**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q/A**

 

----

 

**(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, 2004**                                                                                                                                              |
| ** ** | ** ** | ** **                                                                                                                                                                                          |
| ** ** | ** ** | **OR**                                                                                                                                                                                              |
| ** ** | ** ** | ** **                                                                                                                                                                                          |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**                                                                                             |
| ** ** | ** ** | ** **                                                                                                                                                                                          |
| ** ** | ** ** | **For the transition period from                to             ** |

 

**CommissionFile Number 0-21123**

 

 

**SRS LABS, INC.**

(Exact name of registrant as specified in itscharter)

 
| **Delaware**                                                                        | ** ** | **33-0714264**                        |
|-------------------------------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                     |       | (I.R.S. Employer  Identification No.) |
|                                                                                |       |                                  |
| **2909 Daimler Street, Santa Ana, California 92705**                                |
| (Address of principal executive offices) (Zip Code)                                 |
|                                                                                |       |                                  |
| **(949) 442-1070**                                                             |
| (Registrant’s telephone number, including area code)                           |
|                                                                                |       |                                  |
| **Not Applicable**                                                                  |
| (Former name, former address and former fiscal year, if changed since  last report) |

 

----

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes ý  No o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the ExchangeAct). Yes o   No ý

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date: as of April 30, 2004, 14,415,984of the issuer’s common stock, par value $.001 per share, were outstanding. Inaddition, as of April 30, 2004, 225,300 shares of the issuer’s commonstock were held as treasury shares.

 

 

----

 

**EXPLANATORY NOTE**

 

On May 10, 2005, management of SRS Labs, Inc. (the “Company”)was advised by BDO Seidman, LLP, its independent registered public accountingfirm (“BDO Seidman”), of the conclusion reached by it regarding the Company’sinterim accounting for sales and marketing expenses related to tradeshows.  This conclusion was reached inconnection with BDO Seidman’s financial statement review procedures relating tothe Company’s Quarterly Report on Form 10-Q for the first quarter ofthe year ending December 31, 2005 (“fiscal 2005”).  Commencing in the first quarter of the fiscalyear ended December 31, 2004 (“fiscal 2004”), the Company began tocapitalize 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 quarterreview, BDO Seidman noted that trade show costs previously capitalized andamortized should have been treated as period expenses in fiscal 2004.  As a result, BDO Seidman expressed its viewthat (a) trade show costs previously capitalized and amortized duringfiscal 2004 should have been treated as period expenses in fiscal 2004; (b) eachof the Company’s quarterly reports previously filed in fiscal 2004 should berestated; and (c) no reliance should be placed on the previously issuedfiscal 2004 quarterly financial statements.

 

Acting on the recommendation of BDO Seidman, the Company has restatedits financial statements for the quarterly periods ended March 31, 2004, June 30,2004 and September 30, 2004.  TheCompany is restating these unaudited quarterly financial statements principallyto reflect trade show expenses as period expenses that are expensed asincurred.  This amended Quarterly Reporton Form 10-Q/A principally restates prior reported results andincludes additional disclosures in the appropriate period as a result of thechange in accounting treatment for trade show expenses.  The restatement of our quarterly reports forfiscal 2004 has no impact on the Company’s consolidated net income for fiscal2004 and does not affect the Company’s historical cash flows.  Accordingly, the consolidated financialstatements included in the Company’s Annual Report on Form 10-K for fiscal 2004have not changed.  The Company has amendedits Annual Report on Form 10-K for fiscal 2004 to restate the disclosures ofpreviously reported unaudited quarterly results as a result of the change ofaccounting treatment for trade show expenses.

 

In addition, in the course of BDO Seidman’s financial statement reviewprocedures relating to the Company’s Quarterly Report on Form 10-Qfor the first quarter of fiscal 2005, BDO Seidman advised the Company that theCompany’s decision to capitalize and amortize tradeshow expenses during fiscal2004 constituted a deficiency in the Company’s internal controls and advisedthe Audit Committee that this internal control deficiency constitutes areportable condition and a material weakness as defined in Statement onAuditing 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.

 

This Form 10-Q/A has not been updated except as required toreflect the effects of the restatement. This amendment and restatement includeschanges to Part I, Items 1, 2 and 4 and Part II, Item 6. Except asidentified in the prior sentence, no other item included in the original Form 10-Qhas been amended, and such items shall remain in effect as of the filing dateof the original Form 10-Q. Additionally, this Form 10-Q/Adoes not purport to provide an update or discussion of any other developmentsat the Company subsequent to its original filing.

 

2

----

 

**SRS LABS, INC.**

 

**Form 10-Q**

**For the Period Ended March 31, 2004**

 

**Index**

 
| **PART I—FINANCIAL  INFORMATION** |                                                                                                                                                 |
|---------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------|
| Item 1.                                     | Financial Statements                                                                                                                                 |   |
|                                        | Condensed  Consolidated Balance Sheets as of March 31, 2004 (Unaudited) and December 31,  2003                                             |   |
|                                        | Condensed  Consolidated Statements of Operations for the three months ended March 31,  2004 and 2003 (Unaudited)                                |   |
|                                        | Condensed  Consolidated Statements of Stockholders’ Equity and Comprehensive Income for  the three months ended March 31, 2004 (Unaudited) |   |
|                                        | Condensed  Consolidated Statements of Cash Flows for the three months ended March 31,  2004 and 2003 (Unaudited)                                |   |
|                                        | Notes  to the Condensed Interim Consolidated Financial Statements (Unaudited)                                                                        |   |
| Item  2.                                    | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                          |   |
| Item  3.                                    | Quantitative  and Qualitative Disclosures About Market Risk                                                                                          |   |
| Item 4.                                     | Controls and  Procedures                                                                                                                             |   |
| **PART II—OTHER  INFORMATION**    |                                                                                                                                                 |
| Item 6.                                     | Exhibits  and Reports on Form 8-K                                                                                                               |   |
|                                        |                                                                                                                                                 |
| SIGNATURES                                  |                                                                                                                                                 |
| CERTIFICATIONS                              |                                                                                                                                                 |

 

3

----

 

**FORWARD-LOOKING INFORMATION**

 

ThisQuarterly Report on Form 10-Q contains forward-looking statementswithin the meaning of Section 21E of the Securities Exchange Act of 1934,as amended, and Section 27A of the Securities Act of 1933, as amended,reflecting management’s current expectations. Examples of such forward-lookingstatements include the expectations of the Company with respect to itsstrategy. Although the Company believes that its expectations are based uponreasonable assumptions, there can be no assurances that the Company’s financialgoals will be realized. Such forward-looking statements involve known andunknown risks, uncertainties and other factors that may cause the actualresults, performance or achievements of the Company, or industry results, to bematerially different from any future results, performance or achievementsexpressed or implied by such forward-looking statements. Numerous factors mayaffect the Company’s actual results and may cause results to differ materiallyfrom those expressed in forward-looking statements made by or on behalf of theCompany. For this purpose, any statements contained herein that are notstatements of historical fact may be deemed to be forward-looking statements.Without limiting the foregoing, the words, “believes,” “anticipates,” “plans,” “expects”and similar expressions, are intended to identify forward-looking statements.The important factors discussed in Part I, Item 2, “Management’sDiscussion and Analysis of Financial Condition and Results ofOperations—Factors That May Affect Future Results”, herein, among others,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.

 

4

----

 

**PART I — FINANCIAL INFORMATION**

 

**Item 1.Financial Statements.**

 

**SRS LABS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                    | ** ** | **March 31, 2004**     | ** ** | **December 31, 2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                                                                    | ** ** | **(Unaudited)  (Restated)** | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                                                                                                    | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| **Current  Assets**                                                                                                                                                                                                           | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| Cash and cash equivalents                                                                                                                                                                                                     |       | $                           | 20,392,955 |                       | $          | 12,795,620 |   |
| Accounts receivable, net                                                                                                                                                                                                      |       | 783,960                     |       | 1,230,423                  |       |
| Inventories, net                                                                                                                                                                                                              |       | 714,298                     |       | 753,020                    |       |
| Prepaid expenses and other current assets                                                                                                                                                                                     |       | 1,020,980                   |       | 1,073,696                  |       |
| Deferred income taxes                                                                                                                                                                                                         |       | 23,406                      |       | 23,406                     |       |
|                                                                                                                                                                                                                          |       |                        |       |                       |       |
| **Total  Current Assets**                                                                                                                                                                                                     |       | 22,935,599                  |       | 15,876,165                 |       |
|                                                                                                                                                                                                                          |       |                        |       |                       |       |
| Investments available for sale                                                                                                                                                                                                |       | 5,339,428                   |       | 10,490,210                 |       |
| Furniture, fixtures & equipment,  net                                                                                                                                                                                |       | 1,750,476                   |       | 1,661,980                  |       |
| Goodwill, net                                                                                                                                                                                                                 |       | 533,031                     |       | 533,031                    |       |
| Intangible assets, net                                                                                                                                                                                                        |       | 2,711,664                   |       | 2,736,810                  |       |
| Deferred income taxes                                                                                                                                                                                                         |       | 209,673                     |       | 193,134                    |       |
|                                                                                                                                                                                                                          |       |                        |       |                       |       |
| **Total  Assets**                                                                                                                                                                                                             |       | $                           | 33,479,871 |                       | $          | 31,491,330 |   |
|                                                                                                                                                                                                                          |       |                        |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                 | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| **Current  Liabilities**                                                                                                                                                                                                      | ** ** | ** **                  | ** ** | ** **                 | ** ** |
| Accounts payable                                                                                                                                                                                                              |       | $                           | 946,809    |                       | $          | 1,503,851 |   |
| Accrued liabilities                                                                                                                                                                                                           |       | 1,817,275                   |       | 1,606,069                  |       |
| Income taxes payable                                                                                                                                                                                                          |       | 538,000                     |       | 430,949                    |       |
|                                                                                                                                                                                                                          |       |                        |       |                       |       |
| **Total  Current Liabilities**                                                                                                                                                                                                |       | 3,302,084                   |       | 3,540,869                  |       |
|                                                                                                                                                                                                                          |       |                        |       |                       |       |
| Commitments and contingencies                                                                                                                                                                                                 |       |                        |       |                       |       |
|                                                                                                                                                                                                                          |       |                        |       |                       |       |
| **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; 14,255,893 and 13,682,282 shares issued; and 14,030,593  and 13,456,982 shares outstanding at March 31, 2004 and December 31,  2003, respectively |       | 14,256                      |       | 13,683                     |       |
| Additional paid in capital                                                                                                                                                                                                    |       | 60,586,595                  |       | 58,423,249                 |       |
| Accumulated other comprehensive loss                                                                                                                                                                                          |       | (248,408                    | )          | (336,346                   | )          |
| Accumulated deficit                                                                                                                                                                                                           |       | (29,456,055                 | )          | (29,431,524                | )          |
| Treasury stock at cost, 225,300 shares at March 31,  2004 and at December 31, 2003                                                                                                                                  |       | (718,601                    | )          | (718,601                   | )          |
|                                                                                                                                                                                                                          |       |                        |       |                       |       |
| Total Stockholders’ Equity                                                                                                                                                                                               |       | 30,177,787                  |       | 27,950,461                 |       |
|                                                                                                                                                                                                                          |       |                        |       |                       |       |
| Total Liabilities and Stockholders’ Equity                                                                                                                                                                               |       | $                           | 33,479,871 |                       | $          | 31,491,330 |   |

 

See accompanying notes to the condensed interim consolidated financialstatements

 

5

----

 

**SRS LABS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                                       | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                       | ** ** | **2004**                               | ** ** | **2003** | ** ** |
| ** **                                                                       | ** ** | **(Restated)**                         | ** ** | ** ** | ** ** |
| Revenues:                                                                        |       |                                   |       |   |   |
| Semiconductor                                                                    |       | $                                      | 2,415,718  |   | $ | 1,764,080 |   |
| Licensing                                                                        |       | 2,927,327                              |       | 2,706,294 |   |
| Total revenues                                                                   |       | 5,343,045                              |       | 4,470,374 |   |
|                                                                             |       |                                   |       |   |   |
| Cost of sales                                                                    |       | 908,871                                |       | 669,568 |   |
|                                                                             |       |                                   |       |   |   |
| Gross margin                                                                     |       | 4,434,174                              |       | 3,800,806 |   |
|                                                                             |       |                                   |       |   |   |
| Operating expenses:                                                              |       |                                   |       |   |   |
| Sales and marketing                                                              |       | 1,695,368                              |       | 1,352,490 |   |
| Research and development                                                         |       | 1,208,687                              |       | 1,081,215 |   |
| General and administrative                                                       |       | 1,554,197                              |       | 1,314,610 |   |
|                                                                             |       |                                   |       |   |   |
| Total operating expenses                                                         |       | 4,458,252                              |       | 3,748,315 |   |
|                                                                             |       |                                   |       |   |   |
| Income (loss) from operations                                                    |       | (24,078                                | )          | 52,491 |   |
|                                                                             |       |                                   |       |   |   |
| Other income, net                                                                |       | 237,450                                |       | 164,126 |   |
| Minority interest                                                                |       | —                                 |       | 5,430 |   |
|                                                                             |       |                                   |       |   |   |
| Income before income tax expense                                                 |       | 213,372                                |       | 222,047 |   |
|                                                                             |       |                                   |       |   |   |
| Income tax expense                                                               |       | 237,903                                |       | 179,513 |   |
|                                                                             |       |                                   |       |   |   |
| Net income (loss)                                                                |       | $                                      | (24,531    | ) | $ | 42,534 |   |
|                                                                             |       |                                   |       |   |   |
| Net income per common share:                                                     |       |                                   |       |   |   |
|                                                                             |       |                                   |       |   |   |
| Basic                                                                            |       | $                                      | 0.00       |   | $ | 0.00 |   |
|                                                                             |       |                                   |       |   |   |
| Diluted                                                                          |       | $                                      | 0.00       |   | $ | 0.00 |   |
|                                                                             |       |                                   |       |   |   |
| Weighted average shares used in the  calculation of net income per common share: |       |                                   |       |   |   |
| Basic                                                                            |       | 13,746,521                             |       | 12,798,238 |   |
|                                                                             |       |                                   |       |   |   |
| Diluted                                                                          |       | 16,679,373                             |       | 12,983,526 |   |

 

See accompanying notes to the condensed interim consolidated financialstatements

 

6

----

 

**SRS LABS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY ANDCOMPREHENSIVE INCOME (Unaudited)**

 
| ** **                                                     | ** ** | ** **        | ** ** | **Additional** | ** ** | **Accumulated  Other** | ** ** | ** **        | ** ** | ** **   | ** ** | ** ** | ** ** | **Comprehensive  Income** | ** ** |
|----------------------------------------------------------------|------------|-------------------|------------|----------------|------------|------------------------|------------|-------------------|------------|--------------|------------|------------|------------|---------------------------|------------|
| ** **                                                     | ** ** | **Common  Stock** | ** ** | **Paid-In**    | ** ** | **Comprehensive**      | ** ** | **Accumulated**   | ** ** | **Treasury** | ** ** | ** ** | ** ** | **for the  Periods**      | ** ** |
| ** **                                                     | ** ** | **Shares**        | ** ** | **Amount**     | ** ** | **Capital**            | ** ** | **Income (Loss)** | ** ** | **Deficit**  | ** ** | **Stock**  | ** ** | **Total**                 | ** ** | **Ended** | ** ** |
| ** **                                                     | ** ** | ** **        | ** ** | ** **     | ** ** | ** **             | ** ** | ** **        | ** ** | ** **   | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
| BALANCE,  Dec. 31, 2003                                   |       | 13,456,982        |       | $              | 13,683     |                   | $          | 58,423,249        |       | $            | (336,346   | )          | $          | (29,431,524               | )          | $ | (718,601 | ) | $ | 27,950,461 |   |   |   |
| Proceeds  from exercise of stock options                       |       | 573,611           |       | 573            |       | 2,149,746              |       | —            |       | —       |       | —     |       | 2,150,319                 |       |   |   |
| Deferred  stock option compensation                            |       | —            |       | —         |       | 13,600                 |       | —            |       | —       |       | —     |       | 13,600                    |       |   |   |
| Unrealized  gain on investments available for sale, net of tax |       | —            |       | —         |       | —                 |       | 87,938            |       | —       |       | —     |       | 87,938                    |       | 87,938 |   |
| Net  loss                                                      |       | —            |       | —         |       | —                 |       | —            |       | (24,531      | )          | —     |       | (24,531                   | )          | (24,531 | ) |
|                                                           |       |              |       |           |       |                   |       |              |       |         |       |       |       |                      |       |   |   |
| BALANCE,  March 31, 2004                                  |       | 14,030,593        |       | $              | 14,256     |                   | $          | 60,586,595        |       | $            | (248,408   | )          | $          | (29,456,055               | )          | $ | (718,601 | ) | $ | 30,177,787 |   | $ | 63,407 |   |
|                                                                |            |                   |            |                |            |                        |            |                   |            |              |            |            |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to the condensedinterim consolidated financial statements

 

7

----

 

**SRS LABS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                   | ** ** | **2004**                               | ** ** | **2003** | ** ** |
| ** **                                                                                   | ** ** | **(Restated)**                         | ** ** | ** ** | ** ** |
| **Cash  Flows From Operating Activities:**                                                   |       |                                   |       |   |   |
| Net income (loss)                                                                            |       | $                                      | (24,531    | ) | $ | 42,534 |   |
| Adjustments to reconcile net income to net  cash provided by (used in) operating activities: |       |                                   |       |   |   |
| Depreciation and amortization                                                                |       | 310,867                                |       | 286,115 |   |
| Minority interest                                                                            |       | —                                 |       | (5,430 | ) |
| Provision for doubtful accounts                                                              |       | 69,603                                 |       | (8,804 | ) |
| Provision for obsolete inventory                                                             |       | (67,977                                | )          | 27,108 |   |
| Deferred taxes                                                                               |       | (16,539                                | )          | 2,308 |   |
| Amortization on premium on investments  available for sale                                   |       | 3,094                                  |       | — |   |
| Increase in deferred stock option  compensation                                              |       | 13,600                                 |       | 18,236 |   |
| Loss on disposition of furniture, fixtures  and equipment                                    |       | 31                                     |       | — |   |
| Impairment on intangible assets                                                              |       | 3,431                                  |       | — |   |
| Changes in operating assets and  liabilities:                                                |       |                                   |       |   |   |
| Accounts receivable                                                                          |       | 376,860                                |       | 162,943 |   |
| Inventories                                                                                  |       | 106,698                                |       | (74,819 | ) |
| Prepaid expenses and other current assets                                                    |       | 52,716                                 |       | 54,572 |   |
| Accounts payable                                                                             |       | (557,042                               | )          | (195,427 | ) |
| Accrued liabilities                                                                          |       | 211,205                                |       | (632,510 | ) |
| Income taxes payable                                                                         |       | 107,051                                |       | (17,724 | ) |
|                                                                                         |       |                                   |       |   |   |
| Net cash provided by (used in) operating  activities                                         |       | 589,069                                |       | (340,898 | ) |
|                                                                                         |       |                                   |       |   |   |
| **Cash  Flows From Investing Activities:**                                                   |       |                                   |       |   |   |
| Purchase of furniture, fixtures &  equipment                                        |       | (273,889                               | )          | (120,843 | ) |
| Purchase of investments available for sale                                                   |       | —                                 |       | (10,539,580 | ) |
| Proceeds from sale of investments available  for sale                                        |       | 5,235,626                              |       | 8,545,113 |   |
| Expenditures related to patents and  intangible assets                                       |       | (103,790                               | )          | (52,008 | ) |
|                                                                                         |       |                                   |       |   |   |
| Net cash provided by (used in) investing  activities                                         |       | 4,857,947                              |       | (2,167,318 | ) |
|                                                                                         |       |                                   |       |   |   |
| **Cash  Flows From Financing Activities:**                                                   |       |                                   |       |   |   |
| Proceeds from exercise of stock options                                                      |       | 2,150,319                              |       | 13,125 |   |
|                                                                                         |       |                                   |       |   |   |
| Net cash provided by financing activities                                                    |       | 2,150,319                              |       | 13,125 |   |
|                                                                                         |       |                                   |       |   |   |
| **Net  Increase (Decrease) in Cash and Cash Equivalents**                                    |       | 7,597,335                              |       | (2,495,091 | ) |
| **Cash and  Cash Equivalents, Beginning of Period**                                          |       | 12,795,620                             |       | 15,720,860 |   |
|                                                                                         |       |                                   |       |   |   |
| **Cash and  Cash Equivalents, End of Period**                                                |       | $                                      | 20,392,955 |   | $ | 13,225,769 |   |
|                                                                                         |       |                                   |       |   |   |
| **Supplemental  Disclosures of Cash Flow Information:**                                      |       |                                   |       |   |   |
| Cash paid during the period for:                                                             |       |                                   |       |   |   |
| Income taxes                                                                                 |       | $                                      | 211,961    |   | $ | 209,491 |   |
| **Supplemental  Disclosure of Non-Cash Investing and Financing Activities:**                 |       |                                   |       |   |   |
| Unrealized gain (loss) on investments, net                                                   |       | $                                      | 87,938     |   | $ | (85,214 | ) |
| Issuance of Common stock for minority  interest                                              |       | $                                      | —     |   | $ | 960,012 |   |

 

See accompanying notes to the condensed interim consolidated financialstatements

 

8

----

 

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

**March 31, 2004**

 

**1.****                                     ****General/Basis ofPresentation**

 

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

 

*Licensing**:*** Through SRS Labs, the parent company, and its wholly-owned subsidiary,SRSWOWcast.com, Inc., doing business as SRSWOWcast Technologies (“SRSWOWcast”)(collectively “SRS Labs”), the licensing segment develops and licenses audioand voice technology solutions to many of the world’s leading originalequipment manufacturers (“OEMs”), software providers and semiconductorcompanies, as well as licenses and markets hardware and software products forthe Internet and professional audio markets.

 

*Semiconductor:* Through SRS Labs, Inc.’s wholly-owned subsidiary, ValenceTech Limited, andValenceTech Limited’s wholly-owned subsidiaries (collectively “Valence”), thesemiconductor segment develops, designs and markets custom and standardtechnology solutions in the form of analog, digital signal processors (“DSPs”),mixed signal, application specific integrated circuits (“ASICs”) or otherimbedded custom semiconductor designs to OEMs, primarily in the Asia Pacificregion.

 

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

 

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

 

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

 

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

 

OnMay 13, 2005, the Company filed a Current Report on Form 8-Kannouncing that an error had been identified relating to accounting for salesand marketing expenses related to trade shows.  This conclusion wasreached in connection with BDO Seidman, LLP’s, the Company’s independentregistered public accounting firm (“BDO Seidman”), financial statement reviewprocedures relating to the Company’s Quarterly Report on Form 10-Qfor the first quarter of the year ending December 31, 2005 (“fiscal 2005”).

 

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

 

9

----

 

quarterly financialstatements.

 

Actingon the recommendation of BDO Seidman, management of the Company determined thatthe previously issued financial statements contained in the Quarterly Reportson Form 10-Q for the quarters ended March 31, 2004, June 30,2004 and September 30, 2004 should be restated to correct errors in thosefinancial statements.  Consequently, thecondensed consolidated financial statements for the first quarter of 2004 arerestated in this Form 10-Q/A.  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.

 

Theprincipal effects of this adjustment on the accompanying condensed consolidatedfinancial statements is as follows:

 
| ** **                                      | ** ** | **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.****                                     ****Capitalization of softwaredevelopment costs**

 

Costs incurred in the research, design and development of software forsale to others as a separate product or embedded in a product and sold as partof the product as a whole are charged to expense until technologicalfeasibility is established. Under SFAS No. 86, “Accounting for the Costsof Computer Software to be Sold, Leased or Otherwise Marketed,” the Companycapitalizes software purchased from third parties if the related softwareproduct under development has reached technological feasibility or if there arealternative future uses for the purchased software, provided that capitalizedamounts will be realized over a period not exceeding five years. Costs incurredprior to the establishment of technological feasibility are charged to researchand development expense. The establishment of technological feasibility andongoing assessment of recoverability of capitalized software development costsrequire considerable judgment by management with respect to certain externalfactors, including, but not limited to, anticipated future revenues, estimatedeconomic life and changes in software and hardware technologies. Upon thegeneral release of the software product to customers, capitalization ceases andsuch costs are amortized to cost of sales using the straight-line method on aproduct-by-product basis over the estimated life, which is generally threeyears. To the extent that amounts capitalized for R&D become

 

10

----

 

impaired due to a decline in demand or the introduction of newtechnology, such amounts will be written-off. All other research anddevelopment expenditures are charged to research and development expense in theperiod incurred.

 

Capitalized software as of March 31, 2004 and December 31,2003 is as follows:

 
| ** **                | ** ** | **March 31,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Capitalized  software     | ** ** | $                        | 405,615    | ** **                  | $          | 342,760 | ** ** |
| Accumulated amortization  |       | (111,381                 | )          | (96,401                     | )          |
| Capitalized software, net |       | $                        | 294,234    |                        | $          | 246,359 |   |

 

The Company’s weighted average amortization period for capitalizedsoftware is approximately 5 years. The following table shows the estimatedamortization expense for those assets for each of the five succeeding fiscalyears.

 
| **Year  ending December 31,** | ** ** | **Estimated  Expense** | ** ** |
|------------------------------------|------------|------------------------|------------|
| 2004                               | ** ** | $                      | 84,053     | ** ** |
| 2005                               | ** ** | 83,662                 | ** ** |
| 2006                               | ** ** | 78,341                 | ** ** |
| 2007                               | ** ** | 39,057                 | ** ** |
| 2008                               | ** ** | 9,121                  | ** ** |
|                                    |            |                        |            |  |

 

**4.****                                     ****Goodwill and IntangibleAssets**

 

On February 28, 2003, the Company completed an exchange offer withthe minority shareholders of SRSWOWcast, pursuant to which SRS Labsacquired all 3,000,000 shares of Series A Convertible Preferred Stock inexchange for the issuance of 332,184 shares of SRS Labs common stocktrading at $2.89 per share at the close of day on the transaction date. Theacquisition resulted in a purchase price of $960,012.

 

SRSWOWcast develops and markets professional software and hardwareproducts and consumer software plugins that incorporate proprietary audioenhancement, voice and surround sound technologies. SRS Labs, as themajority shareholder has consistently included the results of SRSWOWcast in allof the previously reported consolidated financial statements. The acquisitionwas a strategic initiative, which allows the Company to own 100% of the rightsto the license of the Circle Surround technology. Full ownership of thetechnology license will aid in the deployment and marketing of such and willhelp the Company to compete more effectively.

 

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

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

 

Current assets primarily consisted of cash, accounts receivable andprepaid expenses and current liabilities were valued at stated value. Propertyand equipment was valued at net book value. The $640,071 of acquired intangibleassets was assigned to a license agreement between SRS Labs, Inc andSRSWOWcast, which is being amortized over 10 years.

 

OnJanuary 1, 2002, the Company adopted SFAS No. 142, “Goodwill andOther Intangible Assets”, which, among other things, establishes new standardsfor goodwill acquired in a business combination, eliminates the amortization ofgoodwill and requires the carrying value of goodwill and identifiableintangibles to be evaluated for impairment on at least an annual basis.Identifiable intangible assets with a determinable useful life are amortizedover that period.

 

11

----

 

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

 

Goodwill and intangible assets consist of the following:

 
| ** **                                                                       | ** ** | **March 31,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Goodwill, net                                                                    |       | $                        | 533,031    |                        | $          | 533,031 |   |
| Patents                                                                          |       | 1,795,508                |       | 1,760,236                   |       |
| Accumulated amortization                                                         |       | (780,607                 | )          | (739,792                    | )          |
| Patents, net                                                                     |       | 1,014,901                |       | 1,020,444                   |       |
| Other intangibles                                                                |       | 5,956,085                |       | 5,893,229                   |       |
| Accumulated amortization                                                         |       | (4,259,322               | )          | (4,176,863                  | )          |
| Other intangibles, net  (including software development costs — see note 2) |       | 1,696,763                |       | 1,716,366                   |       |
| Goodwill and intangible assets, net                                              |       | $                        | 3,244,695  |                        | $          | 3,269,841 |   |

 

Amortizationperiods range from three to eleven years depending on the estimated useful lifeof the asset.

Amortizationexpense consists of the following:

 
| ** **                       | ** ** | **Three months ended  March 31,** | ** ** |
|----------------------------------|------------|----------------------------------------|------------|
| ** **                       | ** ** | **2004**                               | ** ** | **2003** | ** ** |
|                             |       |                                   |       |   |   |
| Goodwill and assembled workforce |       | $                                      | —     |   | $ | — |   |
| Patents                          |       | 40,815                                 |       | 35,013 |   |
| Other intangibles                |       | 84,690                                 |       | 65,451 |   |
| Total amortization expense       |       | $                                      | 125,505    |   | $ | 100,464 |   |

 

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

 

| **Year  ending  December 31,** | ** ** | **Estimated expense** | ** ** |
|-------------------------------------|------------|-----------------------|------------|
|                                |       |                  |       |
| 2004                                |       | $                     | 533,773    |   |
| 2005                                |       | $                     | 526,416    |   |
| 2006                                |       | $                     | 508,613    |   |
| 2007                                |       | $                     | 424,943    |   |
| 2008                                |       | $                     | 212,520    |   |
| Thereafter                          |       | $                     | 1,038,435  |   |

 

**5.**                                      **Investments Available forSale**

 

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

 
| ** **           | ** ** | **March 31, 2004** | ** ** | **December 31, 2003** | ** ** |
|----------------------|------------|-------------------------|------------|----------------------------|------------|
|                 |       |                    |       |                       |       |
| Cost                 |       | $                       | 5,506,534  |                       | $          | 10,745,254 |   |
| Unrealized loss      |       | (167,106                | )          | (255,044                   | )          |
| Estimated fair value |       | $                       | 5,339,428  |                       | $          | 10,490,210 |   |

 

12

----

 

The contractual maturities of investments are shown below. Actualmaturities may differ from contractual maturities.

 

| ** **                                      | ** ** | **March 31, 2004** | ** ** | **December 31, 2003** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                      | ** ** | **Cost**                | ** ** | **Estimated  Fair Value**  | ** ** | **Cost** | ** ** | **Estimated  Fair Value** | ** ** |
|                                            |       |                    |       |                       |       |   |   |   |   |
| U.S. Government securities available for  sale: |       |                    |       |                       |       |   |   |   |   |
| Due in one to five years                        |       | $                       | 5,506,534  |                       | $          | 5,339,428 |   | $ | 10,745,254 |   | $ | 10,490,210 |   |
|                                                 |            |                         |            |                            |            |  |  |  |  |  |  |  |  |

 

The following table summarizes sales of available-for-sale securitiesfor the quarters ended March 31, 2004 and 2003. Specific identificationwas used to determine costs in computing realized gains or losses.

 

| ** **         | ** ** | **Quarter Ended March 31,** | ** ** |
|--------------------|------------|----------------------------------|------------|
| ** **         | ** ** | **2004**                         | ** ** | **2003** | ** ** |
| Proceeds from sale |       | $                                | 5,235,626  |   | $ | 8,545,113 |   |
| Realized gains     |       | 139,375                          |       | 31,286 |   |
| Realized losses    |       | —                           |       | — |   |
|                    |            |                                  |            |  |  |  |  |

 

**6.**                                      **Inventories**

 

Inventories, which consist of finished goods, are stated at the lower ofcost or net realizable value. Cost is calculated using the weighted averagemethod and is comprised of material costs and, where applicable, subcontractingand overhead costs that have been incurred in bringing the inventories to theirpresent location and condition. Net realizable value represents the estimatedselling price less costs to be incurred in selling and distribution. Market isdetermined by comparison with recent purchases or net realizable value. Netrealizable value is based on forecasts for sales of the Company’s products inthe ensuing years. Should demand for the Company’s products prove to besignificantly less than anticipated, the ultimate realizable value of theCompany’s inventories could be substantially less than the amount shown on theaccompanying consolidated balance sheets.

 

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

 

Minority interest in consolidated subsidiary represents the minoritystockholders’ proportionate share of the equity of SRSWOWcast, which was approximately 13% at December 31,2002. In February 2003, SRS Labs completed an exchange offer withthe minority shareholders of SRSWOWcast, pursuant to which SRS Labs acquiredall 3,000,000 outstanding shares of Series A Convertible Preferred Stockin exchange for the issuance of 332,184 shares of SRS Labs common stock. As aresult of the exchange offer, an intangible asset in the amount of $640,071 fora 10-year license agreement was recorded and SRSWOWcast became awholly-owned subsidiary of SRS Labs.  The proforma effect of the transaction as ifit had occurred at the beginning of the quarter ended March 31, 2003 wouldhave been immaterial.

 

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

 

TheCompany applies SFAS No. 128, “Earnings per Share,” which requires thedisclosure of basic and diluted net income or loss per share for all currentand prior periods. Basic net income or loss per common share is computed bydividing net income or loss available to common stockholders by the weightedaverage number of common shares outstanding during each year. Diluted net incomeor loss per common share reflects the maximum dilution, based on the averageprice of the Company’s common stock each period, and is computed similar tobasic income or loss per share except that the denominator is increased toinclude the number of additional shares that would have been outstanding ifpotentially dilutive stock options and warrants had been exercised.

 

13

----

 

Basicand diluted net income per share computed in accordance with SFAS 128 forthe three months ended March 31, are as follows:

 
| ** **                                               | ** ** | **For the three months  ended March 31,** | ** ** |
|----------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                               | ** ** | **2004**                                       | ** ** | **2003** | ** ** |
| ** **                                               | ** ** | **(Restated)**                                 | ** ** | ** ** | ** ** |
| BASIC EPS                                                |       |                                           |       |   |   |
| Net income (loss)                                        |       | $                                              | (24,531    | ) | $ | 42,534 |   |
| Denominator: weighted average common shares  outstanding |       | 13,746,521                                     |       | 12,798,238 |   |
| Net income per share-basic                               |       | $                                              | 0.00       |   | $ | 0.00 |   |
|                                                     |       |                                           |       |   |   |
| DILUTED EPS                                              |       |                                           |       |   |   |
| Net income (loss)                                        |       | $                                              | (24,531    | ) | $ | 42,534 |   |
| Denominator: weighted average common shares  outstanding |       | 13,746,521                                     |       | 12,798,238 |   |
| Common equivalent shares outstanding:                    |       |                                           |       |   |   |
| Options                                                  |       | 2,932,852                                      |       | 185,288 |   |
| Total diluted shares                                     |       | 16,679,373                                     |       | 12,983,526 |   |
| Net income per share-diluted                             |       | $                                              | 0.00       |   | $ | 0.00 |   |

 

Therewere 40,000 and 4,237,038 potentially dilutive options outstanding for thequarters ending March 31, 2004 and 2003, respectively, that were notincluded in the table above because they would be anti-dilutive.

 

**9.**                                      **Stock-Based Compensation**

 

TheCompany accounts for stock-based awards to employees under the recognition andmeasurement principles of APB No. 25, “Accounting for Stock Issued toEmployees,” and related interpretations. The Company provides additional pro forma disclosures as required underSFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) andSFAS No. 148, “Accounting for Stock-Based Compensation — Transition andDisclosure — an Amendment of SFAS No. 123.” Accordingly, no stock-based employee compensation cost is reflected innet income (loss), as all options granted under the plan had an exercise priceequal to the market value of the underlying common stock on the date of grant.Had compensation cost for the Company’s stock option plan been determined basedon the fair value at the grant date for awards for the three months ended March 31,2004 and 2003, consistent with the provisions of SFAS No. 123, the Company’snet income (loss) and earnings per share would have been decreased to the proforma amounts indicated below:

 
| ** **                                                                                         | ** ** | **For the three months ended****March 31,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                         | ** ** | **2004**                                         | ** ** | **2003** | ** ** |
| ** **                                                                                         | ** ** | **(Restated)**                                   | ** ** | ** ** | ** ** |
| Net income (loss) (attributable to common  shareholders)—as reported                          |       | $                                                | (24,531    | ) | $ | 42,534 |   |
| Add: stock based employee compensation  expense included in reported net income, net of tax effect |       | 8,160                                            |       | 10,942 |   |
| Less fair value of stock-based employee  compensation expense                                      |       | (393,669                                         | )          | (528,674 | ) |
| Net loss (attributable to common  shareholder)—pro forma                                      |       | $                                                | (410,040   | ) | $ | (475,198 | ) |
| Net income (loss) per share:                                                                       |       |                                             |       |   |   |
| Basic, as reported                                                                                 |       | $                                                | 0.00       |   | $ | 0.00 |   |
| Basic, pro forma                                                                                   |       | $                                                | (0.03      | ) | $ | (0.04 | ) |
| Diluted, as reported                                                                               |       | $                                                | 0.00       |   | $ | 0.00 |   |
| Diluted, pro forma                                                                                 |       | $                                                | (0.02      | ) | $ | (0.04 | ) |

 

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, 2004.

 

| Risk free interest rate |   | 2.85    | %      |
|-------------------------|--------|---------|--------|
| Expected life           |   | 5 years |   |
| Expected volatility     |   | 74      | %      |

 

BecauseFAS No. 123 has not been applied to options granted prior to January 1,1995, the resulting pro forma compensation cost may not be representative ofthat to be expected in future years.

 

14

----

 

**10.**                               **Commitments andContingencies**

 

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

 

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

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

 

**11.**                               **Stockholders’ Equity**

 

OnMay 9, 2002, the Company’s Board of Directors authorized the repurchase ofup to 500,000 of the outstanding shares of the Company’s common stock for aperiod from May 10, 2002 to November 10, 2002 (the “2002 RepurchaseProgram”). As of March 31, 2004, 225,300 shares had been repurchased at acost of $718,601 under the 2002 Repurchase Program. All repurchased shares arereflected as treasury stock in the accompanying consolidated balance sheets.

 

**12.**                               **Segment Information**

 

TheCompany operates two business segments – licensing and semiconductors.  In 2003, the Company reported its revenues inthe following five segments: licensing; semiconductors; component distribution;product sales; and Internet and broadcast. In 2004, the Company decided to reduce its segments because of themateriality of the revenues attributable to the other three segments;accordingly, we have condensed the revenues of the deleted segments into thetwo current segments.  Segmentinformation for the 2003 segments has been restated to conform to the currentyear presentation.  Revenue from thecomponent distribution segment will now be reported in the semiconductorsegment and revenues from product sales and internet and broadcast segmentswill now be reported in the licensing segment The Company does not allocatecorporate operating expenses or specific assets to these segments. Therefore,the segment information that follows includes only net revenues, cost of salesand gross margins of the identified segments:

 

| ** **                                  | ** ** | **Valence  Semiconductor** | ** ** | **SRS Labs  Licensing** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|----------------------------|------------|-------------------------|------------|-----------|------------|
| **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 |   |
|                                        |       |                       |       |                    |       |      |       |
| **Three  Months Ended March 31, 2003** |       |                       |       |                    |       |      |       |
| Total revenues                              |       | $                          | 1,764,080  |                    | $          | 2,706,294 |       | $ | 4,470,374 |   |
| Cost of sales                               |       | (642,587                   | )          | (26,981                 | )          | (669,568  | )          |
|                                        |       |                       |       |                    |       |      |       |
| Gross margin                                |       | $                          | 1,121,493  |                    | $          | 2,679,313 |       | $ | 3,800,806 |   |

 

15

----

 

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

 
| ** **                    | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------|------------|----------------------------------------|------------|
| ** **                    | ** ** | **2004**                               | ** ** | **2003** | ** ** |
| **Geographic  Area Revenue:** |       |                                   |       |   |   |
|                          |       |                                   |       |   |   |
| Asia Pacific                  |       | $                                      | 4,414,000  |   | $ | 4,020,933 |   |
| Americas                      |       | 785,612                                |       | 417,850 |   |
| Europe                        |       | 143,433                                |       | 31,591 |   |
|                          |       |                                   |       |   |   |
| Total                         |       | $                                      | 5,343,045  |   | $ | 4,470,374 |   |

 

**13.**                               **Recent AccountingPronouncements**

 

In January 2003, the FASB issued interpretation No. 46, “Consolidationof Variable Interest Entities” (FIN 46), which requires the consolidationof variable interest entities, as defined. FIN 46 is applicable tofinancial statements to be issued by the Company after 2003; however,disclosures are required currently if the Company expects to consolidate anyvariable interest entities. No material entities were consolidated as a resultof FIN 46.

 

In April 2003, the FSAB issued SFAS No. 149, “Amendment ofStatement 133 on Derivative Instruments and Hedging Activities.” This statementamends and clarifies financial accounting and reporting for derivativeinstruments, including certain derivative instruments embedded in othercontracts (collectively referred to as derivatives) and for hedging activitiesunder SFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities.” This statement is effective for contracts entered into or modifiedafter June 30, 2003. Adoption of this statement did not have a significanteffect on the Company’s financial position or results of operations.

 

In May 2003, the FASB issued SFAS No. 150, “Accounting forCertain Financial Instruments with Characteristics of Both Liabilities andEquity.” This statement establishes standards for how an issuer classifies andmeasures certain financial instruments with characteristics of both liabilitiesand equity. This statement is effective for financial instruments entered intoor modified after May 31, 2003, and otherwise is effective for the firstinterim period beginning after June 15, 2003. The adoption of SFAS No. 150did not have a significant effect on the Company’s financial position, resultsof operations or cash flows.

 

In December 2003, the SEC issued Staff Accounting Bulletin (SAB) No. 104,Revenue Recognition (SAB No. 104), which codifies, revises and rescindscertain sections of SAB No. 101, Revenue Recognition, in order to makethis interpretive guidance consistent with current authoritative accounting andauditing guidance and SEC rules and regulations. The changes noted in SAB No. 104did not have a material effect on the Company’s results of operations,financial position or cash flows.

 

16

----

 

**Item 2.  Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

Thisinformation should be read in conjunction with the audited consolidatedfinancial statements and notes thereto and Management’s Discussion and Analysisof Financial Condition and Results of Operations contained in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2003(the “Form 10-K”), the audited consolidated financial statements andthe notes thereto included in the Form 10-K and the unauditedcondensed interim consolidated financial statements and notes thereto includedin this Quarterly Report.

 

**Overview**

 

SRS Labs is a leading developer and provider of application specificintegrated circuits (“ASICs”), standard integrated circuits (“ICs”) and audioand voice technology solutions for the home theater, portable audio, wireless,computer, game, automotive, broadcast, Internet and telecommunications markets.The Company operates in the following two business segments:

 

*Licensing**:*** Through SRS Labs, the parent company, and its wholly-owned subsidiary,SRSWOWcast.com, Inc., doing business as SRSWOWcast Technologies (“SRSWOWcast”)(collectively “SRS Labs”), the licensing segment develops and licenses audioand voice technology solutions to many of the world’s leading originalequipment manufacturers (“OEMs”), software providers and semiconductorcompanies, as well as licenses and markets hardware and software products forthe Internet and professional audio markets.

 

*Semiconductor:* Through SRS Labs, Inc.’s wholly-owned subsidiary, ValenceTech Limited, andValenceTech Limited’s wholly-owned subsidiaries (collectively “Valence”), thesemiconductor segment develops, designs and markets custom and standardtechnology solutions in the form of analog, digital signal processors (“DSPs”),mixed signal, application specific integrated circuits (“ASICs”) or otherimbedded custom semiconductor designs to OEMs, primarily in the Asia Pacificregion.

 

In2003, the Company reported its revenues in the following five segments:licensing; semiconductors; component distribution; product sales; and Internetand broadcast.  In 2004, the Companydecided to reduce its segments because of the materiality of the revenuesattributable to the other three segments. Revenue from the component distribution segment will now be reported inthe semiconductor segment and revenues from product sales and internet andbroadcast segments will now be reported in the licensing segment as usedherein, the “Company,” “SRS Labs,”“we,” “us,” or “our” means SRS Labs, Inc. and its wholly-ownedsubsidiaries, including Valence and SRSWOWcast.

 

Wehave determined that the most effective strategy for the creation of stable andsustainable revenue growth is to diversify our revenue base.  In our licensing segment, our goal is todiversify our revenue base from our historical concentration in hometheater.  We believe that the mobilephone, portable audio, PC and automotive areas within the consumer electronicsmarket present new high volume, high growth opportunities for application ofour audio technologies.  Ourdiversification strategy also extends to our semiconductor segment in which wehave refocused our team away from the heavy concentration on custom applicationspecific projects for a few customers. We are now also focused on marketing our standard branded chips, includingnew chips that embed SRS Labs’ technologies, with particular attention towardthe large manufacturing market in China.

 

**Critical Accounting Policies**

 

Our discussion and analysis of our results of operations and liquidityand capital resources are based on our consolidated financial statements whichhave been prepared in accordance with accounting principles generally acceptedin the United States.

 

The preparation of these financial statements requires us to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and disclosure of contingent assets andliabilities. We base our estimates on historical and anticipated results andtrends and on various other assumptions that we believe are reasonable underthe circumstances, including assumptions as to future events. These estimatesform the basis for making judgments about the carrying value of assets andliabilities that are not readily apparent from other sources. By their nature,estimates are subject to an inherent degree of uncertainty. Actual results maydiffer from our estimates.

 

The following represents a summary of our critical accounting policies,defined as those policies that we believe are: (a) the most important tothe portrayal of our financial condition and results of operations; and (b) thatrequire management’s most difficult, subjective or complex judgments, often asa result of the need to make estimates about the matters that are

 

17

----

 

inherently uncertain. Our most critical accounting estimates includevaluation of accounts receivable, which impacts operating expenses; valuationof inventory, which impacts gross margin; valuation of intangible assets andcapitalization of software, which primarily impacts operating expenses when weimpair assets or accelerate their depreciation; and recognition and measurementof current and deferred income tax assets and liabilities, which impacts ourtax provision. Below, we discuss these policies further, as well as theestimates and judgments involved. We also have other policies that we considerkey accounting policies, such as our policies for revenue recognition; however,these policies do not meet the definition of critical accounting estimates,because they do not generally require us to make estimates or judgments thatare difficult or subjective.

 

*Accounts Receivable*

 

We perform ongoing credit evaluations of our customers and adjustcredit limits based upon payment history, the customer’s current creditworthiness and various other factors, as determined by our review of theircurrent credit information. We continuously monitor collections and paymentsfrom our customers and maintain allowances for doubtful accounts based uponspecific customer circumstances, current economic trends, historical experienceand the age of past due receivables. While such credit losses have historicallybeen within our expectations and the provisions established, we cannotguarantee that we will continue to experience the same credit loss rates thatwe have in the past. Unanticipated changes in the liquidity or financialposition of our customers may require additional provisions for doubtfulaccounts.

 

*Inventory*

 

Inventory is stated at the lower of cost or net realizable value. Weperiodically assess our inventory for potential obsolescence andlower-of-cost-or-market issues. We make estimates of inventory obsolescence,providing reserves when necessary, based on, among other factors, demand forinventory based on backlog, product pricing, the ability to liquidate or sellolder inventory and the impact of introducing new products. If actual marketconditions or our customer’s product demands are less favorable than thoseprojected, additional provisions may be required.

 

*Intangible Assets & Capitalizationof Software*

 

In accordance with Statement of Financial Accounting Standards (“SFAS”)No. 142, “Goodwill and Other Intangible Assets,” we assess potentialimpairments to intangible assets when there is evidence that events or changesin circumstances indicate that the carrying amount of an asset may not berecovered. Our judgments regarding the existence of impairment indicators andfuture cash flows related to intangible assets are based on operationalperformance of our acquired businesses, market conditions and other factors. Ifthe carrying value of a reporting unit exceeds its fair value, goodwill isconsidered impaired and a second test is performed to measure the amount ofimpairment loss, if any. For fiscal 2003, an independent valuation of goodwilland other intangibles was performed. To date, we have not recognized anyimpairment of our goodwill and other intangible assets in connection with ouradoption of SFAS 142. However, no assurances can be given that futureevaluation of goodwill will not result in charges as a result of futureimpairment.

 

Costs incurred in the research, design and development of software forsale to others as a separate product or embedded in a product and sold as partof the product as a whole are charged to expense until technologicalfeasibility is established. Under SFAS No. 86, “Accounting for the Costsof Computer Software to be Sold, Leased or Otherwise Marketed,” we capitalizesoftware purchased from third parties if the related software product underdevelopment has reached technological feasibility or if there are alternativefuture uses for the purchased software, provided that capitalized amounts willbe realized over a period not exceeding five years. Costs incurred prior to theestablishment of technological feasibility are charged to research anddevelopment expense. The establishment of technological feasibility and ongoingassessment of recoverability of capitalized software development costs requireconsiderable judgment by management with respect to certain external factors,including, but not limited to, anticipated future revenues, estimated economiclife and changes in software and hardware technologies. Upon the generalrelease of the software product to customers, capitalization ceases and suchcosts are amortized to cost of sales using the straight-line method on aproduct-by-product basis over the estimated life, which is generally threeyears. To the extent that amounts capitalized for R&D become impaired dueto a decline in demand or the introduction of new technology, such amounts willbe written-off. All other research and development expenditures are charged toresearch and development expense in the period incurred.

 

18

----

 

*Income Taxes*

 

In preparing our consolidated financial statements, we go through aprocess to estimate our income taxes in each of the countries in which weoperate. The process includes an assessment of the current tax expense, theresults from tax examinations and the effects of temporary differencesresulting from the different treatment of transactions for tax and financialaccounting purposes. These differences result in deferred tax assets andliabilities, which are included in the Consolidated Balance Sheet. We accountfor income taxes in accordance with Statement of Financial Accounting StandardsNo. 109, or SFAS 109, “Accounting for Income Taxes,” which requiresthat deferred tax assets and liabilities be recognized using enacted tax ratesfor the effect of temporary differences between the book and tax bases ofrecorded assets and liabilities. SFAS 109 also requires that deferred taxassets be reduced by a valuation allowance if it is more likely than not thatsome portion or all of the deferred tax asset will not be realized. We evaluatethe reliability of our deferred tax assets by assessing our valuation allowanceand by adjusting the amount of such allowance, if necessary. At December 31,2003, we had net deferred tax assets primarily resulting from temporarydifferences between the book and tax bases of assets and liabilities, and lossand credit carry forwards. We continue to provide a valuation allowance oncertain deferred tax assets based on an assessment of the likelihood of theirrealization. In reaching our conclusion, we evaluated certain relevant criteriaincluding deferred tax liabilities that can be used to offset deferred taxassets, estimates of future taxable income of appropriate character within thecarry forward period available under the tax law and tax planning strategies.Our judgments regarding future taxable income may change due to marketconditions, changes in U.S. or international tax laws, and other factors. Thesechanges, if any, may require material adjustments to these deferred tax assets,resulting in either a tax benefit, if it is estimated that future taxableincome is likely, or a reduction in the value of the deferred tax assets, if itis determined that their value is impaired, resulting in a reduction in netincome or an increase in net loss in the period when such determinations aremade.

 

Our income tax provision is based on calculations and assumptions thatwill be subject to examination by the taxing authorities in the jurisdictionsin which we operate. Should the actual results differ from our estimates, wewould have to adjust the income tax provision in the period in which the factsand circumstances that give rise to the revision become known. Tax law and ratechanges are reflected in the income tax provision in the period in which suchchanges are enacted.

 

**Results of Operations**

 

**Three Months Ended March 31, 2004 Compared to ThreeMonths Ended March 31, 2003**

 

*Revenues*

 

Semiconductorrevenues consists of (a) design fees relating to, and sales of,application specific integrated circuits (“ASIC”) for third parties by Valenceto original equipment manufacturers (“OEMs”); and (b) sales of generalpurpose integrated circuits (“ICs”) designed by Valence under the brand nameASP.  Licensing revenues consistprimarily of royalties generated from the license of SRS Labs’ audio and voicetechnologies.  License and royaltyagreements generally provide for the license of technologies for a specifiedperiod of time for either a single fee or a fee based on the number of unitsdistributed by the licensee. Also included in licensing revenue are revenuesgenerated from the sale of hardware and software applications into thebroadcast audio markets.

 

Totalrevenues for the three months ended March 31, 2004 were $5,343,045compared to $4,470,374 for the three months ended March 31, 2003, anincrease of $872,671 or 19.5%. Semiconductor revenues were $2,415,718 for the three months ended March 31,2004 compared to $1,764,080 for the three months ended March 31, 2003, anincrease of $651,638 or 36.9%. This increase was attributable to increasedsales of ASIC chips in the PC peripheral and healthcare markets and theincrease in ASP chips sales to the TV and portable audio products markets.  Licensing revenues were $2,927,327 for thethree months ended March 31, 2004, compared to $2,706,294 for the threemonths ended March 31, 2003, an increase of $221,033 or 8.2%.  This increase was attributable to thecontinuation of the sales growth in the consumer electronics markets,specifically, home entertainment products, mobile phones, and portable audioproducts.  Licensing revenue was alsopositively impacted during the period by a licensee who paid an upfronttechnology transfer fee of $250,000 in addition to an ongoing per unit royaltyfrom products sold.

 

*Gross Margin*

 

Cost of sales consists primarily of fabrication costs, assembly andtest costs, and the cost of materials and overhead from operations. Grossmargins are dependent on the mix of products sold, services provided androyalties earned. Thegross margin percentage for the three months ended March 31, 2004decreased to 83.0% as a percentage of total revenue as compared to 85% for thethree months ended March 31, 2003. The decrease in gross margin wasprimarily due to the sales mix between semiconductor and licensing.  Gross margins for the semiconductor businessfor the quarter ended March 31, 2004 were 63.5% compared to 63.6% for

 

19

----

 

the same period in 2003. Semiconductor revenues accounted for 45% oftotal revenues for the quarter ended March 31, 2004 compared to 40% forthe same period in 2003. Gross margins for the licensing business for thequarter ended March 31, 2004 were 99.1% compared to 99.0% for the sameperiod in 2003. Licensing revenues accounted for 55% the quarter ended March 31,2004 compared to 60% for the same period in 2003.

 

*Sales and Marketing*

 

Salesand marketing expenses consist primarily of employee salaries, salesconsultants’ fees and related expenses, sales commissions and product promotioncosts. Sales and marketing expenses were $1,695,368 for the three months ended March 31,2004 compared to $1,352,490 for the same prior year period, an increase of$342,878 or 25.4%. The net increase in sales and marketing expenses for thethree months ended March 31, 2004 is attributable primarily toinvestments in branding and promotion of our technologies and products in newmarkets designed to increase future revenues and co-promotional activities withour licensees.  As a percentage of total revenues, sales andmarketing expenses increased from 30.3% for the quarter ended March 31,2003, to 31.7% for the same period this year.

 

*Research and 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$1,208,687 for the three months ended March 31, 2004 compared to$1,081,215 for the same prior year period, an increase of $127,472 or 11.8%.The increase in research and development costs is primarily due to the additionof research and development personnel added in the fourth quarter of 2003.  As a percentage of total revenues, research anddevelopment expenses decreased from 24.2% for the quarter ended March 31,2003, to 22.6% for the same period this year.

 

*General and Administrative*

 

Generaland administrative (“G&A”) expenses consist primarily of employee-relatedexpenses, legal costs associated with the administration of intellectualproperty and other professional fees. G&A expenses were $1,554,197 for thethree months ended March 31, 2004 compared to $1,314,610 for the sameprior year period, an increase of $239,587 or 18.2%. The increase was primarilyattributable to increased professional fees and public company expenses.  As a percentage of total revenues, G&Aexpenses decreased from 29.4% for the quarter ended March 31, 2003, to29.1% for the same period this year.

 

*Income (Loss) From Operations*

 

Forthe quarter ended March 31, 2004 there was a loss from operations of$24,078 as opposed to income from operations of $52,491 in the same quarterlast year.  The decrease of $76,569 isdue to an increase in gross profit of $633,368, offset by an increase in salesand marketing, research and development and general and administrative expensesof $709,937.

 

*Other Income, Net*

 

Other income, net, consists primarily of interest income, gain or(loss) on sale of securities, interest expense and foreign currency transactiongains and losses. Other income, net, was $237,450 for the three months ended March 31,2004, compared to $164,126 for the same prior year period, an increase of$73,324 or 44.7%. The increase is primarily attributable to investment gainsfrom sales of US Treasury in 2004.

 

*Minority Interest*

 

Minorityinterest represents the minority shareholders’ proportionate share of losses inSRSWOWcast. For the quarter ended March 31, 2004, minority interestwas $0 compared to $5,430 for the same period in 2003, a decrease of $5,430. In February 2003, SRS Labs completed anexchange offer with the minority shareholders of SRSWOWcast, pursuant to whichSRS Labs acquired all of the outstanding shares of Series A ConvertiblePreferred Stock in exchange for the issuance of shares of SRS Labs commonstock. As a result of the exchange offer, SRSWOWcast became a wholly-ownedsubsidiary of SRS Labs.

 

20

----

 

*Provision for Income Taxes*

 

Theincome tax expense for the three months ended March 31, 2004 was $237,903,compared to tax expense of $179,513 for the same prior year period, an increaseof $58,390 or 32.5%. The provision consists primarily of taxes paid onlicensing revenues sourced from countries requiring foreign tax withholdingsand taxes paid on profits in Hong Kong at the rate of 17.5%.  The increase in income tax for the quarterended March 31, 2004 was attributable to higher profits in Hong Kong.

 

**Liquidity and Capital Resources**

 

TheCompany’s principal source of liquidity to fund ongoing operations at March 31,2004 consisted of cash, cash equivalents and long-term investments aggregating$25,732,383.  At March 31, 2003, theCompany had cash and cash equivalents of $20,392,955 and long-term investmentsof $5,339,428. Cash and cash equivalents generally consist of cash, moneymarket funds and other money market instruments with original maturities ofthree months or less. Investments consist of U.S. government securities ratedAAA.

 

Cashand cash equivalents increased $7,597,335 during the first quarter of 2004 to$20,392,955.  The increase was primarilydue to the net cash provided by operating activities of $589,069, investingactivities from the sale of long-term investments of $5,235,626 and financingactivities from the exercise of stock options of $2,150,319 partially offset bynet cash used for capital expenditures and patents of $377,679.

 

Based on current plans and business conditions, the Company expectsthat its cash, cash equivalents and investments together with any amounts generatedfrom operations will be sufficient to meet the Company’s cash requirements forthe foreseeable future. However, there can be no assurance that the Companywill not be required to seek other financing sooner or that such financing, ifrequired, will be available on terms satisfactory to the Company.

 

**Newly Adopted and Recent Accounting Pronouncements**

 

In January 2003, the FASB issued interpretation No. 46, “Consolidationof Variable Interest Entities” (FIN 46), which requires the consolidation ofvariable interest entities, as defined. FIN 46 is applicable to financialstatements to be issued by the Company after 2003; however, disclosures arerequired currently if the Company expects to consolidate any variable interestentities. No material entities were consolidated as a result of FIN 46.

 

In April 2003, the FSAB issued SFAS No. 149, “Amendment ofStatement 133 on Derivative Instruments and Hedging Activities.” This statementamends and clarifies financial accounting and reporting for derivative instruments,including certain derivative instruments embedded in other contracts(collectively referred to as derivatives) and for hedging activities under SFASNo. 133, “Accounting for Derivative Instruments and Hedging Activities.”This statement is effective for contracts entered into or modified after June 30,2003. Adoption of this statement did not have a significant effect on theCompany’s financial position or results of operations.

 

In May 2003, the FASB issued SFAS No. 150, “Accounting forCertain Financial Instruments with Characteristics of Both Liabilities andEquity.” This statement establishes standards for how an issuer classifies andmeasures certain financial instruments with characteristics of both liabilitiesand equity. This statement is effective for financial instruments entered intoor modified after May 31, 2003, and otherwise is effective for the firstinterim period beginning after June 15, 2003. The adoption of SFAS No. 150did not have a significant effect on the Company’s financial position, resultsof operations, or cash flows.

 

In December 2003, the SEC issued Staff Accounting Bulletin (SAB) No. 104,Revenue Recognition (SAB No. 104), which codifies, revises and rescindscertain sections of SAB No. 101, Revenue Recognition, in order to makethis interpretive guidance consistent with current authoritative accounting andauditing guidance and SEC rules and regulations. The changes noted in SAB No. 104did not have a material effect on the Company’s results of operations,financial position or cash flows.

 

**Factors That May Affect Future Results**

 

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

 

Currently, our licensing revenue is concentrated in the home theatermarket with the majority of revenue generated from the inclusion of SRStechnology inside televisions, DVD players and set-top boxes. We expect thatthe consumer home

 

21

----

 

entertainment market will continue to account for a significant portionof our licensing revenues for the foreseeable future. While consumer spendingin general on consumer electronic products has increased, retail prices forcertain consumer electronics products that include our audio technology, suchas DVD players have decreased significantly and indications are that this trendwill continue for the foreseeable future. In addition, from time to time,certain of our original equipment manufacturer and semiconductor manufacturercustomers may account for a significant portion of revenue from a particularproduct application, such as DVD players, set-top boxes or televisions.Consumer electronics products manufacturers could decide to exclude our audioenhancement technology from their home theater products altogether in an effortto reduce cost. The loss of any such customer could have a material adverseaffect on the Company’s financial condition and results of operations.

 

Declining prices of consumer electronic products could put pressure onour licensing fees that are charged to the manufacturers. Also, given thecurrent economic environment, consumer spending on DVD players and other homeelectronic products may not increase as expected. Such declines in consumerspending, should they occur, and continued decreases in consumer productpricing for electronic goods may have a significant negative impact on ourfinancial results. The Company’s strategy is to diversify its customer base inan effort to decrease the impact from the loss of a particular customer,product segment or change in market trend.

 

*Our quarterly results may fluctuate*

 

Our operating results may fluctuate from those in prior quarters andwill continue to be subject to quarterly and other fluctuations due to avariety of factors, including the extent to which our licensees incorporate ourtechnologies into their products; the timing of orders from, and the shipmentsto, major customers; the timing of new product introductions; the gain or lossof significant 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.

 

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

 

We derive a significant amount of our revenue from Valence’s ASICbusiness. Valence’s engineering team focuses on the design of custom ASICs tomeet specific customers’ requirements and outsources the production of thedesign to mask houses, foundries and packaging houses located primarily inAsia. The operations of Valence could be affected by a variety of factors,including the timing of customer orders, the timing of development revenue,changes in the mix of products distributed and the mix of distribution channelsemployed, the emergence of a new industry standard, product obsolescence andchanges in pricing policies by the Company, its competitors or its suppliers.

 

Business revenue from ASICs is concentrated in a limited number ofcustomers in the areas of consumer electronics, communications products,computers and computer peripherals. The business generated from any onecustomer may be for a fixed length or quantity. As such, it is customary in ourASIC business to have a certain amount of customer turnover as new ASICprojects are obtained for different customers. However, it is possible that theloss of any particular customer or any bad debt arising from such customer mayhave a material adverse impact on our financial condition and results ofoperation. Beginning in fiscal 1999, Valence began to exit from certain lowermargin product offerings in the distribution side of the business and hasplaced more emphasis on developing and distributing products that are relatedto or incorporate our proprietary technologies. As a result, the immediate lossin revenue of the low margin distribution business will not be entirely offsetby the new proprietary technology based products, which will take time todevelop and be introduced into the marketplace. There can be no assurance thatwe will be able to quickly introduce new products to offset the loss in revenueor that the new products developed will receive a favorable market acceptance.

 

Valence adds significant diversity to our overall business structureand opportunities. We recognize that in the presence of such corporatediversity, and in particular with regard to the semiconductor industry, therewill always exist a potential for a conflict among sales channels between theCompany 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.

 

22

----

 

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

 

Valence is a “fabless” semiconductor company meaning that Valencedesigns, develops and markets our selection of custom and standard integratedcircuits but we rely on third party contractors to manufacture, assemble andtest our products. Currently, there is a shortage of foundry capacity, which isaffecting the semiconductor industry. Although we believe our relationships are generally good, we do not havelong-term supply agreements with our third-party vendors and they are notobligated to perform services or supply products to us for any particularperiod or in any particular quantities, except as provided in each separatepurchase order accepted by them. The increased demand for our products coupledwith the demand for foundry services, is, and will continue to be for theforeseeable future, a challenge for us. In these times of high demand, there are significant risks associatedwith our reliance on third-party vendors including: reallocation of capacity toother customers, potential price increases, delays and interruptions in orderdeliveries, reduced control over product quality and increased risk of misappropriationof intellectual property.

 

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

 

We have significant operations in Hong Kong, the PRC and other parts ofAsia that require refinement to adapt to the changing market conditions in thatregion. Our operations in Asia, and international operations in general, aresubject to risks of unexpected changes in, or impositions of, legislative orregulatory requirements.

 

Our customers geographically located in the Asia Pacific marketsaccounted for approximately 93%, 90% and 90% of total Company sales in 2003,2002 and 2001, respectively and are expected to continue to account for asubstantial percentage of sales in the future. The economic climate in Asiacontinues to be impacted by increases in unemployment, declines in consumerspending, currency devaluation and bank failures. Any of these factors, shouldthey continue, could significantly reduce the demand for the end user goods inwhich our products and technologies are used.

 

The PRC economy has experienced significant growth in the past decade;but such growth has been uneven across geographic and economic sectors. Therecan be no assurance that such growth will continue or that any potentialcurrency devaluation in the region will not have a negative effect on ourbusiness, including Valence. The PRC economy has also experienced deflation inthe past, which may continue in the future. The current economic situation mayadversely affect our profitability over time as expenditures for consumerelectronics products and information technology may decrease due to the resultsof slowing domestic demand and deflation.

 

Hong Kong is a Special Administrative Region of the PRC with its owngovernment and legislature. Hong Kong enjoys a high degree of autonomy from thePRC under the principle of “one country, two systems.” We can give no assurancethat Hong Kong will continue to enjoy autonomy from the PRC.

 

The Hong Kong dollar has remained relatively constant due to the U.S.dollar peg and currency board system that has been in effect in Hong Kong since1983. Since mid-1997, interest rates in Hong Kong have fluctuatedsignificantly and real estate and retail sales have declined. We can give noassurance that the Hong Kong economy will not worsen or that the historicalcurrency peg of the Hong Kong dollar to the U.S. dollar will be maintained.Continued declining consumer spending in Hong Kong, deflation or thediscontinuation of the currency peg could adversely affect our business.

 

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

 

We expect that international sales will continue to represent asignificant portion of our total revenues. To date, all of our licensingrevenues have been denominated in U.S. dollars and most costs have beenincurred in U.S. dollars. It is our expectation that licensing revenues willcontinue to be denominated in U.S. dollars for the foreseeable future. BecauseValence’s business is primarily focused in Asia and because of our anticipatedexpansion of business in the PRC and other parts of Asia, our consolidatedresults of operations and financial position could be significantly affected byrisks associated with international activities, including economic and laborconditions, political instability, tax laws (including U.S. taxes on foreignsubsidiaries) and changes in the value of the U.S. dollar versus the localcurrency in which the products are sold. In addition, our valuation of assets recorded as a result of the Valenceacquisition may also be adversely impacted by the currency fluctuationsrelative to the U.S. dollar.  We intendto actively monitor our****foreignexchange exposure and to implement strategies to reduce our foreign exchangerisk at such time that we determine the benefits of such strategies outweighthe associated costs. However, there is no guarantee that we will take steps toinsure against such risks, and should such risks occur, there is no guaranteethat we will not be significantly impacted. Countries in the Asia Pacific region have experienced weakness in theircurrency, banking and equity markets. These weaknesses could adversely affectconsumer

 

23

----

 

demand for Valence’s products, the U.S. dollar value of the Company’sand its subsidiaries’ foreign currency denominated sales, the availability andsupply of product components to Valence and ultimately, our consolidatedresults of operations.

 

*We are subject to competitive pressures*

 

Our existing and potential competitors include both large and emergingdomestic and international companies that have substantially greater financial,manufacturing, technical, marketing, distribution and other resources. Present orfuture competitors may be able to develop products and technologies comparableor superior to ours, and to adapt more quickly than us to new technologies orevolving market needs. We believe that the competitive factors affecting themarket for our products and technologies include product performance, price andquality; product functionality and features; the ease of 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.

 

*We strongly rely on our intellectual property*

 

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

 

*We depend on our executive officers and other key personnel*

 

Our future success depends to a large extent upon the continued serviceof our executives, as well as key engineering, sales, and marketing staff,including highly skilled semiconductor design personnel. We anticipate that anyfuture growth will require us to recruit and hire a number of new personnel inengineering, operations, finance, sales and marketing. Competition for suchpersonnel during times of economic growth is intense, and there can be noassurance that we can recruit and retain necessary personnel to operate itsbusiness and support future growth.

 

*The market price of our common stock is volatile*

 

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

 

*We may encounter difficulties with acquisitions, which could harm ourbusiness*

 

From time-to-time, we expect to make acquisitions of businesses ortechnologies that are complementary to our business strategy. Such futureacquisitions would expose the Company to risks commonly encountered inacquisitions of businesses. Such risks include, among others, difficulty ofassimilating the operations, information systems and personnel of the acquiredbusiness(es), the potential disruption of our ongoing business; and theinability of management to maximize the financial and strategic position of theCompany through successful incorporation of the acquired technologies,employees and customers. There can be no assurance that any potentialacquisition will be consummated or, if consummated, that it will not have amaterial adverse effect on our business, financial condition and results ofoperations.

 

24

----

 

**Item 3.  Quantitativeand Qualitative Disclosures about Market Risk**

 

There have been no material changes to the information called for bythis Item 3 from the disclosures set forth in Part II, Item 7A in theCompany’s Annual Report on Form 10-K for the year ended December 31,2003.

 

**Item4.  Controls and Procedures**

 

*Restatements*

 

On May 10, 2005, management of the Company was advised by BDOSeidman, LLP, its independent registered public accounting firm (“BDO Seidman”),of the conclusion reached by it regarding the Company’s interim accounting forsales and marketing expenses related to trade shows.  This conclusion was reached in connectionwith BDO Seidman’s financial statement review procedures relating to theCompany’s Quarterly Report on Form 10-Q for the first quarter of theyear ending December 31, 2005 (“fiscal 2005”).  Commencing in the first quarter of the fiscalyear ended December 31, 2004 (“fiscal 2004”), the Company began tocapitalize 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 quarterreview, BDO Seidman noted that trade show costs previously capitalized andamortized should have been treated as period expenses in fiscal 2004.  As a result, BDO Seidman expressed its viewthat (a) trade show costs previously capitalized and amortized duringfiscal 2004 should have been treated as period expenses in fiscal 2004; (b) eachof the Company’s quarterly reports previously filed in fiscal 2004 should beamended; and (c) no reliance should be placed on the previously issuedfiscal 2004 quarterly financial statements. We restated our financial results for the quarters ended March 31, June 30,and September 30, 2004 to reflect adjustments to our previously reportedfinancial information.  In addition, theCompany’s annual report on Form 10-K for fiscal 2004 has beenamended to reflect such quarterly results including the quarter ended December 31,2004.

 

*Evaluation of Disclosure Controls andProcedures*

 

The Company conducted an evaluation of the effectiveness of the designand operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the“Exchange Act”)) as of the end of the period covered by this Quarterly Reportin connection with the filing of its initial Quarterly Report on Form 10-Qbased upon the information available at that time and concluded that theCompany’s disclosure controls and procedures were effective. The controlsevaluation was done under the supervision and with the participation ofmanagement, including our Chief Executive Officer and Chief Financial Officer.

 

Subsequent to that evaluation, in connection with the restatementsdescribed above, under the direction of our Chief Executive Officer and ChiefFinancial Officer, we reevaluated our disclosure controls and procedures. Inthe course of BDO Seidman’s financial review procedures relating to theCompany’s Quarterly Report on Form 10-Q for the quarterly period ended March 31,2005, our Chief Executive Officer and Chief Financial Officer were advised byBDO Seidman that the Company’s improper interpretation of accounting literaturewith respect to interim accounting for sales and marketing expenses related totrade show expenses described above constituted a material weakness in ourinternal control over financial reporting. Solely as a result of this material weakness, we concluded that ourdisclosure controls and procedures were not effective as of the end of theperiod covered by this Quarterly Report.

 

In connection with this amended Quarterly Report on Form 10-Q/A,under the direction of our Chief Executive Officer and Chief Financial Officer,we have re-evaluated our disclosure controls and procedures as currently ineffect, including the changes in internal controls over financial reportingdescribed below, and we have concluded that, as of the date of this amendedQuarterly Report on Form 10-Q/A, our disclosure controls andprocedures are effective.

 

*Changes in Internal Controls*

 

In the course of BDO Seidman’s financial statement review proceduresrelating to the Company’s Quarterly Report on Form 10-Q for thequarterly period ended March 31, 2005, 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

 

25

----

 

identified above, but the Company will continue to monitor theeffectiveness of these actions and will make any other changes or take suchother actions as management determines to be appropriate.

 

As previously reported, there was no change in our internal controlover financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) during the first quarter of fiscal 2004, that materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting. However, subsequent to March 31, 2005, we tookthe remedial actions described above.

 

26

----

 

**PART II — OTHER INFORMATION**

 

**Item 6.  Exhibits andReports on Form 8-K.**

 

(a)                                  *Exhibits*.

 

Theexhibits listed below are hereby filed with the Securities and ExchangeCommission (the “SEC”) as part of this Report.

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

 

(b)                                 *Reports on Form 8-K.*

 

On March 25, 2004, we filed with the SEC a Current Report on Form 8-Kdated March 25, 2004 announcing our operating results for the fourthquarter and year ended December 31, 2003.

 

27

----

 

**SIGNATURES**

 

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

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

 

28

----