**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q/A**

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| **(Mark One)**                                                                                                                                        |                                                                                                |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------|
| **ý**                                                                                                                                            | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**  |
| ** **                                                                                                                                            | ** **                                                                                          |
| **For the quarterly period ended September 30, 2004**                                                                                                 |
| **OR**                                                                                                                                                |
| **o**                                                                                                                                                 | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
| ** **                                                                                                                                            | ** **                                                                                          |
| **For the transition period from            to           ** |
| ** **                                                                                                                                            | ** **                                                                                          |
| **Commission File Number 0-21123**                                                                                                                    |

 

**SRS LABS, INC.**

(Exact name of registrant as specified in itscharter)

| **Delaware**                         | ** ** | **33-0714264**                       |
|--------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of      |       | (I.R.S. Employer Identification No.) |
|  incorporation or organization) |       |                                 |

 

| **2909 Daimler Street, Santa Ana, California 92705** |
|------------------------------------------------------|
| (Address of principal executive offices) (Zip Code)  |

 

| **(949) 442-1070**                                   |
|-----------------------------------------------------------|
| (Registrant’s telephone number, including area code) |

 

| **Not Applicable**                                                                  |
|-------------------------------------------------------------------------------------|
| (Former name, former address and former fiscal year, if changed since  last report) |

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes ý No o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act). Yes o   No ý

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date: as of October 27, 2004, 14,645,253 of the issuer’scommon stock, par value $.001 per share, were outstanding.  In addition, as of October 27, 2004, 258,957shares of the issuer’s common stock were held as treasury shares.

 

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**EXPLANATORY NOTE**

 

**               **On May 10,2005, management of SRS Labs, Inc. (the “Company”) was advised by BDO Seidman,LLP, its independent registered public accounting firm (“BDO Seidman”), of theconclusion reached by it regarding the Company’s interim accounting for salesand marketing expenses related to trade shows. This conclusion was reached in connection with BDO Seidman’s financialstatement review procedures relating to the Company’s Quarterly Report on Form10-Q for the first quarter of the year ending December 31, 2005 (“fiscal 2005”).  Commencing in the first quarter of the fiscalyear ended December 31, 2004 (“fiscal 2004”), the Company began to capitalizeand amortize trade show expenses incurred in the fiscal year to reflect thefuture economic benefits received during such fiscal year.  Management discussed the issue with the AuditCommittee of the Company’s Board of Directors and BDO Seidman and was of theview that capitalization and amortization of trade show expenses wasallowable.  As part of the first quarterreview, BDO Seidman noted that trade show costs previously capitalized andamortized should have been treated as period expenses in fiscal 2004.  As a result, BDO Seidman expressed its viewthat (a) trade show costs previously capitalized and amortized during fiscal2004 should have been treated as period expenses in fiscal 2004; (b) each ofthe Company’s quarterly reports previously filed in fiscal 2004 should berestated; and (c) no reliance should be placed on the previously issued fiscal2004 quarterly financial statements.

 

                 Acting on the recommendation of BDO Seidman,the Company has restated its financial statements for the quarterly periodsended March 31, 2004, June 30, 2004 and September 30, 2004.  The Company is restating these unauditedquarterly financial statements principally to reflect trade show expenses asperiod expenses that are expensed as incurred. This amended Quarterly Report on Form 10-Q/A principally restates priorreported results and includes additional disclosures in the appropriate periodas a result of the change in accounting treatment for trade show expenses. Therestatement of our quarterly reports for fiscal 2004 has no impact on theCompany’s consolidated net income for fiscal 2004 and does not affect theCompany’s historical cash flows. Accordingly, the consolidated financialstatements included in the Company’s Annual Report on Form 10-K for fiscal 2004have not changed. The Company has amended its Annual Report on Form 10-K forfiscal 2004 to restate the disclosures of previously reported unauditedquarterly results as a result of change of accounting treatment for trade showexpenses.

 

                Inaddition, in the course of BDO Seidman’s financial statement review proceduresrelating to the Company’s Quarterly Report on Form 10-Q for the first quarterof fiscal 2005, BDO Seidman advised the Company that the Company’s decision tocapitalize and amortize tradeshow expenses during fiscal 2004 constituted adeficiency in the Company’s internal controls and advised the Audit Committeethat this internal control deficiency constitutes a reportable condition and amaterial weakness as defined in Statement on Auditing Standards No. 60. As aresult of this internal control deficiency, the Company has implemented moreformal procedures regarding changes in accounting treatment and relatedcommunications with the Audit Committee and the Company’s independentregistered public accounting firm.

 

**               **This Form 10-Q/A has not been updated except asrequired to reflect the effects of the restatement. This amendment andrestatement includes changes to Part I, Items 1, 2 and 4 and Part II, Item 6.Except as identified in the prior sentence, no other item included in theoriginal Form 10-Q has been amended, and such items shall remain in effect asof the filing date of the original Form 10-Q. Additionally, this Form 10-Q/Adoes not purport to provide an update or discussion of any other developmentsat the Company subsequent to its original filing.

 

2

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**SRSLABS, INC.**

 

**Form 10-Q**

**For the Period Ended September 30, 2004**

 

**Index**

 
| **PART I—FINANCIAL INFORMATION** |                                                                                                                                                      |
|---------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|
| Item  1.                              | Financial  Statements                                                                                                                                     |   |
|                                  | Condensed Consolidated  Balance Sheets as of September 30, 2004 (Unaudited) and December 31, 2003                                                         |   |
|                                  | Condensed  Consolidated Statements of Operations for the three months and nine months  ended September 30, 2004 and 2003 (Unaudited)                      |   |
|                                  | Condensed  Consolidated Statements of Stockholders’ Equity and Comprehensive Income  (Loss) for the nine months ended September 30, 2004 (Unaudited) |   |
|                                  | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2004 and 2003 (Unaudited)                                       |   |
|                                  | Notes  to the Condensed Interim Consolidated Financial Statements (Unaudited)                                                                             |   |
| Item  2.                              | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                               |   |
| Item  3.                              | Quantitative  and Qualitative Disclosures About Market Risk                                                                                               |   |
| Item  4.                              | Controls  and Procedures                                                                                                                                  |   |
| **PART II—OTHER INFORMATION**    |                                                                                                                                                      |
| Item  2.                              | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                              |   |
| Item  6.                              | Exhibits                                                                                                                                                  |   |
|                                  |                                                                                                                                                      |   |
| SIGNATURES                            |                                                                                                                                                      |

 

3

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**FORWARD-LOOKING INFORMATION**

 

ThisQuarterly Report on Form 10-Q contains forward-looking statementsreflecting management’s current expectations. Examples of such forward-lookingstatements include the expectations of the Company with respect to itsstrategy. Although the Company believes that its expectations are based uponreasonable assumptions, there can be no assurances that the Company’s financialgoals will be realized. Such forward-looking statements involve known andunknown risks, uncertainties and other factors that may cause the actualresults, performance or achievements of the Company, or industry results, to bematerially different from any future results, performance or achievementsexpressed or implied by such forward-looking statements. Numerous factors mayaffect the Company’s actual results and may cause results to differ materiallyfrom those expressed in forward-looking statements made by or on behalf of theCompany. For this purpose, any statements contained herein that are notstatements of historical fact may be deemed to be forward-looking statements.Without limiting the foregoing, the words, “believes,” “anticipates,” “plans,” “expects”and similar expressions, are intended to identify forward-looking statements.The important factors discussed in Part I, Item 2, “Management’sDiscussion and Analysis of Financial Condition and Results ofOperations—Factors That May Affect Future Results”, herein, among others, couldcause actual results to differ materially from those indicated byforward-looking statements made herein and presented elsewhere by management.Such forward-looking statements represent management’s current expectations andare inherently uncertain. Investors are warned that actual results may differfrom management’s expectations. The Company assumes no obligation to update theforward-looking information to reflect actual results or changes in the factorsaffecting such forward-looking information.

 

4

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**PART I****—FINANCIAL INFORMATION**

 

**Item 1****. Financial Statements.**

 

**SRS LABS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                                                                                      | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                                                                      | ** ** | **(Unaudited)**             | ** ** | ** **                 | ** ** |
| ** **                                                                                                                                                                                                                      | ** ** | **(Restated)**              | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                                                                                                      |       |                        |       |                       |       |
| **Current Assets**                                                                                                                                                                                                              |       |                        |       |                       |       |
| Cash and cash equivalents                                                                                                                                                                                                       |       | $                           | 16,020,285 |                       | $          | 12,795,620 |   |
| Accounts receivable, net                                                                                                                                                                                                        |       | 1,258,982                   |       | 1,230,423                  |       |
| Inventories, net                                                                                                                                                                                                                |       | 767,006                     |       | 753,020                    |       |
| Prepaid expenses and other current assets                                                                                                                                                                                       |       | 880,931                     |       | 1,073,696                  |       |
| Deferred income taxes                                                                                                                                                                                                           |       | 23,406                      |       | 23,406                     |       |
|                                                                                                                                                                                                                            |       |                        |       |                       |       |
| **Total Current Assets**                                                                                                                                                                                                        |       | 18,950,610                  |       | 15,876,165                 |       |
|                                                                                                                                                                                                                            |       |                        |       |                       |       |
| Investments available for sale                                                                                                                                                                                                  |       | 10,281,176                  |       | 10,490,210                 |       |
| Investment in LLC                                                                                                                                                                                                               |       | 2,025,626                   |       | —                     |       |
| Furniture, fixtures and equipment, net                                                                                                                                                                                     |       | 1,956,784                   |       | 1,661,980                  |       |
| Goodwill                                                                                                                                                                                                                        |       | 533,031                     |       | 533,031                    |       |
| Intangible assets, net                                                                                                                                                                                                          |       | 2,748,289                   |       | 2,736,810                  |       |
| Deferred income taxes                                                                                                                                                                                                           |       | 213,647                     |       | 193,134                    |       |
|                                                                                                                                                                                                                            |       |                        |       |                       |       |
| **Total Assets**                                                                                                                                                                                                                |       | $                           | 36,709,163 |                       | $          | 31,491,330 |   |
|                                                                                                                                                                                                                            |       |                        |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                                                  |       |                        |       |                       |       |
| **Current Liabilities**                                                                                                                                                                                                         |       |                        |       |                       |       |
| Accounts payable                                                                                                                                                                                                                |       | $                           | 1,481,449  |                       | $          | 1,503,851 |   |
| Accrued liabilities                                                                                                                                                                                                             |       | 2,218,691                   |       | 1,606,069                  |       |
| Income taxes payable                                                                                                                                                                                                            |       | 538,751                     |       | 430,949                    |       |
|                                                                                                                                                                                                                            |       |                        |       |                       |       |
| **Total Current Liabilities**                                                                                                                                                                                                   |       | 4,238,891                   |       | 3,540,869                  |       |
|                                                                                                                                                                                                                            |       |                        |       |                       |       |
| Commitments and contingencies (Note 11)                                                                                                                                                                                         |       |                        |       |                       |       |
|                                                                                                                                                                                                                            |       |                        |       |                       |       |
| **Stockholders’ Equity**                                                                                                                                                                                                   |       |                        |       |                       |       |
| Preferred stock—$.001 par value; 2,000,000 shares authorized; no  shares issued or outstanding                                                                                                                             |       | —                      |       | —                     |       |
| Common stock—$.001 par value; 56,000,000 shares authorized;14,626,922  and 13,682,282 shares issued; and 14,367,965 and 13,456,982 shares outstanding  at September 30, 2004 and December 31, 2003, respectively |       | 14,627                      |       | 13,683                     |       |
| Additional paid-in capital                                                                                                                                                                                                      |       | 62,058,625                  |       | 58,423,249                 |       |
| Accumulated other comprehensive loss                                                                                                                                                                                            |       | (297,523                    | )          | (336,346                   | )          |
| Accumulated deficit                                                                                                                                                                                                             |       | (28,422,395                 | )          | (29,431,524                | )          |
| Treasury stock at cost, 258,957 and 225,300 shares at  September 30, 2004 and December 31, 2003 respectively                                                                                                          |       | (883,062                    | )          | (718,601                   | )          |
|                                                                                                                                                                                                                            |       |                        |       |                       |       |
| **Total Stockholders’ Equity**                                                                                                                                                                                             |       | 32,470,272                  |       | 27,950,461                 |       |
|                                                                                                                                                                                                                            |       |                        |       |                       |       |
| **Total Liabilities and Stockholders’ Equity**                                                                                                                                                                             |       | $                           | 36,709,163 |                       | $          | 31,491,330 |   |

 

See accompanying notes to the condensed interim consolidated financialstatements

 

5

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**SRSLABS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

**(Unaudited)**
| ** **                                                                       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                       | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                                       | ** ** | **2004**               | ** ** | **2003**               | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                       | ** ** | **(Restated)**         | ** ** | ** **             | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| Revenues:                                                                        |       |                   |       |                   |       |   |   |   |   |
| Semiconductor                                                                    |       | $                      | 3,644,298  |                   | $          | 2,966,923 |   | $ | 8,992,511 |   | $ | 7,244,323 |   |
| Licensing                                                                        |       | 2,727,861              |       | 1,919,471              |       | 8,140,592 |   | 6,638,291 |   |
| Total revenues                                                                   |       | 6,372,159              |       | 4,886,394              |       | 17,133,103 |   | 13,882,614 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Cost of sales:                                                                   |       |                   |       |                   |       |   |   |   |   |
| Semiconductor                                                                    |       | 1,320,855              |       | 1,226,407              |       | 3,269,622 |   | 2,750,437 |   |
| Licensing                                                                        |       | 100,342                |       | 16,029                 |       | 146,886 |   | 62,132 |   |
| Total cost of sales                                                              |       | 1,421,197              |       | 1,242,436              |       | 3,416,508 |   | 2,812,569 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Gross margin                                                                     |       | 4,950,962              |       | 3,643,958              |       | 13,716,595 |   | 11,070,045 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Operating expenses:                                                              |       |                   |       |                   |       |   |   |   |   |
| Sales and marketing                                                              |       | 1,305,349              |       | 1,216,568              |       | 4,260,784 |   | 3,840,155 |   |
| Research and development                                                         |       | 1,266,606              |       | 1,032,100              |       | 3,620,219 |   | 3,083,438 |   |
| General and administrative                                                       |       | 1,452,236              |       | 1,143,930              |       | 4,490,732 |   | 3,668,573 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Total operating expenses                                                         |       | 4,024,191              |       | 3,392,598              |       | 12,371,735 |   | 10,592,166 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Income from operations                                                           |       | 926,771                |       | 251,360                |       | 1,344,860 |   | 477,879 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Other income, net                                                                |       | 118,908                |       | 131,925                |       | 455,132 |   | 414,655 |   |
| Minority interest                                                                |       | —                 |       | —                 |       | — |   | 5,430 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Income before income tax expense                                                 |       | 1,045,679              |       | 383,285                |       | 1,799,992 |   | 897,964 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Income tax expense                                                               |       | 241,721                |       | 264,459                |       | 790,863 |   | 770,486 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Net income                                                                       |       | $                      | 803,958    |                   | $          | 118,826 |   | $ | 1,009,129 |   | $ | 127,478 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Net income per common share:                                                     |       |                   |       |                   |       |   |   |   |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Basic                                                                            |       | $                      | 0.06       |                   | $          | 0.01 |   | $ | 0.07 |   | $ | 0.01 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Diluted                                                                          |       | $                      | 0.05       |                   | $          | 0.01 |   | $ | 0.06 |   | $ | 0.01 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Weighted average shares used in the calculation of net income per  common share: |       |                   |       |                   |       |   |   |   |   |
| Basic                                                                            |       | 14,278,589             |       | 13,076,315             |       | 14,045,162 |   | 12,956,971 |   |
|                                                                             |       |                   |       |                   |       |   |   |   |   |
| Diluted                                                                          |       | 15,395,792             |       | 14,730,290             |       | 15,991,331 |   | 13,729,676 |   |

 

 See accompanying notes to thecondensed interim consolidated financial statements

 

6

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**SRSLABS, INC.**

### **CONDENSED CONSOLIDATED STATEMENTSOF STOCKHOLDERS’ EQUITY ANDCOMPREHENSIVE INCOME (Unaudited)**

 
| ** **                                                     | ** ** | ** **        | ** ** | ** **  | ** ** | ** **        | ** ** | **Accumulated**    | ** ** | ** **   | ** ** | ** ** | ** ** | ** **           | ** ** | **Comprehensive** | ** ** |
|----------------------------------------------------------------|------------|-------------------|------------|-------------|------------|-------------------|------------|--------------------|------------|--------------|------------|------------|------------|----------------------|------------|-------------------|------------|
| ** **                                                     | ** ** | ** **        | ** ** | ** **  | ** ** | **Additional**    | ** ** | **Other**          | ** ** | ** **   | ** ** | ** ** | ** ** | ** **           | ** ** | **Income**        | ** ** |
| ** **                                                     | ** ** | **Common  Stock** | ** ** | **Paid-In** | ** ** | **Comprehensive** | ** ** | **Accumulated**    | ** ** | **Treasury** | ** ** | ** ** | ** ** | **for the  Periods** | ** ** |
| ** **                                                     | ** ** | **Shares**        | ** ** | **Amount**  | ** ** | **Capital**       | ** ** | **Income  (Loss)** | ** ** | **Deficit**  | ** ** | **Stock**  | ** ** | **Total**            | ** ** | **Ended**         | ** ** |
| BALANCE,  Dec. 31, 2003                                   |       | 13,456,982        |       | $           | 13,683     |              | $          | 58,423,249         |       | $            | (336,346   | )          | $          | (29,431,524          | )          | $                 | (718,601   | ) | $ | 27,950,461 |   | $ | — |   |
| Proceeds from  exercise of stock options                       |       | 573,611           |       | 573         |       | 2,149,746         |       | —             |       | —       |       | —     |       | 2,150,319            |       | —            |       |
| Deferred stock  option compensation                            |       | —            |       | —      |       | 13,600            |       | —             |       | —       |       | —     |       | 13,600               |       | —            |       |
| Unrealized gain  on investments available for sale, net of tax |       | —            |       | —      |       | —            |       | 87,938             |       | —       |       | —     |       | 87,938               |       | 87,938            |       |
| Net loss                                                       |       | —            |       | —      |       | —            |       | —             |       | (24,531      | )          | —     |       | (24,531              | )          | (24,531           | )          |
|                                                           |       |              |       |        |       |              |       |               |       |         |       |       |       |                 |       |              |       |
| BALANCE,  March 31, 2004                                  |       | 14,030,593        |       | $           | 14,256     |              | $          | 60,586,595         |       | $            | (248,408   | )          | $          | (29,456,055          | )          | $                 | (718,601   | ) | $ | 30,177,787 |   | $ | 63,407 |   |
| Proceeds from  exercise of stock options                       |       | 182,854           |       | 183         |       | 837,669           |       | —             |       | —       |       | —     |       | 837,852              |       | —            |       |
| Deferred stock  option compensation                            |       | —            |       | —      |       | 26,601            |       | —             |       | —       |       | —     |       | 26,601               |       | —            |       |
| Unrealized loss  on investments available for sale, net of tax |       | —            |       | —      |       | —            |       | (187,991           | )          | —       |       | —     |       | (187,991             | )          | (187,991          | )          |
|                                                           |       |              |       |        |       |              |       |               |       |         |       |       |       |                 |       |              |       |
| Net income                                                     |       | —            |       | —      |       | —            |       | —             |       | 229,702      |       | —     |       | 229,702              |       | 229,702           |       |
|                                                           |       |              |       |        |       |              |       |               |       |         |       |       |       |                 |       |              |       |
| BALANCE,  June 30, 2004                                   |       | 14,213,447        |       | $           | 14,439     |              | $          | 61,450,865         |       | $            | (436,399   | )          | $          | (29,226,353          | )          | $                 | (718,601   | ) | $ | 31,083,951 |   | $ | 105,118 |   |
| Proceeds from  exercise of stock options                       |       | 154,518           |       | 188         |       | 581,568           |       | —             |       | —       |       | —     |       | 581,756              |       | —            |       |
| Deferred stock  option compensation                            |       | —            |       | —      |       | 26,192            |       | —             |       | —       |       | —     |       | 26,192               |       | —            |       |
| Treasury stock                                                 |       | —            |       | —      |       | —            |       | —             |       | —       |       | (164,461   | )          | (164,461             | )          | —            |       |
| Unrealized gain  on investments available for sale, net of tax |       | —            |       | —      |       | —            |       | 138,876            |       | —       |       | —     |       | 138,876              |       | 138,876           |       |
| Net income                                                     |       | —            |       | —      |       | —            |       | —             |       | 803,958      |       | —     |       | 803,958              |       | 803,958           |       |
|                                                           |       |              |       |        |       |              |       |               |       |         |       |       |       |                 |       |              |       |
| BALANCE,  Sept. 30, 2004                                  |       | 14,367,965        |       | $           | 14,627     |              | $          | 62,058,625         |       | $            | (297,523   | )          | $          | (28,422,395          | )          | $                 | (883,062   | ) | $ | 32,470,272 |   | $ | 1,047,952 |   |

 

See accompanying notes to the condensedinterim consolidated financial statements

 

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**SRSLABS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS**

**(Unaudited)**
| ** **                                                                         | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                         | ** ** | **September 30,** | ** ** |
| ** **                                                                         | ** ** | **2004**               | ** ** | **2003** | ** ** |
| ** **                                                                         | ** ** | **(Restated)**         | ** ** | ** ** | ** ** |
| **Cash Flows From Operating Activities:**                                          |       |                   |       |   |   |
| Net income                                                                         |       | $                      | 1,009,129  |   | $ | 127,478 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                   |       |   |   |
| Depreciation and amortization                                                      |       | 966,692                |       | 833,508 |   |
| Minority interest                                                                  |       | —                 |       | (5,430 | ) |
| Provision for doubtful accounts                                                    |       | 153,859                |       | 21,410 |   |
| (Benefit) Provision for obsolete inventory                                         |       | (44,600                | )          | 39,453 |   |
| Deferred taxes                                                                     |       | (20,513                | )          | (22,820 | ) |
| Amortization of premium on investments available for sale                          |       | 5,981                  |       | — |   |
| Increase in deferred stock option compensation                                     |       | 66,393                 |       | 54,708 |   |
| Loss on disposition of furniture, fixtures and equipment                           |       | 6,791                  |       | — |   |
| Impairment on intangible assets                                                    |       | 12,163                 |       | — |   |
| Changes in operating assets and liabilities:                                       |       |                   |       |   |   |
| Accounts receivable                                                                |       | (182,417               | )          | (102,874 | ) |
| Inventories                                                                        |       | 30,612                 |       | (180,887 | ) |
| Prepaid expenses and other current assets                                          |       | 192,765                |       | (144,923 | ) |
| Accounts payable                                                                   |       | (22,402                | )          | 153,707 |   |
| Accrued liabilities                                                                |       | 612,623                |       | (1,143,468 | ) |
| Income taxes payable                                                               |       | 107,802                |       | 250,634 |   |
|                                                                               |       |                   |       |   |   |
| Net cash provided by (used in) operating activities                                |       | 2,894,878              |       | (119,504 | ) |
|                                                                               |       |                   |       |   |   |
| **Cash Flows From Investing Activities:**                                          |       |                   |       |   |   |
| Purchase of furniture, fixtures and equipment                                      |       | (874,737               | )          | (396,161 | ) |
| Proceeds from sales of furniture, fixtures and equipment                           |       | 550                    |       | — |   |
| Purchase of investments available for sale                                         |       | —                 |       | (5,232,533 | ) |
| Proceeds from sale of investments available for sale                               |       | 241,876                |       | 1,108,407 |   |
| Investment in LLC                                                                  |       | (2,025,626             | )          | — |   |
| Expenditures related to patents and intangible assets                              |       | (417,742               | )          | (175,649 | ) |
|                                                                               |       |                   |       |   |   |
| Net cash used in investing activities                                              |       | (3,075,679             | )          | (4,695,936 | ) |
|                                                                               |       |                   |       |   |   |
| **Cash Flows From Financing Activities:**                                          |       |                   |       |   |   |
| Purchase of treasury stock                                                         |       | (164,461               | )          | — |   |
| Proceeds from exercise of stock options                                            |       | 3,569,927              |       | 385,529 |   |
|                                                                               |       |                   |       |   |   |
| Net cash provided by financing activities                                          |       | 3,405,466              |       | 385,529 |   |
|                                                                               |       |                   |       |   |   |
| **Net Increase (Decrease) in Cash and Cash  Equivalents**                          |       | 3,224,665              |       | (4,429,911 | ) |
| **Cash and Cash Equivalents, Beginning of Period**                                 |       | 12,795,620             |       | 15,720,860 |   |
|                                                                               |       |                   |       |   |   |
| **Cash and Cash Equivalents, End of Period**                                       |       | $                      | 16,020,285 |   | $ | 11,290,949 |   |
|                                                                               |       |                   |       |   |   |
| **Supplemental Disclosures of Cash Flow  Information:**                            |       |                   |       |   |   |
| Cash paid during the period for:                                                   |       |                   |       |   |   |
| Income taxes                                                                       |       | $                      | 456,600    |   | $ | 469,928 |   |
| **Supplemental Disclosure of Non-Cash Investing  and Financing Activities:**       |       |                   |       |   |   |
| Unrealized gain on investments, net                                                |       | $                      | 38,823     |   | $ | (67,082 | ) |
| Issuance of Common stock for minority interest                                     |       | $                      | —     |   | $ | 960,012 |   |

 

See accompanying notes to the condensed interim consolidated financialstatements

 

8

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**NOTESTO THE CONDENSED INTERIM CONSOLIDATED FINANCIAL STATEMENTS****(Unaudited)**

**September30, 2004**

**1.             Basisof Presentation and Summary of Significant Accounting Policies**

As used herein, the “Company,” “SRS Labs,” “we,” “us,”or “our” means SRS Labs, Inc. and its wholly-owned subsidiaries, Valence TechLimited (including its wholly-owned subsidiaries) and SRSWOWcast.com, Inc. (“SRSWOWcast”).  The accompanying condensed interimconsolidated financial statements have been prepared by the Company withoutaudit in conformity with accounting principles generally accepted in the UnitedStates of America (“generally accepted accounting principles”) for interimfinancial information and the rules and regulations of the U.S. Securities andExchange Commission (“SEC”). In the opinion of management, all adjustments(which include only normal recurring adjustments) considered necessary for afair presentation have been included. The Company previously reported fivebusiness segments (see Note 12). Certain accounts have been reclassified fromthat previously reported to conform to the current period presentation.

Certain information and footnote disclosuresnormally included in financial statements prepared in accordance with generallyaccepted accounting principles have been condensed or omitted pursuant to SECrules and regulations for presentation of interim financial information.Therefore, the condensed interim consolidated financial statements should beread in conjunction with the Company’s Annual Report on Form 10-K for thefiscal year ended December 31, 2003. Current and future financialstatements may not be directly comparable to the Company’s historical financialstatements. The results of operations for the interim periods are notnecessarily indicative of the results to be expected for the full year.

Certainamounts included in the accompanying prior periods’ consolidated financialstatements have been reclassified to conform to the current period presentation.

**Estimates**

Thepreparation of financial statements in accordance with accounting principlesgenerally accepted in the United States of America requires management to makeuse of certain estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosure of contingent assets and liabilities at the dateof the financial statements and the reported amounts of revenues and expensesduring the reported periods. We base our estimates on historical experience andon various other assumptions that we believe are reasonable under thecircumstances, the results of which form the basis for making judgments aboutcarrying values of assets and liabilities that are not readily apparent fromother sources. Actual results could differ from those estimates. See theaudited consolidated financial statements and notes thereto included in ourAnnual Report on Form 10-K for the year ended December 31, 2003 for anadditional discussion of the most significant accounting policies and estimatesused in the preparation of our financial statements.

**2.****                                     ****Restatement**

 

On May13, 2005, the Company filed a Current Report on Form 8-K announcing that anerror had been identified relating to accounting for sales and marketingexpenses related to trade shows.  This conclusion was reached inconnection with BDO Seidman, LLP’s, the Company’s independent registered publicaccounting firm (“BDO Seidman”), financial statement review procedures relatingto the Company’s Quarterly Report on Form 10-Q for the first quarter of theyear ending December 31, 2005 (“fiscal 2005”).

Theaccounting issue relates to an interpretation of Accounting Principles BoardOpinion No. 28 (“APB 28”), “Interim Financial Reporting.” Commencing in thefirst quarter of fiscal 2004, the Company began to capitalize and amortizetrade show expenses incurred in the fiscal year to reflect the future economicbenefits received during such fiscal year. Management discussed the issue with the Audit Committee of the Company’sBoard of Directors and BDO Seidman and was of the view that capitalization andamortization of trade show expenses was allowable.  As part of its review of the unauditedquarterly financial statements for the first quarter of fiscal 2005, BDOSeidman noted that trade show costs previously capitalized and amortized shouldhave been treated as period expenses in the fiscal year ended December 31, 2004(“fiscal 2004”).  As a result, BDO Seidman expressed its view that (a)trade show costs previously capitalized and amortized during fiscal 2004 shouldhave been treated as period expenses in fiscal 2004; (b) each of the Company’squarterly reports previously filed in fiscal 2004 should be restated; and (c)no reliance should be placed on the previously issued fiscal 2004 quarterlyfinancial statements.

Acting on therecommendation of BDO Seidman, management of the Company determined that thepreviously issued financial statements contained in the Quarterly Reports onForm 10-Q for the quarters ended March 31, 2004, June 30, 2004 and September30, 2004 should be restated to correct errors in those financialstatements.  Consequently, the condensedconsolidated financial statements for the third quarter of 2004 are restated inthis Form 10-Q/A.  These restated condensed consolidated financialstatements reflect an adjustment to account for trade show expenses as periodexpenses.  The adjustment results in adecrease of $66,954 and an increase of $110,897 in sales and marketing expensefor the three and nine 

 

9

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months ended September30, 2004, respectively.   The restatementhas no impact on the Company’s consolidated net income for fiscal 2004 and doesnot affect the Company’s historical cash flow.

Theprincipal effects of this adjustment on the accompanying condensed consolidatedfinancial statements is as follows:
| ** **                                      | ** ** | **Condensed Consolidated Balance Sheet** | ** ** |
|-------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                      | ** ** | **September 30, 2004**              | ** ** |
| ** **                                      | ** ** | ** **                               | ** ** | **As previously** | ** ** |
| ** **                                      | ** ** | **As restated**                          | ** ** | **reported** | ** ** |
|                                            |       |                                     |       |   |   |
| Prepaid expenses and other current assets       |       | $                                        | 880,931    |   | $ | 991,828 |   |
| Total Current Assets                            |       | 18,950,610                               |       | 19,061,507 |   |
| Total Assets                                    |       | 36,709,163                               |       | 36,820,060 |   |
|                                            |       |                                     |       |   |   |
| Accumulated deficit .                           |       | (28,422,395                              | )          | (28,311,498 | ) |
| Total Stockholders’ Equity                 |       | 32,470,272                               |       | 32,581,169 |   |
| Total Liabilities and Stockholders’ Equity |       | $                                        | 36,709,163 |   | $ | 36,820,060 |   |

 

 
| ** **                                          | ** ** | **Condensed Consolidated**     | ** ** | **Condensed Consolidated**    | ** ** |
|-----------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                          | ** ** | **Statement of Operations**    | ** ** | **Statement of Operations**   | ** ** |
| ** **                                          | ** ** | **for the three months ended** | ** ** | **for the nine months ended** | ** ** |
| ** **                                          | ** ** | **September 30, 2004**         | ** ** | **September 30, 2004**        | ** ** |
| ** **                                          | ** ** | ** **                     | ** ** | **As**                        | ** ** | ** ** |   | **As** |   |
| ** **                                          | ** ** | **As**                         | ** ** | **previously**                | ** ** | **As** |   | **previously** |   |
| ** **                                          | ** ** | **restated**                   | ** ** | **reported**                  | ** ** | **restated** |   | **reported** |   |
|                                                |       |                           |       |                          |       |   |   |   |   |
| (Decrease) increase in sales and marketing expenses |       | $                              | (66,954    | )                             | $          | — |   | $ | 110,897 |   | $ | — |   |
| Total operating expenses                            |       | 4,024,191                      |       | 4,091,145                     |       | 12,371,735 |   | 12,260,838 |   |
| Income from operations                              |       | 926,771                        |       | 859,817                       |       | 1,344,860 |   | 1,455,757 |   |
| Income before income tax expense                    |       | 1,045,679                      |       | 978,725                       |       | 1,799,992 |   | 1,910,889 |   |
| Net income                                          |       | 803,958                        |       | 737,004                       |       | 1,009,129 |   | 1,120,026 |   |
| Net income per common share:                        |       |                           |       |                          |       |   |   |   |   |
| Basic.                                              |       | $                              | 0.06       |                          | $          | 0.05 |   | $ | 0.07 |   | $ | 0.08 |   |
| Diluted                                             |       | $                              | 0.05       |                          | $          | 0.05 |   | $ | 0.06 |   | $ | 0.07 |   |

 

**3.**             **Stock-BasedCompensation**

TheCompany accounts for stock-based awards to employees under the recognition andmeasurement principles of APB No. 25, “Accounting for Stock Issued toEmployees,” and related interpretations. The Company provides additional pro forma disclosuresas required under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS123”) and SFAS No. 148, “Accounting for Stock-Based Compensation —Transition and Disclosure — an Amendment of SFAS No. 123.” Accordingly,no stock-based employee compensation cost is reflected in net income (loss), asall options granted under the plan had an exercise price equal to the marketvalue of the underlying common stock on the date of grant. Had compensationexpense been recorded under the provisions of SFAS No. 123, the Company’snet income, (loss) and earnings per share would have been the pro forma amountsindicated below:

 

10

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| ** **                                                                                             | ** ** | **For the three months ended** | ** ** | **For the nine months ended** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                                                                             | ** ** | **September 30,**         | ** ** | **September 30****,**    | ** ** |
| ** **                                                                                             | ** ** | **2004**                       | ** ** | **2003**                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                             | ** ** | **(Restated)**                 | ** ** | ** **                    | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
|                                                                                                   |       |                           |       |                          |       |   |   |   |   |
| Net income (attributable to common shareholder) — as reported                                     |       | $                              | 803,958    |                          | $          | 118,826 |   | $ | 1,009,129 |   | $ | 127,478 |   |
| Add: stock based employee compensation expense included in reported  net income, net of 40% tax effect |       | 15,715                         |       | 18,236                        |       | 39,590 |   | 54,708 |   |
| Less fair value of stock-based employee compensation expense                                           |       | (380,894                       | )          | (563,564                      | )          | (1,215,778 | ) | (1,671,514 | ) |
| Net income (loss) (attributable to common shareholder) — pro forma                                |       | $                              | 438,779    |                          | $          | (426,502 | ) | $ | (167,059 | ) | $ | (1,489,328 | ) |
| Net income (loss) per share:                                                                           |       |                           |       |                          |       |   |   |   |   |
| Basic, as reported                                                                                     |       | $                              | 0.06       |                          | $          | 0.01 |   | $ | 0.07 |   | $ | 0.01 |   |
| Basic, pro forma                                                                                       |       | $                              | 0.03       |                          | $          | (0.03 | ) | $ | (0.01 | ) | $ | (0.12 | ) |
| Diluted, as reported                                                                                   |       | $                              | 0.05       |                          | $          | 0.01 |   | $ | 0.06 |   | $ | 0.01 |   |
| Diluted, pro forma                                                                                     |       | $                              | 0.03       |                          | $          | (0.03 | ) | $ | (0.01 | ) | $ | (0.12 | ) |

 

The fair value of each option grant was estimated on the date of grantusing the Black-Scholes option-pricing model with the following weightedaverage assumptions used for grants during the quarter ended September 30,2004:

 

| Risk free interest rate |   | 3.3      | %      |
|-------------------------|--------|----------|--------|
| Expected life           |   | 5  years |   |
| Expected volatility     |   | 76       | %      |

 

BecauseFAS No. 123 has not been applied to options granted prior toJanuary 1, 1995, the resulting pro forma compensation cost may not berepresentative of that to be expected in future years.

 

**4.             Capitalizationof Software Development Costs**

 

Costsincurred in the research, design and development of software for sale to othersas a separate product or embedded in a product and sold as part of the productas a whole are charged to expense until technological feasibility isestablished. Under SFAS No. 86, “Accounting for the Costs of ComputerSoftware to be Sold, Leased or Otherwise Marketed,” the Company capitalizessoftware purchased from third parties if the related software product underdevelopment has reached technological feasibility or if there are alternativefuture uses for the purchased software, provided that capitalized amounts willbe realized over a period not exceeding five years. Costs incurred prior to theestablishment of technological feasibility are charged to research anddevelopment expense.

 

Capitalizedsoftware as of September 30, 2004 and December 31, 2003 is as follows:

 
| ** **                | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                | ** ** | **2004**               | ** ** | **2003**              | ** ** |
| Capitalized software      |       | $                      | 489,015    |                  | $          | 342,760 |   |
| Accumulated amortization  |       | (170,570               | )          | (96,401               | )          |
| Capitalized software, net |       | $                      | 318,445    |                  | $          | 246,359 |   |

 

TheCompany’s weighted average amortization period for capitalized software isapproximately three to five years. The following table shows the estimatedamortization expense for those assets for the current year and each of the foursucceeding fiscal years.

 
| ** **                        | ** ** | **Estimated** | ** ** |
|-----------------------------------|------------|---------------|------------|
| **Year ending December 31,** | ** ** | **Expense**   | ** ** |
| 2004                              |       | $             | 31,434     |   |
| 2005                              |       | 105,352       |       |
| 2006                              |       | 100,669       |       |
| 2007                              |       | 48,365        |       |
| 2008                              |       | 28,692        |       |
| Thereafter                        |       | 3,933         |       |
|                                   |            |               |            |  |

 

11

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**5.             Goodwilland Intangible Assets**

 

OnJanuary 1, 2002, the Company adopted SFAS No. 142, “Goodwill andOther Intangible Assets,” which, among other things, establishes new standardsfor goodwill acquired in a business combination, eliminates the amortization ofgoodwill and requires the carrying value of goodwill and identifiableintangibles to be evaluated for impairment on at least an annual basis.  At December 31, 2003, the Companyevaluated goodwill and determined that no adjustment to impair goodwill wasnecessary.  In accordance with SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,”all of the Company’s intangible assets that have definite lives are beingamortized on a straight-line basis over their estimated useful lives.

 

Anintangible asset in the amount of $640,071 was recorded representing the prior “minorityinterest” portion of the Circle Surround license agreement held by SRSWOWcast(See Note 8).

 

Goodwilland intangible assets consist of the following:

 
| ** **                                                                                                                                                                     | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                     | ** ** | **2004**               | ** ** | **2003**              | ** ** |
| Goodwill                                                                                                                                                                       |       | $                      | 533,031    |                  | $          | 533,031 |   |
|                                                                                                                                                                           |       |                   |       |                  |       |
| Patents                                                                                                                                                                        |       | $                      | 1,959,199  |                  | $          | 1,760,236 |   |
| Accumulated amortization                                                                                                                                                       |       | (843,010               | )          | (739,792              | )          |
| Patents, net                                                                                                                                                                   |       | 1,116,189              |       | 1,020,444             |       |
| Other Intangibles:                                                                                                                                                             |       |                   |       |                  |       |
| Assets acquired in the purchase of our subsidiary Valence Technology  in 1998: Covenant not to compete, Developed Technology, ASP brand name, Cell  Library, and Customer List |       | 4,910,400              |       | 4,910,400             |       |
| Asset acquired in purchase of our subsidiary SRSWOWcast in February  2003                                                                                                      |       | 640,071                |       | 640,071               |       |
| Poly Planar purchased technology for speaker products                                                                                                                          |       | 120,000                |       | 120,000               |       |
| Capitalized software and hardware for several technologies                                                                                                                     |       | 419,287                |       | 222,758               |       |
| Total of Other Intangibles                                                                                                                                                     |       | 6,089,758              |       | 5,893,229             |       |
| Accumulated amortization, other intangibles                                                                                                                                    |       | (4,457,658             | )          | (4,176,863            | )          |
| Other intangibles, net                                                                                                                                                         |       | 1,632,100              |       | 1,716,366             |       |
| Intangible assets, net                                                                                                                                                         |       | $                      | 2,748,289  |                  | $          | 2,736,810 |   |

 

Amortizationperiods range from three to eleven years depending on the estimated useful lifeof the asset. Amortization expense consists of the following:

 
| ** **                                                                                     | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                     | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| ** **                                                                                     | ** ** | **2004**               | ** ** | **2003**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Patents                                                                                        |       | $                      | 46,331     |                  | $          | 37,592 |   | $ | 113,307 |   | $ | 108,519 |   |
| Other intangibles:                                                                             |       |                   |       |                  |       |   |   |   |   |
| Covenant not to compete, developed technology, ASP brand name, cell  library and customer list |       | 67,479                 |       | 51,477                |       | 202,436 |   | 162,405 |   |
| Poly Planar purchased technology                                                               |       | 6,000                  |       | 6,000                 |       | 18,000 |   | 18,000 |   |
| Capitalized software and hardware                                                              |       | 29,713                 |       | —                |       | 60,358 |   | — |   |
| Total intangible amortization expense                                                          |       | $                      | 149,523    |                  | $          | 95,069 |   | $ | 394,101 |   | $ | 288,924 |   |

 

TheCompany’s weighted average amortization period for patents and otherintangibles is approximately three to ten years. The following table showsthe estimated amortization expense for those assets for the current year andeach of the four succeeding fiscal years:

 

| **Year ending**       | ** ** | ** **            | ** ** |
|-----------------------|------------|-----------------------|------------|
| **December 31,** | ** ** | **Estimated expense** | ** ** |
| 2004                  |       | $                     | 569,691    |   |
| 2005                  |       | $                     | 580,279    |   |
| 2006                  |       | $                     | 567,785    |   |
| 2007                  |       | $                     | 498,313    |   |
| 2008                  |       | $                     | 268,625    |   |

 

12

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**6.**             **Investments Availablefor Sale**

 

TheCompany has classified its investments as available for sale in accordance withSFAS No. 115, “Accounting for Certain Investments in Debt and EquitySecurities.” The following table summarizes the Company’sinvestment securities available for sale:

 
| ** **           | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|----------------------|------------|-----------------------------|------------|----------------------------|------------|
| Cost                 |       | $                           | 10,497,397 |                       | $          | 10,745,254 |   |
| Unrealized loss      |       | (216,221                    | )          | (255,044                   | )          |
| Estimated fair value |       | $                           | 10,281,176 |                       | $          | 10,490,210 |   |

 

Thecontractual maturities of investments are shown below. Actual maturities maydiffer from contractual maturities.

 
| ** **                                     | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                     | ** ** | ** **             | ** ** | **Estimated**              | ** ** | ** ** | ** ** | **Estimated** | ** ** |
| ** **                                     | ** ** | **Cost**               | ** ** | **Fair Value**             | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| U.S. Government securities available for sale: |       |                   |       |                       |       |   |   |   |   |
| Due in one to five years                       |       | $                      | 10,497,397 |                       | $          | 10,281,176 |   | $ | 10,745,254 |   | $ | 10,490,210 |   |
|                                                |            |                        |            |                            |            |  |  |  |  |  |  |  |  |

 

Thefollowing table summarizes sales of available for sale securities for the threemonths and nine months ended September 30, 2004 and 2003. Specificidentification was used to determine costs in computing realized gains orlosses.

 
| ** **         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|--------------------|------------|------------------------|------------|------------------------|------------|
| ** **         | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **         | ** ** | **2004**               | ** ** | **2003**               | ** ** | **2004** | ** ** | **2003** | ** ** |
| Proceeds from sale |       | $                      | —     |                   | $          | — |   | $ | 5,235,626 |   | $ | 16,862,523 |   |
| Realized gains     |       | —                 |       | —                 |       | 139,375 |   | 36,739 |   |
|                    |            |                        |            |                        |            |  |  |  |  |  |  |  |  |

 

**7.**             **Inventories**

 

Inventories,which consist of finished goods, are stated at the lower of cost or netrealizable value. Cost is calculated using the weighted average method and iscomprised of material costs and, where applicable, subcontracting and overheadcosts that have been incurred in bringing the inventories to their presentlocation and condition. Net realizable value represents the estimated sellingprice less costs to be incurred in selling and distribution. Market isdetermined by comparison with recent purchases or net realizable value. Netrealizable value is based on forecasts for sales of the Company’s products inthe ensuing years. Should demand for the Company’s products prove to besignificantly less than anticipated, the ultimate realizable value of theCompany’s inventories could be substantially less than the amount shown on theaccompanying consolidated balance sheets.

 

**8.             Investmentin LLC**

 

On September 23, 2004, theCompany entered into a strategic alliance with Coming Home Studios LLC (“CHS”)to produce and sell concert DVD’s which include the Company’s Circle Surroundtechnology.   In connection with thestrategic alliance, SRS and CHS entered into four agreements:  a StrategicAlliance Agreement, the CHS/SRS LLC Operating Agreement, a Warrant Agreementand a Production Services Agreement.

 

In the Strategic AllianceAgreement, CHS and SRS agree to work together to identify and implementco-promotional opportunities, including trade shows, movie theatres, videostreaming, concert DVDs, artist endorsements, bundling and premium deals,web-based promotional clips and road shows.  The initial term of theagreement expires on July 9, 2006 and is automatically renewable for successiveone-year terms.

 

The Operating Agreementgoverns CHS/SRS, LLC, which is a joint venture between CHS and SRS formed tocomplete and distribute concert videos featuring Duran Duran, Boz Scaggs— Jazz,Boz Scaggs— Greatest Hits, Godsmack and All Access.

 

13

----

 

Pursuant to the OperatingAgreement each of CHS and SRS contributed capital with a value of$1,800,000.  CHS is the managing memberof the joint venture.  CHS’ capitalcontribution to CHS/SRS, LLC consists of the artist agreements and relatedcontracts pursuant to which CHS/SRS, LLC will produce and distribute theabove-referenced concert videos.  SRS’ capital contribution is anaggregate of $1,800,000, consisting of a $700,000 bridge loan that SRS extendedto CHS on July 9, 2004 in anticipation of the strategic alliance, plus$1,100,000 in new cash.  In addition, the Company capitalized $185,626consisting of costs associated with the formation of the LLC and co-promotionalprojects.  CHS’ capital contributionconsisted of the artist agreements with Duran Duran, Boz Scaggs, Godsmack andAll Access pursuant to which the concert videos are filmed, produced anddistributed.  CHS/SRS, LLC contractedwith CHS to complete production of the concert videos pursuant to theProduction Services Agreement.

Profitsfrom the distribution of the concert videos and related assets will beallocated and distributed equally until SRS and CHS have both received 1.75times their original $1,800,000 capital contributions, after which profits willbe allocated and distributed 90% to CHS and 10% to SRS.  Profits will berecognized upon cash distributions.

Underthe Warrant Agreement, SRS paid CHS $40,000 to acquire a warrant to purchase upto 122,000 units of Class A membership interests in CHS, which representsapproximately 10% of the equity of CHS, for an exercise price of $9.836 perunit, subject to adjustment based on valuation of CHS at the time of anadditional funding.  The warrant is immediately vested and exercisable forup to two years.  It is transferable and contains customary antidilutionand price protection provisions for warrants of this type.

Underthe Production Services Agreement, CHS/SRS, LLC contracted with CHS as anindependent contractor to perform all production services and to provide allother services, personnel, materials and elements for the production,completion and delivery of the concert videos.  CHS, as the independentcontractor, shall receive an aggregate of $365,000 in production fees for allof its services under the Production Services Agreement.  CHS is responsiblefor payment of all costs and expenses in connection with the production andcompletion of the concert videos.

**9.**             **Minority Interest**

Minority interest in consolidated subsidiary represents the minoritystockholders’ proportionate share of the equity of SRSWOWcast, which was 13%at December 31, 2002.  OnFebruary 28, 2003, the Company completed an exchange offer with theminority shareholders representing 13% of SRSWOWcast, pursuant to whichSRS Labs acquired all 3,000,000 shares of Series A ConvertiblePreferred Stock in exchange for the issuance of 332,184 shares of SRS Labscommon stock trading at $2.89 per share at the closing price on the transactiondate. The acquisition resulted in a purchase price of $960,012.  As a result of the exchange offer, SRSWOWcastbecame a wholly owned subsidiary of SRS Labs.

SRSWOWcast develops and markets professional software and hardwareproducts and consumer software plug-ins that incorporate proprietary audioenhancement and voice and surround sound technologies. SRS Labs, as themajority shareholder, has consistently included the results of SRSWOWcast inall of the previously reported consolidated financial statements.

The following table summarizes the stated values of the assets acquiredand liabilities assumed at the date of acquisition:

 

| Current Assets           |   | $       | 324,002 |   |
|--------------------------|--------|---------|---------|--------|
| Property & Equipment |   | 3,774   |    |
| Current Liabilities      |   | (7,835  | )       |
| Intangible Assets        |   | 640,071 |    |
| Purchase Price           |   | $       | 960,012 |   |
|                          |        |         |         |        |  |

 

Current assets primarily consisted of cash, accountsreceivable and prepaid expenses and current liabilities were valued at statedvalue. Property and equipment was valued at net book value. The $640,071 ofacquired intangible assets was assigned to a license agreement betweenSRS Labs, Inc and SRSWOWcast, which is being amortized over 10 years.  The proforma effect of thetransaction, as if it had occurred at the beginning of the quarter endedMarch 31, 2003, would have been immaterial.

**10.**          **NetIncome Per Common Share**

The Company applies SFAS No. 128, “Earnings per Share,” which requiresthe disclosure of basic and diluted net income or loss per share for allcurrent and prior periods. Basic net income or loss per common share iscomputed by

 

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dividingnet income or loss available to common stockholders by the weighted averagenumber of common shares outstanding during each year. Diluted net income orloss per common share reflects the maximum dilution, based on the average priceof the Company’s common stock each period, and is computed similar to basicincome or loss per share except that the denominator is increased to includethe number of additional shares that would have been outstanding if potentiallydilutive stock options and warrants had been exercised.

 

Basicand diluted net income per share computed in accordance with SFAS 128 forthe three months and nine months ended September 30, 2004 and 2003 are asfollows:

 
| ** **                                              | ** ** | **For the three months** | ** ** | **For the nine months** | ** ** |
|---------------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                                              | ** ** | **ended September 30,**  | ** ** | **ended September 30,** | ** ** |
| ** **                                              | ** ** | **2004**                 | ** ** | **2003**                | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                              | ** ** | **(Restated)**           | ** ** | ** **              | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| BASIC EPS                                               |       |                     |       |                    |       |   |   |   |   |
| Net income                                              |       | $                        | 803,958    |                    | $          | 118,826 |   | $ | 1,009,129 |   | $ | 127,478 |   |
| Denominator: weighted average common shares outstanding |       | 14,278,589               |       | 13,076,315              |       | 14,045,162 |   | 12,956,971 |   |
| Net income per share—basic                         |       | $                        | 0.06       |                    | $          | 0.01 |   | $ | 0.07 |   | $ | 0.01 |   |
|                                                    |       |                     |       |                    |       |   |   |   |   |
| DILUTED EPS                                             |       |                     |       |                    |       |   |   |   |   |
| Net income                                              |       | $                        | 803,958    |                    | $          | 118,826 |   | $ | 1,009,129 |   | $ | 127,478 |   |
| Denominator: weighted average common shares outstanding |       | 14,278,589               |       | 13,076,315              |       | 14,045,162 |   | 12,956,971 |   |
| Common equivalent shares outstanding:                   |       |                     |       |                    |       |   |   |   |   |
| Options                                                 |       | 1,117,203                |       | 1,653,975               |       | 1,946,169 |   | 772,705 |   |
| Total diluted shares                                    |       | 15,395,792               |       | 14,730,290              |       | 15,991,331 |   | 13,729,676 |   |
| Net income per share—diluted                       |       | $                        | 0.05       |                    | $          | 0.01 |   | $ | 0.06 |   | $ | 0.01 |   |

 

Therewere 1,308,500 and 1,109,881 potentially dilutive options outstanding for thequarters ending September 30, 2004 and 2003, respectively and there were164,000 and 2,113,419 potentially dilutive options outstanding for the ninemonths ending September 30, 2004 and 2003, respectively, that were notincluded in the table above because they would be anti-dilutive.

 

**11.**          **Commitmentsand Contingencies**

 

TheCompany is subject to legal proceedings and claims that arise in the normalcourse of business. While the outcome of these proceedings and claims cannot bepredicted with certainty, management does not believe that the outcome of anyof these matters will have a material adverse effect on the Company’sconsolidated financial position or results of operations.

TheCompany has contractual obligations and commitments with regards to operatinglease arrangements. The following table quantifies the expected contractualobligations and commitments subsequent to December 31, 2003:

 

| ** **                        | ** ** | ** **   | ** ** | **Facility-Related** | ** ** | **Office**    | ** ** | ** ** | ** ** |
|-----------------------------------|------------|--------------|------------|----------------------|------------|---------------|------------|------------|------------|
| **Year ending December 31,** | ** ** | **Facility** | ** ** | **Party**            | ** ** | **Equipment** | ** ** | **Total**  | ** ** |
| 2004                              |       | $            | 138,333    |                 | $          | 210,600       |       | $          | 10,504     |   | $ | 359,437 |   |
| 2005                              |       | 145,250      |       | 87,750               |       | 7,030         |       | 240,030    |       |
| 2006                              |       | 159,083      |       | —               |       | 6,534         |       | 165,617    |       |
| 2007                              |       | —       |       | —               |       | 6,534         |       | 6,534      |       |
| 2008                              |       | —       |       | —               |       | 2,995         |       | 2,995      |       |
|                              |       | $            | 442,666    |                 | $          | 298,350       |       | $          | 33,597     |   | $ | 774,613 |   |
|                                   |            |              |            |                      |            |               |            |            |            |  |  |  |  |  |  |

 

**12.**          **Stockholders’Equity**

 

OnMay 9, 2002, the Company’s Board of Directors authorized the repurchase ofup to 500,000 of the outstanding shares of the Company’s common stock for aperiod from May 10, 2002 to November 10, 2002 (the “2002 RepurchaseProgram”). As of March 31, 2004, 225,300 shares had been repurchased at acost of $718,601 under the 2002 Repurchase Program. On June 30, 2004, theCompany’s Board of Directors authorized a stock repurchase program (the “2004Repurchase Program”).  Under the 2004Repurchase Program the Company may acquire up to $3,000,000 of its outstanding

 

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common stock for a six-month period fromJuly 1, 2004 to December 31, 2004. Purchases may be made from time to time in the open market, blockpurchases or privately negotiated transactions, depending on market conditions,share price and other factors.  Thefollowing table shows activity under the 2004 Repurchase Program for thequarter ending September 30, 2004:

 
| ** **                      | ** ** | **September 30,** | ** ** |
|---------------------------------|------------|------------------------|------------|
| ** **                      | ** ** | **2004**               | ** ** |
| Shares repurchased              |       | 33,957                 |       |
| Average price per share         |       | $                      | 4.84       |   |
| Total repurchase authorized     |       | $                      | 3,000,000  |   |
| Repurchases under the plan      |       | $                      | 164,461    |   |
| Authorized repurchase remaining |       | $                      | 2,835,539  |   |

 

Allrepurchased shares are reflected as treasury stock in the accompanyingconsolidated balance sheets.

 

**13.****      ****SegmentInformation**

 

The Company operates two business segments — semiconductors andlicensing.  In 2003, the Company reportedits revenues in the following five segments: licensing; semiconductors;component distribution; product sales; and Internet and broadcast.  In 2004, the Company decided to reduce itssegments because the revenue attributable to the discontinued segments were notmaterial compared to revenues relating to semiconductors and licensing.  Segment information for the 2003 segments hasbeen restated to conform to the current year presentation.  Revenue from the component distributionsegment is now reported in the semiconductor segment and revenues from productsales and Internet and broadcast segments are now reported in the licensingsegment. The Company does not allocate corporate operating expenses or specificassets to these segments. Therefore, the segment information that followsincludes only net revenues, cost of sales and gross margins of the identifiedsegments:

 
| ** **                           | ** ** | **Valence**       | ** ** | **SRS Labs**  | ** ** | ** ** | ** ** |
|--------------------------------------|------------|-------------------|------------|---------------|------------|------------|------------|
| ** **                           | ** ** | **Semiconductor** | ** ** | **Licensing** | ** ** | **Total**  | ** ** |
| **Three Months Ended Sept 30, 2004** |       |              |       |          |       |       |       |
| Total revenues                       |       | $                 | 3,644,298  |          | $          | 2,727,861  |       | $ | 6,372,159 |   |
| Cost of sales                        |       | 1,320,855         |       | 100,342       |       | 1,421,197  |       |
|                                 |       |              |       |          |       |       |       |
| Gross margin                         |       | $                 | 2,323,443  |          | $          | 2,627,519  |       | $ | 4,950,962 |   |
|                                 |       |              |       |          |       |       |       |
| **Three Months Ended Sept 30, 2003** |       |              |       |          |       |       |       |
| Total revenues                       |       | $                 | 2,966,923  |          | $          | 1,919,471  |       | $ | 4,886,394 |   |
| Cost of sales                        |       | 1,226,407         |       | 16,029        |       | 1,242,436  |       |
|                                 |       |              |       |          |       |       |       |
| Gross margin                         |       | $                 | 1,740,516  |          | $          | 1,903,442  |       | $ | 3,643,958 |   |

 
| ** **                                | ** ** | **Valence**       | ** ** | **SRS Labs**  | ** ** | ** ** | ** ** |
|-------------------------------------------|------------|-------------------|------------|---------------|------------|------------|------------|
| ** **                                | ** ** | **Semiconductor** | ** ** | **Licensing** | ** ** | **Total**  | ** ** |
| **Nine  Months Ended Sept 30, 2004** |       |              |       |          |       |       |       |
| Total revenues                            |       | $                 | 8,992,511  |          | $          | 8,140,592  |       | $ | 17,133,103 |   |
| Cost of sales                             |       | 3,269,622         |       | 146,886       |       | 3,416,508  |       |
|                                      |       |              |       |          |       |       |       |
| Gross margin                              |       | $                 | 5,722,889  |          | $          | 7,993,706  |       | $ | 13,716,595 |   |
|                                      |       |              |       |          |       |       |       |
| **Nine Months Ended Sept 30, 2003**  |       |              |       |          |       |       |       |
| Total revenues                            |       | $                 | 7,244,323  |          | $          | 6,638,291  |       | $ | 13,882,614 |   |
| Cost of sales                             |       | 2,750,437         |       | 62,132        |       | 2,812,569  |       |
|                                      |       |              |       |          |       |       |       |
| Gross margin                              |       | $                 | 4,493,886  |          | $          | 6,576,159  |       | $ | 11,070,045 |   |

 

Forthe three months ending September 30, 2004, one customer accounted forapproximately 12% of revenues, or $757,886, in the semiconductor segment. Forthe same period in the prior year, one customer accounted for approximately

 

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13%of revenues, or $620,766, in the semiconductor segment. There was nosignificant customer in the licensing segment for the three months endedSeptember 30, 2004 and September 30, 2003. For the nine months ending September 30, 2004, no single customeraccounted for more than 10% of revenues in either segment. For the same periodin the prior year, one customer accounted for approximately 11% of revenues, or$1,517,953, in the semiconductor segment.

 

Thefollowing schedule presents the Company’s revenue by geographic area. Forproduct sales, revenue is allocated based on the country to which the productwas shipped. For licensing-related revenue, the allocation is based on thelocation of the licensee’s corporate headquarters. The Americas region includesNorth, Central and South America.

 
| ** **                    | ** ** | **Three  Months Ended** | ** ** | **Nine  Months Ended** | ** ** |
|-------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                    | ** ** | **September  30,**      | ** ** | **September  30,**     | ** ** |
| ** **                    | ** ** | **2004**                | ** ** | **%**                  | ** ** | **2003** | ** ** | **%** | ** ** | **2004** | ** ** | **%** | ** ** | **2003** | ** ** | **%** | ** ** |
| **Geographic  Area Revenue:** |       |                    |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Hong Kong                     |       | $                       | 3,283,202  |                   | 52         | % | $ | 2,619,125 |   | 48 | % | $ | 8,264,269 |   | 54 | % | $ | 6,323,620 |   | 46 | % |
| Japan                         |       | 1,098,643               |       | 17                     | %          | 933,546 |   | 22 | % | 3,756,473 |   | 19 | % | 4,173,863 |   | 30 | % |
| China                         |       | 797,074                 |       | 13                     | %          | 453,442 |   | 9 | % | 1,590,754 |   | 9 | % | 1,315,920 |   | 9 | % |
| Americas                      |       | 512,699                 |       | 8                      | %          | — |   | 10 | % | 1,824,668 |   | 3 | % | 736,567 |   | 5 | % |
| Other Asia  Pacific           |       | 502,769                 |       | 7                      | %          | 399,314 |   | 8 | % | 1,103,930 |   | 9 | % | 841,274 |   | 6 | % |
| Europe                        |       | 177,772                 |       | 3                      | %          | — |   | 3 | % | 593,009 |   | 6 | % | 491,370 |   | 4 | % |
|                          |       |                    |       |                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total                         |       | $                       | 6,372,159  |                   | 100        | % | $ | 4,886,394 |   | 100 | % | $ | 17,133,103 |   | 100 | % | $ | 13,882,614 |   | 100 | % |

 

 

**14.**          **RecentAccounting Pronouncements**

 

InDecember 2003, the SEC issued Staff Accounting Bulletin (SAB)No. 104, Revenue Recognition (SAB No. 104), which codifies, revisesand rescinds certain sections of SAB No. 101, Revenue Recognition, inorder to make this interpretive guidance consistent with current authoritativeaccounting and auditing guidance and SEC rules and regulations. The changesnoted in SAB No. 104 did not have a material effect on the Company’sresults of operations, financial position or cash flows.

 

InMarch 2004, the Emerging Issues Task Force (EITF) reached a consensus onEITF No. 03-06, Participating Securities and Two-Class Method under FASBStatement No. 128, Earnings per Share. EITF No. 03-06 addresses a number ofquestions regarding the computation of earnings per share (EPS) by companiesthat have issued securities other than common stock that contractually entitlethe holder to participate in dividends and earnings of the company when, andif, it declares dividends on its common stock. The issue also provides furtherguidance in applying the two-class method of calculating EPS. It clarifies whatconstitutes a participating security and how to apply the two-class method ofcomputing EPS once it is determined that a security is participating, includinghow to allocate undistributed earnings to such a security. The consensusreached on EITF No. 03-06 is effective for fiscal periods beginning afterMarch 31, 2004. Prior period earnings per share amounts will be restatedto conform to the consensus to ensure comparability year over year. Theadoption of EITF No. 03-06 did not have any impact on our results of operationsor financial condition.

 

The Financial Accounting Standard Board (“FASB”)issued an exposure draft entitled “ *Share-BasedPayment, an Amendment of FASB Statements Nos. 123 and 95.”*Thisexposure draft would require stock-based compensation to employees to be recognizedas a cost in the financial statements and that such cost be measured accordingto the fair value of the stock options. In the absence of an observable marketprice for the stock awards, the fair value of the stock options would be basedupon a valuation methodology that takes into consideration various factors,including the exercise price of the option, the expected term of the option,the current price of the underlying shares, the expected volatility of theunderlying share price, the expected dividends on the underlying shares and therisk-free interest rate. The proposed requirements in the exposure draft wouldbe effective for the first fiscal year beginning after June 15, 2005.  See Note 2 for pro forma disclosuresregarding the effect on net income and earnings per share if we had applied thefair value recognition provisions of the exposure draft and SFAS No. 123.  We will continue to monitor communications onthis subject from the FASB in order to determine the impact on our consolidatedfinancial statements.

 

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**Item 2****.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

This information should be read in conjunction withthe audited consolidated financial statements and notes thereto and Management’sDiscussion and Analysis of Financial Condition and Results of Operationscontained in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2003 (the “Form 10-K”), the audited consolidated financialstatements and the notes thereto included in the Form 10-K and the unauditedcondensed interim consolidated financial statements and notes thereto includedin this Quarterly Report.

**Overview**

SRS Labs is a leading developer and provider ofapplication specific integrated circuits (“ASICs”), standard integrated circuits (“ICs”) andaudio and voice technology solutions for the home theater, portable audio,wireless, computer, game, automotive, broadcast, Internet andtelecommunications markets. The Company operates in the following two businesssegments:

*Semiconductor:*  ThroughSRS Labs, Inc.’s wholly-owned subsidiary, ValenceTech Limited, and ValenceTechLimited’s wholly-owned subsidiaries (collectively “Valence”), the semiconductorsegment develops, designs and markets standard and custom, applicationspecific technology solutions in the form of analog, digital signal processors(“DSPs”), and mixed signal, integrated circuits primarily to original equipmentmanufacturers (“OEMs”), in the Asia Pacific region.

*Licensing**:***  Through SRS Labs, theparent company, and its wholly-owned subsidiary, SRSWOWcast.com, Inc., doingbusiness as SRSWOWcast Technologies (“SRSWOWcast”), the licensing segmentdevelops and licenses audio and voice technology solutions to manyof the world’s leading OEMs, software providers and semiconductor companies,and licenses and markets hardware and software products for the Internet andprofessional audio markets.

In 2003, the Company reported its revenues in thefollowing five segments: licensing; semiconductors; component distribution;product sales; and Internet and broadcast. In 2004, the Company decided to reduce its segments because of themateriality of the revenues attributable to the other three segments.  Revenue from the component distributionsegment is now reported in the semiconductor segment and revenues from productsales and Internet and broadcast segments are now reported in the licensingsegment.  As used herein, the “Company,”“SRS Labs,” “we,” “us,” or “our” means SRS Labs, Inc. and its wholly ownedsubsidiaries, including Valence and SRSWOWcast.

We have determined that the most effectivestrategy for the creation of stable and sustainable revenue growth is todiversify our revenue base.  In ourlicensing segment, our goal is to diversify our revenue base from ourhistorical concentration in home theater. We believe that the mobile phone, portable audio, PC and automotiveareas within the consumer electronics market present new high volume, highgrowth opportunities for application of our audio technologies.  Our diversification strategy also extends toour semiconductor segment in which we have refocused our team away from theheavy concentration on custom application specific projects for a fewcustomers.  In addition, we are now alsofocused on marketing our standard branded chips, including new chips that embedSRS Labs’ technologies, with particular attention toward the largemanufacturing market in China.

In September 2004, we entered into astrategic alliance with Coming Home Studios LLC (“CHS”) to produce and sellconcert DVD’s which include our Circle Surround technology.  In connection with the strategic alliance,SRS and CHS entered into four agreements: a Strategic Alliance Agreement, the CHS/SRS LLC Operating Agreement, aWarrant Agreement and a Production Services Agreement.  In the Strategic Alliance Agreement, CHS andSRS agree to work together to identify and implement co-promotionalopportunities, including trade shows, movie theatres, video streaming, concertDVDs, artist endorsements, bundling and premium deals, web-based promotionalclips and road shows.  The initial termof the agreement expires on July 9, 2006 and is automatically renewable forsuccessive one-year terms.

Pursuant to the Operating Agreement each ofCHS and us contributed capital with a value of $1,800,000.  In connection with this strategic alliance,we capitalized $185,626 consisting of costs associated with the formation ofthe LLC and co-promotional projects. Profits from the distribution of the concert videos and related assetswill be allocated and distributed equally until we and CHS have each received1.75 times their original capital contribution, after which profits will beallocated and distributed 90% to CHS and 10% to SRS.  Revenues will be recognized upon profitdistributions.  Under the WarrantAgreement, we paid CHS $40,000 to acquire a warrant to purchase up to 122,000units of Class A membership interests in CHS, which represents approximately10% of the equity of CHS, for an exercise price of $9.836 per unit, subject toadjustment based on a valuation of CHS at the time of an additionalfunding.  The warrant is immediatelyvested and exercisable for up to two years. It is transferable and contains customary anti-dilution and priceprotection provisions for warrants of this type.

 

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**Critical Accounting Policies**

Our discussion and analysisof our results of operations and liquidity and capital resources are based onour consolidated financial statements which have been prepared in accordancewith accounting principles generally accepted in the United States.

The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and disclosure of contingent assetsand liabilities. We base our estimates on historical and anticipated resultsand trends and on various other assumptions that we believe are reasonableunder the circumstances, including assumptions as to future events. Theseestimates form the basis for making judgments about the carrying value ofassets and liabilities that are not readily apparent from other sources. Bytheir nature, estimates are subject to an inherent degree of uncertainty.Actual results may differ from our estimates.

The following represents a summary of our criticalaccounting policies, defined as those policies that we believe are:(a) the most important to the portrayal of our financial condition andresults of operations; and (b) that require management’s most difficult,subjective or complex judgments, often as a result of the need to makeestimates about the matters that are inherently uncertain. Our most criticalaccounting estimates include valuation of accounts receivable, which impactsoperating expenses; valuation of inventory, which impacts gross margin;valuation of intangible assets and capitalization of software, which primarilyimpacts operating expenses when we impair assets or accelerate theirdepreciation; and recognition and measurement of current and deferred incometax assets and liabilities, which impacts our tax provision.  We discuss these policies, as well as theestimates and judgments involved in greater detail below. We also have otherpolicies that we consider key accounting policies, such as our policies forrevenue recognition; however, these policies do not meet the definition ofcritical accounting estimates, because they do not require us to make estimatesor judgments that are difficult or subjective.

*Accounts Receivable*

We perform ongoing credit evaluations of ourcustomers and adjust credit limits based upon payment history, the customer’scurrent credit worthiness and various other factors, as determined by ourreview of their current credit information. We continuously monitor collectionsand payments from our customers and maintain allowances for doubtful accountsbased upon specific customer circumstances, current economic trends, historicalexperience and the age of past due receivables. While such credit losses havehistorically been within our expectations and the provisions established, wecannot guarantee that we will continue to experience the same credit loss ratesthat we have in the past. Unanticipated changes in the liquidity or financialposition of our customers may require additional provisions for doubtfulaccounts.

*Inventory*

Inventory is stated at the lower of cost or netrealizable value. We periodically assess our inventory for potential obsolescenceand lower-of-cost-or-market issues. We make estimates of inventoryobsolescence, providing reserves when necessary, based on, among other factors,demand for inventory based on backlog, product pricing, the ability toliquidate or sell older inventory and the impact of introducing new products.If actual market conditions or our customer’s product demands are lessfavorable than those projected, additional provisions may be required.

*Intangible Assets & Capitalization ofSoftware*

Inaccordance with SFAS No. 142, “Goodwill and Other Intangible Assets”, goodwilland intangible assets deemed to have indefinite lives are no longer amortized,but are instead tested for impairment annually or sooner if circumstancesindicate they may no longer be recoverable. Our judgments regarding the existence of impairment indicators andfuture cash flows related to intangible assets are based on operationalperformance of our acquired businesses, market conditions and other factors. Ifthe carrying value of a reporting unit exceeds its fair value, goodwill isconsidered impaired and a second test is performed to measure the amount ofimpairment loss, if any. For fiscal 2003, an independent valuation of goodwilland other intangibles was performed. To date, we have not recognized anyimpairment of our goodwill and other intangible assets in connection with ouradoption of SFAS 142. However, no assurances can be given that futureevaluation of goodwill will not result in charges as a result of futureimpairment. In accordance with SFAS No. 144, “Accounting for the Impairment orDisposal of Long-Lived Assets,” all of the Company’s intangible assets thathave definite lives are being amortized on a straight-line basis over theirestimated useful lives.

Costs incurred in the research, design anddevelopment of software for sale to others as a separate product or embedded ina product and sold as part of the product as a whole are charged to expenseuntil technological feasibility is established. Under SFAS No. 86, “Accountingfor the Costs of Computer Software to be Sold, Leased or Otherwise

 

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Marketed,”we capitalize software purchased from third parties if the related softwareproduct under development has reached technological feasibility or if there arealternative future uses for the purchased software, provided that capitalizedamounts will be realized over a period not exceeding five years. Costs incurredprior to the establishment of technological feasibility are charged to researchand development expense. The establishment of technological feasibility andongoing assessment of recoverability of capitalized software development costsrequire considerable judgment by management with respect to certain externalfactors, including, but not limited to, anticipated future revenues, estimatedeconomic life and changes in software and hardware technologies. Upon thegeneral release of the software product to customers, capitalization ceases andsuch costs are amortized to cost of sales using the straight-line method on aproduct-by-product basis over the estimated life, which is generally threeyears. To the extent that amounts capitalized for research and developmentbecome impaired due to a decline in demand or the introduction of newtechnology, such amounts will be written-off. All other research anddevelopment expenditures are charged to research and development expense in theperiod incurred.

 

*IncomeTaxes*

In preparing our consolidated financial statements,we go through a process to estimate our income taxes in each of the countriesin which we operate. The process includes an assessment of the current taxexpense, the results from tax examinations and the effects of temporarydifferences resulting from the different treatment of transactions for tax andfinancial accounting purposes. These differences result in deferred tax assetsand liabilities, which are included in the Consolidated Balance Sheet. Weaccount for income taxes in accordance with Statement of Financial AccountingStandards No. 109, or SFAS 109, “Accounting for Income Taxes,” whichrequires that deferred tax assets and liabilities be recognized using enactedtax rates for the effect of temporary differences between the book and taxbases of recorded assets and liabilities. SFAS 109 also requires thatdeferred tax assets be reduced by a valuation allowance if it is more likelythan not that some portion or all of the deferred tax asset will not berealized. We evaluate the reliability of our deferred tax assets by assessingour valuation allowance and by adjusting the amount of such allowance, ifnecessary. At December 31, 2003, we had net deferred tax assets primarilyresulting from temporary differences between the book and tax bases of assetsand liabilities, and loss and credit carry forwards. We continue to provide avaluation allowance on certain deferred tax assets based on an assessment ofthe likelihood of their realization. In reaching our conclusion, we evaluatedcertain relevant criteria including deferred tax liabilities that can be usedto offset deferred tax assets, estimates of future taxable income ofappropriate character within the carry forward period available under the taxlaw and tax planning strategies. Our judgments regarding future taxable incomemay change due to market conditions, changes in U.S. or international tax laws,and other factors. These changes, if any, may require material adjustments tothese deferred tax assets, resulting in either a tax benefit, if it isestimated that future taxable income is likely, or a reduction in the value ofthe deferred tax assets, if it is determined that their value is impaired,resulting in a reduction in net income or an increase in net loss in the periodwhen such determinations are made.

Our income tax provision is based on calculationsand assumptions that will be subject to examination by the taxing authoritiesin the jurisdictions in which we operate. Should the actual results differ fromour estimates, we would have to adjust the income tax provision in the periodin which the facts and circumstances that give rise to the revision becomeknown. Tax law and rate changes are reflected in the income tax provision inthe period in which such changes are enacted.

**Results of Operations**

**Three Months Ended September 30, 2004 Compared toThree Months Ended September 30, 2003**

*Revenues*

Semiconductor revenues consists of (a) design feesrelating to, and sales of, application specific integrated circuits (“ASIC”)for third parties by Valence to original equipment manufacturers (“OEMs”);and  (b) sales of general purposeintegrated circuits (“ICs”) designed by Valence under the brand name ASP.  Licensing revenues consist primarily ofroyalties generated from the license of SRS Labs’ audio and voice technologies.  License and royalty agreements generallyprovide for the license of technologies for a fee based on the number of unitsdistributed by the licensee.  However, wehave in the past and may again in the future, enter into a license agreementfor a one-time fee. Also included in licensing revenue are revenues generatedfrom the sale of hardware and software applications into the broadcast audiomarkets.

Total revenues for the three months endedSeptember 30, 2004 were $6,372,159 compared to $4,886,394****for the three months endedSeptember 30, 2003, an increase of $1,485,765 or 30.4%.  Semiconductor revenues were $3,644,298 forthe three months ended September 30, 2004 compared to $2,966,923for the threemonths ended September 30, 2003, an increase of $677,375 or 22.8%. Withinsemiconductor revenue, ASIC accounted for $2,526,417 or 69.3% for the three

 

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months ended September 30, 2004 compared to$2,310,406 or 77.9% for same period last year, an increase of $216,011 or 9.3%.ASP chips accounted for $1,117,881, or 30.7% for the three months endedSeptember 30, 2004 compared to $656,517 or 22.1% for the same period last year,an increase of $461,364 or 70.3%.  WithinASP revenues, SRS chips accounted for 49.5% this year compared to 22.9% lastyear, a growth of 60.8%.  The increase insemiconductor sales can be primarily attributed to traditional seasonality andthe increased sales of ASP chips to the TV and portable audio markets.Semiconductor revenue also improved due to the movement of backlog, which builtup in Q2 due to foundry capacity constraints.

 

Licensing revenues were $2,727,861 for the threemonths ended September 30, 2004, compared to $1,919,471****for the three months endedSeptember 30, 2003, an increase of $808,390 or 42.1%.  The sales growth in licensing wasattributable to our continued diversification strategy, which expanded the useof our technologies in the portable devices, PC, mobile phone and automotivemarkets. The following table presents the Company’s Licensing revenues mix bymarket segment:
| ** **                                               | ** ** | **Three Months Ended Sept 30,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                               | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Home Entertainment (TV, Set Top Box, A/V Receiver, DVD)  |       | 69                                   | %          | 74 | % |
| Portable Media Devices (Digital Media Player, Headphone) |       | 13                                   | %          | 12 | % |
| PC (Software, Hardware)                                  |       | 8                                    | %          | 7 | % |
| Personal Telecommunications (Mobile phone, PDA)          |       | 7                                    | %          | 6 | % |
| Automotive                                               |       | 3                                    | %          | 1 | % |

 

*Gross Margin*

 

Cost of sales consists primarily of fabricationcosts, assembly and test costs, and the cost of materials and overhead fromoperations. Gross margins are dependent on the mix of products sold, servicesprovided and royalties earned. The following table presentsthe Company’s gross margin percentages for the three months ended September 30,2004 compared to September 30, 2003:

 
| ** **                                                   | ** ** | **Three Months  Ended Sept 30,** | ** ** |
|--------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                   | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| **Semiconductor**                                            |       |                                  |       |   |   |
| ASIC revenue as a percentage of total semiconductor revenue  |       | 69.3                                  | %          | 77.9 | % |
| ASIC gross margin                                            |       | 63.0                                  | %          | 58.5 | % |
|                                                         |       |                                  |       |   |   |
| ASP revenue as a percentage of total semiconductor revenue   |       | 30.7                                  | %          | 22.1 | % |
| ASP gross margin                                             |       | 65.5                                  | %          | 59.3 | % |
|                                                         |       |                                  |       |   |   |
| Total semiconductor revenue as a percentage of total revenue |       | 57.2                                  | %          | 60.7 | % |
| Total semiconductor gross margin                             |       | 63.8                                  | %          | 58.7 | % |
|                                                         |       |                                  |       |   |   |
| **Licensing**                                                |       |                                  |       |   |   |
| Licensing revenue as a percentage of total revenue           |       | 42.8                                  | %          | 39.3 | % |
| Licensing gross margin                                       |       | 96.3                                  | %          | 99.2 | % |
|                                                         |       |                                  |       |   |   |
| **Total Gross Margin**                                       |       | 77.7                                  | %          | 74.6 | % |

 

ASIC gross margins increased due to increase indesign fees and sales of component inventory previously written off.  The increase in ASP gross margins can beattributable to new chips with higher gross margins representing 43.6% of totalASP chip sales.  The slight decrease inlicensing gross margins is attributable to the write-off of speaker inventory,which was deemed to be obsolete, and the cost of logo materials for licensee products.

 

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*Sales and Marketing*

Sales and marketing expensesconsist primarily of employee salaries, sales consultants’ fees and relatedexpenses, sales commissions and product promotion costs. Sales and marketingexpenses were $1,305,349 for the three months ended September 30, 2004 comparedto $1,216,568**for the same prioryear period, an increase of $88,781 or 7.3%. The increase in salesexpenses can be primarily attributed to severance costs and increased travelrelated to customer support and co-promotional activities.  As a percentage of totalrevenues, sales and marketing expenses decreased from 24.9% for the quarterended September 30, 2003 to 20.5% for the same period this year.

*Researchand Development*

Research and development expenses consist ofsalaries and related costs of employees engaged in ongoing research, design anddevelopment activities and costs for engineering materials and supplies.Research and development expenses were $1,266,606 for the three months endedSeptember 30, 2004 compared to $1,032,100****for the same prior year period, an increase of $234,506 or 22.7%.The increase in research and development costs is primarily due to the additionof research and development personnel added in the fourth quarter of 2003.  As a percentage of total revenues, researchand development expenses decreased from 21.1%for the quarter ended September 30, 2003, to 19.9% for the same period thisyear.

*Generaland Administrative*

General and administrative (“G&A”)expenses consist primarily of employee-related expenses, legal costs associatedwith the administration of intellectual property and other professional fees.G&A expenses were $1,452,236 for the three months ended September 30,2004 compared to $1,143,930 for the same prior yearperiod, an increase of $308,306 or 27.0%. The increase is attributable toincreases in professional fees, public company costs, bad debt and increases inamortization associated with increased capitalization of patents and purchasedtechnology.  As a percentage of totalrevenues, G&A expenses decreased from 23.4% for the quarter endedSeptember 30, 2003, to 22.8% for the same period this year.

*IncomeFrom Operations*

Income from operationsincreased by $675,411 to $926,771 for the quarter ended September 30, 2004 ascompared to income from operations of $251,360 for the quarter ended September30, 2003.  The increase in income fromoperations is due to an increase in revenue, partially offset by an increase inoperating expenses.

*OtherIncome, Net*

Other income, net, consists primarily ofinterest income, gain or (loss) on sale of securities, interest expense andforeign currency transaction gains and losses. Other income, net, was $118,908for the three months ended September 30, 2004, compared to $131,925 forthe same prior year period, a decrease of $13,017 or 9.9%. The decrease isprimarily attributable to lower interest rates in 2004.

*Provisionfor Income Taxes*

The income tax expense for the three months endedSeptember 30, 2004 was $241,721, compared to tax expense of $264,459 forthe same prior year period, a decrease of $22,738 or 8.6%. The provisionconsists primarily of taxes paid on licensing revenues sourced from countriesrequiring foreign tax withholdings and taxes paid on profits in Hong Kong atthe rate of 17.5%.  The decrease inincome tax for the quarter ended September 30, 2004 was attributable tothe U.S. Japan taxtreaty that went into effect on July 1, 2004 and eliminates source-countrywithholdings on royalties. Congress passed the American Jobs Creation Act of2004 on October 22, 2004 (“the Act”). The Act contains numerous changes to existing tax laws including, butnot limited to, incentives to repatriate foreign accumulated earnings and otherinternational tax provisions regarding foreign tax credits.  The company has not yet evaluated anddetermined what impact, if any, the Act may have on our results of operationsand financial condition in the future.

**Nine MonthsEnded September 30, 2004 Compared to Nine Months Ended September 30, 2003**

*Revenues*

Total revenues for the ninemonths ended September 30, 2004 were $17,133,103 compared to $13,882,614**for the nine months endedSeptember 30, 2003, an increase of $3,250,489 or 23.4%. Semiconductorrevenues were $8,992,511 for

 

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thenine months ended September 30, 2004 compared to $7,244,323 for the nine monthsended September 30, 2003, an increase of $1,748,188 or 24.1%. Withinsemiconductor revenue, ASIC accounted for $6,188,486 or 68.8% for the ninemonths ended September 30, 2004 compared to $5,696,957 or 78.6% for the ninemonths ended September 30, 2003, an increase of $491,529 or 8.6%. ASP chipsaccounted for $2,804,025 or 31.2% for the nine months ended September 30, 2004compared to $1,547,366 or 21.4% for the nine months ended September 30, 2003,an increase of $1,256,659 or 81.2%, of which SRS technology chips accounted for62.4% of ASP growth. This increase in semiconductor sales is attributable tonew design wins with new chip offerings including SRS chips. Licensing revenueswere $8,140,592 for the nine months ended September 30, 2004, compared to$6,638,291 for the nine months ended September 30, 2003, an increase of$1,502,301 or 22.6%. This increase is attributable to our diversificationstrategy and revenues generated in new product categories such as mobilephones, portable audio devices, and PCs and increased penetration in theCompany’s key home theater market, including set top boxes and televisions,which incorporate SRS Labs’ technologies. The following table presentsthe Company’s Licensing revenues mix by market segment:

 
| ** **                                               | ** ** | **Nine Months Ended Sept 30,** | ** ** |
|----------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                               | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| Home Entertainment (TV, Set Top Box, A/V Receiver, DVD)  |       | 68                                  | %          | 84 | % |
| Portable Media Devices (Digital Media Player, Headphone) |       | 10                                  | %          | 7 | % |
| PC (Software, Hardware).                                 |       | 11                                  | %          | 4 | % |
| Personal Telecommunications (Mobile phone, PDA)          |       | 10                                  | %          | 4 | % |
| Automotive.                                              |       | 1                                   | %          | 1 | % |

 

###### *Gross Margin*

 

Cost of sales consists primarily offabrication costs, assembly and test costs, and the cost of materials andoverhead from operations. The following table presents the Company’s grossmargin percentages for the nine months ended September 30, 2004 compared toSeptember 30, 2003:

 
| ** **                                                   | ** ** | **Nine Months  Ended Sept 30,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                   | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| **Semiconductor**                                            | ** ** | ** **                           | ** ** | ** ** | ** ** |
| ASIC revenue as a percentage of total semiconductor revenue  |       | 68.8                                 | %          | 78.6 | % |
| ASIC gross margin                                            |       | 65.4                                 | %          | 62.0 | % |
|                                                         |       |                                 |       |   |   |
| ASP revenue as a percentage of total semiconductor revenue   |       | 31.2                                 | %          | 21.4 | % |
| ASP gross margin                                             |       | 59.8                                 | %          | 62.2 | % |
|                                                         |       |                                 |       |   |   |
| Total semiconductor revenue as a percentage of total revenue |       | 52.5                                 | %          | 52.2 | % |
| Total semiconductor gross margin                             |       | 63.6                                 | %          | 62.0 | % |
|                                                         |       |                                 |       |   |   |
| **Licensing**                                                | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Licensing revenue as a percentage of total revenue           |       | 47.5                                 | %          | 47.8 | % |
| Licensing gross margin                                       |       | 98.2                                 | %          | 99.1 | % |
|                                                         |       |                                 |       |   |   |
| **Total Gross Margin**                                       |       | 80.1                                 | %          | 79.7 | % |

 

*Sales and Marketing*

 

Sales and marketing expenses consistprimarily of employee salaries, sales consultants’ fees and related expenses,sales commissions and product promotion costs. Sales and marketing expenseswere $4,260,784 for the nine months ended September 30, 2004 compared to$3,840,155**for the same prioryear period, an increase of $420,629 or 11.0%. The net increase in sales andmarketing expenses for the nine months ended September 30, 2004 isattributable to severance costs and

 

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increased promotion costs associated withhigher licensing revenue and investments in branding and promotion of ourtechnologies in new markets designed to increase future revenues. As apercentage of total revenues, sales and marketing expenses decreased from 27.7%for the nine months ended September 30, 2003, to 24.9% for the same periodthis year.

 

*Research and Development*

 

Research and development expenses consist ofsalaries and related costs of employees engaged in ongoing research, design anddevelopment activities and costs for engineering materials and supplies.Research and development expenses were $3,620,219 for the nine months endedSeptember 30, 2004 compared to $3,083,438 for the same prior year period, anincrease of $536,781 or 17.4%. The increase in research and development costsis primarily due to the addition of research and development personnel andincreased costs associated with the increased semiconductor businessactivity.  As a percentage of totalrevenues, research and development expenses decreased from 22.2% for the ninemonths ended September 30, 2003, to 21.1% for the same period this year.

 

*General and Administrative*

 

G&A expenses consist primarily of employee-related expenses, legalcosts associated with the administration of intellectual property and otherprofessional fees. G&A expenses were $4,490,732 for the nine months endedSeptember 30, 2004 compared to $3,668,573 for the same prior year period,an increase of $822,159 or 22.4%. The increase was primarily attributable toincreased professional fees, public company expenses, and increasedamortization associated with the increased capitalization of patents andpurchased technology. As a percentage of total revenues, G&A expensesdecreased from 26.4% for the nine months ended September 30, 2003, to26.2% for the same period this year.

 

*Income From Operations*

 

Incomefrom operations increased by $866,981 to $1,344,860 for the nine months endedSeptember 30, 2004, as compared to income from operations of $477,879 for the sameperiod last year.  The increase in incomefrom operations is due to an increase in revenue, partially offset by anincrease in operating expenses.

 

*Other Income, Net*

 

Other income, net, consists primarily ofinterest income, gain or (loss) on sale of securities, interest expense andforeign currency transaction gains and losses. Other income, net, was $455,132for the nine months ended September 30, 2004, compared to $414,655 for thesame prior year period, an increase of $40,477 or 9.8%. The increase isprimarily attributable to investment gains from sales of U.S. Treasury in 2004.

 

###### *Minority Interest*

 

Minority interest represents the minorityshareholders’, 13%, proportionate share of losses in SRSWOWcast. Minorityinterest was $0 for the nine months ended September 30, 2004, compared to$5,430 for the nine months ended September 30, 2003. InFebruary 2003, SRS Labs completed an exchange offer with the minorityshareholders of SRSWOWcast, pursuant to which SRS Labs acquired all of theoutstanding shares of Series A Convertible Preferred Stock in exchange forthe issuance of shares of SRS Labs common stock. As a result of the exchangeoffer, SRSWOWcast became a wholly owned subsidiary of SRS Labs.

 

*Provision for Income Taxes*

 

The income tax expense forthe nine months ended September 30, 2004 was $790,863, compared to taxexpense of $770,486 for the same prior year period, an increase of $20,377 or2.6%. The provision consists primarily of taxes paid on licensing revenuessourced from countries requiring foreign tax withholdings and taxes paid onprofits in Hong Kong at the rate of 17.5%. The increase in income tax for the nine months ended September 30, 2004was attributable to higher profits in Hong Kong offset by the U.S. Japan tax treaty that went intoeffect on July 1, 2004, which eliminated source-country withholdings onroyalties.

 

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**Liquidity and Capital Resources**

The Company’s principal source of liquidityto fund ongoing operations at September 30, 2004 consisted of cash, cashequivalents and long-term investments of $26,301,461.  At September 30, 2004, the Company hadcash and cash equivalents of $16,020,285 and long-term investments of$10,281,176. Cash and cash equivalents generally consist of cash, money marketfunds and other money market instruments with original maturities of threemonths or less. Investments consist of U.S. government securities rated AAA.

Cash and cash equivalents increased $3,224,665during the nine months ended September 30, 2004 to $16,020,285.  The increase was primarily due to the netcash provided by operating activities of $2,894,878, and financing activitiesof $3,405,466 derived primarily from the exercise of stock options, offset bynet cash used in investing activities of $3,075,679 relating primarily to aninvestment in a strategic alliance for $2,025,626, as well as capital andpatent expenditures of $1,292,479. Net cash provided by operating activitieswas $2,894,878 versus net cash used of $119,504 for the nine months endedSeptember 30, 2004 and 2003 respectively. The improvement in our operating cashflows is primarily the result of increased revenues, gross margins and net income.Our inventories decreased $30,612 and increased $180,887 for the nine monthsended September 30, 2004 and 2003 respectively. The decrease in 2004 resulted from increased semiconductor sales and thesell off of backlog, which built up in Q2 due to foundry capacityconstraints.  Also, during the quarter,the company sold component inventory, which was previously reserved for in ourprovision for slow moving and obsolete inventory.  The reversal of the provision, provided abenefit of $160,855 for the nine months ended September 30, 2004, which wasoffset by increases in the reserve of $116,255 associated with our periodicassessment of inventory to arrive at a net benefit of $44,600.  Accrued liabilities increased $612,623 anddecreased $1,143,468 during the nine months ended September 30, 2004 and 2003respectively.  These changes relate toprofessional fees, commissions and bonus and the timing of payments to vendorsand employees.

Our net cash used for investing activities was$3,075,679 and $4,695,936 during the nine months ended September 30, 2004 andSeptember 30, 2003 respectively. Investing activities in 2004 primarily represented an investment in thestrategic alliance with Coming Home Studios LLC, referenced above under thecaption “Overview,” and purchases of capital equipment, patents and intangibleassets.  Investing activities in 2003primarily represented purchases of investments available for sale and capitalequipment. Our financing activities, primarily consisted of proceeds from theexercise of employee stock options, provided $3,405,466 and $385,529 during thenine months ended September 30, 2004 and September 30, 2003 respectively.

 On June 30,2004, the Company’s Board of Directors authorized a stock repurchaseprogram.  Under the repurchase program,the Company may acquire up to $3,000,000 of its outstanding common stock for aperiod of six months from July 1, 2004 to December 31, 2004.  Purchases may be made from time to time inthe open market, block purchases or privately negotiated transactions,depending on market conditions, share price and other factors.

Congresspassed the American Jobs Creation Act of 2004 on October 22, 2004 (the “Act”).  The Act contains numerous changes to existingtax laws including, but not limited to, incentives to repatriate foreignaccumulated earnings and other international tax provisions regarding foreigntax credits.  The Company is in theprocess of evaluating what impact, if any, the Act may have on our results ofoperations and financial condition in the future.

Based on current plans and business conditions, theCompany expects that its cash, cash equivalents and investments together withany amounts generated from operations will be sufficient to meet the Company’scash requirements for the foreseeable future. However, there can be noassurance that the Company will not be required to seek other financing sooneror that such financing, if required, will be available on terms satisfactory tothe Company.

**Factors That May Affect Future Results**

*We are exposed to risks in our licensing business related to productand customer concentration*

Currently, our licensing revenue is concentrated inthe home theater market with the majority of revenue generated from theinclusion of SRS technology inside televisions, DVD players and set-top boxes.We expect that the consumer home entertainment market will continue to accountfor a significant portion of our licensing revenues for the foreseeable future.While consumer spending in general on consumer electronic products hasincreased, retail prices for certain consumer electronics products that includeour audio technology, such as DVD players, have decreased significantly.  Indications are that this trend will continuefor the foreseeable future. In addition, from time to time, certain of ouroriginal equipment manufacturer and semiconductor manufacturer customers mayaccount for a significant portion of revenue from a particular productapplication, such as DVD players, set-top boxes or televisions. Consumer electronicsproducts manufacturers could decide to exclude our audio enhancement technologyfrom their home theater products altogether in an effort to reduce cost. Theloss of any such customer could have a material adverse affect on the Company’sfinancial condition and results of operations.

 

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Declining prices of consumer electronic productscould put pressure on our licensing fees that are charged to manufacturers.Also, given the current economic environment, consumer spending on DVD playersand other home electronic products may not increase as expected. Such declinesin consumer spending, should they occur, and continued decreases in consumerproduct pricing for electronic goods may have a significant negative impact onour financial results. The Company’s strategy is to diversify its customer basein an effort to decrease the impact from the loss of a particular customer,product segment or change in market trend.

*Our quarterly results may fluctuate*

Our operating results may fluctuate from those inprior quarters and will continue to be subject to quarterly and otherfluctuations due to a variety of factors, including the extent to which ourlicensees incorporate our technologies into their products; the timing oforders from, and the shipments to, major customers; the timing of new productintroductions; the gain or loss of significant customers; competitive pressureson selling prices; the market acceptance of new or enhanced versions of ourtechnologies; the rate that our semiconductor licensees manufacture anddistribute chips to product manufacturers; and fluctuations in general economicconditions, particularly those affecting the consumer electronics market. Dueto our dependence on the consumer electronics market, the substantialseasonality of sales in the market could impact our revenues and net income. Inparticular, we believe that there is seasonality relating to the Christmasseason generally and the Chinese New Year within the Asia region, which fallinto the fourth and first quarters respectively. As a result, we believe thatperiod-to-period comparisons of our results of operations are not necessarilymeaningful and should not be relied on as indications of future performance.

*We rely on revenue contribution from our ASIC and standard IC business*

We derive a significant amount of our revenue fromValence’s ASIC business. Valence’s engineering team focuses on the design ofcustom ASICs to meet specific customers’ requirements and outsources theproduction of the design to mask houses, foundries and packaging houses locatedprimarily in Asia. The operations of Valence could be affected by a variety offactors, including the timing of customer orders, the timing of developmentrevenue, changes in the mix of products distributed and the mix of distributionchannels employed, the emergence of a new industry standard, productobsolescence and changes in pricing policies by the Company, its competitors orits suppliers.

Business revenue from ASICs is concentrated in alimited number of customers in the areas of consumer electronics,communications products, computers and computer peripherals. The businessgenerated from any one customer may be for a fixed length or quantity. As such,it is customary in our ASIC business to have a certain amount of customerturnover as new ASIC projects are obtained for different customers. However, itis possible that the loss of any particular customer or any bad debt arisingfrom such customer may have a material adverse impact on our financialcondition and results of operation. Beginning in fiscal 1999, Valence began toexit from certain lower margin product offerings in the distribution side ofthe business and has placed more emphasis on developing and distributingproducts that are related to, or incorporate, our proprietary technologies. Asa result, the immediate loss in revenue of the low margin distribution businesswill not be entirely offset by the new proprietary technology based products,which will take time to develop and be introduced into the marketplace. Therecan be no assurance that we will be able to quickly introduce new products tooffset the loss in revenue or that the new products developed will receive afavorable market acceptance.

Valence adds significant diversity to our overallbusiness structure and opportunities. We recognize that in the presence of suchcorporate diversity, and in particular with regard to the semiconductorindustry, there will always exist a potential for conflict among sales channelsbetween the Company and our technology licensees. Although the operations ofour licensing business and those of Valence are generally complementary, therecan be no assurances that sales channel conflicts will not arise. If suchpotential conflicts do materialize, we may or may not be able to mitigate theeffect of such perceived conflicts, which, if not resolved, may impact theresults of operations.

*We are exposed to risks in our Valence business related to productfabrication outsourcing to third parties*

Valence is a “fabless” semiconductor company meaningthat Valence designs, develops and markets our selection of custom and standardintegrated circuits but we rely on third party contractors to manufacture,assemble and test our products. From time to time there can be foundry capacityissues due to global demands that affect the semiconductor industry.  Although we believe our relationships aregenerally good, we do not have long-term supply agreements with our third-partyvendors and they are not obligated to perform services or supply products to usfor any particular period or in any particular quantities, except as providedin each separate purchase order accepted by them. The increased demand for ourproducts coupled with the demand for foundry services, is, and will continue tobe for the foreseeable future, a challenge for us.  In these times of high demand, there aresignificant risks associated with our reliance on third-party vendors including:reallocation of capacity to other foundry customers, potential price increases,delays and interruptions in order deliveries, reduced control over productquality and increased risk of misappropriation of intellectual property.

 

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*We conduct operations in a numberof countries and are subject to risks of international operations, particularlyin Asia and the PRC*

We have significantoperations in Hong Kong, the PRC and other parts of Asia that requirerefinement to adapt to the changing market conditions in that region. Ouroperations in Asia, and international operations in general, are subject torisks of unexpected changes in, or impositions of, legislative or regulatoryrequirements.

Our customers geographicallylocated in the Asia Pacific markets accounted for approximately 93%, 90% and90% of total Company sales in 2003, 2002 and 2001, respectively and areexpected to continue to account for a substantial percentage of sales in thefuture. The economic climate in Asia continues to be impacted by increases inunemployment, declines in consumer spending, currency devaluation and bankfailures. Any of these factors, should they continue, could significantlyreduce the demand for the end user goods in which our products and technologiesare used.

The PRC economy hasexperienced significant growth in the past decade; but such growth has beenuneven across geographic and economic sectors. There can be no assurance thatsuch growth will continue or that any potential currency devaluation in theregion will not have a negative effect on our business, including Valence. ThePRC economy has also experienced deflation in the past, which may continue inthe future. The current economic situation may adversely affect ourprofitability over time as expenditures for consumer electronics products andinformation technology may decrease due to the results of slowing domesticdemand and deflation.

Hong Kong is a SpecialAdministrative Region of the PRC with its own government and legislature. HongKong enjoys a high degree of autonomy from the PRC under the principle of “onecountry, two systems.” We can give no assurance that Hong Kong will continue toenjoy autonomy from the PRC.

The Hong Kong dollar hasremained relatively constant due to the U.S. dollar peg and currency boardsystem that has been in effect in Hong Kong since 1983. Since mid-1997,interest rates in Hong Kong have fluctuated significantly and real estate andretail sales have declined. We can give no assurance that the Hong Kong economywill not worsen or that the historical currency peg of the Hong Kong dollar tothe U.S. dollar will be maintained. Continued declining consumer spending inHong Kong, deflation or the discontinuation of the currency peg could adverselyaffect our business.

*We are exposed to currencyfluctuations and instability in the Asian markets*

We expect that internationalsales will continue to represent a significant portion of our total revenues.To date, all of our licensing revenues have been denominated in U.S. dollarsand most costs have been incurred in U.S. dollars. It is our expectation thatlicensing revenues will continue to be denominated in U.S. dollars for theforeseeable future. Because Valence’s business is primarily focused in Asia andbecause of our anticipated expansion of business in the PRC and other parts ofAsia, our consolidated results of operations and financial position could besignificantly affected by risks associated with international activities,including economic and labor conditions, political instability, tax laws(including U.S. taxes on foreign subsidiaries) and changes in the value of theU.S. dollar versus the local currency in which the products are sold.  In addition, our valuation of assets recordedas a result of the Valence acquisition may also be adversely impacted by thecurrency fluctuations relative to the U.S. dollar.  We intend to actively monitor our****foreign exchange exposure and to implementstrategies to reduce our foreign exchange risk at such time that we determinethe benefits of such strategies outweigh the associated costs. However, thereis no guarantee that we will take steps to insure against such risks, andshould such risks occur, there is no guarantee that we will not besignificantly impacted.  Countries in theAsia Pacific region have experienced weakness in their currency, banking andequity markets. These weaknesses could adversely affect consumer demand forValence’s products, the U.S. dollar value of the Company’s and its subsidiaries’foreign currency denominated sales, the availability and supply of productcomponents to Valence and ultimately, our consolidated results of operations.

*We are subject to competitivepressures*

Ourexisting and potential competitors include both large and emerging domestic andinternational companies that have substantially greater financial,manufacturing, technical, marketing, distribution and other resources. Presentor future competitors may be able to develop products and technologiescomparable or superior to ours, and to adapt more quickly than us to newtechnologies or evolving market needs. We believe that the competitive factorsaffecting the market for our products and technologies include productperformance, price and quality; product functionality and features; the ease ofintegration; and implementation of the products and technologies with otherhardware and software components in the OEM’s products. In addition, themarkets in which we compete are intensely competitive and are characterized byrapid technological changes, declining average sales prices and rapid productobsolescence. Accordingly, there can be no assurance that we will be able tocontinue to compete effectively in its respective markets, that competitionwill not intensify or that future competition will not have a material adverseeffect on our business, operating results, cash flows and financial condition.

 

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*We strongly rely on our intellectual property*

Our ability to compete may be affected by our ability to protect ourproprietary information. We have filed numerous U.S. and foreign patentapplications and to date have a number of issued U.S. and foreign patentscovering various aspects of our technologies. There can be no assurance thatthe steps taken by SRS Labs to protect our intellectual property will beadequate to prevent misappropriation of our technology or that our competitorswill not independently develop technologies that are substantially equivalentor superior to our technology. In addition, the laws of certain foreigncountries may not protect our intellectual property rights to the same extent,as do the laws of the U.S. The semiconductor industry is characterized byfrequent claims and litigation regarding patent and other property rights. Weare not currently a party to any claims of this nature. There can be noassurances that third parties will not assert claims or initiate litigationagainst the Company or our customers with respect to existing or futureproducts. In addition, we may initiate claims or litigation against thirdparties for infringement of our proprietary rights or to determine the scopeand validity of our proprietary rights.

*We depend on our key personnel*

Ourfuture success depends to a large extent upon the continued service of keypersonnel, including engineering, sales and marketing staff, and highly skilledsemiconductor design staff. We anticipate that any future growth will requireus to recruit and hire a number of new personnel in engineering, operations,finance, sales and marketing. Competition for such personnel can be intense,and there can be no assurance that we can recruit and retain necessarypersonnel to operate our business and support future growth.

 

*The market price of our common stock is volatile*

Thetrading price of our Common Stock has been, and will likely continue to be,subject to wide fluctuations in response to quarterly variations in ouroperating results, announcements of new products or technological innovationsby the Company or our competitors, strategic alliances between SRS Labs andthird parties, general market fluctuations and other events and factors.Changes in earnings estimates made by brokerage firms and industry analystsrelating to the markets in which we do business, or relating to the Companyspecifically, have in the past resulted in, and could in the future result in,an immediate and adverse effect on the market price of the Common Stock. Eventhough our stock is quoted on the Nasdaq Stock Market, our stock has had andmay continue to have low trading volume and high volatility. The historicallylow trading volume of our stock makes it more likely that a severe fluctuationin volume, either up or down, will significantly impact the stock price. Sinceour shares are thinly traded, our shareholders may have difficulty selling ourcommon stock.

 

**Item 3****.  Quantitative and QualitativeDisclosures about Market Risk**

 

Therehave been no material changes to the information called for by this Item 3 fromthe disclosures set forth in Part II, Item 7A in the Company’s Annual Report onForm 10-K for the year ended December 31, 2003.

 

**Item 4****.  Controls and Procedures**

 

*Restatements*

 

                OnMay 10, 2005, management of the Company was advised by BDO Seidman, LLP, itsindependent registered public accounting firm (“BDO Seidman”), of theconclusion reached by it regarding the Company’s interim accounting for salesand marketing expenses related to trade shows. This conclusion was reached in connection with BDO Seidman’s financialstatement review procedures relating to the Company’s Quarterly Report on Form10-Q for the first quarter of the year ending December 31, 2005 (“fiscal 2005”).  Commencing in the first quarter of the fiscalyear ended December 31, 2004 (“fiscal 2004”), the Company began to capitalizeand amortize trade show expenses incurred in the fiscal year to reflect thefuture economic benefits received during such fiscal year.  Management discussed the issue with the AuditCommittee of the Company’s Board of Directors and BDO Seidman and was of theview that capitalization and amortization of trade show expenses wasallowable.  As part of the first quarterreview, BDO Seidman noted that trade show costs previously capitalized andamortized should have been treated as period expenses in fiscal 2004.  As a result, BDO Seidman expressed its viewthat (a) trade show costs previously capitalized and amortized during fiscal2004 should have been treated as period expenses in fiscal 2004; (b) each ofthe Company’s quarterly reports previously filed in fiscal 2004 should beamended; and (c) no reliance should be placed on the previously issued fiscal2004 quarterly financial statements.  Werestated our financial results for the quarters ended March 31, June 30, andSeptember 30, 2004 to reflect adjustments to our previously reported financialinformation.  In addition, the Company’sannual report on Form 10-K for fiscal 2004 has been amended to reflect suchquarterly results including the quarter ended December 31, 2004.

 

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*Evaluationof Disclosure Controls and Procedures*

 

The Company conducted anevaluation of the effectiveness of the design and operation of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) as of the end of the period covered by this Quarterly Report inconnection with the filing of its initial Quarterly Report on Form 10-Q basedupon the information available at that time and concluded that the Company’sdisclosure controls and procedures were effective. The controls evaluation wasdone under the supervision and with the participation of management, includingour Chief Executive Officer and Chief Financial Officer.

 

Subsequent to thatevaluation, in connection with the restatements described above, under thedirection of our Chief Executive Officer and Chief Financial Officer, wereevaluated our disclosure controls and procedures. In the course of BDOSeidman’s financial review procedures relating to the Company’s QuarterlyReport on Form 10-Q for the quarterly period ended March 31, 2005, our ChiefExecutive Officer and Chief Financial Officer were advised by BDO Seidman thatthe Company’s improper interpretation of accounting literature with respect tointerim accounting for sales and marketing expenses related to trade showexpenses described above constituted a material weakness in our internalcontrol over financial reporting.  Solelyas a result of this material weakness, we concluded that our disclosurecontrols and procedures were not effective as of the end of the period coveredby this Quarterly Report.

 

In connection with thisamended Quarterly Report on Form 10-Q/A, under the direction of our ChiefExecutive Officer and Chief Financial Officer, we have re-evaluated ourdisclosure controls and procedures as currently in effect, including thechanges in internal controls over financial reporting described below, and wehave concluded that, as of the date of this amended Quarterly Report on Form10-Q/A, our disclosure controls and procedures are effective.

 

*Changes in Internal Controls*

 

In the course of BDO Seidman’sfinancial statement review procedures relating to the Company’s QuarterlyReport on Form 10-Q for the quarterly period ended March 31, 2005, BDO Seidmanadvised the Company that the Company’s improper interpretation of accountingliterature with respect to interim accounting for sales and marketing expensesrelated to trade show expenses described above constituted a deficiency in theCompany’s internal controls and advised the Audit Committee that this internalcontrol deficiency constitutes a reportable condition and a material weaknessas defined in Statement on Auditing Standards No. 60.  As a result of this internal controldeficiency, the Company has implemented more formal procedures regardingchanges in accounting treatment and related communications with the AuditCommittee and the Company’s independent registered public accounting firm.

 

The Company believes thatthese corrective actions, taken as a whole, will remediate the controldeficiency identified above, but the Company will continue to monitor theeffectiveness of these actions and will make any other changes or take suchother actions as management determines to be appropriate.

 

As previously reported,there was no change in our internal control over financial reporting  (as defined in Rules 13a-15(f) and 15d-15(f)under the Exchange Act) during the third quarter of fiscal 2004, thatmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting. However, subsequent to March 31, 2005, wetook the remedial actions described above.

 

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**PART II****—OTHERINFORMATION**

 

**Item 2****.  Unregistered Sales of Equity Securities andUse of Proceeds.**

                The following table details ourcommon stock repurchases for the three months ended September 30, 2004:  
| **Issuer Purchases of Equity Securities** | ** ** |
|-------------------------------------------|------------|
| ** **                                | ** ** | **(a)** | ** ** | **(b)** | ** ** | **(c)** | ** ** | **(d)** | ** ** |
| ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Maximum Number** | ** ** |
| ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **(or Approximate** | ** ** |
| ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | **Total Number of** | ** ** | **Dollar Value) of** | ** ** |
| ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | **Shares (or Units)** | ** ** | **Shares (or Units)** | ** ** |
| ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | **Purchased as Part** | ** ** | **that May Yet Be** | ** ** |
| ** **                                | ** ** | **Total Number of** | ** ** | ** ** | ** ** | **of Publicly** | ** ** | **Purchased Under** | ** ** |
| ** **                                | ** ** | **Shares (or Units)** | ** ** | **Average Price Paid** | ** ** | **Announced Plans** | ** ** | **the Plans or** | ** ** |
| **Period**                                | ** ** | **Purchased** | ** ** | **per Share (or Unit)** | ** ** | **or Programs** | ** ** | **Programs** | ** ** |
| July 1 - 31, 2004                         |       | — |   | — |   | — |   | $ | 3,00,000 |   |
| August 1 - 31, 2004                       |       | 31,114 |   | $ | 4.87 |   | 31,114 |   | $ | 2,848,330 |   |
| September 1 - 30, 2004                    |       | 2,543 |   | $ | 5.03 |   | 33,657 |   | $ | 2,835,539 |   |

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(1)                                  On June 30, 2004, the Company’s Board of Directors authorizeda stock repurchase program (the “2004 Repurchase Program”).  Under the 2004 Repurchase Program the Companymay acquire up to $3,000,000 of its outstanding common stock for a six-monthperiod from July 1, 2004 to December 31, 2004. Purchases may be made from time to time in the open market, blockpurchases or privately negotiated transactions, depending on market conditions,share price and other factors.

 

**Item 6****.  Exhibits**

 

(a)           *Exhibits*.

 

Theexhibits listed below are hereby filed with the U.S. Securities and ExchangeCommission as part of this Report.

 
| **Exhibit Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                       |
|--------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1               |       | Strategic Alliance  Agreement between SRS Labs, Inc. and Coming Home Studios, LLC dated September  23, 2004, previously filed with the Securities and Exchange Commission (the  “Commission”) on September 28, 2004 as Exhibit 10.1 to the Company’s Current  Report on Form 8-K dated September 23, 2004, which is incorporated herein by  reference. |
| ** **         | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                            |
| 10.2               |       | CHS/SRS, LLC Operating  Agreement between SRS Labs, Inc. and Coming Home Studios, LLC dated September  23, 2004, previously filed with the Commission on September 28, 2004 as  Exhibit 10.2 to the Company’s Current Report on Form 8-K dated September 23,  2004, which is incorporated herein by reference.                                                   |
| ** **         | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                            |
| 10.3               |       | Warrant Agreement** **between SRS Labs, Inc. and Coming Home  Studios, LLC dated September 23, 2004, previously filed with the Commission  on September 28, 2004 as Exhibit 10.3 to the Company’s Current Report on Form  8-K dated September 23, 2004, which is incorporated herein by reference.                                                          |
| ** **         | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                            |
| 10.4               |       | Production Services  Agreement between CHS/SRS, LLC and Coming Home Studios, LLC dated September  23, 2004, previously filed with the Commission on September 28, 2004 as  Exhibit 10.4 to the Company’s Current Report on Form 8-K dated September 23,  2004, which is incorporated herein by reference.                                                        |

 

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| 31.1   |   | Certification  of Chief Executive Officer of SRS Labs, Inc., pursuant to Rule 13a-14 of the  Securities Exchange Act.         |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                          |
| 31.2   |   | Certification  of Chief Financial Officer of SRS Labs, Inc., pursuant to Rule 13a-14 of the  Securities Exchange Act.         |
|   |   |                                                                                                                          |
| 32.1   |   | Certification  of Chief Executive Officer of SRS Labs, Inc., pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002. |
|   |   |                                                                                                                          |
| 32.2   |   | Certification  of Chief Financial Officer of SRS Labs, Inc., pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002. |

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this Quarterly Report on Form 10-Q/A to be signed on its behalf bythe undersigned thereunto duly authorized.

 
|                                | SRS LABS, INC., a  Delaware corporation |
|-------------------------------------|----------------------------------------------|
|                                |                                         |   |
| Date:  May 17,  2005      | By:                                     | /s/ THOMAS C.K.  YUEN |
|                                |                                         | Thomas  C.K. Yuen |
|                                |                                         | Chairman of the Board  and Chief Executive Officer |
|                                |                                         | (Principal Executive  Officer) |
| ** **                          | ** **                                   | ** ** |
| ** **                          | ** **                                   | ** ** |
| Date:  May 17,  2005 | By:                                     | /s/ JANET M.  BISKI |
|                                |                                         | Janet  M. Biski |
|                                |                                         | Chief Financial Officer |
|                                |                                         | (Principal Financial  and Accounting Officer) |

 

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