UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

[X]	Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended September 30, 2009, or

[ ]	Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from ______________ to _____________.

Commission File No. 0-23862

Fonix Corporation

(Exact name of registrant as specified in its charter)

Delaware	22-2994719
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

387 South 520 West, Suite 110

Lindon, Utah 84042

(Address of principal executive offices with zip code)

(801) 553-6600

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes [X] No[ ].

Indicate by check mark whether the registrant has submitted electronically and posted on its Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ___ No ___

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company. (Check one):

Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [ ] Smaller reporting company [X]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-25 of the Exchange Act). Yes __ No X

As of November 12, 2009, there were issued and outstanding 64,815,229 shares of our Class A common stock.

FONIX CORPORATION

FORM 10-Q

TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION

		Page
Item 1.	Financial Statements (Unaudited)

	Condensed Consolidated Balance Sheets – As of September 30, 2009, and December 31, 2008	3

	Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the
	Three and Nine Months Ended September 30, 2009 and 2008	4

	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended
	September 30, 2009 and 2008	5

	Notes to Condensed Consolidated Financial Statements (Unaudited)	8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	22

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	35

Item 4.	Controls and Procedures	35


PART II - OTHER INFORMATION

Item 1.	Legal Proceedings	37

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	37

Item 3.	Defaults Upon Senior Securities	37

Item 4.	Submission of Matters to a Vote of Security Holders	37

Item 5.	Other Information	37

Item 6.	Exhibits	38

Fonix Corporation and Subsidiaries

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)



	September 30,			December 31,
	2009			2008

ASSETS

Current assets
Cash and cash equivalents	$	1,011,000		$	2,000
Accounts receivable, net of allowance of doubtful accounts of $4,000 and $0, respectively		2,000,000			-
Bills receivable		396,000			-

Total current assets		3,407,000			2,000

Property and equipment, net of accumulated depreciation of $1,314,000 and $1,303,000, respectively		56,000			26,000

Goodwill		658,000			-

Deposits and other assets		12,000			12,000

Total assets	$	4,133,000		$	40,000

LIABILITIES AND STOCKHOLDERS' DEFICIT

Current liabilities
Accrued liabilities	$	8,942,000		$	6,510,000
Accounts payable		2,215,000			1,715,000
Related party accounts payable		107,000			86,000
Tax payable		29,000			-
Derivative liability		36,460,000			34,582,000
Accrued payroll and other compensation		902,000			211,000
Deferred revenues		465,000			445,000
Notes payable - related parties		777,000			917,000
Deferred tax liabilities, net		228,000			-
Deposits and other		7,000			7,000

Total current liabilities		50,132,000			44,473,000

Total liabilities		50,132,000			44,473,000

Commitments and contingencies

Stockholders' deficit
Preferred stock, $0.0001 par value; 50,000,000 shares authorized;
Series A, convertible; 166,667 shares outstanding (aggregate liquidation preference of $6,055,000)		500,000			500,000
Series L, convertible; 1,467 shares and 1,498 shares outstanding , respectively		-			-
Common stock, $0.0001 par value; 20,000,000,000 shares authorized;
Class A voting, 45,706,715 shares and 3,447,501 shares outstanding, respectively		5,000			1,000
Class B non-voting, none outstanding		-			-
Additional paid-in capital		241,958,000			240,949,000
Outstanding warrants to purchase Class A common stock		474,000			474,000
Cumulative foreign currency translation adjustment		(97,000	)		10,000
Accumulated deficit		(288,839,000	)		(286,367,000	)

Total stockholders' deficit		(45,999,000	)		(44,433,000	)

Total liabilities and stockholders' deficit	$	4,133,000		$	40,000

See accompanying notes to condensed consolidated financial statements.

Fonix Corporation and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2009			2008			2009			2008


Revenues
Operating revenues	$	335,000		$	223,000		$	1,301,000		$	1,069,000

Total Revenue		335,000			223,000			1,301,000			1,069,000

Cost of revenues
Cost of goods sold		65,000			3,000			313,000			53,000
Main operating taxes and surcharges		8,000			-			17,000			-

Total cost of revenues		73,000			3,000			330,000			53,000

Gross profit		262,000			220,000			971,000			1,016,000

Operating expenses:
Selling, general and administrative		597,000			343,000			1,704,000			1,431,000
Product development and research		155,000			300,000			620,000			992,000

Total operating expenses		752,000			643,000			2,324,000			2,423,000

Other income (expense):
Other income		235,000			-			235,000			-
Interest income		57,000			-			97,000			-
Interest expense		(28,000	)		(1,686,000	)		(76,000	)		(2,723,000	)
Gain on forgiveness of liabilities		56,000			-			56,000			-
Gain (loss) on derivative liability		431,000			408,000			1,022,000			95,000

Other income (expense), net		751,000			(1,278,000	)		1,334,000			(2,628,000	)

Income (loss) from continuing operations		261,000			(1,701,000	)		(19,000	)		(4,035,000	)

Provision for foreign income taxes		(31,000	)		-			(31,000	)		-

Net income (loss)		230,000			(1,701,000	)		(50,000	)		(4,035,000	)
Preferred stock dividends		(536,000	)		(466,000	)		(2,416,000	)		(1,491,000	)

Income (loss) attributable to common stockholders	$	(306,000	)	$	(2,167,000	)	$	(2,466,000	)	$	(5,526,000	)

Basic and diluted loss per common share from continuing operations	$	(0.01	)	$	(0.85	)	$	(0.16	)	$	(3.44	)

Net income (loss)		230,000			(1,701,000	)		(50,000	)		(4,035,000	)
Other comprehensive income - foreign currency translation	$	(7,000	)	$	-		$	(107,000	)	$	-
Comprehensive income (loss)	$	223,000		$	(1,701,000	)	$	(157,000	)	$	(4,035,000	)

See accompanying notes to condensed consolidated financial statements.

Fonix Corporation and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

Nine Months Ended September 30,	2009			2008
Cash flows from operating activities
Net loss	$	(50,000	)	$	(4,035,000	)
Adjustments to reconcile net loss to net cash used in operating activities:
Gain on derivative liability		(1,022,000	)		(95,000	)
Gain on forgiveness of liabilities		(56,000	)		-
Accretion of discount on notes payable		-			2,124,000
Deferred income taxes		(9,000	)		-
Issuance of shares for employee grants		-			709,000
Depreciation		11,000			8,000
Foreign exchange gain		(107,000	)		-
Changes in assets and liabilities
Accounts receivable		615,000			-
Bills receivable		(396,000	)		-
Prepaid expenses and other current assets		-			134,000
Inventory		2,000			-
Other assets		-			96,000
Accounts payable		189,000			242,000
Related party accounts payable		21,000			32,000
Tax payable		(4,000	)		-
Accrued payroll and other compensation		747,000			-
Deferred revenues		20,000			-
Other accrued liabilities		124,000			576,000

Net cash provided (used) in operating activities		85,000			(209,000	)

Cash flows from investing activities
Purchase of property and equipment		-			(20,000	)
Net cash acquired in acquistion		796,000			-

Net cash used in investing activities		796,000			(20,000	)

Cash flows from financing activities
Proceeds from related party note payable		50,000			59,000
Proceeds from issuance of Series O Preferred Stock		-			609,000
Proceeds from issuance of Series P Preferred Stock		78,000			-
Payments on accrued settlement obligation		-			(455,000	)

Net cash provided by financing activities		128,000			213,000

Net increase in cash and cash equivalents		1,009,000			(16,000	)

Cash and cash equivalents at beginning of period		2,000			26,000

Cash and cash equivalents at end of period	$	1,011,000		$	10,000

See accompanying notes to condensed consolidated financial statements.

Fonix Corporation and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(Unaudited)

Supplemental schedule of noncash investing and financing activities

For the Nine Months Ended September 30, 2009:

Issued 351 shares of Series P Preferred stock for the acquisition of G-Soft Limited.

Issued 320,702 shares of Class A common stock for unpaid legal fees.

Issued 6,950,000 shares of Class A common stock for consulting services.

Issued 6,088,466 shares of Class A common stock upon conversion of 10 shares of Series P Convertible Preferred Stock.

Issued 22,323,333 shares of Class A common stock upon conversion of 31 shares of Series L Convertible Preferred Stock including accrued interest converted of $71,000.

Issued 6,095,331 shares of Class A common stock upon conversion of $197,000 in notes payable.

Issued 480,969 shares of Class A common stock upon conversion of $15,000 in accrued interest on notes payable.

Accrued $1,007,000 of dividends on Series L Preferred Stock.

Accrued $102,000 of dividends on Series M Preferred Stock.

Accrued $120,000 of dividends on Series N Preferred Stock.

Accrued $50,000 of dividends on Series O Preferred Stock.

Accrued $1,052,000 of dividends on Series P Preferred Stock.

Accrued $85,000 of dividends on Fonix Speech Series B Preferred Stock.

The Company acquired the following balance sheet items as a result of the acquisition of G-Soft Limited:

Cash - $796,000

Accounts receivable - $2,600,000

Other receivables - $15,000

Inventory - $2,000

Property, plant and equipment - $41,000

Goodwill - $658,000

Accounts payable - $319,000

Accrued liabilities - $13,000

Taxes payable - $33,000

Deferred tax liabilities, assumed - $237,000

See accompanying notes to condensed consolidated financial statements.

Fonix Corporation and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(Unaudited)

For the Nine Months Ended September 30, 2008:

Issued 645,696 shares of Class A common stock upon conversion of 34 shares of Series L Convertible Preferred Stock.

Issued 896,788 shares of Class A common stock for employee stock grants.

Issued 124,941 shares of Class A common stock for unpaid legal fees.

Issued 145,225 shares of Class A common stock for consulting services.

Issued 267,949 shares of Class A common stock upon conversion of $162,000 in accrued interest.

Issued 41,985 shares of Class A common stock upon conversion of $21,000 in notes payable – related parties.

Accrued $1,040,000 of dividends on Series L Preferred Stock.

Accrued $103,000 of dividends on Series M Preferred Stock.

Accrued $105,000 of dividends on Series N Preferred Stock.

Accrued $23,000 of dividends on Series O Preferred Stock.

Accrued $86,000 of dividends on Fonix Speech Series B Preferred Stock.

See accompanying notes to condensed consolidated financial statements.

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation – The accompanying unaudited condensed consolidated financial statements of Fonix Corporation and subsidiaries (collectively, the “Company” or “Fonix”) have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the following disclosures are adequate to make the information presented not misleading. The Company suggests that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s 2008 Annual Report on Form 10-K.

These condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary to present fairly the financial position and results of operations of the Company for the periods presented. The Company’s business strategy is not without risk, and readers of these condensed consolidated financial statements should carefully consider the risks set forth under the heading “Certain Significant Risk Factors” in the Company’s 2008 Annual Report on Form 10-K.

On July 1, 2009, the Company adopted the FASB Accounting Standards Codification (“ASC”). The ASC does not alter current U.S. GAAP, but rather integrated existing accounting standards with other authoritative guidance. The ASC provides a single source of authoritative U.S. GAAP for nongovernmental entities and supersedes all other previously issued non-SEC accounting and reporting guidance. The adoption of the ASC did not have any effect on the results of operations or financial position of the company. All prior references to U.S. GAAP have been revised to conform to the ASC. Updates to the ASC are issued in the form of Accounting Standards Updates (“ASU”).

Operating results for the nine months ended September 30, 2009, are not necessarily indicative of the results that may be expected for the year ending December 31, 2009.

Nature of Operations – Fonix Corporation (the “Company,” or “Fonix,”) was incorporated in Delaware in 1985, and, pursuant to a merger transaction in 1994, the Company’s name was changed to Fonix Corporation. The Company’s operations are managed through two wholly owned subsidiaries, Fonix Speech, Inc. (“Fonix Speech”) and Fonix GS Acquisition Co., Inc. (“Fonix GS”).

Fonix Speech

Fonix Speech provides value-added speech-enabling technologies, speech interface development tools, and speech solutions and applications, including automated speech recognition (“ASR”) and text-to-speech (“TTS,” together with ASR, the “Core Technologies”) that empower users to interact conversationally with information systems and devices. Fonix Speech offers speech-enabling technologies to markets for personal software for consumer applications including video games, e.Dictionaries and mobile navigation devices with GPS, wireless and mobile devices, computer telephony, and server solutions. Fonix Speech’s products enhance user productivity, ease of use and efficiency in a broad range of market segments, including mobile and wireless devices; videogame consoles; electronic devices for the assistive and language learning markets, robots, appliances; automotive telematics, computer telephony and server applications.

Fonix Speech has received various patents for certain elements of the Core Technologies and has filed applications for patents covering other aspects of the Core Technologies. Fonix Speech seeks to develop relationships and strategic alliances with third-party developers and vendors in telecommunications, computers, electronic devices and related industries, including producers of application software, operating systems, computers and microprocessor chips. Revenues are generated through licensing of speech-enabling technologies, unit royalties, maintenance contracts and services.

Prior to 2002, Fonix Speech focused on research and development (“R&D”) projects for customized applications. R&D and prototype development used the Core Technologies to develop applications and engines marketed for multiple operating systems and hardware platforms. Today, Fonix Speech serves markets that are adopting speech-enabled interfaces, solutions and applications. As memory requirements, noise robustness, speech recognition accuracy and efficiency of speech interface solutions become increasingly critical, Fonix Speech anticipates that its Core Technologies and related solutions will meet customer demand for simple, convenient user interfaces.

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Fonix GS

Fonix GS was formed on June 27, 2008, to facilitate the acquisition of Shanghai Gaozhi Software Systems Limited (“GaozhiSoft”). The acquisition was completed in early 2009. GaozhiSoft is a Chinese software developer and solutions provider in 2G (second-generation) and 3G (third-generation) telecommunication operation support systems in China and throughout the Asian-Pacific region. Gaozhisoft is qualified by the appropriate Chinese governmental entities as a competitor for telecommunication operation support systems. GaozhiSoft’s products are designed to increase data transferring speed, reduce telecommunications data loss, and provide network management, billing accuracy and improved implementation techniques to telecom carriers.

GaozhiSoft’s software products are divided into two main categories: (1) MOSS series and (2) MDtrac series. MOSS products provide service providers with integrated electronic management platforms for peer-to-peer business operation and automatic management. MDtrac products provide data collection solutions. GaozhiSoft has received various copyrights and patents for certain of its products and has filed applications for other copyrights and patents covering other aspects of its products.

Business Condition - For the three months ended September 30, 2009 and 2008, the Company generated revenues of $335,000 and $223,000, respectively, and incurred net income of $230,000 and a net loss of $1,701,000, respectively. For the nine months ended September 30, 2009 and 2008, the Company generated revenues of $1,301,000 and $1,069,000, respectively, incurred net losses attributable to common stockholders of $2,466,000 and $5,526,000, respectively, and had cash flows from operating activities of $85,000 and negative cash flows from operating activities of $209,000, respectively. As of September 30, 2009, the Company had an accumulated deficit of $288,839,000; negative working capital of $46,725,000; derivative liabilities of $36,460,000 related to the issuance of Series P Preferred Stock, Series L Preferred Stock, Series M Preferred Stock, Series N Preferred Stock, Series O Preferred Stock and Series E Convertible Debentures and Series B Preferred Stock of its subsidiary, Fonix Speech; accrued liabilities of $8,942,000; accrued payroll and other compensation of $902,000; accounts payable of $2,215,000; related party accounts payable of $107,000; tax payable of $29,000; deferred tax liabilities of $228,000; related party notes payable of $777,000; and deferred revenues of $465,000. The Company expects to continue to incur significant losses and negative cash flows from operating activities at least through December 31, 2009, primarily due to expenditure requirements associated with continued marketing and development of our speech-enabling technologies.

The Company’s cash resources, limited to collections from customers, sales of our equity and debt securities and loans, have not been sufficient to cover operating expenses. As a result, some payments to vendors and service providers have been delayed.

These factors, as well as the risk factors set out in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008, raise substantial doubt about the Company’s ability to continue as a going concern. The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty. Management plans to fund further operations of the Company from cash flows from future license and royalty arrangements and with proceeds from additional issuance of debt and equity securities. There can be no assurance that management’s plans will be successful.

Net Income/Loss Per Common Share – Basic and diluted net income/loss per common share are calculated by dividing net income/loss attributable to common stockholders by the weighted average number of shares of common stock outstanding during the period. As of September 30, 2009 and 2008, there were outstanding common stock equivalents to purchase or receive 2,282,671,661 and 8,568,133 shares of common stock, respectively. All common stock equivalents at September 30, 2009 and 2008, were excluded in the computation of diluted net income/loss per common share as their effect would have been anti-dilutive, thereby decreasing the net loss per common share.

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

The following table is a reconciliation of the net income/loss numerator of basic and diluted net loss per common share for the three and nine months ended September 30, 2009 and 2008:

	Three Months Ended September 30,
	2009						2008
				Per						Per
				Share						Share
	Amount			Amount			Amount			Amount
Net income (loss)	$	230,000					$	(1,701,000	)
Preferred stock dividends		(536,000	)					(466,000
Loss attributable to common stockholders	$	(306,000	)	$	( 0.01	)	$	(2,167,000	)	$	(0.85	)
Weighted-average common shares outstanding		30,796,779						2,546,643

	Nine Months Ended September 30,
	2009						2008
				Per						Per
				Share						Share
	Amount			Amount			Amount			Amount
Net income (loss)	$	(50,000	)				$	(4,035,000	)
Preferred stock dividends		(2,416,000	)					(1,491,000	)
Loss attributable to common stockholders	$	(2,466,000	)	$	(0.16	)	$	(5,526,000	)	$	(3.44	)
Weighted-average common shares outstanding		15,624,184						1,605,706

Imputed Interest Expense – Interest is imputed on long-term debt obligations where management has determined that the contractual interest rates are below the market rate for instruments with similar risk characteristics.

Comprehensive Loss – Other comprehensive loss as presented in the accompanying condensed consolidated financial statements consists of cumulative foreign currency translation adjustments.

Revenue Recognition – The Company recognizes revenue when pervasive evidence of an arrangement exists; services have been rendered or products have been delivered; the price to the buyer is fixed and determinable; and collectability is reasonably assured. Revenues are recognized by the Company based on the various types of transactions generating the revenue. The Company generates revenues from licensing the rights to its software products to end users and from royalties.

For Fonix Speech, revenue of all types is recognized when acceptance of functionality, rights of return, and price protection are confirmed or can be reasonably estimated, as appropriate. Revenues from development and consulting services are recognized on a completed-contract basis when the services are completed and accepted by the customer. The completed-contract method is used because the Company’s contracts are typically either short-term in duration or the Company is unable to make reasonably dependable estimates of the costs of the contracts. Revenue for hardware units delivered is recognized when delivery is verified and collection assured.

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Revenue for products distributed through wholesale and retail channels and through resellers is recognized upon verification of final sell-through to end users, after consideration of rights of return and price protection. Typically, the right of return on such products has expired when the end user purchases the product from the retail outlet. Once the end user opens the package, it is not returnable unless the medium is defective.

When arrangements to license software products do not require significant production, modification or customization of software, revenue from licenses and royalties are recognized when persuasive evidence of a licensing arrangement exists, delivery of the software has occurred, the fee is fixed or determinable, and collectability is probable. Post-contract obligations, if any, generally consist of one year of support including such services as customer calls, bug fixes, and upgrades. Related revenue is recognized over the period covered by the agreement. Revenues from maintenance and support contracts are also recognized over the term of the related contracts.

Revenues applicable to multiple-element fee arrangements are bifurcated among the elements such as license agreements and support and upgrade obligations using vendor-specific objective evidence of fair value. Such evidence consists primarily of pricing of multiple elements as if sold as separate products or arrangements. These elements vary based upon factors such as the type of license, volume of units licensed, and other related factors.

Deferred revenue as of September 30, 2009, and December 31, 2008, consisted of the following:

Description	Criteria for Recognition		September 30, 2009				December 31, 2008
Deferred unit royalties and license fees	Delivery of units to end users or expiration of contract		$	465,000			$	445,000

Cost of Revenues – Cost of revenues from license, royalties, and maintenance consists of costs to distribute the product, installation and support personnel compensation, amortization and impairment of capitalized speech software costs, licensed technology, and other related costs. Cost of service revenues consists of personnel compensation and other related costs.

Software Technology Development and Production Costs – All costs incurred to establish the technological feasibility of speech software technology to be sold, leased, or otherwise marketed are charged to product development and research expense. Technological feasibility is established when a product design and a working model of the software product have been completed and confirmed by testing. Costs to produce or purchase software technology incurred subsequent to establishing technological feasibility are capitalized. Capitalization of software costs ceases when the product is available for general release to customers. Costs to perform consulting or development services are charged to cost of revenues in the period in which the corresponding revenues are recognized. The cost of maintenance and customer support is charged to expense when related revenue is recognized or when these costs are incurred, whichever occurs first.

Goodwill - The Company tests its recorded goodwill for impairment on an annual basis during the fourth quarter, or more often if indicators of potential impairment exist, by determining if the carrying value of each reporting unit exceeds its estimated fair value. Factors that could trigger impairment include, but are not limited to, underperformance relative to historical or projected future operating results, significant changes in the manner of use of the acquired assets or the Company’s overall business and significant negative industry or economic trends. Future impairment reviews may require write-downs in the Company’s goodwill and could have a material adverse impact on the Company’s operating results for the periods in which such write-downs occur.

Bills Receivable - Bills receivable in China are undertaken by the banks to honor the payments at maturity, and the customers are required to place deposits with the banks equivalent to a certain percentage of the bills amount as collateral. These bills receivable can be sold to any third party at a discount before maturity. The Company does not maintain allowance for bills receivable in the absence of bad debt experience, and the payments are undertaken by the banks. The financial guarantees issued to third parties are located in the PRC.

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Concentration of Credit Risk and Major Customer - During the nine months ended September 30, 2009, sales to two customers represented 22% and 11%, respectively, of revenues. At September 30, 2009, these customers made up 50% and 0%, respectively, of accounts receivable.

Fair Value of Financial Instruments - The carrying amount of cash and cash equivalents, receivables, accounts payable and accrued expenses approximates fair value because of their short maturity. The carrying value of the goodwill approximates its fair value.

Reclassification - Certain amounts in the 2008 financial statements have been reclassified to conform to the 2009 presentation.

2. NOTES PAYABLE

In connection with the acquisition of the capital stock of LTEL Holdings in 2004, the Company issued a 5%, $10,000,000, secured, six-year note (the “Note”) payable to McCormack Avenue, Ltd. (“McCormack”). Under the terms of the Note, quarterly interest-only payments were required through January 15, 2005, with quarterly principal and interest payments of $319,000 beginning April 2005 and continuing through January 2010. Interest on the Note is payable in cash or, at the Company’s option, in shares of the Company’s Class A common stock. The Note was secured by the capital stock and all of the assets of LTEL Holdings and its subsidiaries. The Note was originally valued at $4,624,000 based on an imputed interest rate of 25 percent per annum.

On September 8, 2006, the Company received a default notice (the “Default Notice”) from McCormack in respect of the Note In the Default Notice, McCormack stated that it intended to exercise its rights, including any and all rights set forth in the Note, as amended. McCormack has taken no action to collect amounts due under the Note.

During the fourth quarter of 2006, the Company entered into two promissory notes with McCormack Avenue, Ltd., in the aggregate amount of $330,000. These notes accrue interest at 10% annually and were due and payable during the second quarter of 2007. These promissory notes were exchanged for shares of the Company’s Series P Preferred Stock. See table below.

During the quarter ended March 31, 2007, the Company entered into five promissory notes with McCormack Avenue, Ltd. and Sovereign Partners LP., in the aggregate amount of $450,000. These notes accrue interest at 10% annually and were due and payable during the third quarter of 2007. These promissory notes were exchanged for shares of the Company’s Series P Preferred Stock. See table below.

On September 30, 2008, the Company entered into a Series P 9% Convertible Preferred Stock Exchange Agreement (the “Exchange Agreement”) with McCormack and Sovereign Partners, LP (“Sovereign”), whereby McCormack exchanged the Note, along with other promissory notes and the Series E debenture (discussed in Note 5), and Sovereign exchanged two promissory notes, for shares of the Company’s Series P 9% Convertible Preferred Stock (the Series P Preferred Stock”). The obligations exchanged and the number of shares of Series P Preferred Stock issued is as follows:

Purchaser	Nature of Obligation Exchanged	Amount of Obligation Exchanged	Number of Series P Preferred Shares Issued
Sovereign Partners LP	Promissory Note, dated February 22, 2007, in the principal amount of $100,000, and interest of $16,278	$116,278	11.6278
Sovereign Partners LP	Promissory Note, dated March 13, 2007, in the principal amount of $100,000, and interest of $15,750	$115,750	11.575
McCormack Avenue, Ltd.	Promissory Note, dated January 11, 2007, in the principal amount of $50,000, and interest of $8,722	$58,722	5.8722
McCormack Avenue, Ltd.	Promissory Note, dated January 19, 2007, in the principal amount of $100,000, and interest of $17,222	$117,222	11.7222
McCormack Avenue, Ltd.	Promissory Note, dated January 26, 2007, in the principal amount of $100,000, and interest of $17,028	$117,028	11.7028
McCormack Avenue, Ltd.	Promissory Note, dated December 28, 2006, in the principal amount of $95,000, and $16,942	$111,942	11.1942
McCormack Avenue, Ltd.	Promissory Note, dated December 15, 2006, in the principal amount of $235,000, and interest of $42,701	$277,701	27.7701
McCormack Avenue, Ltd.	Note Payable, dated February, 2004, in the principal amount of $8,732,620, and interest of $1,311,105	$10,043,725	1,004.3725
McCormack Avenue, Ltd.	Series E Debenture, dated December 7, 2007, in the principal amount of $1,754,464, and interest of $291,763	$2,046,227	204.6227

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

3. RELATED-PARTY NOTES PAYABLE AND ACCOUNTS PAYABLE

During 2002, two executive officers of the Company (the “Lenders”) sold shares of the Company’s Class A common stock owned by them and advanced the resulting proceeds amounting to $333,000 to the Company under the terms of a revolving line of credit and related promissory note. The funds were advanced for use in Company operations. The advances bear interest at 12 percent per annum, payable on a semi-annual basis. The entire principal, along with unpaid accrued interest and any other unpaid charges or related fees, was originally due and payable on June 10, 2003. The Company and the Lenders have agreed to postpone the maturity date on several occasions. The note was due September 30, 2006. As of June 30, 2008, the Company had not made payment against the outstanding balance due on the note. All or part of the outstanding balance and unpaid interest may be converted at the option of the Lenders into shares of Class A common stock of the Company at any time. The conversion price was the average closing bid price of the shares at the time of the advances. To the extent the market price of the Company’s shares is below the conversion price at the time of conversion, the Lenders are entitled to receive additional shares equal to the gross dollar value received from the original sale of the shares. A beneficial conversion option of $15,000 was recorded as interest expense in connection with this transaction. The Lenders may also receive additional compensation as determined appropriate by the Board of Directors.

During the year ended December 31, 2005, the Company received an additional advance of $50,000 from the Lenders. The balance due at December 31, 2005 was $486,000. During the year ended December 31, 2006, the Company received additional advances and other consideration from the Lenders in the aggregate amount of $419,000 and made principal payments to the Lenders against the note of $105,000. During the year ended December 31, 2007, the Company received additional advances of $102,000. During the nine months ended September 30, 2009, the Company received additional advances of $49,500. The balance due at September 30, 2009, was $777,000.

The balance due of $777,000 is secured by the Company’s intellectual property rights and common stock of Fonix Speech. For the nine months ended September 30, 2009, one of the Lenders, Thomas A. Murdock, a former officer and director of the Company, converted $190,000 of the principal balance into 6,095,331 shares common stock, and also converted $22,000 of accrued interest into 480,969 shares of common stock.

The Company currently owes an officer and former officer $107,000 for travel related expenses.

4. PREFERRED STOCK

The Company’s certificate of incorporation allows for the issuance of preferred stock in such series and having such terms and conditions as the Company’s board of directors may designate.

Series A Convertible Preferred Stock – As of September 30, 2009, there were 166,667 shares of Series A convertible preferred stock outstanding. Holders of the Series A convertible preferred stock have the same voting rights as common stockholders, have the right to elect one person to the board of directors and are entitled to receive a one time preferential dividend of $2.905 per share of Series A convertible preferred stock prior to the payment of any dividend on any class or series of stock. At the option of the holders, each share of Series A convertible preferred stock is convertible into one share of Class A common stock and in the event that the common stock price has equaled or exceeded $15 per share for a 15 day period, the shares of Series A convertible preferred stock will automatically be converted into Class A common stock. In the event of liquidation, the holders are entitled to a liquidating distribution of $36.33 per share and a conversion of Series A convertible preferred stock at an amount equal to .0000075 shares of common stock for each share of Series A convertible preferred stock.

Series L Preferred Stock – On September 7, 2006, the Company entered into a Series L 9% Convertible Preferred Stock Exchange Agreement (the "Exchange Agreement") with McCormack and Kenzie Financial (“Kenzie”), a British Virgin Islands company. Pursuant to the Exchange Agreement, McCormack and Kenzie exchanged all 2,000 shares of Series H Preferred Stock that they acquired from the sale of LTEL Holdings, for 1,960.8 and 39.2 shares, respectively, of the Company's Series L 9% Convertible Preferred Stock (the "Series L Preferred Stock").

Because the shares of Series L Preferred Stock were issued in exchange for the remaining outstanding shares of Series H Preferred Stock, the Company did not receive any proceeds in connection with the issuance of the Series L Preferred Stock.

The Series L Preferred Stock entitles McCormack and Kenzie to receive dividends in an amount equal to 9% of the then-outstanding balance of shares of Series L Preferred Stock. The dividends are payable in cash or shares of the Company's Class A common stock, at the Company's option.

The Series L Preferred Stock is convertible into common stock of the Company at the option of the holder by using a conversion price which was 80% of the average of the two (2) lowest closing bid prices for the twenty-day trading period prior to the conversion date.

Redemption of the Series L Preferred Stock, whether at the Company’s option or that of McCormack or Kenzie, requires the Company to pay, as a redemption price, the stated value of the outstanding shares of Series L Preferred Stock to be redeemed, together with any accrued but unissued dividends thereon, multiplied by one hundred ten percent (110%).

The Company accounted for the exchange as redemption of the outstanding Series H Preferred Stock as the Series H Preferred Stock was not convertible into shares of common stock of the Company. The Series L Preferred Stock is convertible into shares of common stock of the Company. The Company recognized a derivative liability upon the redemption of $30,991,000 due to the value of the conversion feature of the Series L Preferred Stock. The liability was calculated using the Black-Scholes valuation model with the following assumptions: dividend yield of 0%, expected volatility of 140%, risk-free rate of 3.75% and expected life of 4 years. As the value of the derivative liability was greater than the face value of the Series L Preferred Stock, no value was prescribed to the Series L Preferred Stock. Also in connection with the redemption, the Company recognized a preferred stock dividend of $16,000,000, equal to the original discount the Company had assigned to the Series H Preferred Stock. At September 30, 2009, the fair value of the Series L Preferred Stock derivative liability was $14,697,000.

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

For the nine months ended September 30, 2009, the Company issued 22,323,333 shares of its Class A common stock in conversion of 31 shares of its Series L Preferred Stock including total interest converted of $71,000. At September 30, 2009, 1,467 shares of Series L Preferred Stock remained outstanding. (See Note 11 for discussion of conversions subsequent to September 30, 2009.)

Series M Preferred Stock – On April 4, 2007, the Company entered into a Series M 9% Convertible Preferred Stock Exchange Agreement with Sovereign Partners, LP (“Sovereign”). Pursuant to the exchange agreement, Sovereign exchanged 150 shares of the Company’s Series L Preferred Stock for 150 shares of the Company’s Series M 9% Convertible Preferred Stock (the “Series M Preferred Stock”).

The Series M Preferred Stock entitles Sovereign or its assignees to receive dividends in an amount equal to 9% of the then-outstanding balance of shares of Series M Preferred Stock. The dividends are payable in cash or shares of the Company’s Class A common stock, at the Company’s option.

The Series M Preferred Stock may be converted into common stock of the Company at the option of the holder by using a conversion price which shall be the lower of (i) 80% of the average of the two lowest closing bid prices for the twenty-day trading period prior to the conversion date, or (ii) $0.004.

Redemption of the Series M Preferred Stock, whether at the Company’s option or that of Sovereign, requires the Company to pay, as a redemption price, the stated value of the outstanding shares of Series M Preferred Stock to be redeemed, together with any accrued but unissued dividends thereon, multiplied by one hundred ten percent (110%).

Because the shares of Series M were issued in exchange for the outstanding shares of Series L Preferred Stock, the Company did not receive any proceeds in connection with the issuance of the Series M Preferred Stock.

The Company recognized a derivative liability upon the redemption of $1,603,000 due to the value of the conversion feature of the Series M Preferred Stock, which was previously recorded as part of the Series L Preferred Stock derivative liability. The liability was calculated using the Black-Scholes valuation model with the following assumptions: dividend yield of 0%, expected volatility of 134%, risk-free rate of 5% and expected life of 4 years. As the value of the derivative liability was greater than the face value of the Series M Preferred Stock, no value was prescribed to the Series M Preferred Stock. At September 30, 2009, the fair value of the Series M Preferred Stock derivative liability was $1,502,000.

As of September 30, 2009, there were 150 shares of Series M Preferred Stock convertible preferred stock outstanding.

Series N Convertible Preferred Stock – On August 24, 2007, the Company entered into a Securities Purchase Agreement with Trillium Partners, LP and other unnamed future investors relating to the issuance and sale of the Company’s Series N 9% Convertible Preferred Stock.

Pursuant to the agreement, the Company agreed to issue up to 2,400 shares of its Series N 9% Convertible Preferred Stock (the “Series N Preferred Stock”) at a per share price of $1,000 to Trillium Partners, LP and other unnamed future investors, for gross proceeds of up to $2,400,000. As of the date of this report, the Company had issued 1,755 shares of the Series N Preferred Stock, for cash proceeds of $1,350,000.

The Series N Preferred Stock entitles the Purchasers to receive dividends in an amount equal to 9% of the then-outstanding balance of shares of Series N Preferred Stock. The dividends are payable in cash or shares of the Company's Class A common stock, at the Company's option.

The Series N Preferred Stock is convertible into Class A common stock of the Company at the option of the holder by using a conversion price equal to 80% of the average of the two lowest closing bid prices for the twenty-day trading period prior to the conversion date.

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Redemption of the Series N Preferred Stock, whether at the Company’s option or that of the Purchasers requires the Company to pay, as a redemption price, the stated value of the outstanding shares of Series N Preferred Stock to be redeemed, together with any accrued but unissued dividends thereon, multiplied by one hundred ten percent (110%).

The Company recognized a derivative liability upon the redemption of $957,000 due to the value of the conversion feature of the Series N Preferred Stock. The liability was calculated using the Black-Scholes valuation model with the following assumptions: dividend yield of 0%, expected volatility of 128%, risk-free rate of 5.0% and expected life of 4 years. As the value of the derivative liability was greater than the face value of the Series N Preferred Stock, no value was prescribed to the Series N Preferred Stock. At September 30, 2009, the fair value of the Series N Preferred Stock derivative liability was $1,757,000.

As of September 30, 2009, there were 1,755 shares of Series N Preferred Stock convertible preferred stock outstanding.

Series O Convertible Preferred Stock – Between January 25, 2008, and September 30, 2008, the Company received advances from three entities in connection with the purchase agreements related to the Company’s Series O 9% Convertible Preferred Stock (“Series O Preferred Stock”). On May 20, 2008, the Company entered into Securities Purchase Agreements with Southridge Partners LP, Southshore Capital Fund LTD, Sovereign Partners LP (collectively, the “Series O Purchasers”) for the sale of an aggregate of 730 shares of Series O Preferred Stock for gross proceeds of $730,000. The material terms of the purchase agreements had been agreed upon prior to receipt of the advances. Therefore, the Series O Preferred Stock was accounted for as discussed below on the dates cash proceeds were received by the Company. The Company also began accruing dividends upon receiving the advances.

The Series O Preferred Stock entitles the Purchasers to receive dividends in an amount equal to 9% of the then-outstanding balance of shares of Series O Preferred Stock. The dividends are payable in cash or shares of the Company's Class A common stock, at the Company's option.

The Series O Preferred Stock is convertible into common stock of the Company at the option of the holder by using a conversion price, equal to 80% of the average of the two lowest closing bid prices for the twenty-day trading period prior to the conversion date.

Redemption of the Series O Preferred Stock, whether at the Company’s option or that of the Purchasers requires the Company to pay, as a redemption price, the stated value of the outstanding shares of Series O Preferred Stock to be redeemed, together with any accrued but unissued dividends thereon, multiplied by one hundred ten percent (110%).

The Company recognized a derivative liability upon the redemption of $290,000 due to the value of the conversion feature of the Series O Preferred Stock. The liability was calculated using the Black-Scholes valuation model with the following assumptions: dividend yield of 0%, expected volatility of 128%, risk-free rate of 5.0% and expected life of 4 years. As the value of the derivative liability was greater than the face value of the Series O Preferred Stock, no value was prescribed to the Series O Preferred Stock. At September 30, 2009, the fair value of the Series O Preferred Stock derivative liability was $731,000.

As of September 30, 2009, there were 730 shares of Series O Preferred Stock convertible preferred stock outstanding.

Series P Convertible Preferred Stock – On September 30, 2008, the Company entered into a Series P 9% Convertible Preferred Stock Exchange Agreement (the “Exchange Agreement”) with Sovereign Partners, LP (“Sovereign”), and McCormack Avenue Ltd. (“McCormack”). Pursuant to the Exchange Agreement, Sovereign and McCormack exchanged certain debt obligations, discussed more fully below, for shares of the Company’s Series P 9% Convertible Preferred Stock (the “Series P Preferred Stock”).

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

The Series P Preferred Stock entitles the holders to receive dividends in an amount equal to 9% of the then-outstanding balance of shares of Series P Preferred Stock. The dividends are payable in cash or shares of the Company’s Class A common stock, at the Company’s option.

The Series P Preferred Stock may be converted into common stock of the Company at the option of the holder by using a conversion price which shall be 80% of the average of the two (2) lowest closing bid prices for the twenty-day trading period prior to the conversion date.

Redemption of the Series P Preferred Stock, whether at our option or that of the holder, requires us to pay, as a redemption price, the stated value of the outstanding shares of Series P Preferred Stock to be redeemed, together with any accrued but unissued dividends thereon, multiplied by one hundred ten percent (110%).

Because the shares of Series P were issued in exchange for certain outstanding debt obligations, the Company, we did not receive any proceeds in connection with the issuance of the Series P Preferred Stock to McCormack and Sovereign.

In connection with the issuance of the Series P Preferred Stock, on September 26, 2008, the Company filed with the State of Delaware a Certificate of Designation and Series P 9% Convertible Stock Terms (the “Series P Terms”), which become a part of its Certificate of Incorporation, as amended.

The Company recognized a derivative liability upon the redemption of $13,000 due to the value of the conversion feature of the Series P Preferred Stock. The liability was calculated using the Black-Scholes valuation model with the following assumptions: dividend yield of 0%, expected volatility of 128%, risk-free rate of 5.0% and expected life of 4 years. As the value of the derivative liability was greater than the face value of the Series P Preferred Stock, no value was prescribed to the Series P Preferred Stock. At September 30, 2009, the fair value of the Series P Preferred Stock derivative liability was $16,517,000.

For the nine months ended September 30, 2009, the Company issued 6,088,466 shares of its Class A common stock in conversion of 10 shares of its Series P Preferred Stock. At September 30, 2009, 1,649 shares of Series P Preferred Stock remained outstanding. On May 1, 2009 the Company issued 5 shares of Series P Preferred Stock for proceeds of $42,500. On July 7, 2009 the Company issued 3.5 shares of Series P Preferred Stock for proceeds of $35,000. (See Note 11 for discussion of conversions subsequent to September 30, 2009.) Also, during the year ending September 30, 2009, the Company issued the following shares of Series P Preferred Stock for the purchase of G-Soft Limited, a Hong Kong corporation:

Issuance of Series P 9% Convertible Preferred Stock in G-Soft Transaction

On March 27, 2009, the Company issued an aggregate of one hundred and twenty shares of the Company’s Series P Preferred Stock to G-Soft, which is the ultimate parent of GaozhiSoft, and the shareholders of G-Soft (collectively, the “Sellers”). The Shares of Series P Preferred Stock were issued pursuant to an exchange agreement (the “Exchange Agreement”), with Southridge LLC, a Connecticut limited liability company (“Southridge”), and the Sellers. Additionally, subject to the terms of the amended agreement with the Sellers, the Sellers are entitled to annual earn-out payments equal to fifty percent (50%) of the prior year’s net income of GaozhiSoft, to be paid in the form of Series P Preferred Stock (the “Earn-Out Payments”). The aggregate of the Earn-Out Payments is limited to three hundred and eighty shares of Series P Preferred, which were issued into an escrow account.

Under the G-Soft Agreement and the Series P Terms, the holders of the Series P Preferred Stock may convert shares of Series P Preferred Stock into shares of the Company’s common stock.

Issuance of Shares of Series P 9% Convertible Preferred Stock to Acquire Remaining 20% of G-Soft

In connection with the G-Soft transaction described above, on March 27, 2009, the Company entered into a Series P Convertible Preferred Stock Purchase Agreement (the “Preferred Stock Purchase Agreement”), with Southridge. Pursuant to the Preferred Stock Purchase Agreement, the Company issued 189 shares of Series P Preferred Stock in exchange for the 20% of G-Soft shares which Southridge had purchased in the G-Soft Transaction described above.

The Series P Preferred Stock issued to Southridge has the same terms as described above.

Under the Preferred Stock Purchase Agreement and the Series P Terms, Southridge may convert shares of Series P Preferred Stock into shares of the Company’s common stock.

Issuance of Shares of Series P 9% Convertible Preferred Stock In Payment of Notes

In connection with the G-Soft transaction described above, Southridge and Southshore Capital Fund (“Southshore”) made a bridge loan to G-Soft in the amount of $400,000. Upon the acquisition of G-Soft by Fonix GS, Fonix Corporation agreed to repay the bridge loan through the issuance of shares of Series P Preferred Stock.

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

In an agreement dated March 31, 2009, the Company issued an aggregate of 42 shares of Series P Preferred Stock to Southridge and Southshore as repayment of the bridge loans described above.

The Series P Preferred Stock issued to Southridge and Southshore has the same terms as described above.

Under the Preferred Stock Purchase Agreement and the Series P Terms, Southridge and Southshore may convert shares of Series P Preferred Stock into shares of the Company’s common stock.

Fonix Speech, Inc., Series B Convertible Preferred Stock – On April 4, 2007, the Company entered into a Securities Purchase Agreement by and among the Company, Fonix Speech, Inc. (“FSI”), and Sovereign Partners, LP. FSI is a wholly owned subsidiary of the Company.

Pursuant to the FSI purchase agreement, FSI sold 125 shares of its Series B 9% Convertible Preferred Stock (the “Series B Preferred Stock”) at a per share price of $10,000 to Sovereign, for gross proceeds of $1,250,000.

The shares of Series B Preferred Stock are convertible into shares of the Company’s Class A common stock. The Series B Preferred Stock may be converted into common stock of the Company at the option of the holder by using a conversion price which shall be the lower of (i) 80% of the average of the two lowest closing bid prices for the twenty-day trading period prior to the conversion date, or (ii) $0.004.

The Series B Preferred Stock entitles Sovereign or its assignees to receive dividends in an amount equal to 9% of the then-outstanding balance of shares of Series B Preferred Stock. The dividends are payable in cash or shares of the Company's Class A common stock, at the Company's option

The Company recognized a derivative liability upon the issuance of $1,336,207 due to the value of the conversion feature of the Series B Preferred Stock. The liability was calculated using the Black-Scholes valuation model with the following assumptions: dividend yield of 0%, expected volatility of 134%, risk-free rate of 5% and expected life of 4 years. As the value of the derivative liability was greater than the face value of the Series B Preferred Stock, no value was prescribed to the Series B Preferred Stock. At September 30, 2009, the fair value of the Series B Preferred Stock derivative liability was $1,252,000.

As of September 30, 2009, there were 125 shares of Series B Preferred Stock convertible preferred stock outstanding.

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

5. CONVERTIBLE DEBENTURES

On December 7, 2006, the Company entered into a Securities Purchase Agreement, dated as of December 1, 2006 (the “Agreement”), with Southridge Partners, LP (“Southridge”) relating to the purchase and sale of a Series E 9% Secured Subordinated Convertible Debenture (the “Debenture”) in the principal amount of $850,000.

Pursuant to the Agreement, Southridge paid the purchase price by tendering a prior debenture in the aggregate amount (including principal and interest) of $641,000, and agreed that an advance to the Company in the amount of $75,000 made in November 2006 would also constitute part of the purchase price. Southridge agreed to fund the remaining $134,000 upon the effectiveness of a registration statement, to be filed by the Company, to register the resales of shares issuable to Southridge upon conversion of the Debenture. The Company received no new capital in connection with the issuance and sale of the Debenture.

This Debenture was exchanged for shares of the Company’s Series P Preferred Stock. See Note 2.

In addition to the Debenture issued to Southridge described above, on December 7, 2006, the Company entered into a Securities Purchase Agreement, dated as of December 1, 2006 (the “McCormack Agreement”), with McCormack, relating to the purchase and sale of a Series E 9% Secured Subordinated Convertible Debenture (the “McCormack Debenture”) in the principal amount of $1,039,000.

Pursuant to the McCormack Agreement, McCormack paid the purchase price by tendering outstanding promissory notes in the amounts of $300,000 and $350,000, together with combined interest thereon of $64,000, and agreed that advances to the Company in the amount of $325,000, made in September, October, and November 2006, would also constitute part of the purchase price.

This Debenture was also exchanged for shares of the Company’s Series P Preferred Stock. See Note 2.

6. COMMON STOCK, STOCK OPTIONS AND WARRANTS

Class A Common Stock – In December 2008, the Company implemented a 1-for-5,000 share reverse stock split. The share numbers in these notes have been adjusted to reflect the reverse stock split. During the nine months ended September 30, 2009, 22,323,333 shares of Class A common stock were issued in conversion of 31 shares of Series L Preferred Stock including total interest converted of $71,000, 6,088,466 shares of Class A common stock were issued in conversion of 10 shares of Series P Preferred stock, 6,095,331 shares were issued in conversion of the outstanding balance on the related party note and 480,969 shares were issued in conversion of accrued interest on the related party note.

Stock Options – As of September 30, 2009, the Company had a total of 40 options to purchase Class A common stock outstanding. During the nine months ended September 30, 2009 no options were granted.

Warrants – As of September 30, 2009, the Company had warrants to purchase a total of 3 shares of Class A common stock outstanding that expire through 2010.

7. LITIGATION, COMMITMENTS AND CONTINGENCIES

Hite Development Corporation v. Fonix Corporation, Third District Court, Salt Lake County (Civil No. 070900883). In January 2007, Hite Development Corporation (“Hite”) brought a lawsuit against the Company claiming breach of contract and breach of the covenant of good faith and fair dealing, alleging that the Company failed to make certain payments under a settlement agreement with Hite dating from March 2005. The complaint seeks approximately $33,000 plus interest. The Company filed its answer in May 2007. On May 8, 2008, Hite filed a motion for summary judgment, which the Court granted. Judgment was entered against the Company on March 31, 2009.

RR Donnelley Receivables Inc. v. Fonix Corporation, Third District Court, Salt Lake County (Civil No. 070412088). In July 2007, RR Donnelley Receivables Inc. (“Donnelly”) brought a lawsuit against the Company for alleged failure to pay for services provided. The complaint seeks approximately $21,000 plus interest. The Company filed its answer in August 2007, and filed a motion to dismiss the action in December 2007. That motion is currently pending before the court. If the Company’s motion to dismiss is denied, the Company intends to defend against the claims in the complaint.

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Perpetual Storage, Inc. vs. Fonix Corporation, Third District Court, Salt Lake County (Civil No. 080907080). Perpetual Storage, Inc. (“PSI”), brought suit, claiming breach of contract and unjust enrichment, and seeking damages of approximately $12,300 plus attorneys’ fees and costs. The Company filed its answer in July 2008. In December 2008, PSI moved for summary judgment, which the Company opposed. The Court denied the motion at a hearing in April 2009. As of the date of this report, the parties have settled this matter and were working to finalize the terms of the settlement.

8. FAIR VALUE

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The company utilizes a fair value hierarchy, which maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value. The fair value hierarchy has three levels of inputs that may be used to measure fair value:

·	Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

·	Level 2: Level 1 inputs for assets or liabilities that are not actively traded. Also consists of an observable market price for a similar asset or liability. This includes the use of “matrix pricing” used to value debt securities absent the exclusive use of quoted prices.

·	Level 3: Consists of unobservable inputs that are used to measure fair value when observable market inputs are not available. This could include the use of internally developed models, financial forecasting, etc.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability between market participants at the balance sheet date. When possible, the Company looks to active and observable markets to price identical assets or liabilities. When identical assets and liabilities are not traded in active markets, the Company looks to observable market data for similar assets and liabilities. However, when certain assets and liabilities are not traded in observable markets the Company must use other valuation methods to develop a fair value.

The following table presents financial assets and liabilities measured on a nonrecurring basis:

			Fair Value Measurements at Reporting Date Using
Description	Balance at September 30, 2009		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant/Unobservable Inputs (Level 3)
Goodwill	$	658,000		—		—	$	658,000

9. OTHER INCOME

In July 2009 the Company discovered that a former employee, who was not a director or executive officer of the Company, had misappropriated as much as $355,000 during the term of his employment which ended in May 2009. The Company asserted claims against the former employee for the misappropriation, and considered certain defenses and offsets asserted by the former employee, which led to a settlement in which the former employee agreed to pay the Company $235,000 on or before September 30, 2009. The former employee paid the Company $235,000 on September 30, 2009.

10. PROFORMA INFORMATION

As further discussed in Note 4, on March 27, 2009, the Company issued shares of its Series P Convertible Preferred Stock for the purchase of G-Soft Limited, a Hong Kong corporation (“G-Soft”), which is the ultimate parent of Shanghai Gaozhi Software Systems Limited.

Fonix Corporation and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

The following unaudited information is presented to reflect the operations of the Company as if the acquisition of G-Soft had been completed on January 1, 2008:

For the Nine Months Ended September 30,	2009		2008
Total Revenues	$	1,866,000	$	2,308,000
Net Income (Loss) attributable to common stockholders		170,000		(3,698,000	)

Basic and diluted income (loss) per common share from continuing operations	$	0.01	$	(3.23	)

11. SUBSEQUENT EVENTS

Subsequent to September 30, 2009, the Company has issued 7,409,618 shares of its Class A common stock in conversion of 8 shares of Series L Preferred Stock.

Subsequent to September 30, 2009, the Company has issued 738,184 shares of its Class A common stock in payment of interest on the Series L Preferred Stock.

Subsequent to September 30, 2009, the Company has issued 1,794,046 shares of its Class A common stock in conversion of 2 shares of Series P Preferred Stock.

Subsequent to September 30, 2009, the Company has issued 3,500,000 shares of its Class A common stock in payment of principal and interest on related party notes payable.

Subsequent to September 30, 2009, the Company has issued 5,666,667 shares of its Class A common stock for settlement of litigation.

ITEM 2.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This report on Form 10-Q contains, in addition to historical information, forward-looking statements that involve substantial risks and uncertainties. All forward-looking statements contained herein are deemed by Fonix to be covered by and to qualify for the safe harbor protection provided by Section 21E of the Private Securities Litigation Reform Act of 1995. When used in this report, words such as “believes,” “expects,” “intends,” “plans,” “anticipates,” “estimates,” and similar expressions are intended to identify forward-looking statements, although there may be certain forward-looking statements not accompanied by such expressions. Statements relating to the future performance, business strategies and implementation, availability of outside financing, financial performance, market acceptance of our products, and similar statements may also include forward looking statements. Actual results could differ materially from the results anticipated by Fonix and discussed in the forward-looking statements. Factors that could cause or contribute to such differences are discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008. The Company disclaims any obligation or intention to update any forward-looking statements.

To date, we have earned only limited revenue from operations and intend to continue to rely primarily on financing through the sale of our equity and debt securities to satisfy future capital requirements.

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help the reader understand Fonix Corporation, our operations and our present business environment. MD&A is provided as a supplement to, and should be read in conjunction with, our condensed consolidated financial statements and the accompanying notes thereto. This overview summarizes MD&A, which includes the following sections:

Overview – a general description of our business and the markets in which we operate; our objective; our areas of focus; and challenges and risks of our business.

Significant Accounting Policies – a discussion of accounting policies that require critical judgments and estimates.

Results of Operations – an analysis of our Company’s consolidated results of operations for the three years presented in our consolidated financial statements. Except to the extent that differences among our operating segments are material to an understanding of our business as a whole, we present the discussion in the MD&A on a consolidated basis.

Liquidity and Capital Resources – an analysis of cash flows; off-balance sheet arrangements and aggregate contractual obligations; the impact of foregoing exchange; an overview of financial position; and the impact of inflation and changing prices.

We intend for this discussion to provide the reader with information that will assist in understanding our financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our financial statements. The discussion also provides information about the financial results of the various segments of our business to provide a better understanding of how those segments and their results affect the financial condition and results of operations of the Company as a whole. This discussion should be read in conjunction with our financial statements as of December 31, 2008, and the year then ended and the notes accompanying those financial statements.

Overview

We are engaged in providing value-added speech technologies through Fonix Speech, Inc. (“Fonix Speech”). We offer speech-enabling technologies including automated speech recognition (“ASR”) and text-to-speech (“TTS”) through Fonix Speech. We offer our speech-enabling technologies to markets for wireless and mobile devices, computer telephony, server solutions and personal software for consumer applications. We have received various patents for certain elements of our core technologies and have filed applications for other patents covering various aspects of our technologies. We seek to develop relationships and strategic alliances with third-party developers and vendors in telecommunications, computers, electronic devices and related industries, including producers of application software, operating systems, computers and microprocessor chips. Revenues are generated through licensing of speech-enabling technologies, maintenance contracts and services.

For the three months ended September 30, 2009 and 2008, we generated revenues of $335,000 and $223,000, respectively, and incurred net income of $230,000 and a net loss of $1,701,000, respectively. For the nine months ended September 30, 2009 and 2008, we generated revenues of $1,301,000 and $1,069,000, respectively, incurred net losses attributable to common stockholders of $2,466,000 and $5,526,000, respectively, and had cash flows from operating activities of $85,000 and negative cash flows from operating activities of $209,000, respectively. As of September 30, 2009, we had an accumulated deficit of $288,839,000; negative working capital of $46,725,000; derivative liabilities of $36,460,000 related to the issuance of Series P Preferred Stock, Series L Preferred Stock, Series M Preferred stock, Series N Preferred Stock, Series O Preferred Stock, Series E Convertible Debentures and Series B Preferred Stock of our subsidiary Fonix Speech; accrued liabilities of $8,942,000; accrued payroll and other compensation of $902,000; accounts payable of $2,215,000; related party accounts payable of $21,000 tax payable of $29,000; deferred tax liabilities of $228,000; related party notes payable of $777,000; and deferred revenues of $465,000. We expect to continue to incur significant losses and negative cash flows from operating activities at least through December 31, 2009, primarily due to expenditure requirements associated with continued marketing and development of our speech-enabling technologies.

We are continually developing new product offerings in the ASR businesses in an effort to increase our revenue stream, and we are continuing to work with our existing customers to increase sales. We have also experienced operating expense decreases through headcount reductions and overall cost reduction measures. Through the combination of increased recurring revenues and the overall operating cost reduction strategies we have implemented, we hope to achieve positive cash flow from operations in the next 18-24 months. However, there can be no assurance that we will be able to achieve positive cash flow from operations within this time frame.

Fonix GS was formed on June 27, 2008, to facilitate the acquisition of Shanghai Gaozhi Software Systems Limited (“GaozhiSoft”), which was completed in early 2009. GaozhiSoft is a leading Chinese software developer and solutions provider in 2G (second-generation) and 3G (third-generation) telecommunication operation support systems in China and throughout the Asian Pacific region. Gaozhisoft is a qualified competitor for telecommunication operation supports systems.

GaozhiSoft’s products are designed to increase data transferring speed, reduce telecommunications data loss and provide network management, billing accuracy and improved implementation techniques to telecom carriers.

Gaozhisoft has an outstanding management team with extensive industrial knowledge and experience with system developing, marketing and sales. Since completion of the acquisition of GaozhiSoft, Fonix GS, through its wholly owned foreign entities, has been working with the management team to transition the business with a focus on creating synergies among the Company’s existing technologies and GoazhiSoft’s products. Upon completion of the transition, we expect GaozhiSoft to continue its rapid growth and market penetration based on the implementation of the 3G mobile network service with these professional partners.

Historically, our cash resources, limited to collections from customers, draws on equity lines of credit and loans, have not been sufficient to cover operating expenses. We periodically engage in discussions with various sources of financing to facilitate our cash requirements including buyers of both debt and equity securities. To date, no additional sources of funding offering terms superior to those available under equity lines have been implemented, and we rely on first, cash generated from operations, and second, cash provided through convertible debt financing arrangements. We will need to generate approximately $2 to $3 million to continue operations for the next twelve months. There can be no assurance that we will be able to obtain such financing or that, if we can obtain such financing, it will be on terms favorable to us.

Significant Accounting Policies

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make 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 sales and expenses during the reporting period. Significant accounting policies and areas where substantial judgments are made by management include:

Accounting estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Valuation of long-lived assets - The carrying values of our long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that they may not be recoverable. When such an event occurs, we project undiscounted cash flows to be generated from the use of the asset and its eventual disposition over the remaining life of the asset. If projections indicate that the carrying value of the long-lived asset will not be recovered, the carrying value of the long-lived asset, other than software technology, is reduced by the estimated excess of the carrying value over the projected discounted cash flows.

Goodwill – Goodwill represents the excess of the cost over the fair value of net assets of acquired businesses. Goodwill is not amortized, but is tested for impairment quarterly or when a triggering event occurs. The testing for impairment requires the determination of the fair value of the asset or entity to which the goodwill relates (the reporting unit). The fair value of a reporting unit is determined based upon a weighting of the quoted market price of our common stock and present value techniques based upon estimated future cash flows of the reporting unit, considering future revenues, operating costs, the risk-adjusted discount rate and other factors. Impairment is indicated if the fair value of the reporting unit is allocated to the assets and liabilities of that unit, with the excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities assigned to the fair value of goodwill. The amount of impairment of goodwill is measured by the excess of the goodwill’s carrying value over its fair value.

Revenue recognition – We recognize revenue when pervasive evidence of an arrangement exists, services have been rendered or products have been delivered, the price to the buyer is fixed and determinable and collectability is reasonable assured. Revenues are recognized by us based on the various types of transactions generating the revenue. We generate revenues from licensing the rights to its software products to end users and from royalties.

For Fonix Speech, revenue of all types is recognized when acceptance of functionality, rights of return, and price protection are confirmed or can be reasonably estimated, as appropriate. Revenues from development and consulting services are recognized on a completed-contract basis when the services are completed and accepted by the customer. The completed-contract method is used because our contracts are typically either short-term in duration or we are unable to make reasonably dependable estimates of the costs of the contracts. Revenue for hardware units delivered is recognized when delivery is verified and collection assured.

Deferred revenue as of September 30, 2009, and December 31, 2008, consisted of the following:

Description	Criteria for Recognition		September 30, 2009				December 31, 2008
Deferred unit royalties and license fees	Delivery of units to end users or expiration of contract		$	465,000			$	445,000

Cost of revenues - Cost of revenues from license, royalties, and maintenance consists of costs to distribute the product, installation and support personnel compensation, amortization and impairment of capitalized speech software costs, licensed technology, and other related costs. Cost of service revenues consists of personnel compensation and other related costs.

Software Technology Development and Production Costs - All costs incurred to establish the technological feasibility of speech software technology to be sold, leased, or otherwise marketed are charged to product development and research expense. Technological feasibility is established when a product design and a working model of the software product have been completed and confirmed by testing. Costs to produce or purchase software technology incurred subsequent to establishing technological feasibility are capitalized. Capitalization of software costs ceases when the product is available for general release to customers. Costs to perform consulting or development services are charged to cost of revenues in the period in which the corresponding revenues are recognized. Costs of maintenance and customer support are charged to expense when related revenue is recognized or when these costs are incurred, whichever occurs first.

Capitalized software technology costs were amortized on a product-by-product basis. Amortization was recognized from the date the product was available for general release to customers as the greater of (a) the ratio that current gross revenue for a product bears to total current and anticipated future gross revenues for that product or (b) the straight-line method over the remaining estimated economic life of the products. Amortization was charged to cost of revenues.

We assessed unamortized capitalized software costs for possible write down on a quarterly basis based on net realizable value of each related product. Net realizable value was determined based on the estimated future gross revenues from a product reduced by the estimated future cost of completing and disposing of the product, including the cost of performing maintenance and customer support. The amount by which the unamortized capitalized costs of a software product exceeded the net realizable value of that asset was written off.

Imputed Interest Expense and Income - Interest is imputed on long-term debt obligations and notes receivable where management has determined that the contractual interest rates are below the market rate for instruments with similar risk characteristics.

Foreign Currency Translation - The functional currency of our Korean subsidiary is the South Korean won. Consequently, assets and liabilities of the Korean operations are translated into United States dollars using current exchange rates at the end of the year. All revenue is invoiced in South Korean won and revenues and expenses are translated into United States dollars using weighted-average exchange rates for the year.

The functional currency of our operating subsidiaries in the PRC is RMB. Consequently, assets and liabilities of the PRC operations are translated into United States dollars using current exchange rates at the end of the period. All revenue is invoiced in RMB and revenues and expenses are translated into United States dollars using weighted-average exchange rates for the period.

Comprehensive Income - Other comprehensive income presented in the accompanying consolidated financial statements consists of cumulative foreign currency translation adjustments.

Recent Accounting Pronouncements

In October 2009, the FASB issued ASU No. 2009-13, Revenue Recognition (“ASC Topic 605”) - Multiple-Deliverable Revenue Arrangements, a consensus of the FASB Emerging Issues Task Force. This guidance modifies the fair value requirements of ASC subtopic 605-25, “Revenue Recognition-Multiple Element Arrangements” by allowing the use of the “best estimate of selling price” in addition to vendor-specific objective evidence (“VSOE”) (now referred to as “TPE” standing for third-party evidence) for determining the selling price of a deliverable. A vendor is now required to use its best estimate of the selling price when VSOE or TPE of the selling price cannot be determined. In addition, the residual method of allocating arrangement consideration is no longer permitted.

In October 2009, the FASB issued ASU No. 2009-14, Software (“ASC Topic 985”) - Certain Revenue Arrangements That Include Software Elements, a consensus of the FASB Emerging Issues Task Force. This guidance modifies the scope of ASC subtopic 965-605, “Software-Revenue Recognition” to exclude from its requirements (a) non-software components of tangible products and (b) software components of tangible products that are sold, licensed, or leased with tangible products when the software components and non-software components of the tangible product function together to deliver the tangible product’s essential functionality.

ASC Topic 605 and 985 require expanded qualitative and quantitative disclosures and are effective for fiscal years beginning on or after June 15, 2010. However, companies may elect to adopt as early as interim periods ended September 30, 2009. These updates may be applied either prospectively from the beginning of the fiscal year for new or materially modified arrangements or retrospectively. We are currently evaluating the impact of adopting these updates on our consolidated financial statements.

Results of Operations

Three months ended September 30, 2009, compared with three months ended September 30, 2008

During the three months ended September 30, 2009, we recorded revenues of $335,000, an increase of $112,000 from $223,000 for the same period in 2008. The increase was primarily due to increased revenues from the addition of G-Soft of $30,000 and an increase of revenue from software development kits sold of $82,000.

Selling, general and administrative expenses were $597,000 for the three months ended September 30, 2009, an increase of $254,000 from $343,000 for the same period in 2008. The increase is primarily due to an increase of expenses in the quarter of $59,000 related to the acquisition of G-Soft. The remainder of the change is primarily due to decreased salary and wage related expenses of $122,000, increased other expenses of $32,000, decreased occupancy related expenses of $93,000, decreased depreciation expenses of $2,000, decreased investor relations related expenses of $1,000, increased consulting expenses $76,000, decreased travel expenses of $25,000, an increase in other operating expenses of $89,000, a decrease in marketing material of $14,000 and increased legal and accounting fees of $255,000.

We incurred research and product development expenses of $155,000 for the three months ended September 30, 2009, a decrease of $145,000 from $300,000 for the same period in 2008. The decrease was primarily due to an overall decrease in wage related expenses of $122,000, decrease occupancy expenses of $12,000 and decreased travel expenses of $11,000.

Net interest and other expense was a gain of $751,000 for the three months ended September 30, 2009, a decrease of $2,029,000 from net other expense of a loss of $1,278,000 for the same period in 2008. The overall decrease was due to a decrease in interest expense of $1,658,000, an increase in interest income of $57,000, an increase in a gain on the forgiveness of liabilities of $56,000, an increase in other income of $235,000 and a decrease in the loss recognized on the derivative liability of $23,000.

Nine months ended September 30, 2009, compared with nine months ended September 30, 2008

During the nine months ended September 30, 2009, we recorded revenues of $1,301,000, an increase of $232,000 from $1,069,000 for the same period in 2008. The increase was primarily due to an increase of revenue of $595,000 from the acquisition of G-Soft, an increase of $35,000 from software development kit sale and voice related application sales, offset primarily by decreased licensing revenue of $352,000 and decreased support fees of $46,000.

Selling, general and administrative expenses were $1,704,000 for the nine months ended September 30, 2009, an increase of $273,000 from $1,431,000 for the same period in 2008. The increase is primarily due to an increase in expenses from the acquisition of G-Soft of $298,000. The other changes related to decreased salary and wage related expenses of $74,000, increased other expenses of $38,000, decreased taxes, licenses and permits of $3,000, decreased consulting expenses of $52,000, increased legal and accounting fees of $290,000, decreased occupancy related expenses of $183,000, increased investor relations related expenses of $9,000, decreased travel expenses of $33,000, decreased advertising expenses of $15,000 and decreased depreciation expenses of $2,000.

We incurred research and product development expenses of $620,000 for the nine months ended September 30, 2009, a decrease of $372,000 from $992,000 for the same period in 2008. The decrease was primarily due to an overall decrease in wage related expenses of $311,000, decreased travel expenses of $4,000, decreased occupancy expenses of $36,000, decreased depreciation expenses of $2,000, and a decrease in other operating expenses of $19,000.

Liquidity and Capital Resources

We must raise additional funds to be able to satisfy our cash requirements during the next 12 months. It is anticipated that we will need to raise approximately $2.5 to $3 million over the next 12 months to meet obligations and continue our product development, corporate operations and marketing expenses. Because we presently have only limited revenue from operations, we intend to continue to rely primarily on financing through the sale of our equity and debt securities to satisfy future capital requirements until such time as we are able to enter into additional third-party licensing, collaboration, or co-marketing arrangements such that we will be able to finance ongoing operations from license, royalty, and sales revenue. We are working with game developers and other potential licensors of our speech product offerings to develop additional revenue streams for our speech technologies. There can be no assurance that we will be able to enter into such agreements. Furthermore, the issuance of equity or debt securities which are or may become convertible into equity securities of Fonix in connection with such financing could result in substantial additional dilution to the stockholders of Fonix.

Our cash resources are limited to collections from customers, proceeds from the issuance of preferred stock, and loan proceeds, and are not sufficient to cover current operating expenses and payments of current liabilities. At September 30, 2009, we had negative working capital of $46,725,000; derivative liabilities of $36,460,000 related to the issuance of Series L Preferred Stock, Series M Preferred Stock, Series N Preferred Stock, Series O Preferred Stock, Series P Preferred Stock and Series B Preferred Stock of our subsidiary, Fonix Speech; accrued liabilities of $8,942,000; accounts payable of $2,215,000; related party accounts payable of $107,000; notes payable to related parties of $777,000; accrued payroll and other compensation of $902,000; deferred tax liabilities of $228,000; and deferred revenues of $465,000. In July 2009 the Company discovered that a former employee, who was not a director or executive officer of the Company, had misappropriated funds during the term of his employment which ended in May 2009. The Company asserted claims against the former employee for the misappropriation which lead to a settlement in which the former employee agreed to pay the Company $235,000 on or before September 30, 2009. The former employee paid the Company $235,000 on September 30, 2009.

We had $1,301,000 in revenue and a loss of $50,000 for the nine months ended September 30, 2009. Net cash provided in operating activities of $85,000 for the nine months ended September 30, 2009, resulted principally from the net loss incurred of $50,000, offset by increased accrued liabilities of $290,000, non-cash gain recognized on the derivative liability of $1,236,000, decrease in accounts receivable of $615,000, decreased accounts payable of $9,000, decreased related party accounts payable of $11,000 and depreciation expense of $11,000. Net cash obtained in investing activities of $796,000, for the nine months ended September 30, 2009, consisted of the cash acquired in the acquisition of $796,000. Net cash provided by financing activities was $128,000 obtained from the proceeds from the related party note of $50,000 and the issuance of Series P preferred stock of $78,000.

We had negative working capital of $46,725,000 at September 30, 2009, compared to negative working capital of $44,471,000 at December 31, 2008. Current assets increased by $3,405,000 to $3,407,000 from $2,000 from December 31, 2008, to September 30, 2009. Current liabilities increased by $5,659,000 to $50,132,000 from $44,473,000 during the same period. The change in working capital from December 31, 2008, to September 30, 2009, reflects, in part, increased accrued liabilities of $2,432,000, increased accounts payable of $500,000, increased related party accounts payable of $21,000 increased derivative liability of $1,878,000, increased accrued payroll and other compensation of $691,000, increased tax payable of $29,000, and an increase in deferred tax liabilities of $228,000. Total assets were $4,133,000 at September 30, 2009, compared to $40,000 at December 31, 2008.

As of September 30, 2009, we had $396,000 in bills receivable, which we received from our customers in the form of bankers' acceptance drafts. In China, bankers' acceptance drafts are used to settle trade debts between companies. A banker's acceptance draft is issued by a depositor who maintains an account at an acceptance bank. The acceptance bank ensures unconditional payment to the draft holder on the designated maturity date specified on the draft. Typically, our customers pay us with bankers' acceptance drafts with maturity dates ranging from 60 to 90 days. We reasonably expect that all of our bankers' acceptance drafts will be paid upon maturity. In addition, we can endorse and transfer those bankers' acceptance drafts to pay our suppliers. Overall, we believe that our cash flow from operating activities should be adequate to sustain our operations at our current levels through the rest of the 2009 year.

Notes Payable and Accounts Payable - Related Parties

During 2002, two executive officers of the Company (the “Lenders”) sold shares of the Company’s Class A common stock owned by them and advanced the resulting proceeds amounting to $333,000 to the Company under the terms of a revolving line of credit and related promissory note. The funds were advanced for use in Company operations. The advances bear interest at 12 percent per annum, which interest is payable on a semi-annual basis. The entire principal, along with unpaid accrued interest and any other unpaid charges or related fees, was originally due and payable on June 10, 2003. The Company and the Lenders have agreed to postpone the maturity date on several occasions. The note was due September 30, 2006. As of September 30, 2009, the Company had not made payment against the outstanding balance due on the note. All or part of the outstanding balance and unpaid interest may be converted at the option of the Lenders into shares of Class A common stock of the Company at any time. The conversion price was the average closing bid price of the shares at the time of the advances. To the extent the market price of the Company’s shares is below the conversion price at the time of conversion, the Lenders are entitled to receive additional shares equal to the gross dollar value received from the original sale of the shares. A beneficial conversion option of $15,000 was recorded as interest expense in connection with this transaction. The Lenders may also receive additional compensation as determined appropriate by the Board of Directors.

During the year ended December 31, 2005, the Company received an additional advance of $50,000 against the promissory note. The balance due at December 31, 2005 was $486,000. During the year ended December 31, 2006, the Company received additional advances and other consideration from the Lenders in the aggregate amount of $419,000 and made principal payments to the Lenders against the note of $105,000. During the year ended December 31, 2007, the Company received additional advances of $102,000. During the nine months ended September 30, 2009, the Company received additional advances of $49,500. The balance due at September 30, 2009, was $777,000.

The Company currently owes an officer and former officer $107,000 for travel related expenses.

Notes Payable

In connection with the acquisition of the capital stock of LTEL Holdings in 2004, the Company issued a 5%, $10,000,000, secured, six-year note (the “Note”) payable to McCormack Avenue, Ltd. (“McCormack”). Under the terms of the Note, quarterly interest-only payments were required through January 15, 2005, with quarterly principal and interest payments of $319,000 beginning April 2005 and continuing through January 2010. Interest on the Note was payable in cash or, at the Company’s option, in shares of the Company’s Class A common stock. The Note was secured by the capital stock and all of the assets of LTEL Holdings and its subsidiaries. The Note was originally valued at $4,624,000 based on an imputed interest rate of 25 percent per annum.

On September 8, 2006, the Company received a default notice (the “Default Notice”) from McCormack in respect of the Note. In the Default Notice, McCormack stated that it intended to exercise its rights, including any and all rights set forth in the Note, as amended. McCormack took no action to collect amounts due under the Note.

During the fourth quarter of 2006, the Company entered into two promissory notes (the “Additional Notes”) with McCormack Avenue, Ltd., in the aggregate amount of $330,000. These Additional Notes accrue interest at 10% annually and were due and payable during the second quarter of 2007. The Additional Notes were exchanged for shares of the Company’s Series P Preferred Stock. See below.

On September 30, 2008, the Company entered into a Series P 9% Convertible Preferred Stock Exchange Agreement (the “Exchange Agreement”) with McCormack and Sovereign Partners, LP (“Sovereign”), whereby McCormack exchanged the Note, along with the Additional Notes and the Series E debenture (discussed in Note 5), and Sovereign exchanged two promissory notes, for shares of the Company’s Series P 9% Convertible Preferred Stock (the Series P Preferred Stock”). A table listing the obligations exchanged and the number of shares of Series P Preferred Stock issued.

For the nine months ended September 30, 2009, the Company issued 22,323,333 shares of its Class A common stock in conversion of 31 shares of its Series L Preferred Stock including total interest converted of $71,000. At September 30, 2009, 1,467 shares of Series L Preferred Stock remained outstanding. (See Note 11 to the condensed consolidated financial statements above for discussion of conversions subsequent to September 30, 2009.)

As of September 30, 2009, there were 150 shares of Series M Preferred Stock convertible preferred stock outstanding.

As of September 30, 2009, there were 1,755 shares of Series N Preferred Stock convertible preferred stock outstanding.

As of September 30, 2009, there were 730 shares of Series O Preferred Stock convertible preferred stock outstanding.

For the nine months ended September 30, 2009, the Company issued 6,088,468 shares of its Class A common stock in conversion of 10 shares of its Series P Preferred Stock. At September 30, 2009, 1,649 shares of Series P Preferred Stock remained outstanding. On May 1, 2009 the Company issued 5 shares of Series P Preferred Stock for proceeds of $42,500. On July 7, 2009 the Company issued 3.5 shares of Series P Preferred Stock for proceeds of $35,000. (See Note 11 to the condensed consolidated financial statements above for discussion of conversions subsequent to September 30, 2009.) Also, during the year ending September 30, 2009, the Company issued the following shares of Series P Preferred Stock for the purchase of G-Soft Limited, a Hong Kong corporation:

FONIX CORP 10-Q