**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

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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 March 31, 2005**                                                                                               |
| ** **                                                                                                                                            |
| **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 ofregistrant as specified in its charter)

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

 

**2909Daimler Street, Santa Ana, California 92705**

(Address of principal executive offices) (ZipCode)

 

**(949) 442-1070**

(Registrant’s telephone number, includingarea code)

 

**NotApplicable**

(Former name, former address and formerfiscal year, if changed since last report)

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d)of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past90 days. Yes ý No o

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange Act). Yes o   No ý

 

Indicate the number of shares outstanding of each ofthe issuer’s classes of common stock, as of the latest practicable date: as of April 29,2005, 14,740,665 of the issuer’s common stock, par value $.001 per share, wereoutstanding.  In addition, as of April 29,2005, 592,186 shares of the issuer’s common stock were held as treasury shares.

 

 

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**SRSLABS, INC.**

 

**Form 10-Q**

**For thePeriod Ended March 31, 2005**

 

**Index**

 
| **PART I-FINANCIAL INFORMATION** |                                                                                                                                                        |
|----------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Item 1.                          | Financial  Statements                                                                                                                                       |   |
|                             | Condensed  Consolidated Balance Sheets as of March 31, 2005 (Unaudited) and December 31,  2004                                                    |   |
|                             | Condensed Consolidated  Statements of Operations for the three months ended March 31, 2005 and  2004 (Unaudited)                                       |   |
|                             | Condensed Consolidated Statements  of Stockholders’ Equity and Comprehensive Income (Loss) for the three months  ended March 31, 2005 (Unaudited) |   |
|                             | Condensed  Consolidated Statements of Cash Flows for the three months ended March 31,  2005 and 2004 (Unaudited)                                       |   |
|                             | Notes to the  Condensed 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 6.                          | Exhibits                                                                                                                                                    |   |
|                             |                                                                                                                                                        |
| SIGNATURES                       |                                                                                                                                                        |

 

2

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**FORWARD-LOOKINGINFORMATION**

 

This Quarterly Report on Form 10-Q containsforward-looking statements reflecting management’s current expectations.Examples of such forward-looking statements include the expectations of theCompany with respect to its strategy. Although the Company believes that itsexpectations are based upon reasonable assumptions, there can be no assurancesthat the Company’s financial goals will be realized. Such forward-lookingstatements involve known and unknown risks, uncertainties and other factorsthat may cause the actual results, performance or achievements of the Company,or industry results, to be materially different from any future results,performance or achievements expressed or implied by such forward-looking statements.Numerous factors may affect the Company’s actual results and may cause resultsto differ materially from those expressed in forward-looking statements made byor on behalf of the Company. For this purpose, any statements contained hereinthat are not statements of historical fact may be deemed to be forward-lookingstatements. Without limiting the foregoing, the words, “believes,” “anticipates,”“plans,” “expects” and similar expressions, are intended to identifyforward-looking statements. The important factors discussed in Part I,Item 2, “Management’s Discussion and Analysis of Financial Condition andResults of Operations—Factors That May Affect Future Results”, herein, amongothers, could cause 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.

 

3

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**PART I****— FINANCIAL INFORMATION**

 

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

 

**SRSLABS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                   | ** ** | **March 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                                                                   | ** ** | **(unaudited)**         | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                                                                                                   |       |                    |       |                       |       |
| **Current  Assets**                                                                                                                                                                                                          |       |                    |       |                       |       |
| Cash and  cash equivalents                                                                                                                                                                                                   |       | $                       | 7,000,241  |                       | $          | 7,011,912 |   |
| Accounts  receivable, net                                                                                                                                                                                                    |       | 1,969,922               |       | 1,318,665                  |       |
| Inventories,  net                                                                                                                                                                                                            |       | 548,822                 |       | 571,280                    |       |
| Prepaid  expenses and other current assets                                                                                                                                                                                   |       | 1,383,139               |       | 1,337,506                  |       |
| Deferred  income taxes                                                                                                                                                                                                       |       | 23,406                  |       | 23,406                     |       |
|                                                                                                                                                                                                                         |       |                    |       |                       |       |
| **Total  Current Assets**                                                                                                                                                                                                    |       | 10,925,530              |       | 10,262,769                 |       |
|                                                                                                                                                                                                                         |       |                    |       |                       |       |
| Investments  available for sale                                                                                                                                                                                              |       | 17,001,807              |       | 17,261,267                 |       |
| Investment  in LLC                                                                                                                                                                                                           |       | 2,674,247               |       | 2,596,090                  |       |
| Furniture,  fixtures and equipment, net                                                                                                                                                                                 |       | 1,835,350               |       | 1,995,579                  |       |
| Intangible  assets, net                                                                                                                                                                                                      |       | 2,653,316               |       | 2,660,955                  |       |
| Goodwill                                                                                                                                                                                                                     |       | 533,031                 |       | 533,031                    |       |
| Deferred  income taxes                                                                                                                                                                                                       |       | 209,596                 |       | 192,750                    |       |
|                                                                                                                                                                                                                         |       |                    |       |                       |       |
| **Total  Assets**                                                                                                                                                                                                            |       | $                       | 35,832,877 |                       | $          | 35,502,441 |   |
|                                                                                                                                                                                                                         |       |                    |       |                       |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                               |       |                    |       |                       |       |
| **Current  Liabilities**                                                                                                                                                                                                     |       |                    |       |                       |       |
| Accounts  payable                                                                                                                                                                                                            |       | $                       | 1,122,289  |                       | $          | 984,805 |   |
| Accrued  liabilities                                                                                                                                                                                                         |       | 1,798,777               |       | 1,640,714                  |       |
| Deferred  revenue                                                                                                                                                                                                            |       | 437,309                 |       | 436,910                    |       |
| Income taxes  payable                                                                                                                                                                                                        |       | —                  |       | 8,628                      |       |
|                                                                                                                                                                                                                         |       |                    |       |                       |       |
| **Total  Current Liabilities**                                                                                                                                                                                               |       | 3,358,375               |       | 3,071,057                  |       |
|                                                                                                                                                                                                                         |       |                    |       |                       |       |
| Commitments  and contingencies (Note 8)                                                                                                                                                                                      |       |                    |       |                       |       |
|                                                                                                                                                                                                                         |       |                    |       |                       |       |
| **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;14,689,028 and 14,671,416  shares issued; and 14,247,153 and 14,229,541 shares outstanding at March 31,  2005 and December 31, 2004, respectively |       | 14,690                  |       | 14,672                     |       |
| Additional  paid-in capital                                                                                                                                                                                                  |       | 62,604,392              |       | 62,523,292                 |       |
| Accumulated  other comprehensive loss                                                                                                                                                                                        |       | (569,182                | )          | (309,722                   | )          |
| Accumulated  deficit                                                                                                                                                                                                         |       | (27,631,543             | )          | (27,853,003                | )          |
| Treasury  stock at cost, 441,875 shares at March 31, 2005 and December 31,  2004                                                                                                                                   |       | (1,943,855              | )          | (1,943,855                 | )          |
|                                                                                                                                                                                                                         |       |                    |       |                       |       |
| **Total  Stockholders’ Equity**                                                                                                                                                                                         |       | 32,474,502              |       | 32,431,384                 |       |
|                                                                                                                                                                                                                         |       |                    |       |                       |       |
| **Total  Liabilities and Stockholders’ Equity**                                                                                                                                                                         |       | $                       | 35,832,877 |                       | $          | 35,502,441 |   |

 

See accompanying notes to the condensedconsolidated financial statements

 

4

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**SRSLABS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                                       | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                       | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| ** **                                                                       | ** ** | ** **                             | ** ** | **(Restated)** | ** ** |
| Revenues:                                                                        |       |                                   |       |   |   |
| Semiconductor                                                                    |       | $                                      | 1,984,563  |   | $ | 2,415,718 |   |
| Licensing                                                                        |       | 3,264,095                              |       | 2,927,327 |   |
| Total  revenues                                                                  |       | 5,248,658                              |       | 5,343,045 |   |
| Cost of  sales:                                                                  |       |                                   |       |   |   |
| Semiconductor                                                                    |       | 728,240                                |       | 882,734 |   |
| Licensing                                                                        |       | 56,345                                 |       | 26,137 |   |
| Total cost  of sales                                                             |       | 784,585                                |       | 908,871 |   |
|                                                                             |       |                                   |       |   |   |
| Gross margin                                                                     |       | 4,464,073                              |       | 4,434,174 |   |
|                                                                             |       |                                   |       |   |   |
| Operating  expenses:                                                             |       |                                   |       |   |   |
| Sales and  marketing                                                             |       | 1,692,378                              |       | 1,695,368 |   |
| Research and  development                                                        |       | 1,182,069                              |       | 1,208,687 |   |
| General and  administrative                                                      |       | 1,469,228                              |       | 1,554,197 |   |
|                                                                             |       |                                   |       |   |   |
| Total  operating expenses                                                        |       | 4,343,675                              |       | 4,458,252 |   |
|                                                                             |       |                                   |       |   |   |
| Income  (loss) from operations                                                   |       | 120,398                                |       | (24,078 | ) |
| Equity in  income of investee                                                    |       | 77,332                                 |       | — |   |
| Other  income, net                                                               |       | 147,932                                |       | 237,450 |   |
| Income  before income tax expense                                                |       | 345,662                                |       | 213,372 |   |
| Income tax  expense                                                              |       | 124,202                                |       | 237,903 |   |
| Net income  (loss)                                                               |       | $                                      | 221,460    |   | $ | (24,531 | ) |
|                                                                             |       |                                   |       |   |   |
| Net income  per common share:                                                    |       |                                   |       |   |   |
|                                                                             |       |                                   |       |   |   |
| Basic                                                                            |       | $                                      | 0.02       |   | $ | 0.00 |   |
|                                                                             |       |                                   |       |   |   |
| Diluted                                                                          |       | $                                      | 0.01       |   | $ | 0.00 |   |
|                                                                             |       |                                   |       |   |   |
| Weighted  average shares used in the calculation of net income per common share: |       |                                   |       |   |   |
| Basic                                                                            |       | 14,241,522                             |       | 13,746,521 |   |
|                                                                             |       |                                   |       |   |   |
| Diluted                                                                          |       | 15,255,107                             |       | 16,679,373 |   |

 

 Seeaccompanying notes to the condensed consolidated financial statements

 

5

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**SRSLABS, INC.**

### **CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITY ANDCOMPREHENSIVE INCOME (LOSS) (Unaudited)**

 
| ** **                                                     | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Accumulated** | ** ** | **Treasury** | ** ** | ** ** | ** ** | **Comprehensive  Income (Loss)  for the Period** | ** ** |
|----------------------------------------------------------------|------------|------------------|------------|-------------------------|------------|---------------------------------------|------------|-----------------|------------|--------------|------------|------------|------------|--------------------------------------------------|------------|
| ** **                                                     | ** ** | **Shares**       | ** ** | **Amount**              | ** ** | **Capital**                           | ** ** | **Loss**        | ** ** | **Deficit**  | ** ** | **Stock**  | ** ** | **Total**                                        | ** ** | **Ended** | ** ** |
| ** **                                                     | ** ** | ** **       | ** ** | ** **              | ** ** | ** **                            | ** ** | ** **      | ** ** | ** **   | ** ** | ** ** | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| BALANCE,  Dec. 31, 2004                                        |       | 14,229,541       |       | $                       | 14,672     |                                  | $          | 62,523,292      |       | $            | (309,722   | )          | $          | (27,853,003                                      | )          | $ | (1,943,855 | ) | $ | 32,431,384 |   |   |   |
| Proceeds from exercise of stock options                        |       | 17,612           |       | 18                      |       | 66,269                                |       | —          |       | —       |       | —     |       | 66,287                                           |       |   |   |
| Deferred stock option compensation                             |       | —           |       | —                  |       | 14,831                                |       | —          |       | —       |       | —     |       | 14,831                                           |       |   |   |
| Unrealized loss on investments available for sale,  net of tax |       | —           |       | —                  |       | —                                |       | (259,460        | )          | —       |       | —     |       | (259,460                                         | )          | (259,460 | ) |
| Net income                                                     |       | —           |       | —                  |       | —                                |       | —          |       | 221,460      |       | —     |       | 221,460                                          |       | 221,460 |   |
|                                                           |       |             |       |                    |       |                                  |       |            |       |         |       |       |       |                                             |       |   |   |
| BALANCE, March 31, 2005                                   |       | 14,247,153       |       | $                       | 14,690     |                                  | $          | 62,604,392      |       | $            | (569,182   | )          | $          | (27,631,543                                      | )          | $ | (1,943,855 | ) | $ | 32,474,502 |   | $ | (38,000 | ) |
|                                                                |            |                  |            |                         |            |                                       |            |                 |            |              |            |            |            |                                                  |            |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to thecondensed consolidated financial statements

 

6

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**SRSLABS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                         | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| ** **                                                                         | ** ** | ** **                             | ** ** | **(Restated)** | ** ** |
| **Cash Flows From Operating  Activities:**                                         |       |                                   |       |   |   |
| Net income  (loss)                                                                 |       | $                                      | 221,460    |   | $ | (24,531 | ) |
| Adjustments  to reconcile net income to net cash provided by operating activities: |       |                                   |       |   |   |
| Depreciation  and amortization                                                     |       | 346,537                                |       | 310,867 |   |
| Provision  for doubtful accounts                                                   |       | 7,821                                  |       | 69,603 |   |
| Provision  for obsolete inventory                                                  |       | 2,714                                  |       | 40,408 |   |
| Deferred  taxes                                                                    |       | (16,846                                | )          | (16,539 | ) |
| (Accretion)  amortization of (discount) premium on investments available for sale  |       | (508                                   | )          | 3,095 |   |
| Net realized  gain on sale of investments available for sale                       |       | —                                 |       | (139,375 | ) |
| Increase in  deferred stock option compensation                                    |       | 14,831                                 |       | 13,600 |   |
| Loss on  disposition of furniture, fixtures and equipment                          |       | 2,267                                  |       | 31 |   |
| Impairment  on intangible assets                                                   |       | —                                 |       | 3,431 |   |
| Investment  in LLC                                                                 |       | (78,157                                | )          | — |   |
| Changes in  operating assets and liabilities:                                      |       |                                   |       |   |   |
| Accounts  receivable                                                               |       | (659,078                               | )          | 376,860 |   |
| Inventories                                                                        |       | 19,744                                 |       | (1,686 | ) |
| Prepaid  expenses and other current assets                                         |       | (45,125                                | )          | 52,716 |   |
| Accounts  payable                                                                  |       | 137,484                                |       | (557,042 | ) |
| Accrued  liabilities                                                               |       | 158,063                                |       | 211,971 |   |
| Deferred  revenue                                                                  |       | 399                                    |       | (765 | ) |
| Income taxes  payable                                                              |       | (8,628                                 | )          | 107,051 |   |
|                                                                               |       |                                   |       |   |   |
| Net cash  provided by operating activities                                         |       | 102,978                                |       | 449,695 |   |
|                                                                               |       |                                   |       |   |   |
| **Cash  Flows From Investing Activities:**                                         |       |                                   |       |   |   |
| Purchase of  furniture, fixtures and equipment                                     |       | (37,440                                | )          | (273,889 | ) |
| Proceeds  from sale of investments available for sale                              |       | —                                 |       | 5,375,000 |   |
| Expenditures  related to patents and intangible assets                             |       | (143,496                               | )          | (103,790 | ) |
|                                                                               |       |                                   |       |   |   |
| Net cash  provided by (used in) investing activities                               |       | (180,936                               | )          | 4,997,321 |   |
|                                                                               |       |                                   |       |   |   |
| **Cash  Flows From Financing Activities:**                                         |       |                                   |       |   |   |
| Proceeds  from exercise of stock options                                           |       | 66,287                                 |       | 2,150,319 |   |
|                                                                               |       |                                   |       |   |   |
| Net cash  provided by financing activities                                         |       | 66,287                                 |       | 2,150,319 |   |
|                                                                               |       |                                   |       |   |   |
| **Net  Increase (Decrease) in Cash and Cash Equivalents**                          |       | (11,671                                | )          | 7,597,335 |   |
| **Cash and  Cash Equivalents, Beginning of Period**                                |       | 7,011,912                              |       | 12,795,620 |   |
|                                                                               |       |                                   |       |   |   |
| **Cash and  Cash Equivalents, End of Period**                                      |       | $                                      | 7,000,241  |   | $ | 20,392,955 |   |
|                                                                               |       |                                   |       |   |   |
| **Supplemental  Disclosure of Cash Flow Information:**                             |       |                                   |       |   |   |
| Cash paid  during the period for:                                                  |       |                                   |       |   |   |
| Income taxes                                                                       |       | $                                      | 247,559    |   | $ | 211,961 |   |
| **Supplemental  Disclosure of Non-Cash Investing Activities:**                     |       |                                   |       |   |   |
| Unrealized  gain (loss) on investments, net                                        |       | $                                      | (259,460   | ) | $ | 87,938 |   |

 

See accompanying notes to the condensedconsolidated financial statements

 

7

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**SRS LABS,INC.**

**NOTES****TO THE CONDENSED CONSOLIDATED FINANCIALSTATEMENTS (Unaudited)**

 

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

 

As used herein, the “Company,” “SRS Labs,” “we,” “us,”or “our” means SRS Labs, Inc. and its wholly-owned subsidiaries, Valence TechLimited (including its wholly-owned subsidiaries) and SRSWOWcast.com, Inc. (“SRSWOWcast”).  The accompanying unaudited condensedconsolidated financial statements have been prepared by the Company inconformity with accounting principles generally accepted in the United Statesof America (“generally accepted accounting principles”) for interim financialinformation and the rules and regulations of the U.S. Securities and ExchangeCommission (“SEC”) for interim reporting. In the opinion of management, alladjustments (which include only normal recurring adjustments) considerednecessary for a fair presentation of our financial position and results ofoperations have been included. Certain amounts included in the accompanying prior periods’consolidated financial statements have been reclassified to conform to thecurrent period presentation.

 

The condensed consolidated financial statementsinclude the accounts of SRS Labs, Inc. and its subsidiaries. All inter-companyaccounts and transactions have been eliminated.

 

Certain information and footnote disclosuresnormally included in financial statements prepared in accordance with generallyaccepted accounting principles have been condensed or omitted pursuant to SECrules and regulations for presentation of interim financial information.Therefore, the condensed interim consolidated financial statements should beread in conjunction with the Company’s Annual Report on Form 10-K for thefiscal year ended December 31, 2004. Current and future financialstatements may not be directly comparable to the Company’s historical financialstatements. The results of operations for the interim periodis not necessarily indicative of the results to be expected for anyother interim period or for the full year.

 

**Estimates**

 

The preparation of financial statements inaccordance with generally accepted accounting principles requires management tomake use of certain estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reported periods. We base our estimates on historicalexperience and on various other assumptions that we believe are reasonableunder the circumstances, the results of which form the basis for makingjudgments about carrying values of assets and liabilities that are not readilyapparent from other sources. Actual results could differ materially from thoseestimates. See the audited consolidated financial statements and notes theretoincluded in our Annual Report on Form 10-K for the year ended December 31,2004 for an additional discussion of the significant accounting policies andestimates used in the preparation of our financial statements.

 

**2.****                                      Restatement**

 

On May 13, 2005, the Company filed a CurrentReport on Form 8-K announcing that an error had been identified relating toaccounting for sales and marketing expenses related to trade shows.  This conclusion was reached in connectionwith BDO Seidman, LLP’s, it’s independent registered public accounting firm(“BDO Seidman”), financial statement review procedures relating to theCompany’s Quarterly Report on Form 10-Q for the first quarter of the yearending December 31, 2005 (“fiscal 2005”).

 

The accounting issue relates to aninterpretation of Accounting Principles Board Opinion No. 28 (“APB 28”),“Interim Financial Reporting.” 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 its review of theunaudited quarterly financial statements for the first quarter of fiscal 2005,BDO Seidman noted that trade show costs previously capitalized and amortizedshould have been treated as period expenses in fiscal 2004.  As a result, BDO Seidman expressed its viewthat (a) trade show costs previously capitalized and amortized during fiscal2004 should have been treated as period expenses in fiscal 2004; (b) each ofthe Company’s quarterly reports previously filed in fiscal 2004 should berestated; and (c) no reliance should be placed on the previously issued fiscal2004 quarterly financial statements.

 

Acting on the recommendation of BDO Seidman,management of the Company determined that the previously issued financialstatements contained in the Quarterly Reports on Form 10-Q for the quartersended March 31, 2004, June 30, 2004 and September 30, 2004 should be restatedto correct errors in those financial statements.  Consequently, the condensed consolidatedfinancial statements for the first quarter of 2004 are restated in this Form10-Q.  These restated condensedconsolidated financial statements reflect an adjustment to account for tradeshow expenses as period expenses.  Theadjustment results in a $159,460 increase in sales and marketing expense forthe first fiscal quarter of 2004.   Therestatement has no impact on the Company’s consolidated net income for fiscal2004 and does not affect the Company’s historical cash flow.  The Company will amend its annual report onForm 10-K for fiscal 2004 to reflect the disclosures made to the above-referencedrestated quarterly reports.

 

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

 

8

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| ** **                                      | ** ** | **Condensed Consolidated Balance Sheet  March 31, 2004** | ** ** |
|-------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                      | ** ** | **As restated**                                          | ** ** | **As previously  reported** | ** ** |
|                                            |       |                                                     |       |   |   |
| Prepaid expenses and other current assets       |       | $                                                        | 1,020,980  |   | $ | 1,180,440 |   |
| Total Current Assets                            |       | 22,935,599                                               |       | 23,095,059 |   |
| Total Assets                                    |       | 33,479,871                                               |       | 33,639,331 |   |
|                                            |       |                                                     |       |   |   |
| Accumulated deficit                             |       | (29,456,055                                              | )          | (29,296,595 | ) |
| Total Stockholders’ Equity                 |       | 30,177,787                                               |       | 30,337,247 |   |
| Total Liabilities and Stockholders’ Equity |       | $                                                        | 33,479,871 |   | $ | 33,639,331 |   |

 
| ** **                               | ** ** | **Condensed Consolidated  Statement of Operations  for the three months ended  March 31, 2004** | ** ** |
|------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **As  restated**                                                                                | ** ** | **As Previously  reported** | ** ** |
|                                     |       |                                                                                            |       |   |   |
| Increase in sales and marketing expenses |       | $                                                                                               | 159,460    |   | $ | — |   |
| Total operating expenses                 |       | 4,458,252                                                                                       |       | 4,298,792 |   |
| Income (loss) from operations            |       | (24,078                                                                                         | )          | 135,382 |   |
| Income before income tax expense         |       | 213,372                                                                                         |       | 372,832 |   |
| Net income (loss)                        |       | (24,531                                                                                         | )          | 134,929 |   |
| Net income per common share:             |       |                                                                                            |       |   |   |
| Basic                                    |       | $                                                                                               | 0.00       |   | $ | 0.01 |   |
| Diluted                                  |       | $                                                                                               | 0.00       |   | $ | 0.01 |   |

 

**3.**                                      **Stock-Based Compensation**

 

The Company accounts for stock-based awards toemployees under the recognition and measurement principles of AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued toEmployees,” and related interpretations. The Company provides additional pro forma disclosures as required underStatement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting forStock-Based Compensation” and SFAS No. 148, “Accounting for Stock-BasedCompensation — Transition and Disclosure — an Amendment of SFAS No. 123.” Accordingly, no stock-based employeecompensation cost is reflected in net income (loss), as all options grantedunder the plan had an exercise price equal to the market value of theunderlying common stock on the date of grant. Had compensation expense beenrecorded under the provisions of SFAS No. 123, the Company’s net income(loss) and earnings per share would have been the pro forma amounts indicatedbelow:

 
| ** **                                                                                              | ** ** | **For the three months ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2005**                                       | ** ** | **2004** | ** ** |
| ** **                                                                                              | ** ** | ** **                                     | ** ** | **(Restated)** | ** ** |
| Net income  (loss)(attributable to common shareholders) — as reported                              |       | $                                              | 221,460    |   | $ | (24,531 | ) |
| Add: stock  based employee compensation expense included in reported net income, net of  40% tax effect |       | 8,899                                          |       | 8,160 |   |
| Less fair  value of stock-based employee compensation expense                                           |       | (305,103                                       | )          | (393,669 | ) |
| Net loss  (attributable to common shareholder) — pro forma                                         |       | $                                              | (74,744    | ) | $ | (410,040 | ) |
| Net income  (loss) per share:                                                                           |       |                                           |       |   |   |
| Basic, as  reported                                                                                     |       | $                                              | 0.02       |   | $ | 0.00 |   |
| Basic, pro  forma                                                                                       |       | $                                              | (0.01      | ) | $ | (0.03 | ) |
| Diluted, as  reported                                                                                   |       | $                                              | 0.01       |   | $ | 0.00 |   |
| Diluted, pro  forma                                                                                     |       | $                                              | 0.00       |   | $ | (0.02 | ) |

 

9

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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 March 31, 2005:

 
| Risk free  interest rate |   | 4.2        | %      |
|--------------------------|--------|------------|--------|
| Expected  life           |   | 6.25 years |   |
| Expected  volatility     |   | 67         | %      |

 

**4.****                                     ****Capitalization of SoftwareDevelopment Costs**

 

Costs incurred in the research, design anddevelopment of software for sale to others as a separate product or embedded ina product and sold as part of the product as a whole are charged to expenseuntil technological feasibility is established. Under SFAS No. 86, “Accountingfor the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,”the Company capitalizes software purchased from third parties if the relatedsoftware product under development has reached technological feasibility or ifthere are alternative future uses for the purchased software, provided thatcapitalized amounts will be realized over a period not exceeding five years.Costs incurred prior to the establishment of technological feasibility arecharged to research and development expense.

 

Capitalized software as of March 31,2005 and December 31, 2004 is as follows:

 
| ** **                 | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Capitalized  software      |       | $                        | 530,568    |                        | $          | 464,568 |   |
| Accumulated  amortization  |       | (222,532                 | )          | (193,003                    | )          |
| Capitalized  software, net |       | $                        | 308,036    |                        | $          | 271,565 |   |

 

As of March 31, 2005, the weighted average useful life of theCompany’s capitalized software is approximately 2.3 years. The following tableshows the estimated amortization expense for those assets for the remainingnine months of the current fiscal year end and each of the four succeedingfiscal years.

 
| **Year ending December 31,** | ** ** | **Estimated  Expense** | ** ** |
|-----------------------------------|------------|------------------------|------------|
| 2005                              |       | $                      | 91,964     |   |
| 2006                              |       | 119,969                |       |
| 2007                              |       | 67,689                 |       |
| 2008                              |       | 24,481                 |       |
| 2009                              |       | 3,933                  |       |
|                                   |            |                        |            |  |

 

**5.****                                     ****Goodwill and IntangibleAssets**

 

OnJanuary 1, 2002, the Company adopted SFAS No. 142 “Goodwill and OtherIntangible Assets,” which, among other things, establishes new standards forgoodwill acquired in a business combination, eliminates the amortization ofgoodwill and requires the carrying value of goodwill and identifiableintangibles to be evaluated for impairment on an annual basis.

 

Inaccordance with SFAS No. 142, all of our intangible assets that havedefinite lives are being amortized on a straight-line basis over theirestimated useful lives and goodwill is evaluated at least annually to determineif fair value of the asset has decreased below its carrying value. At December 31,2004, we performed our annual assessment of goodwill and determined that noadjustment to impair goodwill was necessary.

 

10

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Goodwilland intangible assets consist of the following:

 
| ** **                                                                                                                                                                      | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Goodwill                                                                                                                                                                        |       | $                        | 533,031    |                        | $          | 533,031 |   |
|                                                                                                                                                                            |       |                     |       |                        |       |
| Patents                                                                                                                                                                         |       | $                        | 2,116,077  |                        | $          | 2,038,582 |   |
| Accumulated  amortization                                                                                                                                                       |       | (941,115                 | )          | (891,178                    | )          |
| Patents, net                                                                                                                                                                    |       | 1,174,962                |       | 1,147,404                   |       |
| Other  Intangibles:                                                                                                                                                             |       |                     |       |                        |       |
| Assets  acquired in the purchase of our subsidiary Valence Technology in 1998:  Covenant not to compete, Developed Technology, ASP brand name, Cell Library,  and Customer List |       | 4,910,400                |       | 4,910,400                   |       |
| License  agreements acquired in purchase of our subsidiary SRSWOWcast in February 2003                                                                                     |       | 640,071                  |       | 640,071                     |       |
| Poly Planar  purchased technology for speaker products                                                                                                                          |       | 120,000                  |       | 120,000                     |       |
| Capitalized  software and hardware for several technologies                                                                                                                     |       | 460,841                  |       | 394,840                     |       |
| Total of  Other Intangibles                                                                                                                                                     |       | 6,131,312                |       | 6,065,311                   |       |
| Accumulated  amortization, other intangibles                                                                                                                                    |       | (4,652,958               | )          | (4,551,760                  | )          |
| Other  intangibles, net                                                                                                                                                         |       | 1,478,354                |       | 1,513,551                   |       |
| Intangible  assets, net                                                                                                                                                         |       | $                        | 2,653,316  |                        | $          | 2,660,955 |   |

 

Amortization periods range from three to eleven years depending on theestimated useful life of the asset. Amortization expense consists of thefollowing:

 

| ** **                                                                                      | ** ** | **Three months ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                      | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Patents                                                                                         |       | $                                      | 49,937     |   | $ | 40,815 |   |
| Other  intangibles:                                                                             |       |                                   |       |   |   |
| Covenant not  to compete, developed technology, ASP brand name, cell library and customer  list |       | 51,478                                 |       | 51,477 |   |
| License  agreements acquired in purchase of our subsidiary SRSWOWcast in February 2003     |       | 16,001                                 |       | 16,001 |   |
| Poly Planar  purchased technology                                                               |       | 4,000                                  |       | 6,000 |   |
| Capitalized  software and hardware                                                              |       | 29,719                                 |       | 11,212 |   |
| Total  intangible amortization expense                                                          |       | $                                      | 151,135    |   | $ | 125,505 |   |

 

As of March 31, 2005, the weightedaverage useful life of the Company’s patents and intangible assets isapproximately 3.5 years. The following table shows the estimatedamortization expense for those assets for the remaining nine months of thecurrent fiscal year and each of the four succeeding fiscal years:

 

| **Year  ending  December 31,** | ** ** | **Estimated expense** | ** ** |
|------------------------------------------|------------|-----------------------|------------|
| 2005                                     |       | $                     | 465,675    |   |
| 2006                                     |       | $                     | 613,010    |   |
| 2007                                     |       | $                     | 532,614    |   |
| 2008                                     |       | $                     | 309,825    |   |
| 2009                                     |       | $                     | 168,124    |   |
| Thereafter                               |       | $                     | 564,068    |   |

 

11

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**6.**                                      **Investments Available forSale**

 

The Company has classified its investments asavailable for sale in accordance with SFAS No. 115, “Accounting forCertain Investments in Debt and Equity Securities.” The following tablesummarizes the Company’s investment securities available for sale:

 
| ** **            | ** ** | **March 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|-----------------------|------------|-------------------------|------------|----------------------------|------------|
| Cost                  |       | $                       | 17,489,688 |                       | $          | 17,489,688 |   |
| Unrealized  loss      |       | (487,881                | )          | (228,421                   | )          |
| Estimated  fair value |       | $                       | 17,001,807 |                       | $          | 17,261,267 |   |

 

The contractual maturities of investments areshown below. Actual maturities may differ from contractual maturities.

 
| ** **                                      | ** ** | **March 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                      | ** ** | **Cost**                | ** ** | **Estimated  Fair Value**  | ** ** | **Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| U.S.  Government securities available for sale: |       |                    |       |                       |       |   |   |   |   |
| Due in one  to five years                       |       | $                       | 17,489,688 |                       | $          | 17,001,807 |   | $ | 17,489,688 |   | $ | 17,261,267 |   |
|                                                 |            |                         |            |                            |            |  |  |  |  |  |  |  |  |

 

The following table summarizes sales ofavailable for sale securities for quarters ended March 31. Specificidentification was used to determine costs in computing realized gains orlosses.

 

| ** **          | ** ** | **Quarters Ended  March 31,** | ** ** |
|---------------------|------------|------------------------------------|------------|
| ** **          | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| Proceeds  from sale |       | $                                  | —     |   | $ | 5,375,000 |   |
| Realized  gains     |       | —                             |       | 139,375 |   |
|                     |            |                                    |            |  |  |  |  |

 

**7.****                                     ****Investment in LLC**

 

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

 

In the Strategic Alliance Agreement, CHS andthe Company agree to work together to identify and implement co-promotionalopportunities, including trade shows, movie theatres, video streaming, concertDVDs, artist endorsements, bundling and premium deals, web-based promotionalclips and road shows.  The initial term of the agreement expires on July 9,2006 and is automatically renewable for successive one-year terms.

 

The Operating Agreement governs CHS/SRS, LLC,which is a joint venture between CHS and the Company formed to complete anddistribute concert videos featuring Duran Duran, Boz Scaggs— Jazz, Boz Scaggs—Greatest Hits, Godsmack and All Access.

 

12

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Pursuantto the Operating Agreement each of CHS and the Company contributed capital witha value of $2,346,621. CHS is the managing member of the joint venture and isentitled to receive a 5% management fee of all net revenues received. CHS’capital contribution to CHS/SRS, LLC consists of the artist agreements andrelated contracts pursuant to which CHS/SRS, LLC will produce and distributethe above-referenced concert videos. The Company’s capital contribution is anaggregate of $2,346,621, consisting of a $700,000 bridge loan that the Companyextended to CHS on July 9, 2004 in anticipation of the strategic alliance,which converted to equity on September 23, 2004, plus $1,646,621 in newcash.  In addition, the Companycapitalized $177,936 consisting of costs associated with the formation of theLLC and co-promotional projects. CHS’ capital contribution consisted of theartist agreements with Duran Duran, Boz Scaggs, Godsmack and All Accesspursuant to which the concert videos are filmed, produced and distributed.CHS/SRS, LLC contracted with CHS to complete production of the concert videospursuant to the Production Services Agreement. Profits from the distribution ofthe concert videos and related assets will be allocated and distributed in thefollowing manner and order: (i) 100% to the Company until such time as theCompany has received 130% of the 133,000 additional advance that the Companyprovided to the CHS/SRS, LLC to fund the Godsmack acoustical project ; (ii)equally until the Company and CHS have each both received 1.75 times theiroriginal capital contributions; and thereafter (iii) 90% to CHS and 10% to theCompany. The joint venture is accounted for using the equity method and profitsare recognized following the guidance for equity method accounting. As of March 31,2005, two of the concert videos, Boz Scaggs and Godsmack have been released.Profits of $77,332 generated from these videos have been recognized andincluded in “Equity in Income of Investee” in the Consolidated Statements ofOperations for the three months ended March 31, 2005.

 

Underthe Warrant Agreement, the Company paid CHS $40,000 to acquire a warrant topurchase up to 122,000 units of Class A membership interests in CHS, whichrepresents approximately 10% of the equity of CHS, for an exercise price of$9.836 per unit, subject to adjustment based on valuation of CHS at the time ofan additional funding. The warrant is immediately vested and exercisable for upto two years. It is transferable and contains customary antidilution and priceprotection provisions for warrants of this type.

 

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

 

**8.**                                      **Net Income Per Common Share**

 

The Company applies SFAS No. 128, “Earnings perShare,” which requires the disclosure of basic and diluted net income or lossper share for all current and prior periods. Basic net income or loss percommon share is computed by dividing net income or loss available to commonstockholders by the weighted average number of common shares outstanding duringeach year. Diluted net income or loss per common share reflects the maximumdilution, based on the average price of the Company’s common stock each period,and is computed similar to basic income or loss per share except that thedenominator is increased to include the number of additional shares that wouldhave been outstanding if potentially dilutive stock options and warrants hadbeen exercised.

 

Basic and diluted net income per share computed inaccordance with SFAS 128 for the three months ended March 31, are asfollows:

 

| ** **                                               | ** ** | **For the three months  ended March 31,** | ** ** |
|----------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                               | ** ** | **2005**                                       | ** ** | **2004** | ** ** |
|                                                     | ** ** | ** **                                     | ** ** | **(Restated)** | ** ** |
| BASIC EPS                                                | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Net income  (loss)                                       |       | $                                              | 221,460    |   | $ | (24,531 | ) |
| Denominator:  weighted average common shares outstanding |       | 14,241,522                                     |       | 13,746,521 |   |
| Net income per  share—basic                         |       | $                                              | 0.02       |   | $ | 0.00 |   |
|                                                     |       |                                           |       |   |   |
| DILUTED EPS                                              |       |                                           |       |   |   |
| Net income  (loss)                                       |       | $                                              | 221,460    |   | $ | (24,531 | ) |
| Denominator:  weighted average common shares outstanding |       | 14,241,522                                     |       | 13,746,521 |   |
| Common  equivalent shares outstanding:                   |       |                                           |       |   |   |
| Options                                                  |       | 1,013,585                                      |       | 2,932,852 |   |
| Total  diluted shares                                    |       | 15,255,107                                     |       | 16,679,373 |   |
| Net income  per share—diluted                       |       | $                                              | 0.01       |   | $ | 0.00 |   |

 

There were 1,404,000 and 40,000 potentially dilutiveoptions outstanding for the quarters ending March 31, 2005 and 2004, respectively, that were not included in the table abovebecause they would be anti-dilutive.

 

13

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**9.**                                      **Commitments andContingencies**

 

The Company is subject to legal proceedings andclaims that arise in the normal course of business. While the outcome of theseproceedings and claims cannot be predicted with certainty, management does notbelieve that the outcome of any of these matters will have a material adverseeffect on the Company’s consolidated financial position or results ofoperations.

 

**10.**                               **Stockholders’ Equity**

 

On June 30, 2004, the Company’s Board ofDirectors authorized the repurchase of up to $3,000,000 of its outstanding commonstock for a period from July 1, 2004 to December 31, 2004 (the “2004Repurchase Program”).  The Companyrepurchased 216,575 shares at a cost of $1,225,254 under the 2004 RepurchaseProgram.

 

On March 24, 2005, the Company’s Board ofDirectors authorized the repurchase of up to $3,000,000 of the outstandingshares of the Company’s common stock for a period from January 1, 2005 to December 31,2005 (the “2005 Repurchase Program”). As of March 31, 2005, no shares hadbeen repurchased under the 2005 Repurchase Program. Purchases may be made fromtime to time in the open market, block purchases or privately negotiatedtransactions, depending on market conditions, share price and otherfactors.  All repurchased shares arereflected as treasury stock in the accompanying consolidated balance sheets.

 

14

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**11.****                              ****Segment Information**

 

The Company operates two business segments —semiconductors and licensing.  TheCompany does not allocate corporate operating expenses or specific assets tothese segments. Therefore, the segment information that follows includes onlynet revenues, cost of sales and gross margins of the identified segments:

 
| ** **                                  | ** ** | **Valence  Semiconductor** | ** ** | **SRS Labs  Licensing** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|----------------------------|------------|-------------------------|------------|-----------|------------|
| **Three  Months Ended March 31, 2005** |       |                       |       |                    |       |      |       |
| Total  revenues                             |       | $                          | 1,984,563  |                    | $          | 3,264,095 |       | $ | 5,248,658 |   |
| Cost of  sales                              |       | 728,240                    |       | 56,345                  |       | 784,585   |       |
|                                        |       |                       |       |                    |       |      |       |
| Gross margin                                |       | $                          | 1,256,323  |                    | $          | 3,207,750 |       | $ | 4,464,073 |   |
|                                        |       |                       |       |                    |       |      |       |
| **Three  Months Ended March 31, 2004** |       |                       |       |                    |       |      |       |
| Total  revenues                             |       | $                          | 2,415,718  |                    | $          | 2,927,327 |       | $ | 5,343,045 |   |
| Cost of  sales                              |       | 882,734                    |       | 26,137                  |       | 908,871   |       |
|                                        |       |                       |       |                    |       |      |       |
| Gross margin                                |       | $                          | 1,532,984  |                    | $          | 2,901,190 |       | $ | 4,434,174 |   |

 

For the three months ending March 31, 2005, onecustomer accounted for approximately 11% of consolidated revenues, or $562,426,in the semiconductor segment. For the same period in the prior year, twocustomers accounted for approximately 18% and 10% of consolidated revenues, or$968,890 and $542,389, in the semiconductor segment, respectively. There was nosignificant customer in the licensing segment for the three months ended March 31,2005 and March 31, 2004.

 

The following schedule presents the Company’srevenue by geographic area. For product sales, revenue is allocated based onthe country to which the product was shipped. For licensing-related revenue,the allocation is based on the location of the licensee’s corporateheadquarters. The Americas region includes North, Central and South America.

 

| ** **                     | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------|------------|----------------------------------------|------------|
| ** **                     | ** ** | **2005**                               | ** ** | **%** | ** ** | **2004** | ** ** | **%** | ** ** |
| **Geographic  Area  Revenue:** |       |                                   |       |   |   |   |   |   |   |
| Hong Kong                      |       | $                                      | 1,734,191  |   | 33 | % | $ | 2,222,537 |   | 42 | % |
| Japan                          |       | 1,520,489                              |       | 29 | % | 1,358,307 |   | 25 | % |
| Other Asia  Pacific            |       | 879,878                                |       | 16 | % | 334,265 |   | 6 | % |
| Americas                       |       | 723,526                                |       | 14 | % | 785,612 |   | 15 | % |
| China                          |       | 350,157                                |       | 7 | % | 280,021 |   | 5 | % |
| Europe                         |       | 40,417                                 |       | 1 | % | 362,303 |   | 7 | % |
|                           |       |                                   |       |   |   |   |   |   |   |
| Total                          |       | $                                      | 5,248,658  |   | 100 | % | $ | 5,343,045 |   | 100 | % |

 

**12.**                               **Recent AccountingPronouncements**

 

In March 2005, the Financial AccountingStandards Board (“FASB”) issued Interpretation No. 47, “Accounting forConditional Asset Retirement Obligations—an interpretation of FASB StatementNo. 143”  (“FIN 47”).   FIN 47 clarifies the term “conditional assetretirement obligation” as used in FASB Statement No. 143.  This Interpretation also clarifies that anentity is required to recognize a liability for the fair value of a conditionalasset retirement obligation when incurred if the liability’s fair value can bereasonably estimated.  The FIN alsoclarifies when an entity would have sufficient information to reasonablyestimate the fair value of an asset retirement obligation.  This Interpretation is effective for theCompany beginning December 31, 2005. The Company does not expect the adoption of FIN 47 to have a significantimpact on its consolidated financial position, results of operations or cashflows.

 

15

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In December 2004, the FASB  issued SFAS No. 123(R), “Share-BasedPayment”. This statement replaces SFAS No. 123, “Accounting forStock-Based Compensation” and supersedes APB No. 25, “Accounting for StockIssued to Employees.*”* SFAS123(R) requires all stock-based compensation to be recognized as anexpense in the financial statements and that such cost bemeasured according to the fair value of stock options. In April 2005, theSEC announced that the implementation of SFAS 123(R) has been delayed andwill now be effective for the Company beginning January 1, 2006. Theadoption of SFAS 123R will have a significant impact on the Company’s resultsof operations, as demonstrated by the SFAS 123 pro-forma disclosures atFootnote 2.  The adoption of the standardwill have no impact on the Company’s cash flows.

 

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

 

This information should be read in conjunction withthe audited consolidated financial statements and notes thereto and Management’sDiscussion and Analysis of Financial Condition and Results of Operationscontained in the Company’s Annual Report on Form 10-K for the year ended December 31,2004 (the “Form 10-K”), the audited consolidated financial statements and thenotes thereto included in the Form 10-K and the unaudited condensed interimconsolidated financial statements and notes thereto included in this QuarterlyReport.

 

**Overview**

 

SRSLabs is a leading developer and provider of application specific integratedcircuits, or ASICs, standard integrated circuits, or ICs, and audio and voicetechnology solutions for the home entertainment, portable media device,personal telecommunications, personal computer, automotive and broadcastmarkets. We operate in the following two business segments:

 

*Semiconductors:  *Through SRSLabs, Inc.’s wholly-owned subsidiary, ValenceTech Limited, and ValenceTechLimited’s wholly-owned subsidiaries (collectively “Valence”), we operate afabless semiconductor business which develops, designs and markets standard andcustom analog ICs, digital signal processors, or DSPs, and mixed signalintegrated circuits primarily to original equipment manufacturers, or OEMs, andoriginal design manufacturers , or ODMs, in the Asia Pacific region.

 

*Licensing:**  ***Through SRSLabs, the parent company, and its wholly-owned subsidiary,SRSWOWcast.com, Inc., doing business as SRSWOWcast Technologies (“SRSWOWcast”),the licensing segment develops and licenses audio, voice and surround soundtechnology solutions to many of the world’s leading OEMs, software providersand semiconductor companies, and licenses and markets hardware and softwareproducts for the Internet and professional audio markets.

 

Asused herein, the “Company,” “SRS Labs,” “we,” “us,” or “our” means SRSLabs, Inc. and its wholly owned subsidiaries, includingValence and SRSWOWcast.com Inc.

 

#### **Critical Accounting Policies**

 

Our discussion and analysis of our resultsof operations and liquidity and capital resources are based on our consolidatedfinancial statements which have been prepared in accordance with accountingprinciples generally accepted in the United States of America.

 

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 materially differ from our estimates.

 

**Results of Operations**

 

**Three Months Ended March 31, 2005 Compared toThree Months Ended March 31, 2004**

 

*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 fee based onthe number of units distributed by the licensee.  However, we have in the past

 

16

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and may again in the future, enter into a license agreement for a one-timefee. Also included in licensing revenue are revenues generated from the sale ofhardware and software applications into the broadcast audio markets.

 

Total revenues for the three months ended March 31,2005 were $5,248,658 compared to $5,343,045****forthe three months ended March 31, 2004, a decrease of $94,387 or 1.8%.  Semiconductor revenues were $1,984,563 forthe three months ended March 31, 2005 compared to $2,415,718for the three months ended March 31,2004, a decrease of $431,155 or 17.8%. Within semiconductor revenue, ASICaccounted for $1,469,463 or 74.0% for the three months ended March 31,2005 compared to $1,649,131 or 68.3% for the same period last year, a decreaseof $179,668 or 10.9%. ASP chips accounted for $515,100, or 26.0% for the threemonths ended March 31, 2005 compared to $766,587 or 31.7% for the sameperiod last year, a decrease of $251,487 or 32.8%.  Within ASP revenues, SRS chips accounted for64.0% for the three months ended March 31, 2005 compared to 37.5% for thesame period last year. The decrease in ASIC and ASP  sales can be primarily attributed to competitivepressures and the ramp up period for the new sales organization.

 

Licensing revenues were $3,264,095 for the threemonths ended March 31, 2005, compared to $2,927,327****for the three months ended March 31,2004, an increase of $336,768 or 11.5%. The sales growth in licensing was attributable to our continueddiversification strategy, which expanded the use of our technologies in theportable devices, PC, mobile phone and automotive markets. The followingtable presents the Company’s licensing revenues mix by market segment:

 
| ** **                                                | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Home  Entertainment (TV, Set Top Box, A/V Receiver, DVD)  |       | 64                                    | %          | 71 | % |
| Portable  Media Devices (Digital Media Player, Headphone) |       | 13                                    | %          | 9 | % |
| PC  (Software, Hardware)                                  |       | 12                                    | %          | 15 | % |
| Personal  Telecommunications (Mobile phone, PDA)          |       | 9                                     | %          | 4 | % |
| Automotive                                                |       | 2                                     | %          | 1 | % |

 

*Gross Margin*

 

Cost of sales consists primarily offabrication costs, assembly and test costs, and the cost of materials andoverhead from operations. Gross margins are dependent on the mix of productssold, services provided and royalties earned. The following table presents the Company’sgross margin percentages for the three months ended March 31:

 
| ** **                                                    | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| **Semiconductor**                                             |       |                                  |       |   |   |
| ASIC revenue  as a percentage of total semiconductor revenue  |       | 74.0                                  | %          | 68.3 | % |
| ASIC gross  margin                                            |       | 66.5                                  | %          | 67.4 | % |
|                                                          |       |                                  |       |   |   |
| ASP revenue  as a percentage of total semiconductor revenue   |       | 26.0                                  | %          | 31.7 | % |
| ASP gross  margin                                             |       | 54.2                                  | %          | 55.0 | % |
|                                                          |       |                                  |       |   |   |
| Total  semiconductor revenue as a percentage of total revenue |       | 37.8                                  | %          | 45.2 | % |
| Total  semiconductor gross margin                             |       | 63.3                                  | %          | 63.5 | % |
|                                                          |       |                                  |       |   |   |
| **Licensing**                                                 |       |                                  |       |   |   |
| Licensing  revenue as a percentage of total revenue           |       | 62.2                                  | %          | 54.8 | % |
| Licensing  gross margin                                       |       | 98.3                                  | %          | 99.1 | % |
|                                                          |       |                                  |       |   |   |
| **Total  Gross Margin**                                       |       | 85.1                                  | %          | 83.0 | % |

 

*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 $1,692,378 for the three months ended March 31, 2005, essentiallyunchanged from $1,695,368**for thesame prior year period.  As a percentageof total revenues, sales and marketing expenses increased from 31.7% for thequarter ended March 31, 2004 to 32.2% for the same period this year.

 

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*Researchand Development*

 

Researchand development expenses consist of salaries and related costs of employeesengaged in ongoing research, design and development activities and costs forengineering materials and supplies. Research and development expenses were$1,182,069 for the three months ended March 31, 2005, essentiallyunchanged from $1,208,687****for thesame prior year period. As a percentage of total revenues, research anddevelopment expenses were 22.6% for thequarter ended March 31, 2004, and 22.5% for the same period this year.

 

*Generaland Administrative*

 

General and administrative (“G&A”)expenses consist primarily of employee-related expenses, legal costs associatedwith the administration of intellectual property and other professional fees. G&Aexpenses were $1,469,228 for the three months ended March 31, 2005compared to $1,554,197for the same prior year period, a decrease of $84,969 or 5.5%. The decrease isprimarily attributable to a decrease in bad debt expense.  As a percentage of total revenues, G&Aexpenses decreased from 29.1% for the quarter ended March 31, 2004, to28.0% for the same period this year.

 

*Equityin Income of Investee*

* *

Equityin income of investee represents the Company’s proportionate share of profitfrom the CHS/SRS,LLC joint venture we entered intowith Coming Home Studios. On September 23, 2004, the Company entered intoa strategic alliance with Coming Home Studios LLC (“CHS”) to produce and sellconcert DVDs featuring Duran Duran, Boz Scaggs, Godsmack and All Access, whichinclude the Company’s Circle Surround technology. Profits from the distributionof the concert videos and related assets will be allocated and distributed inthe following manner and order: (i) 100% to the Company until such time as theCompany has received 130% of the $133,000 additional advance that the Companyprovided to the CHS/SRS, LLC to fund the Godsmack acoustical project; (ii)equally until the Company and CHS have each both received 1.75 times theiroriginal capital contributions; and thereafter (iii) 90% to CHS and 10% to theCompany. The joint venture is accounted for using the equity method and profitsare recognized following the guidance for equity method accounting. Werecognize and accrue profits as we get sales and/or royalty reports. For thethree months ended March 31, 2005, the profit recognized under theagreement was $77,332.

 

*OtherIncome, Net*

 

Otherincome, net, consists primarily of interest income, gain on sale of securitiesand foreign currency transaction gains and losses. Other income, net, was$147,932 for the three months ended March 31, 2005, compared to $237,450for the same prior year period, a decrease of $89,518 or 37.7%. The decrease isprimarily attributable to lower cash and investment balances in 2005 due to thecompany’s repurchase of treasury shares in 2004.

 

*Provisionfor Income Taxes*

 

The income tax expense for the threemonths ended March 31, 2005 was $124,202, compared to tax expense of$237,903 for the same prior year period, a decrease of $113,701 or 47.8%. 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 lowertax expense in fiscal 2005 resulted from decreased taxable income in ourforeign subsidiary.  In addition,  we benefited fromthe U.S. Japan tax treaty, which eliminated source-country withholdings onroyalties. That treaty became effective on July 1, 2004.

 

**Liquidity and Capital Resources**

 

The Company’s principal source of liquidityto fund ongoing operations at March 31, 2005 consisted of cash, cashequivalents and long-term investments of $24,002,048. At March 31, 2005,the Company had cash and cash equivalents of $7,000,241 and long-terminvestments of $17,001,807. Cash and cash equivalents generally consist ofcash, money market funds and other money market instruments with originalmaturities of three months or less. Investments consist of U.S. governmentsecurities rated AAA.

 

Net cash provided by operating activities was $102,978and $449,695 during the three months ended March 31, 2005 and March 31,2004, respectively. The decrease in our operating cash flows is primarily theresult of an increase in accounts receivable associated with increased licensingactivity.  Prepaids and other assets alsoincreased in the quarter due to annual premiums associated with insurance.  Offsetting those increases, our inventoriesdecreased $19,744 for the three months ended March 31, 2005 as opposed toan increase of $1,686 for the same period last year, as we sold through ourexisting inventory.  Our reserve for slowmoving and obsolete inventory as a percentage of total inventory was 23.8% and29.7% as of March 31, 2005 and December 31, 2004, respectively.  We monitor and analyze our inventory forobsolescence and adjust this reserve accordingly.  Our accounts payable increased $137,484 anddecreased $557,042 during the three months ended March 31, 2005 and 2004,respectively.  Our accrued liabilities  increased$158,063  and $211,971 during the

 

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three months ended March 31, 2005 and 2004, respectively.  The changes in liability accounts generallyrelate to increases in professional fees, commissions and bonus and the timingof payments to vendors and employees.

 

Our net cash used for and provided by investing activities was $180,936 and $4,997,321 during the three months ended March 31, 2005 and March 31, 2004, respectively. The shift from net cash provided by investing activities during the quarter ended March 31, 2004, as compared to net cash used in investing activities during the quarter ended March 31, 2005, was attributable primarily to a $5,375,000 decrease in proceeds from sales of investments available for sale, $39,706 increase in cash used in expenditures related to patents and intangible assets, offset by $236,449 decrease in purchases of furniture, fixtures and equipment.

 

We expect expenditures related to patents andintangible assets to increase in the future consistent with the growth in ourlicensing business, as we continue to invest in the development of newtechnologies.

 

Based on current plans and businessconditions, the Company expects that its cash, cash equivalents and investmentstogether with any amounts generated from operations will be sufficient to meetthe Company’s cash requirements for the foreseeable future. However, there canbe no assurance that the Company will not be required to seek other financingsooner or that such financing, if required, will be available on termssatisfactory to the Company.

 

**Factors That May Affect Future Results**

 

*Weare exposed to risks in our licensing business related to product and customerconcentration*

* *

Currently,our licensing revenue is concentrated in the home theater market with themajority of revenue generated from the inclusion of SRS technology insidetelevisions, DVD players and set-top boxes. We expect that the consumer homeentertainment market will continue to account for a significant portion of ourlicensing revenues for the foreseeable future. While consumer spending ingeneral on consumer electronic products has increased, retail prices forcertain consumer electronics products that include our audio technology, suchas DVD players, have decreased significantly.Indications are that this trend will continue for the foreseeable future. Fromtime to time, certain of our original equipment manufacturer and semiconductormanufacturer customers may account for a significant portion of revenue from aparticular product application, such as DVD players, set-top boxes ortelevisions. Consumer electronics products manufacturers could decide toexclude our audio enhancement technology from their home theater productsaltogether in an effort to reduce cost. The loss of any such customer couldhave a material adverse affect on our financial condition and results ofoperations.

 

*Ourbusiness is highly dependent on the consumer electronics market, which ischaracterized by short product life cycles, fluctuations in demand andseasonality, and subject to risks related to product transitions and supply ofother components*

* *

Theconsumer electronics market is characterized by intense competition, rapidlyevolving technology, and ever-changing consumer preferences. These factorsresult in the frequent introduction of new products, short product life cyclesand significant price competition. The dynamic nature of this market limitsour, as well as our customers’, ability to accurately forecast quarterly andannual sales. If we, or our customers, are unable to manage producttransitions, our business and results of operations could be negativelyaffected.

 

*Pricingpressures on the consumer electronics product manufacturers who incorporate ourtechnologies into their products could limit the licensing fees we charge forour technologies, which could adversely affect our revenues*

* *

Themarkets for the consumer electronics products in which our technologies areincorporated are intensely competitive and price sensitive. Retail prices forconsumer electronics products that include our technologies, such as DVDplayers and home theater systems, have decreased significantly, and we expectprices to continue to decrease for the foreseeable future. In response,manufacturers have sought to reduce their product costs, which can result indownward pressure on the licensing fees we charge our customers who incorporateour technologies. A decline in the licensing fees we charge could materiallyand adversely affect our operating results.

 

*Ourbusiness and prospects depend on the strength of our brand, and if we do notmaintain and strengthen our brand, our business will be materially harmed*

* *

Maintainingand strengthening the “SRS” brand is critical to maintaining and expanding bothour products and services business and our technology licensing business, aswell as to our ability to enter new markets for our audio and othertechnologies. Our continued success is due, in part, to our reputation forproviding high quality products, services and technologies across multipleconsumer electronics product segments. If we fail to effectively promote andmaintain the SRS brand, our business and prospects will suffer.

 

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*Ourquarterly results may fluctuate*

* *

Ouroperating results may fluctuate from those in prior quarters and will continueto be subject to quarterly and other fluctuations due to a variety of factors,including the extent to which our licensees incorporate our technologies intotheir products; the timing of orders from, and the shipments to, majorcustomers; the timing of new product introductions; the gain or loss ofsignificant customers; competitive pressures on selling prices; the marketacceptance of new or enhanced versions of our technologies; the rate that oursemiconductor licensees manufacture and distribute chips to productmanufacturers; and fluctuations in general economic conditions, particularlythose affecting the consumer electronics market. Due to our dependence on theconsumer electronics market, the substantial seasonality of sales in the marketcould impact our revenues and net income. In particular, we believe that thereis seasonality relating to the Christmas season generally and the Chinese NewYear within the Asia region, which fall into the fourth and first quartersrespectively. As a result, we believe that period-to-period comparisons of ourresults of operations are not necessarily meaningful and should not be reliedon as indications of future performance.

 

*Weare subject to the highly cyclical nature of the semiconductor industry*

* *

Thesemiconductor industry is highly cyclical. The industry has experiencedsignificant downturns, often in connection with, or in anticipation of,maturing product cycles (of both semiconductor companies’ and their customers’products) and declines in general economic conditions. These downturns havebeen characterized by production overcapacity, high inventory levels andaccelerated erosion of average selling prices. Any future downturns couldsignificantly harm our sales or reduce our profitability for a prolonged periodof time. From time to time, the semiconductor industry also has experiencedperiods of increased demand and production capacity constraints. We mayexperience substantial changes in future operating results due to generalsemiconductor industry conditions, general economic conditions and otherfactors.

 

*Werely on revenue contribution from our ASIC and standard IC business*

* *

Wederive a significant amount of our revenue from Valence’s ASIC business.Valence’s engineering team focuses on the design of custom ASICs to meetspecific customers’ requirements and out sources the production of the designto mask houses, foundries and packaging houses located primarily in Asia. Theoperations of Valence could be affected by a variety of factors, including thetiming of customer orders, the timing of development revenue, changes in themix of products distributed and the mix of distribution channels employed, the emergence of a new industry standard, productobsolescence and changes in pricing policies by us, our competitors or oursuppliers.

 

Businessrevenue from ASICs is concentrated in a limited number of customers in theareas of consumer electronics, communications products, computers and computerperipherals. The business generated from any one customer may be for a fixedlength or quantity. As such, it is customary in our ASIC business to have acertain amount of customer turnover as new ASIC projects are obtained for differentcustomers. However, it is possible that the loss of any particular customer orany bad debt arising from such customer may have a materially adverse impact onour financial condition and results of operation.

 

Valenceadds significant diversity to our overall business structure and opportunities.We recognize that in the presence of such corporate diversity, and inparticular with regard to the semiconductor industry, there will always exist a potential for conflict among sales channels betweenus and our technology licensees. Although the operations of our licensingbusiness and those of Valence are generally complementary, there can be noassurances that sales channel conflicts will not arise. If such potentialconflicts do materialize, we may or may not be able to mitigate the effect ofsuch perceived conflicts, which, if not resolved, may impact the results ofoperations.

 

*Potentialchannel conflict with existing semiconductor partners could cause us to losefuture business*

* *

Aswe bring out more and more Valence semiconductors with SRS audio technologiesembedded in them, our current semiconductor partners may perceive those newdevices as threats to their own products. The semiconductor partners mayrespond by reducing or eliminating the volumes of business they presently dowith us, which would have an adverse effect on our licensing revenue.

 

*Weare exposed to risks in our Valence business related to product fabricationoutsourcing 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. Fromtime to time there can be foundry capacity issues due to global demands thataffect the semiconductor industry. Although we believe our relationships aregenerally good, we do not have long-term supply agreements with our third-partyvendors and they are not obligated to perform services or supply products to usfor any particular period or in any particular quantities, except as providedin each separate purchase order accepted by them. The increased demand for ourproducts coupled with the demand for foundry services, is, and will continue tobe for the foreseeable future, a challenge for us. In

 

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times of highdemand, there are significant risks associated with our reliance on third-partyvendors including: reallocation of capacity to other foundry customers, potentialprice increases, delays and interruptions in order deliveries, reduced controlover product quality and increased risk of misappropriation of intellectualproperty.

 

*Weconduct operations in a number of countries and are subject to risks of internationaloperations, particularly in the People’s Republic of China (PRC) and otherparts of Asia*

* *

Wehave significant operations in the PRC and other parts of Asia that requirerefinement to adapt to the changing market conditions in those regions. Ouroperations in Asia, and international operations ingeneral, are subject to risks of unexpected changes in, or impositions of,legislative or regulatory requirements.

 

Ourcustomers geographically located in the Asia Pacific markets accounted forapproximately 86%, 93% and 90% of total Company sales in 2004, 2003 and 2002,respectively and are expected to continue to account for a substantialpercentage of sales in the future.

 

ThePRC economy has experienced significant growth in the past decade; but suchgrowth has been uneven across geographic and economic sectors. There can be noassurance that such growth will continue or that any potential currencydevaluation in the region will not have a negative effect on our business,including Valence. The PRC economy has also experienced deflation in the past,which may continue in the future. The current economic situation may adverselyaffect our profitability over time as expenditures for consumer electronicsproducts and information technology may decrease due to the results of slowingdomestic demand and deflation.

 

HongKong is a Special Administrative Region of the PRC with its own government andlegislature. Hong Kong enjoys a high degree of autonomy from the PRC under theprinciple of “one country, two systems.” We can give no assurance that HongKong will continue to enjoy autonomy from the PRC.

 

TheHong Kong dollar has remained relatively constant due to the U.S. dollar pegand currency board system that has been in effect in Hong Kong since 1983.Since mid-1997, interest rates in Hong Kong have fluctuated significantly andreal estate and retail sales have declined. We can give no assurance that theHong Kong economy will not worsen or that the historical currency peg of theHong Kong dollar to the U.S. dollar will be maintained. Continued decliningconsumer spending in Hong Kong, deflation or the discontinuation of thecurrency peg could adversely affect our business.

 

*Weare exposed to currency fluctuations and instability in the Asian markets*

* *

Weexpect that international sales will continue to represent a significantportion of our total revenues. To date, all of our licensing revenues have beendenominated in U.S. dollars and most costs have been incurred in U.S. dollars.It is our expectation that licensing revenues will continue to be denominatedin U.S. dollars for the foreseeable future. Because Valence’s business isprimarily focused in Asia and because of our anticipated expansion of businessin the PRC and other parts of Asia, our consolidated results of operations andfinancial position could be significantly affected by risks associated withinternational activities, including economic and labor conditions, politicalinstability, tax laws (including U.S. taxes on foreign subsidiaries) andchanges in the value of the U.S. dollar versus the local currency in which theproducts are sold. In addition, our valuation of assets recorded as a result ofthe Valence acquisition may also be adversely impacted by the currencyfluctuations 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.

 

*Ifthe sale of consumer electronics products incorporating our technologies doesnot grow in emerging markets, our ability to increase our licensing revenue maybe limited*

* *

Wealso expect that growth in our licensing revenue will depend, in part, upon thegrowth of sales of consumer electronics products incorporating our technologiesin other countries, including China and India, as consumers in these marketshave more disposable income and are increasingly purchasing entertainmentproducts with surround sound capabilities. However, if our licensing revenuefrom the use of our technologies in these new markets or geographic areas doesnot expand, our prospects could be adversely affected.

 

*Weare 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 of

 

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integration; andimplementation of the products and technologies with other hardware andsoftware components in the OEM’s products. In addition, the markets in which wecompete are intensely competitive and are characterized by rapid technologicalchanges, declining average sales prices and rapid product obsolescence.Accordingly, there can be no assurance that we will be able to continue tocompete effectively in its respective markets, that competition will notintensify or that future competition will not have a material adverse effect onour business, operating results, cash flows and financial condition.

 

*Wehave a long and unpredictable sales cycle, which can result in uncertainty anddelays in generating additional revenues*

* *

Historically,because of the complexity of our technologies, it can take a significant amountof time and effort to explain the benefits and to negotiate a sale. Forexample, it typically takes six to nine months after our first contact with aprospective customer before we start licensing our technology to that customer.In addition, purchase of our products is usually made in connection with newdesign starts, the timing of which is outside of our control. Accordingly, wemay be unable to predict accurately the timing of any significant future salesof our products. We may also spend substantial time and management attention onpotential license agreements that are not consummated, thereby foregoing otheropportunities.

 

*Westrongly rely on our intellectual property*

* *

Ourability to compete may be affected by our ability to protect our proprietaryinformation. We have filed numerous U.S. and foreign patent applications and todate have a number of issued U.S. and foreign patents covering various aspectsof our technologies. There can be no assurance that the steps taken by us toprotect our intellectual property will be adequate to prevent misappropriationof our technology or that our competitors will not independently developtechnologies that are substantially equivalent or superior to our technology.In addition, the laws of certain foreign countries may not protect ourintellectual property rights to the same extent, as do the laws of the U.S. Thesemiconductor industry is characterized by frequent claims and litigationregarding patent and other property rights. We are not currently a party to anyclaims of this nature. There can be no assurances that third parties will notassert claims or initiate litigation against us or our customers with respectto existing or future products. In addition, we may initiate claims orlitigation against third parties for infringement of our proprietary rights orto determine the scope and validity of our proprietary rights.

 

*Wedepend on our key personnel*

* *

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

 

*Themarket price of our common stock is volatile*

* *

Thetrading price of our common stock has been, and will likely continue to be,subject to wide fluctuations in response to quarterly variations in ouroperating results, announcements of new products or technological innovationsby us or our competitors, strategic alliances between us and third parties,general market fluctuations and other events and factors. Changes in earningsestimates made by brokerage firms and industry analysts relating to the marketsin which we do business, or relating to us specifically, have in the pastresulted in, and could in the future result in, an immediate and adverse effecton the market price of the common stock. Even though our stock is quoted on theNasdaq Stock Market, our stock has had and may continue to have low tradingvolume and high volatility. The historically low trading volume of our stockmakes it more likely that a severe fluctuation in volume, either up or down,will significantly impact the stock price. Since our shares are thinly traded,our shareholders may have difficulty selling our common stock.

 

*Ourcertificate of incorporation, bylaws, change in control agreements withofficers and key employees,  as well asDelaware law contain provisions that could discourage transactions resulting ina change in control, which may negatively affect the market price of our commonstock*

* *

Ourcertificate of incorporation, bylaws, change in control agreements with officers and keyemployees and Delaware law contain provisions that might enable our managementto discourage, delay or prevent change in control. In addition, theseprovisions could limit the price that investors would be willing to pay in thefuture for shares of our common stock.

 

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**Item 3****.****  Quantitative and Qualitative Disclosuresabout 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 ended December 31,2004.

 

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

 

*Restatements*

 

On May 10, 2005, management of 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 (“fiscal2005”).  Commencing in the first quarterof the fiscal year ended December 31, 2004 (“fiscal 2004”), the Company beganto capitalize and amortize trade show expenses incurred in the fiscal year toreflect the future 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 quarter fiscal2005 review, 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.  We willrestate 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 will be amended to reflect therestated quarterly results including the quarter ended December 31, 2004.

 

*Evaluationof Disclosure Controls and Procedures*

 

We conducted an evaluation of the effectiveness of the design andoperation of our disclosure controls and procedures (as defined in Rules13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended(the “Exchange Act”)) as of the end of the period covered by this QuarterlyReport. The controls evaluation was done under the supervision and with theparticipation of management, including our Chief Executive Officer and ChiefFinancial Officer. In the course of the evaluation as of the end of the period coveredby this Quarterly Report, our Chief Executive Officer and Chief FinancialOfficer were advised by BDO Seidman that the Company’s improper interpretationof accounting literature with respect to interim accounting for sales andmarketing expenses related to trade show expenses described above constituted amaterial weakness in our internal control over financial reporting.  Solely as a result of this material weakness,we concluded that our disclosure controls and procedures were not effective asof March 31, 2005.

 

In connection with this Quarterly Report on Form 10-Q, under thedirection of our Chief Executive Officer and Chief Financial Officer, we haveevaluated our disclosure controls and procedures as currently in effect,including the changes in internal controls over financial reporting recentlyimplemented and described below, and we have concluded that, as of this date,our disclosure controls and procedures are effective.

 

*Changes inInternal Controls*

 

In the course of BDO Seidman’s financial statement review proceduresrelating to this Quarterly Report on Form 10-Q, BDO Seidman advised the Companythat the Company’s improper interpretation of accounting literature withrespect to interim accounting for sales and marketing expenses related to tradeshow expenses described above 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 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 that these corrective actions, taken as a whole,will remediate the control deficiency identified above, but the Company willcontinue to monitor the effectiveness of these actions and will make any otherchanges or take such other actions as management determines to be appropriate.

 

Except for the controls described above, no change in the Company’sinternal controls over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) occurred during the first quarter ended March31, 2005, that has materially affected, or is reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

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

 

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

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                              |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Separation Agreement dated as of August 9,  2004 by and between SRS Labs, Inc. and Theodore A. Franceschi.                                                                                                                                                                              |
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                   |
| 10.2                |       | Non-employee Director Compensation Policy  adopted by the Company’s Board of Directors on January 28, 2005,  previously filed with the Commission as Exhibit 10.5 to the Form 8-K filed  with the Commission on February 3, 2005, which is incorporated herein by  reference. |
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                   |
| 10.3                |       | Form of Nonqualified Stock Option Agreement  (with schedule of parties attached), previously filed with the  Commission as Exhibit 10.1 to the Form 8-K filed with the Commission on April 4,  2005, which is incorporated herein by reference.                                    |
|                |       |                                                                                                                                                                                                                                                                                         |
| 31.1                |       | Certification of Chief Executive Officer of  SRS Labs, Inc., pursuant to Rule 13a-14 of the Securities Exchange Act.                                                                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                         |
| 31.2                |       | Certification of Chief Financial Officer of  SRS Labs, Inc., pursuant to Rule 13a-14 of the Securities Exchange Act.                                                                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                         |
| 32.1                |       | Certification of Chief Executive Officer of  SRS Labs, Inc., pursuant to Section 906 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                         |
| 32.2                |       | Certification of Chief Financial Officer of  SRS Labs, Inc., pursuant to Section 906 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                |

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|                               | SRS LABS, INC., a Delaware corporation |
|------------------------------------|---------------------------------------------|
|                               |                                        |   |
| Date:  May 16, 2005      | By:                                         | /s/ THOMAS C.K. YUEN |
|                               |                                        | Thomas C.K. Yuen |
|                               |                                        | Chairman of the Board and Chief Executive Officer |
|                               |                                        | (Principal Executive Officer) |
| ** **                         | ** **                                  | ** ** |
| ** **                         | ** **                                  | ** ** |
| Date:  May 16, 2005 | By:                                         | /s/ JANET M. BISKI |
|                               |                                        | Janet M. Biski |
|                               |                                        | Chief Financial Officer |
|                               |                                        | (Principal Financial and Accounting Officer) |

 

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