Raw materials    |  | $    | 1,709 |      | $ | 1,480
|Components       |  |      | 2,244 |      |   | 1,352
|Work in progress |  |      | 223   |      |   | 165  
|Finished goods   |  |      | 5,185 |      |   | 3,488
|                 |  |      |       |      |   |      
|Total            |  | $    | 9,361 |      | $ | 6,485
|                 |  |      |       |      |   |      



Provision is made to
reduce excess and obsolete inventories to their estimated net realizable values. As of December 31, 2003 and 2002, reserves for excess and obsolete inventories were $1,864 and $1,111, respectively.



Purchase Commitments.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



F-8



---

SONIC INNOVATIONS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(In thousands, except share data)



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 2003, 2002 and 2001.



Property and
Equipment.Property and equipment are stated at cost. Depreciation is calculated using the straight-line method over the estimated useful lives of 7 years for furniture and fixtures and 3 to 5 years for machinery and equipment. Leasehold
improvements are amortized over the lease term of up to 5 years. 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 (loss). Major renewals and betterments are capitalized while minor expenditures for maintenance and repairs are charged to expense as incurred. Property and equipment as of December 31 consisted of the following:



|                                               |  |      |         |   |      |   |        |  
|---------------------------------------------- |  | ---- | ------- | - | ---- | - | ------ | -
|                                               |  | 2003 |         |   | 2002 |  
|Machinery and equipment                        |  | $    | 5,272   |   |      | $ | 5,372  |  
|Computer equipment and software                |  |      | 7,570   |   |      |   | 3,429  |  
|Furniture and office equipment                 |  |      | 4,188   |   |      |   | 4,324  |  
|Leasehold improvements                         |  |      | 397     |   |      |   | 324    |  
|                                               |  |      |         |   |      |   |        |  
|                                               |  |      | 17,427  |   |      |   | 13,449 |  
|                                               |  |     
|Less accumulated depreciation and amortization |  |      | (10,934 | ) |      |   | (7,587 | )
|                                               |  |      |         |   |      |   |        |  
|Total                                          |  | $    | 6,493   |   |      | $ | 5,862  |  
|                                               |  |      |         |   |      |   |        |  



Impairment of
Long-Lived Assets.Long-lived tangible assets and definite-lived intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Determination of
recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset group and its eventual disposition. Measurement of an impairment loss for such assets is based on the fair value of the asset. There were no
such losses recognized in 2003, 2002 and 2001.



Goodwill and
Indefinite-Lived Intangible Assets.Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, prohibits the amortization of goodwill and certain intangible assets that are deemed to have
indefinite lives. Goodwill and indefinite-lived intangibles are required to be tested for impairment on an annual basis (and between annual tests in certain circumstances) and written down when impaired. Furthermore, SFAS No. 142 requires purchased
intangible assets other than goodwill to be amortized over their useful lives unless these lives are determined to be indefinite. Based on impairment tests performed on each of the Companys acquired operations, there was no impairment of
goodwill or the Companys renewable government license asset in 2003, 2002 and 2001. The Company has chosen to perform annual impairment testing in the fourth quarter of each year. There can be no assurance that future impairment tests will not
result in an impairment charge.



Patents. During 2003,
2002 and 2001, the Company expensed direct costs associated with obtaining and filing patents of $256, $272 and $253, respectively.



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.



Advertising.Advertising costs are expensed as incurred. Advertising costs for 2003, 2002 and 2001 were $2,209, $2,605 and $1,822, respectively.



F-9



---

SONIC INNOVATIONS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(In thousands, except share data)



Earnings (Loss) Per Common Share.Basic earnings (loss) per common share is calculated based
upon the weighted average shares of common stock outstanding during the period. Diluted earnings (loss) per common share is calculated based upon the weighted average shares of common stock outstanding, plus the dilutive effect of common stock
equivalents calculated using the treasury stock method. Dilutive common stock equivalents in 2003 and 2002 consisted of 1,030,412 and 1,273,619 shares, respectively pertaining to 2,855,110 and 2,978,695 stock options, respectively. Antidilutive
common stock equivalents, consisting of stock options and warrants, of 1,920,081, 1,548,439 and 3,580,994 in 2003, 2002 and 2001, respectively were excluded from diluted earnings (loss) per common share calculations.



Fair Value of Financial Instruments.The Companys financial
instruments consist primarily of cash equivalents, marketable securities, accounts receivable, accounts payable and long-term debt. The carrying values of the financial instruments approximate their fair values. The estimated fair values have been
determined using appropriate market information and valuation methodologies.



Foreign Currency Translation.The accounts of the Companys subsidiaries are translated into United States (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).



Employee Stock Option
Plans.In December 2002, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 148, Accounting for Stock-Based CompensationTransition and Disclosure, which amended SFAS
No. 123, Accounting for Stock-Based Compensation, and gives companies electing to expense employee stock options three methods to do so. In addition, the statement amends the disclosure requirements to require more prominent disclosures
about the method of accounting for stock-based employee compensation and the effect of the method used on reported results in both annual and interim financial statements. The Company has elected to continue using the intrinsic value method of
accounting for stock-based compensation. Therefore, SFAS No. 148 did not have any effect on the Companys results of operations and financial position. See information below and Note 11 for additional disclosures regarding stock-based
compensation.



F-10



---

SONIC INNOVATIONS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(In thousands, except share data)



Under the intrinsic value method, when the exercise price of the Companys employee stock
options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized in the Companys results of operations. However, the Company is required under SFAS No. 123 to disclose pro forma information
regarding stock option grants made to its employees based on specified valuation techniques that produce estimated compensation charges. Pro forma information was as follows:



|                                                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|------------------------------------------------------------------------------------------ |  | ---- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                                                           |  | 2003 |        |   | 2002 |   |        | 2001 | 
|Net income (loss):                                                                         |  |      |        |   |      |   |        |      |  |   |        |  
|As reported                                                                                |  | $    | 376    |   |      | $ | 32     |      |  | $ | (5,635 | )
|Add: Stock-based employee compensation included in reported net income (loss)              |  |      | 118    |   |      |   | 351    |      |  |   | 727    |  
|Deduct: Stock-based employee compensation expense determined under fair value-based method |  |      | (3,280 | ) |      |   | (3,792 | )    |  |   | (2,746 | )
|                                                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|Pro forma                                                                                  |  | $    | (2,786 | ) |      | $ | (3,409 | )    |  | $ | (7,654 | )
|                                                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|                                                                                           |  |      |       
|Basic earnings (loss) per share:                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|As reported                                                                                |  | $    | 0.02   |   |      | $ | 0.00   |      |  | $ | (0.28  | )
|                                                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|Pro forma                                                                                  |  | $    | (0.14  | ) |      | $ | (0.17  | )    |  | $ | (0.39  | )
|                                                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|                                                                                           |  |      |       
|Diluted earnings (loss) per share:                                                         |  |      |        |   |      |   |        |      |  |   |        |  
|As reported                                                                                |  | $    | 0.02   |   |      | $ | 0.00   |      |  | $ | (0.28  | )
|                                                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|Pro forma                                                                                  |  | $    | (0.14  | ) |      | $ | (0.17  | )    |  | $ | (0.39  | )
|                                                                                           |  |      |        |   |      |   |        |      |  |   |        |  



In determining the
pro forma amounts in the table above, the fair market value of each option was estimated on the date of grant using the Black-Scholes option-pricing model amortized on a straight-line basis over the vesting period of the option and based on the
following weighted average assumptions:



|                         |  |         |   |  |         |   |  |         |  
|------------------------ |  | ------- | - |  | ------- | - |  | ------- | -
|                         |  | 2003    |   |  | 2002    |   |  | 2001    |  
|Risk free rate of return |  | 3.07    | % |  | 4.63    | % |  | 6.50    | %
|Expected dividend yield  |  | 0.00    | % |  | 0.00    | % |  | 0.00    | %
|Volatility               |  | 86.7    | % |  | 89.1    | % |  | 95.5    | %
|Expected life            |  | 5 years |   |  | 5 years |   |  | 5 years |  



Comprehensive
Income (Loss).The Company computes comprehensive income (loss) in accordance with SFAS No. 130, Reporting Comprehensive Income. SFAS No. 130 establishes standards for the reporting and presentation of other comprehensive income
(loss) and its components in the financial statements. Other comprehensive income (loss) includes net income (loss) plus the results of certain shareholders equity changes 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 relate to specific indefinite investments in international subsidiaries.



NOTE 3    ACQUISITIONS



In May 2003, the Company acquired 100% of the stock of Sanomed
Handelsgesellschaft mbH (Sanomed), a distribution company that markets hearing aids directly to German hearing impaired customers through ear-nose-



F-11



---

SONIC INNOVATIONS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(In thousands, except share data)



throat (ENT) physicians. Sanomed was founded in 1990 as a limited liability company. The Company acquired Sanomed to establish a location and meaningful
presence in Germany. The acquisition was effected through a wholly owned subsidiary of the Company, PALME Verwaltungsgellschaft mbH, whose name was subsequently changed to Sonic Innovations GmbH. The initial consideration paid by the Company
including expenses was $13,414. Additional consideration of up to a maximum of $5,021 may be payable based on sales performance over a three-year period.



In 2002, the Company acquired seven hearing aid businesses outside the U.S. for a total cash purchase price of $8,716 and in 2001 acquired one hearing aid
business for a purchase price of $5,152. Additional payments of $635 have been made since the acquisitions based on sales performance and were accounted for as increases to goodwill. As of December 31, 2003 and 2002, there were accrued milestone
payments of $350 included in accounts payable. Additional consideration for these acquisitions of up to a maximum of $746 may be payable based on 2004 sales performance.



Goodwill was reduced in 2003 by $512 as a result of the reversal of certain deferred tax asset valuation allowances, which
had been established in the Australian subsidiary when it was purchased due to the initial uncertainty of their realization.



The Companys acquisitions have all been accounted for as purchases in accordance with SFAS No. 141, Business Combinations. The purchase
prices of these businesses have been allocated to the net assets acquired based on independent valuations. The following table sets forth the allocation of the aggregate purchase price of the acquired businesses:



|                                                |  |      |        |   |      |   |        |      |  |   |        |  
|----------------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                |  | 2003 |        |   | 2002 |   |        | 2001 | 
|Current assets                                  |  | $    | 10,576 |   |      | $ | 4,555  |      |  | $ | 1,394  |  
|Property and equipment and other assets         |  |      | 401    |   |      |   | 457    |      |  |   | 1,030  |  
|Goodwill and indefinite-lived intangible assets |  |      | 10,469 |   |      |   | 7,834  |      |  |   | 4,206  |  
|Definite-lived intangible assets                |  |      | 2,046  |   |      |   | 565    |      |  |   |       |  
|Current liabilities                             |  |      | (2,480 | ) |      |   | (4,695 | )    |  |   | (1,478 | )
|Deferred revenue                                |  |      | (3,543 | ) |      |   |       |      |  |   |       |  
|Deferred taxes and other liabilities            |  |      | (3,420 | ) |      |   |       |      |  |   |       |  
|                                                |  |      |        |   |      |   |        |      |  |   |        |  
|Total                                           |  | $    | 14,049 |   |      | $ | 8,716  |      |  | $ | 5,152  |  
|                                                |  |      |        |   |      |   |        |      |  |   |        |  



Goodwill represents
the excess purchase price over the net identifiable assets acquired in the Companys various acquisitions. In 2003, acquired other assets included $370 of Sonic Innovations, Inc. common stock, which had been previously purchased by Sanomed.
This amount has been classified as treasury stock in the consolidated financial statements.



F-12



---

SONIC INNOVATIONS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(In thousands, except share data)



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



|                                                      |  |      |        |      |   |       
|----------------------------------------------------- |  | ---- | ------ | ---- | - | ------
|                                                      |  | 2003 |        | 2002
|Net sales                                             |  | $    | 94,163 |      | $ | 84,730
|Operating profit                                      |  |      | 1,287  |      |   | 145   
|Net income                                            |  |      | 1,306  |      |   | 771   
|Earnings per common share:                            |  |      |        |      |   |       
|Basic                                                 |  | $    | 0.07   |      | $ | 0.04  
|                                                      |  |      |        |      |   |       
|Diluted                                               |  | $    | 0.06   |      | $ | 0.04  
|                                                      |  |      |        |      |   |       
|Weighted average number of common shares outstanding: |  |      |        |      |   |       
|Basic                                                 |  |      | 19,908 |      |   | 19,587
|                                                      |  |      |        |      |   |       
|Diluted                                               |  |      | 20,938 |      |   | 20,864
|                                                      |  |      |        |      |   |       



NOTE
4    INTANGIBLE ASSETS



Intangible
assets as of December 31 consisted of the following:



|                                                |  |              |        |                         |   |      |             |  |   |               |   |              |   |        |  |           
|----------------------------------------------- |  | ------------ | ------ | ----------------------- | - | ---- | ----------- |  | - | ------------- | - | ------------ | - | ------ |  | ----------
|                                                |  | 2003        
|                                                |  | OriginalCost |        | AccumulatedAmortization |   |      | Translation |  |   | CarryingValue |   | Useful Lives
|Definite-lived intangible assets:               |  |              |        |                         |   |      |             |  |   |               |   |              |   |        |  |           
|Technology license                              |  | $            | 1,350  |                         | $ | (416 | )           |  | $ |              |   |              | $ | 934    |  | 13 years  
|Trademarks                                      |  |              | 1,701  |                         |   | (205 | )           |  |   | 160           |   |              |   | 1,656  |  | 3-10 years
|Distribution agreements                         |  |              | 456    |                         |   | (224 | )           |  |   | 98            |   |              |   | 330    |  | 2-5 years 
|Non-compete agreements                          |  |              | 362    |                         |   | (56  | )           |  |   | 56            |   |              |   | 362    |  | 5 years   
|Other intangibles                               |  |              | 283    |                         |   | (97  | )           |  |   | 61            |   |              |   | 247    |  | 2-5 years 
|                                                |  |              |        |                         |   |      |             |  |   |               |   |              |   |        |  |           
|Sub-total                                       |  |              | 4,152  |                         |   | (998 | )           |  |   | 375           |   |              |   | 3,529  |  |           
|Goodwill and indefinite-lived intangible assets |  |              | 21,906 |                         |   |     |             |  |   | 5,066         |   |              |   | 26,972 |  |           
|                                                |  |              |        |                         |   |      |             |  |   |               |   |              |   |        |  |           
|Total                                           |  | $            | 26,058 |                         | $ | (998 | )           |  | $ | 5,441         |   |              | $ | 30,501 |  |           
|                                                |  |              |        |                         |   |      |             |  |   |               |   |              |   |        |  |           
|                                                | 
|                                                |  | 2002        
|                                                |  | OriginalCost |        | AccumulatedAmortization |   |      | Translation |  |   | CarryingValue |   | Useful Lives
|Definite-lived intangible assets:               |  |              |        |                         |   |      |             |  |   |               |   |              |   |        |  |           
|Technology licenses                             |  | $            | 1,425  |                         | $ | (317 | )           |  | $ |              |   |              | $ | 1,108  |  | 1-13 years
|Trademarks                                      |  |              | 208    |                         |   | (34  | )           |  |   | 17            |   |              |   | 191    |  | 3-5 years 
|Distribution agreements                         |  |              | 186    |                         |   | (57  | )           |  |   | 34            |   |              |   | 163    |  | 3-5 years 
|Other intangibles                               |  |              | 171    |                         |   | (18  | )           |  |   | (6            | ) |              |   | 147    |  | 3-5 years 
|                                                |  |              |        |                         |   |      |             |  |   |               |   |              |   |        |  |           
|Sub-total                                       |  |              | 1,990  |                         |   | (426 | )           |  |   | 45            |   |              |   | 1,609  |  |           
|Goodwill and indefinite-lived intangible assets |  |              | 12,083 |                         |   |     |             |  |   | 1,228         |   |              |   | 13,311 |  |           
|                                                |  |              |        |                         |   |      |             |  |   |               |   |              |   |        |  |           
|Total                                           |  | $            | 14,073 |                         | $ | (426 | )           |  | $ | 1,273         |   |              | $ | 14,920 |  |           
|                                                |  |              |        |                         |   |      |             |  |   |               |   |              |   |        |  |           



F-13



---

SONIC INNOVATIONS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(In thousands, except share data)



During 2003, the impact of foreign currency translation increased the balance of intangible assets by
$5,441. Amortization expense was $498 and $207 in 2003 and 2002, respectively. Annual forecasted amortization expense for the years 2004 through 2008 is as follows: 2004$622; 2005$554; 2006$486; 2007$422; and 2008$294.



Technology licenses relate to agreements with (i) a
partnership of hearing aid companies to which the Company paid $1,800 for a paid-up license to use the partnerships technology, and (ii) a private company to which the Company paid $75 for the use of a certain material used in hearing aids.
The Company received cash dividends from the partnership of $100 in 2002 and $350 in 2001, which were accounted for as reductions to the technology license. The license from the partnership is being amortized over the life of the technology through
2013. The Company chose not to integrate the certain material used in hearing aids and therefore, expensed the $75 technology license in 2003.



NOTE 5    OTHER ASSETS



Other assets as of December 31 consisted of the following:



|                         |  |      |       |      |   |      
|------------------------ |  | ---- | ----- | ---- | - | -----
|                         |  | 2003 |       | 2002
|Investments and advances |  | $    | 1,461 |      | $ | 1,707
|Other assets             |  |      | 244   |      |   | 194  
|                         |  |      |       |      |   |      
|Total                    |  | $    | 1,705 |      | $ | 1,901
|                         |  |      |       |      |   |      



Investments and
advances consisted of one investment and one advance to two separate business partners and several advances to customers. The advances are secured by the assets of the business, life insurance policies and/or personal guarantees. Prior to the
advance, the Company performs a credit evaluation. The advances bear interest at rates ranging from 5% to 8%, are evidenced by promissory notes, and have terms from one to five years. The Company discontinues the accrual of interest income when a
loan is determined to be non-performing. Investments and advances are stated at cost, net of valuation allowances of $153 and $110 as of December 31, 2003 and 2002, respectively.



NOTE 6    LONG-TERM OBLIGATIONS



The $13,000 initial purchase price of the Companys German acquisition was funded by a short-term loan from a U.S.
bank. During the third quarter 2003, the loan was repaid and partially replaced with a long-term loan of 7,500 Euro ($8,445) from a German bank. The interest rate applicable to the new loan is 1.0% above the EURIBOR rate (3.18% as of December 31,
2003) as defined in the loan agreement. The loan is collateralized by a letter of credit from a U.S. bank, and the Company pledged $11,852 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 ($314 as of December 31, 2003) per quarter. The Companys effective interest rate for the period through December 31, 2003 was 3.78%.



The long-term capital lease obligation as of December 31, 2002 of $103
(present value of $102) was paid in full in 2003. As of December 31, 2002, the Company held certain property and equipment with a cost of $973 under this capital lease agreement with a bank and had recorded accumulated amortization of $875.



F-14



---

SONIC INNOVATIONS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(In thousands, except share data)



NOTE 7    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, 2003, 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.



NOTE 8    OTHER INCOME



Other income consisted of the following:



|                                      |  |      |       |   |      |   |       |      |  |   |       |  
|------------------------------------- |  | ---- | ----- | - | ---- | - | ----- | ---- |  | - | ----- | -
|                                      |  | 2003 |       |   | 2002 |   |       | 2001 | 
|Interest income and other             |  | $    | 482   |   |      | $ | 982   |      |  | $ | 2,268 |  
|Interest expense                      |  |      | (165  | ) |      |   | (33   | )    |  |   | (109  | )
|Foreign currency exchange gain (loss) |  |      | 1,220 |   |      |   | 527   |      |  |   | (66   | )
|                                      |  |      |       |   |      |   |       |      |  |   |       |  
|Total                                 |  | $    | 1,537 |   |      | $ | 1,476 |      |  | $ | 2,093 |  
|                                      |  |      |       |   |      |   |       |      |  |   |       |  



NOTE
9    COMMITMENTS AND CONTINGENCIES



Operating Leases.The Company leases various equipment and office space under noncancelable operating leases that expire at various dates through 2009. Rental expense for 2003, 2002 and 2001 was $3,545, $2,233 and $1,750,
respectively. Future minimum lease payments under noncancelable leases for the next five years and thereafter as of December 31, 2003 totaled $6,981 and are due as follows: 2004$3,046; 2005$1,605; 2006$1,214; 2007$740;
2008$306; and thereafter$70. Sublease revenue of $118, $263 and $186 in 2002, 2001 and 2000, respectively was netted against lease expense. Future sublease revenue of $112 is due in 2004.



Brigham Young University Technology License Agreements.In 1995, the
Company entered into a license agreement, as amended in 1996 and 2000, 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. As consideration for the license, the Company issued 105,567 shares of its common stock and paid license fees totaling $580 through 2001, at which time the license was paid in full.



In 1997, the Company entered into a separate 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 $129, $160 and $139 in 2003, 2002 and 2001, respectively.



F-15



---

SONIC INNOVATIONS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(In thousands, except share data)



K/S HIMPP License Agreement.In 2000, the Company entered into a license agreement with K/S
HIMPP, a Danish partnership, whereby the Company licensed rights 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 Company paid $1,800 for a paid-up
license to use this technology and an equity interest in K/S HIMPP. The paid-up license is being amortized over the life of the technology through 2013. Amortization expense pertaining to this license was $99, $106 and $136 in 2003, 2002 and 2001,
respectively.



Digital License Agreement.In 2003, the
Company entered into a license agreement with another company that provides the Company with 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 or a minimum quarterly fee, whichever is greater. Royalty expense pertaining to this license was $40 in 2003.



Manufacturing License Agreement.In 2003, the Company entered into 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 royalty based on the number of units produced using such technology. There was no
royalty expense pertaining to this license in 2003.



Other
License Agreements.In 1999, the Company entered into a license agreement to resolve a claim of patent infringement made by a competitor under which the Company paid a 1.5% royalty on all net sales of hearing aids for the period 1998 through
2001, at which time the license was paid in full. Royalty expense pertaining to this license was $559 in 2001 and no subsequent payments are required.



Supplier Purchase Commitment and Concentrations.In 1997, the Company entered into an agreement, as amended in 2000 and 2002, with an integrated
circuit manufacturer to purchase integrated circuits used in all the Companys products. The agreement provides the manufacturer with a non-exclusive, non-transferable license to use the Companys technology for non-hearing applications.
The manufacturer granted the Company a license to minor improvements or enhancements made to the technology by the manufacturer for hearing applications. The Company made purchases from this manufacturer totaling $2,601, $1,550 and $1,525, in 2003,
2002 and 2001, respectively. The agreement requires the Company to make minimum purchases based on a fixed minimum number of integrated circuits at a fixed price per integrated circuit. Minimum payments remaining under the agreement are $1,800 in
2004. The Company purchases all of its integrated circuits from this manufacturer. Should this manufacturer be unable to provide the Company with these integrated circuits, the ability of the Company to produce products for sale would be materially
impaired.



Legal Matters.The Company is a defendant in
a lawsuit filed in October 2000 claiming that the Company and certain of its officers and directors violated federal securities laws by providing materially false and misleading information or concealing information about the Companys
relationship with Starkey Laboratories, Inc. The complaint alleges that as a result of false statements or omissions, the Company was able to complete its IPO, artificially inflate its financial projections and results and have its stock trade at
inflated levels. The Company reached an agreement in principle to settle the securities class action lawsuits that have been consolidated under the caption Lynda Steinbeck, et al. v. Sonic Innovations, Inc., et al., in the United States
District Court for the District of Utah. The terms of the settlement call for a cash payment of $7,000 which will be funded by the Companys directors and officers liability insurance. The settlement is expected to have no impact on the
Companys results of operations and financial position. Final settlement is contingent on



F-16



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SONIC INNOVATIONS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(In thousands, except share data)



negotiation and execution of a formal settlement stipulation and court approvals of the settlement following notification to members of the class and an
opportunity for class members to object.



In addition, the
Company is subject to legal proceedings, claims, and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, the Company does not expect that the ultimate resolution of these matters
will have a material adverse effect on the Companys results of operations and financial position.



NOTE 10    INCOME TAXES



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



|         |  |      |        |   |      |   |      |      |  |   |        |  
|-------- |  | ---- | ------ | - | ---- | - | ---- | ---- |  | - | ------ | -
|         |  | 2003 |        |   | 2002 |   |      | 2001 | 
|Domestic |  | $    | 3,495  |   |      | $ | 315  |      |  | $ | (4,108 | )
|Foreign  |  |      | (2,302 | ) |      |   | (217 | )    |  |   | (1,527 | )
|         |  |      |        |   |      |   |      |      |  |   |        |  
|Total    |  | $    | 1,193  |   |      | $ | 98   |      |  | $ | (5,635 | )
|         |  |      |        |   |      |   |      |      |  |   |        |  



The provision for
income taxes consisted of the following:



|          |  |      |     |      |   |      |  |   |  
|--------- |  | ---- | --- | ---- | - | ---- |  | - | -
|          |  | 2003 |     | 2002 |   | 2001
|Domestic: |  |      |     |      |   |      |  |   |  
|Current   |  | $    | 119 |      | $ |     |  | $ | 
|Deferred  |  |      |    |      |   |     |  |   | 
|          |  |      |     |      |   |      |  |   |  
|          |  |      | 119 |      |   |     |  |   | 
|Foreign:  |  |      |     |      |   |      |  |   |  
|Current   |  |      | 408 |      |   | 66   |  |   | 
|Deferred  |  |      | 290 |      |   |     |  |   | 
|          |  |      |     |      |   |      |  |   |  
|          |  |      | 698 |      |   | 66   |  |   | 
|          |  |      |     |      |   |      |  |   |  
|Total     |  | $    | 817 |      | $ | 66   |  | $ | 
|          |  |      |     |      |   |      |  |   |  



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. As a result, in accordance with APB No. 23, the foreign
currency translation adjustment included in other comprehensive income (loss) has not been tax effected. It is not practical to estimate the amount of additional taxes that might be payable on such undistributed earnings.



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:



|                                                         |  |        |   |  |        |  
|-------------------------------------------------------- |  | ------ | - |  | ------ | -
|                                                         |  | 2003   |   |  | 2002   |  
|U.S. federal statutory income tax rate                   |  | 34.0   | % |  | 34.0   | %
|State income tax rate, net of federal income tax effect  |  | 1.5    |   |  |       |  
|Foreign earnings taxed at different rates                |  | 124.1  |   |  | 142.6  |  
|Non-deductible items                                     |  | 11.1   |   |  | 37.8   |  
|Change in valuation allowance attributable to operations |  | (102.2 | ) |  | (147.1 | )
|                                                         |  |        |   |  |        |  
|Effective income tax rate                                |  | 68.5   | % |  | 67.3   | %
|                                                         |  |        |   |  |        |  



In 2001, operating
losses were incurred in all tax jurisdictions and offset in full by valuation allowances. Therefore, no income tax reconciliation is presented.



F-17



---

SONIC INNOVATIONS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(In thousands, except share data)



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. As of December 31 the components of the net deferred income tax liability were as follows:



|                                                  |  |      |         |   |      |   |         |  
|------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                                  |  | 2003 |         |   | 2002 |  
|Deferred income tax assets:                       |  |      |         |   |      |   |         |  
|Net operating loss carry-forwards                 |  | $    | 9,971   |   |      | $ | 10,909  |  
|Allowance for sales returns and doubtful accounts |  |      | 1,479   |   |      |   | 1,102   |  
|Inventory allowances and warranty accruals        |  |      | 956     |   |      |   | 998     |  
|Deferred revenue                                  |  |      | 730     |   |      |   | 398     |  
|Accumulated research and development credits      |  |      | 854     |   |      |   | 704     |  
|Start up amortization                             |  |      |        |   |      |   | 429     |  
|Other                                             |  |      | 958     |   |      |   | 562     |  
|                                                  |  |      |         |   |      |   |         |  
|Sub-total                                         |  |      | 14,948  |   |      |   | 15,102  |  
|                                                  |  |      |         |   |      |   |         |  
|Valuation allowance                               |  |      | (14,348 | ) |      |   | (15,102 | )
|                                                  |  |      |         |   |      |   |         |  
|Deferred income tax assets                        |  |      | 600     |   |      |   |        |  
|                                                  |  |      |         |   |      |   |         |  
|                                                  |  |     
|Deferred income tax liabilities:                  |  |      |         |   |      |   |         |  
|Inventory                                         |  |      | (1,020  | ) |      |   |        |  
|Depreciation                                      |  |      | (65     | ) |      |   |        |  
|Acquired intangible assets                        |  |      | (866    | ) |      |   |        |  
|Other                                             |  |      | (622    | ) |      |   |        |  
|                                                  |  |      |         |   |      |   |         |  
|Deferred income tax liabilities                   |  |      | (2,573  | ) |      |   |        |  
|                                                  |  |      |         |   |      |   |         |  
|Net deferred income tax liability                 |  | $    | (1,973  | ) |      | $ |        |  
|                                                  |  |      |         |   |      |   |         |  



Valuation allowances
for the deferred income tax assets were recorded due to the uncertainty of their realization based principally upon the Companys lack of profitability to date. In addition, deferred income tax assets recognized in the Companys
acquisitions were fully reserved. In 2003, the Company reversed a valuation allowance of $512 established in connection with the acquisition of its Australian business and accordingly reduced the recorded indefinite-lived intangible asset. As of
December 31, 2003, the Company had net operating loss carry-forwards for U.S. federal income tax reporting purposes totaling $20,888 that will begin to expire in 2018 if not utilized. The Company has various state net operating loss carry-forwards,
which expire depending on the rules of the various states to which the net operating loss is allocated. Non-U.S. net operating loss carry-forwards of $8,147 will begin to expire in 2004.



Approximately $895 of net operating loss carry-forwards as of December 31, 2003 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.





F-18



---

SONIC INNOVATIONS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(In thousands, except share data)



NOTE 11    STOCKBASED COMPENSATION



Stock Options.The Companys 2000 Stock Plan provides for the
issuance of a maximum of 7,552,632 shares of common stock. The plan allows for the grant of incentive or nonqualified stock options and stock purchase rights and is administered by the Board of Directors who determines the type, quantity and terms
and conditions of any award, including any vesting conditions. The maximum term of an option may not exceed ten years and the plan will expire in 2010. As of December 31, 2003, 624,076 shares were available for grant under the plan. Options
generally vest over a four-year period from the grant date. 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.



In connection with the grant of certain stock options prior to the Companys initial public offering in May 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. The Company is amortizing the deferred
stock-based compensation over the option vesting periods of three to six years and periodically adjusts the balance for option forfeitures. The Companys stock option activity was as follows:



|                                 |  |              |   |  |                                 |     
|-------------------------------- |  | ------------ | - |  | ------------------------------- | ----
|                                 |  | Optionshares |   |  | Weighted average exercise price
|Outstanding at December 31, 2000 |  | 2,988,645    |   |  | $                               | 4.52
|Granted                          |  | 851,463      |   |  |                                 | 4.47
|Exercised                        |  | (115,224     | ) |  |                                 | 1.25
|Forfeited or expired             |  | (164,596     | ) |  |                                 | 7.10
|                                 |  |              |   |  |                                 |     
|Outstanding at December 31, 2001 |  | 3,560,288    |   |  |                                 | 4.50
|Granted                          |  | 1,523,989    |   |  |                                 | 4.70
|Exercised                        |  | (352,283     | ) |  |                                 | 1.44
|Forfeited or expired             |  | (204,860     | ) |  |                                 | 6.70
|                                 |  |              |   |  |                                 |     
|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
|                                 |  |              |   |  |                                 |     



F-19



---

SONIC INNOVATIONS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(In thousands, except share data)



As of December 31, 2003, 2002 and 2001, there were options exercisable for 2,546,903, 2,051,019 and
1,694,567 shares of common stock at weighted average exercise prices of $4.54, $4.13 and $3.12 per share, respectively. Stock options outstanding and exercisable as of December 31, 2003 were as follows:



|                         |  |                     |  |                                 |       |                                 |      |        |           |                                 |   |      
|------------------------ |  | ------------------- |  | ------------------------------- | ----- | ------------------------------- | ---- | ------ | --------- | ------------------------------- | - | -----
|                         |  | Options Outstanding |  | Options Exercisable            
|Range of exercise prices |  | Shares              |  | Weighted average exercise price |       | Weighted average remaining life |      | Shares |           | Weighted average exercise price
|$  0.19  $  2.86        |  | 1,150,233           |  | $                               | 1.85  |                                 | 6.37 |        | 631,880   |                                 | $ | 1.03 
|3.49      4.20          |  | 1,070,595           |  |                                 | 3.81  |                                 | 7.31 |        | 818,254   |                                 |   | 3.86 
|4.36      5.44          |  | 823,464             |  |                                 | 4.82  |                                 | 8.52 |        | 264,721   |                                 |   | 5.02 
|5.47      6.18          |  | 846,221             |  |                                 | 5.91  |                                 | 8.12 |        | 366,682   |                                 |   | 5.76 
|6.23    10.88           |  | 902,548             |  |                                 | 7.31  |                                 | 8.32 |        | 370,980   |                                 |   | 8.16 
|13.30    18.00          |  | 99,141              |  |                                 | 13.84 |                                 | 6.24 |        | 94,386    |                                 |   | 13.80
|                         |  |                     |  |                                 |       |                                 |      |        |           |                                 |   |      
|Total                    |  | 4,892,202           |  | $                               | 4.73  |                                 | 7.60 |        | 2,546,903 |                                 | $ | 4.54 
|                         |  |                     |  |                                 |       |                                 |      |        |           |                                 |   |      



Warrant.The
Company issued a warrant in 2000 to purchase 20,706 shares of common stock at $3.80 per share in connection with obtaining a bank line of credit, and this warrant was subsequently exercised on a net basis and 7,806 shares were issued in 2002. As of
December 31, 2003, there were no warrants outstanding.



NOTE
12    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. The Company began matching 25% of
each employees first 4% of salary deferral in May 2002 and expensed $109 in 2003 and $72 in 2002.



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 204,556, 205,841 and 184,724 shares of common stock in 2003, 2002 and 2001, respectively under the plan. As of December 31, 2003, 153,329
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.



F-20



---

SONIC INNOVATIONS, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(In thousands, except share data)



NOTE 13    SEGMENT INFORMATION



The Companys operations involve the design, development, manufacturing
and marketing of hearing aids. The Company conducts business globally and is managed geographically. The Companys Chief Executive Officer and senior management rely on internal management reports that provide sales and operational information
by geographic location. Sales are attributed to a location based on the ordering location of the customer. The Companys management makes financial decisions and allocates resources based on the information it receives from these internal
management reports. The Company does not allocate its U.S.-based corporate research and development, sales and marketing and general and administrative expenses to its non-U.S. locations. Management considers these expenses part of its U.S.
operations in evaluating U.S. performance. Accordingly, these expenses are included in the Companys North American segment. Based on established criteria, the Company has three reportable segments: North America, Europe and Rest-of-world.



|                                                |  |               |        |   |        |   |        |               |  |       |        |  |   |         |  
|----------------------------------------------- |  | ------------- | ------ | - | ------ | - | ------ | ------------- |  | ----- | ------ |  | - | ------- | -
|                                                |  | North America |        |   | Europe |   |        | Rest-of-world |  | Total |       
|2003                                            |  |               |        |   |        |   |        |               |  |       |        |  |   |         |  
|Net sales to external customers                 |  | $             | 40,834 |   |        | $ | 31,695 |               |  | $     | 15,161 |  | $ | 87,690  |  
|Operating profit (loss)                         |  |               | 1,209  |   |        |   | (2,502 | )             |  |       | 949    |  |   | (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                               |  |               | 8,600  |   |        |   | 21,061 |               |  |       | 9,390  |  |   | 39,051  |  
|                                                |  |               |        |  
|2002                                            |  |               |        |   |        |   |        |               |  |       |        |  |   |         |  
|Net sales to external customers                 |  | $             | 39,881 |   |        | $ | 14,209 |               |  | $     | 13,928 |  | $ | 68,018  |  
|Operating profit (loss)                         |  |               | (2,333 | ) |        |   | 244    |               |  |       | 711    |  |   | (1,378  | )
|Identifiable segment assets                     |  |               | 50,305 |   |        |   | 14,047 |               |  |       | 10,394 |  |   | 74,746  |  
|Goodwill and indefinite-lived intangible assets |  |               | 1,655  |   |        |   | 5,937  |               |  |       | 5,719  |  |   | 13,311  |  
|Long-lived assets                               |  |               | 8,776  |   |        |   | 6,764  |               |  |       | 7,143  |  |   | 22,683  |  
|                                                |  |               |        |  
|2001                                            |  |               |        |   |        |   |        |               |  |       |        |  |   |         |  
|Net sales to external customers                 |  | $             | 41,433 |   |        | $ | 8,904  |               |  | $     | 6,930  |  | $ | 57,267  |  
|Operating profit (loss)                         |  |               | (8,114 | ) |        |   | (887   | )             |  |       | 1,273  |  |   | (7,728  | )
|Identifiable segment assets                     |  |               | 59,629 |   |        |   | 4,055  |               |  |       | 7,172  |  |   | 70,856  |  
|Goodwill and indefinite-lived intangible assets |  |               |       |   |        |   |       |               |  |       | 5,719  |  |   | 5,719   |  
|Long-lived assets                               |  |               | 5,171  |   |        |   | 365    |               |  |       | 5,457  |  |   | 10,993  |  



The majority of the
Companys assets as of December 31, 2003, 2002 and 2001 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.



F-21