** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM10-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 June 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  its charter)                             |
|                                                                                |
| **Delaware**                                                                        | ** ** | **33-0714264** |
| (State or other jurisdiction of  incorporation or organization)                     |   | (I.R.S. Employer  Identification No.) |
|                                                                                |
| **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) |

 

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Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  Yes ý  No o

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o  No ý

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date: as of July 19, 2004, 14,438,747shares of the issuer’s common stock, par value $.001 per share, wereoutstanding. In addition, as of July 19, 2004, 225,300 shares of theissuer’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 ofBDO Seidman, the Company has restated its financial statements for thequarterly periods ended 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.  The restatement of our quarterly reports forfiscal 2004 has no impact on the Company’s consolidated net income for fiscal2004 and does not affect the Company’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 amendedits Annual Report on Form 10-K for fiscal 2004 to restate the disclosures of previouslyreported unaudited quarterly results as a result of the change of accountingtreatment for trade show expenses.

 

                In addition, in the course ofBDO Seidman’s financial statement review procedures relating to the Company’sQuarterly Report on Form 10-Q for the first quarter of fiscal 2005, BDO Seidmanadvised the Company that the Company’s decision to capitalize and amortizetradeshow expenses during fiscal 2004 constituted a deficiency in the Company’sinternal controls and advised the Audit Committee that this internal controldeficiency constitutes a reportable condition and a material weakness asdefined in Statement on Auditing Standards No. 60. As a result of this internalcontrol deficiency, 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.

 

                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, noother item included in the original Form 10-Q has been amended, and such itemsshall remain in effect as of the filing date of the original Form 10-Q.Additionally, this Form 10-Q/A does not purport to provide an update ordiscussion of any other developments at the Company subsequent to its originalfiling.

 

2

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**SRS LABS, INC.**

 

**Form 10-Q**

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

 

**Index**

 
| **PART  I—FINANCIAL INFORMATION** |                                                                                                                                              |
|----------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------|
| Item 1.                           | Financial Statements                                                                                                                              |   |
|                                   | Condensed  Consolidated Balance Sheets as of June 30, 2004 (Unaudited) and  December 31, 2003                                           |   |
|                                   | Condensed  Consolidated Statements of Operations for the three months and six months  ended June 30, 2004 and 2003 (Unaudited)               |   |
|                                   | Condensed  Consolidated Statements of Stockholders’ Equity and Comprehensive Income for  the six months ended June 30, 2004 (Unaudited) |   |
|                                   | Condensed  Consolidated Statements of Cash Flows for the six months ended June 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 4                                 | Submission of Matters to a  Vote of Security Holders                                                                                              |   |
| Item 6.                           | Exhibits and Reports on  Form 8-K                                                                                                            |   |
|                                   |                                                                                                                                              |   |
| SIGNATURES                             |                                                                                                                                              |
| CERTIFICATIONS                         |                                                                                                                                              |

 

3

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**FORWARD-LOOKING INFORMATION**

 

ThisQuarterly Report on Form 10-Q contains forward-looking statements withinthe meaning of Section 21E of the Securities Exchange Act of 1934, asamended, and Section 27A of the Securities Act of 1933, as amended,reflecting 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.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                  | ** ** | **June 30, 2004**          | ** ** | **December 31, 2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                                                                  | ** ** | **(Unaudited)**

**(Restated)** | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                                                                                                  |       |                            |       |                       |       |
| **Current Assets**                                                                                                                                                                                                          |       |                            |       |                       |       |
| Cash and cash equivalents                                                                                                                                                                                                   |       | $                               | 21,297,168 |                       | $          | 12,795,620 |   |
| Accounts receivable, net                                                                                                                                                                                                    |       | 1,302,283                       |       | 1,230,423                  |       |
| Inventories, net                                                                                                                                                                                                            |       | 783,990                         |       | 753,020                    |       |
| Prepaid expenses and other current assets                                                                                                                                                                                   |       | 1,141,638                       |       | 1,073,696                  |       |
| Deferred income taxes                                                                                                                                                                                                       |       | 23,406                          |       | 23,406                     |       |
|                                                                                                                                                                                                                        |       |                            |       |                       |       |
| **Total Current Assets**                                                                                                                                                                                                    |       | 24,548,485                      |       | 15,876,165                 |       |
|                                                                                                                                                                                                                        |       |                            |       |                       |       |
| Investments available for sale                                                                                                                                                                                              |       | 5,148,343                       |       | 10,490,210                 |       |
| Furniture, fixtures and equipment, net                                                                                                                                                                                 |       | 1,853,928                       |       | 1,661,980                  |       |
| Goodwill                                                                                                                                                                                                                    |       | 533,031                         |       | 533,031                    |       |
| Intangible assets, net                                                                                                                                                                                                      |       | 2,736,651                       |       | 2,736,810                  |       |
| Deferred income taxes                                                                                                                                                                                                       |       | 213,262                         |       | 193,134                    |       |
|                                                                                                                                                                                                                        |       |                            |       |                       |       |
| **Total Assets**                                                                                                                                                                                                            |       | $                               | 35,033,700 |                       | $          | 31,491,330 |   |
|                                                                                                                                                                                                                        |       |                            |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                                              |       |                            |       |                       |       |
| **Current Liabilities**                                                                                                                                                                                                     |       |                            |       |                       |       |
| Accounts payable                                                                                                                                                                                                            |       | $                               | 1,387,929  |                       | $          | 1,503,851 |   |
| Accrued liabilities                                                                                                                                                                                                         |       | 1,873,690                       |       | 1,606,069                  |       |
| Income taxes payable                                                                                                                                                                                                        |       | 688,130                         |       | 430,949                    |       |
|                                                                                                                                                                                                                        |       |                            |       |                       |       |
| **Total Current Liabilities**                                                                                                                                                                                               |       | 3,949,749                       |       | 3,540,869                  |       |
|                                                                                                                                                                                                                        |       |                            |       |                       |       |
| Commitments and contingencies (Note 10)                                                                                                                                                                                     |       |                            |       |                       |       |
|                                                                                                                                                                                                                        |       |                            |       |                       |       |
| **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;  14,438,747 and 13,682,282 shares issued; and 14,213,447 and 13,456,982 shares  outstanding at June 30, 2004 and December 31, 2003, respectively |       | 14,439                          |       | 13,683                     |       |
| Additional paid-in capital                                                                                                                                                                                                  |       | 61,450,865                      |       | 58,423,249                 |       |
| Accumulated other comprehensive loss                                                                                                                                                                                        |       | (436,399                        | )          | (336,346                   | )          |
| Accumulated deficit                                                                                                                                                                                                         |       | (29,226,353                     | )          | (29,431,524                | )          |
| Treasury stock at cost, 225,300 shares at June 30, 2004 and  December 31, 2003                                                                                                                                    |       | (718,601                        | )          | (718,601                   | )          |
|                                                                                                                                                                                                                        |       |                            |       |                       |       |
| **Total Stockholders’ Equity**                                                                                                                                                                                         |       | 31,083,951                      |       | 27,950,461                 |       |
|                                                                                                                                                                                                                        |       |                            |       |                       |       |
| **Total Liabilities and Stockholders’ Equity**                                                                                                                                                                         |       | $                               | 35,033,700 |                       | $          | 31,491,330 |   |

 

See accompanying notes to the condensed interim consolidated financialstatements

 

5

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**SRS LABS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                       | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                                       | ** ** | **2004**               | ** ** | **2003**             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                       | ** ** | **(Restated)**         | ** ** | ** **           | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| Revenues:                                                                        |       |                   |       |                 |       |   |   |   |   |
| Semiconductor                                                                    |       | $                      | 2,932,495  |                 | $          | 2,513,320 |   | $ | 5,348,213 |   | $ | 4,277,400 |   |
| Licensing                                                                        |       | 2,485,404              |       | 2,012,526            |       | 5,412,731 |   | 4,718,820 |   |
| Total revenues                                                                   |       | 5,417,899              |       | 4,525,846            |       | 10,760,944 |   | 8,996,220 |   |
|                                                                             |       |                   |       |                 |       |   |   |   |   |
| Cost of sales                                                                    |       | 1,086,440              |       | 900,565              |       | 1,995,311 |   | 1,570,133 |   |
|                                                                             |       |                   |       |                 |       |   |   |   |   |
| Gross margin                                                                     |       | 4,331,459              |       | 3,625,281            |       | 8,765,633 |   | 7,426,087 |   |
|                                                                             |       |                   |       |                 |       |   |   |   |   |
| Operating expenses:                                                              |       |                   |       |                 |       |   |   |   |   |
| Sales and marketing                                                              |       | 1,260,067              |       | 1,271,097            |       | 2,955,435 |   | 2,623,587 |   |
| Research and development                                                         |       | 1,144,926              |       | 970,123              |       | 2,353,613 |   | 2,051,338 |   |
| General and administrative                                                       |       | 1,484,299              |       | 1,210,033            |       | 3,038,496 |   | 2,524,643 |   |
|                                                                             |       |                   |       |                 |       |   |   |   |   |
| Total operating expenses                                                         |       | 3,889,292              |       | 3,451,253            |       | 8,347,544 |   | 7,199,568 |   |
|                                                                             |       |                   |       |                 |       |   |   |   |   |
| Income from operations                                                           |       | 442,167                |       | 174,028              |       | 418,089 |   | 226,519 |   |
|                                                                             |       |                   |       |                 |       |   |   |   |   |
| Other income, net                                                                |       | 98,774                 |       | 118,604              |       | 336,224 |   | 282,730 |   |
| Minority interest                                                                |       | —                 |       | —               |       | — |   | 5,430 |   |
|                                                                             |       |                   |       |                 |       |   |   |   |   |
| Income before income tax expense                                                 |       | 540,941                |       | 292,632              |       | 754,313 |   | 514,679 |   |
|                                                                             |       |                   |       |                 |       |   |   |   |   |
| Income tax expense                                                               |       | 311,239                |       | 326,514              |       | 549,142 |   | 506,027 |   |
|                                                                             |       |                   |       |                 |       |   |   |   |   |
| Net income (loss)                                                                |       | $                      | 229,702    |                 | $          | (33,882 | ) | $ | 205,171 |   | $ | 8,652 |   |
|                                                                             |       |                   |       |                 |       |   |   |   |   |
| Net income per common share:                                                     |       |                   |       |                 |       |   |   |   |   |
|                                                                             |       |                   |       |                 |       |   |   |   |   |
| Basic                                                                            |       | $                      | 0.02       |                 | $          | 0.00 |   | $ | 0.01 |   | $ | 0.00 |   |
|                                                                             |       |                   |       |                 |       |   |   |   |   |
| Diluted                                                                          |       | $                      | 0.01       |                 | $          | 0.00 |   | $ | 0.01 |   | $ | 0.00 |   |
|                                                                             |       |                   |       |                 |       |   |   |   |   |
| Weighted average shares used in the calculation of net income per  common share: |       |                   |       |                 |       |   |   |   |   |
| Basic                                                                            |       | 14,175,127             |       | 12,993,305           |       | 13,960,824 |   | 12,896,338 |   |
|                                                                             |       |                   |       |                 |       |   |   |   |   |
| Diluted                                                                          |       | 15,348,428             |       | 12,993,305           |       | 16,267,317 |   | 13,142,519 |   |

 

 See accompanying notes to thecondensed interim consolidated financial statements

 

6

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**SRS LABS, INC.**

### **CONDENSED CONSOLIDATEDSTATEMENTS OF 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 |   |

 

See accompanying notes to the condensed interim consolidated financialstatements

 

7

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**SRS LABS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                         | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                         | ** ** | **June 30,**    | ** ** |
| ** **                                                                         | ** ** | **2004**             | ** ** | **2003** | ** ** |
| ** **                                                                         | ** ** | **(Restated)**       | ** ** | ** ** | ** ** |
| **Cash Flows From Operating Activities:**                                          |       |                 |       |   |   |
| Net income                                                                         |       | $                    | 205,171    |   | $ | 8,652 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                 |       |   |   |
| Depreciation and amortization                                                      |       | 622,288              |       | 561,519 |   |
| Minority interest                                                                  |       | —               |       | (5,430 | ) |
| Provision (Benefit) for doubtful accounts                                          |       | 84,564               |       | (3,894 | ) |
| (Benefit) Provision for obsolete inventory                                         |       | (57,451              | )          | 17,541 |   |
| Deferred taxes                                                                     |       | (20,128              | )          | (10,769 | ) |
| Amortization of premium on investments available for sale                          |       | 6,188                |       | — |   |
| Increase in deferred stock option compensation                                     |       | 40,201               |       | 36,472 |   |
| Loss on disposition of furniture, fixtures and equipment                           |       | 31                   |       | — |   |
| Impairment on intangible assets                                                    |       | 3,431                |       | — |   |
| Changes in operating assets and liabilities:                                       |       |                 |       |   |   |
| Accounts receivable                                                                |       | (156,424             | )          | 147,834 |   |
| Inventories                                                                        |       | 26,481               |       | (82,953 | ) |
| Prepaid expenses and other current assets                                          |       | (67,942              | )          | 35,782 |   |
| Accounts payable                                                                   |       | (115,922             | )          | (8,978 | ) |
| Accrued liabilities                                                                |       | 267,620              |       | (590,213 | ) |
| Income taxes payable                                                               |       | 257,181              |       | 109,199 |   |
|                                                                               |       |                 |       |   |   |
| Net cash provided by operating activities                                          |       | 1,095,289            |       | 214,762 |   |
|                                                                               |       |                 |       |   |   |
| **Cash Flows From Investing Activities:**                                          |       |                 |       |   |   |
| Purchase of furniture, fixtures and equipment                                      |       | (569,688             | )          | (212,932 | ) |
| Purchase of investments available for sale                                         |       | —               |       | (15,754,116 | ) |
| Proceeds from sale of investments available for sale                               |       | 5,235,626            |       | 16,862,523 |   |
| Expenditures related to patents and intangible assets                              |       | (247,850             | )          | (95,807 | ) |
|                                                                               |       |                 |       |   |   |
| Net cash provided by investing activities                                          |       | 4,418,088            |       | 799,668 |   |
|                                                                               |       |                 |       |   |   |
| **Cash Flows From Financing Activities:**                                          |       |                 |       |   |   |
| Proceeds from exercise of stock options                                            |       | 2,988,171            |       | 52,146 |   |
|                                                                               |       |                 |       |   |   |
| Net cash provided by financing activities                                          |       | 2,988,171            |       | 52,146 |   |
|                                                                               |       |                 |       |   |   |
| **Net Increase in Cash and Cash Equivalents**                                      |       | 8,501,548            |       | 1,066,576 |   |
| **Cash and Cash Equivalents, Beginning of Period**                                 |       | 12,795,620           |       | 15,720,860 |   |
|                                                                               |       |                 |       |   |   |
| **Cash and Cash Equivalents, End of Period**                                       |       | $                    | 21,297,168 |   | $ | 16,787,436 |   |
|                                                                               |       |                 |       |   |   |
| **Supplemental Disclosures of Cash Flow  Information:**                            |       |                 |       |   |   |
| Cash paid during the period for:                                                   |       |                 |       |   |   |
| Income taxes                                                                       |       | $                    | 360,741    |   | $ | 379,581 |   |
| **Supplemental Disclosure of Non-Cash Investing  and Financing Activities:**       |       |                 |       |   |   |
| Unrealized loss on investments, net                                                |       | $                    | (100,053   | ) | $ | (92,818 | ) |
| Issuance of Common stock for minority interest                                     |       | $                    | —     |   | $ | 960,012 |   |

 

See accompanying notes to the condensed interim consolidated financialstatements

 

8

----

 

**NOTES****TO THECONDENSED INTERIM CONSOLIDATED FINANCIAL STATEMENTS (Unaudited****)**

**June 30, 2004**

 

**1.****                                     ****General/Basis of Presentation**

 

SRSLabs is a leading developer and provider of application specific integratedcircuits (“ASICs”), standard integrated circuits (“ICs”) and audio and voicetechnology solutions for the home theater, portable audio, wireless, computer,game, automotive, broadcast, Internet and telecommunications markets.  The Company operates in the following twobusiness segments:

 

*Semiconductor:*  Through SRS Labs,Inc.’s wholly-owned subsidiary, ValenceTech Limited, and ValenceTech Limited’swholly-owned subsidiaries (collectively “Valence”), the semiconductor segmentdevelops, designs and markets standard and custom, application specifictechnology 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**:***  ThroughSRS Labs, the parent company, and its wholly-owned subsidiary, SRSWOWcast.com,Inc., doing business as SRSWOWcast Technologies (“SRSWOWcast”), the licensingsegment develops and licenses audio and voice technology solutions to many ofthe world’s leading OEMs, software providers and semiconductor companies, andlicenses and markets hardware and software products for the Internet andprofessional audio markets.

 

Asused herein, the “Company,” “SRS Labs,” “we,” “us,” or “our”means SRS Labs, Inc. and its wholly-owned subsidiaries, including Valence andSRSWOWcast.

 

Theaccompanying condensed interim consolidated financial statements have beenprepared by the Company without audit in conformity with accounting principlesgenerally accepted in the United States of America (“generally acceptedaccounting principles”) for interim financial information and the rules andregulations of the U.S. Securities and Exchange Commission (“SEC”). In theopinion of management, all adjustments (which include only normal recurringadjustments) considered necessary for a fair presentation have been included.The Company previously reported five business segments  (see Note 11). Certain accounts have beenreclassified from that previously reported to conform to the current periodpresentation.

 

Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles have beencondensed or omitted pursuant to SEC rules and regulations for presentation ofinterim financial information. Therefore, the condensed interim consolidatedfinancial statements should be read in conjunction with the Company’s AnnualReport on Form 10-K for the fiscal year ended December 31, 2003.Current and future financial statements may not be directly comparable to theCompany’s historical financial statements. The results of operations for theinterim periods are not necessarily indicative of the results to be expectedfor the full year.

 

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

 

On May 13, 2005, the Companyfiled a Current Report on Form 8-K announcing that an error had been identifiedrelating to accounting for sales and marketing expenses related to tradeshows.  This conclusion was reached in connection with BDO Seidman, LLP’s,the Company’s independent registered public accounting firm (“BDO Seidman”),financial statement review procedures relating to the Company’s QuarterlyReport on Form 10-Q for the first quarter of the year ending December 31, 2005(“fiscal 2005”).

 

The accounting issue relatesto an interpretation of Accounting Principles Board Opinion No. 28 (“APB 28”), “InterimFinancial Reporting.” Commencing in the first quarter of fiscal 2004, theCompany began to capitalize and amortize trade show expenses incurred in thefiscal year to reflect the future economic benefits received during such fiscalyear.  Management discussed the issuewith the Audit Committee of the Company’s Board of Directors and BDO Seidmanand was of the view that capitalization and amortization of trade show expenseswas allowable.  As part of its review ofthe unaudited quarterly financial statements for the first quarter of fiscal2005, BDO Seidman noted that trade show costs previously capitalized andamortized should have been treated as period expenses in the fiscal year endedDecember 31, 2004 (“fiscal 2004”).  As a result, BDO Seidman expressed itsview that (a) trade show costs previously capitalized and amortized duringfiscal 2004 should have been treated as period expenses in fiscal 2004; (b)each of the Company’s quarterly reports previously filed in fiscal 2004 shouldbe restated; and (c) no reliance should be placed on the previously issuedfiscal 2004 quarterly financial statements.

 

9

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Acting on the recommendationof BDO Seidman, management of the Company determined that the previously issuedfinancial statements contained in the Quarterly Reports on Form 10-Q for thequarters ended March 31, 2004, June 30, 2004 and September 30, 2004 should berestated to correct errors in those financial statements.  Consequently, the condensed consolidatedfinancial statements for the second quarter of 2004 are restated in this Form10-Q/A.  These restated condensed consolidated financial statementsreflect an adjustment to account for trade show expenses as periodexpenses.  The adjustment results in an$18,391 and $177,851 increase in sales and marketing expense for the three andsix months ended June 2004, respectively.  The restatement has no impact on the Company’s consolidated net incomefor fiscal 2004 and does not affect the Company’s historical cash flow.

 

The principal effects ofthis adjustment on the accompanying condensed consolidated financial statementsis as follows:

 
| ** **                                      | ** ** | **Condensed Consolidated Balance Sheet**

**June 30, 2004** | ** ** |
|-------------------------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                                      | ** ** | **As restated**                                                  | ** ** | **As previously**

**reported** | ** ** |
|                                            |       |                                                             |       |   |   |
| Prepaid expenses and other current assets       |       | $                                                                | 1,141,638  |   | $ | 1,319,489 |   |
| Total Current Assets                            |       | 24,548,485                                                       |       | 24,726,336 |   |
| Total Assets                                    |       | 35,033,700                                                       |       | 35,211,551 |   |
|                                            |       |                                                             |       |   |   |
| Accumulated deficit                             |       | (29,226,353                                                      | )          | (29,048,502 | ) |
| Total Stockholders’ Equity                 |       | 31,083,951                                                       |       | 31,261,802 |   |
| Total Liabilities and Stockholders’ Equity |       | $                                                                | 35,033,700 |   | $ | 35,211,551 |   |

 

 
| ** **                               | ** ** | **Condensed Consolidated Statement of Operations for the three months  ended**

**June 30, 2004** | ** ** | **Condensed Consolidated Statement of Operations for the six months  ended**

**June 30, 2004** | ** ** |
|------------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **As restated**                                                                                   | ** ** | **As**

**previously**

**reported**                                                            | ** ** | **As restated** | ** ** | **As**

**previously**

**reported** | ** ** |
|                                     |       |                                                                                              |       |                                                                                            |       |   |   |   |   |
| Increase in sales and marketing expenses |       | $                                                                                                 | 18,391     |                                                                                            | $          | — |   | $ | 177,851 |   | $ | — |   |
| Total operating expenses                 |       | 3,889,292                                                                                         |       | 3,870,901                                                                                       |       | 8,347,544 |   | 8,169,693 |   |
| Income from operations                   |       | 442,167                                                                                           |       | 460,558                                                                                         |       | 418,089 |   | 595,940 |   |
| Income before income tax expense         |       | 540,941                                                                                           |       | 559,332                                                                                         |       | 754,313 |   | 932,164 |   |
| Net income                               |       | 229,702                                                                                           |       | 248,093                                                                                         |       | 205,171 |   | 383,022 |   |
| Net income per common share:             |       |                                                                                              |       |                                                                                            |       |   |   |   |   |
|                                     |       |                                                                                              |       |                                                                                            |       |   |   |   |   |
| Basic                                    |       | $                                                                                                 | 0.02       |                                                                                            | $          | 0.02 |   | $ | 0.01 |   | $ | 0.03 |   |
|                                     |       |                                                                                              |       |                                                                                            |       |   |   |   |   |
| Diluted                                  |       | $                                                                                                 | 0.01       |                                                                                            | $          | 0.02 |   | $ | 0.01 |   | $ | 0.02 |   |

 

 

**3.             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. The establishment of technological feasibility and ongoingassessment of recoverability of capitalized software development costs requireconsiderable judgment by management with respect to certain external factors,including, but not limited to, anticipated future revenues, estimated economiclife and changes in software and hardware technologies. Upon the generalrelease of the software product to customers, capitalization ceases and suchcosts 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

 

10

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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.

 

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

 
| ** **                | ** ** | **June 30,**

**2004** | ** ** | **December 31,**

**2003** | ** ** |
|---------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| Capitalized software      |       | $                           | 464,015    |                            | $          | 342,760 |   |
| Accumulated amortization  |       | (139,046                    | )          | (96,401                         | )          |
| Capitalized software, net |       | $                           | 324,969    |                            | $          | 246,359 |   |

 

TheCompany’s weighted average amortization period for capitalized software isapproximately 5 years. The following table shows the estimatedamortization expense for those assets for the current year and each of the foursucceeding fiscal years.

 
| **Year ending December 31,** | ** ** | **Estimated**

**Expense** | ** ** |
|-----------------------------------|------------|----------------------------|------------|
| 2004                              |       | $                          | 90,913     |   |
| 2005                              |       | 94,419                     |       |
| 2006                              |       | 83,376                     |       |
| 2007                              |       | 39,338                     |       |
| 2008                              |       | 14,522                     |       |
| Thereafter                        |       | 2,401                      |       |
|                                   |            |                            |            |  |

 

**4.             Goodwilland Intangible Assets**

 

OnFebruary 28, 2003, the Company completed an exchange offer with theminority shareholders of SRSWOWcast, pursuant to which SRS Labs acquiredall 3,000,000 shares of Series A Convertible Preferred Stock in exchangefor the issuance of 332,184 shares of SRS Labs common stock trading at$2.89 per share at the close of day on the transaction date. The acquisitionresulted in a purchase price of $960,012.

 

SRSWOWcastdevelops and markets professional software and hardware products and consumersoftware plugins that incorporate proprietary audio enhancement and voice andsurround sound technologies. SRS Labs, as the majority shareholder, hasconsistently included the results of SRSWOWcast in all of the previouslyreported consolidated financial statements. The acquisition to acquire all ofthe outstanding common stock of SRSWOWcast was a strategic initiative, which webelieve will allow us to better deploy and market the Circle Surroundtechnology and compete with other competitors. SRSWOWcast holds an exclusive license to use the Circle Surroundtechnology.

 

Thefollowing table summarizes the stated values of the assets acquired andliabilities 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 |   |

 

Currentassets primarily consisted of cash, accounts receivable and prepaid expensesand current liabilities were valued at stated value. Property and equipment wasvalued at net book value. The $640,071 of acquired intangible assets wasassigned to a license agreement between SRS Labs, Inc and SRSWOWcast,which is being amortized over 10 years.

 

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.Identifiable intangible assets are amortized over a determinable useful life.

 

11

----

 

Inaccordance with SFAS No. 142, all of the Company’s intangible assets thathave definite lives are being amortized on a straight-line basis over theirestimated useful lives and goodwill is evaluated to determine if fair value ofthe asset has decreased below its carrying value. At December 31, 2003,the Company evaluated goodwill and determined that no adjustment to impairgoodwill was necessary.

 

Goodwilland intangible assets consist of the following:

 
| ** **                                                                       | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                       | ** ** | **2004**          | ** ** | **2003**              | ** ** |
| Goodwill                                                                         |       | $                 | 533,031    |                  | $          | 533,031 |   |
| Patents                                                                          |       | 1,881,168         |       | 1,760,236             |       |
| Accumulated amortization                                                         |       | (804,536          | )          | (739,792              | )          |
| Patents, net                                                                     |       | 1,076,632         |       | 1,020,444             |       |
| Other intangibles                                                                |       | 6,014,485         |       | 5,893,229             |       |
| Accumulated amortization                                                         |       | (4,354,466        | )          | (4,176,863            | )          |
| Other intangibles, net (including software development costs — see  note 2) |       | 1,660,019         |       | 1,716,366             |       |
| Goodwill and intangible assets, net                                              |       | $                 | 3,269,682  |                  | $          | 3,269,841 |   |

 

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

 
| ** **                 | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|----------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                 | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                 | ** ** | **2004**               | ** ** | **2003**             | ** ** | **2004** | ** ** | **2003** | ** ** |
|                       |       |                   |       |                 |       |   |   |   |   |
| Patents                    |       | $                      | 23,929     |                 | $          | 35,913 |   | $ | 64,744 |   | $ | 70,926 |   |
| Other intangibles          |       | 95,144                 |       | 57,477               |       | 177,603 |   | 122,928 |   |
| Total amortization expense |       | $                      | 119,073    |                 | $          | 93,390 |   | $ | 242,347 |   | $ | 193,854 |   |

 

TheCompany’s weighted average amortization period for patents and otherintangibles is approximately 10 years. The following table shows theestimated amortization expense for those assets for the current year and eachof the four succeeding fiscal years:

 

| **Year ending**

**December 31,** | ** ** | **Estimated expense** | ** ** |
|----------------------------------------|------------|-----------------------|------------|
|                                   |       |                  |       |
| 2004                                   |       | $                     | 558,037    |   |
| 2005                                   |       | $                     | 558,683    |   |
| 2006                                   |       | $                     | 540,112    |   |
| 2007                                   |       | $                     | 409,439    |   |
| 2008                                   |       | $                     | 156,604    |   |

 

**5.**             **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’s investmentsecurities available for sale:

 

| ** **           | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|----------------------|------------|-------------------|------------|-----------------------|------------|
| ** **           | ** ** | **2004**          | ** ** | **2003**              | ** ** |
|                 |       |              |       |                  |       |
| Cost                 |       | $                 | 5,503,440  |                  | $          | 10,745,254 |   |
| Unrealized loss      |       | (355,097          | )          | (255,044              | )          |
| Estimated fair value |       | $                 | 5,148,343  |                  | $          | 10,490,210 |   |

 

12

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

 

| ** **                                     | ** ** | **June 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                       |       | $                      | 5,503,440  |                       | $          | 5,148,343 |   | $ | 10,745,254 |   | $ | 10,490,210 |   |
|                                                |            |                        |            |                            |            |  |  |  |  |  |  |  |  |

 

Thefollowing table summarizes sales of available for sale securities for the threemonths and six months ended June 30, 2004 and 2003. Specific identificationwas used to determine costs in computing realized gains or losses.

 

| ** **         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------|------------|------------------------|------------|----------------------|------------|
| ** **         | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **         | ** ** | **2004**               | ** ** | **2003**             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Proceeds from sale |       | $                      | —     |                 | $          | 8,317,410 |   | $ | 5,235,626 |   | $ | 16,862,523 |   |
| Realized gains     |       | —                 |       | 2,550                |       | 139,375 |   | 33,836 |   |
|                    |            |                        |            |                      |            |  |  |  |  |  |  |  |  |

 

**6.**             **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 is determinedby comparison with recent purchases or net realizable value. Net realizablevalue is based on forecasts for sales of the Company’s products in the ensuingyears. Should demand for the Company’s products prove to be significantly lessthan anticipated, the ultimate realizable value of the Company’s inventoriescould be substantially less than the amount shown on the accompanyingconsolidated balance sheets.

 

**7.**             **Minority Interest**

 

Minorityinterest in consolidated subsidiary represents the minority stockholders’proportionate share of the equity of SRSWOWcast, which was approximately 13%at December 31, 2002. In February 2003, SRS Labs completedan exchange offer with the minority shareholders of SRSWOWcast, pursuant towhich SRS Labs acquired all 3,000,000 outstanding shares of Series AConvertible Preferred Stock in exchange for the issuance of 332,184 shares ofSRS Labs common stock.  As a result ofthe exchange offer, SRSWOWcast became a wholly-owned subsidiary of SRSLabs.  An intangible asset in the amountof $640,071 was recorded representing the prior “minority interest” portion ofthe Circle Surround license agreement held by SRSWOWcast.  The proforma effect of thetransaction, as if it had occurred at the beginning of the quarter endedMarch 31, 2003, would have been immaterial.

 

**8.**             **Net Income Per CommonShare**

 

TheCompany applies SFAS No. 128, “Earnings per Share,” which requires thedisclosure of basic and diluted net income or loss per share for all currentand prior periods. Basic net income or loss per common share is computed bydividing net income or loss available to common stockholders by the weightedaverage number of common shares outstanding during each year. Diluted netincome or loss per common share reflects the maximum dilution, based on theaverage price of the Company’s common stock each period, and is computedsimilar to basic income or loss per share except that the denominator isincreased to include the number of additional shares that would have beenoutstanding if potentially dilutive stock options and warrants had beenexercised.

 

13

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Basicand diluted net income per share computed in accordance with SFAS 128 forthe three months and six months ended June 30, 2004 are as follows:

 
| ** **                                              | ** ** | **For the three months** | ** ** | **For the six months**  | ** ** |
|---------------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                                              | ** ** | **ended June 30,**  | ** ** | **Ended June 30,** | ** ** |
| ** **                                              | ** ** | **2004**                 | ** ** | **2003**                | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                              | ** ** | **(Restated)**           | ** ** | ** **              | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| BASIC EPS                                               |       |                     |       |                    |       |   |   |   |   |
| Net income (loss)                                       |       | $                        | 229,702    |                    | $          | (33,882 | ) | $ | 205,171 |   | $ | 8,652 |   |
| Denominator: weighted average common shares outstanding |       | 14,175,127               |       | 12,993,305              |       | 13,960,824 |   | 12,896,338 |   |
| Net income per share—basic                         |       | $                        | 0.02       |                    | $          | 0.00 |   | $ | 0.01 |   | $ | 0.00 |   |
| DILUTED EPS                                             |       |                     |       |                    |       |   |   |   |   |
| Net income (loss)                                       |       | $                        | 229,702    |                    | $          | (33,882 | ) | $ | 205,171 |   | $ | 8,652 |   |
| Denominator: weighted average common shares outstanding |       | 14,175,127               |       | 12,993,305              |       | 13,960,824 |   | 12,896,338 |   |
| Common equivalent shares outstanding:                   |       |                     |       |                    |       |   |   |   |   |
|                                                    |       |                     |       |                    |       |   |   |   |   |
| Options                                                 |       | 1,173,301                |       | —                  |       | 2,306,493 |   | 246,181 |   |
| Total diluted shares                                    |       | 15,348,428               |       | 12,993,305              |       | 16,267,317 |   | 13,142,519 |   |
| Net income per share—diluted                       |       | $                        | 0.01       |                    | $          | 0.00 |   | $ | 0.01 |   | $ | 0.00 |   |
|                                                         |            |                          |            |                         |            |  |  |  |  |  |  |  |  |  |

 

Therewere 1,672,625 and 3,921,531 potentially dilutive options outstanding for thequarters ending June 30, 2004 and 2003, respectively and there were260,000 and 4,058,712 potentially dilutive options outstanding for the sixmonths ending June 30, 2004 and 2003, respectively, that were not includedin the table above because they would be anti-dilutive.

 

**9.**             **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 compensationcost for the Company’s stock option plan been determined based on the fairvalue at the grant date for awards for the three months ended June 30,2004 and 2003, consistent with the provisions of SFAS No. 123, the Company’snet income and earnings per share would have been decreased to the pro formaamounts indicated below:

 
| ** **                                                                                         | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                                                                         | ** ** | **June 30,**              | ** ** | **June 30****,**        | ** ** |
| ** **                                                                                         | ** ** | **2004**                       | ** ** | **2003**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                         | ** ** | **(Restated)**                 | ** ** | ** **                   | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| Net income (loss) (attributable to common shareholder) — as reported                          |       | $                              | 229,702    |                         | $          | (33,882 | ) | $ | 205,171 |   | $ | 8,652 |   |
| Add: stock based employee compensation expense included in reported  net income, net of tax effect |       | 15,715                         |       | 18,236                       |       | 23,875 |   | 36,472 |   |
| Less fair value of stock-based employee compensation expense                                       |       | (441,215                       | )          | (593,085                     | )          | (834,883 | ) | (1,107,950 | ) |
| Net loss (attributable to common shareholder) - pro forma                                          |       | $                              | (195,798   | )                            | $          | (608,731 | ) | $ | (605,837 | ) | $ | (1,062,826 | ) |
| Net income (loss) per share:                                                                       |       |                           |       |                         |       |   |   |   |   |
| Basic, as reported                                                                                 |       | $                              | 0.02       |                         | $          | 0.00 |   | $ | 0.01 |   | $ | 0.00 |   |
| Basic, pro forma                                                                                   |       | $                              | (0.01      | )                            | $          | (0.05 | ) | $ | (0.04 | ) | $ | (0.08 | ) |
| Diluted, as reported                                                                               |       | $                              | 0.01       |                         | $          | 0.00 |   | $ | 0.01 |   | $ | 0.00 |   |
| Diluted, pro forma                                                                                 |       | $                              | (0.01      | )                            | $          | (0.05 | ) | $ | (0.04 | ) | $ | (0.08 | ) |

 

Thefair value of each option grant was estimated on the date of grant using theBlack-Scholes option-pricing model with the following weighted averageassumptions used for grants during the quarter ended June 30, 2004:

 

14

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| Risk free interest rate |   | 3.6      | %      |
|-------------------------|--------|----------|--------|
| 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 be representativeof that to be expected in future years.

 

**10.**          **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 |   |

 

**11.**          **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 2004 RepurchaseProgram the company may acquire up to $3,000,000 of its outstanding commonstock for a six-month period from July 1, 2004 to December 31,2004.  Purchases may be made from time totime in the open market, block purchases or privately-negotiated transactions,depending on market conditions, share price and other factors.  All repurchased shares are reflected astreasury stock in the accompanying consolidated balance sheets.

 

**12.**          **SegmentInformation**

 

TheCompany operates two business segments —semiconductors and licensing.  In 2003, the Company reported its revenues inthe following five segments: licensing; semiconductors; component distribution;product sales; and Internet and broadcast. In 2004, the Company decided to reduce its segments because the revenueattributable to the discontinued segments were not material compared torevenues 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**

**Semiconductor** | ** ** | **SRS Labs**

**Licensing** | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|--------------------------------|------------|-----------------------------|------------|-----------|------------|
| **Three Months Ended June 30, 2004** |       |                           |       |                        |       |      |       |
| Total revenues                            |       | $                              | 2,932,495  |                        | $          | 2,485,404 |       | $ | 5,417,899 |   |
| Cost of sales                             |       | 1,066,033                      |       | 20,407                      |       | 1,086,440 |       |
|                                      |       |                           |       |                        |       |      |       |
| Gross margin                              |       | $                              | 1,866,462  |                        | $          | 2,464,997 |       | $ | 4,331,459 |   |
|                                      |       |                           |       |                        |       |      |       |
| **Three Months Ended June 30, 2003** |       |                           |       |                        |       |      |       |
| Total revenues                            |       | $                              | 2,513,320  |                        | $          | 2,012,526 |       | $ | 4,525,846 |   |
| Cost of sales                             |       | 881,442                        |       | 19,123                      |       | 900,565   |       |
|                                      |       |                           |       |                        |       |      |       |
| Gross margin                              |       | $                              | 1,631,878  |                        | $          | 1,993,403 |       | $ | 3,625,281 |   |

 

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| ** **                              | ** ** | **Valence**

**Semiconductor** | ** ** | **SRS Labs**

**Licensing** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|--------------------------------|------------|-----------------------------|------------|-----------|------------|
| **Six Months Ended June 30, 2004** |       |                           |       |                        |       |      |       |
| Total revenues                          |       | $                              | 5,348,213  |                        | $          | 5,412,731 |       | $ | 10,760,944 |   |
| Cost of sales                           |       | 1,948,767                      |       | 46,544                      |       | 1,995,311 |       |
|                                    |       |                           |       |                        |       |      |       |
| Gross margin                            |       | $                              | 3,399,446  |                        | $          | 5,366,187 |       | $ | 8,765,633 |   |
|                                    |       |                           |       |                        |       |      |       |
| **Six Months Ended June 30, 2003** |       |                           |       |                        |       |      |       |
| Total revenues                          |       | $                              | 4,277,400  |                        | $          | 4,718,820 |       | $ | 8,996,220 |   |
| Cost of sales                           |       | 1,524,029                      |       | 46,104                      |       | 1,570,133 |       |
|                                    |       |                           |       |                        |       |      |       |
| Gross margin                            |       | $                              | 2,753,371  |                        | $          | 4,672,716 |       | $ | 7,426,087 |   |

 

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**

**June 30,** | ** ** | **Six Months Ended**

**June 30,** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                   | ** ** | **2004**                                  | ** ** | **2003**                                | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Geographic Area Revenue:** |       |                                      |       |                                    |       |   |   |   |   |
|                         |       |                                      |       |                                    |       |   |   |   |   |
| Asia Pacific                 |       | $                                         | 4,838,606  |                                    | $          | 4,357,278 |   | $ | 9,033,736 |   | $ | 8,323,965 |   |
| Americas                     |       | 526,359                                   |       | 49,169                                  |       | 1,311,971 |   | 521,266 |   |
| Europe                       |       | 52,934                                    |       | 119,399                                 |       | 415,237 |   | 150,989 |   |
| Total                        |       | $                                         | 5,417,899  |                                    | $          | 4,525,846 |   | $ | 10,760,944 |   | $ | 8,996,220 |   |

 

**13.**          **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 changes notedin SAB No. 104 did not have a material effect on the Company’s results ofoperations, 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.

 

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**Item 2****.  Management’s Discussion andAnalysis of Financial 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 tomany of the world’s leading OEMs, software providers and semiconductorcompanies, and licenses and markets hardware and software products for theInternet and professional 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 effective strategyfor the creation of stable and sustainable revenue growth is to diversify ourrevenue base.  In our licensing segment,our goal is to diversify our revenue base from our historical concentration inhome theater.  We believe that the mobilephone, portable audio, PC and automotive areas within the consumer electronicsmarket present new high volume, high growth opportunities for application ofour audio technologies.  Our diversificationstrategy also extends to our semiconductor segment in which we have refocusedour team away from the heavy concentration on custom application specificprojects for a few customers.  Inaddition, we are now also focused on marketing our standard branded chips,including new chips that embed SRS Labs’ technologies, with particularattention toward the large manufacturing market in China.

**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

 

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andmeasurement of current and deferred income tax assets and liabilities, whichimpacts our tax provision. Below, we discuss these policies further, as well asthe estimates and judgments involved. We also have other policies that weconsider key accounting policies, such as our policies for revenue recognition;however, these policies do not meet the definition of critical accountingestimates, because they do not generally require us to make estimates orjudgments that are difficult or subjective.

 

*Accounts Receivable*

 

Weperform ongoing credit evaluations of our customers and adjust credit limitsbased upon payment history, the customer’s current credit worthiness and variousother factors, as determined by our review of their current credit information.We continuously monitor collections and payments from our customers andmaintain allowances for doubtful accounts based upon specific customercircumstances, current economic trends, historical experience and the age ofpast due receivables. While such credit losses have historically been withinour expectations and the provisions established, we cannot guarantee that wewill continue to experience the same credit loss rates that we have in thepast. Unanticipated changes in the liquidity or financial position of ourcustomers may require additional provisions for doubtful accounts.

 

*Inventory*

 

Inventoryis stated at the lower of cost or net realizable value. We periodically assessour inventory for potential obsolescence and lower-of-cost-or-market issues. Wemake estimates of inventory obsolescence, providing reserves when necessary,based on, among other factors, demand for inventory based on backlog, productpricing, the ability to liquidate or sell older inventory and the impact ofintroducing new products. If actual market conditions or our customer’s productdemands are less favorable than those projected, additional provisions may berequired.

 

*Intangible Assets & Capitalization of Software*

 

Inaccordance with Statement of Financial Accounting Standards (“SFAS”)No. 142, “Goodwill and Other Intangible Assets,” we assess potentialimpairments to intangible assets when there is evidence that events or changesin circumstances indicate that the carrying amount of an asset may not berecovered. 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.

 

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,” we capitalize softwarepurchased from third parties if the related software product under developmenthas reached technological feasibility or if there are alternative future usesfor the purchased software, provided that capitalized amounts will be realizedover a period not exceeding five years. Costs incurred prior to theestablishment of technological feasibility are charged to research anddevelopment expense. The establishment of technological feasibility and ongoingassessment of recoverability of capitalized software development costs requireconsiderable judgment by management with respect to certain external factors,including, but not limited to, anticipated future revenues, estimated economiclife and changes in software and hardware technologies. Upon the generalrelease of the software product to customers, capitalization ceases and such costsare 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.

 

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*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 June 30, 2004 Compared toThree Months Ended June 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 voicetechnologies.  License and royaltyagreements generally provide for the license of technologies for a specifiedperiod of time for either a single fee or a fee based on the number of unitsdistributed by the licensee. Also included in licensing revenue are revenuesgenerated from the sale of hardware and software applications into thebroadcast audio markets.

Total revenues for the three months endedJune 30, 2004 were $5,417,899 compared to $4,525,846 for the three monthsended June 30, 2003, an increase of $892,053 or 19.7%.  Semiconductor revenues were $2,932,495 forthe three months ended June 30, 2004 compared to $2,513,320 for the threemonths ended June 30, 2003, an increase of $419,175 or 16.7%. Thisincrease was attributable to increased sales of ASP chips to the TV andportable audio markets.  Licensingrevenues were $2,485,404 for the three months ended June 30, 2004,compared to $2,012,526 for the three months ended June 30, 2003, anincrease of $472,878 or 23.5%.  The salesgrowth was attributable to the expanded use of our technologies in the PC andmobile phone markets.

*Gross Margin*

Costof sales consists primarily of fabrication costs, assembly and test costs, andthe cost of materials and overhead from operations. Gross margins are dependenton the mix of products sold, services provided and royalties earned. The grossmargin percentage for the three months ended June 30, 2004 decreased to79.9% as a percentage of total revenue as compared to 80.1% for the threemonths ended June 30, 2003.  Gross margins for the semiconductor businessfor the quarter ended June 30, 2004 were 63.6% compared to 64.9% for thesame period in 2003. Semiconductor revenues accounted for 54.1% of totalrevenues for the quarter ended June 30, 2004 compared to 55.5% for thesame period in 2003. Within semiconductors, the slight decrease in gross margincan be attributable to the mix of ASIC and ASP chips.  ASP chips have a gross margin ofapproximately 57% and accounted for 31% of revenues this year compared to 16%last year.  ASICs have a gross margin ofapproximately 67% and accounted for 69% of revenue as compared to 84% lastyear.  Gross margins for the licensingbusiness for the quarter ended June 30, 2004 were 99.2% compared to 99.0%for the same period in 2003. Licensing revenues accounted for 45.9% the quarterended June 30, 2004 compared to 44.5% for the same period in 2003.

 

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*Sales and Marketing*

 

Salesand marketing expenses consist primarily of employee salaries, salesconsultants’ fees and related expenses, sales commissions and product promotioncosts. Sales and marketing expenses were essentially unchanged at $1,260,067for the three months ended June 30, 2004 compared to $1,271,097 for thesame prior year period. As apercentage of total revenues, sales and marketing expenses decreased from 28.1%for the quarter ended June 30, 2003 to 23.3% for the same period thisyear.

 

*Research and Development*

 

Research and development expenses consist of salaries and related costsof employees engaged in ongoing research, design and development activities andcosts for engineering materials and supplies. Research and development expenseswere $1,144,926 for the three months ended June 30, 2004 compared to$970,123 for the same prior year period, an increase of $174,803 or 18.0%. Theincrease in research and development costs is primarily due to the addition ofresearch and development personnel added in the fourth quarter of 2003.  As a percentage of total revenues, researchand development expenses decreased from 21.4% for the quarter endedJune 30, 2003, to 21.1% for the same period this year.

 

*General and Administrative*

 

Generaland administrative (“G&A”) expenses consist primarily of employee-relatedexpenses, legal costs associated with the administration of intellectualproperty and other professional fees. G&A expenses were $1,484,299 for thethree months ended June 30, 2004 compared to $1,210,033 for the same prioryear period, an increase of $274,266 or 22.7%. The increase was primarilyattributable to increased professional fees and public company expenses.  As a percentage of total revenues, G&Aexpenses increased from 26.7% for the quarter ended June 30, 2003, to27.4% for the same period this year.  Weexpect that G&A will increase in absolute dollars in future periods as weintensify our effort on the SOX 404 project, but such expenses will fluctuateas a percentage of revenue due to changes in revenue.

 

*Income From Operations*

 

Income from operations increased by $268,140 to $442,168 for the quarterended June 30, 2004, as compared to $174,028 for the quarter endedJune 30, 2003.  The increase inincome from operations is due to an increase in revenue, partially offset by anincrease in operating expenses.

 

*Other Income, Net*

 

Other income, net, consists primarily of interest income, gain or(loss) on sale of securities, interest expense and foreign currency transactiongains and losses. Other income, net, was $98,774 for the three months endedJune 30, 2004, compared to $118,604 for the same prior year period, adecrease of $19,830 or 16.7%. The decrease is primarily attributable to lowerinterest rates in 2004.

 

*Provision for Income Taxes*

 

The income tax expense forthe three months ended June 30, 2004 was $311,239, compared to tax expenseof $326,514 for the same prior year period, a decrease of $15,275 or 4.7%. Theprovision consists primarily of taxes paid on licensing revenues sourced fromcountries requiring foreign tax withholdings and taxes paid on profits in HongKong at the rate of 17.5%.  The decreasein income tax for the quarter ended June 30, 2004 was attributable tohigher licensing revenues sourced in the Americas, which are not subject toforeign withholding taxes.  We expectthat the tax rate will be lower in the second half of the year, due to the US Japan tax treaty that went into effecton July 1, 2004 and eliminates source-country withholdings on royalties.

 

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**Six MonthsEnded June 30, 2004 Compared to Six Months Ended June 30, 2003**

*Revenues*

Total revenues for the six months endedJune 30, 2004 were $10,760,944 compared to $8,996,220 for the six monthsended June 30, 2003, an increase of $1,764,724 or 19.6%. Semiconductorrevenues were $5,348,213 for the six months ended June 30, 2004 comparedto $4,277,400 for the six months ended June 30, 2003, an increase of$1,070,813 or 25.0%. This increase was attributable to expansion of Valence’scustomer base, increased design wins and new chip offerings. Licensing revenueswere $5,412,731 for the six months ended June 30, 2004, compared to$4,718,820 for the six months ended June 30, 2003, an increase of $693,911or 14.7%. This increase was attributable to revenues generated in new productcategories such as mobile phones, portable audio devices, and PCs and increasedpenetration in the Company’s key home theater market, including set top boxesand televisions, which incorporate SRS Labs’ technologies.

###### ***Gross Margin***

Cost of sales consists primarily of fabricationcosts, assembly and test costs, and the cost of materials and overhead fromoperations. The gross margin percentage for the six months ended June 30,2004 decreased to 81.5% as a percentage of total revenue as compared to 82.5%for the six months ended June 30, 2003. Gross margins for thesemiconductor business for the six months ended June 30, 2004 and 2003were 63.6% and 64.9%, respectively. Semiconductor revenues accounted for 49.7% of total revenues as comparedto 47.5% for the six months ended June 30, 2004 and 2003, respectively. Withinsemiconductors, the slight decrease in gross margin can be attributable to themix of ASIC and ASP chips.  ASP chipshave a gross margin of approximately 56% and accounted for 32% of revenues forthe six months ended June 30, compared to 21% last year for the sameperiod.  ASIC’s have a gross margin ofapproximately 67% and accounted for 69% of revenue compared to 79% lastyear.  Gross margins for thelicensing business for the six months ended June 30, 2004 and 2003 were99.1% and 99.0%, respectively. Licensing revenues accounted for 50.3% of totalrevenues as compared to 52.4% for the six months ended June 30, 2004 and2003, respectively.

*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 $2,955,435 for the six months ended June 30, 2004 compared to$2,623,587 for the same prior year period, an increase of $331,848 or 12.7%.The net increase in sales and marketing expenses for the six months endedJune 30, 2004 is primarily attributable to increased promotion costsassociated with higher licensing revenue and investments in branding andpromotion of our technologies in new markets designed to increase futurerevenues. As a percentage of total revenues, sales and marketing expensesdecreased from 29.2% for the six months ended June 30, 2003, to 27.5% forthe same period this 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 $2,353,613 for the six months endedJune 30, 2004 compared to $2,051,338 for the same prior year period, anincrease of $302,275 or 14.7%. The increase in research and development costsis primarily due to the addition of research and development personnel andincreased costs associated with the increased semiconductor business activity.  As a percentage of total revenues, researchand development expenses decreased from 22.8% for the six months endedJune 30, 2003, to 21.9% for the same period this year.

*General and Administrative*

G&A expenses consist primarily ofemployee-related expenses, legal costs associated with the administration ofintellectual property and other professional fees. G&A expenses were$3,038,496 for the six months ended June 30, 2004 compared to $2,524,643for the same prior year period, an increase of $513,853 or 20.4%. The increasewas primarily attributable to increased professional fees and public companyexpenses. As a percentage of total revenues, G&A expenses increased from28.1% for the six months ended June 30, 2003, to 28.2% for the same periodthis year.  We expect that G&A willincrease in absolute dollars in future periods as we intensify our effort onthe SOX 404 project, but such expenses will fluctuate as a percentage ofrevenue due to changes in revenue.

*Income From Operations*

Income from operations increased by $191,570to $418,089 for the six months ended June 30, 2004, as compared to incomefrom operations of $226,519 for the same period last year.  The increase in income from operations is dueto an increase in revenue, partially offset by an increase in operatingexpenses.

 

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*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 $336,224for the six months ended June 30, 2004, compared to $282,730 for the sameprior year period, an increase of $53,494 or 18.9%. The increase is primarilyattributable to investment gains from sales of US Treasury in 2004.

###### ***Minority Interest***

Minority interest represents the minorityshareholders’ proportionate share of losses in SRSWOWcast. Minority interestwas $0 for the six months ended June 30, 2004, compared to $5,430 for thesix months ended June 30, 2003. In February 2003, SRS Labs completedan exchange offer with the minority shareholders of SRSWOWcast, pursuant towhich SRS Labs acquired all of the outstanding shares of Series AConvertible Preferred Stock in exchange for the issuance of shares of SRS Labscommon stock. As a result of the exchange offer, SRSWOWcast became a wholly-ownedsubsidiary of SRS Labs.

*Provision for Income Taxes*

The income tax expense for the six months endedJune 30, 2004 was $549,142, compared to tax expense of $506,027 for thesame prior year period, an increase of $43,115 or 8.5%. The provision consistsprimarily of taxes paid on licensing revenues sourced from countries requiringforeign tax withholdings and taxes paid on profits in Hong Kong at the rate of17.5%.  The increase in income tax forthe six months ended June 30, 2004 was attributable to higher profits inHong Kong.  We expect that the tax ratewill be lower in the second half of the year, due to the US Japan tax treaty that went into effecton July 1 and eliminates source-country withholdings on royalties.

**Liquidity and Capital Resources**

The Company’s principal source of liquidityto fund ongoing operations at June 30, 2004 consisted of cash, cashequivalents and long-term investments aggregating $26,445,511.  At June 30, 2004, the Company had cashand cash equivalents of $21,297,168 and long-term investments aggregating$5,148,343. 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 $8,501,548during the six months ended June 30, 2004 to $21,297,168.  The increase was primarily due to the netcash provided by operating activities of $1,095,289, investing activities fromthe sale of long-term investments of $5,235,626 and financing activities fromthe exercise of stock options of $2,988,171 partially offset by net cash usedfor capital expenditures and patents of $817,538.

On June 30, 2004, the Company’s Board of Directorsauthorized a stock repurchase program. Under the repurchase program, the Company may acquire up to $3,000,000of its outstanding common stock for a period of six months from July 1, 2004 toDecember 31, 2004.  Purchases may be madefrom time to time in the open market, block purchases or privately-negotiatedtransactions, depending on market conditions, share price and other factors.

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. Consumerelectronics products manufacturers could decide to exclude our audioenhancement technology from their home theater products altogether in an effortto reduce cost. The loss of any such customer could have a material adverseaffect on the Company’s financial condition and results of

 

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operations.

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*

Valenceis a “fabless” semiconductor company meaning that Valence designs, develops andmarkets our selection of custom and standard integrated circuits but we rely onthird party contractors to manufacture, assemble and test our products.Currently, there is a shortage of foundry capacity which is affecting thesemiconductor industry.  Although webelieve our relationships are generally good, we do not have long-term supplyagreements with our third-party vendors and they are not obligated to performservices or supply products to us for any particular period or in anyparticular quantities, except as provided in each separate purchase orderaccepted by them. The increased demand for our products coupled with the demandfor foundry services, is, and will continue to be for the foreseeable future, achallenge for us.  In these times of highdemand,

 

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thereare significant risks associated with our reliance on third-party vendorsincluding: reallocation of capacity to other foundry customers, potential priceincreases, delays and interruptions in order deliveries, reduced control overproduct quality and increased risk of misappropriation of intellectualproperty.

*We conduct operations in a number of countries and are subject to risksof international operations, particularly in Asia and the PRC*

We have significant operations in Hong Kong, the PRCand other parts of Asia that require refinement to adapt to the changing marketconditions in that region. Our operations in Asia, and international operationsin general, are subject to risks of unexpected changes in, or impositions of,legislative or regulatory requirements.

Our customers geographically located in the AsiaPacific markets accounted for approximately 93%, 90% and 90% of total Companysales in 2003, 2002 and 2001, respectively and are expected to continue toaccount for a substantial percentage of sales in the future. The economicclimate in Asia continues to be impacted by increases in unemployment, declinesin consumer spending, currency devaluation and bank failures. Any of thesefactors, should they continue, could significantly reduce the demand for theend user goods in which our products and technologies are used.

The PRC economy has experienced significant growthin the past decade; but such growth has been uneven across geographic andeconomic sectors. There can be no assurance that such growth will continue orthat any potential currency devaluation in the region will not have a negativeeffect on our business, including Valence. The PRC economy has also experienceddeflation in the past, which may continue in the future. The current economicsituation may adversely affect our profitability over time as expenditures forconsumer electronics products and information technology may decrease due tothe results of slowing domestic demand and deflation.

Hong Kong is a Special Administrative Region of thePRC with its own government and legislature. Hong Kong enjoys a high degree ofautonomy from the PRC under the principle of “one country, two systems.” We cangive no assurance that Hong Kong will continue to enjoy autonomy from the PRC.

The Hong Kong dollar has remained relativelyconstant due to the U.S. dollar peg and currency board system that has been ineffect in Hong Kong since 1983. Since mid-1997, interest rates in Hong Konghave fluctuated significantly and real estate and retail sales have declined.We can give no assurance that the Hong Kong economy will not worsen or that thehistorical currency peg of the Hong Kong dollar to the U.S. dollar will bemaintained. Continued declining consumer spending in Hong Kong, deflation orthe discontinuation of the currency peg could adversely affect our business.

*We are exposed to currency fluctuations and instability in the Asianmarkets*

We expect that international sales will continue torepresent a significant portion of our total revenues. To date, all of ourlicensing revenues have been denominated in U.S. dollars and most costs havebeen incurred in U.S. dollars. It is our expectation that licensing revenueswill continue to be denominated in U.S. dollars for the foreseeable future.Because Valence’s business is primarily focused in Asia and because of ouranticipated expansion of business in the PRC and other parts of Asia, ourconsolidated 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 competitive pressures*

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

 

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OEM’sproducts. In addition, the markets in which we compete are intenselycompetitive and are characterized by rapid technological changes, decliningaverage sales prices and rapid product obsolescence. Accordingly, there can beno assurance that we will be able to continue to compete effectively in itsrespective markets, that competition will not intensify or that futurecompetition will not have a material adverse effect on our business, operatingresults, cash flows and financial condition.

*We strongly rely on our intellectual property*

Our ability to compete may be affected by ourability to protect our proprietary information. We have filed numerous U.S. andforeign patent applications and to date have a number of issued U.S. andforeign patents covering various aspects of our technologies. There can be noassurance that the steps taken by SRS Labs to protect our intellectual propertywill be adequate to prevent misappropriation of our technology or that ourcompetitors will not independently develop technologies that are substantiallyequivalent or superior to our technology. In addition, the laws of certainforeign countries may not protect our intellectual property rights to the sameextent, as do the laws of the U.S. The semiconductor industry is characterizedby frequent claims and litigation regarding patent and other property rights.We are 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 executive officers and other key personnel*

Our future success depends to a large extent uponthe continued service of our executives, as well as key engineering, sales, andmarketing staff, including highly skilled semiconductor design personnel. Weanticipate that any future growth will require us to recruit and hire a numberof new personnel in engineering, operations, finance, sales and marketing.Competition for such personnel during times of economic growth is intense, andthere can be no assurance that we can recruit and retain necessary personnel tooperate its business and support future growth.

*The market price of our common stock is volatile*

The trading price of our Common Stock has been, andwill likely continue to be, subject to wide fluctuations in response toquarterly variations in our operating results, announcements of new products ortechnological innovations by the Company or our competitors, strategicalliances between SRS Labs and third parties, general market fluctuations andother events and factors. Changes in earnings estimates made by brokerage firmsand industry analysts relating to the markets in which we do business, orrelating to the Company specifically, have in the past resulted in, and couldin the future result in, an immediate and adverse effect on the market price ofthe Common Stock. Even though our stock is quoted on the Nasdaq Stock Market,our stock has had and may continue to have low trading volume and highvolatility. The historically low trading volume of our stock makes it morelikely that a severe fluctuation in volume, either up or down, willsignificantly impact the stock price. Since our shares are thinly traded, ourshareholders may have difficulty selling our common stock.

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

There have been no material changes to theinformation called for by this Item 3 from the disclosures set forth in PartII, Item 7A in the Company’s Annual Report on Form 10-K for the year endedDecember 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 disclosure controlsand procedures were not effective as of the end of the period covered by thisQuarterly 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 second 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.

 

 

**PART II****—OTHER INFORMATION**

 

**Item 4****.  Submission of Matters to a Vote of SecurityHolders**

 

The Annual Meeting of Stockholders of SRS Labs, Inc. washeld on June 30, 2004 for the purpose of (a) electing one Class IIdirector to the Board of Directors and (b) voting on a proposal to ratifythe appointment of BDO Seidman LLP as independent auditors for the fiscal yearending December 31, 2004.

 

David R. Dukes was elected to serve as a Class IIDirector of the Company for a three-year term expiring at the 2007 AnnualMeeting of Stockholders.  Winston Hickmancontinued as a Class I Director and Stephen V. Sedmak, Sam Yau and Thomas C.K.Yuen continued in office as Class III Directors.  The tabulation of the votes cast for theelection of Mr. Dukes was as follows:

 

| **Votes For** | ** ** | **Votes Withheld** | ** ** |
|---------------|------------|--------------------|------------|
| 12,099,633    |       | 156,172            |       |

 

The proposal to ratify the appointment of BDO SeidmanLLP as independent auditors for the fiscal year ending December 31, 2004was approved.  The tabulation of voteswas as follows:

 

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| **Votes For** | ** ** | **Votes Against** | ** ** | **Abstentions** | ** ** | **Broker Non-Votes** | ** ** |
|---------------|------------|-------------------|------------|-----------------|------------|----------------------|------------|
| 12,161,478    |       | 84,421            |       | 9,906           |       | 0                    |       |

 

**Item 6****.  Exhibits and Reports on Form8-K.**

 

(a)           *Exhibits*.

 

Theexhibits listed below are hereby filed with the SEC as part of this Report.

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                               |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                          |
| 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. |

 

 

(b)           *Reportson Form 8-K.*

 

OnMay 13, 2004, SRS Labs filed a report on Form 8-K dated May 13, 2004 announcingits operating results for the first quarter of the fiscal year endingDecember 31, 2004.

 

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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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