PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

SRS LABS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

	June 30, 2006			December 31, 2005
	(unaudited)
ASSETS
Current Assets
Cash and cash equivalents	12,071,951			$	8,752,339
Accounts receivable, net	1,453,597			1,886,780
Inventories, net	59,518			80,421
Prepaid expenses and other current assets	452,158			522,426
Investments available for sale	11,968,615			—
Assets held for sale	2,264,847			1,859,127

Total Current Assets	28,270,686			13,101,093

Investments available for sale	5,099,589			17,077,170
Furniture, fixtures and equipment, net	486,460			425,288
Intangible assets, net	2,108,121			2,015,605
Deferred income taxes	386,412			380,386
Long term assets held for sale	2,113,613			2,065,123

Total Assets	$	38,464,881		$	35,064,665

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities
Accounts payable	$	898,905		$	741,811
Accrued liabilities	852,956			801,898
Deferred revenue	110,254			537,636
Liabilities related to assets held for sale	1,700,706			2,170,701

Total Current Liabilities	3,562,821			4,252,046

Commitments and contingencies and subsequent events (Note 7 and 12)

Stockholders’ Equity
Preferred stock—$.001 par value; 2,000,000 shares authorized; no shares issued or outstanding	—			—
Common stock—$.001 par value; 56,000,000 shares authorized; 15,584,819 and 14,953,690 shares issued; and 14,910,721 and 14,279,592 shares outstanding at June 30, 2006 and December 31, 2005, respectively	15,586			14,955
Additional paid-in capital	66,581,360			63,574,518
Accumulated other comprehensive loss	(506,046		)	(496,021		)
Accumulated deficit	(28,185,395		)	(29,277,388		)
Treasury stock at cost, 674,098 shares at June 30, 2006 and December 31, 2005	(3,003,445		)	(3,003,445		)

Total Stockholders’ Equity	34,902,060			30,812,619

Total Liabilities and Stockholders’ Equity	$	38,464,881		$	35,064,665

See accompanying notes to the condensed consolidated financial statements

SRS LABS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

	Three Months Ended					Six Months Ended
	June 30,					June 30,
	2006			2005		2006		2005

Revenues	$	4,259,839		$	3,539,977	$	8,595,507	$	6,804,072
Cost of sales	35,293			94,838		83,105		151,183

Gross margin	4,224,546			3,445,139		8,512,402		6,652,889

Operating expenses:
Sales and marketing	1,885,416			1,026,477		3,750,785		2,208,924
Research and development	631,739			547,787		1,286,028		1,123,992
General and administrative	1,357,789			1,427,501		2,994,997		2,700,352

Total operating expenses	3,874,944			3,001,765		8,031,810		6,033,268

Income from continuing operations	349,602			443,374		480,592		619,621
Other income, net	224,005			160,341		403,718		309,611
Income from continuing operations before income tax expense	573,607			603,715		884,310		929,232
Income tax expense	167,745			168,506		327,168		287,530
Income from continuing operations	405,862			435,209		557,142		641,702

Discontinued operations (Note 9):
Income from discontinued operations before income tax expense	151,876			79,088		194,252		99,233
Gain on disposal	371,295			—		371,295		—
Income tax (benefit) expense	(385		)	563		30,696		5,741
Income from discontinued operations	523,556			78,525		534,851		93,492

Net income	$	929,418		$	513,734	$	1,091,993	$	735,194

Income from continuing operations per common share:
Basic	$	0.03		$	0.03	$	0.04	$	0.05
Diluted	$	0.02		$	0.03	$	0.03	$	0.04

Income from discontinued operations per common share:
Basic	$	0.04		$	0.01	$	0.04	$	0.01
Diluted	$	0.03		$	0.01	$	0.03	$	0.01

Net income per common share:
Basic	$	0.06		$	0.04	$	0.08	$	0.05
Diluted	$	0.06		$	0.03	$	0.07	$	0.05

Weighted average shares used in the calculation of net income per common share:
Basic	14,622,210			14,076,866		14,523,459		14,043,269
Diluted	16,334,105			14,881,495		16,206,277		14,950,693

See accompanying notes to the condensed consolidated financial statements

SRS LABS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND
COMPREHENSIVE INCOME (Unaudited)

	Common Stock			Additional Paid-In		Accumulated Other Comprehensive			Accumulated			Treasury						Comprehensive Income for the Period
	Shares	Amount		Capital		(Loss) Income			Deficit			Stock			Total			Ended

BALANCE, Dec. 31, 2005	14,279,592	$	14,955	$	63,574,518	$	(496,021	)	$	(29,277,388	)	$	(3,003,445	)	$	30,812,619
Proceeds from exercise of stock options	230,370	230		1,014,988		—			—			—			1,015,218
Stock based compensation	—	—		399,738		—			—			—			399,738
Unrealized loss on investments available for sale, net of tax	—	—		—		(58,282		)	—			—			(58,282		)	(58,282		)
Net income	—	—		—		—			162,575			—			162,575			162,575

BALANCE, March 31, 2006	14,509,962	$	15,185	$	64,989,244	$	(554,303	)	$	(29,114,813	)	$	(3,003,445	)	$	32,331,868		$	104,293
Proceeds from exercise of stock options	400,759	401		1,203,311		—			—			—			1,203,712
Stock based compensation	—	—		388,805		—			—			—			388,805
Unrealized gain on investments available for sale, net of tax	—	—		—		48,257			—			—			48,257			48,257
Net income	—	—		—		—			929,418			—			929,418			929,418

BALANCE, June 30, 2006	14,910,721	$	15,586	$	66,581,360	$	(506,046	)	$	(28,185,395	)	$	(3,003,445	)	$	34,902,060		$	1,081,968

See accompanying notes to the condensed consolidated financial statements

SRS LABS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Six Months Ended June 30,
	2006			2005
Cash Flows From Operating Activities:
Income from continuing operations	$	557,142		$	641,702
Adjustments to reconcile income from continuing operations to net cash provided by operating activities:
Depreciation and amortization	355,866			417,022
Provision for doubtful accounts	(7,532		)	8,425
Deferred taxes	(6,026		)	—
Accretion of discount on investments available for sale	(1,059		)	(1,185		)
Stock-based compensation expense	687,400			24,570
Loss on disposition of furniture, fixtures and equipment	1,582			2,267
Changes in operating assets and liabilities:
Accounts receivable	440,715			287,557
Inventories	20,903			(30,752		)
Prepaid expenses and other current assets	70,268			163,264
Accounts payable	157,094			(88,470		)
Accrued liabilities	51,058			1,149,403
Deferred revenue	(427,382		)	(128,702		)
Income taxes payable	—			103,111

Net cash provided by operating activities	1,900,029			2,548,212

Cash Flows From Investing Activities:
Purchase of furniture, fixtures and equipment	(183,330		)	(45,252		)
Expenditures related to patents and intangible assets	(327,806		)	(245,316		)

Net cash used in investing activities	(511,136		)	(290,568		)

Cash Flows From Financing Activities:
Purchase of treasury stock	—			(1,059,590		)
Proceeds from exercise of stock options	1,923,257			407,740

Net cash provided by (used in) financing activities	1,923,257			(651,850		)

Net Increase in Cash from Continuing Operations	3,312,150			1,605,794

Cash Flows From Discontinued Operations:
Net cash used in operating activities	(128,298		)	(1,708,743		)
Net cash used in investing activities	(159,913		)	(88,491		)
Net cash provided by financing activities	295,673			14,399
Net Increase (Decrease) in Cash from Discontinued Operations	7,462			(1,782,835		)

Net Increase (Decrease) in Cash and Cash Equivalents	3,319,612			(177,041		)
Cash and Cash Equivalents, Beginning of Period	8,752,339			7,011,912
Cash and Cash Equivalents, End of Period	$	12,071,951		$	6,834,871

Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Income taxes	$	311,102		$	377,551
Supplemental Disclosure of Non-Cash Investing Activities:
Unrealized loss on investments, net	$	(10,025	)	$	(41,112	)

See accompanying notes to the condensed consolidated financial statements

SRS LABS, INC.

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

1. Basis of Presentation and Summary of Significant Accounting Policies and Estimates

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

Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to SEC rules and regulations for presentation of interim financial information. Therefore, the condensed interim consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005. Current and future financial statements may not be directly comparable to the Company’s historical financial statements. The results of operations for the interim period are not necessarily indicative of the results to be expected for any other interim period or for the full year.

On February 23, 2006, the Board of Directors of the Company (the “Board of Directors” or the “Board”) approved a plan to sell Valence in order to focus increased management attention and financial resources on its licensing business. On July 14, 2006, the Company entered into a definitive Sale and Purchase Agreement to sell Valence to Noblehigh Enterprises Inc. (“Noblehigh”). See Note 12.

Additionally, on February 23, 2006, the Board authorized management to take all reasonable steps to divest the Company’s entire equity interest in the CHS/SRS LLC joint venture (the “Joint Venture”) to produce and distribute six concert videos featuring our Circle Surround Technology. On June 30, 2006 the Company completed the sale of its interest in the Joint Venture to Coming Home Studios, LLC (“CHS”) in exchange for $200,000, the rights to all cash assets of the Joint Venture, and a promissory note in the amount of $175,000. See Note 9.

As a result of our decisions to sell Valence and our entire equity interest in the joint venture, we have accounted for the semiconductor business segment and the joint venture as discontinued operations in the accompanying condensed consolidated financial statements. We have reclassified prior periods to conform to the current period presentation.

Estimates

The preparation of financial statements in accordance with generally accepted accounting principles requires management to make use of certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported periods. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ materially from those estimates. See the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2005 for an additional discussion of the significant accounting policies and estimates used in the preparation of our financial statements.

2. Stock-Based Compensation

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

Effective for the first quarter of fiscal 2006, we adopted SFAS 123R using the modified prospective method, which requires us to record compensation expense for all awards granted after the date of adoption, and for the unvested portion of previously granted awards that remain outstanding at the date of adoption. Accordingly, prior period amounts presented herein have not been restated to reflect the adoption of SFAS 123R.

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

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

	Three Months Ended			Six Months Ended
	June 30,			June 30,
	2005			2005

Net income - as reported	$	513,734		$	735,194
Add: Share-based employee compensation expense included in net income, net of related tax effects - as reported	5,843			14,742
Deduct: Share-based employee compensation expense determined under fair value method, net of related tax effects - pro forma	(275,174		)	(580,277		)
Net income - pro forma	$	244,403		$	169,659
Basic - as reported	$	0.04		$	0.05
Basic - pro forma	$	0.02		$	0.01
Diluted - as reported	$	0.03		$	0.05
Diluted - pro forma	$	0.02		$	0.01

Share Option Plans

The Company has in effect several share-based plans under which non-qualified and incentive stock options have been granted to employees, non-employees and board members. The following equity compensation plans have also been approved by our stockholders: the SRS Labs, Inc. 2006 Stock Incentive Plan (the “2006 Plan”), the SRS Labs, Inc. Amended and Restated 1996 Long-Term Incentive Plan (the “1996 Plan”), and the SRS Labs, Inc. Amended and Restated 1996 Non-employee Directors’ Stock Option Plan (the “Non-employee Directors Plan”). The Board of Directors determines eligibility, vesting schedules and exercise prices for options granted under the plans. We issue new shares to satisfy stock option exercises under our share-based plans. No income tax benefit was realized from activity in our share-based plans during the three and six months ended fiscal 2006 and 2005.

A summary of the shares reserved for grant and options available for grant under each plan is as follows:

	June 30, 2006
	Shares	Shares
	Reserved	Available
	for Grant	for Grant
2006 Plan	1,500,000	1,380,000
1996 Plan	8,500,000	0
Non-employee Directors Plan	500,000	340,000
Total	10,500,000	1,720,000

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

The fair value of each share-based award is estimated on the grant date using the BSM option-pricing formula. Expected volatilities are based on the historical volatility of the Company’s stock price. The expected term of options granted subsequent to the adoption of SFAS 123R is derived using the simplified method as defined in the SEC’s Staff Accounting Bulletin 107, “Implementation of FASB 123R.” The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury interest rates in effect at the time of grant. The fair value of options granted was estimated using the following weighted-average assumptions:

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2006		2005		2006		2005
Expected term (in years)	6.25		6.25		6.25		6.25
Expected volatility	56	%	59	%	57	%	62	%
Risk-free interest rate	5.0	%	3.8	%	4.9	%	4.0	%
Dividend yield	0.00	%	0.00	%	0.00	%	0.00	%

Total compensation cost recognized in the three and six months ending June 30, 2006 is as follows:

	Three Months		Six Months
Continuing Operations:
Sales and Marketing	$	136,459	$	298,512
Research and Development	75,174		202,161
General and Administrative	132,387		186,727
Total compensation cost recognized in Continuing Operations	$	344,020	$	687,400

Total compensation cost recognized in Discontinued Operations	$	44,785	$	101,143
Total compensation cost recognized	$	388,805	$	788,543

A summary of option activity under the stock option plans and changes during the quarter then ended is presented below:

	June 30, 2006
			Weighted-Average
					Remaining	Aggregate
			Exercise		Contractual	Intrinsic
	Shares		Price		Term	Value
Outstanding at beginning of period	4,263,040		$	4.47
Granted	385,900		5.70
Cancelled/forfeited	(66,963	)	6.28
Exercised	(400,759	)	3.00
Outstanding at end of period	4,181,218		$	4.69	5.4	$	1,236,775
Options exercisable at end of period	2,891,745		$	4.28	4.4	$	2,060,012

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

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2006		2005		2006		2005
Weighted-average grant-date fair value per share	$	3.37	$	3.36	$	3.46	$	2.98
Intrinsic value of options exercised	$	972,818	$	172,957	$	1,355,027	$	202,841

A summary of the activity of the Company’s non-vested shares during the six months ended June 30, 2006 is presented below:

			Weighted-Average			Remaining
					Remaining	Unrecognized
			Grant-Date		Years	Compensation
	Shares		Fair Value		To Vest	Cost
Nonvested outstanding at beginning of period	1,195,964		$	3.21
Granted	495,900		3.46
Vested	(334,678	)	3.02
Forfeited	(67,713	)	2.69
Nonvested outstanding at end of period	1,289,473		$	3.58	2.95	$	2,636,148

3. Capitalization of Software Development Costs

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

Capitalized software as of June 30, 2006 and December 31, 2005 is as follows:

	June 30, 2006			December 31, 2005
Capitalized software	$	707,008		$	595,568
Accumulated amortization	(386,819		)	(309,990		)
Capitalized software, net	$	320,189		$	285,578

As of June 30, 2006, the weighted average useful life of the Company’s capitalized software is approximately 1.8 years. The following table shows the estimated amortization expense for those assets for the remaining six months of the current fiscal year end and each of the four succeeding fiscal years.

Year ending December 31,	Estimated Expense
2006	$	73,817
2007	104,276
2008	54,997
2009	10,270
2010	—

4. Intangible Assets

On January 1, 2002, the Company adopted SFAS No. 142 “Goodwill and Other Intangible Assets,” which, among other things, establishes new standards for goodwill acquired in a business combination, eliminates the amortization of goodwill and requires the carrying value of goodwill and identifiable intangibles to be evaluated for impairment on an annual basis.

In accordance with SFAS No. 142, all of our intangible assets that have definite lives are being amortized on a straight-line basis over their estimated useful lives and are evaluated at least annually to determine if fair value of the asset has decreased below its carrying value. At December 31, 2005, we performed our annual assessment and determined that no impairment existed.

Intangible assets consist of the following:

	June 30, 2006			December 31, 2005

Patents	$	2,555,908		$	2,339,543
Accumulated amortization	(1,211,447		)	(1,093,368		)
Patents, net	1,344,461			1,246,175
Other Intangibles:
License agreements acquired in purchase of SRSWOWcast in February 2003	640,071			640,071
Poly Planar purchased technology for speaker products	120,000			120,000
Capitalized software and hardware for several technologies	637,281			525,840
Total of Other Intangibles	1,397,352			1,285,911
Accumulated amortization, other intangibles	(633,692		)	(516,481		)
Other intangibles, net	763,660			769,430
Intangible assets, net	$	2,108,121		$	2,015,605

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

	Three months ended June 30,				Six Months ended June 30,
	2006		2005		2006		2005
Patents	$	60,411	$	51,445	$	118,079	$	101,382
Other intangibles:
License agreements acquired in purchase of our subsidiary SRSWOWcast in February 2003	16,002		16,002		32,003		32,003
Poly Planar purchased technology	—		—		—		4,000
Capitalized software and hardware	44,518		31,784		85,208		61,503
Total intangible amortization expense	$	120,931	$	99,231	$	235,290	$	198,888

As of June 30, 2006, the weighted average useful life of the Company’s patents and intangible assets is approximately 2.7 years. The following table shows the estimated amortization expense for those assets for the remaining six months of the current fiscal year and each of the four succeeding fiscal years:

Year ending December 31,	Estimated expense
2006	$	171,872
2007	$	407,573
2008	$	291,292
2009	$	217,082
2010	$	206,196
Thereafter	$	578,816

5. Investments Available for Sale

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

	June 30, 2006			December 31, 2005
Cost	$	17,489,688		$	17,489,688
Accretion of discount	3,261			2,202
Unrealized loss	(424,745		)	(414,720		)
Estimated fair value	$	17,068,204		$	17,077,170

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

	June 30, 2006				December 31, 2005
	Cost		Estimated Fair Value		Cost		Estimated Fair Value
U.S. Government securities available for sale:
Due in one year or less (a)	11,992,949		11,968,615		—		—
Due in one to five years	5,500,000		5,099,589		17,491,890		17,077,170
	$	17,492,949	$	17,068,204	$	17,491,890	$	17,077,170

(a) Available for sale securities due in one year or less are classified as short-term in the condensed consolidated balance sheets, as the original contractual maturities are greater than 90 days.

6. Net Income Per Common Share

The Company applies SFAS No. 128, “Earnings per Share,” which requires the disclosure of basic and diluted net income or loss per share for all current and prior periods. Basic net income or loss per common share is computed by dividing net income or loss available to common stockholders by the weighted average number of common shares outstanding during each year. Diluted net income or loss per common share reflects the maximum dilution, based on the average price of the Company’s common stock each period, and is computed similar to basic income or loss per share except that the denominator is increased to include the number of additional shares that would have been outstanding if potentially dilutive stock options and warrants had been exercised.

Basic and diluted net income per share computed in accordance with SFAS 128 for the three and six months ended June 30, are as follows:

	For the three months				For the six months
	Ended June 30,				Ended June 30,
	2006		2005		2006		2005
BASIC EPS
Income from continuing operations	$	405,862	$	435,209	$	557,142	$	641,702
Income from discontinued operations	523,556		78,525		534,851		93,492
Net income	$	929,418	$	513,734	$	1,091,993	$	735,194
Denominator: weighted average common shares outstanding	14,622,210		14,076,866		14,523,459		14,043,269
Income from continuing operations—basic	$	0.03	$	0.03	$	0.04	$	0.05
Income from discontinued operations—basic	$	0.04	$	0.01	$	0.04	$	0.01
Net income per share—basic	$	0.06	$	0.04	$	0.08	$	0.05

DILUTED EPS
Income from continuing operations	$	405,862	$	435,209	$	557,142	$	641,702
Income from discontinued operations	523,556		78,525		534,851		93,492
Net income	$	929,418	$	513,734	$	1,091,993	$	735,194
Denominator: weighted average common shares outstanding	14,622,210		14,076,866		14,523,459		14,043,269
Common equivalent shares outstanding:
Options	1,711,895		804,629		1,682,818		907,424
Total diluted shares	16,334,105		14,881,495		16,206,277		14,950,693
Income from continuing operations—diluted	$	0.02	$	0.03	$	0.03	$	0.04
Income from discontinued operations—diluted	$	0.03	$	0.01	$	0.03	$	0.01
Net income per share—diluted	$	0.06	$	0.03	$	0.07	$	0.05

There were 1,614,619 and 1,979,479 potentially dilutive options outstanding for the three months ending June 30, 2006 and 2005, respectively, and there were 1,614,619 and 1,964,479 potentially dilutive options outstanding for the six months ending June 30, 2006 and 2005, respectively, that were not included in the table above because they would be anti-dilutive.

7. Commitments and Contingencies

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

8. Stockholders’ Equity

On March 24, 2005, the Company’s Board of Directors authorized the repurchase of up to $3,000,000 of the outstanding shares of the Company’s common stock for a period from March 25, 2005 to March 24, 2006 (the “2005 Repurchase Program”). The Company repurchased 232,223 shares under this plan. There was no activity under the 2005 Repurchase Program during the first fiscal quarter of 2006, and the program expired on March 24, 2006.

On June 22, 2006, the Company’s Board of Directors adopted and the Company’s stockholders approved the 2006 Stock Incentive Plan (the “2006 Plan”), a plan for which 1,500,000 shares of the Company’s common stock may be issued pursuant to Awards under the Plan provided that the Company shall not make additional awards under the 1996 Plan. Either the Board of Directors or a committee appointed by the Board will administer the 2006 Plan. Under the 2006 Plan, the Committee may grant options that are intended to qualify as incentive stock options (“ISOs”). Additionally, the Committee may also grant share appreciation rights, restricted shares, restricted share units, unrestricted shares, deferred share units, and performance awards. The vesting period is dependent on the type of Award granted.

9. Discontinued Operations

On February 23, 2006, the Board approved a plan to sell Valence in order to focus increased management attention and financial resources on its licensing business. We have retained Kaufman Bros., L.P., a financial advisor based in New York City, to assist us in facilitating the sale. On July 14, 2006, the Company entered into a definitive Sale and Purchase Agreement to sell Valence to Noblehigh. See Note 12.

Additionally, on February 23, 2006, the Board authorized management to take all reasonable steps to divest the Company’s entire equity interest in the Joint Venture. On June 30, 2006, the Company completed the sale of its interest in the Joint Venture to Coming Home Studios, LLC (“CHS”) in exchange for $200,000, the rights to all cash assets of the joint venture, and a promissory note in the amount of $175,000. As of the close of business on June 30, 2006, SRS had received $150,000 from CHS and had transferred the cash assets of the joint venture to SRS. The remaining $50,000 was received from CHS on July 5, 2006. The Company has recorded a gain on disposal of its interest in the LLC of $371,295 in the accompanying condensed consolidated statement of operations for the three month period ended June 30, 2006. Any amounts related to the promissory note will be recorded at the time the cash is received by SRS.

Income from discontinued operations consists of direct revenues and direct expenses of Valence and CHS/SRS LLC. General corporate overhead costs have not been allocated to discontinued operations. A summary of the operating results of Valence and the Joint Venture included in discontinued operations in the accompanying condensed consolidated statements of operation is as follows:

	For the three months ended June 30,					For the six months ended June 30,
	2006			2005		2006		2005
Semiconductors:
Revenues.	$	2,228,826		$	2,521,174	$	4,370,534	$	4,505,737
Cost of sales	1,001,262			999,166		2,069,746		1,727,406
Gross margin	1,227,564			1,522,008		2,300,788		2,778,331
Total operating expenses	1,081,015			1,462,636		2,210,163		2,774,808
Income from operations	146,549			59,372		90,625		3,523
Other income, net	3,678			5,952		7,863		4,614
Income before income tax (benefit) expense	150,227			65,324		98,488		8,137
Income tax (benefit) expense	(385		)	563		30,696		5,741
Net income from semiconductors	150,612			64,761		67,792		2,396
Net income from CHS/SRS LLC	1,649			13,764		95,764		91,096
Gain on Sale of CHS/SRS LLC	371,295			—		371,295		—
Total income from discontinued operations	$	523,556		$	78,525	$	534,851	$	93,492

A summary of the assets and liabilities related to the discontinued operations of Valence and the Joint Venture classified as held for sale in the accompanying condensed consolidated balance sheet is as follows:

	June 30, 2006		December 31, 2005
	(unaudited)
Current assets held for sale:
Accounts receivable, net	$	950,081	$	902,771
Inventories, net	1,032,771		534,226
Prepaid expenses and other current assets	281,995		422,130
Total	2,264,847		1,859,127

Long term assets held for sale:
Furniture, fixtures and equipment, net	1,143,439		1,060,631
Goodwill	533,031		533,031
Intangibles, net	437,143		471,461
Total	2,113,613		2,065,123

Liabilities related to assets held for sale:
Accounts payable	858,256		855,559
Accrued liabilities	842,450		1,315,142
Total	1,700,706		2,170,701

10. Segment Information

The Company previously operated in two business segments — semiconductors and licensing. However, as a result of the Board’s decision on February 23, 2006 to sell the semiconductor business, the Company now has continuing operations in only one business segment, licensing. Our revenue from continuing operations is solely derived from licensing related revenue.

For the three and six months ending June 30, 2006, there was no significant customer in the licensing segment. For the same period in the prior year, two customers accounted for approximately 10% each in the licensing segment. The following schedule presents the Company’s revenue from continuing operations by geographic area. Licensing-related revenue is allocated based on the location of the licensee’s corporate headquarters. The Americas region includes North, Central and South America.

	Three Months Ended June 30,						Six Months Ended June 30,
	2006		%	2005		%	2006		%	2005		%
Geographic Area Revenue:

Japan	$	1,883,315	44	$	1,446,553	41	$	3,911,095	45	$	2,967,042	44
Korea	1,208,108		28	962,787		27	2,384,609		28	1,654,821		24
Americas	336,081		8	427,239		12	806,520		9	1,099,039		16
China	806,806		19	611,566		17	1,425,828		17	950,923		14
Europe	25,529		1	91,832		3	67,455		1	132,247		2
Total	$	4,259,839	100	$	3,539,977	100	$	8,595,507	100	$	6,804,072	100

11. Recent Accounting Pronouncements

In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. (FIN) 48, Accounting for Uncertainty in Income Taxes. FIN 48 is an interpretation of FASB Statement No. 109, “Accounting for Income Taxes,” and it seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. In addition, FIN 48 requires expanded disclosure with respect to the uncertainty in income taxes and is effective as of the beginning of our 2007 fiscal year. We are currently evaluating the impact, if any, that FIN 48 will have on our consolidated financial statements.

12. Subsequent Events

On July 14, 2006, the Company entered into a definitive Sale and Purchase Agreement (“Purchase Agreement”) to sell Valence to Noblehigh Enterprises Inc. (“Noblehigh”). Noblehigh is owned by Willas Array Electronics (Holding) Limited (“Willas-Array”) as well as certain members of management of Valence (collectively referred to herein as the “Management Buyers”).

The sale to Noblehigh will be effected through two simultaneous transactions: (1) the repurchase by Valence of approximately 74% of the outstanding shares of Valence from SRS and (2) the purchase by Noblehigh of the remaining outstanding shares of Valence from SRS for $4.3 million. Valence will repurchase shares from SRS using its existing cash, cash equivalents and other current assets, all of which are reflected on SRS’s balance sheet. The purchase price is subject to adjustment dependent upon Valence’s net current assets as of June 30, 2006 subject to review by the parties’ auditors. The Company expects to recognize a gain from the sale of Valence.

In connection with the sale of Valence to Noblehigh, the majority of management personnel of Valence will execute Waiver of Change of Control agreements to confirm that they are not entitled to any payments or other benefits as a result of the sale of Valence. Also, subject to the sale of Valence, SRS will repurchase from Management Buyers up to 550,000 shares of SRS common stock, which such individuals may obtain through the exercise of vested employee stock options. The repurchase price payable for such shares shall be equal to the average closing price of SRS common stock for the 10 trading days prior to the closing date of the sale of Valence. The repurchase of any shares from the Management Buyers will occur concurrently with the closing of the sale of Valence.

The Purchase Agreement contains customary representations, covenants, warranties indemnification and termination provisions. The closing of the sale of Valence is subject to a number of conditions, including the approval of the transaction by the shareholders of Willas-Array.

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

This information should be read in conjunction with the audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, or the Form 10-K, the audited consolidated financial statements and the notes thereto included in the Form 10-K and the unaudited condensed interim consolidated financial statements and notes thereto included in this Quarterly Report.

Overview

SRS Labs is a leading developer and provider of audio and voice technology solutions for the home entertainment, portable media device, personal telecommunications, personal computer, automotive, and broadcast markets, and a developer and provider of application specific integrated circuits, or ASICs, and standard integrated circuits, or ICs.

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

Licensing: Through SRS Labs, the parent company, and its wholly-owned subsidiary, SRSWOWcast.com, Inc., doing business as SRSWOWcast Technologies, or SRSWOWcast, we develop and license audio, voice and surround sound technology solutions to many of the world’s leading OEMs, software providers and semiconductor companies, and license and market hardware and software products for the Internet and professional audio markets.

Discontinued Operations:

Semiconductors: Through SRS Labs, Inc.’s wholly-owned subsidiary, ValenceTech Limited, and ValenceTech Limited’s wholly-owned subsidiaries (collectively “Valence”), we operate a fabless semiconductor business which develops, designs and markets standard and custom analog ICs, digital signal processors, and mixed signal integrated circuits primarily to original equipment manufacturers and original design manufacturers, in the Asia Pacific region. On February 23, 2006, the Board approved a plan to sell Valence in order to focus increased management attention and financial resources on its licensing business. On July 14, 2006, the Company entered into a definitive Sale and Purchase Agreement to sell Valence to Noblehigh Enterprises Inc. As a result of our decision to sell Valence, we have accounted for the semiconductor business segment as discontinued operations in the accompanying condensed consolidated financial statements.

CHS/SRS LLC: In September 2004, we entered into a strategic alliance with Coming Home Studios LLC, or CHS, to use and promote SRS Labs technologies, promote CHS productions and to promote each company’s respective brands. In connection with the strategic alliance, the Company and CHS established a joint venture, CHS/SRS, LLC, or the Joint Venture, to produce and distribute six concert videos featuring our Circle Surround technology, or the Concert Videos. Initially, Coming Home Studios LLC was the manager of the CHS/SRS Joint Venture; however, the Company became manager of the Joint Venture in July, 2005. As a result of becoming the manager of, and providing financial support to the Joint Venture, the Company was required under FASB Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46R), to consolidate the financial statements of the Joint Venture into our financial statements commencing with the third quarter of fiscal 2005. Previously, we accounted for our 50% equity ownership in the Joint Venture as an investment using the equity method.

In February 2006, our Board of Directors, or the Board, authorized management to take all reasonable steps to divest our entire equity interest in the Joint Venture. As a result of our decision to sell our entire equity interest in the Joint Venture, we have accounted for the Joint Venture as a discontinued operation in the accompanying condensed consolidated financial statements. On June 30, 2006, the Company completed the sale of its interest in the Joint Venture to Coming Home Studios, LLC (“CHS”) in exchange for $200,000, the rights to all cash assets of the joint venture, and a promissory note in the amount of $175,000. As of the close of business on June 30, 2006, SRS had received $150,000 from CHS and had transferred the cash assets of the joint venture to SRS. The remaining $50,000 was received from CHS on July 5, 2006. The Company has recorded a gain on disposal of its interest in the LLC of approximately $370,000. Any amounts related to the promissory note will be recorded as a gain at the time the cash is received by SRS.

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

Critical Accounting Policies

Our discussion and analysis of our results of operations and liquidity and capital resources are based on our consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States of America.

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

Stock Based Compensation

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

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

The following table illustrates the effect on net income and income per share if we had applied the fair value recognition provisions of SFAS 123 to options granted under our stock option plans in the first fiscal quarter of 2005. For purposes of this pro forma disclosure, the fair value of the options is estimated using a BSM option-pricing formula and amortized on a straight-line basis to expense over the options’ vesting period:

	Three Months Ended			Six Months Ended
	June 30,			June 30,
	2005			2005

Net income - as reported	$	513,734		$	735,194
Add: Share-based employee compensation expense included in net income, net of related tax effects - as reported	5,843			14,742
Deduct: Share-based employee compensation expense determined under fair value method, net of related tax effects - pro forma	(275,174		)	(580,277		)
Net income - pro forma	$	244,403		$	169,659
Basic - as reported	$	0.04		$	0.05
Basic - pro forma	$	0.02		$	0.01
Diluted - as reported	$	0.03		$	0.05
Diluted - pro forma	$	0.02		$	0.01

Results of Continuing Operations

Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005

Revenues

Licensing revenues consist primarily of royalties generated from the license of SRS Labs’ audio and voice technologies. License and royalty agreements generally provide for the license of technologies for a fee based on the number of units distributed by the licensee. However, we have in the past and may again in the future, enter into a license agreement for a one-time fee. Also included in licensing revenue are revenues generated from the sale of hardware and software applications into the broadcast audio markets.

Licensing revenues were $4,259,839 for the three months ended June 30, 2006, compared to $3,539,977 for the three months ended June 30, 2005, an increase of $719,862 or 20.3%. The sales growth in licensing was primarily attributable to continued strong sales in the Home Entertainment and Automotive segments. Within the Home Entertainment segment, revenue growth is due to increased licensing fees related to flat panel monitors and televisions. The following table presents the Company’s licensing revenues mix by market segment:

	Three Months Ended June 30,
	2006		2005
Home Entertainment (TV, Set Top Box, A/V Receiver, DVD)	53	%	47	%
Portable Media Devices (Digital Media Player, Headphone)	19	%	24	%
Personal Telecommunications (Mobile phone, PDA)	11	%	16	%
PC (Software, Hardware)	10	%	9	%
Automotive	7	%	4	%

Sales and Marketing

Sales and marketing expenses consist primarily of employee salaries, sales consultants’ fees and related expenses, sales commissions and product promotion costs. Sales and marketing expenses were $1,885,416 for the three months ended June 30, 2006, compared to $1,026,477 for the same prior year period, an increase of $858,939 or 83.7%. This increase is primarily attributable to increased sales headcount in overseas markets and related expenses, increased commissions on higher revenues, and increased marketing expenses, including headcount in the United States, related to efforts to enhance the Company’s brand. In addition, the increase is attributable to $136,459 in stock option expense that was recognized due to the adoption of FAS 123R in the current fiscal year. As a percentage of total revenues, sales and marketing expenses increased from 29.0% for the quarter ended June 30, 2005 to 44.3% for the same period this year.

Research and Development

Research and development expenses consist of salaries and related costs of employees engaged in ongoing research, design and development activities and costs for engineering materials and supplies. Research and development expenses were $631,739 for the three months ended June 30, 2006, compared to $547,787 for the same prior year period, an increase of $83,952 or 15.3%. This increase is primarily attributable to $75,174 in stock option expense that was recognized due to the adoption of FAS 123R in the current fiscal year. As a percentage of total revenues, research and development expenses were 15.5% for the quarter ended June 30, 2005, and 14.8% for the same period this year.

General and Administrative

General and administrative (“G&A”) expenses consist primarily of employee-related expenses, legal costs associated with the administration of intellectual property and other professional fees. G&A expenses were $1,357,789 for the three months ended June 30, 2006, compared to $1,427,501 for the same prior year period, a decrease of $69,712 or 4.9%. The decrease is primarily attributable to decreased accounting and legal fees and outside consulting costs. In addition, the decrease was offset by the Company recognizing $132,387 in stock option expense due to the adoption of FAS 123R in the current fiscal year. As a percentage of total revenues, G&A expenses decreased from 40.3% for the quarter ended June 30, 2005, to 31.9% for the same period this year.

Other Income, Net

Other income, net, consists primarily of interest income. Other income, net, was $224,005 for the three months ended June 30, 2006, compared to $160,341 for the same prior year period, an increase of $63,664 or 39.7%. This increase is primarily attributable to higher interest income on larger cash balances invested.

Provision for Income Taxes

The income tax expense for the three months ended June 30, 2006 was $167,745, compared to tax expense of $168,506 for the same prior year period. This provision consists primarily of taxes paid on licensing revenues sourced from countries requiring foreign tax withholdings, principally Korea.

Discontinued Operations

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

	For the three months ended June 30,
	2006			2005
Semiconductors:
Revenues	$	2,228,826		$	2,521,174
Cost of sales	1,001,262			999,166
Gross margin	1,227,564			1,522,008
Total operating expenses	1,081,015			1,462,636
Income from operations	146,549			59,372
Other income, net	3,678			5,952
Income before income tax (benefit) expense	150,227			65,324
Income tax (benefit) expense	(385		)	563
Net income from semiconductors	150,612			64,761
Net income from CHS/SRS LLC	1,649			13,764
Gain on Sale of CHS/SRS LLC	371,295			—
Total income from discontinued operations	$	523,556		$	78,525

Semiconductor revenues were $2,228,826 in the three months ended June 30, 2006 compared to $2,521,174 in the three months ended June 30, 2005, a decrease of $292,348 or 11.6%. ASP revenues increased $141,925 due to the introduction of several new ASP chips. The increase in ASP revenues was offset by a decrease in ASIC revenues of $434,273, due to a decline in ASIC product demand. Gross margin decreased from 60% to 55% in the quarters ended June 30, 2005 and 2006, respectively, due to an increase in lower margin ASP sales. Operating expenses decreased $381,621 primarily due to decreased head count and related expenses. Other income (expense), net and income tax expense were comparable with the prior period. Net income from CHS/SRS LLC was comparable to the prior period. The Company recognized a gain on the sale of its interest in CHS/SRS LLC of $371,295 on June 30, 2006.

Six Months Ended June 30, 2006 Compared to Six Months Ended June 30, 2005

Revenues

Licensing revenues were $8,595,507 for the six months ended June 30, 2006, compared to $6,804,072 for the six months ended June 30, 2005, an increase of $1,791,435 or 26.3%. The sales growth in licensing was attributable to our continued strong sales in all five of our market segments with four of the five segments achieving year over year growth. The Home Entertainment segment continues to grow in total revenues due to increases in Advanced Display revenues, partially offset by a decrease in Set Top Box and CRT revenues. The following table presents the Company’s licensing revenues mix by market segment:

	Six Months Ended June 30,
	2006		2005
Home Entertainment (TV, Set Top Box, A/V Receiver, DVD)	54	%	55	%
Portable Media Devices (Digital Media Player, Headphone)	20	%	19	%
Personal Telecommunications (Mobile phone, PDA)	11	%	13	%
PC (Software, Hardware)	9	%	10	%
Automotive	6	%	3	%

Sales and Marketing

Sales and marketing expenses consist primarily of employee salaries, sales consultants’ fees and related expenses, sales commissions and product promotion costs. Sales and marketing expenses were $3,750,785 for the six months ended June 30, 2006, compared to $2,208,924 for the same prior year period, an increase of $1,541,861 or 69.8%. This increase is primarily attributable to increased headcount and related expenses, increased commissions on higher revenues, and increased marketing activities related to efforts to enhance the Company’s brand. In addition, the increase is primarily attributable to $298,512 in stock option expense that was recognized due to the adoption of FAS 123R in the current fiscal year. As a percentage of total revenues, sales and marketing expenses increased from 32.5% for the six months ended June 30, 2005 to 43.6% for the same period this year.

Research and Development

Research and development expenses consist of salaries and related costs of employees engaged in ongoing research, design and development activities and costs for engineering materials and supplies. Research and development expenses were $1,286,028 for the six months ended June 30, 2006, compared to $1,123,992 for the same prior year period, an increase of $162,036 or 14.4%. This increase is primarily attributable to $202,161 in stock option expense that was recognized due to the adoption of FAS 123R in the current fiscal year, offset by decreased head count and related expenses. As a percentage of total revenues, research and development expenses were 16.5% for the six months ended June 30, 2005, and 15.0% for the same period this year.

General and Administrative

General and administrative (“G&A”) expenses consist primarily of employee-related expenses, legal costs associated with the administration of intellectual property and other professional fees. G&A expenses were $2,994,997 for the six months ended June 30, 2006, compared to $2,700,352 for the same prior year period, an increase of $294,645 or 10.9%. This increase is primarily attributable to increased professional fees, costs associated with the Company’s separation from its former Chief Financial Officer and consulting agreements related to human resources activities. In addition, the increase is attributable to $186,727 in stock option expense that was recognized due to the adoption of FAS 123R in the current fiscal year. As a percentage of total revenues, G&A expenses decreased from 39.7% for the six months ended June 30, 2005, to 34.8% for the same period this year.

Other Income, Net

Other income, net, consists primarily of interest income. Other income, net, was $403,718 for the six months ended June 30, 2006, compared to $309,611 for the same prior year period, an increase of $94,107 or 30.4%. This increase is primarily attributable to higher interest income on larger cash balances invested.

Provision for Income Taxes

The income tax expense for the six months ended June 30, 2006 was $327,168, compared to tax expense of $287,530 for the same prior year period, an increase of $39,638 or 13.8%. This provision consists primarily of taxes paid on licensing revenues sourced from countries requiring foreign tax withholdings, principally Korea.

Discontinued Operations

	For the six months ended June 30,
	2006		2005
Semiconductors:
Revenues.	$	4,370,534	$	4,505,737
Cost of sales	2,069,746		1,727,406
Gross margin	2,300,788		2,778,331
Total operating expenses	2,210,163		2,774,808
Income from operations	90,625		3,523
Other income, net	7,863		4,614
Income before income tax (benefit) expense	98,488		8,137
Income tax (benefit) expense	30,696		5,741
Net income from semiconductors	67,792		2,396
Net income from CHS/SRS LLC	95,764		91,096
Gain on Sale of CHS/SRS LLC	371,295		—
Total income from discontinued operations	$	534,851	$	93,492

Semiconductor revenues were $4,370,534 for the six months ended June 30, 2006 compared to $4,505,737 for the six months ended June 30, 2005, a decrease of $135,203 or 3%. ASP revenues increased $654,740 due to the introduction of several new ASP chips. The increase in ASP revenues was offset by a decrease in ASIC revenues of $789,943, due to a decline in ASIC product demand. Gross margin decreased from 62% to 53% in the quarters ended June 30, 2005 and 2006, respectively, due to an increase in lower margin ASP sales. Operating expenses decreased $564,645 or 20% primarily due to decreased head count and related expenses. Other income, net and income tax expense were materially consistent with the prior period. Net income from CHS/SRS LLC was comparable to the prior period. The Company recognized a gain on the sale of its interest in CHS/SRS LLC of $371,295 on June 30, 2006.

Liquidity and Capital Resources

The Company’s principal source of liquidity to fund ongoing operations at June 30, 2006 consisted of cash, cash equivalents and long-term investments of $29,140,155. At June 30, 2006, the Company had cash and cash equivalents and short term investments of $24,040,566 and long-term investments of $5,099,589. Cash and cash equivalents generally consist of cash, money market funds and other money market instruments with original maturities of three months or less. Investments consist of U.S. government securities rated AAA.

Net cash provided by operating activities from continuing operations was $1,900,029 and $2,548,212 during the six months ended June 30, 2006 and June 30, 2005, respectively. The decrease in our operating cash flows is primarily the result of our deferred revenue decreasing $427,382 and $128,702 in the six months ended June 30, 2006 and June 30, 2005, respectively, due to recognition of revenue on prepaid royalties. Accrued liabilities increased $51,058 and $1,149,403 during the six months ended June 30, 2006 and 2005, respectively. The changes in liability accounts generally relate to increases in professional fees, commissions and bonus and the timing of payments to vendors and employees. Accounts receivable decreased $440,715 and $287,557 during the six months ended June 30, 2006 and 2005, respectively, due to timing of billing and cash receipts, which partially offset the decreases in operating cash flows.

PART II - OTHER INFORMATION

Item 6. Exhibits

The exhibits listed below are hereby filed with the U.S. Securities and Exchange Commission (the “SEC”) as part of this Report.

Exhibit Number		Description
3.1		Certificate of Incorporation of the Company, previously filed with the SEC as Exhibit 3.1 to the Company’s Registration Statement on Form SB-2, specifically included in Amendment No. 1 to such Registration Statement filed with the SEC on July 3, 1996 (File No. 333-4974-LA), which is incorporated herein by reference.
3.2		Bylaws of the Company, previously filed with the SEC as Exhibit 3.1 to the Company’s Quarterly Report on Form 10-Q for the period ended September 30, 1999, filed with the SEC on November 12, 1999, which is incorporated herein by reference.
10.1		Termination Agreement dated June 30, 2006 between SRS Labs, Inc. and Coming Home Studios, LLC, previously filed as Exhibit 10.1 to the Company’s Form 8-K filed with the Securities and Exchange Commission on July 7, 2006, which is incorporated herein by reference.
10.2		Promissory Note dated June 30, 2006 between SRS Labs, Inc. and Coming Home Studios, LLC. previously filed as Exhibit 10.2 to the Company’s Form 8-K filed with the Securities and Exchange Commission on July 7, 2006, which is incorporated herein by reference.
10.3		Security Agreement dated June 30, 2006 between SRS Labs, Inc. and Coming Home Studios, LLC, previously filed as Exhibit 10.3 to the Company’s Form 8-K filed with the Securities and Exchange Commission on July 7, 2006, which is incorporated herein by reference.
10.4		Assignment dated June 30, 2006 between SRS Labs, Inc. and Coming Home Studios, LLC, previously filed as Exhibit 10.4 to the Company’s Form 8-K filed with the Securities and Exchange Commission on July 7, 2006, which is incorporated herein by reference.
10.5		First Amendment to the Strategic Alliance Agreement dated June 30, 2006 between SRS Labs, Inc. and Coming Home Studios, LLC, previously filed as Exhibit 10.5 to the Company’s Form 8-K filed with the Securities and Exchange Commission on July 7, 2006, which is incorporated herein by reference.
10.6		SRS Labs, Inc. 2006 Stock Incentive Plan, previously filed as Exhibit 10.1 to the Company’s Form 8-K filed with the Securities and Exchange Commission on June 28, 2006, which is incorporated herein by reference.
10.7		SRS Labs, Inc. Patent Reward Program, previously filed as Exhibit 10.2 to the Company’s Form 8-K filed with the Securities and Exchange Commission on June 28, 2006, which is incorporated herein by reference.
10.8		SRS Labs, Inc. 2006 Profit Sharing and Bonus Plan, previously filed as Exhibit 99.1 to the Company’s Form 8-K filed with the Securities and Exchange Commission on April 18, 2006, which is incorporated herein by reference.
31.1		Certification of Chief Executive Officer of SRS Labs, Inc., pursuant to Rule 13a-14 of the Securities Exchange Act.
31.2		Certification of Chief Financial Officer of SRS Labs, Inc., pursuant to Rule 13a-14 of the Securities Exchange Act.
32.1		Certification of Chief Executive Officer of SRS Labs, Inc., pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Certification of Chief Financial Officer of SRS Labs, Inc., pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(Mark One)
ý		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2006

OR

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period to

Commission File Number 0-21123

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

PART I-FINANCIAL INFORMATION
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets as of June 30, 2006 (Unaudited) and December 31, 2005
	Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2006 and 2005 (Unaudited)
	Condensed Consolidated Statements of Stockholders’ Equity and Comprehensive Income for the three and six months ended June 30, 2006 (Unaudited)
	Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2006 and 2005 (Unaudited)
	Notes to the Condensed Consolidated Financial Statements (Unaudited)
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
PART II-OTHER INFORMATION
Item 6.	Exhibits

SIGNATURES

	SRS LABS, INC., a Delaware corporation

Date: August 8, 2006	By:	/S/ THOMAS C.K. YUEN
		Thomas C.K. Yuen
		Chairman of the Board and Chief Executive Officer
		(Principal Executive Officer)


Date: August 8, 2006	By:	/S/ ULRICH GOTTSCHLING
		Ulrich Gottschling
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

Commission File Number 0-21123

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME (Unaudited)

Critical Accounting Policies

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND
COMPREHENSIVE INCOME (Unaudited)