**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 
| **(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, 2006**                                                                            |
| ** **                                                                                                                         |
| **OR**                                                                                                                             |
| ** **                                                                                                                         |
| **o**                                                                                                                              | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
| ** **                                                                                                                         | ** **                                                                                          |
| **For the  transition period          to        ** |
| ** **                                                                                                                         | ** **                                                                                          |
| **Commission  File Number 0-21123**                                                                                                |

 

**SRS LABS, INC.**

(Exact name ofregistrant as specified in its charter)

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

 

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

(Address of principal executive offices) (ZipCode)

 

**(949) 442-1070**

(Registrant’s telephone number, includingarea code)

 

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

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 
| Large  accelerated filer   ̈ |   | Accelerated  filer   ̈ |   | Non-accelerated  filer  x |
|--------------------------------------------|--------|--------------------------------------|--------|-------------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o   No ý

 

As of April 28, 2006, 15,206,060 of the issuer’scommon stock, par value $.001 per share, were outstanding; of this amount,674,098 shares of the common stock were held as treasury shares.

 

 

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**SRSLABS, INC.**

 

**Form 10-Q**

**For thePeriod Ended March 31, 2006**

**Index**

 
| **PART  I-FINANCIAL INFORMATION** |                                                                                                                                                 |
|-----------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------|
| Item 1.                           | Financial Statements                                                                                                                                 |   |
|                              | Condensed Consolidated  Balance Sheets as of March 31, 2006 (Unaudited) and December 31,  2005                                             |   |
|                              | Condensed Consolidated  Statements of Operations for the three months ended March 31, 2006 and  2005 (Unaudited)                                |   |
|                              | Condensed Consolidated  Statements of Stockholders’ Equity and Comprehensive Income for the three  months ended March 31, 2006 (Unaudited) |   |
|                              | Condensed Consolidated  Statements of Cash Flows for the three months ended March 31, 2006 and  2005  (Unaudited)** **                |   |
|                              | Notes to the Condensed  Consolidated Financial Statements (Unaudited)                                                                                |   |
| Item 2.                           | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                                                          |   |
| Item 3.                           | Quantitative and Qualitative  Disclosures About Market Risk                                                                                          |   |
| Item 4.                           | Controls and Procedures                                                                                                                              |   |
| **PART  II-OTHER INFORMATION**    |                                                                                                                                                 |
| Item 5.                           | Other Information                                                                                                                                    |   |
| Item 6.                           | Exhibits                                                                                                                                             |   |
|                              |                                                                                                                                                 |
| SIGNATURES                        |                                                                                                                                                 |

 

2

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**FORWARD-LOOKINGINFORMATION**

 

As usedherein, the “Company,” “SRS Labs,” “we,” “us,” or “our” means SRS Labs, Inc.and its wholly-owned subsidiaries, including ValenceTech Limited, ValenceTechnology Limited (including its direct and indirect wholly-ownedsubsidiaries, collectively “Valence”), SRSWOWcast.com, Inc. and the jointventure with Coming Home Studios LLC, CHS/SRS LLC.

 

Some of thestatements in this Quarterly Report on Form 10-Q contain forward–lookingstatements regarding our assumptions, projections, expectations, targets,intentions or beliefs about future events, which involve risks and uncertainties.All statements other than statements of historical facts included in thisQuarterly Report relating to expectation of future financial performance,continued growth, changes in economic conditions or capital markets and changesin customer usage patterns and preferences, are forward-looking statements. Insome cases, you can identify forward-looking statements by terms such as may,will, should, expect, plan, intend, forecast, anticipate, believe, estimate,predict, potential, continue or the negative of these terms or other comparableterminology. The forward-looking statements contained in this Quarterly Reportinvolve known and unknown risks, uncertainties and situations that may causeour or our industry’s actual results, level of activity, performance orachievements to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by these statements.Factors that might cause actual events or results to differ materially fromthose indicated by these forward-looking statements may include the matterslisted under “Risk Factors” in Item 1A in our most recently filed Form 10-K andelsewhere in this Form 10-Q, including, but not limited to, uncertaintiesrelated to the sale of Valence and the divestiture of the Company’s equityinvestment in CHS/SRS LLC; the general market conditions concerning thesemiconductor business; the acceptance of new SRS Labs products andtechnologies; the import of competitive products and pricing; the timely developmentand release of technologies by the Company; general business and economicconditions, especially in Asia; product and customer concentration in ourbusiness; our high dependence on the consumer electronics market, which ischaracterized by short product life cycles, fluctuations in demand andseasonality; the risk of widespread illness; our dependence on growth inemerging markets; the length and unpredictable nature of our sales cycle; ourability to protect our products through patents and other intellectual propertyrights; our dependence on key personnel; the volatility of the price of ourcommon stock; provisions that could discourage transactions resulting in achange in control contained in our certificate of incorporation and bylaws aswell as Delaware law; competition we face from companies with greater brandrecognition and resources; pricing pressures on the consumer electronicsproduct manufacturers; adverse state, federal or foreign legislation orregulation or adverse determinations by regulators; and other factorsidentified from time to time in our filings with the Securities and ExchangeCommission.

 

Anyforward-looking statement speaks only as of the date on which such statement ismade, and, except as required by law, we undertake no obligation to update anyforward-looking statement to reflect events or circumstances after the date onwhich such statement is made or to reflect the occurrence of unanticipatedevents. New factors emerge from time to time, and it is not possible for managementto predict all such factors.

 

3

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**PART I — FINANCIAL INFORMATION**

 

**Item 1. Financial Statements**

 

**SRSLABS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                    | ** ** | **March 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                                                                    | ** ** | **(unaudited)**         | ** ** | ** **                 | ** ** |
| **ASSETS**                                                                                                                                                                                                                    |       |                    |       |                       |       |
| **Current  Assets**                                                                                                                                                                                                           |       |                    |       |                       |       |
| Cash and cash equivalents                                                                                                                                                                                                     |       | 10,627,409              |       | $                          | 8,752,339  |   |
| Accounts receivable, net                                                                                                                                                                                                      |       | 1,150,103               |       | 1,886,780                  |       |
| Inventories, net                                                                                                                                                                                                              |       | 74,318                  |       | 80,421                     |       |
| Prepaid expenses and other current assets                                                                                                                                                                                     |       | 504,421                 |       | 522,426                    |       |
| Assets held for sale                                                                                                                                                                                                          |       | 2,216,084               |       | 1,859,127                  |       |
|                                                                                                                                                                                                                          |       |                    |       |                       |       |
| **Total Current Assets**                                                                                                                                                                                                      |       | 14,572,335              |       | 13,101,093                 |       |
|                                                                                                                                                                                                                          |       |                    |       |                       |       |
| Investments available for sale                                                                                                                                                                                                |       | 17,019,395              |       | 17,077,170                 |       |
| Furniture, fixtures and equipment, net                                                                                                                                                                                   |       | 485,686                 |       | 425,288                    |       |
| Intangible assets, net                                                                                                                                                                                                        |       | 2,098,295               |       | 2,015,605                  |       |
| Deferred income taxes                                                                                                                                                                                                         |       | 386,412                 |       | 380,386                    |       |
| Long term assets held for sale                                                                                                                                                                                                |       | 1,997,510               |       | 2,065,123                  |       |
|                                                                                                                                                                                                                          |       |                    |       |                       |       |
| **Total Assets**                                                                                                                                                                                                              |       | $                       | 36,559,633 |                       | $          | 35,064,665 |   |
|                                                                                                                                                                                                                          |       |                    |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                 |       |                    |       |                       |       |
| **Current  Liabilities**                                                                                                                                                                                                      |       |                    |       |                       |       |
| Accounts payable                                                                                                                                                                                                              |       | $                       | 856,042    |                       | $          | 741,811 |   |
| Accrued liabilities                                                                                                                                                                                                           |       | 860,816                 |       | 801,898                    |       |
| Deferred revenue                                                                                                                                                                                                              |       | 408,654                 |       | 537,636                    |       |
| Liabilities related to assets held for sale                                                                                                                                                                                   |       | 2,102,253               |       | 2,170,701                  |       |
|                                                                                                                                                                                                                          |       |                    |       |                       |       |
| **Total Current Liabilities**                                                                                                                                                                                                 |       | 4,227,765               |       | 4,252,046                  |       |
|                                                                                                                                                                                                                          |       |                    |       |                       |       |
| Commitments  and contingencies (Note 7)                                                                                                                                                                                       |       |                    |       |                       |       |
|                                                                                                                                                                                                                          |       |                    |       |                       |       |
| **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; 15,184,060 and 14,953,690 shares issued; and 14,509,962  and 14,279,592 shares outstanding at March 31, 2006 and  December 31, 2005, respectively |       | 15,185                  |       | 14,955                     |       |
| Additional paid-in capital                                                                                                                                                                                                    |       | 64,989,244              |       | 63,574,518                 |       |
| Accumulated other comprehensive loss                                                                                                                                                                                          |       | (554,303                | )          | (496,021                   | )          |
| Accumulated deficit                                                                                                                                                                                                           |       | (29,114,813             | )          | (29,277,388                | )          |
| Treasury stock at cost, 674,098 shares at  March 31, 2006 and December 31, 2005                                                                                                                                     |       | (3,003,445              | )          | (3,003,445                 | )          |
|                                                                                                                                                                                                                          |       |                    |       |                       |       |
| **Total Stockholders’ Equity**                                                                                                                                                                                           |       | 32,331,868              |       | 30,812,619                 |       |
|                                                                                                                                                                                                                          |       |                    |       |                       |       |
| **Total Liabilities and Stockholders’ Equity**                                                                                                                                                                           |       | $                       | 36,559,633 |                       | $          | 35,064,665 |   |

 

See accompanying notes to the condensedconsolidated financial statements

 

4

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**SRSLABS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                     | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                                                     | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Revenues                                                       |       | $                                      | 4,335,668  |   | $ | 3,264,095 |   |
| Cost of  sales                                                 |       | 47,812                                 |       | 56,345 |   |
|                                                           |       |                                   |       |   |   |
| Gross margin                                                   |       | 4,287,856                              |       | 3,207,750 |   |
|                                                           |       |                                   |       |   |   |
| Operating  expenses:                                           |       |                                   |       |   |   |
| Sales and marketing                                            |       | 1,865,369                              |       | 1,182,447 |   |
| Research and development                                       |       | 654,289                                |       | 576,205 |   |
| General and administrative                                     |       | 1,637,208                              |       | 1,272,851 |   |
|                                                           |       |                                   |       |   |   |
| Total operating expenses                                       |       | 4,156,866                              |       | 3,031,503 |   |
|                                                           |       |                                   |       |   |   |
| Income from  continuing operations                             |       | 130,990                                |       | 176,247 |   |
| Other  income, net                                             |       | 179,713                                |       | 149,270 |   |
| Income from  continuing operations before income tax expense   |       | 310,703                                |       | 325,517 |   |
| Income tax  expense                                            |       | 159,423                                |       | 119,024 |   |
| Income from  continuing operations                             |       | 151,280                                |       | 206,493 |   |
|                                                           |       |                                   |       |   |   |
| Discontinued  operations (Note 9):                             |       |                                   |       |   |   |
| Income from discontinued operations before  income tax expense |       | 42,376                                 |       | 20,145 |   |
| Income tax expense                                             |       | 31,081                                 |       | 5,178 |   |
| Income from  discontinued operations                           |       | 11,295                                 |       | 14,967 |   |
| Net income                                                     |       | $                                      | 162,575    |   | $ | 221,460 |   |
|                                                           |       |                                   |       |   |   |
| Income from  continuing operations per common share:           |       |                                   |       |   |   |
|                                                           |       |                                   |       |   |   |
| Basic                                                          |       | $                                      | 0.01       |   | $ | 0.01 |   |
| Diluted                                                        |       | $                                      | 0.01       |   | $ | 0.01 |   |
|                                                           |       |                                   |       |   |   |
| Income from  discontinued operations per common share:         |       |                                   |       |   |   |
| Basic                                                          |       | $                                      | 0.00       |   | $ | 0.00 |   |
| Diluted                                                        |       | $                                      | 0.00       |   | $ | 0.00 |   |
|                                                           |       |                                   |       |   |   |
| Net income  per common share:                                  |       |                                   |       |   |   |
| Basic                                                          |       | $                                      | 0.01       |   | $ | 0.02 |   |
| Diluted                                                        |       | $                                      | 0.01       |   | $ | 0.01 |   |
|                                                           |       |                                   |       |   |   |
| Weighted  average shares used in the per share calculation:    |       |                                   |       |   |   |
| Basic                                                          |       | 14,423,611                             |       | 14,241,522 |   |
|                                                           |       |                                   |       |   |   |
| Diluted                                                        |       | 15,843,052                             |       | 15,255,107 |   |

 

 Seeaccompanying notes to the condensed consolidated financial statements

 

5

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**SRSLABS, INC.**

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

 
| ** **                                                     | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Accumulated** | ** ** | **Treasury** | ** ** | ** ** | ** ** | **Comprehensive  Income  for the Period** | ** ** |
|----------------------------------------------------------------|------------|-------------------|------------|-------------------------|------------|---------------------------------------|------------|-----------------|------------|--------------|------------|------------|------------|-------------------------------------------|------------|
| ** **                                                     | ** ** | **Shares**        | ** ** | **Amount**              | ** ** | **Capital**                           | ** ** | **Loss**        | ** ** | **Deficit**  | ** ** | **Stock**  | ** ** | **Total**                                 | ** ** | **Ended** | ** ** |
| ** **                                                     | ** ** | ** **        | ** ** | ** **              | ** ** | ** **                            | ** ** | ** **      | ** ** | ** **   | ** ** | ** ** | ** ** | ** **                                | ** ** | ** ** | ** ** |
| BALANCE, Dec. 31, 2005                                         |       | 14,279,592        |       | $                       | 14,955     |                                  | $          | 63,574,518      |       | $            | (496,021   | )          | $          | (29,277,388                               | )          | $ | (3,003,445 | ) | $ | 30,812,619 |   |   |   |
| Proceeds from  exercise of stock options                       |       | 230,370           |       | 230                     |       | 1,014,988                             |       | —          |       | —       |       | —     |       | 1,015,218                                 |       |   |   |
| Stock based compensation                                       |       | —            |       | —                  |       | 399,738                               |       | —          |       | —       |       | —     |       | 399,738                                   |       |   |   |
| Unrealized loss  on investments available for sale, net of tax |       | —            |       | —                  |       | —                                |       | (58,282         | )          | —       |       | —     |       | (58,282                                   | )          | (58,282 | ) |
| Net income                                                     |       | —            |       | —                  |       | —                                |       | —          |       | 162,575      |       | —     |       | 162,575                                   |       | 162,575 |   |
|                                                           |       |              |       |                    |       |                                  |       |            |       |         |       |       |       |                                      |       |   |   |
| BALANCE,  March 31, 2006                                  |       | 14,509,962        |       | $                       | 15,185     |                                  | $          | 64,989,244      |       | $            | (554,303   | )          | $          | (29,114,813                               | )          | $ | (3,003,445 | ) | $ | 32,331,868 |   | $ | 104,293 |   |
|                                                                |            |                   |            |                         |            |                                       |            |                 |            |              |            |            |            |                                           |            |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to thecondensed consolidated financial statements

 

6

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**SRSLABS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASHFLOWS**

**(Unaudited)**

 
| ** **                                                                                                | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| **Cash  Flows From Operating Activities:**                                                                |       |                                   |       |   |   |
| Income from  continuing operations                                                                        |       | $                                      | 151,280    |   | $ | 206,493 |   |
| Adjustments to reconcile income from  continuing operations to net cash provided by operating activities: |       |                                   |       |   |   |
| Depreciation and amortization                                                                             |       | 171,548                                |       | 210,287 |   |
| Deferred taxes                                                                                            |       | (6,026                                 | )          | — |   |
| Accretion of discount on investments  available for sale                                                  |       | (507                                   | )          | (508 | ) |
| Stock-based compensation expense                                                                          |       | 343,380                                |       | 14,831 |   |
| Loss on disposition of furniture, fixtures  and equipment                                                 |       | 1,166                                  |       | 2,267 |   |
| Investment in LLC                                                                                         |       | —                                 |       | (78,157 | ) |
| Changes in operating assets and  liabilities:                                                             |       |                                   |       |   |   |
| Accounts receivable                                                                                       |       | 736,677                                |       | (244,552 | ) |
| Inventories                                                                                               |       | 6,103                                  |       | (80,142 | ) |
| Prepaid expenses and other current assets                                                                 |       | 18,005                                 |       | (58,484 | ) |
| Accounts payable                                                                                          |       | 114,231                                |       | 122,037 |   |
| Accrued liabilities                                                                                       |       | 58,918                                 |       | 950,276 |   |
| Deferred revenue                                                                                          |       | (128,982                               | )          | 399 |   |
| Income taxes payable                                                                                      |       | —                                 |       | 97,883 |   |
|                                                                                                      |       |                                   |       |   |   |
| Net cash provided by operating activities                                                                 |       | 1,465,793                              |       | 1,142,630 |   |
|                                                                                                      |       |                                   |       |   |   |
| **Cash  Flows From Investing Activities:**                                                                |       |                                   |       |   |   |
| Purchase of  furniture, fixtures and equipment                                                            |       | (118,753                               | )          | (22,153 | ) |
| Expenditures  related to patents and intangible assets                                                    |       | (197,049                               | )          | (143,496 | ) |
|                                                                                                      |       |                                   |       |   |   |
| Net cash used in investing activities                                                                     |       | (315,802                               | )          | (165,649 | ) |
|                                                                                                      |       |                                   |       |   |   |
| **Cash Flows  From Financing Activities:**                                                                |       |                                   |       |   |   |
| Proceeds  from exercise of stock options                                                                  |       | 914,830                                |       | 66,287 |   |
|                                                                                                      |       |                                   |       |   |   |
| Net cash provided by financing activities                                                                 |       | 914,830                                |       | 66,287 |   |
|                                                                                                      |       |                                   |       |   |   |
| **Net  Increase in Cash from Continuing Operations**                                                      |       | 2,064,821                              |       | 1,043,268 |   |
|                                                                                                      |       |                                   |       |   |   |
| **Cash  Flows From Discontinued Operations:**                                                             |       |                                   |       |   |   |
| Net cash used in operating activities                                                                     |       | (246,329                               | )          | (1,039,652 | ) |
| Net cash used in investing activities                                                                     |       | (43,810                                | )          | (15,287 | ) |
| Net cash provided by financing activities                                                                 |       | 100,388                                |       | — |   |
| **Net  Decrease in Cash from Discontinued Operations**                                                    |       | (189,751                               | )          | (1,054,939 | ) |
|                                                                                                      |       |                                   |       |   |   |
| **Net  Increase (Decrease) in Cash and Cash Equivalents**                                                 |       | 1,875,070                              |       | (11,671 | ) |
| **Cash and  Cash Equivalents, Beginning of Period**                                                       |       | 8,752,339                              |       | 7,011,912 |   |
|                                                                                                      |       |                                   |       |   |   |
| **Cash and  Cash Equivalents, End of Period**                                                             |       | $                                      | 10,627,409 |   | $ | 7,000,241 |   |
|                                                                                                      |       |                                   |       |   |   |
| **Supplemental  Disclosure of Cash Flow Information:**                                                    |       |                                   |       |   |   |
| Cash paid during the period for:                                                                          |       |                                   |       |   |   |   |   |
| Income taxes                                                                                              |       | $                                      | 153,836    |   | $ | 247,559 |   |
| **Supplemental  Disclosure of Non-Cash Investing Activities:**                                            |       |                                   |       |   |   |
| Unrealized loss on investments, net                                                                       |       | $                                      | (58,282    | ) | $ | (259,460 | ) |

 

See accompanying notes to the condensedconsolidated financial statements

 

7

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**SRS LABS,INC.**

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

 

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

 

As used herein, the “Company,”“SRS Labs,” “we,” “us,” or “our” means SRS Labs, Inc. and its wholly-ownedsubsidiaries, including ValenceTech Limited, Valence Technology Limited(including its direct and indirect wholly-owned subsidiaries, collectively “Valence”),SRSWOWcast.com, Inc. (“SRSWOWcast”) and the joint venture with Coming HomeStudios LLC, CHS/SRS LLC.  Theaccompanying unaudited condensed consolidated financial statements have beenprepared by the Company in conformity with accounting principles generallyaccepted in the United States of America (“generally accepted accountingprinciples”) for interim financial information and the rules and regulations ofthe U.S. Securities and Exchange Commission (“SEC”) for interim reporting. Inthe opinion of management, all adjustments (which include only normal recurringadjustments) considered necessary for a fair presentation of our financialposition and results of operations have been included. Certain amounts includedin the accompanying prior periods’ consolidated financial statements have beenreclassified to conform to the current period presentation. All inter-companyaccounts and transactions have been eliminated.

 

Certain information and footnote disclosuresnormally included in financial statements prepared in accordance with generallyaccepted accounting principles have been condensed or omitted pursuant to SECrules and regulations for presentation of interim financial information.Therefore, the condensed interim consolidated financial statements should beread in conjunction with the Company’s Annual Report on Form 10-K for thefiscal year ended December 31, 2005. Current and future financialstatements may not be directly comparable to the Company’s historical financialstatements. The results of operations for the interim period are notnecessarily indicative of the results to be expected for any other interimperiod or for the full year.

 

OnFebruary 23, 2006, the Board of Directors of the Company (the “Board ofDirectors” or the “Board”) approved a plan to sell Valence in order to focusincreased management attention and financial resources on its licensingbusiness.  Additionally, on February 23,2006, the Board authorized management to take all reasonable steps to divestthe Company’s entire equity interest in the CHS/SRS LLC, a joint venture, orthe Joint Venture, to produce and distribute six concert videos featuring ourCircle Surround Technology.  As a resultof our decisions to sell Valence and our entire equity interest in the CHS/SRSLLC, we have accounted for the semiconductor business segment and the CHS/SRSLLC as discontinued operations in the accompanying condensed consolidatedfinancial statements.  We havereclassified prior periods to conform to the current period presentation.

 

**Estimates**

 

The preparation of financial statements inaccordance with generally accepted accounting principles requires management tomake use of certain estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reported periods. We base our estimates on historicalexperience and on various other assumptions that we believe are reasonableunder the circumstances, the results of which form the basis for makingjudgments about carrying values of assets and liabilities that are not readilyapparent from other sources. Actual results could differ materially from thoseestimates. See the audited consolidated financial statements and notes theretoincluded in our Annual Report on Form 10-K for the year ended December 31,2005 for an additional discussion of the significant accounting policies andestimates used in the preparation of our financial statements.

 

**2.**             **Stock-Based Compensation**

 

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of Financial AccountingStandards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment,” ** **(“SFAS123R”). This Statement requires companies to expense the estimated fair valueof stock options and similar equity instruments issued to employees over therequisite service period. SFAS 123R eliminates the alternative to use theintrinsic method of accounting provided for in Accounting Principles BoardOpinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), whichgenerally resulted in an immaterial amount of compensation expense recorded inthe financial statements related to the grant of stock options to employees ifcertain conditions were met. The pro forma impact from recognition of theestimated fair value of stock options granted to employees has been previously disclosedin our footnotes as required under previous accounting rules.

 

8

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Effective for the firstquarter of fiscal 2006, we adopted SFAS 123R using the modified prospectivemethod, which requires us to record compensation expense for all awards grantedafter the date of adoption, and for the unvested portion of previously grantedawards that remain outstanding at the date of adoption. Accordingly, priorperiod amounts presented herein have not been restated to reflect the adoptionof SFAS 123R.

 

The fair value concepts werenot changed significantly in SFAS 123R; however, in adopting SFAS 123R,companies must choose among alternative valuation models and amortizationassumptions. After assessing alternative valuation models and amortizationassumptions, we are continuing to use both the Black-Scholes-Merton (“BSM”)option-pricing formula and straight-line amortization of compensation expenseover the requisite service period of the grant. We will reconsider use of thismodel if additional information becomes available in the future that indicatesanother model would be more appropriate for us, or if grants issued in futureperiods have characteristics that cannot be reasonably estimated using this model.Under SFAS No. 123, “Accounting for Stock Based Compensation” (“SFAS 123”), wewere not required to estimate forfeitures in our expense calculation for thestock compensation pro forma footnote disclosure; however, SFAS 123R requiresan estimate of forfeitures and upon adoption we changed our methodology toinclude an estimate of forfeitures. The adoption of SFAS 123R had no effect oncash flows from financing activities.

 

The following tableillustrates (i) the impact of adopting SFAS 123R on net income and basic anddiluted income per share and (ii) as if the Company had continued to accountfor share-based compensation under APB 25:

 
| **** ****                | **** **** | ****Three Months Ended**** | **** **** |
|-------------------------------|----------------|----------------------------|----------------|
| **** ****                | **** **** | ****March 31, 2006****     | **** **** |
| **** ****                | **** **** | ****SFAS 123R****          | **** **** | ****APB 25**** | **** **** |
| Net income                    |           | $                          | 162,575        |   | $ | 546,803 |   |
| Basic net  income per share   |           | $                          | 0.01           |   | $ | 0.04 |   |
| Diluted net  income per share |           | $                          | 0.01           |   | $ | 0.03 |   |

 

The following table illustratesthe effect on net income and net income per share as if the Company had appliedthe fair value recognition provisions of SFAS 123 to options granted under theCompany’s stock option plans as of January 1, 2005. For purposes of this proforma disclosure, the fair value of the options is estimated using a BSMoption-pricing formula and amortized on a straight-line basis to expense over theoptions’ vesting period:

 
| **** ****                                                                                                                 | **** **** | ****Three  Months  Ended**** | **** **** |
|--------------------------------------------------------------------------------------------------------------------------------|----------------|------------------------------|----------------|
| **** ****                                                                                                                 | **** **** | ****March 31,****            | **** **** |
| **** ****                                                                                                                 | **** **** | ****2005****                 | **** **** |
|                                                                                                                           |           |                         |           |
| Net income - as reported                                                                                                       |           | $                            | 221,460        |   |
| Add: Share-based employee compensation  expense included in net income, net of related tax effects - as reported               |           | 8,899                        |           |
| Deduct: Share-based employee compensation  expense determined under fair value method, net of related tax effects - pro  forma |           | (305,103                     | )              |
| Net loss - pro forma                                                                                                           |           | $                            | (74,744        | ) |
| Basic - as reported                                                                                                            |           | $                            | 0.02           |   |
| Basic - pro forma                                                                                                              |           | $                            | (0.01          | ) |
| Diluted - as reported                                                                                                          |           | $                            | 0.01           |   |
| Diluted - pro forma                                                                                                            |           | $                            | 0.00           |   |

 

**ShareOption Plans**

 

 The Company has in effect several share-basedplans under which non-qualified and incentive stock options have been grantedto employees, non-employees and board members. The following equitycompensation plans have been approved by our stockholders: the SRSLabs, Inc. Amended and Restated 1996 Long-Term Incentive Plan (the “1996Plan”), and the SRS Labs, Inc. Amended and Restated 1996 Non-employeeDirectors’ Stock Option Plan (the “Non-employee Directors Plan”). The Board ofDirectors determines eligibility, vesting schedules and exercise prices foroptions granted

 

9

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under the plans. We issue newshares to satisfy stock option exercises under our share-based plans. No incometax benefit was realized from activity in our share-based plans during thethree months ended fiscal 2006 and 2005.

 

A summary of the sharesreserved for grant and options available for grant under each plan is asfollows:

 
| **** ****               | **** **** | ****March 31, 2006**** | **** **** |
|------------------------------|----------------|------------------------|----------------|
| **** ****               | **** **** | ****Shares****         | **** **** | ****Shares**** | **** **** |
| **** ****               | **** **** | ****Reserved****       | **** **** | ****Available**** | **** **** |
| **** ****               | **** **** | ****for Grant****      | **** **** | ****for Grant**** | **** **** |
| 1996 Plan                    |           | 8,500,000              |           | 2,142,863 |   |
| Non-employee  Directors Plan |           | 500,000                |           | 370,000 |   |
| Total                        |           | 9,000,000              |           | 2,512,863 |   |

 

Option awards are generallygranted with an exercise price equal to the market price of the Company’s stockat the date of grant. Option awards generally have a term of 10 years and vestand become exercisable over a four-year service period.

 

The fair value of eachshare-based award is estimated on the grant date using the BSM option-pricingformula. Expected volatilities are based on the historical volatility of theCompany’s stock price. The expected term of options granted subsequent to theadoption of SFAS 123R is derived using the simplified method as defined in theSEC’s Staff Accounting Bulletin 107, “Implementation of FASB 123R.” Therisk-free rate for periods within the contractual life of the option is basedon the U.S. Treasury interest rates in effect at the time of grant. The fairvalue of options granted was estimated using the following weighted-averageassumptions:

 
| **** ****            | **** **** | ****Three Months Ended**** | **** **** |
|---------------------------|----------------|----------------------------|----------------|
| **** ****            | **** **** | ****March 31,****          | **** **** |
| **** ****            | **** **** | ****2006****               | **** **** | ****2005**** | **** **** |
| Expected  term (in years) |           | 6.25                       |           | 6.25 |   |
| Expected  volatility      |           | 60                         | %              | 67 | % |
| Risk-free  interest rate  |           | 4.4                        | %              | 4.2 | % |
| Dividend  yield           |           | 0.00                       | %              | 0.00 | % |

 

Total compensation costrecognized in the current quarter is as follows:

 
| ** **                                                     | ** ** | **March 31, 2006** | ** ** |
|----------------------------------------------------------------|------------|--------------------|------------|
| Continuing  Operations:                                        |       |               |       |
| Sales and Marketing                                            |       | $                  | 162,053    |   |
| Research and Development                                       |       | 126,987            |       |
| General and Administrative                                     |       | 54,340             |       |
| Total  compensation cost recognized in Continuing Operations   |       | $                  | 343,380    |   |
|                                                           |       |               |       |
| Total  compensation cost recognized in Discontinued Operations |       | $                  | 56,358     |   |
| Total  compensation cost recognized                            |       | $                  | 399,738    |   |

 

10

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A summary of option activityunder the stock option plans and changes during the quarter then ended ispresented below:

 
| **** ****                        | **** **** | ****March 31, 2006**** | **** **** |
|---------------------------------------|----------------|------------------------|----------------|
| **** ****                        | **** **** | **** ****         | **** **** | ****Weighted-Average**** | **** **** | **** **** | **** **** |
| **** ****                        | **** **** | **** ****         | **** **** | **** **** | **** **** | ****Remaining**** | **** **** | ****Aggregate**** | **** **** |
| **** ****                        | **** **** | **** ****         | **** **** | ****Exercise**** | **** **** | ****Contractual**** | **** **** | ****Intrinsic**** | **** **** |
| **** ****                        | **** **** | ****Shares****         | **** **** | ****Price**** | **** **** | ****Term**** | **** **** | ****Value**** | **** **** |
| Outstanding  at beginning of period   |           | 4,444,254              |           | $ | 4.41 |   |   |   |   |   |
| Granted                               |           | 110,000                |           | 6.20 |   |   |   |   |   |
| Cancelled/forfeited                   |           | (60,000                | )              | 3.33 |   |   |   |   |   |
| Exercised                             |           | (230,370               | )              | 4.41 |   |   |   |   |   |
| Outstanding  at end of period         |           | 4,263,884              |           | $ | 4.47 |   | 5.1 |   | $ | 6,610,305 |   |
| Options  exercisable at end of period |           | 3,209,503              |           | $ | 4.14 |   | 4.6 |   | $ | 6,047,020 |   |

 

A summary of the grant-datefair value and intrinsic value information is as follows:

 
| **** ****                                    | **** **** | ****Three Months Ended**** | **** **** |
|---------------------------------------------------|----------------|----------------------------|----------------|
| **** ****                                    | **** **** | ****March 31,****          | **** **** |
| **** ****                                    | **** **** | ****2006****               | **** **** | ****2005**** | **** **** |
| Weighted-average  grant-date fair value per share |           | $                          | 3.77           |   | $ | 2.61 |   |
| Intrinsic  value of options exercised             |           | $                          | 382,209        |   | $ | 29,884 |   |

 

A summary of the activity ofthe Company’s non-vested shares is presented below:

 
| **** ****                                | **** **** | **** **** | **** **** | ****Weighted-Average**** | **** **** | ****Remaining**** | **** **** |
|-----------------------------------------------|----------------|----------------|----------------|--------------------------|----------------|-------------------|----------------|
| **** ****                                | **** **** | **** **** | **** **** | **** ****           | **** **** | ****Remaining**** | **** **** | ****Unrecognized**** | **** **** |
| **** ****                                | **** **** | **** **** | **** **** | ****Grant-Date****       | **** **** | ****Years****     | **** **** | ****Compensation**** | **** **** |
| **** ****                                | **** **** | ****Shares**** | **** **** | ****Fair Value****       | **** **** | ****To Vest****   | **** **** | ****Cost**** | **** **** |
| Nonvested  outstanding at beginning of period |           | 1,195,964      |           | $                        | 3.21           |              |           |   |   |   |
| Granted                                       |           | 110,000        |           | 3.77                     |           |              |           |   |   |
| Vested                                        |           | (191,583       | )              | 2.76                     |           |              |           |   |   |
| Forfeited                                     |           | (60,000        | )              | 2.62                     |           |              |           |   |   |
| Nonvested  outstanding at end of period       |           | 1,054,381      |           | $                        | 3.62           |              | 2.72           |   | $ | 2,215,074 |   |
|                                               |                |                |                |                          |                |                   |                |  |  |  |  |

 

**3.             Capitalizationof Software Development Costs**

 

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

 

11

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Capitalized software as of March 31, 2006 and December 31,2005 is as follows:

 
| ** **                 | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Capitalized  software      |       | $                        | 678,528    |                        | $          | 595,568 |   |
| Accumulated  amortization  |       | (346,491                 | )          | (309,990                    | )          |
| Capitalized  software, net |       | $                        | 332,037    |                        | $          | 285,578 |   |

 

As of March 31, 2006, the weighted average useful life of theCompany’s capitalized software is approximately 2.0 years. The following tableshows the estimated amortization expense for those assets for the remainingnine months of the current fiscal year end and each of the four succeedingfiscal years.

 
| **Year ending December 31,** | ** ** | **Estimated  Expense** | ** ** |
|-----------------------------------|------------|------------------------|------------|
| 2006                              |       | $                      | 126,786    |   |
| 2007                              |       | 117,013                |       |
| 2008                              |       | 77,165                 |       |
| 2009                              |       | 11,073                 |       |
| 2010                              |       | —                 |       |
|                                   |            |                        |            |  |

 

**4.             IntangibleAssets**

 

OnJanuary 1, 2002, the Company adopted SFAS No. 142 “Goodwill and OtherIntangible Assets,” which, among other things, establishes new standards for goodwillacquired in a business combination, eliminates the amortization of goodwill andrequires the carrying value of goodwill and identifiable intangibles to beevaluated for impairment on an annual basis.

 

Inaccordance with SFAS No. 142, all of our intangible assets that havedefinite lives are being amortized on a straight-line basis over theirestimated useful lives and are evaluated at least annually to determine if fairvalue of the asset has decreased below its carrying value. At December 31,2005, we performed our annual assessment and determined that no impairmentexisted.

 

Intangibleassets consist of the following:

 
| ** **                                                                   | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                                                                         |       |                     |       |                        |       |
| Patents                                                                      |       | $                        | 2,453,632  |                        | $          | 2,339,543 |   |
| Accumulated  amortization                                                    |       | (1,151,036               | )          | (1,093,368                  | )          |
| Patents, net                                                                 |       | 1,302,596                |       | 1,246,175                   |       |
| Other  Intangibles:                                                          |       |                     |       |                        |       |
| License agreements acquired in purchase of  SRSWOWcast in February 2003 |       | 640,071                  |       | 640,071                     |       |
| Poly Planar purchased technology for  speaker products                       |       | 120,000                  |       | 120,000                     |       |
| Capitalized software and hardware for  several technologies                  |       | 608,800                  |       | 525,840                     |       |
| Total of Other Intangibles                                                   |       | 1,368,871                |       | 1,285,911                   |       |
| Accumulated  amortization, other intangibles                                 |       | (573,172                 | )          | (516,481                    | )          |
| Other  intangibles, net                                                      |       | 795,699                  |       | 769,430                     |       |
| Intangible  assets, net                                                      |       | $                        | 2,098,295  |                        | $          | 2,015,605 |   |

 

12

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

 
| ** **                                                                   | ** ** | **Three months ended  March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| Patents                                                                      |       | $                                      | 57,668     |   | $ | 49,937 |   |
| Other  intangibles:                                                          |       |                                   |       |   |   |
| License agreements acquired in purchase of  SRSWOWcast in February 2003 |       | 16,001                                 |       | 16,001 |   |
| Poly Planar purchased technology                                             |       | —                                 |       | 4,000 |   |
| Capitalized  software and hardware                                           |       | 40,690                                 |       | 29,719 |   |
| Total  intangible amortization expense                                       |       | $                                      | 114,359    |   | $ | 99,657 |   |

 

As of March 31, 2006, the weightedaverage useful life of the Company’s patents and intangible assets isapproximately 2.9 years. The following table shows the estimated amortizationexpense for those assets for the remaining nine months of the current fiscalyear and each of the four succeeding fiscal years:

 
| **Year  ending  December 31,** | ** ** | **Estimated expense** | ** ** |
|-------------------------------------|------------|-----------------------|------------|
| 2006                                |       | $                     | 371,286    |   |
| 2007                                |       | $                     | 425,419    |   |
| 2008                                |       | $                     | 321,455    |   |
| 2009                                |       | $                     | 209,452    |   |
| 2010                                |       | $                     | 196,584    |   |
| Thereafter                          |       | $                     | 574,099    |   |

 

**5.**             **Investments Available for Sale**

 

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

 
| ** **             | ** ** | **March 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|------------------------|------------|-------------------------|------------|----------------------------|------------|
| Cost                   |       | $                       | 17,489,688 |                       | $          | 17,489,688 |   |
| Accretion of  discount |       | 2,709                   |       | 2,202                      |       |
| Unrealized  loss       |       | (473,002                | )          | (414,720                   | )          |
| Estimated  fair value  |       | $                       | 17,019,395 |                       | $          | 17,077,170 |   |

 

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

 
| ** **                                      | ** ** | **March 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                      | ** ** | **Cost**                | ** ** | **Estimated  Fair Value**  | ** ** | **Cost** | ** ** | **Estimated  Fair Value** | ** ** |
| U.S. Government securities available for  sale: |       |                    |       |                       |       |   |   |   |   |
| Due in one  year or less (a)                    |       | 11,992,395              |       | 11,882,065                 |       | 11,991,890 |   | 11,879,670 |   |
| Due in one  to five years                       |       | 5,500,000               |       | 5,137,330                  |       | 5,500,000 |   | 5,197,500 |   |
|                                            |       | $                       | 17,492,395 |                       | $          | 17,019,395 |   | $ | 17,491,890 |   | $ | 17,077,170 |   |
|                                                 |            |                         |            |                            |            |  |  |  |  |  |  |  |  |

 

----

(a)    Available for sale securities due in oneyear or less are classified as long-term in the condensed consolidated balancesheets, as the original contractual maturities are greater than 90 days.

 

13

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**6.**             **Net Income Per Common Share**

 

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

 

Basic and diluted net incomeper share computed in accordance with SFAS 128 for the three months endedMarch 31, are as follows:

 
| ** **                                               | ** ** | **For the three months  ended March 31,** | ** ** |
|----------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                       | ** ** | **2005** | ** ** |
| ** **                                               | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| BASIC EPS                                                | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Income from continuing operations                        |       | $                                              | 151,280    |   | $ | 206,493 |   |
| Income from discontinued operations                      |       | 11,295                                         |       | 14,967 |   |
| Net income                                               |       | $                                              | 162,575    |   | $ | 221,460 |   |
| Denominator: weighted average common shares  outstanding |       | 14,423,611                                     |       | 14,241,522 |   |
| Income from  continuing operations—basic            |       | $                                              | 0.01       |   | $ | 0.01 |   |
| Income from  discontinued operations—basic          |       | $                                              | 0.00       |   | $ | 0.00 |   |
| Net income  per share—basic                         |       | $                                              | 0.01       |   | $ | 0.02 |   |
|                                                     |       |                                           |       |   |   |
| DILUTED EPS                                              |       |                                           |       |   |   |
| Income from continuing operations                        |       | $                                              | 151,280    |   | $ | 206,493 |   |
| Income from discontinued operations                      |       | 11,295                                         |       | 14,967 |   |
| Net income                                               |       | $                                              | 162,575    |   | $ | 221,460 |   |
| Denominator: weighted average common shares  outstanding |       | 14,423,611                                     |       | 14,241,522 |   |
| Common equivalent shares outstanding:                    |       |                                           |       |   |   |
| Options                                                  |       | 1,419,441                                      |       | 1,013,585 |   |
| Total diluted shares                                     |       | 15,843,052                                     |       | 15,255,107 |   |
| Income from  continuing operations—diluted          |       | $                                              | 0.01       |   | $ | 0.01 |   |
| Income from  discontinued operations—diluted        |       | $                                              | 0.00       |   | $ | 0.00 |   |
| Net income  per share—diluted                       |       | $                                              | 0.01       |   | $ | 0.01 |   |

 

There were 715,750 and 1,404,000 potentially dilutiveoptions outstanding for the quarters ending March 31, 2006 and 2005,respectively, that were not included in the table above because they would beanti-dilutive.

 

**7.**             **Commitmentsand Contingencies**

 

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

 

**8.**             **Stockholders’Equity**

 

On March 24, 2005,the Company’s Board of Directors authorized the repurchase of up to $3,000,000of the outstanding shares of the Company’s common stock for a period from March25, 2005 to March 24, 2006 (the “2005 Repurchase Program”).  The Company repurchased 232,223 shares underthis plan.  There was no activity underthe 2005 Repurchase Program during the current fiscal quarter, and the programexpired on March 24, 2006.

 

14

----

 

**9.**             **DiscontinuedOperations**

 

On February 23,2006, the Board approved a plan to sell Valence in order to focus increasedmanagement attention and financial resources on its licensing business. We haveretained Kaufman Bros., L.P., a financial advisor based in New York City, toassist us in facilitating a sale. Additionally, on February 23, 2006, the Board authorized managementto take all reasonable steps to divest the Company’s entire equity interest in theJoint Venture.  As a result of ourdecision to sell Valence and our entire equity interest in the Joint Venture,we have accounted for the semiconductor business segment and the Joint Ventureas discontinued operations.  All priorperiods have been reclassified to conform to the current period presentation.

 

Incomefrom discontinued operations consists of direct revenues and direct expenses ofValence and CHS/SRS LLC. General corporate overhead costs have not beenallocated to discontinued operations.  Asummary of the operating results of Valence and the Joint Venture included indiscontinued operations in the accompanying condensed consolidated statementsof operation is as follows:

 
| ** **                                     | ** ** | **For the three months  ended March 31,** | ** ** |
|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                       | ** ** | **2005** | ** ** |
| **Semiconductors:**                            | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Revenues                                       |       | $                                              | 2,141,708  |   | $ | 1,984,563 |   |
| Cost of sales                                  |       | 1,068,484                                      |       | 728,240 |   |
| Gross margin                                   |       | 1,073,224                                      |       | 1,256,323 |   |
| Total operating expenses                       |       | 1,129,148                                      |       | 1,312,172 |   |
| Loss from  operations                          |       | (55,924                                        | )          | (55,849 | ) |
| Other income  (expense), net                   |       | 4,185                                          |       | (1,338 | ) |
| Loss before  income tax expense                |       | (51,739                                        | )          | (57,187 | ) |
| Income tax  expense                            |       | 31,081                                         |       | 5,178 |   |
| **Net loss  from semiconductors**              |       | (82,820                                        | )          | (62,365 | ) |
| **Net  income from CHS/SRS LLC**               |       | 94,115                                         |       | 77,332 |   |
| **Total  income from discontinued operations** |       | $                                              | 11,295     |   | $ | 14,967 |   |

 

Asummary of the assets and liabilities related to the discontinued operations ofValence and the Joint Venture classified as held for sale in the accompanyingcondensed consolidated balance sheet is as follows:

 
| ** **                                        | ** ** | **March 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                        | ** ** | **(unaudited)**         | ** ** | ** **                 | ** ** |
| **Current  assets held for sale:**                |       |                    |       |                       |       |
| Accounts receivable, net                          |       | $                       | 1,199,019  |                       | $          | 902,771 |   |
| Inventories, net                                  |       | 723,428                 |       | 534,226                    |       |
| Prepaid expenses and other current assets         |       | 293,637                 |       | 422,130                    |       |
| Total                                             |       | 2,216,084               |       | 1,859,127                  |       |
|                                              |       |                    |       |                       |       |
| **Long  term assets held for sale:**              |       |                    |       |                       |       |
| Furniture, fixtures and equipment, net       |       | 1,027,336               |       | 1,060,631                  |       |
| Goodwill                                          |       | 533,031                 |       | 533,031                    |       |
| Intangibles, net                                  |       | 437,143                 |       | 471,461                    |       |
| Total                                             |       | 1,997,510               |       | 2,065,123                  |       |
|                                              |       |                    |       |                       |       |
| **Liabilities  related to assets held for sale:** |       |                    |       |                       |       |
| Accounts payable                                  |       | 908,250                 |       | 855,559                    |       |
| Accrued liabilities                               |       | 1,194,003               |       | 1,315,142                  |       |
| Total                                             |       | 2,102,253               |       | 2,170,701                  |       |
|                                                   |            |                         |            |                            |            |  |  |

 

15

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**10.          SegmentInformation**

 

The Company previouslyoperated in two business segments — semiconductors and licensing.  However, as a result of the Board’s decisionon February 23, 2006 to sell the semiconductor business, the Company nowhas continuing operations in only one business segment, licensing.  Our revenue from continuing operations is solelyderived from licensing related revenue.

 

For the three months ending March 31, 2006, therewas no significant customer in the licensing segment. For the same period inthe prior year, two customers accounted for approximately 12% and 10% in thelicensing segment. The following schedule presents the Company’s revenue fromcontinuing operations by geographic area. Licensing-related revenue isallocated based on the location of the licensee’s corporate headquarters. TheAmericas region includes North, Central and South America.

 
| ** **                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------|------------|----------------------------------------|------------|
| ** **                   | ** ** | **2006**                               | ** ** | **%** | ** ** | **2005** | ** ** | **%** | ** ** |
| **Geographic Area Revenue:** |       |                                   |       |   |   |   |   |   |   |
| Japan                        |       | $                                      | 2,027,781  |   | 47 | % | $ | 1,520,489 |   | 47 | % |
| Korea                        |       | 1,176,501                              |       | 27 | % | 692,034 |   | 21 | % |
| China                        |       | 604,142                                |       | 14 | % | 339,357 |   | 10 | % |
| Americas                     |       | 470,439                                |       | 11 | % | 671,798 |   | 21 | % |
| Europe                       |       | 56,805                                 |       | 1 | % | 40,417 |   | 1 | % |
|                         |       |                                   |       |   |   |   |   |   |   |
| Total                        |       | $                                      | 4,335,668  |   | 100 | % | $ | 3,264,095 |   | 100 | % |

 

**11.**          **RecentAccounting Pronouncements**

 

InNovember 2005, the FASB issued Staff Position (“FSP”) FAS115-1/124-1, *The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments*, which addresses thedetermination as to when an investment is considered impaired, whether thatimpairment is other than temporary, and the measurement of an impairmentloss. This FSP also includes accounting considerations subsequent to therecognition of an other-than-temporary impairment and requires certaindisclosures about unrealized losses that have not been recognized asother-than-temporary impairments. The guidance in this FSP amends FASBStatements No. 115, *Accounting forCertain Investments in Debt and Equity Securities*, andNo. 124, *Accounting for CertainInvestments Held by Not-for-Profit Organizations*, and APB OpinionNo. 18, *The Equity Method of Accountingfor Investments in Common Stock*. We adopted this FSP duringthe three months ended March 31, 2006 and it did not have a materialimpact on our financial statements.

 

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

 

This information should be read in conjunction withthe audited consolidated financial statements and notes thereto and Management’sDiscussion and Analysis of Financial Condition and Results of Operationscontained in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2005, or the Form 10-K, the audited consolidated financialstatements and the notes thereto included in the Form 10-K and the unauditedcondensed interim consolidated financial statements and notes thereto includedin this Quarterly Report.

 

**Overview**

 

SRSLabs is a leading developer and provider of audio and voice technologysolutions for the home entertainment, portable media device, personaltelecommunications, personal computer, automotive, and broadcast markets, and adeveloper and provider of application specific integrated circuits, or ASICs,and standard integrated circuits, or ICs.

 

Historically,we have operated in the two business segments, licensing and semiconductors.

 

*Licensing:**  ***Through SRSLabs, the parent company, and its wholly-owned subsidiary,SRSWOWcast.com, Inc., doing business as SRSWOWcast Technologies, or SRSWOWcast,we develop and license audio, voice and surround sound

 

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technology solutions to many ofthe world’s leading OEMs, software providers and semiconductor companies, andlicense and market hardware and software products for the Internet andprofessional audio markets.

 

In September 2004, weentered into a strategic alliance with Coming Home Studios LLC, or CHS, to useand promote SRS Labs technologies, promote CHS productions and to promote eachcompany’s respective brands. In connection with the strategic alliance, theCompany and CHS established a joint venture, CHS/SRS, LLC, or the JointVenture, to produce and distribute six concert videos featuring our CircleSurround technology, or the Concert Videos. Initially, Coming Home Studios LLCwas the manager of the CHS/SRS Joint Venture; however, the Company becamemanager of the Joint Venture in July, 2005. As a result of becoming the managerof, and providing financial support to the Joint Venture, the Company wasrequired under FASB Interpretation No. 46, Consolidation of Variable InterestEntities (FIN 46R), to consolidate the financial statements of the JointVenture into our financial statements commencing with the third quarter offiscal 2005. Previously, we accounted for our 50% equity ownership in the JointVenture as an investment using the equity method.

 

In February 2006, ourBoard of Directors, or the Board, authorized management to take all reasonablesteps to divest our entire equity interest in the Joint Venture. We have notyet estimated the costs we will incur in connection with the divestiture of ourequity interest in the Joint Venture.  Asa result of our decision to sell our entire equity interest in the JointVenture, we have accounted for the Joint Venture as a discontinued operation inthe accompanying condensed consolidated financial statements.

 

*Semiconductors:  *Through SRSLabs, Inc.’s wholly-owned subsidiary, ValenceTech Limited, and ValenceTechLimited’s wholly-owned subsidiaries (collectively “Valence”), we operate afabless semiconductor business which develops, designs and markets standard andcustom analog ICs, digital signal processors, and mixed signal integratedcircuits primarily to original equipment manufacturers and original designmanufacturers, in the Asia Pacific region. On February 23, 2006, the Board approved a plan to sell Valence inorder to focus increased management attention and financial resources on itslicensing business.    As a result of ourdecision to sell Valence, we have accounted for the semiconductor businesssegment as discontinued operations in the accompanying condensed consolidatedfinancial statements.

 

As used herein, the “Company,”“SRS Labs,” “we,” “us,” or “our” means SRS Labs, Inc. and its direct andindirect wholly-owned subsidiaries, including ValenceTech Limited, Valence,SRSWOWcast.com, Inc. and the joint venture with Coming Home Studios LLC,CHS/SRS LLC.

 

#### **Critical Accounting Policies**

 

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

 

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

 

*Stock Based Compensation*

 

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 123 (revised 2004), “Share-BasedPayment,” ** **(“SFAS 123R”). This Statement requires companies to expense theestimated fair value of stock options and similar equity instruments issued toemployees over the requisite service period. SFAS 123R eliminates thealternative to use the intrinsic method of accounting provided for inAccounting Principles Board Opinion No. 25, Accounting for Stock Issued toEmployees (“APB 25”), which generally resulted in an immaterial amount ofcompensation expense recorded in the financial statements related to the grantof stock options to employees if certain conditions were met. The pro formaimpact from recognition of the estimated fair value of stock options granted toemployees has been disclosed in our footnotes as required under previousaccounting rules.

 

Effective for the firstquarter of fiscal 2006, we adopted SFAS 123R using the modified prospectivemethod, which requires us to record compensation expense for all awards grantedafter the date of adoption, and for the unvested portion of

 

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previously granted awards thatremain outstanding at the date of adoption. Accordingly, prior period amountspresented herein have not been restated to reflect the adoption of SFAS 123R.

 

The fair value concepts werenot changed significantly in SFAS 123R; however, in adopting this SFAS 123R,companies must choose among alternative valuation models and amortizationassumptions. After assessing alternative valuation models and amortizationassumptions, we are continuing to use both the Black-Scholes-Merton (“BSM”)option-pricing formula and straight-line amortization of compensation expenseover the requisite service period of the grant. We will reconsider use of thismodel if additional information becomes available in the future that indicatesanother model would be more appropriate for us, or if grants issued in futureperiods have characteristics that cannot be reasonably estimated using thismodel. Under SFAS No. 123, “Accounting for Stock Based Compensation” (“SFAS 123”),we were not required to estimate forfeitures in our expense calculation for thestock compensation pro forma footnote disclosure; however, SFAS 123R requiresan estimate of forfeitures and upon adoption we changed our methodology toinclude an estimate of forfeitures.

 

The following tableillustrates (i) the impact of adopting SFAS 123R on net income and basic anddiluted income per share and (ii) as if we had continued to account forshare-based compensation under APB 25:

  
| **** ****                | **** **** | ****Three Months Ended**** | **** **** |
|-------------------------------|----------------|----------------------------|----------------|
| **** ****                | **** **** | ****March 31, 2006****     | **** **** |
| **** ****                | **** **** | ****SFAS 123R****          | **** **** | ****APB 25**** | **** **** |
| Net income                    |           | $                          | 162,575        |   | $ | 546,803 |   |
| Basic net  income per share   |           | $                          | 0.01           |   | $ | 0.04 |   |
| Diluted net  income per share |           | $                          | 0.01           |   | $ | 0.03 |   |

 

The following tableillustrates the effect on net income and income per share if we had applied thefair value recognition provisions of SFAS 123 to options granted under ourstock option plans in the first fiscal quarter of 2005. For purposes of thispro forma disclosure, the fair value of the options is estimated using a BSMoption-pricing formula and amortized on a straight-line basis to expense overthe options’ vesting period:

 
| **** ****                                                                                                                 | **** **** | ****Three   Months   Ended**** | **** **** |
|--------------------------------------------------------------------------------------------------------------------------------|----------------|--------------------------------|----------------|
| **** ****                                                                                                                 | **** **** | ****March 31,****              | **** **** |
| **** ****                                                                                                                 | **** **** | ****2005****                   | **** **** |
|                                                                                                                           |           |                           |           |
| Net income - as reported                                                                                                       |           | $                              | 221,460        |   |
| Add: Share-based employee compensation  expense included in net income, net of related tax effects - as reported               |           | 8,899                          |           |
| Deduct: Share-based employee compensation  expense determined under fair value method, net of related tax effects - pro  forma |           | (305,103                       | )              |
| Net income - pro forma                                                                                                         |           | $                              | (74,744        | ) |
| Basic - as reported                                                                                                            |           | $                              | 0.02           |   |
| Basic - pro forma                                                                                                              |           | $                              | (0.01          | ) |
| Diluted - as reported                                                                                                          |           | $                              | 0.01           |   |
| Diluted - pro forma                                                                                                            |           | $                              | 0.00           |   |

 

The fair value of eachshare-based award is estimated on the grant date using the BSM option-pricingformula. Expected volatilities are based on the historical volatility of theCompany’s stock price. The expected term of options granted subsequent to theadoption of SFAS 123R is derived using the simplified method as defined in theSEC’s Staff Accounting Bulletin 107, “Implementation of FASB 123R.” Therisk-free rate for periods within the contractual life of the option is basedon the U.S. Treasury interest rates in effect at the time of grant.

 

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Total compensation costrecognized in the current quarter is as follows:

 
| ** **                                                     | ** ** | **March 31, 2006** | ** ** |
|----------------------------------------------------------------|------------|--------------------|------------|
| Continuing  Operations:                                        |       |               |       |
| Sales and Marketing                                            |       | $                  | 162,053    |   |
| Research and Development                                       |       | 126,987            |       |
| General and Administrative                                     |       | 54,340             |       |
| Total  compensation cost recognized in Continuing Operations   |       | $                  | 343,380    |   |
|                                                           |       |               |       |
| Total  compensation cost recognized in Discontinued Operations |       | $                  | 56,358     |   |
| Total  compensation cost recognized                            |       | $                  | 399,738    |   |

 

**Results of Continuing Operations**

 

**Three Months Ended March 31, 2006 Compared toThree Months Ended March 31, 2005**

 

*Revenues*

 

Licensing revenues consist primarily of royaltiesgenerated from the license of SRS Labs’ audio and voice technologies.  License and royalty agreements generallyprovide for the license of technologies for a fee based on the number of unitsdistributed by the licensee.  However, wehave in the past and may again in the future, enter into a license agreementfor a one-time fee. Also included in licensing revenue are revenues generatedfrom the sale of hardware and software applications into the broadcast audiomarkets.

 

Licensing revenues were $4,335,668 for the threemonths ended March 31, 2005, compared to $3,264,095 for the three monthsended March 31, 2005, an increase of $1,071,573 or 32.8 %.  The sales growth in licensing wasattributable to our continued strong sales in all five of our market segments.  Percentage increases were noted in thePortable Media Devices and Automotive segments, which reflect our strategy ofdiversification across all market segments. The Home Entertainment segment continues to grow in total revenues whiledecreasing as a percentage of total revenues. Within the Home Entertainmentsegment, revenues grew in Advanced Displays, partially offset by a decrease inSet Top Box revenues.  Thefollowing table presents the Company’s licensing revenues mix by marketsegment:

 
| ** **                                               | ** ** | **Three Months Ended March 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                               | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Home  Entertainment (TV, Set Top Box, A/V Receiver, DVD) |       | 55                                    | %          | 66 | % |
| Portable Media Devices (Digital Media Player, Headphone) |       | 20                                    | %          | 13 | % |
| Personal Telecommunications (Mobile phone, PDA)          |       | 11                                    | %          | 9 | % |
| PC  (Software, Hardware)                                 |       | 9                                     | %          | 10 | % |
| Automotive                                               |       | 5                                     | %          | 2 | % |

 

*Sales and Marketing*

 

Sales and marketing expenses consistprimarily of employee salaries, sales consultants’ fees and related expenses,sales commissions and product promotion costs. Sales and marketing expenseswere $1,865,369 for the three months ended March 31, 2006, compared to$1,182,447 for the same prior year period, an increase of $682,922 or 57.8%.  This increase is primarily attributable toincreased headcount and related expenses, increased commissions on higherrevenues, and increased marketing activities related to enhancement of theCompany’s brand.   In addition, theincrease is attributable to recognizing $162,053 in stock option expense due tothe adoption of FAS 123R in the current quarter.  As a percentage of total revenues, sales andmarketing expenses increased from 36.2 % for the quarter ended March 31,2005 to****43.0% for the same period this year.

 

*Researchand Development*

 

Researchand development expenses consist of salaries and related costs of employeesengaged in ongoing research, design and development activities and costs forengineering materials and supplies. Research and development expenses were

 

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$654,289 for the three monthsended March 31, 2006, compared to $576,205 for the same prior year period,an increase of $78,084 or 13.6%.  The increaseis attributable to recognizing $126,987 in stock option expense due to the adoption of FAS 123R in the currentquarter, offset by decreased head count and related expenses.   As a percentage of total revenues, researchand development expenses were 17.7%for the quarter ended March 31, 2005, and 15.1% for the same period thisyear.

 

*Generaland Administrative*

 

General and administrative (“G&A”) expensesconsist primarily of employee-related expenses, legal costs associated with theadministration of intellectual property and other professional fees. G&Aexpenses were $1,637,208 for the three months ended March 31, 2006, comparedto $1,272,851 for the same prior year period, an increase of $364,357 or 28.6%. The increase is primarilyattributable to increased professional fees, costs associated with the Company’sseparation from its former Chief Financial Officer and consulting agreementsrelated to human resources activities.  Inaddition, the increase is attributable to recognizing $54,340 in stock optionexpense due to the adoption of FAS 123R in the current quarter.  As a percentage of total revenues, G&Aexpenses increased from 39.0%for the quarter ended March 31, 2005, to 37.8% for the same period this year.

 

*OtherIncome, Net*

 

Otherincome, net, consists primarily of interest income and foreign currencytransaction gains and losses. Other income net, was $179,713 for the threemonths ended March 31, 2006, compared to $149,270 for the same prior yearperiod, an increase of $30,443 or 20.4 %. The increase is primarilyattributable to higher interest income on larger cash balances invested.

 

*Provisionfor Income Taxes*

 

The income tax expense for the threemonths ended March 31, 2006 was $159,423,compared to tax expense of $119,024 for the same prior year period, an increaseof $40,399 or 33.9%. The provision consists primarily of taxes paid onlicensing revenues sourced from countries requiring foreign tax withholdings,principally Korea.

 

*Discontinued Operations*

 

Asa result of our decision to sell Valence and our entire equity interest in theJoint Venture, we have accounted for the semiconductor business segment and theJoint Venture as discontinued operations. All prior periods have been reclassified to conform to the currentperiod presentation.

 

Incomefrom discontinued operations consists of direct revenues and direct expenses ofValence and CHS/SRS LLC. General corporate overhead costs have not beenallocated to discontinued operations.  Asummary of the operating results of Valence and the Joint Venture included indiscontinued operations in the accompanying condensed consolidated statementsof operation is as follows:

 
| ** **                                     | ** ** | **For the three months  ended March 31,** | ** ** |
|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                       | ** ** | **2005** | ** ** |
| **Semiconductors:**                            | ** ** | ** **                                     | ** ** | ** ** | ** ** |
| Revenues                                       |       | $                                              | 2,141,708  |   | $ | 1,984,563 |   |
| Cost of sales                                  |       | 1,068,484                                      |       | 728,240 |   |
| Gross margin                                   |       | 1,073,224                                      |       | 1,256,323 |   |
| Total operating expenses                       |       | 1,129,148                                      |       | 1,312,172 |   |
| Loss from  operations                          |       | (55,924                                        | )          | (55,849 | ) |
| Other income  (expense), net                   |       | 4,185                                          |       | (1,338 | ) |
| Loss before  income tax expense                |       | (51,739                                        | )          | (57,187 | ) |
| Income tax  expense                            |       | 31,081                                         |       | 5,178 |   |
| **Net loss  from semiconductors**              |       | (82,820                                        | )          | (62,365 | ) |
| **Net  income from CHS/SRS LLC**               |       | 94,115                                         |       | 77,332 |   |
| **Total income  from discontinued operations** |       | $                                              | 11,295     |   | $ | 14,967 |   |

 

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Semiconductor revenueswere $2,141,708 in the three months ended March 31, 2006 compared to $1,984,563in the three months ended March 31, 2005, an increase of $157,145 or 7.9%. ASPrevenues increased $512,815 due to the introduction of several new ASPchips.  The increase was offset by a decreasein ASIC revenue of $355,670, due to a decline in ASIC product demand. Grossmargin decreased from 63% to 50% in the quarters ended March 31, 2005 and 2006,respectively, due to an increase in lower margin ASP sales.  Operating expenses decreased $183,024primarily attributable to decreased head count and related expenses.  Other income (expense), net and income taxexpense were materially consistent with the prior period.  Net income from CHS/SRS LLC increased $16,783due to increased concert DVD sales due to the release of the Duran Duranconcert DVD in the fourth quarter of fiscal 2005.

 

**Liquidity and Capital Resources**

 

The Company’s principal source of liquidityto fund ongoing operations at March 31, 2006 consisted of cash, cashequivalents and long-term investments of $27,646,804. At March 31, 2006,the Company had cash and cash equivalents of $10,627,409 and long-term investments of $17,019,395. Cash and cash equivalents generally consist of cash,money market funds and other money market instruments with original maturitiesof three months or less. Investments consist of U.S. government securities ratedAAA.

 

Net cash provided by operating activitiesfrom continuing operations was $1,465,793 and $1,142,630 during the threemonths ended March 31, 2006 and March 31, 2005, respectively. The increasein our operating cash flows is primarily the result of our accounts receivabledecreased $736,677 and increased $244,522 during the three months ended March31, 2006 and 2005, respectively, due to timing of billing and cashreceipts.  Accrued liabilities increased $58,918and $950,276 during the three months ended March 31, 2006 and 2005,respectively.  The changes in liabilityaccounts generally relate to increases in professional fees, commissions andbonus and the timing of payments to vendors and employees. Offsetting theincreases, deferred revenue decreased $128,982 in the current quarter, due torealization and recognition of revenue on prepaid royalties.

 

Our net cash used in investing activities from continuing operations was $315,802 and $165,649 during the three months ended March 31, 2006 and March 31, 2005, respectively. The increase in net cash used by investing activities was attributable primarily to a $53,553 increase in cash used in expenditures related to patents and intangible assets and a $96,600 increase in purchases of furniture, fixtures and equipment.

 

Our net cash provided by financing activities from continuing operations was $914,830 and $66,287 during the three months ended March 31, 2006 and March 31, 2005, respectively. The increase in net cash provided by financing activities was attributable to increase an increase in stock option exercises.

 

Our net cash decrease from discontinued operations was $189,751 and $1,054,939 during the three months ended March 31, 2006 and March 31, 2005, respectively.  We are unable to estimate at this time the future cash expenditures that the Company will incur related to the disposition of the Company’s interest in Valence and CHS/SRS LLC.

 

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

 

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

 

Our operations and financial results aresubject to various risks and uncertainties that could adversely affect ourbusiness, financial condition, results of operations and trading price of ourcommon stock. Please refer to Item 1A, “Risk Factors” in our annual report onForm 10-K for fiscal year 2005 for information concerning these and otheruncertainties that could negatively impact the Company.

 

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

 

There have been no material changes to theinformation called for by this Item 3 from the disclosures set forth in PartII, Item 7A in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2005.

 

**Item4.  Controls and Procedures**

 

*Evaluation of Disclosure Controls andProcedures.**  *Our ChiefExecutive Officer and President and our Chief Financial Officer have evaluatedthe effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15 (e) under the Securities Exchange Act of 1934,as amended) as of the end of the period covered by this Quarterly Report onForm 10-Q and, based on this evaluation, have concluded that ourdisclosure controls and procedures are effective.

 

*Changes in Internal Controls.**  *There have been no changes in ourinternal controls over financial reporting that occurred during our firstquarter ended March 31, 2006 that have materially affected, or arereasonably likely to materially affect, our internal controls over financialreporting.

 

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**PARTII - OTHER INFORMATION**

 

**Item 5. Other Information**

 

*Merit Bonus Payments.*  On March 23, 2006, based upon the overallperformance of the Company and the individual and collective performance as amanagement team, the following executive officers of the Company were awardeddiscretionary merit bonuses for their efforts relating to the third and fourthquarters of the Company’s fiscal year ended December 31, 2005: Thomas C.K.Yuen, the Company’s Chief Executive Officer – $8,775; Janet M. Biski, theCompany’s Chief Financial Officer, Secretary and Treasurer until January 2,2006 and the Company’s Vice President from January 2, 2006 to March 31, 2006 –  $5,850; Michael Franzi, the Company’s VicePresident, Sales – Licensing – $7,500; Alan D. Kraemer, the Company’s ExecutiveVice President, Chief Technology Officer – $7,633; and Sarah Yang, the Company’sVice President, Software Engineering – $6,055.

 

*Amendments to the 2006 Profit Sharing andBonus Plan*.  OnMay 10, 2006, the Company amended the SRS Labs, Inc. 2006 Profit Sharing andBonus Plan (as amended, the “Bonus Plan”) relating to the fiscal year endingDecember 31, 2006 (i) to grant the Board discretion in future fiscal years tochange the percentage of the Company’s net income that may be allocated forprofit-sharing awards and bonuses under the Bonus Plan, (ii) to eliminatediscretion with respect to the Broad-Based and Executive Staff Bonus Pools andeliminate the Company’s executive officers and other senior managementpersonnel (the “Executive Staff”) from consideration with respect to allocationof the Discretionary Bonus Pool and (iii) to change the Bonus Plan’s name tothe “SRS Labs, Inc. Profit Sharing and Bonus Plan”.

 

Under the Bonus Plan, the Company’s executiveofficers (including the named executive officers), other management personneland other eligible employees will be entitled to quarterly and annual cashbonuses if pre-established levels of performance under designated criteria aremet or exceeded for the applicable quarters and the fiscal year.  The financial performance goals are based onthe Company’s attainment of a certain level of net income, defined under theBonus Plan to exclude Financial Accounting Standards Board (“FASB”) Statementof Financial Accounting Standards (“SFAS”) 123(R), Share-Based Payment (“SFAS123R”) charges.

 

Under the Bonus Plan, the Company willestablish a quarterly bonus pool for each of the first three fiscal quartersranging from zero to 8% of the Company’s net income for the quarter, dependingon the level of the Company’s net income for the applicable quarter and subjectto the Board’s discretion in future fiscal years to change the percentage ofthe Company’s net income that may be allocated for the quarterly bonus pool.The quarterly bonus pools will be allocated as follows: (i) 42.5% of eachquarterly bonus pool to the Executive Staff, which will be distributed tomembers of the Executive Staff pro rata in proportion to their respective basesalaries in effect on the payment date; (ii) 50% of each quarterly bonus poolto the Company’s remaining employees, which will be allocated among suchemployees pro rata in proportion to their respective base salaries in effect onthe payment date; and (iii) 7.5% of each quarterly bonus pool to adiscretionary bonus pool, which will be allocated to eligible employees (otherthan the Executive Staff) at the discretion of the Company’s Chief ExecutiveOfficer.

 

In addition, the Bonus Plan provides that theCompany will establish an annual bonus pool ranging from zero to 15% of theCompany’s net income for the fourth quarter, plus zero to 3% of the Company’snet income for each of the first three quarters, depending on the level of theCompany’s net income for the year and subject to the Board’s discretion infuture fiscal years to change the percentage of the Company’s net income thatmay be allocated for the annual bonus pool. The annual bonus pools will be allocated as follows: (i) 42.5% of theannual bonus pool to the Executive Staff, which will be distributed to membersof the Executive Staff pro rata in proportion to their respective base salariesin effect on the payment date; (ii) 50% of the annual bonus pool to the Company’sremaining employees, which will be allocated among such employees pro rata inproportion to their respective base salaries in effect on the payment date; and(iii) 7.5% of the annual bonus to a discretionary bonus pool, which will beallocated to eligible employees (other than the Executive Staff) at thediscretion of the Company’s Chief Executive Officer.

 

Under the Bonus Plan, the Company will alsomake quarterly profit-sharing payments to all of the Company’s eligibleemployees.  For each fiscal quarter, theCompany will allocate 5% of the Company’s net income (also defined to excludeSFAS 123R charges) for the quarter for profit sharing payments (subject to theBoard’s discretion in future fiscal years to change the percentage of theCompany’s net income that may be allocated for profit sharing payments), whichwill be allocated among eligible employees according to each participant’s basesalary in effect on the payment date.

 

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The obligations of the Bonus Plan will bebinding on any employer that acquires, through stock purchase or merger, orthrough an asset purchase, or otherwise, part or all the assets of the Companyfollowing a change of control, as defined under the Bonus Plan.

 

The foregoing description of the Bonus Planis qualified in its entirety by reference to the copy of the Bonus Plan whichis filed as Exhibit 99.1 to this Quarterly Report and is incorporated byreference herein. Capitalized terms used in this Item 5 in reference to theBonus Plan and not otherwise defined, have the meaning ascribed to them in theBonus Plan.

 

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**Item6.  Exhibits**

 

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

 
| **Exhibit  Number** | ** ** | **Description** |
|---------------------|------------|-----------------|
|                | 3.1        |            | Certificate of Incorporation of the Company, previously filed with  the SEC as Exhibit 3.1 to the Company’s Registration Statement on Form SB-2,  specifically included in Amendment No. 1 to such Registration Statement filed  with the SEC on July 3, 1996 (File No. 333-4974-LA), which is incorporated  herein by reference. |
|                | 3.2        |            | Bylaws of the Company, previously filed with the SEC as Exhibit 3.1  to the Company’s Quarterly Report on Form 10-Q for the period ended September  30, 1999, filed with the SEC on November 12, 1999, which is incorporated  herein by reference. |
| ** **          | 10.1       |            | Transition Agreement and General Release dated March 31, 2006 by and  between SRS Labs, Inc. and Janet M. Biski, previously filed with the SEC as  Exhibit 99.1 to the Company’s Current Report on Form 8-K filed with the SEC  on April 4, 2006, which is incorporated herein by reference. |
| ** **          | 10.2       |            | Amendment No. 1 to Employment Agreement dated March 31, 2006 by and  between SRS Labs, Inc. and Janet M. Biski, previously filed with the SEC as  Exhibit 99.2 to the Company’s Current Report on Form 8-K filed with the SEC  on April 4, 2006, which is incorporated herein by reference. |
|                | 10.3       |            | SRS Labs, Inc. 2006 Profit Sharing and Bonus Plan, previously filed  with the SEC as Exhibit 99.1 to the Company’s Current Report on  Form 8-K filed with the SEC on April 18, 2006, which is  incorporated herein by reference. |
|                | 10.4       |            | Participation Agreement for Ulrich E. Gottschling under the SRS Labs,  Inc. 2005 Change in Control Protection Plan, dated January 12, 2006,  previously filed with the SEC as Exhibit 99.1 to the Company’s Current Report  on Form 8-K filed with the SEC on January 18, 2006, which is incorporated  herein by reference. |
|                | 10.5       |            | Participation Agreement for Michael Franzi under the SRS Labs, Inc.  2005 Change in Control Protection Plan, dated January 12, 2005, previously  filed with the SEC as Exhibit 99.2 to the Company’s Current Report on Form  8-K filed with the SEC on January 18, 2006, which is incorporated herein by  reference. |
|                | 10.6       |            | Nonqualified Stock Option Agreement by and between the Company and  Ulrich E. Gottschling, dated January 12, 2006, previously filed with the SEC  as Exhibit 99.6 to the Company’s Current Report on Form 8-K filed with the  SEC on January 18, 2006, which is incorporated herein by reference. |
|                | 10.7       |            | Nonqualified Stock Option Agreement by and between the Company and  Sarah Yang, dated January 12, 2006, previously filed with the SEC as Exhibit  99.7 to the Company’s Current Report on Form 8-K filed with the SEC on January  18, 2006, which is incorporated herein by reference. |
|                | 10.8       |            | Form of Nonqualified Stock Option Agreement under the SRS Labs, Inc.  1996 Amended and Restated Long-Term Incentive Plan, as Amended, previously  filed with the SEC as Exhibit 99.8 to the Company’s Current Report on Form  8-K filed with the SEC on January 18, 2006, which is incorporated herein by  reference. |
|                | 31.1       |            | Certification of Chief Executive Officer of SRS Labs, Inc., pursuant  to Rule 13a-14 of the Securities Exchange Act. |
|                | 31.2       |            | Certification of Chief Financial Officer of SRS Labs, Inc., pursuant  to Rule 13a-14 of the Securities Exchange Act. |
|                | 32.1       |            | Certification of Chief Executive Officer of SRS Labs, Inc., pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                | 32.2       |            | Certification of Chief Financial Officer of SRS Labs, Inc., pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                | 99.1       |            | SRS Labs, Inc. Profit Sharing and Bonus Plan, dated May 10, 2006. |

 

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**SIGNATURES**

 

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

 
|                               | SRS LABS, INC., a Delaware corporation |
|------------------------------------|---------------------------------------------|
|                               |                                        |   |
| Date:  May 11, 2006      | By:                                         | /S/ THOMAS C.K. YUEN |
|                               |                                        | Thomas C.K. Yuen |
|                               |                                        | Chairman of the Board and Chief Executive Officer |
|                               |                                        | (Principal Executive Officer) |
| ** **                         | ** **                                  | ** ** |
| ** **                         | ** **                                  | ** ** |
| Date:  May 11, 2006 | By:                                         | /S/ ULRICH GOTTSCHLING |
|                               |                                        | Ulrich Gottschling |
|                               |                                        | Chief Financial Officer |
|                               |                                        | (Principal Financial and Accounting Officer) |

 

 

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**EXHIBIT INDEX**

The exhibitslisted below are hereby filed with the SEC as part of this Report.

 
| **Exhibit  Number** | ** ** | **Description** |
|---------------------|------------|-----------------|
| ** **          | ** ** | ** **      |
|                | 31.1       |            | Certification  of Chief Executive Officer of SRS Labs, Inc., pursuant to Rule 13a-14 of the 

Securities  Exchange Act. |
|                | 31.2       |            | Certification  of Chief Financial Officer of SRS Labs, Inc., pursuant to Rule 13a-14 of the 

Securities  Exchange Act. |
| ** **          | 32.1       |            | Certification  of Chief Executive Officer of SRS Labs, Inc., pursuant to Section 906 of the 

Sarbanes-Oxley  Act of 2002. |
| ** **          | 32.2       |            | Certification  of Chief Financial Officer of SRS Labs, Inc., pursuant to Section 906 of the 

Sarbanes-Oxley  Act of 2002. |
|                | 99.1       |            | SRS Labs,  Inc.  Profit Sharing and Bonus Plan,  dated May 10, 2006. |

 

 

 

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