Edgar Filing: CLEARONE COMMUNICATIONS INC

ClearOne Communications, Inc. Form 10-Q For the Period Ended 03/31/2006

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 March 31, 2006

¨ Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from _______________ to _______________

Commission file number: 000-17219

CLEARONE COMMUNICATIONS, INC.

(Exact name of registrant as specified in its charter)

Utah		87-0398877
(State or other jurisdiction of incorporation or organization)		(I.R.S. employer identification number)

1825 Research Way, Salt Lake City, Utah		84119
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (801) 975-7200

Indicate by check 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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and larger accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Larger Accelerated Filer ¨ Accelerated Filer ¨ Non-Accelerated Filer x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY

PROCEEDINGS DURING THE PRECEDING FIVE YEARS

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13, or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes ¨ No ¨

APPLICABLE ONLY TO CORPORATE REGISTRANTS

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date. There were 12,184,727 shares of the Company’s Common Stock, par value $0.001, outstanding on June 15, 2006.

CLEARONE COMMUNICATIONS, INC.

REPORT ON FORM 10-Q

FOR THE QUARTER ENDED MARCH 31, 2006

INDEX

		Page Number
Disclosure Regarding Forward-Looking Statements		3
PART I - FINANCIAL INFORMATION
Item 1	Condensed Consolidated Financial Statements
	Condensed Consolidated Balance Sheets as of March 31, 2006 and June 30, 2005 (Unaudited)	4
	Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the Three Months Ended March 31, 2006 and 2005 and the Nine Months Ended March 31, 2006 and 2005 (Unaudited)	5
	Condensed Consolidated Statement of Shareholders’ Equity for the Nine Months Ended March 31, 2006 (Unaudited)	7
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended March 31, 2006 and 2005 (Unaudited)	8
	Notes to Condensed Consolidated Financial Statements (Unaudited)	10
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	26
Item 3	Quantitative and Qualitative Disclosures about Market Risk	41
Item 4	Controls and Procedures	41
PART II - OTHER INFORMATION
Item 1	Legal Proceedings	43
Item 1A	Risk Factors	44
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	50
Item 3	Defaults Upon Senior Securities	50
Item 4	Submission of Matters to a Vote of Security Holders	50
Item 5	Other Information	50
Item 6	Exhibits	51
Signatures		52

DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements reflect our views with respect to future events based upon information available to us at this time. These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially from these statements. Forward-looking statements are typically identified by the use of the words “believe,” “may,” “could,” “will,” “should,” “expect,” “anticipate,” “estimate,” “project,” “propose,” “plan,” “intend,” and similar words and expressions; however, not all forward-looking statements contain these words. Examples of forward-looking statements are statements that describe the proposed development, manufacturing, and sale of our products; statements that describe our results of operations, pricing trends, the markets for our products, our anticipated capital expenditures, our cost reduction and operational restructuring initiatives, and regulatory developments; statements with regard to the nature and extent of competition we may face in the future; statements with respect to the sources of and need for future financing; and statements with respect to future strategic plans, goals, and objectives. Forward-looking statements are contained in this report in Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” Item 3, “Quantitative and Qualitative Disclosures About Market Risk,” and Item 4, “Controls and Procedures” included in this Quarterly Report on Form 10-Q. The forward-looking statements are based on present circumstances and on our predictions respecting events that have not occurred, that may not occur, or that may occur with different consequences and timing than those now assumed or anticipated. Actual events or results may differ materially from those discussed in the forward-looking statements as a result of various factors, including the risk factors discussed in this report under Part II - Other Information, Item 1A, “Risk Factors” and the application of “Critical Accounting Policies” as discussed in Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” These cautionary statements are intended to be applicable to all related forward-looking statements wherever they appear in this report. The cautionary statements contained or referred to in this report should also be considered in connection with any subsequent written or oral forward-looking statements that may be issued by us or persons acting on our behalf. Any forward-looking statements are made only as of the date of this report and ClearOne assumes no obligation to update forward-looking statements to reflect subsequent events, changes in circumstances, or changes in estimates.

CAUTIONARY STATEMENT REGARDING THE FILING DATE OF THIS REPORT AND THE ANTICIPATED FUTURE FILINGS OF ADDITIONAL PAST-DUE REPORTS

This Quarterly Report on Form 10-Q for the third quarter of the fiscal year ending June 30, 2006 is first being filed in June 2006. Shareholders and others are cautioned that the financial statements included in this report are close to three months old and are not necessarily indicative of the operating results that may be expected for the fiscal year ending June 30, 2006. Shareholders and others should also be aware that the staff of the Salt Lake District Office of the Securities and Exchange Commission (“SEC”) intended to recommend to the Commission that administrative proceedings be instituted to revoke the registration of the Company’s common stock based on the Company’s failure to timely file annual and quarterly reports with the Commission. The Company provided the staff with a so-called “Wells Submission” setting forth its position with respect to the staff’s intended recommendation. To date, the Commission has not instituted an administrative proceeding against the Company; however, there can be no assurance that the Commission will not institute an administrative proceeding in the future or that the Company would prevail if an administrative proceeding were instituted.

CLEARONE COMMUNICATIONS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands of dollars, except per share amounts)

	March 31,			June 30,
	2006			2005

ASSETS
Current assets:
Cash and cash equivalents	$	1,631		$	1,892
Marketable securities		18,850			15,800
Accounts receivable, net of allowance for doubtful accounts of $49 and $46, respectively		6,981			6,859
Inventories, net		5,658			5,806
Income tax receivable		3,658			3,952
Deferred income taxes, net		135			270
Prepaid expenses		514			300
Total current assets		37,427			34,879

Property and equipment, net		2,017			2,805
Intangibles, net		196			322
Other assets		15			15
Deferred taxes		-			-
Total assets	$	39,655		$	38,021

LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable	$	1,797		$	2,163
Accrued liabilities		1,710			5,622
Deferred product revenue		5,355			5,055
Total current liabilities		8,862			12,840

Deferred income taxes, net		135			270
Total liabilities		8,997			13,110

Commitments and contingencies (see Note 8)

Shareholders' equity:
Common stock, par value $0.001; 50,000,000 shares authorized;
12,184,727 and 11,264,233 shares issued and outstanding, respectively		12			11
Additional paid-in capital		52,498			49,393
Deferred compensation		-			(33	)
Accumulated deficit		(21,852	)		(24,460	)
Total shareholders' equity		30,658			24,911
Total liabilities and shareholders' equity	$	39,655		$	38,021

See accompanying notes to condensed consolidated financial statements

CLEARONE COMMUNICATIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND

COMPREHENSIVE INCOME (LOSS)

(Unaudited)

(in thousands of dollars, except per share amounts)

	Three Months Ended						Nine Months Ended
	March 31,			March 31,			March 31,			March 31,
	2006			2005			2006			2005

Product Revenue:	$	8,700		$	7,103		$	27,902		$	22,542

Cost of goods sold:
Product		4,477			3,167			13,788			10,307
Product inventory write-offs		148			13			425			618
Total cost of goods sold		4,625			3,180			14,213			10,925
Gross profit		4,075			3,923			13,689			11,617

Operating expenses:
Marketing and selling		1,920			2,151			5,542			6,578
General and administrative		1,060			1,287			4,288			4,110
Settlement in shareholders' class action		-			(855	)		(1,205	)		(2,609	)
Research and product development		2,201			1,423			5,778			3,810
Total operating expenses		5,181			4,006			14,403			11,889

Operating (loss) income		(1,106	)		(83	)		(714	)		(272	)

Other income (expense), net:
Interest income		218			110			563			292
Interest expense		-			(2	)		-			(105	)
Other, net		19			(13	)		31			6
Total other income (expense), net		237			95			594			193

(Loss) income from continuing operations before income taxes		(869	)		12			(120	)		(79	)
Benefit (provision) for income taxes		763			(5	)		1,050			29
(Loss) income from continuing operations		(106	)		7			930			(50	)

Discontinued operations:
Income from discontinued operations		-			171			-			225
Gain on disposal of discontinued operations		1,030			332			2,676			17,701
Income tax provision		(384	)		(115	)		(998	)		(4,119	)
Income from discontinued operations		646			388			1,678			13,807

Net income	$	540		$	395		$	2,608		$	13,757

Comprehensive income (loss):
Net income	$	540		$	395		$	2,608		$	13,757
Foreign currency translation adjustments		-			(17	)		-			112
Less: reclassification adjustments for foreign currency translation
adjustments included in net income (loss)		-			(1,301	)		-			(1,301	)

Comprehensive income (loss)	$	540		$	(923	)	$	2,608		$	12,568

See accompanying notes to condensed consolidated financial statements

CLEARONE COMMUNICATIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND

COMPREHENSIVE INCOME (LOSS) (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

	Three Months Ended					Nine Months Ended
	March 31,			March 31,		March 31,		March 31,
	2006			2005		2006		2005

Basic earnings (loss) per common share from continuing operations	$	(0.01	)	$	-	$	0.08	$	-
Diluted earnings (loss) per common share from continuing operations	$	(0.01	)	$	-	$	0.08	$	-

Basic earnings (loss) per common share from discontinued operations	$	0.05		$	0.03	$	0.14	$	1.24
Diluted earnings (loss) per common share from discontinued operations	$	0.05		$	0.03	$	0.14	$	1.11

Basic earnings (loss) per common share	$	0.04		$	0.03	$	0.22	$	1.23
Diluted earnings (loss) per common share	$	0.04		$	0.03	$	0.21	$	1.11

Basic weighted average shares outstanding		12,184,727			11,264,233		11,882,375		11,148,569
Diluted weighted average shares outstanding		12,187,446			12,300,869		12,214,401		12,355,366

See accompanying notes to condensed consolidated financial statements

CLEARONE COMMUNICATIONS, INC.

CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(Unaudited)

(in thousands of dollars, except per share amounts)

										Retained
					Additional					Earnings			Total
	Common Stock				Paid-In		Deferred			(Accumulated			Shareholders'
	Shares		Amount		Capital		Compensation			Deficit)			Equity

Balances at June 30, 2005		11,264,233	$	11	$	49,393	$	(33	)	$	(24,460	)	$	24,911

Issuance of Common Shares related to
shareholder settlement agreement		920,494		1		2,263		-			-			2,264
SFAS No. 123R compensation cost		-		-		827		-			-			827
Compensation expense resulting from
the modification of stock options		-		-		15		-			-			15
SFAS No. 123R transition expense		-		-		-		33			-			33
Net income		-		-		-		-			2,608			2,608
Balances at March 31, 2006		12,184,727	$	12	$	52,498	$	-		$	(21,852	)	$	30,658

See accompanying notes to consolidated financial statements

CLEARONE COMMUNICATIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands of dollars, except per share amounts)

	Nine Months Ended
	March 31,			March 31,
	2006			2005
Cash flows from operating activities:
Net income (loss) from continuing operations	$	930		$	(50	)
Adjustments to reconcile net income (loss) from continuing operations
to net cash provided by operations:
Depreciation and amortization expense		1,124			1,813
Stock-based compensation		873			57
Write-off of inventory		425			618
(Gain) loss on disposal of assets and fixed assets write-offs		(59	)		(7	)
Provision for doubtful accounts		3			41
Purchase accounting adjustment		-			395
Changes in operating assets and liabilities:
Accounts receivable		(125	)		(108	)
Inventories		(277	)		(23	)
Prepaid expenses and other assets		(214	)		112
Accounts payable		(366	)		(813	)
Accrued liabilities		(1,646	)		(4,796	)
Income taxes		294			2,620
Deferred product revenue		300			(619	)
Net change in other assets/liabilities		-			4
Net cash provided by (used in) continuing operating activities		1,262			(756	)
Net cash provided by discontinued operating activities		-			168
Net cash provided by (used in) operating activities		1,262			(588	)

Cash flows from investing activities:
Purchase of property and equipment		(233	)		(929	)
Proceeds from the sale of property and equipment		82			8
Purchase of marketable securities		(5,450	)		(43,300	)
Sale of marketable securities		2,400			31,050
Net cash used in continuing investing activities		(3,201	)		(13,171	)
Net cash provided by discontinued investing activities		1,678			14,057
Net cash (used in) provided by investing activities		(1,523	)		886

Cash flows from financing activities:
Principal payments on capital lease obligations		-			(8	)
Principal payments on note payable		-			(932	)
Net cash used in continuing financing activities		-			(940	)
Net cash used in discontinued financing activities		-			-
Net cash used in financing activities		-			(940	)

Net increase (decrease) in cash and cash equivalents		(261	)		(642	)
Cash and cash equivalents at the beginning of the period		1,892			4,207
Cash and cash equivalents at the end of the period	$	1,631		$	3,565

See accompanying notes to condensed consolidated financial statements

CLEARONE COMMUNICATIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

	Nine Months Ended
	March 31,			March 31,
	2006			2005
Supplemental disclosure of cash flow information:
Cash paid for interest	$	-		$	104
Cash paid (received) for income taxes		(346	)		1,114

Supplemental disclosure of non-cash financing activities:
Value of common shares issued in shareholder settlement	$	2,264		$	957

See accompanying notes to condensed consolidated financial statements

CLEARONE COMMUNICATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(in thousands of dollars, except per share amounts)

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements, consisting of the condensed consolidated balance sheets as of March 31, 2006 and June 30, 2005, the condensed consolidated statements of operations and comprehensive income (loss) for the three months and nine months ended March 31, 2006 and 2005, the condensed consolidated statement of shareholders’ equity for the nine months ended March 31, 2006, and the condensed consolidated statements of cash flows for the nine months ended March 31, 2006 and 2005, have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in complete financial statements have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended June 30, 2005.

In management’s opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. The results of operations for interim periods are not necessarily indicative of the results of operations to be expected for the entire year or for any future period.

2. Summary of Significant Accounting Policy Update

Pervasiveness of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America 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 periods. Key estimates in the accompanying condensed consolidated financial statements include, among others, revenue recognition, allowances for doubtful accounts and product returns, provisions for obsolete inventory, valuation of long-lived assets including goodwill, and deferred income tax asset valuation allowances. Actual results could differ materially from these estimates.

Revenue Recognition - The Company evaluates, at each quarter-end, the inventory in the channel through information provided by certain of its distributors. The level of inventory in the channel will fluctuate up or down, each quarter, based upon these distributors’ individual operations. Accordingly, each quarter-end revenue deferral is calculated and recorded based upon the underlying, estimated channel inventory at quarter-end. The amounts of deferred cost of goods sold were included in consigned inventory. The following table details the amount of deferred revenue, cost of goods sold, and gross profit at each period end for the 21-month period ended March 31, 2006.

	Deferred Revenue		Deferred Cost of Goods Sold		Deferred Gross Profit

March 31, 2006	$	5,355	$	2,443	$	2,912
December 31, 2005		4,936		2,199		2,737
September 30, 2005		4,848		2,373		2,475
June 30, 2005		5,055		2,297		2,758
March 31, 2005		5,456		2,321		3,135
December 31, 2004		4,742		1,765		2,977
September 30, 2004		5,617		1,920		3,697
June 30, 2004		6,107		2,381		3,726

CLEARONE COMMUNICATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

Share-Based Payment - Prior to June 30, 2005 and as permitted under the original Statement of Financial Accounting Standards (“SFAS”) No. 123, the Company accounted for its share-based payments following the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” as interpreted. Accordingly, no share-based compensation expense had been reflected in the Company’s fiscal 2005 statements of operations for unmodified option grants since (1) the exercise price equaled the market value of the underlying common stock on the grant date and (2) the related number of shares to be granted upon exercise of the stock option was fixed on the grant date.

If the compensation cost of its stock options had been determined consistent with the original SFAS No. 123, the Company’s net income and earnings per common share and common share equivalent would have changed to the pro-forma amounts indicated below:

	Three Months Ended			Nine Months Ended
	March 31,			March 31,
	2005			2005
Net income:
As reported	$	395		$	13,757
Stock-based employee compensation expense included in
reported net income, net of income taxes		3			10
Stock-based employee compensation expense determined
under the fair-value method of all awards, net of income taxes		(166	)		(498	)
Pro forma	$	232		$	13,269

Basic earnings (loss) per common share:
As reported	$	0.03		$	1.23
Pro forma		0.02			1.19
Diluted earnings (loss) per common share:
As reported	$	0.03		$	1.11
Pro forma		0.02			1.07

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, “Share-Based Payment.” SFAS No. 123R is a revision of SFAS No. 123. SFAS No. 123R establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. Primarily, SFAS No. 123R focuses on accounting for transactions in which an entity obtains employee services in share-based payment transactions. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments.

SFAS No. 123R requires the Company to measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the awards - the requisite service period (usually the vesting period). No compensation cost is recognized for equity instruments for which employees do not render the requisite service. Therefore, if an employee does not ultimately render the requisite service, the costs associated with the unvested options will not be recognized, cumulatively.

Effective July 1, 2005, the Company adopted SFAS No. 123R and its fair value recognition provisions using the modified prospective transition method. Under this transition method, stock-based compensation cost recognized after July 1, 2005 includes the straight-line basis compensation cost for (a) all share-based payments granted prior to July 1, 2005, but not yet vested, based on the grant date fair values used for the pro-forma disclosures under the original SFAS No. 123 and (b) all share-based payments granted or modified on or after July 1, 2005, in accordance with the provisions of SFAS No. 123R. See Note 9 for information about the Company’s various share-based compensation plans, the impact of adoption of SFAS No. 123R, and the assumptions used to calculate the fair value of share-based compensation.

CLEARONE COMMUNICATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

If assumptions change in the application of SFAS No. 123R in future periods, the stock-based compensation cost ultimately recorded under SFAS No. 123R may differ significantly from what was recorded in the current period.

Recent Accounting Pronouncements

Accounting for Asset Retirement Obligations in the European Union

In June 2005, the FASB issued a FASB Staff Position (“FSP”) interpreting SFAS No. 143, “Accounting for Asset Retirement Obligations,” specifically FSP 143-1, “Accounting for Electronic Equipment Waste Obligations.” FSP 143-1 addresses the accounting for obligations associated with Directive 2002/96/EC, “Waste Electrical and Electronic Equipment,” which was adopted by the European Union (“EU”). The FSP provides guidance on how to account for the effects of the Directive but only with respect to historical waste associated with products placed on the market on or before August 13, 2005. FSP 143-1 was effective beginning with the Company’s fiscal 2006 financial statements. Management does not believe that the adoption of FSP 143-1 had a material effect on the Company’s business, results of operations, financial position, or liquidity.

Inventory Costs

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs - an Amendment of ARB No. 43,” which is the result of its efforts to converge U.S. accounting standards for inventories with International Accounting Standards. SFAS No. 151 requires idle facility expenses, freight, handling costs, and wasted material (spoilage) costs to be recognized as current-period charges. It also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 was effective beginning with the Company’s fiscal 2006 financial statements. There was not a significant impact on the Company’s business, results of operations, financial position, or liquidity from the adoption of this standard.

Accounting Changes and Error Corrections

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections - a Replacement of APB Opinion No. 20 and FASB Statement No. 3,” in order to converge U.S. accounting standards with International Accounting Standards. SFAS No. 154 changes the requirements for the accounting for and reporting of a change in accounting principle. Previously, most voluntary changes in accounting principles required recognition of a cumulative effect adjustment within net income of the period of the change. SFAS No. 154 requires retrospective application to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, it does not change the transition provisions of any existing accounting pronouncements. The Company does not believe that the adoption of SFAS No. 154 will have a material effect on its business, results of operations, financial position, or liquidity.

Other-Than-Temporary Impairment

In March 2004, the FASB issued Emerging Issues Task Force (“EITF”) Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,” which provides new guidance for assessing impairment losses on debt and equity investments. The new impairment model applies to investments accounted for under the cost or equity method and investments accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” EITF No. 03-01 also includes new disclosure requirements for cost method investments and for all investments that are in an unrealized loss position. In September 2004, the FASB delayed the accounting provisions of EITF No. 03-01; however, the disclosure requirements remain effective. The Company does not expect that the adoption of this EITF, when the delay is suspended, will have a material impact on its business, results of operations, financial position, or liquidity.

CLEARONE COMMUNICATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

3. Earnings Per Common Share

The following table sets forth the computation of basic and diluted earnings (loss) per common share:

	Three Months Ended					Nine Months Ended
	March 31,			March 31,		March 31,		March 31,
	2006			2005		2006		2005
Numerator:
Income (loss) from continuing operations	$	(106	)	$	7	$	930	$	(50	)
Income (loss) from discontinued operations, net of tax		-			132		-		173
Gain (loss) on disposal of discontinued operations, net of tax		646			256		1,678		13,634
Net income (loss)	$	540		$	395	$	2,608	$	13,757
Denominator:
Basic weighted average shares outstanding		12,184,727			11,264,233		11,882,375		11,148,569
Dilutive common stock equivalents using treasury stock method		2,719			1,036,636		332,026		1,206,797
Diluted weighted average shares outstanding		12,187,446			12,300,869		12,214,401		12,355,366

Basic earnings (loss) per common share:
Continuing operations	$	(0.01	)	$	-	$	0.08	$	-
Discontinued operations		-			0.01		-		0.02
Disposal of discontinued operations		0.05			0.02		0.14		1.22
Net income (loss)		0.04			0.03		0.22		1.23
Diluted earnings (loss) per common share:
Continuing operations	$	(0.01	)	$	-	$	0.08	$	-
Discontinued operations		-			0.01		-		0.01
Disposal of discontinued operations		0.05			0.02		0.14		1.10
Net income (loss)		0.04			0.03		0.21		1.11

Options that had an exercise price greater than the average market price of the common shares (“Out-of-the-Money Options”) during the respective period were not included in the computation of diluted earnings per share as the effect would be anti-dilutive. An average total of 1,302,769 and 1,469,965 Out-of-the-Money Options were not included during the three months ended March 31, 2006 and 2005, respectively. An average total of 1,393,384 and 1,433,969 Out-of-the-Money Options were not included during the nine months ended March 31, 2006 and 2005, respectively. Warrants to purchase 150,000 shares of common stock were outstanding as of March 31, 2006 and 2005, but were not included in the computation of diluted earnings per share for the three-month and nine-month periods ended March 31, 2006 and 2005, as the effect would be anti-dilutive. During fiscal 2004, the Company entered into a settlement agreement related to the shareholders’ class action and agreed to issue 1.2 million shares of its common stock; however, certain of these shares were settled in cash in lieu of common stock (see Note 8). The Company issued 228,000 shares in November 2004 and 920,494 shares in September 2005.

CLEARONE COMMUNICATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

4. Discontinued Operations

During fiscal 2005, the Company completed the sale of its conferencing services business component to Clarinet, Inc., an affiliate of American Teleconferencing Services, Ltd. doing business as Premiere Conferencing (“Premiere”) and the sale of its Canadian audiovisual integration services, OM Video, to 6351352 Canada Inc, a Canada corporation (the “OM Purchaser”). Accordingly, the results of operations and the financial position have been reclassified in the accompanying condensed consolidated financial statements as discontinued operations. Additionally, during fiscal 2001, the Company sold certain assets to Burk Technology, Inc. (“Burk”) whose sales proceeds are included with discontinued operations. Summary operating results of the discontinued operations are as follows:

	Three Months Ended						Nine Months Ended
	March 31,			March 31,			March 31,			March 31,
	2006			2005			2006			2005

Income from discontinued operations:
OM Video	$	-		$	171		$	-		$	225

Gain on disposal of discontinued operations:
Conferencing services business	$	1,030		$	-		$	1,030		$	17,369
OM Video		-			145			300			145
Burk		-			187			1,346			187
Total gain on disposal of discontinued operations		1,030			332			2,676			17,701

Income tax provision:
Conferencing services business	$	(384	)	$	-		$	(384	)	$	(3,991	)
OM Video		-			(72	)		(112	)		(85	)
Burk		-			(43	)		(502	)		(43	)
Total income tax provision		(384	)		(115	)		(998	)		(4,119	)

Total income from discontinued operations, net of income taxes:
Conferencing services business	$	646		$	-		$	646		$	13,378
OM Video		-			244			188			285
Burk		-			144			844			144
Total income from discontinued operations,
net of income taxes	$	646		$	388		$	1,678		$	13,807

Conferencing Services

On July 1, 2004, the Company sold its conferencing services business component to Premiere. Consideration for the sale consisted of $21,300 in cash. Of the purchase price, $300 was placed into a working capital escrow account and an additional $1,000 was placed into an 18-month Indemnity Escrow account. The Company received the $300 working capital escrow funds approximately 90 days after the execution date of the contract. The Company received the $1,000 in the Indemnity Escrow account in January 2006. Additionally, $1,365 of the proceeds was utilized to pay off equipment leases pertaining to assets being conveyed to Premiere. The Company reported pre-tax gain of $1,030 for the three and nine months ended March 31, 2006 due to the receipt of the $1,000 in the Indemnity Escrow account together with the $30 in related interest income. The Company realized a pre-tax gain on the sale of $17,369 during the nine months ended March 31, 2005.

CLEARONE COMMUNICATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

OM Video

On March 4, 2005, the Company sold all of the issued and outstanding stock of its Canadian subsidiary, ClearOne Communications of Canada, Inc. (“ClearOne Canada”) to 6351352 Canada Inc., a Canada corporation. ClearOne Canada owned all the issued and outstanding stock of Stechyson Electronics, Ltd., which conducts business under the name OM Video. The Company agreed to sell the stock of ClearOne Canada for $200 in cash; a $1,256 note receivable over a 15-month period, with interest accruing on the unpaid balance at the rate of 5.3 percent per year; and contingent consideration ranging from 3.0 percent to 4.0 percent of related gross revenues over a five-year period. In June 2005, the Company was advised that the OM Purchaser had settled an action brought by the former employer of certain of OM Purchaser’s owners and employees alleging violation of non-competition agreements. The settlement reportedly involved a cash payment and an agreement not to sell certain products for a period of one year. Based on an analysis of the facts and circumstances that existed at the end of fiscal 2005, and considering the guidance from Topic 5U of the SEC Rules and Regulations, “Gain Recognition on the Sale of a Business or Operating Assets to a Highly Leveraged Entity,” the gain is being recognized as cash is collected (as collection was not reasonably assured). OM Video revenues, reported in discontinued operations, for the three months and nine months ended March 31, 2005 were $1,449 and $3,805, respectively. OM Video pre-tax income, reported in discontinued operations, for the three months and nine months ended March 31, 2005 was $171 and $225, respectively. OM Video pre-tax gain on disposal, reported in discontinued operations, for the three months and nine months ended March 31, 2006 was $0 and $300, respectively. OM Video pre-tax gain on disposal, reported in discontinued operations, for the three months and nine months ended March 31, 2005 was $145.

Through December 31, 2005, all payments required through such date had been received and $854 of the promissory note remained outstanding; however, OM Purchaser has failed to make any subsequent, required payments under the note receivable and is in default thereunder. The Company is currently considering its collection options.

Burk

On August 22, 2005, the Company entered into a Mutual Release and Waiver Agreement with Burk pursuant to which Burk paid the Company $1,346 in full satisfaction of the promissory note, which included a discount of $119. As part of the Mutual Release and Waiver Agreement, the Company waived any right to future commission payments from Burk. Additionally, Burk and the Company granted mutual releases to one another with respect to future claims and liabilities. Accordingly, the total pre-tax gain on the disposal of discontinued operations, related to Burk, was approximately $2,419. The gain was recognized beginning in fiscal 2001. The Company realized pre-tax gain on the disposal of discontinued operations of $1,346 during the nine months ended March 31, 2006. The Company realized pre-tax gain on the disposal of discontinued operations of $187 for the three months and nine months ended March 31, 2005.

5. Income Taxes

During the three months ended March 31, 2006, the Company recorded a benefit for income taxes from continuing operations of $763. This compares to a provision for income taxes of ($5) during the three months ended March 31, 2005. During the nine months ended March 31, 2006, the Company recorded a benefit for income taxes from continuing operations of $1,050. This compares to a benefit for income taxes of $29 during the nine months ended March 31, 2005. Taxes are based on the estimated annual effective tax rate.

SFAS No. 109, “Accounting for Income Taxes,” requires that a valuation allowance be established when it is more likely than not that all or a portion of a deferred tax asset will not be realized. Valuation allowances were recorded in fiscal 2006 and fiscal 2005 due to the uncertainty of realization of the assets. As of March 31, 2006, the Company has recorded a valuation allowance against all of its net deferred tax assets. Based on the Company’s lack of cumulative profitability in recent years it is more likely than not that all of the net deferred tax assets will not be realized.

CLEARONE COMMUNICATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

6. Inventory

Inventories, net of reserves, consist of the following as of March 31, 2006 and June 30, 2005:

	March 31,		June 30,
	2006		2005

Raw materials	$	134	$	1,804
Finished goods		3,081		1,705
Consigned inventory		2,443		2,297
Total inventory	$	5,658	$	5,806

Consigned inventory represents inventory at distributors and other customers where revenue recognition criteria have not been achieved.

7. Accrued Liabilities

Accrued liabilities consist of the following as of March 31, 2006 and June 30, 2005:

	March 31,		June 30,
	2006		2005
Accrued salaries and other compensation	$	748	$	977
Other accrued liabilities		962		1,049
Class action settlement		-		3,596
Total	$	1,710	$	5,622

8. Commitments and Contingencies

The Company establishes contingent liabilities when a particular contingency is both probable and estimable. For the contingencies noted below, the Company has accrued amounts considered probable and estimable. The Company is not aware of pending claims or assessments, other than as described below, which may have a material adverse impact on the Company’s business, results of operations, financial position, or liquidity.

Legal Proceedings. In addition to the legal proceedings described below, the Company is also involved from time to time in various claims and other legal proceedings which arise in the normal course of business. Such matters are subject to many uncertainties and outcomes that are not predictable. However, based on the information available to the Company as of June 15, 2006 and after discussions with legal counsel, the Company does not believe any such other proceedings will have a material, adverse effect on its business, results of operations, financial position, or liquidity, except as described below.

CLEARONE COMMUNICATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

The Shareholders’ Class Action. On June 30, 2003, a consolidated complaint was filed against the Company, eight present or former officers and directors of the Company, and Ernst & Young LLP (“Ernst & Young”), the Company’s former independent public accountants, by a class consisting of purchasers of the Company’s common stock during the period from April 17, 2001 through January 15, 2003. The action followed the consolidation of several previously filed class action complaints and the appointment of lead counsel for the class. The allegations in the complaint were essentially the same as those contained in an SEC complaint described in the Company’s Annual Report on Form 10-K for the year ended June 30, 2005. On December 4, 2003, the Company, on behalf of itself and all other defendants with the exception of Ernst & Young, entered into a settlement agreement with the class pursuant to which the Company agreed to pay the class $5,000 and to issue the class 1.2 million shares of its common stock. The cash payment was made in two equal installments, the first on November 10, 2003 (fiscal 2004) and the second on January 14, 2005 (fiscal 2005). On May 23, 2005, the court order was amended to require the Company to pay cash in lieu of stock to those members of the class who would otherwise have been entitled to receive fewer than 100 shares of stock. On September 29, 2005 (fiscal 2006), the Company completed its obligations under the settlement agreement by issuing a total of 1,148,494 shares of the Company’s common stock to the plaintiff class, including 228,000 shares previously issued in November 2004 (fiscal 2005), and the Company paid an aggregate of $127 in cash in lieu of shares to those members of the class who would otherwise have been entitled to receive an odd-lot number of shares or who resided in states in which there was no exemption available for the issuance of shares. The cash payments were calculated on the basis of $2.46 per share which was equal to the higher of (i) the closing price for the Company’s common stock as reported by the Pink Sheets on the business day prior to the date the shares were mailed, or (ii) the average closing price over the five trading days prior to such mailing date. The 920,494 shares that were issued on September 29, 2005 were also valued at $2.46 per share.

On a quarterly basis, the Company revalued the un-issued shares to the closing price of the stock on the later of the date the shares were mailed or the last day of the quarter. During the nine months ended March 31, 2006 and 2005, the Company received a benefit of $1,205 and $2,609, respectively, related to the revaluation of the 1.2 million shares of the Company’s common stock that were issued in November 2004 and September 2005. During the three months ended March 31, 2005, the Company received a benefit of $855.

The Shareholder Derivative Actions. Between March and August 2003, four shareholder derivative actions were filed by certain shareholders of the Company against various present and past officers and directors of the Company and against Ernst & Young. The complaints asserted allegations similar to those asserted in an SEC complaint described in the Company’s Annual Report on Form 10-K for the year ended June 30, 2005 and the shareholders’ class action described above and also alleged that the defendant directors and officers violated their fiduciary duties to the Company by causing or allowing the Company to recognize revenue in violation of generally accepted accounting principles (“GAAP”) and to issue materially misstated financial statements and that Ernst & Young breached its professional responsibilities to the Company and acted in violation of GAAP by failing to identify or prevent the alleged revenue recognition violations and by issuing unqualified audit opinions with respect to the Company’s fiscal 2002 and 2001 financial statements. One of these actions was dismissed without prejudice on June 13, 2003. As to the other three actions, the Company’s Board of Directors appointed a special litigation committee of independent directors to evaluate the claims made by these shareholders. That committee determined that the maintenance of the derivative proceedings against the individual defendants was not in the best interest of the Company. Accordingly, on December 12, 2003, the Company moved to dismiss those claims. In March 2004, the Company’s motions to dismiss those claims were granted and the derivative claims were dismissed with prejudice as to all defendants except Ernst & Young. The Company was substituted as the plaintiff in the action and is now pursuing in its own name the claims against Ernst & Young.

CLEARONE COMMUNICATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

The Insurance Coverage Action. On February 9, 2004, the Company and Edward Dallin Bagley, the Chairman of the Board of Directors and a significant shareholder of the Company, jointly filed an action against National Union Fire Insurance Company of Pittsburgh, Pennsylvania (“National Union”) and Lumbermens Mutual Insurance Company of Berkeley Heights, New Jersey (“Lumbermens Mutual”), the carriers of certain prior period directors and officers’ liability insurance policies, to recover the costs of defending and resolving claims against certain of the Company’s present and former directors and officers in connection with an SEC complaint described in the Company’s Annual Report on Form 10-K for the year ended June 30, 2005, and the shareholders’ class action and the shareholder derivative actions described above, and seeking other damages resulting from the refusal of such carriers to timely pay the amounts owing under such liability insurance policies. This action has been consolidated into a declaratory relief action filed by one of the insurance carriers on February 6, 2004 against the Company and certain of its current and former directors. In this relief action, the insurers assert that they are entitled to rescind insurance coverage under the Company’s directors and officers liability insurance policies, $3,000 of which was provided by National Union and $2,000 of which was provided by Lumbermens Mutual, based on alleged misstatements in the Company’s insurance applications. In February 2005, the Company entered into a confidential settlement agreement with Lumbermens Mutual pursuant to which the Company and Mr. Bagley received a lump-sum cash amount and the plaintiffs agreed to dismiss their claims against Lumbermens Mutual with prejudice. The cash settlement is held in a segregated account that has not been recorded in the accompanying financial statements and will not be until the claims involving National Union have been resolved, at which time the amounts received in the action will be allocated between the Company and Mr. Bagley. The amount distributed to the Company and Mr. Bagley will be determined based on future negotiations between the Company and Mr. Bagley. The Company cannot currently estimate the amount of the settlement which it will ultimately receive. Upon determining the amount of the settlement which the Company will ultimately receive, the Company will record this as a contingent gain. On October 21, 2005, the court granted summary judgment in favor of National Union on its rescission defense and accordingly entered a judgment dismissing all of the claims asserted by ClearOne and Mr. Bagley. In connection with the summary judgment, the Company has been ordered to pay approximately $59 in expenses. However, due to the Lumbermans Mutual cash proceeds discussed above and the appeal of the summary judgment discussed below, this potential liability has not been recorded in the balance sheet as of March 31, 2006. On February 2, 2006, the Company and Mr. Bagley filed an appeal of the summary judgment granted on October 21, 2005 and intend to vigorously pursue the appeal and any follow-up proceedings regarding their claims against National Union, although no assurances can be given that they will be successful. The Company and Mr. Bagley have entered into a Joint Prosecution and Defense Agreement in connection with the action and the Company is paying all litigation expenses except litigation expenses which are solely related to Mr. Bagley’s claims in the litigation.

Wells Submission. The Company had been advised by the staff of the Salt Lake District Office of the SEC that the staff intended to recommend to the Commission that administrative proceedings be instituted to revoke the registration of the Company’s common stock based on the Company’s failure to timely file annual and quarterly reports with the Commission. The Company provided the staff with a so-called “Wells Submission” setting forth its position with respect to the staff’s intended recommendation. To date, the Commission has not instituted an administrative proceeding against the Company; however, there can be no assurance that the Commission will not institute an administrative proceeding in the future or that the Company would prevail if an administrative proceeding were instituted.

CLEARONE COMMUNICATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

9. Share-Based Payment

Our share-based compensation primarily consists of the following plans:

The Company’s 1990 Incentive Plan (the “1990 Plan”) had shares of common stock available for issuance to employees and directors. Provisions of the 1990 Plan included the granting of stock options. Generally, stock options vested over a five-year period at 10 percent, 15 percent, 20 percent, 25 percent, and 30 percent per year. Certain other stock options vested in full after eight years. During the nine months ended March 31, 2006, the 30,750 options outstanding under the 1990 Plan as of June 30, 2005 expired and were canceled. As of March 31, 2006, there were no options outstanding under the 1990 Plan and no additional options were available for grant under such plan.

The Company also has a 1998 Stock Option Plan (the “1998 Plan”). Provisions of the 1998 Plan include the granting of incentive and non-qualified stock options. Options may be granted to directors, officers, and key employees and may be granted upon such terms as the Board of Directors, in their sole discretion, determine. Through December 1999, 1,066,000 options were granted that would cliff vest after 9.8 years; however, such vesting was accelerated for 637,089 of these options upon meeting certain earnings per share goals through the fiscal year ended June 30, 2003. Subsequent to December 1999 and through June 2002, 1,248,250 options were granted that would cliff vest after 6.0 years; however, such vesting was accelerated for 300,494 of these options upon meeting certain earnings per share goals through the fiscal year ended June 30, 2005. As of March 31, 2006, 53,600 and 202,060 of these options that cliff vest after 9.8 and 6.0 years, respectively, remain outstanding.

Of the options granted subsequent to June 2002, all vesting schedules are based on 3 or 4-year vesting schedules, with either one-third or one-fourth vesting on the first anniversary and the remaining options vesting ratably over the remainder of the vesting term. Generally, directors and officers have 3-year vesting schedules and all other employees have 4-year vesting schedules. All options have contractual lives of ten years. Under the 1998 Plan, 2,500,000 shares were authorized for grant. The 1998 Plan expires June 10, 2008, or when all the shares available under the plan have been issued if this occurs earlier. As of March 31, 2006, there were 1,241,879 options outstanding under the 1998 Plan, which includes the cliff vesting and 3 or 4-year vesting options discussed above, and 955,997 options available for grant in the future.

In addition to the two stock option plans, the Company has an Employee Stock Purchase Plan (“ESPP”). Employees can purchase common stock through payroll deductions of up to 10 percent of their base pay. Amounts deducted and accumulated by the employees are used to purchase shares of common stock on the last day of each month. The Company contributes to the account of the employee one share of common stock for every nine shares purchased by the employee under the ESPP. The program was suspended during fiscal 2003 due to the Company’s failure to remain current in its filing of periodic reports with the SEC.

Prior to July 1, 2005, the Company accounted for compensation expense associated with its stock options under the intrinsic value method in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Accordingly, no compensation cost has been recognized for the Company’s unmodified stock options in its condensed consolidated financial statements for the three months and nine months ended March 31, 2005.

Effective July 1, 2005, the Company adopted SFAS No. 123R, “Share-Based Payment.” The Company adopted the fair value recognition provisions of SFAS No. 123R using the modified prospective transition method. Under this transition method, stock-based compensation cost recognized beginning July 1, 2005 includes the straight-line compensation cost for (a) all share-based payments granted prior to July 1, 2005, but not yet vested, based on the grant date fair values used in the pro-forma disclosures under the original SFAS No. 123 and (b) all share-based payments granted on or after July 1, 2005, in accordance with the provisions of SFAS No. 123R.

CLEARONE COMMUNICATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

The Company uses judgment in determining the fair value of the share-based payments on the date of grant using an option-pricing model with assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the risk-free interest rate of the awards, the expected life of the awards, the expected volatility over the term of the awards, the expected dividends of the awards, and an estimate of the amount of awards that are expected to be forfeited. The Company uses the Black-Scholes option pricing model to determine the fair value of share-based payments granted under SFAS No. 123R and the original SFAS No. 123.

In applying the Black-Scholes methodology to the options granted during the three months and nine months ended March 31, 2006 and 2005, the Company used the following assumptions:

	Three Months Ended				Nine Months Ended
	March 31,		March 31,		March 31,		March 31,
	2006		2005		2006		2005
Risk-free interest rate, average		4.0%		4.0%		4.3%		4.1%
Expected option life, average		5.9 years		5.8 years		5.9 years		5.8 years
Expected price volatility, average		86.5%		91.2%		87.4%		92.3%
Expected dividend yield		0.0%		0.0%		0.0%		0.0%
Expected annual forfeiture rate		10.0%		0.0%		10.0%		0.0%

The risk-free interest rate is determined using the U.S. Treasury rate in effect as of the date of the grant, based on the expected life of the stock option. The expected life of the stock option is determined using historical data. The expected price volatility is determined using a weighted average of daily historical volatility of the Company’s stock price over the corresponding expected option life. The Company does not currently intend to distribute any dividend payments to shareholders. The Company recognizes compensation cost net of an expected forfeiture rate and recognized the associated compensation cost for only those awards expected to vest on a straight-line basis over the underlying requisite service period. The Company estimated the forfeiture rates based on its historical experience and expectations about future forfeitures. The Company determined the annual forfeiture rate for options that will cliff vest after 9.8 or 6.0 years to be 38.0 percent and the annual forfeiture rate for options that vest on 3 or 4-year vesting schedules to be 10.0 percent.

In the three months ended March 31, 2006, the adoption of SFAS No. 123R resulted in incremental, pre-tax, stock-based compensation cost of $260. For the three months ended March 31, 2006, the Company expensed $12 in cost of goods sold, $25 in marketing and selling, $179 in general and administrative, and $44 in research and product development expense related to the transition to SFAS No. 123R. The stock-based compensation cost associated with adoption of SFAS No. 123R reduced net operating income for the three months ended March 31, 2006 by $260, decreased net income by $32, and reduced basic and diluted earnings per share by $0.00 per share. The total income tax provision (benefit) related to share-based compensation for the three months ended March 31, 2006 was ($228) and is shown as a cash flow from operating activities in our cash flow statement.

CLEARONE COMMUNICATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

	Three Months Ended
	March 31,
	2006

				SFAS
				No. 123R
				Compensation
	As Reported			Expense

Revenue	$	8,700		$	-
Cost of goods sold		4,625			12
Gross profit		4,075			(12	)
Operating expenses:
Marketing and selling		1,920			25
General and administrative		1,060			179
Settlement in shareholders' class action		-			-
Research and product development		2,201			44
Total operating expenses		5,181			248
Operating (loss) income		(1,106	)		(260	)
Other income (expense), net		237			-
(Loss) income from continuing operations before income taxes		(869	)		(260	)
Benefit for income taxes		763			228
(Loss) income from continuing operations		(106	)		(32	)
Income from discontinued operations, net of tax		646			-
Net income	$	540		$	(32	)

Basic earnings (loss) per common share:
Continuing operations	$	(0.01	)	$	-
Discontinued operations		0.05			-
Net income		0.04			-
Diluted earnings (loss) per common share:
Continuing operations	$	(0.01	)	$	-
Discontinued operations		0.05			-
Net income		0.04			-

In the nine months ended March 31, 2006, the adoption of SFAS No. 123R resulted in incremental, pre-tax, stock-based compensation cost of $874. For the nine months ended March 31, 2006, the Company expensed $36 in cost of goods sold, $75 in marketing and selling, $598 in general and administrative, and $131 in research and product development expense, and $34 in other income (expense) related to the transition to SFAS No. 123R. The stock-based compensation cost associated with adoption of SFAS No. 123R reduced net operating income for the nine months ended March 31, 2006 by $874, decreased net income by $473, and reduced basic and diluted earnings per share by $0.04 per share. The total income tax provision (benefit) related to share-based compensation for the nine months ended March 31, 2006 was ($401) and is shown as a cash flow from operating activities in our cash flow statement.

CLEARONE COMMUNICATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

	Nine Months Ended
	March 31,
	2006

				SFAS
				No. 123R
				Compensation
	As Reported			Expense

Revenue	$	27,902		$	-
Cost of goods sold		14,213			36
Gross profit		13,689			(36	)
Operating expenses:
Marketing and selling		5,542			75
General and administrative		4,288			598
Settlement in shareholders' class action		(1,205	)		-
Research and product development		5,778			131
Total operating expenses		14,403			804
Operating (loss) income		(714	)		(840	)
Other income (expense), net		594			(34	)
(Loss) income from continuing operations before income taxes		(120	)		(874	)
Benefit for income taxes		1,050			401
Income from continuing operations		930			(473	)
Income from discontinued operations, net of tax		1,678			-
Net income	$	2,608		$	(473	)

Basic earnings per common share:
Continuing operations	$	0.08		$	0.04
Discontinued operations		0.14			-
Net income		0.22			0.04
Diluted earnings per common share:
Continuing operations	$	0.08		$	0.04
Discontinued operations		0.14			-
Net income		0.21			0.04

As of March 31, 2006, the total compensation cost related to unvested stock options not yet recognized was $1,164, which is expected to be recognized over the next 3.9 years on a straight-line basis.

The weighted-average estimated fair value of the stock options granted during the three months ended March 31, 2006 and 2005 was $2.08 and $3.03, per share, respectively. The weighted-average estimated fair value of the stock options granted during the nine months ended March 31, 2006 and 2005 was $1.89 and $3.84, per share, respectively.

CLEARONE COMMUNICATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

The following table shows the stock option activity for the nine months ended March 31, 2006.

Stock Options	Number of Shares			Weighted Average Exercise Price		Weighted Remaining Contractual Term (years)		Aggregate Intrinsic Value

Outstanding at June 30, 2005		1,493,112		$	6.21

Granted		27,000			2.52
Expired and canceled		(117,603	)		3.55
Forfeited prior to vesting		(160,630	)		8.26
Exercised		-			-			$	-
Outstanding at March 31, 2006		1,241,879			6.11		7.0 years	$	170
Exercisable		817,764			5.89		6.8 years	$	105

Non-vested Shares	Number of Shares			Weighted Average Grant Date Fair Value

Non-vested at June 30, 2005		802,400		$	4.73

Granted		27,000			1.89
Vested		(244,655	)		3.63
Forfeited prior to vesting		(160,630	)		6.04
Non-vested at March 31, 2006		424,115		$	4.68

Due to the Company’s failure to remain current in its filing of periodic reports with the SEC, employees, executive officers, and directors are currently not allowed to exercise options under the 1998 Plan. Since December 2003, individual grants that had been affected by this situation were modified to extend the exercise period of the option through the date the Company becomes current in its filings with the SEC and options again become exercisable. Since July 1, 2005, modifications of stock option grants include the extension of the post-service exercise period of vested options held by persons who have ceased to remain employed by the Company. Compensation cost is recognized immediately for options that are fully vested on the date of modification. In the three months ended March 31, 2006, the Company expensed $0 in compensation cost associated with these modifications. In the nine months ended March 31, 2006, the Company expensed $15 in compensation cost associated with these modifications. These costs are included in the $260 and $874 of SFAS No. 123R compensation expense disclosed above for the three-month and nine-month periods ended March 31, 2006, respectively.

CLEARONE COMMUNICATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

10. Segment and Geographic Information

During fiscal 2006 and fiscal 2005, all revenue and income (loss) from continuing operations was included in the product segment. Additionally, the United States was the only country to contribute more than 10 percent of total revenues in each fiscal year. The Company’s revenues are substantially denominated in U.S. dollars and are summarized geographically as follows:

	Three Months Ended				Nine Months Ended
	March 31,		March 31,		March 31,		March 31,
	2006		2005		2006		2005

United States	$	5,878	$	5,189	$	20,526	$	16,436
All other countries		2,822		1,914		7,376		6,106
Total	$	8,700	$	7,103	$	27,902	$	22,542

11. Manufacturing Transition

In May 2005, the Company approved an impairment action and a restructuring action in connection with its decision to outsource its Salt Lake City manufacturing operations. These actions were intended to improve the overall cost structure for the product segment by focusing resources on other strategic areas of the business. The Company recorded an impairment charge of $180 and a restructuring charge of $110 during the fiscal year ended June 30, 2005 as a result of these actions. These charges were disclosed separately in the consolidated statements of operations. The impairment charge consisted of an immediate impairment of certain property and equipment of $180 that had value to the Company while it manufactured product but that was not purchased by Third Party Manufacturer (“TPM”) and at the time were not considered likely to be sold. These assets would have remained in service had the Company not outsourced its manufacturing operations. The restructuring charge also consisted of severance and other employee termination benefits of $70 related to a workforce reduction of approximately 20 employees who were transferred to an employment agency used by TPM to transition the workforce and a charge of $40 related to the operating lease for the Company’s manufacturing facilities that would no longer be used by the Company. All severance payments were paid by December 31, 2005.

The following table summarizes changes in the Company’s restructuring charge liabilities during the nine months ended March 31, 2006:

	Severance			Manufacturing Facilities Lease			Total

Balance at June 30, 2005	$	70		$	40		$	110
Utilized		(70	)		(89	)		(159	)
Sublease payments received		-			88			88
Balance at March 31, 2006	$	-		$	39		$	39

On August 1, 2005, the Company entered into a Manufacturing Agreement with TPM pursuant to which the Company agreed to outsource its Salt Lake City manufacturing operations. The parties also entered into a one-year sublease for approximately 12,000 square feet of manufacturing space located in the Company's headquarters in Salt Lake City, Utah. TPM paid $11 per month under the sublease through May 31, 2006 when the sublease was terminated.

CLEARONE COMMUNICATIONS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

(in thousands of dollars, except per share amounts)

12. Settlement Agreement and Release

The Company entered into a settlement agreement and release with its former Vice-President - Human Resources in connection with the cessation of her employment, which generally provided for her resignation from her position and employment with the Company, the payment of severance, and a general release of claims against the Company by her. On February 20, 2006, an agreement was entered into which generally provided for a severance payment of $93 and her surrender and delivery to the Company of 145,000 stock options (86,853 of which were vested).

13. Subsequent Events

Sale of OM Video. Through December 31, 2005, all payments due under the note receivable through such date had been received and $854 of the promissory note remained outstanding; however, OM Purchaser has failed to make any subsequent, required payments under the note receivable and is in default thereunder. The Company is currently considering its collection options.

Item 2.

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

The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and related notes to condensed consolidated financial statements included in this Form 10-Q and our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended June 30, 2005 filed with the SEC and management’s discussion and analysis contained therein. This discussion contains forward-looking statements based on current expectations that involve risks and uncertainties, such as our plans, objectives, expectations, and intentions, as set forth under “Disclosure Regarding Forward-Looking Statements.” Our actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth in the following discussion and under the caption “Risk Factors” in Part II, Item 1A, as well as other information found in the documents we file from time to time with the SEC. Unless otherwise indicated, all references to a year reflect our fiscal year that ends on June 30.

CRITICAL ACCOUNTING POLICIES

Our discussion and analysis of our results of operations and financial condition are based upon our condensed consolidated financial statements, which have been prepared in conformity with U.S. generally accepted accounting principles. We review the accounting policies used in reporting our financial results on a regular basis. 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 revenues and expenses during the reporting period. We evaluate our assumptions and estimates on an ongoing basis and may employ outside experts to assist in our evaluations. We believe that the estimates we use are reasonable; however, actual results could differ from those estimates. We believe the following critical accounting policies affect our more significant assumptions and estimates that we used to prepare our condensed consolidated financial statements.

Revenue and Associated Allowances for Revenue Adjustments and Doubtful Accounts

Included in continuing operations is product revenue, primarily from product sales to distributors, dealers, and end-users. Product revenue is recognized when (i) the products are shipped and any right of return expires, (ii) persuasive evidence of an arrangement exists, (iii) the price is fixed and determinable, and (iv) collection is reasonably assured.

We provide a right of return on product sales to distributors. Currently, we do not have sufficient historical return experience with our distributors that is predictive of future events given historical excess levels of inventory in the distribution channel. Accordingly, revenue from product sales to distributors is not recognized until the return privilege has expired, which approximates when product is sold-through to customers of the Company’s distributors (dealers, system integrators, value-added resellers, and end-users) rather than when the product is initially shipped to a distributor. We evaluate, at each quarter-end, the inventory in the channel through information provided by certain of our distributors. The level of inventory in the channel will fluctuate up or down, each quarter, based upon our distributors’ individual operations. Accordingly, each quarter-end revenue deferral is calculated and recorded based upon the underlying, estimated channel inventory at quarter-end. Although, certain distributors provide certain channel inventory amounts, we make judgments and estimates with regard to the amount of inventory in the entire channel, for all customers and for all channel inventory items, and the appropriate revenue and cost of goods sold associated with those channel products. Although these assumptions and judgments regarding total channel inventory revenue and cost of goods sold could differ from actual amounts, we believe that our calculations are indicative of actual levels of inventory in the distribution channel. As of March 31, 2005, the Company deferred $5.5 million in revenue and $2.3 million in cost of goods sold related to products sold where return rights had not lapsed. As of March 31, 2006, the Company deferred $5.4 million in revenue and $2.4 million in cost of goods sold related to products sold where return rights had not lapsed. The amounts of deferred cost of goods sold were included in consigned inventory. The following table details the amount of deferred revenue, cost of goods sold, and gross profit at each period end for the 21-month period ended March 31, 2006 (in thousands).

	Deferred Revenue		Deferred Cost of Goods Sold		Deferred Gross Profit

March 31, 2006	$	5,355	$	2,443	$	2,912
December 31, 2005		4,936		2,199		2,737
September 30, 2005		4,848		2,373		2,475
June 30, 2005		5,055		2,297		2,758
March 31, 2005		5,456		2,321		3,135
December 31, 2004		4,742		1,765		2,977
September 30, 2004		5,617		1,920		3,697
June 30, 2004		6,107		2,381		3,726

We offer rebates and market development funds to certain of our distributors and direct dealers/resellers based upon volume of product purchased by them. We record rebates as a reduction of revenue in accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-22, “Accounting for Points and Certain Other Time-Based or Volume-Based Sales Incentive Offers, and Offers for Free Products or Services to Be Delivered in the Future.” Beginning January 1, 2002, we adopted EITF Issue No. 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).” We continue to record rebates as a reduction of revenue in the period revenue is recognized.

We offer credit terms on the sale of our products to a majority of our customers and perform ongoing credit evaluations of our customers’ financial condition. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability or unwillingness of our customers to make required payments based upon our historical collection experience and expected collectibility of all accounts receivable. Our actual bad debts in future periods may differ from our current estimates and the differences may be material, which may have an adverse impact on our future accounts receivable and cash position.

Goodwill and Purchased Intangibles

We assess the impairment of goodwill and other identifiable intangibles annually or whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Some factors we consider important which could trigger an impairment review include the following:

·	Significant underperformance relative to projected future operating results;

·	Significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and

·	Significant negative industry or economic trends.

If we determine that the carrying value of goodwill and other identified intangibles may not be recoverable based upon the existence of one or more of the above indicators of impairment, we would typically measure any impairment based on a projected discounted cash flow method using a discount rate determined by us to be commensurate with the risk inherent in our current business model. We evaluate goodwill for impairment at least annually.

We plan to conduct our annual impairment tests in the fourth quarter of every fiscal year, unless impairment indicators exist sooner. Screening for and assessing whether impairment indicators exist or if events or changes in circumstances have occurred, including market conditions, operating fundamentals, competition, and general economic conditions, requires significant judgment. Additionally, changes in the high-technology industry occur frequently and quickly. Therefore, there can be no assurance that a charge to operations will not occur as a result of future purchased intangible impairment tests.

Impairment of Long-Lived Assets

We assess the impairment of long-lived assets, such as property and equipment and definite-lived intangibles subject to amortization, annually or whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset or asset group to estimated future undiscounted net cash flows of the related asset or group of assets over their remaining lives. If the carrying amount of an asset exceeds its estimated future undiscounted cash flows, an impairment charge is recognized for the amount by which the carrying amount exceeds the estimated fair value of the asset. Impairment of long-lived assets is assessed at the lowest levels for which there are identifiable cash flows that are independent of other groups of assets. The impairment of long-lived assets requires judgments and estimates. If circumstances change, such estimates could also change. Assets held for sale are reported at the lower of the carrying amount or fair value, less the estimated costs to sell.

Accounting for Income Taxes

We are subject to income taxes in both the United States and in certain non-U.S. jurisdictions. We estimate our current tax position together with our future tax consequences attributable to temporary differences resulting from differing treatment of items, such as deferred revenue, depreciation, and other reserves for tax and accounting purposes. These temporary differences result in deferred tax assets and liabilities. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income, prior year carryback, or future reversals of existing taxable temporary differences. To the extent we believe that recovery is not more likely than not, we establish a valuation allowance against these deferred tax assets. Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance recorded against our deferred tax assets. To the extent we establish a valuation allowance in a period, we must include an expense for the allowance within the tax provision in the condensed consolidated statement of operations. The reversal of a previously established valuation allowance results in a benefit for income taxes.

Lower-of-Cost or Market Adjustments and Reserves for Excess and Obsolete Inventory

We account for our inventory on a first-in, first-out (“FIFO”) basis, and make appropriate adjustments on a quarterly basis to write down the value of inventory to the lower-of-cost or market.

In order to determine what, if any, inventory needs to be written down, we perform a quarterly analysis of obsolete and slow-moving inventory. In general, we write down our excess and obsolete inventory by an amount that is equal to the difference between the cost of the inventory and its estimated market value if market value is less than cost, based upon assumptions about future product life-cycles, product demand, or market conditions. Those items that are found to have a supply in excess of our estimated demand are considered to be slow-moving or obsolete and the appropriate reserve is made to write down the value of that inventory to its realizable value. These charges are recorded in cost of goods sold. At the point of the loss recognition, a new, lower-cost basis for that inventory is established and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. If there were to be a sudden and significant decrease in demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to increase our inventory allowances, and our gross profit could be adversely affected.

Share-Based Payment

Prior to June 30, 2005 and as permitted under the original SFAS No. 123, we accounted for our share-based payments following the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” as interpreted. Accordingly, no share-based compensation expense had been reflected in our statements of operations for unmodified option grants since (1) the exercise price equaled the market value of the underlying common stock on the grant date and (2) the related number of shares to be granted upon exercise of the stock option was fixed on the grant date.

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment.” SFAS No. 123R is a revision of SFAS No. 123. SFAS No. 123R establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. Primarily, SFAS No. 123R focuses on accounting for transactions in which an entity obtains employee services in share-based payment transactions. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments.

Under SFAS No. 123R, we measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the awards - the requisite service period (usually the vesting period). No compensation cost is recognized for equity instruments for which employees do not render the requisite service. Therefore, if an employee does not ultimately render the requisite service, the costs associated with the unvested options will not be recognized, cumulatively.

Effective July 1, 2005, we adopted SFAS No. 123R and its fair value recognition provisions using the modified prospective transition method. Under this transition method, stock-based compensation cost recognized after July 1, 2005 includes the straight-line basis compensation cost for (a) all share-based payments granted prior to July 1, 2005, but not yet vested, based on the grant date fair values used for the pro-forma disclosures under the original SFAS No. 123 and (b) all share-based payments granted or modified on or after July 1, 2005, in accordance with the provisions of SFAS No. 123R.

Under SFAS No. 123R, we recognize compensation cost net of an anticipated forfeiture rate and recognize the associated compensation cost for those awards expected to vest on a straight-line basis over the requisite service period. We use judgment in determining the fair value of the share-based payments on the date of grant using an option-pricing model with assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the risk-free interest rate of the awards, the expected life of the awards, the expected volatility over the term of the awards, the expected dividends of the awards, and an estimate of the amount of awards that are expected to be forfeited. If assumptions change in the application of SFAS No. 123R in future periods, the stock-based compensation cost ultimately recorded under SFAS No. 123R may differ significantly from what was recorded in the current period.

SEASONALITY

Our audio conferencing products revenue has historically been strongest during our second and fourth quarters. Our camera product line revenue is usually strongest during the third and fourth quarters. There can be no assurance that any historic sales patterns will continue and, as a result, sales for any prior quarter are not necessarily indicative of the sales to be expected in any future quarter.

BUSINESS OVERVIEW

We are an audio conferencing products company. We develop, manufacture, market, and service a comprehensive line of audio conferencing products, which range from tabletop conferencing phones to professionally installed audio systems. We believe we have a strong history of product innovation and plan to continue to apply our expertise in audio engineering to developing innovative new products. The performance and reliability of our high-quality solutions create a natural communication environment, which saves organizations of all sizes time and money by enabling more effective and efficient communication between geographically separated businesses, employees, and customers.

DISCUSSION OF OPERATIONS

Results of Operations for the three months and nine months ended March 31, 2006 and 2005

The following table sets forth certain items from our unaudited condensed consolidated statements of operations (in thousands) for the three and nine months ended March 31, 2006 and 2005, together with the percentage of total revenue which each such item represents:

	Three Months Ended									Nine Months Ended
	(in thousands)									(in thousands)
	March 31,				March 31,					March 31,					March 31,
	2006				2005					2006					2005
			% of Revenue					% of Revenue					% of Revenue					% of Revenue

Revenue	$	8,700		100.0%	$	7,103			100.0%	$	27,902			100.0%	$	22,542			100.0%
Cost of goods sold		4,625		53.2%		3,180			44.8%		14,213			50.9%		10,925			48.5%
Gross profit		4,075		46.8%		3,923			55.2%		13,689			49.1%		11,617			51.5%
Operating expenses:
Marketing and selling		1,920		22.1%		2,151			30.3%		5,542			19.9%		6,578			29.2%
General and administrative		1,060		12.2%		1,287			18.1%		4,288			15.4%		4,110			18.2%
Settlement in shareholders' class action		-		0.0%		(855	)		-12.0%		(1,205	)		-4.3%		(2,609	)		-11.6%
Research and product development		2,201		25.3%		1,423			20.0%		5,778			20.7%