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

FORM 10-Q

(Mark one)

For the quarterly period ended June 30, 2002

or

For the transition period from __________to __________.

Commission File Number 0-24248

AMERICAN TECHNOLOGY CORPORATION
(Exact name of registrant as specified in its charter)

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.        YES  x  NO  o

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

AMERICAN TECHNOLOGY CORPORATION
INDEX

2

American Technology Corporation
BALANCE SHEETS

See accompanying notes to the interim financial statements.

3

American Technology Corporation
STATEMENTS OF OPERATIONS
(Unaudited)

See accompanying notes to the interim financial statements.

4

American Technology Corporation
STATEMENTS OF CASH FLOWS
(Unaudited)

See accompanying notes to the interim financial statements.

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AMERICAN TECHNOLOGY CORPORATION
NOTES TO INTERIM FINANCIAL STATEMENTS
(Unaudited)

1. OPERATIONS

American Technology Corporation (the “Company”), a Delaware corporation, is engaged in design, development and commercialization of sound, acoustics and other technologies and the sales and marketing of portable consumer products.

2. STATEMENT PRESENTATION

The accompanying unaudited interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. In the opinion of management, the interim financial statements reflect all adjustments of a normal recurring nature necessary for a fair presentation of the results for interim periods. Operating results for the three and nine month periods are not necessarily indicative of the results that may be expected for the year. The interim financial statements and notes thereto should be read in conjunction with the Company’s audited financial statements and notes thereto for the year ended September 30, 2001.

3. NET LOSS PER SHARE

The Company applies Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings Per Share.” SFAS No. 128 provides for the calculation of “Basic” and “Diluted” earnings per share (“EPS”). Basic EPS includes no dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution of securities that could share in the earnings of an entity. The Company’s net losses for the periods presented cause the inclusion of potential common stock instruments outstanding to be antidilutive and, therefore, in accordance with SFAS No. 128, the Company is not required to present a diluted EPS. Convertible preferred stock, convertible promissory notes, stock options and warrants convertible or exercisable into approximately 5,127,879 and 2,563,875 shares of common stock were outstanding at June 30, 2002 and 2001, respectively. These securities were not included in the computation of diluted EPS because of the net losses but could potentially dilute EPS in future periods.

Net loss available to common stockholders for the three and nine months ended June 30, 2002, includes imputed deemed dividends based on the value of warrants issued and a discount at issuance in connection with Series D Preferred Stock (see Note 8). The Company has recorded deemed dividends for the warrants and discount at issuance at $35,377 and $40,385, respectively. Such imputed deemed dividends are not included in the Company’s stockholders’ equity as the Company has an accumulated deficit. The imputed deemed dividends are not contractual obligations of the Company to pay such imputed dividends.

The provisions of the Company’s Series B Preferred Stock provided for an accretion in the conversion value (similar to a dividend) of 6% or $0.60 per share per annum. The Series C Preferred Stock provides for an accretion in the conversion value of 6% or $1.20 per share per annum. The Series D Preferred Stock provides for an accretion in the conversion value of 6% or $0.60 per share per annum. The accrued accretion of the Series B, C and D Preferred Stock for the nine months ended June 30, 2002 and 2001 was $48,351 and $92,160, respectively, which increases the net loss available to common stockholders. Net loss available to common stockholders is computed as follows:

4. RECENT ACCOUNTING PRONOUNCEMENTS

In June 2001, the Financial Accounting Standards Board finalized FASB Statements No. 141 “Business Combinations” (SFAS 141) and No. 142; “Goodwill and Other Intangible Assets” (SFAS 142). SFAS 141 requires the use of the purchase method of accounting and prohibits the use of the pooling-of-interest method of accounting for business combinations initiated after June 30, 2001. SFAS 141 also requires that the Company recognize acquired intangible assets apart from goodwill if the acquired intangible assets meet certain criteria. SFAS 141 applies to all business

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AMERICAN TECHNOLOGY CORPORATION
NOTES TO INTERIM FINANCIAL STATEMENTS
(Unaudited)

combinations initiated after June 30, 2001 and for purchase business combinations completed on or after July 1, 2001. It also requires, upon adoption of SFAS 142 that the Company reclassify the carrying amounts of intangible assets and goodwill based on the criteria in SFAS 141.

SFAS 142 requires among other things, that companies no longer amortize goodwill but instead test goodwill for impairment at least annually. In addition, SFAS 142 requires that the Company identify reporting units for the purposes of assessing potential future impairments of goodwill, reassess the useful lives of other existing recognized intangible assets and cease amortization of intangible assets with an indefinite useful life. An intangible asset with an indefinite useful life should be tested for impairment in accordance with the guidance in SFAS 142. SFAS 142 is required to be applied in fiscal years beginning after December 15, 2001 to all goodwill and other intangible assets recognized at that date regardless of when those assets were initially recognized. SFAS 142 requires the Company to complete a transitional goodwill impairment test nine months from the date of adoption. The Company is also required to reassess the useful lives of other intangible assets within the first interim quarter after adoption of SFAS 142. The Company has not entered into any business combinations and has no recorded goodwill. The Company is assessing, but has not yet determined how the adoption of SFAS 142 will impact its financial position and results of operations.

In August 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations.” SFAS No. 143 requires the fair value of a liability for an asset retirement obligation to be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. SFAS No. 143 is effective for the Company, for the fiscal year ending September 30, 2003. The Company believes the adoption of this statement will have no material impact on its financial statements.

In October 2001, the SFAS issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lives Assets”. SFAS 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 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001 and, generally, is to be applied prospectively. The Company has not yet determined what effect, if any, SFAS 144 will have on its financial statements once implemented.

In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB No. 4, 44 and 64, Amendment of FASB No. 13, and Technical Corrections.”  SFAS rescinds FASB No. 4 “Reporting Gains and Losses from Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements.”  This statement also rescinds SFAS No. 44 “Accounting for Intangible Assets of Motor Carriers” and amends SFAS No. 13, “Accounting for Leases”, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions.  This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions.  This statement is effective for fiscal years beginning after May 15, 2002.  The Company does not expect the adoption of this statement to have a material effect on the Company’s financial statements.

In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.”  SFAS No. 146 addresses accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring).”  SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized and measured initially at fair value when the liability is incurred.  SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged.   The Company does not expect the adoption of this statement to have a material effect on the Company’s financial statements.

5. INVENTORIES

Inventories are valued at the lower of cost or market. Cost is determined using the first-in, first-out (FIFO) method. Inventories consist of the following:

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AMERICAN TECHNOLOGY CORPORATION
NOTES TO INTERIM FINANCIAL STATEMENTS
(Unaudited)

6. PURCHASED TECHNOLOGY

In April 2000, the Company acquired all rights to certain loudspeaker technology owned by David Graebener (“Graebener”), Stephen M. Williams (“Williams”) and Hucon Limited, a Washington corporation (“Hucon”).  The purchase price consisted of $300,000 cash plus 200,000 shares of common stock.  The 200,000 shares of common stock were issued in June 2000 and were valued at $962,500. The Company will pay up to an additional 159,843 shares of common stock to Williams and Graebener contingent upon the achievement of certain performance milestones relating to gross revenues received by the Company from the purchased technology. These contingent shares will be recorded as compensation expense when earned and issued. The Company agreed to employ Mr. Williams and Mr. Graebener for a term of three years subject to certain terms and conditions.

7. CONVERTIBLE PROMISSORY NOTES

In September and October, 2001 the Company sold for cash in a private offering $800,000 and $1,225,000, respectively of unsecured 12% Convertible Subordinated Promissory Notes due December 31, 2002 (“Notes”) to accredited investors. The principal and interest amount of each Note may at the election of the Note holder be converted one or more times into fully paid and nonassessable shares of common stock, at a price of $2.00 per share. The Notes may be called by the Company for conversion if the market price exceeds $5.00 per share for five days and certain conditions are met. The purchasers were granted warrants to purchase 1,012,500 common shares of the Company at $2.00 per share until September 30, 2006 (“Warrants”). As of June 30, 2002 the Notes and accrued interest would have been convertible into 1,102,530 shares of common stock.

The Notes and Warrants have antidilution rights reducing the conversion and exercise price for certain issuances of equity securities by the Company at an effective price below the applicable conversion or exercise price. In connection with the Notes and Warrants, the Company recorded $2,025,000 as the value of the beneficial conversion feature of the Notes and the value of the Warrants. The Warrants were valued using the Black-Scholes model and the value was reflected as a discount to the debt. This debt discount is being amortized as non-cash interest expense over the term of the Notes. As of June 30, 2002, $1,215,000 was amortized as non-cash interest expense.

8. STOCKHOLDERS’ EQUITY

The Company has 10,000 shares of Series C Preferred Stock outstanding convertible into 39,562 shares of Common Stock as of June 30, 2002. The dollar amount of Series C Preferred Stock, increased by $1.20 per share accretion per annum and other adjustments, is convertible one or more times into fully paid shares of common stock at a conversion price which is the lower of (i) $8.00 per share or (ii) 92% of the average of the five days closing bid market price prior to conversion, but in no event less than $5.75 per share. The shares of Series C Preferred Stock may be called by the Company for conversion if the market price of the common stock exceeds $20.00 per share for ten days and certain conditions are met. The Series C Preferred Stock is subject to automatic conversion on March 31, 2003.

In May 2002, the Company sold 235,400 shares of Series D Convertible Preferred Stock (“Series D Stock”), par value $.00001 per share, at $10.00 per share for gross cash proceeds of $2,354,000. A total of 250,000 shares of Series D Stock have been authorized. The dollar amount of Series D Stock, increases by $0.60 per share accretion per annum and other adjustments, is convertible one or more times into fully paid shares of common stock at a conversion price which is the lower of (i) $4.50 per share or (ii) 90% of the volume weighted average market price for the five days prior to conversion, but in no event less than $2.00 per share, subject to adjustment. Provided however, that no such conversion may be made prior to January 1, 2003 at a conversion price of less then $4.50 per share. The Company is required to file a registration statement by December 31, 2002, if the registration statement is not filed, the conversion value of the Series D Stock is subject to adjustment. The shares of Series D Stock may be called by the Company for conversion if the market price of the common stock exceeds $9.50 per share for ten days and certain conditions are met. The Series D Stock is subject to automatic conversion on March 31, 2006. The purchasers of the Series D Stock were granted warrants to purchase an aggregate of 517,880 common shares of the Company at $4.50 per share until March 31, 2007 (“D Warrants”). The Series D Stock and the D Warrants have antidilution rights reducing the floor conversion and warrant exercise price for certain issuances of equity securities by the Company at an effective price below the applicable floor conversion or warrant exercise price.  In connection with the Series D Stock financing, the Company incurred closing costs of $78,750. As of June 30, 2002 the Series D Stock

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AMERICAN TECHNOLOGY CORPORATION
NOTES TO INTERIM FINANCIAL STATEMENTS
(Unaudited)

(based on 360-day year) would have been convertible into 528,161 shares of common stock.

In connection with the Series D Stock and D Warrants, the Company recorded $994,310 and $871,000 as the value of the discount at issuance of the Series D Stock and the value of the warrants, respectively.  The warrants were valued using the Black-Scholes model.  The value of the warrants and the discount at issuance are being amortized as a deemed dividend over the period to automatic conversion of the Series D stock (“March 31, 2007”).

As of June 30, 2002, $35,377 and $40,385 was amortized as a deemed dividend.

The following table summarizes changes in equity components from transactions during the nine months ended June 30, 2002:

8. STOCKHOLDERS’ EQUITY (cont’d)

The following table summarizes information about stock option activity during the nine months ended June 30, 2002:

Options outstanding are exercisable at prices ranging from $2.50 to $9.03 and expire over the period from 2002 to 2007 with an average life of three years.

At June 30, 2002, the Company had warrants outstanding, exercisable into the following number of common shares:

In October 2001, the Company granted a total of 110,000 stock options to a consultant in conjunction with related development and manufacturing agreements.  Options to purchase 65,000 shares of common stock vest depending on the consultant’s completion of various project milestones as well as the Company’s acceptance of the specified work. The Company estimates the period required to complete the specified milestones each reporting period and records consulting expense based on the current market price of the Company’s stock and the estimated percentage of the work completed. Consulting expense is adjusted each reporting period until vesting occurs. The Company has recorded consulting expense of $29,797 for the Black Scholes value of 10,000 milestone options vested at March 31, 2002 and

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AMERICAN TECHNOLOGY CORPORATION
NOTES TO INTERIM FINANCIAL STATEMENTS
(Unaudited)

consulting expense of $30,889 for the Black Scholes value of 10,000 milestone options vested at April 30, 2002. Options to purchase 45,000 shares of common stock vest based on the consultant meeting certain performance criteria. The Company records consulting expense at each vesting date. The Company has recorded consulting expense of $96,655 for the Black Scholes value of 45,000 performance options vested during the nine month period ended June 30, 2002.

9. INCOME TAXES

At June 30, 2002, a valuation allowance has been provided to offset the net deferred tax asset as management has determined that it is more likely than not that the deferred tax asset will not be realized. As of September 30, 2001, the Company has for federal income tax purposes net operating loss carryforwards of approximately $17,600,000, which expire through 2021 of which certain amounts are subject to limitations under the Internal Revenue Code of 1986, as amended.

10. RELATED PARTY SALES

On April 19, 2002, We offered to our shareholders and employees the opportunity to purchase limited edition NeoPlanar Speaker Systems with Purebass Subwoofers. The offer was limited to a first come first serve basis.  We offered 100 complete sets at a price of $979.50 per set. As of June 30, 2002 we sold 33 units for cash receipts of $32,323.

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

THE FOLLOWING DISCUSSION INCLUDES FORWARD-LOOKING STATEMENTS WITH RESPECT TO OUR FUTURE FINANCIAL PERFORMANCE. ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE CURRENTLY ANTICIPATED AND FROM HISTORICAL RESULTS DEPENDING UPON A VARIETY OF FACTORS, INCLUDING THOSE DESCRIBED BELOW UNDER THE SUB-HEADING, “BUSINESS RISKS.” ALSO SEE OUR ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED SEPTEMBER 30, 2001.

Overview

We are focused on commercializing our proprietary HyperSonic, NeoPlanar, PureBass and Stratified Field sound technologies. Our HyperSonic Sound (HSS) technology employs a laser-like beam to project sound to any listening environment. Our NeoPlanar technology is a thin film magnetic speaker that uses unique films and materials, which we believe results in superior sound quality and volume for any given size with low distortion. PureBass is an extended range woofer designed to complement our high performance Stratified Field and NeoPlanar technologies. PureBass employs unique cabinet construction and vent configurations along with multiple acoustic filters, which we believe produces improved performance. Our Stratified Field technology features a thin form factor, in a variety of shapes and sizes, producing high-fidelity, low distortion sound reproduction. Our strategy is to commercialize these technologies through OEMs primarily through licensing or supply agreements.

We believe our NeoPlanar, PureBass and Stratified Field technologies currently meet OEM commercial requirements. These technologies have been licensed to OEMs (including Harman International and Amtech Manufacturing Inc.) and are being transferred to commercial production. We expect product royalties to commence in fiscal 2002 from these technologies. We are also completing second generation HSS electronic packages and ultrasonic emitters that can be supplied to OEMs to be incorporated into end-user products. We expect that these components will be supplied to HSS licensees in fiscal 2002 for use in HSS products. We are however in the early stage of licensing of our sound technologies and have not generated significant revenues from such technologies to date.

When we license an audio technology, we typically receive a flat fee up-front, with the balance of payments based upon a percentage of net revenues of the products in which our technology is incorporated. Revenues from up-front license fees are recognized ratably over the specified term of the particular license. Contract fees are recorded as services are performed.

We have developed a strategic manufacturing relationship with HST, Inc., providing for sub-contract manufacturing of our sound technologies. HST has commenced production of HyperSonic sound systems and is currently developing volume manufacturing for magnetic NeoPlanar components for military contracts and other OEM customers. Production of the NeoPlaner transducers is expected in the fourth quarter of fiscal 2002. HST also provides us with additional developmental manufacturing support for ongoing research and future technologies. On April 18, 2002 we announced a letter of intent for the acquisition of HST, Inc., in a stock transaction. No formal merger agreement was executed and the parties announced the mutual termination of acquisition discussions on June 24, 2002.

Our various technologies are high risk in nature. Unanticipated technical obstacles can arise at any time and disrupt licensing activities or OEM product sales or result in lengthy and costly delays. There can be no assurance commercially viable sound products being developed by OEMs will meet with market acceptance or that such products will perform on a cost-effective basis.

Our future is largely dependent upon the success of our sound technologies. We invest significant funds in research and development and on patent applications related to our proprietary technologies. There can be no assurance our technologies will achieve market acceptance sufficient to sustain operations or achieve future profits. See “Business Risks” below.

In past years substantially all of our revenues have been derived from the sale of portable consumer products. We have sourced a total of 16 products targeted for niche markets at retail prices ranging from $11.99 to $29.99. Sourcing is on both an exclusive and nonexclusive basis and for different market territories on a product by product basis. Our market focus is in North America. We inventory finished goods as well as provide direct factory shipment to certain customers. There can be no assurance that our line of products can be marketed successfully. We have also produced high-end NeoPlanar speakers for sale to the marine market and expect to target other high-end sales to selected niche markets.

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We have identified the policies below as critical to our business operations and the understandings of our results of operations.  The impact and any associated risks related to these policies on our business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations when such policies affect our reported and expected financial results.

In the ordinary course of business, we have made a number of estimates and assumptions relating to the reporting of results of operations and financial condition in the preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America.  Actual results could differ significantly from those estimates under different assumptions and conditions.  We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require our most difficult, subjective, and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

We do not have off-balance sheet arrangements, financings, or other relationships with unconsolidated entities or other persons, also known as “special purpose entities” (SPEs).

Revenue Recognition

We derive our revenue primarily from two sources: (i) product revenue and (ii) contract and license fee revenue. We recognize revenue on product sales in the periods that products are shipped. Revenue from on going per unit license fees are based on units shipped incorporating the Company’s patented proprietary technologies and are recognized in the period when the manufacturers’ units shipped information is available to the Company and collectibility is reasonably assured. We recognize revenue from up-front license and other fees and annual license fees ratably over the specified term of the particular license or agreement.

Research and Development Expenses

Research and development expenses are salaries and related expenses associated with the development of our proprietary sound technologies and include compensation paid to engineering personnel and fees to outside contractors and consultants.

Deferred Tax Asset

We have provided a full valuation reserve related to our substantial deferred tax assets. In the future, if sufficient evidence of our ability to generate sufficient future taxable income in certain tax jurisdictions becomes apparent, we may be required to reduce our valuation allowances, resulting in income tax benefits in our consolidated statement of operations. We evaluate the realizability of the deferred tax assets and assesses the need for valuation allowance quarterly.

Results of Operations

Total revenues for the nine months ended June 30, 2002 were $691,745, a 1% increase from the comparable nine months of the prior year. Revenue for the three month period ended June 30, 2002 and 2001 were $235,691 and $150,318, respectively. Product revenue including related party sales for the nine months ended June 30, 2002 was $521,798 a 23% increase from the comparable nine months of the prior year. Contract and license revenues for the nine months ended June 30, 2002 and 2001 were $169,947 and $259,936, respectively. Consumer product sales are subject to significant month to month and quarter to quarter variability based on the timing of orders, new accounts, lost accounts and other factors. At June 30, 2002 and 2001 we had $367,492 and $126,279, respectively, collected and recorded as deferred revenue for existing contracts and licenses. We recognize upfront fees and advance revenues over the term of the respective license agreements.

At June 30, 2002, we had open purchase orders for approximately $316,000 of  backordered products and services to be billed for future work under development contracts. The product is expected to be shipped by December 2002. The contracts are expected to be completed during the fourth quarter ending September 30, 2002. There was no material backlog at June 30, 2001. Anticipated shipments are subject to change due to a variety of factors, many outside our control. Our customers may modify or cancel orders and delay or change schedules. Shipments may also be delayed due to production delay, component shortages and other production related issues.

Cost of sales for the nine months ended June 30, 2002 was $397,843 resulting in a gross profit of $293,902 or 42%. This compares to a gross profit of $205,885 or 30% for the comparable period of the prior year. Cost of sales for the three months ended June 30, 2002 and 2001 were $158,998 and $109,516, representing gross profit percentages of 33% and 27%, respectively. The fiscal 2002 second quarter gross profit is due to the increase in margins for new products introduced in the retail radio division and higher margins for our acoustic technologies. Product cost of sales for the nine months ended June 30, 2002 and 2001 were $329,275 and $344,164, respectively, representing a gross profit of 37%

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Selling, general and administrative expenses for the nine months ended June 30, 2002 and 2001 were $1,864,087 and $1,694,185, respectively. The $169,902 increase resulted primarily from an increase of $35,136 for depreciation and amortization, an increase of $116,611 for professional services and consulting, and an increase of $10,842 for legal and related costs related to the proposed acquisition of HST, Inc.  Selling, general and administrative expenses for the three month period ended June 30, 2002 and 2001 were $760,967 and $545,272, respectively. The $215,695 increase resulted from an increase of $90,160 for professional services and consulting, a $16,629 increase in legal and related costs, an $11,100 increase for annual meeting costs and an increase of $84,912 for personnel and related costs. We may expend additional resources on marketing HSS, NeoPlanar and other technologies in future quarters, which may increase selling, general and administrative expenses.

Research and development costs for the nine months ended June 30, 2002 were $2,883,977 compared to $2,366,262 for the comparable nine months of the prior year. The $517,715 increase resulted from an increase of $374,030 for consulting and professional services and an increase of $151,679 for materials, film and other related costs used in developing our technologies. Research and development costs for the three months ended June 30, 2002 and 2001 were $1,002,980 and $770,848, respectively. The $232,131 increase resulted from an increase of $125,169 for consulting services, an increase of $52,847 for materials, film and other related costs for the development of our sound technologies and an increase of $91,961 for personnel and related costs offset by a decrease of $25,570 for prepaid PMT royalties.

Research and development costs vary quarter by quarter due to the timing of projects, the availability of funds for research and development and the timing and extent of use of outside consulting, design and development firms. We expect fiscal 2002 research and development costs to remain at levels higher than the prior year due to increased staffing and the use of outside designers and consultants.

We recorded in selling, general and administrative expenses non-cash compensation expenses of $106,469 and $153,344 for the nine month periods ended June 30, 2002 and 2001. The non-cash compensation expense was for services paid through the issuance of 24,129 and 35,250 shares of common stock, respectively.  Non-cash compensation costs vary depending on elections regarding the use of common stock to pay services and other factors related to warrant and option valuations.

We experienced a loss from operations of $4,454,162 during the nine months ended June 30, 2002, compared to a loss from operations of $3,854,562 for the comparable nine months ended June 30, 2001. The $599,600 increase is primarily due to the increase in research and development expenses.

The net loss available to common stockholders for the nine months ended June 30, 2002 and 2001 of $5,960,805 and $3,821,660 respectively included $48,351 and $92,160 of accretion on the Series B, C and Series D Preferred Stock, respectively.

At September 30, 2001, we have federal net loss carryforwards of approximately $17,600,000 for federal tax purposes expiring through 2021. The amount and timing of the utilization of our net loss carryforwards may be limited under Section 382 of the Internal Revenue Code. A valuation allowance has been recorded to offset the related net deferred tax asset as management was unable to determine that it is more likely than not that the deferred tax asset will be realized.

Liquidity and Capital Resources

Since we recommenced operations in January 1992, we have had significant negative cash flow from operating activities.  During the nine months ended June 30, 2002, operating activities used cash of $3,316,579. This amount consisted primarily of a net loss of $5,836,692 and a $15,954 increase in accounts receivable and $4,591 in inventories, offset by $545,292 of depreciation and amortization, $1,215,000 of debt discount amortization, $379,008 of compensation paid in options and common stock, an increase of $38,900 in prepaid expenses and other, an increase of $166,575 in accounts payable and an increase of $195,883 in accrued liabilities.

At June 30, 2002, we had gross accounts receivable of $153,729 as compared to $137,775 at September 30, 2001. This represented approximately 72 days of sales. Receivables can vary substantially due to quarterly and seasonal variations in sales and timing of shipments to and receipts from large customers, many of which demand extended terms of 90-120 days.

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At June 30, 2002, we had working capital deficit of $698,573 compared to working capital of $892,040 at September 30, 2001. In May 2002, the Company issued 235,400 shares of Series D Convertible Preferred Stock for gross cash proceeds of $2,354,000 (see Page 8, Note 8).

We have financed our operations primarily through the sale of preferred stock, exercise of stock options, issuances of convertible notes, proceeds from the sale of investment securities and margins from consumer product sales. At June 30, 2002, we had cash of $1,359,272. As a result of the cash used in operations offset by proceeds from convertible notes, our cash position increased by approximately $5,200 from September 30, 2001. Based on our current cash position and projections for future revenues and currently planned expenditures, we will need to raise additional capital of approximately $2.3 million to continue operations at planned levels during the next twelve months. While we believe that investment capital in sufficient amounts will be available to us, there can be no guarantee that we will be able to raise funds on terms acceptable to us, or at all.  In addition, we may be required to repay up to $2,025,000 borrowed under convertible promissory notes, which mature December 31, 2002.  We have the right to require the holders of these notes to convert the entire principal balance of the notes into common shares at a conversion price of $2.00 per share if the closing bid price of our common shares is at least $5.00 per share for five consecutive days of regular trading, and if at such time there is an effective registration statement for resale of such conversion shares on file with the SEC.  We intend to file a registration statement for those shares promptly after the date of this report.  If the conditions for mandatory conversion are not satisfied before December 31, 2002, we anticipate that most or all of the note holders will elect to convert the notes to common shares if the market price of our shares is in excess of $2.00 per share.  On August 7, 2002, our stock closed at $4.39 on the Nasdaq SmallCap Market.  However, there can be no guarantee that our share value will not decrease or that such conversion will occur.  If such conversion does not occur we will attempt to renegotiate the terms of the notes with non-converting note holders or to raise capital from other sources to repay the notes.  If we are not successful with either of those alternatives, we will be obligated to pay the remaining balance due, which would further increase our need for additional capital to maintain operations at planned levels.

Any equity based source of additional funds could be dilutive to existing equity holders and the dilution could be material. The lack of sufficient funds from operations or additional capital could force us to curtail or scale back operations and would therefore have an adverse effect on our business. Other than cash and cash equivalents, we have no unused sources of liquidity at this time. We expect to incur additional operating losses as a result of expenditures for research and development and marketing costs for our sound and other products and technologies. The timing and amounts of these expenditures and the extent of our operating losses will depend on many factors, some of which are beyond our control. We anticipate that the commercialization of our technologies may require increased operating costs, however we cannot currently estimate the amounts of these costs.

Contractual Commitments and Commercial Commitments

The following table summarizes our contractual obligations, including purchase commitments at June 30, 2002, and the effect such obligations are expected to have on our liquidity and cash flow in future periods:

(1) Assumes notes are not sooner converted to common shares at $2.00 per share.

Employment Agreements

The Company has entered into six employment agreements with executive officers and key employees. These agreements are each for one to three-year terms expiring from September 2002 to February 2003.  Certain of the

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New Accounting Pronouncements

A number of new pronouncements have been issued for future implementation as discussed in the footnotes to our interim financial statements (see page 6, Note 4). As discussed in the notes to the interim financial statements, the implementation of these new pronouncements is not expected to have a material effect on our financial position or results of operations.

Business Risks

You should consider each of the following factors as well as the other information in this Quarterly Report in evaluating our business and our prospects. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently consider immaterial may also impair our business operations. If any of the following risks actually occur, our business and financial results could be harmed. In that case the trading price of our common stock could decline. You should also refer to the other information set forth in this Quarterly Report and in our Annual Report of Form 10-K for the fiscal year ended September 30, 2001, including our financial statements and the related notes.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

Market risk represents the risk of loss that may impact our financial position, results of operations or cash due to adverse changes in market prices, including interest rate risk and other relevant market rate or price risks.

We are exposed to some market risk through interest rates, related to our investment of our current cash of $1,359,272 We do not consider this risk to be material, and we manage the risk by continuing to evaluate the best investment rates available for short-term high quality investments.

We have no activities in long-term indebtedness and our other investments are insignificant. At the present time we do not have any significant foreign sales or foreign currency transactions.

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Item 1. Legal Proceedings

From time to time we are involved in routine litigation incidental to the conduct of our business. There are currently no material pending legal proceedings to which we are a party or to which any of our property is subject.

Item 2. Changes in Securities

(a) Not applicable

(b) Not applicable

(c) In May 2002 we sold in a private offering for cash at $10.00 per share a total of 235,400 shares of Series D Preferred Stock to a limited number of accredited or foreign investors for aggregate gross proceeds of $2,354,000. The dollar amount of the Series D stock, increased by $0.60 per share per annum and other adjustments, may be converted one or more times at the election of the Preferred holder, into common stock at a conversion price which is the lower of (i) $4.50 per share or (ii) 90% of the volume weighted average market price of our common stock for the five trading days prior to conversion, but no less than $2.00 per share, subject to certain adjustments. The Series D Preferred Stock may not be converted at less than $4.50 per share prior to December 31, 2002. We may call the shares of Series D Preferred Stock for conversion if the market price of the common stock exceeds $9.50 per share for ten consecutive trading days and certain conditions are met. The Series D Preferred Stock will be subject to automatic conversion on March 31, 2006.

Each purchaser was also granted a warrant to purchase 2.2 common shares at $4.50 per share, subject to certain future adjustments, until March 31, 2007 for each share of preferred stock purchased (aggregate warrants exercisable into 517,880 shares).

The Series D Preferred Stock and the related warrants have antidilution rights reducing the floor price for conversion of the Series D stock and the warrant exercise price for certain issuances of equity securities at an effective price below the applicable floor conversion or warrant exercise price.

We sold these securities without an underwriter. We paid finders fees of $78,750 for the introduction of purchasers. These securities were offered and sold without registration under the Securities Act in reliance upon the exemption provided by Regulation D or Regulation S thereunder, and an appropriate legend was placed on the Series D Preferred Stock and the warrants and will be placed on the shares issuable upon conversion of the Series D Preferred Stock or exercise of the warrants unless registered under the Securities Act prior to issuance. We have agreed to file, not later than December 31, 2002, a registration statement for the resale of the common stock issuable on conversion of the Series D Preferred Stock and exercise of the warrants.

Net proceeds from the sale of the Series D stock of approximately $2,275, 000 will be used for working capital.

(d)    Not applicable

Item 3. Defaults Upon Senior Securities

         Not applicable

Item 4. Submission of Matters to a Vote of Security Holders

             At the Company’s fiscal 2002 Annual Meeting of Stockholders held on May 20, 2002, the following individuals, constituting all of the members of the Board of Director were elected: Elwood G. Norris, Terry Conrad, Richard M. Wagner, David J. Carter, O’Connell J. Benjamin and Daniel Hunter. For each elected director, the results of the voting were:

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      The foregoing proposal was approved and accordingly ratified.

Item 5. Other Information

         Not applicable

Item 6. Exhibits and Reports on Form 8-K

We filed a report on Form 8-K on April 23, 2002 disclosing in Item 5 of a press release concerning our letter of intent to acquire HST, Inc.

We filed a report on Form 8-K on June 24, 2002 disclosing in Item 5 of a press release concerning the termination by mutual agreement of the letter of intent to acquire HST, Inc.

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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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