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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

Commission File No. 000-30335

SONIC INNOVATIONS, INC.
(Exact name of registrant as specified in its charter)

2795 East Cottonwood Parkway, Suite 660
Salt Lake City, UT 84121-7036
(Address of principal executive offices)

(801) 365-2800
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

x Yes o No

As of November 8, 2002, there were 19,807,746 shares of the registrant’s common stock outstanding.

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SONIC INNOVATIONS, INC.
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SONIC INNOVATIONS, INC
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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SONIC INNOVATIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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SONIC INNOVATIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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SONIC INNOVATIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except per share data)
(unaudited)

1.      BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. The results of operations for the three and nine months ended September 30, 2002 are not necessarily indicative of results that may be expected for the full year ending December 31, 2002. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001 as filed with the Securities and Exchange Commission.

The accompanying unaudited condensed consolidated financial statements include the accounts of Sonic Innovations, Inc. and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.

2.      ACQUISITIONS

The Company acquired five hearing aid businesses outside the U.S. in the second quarter of 2002 and one hearing aid business outside the U.S. in the first quarter of 2002 for cash totaling $7,019. In addition, if certain financial milestones are achieved by some of those businesses over a two-year period, the Company is committed to pay up to an additional $1,200. Four of these businesses were existing distributors of the Company’s products. The acquisitions were accounted for as purchases in accordance with Statement of Financial Accounting Standards No. 141 “Business Combinations.” The purchase prices of these businesses have been allocated to the net assets acquired based on management’s preliminary determinations of relative fair market values of the respective net assets and independent valuations.

The following table sets forth the current allocation of the aggregate purchase price of the six acquisitions:

3.      MARKETABLE SECURITIES

Management designates the appropriate classification of marketable securities at the time of purchase and re-evaluates such designation as of each balance sheet date. As of September 30, 2002 and December 31, 2001, the Company’s investment portfolio consisted of money market funds and short and long-term corporate debt securities, which were classified as held-to-maturity and presented at amortized cost, which approximates market value.

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4.      INVENTORIES

Inventories are stated at the lower of cost or market value using the first-in, first-out (“FIFO”) method and consisted of the following:

5.      INTANGIBLE ASSETS

Intangible assets consisted of the following:

Goodwill represents the excess of purchase price and related costs over the fair values assigned to the identifiable tangible and intangible assets (principally proprietary software, name and distribution agreements) of the businesses acquired. Definite-lived assets are being amortized over the estimated lives of the assets ranging from two to five years. The technology license is the right to use HIMPP intellectual property and is being amortized over the life of the patents covered by the related agreement.

6.      OTHER ASSETS

Other assets consisted of the following:

Customer loans are secured by the assets of the customers’ businesses. The loans bear interest at rates ranging from 5% to 8%, mature in four to five years and require minimum purchase commitments.

7.      COMPREHENSIVE INCOME (LOSS)

Comprehensive income (loss) consisted of the following:

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The foreign currency gain (loss) reflects changes in the exchange rates of foreign currencies relative to the U.S. dollar on the translation of the Company’s net investment in its foreign subsidiaries.

8.      EARNINGS (LOSS) PER COMMON SHARE

Basic earnings (loss) per common share was computed by dividing net income (loss) by the weighted average number of common shares outstanding. Diluted earnings per common share was computed by dividing net income by the weighted average number of common shares outstanding as adjusted for the dilutive effect of outstanding stock options. Total options outstanding at September 30, 2002 were 4,243, of which 1,313 and 1,370 were considered in the diluted earnings per share calculation for the three and nine months ended September 30, 2002, respectively. Stock options were not considered for loss periods since their effect would be anti-dilutive, thereby decreasing the loss per common share.

9.       SEGMENT INFORMATION

The table below presents selected information for the Company’s geographic segments. Rest-of-world (ROW) includes export sales from the U.S. to ROW countries.

Previously, Canada was classified as rest-of-world and the United States as its own segment. The current presentation reflects Canada and the United States in North America and the 2001 presentation has been reclassified accordingly.

10.      SHARE REPURCHASE PROGRAM

In May 2001, the Board of Directors authorized the repurchase of up to 1,000 shares of the Company’s common stock as market conditions warranted through December 31, 2001, and subsequently extended the program through March 31, 2002. The Company repurchased 875 shares of common stock at a cost of $3,403 under this program, of which 145 shares at a cost of $658 were repurchased in 2002.

11.      LEGAL PROCEEDINGS

The Company is a defendant in a lawsuit filed in October 2000 claiming that the Company and certain of its officers and directors violated federal securities laws by providing materially false and misleading information or concealing information about the Company’s relationship with Starkey Laboratories, Inc. This lawsuit, which is pending in the US District Court for the District of Utah, purports to be brought as a class action on behalf of all purchasers of the Company’s common stock from May 2, 2000 to October 24, 2000 and seeks damages in an unspecified amount. The complaint alleges that as a result of false statements or omissions, the Company was able to complete its IPO, artificially inflate its financial projections and results and have its stock trade at inflated levels. The Company strongly denies these allegations and will defend itself vigorously; however, litigation is inherently uncertain and there can be no assurance that the Company will not be materially affected. The Company has moved to

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dismiss plaintiffs’ Second Amended Complaint, which was filed after the District Court dismissed plaintiffs’ First Amended Complaint with leave to amend. There has been no discovery to date, no class has been certified and no trial has been scheduled.

12.      RECENTLY ENACTED ACCOUNTING STANDARDS

In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations,” and SFAS No. 142, “Goodwill and Other Intangible Assets.” The Company has applied the new standards to all of its acquisitions. Under the new rules, goodwill and intangible assets deemed to have indefinite lives are no longer amortized, but are subject to annual impairment tests. Other intangible assets will continue to be amortized over their useful lives.

In August 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations.” This statement requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred. When the liability is initially recorded, the entity capitalizes the cost by increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, the entity either settles the obligation for its recorded amount or incurs a gain or loss upon settlement. The Company adopted SFAS No. 143 on January 1, 2002 with no impact on its results of operations and financial position.

In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which replaced SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.” SFAS No. 144 applies to all long-lived assets, including discontinued operations, and replaced the provisions of Accounting Principles Board Opinion No. 30, “Reporting Results of Operations—Reporting the Effects of Disposal of a Segment of a Business,” for the disposal of segments of a business. SFAS No. 144 requires that those long-lived assets be measured at the lower of carrying amount or fair value less cost to sell, whether reported in continuing operations or in discontinued operations. Therefore, discontinued operations will no longer be measured at net realizable value or include amounts for operating losses that have not yet occurred. SFAS No. 144 also broadens the reporting of discontinued operations. The Company adopted SFAS No. 144 on January 1, 2002 with no impact on its results of operations and financial position.

In July 2002, the FASB issued SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities.” Under SFAS No. 146, a company will record a liability for a cost associated with an exit or disposal activity when that liability is incurred and can be measured at fair value. A liability is incurred when an event obligates the entity to transfer or use assets (i.e, when an event leaves the company little or no discretion to avoid transferring or using the assets in the future). Under previous accounting rules, if a company’s management approved an exit plan, the company generally could record the costs of that plan as a liability on the approval date, even if the company did not incur the costs until a later date. Under SFAS No. 146, some of those costs might qualify for immediate recognition, others might be recorded during one or more quarters, and still others might not be recorded until incurred in a much later period. The Company is currently reviewing the standard, which is effective for periods after December 31, 2002 prospectively, and does not expect it to have a material impact on its results of operations and financial position.

The following discussion contains forward-looking statements that involve risks and uncertainties. These statements refer to our future results, plans, objectives, expectations and intentions. These forward-looking statements include statements regarding the following: future component sales levels, factors expected to result in gross margin improvement, shift of sales mix toward lower-priced products and the resultant negative impact on gross margin, increased selling, general and administrative expense, additional customers, expansions in direct sales staff, expanded product offerings, anticipated growth of our business, future branding and advertising campaigns, increased research and development expense, amortization of deferred stock-based compensation, provision for income taxes, sufficiency of cash to fund our operations, future acquisitions and future stock purchases. Our actual results could differ materially and adversely from those anticipated in such forward-looking statements. Factors that could contribute to these differences include, but are not limited to, the risks discussed in the section titled “Factors That May Affect Future Performance” elsewhere in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2001. Our critical accounting policies are described in our Annual Report on Form 10-K for the year ended December 31, 2001. All amounts are reflected in thousands, except per share data.

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OVERVIEW

We design, develop, manufacture and market advanced digital hearing aids designed to provide the highest levels of satisfaction for hearing impaired customers. Capitalizing on our advanced understanding of human hearing, we have developed patented digital signal processing (“DSP”) technologies and embedded them in the smallest single-chip DSP platform ever installed in a hearing aid. In the U.S., Denmark, England, Austria, Switzerland and Canada, we sell finished hearing aids principally to hearing care professionals. In other parts of the world we sell finished hearing aids and hearing aid kits principally to distributors, except in Australia, where we sell hearing aids on a retail basis to hearing impaired consumers. We occasionally sell hearing aid components to other hearing aid manufacturers. We first began shipping product in the fourth quarter of 1998. We completed our initial public offering (“IPO”) in May 2000.

In reporting our financial condition and results of operations, we report three geographic segments. We generally evaluate our operating results on a company-wide basis because all of our products are sourced from the United States, and all research and development and considerable marketing and administrative support are provided globally from the United States.

RESULTS OF OPERATIONS

The following table sets forth selected statements of operations information for the periods indicated expressed as a percentage of net sales.