UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

Commission File Number 0-26660

ESS Technology, Inc.

(Exact name of Registrant as specified in its charter)

Registrant’s telephone number, including area code:

(510) 492-1088

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, no par value

(Title of Class)

     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 þ          No o

      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     o

      Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).     Yes þ          No o

      The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, computed by reference to $10.71, the closing price of the registrant’s common stock as reported on the NASDAQ National Market on June 30, 2004, the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $347,397,250. Shares of common stock held by each officer and director and by each person who owned 5% or more of the registrant’s outstanding common stock on that date have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

      As of February 22, 2005, registrant had outstanding 39,707,473 shares of common stock.

DOCUMENTS INCORPORATED BY REFERENCE

      Portions of the Proxy Statement for Registrant’s 2005 Annual Meeting of Shareholders are incorporated by reference in Part III of this Report.

ESS TECHNOLOGY, INC.

2004 FORM 10-K

TABLE OF CONTENTS

      Certain information contained in or incorporated by reference in this Report contains forward-looking statements that involve risks and uncertainties. The statements contained in this Report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements regarding our expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this Report are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. Our actual results could differ materially from those discussed herein. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in “Factors That May Affect Future Results,” in the section captioned “Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Report. References herein to “ESS,” “the Company,” “we,” “our,” “us” and similar words or phrases are references to ESS Technology, Inc. and its subsidiaries, unless the context otherwise requires. Unless otherwise provided in this Report, trademarks identified by-Registered Trademark- and -TM- are registered trademarks or trademarks, respectively, of ESS Technology, Inc. or its subsidiaries. All other trademarks are the properties of their respective owners.

PART I

      We design, develop and market highly integrated analog and digital processor chips, imaging sensor chips, digital amplifiers, and camera lens modules. Our digital processor chips are the primary processors driving digital video and audio devices, including DVD, Video CD (“VCD”), consumer digital audio players, and digital media players. Our imaging sensor chips utilize advanced Complimentary Metal Oxide Semiconductor (“CMOS”) sensor technology to capture an image for cellular camera phone applications. Our digital amplifiers boost the digital sound to a level required to drive loudspeakers, in such applications as DVD and CD players, home theater systems, audio receivers, boom boxes and television sets. Our camera lens modules provide camera capabilities to electronic devices such as cellular phones and Personal Digital Assistants (“PDAs”). We have also developed and marketed encoding processors to address the growing demand for digital video recorders (“DVRs”) and recordable DVD players. We believe that multi-featured DVD, DVR and recordable DVD players will serve as a platform for the digital home system (“DHS”), integrating various digital home entertainment and information delivery products into a single box. We are also a supplier of chips for use in modems, other communication devices, and PC audio products. Our chips use multiple processors and a programmable architecture that enable us to offer a broad array of features and functionality. We focus on our design and development strengths and outsource all of our chip fabrication and assembly as well as the majority of our test operations.

      We market our products worldwide through our direct sales force, distributors and sales representatives. Substantially all of our sales are to customers in China, Hong Kong, Taiwan, Japan, Korea, Turkey and Singapore. We employ sales and support personnel located outside of the United States in China, Taiwan, Hong Kong, Korea and Japan to support these international sales efforts. We expect that international sales will continue to represent a significant portion of our net revenues. In addition, substantially all of our products are manufactured, assembled and tested by independent third parties in Asia. We also have a number of employees engaged in research and development efforts outside of the United States. There are special risks associated with conducting business outside of the United States. See Item 7, “Factors That May Affect Future Results — We have significant international sales and operations that are subject to the special risks of doing business outside the United States.”

      We were incorporated in California in 1984 and became a public company in 1995. On June 9, 2003, we acquired 100% of the outstanding shares of Pictos Technologies, Inc., a Delaware corporation (“Pictos”). On August 15, 2003, we acquired 100% of the outstanding shares of Divio, Inc., a California corporation (“Divio”). See Note 3, “Significant Business Combinations,” to the consolidated financial statements in Item 8 of this Report.

Industry Background

      The conversion of analog to digital technology is creating a revolution in audio and video consumer electronics. Digital technology continues to improve the consumer entertainment experience with such products as large screen televisions, multi-featured DVD players, home theater systems, navigational systems, digital still cameras, camera enabled cellular phones, and digital camcorders. Technology advancements have enhanced the clarity, color, sound, functionality and convenience of consumer entertainment products. In particular, the transition from analog to digital formats has allowed audio and video data to be compressed with little or no perceptible audio and image degradation, improving storage and transmission efficiency. Digital formats provide users with several benefits, including greatly expanded content selection, accelerated transmission of video and audio content, random access to data, superior editing capabilities and enhanced security features such as protection against unauthorized copying.

      The television, the telephone and the personal computer (“PC”) have emerged as the three principal systems that manage digital entertainment and information. The television and the PC are the principal devices for viewing and manipulating digital content. Digital Set-Top Boxes, DVD players and game consoles connected to televisions are emerging as the principal platforms for viewing and listening to entertainment,

while PCs remain the principle platform for storing, and manipulating data and accessing the internet. The cellular phone is emerging as the principal mobile device for viewing and transmitting digital content. However, because of size limitations for screens and keypads other mobile devices such as PDAs, MPEG Audio Players (“MP3s”), and portable DVD players also enjoy sizable end markets.

      Increasing advances in semiconductor technology are allowing digital products to converge, resulting in cost savings and added convenience for consumers. At the same time, advances in communication allow better distribution of information and entertainment content and provide opportunities for further development of multimedia products. As digital processing and transmission technology improves, we believe additional entertainment products will continue to be introduced.

      Some of the more significant digital entertainment products available today include:

      As digital entertainment products converge and become increasingly complex, makers of these consumer electronic devices increasingly require sophisticated semiconductor chips that are multi-featured, adaptable and cost-effective. Companies, such as ESS, which provide a highly integrated chip with multiple processors and a programmable architecture to address the needs of the latest entertainment products, are well positioned to benefit from growth in these markets.

Our Solution

      Our chips are the primary processors driving multi-featured video, audio and imaging products, and incorporate the latest video standards including MPEG1, MPEG2 and MPEG4. Our chips use multiple processors and a programmable architecture that enable us to offer a broad array of features and functionality. Our decoder chips play DVD, VCD, MPEG4, DivX, CD, MP3, WMA (Windows media audio) and other video formats and support high quality audio formats, including full-featured karaoke, Dolby Digital, DTS Surround, DVD audio and Sony’s Super Audio CD (“SACD”) audio. Our decoder chips also allow consumers to view digital photo CDs with the music slideshow feature on their televisions.

      We also have MPEG2 and MPEG4 encoder chips that provide the digital recording function that enable DVD players to become DVR and recordable DVD players. We believe that multi-featured DVD, DVR and recordable DVD players will serve as a platform integrating various digital home entertainment and information delivery products into a single box, which we call the Digital Home System (“DHS”). Our digital encoding products include a digital camcorder, a DVR and a recordable DVD player.

      We also supply digital image processors and image sensors used to manufacture camera enabled cellular phones. Our CMOS image sensors integrate several functions including image capture, image processing, color processing and the conversion and output of a fully processed image or video stream. Our image processors can be connected directly to a CMOS sensor, process the video information in real time, compress the captured image to a flash memory, and interface to a LCD or micro display. We are also a supplier of chips for use in PC audio products and modems and other communication products.

      We believe we have the following competitive advantages:

Our Strategy

      Our objective is to become a leading supplier of digital semiconductor chips to the consumer electronics entertainment product market. To achieve our objective, we are pursuing the following strategies:

      Leverage Our Proprietary Technology. Our chips are based on a programmable architecture that uses multiple processors working independently, which provides us with several advantages:

      Leverage Expertise Across Multiple Mass Market Applications. We intend to continue to focus on the DVD, VCD, digital camcorder, and cellular camera phone market applications. We believe additional market application will emerge as digital media technology and products converge. We plan to share and leverage our expertise in audio, video and imaging technology to strengthen and broaden our product offerings in existing markets, to expand into other existing digital media markets and to introduce new products into new markets as they emerge in the field of digital entertainment. Past examples of such expansion include, digital media players, MP3 players, boom boxes, audio receivers, digital television products, and cellular camera phones.

      Offer a Low-Cost Total Solution. Our engineers have significant system design expertise at the consumer product level. We design our chips to either work with lower-cost components or to decrease the number of components in our customers’ products to lower their total manufacturing cost. We also work in close collaboration with our customers in their product development processes to reduce the cost of our semiconductor products. By helping our customers design their products using our chips, we can lower their total bill of material. We believe this approach enables us to provide our customers with a low-cost total solution and drive up total demand by reducing the cost to consumer.

      Leverage Our Relationships with Low-Cost OEMs and ODMs to Capture Additional Worldwide Market Share. We believe that consumer electronics companies will continue to move contract manufacturing to lower-cost manufacturers located in Asia. We are a leading supplier of video system processor chips to OEMs and to ODMs, located in Asia. Our customers in Asia manufacture and sell DVD and VCD players both as contract manufacturers for well-known brand labels and under their own brands.

      Expand Relationships with Leading Consumer Electronics Companies. We are increasing our sales efforts to, and actively pursuing key design wins with, leading consumer electronics companies located in Asia, Europe and South America.

      Employ Our Software Expertise to Develop New Technologies. More than 50% of our employees are engineers, a significant number of whom are software engineers. We have a diversified base of technologies and a strong track record for developing new technologies in-house. We intend to leverage our software expertise to continue to develop new technologies and add features to our products.

      Leverage Our Relationships with Large Suppliers to Be One of the Low-Cost Providers. We believe consumer electronics markets are so competitive and rapidly changing that a manufacturer of fabless semiconductor products must focus on being one of the low-cost providers of digital media chips in the world. To do so, our products must have a relatively small die size and achieve high yields throughout the manufacturing process. We utilize long-standing and close relationships with some of the largest third party fabrication companies and assemblers in the world. We are one of the larger customers of many of these companies.

      Pursue Acquisitions of Complementary and Advanced Technologies. We have in the past acquired and will continue to consider acquiring complementary technologies or product lines to enhance our own product offerings and to accelerate our time to market.

      Pursue Licenses of Complementary Technologies. We have in the past licensed and will continue to consider licensing complementary technologies or product lines to enhance our own product offerings and to accelerate our time to market.

Products

      We offer an array of DVD decoder chips, Video CD chips, image sensor chips, image processor chips, DVD encoder chips, consumer digital audio chips, communication chips and PC audio chips.

      DVD Decoder Chips. Our customers can choose from a wide variety of DVD chips with various feature combinations and price points. We provide highly integrated chips using multiple processors and a programmable architecture that enables us to offer a broad array of features and functionality. Our DVD chips enable consumers to play DVD, CD, VCD, DivX, MP3, JPEG, WMA (Windows Media Audio), DVD audio, full-featured karaoke and other audio and video formats. Our DVD chips support high quality video formats such as Progressive Scan, and high quality audio formats, including Dolby Digital, DTS Surround, and DVD audio. These chips can also be used as the primary processor in digital media players. With the popularity of digital media such as Smart Media, Compact Flash, Memory Stick and Secure Digital, there is a growing demand for digital media players that incorporate digital media interface and thereby allow consumers to view digital media content on their consumer electronics devices. We offer both MPEG2 and MPEG4 decoding products and various levels of integrated products incorporating such capabilities as TV encoder, RF, and servo controller.

      Video CD Chips. Our VCD products consist of both standard VCD chips and an enhanced version known as SVCD chips. Our customers can choose from a variety of VCD and SVCD chip products, each with various feature combinations and price points. Our VCD chips include an MPEG1 video and audio system decoder. They deliver full-screen, full-motion video at 30 frames per second with selectable CD-quality audio. The video quality of SVCD is roughly comparable to that of a high-quality VCR, and VCDs have slightly lower quality video. These chips are used in relatively low-cost VCD players that are sold primarily in China, South East Asia, India and other emerging countries.

      Image Sensor Chips. Our CMOS image sensors provide excellent low light sensitivity for a given lens size. Our VGA and Megapixel products are used in camera enabled cellular phones.

      Image Processor Chips. We also offer image processor chips that perform the image processing, color processing and the conversion and output of a fully processed image or video stream. These products are used in camera enable cellular phones.

      DVD Encoder Chips. We are leveraging our existing DVD relationships with our customers to offer our DVD encoder chips to enable them to build DVR or recordable DVD players to broaden their products range. We recently introduced our Vantage II product, an integrated encoder and decoder solution in a simple package. A recordable DVD can record the video and audio signal to an optical drive where the content is stored on a DVD disk while a DVR records the video and audio signal to a magnetic drive (typically referred to as a hard drive) with video editing, instant replay and time delay features. We offer both MPEG2 and MPEG4 encoding products as well as non-integrated and integrated encode and decode versions of our chips.

      Consumer Digital Audio Chips. With the advancement in the high quality audio formats such as Dolby Digital, Dolby ProLogic, Dolby ProLogic II, Dolby Ex, Dolby Virtual Speaker, DTS Surround, DTS ES, MP3, WMA, DVD audio and Sony’s SACD audio, our consumer digital audio chips enable consumer electronics manufacturers to build high quality, low cost 5.1 channel audio video receivers (“AVR”) that compliment the existing installed base of DVD players. Our newly introduced class-D multi-channel digital audio amplifier chip further enables us to deliver a total solution for the home theater systems.

      Communication Chips. Internet-related applications, such as voice e-mail, internet radio and audio home pages and news-on-demand, are increasing the demand for integrated audio and computer fax, modem and network functions on the PC. Our modem chips comply with worldwide modem standards and have various feature combinations and price points. We are no longer emphasizing this business and expect that sales of modem chips will continue to decline.

      PC Audio Chips. Our PC audio chips enable PC manufacturers to provide audio capabilities on add-in sound cards and directly on the motherboards of desktop and notebook computers. We were the pioneers in this market by offering the first single-chip PC audio solution with high-quality sound reproduction. We provide PC audio chips with various feature combinations and price points, but we are no longer emphasizing this business and expect that sales of PC audio chips will continue to decline.

      Sales of these products accounted for the following percentages of our net revenues in the past three years:

Technology and Research and Development

      Our DVD decoder chips incorporate a digital signal processor (“DSP”) and a reduced instruction set computer processor (“RISC”). The two processors work in parallel on separate tasks, which allows us to build a highly integrated chip. In 2001, we integrated a TV encoder into our DVD decoder engine (labeled the Vibratto family of products) to cut down the number of components required to build a DVD player. In 2003, we enhanced the decoder engine to handle MPEG4 technology. The enhanced architecture formed the basis of all our current DVD product offerings, including the integrated front-end, back-end or single chip decoder chip called the Vibratto II, and our newest integrated encoder/decoder chip called the Vantage II.

      We are developing the next generation DVD chip that will incorporate many new advanced capabilities. We are designing this chip with a third independent processor to enable us to support the following standard operating systems: Linux, PocketPC (formerly WinCE) and VxWorks. By supporting standard operating systems, we can leverage third-party software applications, such as standard web browsers, and third-party software drivers to support printers, digital cameras and other consumer electronics products. We believe this product will evolve into a second intelligent and commutative platform in the home and share a home networking backbone and files with the PC.

      Our digital imaging chips are manufactured using the CMOS process, the most widely used method of producing modern integrated circuits and thus also the lowest cost method. Recent advances in manufacturing processes and design techniques have led to increased performance and quality. Our products are produced by a proprietary CMOS process and have a unique architecture and design that produces excellent low light sensitivity at comparative lens sizes. Our digital imaging chips are highly integrated and fully programmable, allowing us to quickly add features and adapt the chip to each customer’s unique requirements.

      In the digital media marketplace we must continually design, develop and introduce new products that take advantage of market opportunities and address emerging technical standards. We intend to leverage our base of design expertise, analog, digital and mixed-signal design capabilities and process technologies, and software and systems expertise to continue to develop audio, video imaging and communication solutions for the consumer electronics marketplace.

      Our design environment is based on workstations, dedicated product simulators, system simulation with hardware and software modeling, and a high-level, design-description language. We invest regularly in new advanced equipment and software tools and we intend to maintain and enhance our library of core cells.

      On research and development activities, we spent approximately $37.5 million during 2004, $33.2 million during 2003, and $27.0 million during 2002, excluding charges of $2.7 million in 2003 for acquired in-process research and development.

Customers

      We sell our chips to distributors and OEMs of DVD, VCD, MP3, digital camcorders, consumer digital audio players, digital media players, cellular phones, modem and PC products. Our customers manufacture and sell these products both as contract manufacturers for well-known brand labels and under their own brands. As a result, our chips can be found in a diverse array of DVD, VCD, cell phone, and PC products on store shelves in the United States, Asia and Europe.

      A substantial portion of our net revenues have been derived from sales to a small number of our customers. Sales to our top five end-customers accounted for approximately 42% of our net revenues in 2004 compared to 34% of our net revenues in 2003. ATLM, one of our top end-customers, accounted for approximately 15% and 12% of our net revenues for 2004 and 2003, respectively. Rikai, another one of our top end-customers, accounted for approximately 7% and 11% of our net revenues for 2004 and 2003, respectively. No other end-customers accounted for more than 10% of our net revenues during 2004 and 2003. Information on net sales from external customers and long lived assets attributable to our geographic regions is included in Note 13, “Business Segment Information and Concentration of Certain Risks,” to the consolidated financial statements in Item 8 of this Report.

Sales and Distribution

      We market our products worldwide through our direct sales force, distributors and sales representatives. We have sales and support offices in the United States, China, Hong Kong, Taiwan, Japan and Korea.

      We believe customer service and technical support are important competitive factors in selling to major customers. Sales representatives and distributors supplement our efforts by providing additional customer service at the local level. We believe close contact with our customers not only improves the customer’s level of satisfaction, but also provides important insight into future market direction.

      International sales comprised approximately 99% of our net revenues in 2004, 2003 and 2002. International sales are based upon destination of the shipment. Our international sales in 2004, 2003 and 2002 were derived primarily from Asian customers who manufacture DVD, VCD, cameras, cell phones, communications and PC audio products. Companies in Asia manufacture a large percentage of the worldwide supply of these products. We believe a significant portion of our chip products are incorporated into consumer electronic devices that are ultimately sold into the United States. We have direct sales personnel and technical staff located in Hong Kong, Taiwan, China, Korea and Japan where significant portions of our sales have historically been derived. Our products are also sold internationally through distributors and sales representatives located in Hong Kong, Korea, Japan and Singapore. For fiscal year 2004, net sales to customers (including distributors) in each region as a percentage of our total net sales were: Hong Kong 53%, Taiwan 15%, Japan 9%, China 6%, Korea 5%, Turkey 4%, and Singapore 4%. All of our international sales are denominated in U.S. dollars. Our business is usually seasonal due to the Christmas holiday season in America and Europe, and the Chinese New Year season in China and Asia. Our sales representatives and distributors are not subject to minimum purchase requirements and can discontinue marketing any of our products at any time. In addition, certain of our distributors have rights of return for unsold product and rights to pricing allowances to compensate for rapid, unexpected price changes.

      We rely on our largest distributor, Dynax Electronics (HK) (“Dynax Electronics”), for a significant portion of our revenues. Sales through Dynax Electronics were approximately 51%, 63% and 57% of our net revenues in 2004, 2003 and 2002, respectively. Dynax Electronics is not subject to any minimum purchase requirements and can discontinue marketing any of our products at any time. In addition, Dynax Electronics has rights of return for unsold product and rights to pricing allowances to compensate for rapid, unexpected price changes, therefore we do not recognize revenue until Dynax Electronics sells through to our end-customers.

Manufacturing

      We contract with third parties for all of our fabrication and assembly as well as the majority of our test operations. This manufacturing strategy enables us to focus on our design and development strengths, minimize fixed costs and capital expenditures and gain access to advanced manufacturing capabilities. Semiconductor manufacturing consists of foundry activity where wafer fabrication takes place, as well as chip assembly and testing activities. We use several independent foundries that use advanced manufacturing technologies to fabricate our chips. Substantially all of our products are manufactured by Taiwan Semiconductor Manufacturing Company (“TSMC”), which has manufactured products for us since 1989, United Microelectronics Corporation (“UMC”), which is also located in Taiwan, and other independent Asian foundries. Most of our products are currently fabricated using both mixed-signal and logic CMOS 0.25 to 0.18 micron process technologies. Manufacturing requires raw materials and a variety of components to be manufactured to our specifications. We depend on a limited number of suppliers to obtain adequate supplies of quality raw materials on a timely basis. We do not generally have guaranteed supply arrangements with our suppliers, and we depend on foundries such as TSMC, UMC and others for foundry capacity to produce products of acceptable quality and with acceptable manufacturing yields in a timely manner. As of December 31, 2004, we believe we have sufficient foundry capacity to meet our forecasted needs for the next 12 months.

      After wafer fabrication by the foundry, all of our semiconductor products and lens modules are assembled and tested by third-party vendors, primarily Advanced Semiconductor Engineering and Amkor Technology. We have internally designed and developed our own test software and purchased certain test equipment, which are provided to our test vendors. See Item 7, “Factors That May Affect Future Results — Our products are manufactured by independent third parties.”

Competition

      Our markets are intensely competitive and are characterized by rapid technological change, price reductions and rapid product obsolescence. Competition typically occurs at the design stage, where the customer evaluates alternative design approaches that require integrated circuits. Because of shortened product life cycles, there are frequent design win competitions for next-generation systems. We expect competition to remain intense from existing competitors and from companies that may enter our existing or future markets. In general, product prices in the semiconductor industry have decreased over the life of a particular product. The markets for our products are characterized by intense price competition. As the markets for our products mature and competition increases, we anticipate that prices for our products will continue to rapidly decline.

      Our existing and potential competitors consist of medium and large domestic and international companies, many of whom have substantially greater financial, manufacturing, technical, marketing, distribution and other resources, greater intellectual property rights, broader product lines and longer-standing relationships with customers than we have. Our competitors also include a number of smaller and emerging companies.

      Our principal competitors in the DVD market include MediaTek Incorporation (“MediaTek”), Zoran, Sony, Panasonic, STMicroelectronic, LSI Logic, Sunplus and Cirrus Logic. In addition, we expect that the DVD platform will face competition from other platforms including STBs, as well as multi-function game boxes. Some of our competitors may supply chips for multiple platforms, such as LSI Logic and STMicroelectronics, each of which makes chips for both DVD players and STBs. We also face strong competition from Sunplus, a competitor in the VCD and DVD market. Our competitors in the digital imaging market include Omnivision, as well as other emerging companies.

      Many of our current and potential competitors have longer operating histories as well as greater name recognition than we have. Any of these competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements and to devote greater resources to the development, promotion and sale of their products than we can.

      In addition, as the market for the digital home system develops, a number of companies with significantly greater resources than us could attempt to increase their presence in the market by acquiring or forming strategic alliances with our competitors resulting in increased competition to us. In the past years, LSI Logic acquired C-Cube Microsystems; Cirrus Logic acquired LuxSonor Semiconductors; Oak Technology acquired TeraLogic; and Zoran acquired Oak Technology.

Proprietary Technology

      We rely on a combination of patents, trademarks, copyrights, trade secret laws and confidentiality procedures to protect our intellectual property rights. As of December 31, 2004, we had 81 patents granted in the U.S., and at least 84 applications on file with the United States Patent and Trademark Office (USPTO). In addition, as of December 31, 2004 we had approximately 15 corresponding foreign patents granted and 59 applications pending. We intend to seek further U.S. and international patents on our technology whenever possible.

      The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights or positions, which have resulted in significant and often protracted and expensive litigation. As of December 31, 2004, there was one intellectual property litigation matter pending against us which we are vigorously defending and believe will not have a material adverse effect on our business. See Item 3, “Legal Proceedings.”

      We currently license certain of the technology we use in our products, and we expect to continue to do so in the future. We have, in the past, granted limited licenses to certain of our technology, some of which have expired. See Item 7, “Factors That May Affect Future Results — We may not be able to adequately protect our intellectual property rights from unauthorized use and we may be subject to claims of infringement of third-party intellectual property rights.”

Backlog

      Our products are generally sold pursuant to standard purchase orders, which are often issued only days in advance of shipment and are frequently revised to reflect changes in the customers’ requirements. Product deliveries are scheduled when we receive purchase orders. Generally, these purchase orders allow customers to reschedule delivery dates and cancel purchase orders without significant penalties. For these reasons, we believe that our backlog, while useful for scheduling production, is not necessarily a reliable indicator of future revenues. Delays in delivery schedules and/or a reduction of backlog during any particular period could have a material adverse effect on our business and results of operations. As of December 31, 2004, our backlog amounted to approximately $19.3 million.

Employees

      As of December 31, 2004, we had 536 full-time employees, including 191 in research and development, 207 in marketing, sales and support, 74 in finance and administration and 64 in manufacturing. Over 50% of our employees are engineers, and a significant number of them are software engineers. Our future success will depend, in part, on our ability to continue to attract, retain and motivate highly qualified technical and management personnel, particularly highly-skilled semiconductor design personnel and software engineers involved in new product development, for whom competition can be intense, particularly in the Silicon Valley. Our employees are not represented by any collective bargaining unit, and we have never experienced a work stoppage. We believe our relationship with our employees is good.

Available Information

      Our website address is http://www.ESSTECH.com. We make available free of charge, on or through our website, our annual, quarterly and current reports, and any amendments to those reports, as soon as reasonably practicable after electronically filing such reports with the Securities and Exchange Commission (the “SEC”). In addition, our Code of Ethics as well as the respective charters for the Audit, Compensation and

Corporate Governance and Nominating Committees of our Board of Directors are available on our website. Information contained on our website is not part of this Report.

Executive Officers of the Registrant

      The following table sets forth certain information regarding our current executive officers:

      Fred S.L. Chan has been a director since January 1986 and has served as Chairman of the Board since October 1992. Mr. Chan is also the Chairman of the Board for Vialta, Inc. and has served in that capacity since September 1999. Mr. Chan served as President and Chief Executive Officer of Vialta from September 1999 to August 2001. Mr. Chan served as our President from November 1985 until October 1996 and from February 1997 to September 1999. He served as our Chief Executive Officer from June 1994 until September 1999. Mr. Chan served as our Chief Financial Officer from October 1992 to May 1995. From 1984 to 1985, Mr. Chan was founder, President and Chief Executive Officer of AC Design, Inc., a VLSI chip design center providing computer aided design (CAD), engineering and other design services. From 1982 to 1984, he was co-founder, President and Chief Executive Officer of CADCAM Technology, Inc., a company in the business of computer aided engineering (CAE) systems development. Mr. Chan holds B.S.E.E. and M.S.C. degrees from the University of Hawaii.

      Robert L. Blair has been our President and Chief Executive Officer since September 1999. Mr. Blair was elected as a director in 1999. Mr. Blair served as our Executive Vice President of Operations and member of the Office of the President from April 1997 to September 1999. From December 1994 to March 1997, he was our Vice President of Operations. From December 1991 to November 1994, he was Senior Vice President of Operations (Software Packaging & Printing Division) of Logistix Corporation, a software turnkey company, and from 1989 to November 1991, he was Vice President and co-owner of Rock Canyon Investments, a real estate development-planning firm in California. From 1986 to 1989, he held various positions at Xidex Corporation, a computer diskette manufacturer, including President and General Manager at XEMAG, a division of Xidex Corporation. From 1973 to 1986, he held several positions including Vice President, High Reliability Operations at Precision Monolithics, Inc.

      James B. Boyd has been our Chief Financial Officer and Assistant Secretary since August 2000. Mr. Boyd was further elected as a Senior Vice President in 2003. Prior to joining ESS, Mr. Boyd served from 1998 until 2000 as Chief Financial Officer of Gatefield Corporation, a Fremont-based manufacturer of field programmable electronic circuits used in PCs and consumer electronics. From 1997 until 1998, he was Chief Financial Officer of AirMedia, a developer of wireless communications software and from 1996 until 1997, he was Corporate Controller at Farallon Communications, a manufacturer and developer of internet hardware and software products. He has also held senior management positions with Fritz Companies, GTE Sprint Communications and Southern Pacific Companies. Mr. Boyd holds B.S. and MBA degrees from the University of Wisconsin — Madison and a J.D. from Golden Gate University.

      The information concerning compliance with Section 16 of the Securities Exchange Act of 1934 is incorporated by reference from the section in the proxy statement for the 2005 Annual Shareholders’ Meeting entitled “Compliance under Section 16(a) of the Securities Exchange Act of 1934.”

      We own nearly 12 acres of land in Fremont, California, on which we built our two-story, 93,000 square-foot corporate headquarters as well as a 77,000 square-foot building next to our corporate headquarters, 40% of which is currently leased to Vialta, Inc. (our former subsidiary) under a Real Estate Matters Agreement entered into in connection with our spin-off of Vialta. On July 1, 2003, we entered into the First Amendment

to the Amended and Restated Commercial Lease Agreement with Vialta to reduce the size of the Fremont facility subject to the lease and to adjust the rental amount. See Note 14, “Related Party Transactions with Vialta, Inc.,” to the consolidated financial statements in Item 8 of this Report.

      In addition we own an adjacent 11,000 square-foot dormitory building used to house visitors and guest workers. We also maintain leased office space in various locations. Additionally, we have an approximately 5,000 square-foot warehouse next to our corporate headquarters in Fremont, California.

      We are productively utilizing most of the above facilities and we consider the above facilities suitable and adequate to meet our current requirements. There are no liens on any of our owned land and buildings.

      On March 12, 2001, we filed a complaint in the U.S. District Court for the Northern District of California (Case No. C01-20208) against Brent Townshend, alleging unfair competition and patent misuse. The complaint seeks specific performance of contractual obligations and declarations of patent misuse, unenforceability, and estoppels against asserting patent rights. All of the claims relate to the refusal of Mr. Townshend to provide us with a license on reasonable and nondiscriminatory terms, as is required by applicable law. The patents relate to the manufacture and sale of high-speed modems. On April 30, 2002, we filed an amended complaint. On September 27, 2002, Townshend filed an answer and counterclaims, alleging patent infringement. We filed our answer to the counterclaims on October 17, 2002, Townshend also filed patent infringement actions against Agere Systems Inc., Analog Devices, Inc., Cisco Systems, Inc., and Intel Corporation, alleging infringement of the same patents. On March 7, 2003, the court issued an order finding that the cases are related and should be tried together. Analog Devices, Inc. has individually settled their claims with Townshend. As of December 31, 2004, the remaining parties were involved with discovery and claim construction proceedings. The estimated trial date is July 2005. We believe we have meritorious claims and intend to pursue them vigorously.

      The DVD Copy Control Association (DVD CCA) licenses the CSS anti-piracy system for use in DVD players. The Motion Picture Association of America (MPAA) filed suit in California Superior Court, Los Angeles County (Case No. BC 313276) against us on April 5, 2004, alleging that we had failed to ensure that all of our customers were duly licensed by DVD CCA. The MPAA plaintiffs requested an injunction against future sales to non-licensees, damages of no more than $100,000, and their attorneys’ fees. On June 25, 2004, the MPAA plaintiffs moved for a preliminary injunction against us, seeking to have us enjoined from selling DVD products to customers not licensed by DVD CCA. On July 23, 2004, the court ruled that ESS must follow these revised procedures by selling only to DVD CCA licensees. The suit is proceeding and discovery has begun. The parties are engaged in settlement discussions at present. If those discussions do not yield a settlement, we believe we have meritorious claims and defenses and intend to pursue them vigorously.

      On September 12, 2002, following our downward revision of revenue and earnings guidance for the third fiscal quarter of 2002, a series of putative federal class action lawsuits were filed against us in the United States District Court, Northern District of California. The complaints alleged that we and certain of our present and former officers and directors made misleading statements regarding our business and failed to disclose certain allegedly material facts during an alleged class period of January 23, 2002 through September 12, 2002, in violation of federal securities laws. These actions were consolidated and are proceeding under the caption “In re ESS Technology Securities Litigation.” The plaintiffs seek unspecified damages on behalf of the putative class. Plaintiffs amended their consolidated complaint on November 3, 2003, which we then moved to dismiss on December 18, 2003. On December 1, 2004, the Court granted in part and denied in part our motion to dismiss, and struck from the complaint allegations arising prior to February 27, 2002. On December 22, 2004, based on the Court’s order, we moved to strike from the complaint all remaining claims and allegations arising prior to September 10, 2002. On February 22, 2005, the Court granted our motion in part and struck all remaining claims and allegations arising prior to August 1, 2002 from the complaint. Discovery is now proceeding in the case. A trial date has tentatively been set for early 2007.

      On September 12, 2002, following the same downward revision of revenue and earnings guidance for the third fiscal quarter of 2002, several holders of our common stock, purporting to represent us, filed a series of derivative lawsuits in California state court, County of Alameda, against us as a nominal defendant and against certain of our present and former directors and officers as defendants. The lawsuits allege certain violations of the federal securities laws, including breaches of fiduciary duty and insider trading. These actions have been consolidated and are proceeding as a Consolidated Derivative Action with the caption “ESS Cases.” The derivative plaintiffs seek compensatory and other damages in an unspecified amount, disgorgement of profits, and other relief. On March 24, 2003, we filed a demurrer to the consolidated derivative complaint and moved to stay discovery in the action pending resolution of the initial pleadings in the related federal action, described above. The Court denied the demurrer but stayed discovery. That stay has since been lifted in light of the procedural progress of the federal action. Discovery is now proceeding in the case. No trial date has been set.

      Although we believe that we and our present and former officers and directors have meritorious defenses to both actions and intend to defend these suits vigorously, we cannot predict with certainty the outcome of these lawsuits. Our defense against these lawsuits may be costly and may require a significant commitment of time and resources by our senior management. Management believes that these lawsuits are subject to coverage under our directors’ and officers’ liability insurance policies, although to date our carriers have reserved their rights with respect to coverage for these claims. In the event of a determination adverse to us, either with respect to coverage or with respect to the underlying merits of the lawsuits, we may incur substantial monetary liability, which could have a material adverse effect on our financial position, results of operations and cash flows.

      We are subject to various other legal proceedings and claims, either asserted or unasserted, that arise in the ordinary course of business. In addition, from time to time, we may receive notification from customers claiming that such customers are entitled to indemnification or other obligations from us related to infringement claims made against the customers by third parties. Although the outcome of claims cannot be predicted with certainty, we do not believe that any of these other existing legal proceedings will have a material adverse effect on our financial condition or results of operations.

      The Annual Meeting of Shareholders of ESS Technology, Inc. was held on November 5, 2004 in Fremont, California. Of the total of 39,567,848 shares outstanding as of the record date, 37,003,722 were present or represented by proxies at the meeting. The table below presents the results of the election of our board of directors.

      The shareholders approved amendments to the 1995 Directors Stock Option Plan to extend the termination date of such plan from 2005 to 2015 and to increase the number of shares of our common stock authorized for issuance to non-employee directors under such plan by 400,000. The proposal received 20,143,409 affirmative votes, 6,934,270 negative votes, and 34,638 abstentions.

      The shareholders approved the material terms of the 2004 Management Incentive Plan under Section 162(m) of the Internal Revenue Code. The proposal received 34,064,834 affirmative votes, 2,883,532 negative votes, and 55,356 abstentions.

      The shareholders also ratified the selection of PricewaterhouseCoopers LLP as the independent registered public accounting firm of the Company for the fiscal year ending December 31, 2004. The proposal received 33,124,549 affirmative votes, 3,853,411 negative votes, and 25,762 abstentions.

PART II

Item 5.      Market for the Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities

      Our common stock has been trading on the NASDAQ National Market under the symbol “ESST” since October 6, 1995. The following table sets forth the high and low sales prices for our common stock as reported by the NASDAQ National Market during the periods indicated.

      As of February 22, 2005, there were approximately 199 record holders of our common stock. Since most shareholders are listed under their brokerage firm’s names, the actual number of beneficial shareholders is higher.

      The remaining information called for by this item relating to “Equity Compensation Plan Information” is reported in Item 12 of this Report.

ISSUER PURCHASES OF EQUITY SECURITIES

Dividend Policy

      We have never declared or paid cash dividends. We currently intend to retain all available funds and any future earnings for use in the operation of our business and do not anticipate paying any cash dividends in the foreseeable future.

      The following data should be read in conjunction with “Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements and related notes thereto included in Item 8 of this Report.

      We derived the selected consolidated statement of operations data for the years ended December 31, 2004, 2003 and 2002 and the selected consolidated balance sheet data as of December 31, 2004 and 2003 from our audited consolidated financial statements appearing elsewhere in this Report. We derived the selected consolidated statement of operations data for the years ended December 31, 2001 and 2000 and the selected consolidated balance sheet data as of December 31, 2002, 2001 and 2000 from our audited consolidated financial statements, which are not included in this Report.

      Certain information contained in or incorporated by reference in the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, in “Factors that May Affect Future Results” below and elsewhere in this Report, contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements include statements concerning the future of our industry, our product development, our business strategy, our future acquisitions, the continued acceptance and growth of our products, and our dependence on significant customers. Actual results may differ materially from those projected in the forward-looking statements as a result of various factors including those discussed in “Factors that May Affect Future Results” below and elsewhere in this Report. In some cases, these statements can be identified by terminologies such as “may,” “will,” “expect,” “anticipate,” “estimate,” “continue,” other similar terms or the negative of these terms. Although we believe that the assumptions underlying the forward-looking statements contained in this Report are reasonable, they may be inaccurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such statements should not be regarded as a representation by us or any other person that the results or conditions described in such statements will be achieved. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.

Executive Overview

      We design, develop and market highly integrated analog and digital processor chips, imaging sensor chips, digital amplifiers, and camera lens modules. Our digital processor chips are the primary processors driving digital video and audio devices, including DVD, Video CD (“VCD”), consumer digital audio players, and digital media players. Our imaging sensor chips utilize advanced Complimentary Metal Oxide Semiconductor (“CMOS”) sensor technology to capture an image for cellular camera phone applications. Our digital amplifiers boost the digital sound to a level required to drive loudspeakers, in such applications as DVD and CD players, home theater systems, audio receivers, boom boxes and television sets. Our camera lens modules provide camera capabilities to electronic devices such as cellular phones and Personal Digital Assistants (“PDAs”). We have also developed and marketed encoding processors to address the growing demand for digital video recorders (“DVRs”) and recordable DVD players. We believe that multi-featured DVD, DVR and recordable DVD players will serve as a platform for the digital home system (“DHS”), integrating various digital home entertainment and information delivery products into a single box. We are also a supplier of chips for use in modems, other communication devices, and PC audio products. Our chips use multiple processors and a programmable architecture that enable us to offer a broad array of features and functionality.

We focus on our design and development strengths and outsource all of our chip fabrication and assembly as well as the majority of our test operations.

      We market our products worldwide through our direct sales force, distributors and sales representatives. Substantially all of our sales are to customers in China, Hong Kong, Taiwan, Japan, Korea, Turkey and Singapore. We employ sales and support personnel located outside of the United States in China, Taiwan, Hong Kong, Korea and Japan to support these international sales efforts. We expect that international sales will continue to represent a significant portion of our net revenues. In addition, substantially all of our products are manufactured, assembled and tested by independent third parties in Asia. We also have a number of employees engaged in research and development efforts outside of the United States. There are special risks associated with conducting business outside of the United States. See Item 7, “Factors That May Affect Future Results — We have significant international sales and operations that are subject to the special risks of doing business outside the United States.”

      We were incorporated in California in 1984 and became a public company in 1995. On June 9, 2003, we acquired 100% of the outstanding shares of Pictos Technologies, Inc., a Delaware corporation (“Pictos”). On August 15, 2003, we acquired 100% of the outstanding shares of Divio, Inc., a California corporation (“Divio”). See Note 3, “Significant Business Combinations,” to the consolidated financial statements in Item 8 of this Report.

      Our financial results for the fourth quarter and fiscal year ended December 31, 2004 were impacted by the fact that demand for digital media products continued to be slower in the fourth quarter of 2004 than expected. Consequently, we booked additional excess and obsolete reserves of $3.7 million and additional lower-of-cost-or-market inventory reserves of $7.4 million in the fourth quarter. The discussion in this section should be read in conjunction with the audited consolidated financial statements and notes thereto included in Item 8 of this Report.

Critical Accounting Policies and Estimates

      Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. The significant accounting policies that we believe are the most critical in understanding and evaluating our reported financial results include the following:

      In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application. There are also cases in which management’s judgment is required in selecting appropriate accounting treatment among available alternatives under GAAP. Our management has reviewed these critical accounting policies and related disclosures with our Audit

Committee. See notes to consolidated financial statements in Item 8 of this Report for additional information regarding our accounting policies and other disclosures required by GAAP.

      Except for sales to distributors, revenue from product sales is generally recognized at the time of shipment when persuasive evidence of an arrangement exists, the price is fixed or determinable and collection of the resulting receivable is reasonably assured. For products sold to certain distributors with certain rights of return and allowances, revenue is deferred until the distributor resells the products to a third party.

      We provide for rebates based on current contractual terms and future returns based on historical experiences at the time revenue is recognized as reductions to product revenue. Actual amounts may be different from management’s estimates. Such differences, if any, are recorded in the period they become known.

      Income from MediaTek royalties for the sale of products utilizing licensed technology is reported as revenue based on the number of units sold as reported to us by MediaTek.

      Our inventory is comprised of raw materials, work-in-process and finished goods, all of which are manufactured by third-party contractors. Inventory is valued at the lower of standard cost (which approximates actual cost on a first-in, first-out basis) or market. We reduce the carrying value of inventory for estimated slow-moving, excess, obsolete, damaged or otherwise unmarketable products by an amount that is the difference between cost and estimated market value based on forecasts of future demand and market conditions.

      We evaluate excess or obsolete inventory primarily by estimating demand for individual products within specific time horizons, typically one year or less. We generally provide a 100% reserve for the cost of products with on-hand and committed quantities in excess of the estimated demand after considering factors such as product life cycles. Once established, reserves for excess or obsolete inventory are only released when the reserved products are scrapped or sold. We also evaluate the carrying value of inventory at the lower of standard cost or market on an individual product basis, and these evaluations are based on the difference between net realizable value and standard cost. Net realizable value is the forecasted selling price of the product less the estimated costs of completion and disposal. When necessary, we reduce the carrying value of inventory to net realizable value.

      The estimates of future demand, forecasted sales prices and market conditions used in the valuation of inventory form the basis for our published and internal revenue forecast. If actual results are substantially lower than the forecast, we may be required to record additional write-downs of product inventory in future periods and this may have a negative impact on gross margins.

      We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that their carrying value may not be recoverable from the estimated future cash flows expected to result from their use and eventual disposition. Our long-lived assets subject to this evaluation include property, plant and equipment and amortizable intangible assets. We assess the impairment of goodwill annually in our fourth fiscal quarter and whenever events or changes in circumstances indicate that it is more likely than not that an impairment loss has been incurred. We are required to make judgments and assumptions in identifying those events or changes in circumstances that may trigger impairment. Some of the factors we consider include:

      The impairment evaluation of long-lived assets includes an analysis of estimated future undiscounted net cash flows expected to be generated by the assets over their remaining estimated useful lives. If the estimated future undiscounted net cash flows are insufficient to recover the carrying value of the assets over the remaining estimated useful lives, we will record an impairment loss in the amount by which the carrying value of the assets exceeds the fair value. If we determine that our amortizable intangible assets or other long-lived assets have been impaired, we will recognize an impairment loss in the period in which the impairment is determined. Any such impairment charge could be significant and could have a material adverse effect on our financial position and results of operations. Major factors that influence our cash flow analysis are our estimates for future revenue and expenses associated with the use of the asset. Different estimates could have a significant impact on the results of our evaluation.

      We completed the annual goodwill impairment review during the fourth quarter of 2004 and found no impairment. Our impairment evaluation of goodwill is based on comparing the fair value to the carrying value. Unless there are indicators of impairment, our next impairment review will be completed in the fourth quarter of 2005. If our revenue and cost forecasts are not achieved, we may incur charges for goodwill impairment, which could be significant and could have a material adverse effect on our net equity and results of operations.

      We account for income taxes under an asset and liability approach that requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of timing differences between the carrying amounts and the tax bases of assets and liabilities. U.S. deferred income taxes are not provided on un-remitted earnings of our foreign subsidiaries as such earnings are considered permanently invested. Assumptions underlying recognition of deferred tax assets and non-recognition of U.S. income tax on un-remitted earnings can change if our business plan is not achieved or if Congress adopts changes in the Internal Revenue Code of 1986, as amended.

      From time to time, we are subject to legal proceedings and claims, including claims of alleged infringement of patents, trademarks, copyrights and other intellectual property rights and other claims arising out of the ordinary course of business. Further, we are currently engaged in certain shareholder class action and derivative lawsuits.

      These contingencies require management judgment in order to assess the likelihood of any adverse judgments or outcomes and the potential range of probable losses. Liabilities for legal matters are accrued for when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated, based upon current law and existing information. Estimates of contingencies may change in the future due to new developments or changes in legal approach.

Recent Accounting Pronouncements

      On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123R (revised 2004), “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation”. SFAS No. 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123R is similar to the approach described in SFAS No. 123. However, SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. The new standard will be effective for our quarter ending September 30,

2005. We are in the process of assessing the impact of adopting this new standard, including the transition method and option pricing model to select.

      In December 2004, the FASB issued SFAS No. 151, “Inventory Costs,” which adopts wording from the International Accounting Standards Board’s IAS 2 “Inventories” in an effort to improve the comparability of international financial reporting. The new standard indicates that abnormal freight, handling costs, and wasted materials (spoilage) are required to be treated as current period charges rather than as a portion of inventory cost. Additionally, the standard clarifies that fixed production overhead should be allocated based on the normal capacity of a production facility. The provisions of SFAS No. 151 are effective for fiscal years beginning after June 15, 2005. Adoption of SFAS No. 151 is not expected to have a material impact on our financial position or results of operations.

      On October 22, 2004, the President signed the American Jobs Creation Act of 2004 (the “Act”). The Act creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85 percent dividends received deduction for certain dividends from controlled foreign corporations. The deduction is subject to a number of limitations and, as of today, uncertainty remains as to how to interpret numerous provisions in the Act. As such, we are not yet in a position to decide on whether, and to what extent, we might repatriate foreign earnings that have not yet been remitted to the U.S.

      In June 2004, the FASB ratified Emerging Issues Task Force Issue No. 03-1 (“EITF 03-1”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. Adoption of the recognition and measurement guidance of EITF 03-1 has been temporarily deferred by the FASB, but the disclosure requirements of EITF 03-1 are effective for our 2004 annual consolidated financial statements. Accordingly, additional disclosures as required by EITF 03-1 are included in Note 6 to consolidated financial statements.

Comparison of Twelve Months ended December 31, 2004 and December 31, 2003

Results of Operations

      The following table sets forth our results of operations for the fiscal years ended December 31, 2004 and 2003:

      Inflation has not had any material impact on our business to date.

      Net revenues were $257.3 million in 2004 and $195.3 million in 2003. Net revenues increased by $62.0 million, or 31.8%, from 2003 to 2004 primarily due to the increases in DVD revenue and MediaTek royalty, partially offset by the decreases in VCD, recordable and other products.

      The following table summarizes percentage of net revenue by our major product categories.

      DVD revenue includes revenue from sales of DVD decoder chips. DVD revenues were $138.6 million in 2004, an increase of $60.2 million, or 76.8%, from 2003 to 2004, primarily due to higher unit sales. Unit sales increased by 71.3% as compared to 2003. We sold approximately 23.3 million of DVD chip products in 2004 as compared to approximately 13.6 million units in 2003. We continue to win new designs, especially with our MPEG 4 products.

      VCD revenue includes revenue from sales of VCD and SVCD chips. VCD revenues were $69.7 million in 2004, a decrease of $5.1 million, or 6.8%, from 2003 to 2004, primarily due to lower unit sales, partially offset by higher average selling price (“ASP”) per unit. Unit sales decreased by 9.6% while ASP per unit increased by 3.0%. The ASP increase in 2004 was primarily due to higher unit sales of Visba3 integrated chips, which have a higher ASP. We sold approximately 40.5 million units of our VCD chip products in 2004 as compared to approximately 44.8 million units in 2003.

      Digital imaging revenue is primarily revenue from sales of image sensor chips and image processor chips. Digital imaging revenues were $14.9 million in 2004, an increase of $0.3 million, or 2.1%, from 2003 to 2004, primarily due to higher ASP, partially offset by lower unit sales. The ASP increased by 37.4% while unit sales decreased by 23.1%. Digital imaging revenues are derived from the sale of products of Pictos, a company that we acquired in June 2003. We sold approximately 1.0 million units of digital imaging chip products in 2004 as compared to approximately 1.3 million units in 2003.

      Recordable revenue includes revenue from sales of integrated encoder and decoder chips, and encoder and decoder chips sold together as a chipset. Recordable revenues were $7.0 million, a decrease of $5.0 million, or 41.7%, from 2003 to 2004 due primarily to lower ASP. ASP decreased by 42.4% from 2003 to 2004.

      Royalty revenue consists of MediaTek royalty payments. Under the settlement agreement between ESS and MediaTek dated June 11, 2003 for a non-exclusive license to our proprietary DVD user interface and other key DVD software, MediaTek is obligated to pay us ongoing royalties with a quarterly cap of $5.0 million and lifetime cap of $45.0 million. Royalty revenue was $20.0 million and $5.0 million for the year ended December 31, 2004 and December 31, 2003, respectively. We expect that MediaTek royalty payment will end after the fourth quarter of 2005.

      Other revenue includes revenue from sales of PC Audio chips, communication modem and other chips, consumer digital media chips and other miscellaneous chips. Other revenue was $7.2 million in 2004, a decrease of $3.3 million, or 31.4%, from 2003 to 2004 primarily due to lower unit sales, partially offset by higher ASP. Unit sales decreased by 57.0% while ASP increased by 60.3%.

      International revenues accounted for approximately 99% of net revenues in both 2004 and 2003. All of our international sales are denominated in U.S. dollars. We expect that international sales will continue to remain a high percentage of our net revenues in the future.

      Gross profit decreased to $37.9 million in 2004 from $62.6 million in 2003. Gross margins were 14.7% in 2004 and 32.0% in 2003. The decrease in gross margin was primarily due to a provision for excess and obsolete inventories of approximately $33.1 million in 2004, partially offset by a higher volume in our DVD business and $15.0 million of additional MediaTek royalty revenue at 100% gross margin. The $20.0 million of MediaTek royalty revenue in 2004 had a positive impact on our gross margin of 7.2%. Although ASP generally increased in 2004 as compared to the preceding year, in the third quarter of 2004, we began experiencing increased competition and pricing pressures for both our DVD and VCD products resulting in an adverse effect on our margins in the second half of the year.

      As a result of intense competition in our markets, we expect the overall ASP per unit for our existing products to decline over their product lives, and in 2005 overall gross margins may continue to decrease. We believe that in order to maintain or increase gross profit in 2005, we must achieve higher unit volume in shipments, reduce costs, add new features as well as introduce new products at higher ASP.

      Research and development expenses were $37.5 million, or 14.5% of net revenues, in 2004 and $33.2 million, or 17.0% of net revenues in 2003. Research and development expenses increased by $4.3 million, or 12.9%, from 2003 to 2004, primarily due to the increases in research and development expenses of $6.1 million and $2.3 million from our subsidiaries Pictos (digital imaging products) and Divio (encoding products), which we acquired in June 2003 and August 2003, respectively.

      In-process research and development expenses were $2.7 million, or 1.4% of net revenues, in 2003. This expense related to the write-off of in-process research and development expenses related to the digital imaging products of Pictos and the encoding products of Divio. There were no in-process research and development expenses in 2004. To date, there have been no significant differences between the actual and estimated results of the in-process research and development projects. We expect to complete the projects within the time frame as originally estimated.

      Selling, general and administrative expenses were $41.1 million, or 16.0% of net revenues, in 2004 and $31.8 million, or 16.2% of net revenues, in 2003. Selling, general and administrative expenses increased by $9.3 million, or 29.3%, from 2003 to 2004, primarily due to the $4.8 million increase in legal expenses related to royalty agreements and general services, $2.3 million increase in salaries and fringe benefits due to higher headcount, $0.9 million increase in amortization expense related to Pictos and Divio acquisitions, $0.7 million increase in consulting and services for Sarbanes-Oxley Act compliance, $0.5 million increase in third party commission due to higher sales, and partially offset by $1.3 million decrease in general liability and officer and director insurance premiums.

      Net non-operating income was $3.4 million in 2004 and $45.9 million in 2003. In 2004, net non-operating income consisted primarily of interest income of $2.0 million and rental income of $0.5 million. In 2003, net non-operating income consisted primarily of net license income of $44.5 million from the MediaTek settlement, interest income of $2.5 million and rental income of $1.2 million, partially offset by the $2.0 million write-off of an investment in Broadmedia and a $1.5 million fee paid to MediaTek for the

successful application for exemption from the Taiwan withholding tax on the $45.0 million license income from MediaTek.

      Our effective tax rate was a benefit of 4.7% for 2004 compared to a 38% effective tax rate for 2003. The primary reason for the decrease in our effective tax rate for 2004 was the impact of foreign losses which could not be benefited, partially offset by tax benefits related to U.S. tax losses and R&D credits. Further, 2003 included the accrual of income taxes on approximately $48.0 million of MediaTek license fees and royalty payments compared to $20 million in 2004.

      Our 4.7% tax rate for 2004 was lower than the combined federal and state statutory rate of 40% primarily as a result of foreign losses which could not be benefited, partially offset by benefits related to U.S. tax losses and R&D credits. Our 38% tax rate for 2003 was lower than the combined federal and state statutory rate of 40% primarily as a result of a release of tax reserves related to the expiration of the statute of limitations on our 1999 return, offset in part by nondeductible expenses.

      Our general policy is to permanently reinvest the net earnings of our foreign subsidiaries. Accordingly, these earnings have not been subject to U.S. income taxes. Under certain circumstances, if we were to repatriate this cash, or a portion thereof, to the U.S., we could be required to pay U.S. income taxes on the transfer.

Comparison of Twelve Months ended December 31, 2003 and December 31, 2002

      The following table sets forth our results of operations for the fiscal years ended December 31, 2003 and 2002:

      Net revenues were $195.3 million in 2003 and $273.4 million in 2002. Net revenues decreased by $78.1 million, or 28.6%, from 2002 to 2003 primarily due to the decreases in DVD, VCD, PC audio and communication and other revenue, partially offset by the increases in consumer digital media revenue and the revenue from the digital imaging and recordable products which were introduced through the acquisitions of Pictos and Divio in 2003.

      The following table summarizes percentage of net revenue by our major product categories.

      DVD revenues were $78.4 million in 2003, a decrease of $83.3 million, or 51.5%, from 2002 to 2003, primarily due to lower unit sales and lower ASP per unit. Unit sales decreased by 36.8% and ASP per unit decreased by 18.4%. We believe this decrease resulted from the entry in the third quarter of 2002 of MediaTek, who introduced to the marketplace a DVD chip that we believed infringed our intellectual property rights. We filed a lawsuit in the United States against MediaTek requesting both damages and an injunction to stop the importation into the United States of DVD players containing products we believe infringed our intellectual property rights. On June 11, 2003, we entered into the Settlement Agreement with MediaTek relating to this lawsuit. Under the terms of the Settlement Agreement, both sides terminated all claims against each other and MediaTek received a non-exclusive worldwide license of our proprietary DVD user interface and other key DVD software. We sold approximately 13.6 million units of our DVD chip products in 2003 as compared to approximately 21.6 million units in 2002.

      VCD revenues were $74.8 million in 2003, a decrease of $9.9 million, or 11.7%, from 2002 to 2003, primarily due to lower ASP per unit. ASP per unit decreased by 44.1% while unit sales increased by 58.1%. The changes were primarily due to the change in the product mix of the VCD group from 2002 to 2003. Beginning in 2003, the VCD chipsets were being phased out and replaced by Visba3 integrated chips. As a result, unit sales of the Visba3 increased significantly while the unit sales of the VCD chipsets declined. However, ASP per unit of the Visba3 was lower than the ASP per unit of the VCD chipsets. Therefore, the overall ASP per unit dropped. We sold approximately 44.8 million units of our VCD chip products in 2003 as compared to approximately 28.3 million units in 2002. We continue to target the market for this product line by lowering our product costs.

      Digital imaging revenues were $14.6 million in 2003 and $0 in 2002. Digital imaging revenues derived from the sale of products of Pictos, a company that we acquired in June 2003. We sold approximately 1.3 million units of digital imaging chip products in 2003.

      Recordable revenues were $12.0 million in 2003 and $0 in 2002. The revenue of the encoding products of Divio, which we acquired in August 2003, was approximately 27% of the total recordable revenues. We sold approximately 0.4 million units of recordable chip products in 2003.

      Under the settlement agreement between ESS and MediaTek dated June 11, 2003, for a non-exclusive license to our proprietary DVD user interface and other key DVD software, MediaTek is obligated to pay us ongoing royalties with a quarterly cap of $5.0 million and lifetime cap of $45.0 million. Royalty revenue was $5.0 million and $0 for the year ended December 31, 2003 and 2002, respectively.

      Other revenue includes revenue from PC Audio, communication, consumer digital media and others. Other revenue was $10.5 million in 2003, a decrease of $16.5 million, or 61.4%, from 2002 to 2003 primarily due to lower unit sales. We sold approximately 3.7 million units in 2003 as compared to 7.1 million units in 2002, or 47.9% decrease.

      International revenues accounted for approximately 99% of net revenues in both 2003 and 2002. Our international sales are denominated in U.S. dollars. We expect that international sales will continue to remain a high percentage of our net revenues in the future.

      Gross profit decreased to $62.6 million in 2003 from $97.0 million in 2002. Gross margins were 32.0% in 2003 and 35.5% in 2002. The decrease in gross margin was primarily due to lower volume in our higher margin DVD business in 2003, and a higher volume of lower margin VCD and digital imaging products, partially offset by a net decrease in the provision for excess and obsolete inventories and $5.0 million of MediaTek royalty revenue at 100% gross margin. The $5.0 million of MediaTek royalty revenue in 2003 had a positive impact on our gross margin of 1.7%. Excess and obsolete reserves of $5.3 million were provided during the twelve months ended December 31, 2002.

      Research and development expenses were $33.2 million, or 17.0% of net revenues, in 2003 and $27.0 million, or 10.0% of net revenues in 2002. Research and development expenses increased by $6.2 million, or 23.1%, from 2002 to 2003, primarily due to the research and development expenses of Pictos of $4.6 million and Divio of $1.7 million, which we acquired in June 2003 and August 2003, respectively.

      In-process research and development expenses were $2.7 million, or 1.4% of net revenues, in 2003 and $0 in 2002. This increase related to the write-off of in-process research and development expenses related to the digital imaging products of Pictos and the encoding products of Divio.

      Selling, general and administrative expenses were $31.8 million, or 16.2% of net revenues, in 2003 and $34.2 million, or 12.5% of net revenues, in 2002. Selling, general and administrative expenses decreased by $2.4 million, or 7.1%, from 2002 to 2003, primarily due to the decrease of commissions by $1.0 million as the result of decreased sales, the decrease of our marketing development fund (“MDF”) by $6.5 million due to the cancellation of our MDF program with some customers, partially offset by the increase of legal expense by $1.0 million related to the MediaTek lawsuit and the increase of insurance expense by $1.4 million due to increased director and officer insurance premiums, as well as the increase of $3.3 million of selling, general and administrative expenses of Pictos and Divio. The selling, general and administrative expenses in 2003 included the amortization of intangibles of $1.2 million and $0.3 million for Pictos and Divio, respectively.

      Net non-operating income was $45.9 million in 2003 and $2.4 million in 2002. In 2003, net non-operating income consisted primarily of net license income of $44.5 million from the MediaTek settlement, interest income of $2.5 million and rental income of $1.2 million from Vialta, partially offset by the $2.0 million write-off of an investment in Broadmedia and a $1.5 million fee paid to MediaTek for the successful application for exemption from the Taiwan withholding tax on the $45.0 million of license income from MediaTek. In 2002, net non-operating income consisted primarily of interest income of $3.6 million and rental income of $1.9 million from Vialta, partially offset by the $3.6 million write-down of and sale of our investment in the stock of Cisco Systems, Inc.

      Our effective tax rate was 38% for 2003 compared to a 3% effective tax rate for 2002. The primary reason for the increase in our effective tax rate for 2003 was an accrual of income taxes for the MediaTek license fee and royalty payments.

      Our 38% tax rate for 2003 was lower than the combined federal and state statutory rate of 40% primarily as a result of a release of tax reserves related to the expiration of the statute of limitations on our 1999 return offset in part by nondeductible expenses. Our 3% tax rate for 2002 was lower than the combined federal and state statutory rate primarily as a result of the lower foreign tax rate on earnings from our foreign subsidiary, which were considered to be permanently reinvested, and tax credits.

Acquisitions and Related Charges

      On August 15, 2003, we acquired 100% of the outstanding shares of Divio for $27.1 million in cash plus transaction costs. Divio, formerly a privately held company based in Sunnyvale, California, designed, manufactured and marketed digital encoding semiconductor products. The estimated fair value of assets acquired and liabilities assumed were included in our consolidated balance sheet as of August 15, 2003, the effective date of the purchase. The results of operations of Divio have been included in our consolidated results of operations since the effective date of the purchase. See Note 3, “Significant Business Combinations,” to the consolidated financial statements in Item 8 of this Report.

      On June 9, 2003, we acquired 100% of the outstanding shares of Pictos for $27.0 million in cash plus transaction costs. Pictos, formerly a privately held company based in Newport Beach, California, designed, manufactured and marketed digital imaging semiconductor products. The estimated fair value of assets acquired and liabilities assumed were included in our consolidated balance sheet as of June 9, 2003, the effective date of the purchase. The results of operations of Pictos have been included in our consolidated results of operations since the effective date of the purchase. See Note 3, “Significant Business Combinations,” to the consolidated financial statements in Item 8 of this Report.

Liquidity and Capital Resources

      Since inception, we have financed our cash requirements from cash generated by operations, the sale of equity securities, and short-term and long-term debt. At December 31, 2004, we had cash, cash equivalents and short-term investments of $126.7 million and working capital of $107.3 million. After assessing our need for a line of credit, on November 9, 2004, we terminated our $10 million line of credit with U.S. Bank National Association, which was originally scheduled to expire on June 5, 2007. We currently have no outstanding borrowings.

      On August 15, 2003, we acquired 100% of the outstanding shares of Divio for $27.1 million in cash plus transaction costs. On June 9, 2003, we acquired 100% of the outstanding shares of Pictos for $27.0 million in cash plus transaction costs.

      Net cash used in operating activities was $31.2 million for the year ended December 31, 2004, net cash provided by operating activities was $56.2 million for the year ended December 31, 2003, and $64.8 million for the year ended December 31, 2002. The net cash used in operating activities for the year ended December 31, 2004 was primarily attributable to a net loss of $35.6 million, a decrease in accounts payable and accrued expenses of $33.8 million due to a decrease in production activities in the fourth quarter of 2004 specifically, an increase in inventories of $12.1 million due to the increases in digital imaging and video product inventories and offset by the increase in excess and obsolete inventory reserve, partially offset by a decrease in accounts receivable of $36.1 million due to lower sales in the fourth quarter of 2004 and depreciation and amortization of $10.3 million. The net cash provided by operating activities for the year ended December 31, 2003 was primarily attributable to a net income of $25.3 million, depreciation and amortization of $6.8 million, an increase in accounts payable and accrued expenses of $41.0 million, primarily due to an increase in inventory purchases, an increase in income tax payable and deferred income taxes of $14.1 million, and charges for purchased in-process research and development of $2.7 million, partially offset by an increase in accounts receivable of $27.4 million due to significantly increased sales in the fourth quarter of 2003 as compared to sales during the fourth quarter of 2002, and an increase in inventories of $6.4 million primarily due to

inventories resulting from the Pictos and Divio acquisitions. The net cash provided by operating activities for the year ended December 31, 2002 was primarily attributable to a net income of $37.3 million, depreciation and amortization of $6.1 million, write-down of investments of $3.6 million, a decrease in accounts receivable of $14.2 million, a decrease in inventories of $13.3 million, and an increase in income tax payable and deferred income taxes of $4.2 million, partially offset by a decrease in accounts payable and accrued expenses of $14.0 million.

      Net cash provided by investing activities was $13.8 million for the year ended December 31, 2004, $10.5 million for the year ended December 31, 2003, and net cash used in investing activities was $159.2 million for the year ended December 31, 2002. The net cash provided by investing activities for the year ended December 31, 2004 was primarily attributable to the proceeds from sales of short-term investments of $152.4 million, partially offset by the purchase of short-term and long-term investments of $129.5 million and $5.2 million, respectively, and the purchase of property, plant and equipment of $3.9 million. The net cash provided by investing activities for the year ended December 31, 2003 was primarily attributable to proceeds from sales of short-term investments of $237.0 million, partially offset by the purchase of short-term and long-term investments of $161.2 million and $5.3 million, respectively, cash paid for acquisitions of Pictos and Divio, net of cash acquired of $52.1 million, and the purchase of property, plant and equipment of $8.0 million mainly for CAD software and testers. The net cash used in investing activities for the year ended December 31, 2002 was primarily attributable to the purchase of short-term and long-term investments of $295.3 million and $5.2 million, respectively, and the purchase of property, plant and equipment of $2.1 million, partially offset by proceeds from sales of short-term and long-term investments of $143.1 million and $0.4 million, respectively.

      Net cash provided by financing activities was $2.5 million for the year ended December 31, 2004, net cash used in financing activities was $24.7 million for the year ended December 31, 2003 and net cash provided by financing activities was $11.9 million for the year ended December 31, 2002. The net cash provided by financing activities for the year ended December 31, 2004, was attributable to the proceeds from the issuance of common stock under the employee stock purchase plan and stock option plans of $2.5 million. The net cash used in financing activities for the year ended December 31, 2003 was primarily attributable to cash paid for repurchase of common stock of $29.3 million, partially offset by the proceeds from the issuance of common stock under the employee stock purchase plan and stock option plans of $4.6 million. The net cash provided by financing activities for the year ended December 31, 2002 was primarily attributable to proceeds from the sale of common stock in the secondary public offering of $45.2 million and proceeds from the issuance of common stock under the employee stock purchase plan and stock option plans of $9.4 million, partially offset by cash paid for repurchase of common stock of $42.7 million.

      To date, we have not declared or paid cash dividends to our shareholders and do not anticipate paying any dividend in the foreseeable future due to a number of factors, including the volatile nature of the semiconductor industry and the potential requirement to finance working capital in the event of a significant upturn in business. We reevaluate this practice from time to time but are not currently contemplating the payment of a cash dividend.

      We have no long-term debt. Our capital expenditures for the next twelve months are anticipated to be approximately $6.3 million. We may also use cash to acquire or invest in complementary business or products or to obtain the right to use complementary technologies. From time to time, in the ordinary course of business, we may evaluate potential acquisitions of, or investment in, such businesses, products or technologies owned by third parties. Also, from time to time the Board of Directors may approve the expenditure of cash resources to repurchase our common stock as market conditions warrant. Based on past performance and current expectations, we believe that our existing cash and short-term investments as of December 31, 2004, together with funds expected to be generated by operations will be sufficient to satisfy our working capital needs, capital expenditures, mergers and acquisitions, strategic investment requirements, acquisitions of property and equipment, stock repurchases and other potential needs for the next twelve months.

      The following table sets forth the amounts of payments due under specified contractual obligations, aggregated by category of contractual obligation, as of December 31, 2004.

      We are not a party to any agreements with, or commitments to, any special purpose entities that would constitute material off-balance sheet financing other than the operating lease obligations listed above.

      As of December 31, 2004, our commitments to purchase inventory from the third-party contractors aggregated approximately $25.5 million of which approximately $5.0 million was adverse purchase order commitments that we have recorded as other accrued liabilities. Under these contractual agreements, we may order inventory from time to time, depending on our needs. There is no termination date to these agreements. Additionally, in the ordinary course of business, we enter into various arrangements with vendors and other business partners, principally for service, license and other operating supplies. As of December 31, 2004, commitments under these arrangements totaled $6.2 million. There are no material commitments for these arrangements extending beyond 2007.

      From time to time, we are subject to legal proceedings and claims, including claims of alleged infringement of trademarks, copyrights and other intellectual property rights and other claims arising out of the ordinary course of business. Further, we are currently engaged in certain shareholder class action and derivative lawsuits. We intend to defend these suits vigorously and we may incur substantial expenses in litigating claims against third parties and defending against existing and future third-party claims that may arise. In the event of a determination adverse to us, we may incur substantial monetary liability and be required to change our business practices. Either of these results could have a material adverse effect on our financial position, results of operations and cash flows. See Part I, Item 3, “Legal Proceedings.”

Factors That May Affect Future Results

      The markets in which we compete are intensely competitive and are characterized by rapid technological changes, price reductions and short product life cycles. Competition typically occurs at the design stage, when customers evaluate alternative design approaches requiring integrated circuits. Because of short product life cycles, there are frequent design win competitions for next-generation systems.

      We expect competition to increase in the future from existing competitors and from other companies that may enter our existing or future markets with products that may be provided at lower costs or provide higher levels of integration, higher performance or additional features. In some cases, our competitors have been acquired by even larger organizations, giving them access to even greater resources with which to compete with us. Advancements in technology can change the competitive environment in ways that may be adverse to us. For example, today’s high-performance central processing units in PCs have enough excess computing capacity to perform many of the functions that formerly required a separate chip set, which has reduced demand for our PC audio chips. The announcements and commercial shipments of competitive products could adversely affect sales of our products and may result in increased price competition that would adversely affect the ASP and margins of our products.

      The following factors may affect our ability to compete in our highly competitive markets:

      Our primary focus has been developing products primarily for the consumer electronics market. Currently, our sales of video system processor chips to the DVD and VCD (including VCD and SVCD) player markets account for a majority of our revenues. We expect these products will continue to account for a significant portion of our net revenues for the foreseeable future. Given the current economic environment, consumer spending on DVD players and cellular camera phones may not increase as expected or may even weaken or fall. Consequently, we continue to invest in new product lines for the consumer electronics market. Nonetheless, our strategy in these new markets may not be successful. If the markets for these products and applications decline or fail to develop as expected, or if we are not successful in our efforts to market and sell our products to manufacturers who incorporate our chip into their products. It could have a material adverse effect on our business financial conditions and results of operations.

      In addition, the potential decline in consumer confidence and consumer spending that may be occasioned by natural disasters, epidemics, terrorist attacks or armed conflict could have a material adverse effect on our business, financial condition and results of operations.

      Historically, our quarterly operating results have fluctuated significantly. Our future quarterly operating results will likely fluctuate from time to time and may not meet the expectations of securities analysts and investors in a particular future period. The price of our common stock could decline due to such fluctuations. The following factors may cause significant fluctuations in our future quarterly operating results:

      We currently place non-cancelable orders to purchase our products from independent foundries and other vendors on an approximately three-month rolling basis, while our customers generally place purchase orders (frequently with short lead times) with us that may be cancelled without significant penalty. Some of these customers may require us to demonstrate our ability to deliver in response to their short lead-time. In order to accommodate such customers, we have to commit to certain inventories before we have a firm commitment from our customers. If anticipated sales and shipments in any quarter are cancelled or do not occur as quickly as expected, expense and inventory levels could be disproportionately high and we may be required to record significant inventory charges in our statement of operations in a particular period. In accordance with our accounting policy, we reduce the carrying value of our inventories for estimated slow-moving, excess, obsolete, damaged or otherwise unmarketable products by an amount that is the difference between cost and estimated market value based on forecasts of future demand and market conditions. As our business grows, we may increasingly rely on distributors, which may further impede our ability to accurately forecast product orders. Additionally, we may venture into new products with different supply chain and logistics requirements which may in turn cause excess or shortage of inventory. For the year ended December 31, 2004, we recorded a net inventory provision of $33.1 million and we may continue to experience these charges in future periods.

      We will continue to regularly consider the acquisition of other companies or the products and technologies of other companies to complement our existing product offerings, improve our market coverage and enhance our technological capabilities. There may be technologies that we need to acquire or license in order to remain competitive. However, we may not be able to identify and consummate suitable acquisitions and investments or be able to acquire them at costs that are competitive. Acquisitions and investments carry risks that could have a material adverse effect on our business, financial condition and results of operations, including:

      In accordance with generally accepted accounting principles, we accounted for our acquisitions of Divio and Pictos using the purchase method of accounting. Under the purchase method of accounting, we have allocated the cost of the individual assets acquired and liabilities assumed, including various identifiable intangible assets (such as existing and core technology and customer and distributor relationships) and in-process research and development, based on their respective fair values at the date of the completion of the business combinations. Intangible assets are required to be amortized prospectively over their estimated useful lives. Any excess of the purchase price over those fair market values will be accounted for as goodwill. We are not required to amortize goodwill against income but will be subject to periodic reviews for impairment. If we are required to recognize impairment charges, the charges will negatively impact reported earnings in the period of the charges.

      We invest a significant amount of time and resources in our research and development activities to maintain and enhance our competitive position. Technical innovations are inherently complex and require long development cycles and the commitment of extensive engineering resources. We incur substantial research and development costs to confirm the technical feasibility and commercial viability of a product that in the end may not be successful. If we are not able to successfully complete our research and development projects on a timely basis, we may face competitive disadvantages. There is no assurance that we will recover the development costs associated with these projects or that we will be able to secure the financial resources necessary to fund future research and development efforts.

      Some of our significant projects include the development of a next generation DVD chip that will incorporate our servo technology and a recordable product that will incorporate our encoder technology. This will require a new architecture and a complete system on a chip design, which is extremely complex and may not ultimately be feasible. If we are unable to successfully develop this next generation DVD processor chip, or complete other significant research and development projects, our business, financial condition and results of operations could be materially adversely affected.

      Since we are primarily focused on the consumer electronics market, we are likely to be affected both by changes in consumer demand and by seasonality in the sales of our products. Historically, over half of consumer electronic products are sold during the holiday seasons. Consumer electronic product sales have historically been much higher during the holiday shopping seasons than during other times of the year, although the manufacturers’ shipments vary from quarter to quarter depending on a number of factors, including retail levels and retail promotional activities. In addition, consumer demand often varies from one product to another in consecutive holiday seasons and is strongly influenced by the overall state of the economy. Because the consumer electronic market experiences substantial seasonal fluctuations, seasonal trends may cause our quarterly operating results to fluctuate significantly and our inability to forecast these trends may adversely affect the market price of our common stock. For instance, in the future, as ASPs for

DVD products decline, customer demands for VCD products may shift to DVD products and ultimately render our VCD products, from which we enjoy a healthy product margin, obsolete. In the future, if the market for our products is not as strong during the holiday seasons, whether as a result of changes in consumer tastes or because of an overall reduction in consumer demand due to economic conditions, we may fail to meet expectations of securities analysts and investors which could cause our stock price to fall.

      The semiconductor industry is characterized by rapid technological changes, evolving industry standards and product obsolescence. Our success is highly dependent upon the successful development and timely introduction of new products at competitive prices and performance levels. The success of new products depends on a number of factors, including:

      Our products are designed to conform to current specific industry standards, however, we have no control over future modifications to these standards. Manufacturers may not continue to follow the current standards, which would make our products less desirable to manufacturers and reduce our sales. Our success is highly dependent upon our ability to develop new products in response to these changing industry standards.

      The markets for most of the applications for our chips are characterized by intense price competition. The willingness of OEMs to design our chips into their products depends, to a significant extent, upon our ability to sell our products at cost-effective prices. We expect the ASP of our existing products (particularly our DVD decoder chip products) to decline significantly over their product lives as the markets for our products mature, new products or technology emerge and competition increases. During the fiscal year ended December 31, 2004, we recorded a charge of $16.4 million for lower of cost and market reserves. If we are unable to reduce our costs sufficiently to offset declines in product prices or are unable to introduce more advanced products with higher margins, our gross margins may decline in the future.

      Our existing and potential competitors consist, in part, of large domestic and international companies that have substantially greater financial, manufacturing, technical, marketing, distribution and other resources, greater intellectual property rights, broader product lines and longer-standing relationships with customers than we have. Our competitors also include a number of independent and emerging companies who may be able to better adapt to changing market conditions and customer demand. In addition, some of our current and potential competitors maintain their own semiconductor fabrication facilities and could benefit from certain capacity, cost and technical advantages. We expect that market experience to date and the predicted growth of the market will continue to attract and motivate more and stronger competitors.

      DVD and VCD players face significant competition from video-on-demand, VCRs and other video formats. In addition, we expect that the DVD platform for the DHS will face competition from other platforms including set-top-boxes, as well as multi-function game boxes being manufactured and sold by large companies. Some of our competitors may be more diversified than us and supply chips for multiple platforms. A decline in DVD sales may have a disproportionate effect on us as it is currently our most important product

line. Any of these competitive factors could reduce our sales and market share and may force us to lower our prices, adversely affecting our business, financial condition and results of operations.

      Our success depends to a significant degree upon the continued contributions of Fred S.L. Chan, our Chairman of the Board, and Robert L. Blair, our President and CEO. In the past, Mr. Chan has served as our President and Chief Executive Officer in addition to being our Chairman of the Board. Mr. Chan is critical to maintaining many of our key relationships with customers, suppliers and foundries in Asia. The loss of the services of Mr. Chan, Mr. Blair, or any of our other key executives could adversely affect our business. On October 4, 2004, Patrick Ang resigned as our Executive Vice President and Chief Operating Officer. While in the case of Mr. Ang, it was for reasons unrelated to the Company’s business, we may not be able to retain our other key personnel and searching for key personnel replacements could divert the attention of other senior management and increase our operating expenses. We currently do not maintain any key person life insurance.

      Additionally, to manage our future operations effectively, we will need to hire and retain additional management personnel, design personnel and software engineers. We may have difficulty recruiting these employees or integrating them into our business. The loss of services of any of our key personnel, the inability to attract and retain qualified personnel in the future, or delays in hiring required personnel, particularly design personnel and software engineers, could make it difficult to implement our key business strategies, such as timely and effective product introductions.

      Sales through our largest distributor Dynax Electronics (a Hong Kong based company) were approximately 51%, 63% and 57% of our net revenues as of the fiscal years ended December 31, 2004, 2003 and 2002, respectively. Dynax Electronics is not subject to any minimum purchase requirements and can discontinue marketing any of our products at any time. In addition, Dynax Electronics has rights of return for unsold product and rights to pricing allowances to compensate for rapid, unexpected price changes, therefore we do not recognize revenue until Dynax Electronics sells through to our end-customers. If our relationship with Dynax Electronics deteriorates, our quarterly results could fluctuate significantly as we experience short-term disruption to our sales and collection processes, particularly in light of the fact that we maintain significant accounts receivable from Dynax Electronics. As our business grows, we may increasingly rely on distributors, which may reduce our exposure to future sales opportunities. Although we believe that we could replace Dynax Electronics as our distributor for the Hong Kong and China markets, there can be no assurance that we could replace Dynax Electronics in a timely manner or if a replacement were found that the new distributor would be as effective as Dynax Electronics in generating revenue for us.

      A substantial portion of our net revenues has been derived from sales to a small number of our customers. During the fiscal year December 31, 2004, sales to our top five end-customers (including end-customers that buy our products from our largest distributor Dynax Electronics) accounted for approximately 42% of our net revenues. This risk is particularly acute in our digital imaging business, which currently has few customers and low sales volume. We expect this concentration of sales to continue along with other changes in the composition of our customer base. The reduction, delay or cancellation of orders from one or more major customers or the loss of one or more major customers could materially and adversely affect our business, financial condition and results of operations. In addition, any difficulty in collecting amounts due from one or more key customers could harm our financial condition.

      We have in the past and will continue to regularly consider the expansion into new businesses and product lines by acquisition or otherwise. As a result of our prior expansions into new businesses and new product lines, we may continue to sell our products to a highly concentrated customer base. The reduction, delay or cancellation of orders from one or more major customers or the loss of one or more major customers in these new businesses or product lines could render our venture in a new product line, such as digital imaging, unsuccessful, and resulting in a material adverse effect on our business, financial condition and results of operations.

      As a result of our acquisitions such as Pictos, we currently purchase custom inventories for certain of our product lines such as image sensor modules for camera enabled cellular phones. This custom inventory is highly tailored to each customer’s specifications. In the event that these customers reduce or cancel their orders for these products, we may not be able to re-sell the custom inventory to any of our other customers. We may also be forced to write off such custom inventory, which may result in a material adverse effect on our business, financial condition and results of operations.

      To protect our intellectual property rights we rely on a combination of patents, trademarks, copyrights and trade secret laws and confidentiality procedures. We have numerous patents granted in the United States with some corresponding foreign patents. These patents will expire at various times. We cannot assure you that patents will be issued from any of our pending applications or applications in preparation or that any claims allowed from pending applications or applications in preparation will be of sufficient scope or strength. We may not be able to obtain patent protection in all countries where our products can be sold. Also, our competitors may be able to design around our patents. The laws of some foreign countries may not protect our products or intellectual property rights to the same extent, as do the laws of the United States. We cannot assure you that the actions we have taken to protect our intellectual property will adequately prevent misappropriation of our technology or that our competitors will not independently develop technologies that are substantially equivalent or superior to our technology.

      The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights or positions. Litigation by or against us could result in significant expense and divert the efforts of our technical and management personnel, whether or not such litigation results in a favorable determination for us. Any claim, even if without merit, may require us to spend significant resources to develop non-infringing technology or enter into royalty or cross-licensing arrangements, which may not be available to us on acceptable terms, or at all. We may be required to pay substantial damages or cease the use and sale of infringing products, or both. In general, a successful claim of infringement against us in connection with the use of our technologies could adversely affect our business and our results of operations could be significantly harmed. See Part I, Item 3, “Legal Proceedings.” We may initiate claims or litigation against third parties for infringement of our proprietary rights or to establish the validity of our proprietary rights. In the event of an adverse result in any such litigation our business could be materially harmed.

      Substantially all of our sales are to customers (including distributors) in Hong Kong, Taiwan, China, Japan, Singapore, Korea and Turkey. During the fiscal year December 31, 2004, sales to customers in Hong Kong, Taiwan and China were approximately 74% of our net revenues. If our sales in one of these countries or territories, such as Hong Kong, were to fall, our financial condition could be materially impaired. We expect that international sales will continue to represent a significant portion of our net revenues. In addition,

substantially all of our products are manufactured, assembled and tested by independent third parties in Asia. There are special risks associated with conducting business outside of the United States, including:

      We rely on independent foundries to manufacture all of our products. Substantially all of our products are currently manufactured by Taiwan Semiconductor Manufacturing Company, Ltd., United Microelectronics Corporation and other independent Asian foundries in Asia. Our reliance on these or other independent foundries involves a number of risks, including:

      Any failure of these third-party foundries to deliver products or otherwise perform as requested could damage our relationships with our customers and harm our sales and financial results.

      To address potential foundry capacity constraints in the future, we may be required to enter into arrangements, including equity investments in or loans to independent wafer manufacturers in exchange for guaranteed production capacity, joint ventures to own and operate foundries, or “take or pay” contracts that commit us to purchase specified quantities of wafers over extended periods. These arrangements could require us to commit substantial capital or to grant licenses to our technology. If we need to commit substantial capital, we may need to obtain additional debt or equity financing, which could result in dilution to our shareholders.

      We depend on a limited number of suppliers to obtain adequate supplies of quality raw materials on a timely basis. We do not generally have guaranteed supply arrangements with our suppliers. If we have difficulty in obtaining materials in the future, alternative suppliers may not be available, or if available, these suppliers may not provide materials in a timely manner or on favorable terms. If we cannot obtain adequate materials for the manufacture of our products, we may be forced to pay higher prices, experience delays and our relationships with our customers may suffer.

      In addition, we license certain technology from third parties that is incorporated into many of our key products. If we are unable to obtain or license the technology on commercially reasonable terms and on a timely basis, we will not be able to deliver products to our customers on competitive terms and in a timely manner and our relationships with our customers may suffer.

      Our potential customers often spend a significant amount of time to evaluate, test and integrate our products. Our sales cycles often last for several months and may last for up to a year or more. These longer sales cycles require us to invest significant resources prior to the generation of revenues and subject us to greater risk that customers may not order our products as anticipated. In addition, orders expected in one quarter could shift to another because of the timing of customers’ purchase decisions. Any cancellation or delay in ordering our products after a lengthy sales cycle could adversely affect our business.

      The greater integration of functions and complexity of our products increase the risk that our customers or end users could discover latent defects or subtle faults in our products. These discoveries could occur after substantial volumes of product have been shipped, which could result in material recalls and replacement costs. Product recalls could also divert the attention of our engineering personnel from our product development needs and could adversely impact our customer relationships. In addition, we could be subject to product liability claims that could distract management, increase costs and delay the introduction of new products.

      The semiconductor industry is subject to cyclical variations in product supply and demand, the timing, length and volatility of which are difficult to predict. Downturns in the industry have been characterized by abrupt fluctuations in product demand, production over-capacity and accelerated decline of ASP. Upturns in the industry have been characterized by rising costs of goods sold and lack of production capacity at our suppliers. These cyclical changes in demand and capacity, upward and downward, could significantly harm our business. Our quarterly net revenues and gross margin performance could be significantly impacted by these cyclical variations. A prolonged downturn in the semiconductor industry could materially and adversely impact our business, financial condition and results of operations. We cannot assure you that the market will improve from a cyclical downturn or that cyclical performance will stabilize or improve.

      We may be required to obtain substantial additional capital to finance our future growth, fund our ongoing research and development activities and acquire new technologies or companies. To the extent that our existing sources of liquidity and cash flow from operations are insufficient to fund our activities, we may need to seek additional equity or debt financing from time to time. If our performance or prospects decrease, we may need to consummate a private placement or public offering of our capital stock at a lower price than you paid for your shares. If we raise additional capital through the issuance of new securities at a lower price than you paid for your shares, you will be subject to additional dilution. Further, such equity securities may have rights, preferences or privileges senior to those of our existing common stock. Additional financing may not be available to us when needed or, if available, it may not be available on terms favorable to us.

      The price of our common stock fluctuates significantly. Many factors influence the price of our common stock, including:

      We are spending an increased amount of management time and external resources to analyze and comply with changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and NASDAQ Stock Market rules and listing requirements. Devoting the necessary resources to comply with evolving corporate governance and public disclosure standards may result in increased general and administrative expenses and attention to these compliance activities and divert management’s attention from our on-going business operations.

      Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we are required to include an internal controls report of management’s assessment of the design and effectiveness of our internal controls as part of our Annual Report on Form 10-K. Our independent registered public accounting firm is required to attest to, and report on, our management’s assessment. In order to issue our report, our management must document both the design for our internal controls and the testing processes that support management’s evaluation and conclusion. During the course of testing our internal controls each year, we may identify deficiencies which we may not be able to remediate, document and retest in time, due to difficulties including those arising from turnover of qualified personnel, to meet the deadline for management to complete its report and our independent registered public accounting firm may not have sufficient time to retest those remediated deficiencies for its attestation of management’s report. Upon the completion of our testing and documentation, certain deficiencies may be discovered that will require remediation, the costs of which could have a material adverse effect on our results of operations. Moreover, our independent registered public accounting firm may not agree with our management’s assessment and may send us a deficiency notice that we are unable to remediate on a timely basis. In addition, if we fail to maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time we may not be able to ensure that our management can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 and we may not be able to retain our independent registered public accounting firm with sufficient resources to attest to and report on our internal control. In the future, if we are unable to assert that our internal control over financial reporting is effective, if our independent registered public accounting firm is unable to attest that our management’s report is fairly stated, if our independent registered public accounting firm is unable to express an opinion on our management’s evaluation or on the effectiveness of the internal controls, or if our independent registered public accounting firm expresses an adverse opinion on

our internal controls, we could lose investor confidence in the accuracy and completeness of our financial reports, which in turn could have an adverse effect on our stock price.

      Technology companies like ours have a history of using broad based employee stock option programs to hire, incentivize and retain our workforce in a competitive marketplace. Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) allowed companies the choice of either using a fair value method of accounting for options, which would result in expense recognition for all options granted, or using an intrinsic value method, as prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), with a pro forma disclosure of the impact on net income (loss) of using the fair value option expense recognition method. We have previously applied APB 25 and accordingly we generally have not recognized any expense with respect to employee stock options as long as such options were granted at exercise prices equal to the fair value of our common stock on the date of grant.

      On December 16, 2004, the FASB issued Statement of SFAS No. 123R (revised 2004), “Share-Based Payment”, which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123R is similar to the approach described in SFAS No. 123. However, SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. The new standard will be effective for our quarter ending September 30, 2005 and will apply to all share-based awards granted after the effective date and to awards modified, repurchased, or cancelled after that date. SFAS 123R will have a significant impact on our consolidated statement of operations as we will be required to expense the fair value of our stock options rather than disclosing the impact on our consolidated result of operations within our footnotes in accordance with the disclosure provisions of SFAS 123. This may result in lower reported earnings per share which could negatively impact our future stock price. In addition, this could impact our ability to utilize broad based employee stock plans to reward employees and could result in a competitive disadvantage to us in the employee marketplace.

      We are exposed to the impact of foreign currency fluctuations and interest rate changes which may lead to changes in the market values of our investments.

Foreign Exchange Risks

      We fund our operations with cash generated by operations, the sale of marketable securities and short and long-term debt. As we operate primarily in Asia, we are exposed to market risk from changes in foreign exchange rates, which could affect our results of operations and financial condition. In order to reduce the risk from fluctuation in foreign exchange rates, our product sales and all of our arrangements with our foundries and test and assembly vendors are denominated in U.S. dollars. We have not entered into any currency hedging activities. We performed a sensitivity analysis assuming a hypothetical 10% adverse movement in foreign exchange rates to the foreign subsidiaries and the underlying exposures described above. As of December 31, 2004, the analysis indicated that these hypothetical market movements would not have a material effect.

Interest Rate Risks

      We also invest in short-term investments. Consequently, we are exposed to fluctuation in rates on these investments. Increases or decreases in interest rates generally translate into decreases and increases in the fair

value of these investments. In addition, the credit worthiness of the issuer, relative values of alternative investments, the liquidity of the instrument, and other general market conditions may affect the fair values of interest rate sensitive investments. In order to reduce the risk from fluctuation in interest rates, we invest in highly liquid governmental notes and bonds with contractual maturities of less than two years. All of the investments have been classified as available-for-sale, and at December 31, 2004, the fair value of our investments approximated their costs.

Investment Risk

      We are exposed to market risk as it relates to changes in the market value of our investments in public companies. We invest in equity instruments of public companies for business and strategic purposes and we have classified these securities as available-for-sale. These available-for-sale equity investments, primarily in technology companies, are subject to significant fluctuations in fair market value due to the volatility of the stock market and the industries in which these companies participate. Our objective in managing our exposure to stock market fluctuations is to minimize the impact of stock market declines to our earnings and cash flows. There are, however, a number of factors beyond our control. Continued market volatility, as well as mergers and acquisitions, have the potential to have a material impact on our results of operations in future periods.

      We are also exposed to changes in the value of our investments in non-public companies, including start-up companies. These long-term equity investments in technology companies are subject to significant fluctuations in fair value due to the volatility of the industries in which these companies participate and other factors.

The following documents are filed as part of this Report:

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

      Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of the compliances with the policies or procedures may deteriorate.

      With the participation of the Chief Executive Officer and the Chief Financial Officer, management conducted an evaluation of the effectiveness of the Company’s internal control over financial reporting based on the framework and criteria established in Internal Control — Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management has concluded that the Company’s internal control over financial reporting was effective as of December 31, 2004.

      Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report which is included herein.

March 15, 2005

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Shareholders and Board of Directors of ESS Technology, Inc.:

      We have completed an integrated audit of ESS Technology, Inc.’s 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements and financial statement schedule

      In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of ESS Technology, Inc. and its subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

Internal control over financial reporting

      Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 8, that the Company maintained effective internal control over financial reporting as of December 31, 2004 based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

      A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of

the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

      Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/ PricewaterhouseCoopers LLP

San Jose, California

March 15, 2005

ESS TECHNOLOGY, INC.

CONSOLIDATED BALANCE SHEETS

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

ESS TECHNOLOGY, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

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

ESS TECHNOLOGY, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY