AUREAL SEMICONDUCTOR INC, 10-K405/A, 1998-06-03

AUREAL SEMICONDUCTOR INC
10-K405/A, 1998-06-03
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------

FORM 10-K/A
AMENDMENT NO. 1
TO FORM 10-K

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

FOR THE FISCAL YEAR ENDED DECEMBER 28, 1997

COMMISSION FILE NUMBER 0-20684

AUREAL SEMICONDUCTOR INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

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DELAWARE 94-3117385
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
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4245 TECHNOLOGY DRIVE
FREMONT, CALIFORNIA 94538
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

(510) 252-4245
REGISTRANT'S TELEPHONE NUMBER

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, $0.001 PAR VALUE

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 last 90 days. Yes [X] No [ ]

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

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 [X] No [ ]

The aggregate market value of the voting stock held by non-affiliates of
the registrant as of March 12, 1998 was approximately $24 million based on the
closing bid price of the Company's Common Stock as reported on the OTC Bulletin
Board. For purposes of this Report only, the Company assumes its affiliates to
be its officers, directors, entities associated with officers and directors, and
holders (or groups of associated holders) of ten percent or more of the Common
Stock of the Company. As of March 12, 1998, the Registrant had outstanding
42,012,938 shares of Common Stock, par value $0.001.

DOCUMENTS INCORPORATED BY REFERENCE

Part III incorporates certain information by reference to the registrant's
Definitive Proxy Statement relating to the Annual Meeting of Stockholders
expected to be held on May 20, 1998.

This report including all exhibits and attachments contains 43 pages. The
Exhibit Index is located on page 40.
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EXPLANATORY NOTE

This Form 10-K/A amends the Annual Report on Form 10-K filed with the
Securities and Exchange Commission on March 30, 1998 by the Registrant. Item 1,
Business; Item 3, Legal Proceedings; Item 5, Market for the Registrant's Common
Equity and Related Stockholder Matters; Item 7, Management's Discussion and
Analysis of Financial Condition and Results of Operations and Item 8 Financial
Statements and Supplementary Data have been revised in response to comments the
Registrant received from the Securities and Exchange Commission. All Items,
including those specifically mentioned above, are restated in their entirety as
they appeared in the previously filed Annual Report on Form 10-K.

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AUREAL SEMICONDUCTOR INC.

1997 FORM 10-K REPORT

TABLE OF CONTENTS

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PART I
Item 1. Business....................................................
Item 2. Properties..................................................
Item 3. Legal Proceedings...........................................
Item 4. Submission of Matters to a Vote of Security Holders.........

PART II
Item 5. Market for the Registrant's Common Equity and Related
Stockholder Matters.........................................
Item 6. Selected Financial Data.....................................
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations...................................
Item 8. Financial Statements and Supplementary Data.................
Item 9. Changes in and Disagreements With Accountants on Accounting
and Financial Disclosure....................................

PART III
Item 10. Directors and Executive Officers of the Registrant..........
Item 11. Executive Compensation......................................
Item 12. Security Ownership of Certain Beneficial Owners and
Management..................................................
Item 13. Certain Relationships and Related Transactions..............

PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form
8-K.........................................................
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PART I

ITEM 1. BUSINESS.

This report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. Any forward-looking statements made herein are made
pursuant to the safe harbor provisions of the Private Securities Litigation Act
of 1995. Investors are cautioned that actual results may differ materially from
those projected in any forward-looking statements due to a number of factors
including, but not limited to, the Company's dependence on the PC and consumer
electronics industries and on product lines based on new technologies; on
foundry capacity, availability and reliability; competition and pricing
pressures, the ability to secure additional financing, and other risks detailed
below and from time to time in the Company's filings with the Securities and
Exchange Commission.

SUMMARY

Aureal Semiconductor Inc. is a producer of audio semiconductor products and
advanced audio technologies for the PC and consumer electronics markets. The
Company contracts with independent silicon foundries for production of its
semiconductor products, and thus is a "fabless" semiconductor company. The
Company's objective is to be the leading provider of advanced digital audio
solutions for the PC and consumer electronics markets. In its pursuit of this
objective, the Company has had several significant accomplishments over the past
year.

In February and March of 1998, Aureal announced several major design wins
for the Vortex AU8820 Digital Audio Processor, including: Dell Computer
Corporation, the world's leading direct computer systems company; Turtle Beach
Systems, a leading U.S. provider of premier audio products for the PC; TerraTec
Electronic GmbH, a leading European provider of sound card products; and Aztech
Systems Ltd., a leading sound card retail and OEM company. By these design wins,
the foregoing manufacturers have agreed to incorporate the Vortex AU8820 in
their products or in their component parts for their products. Pursuant to
standard open purchase orders, these customers, or component manufacturers for
such customers, along with others, have begun to take volume shipments of
Aureal's Vortex AU8820 chip and will promote the Company's A3D technology. To
date however, the Company has not generated significant revenues from the sale
of the Vortex AU8820 chip or any other product.

Earlier in 1998, the Vortex AU8820 received Microsoft's Windows Hardware
Quality Labs (WHQL) certification. Microsoft's WHQL certification virtually
ensures that customers integrating the Vortex AU8820 chip into their audio
subsystems will receive quality approval from Microsoft, which is a key
differentiation for consumers looking for quality in PC products.

During the fourth quarter of 1997, Aureal made initial customer shipments
of the Vortex AU8820. This important milestone brought to an end a transition
period of over two years where Aureal was primarily focused on the development
of the Company's new technology.

The Company also completed some significant financing transactions in 1997
and early 1998. The most recent occurred in March of 1998 with the completion of
a $5 million private placement transaction for three-year 8% convertible
preferred stock. A prior transaction consisted of a private placement of 1.9
million shares of the Company's Common Stock on August 6, 1997 for proceeds of
$3.8 million. In conjunction with the equity placement, the Company's working
capital line of credit was increased from $20.0 million to $31.5 million. To
date, the Company has incurred an aggregate losses of $39 million, including
losses of $104 million, $17 million and $18 million in each of Fiscal 1995, 1996
and 1997, respectively.

In the consumer electronics field, the Company has announced licensing
deals with Zoran Corporation, LSI Logic Corporation and Yamaha Corporation for
its A3D Surround technology. Advent has introduced its Powered Partners speaker
product line, which is based on Aureal's VSP901 ProLogic chip. The Company
continues to invest significant resources towards the development of
semiconductor products targeted for the

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multi-channel mini-component and audio receiver markets that will include the
Company's A3D Surround technology for Dolby ProLogic, Dolby Digital and MPEG II
audio.

In September 1996, the Company announced "A3D", the Company's proprietary
3D audio technologies. These technologies provide an interactive audio
experience by surrounding the listener with sounds in all three dimensions, with
only two-speaker or headphone presentations. The Company now has numerous game
developers and over twenty companies utilizing A3D either as a licensed product
or as a product utilizing the Vortex AU8820. Many of these companies are
actively promoting the A3D brand name on packaging, advertising and at
tradeshows.

The Company's revenues for 1997 were primarily related to the up-front
licensing fees for its A3D technologies, the sale of a modest number of VSP901
chips and the initial shipments of the Vortex AU8820 chip. The Company has begun
volume shipments of its Vortex AU8820 device in 1998.

The Company, in May 1996, acquired 100% ownership of Crystal River
Engineering, Inc. (CRE) a leader in the field of 3D audio technology. This
merger of resources has enabled Aureal Semiconductor to offer hardware and
software solutions optimized for 3D audio presentation.

In August 1995, the Company announced that it was divesting its multimedia
components business to implement its current business plan based on development
and sale of software and semiconductor solutions providing advanced audio for
the PC and consumer electronics markets. The Company was active in the business
of selling multimedia components for the retail market from its founding in 1990
through mid-1995 (operating as Media Vision Technology Inc.) Since November of
1995, the Company has operated under its current name, which was formally
changed at its Annual Stockholders' Meeting in May 1996.

The Company is headquartered in Fremont, California in a leased 36,000
square foot building. As of December 28, 1997, the Company had 81 employees. Of
this total, 45 were engaged in engineering functions, 25 were in sales and
marketing activities, and 11 were engaged in administrative support. Competition
for employees in the Company's industry is intense. None of the Company's
employees are represented by a labor union. The Company considers its relations
with its employees to be good.

Aureal, Aureal 3D, A3D and the A3D logo are trademarks of Aureal
Semiconductor Inc. Other trademarks referred to herein are properties of their
respective owners.

INDUSTRY BACKGROUND

Silicon-based audio for the PC industry has historically been characterized
by a trend in cost reduction with no significant advances in quality. In recent
years, the PC market has made advances in graphics capabilities, especially 3D
graphics. With these advances, consumers and game developers have demanded
higher quality audio with expanded capabilities. Consumers are expected to
desire greater immersion and realism for games, improved music synthesis, better
signal-to-noise ratios and integration with other PC subsystems such as modem
and graphics. These improvements to audio require new audio software and
hardware architectures. Most significantly, PC audio is moving from ISA-bus
based audio systems to PCI-bus based solutions and AC'97 architectures. This
move requires complete redesigns of PC audio semiconductor solutions, therefore
creating a level playing field for new solution providers, such as Aureal
Semiconductor.

The consumer electronics marketplace is also moving toward significant
improvements in audio technologies, especially with regard to home theater
applications. Movie sound quality has improved both in the recording and
playback processes. In today's movie theaters, surround sound presentations with
multiple speakers immerse moviegoers with real-life audio soundtracks, thus
creating a more compelling entertainment experience. Advancements in
audio/visual entertainment is moving into the home, and the home theater concept
is now becoming more common and understood by today's consumers.

As the audio source material for home entertainment continues to improve,
better hardware solutions become necessary. Over time, television audio has
evolved from single in-set speakers, to higher quality in-set stereo speakers,
to stereo audio connection with home stereo equipment (and associated speaker
systems), to surround sound home theater set-ups with five or six speakers
strategically placed about the room. Aureal sees

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the product category "Virtual Speakers" as a potentially significant enlargement
and enhancement of both the stereo television and home theater markets.

COMPANY STRATEGY

The Company's objective is to be a leading supplier of high quality,
advanced audio solutions to both the consumer electronics and PC marketplaces.
The Company believes that its efforts in these two areas are mutually
complementary and give it greater chances for success than if it were to serve
one or the other market exclusively. The Company is pursuing a focused strategy
that includes the following elements:

Create Value in the Aureal Logo: Aureal intends to use a combination of
licensing of its 3D audio technologies in tandem with the sale of its own 3D
audio devices in the PC market, as well as sales of virtual surround devices in
the consumer marketplace, to establish an association in consumers' minds
between the Aureal A3D brand and high-quality audio. Positional 3D audio is an
area in which the Company enjoys clear leadership, and the PC gaming community's
enthusiastic response to Aureal's product is a strong means to establish the
Company's reputation. The Aureal A3D logo will be on the retail packaging and
advertising of many of the leading retail sound card companies, including
Diamond Multimedia Systems, Inc., Turtle Beach Systems, Aztech Systems Ltd, and
TerraTec Electronic GmbH. The logo will also begin to appear on the game boxes
indicating support for A3D, starting with Battlezone, a recently introduced PC
game by Activision, Inc. Several PC magazines such as HomePC have indicated that
A3D is the 3D audio standard. Aureal hopes to continue to leverage this branding
with advertising, joint promotion with A3D partners and the introduction of even
more advanced A3D technologies.

Offer Low-cost PC Audio Acceleration: Aureal will continue to develop
low-cost, high-feature audio accelerators for use in the PC marketplace. Rather
than burdening the audio device with the entire computational task related to
audio, the audio accelerator is developed to be used in conjunction with the
computing power of the general-purpose host CPU. The audio accelerator only
provides enough additional computational power to significantly off-load the
main CPU while providing baseline audio performance which would completely
overwhelm the main CPU if delivered through software alone. This strategy takes
advantage of improvements in host computational power, such as afforded by MMX
instruction-set enhancements, for instance, and results in the most
cost-effective devices, without compromising performance, or concurrency of
audio operations with other multimedia operations.

Provide Integrated Audio Components to the Consumer Market: Aureal is
developing devices targeted to the consumer marketplace which provide lower
system cost through integration of digital, analog and other audio system
functions. The existing VSP901 provides Surround Sound quality through a two
speaker presentation. Further products under development address Dolby Digital
media, and provide integration of various components of the audio sub-system of
consumer market products.

Brand Name Used Throughout All Areas of Digital Audio: Aureal believes it
has core competencies in all areas of digital audio. Aureal breaks these areas
into three categories -- input, processing and output. Input relates to
affecting the source of the audio, whether it be through a game developer
incorporating A3D into their game or the use of a future Aureal production tool
to integrate advanced features into the source material. Processing consists of
the silicon devices used to support A3D, Dolby Digital decoding, wavetable
synthesis or other advanced audio processing. Output relates to devices and
technologies for improving and advancing speaker presentation, such as the
Company's A3D Surround technologies.

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CURRENT PRODUCTS AND TECHNOLOGIES

SEMICONDUCTOR PRODUCTS

[VORTEX LOGO]

The Vortex AU8820 is Aureal's flagship semiconductor product. The AU8820 is
a PCI-based AC'97 Digital Audio Processor. It provides support for A3D audio
technology, DirectSound3D acceleration, studio quality 64-voice wavetable
synthesis, legacy audio support for DOS-based games, and an interface for ISA
modem chipsets. The Vortex AU8820 was originally announced in July 1997, with
shipments to customers beginning in the fourth quarter of 1997. The product
achieved Microsoft's Windows Hardware Quality Labs certification on February 9,
1998. Volume shipments have begun to customers worldwide.

The VSP901 chip, released for production in February of 1997, is designed
to accommodate new emerging home theater applications by "virtually" presenting
Dolby Pro-Logic encoded material with complete surround sound quality through a
two-speaker implementation. The VSP901 both decodes the encoded material and
"virtualizes" the five discrete speakers, allowing significant improvements in
cost and convenience over the five-speaker solutions available for the home
theater market.

Aureal's ASP301 Karaoke processing chip presents state-of-the-art audio
effects processing for stand-alone karaoke systems, VCD and DVD players and PC
platforms. The ASP301 provides the most advanced karaoke features available on
the consumer market today.

TECHNOLOGIES

LOGO LOGO

Aureal's A3D technology is a high quality digital audio technology which
provides "life-like" three dimensional sound through two speakers or headphones.
The technology enables real-time interaction where sounds emanate from multiple
sources or locations, and follow the user's movement throughout three
dimensional space, for PC and dedicated gaming platforms. A3D Interactive
technology is a main component and a competitive advantage for the Vortex AU8820
mentioned above. A3D Surround technology provides for surround playback, through
two speakers, of pre-recorded media in the home theater and PC environments
without the need for or expense of five- or six-speaker setups. The Company has
licensed these technologies to various semiconductor and OEM customers. The
Company also has certain karaoke technologies which it licenses for inclusion
into semiconductor products and OEM systems.

Over the coming year, the Company expects to announce products that expand
the current product line. Product announcements and introductions are expected
for both the PC and the consumer electronics

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markets, including extensions and advancements to the Vortex product line for PC
audio and digital audio solutions targeted at the consumer electronics market.

SALES AND MARKETING

The Company's products are sold worldwide through its direct sales force
located at its headquarters in Fremont, its subsidiary Aureal Semiconductor Ltd.
located in Hong Kong and through distributors and manufacturers' representatives
located throughout North America, Europe and Asia. The Company's manufacturers'
representatives and distributors are not subject to minimum purchase
requirements and can discontinue marketing any of the Company's products at any
time. The Company pays a commission to the manufacturers' representatives and
distributors when they sell the Company's products.

Sales will generally be made pursuant to standard purchase orders, with
product deliveries scheduled upon the Company's receipt of such purchase orders.
In addition to purchase orders, the Company may receive forecasts of future
delivery requirements from OEM customers. These purchase orders and forecasts
generally allow customers to reschedule or cancel deliveries without significant
penalties. For these reasons, the Company believes that this information, while
useful for scheduling production, will not necessarily be a reliable indicator
of future revenues.

Aureal is fully committed to maintaining close, integrated partnerships
with its OEM customers through worldwide technical support. The Company employs
its own in-house technical staff for product development and technical support,
as well as providing support through manufacturers' representatives and
distributors. The Company believes that nurturing these close, supporting
relationships with its customers is vital to ensuring customer satisfaction
while providing important insight into future market and product direction.

RESEARCH AND DEVELOPMENT

Over the last two years, the Company's primary focus had been on the
development of superior audio technologies, and the transformation from
technology to product application. In 1998, an important goal of the Company is
to generate significant revenues from products that have resulted from this
investment in research and development. Aureal also expects to continue to be
research and development intensive as a company. The Company firmly believes
that it must continually develop and introduce new technologies and products
that may replace or expand portions of its product line. Aureal is a technology
leader, and the Company intends to make the investment necessary to stay at the
technological forefront and take advantage of market opportunities.

The Company intends to continue to provide comprehensive solutions for its
OEM customers by developing advanced audio algorithms, firmware and application
software, as well as semiconductor devices for these new solutions. Aureal
utilizes a design environment based on workstations, dedicated product
simulators, system simulation with hardware and software modeling, and a
high-level design description language. The Company invests regularly in new
advanced equipment and software tools and intends to maintain and enhance its
library of core cells.

At December 28, 1997, Aureal had a staff of forty-five research and
development personnel, including those involved in semiconductor design, process
development and software development. In addition, another eleven technical
personnel were part of the product development and customer support team
included in the marketing function. Aureal also engages outside contractors to
supplement its staff and enters into cooperative projects with other companies.

The markets for the Company's products are characterized by evolving
industry standards and rapid technological change and product obsolescence. The
Company's success is highly dependent upon the successful development and timely
introduction of new products at competitive prices and performance levels. The
success of new products depends on a number of factors, including timely
completion of product development, market acceptance of the Company's and its
customers' new products, and the Company's ability to offer new products at
competitive prices. In addition, to be successful, the Company must secure
sufficient foundry capacity for volume manufacturing of wafers and achieve
acceptable wafer fabrication yields by the Company's independent foundries.
Incorporating the Company's new products into its OEM customers' new product
designs requires the anticipation of market trends and performance and
functionality requirements of OEMs, along with the development and

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production of products that meet the timing and pricing requirements of OEMs
that can be tested and be available in a timely manner consistent with the OEMs'
development and production schedule. Accordingly, in selling to OEMs, the
Company can often incur significant expenditures in advance of volume sales of
new products, if any. There can be no assurance that the Company will be able to
identify new product opportunities, develop and market new products, achieve
design wins or respond effectively to new technological changes or product
announcements by others. A failure in any of these areas would have a material
adverse effect on the Company's business, financial condition and results of
operations.

While Aureal believes that its A3D technologies, in both the interactive
and surround modes, offer significantly better 3D sound through a two-speaker or
headphone presentation than any other available technology, competitors can
offer products which are presented to the market as direct competition. The
Company, through its technology subsidiary Crystal River Engineering, Inc., has
been working to develop true positional 3D audio for almost ten years. Patents
on certain techniques utilized in optimizing the technology have been granted to
the Company. The most recent patent granted to the Company was announced in
September 1997. The patent granted covers methods for compressing HRTF (Head
Related Transfer Function) audio filters and is key for A3D audio technology.
The claims covered by the latest patent, together with patents previously
granted to Aureal, form the basis for the Company's A3D three-dimensional audio
processing technology. The patents granted during 1997 increases Aureal's patent
total to 15 issued U.S. patents covering over 240 claims, with an additional 35
patent applications pending in the field of audio. The Company expects to
actively pursue additional patents for its audio technologies.

COMPETITION

The PCI audio market has large and entrenched competitors, including ESS
Technology, Creative Technology Ltd. and its subsidiary Ensoniq, Cirrus Logic
Inc., Yamaha and Analog Devices Inc. Relative to 3D audio, a number of companies
offer licensing for purported 3D audio technology, these include SRS,
Spatializer Labs, and QSound, all of which are public companies. In addition,
Microsoft has 3D audio capabilities in its DirectSound technology. A number of
these and other potential competitors have substantially greater financial,
manufacturing, technical, marketing, distribution, and other resources, greater
intellectual property rights, broader product lines and longer-standing
relationships with customers than the Company. Certain of the Company's current
and potential competitors maintain their own semiconductor foundries and may
therefore benefit from certain capacity, cost and technical advantages. The
Company believes that its ability to compete successfully depends on a number of
factors, both within and outside of its control, including the price, quality
and performance of the Company's and its competitors' products, the timing and
success of new multimedia PC standards, the development of technical
innovations, the ability to obtain adequate foundry capacity and sources of raw
materials, the efficiency of production, the rate at which the Company's
customers design the Company's products into their products, the number and
nature of the Company's competitors in a given market, the assertion of
intellectual property rights and general market and economic conditions.

The markets in which the Company competes are intensely competitive and are
characterized by rapid technological change, product price declines and,
especially in the PC marketplace, rapid product obsolescence. The Company
expects competition to increase in the future from existing competitors and from
other companies that may enter the Company's existing or future markets with
products that may be less costly or provide higher performance or additional
features. The Company competes with semiconductor manufacturers offering various
audio solutions. The Company anticipates that it will continue to compete with
such third parties, and that its competitors may offer more highly integrated
solutions in the future. The Company is unable to predict the timing and nature
of any such competitive product offerings. The announcement and commercial
shipment of competitive products could adversely affect sales of the Company's
products and may result in increased price competition that would adversely
affect the prices and margins of the Company's products. In general, product
prices in the semiconductor industry decrease over the life of a particular
product. The markets for most of the applications for the Company's products,
particularly the PC market, are characterized by intense price competition. The
willingness of prospective customers to design the Company's products into their
products depends to a significant extent upon the ability of the Company to
price its products at a level that is cost-effective for such customers. As the
markets for the Company's products mature and competition increases, the Company
anticipates that prices for its products will decline. If the

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Company is unable to reduce its costs sufficiently to offset declines in product
prices or is unable to introduce new, higher performance products with
competitive product prices, the Company's operating results would be materially
adversely affected. Although the Company believes that it is competitive with
respect to most of these factors, there can be no assurance that it will remain
competitive in the future.

Each successive generation of PC microprocessors has provided increased
performance, which could in the future result in a microprocessor capable of
performing increasingly complex audio functions. In this regard, Intel
Corporation has developed MMX-based signal processing capability for use in
conjunction with its Pentium microprocessor line, and is promoting the
processing power of the Pentium for data and signal intensive functions such as
graphics and audio acceleration and other multimedia functions. Although
Aureal's PC products are designed to be complementary to, and take advantage of,
MMX technology, there can be no assurance that the increased capabilities of
Intel's microprocessors will not adversely affect demand for the Company's
products. Currently, Aureal's A3D Interactive technologies support and are
enabled by Microsoft's DirectSound standard. Any future substantial changes to
Microsoft's DirectSound architecture may affect Aureal's, and its competitors,
abilities to support a revised DirectSound standard.

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MANAGEMENT

OFFICERS AND DIRECTORS

The officers and directors of the Company are as follows:

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Kenneth A. Kokinakis 44 President, Chief Executive Officer
and Director
Gary M. Catlin 42 Vice President, Engineering
David J. Domeier 44 Vice President, Finance and Chief
Financial Officer
Scott H. Foster 44 Chief Technical Officer
Michael L. Hunter 38 Vice President, Sales
S. Murty Cheruvu 48 Vice President, Manufacturing
Operations
Sanjay Iyer 41 Vice President, PC Products
Brendan R. O'Flaherty 35 Vice President, Consumer
Electronics and General Counsel
Toni W. Schneider 28 Vice President, Advanced Audio
Products
Richard E. Christopher(1) 51 Director
L. William Krause(1) 55 Director
D. Richard Masson(2) 39 Director
Thomas K. Smith, Jr.(2) 33 Director
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(1) Member of the Audit Committee.

(2) Member of the Compensation Committee.

Mr. Kokinakis was appointed President and Chief Executive Officer of the
Company effective January 15, 1996 and a Director of the Company effective
February 7, 1996. Prior to joining the Company, Mr. Kokinakis served as the
Managing Director and Chief Executive Officer of Memec (Asia-Pacific), an
electronic component distributor, since January 1991. Prior to 1991, Mr.
Kokinakis held various executive sales and marketing positions at Xilinx, Inc.
and Microchip Technology Inc.

Mr. Catlin has served as Vice President, Engineering since May 1996. Prior
to that time, he served as a senior manager in the engineering department of the
Company since November 1994. Immediately prior to that, he was self-employed for
four years developing and marketing PC software. He previously held engineering
design and management positions with Silicon Graphics, Daisy Systems
Corporation, and Intel Corporation.

Mr. Domeier has served as the Company's Vice President, Finance and Chief
Financial Officer since March 1995. During the period of October 1995 to January
1996, Mr. Domeier served as a member of the "Office of the President" for the
Company. Prior to joining the Company, Mr. Domeier was employed by Safeway Inc.
from 1983 through 1994. His most recent positions with Safeway Inc. were Senior
Vice President, Re-engineering in 1994 and Senior Vice President, Chief
Financial and Administrative Officer of the Northern California Division from
1992 through 1994.

Mr. Foster joined the Company as its Chief Technology Officer in May 1996
with the merger of Crystal River Engineering, Inc., ("CRE") and Aureal. Mr.
Foster founded CRE in 1987 and served as its Chief Executive Officer until the
merger.

Mr. Hunter has served as the Company's Vice President, Sales since March
1995 and Vice President, OEM Sales since January 1995. Prior to joining the
Company, Mr. Hunter served as Vice President of Sales at SCM MicroSystems from
October 1993 to January 1995, as Vice President of Sales and Marketing at

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Criterion Computer from July 1993 to October 1993, and as Senior Vice President
of Sales and Marketing at Orchid Technology from October 1988 to June 1993.

Mr. Cheruvu became the Company's Vice President, Manufacturing Operations
in May 1997 and has been with the Company since June 1995 when he was hired as
the Director of Semiconductor Project Operations. Prior to joining Aureal, he
was Process Manager with Cirrus Logic Inc. for five years and held engineering
positions with Samsung Semiconductor and National Semiconductor. He received his
Ph.D. in Materials Science from U.C. Berkeley.

Mr. Iyer became the Company's Vice President, PC Products in January 1998.
From May 1996 to December 1997, he served as Vice President of Marketing. From
September 1995 to May 1996, Mr. Iyer served as Vice President, Technology, and
prior to then, Mr. Iyer served as the Director of the Digital VLSI group within
the Company from May 1994. Mr. Iyer also served as the Company's Director of
Graphics Hardware from May 1993 to May 1994. Prior to joining the Company, Mr.
Iyer served as the Director of Graphics Hardware of Pellucid, Inc. from 1991 to
May 1993. Prior to joining Pellucid, Mr. Iyer served as Hardware Manager of
Silicon Graphics, Inc. from 1989 to 1991.

Mr. O'Flaherty became the Vice President, Consumer Electronics in January
1998. Prior to then he had served as Vice President, Business Development and
General Counsel of the Company since May 1994. During the period of October 1995
to January 1996, Mr. O'Flaherty served as a member of the "Office of the
President" for the Company. Mr. O'Flaherty was a Director of the Company from
May 1994 to December 30, 1994. Mr. O'Flaherty joined the Company as corporate
counsel in November 1993. Prior to joining the Company, he was associated with
the law firm of Gray Cary Ware & Freidenrich from September 1989 to November
1993.

Mr. Schneider became the Company's Vice President, Advanced Audio products
in January 1998. Mr. Schneider joined the Company in May 1996 through the merger
of Aureal and CRE and served as Vice President, Strategic Alliances from May
1996 through December 1997. Mr. Schneider had served at CRE since 1993 in a
number of capacities including Vice President, Marketing since October 1994.
Prior to joining CRE, he held various engineering positions at Autodesk's
Cyberspace Group and VPL Research while working toward a degree in computer
science at Stanford University.

Mr. Christopher has served as a director of the Company since November
1996. Since July 1992, Mr. Christopher has been the Vice President of Worldwide
Sales for Chips and Technologies, Inc., a supplier of advanced graphics
controllers and accelerators for notebook computers (a subsidiary of Intel
Corporation). Prior to joining Chips and Technologies Inc., Mr. Christopher
spent twelve years at Fujitsu Microelectronics where he became Senior Vice
President and General Manager. Mr. Christopher is also a director of Alpine
Semiconductor.

Mr. Krause has served as a director of the Company since April 1995. Since
1991, he has been the President, Chief Executive Officer and a director of Storm
Technology, Inc., a supplier of computer peripherals and software for digital
imaging. Prior to that, Mr. Krause was President and Chief Executive Officer of
3Com Corporation from 1981 to 1990 and Chairman of the Board from 1987 to 1993.
Mr. Krause is also a director of Sybase, Inc., a client/server software company,
and Infoseek Corporation, an internet media company.

Mr. Masson has served as a director of the Company since December 1994. Mr.
Masson has served as a Principal of Oaktree Capital Management since May 1995.
From 1988 until 1995, Mr. Masson served as Managing Director of Trust Company of
the West and TCW Asset Management Company ("TAMCO"), wholly-owned subsidiaries
of The TCW Group, Inc. TCW Special Credits serves as a general partner and
investment adviser to certain limited partnerships, trusts, and accounts
invested in the securities and debt obligations of financially distressed
companies. TAMCO is the managing general partner of TCW Special Credits, and Mr.
Masson is a partner of TCW Special Credits. Oaktree provides investment
sub-advisory services to TAMCO on certain funds and accounts managed by TAMCO.
Mr. Masson also serves as a director for Peregrine Real Estate Trust.

9
<PAGE> 13

Mr. Smith has served as a director of the Company since December 1994. Mr.
Smith is Senior Vice President of Trust Company of the West and TAMCO,
wholly-owned subsidiaries of The TCW Group, Inc., which he joined in 1991 as an
investment analyst for TCW Special Credits. TCW Special Credits serves as
general partner and investment adviser to certain limited partnerships, trusts,
and accounts invested in the securities and debt obligations of financially
distressed companies. TAMCO is the managing general partner of TCW Special
Credits.

ITEM 2. PROPERTIES

Substantially all of the Company's operations are currently located in
approximately 36,000 square feet of leased office and warehouse space located in
Fremont, California. The Company relocated to this facility during the fourth
quarter of 1995, and has secured a sublease on its former corporate offices
effective January 1996 through the remainder of the lease. The Company's rental
expense for its current facilities in Fremont, California was approximately
$215,000 for the year ended December 28, 1997. (See Note 6 of Notes to
Consolidated Financial Statements) The lease on the Company's current facility
will expire in 1999. A small amount of office space is also leased in Austin,
Texas, and in Hong Kong.

ITEM 3. LEGAL PROCEEDINGS

The Company has received, and may receive in the future, communications
from third parties asserting that the Company's trademarks or products infringe
patents, copyrights or proprietary rights of third parties or seeking
indemnification against such infringement. The costs of any litigation alleging
that the Company has infringed the proprietary rights of a third party, or
damages resulting from such a claim, could be substantial and could materially
adversely affect the Company's business, financial condition and results of
operations.

In March 1998, Aureal was served with a suit for patent infringement filed
by Creative Technology Ltd., a Singapore corporation and its subsidiary, E-MU
Systems, Inc., a California corporation. The suit alleges that Aureal's Vortex
AU8820 AC'97 Digital Audio Processor infringes on a patent which describes a
specific implementation for an electronic musical instrument designed by E-MU
Systems, Inc. Creative and E-MU seek, among other things, a preliminary and
permanent injunction against continuing acts of infringement by the Company and
an accounting of damages plus interest. Aureal has reviewed the allegations in
the complaint and believes that the action is without merit and intends to
vigorously pursue defense of this action.

Shiva Holdings Limited ("Shiva") filed a cross-complaint against the
Company in December 1997 alleging breach of contract, breach of implied covenant
of good faith and fair dealing, fraud and negligent misrepresentation in
connection with the Agreement for Purchase of Certain Assets entered into
between Shiva and the Company in February 1996. The Company had filed an action
against Shiva for breach of contract and specific performance in connection with
the failure of Shiva to perform under the February 1996 agreement between the
companies. Shiva alleges that the Company made certain misrepresentations in the
sale of assets by the Company to Shiva and is seeking damages in excess of
$1,000,000. The Company believes that the claims by Shiva are groundless and
intends to defend them vigorously.

Litigation may be necessary to resolve the claims asserted by Creative and
E-MU and Shiva, and any other claims asserted in the future to defend against
claims of infringement or invalidity or to enforce and protect the Company's
intellectual property rights. There can be no assurance that the Company will
prevail in any litigation with Creative and E-MU or Shiva, or any other party.
Any such litigation, whether or not determined in the Company's favor or settled
by the Company, would be costly and would divert the efforts and attention of
the Company's management and technical personnel from normal business
operations, which could have a material adverse effect on the Company's
business, financial condition and results of operations. Adverse determinations
in litigation could result in the loss of the Company's proprietary rights,
subject the Company to significant liabilities, require the Company to seek
licenses from third parties or prevent the Company from licensing its
technology, any of which could have a material adverse effect on the Company's
business, financial condition and results of operations.

10
<PAGE> 14

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

During the forth quarter of 1997 the Board of Directors authorized a change
to the Corporation's Amended and Restated Certificate of Incorporation, pending
approval from the Corporation's stockholders. A special meeting of the
Stockholders was held on Wednesday, December 17, 1997 at the offices of the
Corporation, to approve an amendment to the Amended and Restated Certificate of
Incorporation to authorize five million (5,000,000) shares of Preferred Stock,
par value one-tenth of one cent ($0.001) per share. A total of 22,370,789
ballots representing 22,370,789 shares were received from the Company's
Stockholders, which represented a quorum. Of those, 21,700,942 voted to approve
authorization of the Preferred Stock, representing holders of 51.9% of the
shares outstanding.

PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS

MARKET INFORMATION

Over the last two years the Company's Common Stock has traded on the OTC
Bulletin Board. As of March 12, 1998, there were approximately 325 stockholders
of record of the Common Stock. The following table sets forth the range of bid
price information for the Common Stock for the quarterly periods within the past
two fiscal years. Such market quotations reflect interdealer prices, without
retail mark-up, mark-down or commission and may not necessarily represent prices
at which actual transactions took place.

<TABLE>
<CAPTION>
COMMON STOCK HIGH LOW
------------ ----- -----
<S> <C> <C>
FISCAL 1996
First Quarter............................................... $1.38 $0.81
Second Quarter.............................................. 3.00 0.75
Third Quarter............................................... 2.50 1.44
Fourth Quarter.............................................. 2.50 1.63

FISCAL 1997
First Quarter............................................... $2.94 $1.75
Second Quarter.............................................. 2.69 1.88
Third Quarter............................................... 2.50 1.97
Fourth Quarter.............................................. 2.53 1.59
</TABLE>

DIVIDENDS

The Company has not paid any cash dividends on its capital stock over the
past two years and currently anticipates that it will retain all available funds
for use in its business. The Company does not, therefore, anticipate paying any
cash dividends in the foreseeable future. Furthermore, the Company is prohibited
from declaring or paying cash dividends on its capital stock under the terms of
the TCW Credit Facility described in Note 5 to the Company's Financial
Statements included herewith.

ITEM 6. SELECTED FINANCIAL DATA

The selected financial data set forth below should be read in conjunction
with the Consolidated Financial Statements and related Notes thereto included in
Item 8 of this Annual Report. The statement of operations data for the years
ended December 28, 1997, December 29, 1996, December 31, 1995 and December 31,
1994 and the balance sheet data as of these dates, have been derived from and
are qualified by reference to the consolidated financial statements which have
been audited by Arthur Andersen LLP, independent public accountants. The
statement of operations data for the year ended December 31, 1993 and the
balance sheet data at that date has been derived from and are qualified by
reference to the consolidated financial statements which have been audited by
Ernst & Young LLP, independent public accountants.

11
<PAGE> 15

During 1995, the Company changed it fiscal year end from a calendar year
end to a fifty-two week period ending on the Sunday closest to the calendar year
end. Consequently, fiscal quarters commencing in 1995 include thirteen weeks.
This change had no impact on the 1995 financial statements, and does not impact
comparability between prior years.

In May 1996, Aureal Semiconductor Inc. acquired 100% ownership of Crystal
River Engineering, Inc., a privately held firm specializing in 3D audio
technology development. The acquisition was recorded under the terms of purchase
accounting. In conjunction with this acquisition, the Company recorded in 1996,
a write-off of $6.0 million due to recognition that in-process research and
development efforts associated with CRE's 3D audio technology had not reached
technological feasibility with respect to the Company's product line at the date
of the acquisition.

In August 1995, the Company announced that is was divesting itself of its
retail multimedia components business to implement a business plan based upon
development and sale of software and semiconductor solutions to provide advanced
audio for the PC and consumer electronics markets. With this significant change
in business, revenues were reduced dramatically in the second half of 1995.
During the transition years of 1996 and 1997, the Company was primarily focused
on the development of the Company's new technology into product applications,
and thus revenue levels were not significant. 1998 is expected to be the first
year in which the Company ships products incorporating the new technology in
significant volumes.

The Company emerged from Chapter 11 Bankruptcy proceedings on December 30,
1994. The Company's Second Amended Plan of Reorganization resulted in a new
entity at that time. The Company adopted fresh start accounting effective
December 31, 1994. Accordingly, the financial data for periods prior to that
date are not considered comparable with financial statements for periods
subsequent to December 31, 1994

Given the significant changes to the Company noted above, comparability of
the information included below between periods is not considered useful. In
addition, as the Company restructured its business in 1995 and began to develop
new technologies during 1996 and 1997, the information shown below should not be
utilized toward making any projections of future revenues or profitability.

<TABLE>
<CAPTION>
FISCAL YEAR
-------------------------------------------------------
1997 1996 1995 1994 1993
-------- -------- --------- --------- ---------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Net sales................................ $ 1,640 $ 3,485 $ 47,747 $ 147,349 $ 145,304
Loss from continuing operations.......... (17,690) (17,020) (103,833) (157,956) (100,886)
Loss before extraordinary item........... (17,690) (17,020) (103,833) (166,457) (99,170)
Extraordinary item, gain on discharge of
indebtedness........................... -- -- -- 131,329 --
-------- -------- --------- --------- ---------
Net loss................................. $(17,690) $(17,020) $(103,833) $ (35,128) $ (99,170)
======== ======== ========= ========= =========
Basic and diluted earnings (loss) per
share:
Continuing operations.................. $ (0.44) $ (0.51) $ (5.19) $ (11.40) $ (7.67)
Discontinued operations................ -- -- -- (0.61) 0.13
Extraordinary item..................... -- -- -- 9.48 --
-------- -------- --------- --------- ---------
$ (0.44) $ (0.51) $ (5.19) $ (2.53) $ (7.54)
======== ======== ========= ========= =========
Shares used in calculating per share
amounts................................ 40,398 33,344 20,000 13,859 13,158
</TABLE>

12
<PAGE> 16

<TABLE>
<CAPTION>
YEAR-END
--------------------------------------------------------
1997 1996 1995 1994 1993
-------- --------- --------- --------- ---------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Working capital (deficiency)............ $ (645) $ (3,500) $ (5,725) $ 37,506 $ (31,638)
Total assets............................ 6,350 4,145 7,761 107,335 176,847
Long-term obligations and redeemable
preferred stock....................... 25,616 15,848 24,289 12,393 3,034
Total liabilities....................... 30,499 19,906 31,594 27,335 184,016
Stockholders' equity (deficit).......... (24,149) (15,761) (23,833) 80,000 (7,169)
</TABLE>

13
<PAGE> 17

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The following discussion should be read in conjunction with the Selected
Financial Data included in Item 6 and the Consolidated Financial Statements
included in Item 8 herein.

Forward-looking statements in this report are made pursuant to the safe
harbor provisions of the Private Securities Litigation Reform Act of 1995.
Investors are cautioned that such forward-looking statements involve risks and
uncertainties, including, but not limited to, the Company's dependence on the PC
and consumer electronics industries and on product lines based on new
technologies; on foundry capacity, availability and reliability; competition and
pricing pressures, ability to secure necessary funds, and other risks detailed
below and from time to time in the Company's filings with the Securities and
Exchange Commission.

OVERVIEW

During the three-year period reported upon herein, significant changes took
place in the business of the Company. These changes included:

- August 1997 -- Private placement of 1.9 million shares of the Company's
Common Stock

- May 1996 -- Acquisition of Crystal River Engineering, Inc.

- February through June 1996 -- Private placement of 18.9 million shares
of the Company's Common Stock

- August 1995 -- Announcement that the Company was exiting the retail PC
products business to focus on development of a business based on the
design, development and marketing of audio semiconductor solutions, and
licensing of audio semiconductor technology.

These changes, in conjunction with the business and financial reporting
changes necessitated thereby, render operating data largely non-comparable for
the years represented. While comparative comments are included herein, the
composition of the business differed greatly between 1996 and 1995. During the
transition years of 1996 and 1997, the Company was primarily focused on the
development of the Company's new technology into product applications, and thus
revenue levels were not significant. 1998 is expected to be the first year in
which the Company ships products incorporating the new technology in significant
volumes. No assumptions should be made as to future operations based upon
amounts or trends indicated for prior years.

The audio semiconductor industry is extremely competitive, and is
characterized by rapid technological change, evolving industry standards,
changing market conditions and frequent new product introductions and
enhancements. The introduction of products embodying new technologies or
standards can render existing products or products under development obsolete or
unmarketable. Many of the Company's competitors have more extensive engineering,
manufacturing, marketing, financial and personnel resources than those of the
Company. The Company expects competition to increase in the future from existing
competitors and from other companies which may enter the markets with products
that may be less costly or provide higher performance or additional features. In
general, product prices in the semiconductor industry have decreased over the
life of a particular product. As the markets for the Company's products mature
and competition increases, the Company anticipates that prices for its products
will decline. If the Company is unable to reduce its cost sufficiently to offset
declines in product prices or is unable to introduce new, higher performance
products with higher product prices, the Company's results of operations could
be materially adversely affected.

RESULTS OF OPERATIONS

FISCAL 1997 COMPARED TO FISCAL 1996

As noted above, 1996 and 1997 were periods where the Company focused
primarily on the development of its new technologies into product applications
in both the PC and consumer electronics markets. Revenues in both years were not
significant, as volume shipments of Aureal-developed semiconductor devices to
customers are not anticipated until 1998. The Company's primary goal in 1996 was
to generate visibility for

14
<PAGE> 18

and recognition of Aureal's technology in the marketplace. For 1997, the goal
was to transform that recognition into relationships in which customers design
Aureal's semiconductor technology into their own products. Those objectives have
been achieved as the Company currently has secured design wins, licensing
agreements, PC game developer commitments and other working relationships with
dozens of firms in the PC and consumer electronics industries.

During the second half of 1997, Aureal introduced the Company's flagship
product, the Vortex AU8820. It is a PCI-based AC'97 Digital Audio Processor, and
sales of this product are anticipated to generate a significant majority of the
Company's revenues during 1998.

Net Sales

Revenues for 1997 totaled $1.6 million resulting primarily from technology
licensing transactions, with approximately 10% coming from semiconductor sales.
The Company has entered into 3D audio technology ("A3D") licenses with several
companies. Due to the timing of license revenue recognition, 1997 revenues have
varied from quarter to quarter. Revenues in future quarters are not expected to
consist primarily of licensing revenues, as volume shipments of the Vortex
AU8820 are expected to occur in 1998. Thus the timing of licensing transactions
is not expected to have a significant affect on quarterly results.

1996 revenues of $3.5 million reflect sales or licensing fees associated
with pre-existing audio technology, primarily during the first half of the year.
Included in the $3.5 million total is $2.0 million associated with a one-time
licensing transaction in January 1996. The Company did not receive significant
revenue relating to this pre-existing technology during 1997, nor does it expect
to in future years.

Gross Margin

Gross margin for the 1997 fiscal year was $1.5 million, or 89% of sales.
The Company expects future gross margins to decrease significantly as the sale
of semiconductor products, which reflect the current cost of producing physical
product for sale, replaces licensing transactions as the dominant source of
revenue.

In 1996, the Company recorded gross margin of 91% of sales, or $3.2
million. The margin reflected the large percentage of net sales represented by
licensing transactions. The vast majority of costs related to technology
licensing are recorded as research and development costs over the development
period of the technology. Relatively little current expense is connected
directly with the recognized revenue, thus producing relatively high gross
margin percentages.

Research and Development

Costs for research and development in 1997 were $7.4 million, up $1.2
million or 19% over the prior year. The increase was due primarily to costs
associated with increased staff levels and reflect the Company's continued
emphasis on new product and technology development. In addition to the costs
identified as research and development, certain employee and other costs related
to creating prototype products for customers to evaluate Aureal's semiconductor
products, as well as finalization of product specifics for individual customers
(product development) are reported as part of sales and marketing expenses in
both years presented. The Company expects to expand its research and development
efforts, and thus costs in this area are anticipated to increase in 1998 and
later years.

Sales and Marketing

Sales and marketing expenses were $3.7 million for 1997, compared to $2.2
million for the 1996 fiscal year. These increases included additions to staffing
as well as costs associated with creating prototype products for customers to
evaluate the Company's semiconductor products. Generally, in the case of
products for sale to original equipment manufacturers ("OEM's"), significant
up-front costs are often incurred before the first order for product is ever
received. Expenses for people, travel, public relations, marketing and trade
shows are a result of the initial effort to introduce the Company's technology
during 1996 and then to introduce semiconductor products during 1997. Although
different specific aspects of sales and marketing expenses may

15
<PAGE> 19

grow and shrink as appropriate over time, the aggregate effort and resulting
cost level is expected to grow in future quarters.

General and Administrative

General and administrative expenses have remained fairly constant over the
last two years. Expenses were $2.4 million in 1997, compared to $2.6 million in
1996. The cost stability in this area reflects continued cost containment
efforts for the Company. Additional administrative staffing has not yet been
necessary, yet this is expected to change as the Company's business grows and
sales volumes increase. In 1996, one significant area of expenditure within this
category was legal costs associated with preparing, filing and prosecuting
numerous patent applications. The Company plans to continue to aggressively
pursue additional patents on its current and future developed technologies.

Amortization of Reorganization Asset

The Company exited Chapter 11 bankruptcy protection on December 30, 1994.
The Reorganization Asset originated pursuant to the Company's valuation upon its
exit from bankruptcy protection whereby the fair value of the Company exceeded
its net assets by $44.1 million. The Reorganization Asset initially was being
amortized over three years at the rate of $3.7 million per fiscal quarter.
During the second quarter of 1995 it was determined that a significant portion
of the Reorganization Asset could no longer be assured of recovery and a $30.5
million write-off was recorded (see Restructuring Charges below). The remaining
Reorganization Asset value after the write-off has been amortized at the rate of
$625,000 per fiscal quarter through 1997 and as of December 28, 1997 is
completely amortized.

Restructuring Charges

During 1995, the Company announced a plan to divest its worldwide retail
operations and provided a $61.6 million restructuring provision to reflect a
write-down of assets and record the incremental costs of exiting the business.
This provision was included as a component of operating expenses for the second
and third quarters of 1995 as the details of the process were determined. During
1995 and 1996, substantially all of the identified liabilities related to the
restructuring were finalized. As a result, a credit of $804,000 was recorded in
the fourth quarter of 1996 reflecting a revision of the original estimated
charges. The Company does not expect that final payment of all restructuring
costs will result in any charges to income in future periods.

Interest Expense

Interest expense of $2.8 million in 1997 and $2.2 million in 1996 consisted
primarily of interest on the Company's working capital line of credit with TCW
(at the rate of prime plus 5%). In both years, the TCW Credit Facility was a
primary source of working capital. The balance on the TCW Credit Facility is
expected to increase in future periods as it is utilized as a primary source of
working capital.

Amortization of Debt Related Warrants

SFAS No. 123 requires accounting on the basis of estimated fair value for
the warrants issued in association with the amendment to the line of credit
("Debt Warrants"), as described in Footnote 5. The fair value of the Debt
Warrants was estimated to be $5.0 million. The value of the Debt Warrants is
included in both current and long-term assets in the accompanying balance sheet.
Amortization of the $5.0 million asset, as additional interest expense over the
life of the loan, commenced in August 1997 at the rate of $0.75 million per
quarter.

Interest Income and Other Income and Expenses

With cash balances at a minimum throughout 1997, interest income was not
significant, and is not expected to be significant in the future.

16
<PAGE> 20

Interest income of $156,000 in 1996 was generated primarily on funds
invested temporarily following the Company's receipt of funds from private
placements of equity in the first quarter. Terms of the funding transactions
placed certain limitations on the Company's ability to use the offering proceeds
to reduce the outstanding balance of the TCW Credit Facility. The invested cash
declined during the second and third quarters as it was utilized for ongoing
operations costs as well as for the acquisition of CRE.

Other income for 1997 totaled $812,000, resulting primarily from the
favorable resolution of certain matters for which liabilities had been provided
in 1996. Also included was a VAT refund and miscellaneous other receipts.

The Company recognized net other income of $563,000 in 1996 from a number
of sources, including receipt of prior year VAT refunds and other favorable
resolutions to previously recorded liabilities, recovery of property loss
insurance proceeds and miscellaneous other receipts.

Income Taxes

Due to its net operating losses in both 1997 and 1996, the Company was not
required to provide for income taxes in either year. No tax benefit has been
recorded for the losses due to the uncertainty as to its realizability.

FISCAL 1996 COMPARED TO FISCAL 1995

As noted above, 1995 and 1996 were periods of tremendous change for the
Company. The Company exited the retail PC upgrade kit market in the second half
of 1995. Through 1996, the Company progressed in its efforts to develop and
begin to market new audio technology to both the PC and consumer electronics
markets. Technology and product announcements were made in the second half of
1996 and in 1997. The Company's primary goal in 1996 was to generate visibility
for and recognition of Aureal's technology in the marketplace.

Due to the above changes in the Company's operations in 1995 and 1996, the
years' financial results are not considered comparable. While some comparative
comments are included herein, the composition of the business varied greatly
between the years, and comparisons are not considered relevant. The financial
results for 1995 and 1996 should not be used to project any future operating
results nor trends.

Net Sales

Sales for 1996 totaled $3.5 million which consisted primarily of technology
licensing transactions along with sales of semiconductor products embodying
pre-existing audio technology in the first half of the year. Included in the
$3.5 million total is $2.0 million associated with a one-time licensing
transaction in early January of 1996. In addition to licenses for Aureal's
pre-existing legacy audio technology, the Company has entered into 3D audio
technology ("A3D") licenses with Diamond Multimedia, Oak Technology, Rockwell
Semiconductor and Analog Devices. No significant revenues were recorded during
1996 with respect to any of these A3D licensing transactions.

1995 sales of $47.7 million reflect PC multimedia upgrade kit sales
primarily during the first half of the year, prior to the announcement in August
that the Company was exiting that market.

Gross Margin

Gross margin of $3.2 million for 1996 (91% of sales) resulted from the
large percentage of net sales represented by licensing transactions. The vast
majority of costs related to technology licensing are recorded as research and
development costs over the development period of the technology. Relatively
little current expense is connected directly with the sales, thus producing
relatively high gross margin percentages.

In 1995, the Company recorded a negative gross margin of $6.1 million on
$47.7 million in PC multimedia upgrade kit sales. The negative margin reflected
write-downs of retail inventories during the year to net realizable value.
Generally, the relatively short market lives of products in that market
(especially

17
<PAGE> 21

CD-ROM drives) keep extremely high pressure on prices of the products and force
prices on "older" products down dramatically over relatively short time frames.

Research and Development

Costs for research and development of $6.2 million and $6.7 million in 1996
and 1995, respectively, reflect the Company's continued emphasis on new product
and technology development. In addition, a transfer of technical staff from
Research and Development to Marketing occurred during the first half of 1996
resulting in certain costs related to product development to be reported as
sales and marketing expenses in 1996.

Sales and Marketing

Sales and marketing expenses increased in each of the four quarters of 1996
as the Company's efforts to introduce its technologies and products to the
marketplace intensified. These increases included additions to staffing as well
as incremental travel and specific product development costs as the Company
worked with potential customers worldwide to blend its technologies for retail
productization.

1995 sales and marketing expenses of $13.2 million related to the domestic
and international efforts in the retail PC upgrade kit marketplace. Those
efforts were reduced in the third quarter and eliminated by the end of 1995.

General and Administrative

General and administrative expenses of $2.6 million in 1996 (down from $4.4
million in 1995) reflected continued cost containment efforts for the Company as
product development efforts continued through the year. One significant area of
expenditure within this category was legal costs associated with preparing,
filing and prosecuting numerous patent applications during the year. To that
end, additional patent claims were granted by the U.S. Patent and Trademark
office on certain of the Company's 3D audio technologies in January 1997.

Amortization of Reorganization Asset

The Reorganization Asset originated pursuant to the Company's valuation
upon its exit from bankruptcy protection on December 30, 1994 whereby the fair
value of the Company exceeded its net assets by $44.1 million. During the second
quarter of 1995 it was determined that a significant portion of the
Reorganization Asset could no longer be assured of recovery and a $30.5 million
write-off was recorded. The remaining Reorganization Asset value after the
write-off has been amortized through 1997 at the rate of $625,000 per fiscal
quarter.

Interest Expense

Interest expense of $2.2 million in 1996 and $3.2 million in 1995 consisted
primarily of interest on the Company's working capital line of credit with TCW
(at the rate of prime plus 5%). In both years, the TCW Credit Facility was a
primary source of working capital. Equity funding of $22 million in the first
half of 1996 was used to both fund current working capital needs and partially
pay down the TCW Credit Facility, thus reducing interest expense in 1996.

Interest Income and Other Income and Expenses

18
<PAGE> 22

Interest income of $142,000 in 1995 was earned primarily on certificates of
deposit used to collateralize the purchase of certain inventory items, a program
terminated in the third quarter of that year.

The Company recognized net other income of $563,000 in 1996 from a number
of sources, including receipt of prior year VAT refunds and other old business
sources in excess of previously recorded amounts, recovery of property loss
insurance proceeds and miscellaneous other receipts.

Income Taxes

Due to its net operating losses in both 1996 and 1995, the Company was not
required to provide for income taxes in either year. No tax benefit has been
recorded for the losses due to the uncertainty as to its realizability.

LIQUIDITY AND CAPITAL RESOURCES

The Company has recorded operating losses for each of the last three years.
Its decision to terminate the prior retail PC upgrade kit business in mid-1995
and concentrate all of its resources on development of audio technologies and
semiconductor solutions for the PC and consumer electronics markets led to a
period of product development without significant revenues.

As of December 28, 1997, the Company had a working capital deficit of $0.6
million and shareholders' deficit of $24.1 million. The net cash flow
requirements for the Company have been running at over $1.5 million per month.
The $13.9 million net cash used in operations for 1997 was approximately $5.0
million more than in 1996, due mainly from an increase in net loss from
operations, after factoring in the 1996 write-off of R&D. Net cash used for
investing in equipment and to make business acquisitions was about $2.5 million
less in 1997 than in 1996. The difference was the result of the cash used to
acquire Crystal River Engineering in 1996. Financing for the aforementioned cash
outlays was provided by borrowings from the Company's line of credit in 1997,
and proceeds from the issuance of common stock in 1996. The Company expects the
need to expand the business with the manufacture of products (through outside
foundries) and financing of customer receivables as sales of semiconductor
products are anticipated to grow in future quarters. For a company just
commencing sales, the timing and uncertain amount of inventory purchases and the
collection of revenues make the forecasting of cash flows from operations
inherently difficult. There is no assurance the Company will generate positive
cash flows in the future.

The Company maintains a line of credit managed by TCW Special Credits, an
affiliate of the TCW Group, Inc. ("TCW"), (See Footnote 5). The maturity date
(originally March 1, 1995) and the total availability under the line (ranging
from $10 million to $31.5 million to date) have been negotiated periodically
with TCW. In conjunction with the private placement of equity, finalized in
August 1997, the line of credit was increased from $20.0 million to $31.5
million, and the maturity date was extended to March 31, 1999. In addition, the
Company has an option to extend the due date an additional year, to March 31,
2000. Borrowings under the facility are secured by substantially all the assets
of the Company and bear interest at the rate of prime (8.50% at December 28,
1997) plus five percent. As of March 12, 1998, $23.2 million was outstanding
under the line, with $8.3 million available for further borrowing.

In March 1998 the Company completed a private placement transaction for the
sale of $5 million of three-year 8% convertible preferred stock. The proceeds
were immediately used to pay down the outstanding line of credit on March 12,
1998. The shares of the preferred stock include conversion rights to Aureal
common stock at either a $2.50 fixed conversion rate or a variable conversion
pricing dependent upon the underlying price of the common stock over the
three-year term. The Company may require financing, in addition to the
availability under its TCW Credit Facility, during 1998 to support its growth.
Although the Company believes that its existing line of credit availability will
be sufficient to meet the Company's capital and operating requirements for the
next 12 months, it may consider various financing options, including additional
equity capitalization. It has no commitments for any specific financing at this
time and there can be no assurance that any such financing can be obtained at
terms acceptable to the Company, or at all.

19
<PAGE> 23

Capital expenditures of $881,000 in 1997 and $590,000 in 1996 consisted
primarily of hardware and software tools utilized in the Company's research and
development activities. Capital expenditures are anticipated to increase
significantly during 1998, to an estimated level of between $3 million and $4
million for the year. The Company believes that funding for the expected
increase in capital expenditures will come primarily from the Company's working
capital line of credit.

The Company's capital requirements for the period beyond the next 12 months
will depend on many factors, including the rate of revenue growth, the Company's
profitability, the timing and extent of spending to support research and
development programs, the expansion of selling and marketing and administrative
activities, and market acceptance of the Company's products. The Company expects
that it may need to raise additional equity or debt financing in the future to
meet these requirements. There can be no assurance that additional equity or
debt financing, if required, will be available on the acceptable terms or at
all. If the Company is unable to obtain such additional capital, if needed, the
Company may be required to reduce the scope of its operations, which would have
a material adverse effect on the Company's business, financial condition and
results of operations.

The Company uses a number of computer software programs and operating
systems in its internal operations, including applications used in financial
business systems and various administration functions. To the extent that these
software applications contain source code that is unable to appropriately
interpret the upcoming calendar year "2000," some level of modification or even
possibly replacement of such source code or applications will be necessary. The
Company is in the process of identifying the software applications that are not
"Year 2000" compliant. Given the information known at this time about the
Company's systems, coupled with the Company's ongoing efforts to upgrade or
replace business critical systems as necessary, it is currently not anticipated
that these "Year 2000" costs will have a material adverse impact on the
Company's business, financial condition and results of operations. However, the
Company is still analyzing its software applications and, to the extent they are
not fully "Year 2000" compliant, there can be no assurance that the costs
necessary to update software or potential systems interruptions would not have a
material adverse effect on the Company's business, financial condition and
results of operations. The Company is not aware that any of its key suppliers or
customers are not fully "Year 2000" compliant. If any of its key suppliers and
customers are not yet fully "Year 2000" compliant, there can be no assurance
that such non-compliance would not have a material adverse effect on the
Company's business, financial condition and results of operations.

FACTORS THAT MAY AFFECT FUTURE RESULTS

History of Losses and Accumulated Deficit; Expectation of Future
Losses. The Company emerged from bankruptcy on December 30, 1994. Since that
time the Company has incurred losses, in the aggregate amount of $139 million,
from (1) its previous retail products operations in 1995, and (2) during the
research and development phases of its advanced audio technologies business
operations in 1996 and 1997. The majority of the Company's revenue in 1996 and
1997 has consisted of fees from the licensing of its audio technologies. While
the Company sees licensing as an important process to develop market knowledge
and acceptance of its technologies as well as generating operating revenues, its
primary business is to develop and sell semiconductor products.

The Company currently has three semiconductor products in full production.
No significant revenues have been generated by any of these products to date.
The Company is working to secure design wins for each of these products,
however, there can be no assurance that the Company will be able to sell
significant volumes of any of its semiconductor products in the future. Future
profitability, if any, is highly dependent on the Company securing design wins
for its products and shipping significant volumes thereof. There can be no
assurance that the Company will attain profitability or generate positive cash
flows.

New Technologies and Products Developed With New Technologies. The
Company's success depends on its ability to develop and market new technologies
aimed at advancing the level of audio quality in the PC and consumer electronics
devices. With respect to the PC Market, audio technology is shifting from
utilization of the ISA bus to utilization of the more advanced (higher
band-width) PCI bus. This change enables advanced digital audio functionality
including positional 3D audio, streaming audio and higher quality presentation.

20
<PAGE> 24

There can be no assurance that the shift from ISA-based audio to PCI-based audio
will occur in a timeframe for the Company to benefit from its PCI-based products
and technologies. As new technologies are developed, there can be no assurance
that markets will develop for them, or that markets will develop on a timely
basis for the Company to benefit therefrom.

The success of new products depends on a number of factors, including
timely completion of product development, market acceptance of the Company's and
its customers new products and the Company's ability to offer new products at
competitive prices. Incorporating the Company's new products into its OEM
customers' new product designs requires the anticipation of market trends and
performance and functionality requirements of OEMs, the development and
production of products that meet the timing and pricing requirements of OEMs and
that can be tested and be available in a timely manner consistent with the OEM's
development and production schedule. Accordingly, in selling to OEMs, the
Company can often incur significant expenditures in advance of volume sales, if
any, of new products. There can be no assurance that the Company will be able to
successfully identify new product opportunities, develop and market new
products, achieve design wins or respond effectively to the new technological
changes or product announcements by others. A failure in any of these areas
could have a material adverse effect on the Company's business, financial
condition and results of operations.

Each successive generation of microprocessors has provided increased
performance, which could in the future result in a microprocessor capable of
performing advanced audio functions to an extent that the need or preference for
the Company's products could be eliminated. In this regard, Intel Corporation
has created the MMX functionality with its Pentium line of processors and is
promoting the processing power of MMX for data and signal intensive functions
such as graphics and audio processing. A product with the processing power
required to execute high quality audio, video and graphics simultaneously with
all other functions which the host processor does, has not yet been marketed by
Intel. The Company believes that advanced audio processing, done in conjunction
with either video or graphics processing is best performed with a separate
accelerator chip in addition to the host processor. There can be no assurance
that the increased capabilities of microprocessors will not adversely affect
demand for the Company's products.

Dependence on Single Product Line and the PC and Consumer Electronics
Markets. The Company has historically derived substantially all of its revenues
from its products, all of which are related to advanced audio solutions for the
PC and consumer electronics markets. The Company expects that such products will
continue to represent substantially all of the Company's revenues. The failure
of this market to continue to grow, any reduction in demand as a result of
increased competition in this market, technological change, failure by the
Company to introduce new versions of products acceptable to the marketplace or
other similar factors would have a material adverse effect on the Company's
business, operating results and financial condition.

Competition and Pricing Pressures. The markets in which the Company
competes are intensely competitive and are characterized by evolving industry
standards, rapid technological advances resulting in relatively short product
life cycles, price reductions, significant price/performance improvements and
frequent new product introductions. The Company expects competition to increase
in the future from existing competitors and from other companies that may enter
the markets with products that may be less costly or provide higher performance
or additional features. The Company is unable to predict the timing and nature
of any such competitive product offerings. In general, product prices in the
semiconductor industry have decreased over the life of a particular product. The
willingness of prospective customers to design the Company's products into their
products depends to a significant extent upon the ability of the Company to
price its products at a level that is cost-effective for such customers. As the
markets for the Company's products mature and competition increases, the Company
anticipates that prices for its products will continue to decline. If the
Company is unable to reduce its cost sufficiently to offset declines in product
prices or is unable to introduce new, higher performance products with higher
product prices, the Company's business, financial condition and results of
operations could be materially adversely affected.

The Company anticipates that it will compete for the development of new
technologies and for the sale of semiconductor products with a number of
companies who have more extensive resources including financial,

21
<PAGE> 25

manufacturing, technical, marketing and distribution. In addition, some of those
firms have greater intellectual property rights, broader product lines and
longer-standing relationships with customers than the Company. The Company's
competitors also include a number of emerging companies.

The Company believes that its ability to compete successfully depends on a
number of factors, both within and outside of its control, including the price,
quality and performance of the Company's and its competitors' products, the
timing and success of new product introductions by the Company, its customers
and its competitors, the emergence of new multimedia PC standards, the
development of technical innovations, the ability to obtain adequate foundry
capacity and sources of raw materials, the efficiency of production, the rate at
which the Company's customers design the Company's products into their products,
the number and nature of the Company's competitors in a given market, the
assertion of intellectual property rights and general market and economic
conditions.

Increased competition could result in price reductions, reduced gross
margins and loss of market share, any of which could materially adversely affect
the Company's business, financial condition or results of operations. There can
be no assurance that the Company will be able to compete successfully against
current or future competitors or that competitive pressures will not materially
adversely affect its business, financial condition or results of operations.

Dependence on Line of Credit. Because it has not been profitable to date,
the Company has had to secure a capital line of credit to provide it with the
liquidity it needs to operate its business. As of April 30, 1998, the Company
had drawn approximately $30.4 million on this line of credit. The line of credit
availability was increased by $5.0 million in May 1998 to a total of $36.5
million. The interest rate on this line of credit is the prime rate plus 5%.
Accordingly, the Company's liquidity has been negatively impacted, and will
continue to be negatively impacted, as a result of the high cost of servicing
this line of credit. There can be no assurance that this line of credit will be
sufficient to meet the Company's needs. In the event the Company is required to
secure additional capital, there can be no assurance that such capital will be
available on acceptable terms or at all. If the Company is unable to obtain such
additional capital, if needed, the Company may be required to reduce the scope
of its operations, which would have a material adverse effect on the Company's
business, financial condition and results of operations.

Dependence on Foundries. The Company, as a "fabless" semiconductor firm,
relies on independent foundries to manufacture all of its semiconductor
products. Currently the Company utilizes two foundries, one domestic and one
foreign to manufacture its existing products. Both of these foundries have
indicated to the Company that they have the manufacturing availability to
provide for the Company's planned production of each product through at least
1998; however the production relationships are based only upon purchase orders
in the case of either foundry, and there is no assurance that the foundries will
continue to provide adequate manufacturing capacity to the Company for its
current level of production or its intended increases in production levels. If
foundry capacity at either manufacturer is substantially reduced or not
increased to cover the Company's anticipated production growth requirements,
such reductions or lack of increases could have a material adverse effect on the
Company's business, financial condition and results of operations.

The manufacture of semiconductor products is a highly complex and precise
process. Minute levels of contaminants in the manufacturing environment, defects
in the masks used to print circuits on wafers, difficulties in the fabrication
process or other factors can cause a substantial percentage of wafers to be
rejected or a significant number of die on each wafer to be non-functional. Many
of these problems are difficult to diagnose, time-consuming or expensive to
remedy. The Company's foundries have experienced irregular yields in the
manufacture of the Company's products. These irregularities have not had a
material adverse effect on the Company's business, financial condition or
results of operations. However, there can be no assurance that the Company's
foundries will not experience irregularities or adverse yield fluctuations in
the manufacturing processes in the future which could have a material adverse
effect on the Company's business, financial condition and results of operations.
Any yield or other production problems or shortages of supply experienced by the
Company or its foundries could have a material adverse effect on the Company's
business, financial condition and results of operations.

22
<PAGE> 26

Dependence on Proprietary Technology. The Company relies on a combination
of patents, trade secret, copyright and trademark laws, nondisclosure
agreements, and other contractual provisions and technical measures to protect
its proprietary rights. There can be no assurance that such measures will be
adequate or safeguard the proprietary technology underlying the Company's
products, or that its agreements with employees, consultants and others who
participate in the development of its products will not be breached, that the
Company will have adequate remedies for any breach or that the Company's
proprietary information or trade secrets will not otherwise become known.
Moreover, notwithstanding the Company's efforts to protect its intellectual
property, there can be no assurance that competitors will not be able to develop
products which are equal or superior to the Company's products without
infringing any of the Company's intellectual property rights. In addition,
effective protection of intellectual property rights may be unavailable or
limited in certain countries. Accordingly, there can be no assurance that the
Company's means of protecting its intellectual property will be adequate or that
the Company's competitors will not independently develop similar technologies or
products.

In March 1998, the Company was served with a suit for patent infringement
filed by Creative Technology Ltd., a Singapore corporation ("Creative"), and its
subsidiary, E-MU Systems, Inc., a California corporation ("E-MU"). The suit
alleges that the Company's Vortex AU8820 AC'97 Digital Audio Processor infringes
on a patent which describes a specific implementation for an electronic musical
instrument designed by E-MU. Creative and E-MU seek, among other things, a
preliminary and permanent injunction against continuing acts of infringement by
the Company and an accounting of damages plus interest. The Company has reviewed
the allegations in the complaint and believes that the action is without merit
and intends to vigorously pursue defense of this action.

Litigation may be necessary to resolve the claims asserted by Creative and
E-MU and any other claims asserted in the future to defend against claims of
infringement or invalidity or to enforce and protect the Company's intellectual
property rights. There can be no assurance that the Company will prevail in any
litigation with Creative and E-MU or any other party. Any such litigation,
whether or not determined in the Company's favor or settled by the Company,
would be costly and would divert the efforts and attention of the Company's
management and technical personnel from normal business operations, which could
have a material adverse effect on the Company's business, financial condition
and results of operations. Adverse determinations in litigation could result in
the loss of the Company's proprietary rights, subject the Company to significant
liabilities, require the Company to seek licenses from third parties or prevent
the Company from licensing its technology, any of which could have a material
adverse effect on the Company's business, financial condition and results of
operations.

Dependence on Key Personnel. The Company's success depends to a significant
extent upon the continued services of key engineering, marketing, sales and
management personnel. The Company's employees may voluntarily terminate their
employment with the Company at any time. The Company recognizes the value of the
contributions of each of its employees and has developed compensation programs,
including stock option plans for granting of options to all employees, designed
to retain its employees. Competition for such employees is intense and the loss
of the services of such employees could have a material adverse effect on the
Company's business, financial condition and results of operations.

Factors Inhibiting Takeover. The Company is subject to the provision of
Section 203 of the Delaware General Corporation Law, which imposes certain
restrictions on the ability of a third party to effect an unsolicited change in
control of the Company. In addition, the Company's Amended and restated
Certificate of Incorporation does not provide for cumulative voting in the
election of directors, and certain provisions of the Company's Amended and
Restated Certificate of Incorporation and Bylaws, including the provision which
divides the Board into three separate classes, may have the effect of delaying
or preventing changes in control or management of the Company.

Trading in the Non-NASDAQ Over-the-Counter Market; Disclosure Relating to
Low Priced Stocks. The Company's Common Stock trades only on the OTC Bulletin
Board and the trading volume has been generally light. The Company does not
currently meet the requirements of the Nasdaq National Market or other

23
<PAGE> 27

national stock exchanges. There can be no assurance that the Company will meet
the listing requirements or that it will be accepted for trading on any such
national exchange in the future.

Because the Company's securities trade on the non-NASDAQ over-the-counter
market, an investor may find it more difficult to dispose of, or to obtain
accurate quotations as to the market value of, the Company's securities. In
addition, because the Company's securities are not listed on NASDAQ, trading in
the Common Stock is also subject to certain rules promulgated under the Exchange
Act, which require additional disclosure by broker-dealers in connection with
any trades involving a stock defined as a penny stock (generally, any non-
NASDAQ equity security that has a market price of less than $5.00 per share,
subject to certain exceptions). Such rules require the delivery, prior to any
penny stock transaction, of a disclosure schedule explaining the penny stock
market and the risks associated therewith, and impose various sales practice
requirements on broker-dealers who sell penny stock to persons other than
established customers and accredited investors (generally institutions). For
these types of transactions, the broker-dealer must make a special suitability
determination for the purchaser and have received the purchaser's written
consent to the transactions prior to sale. On May 29, 1998, the closing price
for the Company's Common Stock was $2.16 per share. The additional burdens
imposed upon broker-dealers by such requirements may discourage broker-dealers
from effecting transactions in the Company's Common Stock, and severely limit
the market liquidity of the Company's Common Stock and the ability of purchasers
of the Company's Common Stock to resell such securities in the secondary market.

Currently, approximately 76% of the outstanding Common Stock is controlled
by three parties, each of whom control at least 10% individually. There can be
no assurance that the liquidity of the market for the Common Stock will be
maintained at or increase over its current levels, and the trading price for the
Common Stock may be influenced by the volume and liquidity of the market for the
Common Stock. Sales of a large percentage of the Company's total outstanding
Common Stock may have an adverse effect on the market price for such securities.

24
<PAGE> 28

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To Aureal Semiconductor Inc.:

We have audited the accompanying consolidated balance sheets of Aureal
Semiconductor Inc. (a Delaware corporation) and subsidiaries as of December 28,
1997 and December 29, 1996, and related consolidated statements of operations,
stockholders' equity (deficit) and cash flows for each of the three fiscal years
in the period ended December 28, 1997. These financial statements and the
schedule referred to below are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements based
on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Aureal Semiconductor Inc.
and subsidiaries as of December 28, 1997 and December 29, 1996 and the results
of their operations and their cash flows for the each of the three fiscal years
in the period ended December 28, 1997, in conformity with generally accepted
accounting principles.

Our audits were made for the purpose of forming an opinion on the basic
financial statements taken as a whole. The schedule listed in Item 14.(a)(2) of
the financial statements is presented for purposes of complying with the
Securities and Exchange Commission's rules and is not part of the basic
financial statements. This schedule has been subjected to the auditing
procedures applied in the audit of the basic financial statements and, in our
opinion, fairly states in all material respects the financial data required to
be set forth therein in relation to the basic financial statements taken as a
whole.

ARTHUR ANDERSEN LLP

San Jose, California
March 12, 1998

25
<PAGE> 29

AUREAL SEMICONDUCTOR INC.

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

ASSETS

<TABLE>
<CAPTION>
YEAR-END
----------------------
1997 1996
--------- ---------
<S> <C> <C>
Current assets:
Cash and cash equivalents................................. $ 135 $ 18
Restricted cash........................................... 109 --
Accounts receivable, net of allowance of $12 and $23,
respectively........................................... 21 63
Inventories............................................... 511 74
Deferred fair value of debt related warrants.............. 3,000 --
Prepaid loan fees and other current assets................ 462 403
--------- ---------
Total current assets.............................. 4,238 558
Property and equipment:
Machinery and equipment................................... 3,785 2,917
Furniture, fixtures and improvements...................... 599 593
--------- ---------
4,384 3,510
Accumulated depreciation and amortization................... (3,170) (2,518)
--------- ---------
Net property and equipment........................ 1,214 992
Reorganization asset, less accumulated amortization of
$13,596 in 1997 and $11,096 in 1996....................... -- 2,500
Long-term portion of fair value of debt related warrants and
other assets.............................................. 898 95
--------- ---------
Total assets...................................... $ 6,350 $ 4,145
========= =========

LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable.......................................... $ 1,523 $ 670
Accrued compensation and benefits......................... 1,115 1,278
Other accrued liabilities................................. 1,365 1,229
Current portion of pre-petition claims.................... 880 881
--------- ---------
Total current liabilities......................... 4,883 4,058
Line of Credit from TCW..................................... 21,975 10,325
Long-term portion of pre-petition claims and deferred
obligations............................................... 3,641 5,523
--------- ---------
30,499 19,906
--------- ---------
Commitments (See Note 6)
Stockholders' equity (deficit):
Preferred Stock, $.001 par value:
Authorized shares -- 5,000,000; None issued and
outstanding..................................... -- --
Common stock, $.001 par value:
Authorized shares -- 100,000,000; Issued and
outstanding shares -- 41,850,205 in 1997 and
39,190,795 in 1996.............................. 42 39
Additional paid-in capital................................ 114,352 105,053
Accumulated deficit....................................... (138,543) (120,853)
--------- ---------
Total stockholders' equity (deficit).............. (24,149) (15,761)
--------- ---------
Total liabilities and stockholders' deficit....... $ 6,350 $ 4,145
========= =========
</TABLE>

See accompanying notes.

26
<PAGE> 30

AUREAL SEMICONDUCTOR INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
FISCAL YEAR
---------------------------------
1997 1996 1995
-------- -------- ---------
<S> <C> <C> <C>
Net Sales................................................. $ 1,640 $ 3,485 $ 47,747
Cost of Sales............................................. 181 304 53,802
-------- -------- ---------
Gross Margin.............................................. 1,459 3,181 (6,055)
Operating expenses:
Research and development................................ 7,425 6,231 6,730
Sales and marketing..................................... 3,662 2,177 13,247
General and administrative.............................. 2,379 2,564 4,422
Amortization of reorganization asset.................... 2,500 2,500 8,596
Restructuring charges................................... -- (804) 61,626
Write-off of acquired research and development in
progress............................................. -- 6,013 --
-------- -------- ---------
Total operating expenses........................ 15,966 18,681 94,621
-------- -------- ---------
Operating loss............................................ (14,507) (15,500) (100,676)
Interest expense........................................ (2,757) (2,239) (3,183)
Amortization of debt related warrants................... (1,250) -- --
Interest income......................................... 12 156 142
Other income (expense).................................. 812 563 (116)
-------- -------- ---------
Loss before income taxes.................................. (17,690) (17,020) (103,833)
Provision (benefit) for income taxes...................... -- -- --
-------- -------- ---------
Net loss.................................................. $(17,690) $(17,020) $(103,833)
======== ======== =========
Basic and Diluted loss per share.......................... $ (0.44) $ (0.51) $ (5.19)
======== ======== =========
Shares used in calculating per share amounts.............. 40,398 33,344 20,000
======== ======== =========
</TABLE>

See accompanying notes.

27
<PAGE> 31

AUREAL SEMICONDUCTOR INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

<TABLE>
<CAPTION>
FISCAL YEAR
---------------------------------
1997 1996 1995
-------- -------- ---------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net loss from operations................................ $(17,690) $(17,020) $(103,833)
Adjustments to reconcile net loss from operations to net
cash used in operating activities:
Depreciation and amortization...................... 4,451 3,262 10,661
Restructuring charges.............................. -- (804) 61,626
Write-off of acquired research and development in
process.......................................... -- 6,013 --
Changes in operating assets and liabilities (net of
assets acquired and liabilities assumed in 1996):
Restricted cash provided or released............. (109) 206 3,025
Accounts receivable.............................. 42 212 14,795
Inventories...................................... (437) 178 10,167
Prepaid expenses and other current assets........ (59) 722 3,351
Other assets..................................... (97) 236 591
Accounts payable................................. 853 (283) (1,594)
Accrued compensation and benefits, and other
liabilities................................... (890) (1,729) (9,262)
-------- -------- ---------
Net cash used in operating activities................... (13,936) (9,007) (10,473)
INVESTING ACTIVITIES
Payment for acquisition of business, net of cash
acquired........................................... -- (2,970) --
Purchases of property and equipment................... (881) (590) (277)
Proceeds from disposition of property and equipment... 8 3 581
-------- -------- ---------
Net cash provided by (used in) investing activities..... (873) (3,557) 304
-------- -------- ---------
FINANCING ACTIVITIES
Proceeds from TCW Credit Facility..................... 15,540 6,153 23,555
Repayment of TCW Credit Facility...................... (3,890) (15,128) (11,450)
Principal payments on pre-petition claims............. (1,020) (661) (2,504)
Proceeds from issuance of common stock and warrants... 3,820 21,957 --
Proceeds from exercise of stock options............... 476 239 --
-------- -------- ---------
Net cash provided by financing activities............... 14,926 12,560 9,601
-------- -------- ---------
Net change in cash and cash equivalents................. 117 (4) (568)
Cash and cash equivalents at beginning of period........ 18 22 590
-------- -------- ---------
Cash and cash equivalents at end of period.............. $ 135 $ 18 $ 22
======== ======== =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Interest paid........................................... $ 2,145 $ 2,685 $ 2,544
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND
FINANCING ACTIVITIES
Valuation of debt related warrants issued............. $ 5,000 -- --
Assumption of stock options in CRE acquisition........ -- $ 2,838 --
</TABLE>

See accompanying notes.

28
<PAGE> 32

AUREAL SEMICONDUCTOR INC.

CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)

<TABLE>
<CAPTION>
TOTAL
COMMON STOCK ADDITIONAL STOCKHOLDERS'
------------------ PAID-IN ACCUMULATED EQUITY
SHARES AMOUNT CAPITAL DEFICIT (DEFICIT)
---------- ------ ---------- ----------- -------------
<S> <C> <C> <C> <C> <C>
BALANCE AT DECEMBER 31, 1994.............. 20,000,000 $20 $ 79,980 -- $ 80,000
Net Loss.................................. -- -- -- $(103,833) (103,833)
---------- --- -------- --------- ---------
BALANCE AT DECEMBER 31, 1995.............. 20,000,000 20 79,980 (103,833) (23,833)
Issuance of Common Stock in private
placement transactions.................. 18,888,888 19 21,938 -- 21,957
Issuance of Common Stock upon exercise of
stock options........................... 301,907 -- 239 -- 239
Value of stock options in CRE
Acquisition............................... -- -- 2,838 -- 2,838
Valuation of stock options and warrants
issued to non-employees................. -- -- 58 -- 58
Net Loss.................................. -- -- -- (17,020) (17,020)
---------- --- -------- --------- ---------
BALANCE AT DECEMBER 29, 1996.............. 39,190,795 39 105,053 (120,853) (15,761)
Issuance of Common Stock and warrants in
private placement transactions.......... 1,910,000 2 3,818 -- 3,820
Issuance of Common Stock upon exercise of
stock options........................... 749,410 1 475 -- 476
Valuation of debt related warrants........ -- -- 5,000 -- 5,000
Valuation of stock options issued to non-
employees............................... -- -- 6 -- 6
Net Loss.................................. -- -- -- (17,690) (17,690)
---------- --- -------- --------- ---------
BALANCE AT DECEMBER 28, 1997.............. 41,850,205 $42 $114,352 $(138,543) $ (24,149)
========== === ======== ========= =========
</TABLE>

See accompanying notes.

29
<PAGE> 33

AUREAL SEMICONDUCTOR INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. THE COMPANY AND RECENT EVENTS

Aureal Semiconductor Inc., together with its subsidiary Crystal River
Engineering, Inc. (combined, the "Company") specialize in the design and
marketing of audio semiconductor technologies for use in both the PC and
consumer electronics markets. Crystal River Engineering, Inc. ("CRE"), founded
in 1987 and acquired by Aureal in the second quarter of 1996, has been a pioneer
in the development of 3D audio technologies. The Company's business involves not
only the development and sale of audio processing semiconductor chips, but the
licensing of technology which is designed to define and develop advanced audio
standards in the marketplace.

In August 1997, the Company completed a private placement of equity
capital. The transaction provided proceeds of approximately $3.8 million from
the sale of 1.9 million common stock units. Each unit consisted of one share of
common stock and one-half of one warrant to purchase one share of common stock
at a price of $2.00 per share. The participants in this private placement
included the TCW Group, Inc., and DDJ Capital Management, LLC. In conjunction
with the equity transaction, the total availability under the Company's line of
credit was increased from $20.0 million to $31.5 million. The maturity date on
this line of credit was extended to March 31, 1999, with an additional year
extension available at the Company's option. In addition, a total of 3,150,000
warrants for the purchase of 3,150,000 shares of common stock (at the purchase
price of $2.00 per share) were issued to the debt holders of the $31.5 million
line of credit (See Note 5). All of the warrants issued in conjunction with the
sale of common stock units and the line of credit extension terminate if not
exercised prior to August 6, 2001. Both the TCW Group, Inc. and DDJ Capital
Management participate in the line of credit as lenders.

The Company, in May 1996, acquired 100% ownership of CRE, a privately held
firm specializing in 3D audio technology development. The total recorded cost of
the acquisition was $6.4 million. Aureal recorded, in the second quarter of
1996, a write-off of $6.0 million due to the recognition that in-process
research and development efforts associated with CRE's 3D audio technologies had
not reached technological feasibility with respect to the Company's product line
at the date of acquisition.

In three transactions from February through June 1996, the Company
completed the private sale of 18.9 million shares of common stock for $22
million. The proceeds from the sale of this common stock were used for working
capital, to pay down the existing working capital line of credit and to
partially fund the acquisition of CRE.

In August 1995, the Company announced that it was divesting its multimedia
components business to implement a business plan based on development and sale
of software and semiconductor solutions providing advanced audio for the PC and
consumer electronics markets. In conjunction with the Company's change in
business, it formally changed its name to Aureal Semiconductor Inc. at its
Annual Stockholders' Meeting in May 1996. The Company's stock symbol on the OTC
Bulletin Board is AURL.

The above noted change during 1995 to the Company's business render
operating data largely non-comparable for 1997 and 1996 relative to 1995. No
assumptions should be made as to future operations based upon amounts or trends
indicated for prior years.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries. Certain reclassifications have been made to
the prior period financial statements to conform to the December 28, 1997
presentation.

30
<PAGE> 34
AUREAL SEMICONDUCTOR INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

During 1995, the Company changed its fiscal year end from a calendar year
end to a fifty-two week period ending on the Sunday closest to the calendar year
end. Consequently, fiscal quarters include thirteen weeks. The fiscal year-ends
presented occurred on December 28, 1997, December 29, 1996 and December 31,
1995.

Use of Estimates

The preparation of financial statements in conformity with generally
accepted accounting principles and pursuant to the rules and regulations of the
Securities and Exchange Commission requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
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.

Cash Equivalents and Restricted Cash

The Company considers all investments purchased with an original maturity
of three months or less to be cash equivalents. As of year end 1997, $109,000 in
restricted cash deposits primarily represented collateral for an outstanding
Stand-by Letter of Credit, supporting product purchase orders.

Inventories

Inventories are stated at the lower-of-cost-or-market value on a
weighted-average costing method. The Company does not consider any inventory to
be raw material, since the Company's initial point of purchase is for fabricated
silicon wafers. Net inventories at December 28, 1997 and December 29, 1996
consist of the following, in thousands:

<TABLE>
<CAPTION>
1997 1996
---- ------
<S> <C> <C>
Work-In-Process....................................... $243 $--
Finished Goods........................................ 268 74
---- ---
Total Inventories........................... $511 $74
==== ===
</TABLE>

Property and Equipment

Property and equipment are stated at cost and depreciated utilizing the
straight-line method over their estimated useful lives (one and one-half to five
years).

Revenue Recognition

The Company's major sources of revenue consisted of sales of proprietary
design, advanced audio semiconductor chips, and licensing of related audio
technologies. Revenue was recognized upon shipment for product sales. Software
licensing revenues are recognized upon shipment of licensed product if a non-
cancelable contract had been signed, the fees were fixed and determinable,
collection of the recognized fees were reasonably assured and there were no
remaining significant obligations.

Concentration of Financial Instrument Risks

Financial instruments which potentially subject the Company to
concentration of market risk consist primarily of the Company's line of credit.
Concentration of market risk on the line of credit is related to changes in the
prime lending rate, as the Company's line of credit bears interest rates which
fluctuate with changes in the prime lending rate.

31
<PAGE> 35
AUREAL SEMICONDUCTOR INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

Stock Option Accounting -- SFAS No. 123 Adoption

The Financial Accounting Standards Board Statement of Financial Accounting
Standards (SFAS) No. 123 "Accounting for Stock-Based Compensation" requires
increased disclosure of certain calculated value information related to stock
options granted to employees and new accounting treatment for stock-based
compensation granted to non-employees. SFAS No. 123 requires that a fair value
be estimated using an option valuation model, such as the Black-Scholes model.
Aureal adopted SFAS No. 123 effective for 1996, as required, although under the
terms of the statement, continue to account for stock-based compensation for
employees under criteria set forth in APB 25. Accordingly, no compensation cost
has been recognized related to employee stock option plan activity.

The amount recognized for 1997 related to stock options granted to
non-employee contractors was not material.

The Company also recorded the estimated fair value for the warrants issued
in association with both the amendment to the line of credit ("Debt Warrants"),
and the sale of common stock ("Equity Warrants"), as described in Footnote 5
below. The fair values of the Debt Warrants and the Equity Warrants were
estimated to be $5.0 million and $1.5 million respectively. The value of the
Debt Warrants is included in both current and long-term assets in the
accompanying balance sheet. Amortization of the $5.0 million asset, as
additional interest expense over the life of the loan, commenced in August 1997
at the rate of $0.75 million per quarter.

Loss Per Share

The Financial Accounting Standards Board has issued SFAS No. 128, which is
effective for financial statements for periods ending after December 15, 1997.
SFAS No. 128 requires that the calculation for basic EPS exclude the dilutive
effect of common stock equivalents in the calculation for basic net income
(loss) per share. Diluted EPS under SFAS No. 128, is calculated using the
weighted average number of common and common stock equivalent shares outstanding
during the period. Common equivalent shares are computed using the treasury
stock method for outstanding warrants and stock options. Common equivalent
shares are excluded from the diluted EPS computation only if their effect is
anti-dilutive. No common stock equivalents were included in the calculations for
any fiscal period presented as, due to the net loss position, any affect would
be anti-dilutive.

Amortization of Intangibles

The Company exited from Chapter 11 bankruptcy protection on December 31,
1994, and on that date the reorganization value of the Company in excess of its
net assets generated a $44.1 million intangible value that was classified as a
reorganization asset in the consolidated balance sheet of the Company
("Reorganization Asset"). The Reorganization Asset consisted primarily of
proprietary technology and other intangibles having an estimated useful life of
three years. Accordingly, the Reorganization Asset was being amortized on a
straight-line basis over three years. The carrying value of the Reorganization
Asset was reviewed during the second quarter of 1995 in light of the Company's
revenue and profitability levels and the related decision to divest its retail
business. This review suggested that the Reorganization Asset was impaired, as
determined based on projected cash flows of the Company over the remaining
amortization period. The cash flow projections anticipated the cost and probable
future savings from the restructuring actions, the expected benefit from
products and technologies then in the latter stages of development, and
availability of existing capital. Consequently, the carrying value of the
Reorganization Asset was reduced during the second quarter of 1995 to $6.2
million in accordance with Statement of Financial Accounting Standards No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of". Amortization of the Reorganization Asset for 1997, 1996 and
1995 was $2.5 million, $2.5 million and $8.6 million, respectively, and was
included as a component of operating expenses. The Reorganization Asset

32
<PAGE> 36
AUREAL SEMICONDUCTOR INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

was amortized at a rate of $625,000 per quarter through 1997 and as of December
28, 1997 was fully amortized.

In conjunction with the acquisition of Crystal River Engineering, Inc. (See
Note 3 below) made during the second quarter of 1996, the allocation of the
purchase price included an intangible asset of $150,000 which was recorded on
the Company's books. Amortization over the estimated useful life of eighteen
months for the intangible asset value commenced in mid-1996. As a result of
further asset value allocations throughout the year, the intangible asset was
reduced by $61,000 during 1996. As of December 28, 1997, the intangible asset
was fully amortized.

Recently Issued Accounting Standards

In October 1997, the American Institute of Certified Public Accountants
(AICPA) issued Statement of Position 97-2 "Software Revenue Recognition" ("SOP
97-2"), and is effective for transactions entered into for fiscal years
beginning after December 15, 1997. SOP 97-2 amends certain provisions of
Statement of Position 91-1, "Software Revenue Recognition", and provides
guidance on when revenue related to licensing or selling computer software
should be recognized. The issuance of SOP 97-2 does not, and is not expected to,
have a material impact on the Company's operating results.

In June 1997, the Financial Accounting Standards Board issued SFAS No. 130,
"Reporting Comprehensive Income", which is required to be adopted by the Company
in its first quarter of fiscal 1998. At that time, the Company must disclose all
non-owner changes in equity, such as cumulative foreign currency translation
adjustments, certain minimum pension liabilities and gains and losses on
available-for-sale securities. The Company does not expect SFAS No. 130 to have
a material impact on the Company's financial statements.

In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information", which
establishes standards for reporting information about operating segments in
annual financial statements and interim financial reports. It also establishes
standards for related disclosures about products and services, major customers
and geographic areas. Generally, financial information is required to be
reported on the basis that it is used internally for evaluating segment
performance and deciding how to allocate resources to segments. The Company will
adopt SFAS 131 in fiscal 1998.

3. ACQUISITION OF CRYSTAL RIVER ENGINEERING, INC. ("CRE")

During the second quarter of 1996, the Company acquired 100% ownership of
CRE, a privately held firm specializing in the development of 3D audio
technologies. The acquisition consideration included purchase of stock for cash
totaling approximately $2.9 million, the exchange of stock options for 2,644,845
shares of Aureal common stock at a fair market value of $2.8 million using
Black-Scholes valuation methodology and other cash considerations (both current
and deferred) totaling approximately $0.6 million. The acquisition was recorded
using purchase accounting. All operating results of CRE subsequent to the date
of acquisition have been included in the consolidated financial statements of
Aureal. The fair value of CRE assets and liabilities at the date of acquisition
were recorded in the Company's consolidated financial statements. As part of the
allocation of fair values, the Company recorded a non-recurring write-off of
approximately $6.0 million in the second quarter due to recognition that
in-process research and development efforts associated with CRE's 3D audio
technology had not reached technological feasibility with respect to the
Company's product line at the date of acquisition.

33
<PAGE> 37
AUREAL SEMICONDUCTOR INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

Pro-forma information assuming the acquisition had taken place at the
beginning of each fiscal year is shown below (in thousands, except per share
amounts):

<TABLE>
<CAPTION>
FISCAL 1996 FISCAL 1995
----------- -----------
<S> <C> <C>
Revenues..................................... $ 3,909 $ 49,628
Costs and expenses........................... 21,725 154,173
-------- ---------
Net loss..................................... $(17,816) $(104,545)
======== =========
Net loss per share........................... $ (0.53) $ (5.23)
======== =========
</TABLE>

4. OTHER ACCRUED LIABILITIES

Other accrued liabilities as of year-end 1997 and 1996 consist of the
following, in thousands:

<TABLE>
<CAPTION>
1997 1996
------ ------
<S> <C> <C>
Interest payable................................... $ 687 $ 325
Warranty and product support....................... 16 224
Professional fees related to bankruptcy filings.... 145 233
Deferred legal..................................... 260 105
Other.............................................. 257 342
------ ------
$1,365 $1,229
====== ======
</TABLE>

5. LINE OF CREDIT FROM TCW

The Company maintains a line of credit managed by TCW Special Credits, an
affiliate of the TCW Group, Inc. ("TCW"). The maturity date (originally March 1,
1995) and the total availability under the line (ranging from $10 million to
$31.5 million to date) have been negotiated periodically with TCW. In
conjunction with a private placement of common stock, finalized in August 1997,
the line of credit was increased from $20.0 million to $31.5 million, and the
maturity date was extended to March 31, 1999. In addition, the Company has an
option to extend the due date an additional year, to March 31, 2000. Borrowings
under the facility are secured by substantially all the assets of the Company
and bear interest at the rate of prime (8.50% at December 28, 1997) plus five
percent. At December 28, 1997, approximately $22.0 million was outstanding under
the line.

The line of credit lenders are entities affiliated with TCW Special Credits
and DDJ Capital Management LLC. As of March 12, 1998 these entities controlled
approximately 45% and 17% of the Company's outstanding common stock,
respectively.

The Company is prohibited from declaring or paying cash dividends on its
capital stock under the terms of the TCW line of credit.

6. COMMITMENTS

Operating Leases

The Company utilizes facilities and certain equipment under non-cancelable
operating leases that expire at various dates through the year 2000. Under the
terms of the leases, the Company is generally responsible for taxes, insurance,
and normal maintenance costs. The Company executed a sublease covering its
former corporate offices which commenced January 1996 and continues through the
term of the underlying lease.

34
<PAGE> 38
AUREAL SEMICONDUCTOR INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

Aggregate future minimum annual payments under the operating leases and
related sublease proceeds as of December 28, 1997 are as follows (in thousands):

<TABLE>
<CAPTION>
MINIMUM
COMMITMENT SUBLEASE
---------- --------
<S> <C> <C>
1998........................................... $ 984 $834
1999........................................... 213 --
2000 and thereafter............................ 34 --
------ ----
Total minimum lease payments................... $1,231 $834
====== ====
</TABLE>

Rent expenses charged to operations totaled $0.2 million, $0.2 million and
$1.1 million for the fiscal years 1997, 1996 and 1995, respectively.

Pre-petition Claims

Pursuant to the Plan of Reorganization under which the Company exited
Chapter 11 bankruptcy protection in 1994, certain lease claims and
administrative tax claims were assumed by the Company as unsecured debt
obligations. These obligations are payable in both monthly and quarterly
installments through 2000 and bear interest at 9.0% to 9.3%.

Minimum future payment obligations as of December 28, 1997 are as follows
(in thousands):

<TABLE>
<S> <C>
1998........................................................ $1,091
1999........................................................ 1,093
2000........................................................ 974
2001 and thereafter......................................... --
------
Total future minimum payments............................... 3,158
Less amounts representing interest........................ (380)
------
Present value of future minimum payments.................... 2,778
Less current portion...................................... (880)
------
Long-term portion........................................... $1,898
======
</TABLE>

Litigation

The Company has received, and may receive in the future, communications
from third parties asserting that the Company's trademarks or products infringe
patents, copyrights or the proprietary rights of third parties or seeking
indemnification against such infringement. The costs of any future litigation
alleging that the Company has infringed the proprietary rights of a third party,
or damages resulting from such a claim, could be substantial and could
materially adversely affect the Company's business, financial condition and
results of operations.

The Company does not believe that any currently known legal matters,
including those mentioned below, will result in a settlement which would
adversely impact the Company's financial position.

Shiva Holdings Limited ("Shiva") filed a cross-complaint against the
Company in December 1997 alleging breach of contract, breach of implied covenant
of good faith and fair dealing, fraud and negligent misrepresentation in
connection with the Agreement for Purchase of Certain Assets entered into
between Shiva and the Company in February 1996. The Company had filed an action
against Shiva for breach of contract and specific performance in connection with
the failure of Shiva to pay certain amounts due under the February 1996
agreement. Shiva alleges that the Company made certain misrepresentations in the
sale of assets by the Company to Shiva and is seeking damages in excess of
$1,000,000. The Company believes that the claims by Shiva are groundless and
intends to defend them vigorously.

35
<PAGE> 39
AUREAL SEMICONDUCTOR INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

In March 1998, Aureal was served with a suit for patent infringement filed
by Creative Technology Ltd., a Singapore corporation and its subsidiary, E-MU
Systems, Inc., a California corporation. The suit alleges that Aureal's Vortex
AU8820 AC'97 Digital Audio Processor infringes on a patent which describes a
specific implementation for an electronic musical instrument designed by E-MU
Systems, Inc. Aureal has reviewed the allegations in the complaint and believes
that the action is without merit and intends to vigorously pursue defense of
this action.

7. STOCKHOLDERS' EQUITY (DEFICIT)

Authorization of Preferred Stock

On December 17, 1997, at a special shareholder's meeting, the Company's
stockholders approved the authorization of five million shares of Preferred
Stock. No issuances of the authorized Preferred Stock were made during 1997.

Private Placement of Common Stock

On August 6, 1997, the Company completed a private placement of equity
capital, and at the same time increased and extended the Company's line of
credit. The equity transaction provided proceeds of approximately $3.8 million
from the sale of 1.9 million common stock units at a price of $2.00 per unit.
Each unit consisted of one share of common stock and one-half of one warrant to
purchase one share of common stock at a price of $2.00 per share. The
participants in this private placement included the TCW Group, Inc., and DDJ
Capital Management, LLC. Also occurring on August 6, 1997, a total of 3,150,000
warrants for the purchase of 3,150,000 shares of common stock (at a purchase
price of $2.00 per share) were issued to the debt holders of the $31.5 million
line of credit. Up to 2,000,000 of the warrants associated with the line of
credit can be rescinded by the Company upon cancellation of up to $20,000,000 of
borrowing capacity, at the rate of one warrant rescission for each $10 of
borrowing capacity canceled by the Company prior to March 31, 1998. All of the
warrants issued in conjunction with the sale of common stock units and the line
of credit extension terminate if not exercised prior to August 6, 2001. Net
proceeds from the sale of stock were used to pay down the line of credit.

All shares sold in these transactions, along with the common stock
underlying the warrants granted have been registered for potential resale by the
holders into the public market via a Form S-3 registration statement declared
effective in September 1997 by the Securities and Exchange Commission.

During the first half of 1996, in three private transactions, the Company
sold a total of 18.9 million shares of Common Stock for $22 million. The
proceeds from the sale of this stock were used for working capital, to pay down
the existing TCW Credit Facility and to partially fund the acquisition of CRE.
All shares sold in these transactions, along with other shares previously
acquired by TCW have been registered for potential resale by the holders into
the public market via a Form S-3 registration statement declared effective in
June 1996 by the Securities and Exchange Commission.

Stock Option Plans

The Company has three stock option plans under which eligible individuals
have been granted options to purchase shares of Common Stock. In 1994, the Board
of Directors established and stockholders approved the 1994 Stock Option Plan
(the "1994 Option Plan") whereby 3,000,000 shares of Common Stock were reserved
for issuance to employees (including consultants and directors who are
employees). In August 1995, the Board of Directors established the 1995 Stock
Option Plan (the "1995 Option Plan") whereby 1,000,000 additional shares were
reserved for future issuance to employees (including consultants and directors
who are not employees). In February 1996, the Board of Directors, in
anticipation of the above noted private placement transactions, approved an
increase of the share reserve under the 1995 Option Plan such that an

36
<PAGE> 40
AUREAL SEMICONDUCTOR INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

aggregate 20% of all outstanding shares on a fully diluted basis would be
available for issuance under the 1994 Option Plan and the 1995 Option Plan,
combined. The 1995 Option Plan was approved by the stockholders at their May
1996 meeting. Options granted under the 1994 and 1995 Option Plans are either
incentive stock options or non-statutory stock options, as designated by the
plan administrator. In November 1996, the Board of Directors established the
1996 Outside Directors Stock Option Plan (the "1996 Directors Option Plan")
whereby 200,000 shares of Common Stock were reserved for issuance to directors
who are not employees. The 1996 Director Option Plan was formally approved at
the Stockholders' meeting in May 1997.

The 1994 Option Plan provides that (i) the exercise price of an incentive
stock option will be no less than the fair market value of the Company's Common
Stock at the date of grant, and (ii) the exercise price to an optionee who
possesses more than 10% of the total combined voting power of all classes of
stock will be no less than 110% of the fair market value, all as determined by
the plan administrator. Vesting under the 1994 Option Plan provides the holder
the right to exercise 20% of the shares 180 days after the date of grant, and
the remaining 80% at the rate of 1/42 per month over the succeeding 42 months.
The plan administrator has the authority to set exercise dates (no longer than
ten years from date of grant, or five years for an optionee who meets the 10%
criteria), payment terms and other provisions for each grant.

The 1995 Option Plan provides that (i) the exercise price of an incentive
stock option will be no less than the fair market value of the Company's Common
Stock at the date of grant, and (ii) the exercise price to an optionee who
possesses more than 10% of the total combined voting power of all classes of
stock will be no less than 110% of the fair market value, all as determined by
the plan administrator. Options under the 1995 Option Plan are generally
exercisable immediately, but are subject to repurchase based upon certain
criteria established by the plan administrator at the time the option is
granted. The plan administrator has the authority to set exercise dates (no
longer than ten years from date of grant, or five years for an optionee who
meets the 10% criteria), payment terms and other provisions for each grant.

The 1996 Directors Option Plan provides that (i) automatic grants of 30,000
stock options are made to eligible directors upon appointment or election to the
Board and incremental grants of 5,000 stock options are made annually
thereafter, and (ii) the exercise prices of the options will be the fair market
value of the shares of stock on the date the options are granted. Vesting under
the 1996 Directors Option Plan provides the holder the right to exercise 25% of
the shares one year after the date of grant, and the remaining 75% at the rate
of 2.08% per month over the succeeding 36 months. Any outstanding options
terminate 10 years from the date of grant if not exercised previously.

37
<PAGE> 41
AUREAL SEMICONDUCTOR INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

During 1995, approximately 1.3 million options granted under the 1994 Stock
Option Plan were regranted at exercise prices equal to the fair market value on
the dates of the regrants. The regrants did not affect the vested status of the
shares. Activity under the three option plans described above from 1995 through
1997 has been as follows:

<TABLE>
<CAPTION>
OPTIONS OUTSTANDING
OPTIONS ----------------------------------------------
AVAILABLE STOCK EXERCISE PRICE WEIGHTED AVERAGE
FOR GRANT OPTIONS PER SHARE EXERCISE PRICE
---------- ---------- -------------- ----------------
<S> <C> <C> <C> <C>
Shares reserved for issuance in March
1995.................................... 3,000,000
Additional share reservation............ 1,000,000
Options granted......................... (5,310,400) 5,310,400 $0.93 - $4.00 $2.30
Options canceled........................ 2,308,953 (2,308,953) $0.93 - $4.00 $3.42
---------- ----------
Balance at December 31, 1995.............. 998,553 3,001,447 $0.93 - $1.88 $1.43
Additional share reservation............ 8,567,067
Options granted......................... (4,278,750) 4,278,750 $0.88 - $2.48 $1.38
Options issued in CRE
Acquisition............................... (2,644,845) 2,644,845 $0.12 - $0.40 $0.28
Options exercised....................... (301,907) $0.12 - $1.88 $0.79
Options canceled........................ 410,448 (461,287) $0.36 - $1.88 $1.60
---------- ----------
Balance at December 29, 1996.............. 3,052,473 9,161,848 $0.12 - $2.48 $1.09
Additional share reservation............ 475,566
Options granted......................... (3,002,000) 3,002,000 $1.75 - $2.80 $2.00
Options exercised....................... (749,410) $0.12 - $2.00 $0.74
Options canceled........................ 661,186 (661,186) $0.36 - $2.37 $1.46
---------- ----------
Balance at December 28, 1997.............. 1,187,225 10,753,252 $0.12 - $2.80 $1.35
========== ==========
</TABLE>

As of December 28, 1997, options for 10,204,784 shares were exercisable at
exercise prices ranging from $0.12 to $2.80 per share. Of the shares
exercisable, 5,047,546 are subject to Company buyback provisions (which allow
the Company to repurchase the shares at the option exercise price) as of
December 28, 1997.

In addition to the above stock option activity, the Company has 4,155,000
stock warrants outstanding at December 28, 1997 at prices ranging from $1.62 to
$2.00. These warrants will expire by August 6, 2001 if not previously exercised.

SFAS No. 123 Disclosure

SFAS No. 123 requires disclosure of calculated values for a fair value
method of accounting for stock-based compensation granted to employees if such
accounting under SFAS No. 123 is not implemented. As noted previously, such
valuation calculations are not necessarily indicative of the value of the stock
options at the time of grant or any specific time in the future, but rather
represent a calculation called for under the provisions of SFAS No. 123. Had the
Company elected to recognize compensation cost, determined as the fair value of
the options at grant date, under the provisions of SFAS No. 123, the Company's
net loss and loss per share would have been increased to the pro forma amounts
indicated below:

<TABLE>
<CAPTION>
1997 1996
-------- --------
<S> <C> <C> <C>
Net loss (in thousands) As reported $(17,690) $(17,020)
======== ========
Pro forma $(20,365) $(20,439)
======== ========
Loss per share (basic and
diluted) As reported $ (0.44) $ (0.51)
======== ========
Pro forma $ (0.50) $ (0.61)
======== ========
</TABLE>

38
<PAGE> 42
AUREAL SEMICONDUCTOR INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

For purposes of this disclosure, the fair value of each option granted to
employees is estimated on the grant date using the Black-Scholes option pricing
model, with the following weighted average assumptions for both years:

<TABLE>
<S> <C>
Expected dividend yield.................................. 0%
Expected stock price volatility.......................... 80%
Risk-free interest rate utilized......................... 6%
Expected option life..................................... 3.4 years
</TABLE>

The weighted average grant date fair value of options granted during 1997
and 1996 were estimated as $1.55 and $1.09, respectively, utilizing the above
assumptions and the estimation process called for under SFAS No. 123.

8. EMPLOYEE BENEFIT PLAN

The Company maintains the Aureal Semiconductor Tax Deferred Savings Plan
(the "401(k) Plan") to provide retirement benefits for eligible employees. Under
the terms of the 401(k) Plan, employees may elect to contribute up to 15% of
their gross compensation limited to a statutory maximum. The Company matches
employee contributions at the rate of 50%. The 401(k) Plan was modified during
1995 whereby the Company contributions for participants vest over five years
based upon the number of years employed. The matching contribution expense was
$225,000, $183,000, and $107,000 in 1997, 1996 and 1995, respectively.

9. INCOME TAXES

The benefit for income taxes reconciles to the amount calculated by
applying the federal statutory rate to income from continuing operations before
provision for income taxes as follows:

<TABLE>
<CAPTION>
1997 1996 1995
------- ------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
Federal tax benefit on loss from continuing
operations before reorganization costs
computed at statutory rate................. $(6,015) $(5,787) $(35,303)
Changes in prior year valuation allowance:
Increase in valuation allowance............ 5,379 2,396 22,539
Non-deductible reorganization expenses....... 850 2,894 13,288
Research credits and other................... (214) 497 (524)
------- ------- --------
$ -- $ -- $ --
======= ======= ========
</TABLE>

Deferred tax assets are comprised of the following:

<TABLE>
<CAPTION>
1997 1996
------- -------
(IN THOUSANDS)
<S> <C> <C>
Federal net operating loss carryforward.................. $96,967 $91,308
Temporary differences.................................... 559 1,089
Tax credit carryforwards................................. 2,472 2,222
------- -------
99,998 94,619
Valuation allowance...................................... (99,998) (94,619)
------- -------
$ -- $ --
======= =======
</TABLE>

39
<PAGE> 43
AUREAL SEMICONDUCTOR INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

Temporary differences represent differences in the recognition of assets
and liabilities for tax and financial reporting purposes, primarily receivable
and inventory allowances and obligations for restructuring and bankruptcy
proceedings attributable to the Company's former retail operations.

At December 28, 1997, the Company had available net operating loss
carryforwards ("NOL's") of approximately $285 million to reduce future taxable
income. The NOL's expire on various dates through 2012. In connection with the
adoption of fresh start accounting, any tax benefit resulting from the use of
these NOL's or future tax deductible amounts will be reported as a direct
addition to stockholders' equity.

10. INDUSTRY SEGMENTS AND MAJOR CUSTOMERS

During 1997, the majority of the revenues resulted from licensing or
contract transactions, rather than the sale of semiconductors. Essentially all
of the revenues related to newly developed technologies, and not to the
Company's legacy technologies. Three customers accounted for approximately 15%,
15% and 14%, respectively. None of the three customers purchased semiconductor
chips from Aureal in 1997. Approximately 28% of 1997 revenues came from sales or
licensing transactions with foreign customers.

Pursuant to the Company's restructuring in mid-1995, revenues after that
time through 1996, consisted primarily of audio technology licensing fees
related to the Company's legacy technologies, as the Company focused on the
development of a number of new audio semiconductor products. During 1996, two
customers accounted for approximately $2.5 million ($2.0 million and $500,000,
respectively), or 72% of net sales, through license payments for these legacy
audio technologies. Neither of the companies accounted for significant revenues
in 1997. The Company discontinued operations in its foreign locations during
1995, however, approximately 10% of the Company's 1996 revenues came from sales
to foreign customers.

Prior to the mid-1995 restructuring, the Company's sales consisted
primarily of PC upgrade kits sold into both the U.S. and international PC
retailer distribution channels. Sales in 1995 were split approximately 60%
domestic to 40% international with that segment being nearly equally split
between the European market and the combined Central and South American markets.
One customer accounted for approximately 21% of net sales in 1995.

11. 1995 RESTRUCTURING CHARGE ATTRIBUTABLE TO RETAIL OPERATIONS

The Company recorded a $61.6 million restructuring charge in 1995 to
reflect the divestiture of its PC upgrade products retail operations. During the
fourth quarter of 1996, the Company recorded an adjustment of $804,000 to reduce
that charge based on its review of the remaining identified costs. The Company
believes that no further costs will be incurred in connection with the
restructuring.

The following table summarizes the significant provisions included in the
restructuring charge (in thousands):

<TABLE>
<S> <C>
Writedown of Assets:
Reorganization Asset..................................... $30,485
Inventories.............................................. 16,712
Equipment and Other...................................... 8,915
Severance and Other Retail Obligations..................... 5,514
-------
Total............................................ $61,626
=======
</TABLE>

The Reorganization Asset originated pursuant to the Company's exit from
Chapter 11 bankruptcy whereby the fair value of the Company exceeded its net
assets by $44.1 million as of December 30, 1994. In light of second quarter 1995
results and the Company's decision to divest its retail operations, it was
determined that the Reorganization Asset could no longer be assured of recovery
and a $30.5 million write-off

40
<PAGE> 44
AUREAL SEMICONDUCTOR INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

was necessary. The write-off was calculated by comparing the carrying value of
Reorganization Asset with discounted future cash flow projections over the
remaining life of the Asset using the Company's incremental borrowing rate. The
cash flow projections anticipate the cost and probable future savings from the
restructuring actions, the expected benefit from products and technologies
currently in the latter stages of development, and availability of existing
capital.

Severance and Other Retail Obligations included estimated future costs for
severance, adverse purchase commitments (net of related proceeds from scrap
sales) and contractual obligations for worldwide facilities.

12. SUBSEQUENT EVENT -- PRIVATE PLACEMENT OF PREFERRED STOCK

In March 1998, the Company completed the sale of $5 million of the
Company's Series A Preferred Stock. The shares of the preferred stock include
conversion rights to Aureal common stock at either a $2.50 fixed conversion rate
or a variable conversion pricing dependent upon the underlying price of the
common stock over the three-year term. The proceeds were used to pay down the
outstanding balance on the Company's line of credit.

41
<PAGE> 45

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

The Company reported no changes in independent accountants, nor
disagreements with accountants on accounting and financial disclosure issues
during 1997.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

For information required under this item with respect to directors of the
Company, see "Information Concerning the Board of Directors" and "Compliance
with Section 16(a) of the Securities Exchange Act of 1934" in the Company's
definitive Proxy Statement relating to the Annual Meeting of Stockholders
expected to be held on May 20, 1998 which sections are hereby incorporated by
reference.

For information required under this item with respect to executive officers
of the Company see "Executive Officers of the Company" under Item 1.

ITEM 11. EXECUTIVE COMPENSATION

For information required under this item with respect to executive
compensation, see "Executive Compensation" in the Company's definitive Proxy
Statement relating to the Annual Meeting of Stockholders expected to be held on
May 20, 1998, which sections are hereby incorporated by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

For information required under this item with respect to beneficial
ownership of the Company's voting securities by each director and all executive
officers and directors as a group, and by any person known to beneficially own
more than 5% of any class of voting security of the Company, see "Security
Ownership by Certain Beneficial Holders" in the Company's definitive Proxy
Statement relating to the Annual Meeting of Stockholders expected to be held on
May 20, 1998, which sections are hereby incorporated by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

For information required under this item with respect to certain
relationships and related transactions, see "Board Compensation and "Certain
Relationships and Related Transactions" in the Company's definitive Proxy
Statement relating to the Annual Meeting of Stockholders expected to be held on
May 20, 1998, which sections are hereby incorporated by reference.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a)(1) Financial Statements:

The following financial statements of Aureal Semiconductor Inc. and related
notes, together with the report thereon of Arthur Andersen LLP, the Company's
independent public accountants, are set forth herein as indicated below.

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Report of Independent Public Accountants.................... 22
Audited Consolidated Financial Statements:
Consolidated Balance Sheets............................... 23
Consolidated Statements of Operations..................... 24
Consolidated Statements of Cash Flows..................... 25
Consolidated Statement of Stockholders' Equity
(Deficit).............................................. 26
Notes to Consolidated Financial Statements.................. 27
</TABLE>

42
<PAGE> 46

(a)(2) Financial Statement Schedules:

Included in Part IV of this Annual Report is the following schedule:

Schedule II Valuation and Qualifying Accounts

Schedules not listed above have been omitted because the information
required to be set forth therein is not applicable or is shown in the Financial
Statements or notes thereto.

(a)(3) Exhibits:

<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION OF DOCUMENT
----------- -----------------------
<C> <S>
2.1 Agreement and Plan of Reorganization among the Company,
Aureal Acquisition Corporation, a wholly-owned subsidiary of
the Company and Crystal River Engineering, Inc., dated as of
May 7, 1996(1)
2.2 Second Amended Joint Plan of Reorganization dated November
10, 1994(4)
3.1 Second Amended and Restated Certificate of Incorporation of
the Company dated May 8, 1996(2)
3.2 Restated Bylaws of Aureal Semiconductor Inc.(6)
4.1 Common Stock Purchase Agreement by and among the Company and
certain beneficial owners of 5% or more of the Company's
Common Stock, as amended(3)
4.2 Common Stock Purchase Agreement by and among the Company and
certain entities and individuals dated June 10, 1996(5)
4.3 Common Stock Purchase Agreement by and among the Company and
certain entities and individuals dated August 6, 1997(8)
4.4 Preferred Stock Regulation D Subscription Agreement(10)
4.5 Certificate of Designation of Series A Preferred Stock of
Aureal Semiconductor Inc.(10)
4.6 Preferred Stock Registration Rights Agreement(10)
10.1 Second Amended and Restated Loan Agreement between TCW
Special Credits and the Company dated August 6, 1997
increasing the loan commitment from $20 million to $31.5
million.(9)
10.2 1995 Stock Option Plan(3)
10.3 Form of incentive option agreement and non-statutory stock
option agreement used under 1995 Stock Option Plan(3)
10.4 1994 Stock Option Plan(4)
10.5 Form of incentive option agreement and non-statutory stock
option agreement used under 1994 Stock Option Plan(4)
10.6 Industrial Space Sublease with Chemical Waste Management,
Inc. dated September 13, 1995(3)
10.7 Form of Indemnity Agreement for Directors and Officers(6)
10.8 1996 Outside Directors Stock Option Plan(7)
23.1 Consent of Arthur Andersen LLP
27.1 Financial Data Schedule(Edgar Only)
</TABLE>

- ---------------
(1) Incorporated by reference to the exhibits filed with Form 8-K dated May 22,
1996

(2) Incorporated by reference to the exhibits filed with Form S-8 (Registration
number 333-09531) filed August 2, 1996

(3) Incorporated by reference to the exhibits filed with Form 10-K for the year
ended December 31, 1995

(4) Incorporated by reference to the exhibits filed with Form 10-K for the year
ended December 31, 1994

43
<PAGE> 47

(5) Incorporated by reference to the exhibits filed with Form S-3 (Registration
number 333-3870) filed June 26, 1996

(6) Incorporated by reference to the exhibits filed with Form 10-Q for the
quarter ended September 29, 1996

(7) Incorporated by reference to the exhibits filed with Form 10-K for the year
ended December 29, 1996.

(8) Incorporated by reference to the exhibits filed with Form S-3 (As
Post-Effective Amendment No. 1, Registration number 333-3870) filed
September 12, 1997.

(9) Incorporated by reference to the exhibits filed with Form 10-Q for the
quarter ended September 28, 1997

(10) Incorporated by reference to the exhibits filed with Form 8-K dated March
16, 1998

(b) Reports on Form 8-K:

The Company filed no reports on Form 8-K during the fourth quarter ended
December 28, 1997.

44
<PAGE> 48

AUREAL SEMICONDUCTOR INC.

SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)

<TABLE>
<CAPTION>
ADDITIONS
BALANCE AT CHARGED TO BALANCE AT
BEGINNING COSTS AND END OF
OF PERIOD EXPENSES DEDUCTIONS PERIOD
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Year ended December 31, 1995:
Accounts receivable allowances...................... -- 12,840 10,255 2,585
Allowances for excess and obsolete inventory........ -- 20,062 16,266 3,796
Year ended December 29, 1996:
Accounts receivable allowances...................... 2,585 -- 2,562 23
Allowances for excess and obsolete inventory........ 3,796 -- 3,796 --
Year ended December 28, 1997:
Accounts receivable allowances...................... 23 -- 11 12
Allowances for excess and obsolete inventory........ -- 247 -- 247
</TABLE>

45
<PAGE> 49

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, Aureal Semiconductor Inc. has duly caused this Report on
Form 10-K to be signed on its behalf by the undersigned, thereunto duly
authorized, on June 2, 1998.

AUREAL SEMICONDUCTOR INC.

/s/ KENNETH A. KOKINAKIS
--------------------------------------
Kenneth A. Kokinakis, President and
Chief Executive Officer

Pursuant to the requirements of the Securities and Exchange Act of 1934,
this Annual Report on Form 10-K/A has been signed below by the following persons
on behalf of the Company and in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<S> <C> <C>

/s/ KENNETH A. KOKINAKIS President, Chief Executive June 2, 1997
- -------------------------------------------------------- Officer and Director
Kenneth A. Kokinakis

/s/ DAVID J. DOMEIER Vice President, Finance and June 2, 1997
- -------------------------------------------------------- Chief Financial Officer
David J. Domeier (Principle Accounting
Officer)

RICHARD E. CHRISTOPHER* Director June 2, 1997
- --------------------------------------------------------
Richard E. Christopher

L. WILLIAM KRAUSE* Director June 2, 1997
- --------------------------------------------------------
L. William Krause

D. RICHARD MASSON* Director June 2, 1997
- --------------------------------------------------------
D. Richard Masson

THOMAS K. SMITH, JR.* Director June 2, 1997
- --------------------------------------------------------
Thomas K. Smith, Jr.

*By: /s/ DAVID J. DOMEIER
---------------------------------------------------
David J. Domeier
(Attorney-in-Fact)
</TABLE>

46
<PAGE> 50

AUREAL
SEMICONDUCTOR INC.

4245 Technology Drive
Fremont, CA 94538
Tel: 408-252-4245
Fax: 408-252-4434

AUREAL
SEMINCONDUCTOR
LIMITED., HONG KONG

Unit 702, Wing On Plaza
No. 62, Mody Road
Tsim Sha Tsui
Kowloon Hong Kong

COMMON STOCK

Aureal Semiconductor Inc.
common stock is traded on the
OTC Bulletin Board under the
symbol AURL

INVESTOR RELATIONS

(510) 252-4582

Please visit our website at
www.aureal.com

INDEPENDENT
ACCOUNTANTS

Arthur Andersen LLP
San Jose, CA

OUTSIDE CORPORATE
COUNSEL

Gray Cary Ware & Freidenrich
Palo Alto, CA

PATENT COUNSEL

Weil, Gotshal & Manges LLP
Menlo Park, CA

STOCK TRANSFER AGENT
AND REGISTRAR

ChaseMellon Shareholder
Services, L.L.C.
Shareholder Relations
P.O. Box 3315
South Hackensack, NJ 07606
(800) 356-2017

TECHNICAL ADVISORY
BOARD

Perry Cook
Assistant Professor of
Computer Science
Princeton University

David Baker
Vice President of
Systems Engineering
Equator Technologies, Inc.

Robert Belleville
Researcher
Silicon Graphics

BOARD OF DIRECTORS

Kenneth A. Kokinakis
President and
Chief Executive Officer
Aureal Semiconductor Inc.

Richard E. Christopher
Vice President --
Worldwide Sales
Chips and Technologies, Inc.

L. William Krause
President and
Chief Executive Officer
Storm Technology, Inc.

D. Richard Masson
Principal
Oaktree Capital Management, LLC

Thomas K. Smith, Jr.
Senior Vice President
Trust Company of the West

CORPORATE OFFICERS

Kenneth A. Kokinakis
President and
Chief Executive Officer
Aureal Semiconductor Inc.

Gary M. Catlin
Vice President, Engineering

David J. Domeier
Vice President, Finance and
Chief Financial Officer

Scott H. Foster
Chief Technical Officer

Michael L. Hunter
Vice President, Sales

Sanjay Iyer
Vice President, PC Products

Brendan R. O'Flaherty
Vice President, Consumer
Products and General Counsel

Toni W. Schneider
Vice President,
Advanced Audio Products

Suryanarayana "Murty"
Cheruvu
Vice President, Operations

[AUREAL LOGO]
<PAGE> 51

UNITED STATES AND CANADA
REPRESENTATIVES/DISTRIBUTORS

CALIFORNIA
BROOKS TECHNICAL GROUP
Cupertino, CA
Tel: 408-252-3880

VISION TECHNICAL GROUP
Calabasas, CA
Tel: 818-878-7955

VISION TECHNICAL GROUP
Irvine, CA
Tel: 714-450-9050

HADDEN ASSOCIATES INC.
San Diego, CA
Tel: 619-565-9444

BETA TECHNOLOGY SALES
Itasca, IL
Tel: 630-250-9586

NEW YORK
PARALLAX
Melville, NY
Tel: 516-351-1000

TEXAS
BONSER-PHILHOWER SALES
Richardson Texas
Tel: 972-234-8438

CANADA
ELECTRO SOURCE, INC.
Calgary, Alberta
Tel: 403-735-6230

ELECTRO SOURCE, INC.
Pointe Claire, Quebec
Tel: 514-630-7486

ELECTRO SOURCE, INC.
Kanata, Ontario
Tel: 613-592-3214

ELECTRO SOURCE, INC.
Rexdale, Ontario
Tel: 416-675-4490

ELECTRO SOURCE, INC.
Burnaby, British Columbia
Tel: 604-435-2533

INTERNATIONAL REPRESENTATIVES/DISTRIBUTORS

AUSTRALIA/NEW ZEALAND
Insight Electronics
Tel: 61-3-9761-3455

BELGIUM
Memec Benelux (Belgium)
Tel: 32-2-778-9850

FRANCE
Micro Puissance
Tel: 33-1-69-07-1211

GERMANY
REIN Components GmbH
Tel: 49-2153-733-234

HONG KONG / CHINA
The Yang Group Ltd.
Tel: 852-2881-6016

ISRAEL
Boran Technologies Ltd.
Tel: 972-3-934-5171

JAPAN
Asahi Kasei Microsystems, Co
Tel: 81-3-3320-2065

Marubeni Solutions Corp.
Tel: 81-3-5778-8660

KOREA
Se Wung Corporation
Tel: 82-2-521-5711

NETHERLANDS
Memec Benelux
Tel: 31-40-265-9399

SINGAPORE
CiNERGi Technology and Devices
Tel: 65-778-9331

SWEDEN/FINLAND/DENMARK
Memec Scandinavia AB
Tel: 46-8-459-7900

TAIWAN
Solomon Technology Corp.
Tel: 886-2-2788-8989

TURKEY
Inter. Electronik
Tel: 90-216-349-9400

[AUREAL LOGO]
<PAGE> 52

EXHIBIT INDEX

<TABLE>
<CAPTION>
SEQUENTIALLY
NUMBERED
EXHIBIT NO. DESCRIPTION OF DOCUMENT PAGE
----------- ----------------------- ------------
<C> <S> <C>
2.1 Agreement and Plan of Reorganization among the Company,
Aureal Acquisition Corporation, a wholly-owned subsidiary of
the Company and Crystal River Engineering, Inc., dated as of
May 7, 1996(1)..............................................
2.2 Second Amended Joint Plan of Reorganization dated November
10, 1994(4).................................................
3.1 Second Amended and Restated Certificate of Incorporation of
the Company dated May 8, 1996(2)............................
3.2 Restated Bylaws of Aureal Semiconductor Inc.(6).............
4.1 Common Stock Purchase Agreement by and among the Company and
certain beneficial owners of 5% or more of the Company's
Common Stock, as amended(3).................................
4.2 Common Stock Purchase Agreement by and among the Company and
certain entities and individuals dated June 10, 1996(5).....
4.3 Common Stock Purchase Agreement by and among the Company and
certain entities and individuals dated August 6, 1997(8)....
4.4 Preferred Stock Regulation D Subscription Agreement(10).....
4.5 Certificate of Designation of Series A Preferred Stock of
Aureal Semiconductor Inc.(10)...............................
4.6 Preferred Stock Registration Rights Agreement(10)...........
10.1 Second Amended and Restated Loan Agreement between TCW
Special Credits and the Company dated August 6, 1997
increasing the loan commitment from $20 million to $31.5
million.(9).................................................
10.2 1995 Stock Option Plan(3)...................................
10.3 Form of incentive option agreement and non-statutory stock
option agreement used under 1995 Stock Option Plan(3).......
10.4 1994 Stock Option Plan(4)...................................
10.5 Form of incentive option agreement and non-statutory stock
option agreement used under 1994 Stock Option Plan(4).......
10.6 Industrial Space Sublease with Chemical Waste Management,
Inc. dated September 13, 1995(3)............................
10.7 Form of Indemnity Agreement for Directors and Officers(6)...
10.8 1996 Outside Directors Stock Option Plan(7).................
23.1 Consent of Arthur Andersen LLP..............................
27.1* Financial Data Schedule (Edgar Only)........................
</TABLE>

- ---------------
* Previously Filed

(1) Incorporated by reference to the exhibits filed with Form 8-K dated May 22,
1996

(2) Incorporated by reference to the exhibits filed with Form S-8 (Registration
number 333-09531) filed August 2, 1996

(3) Incorporated by reference to the exhibits filed with Form 10-K for the year
ended December 31, 1995

(4) Incorporated by reference to the exhibits filed with Form 10-K for the year
ended December 31, 1994

(5) Incorporated by reference to the exhibits filed with Form S-3 (Registration
number 333-3870) filed June 26, 1996
<PAGE> 53

(6) Incorporated by reference to the exhibits filed with Form 10-Q for the
quarter ended September 29, 1996

(7) Incorporated by reference to the exhibits filed with Form 10-K for the year
ended December 29, 1996.

(8) Incorporated by reference to the exhibits filed with Form S-3 (As
Post-Effective Amendment No. 1, Registration number 333-3870) filed
September 12, 1997.

(9) Incorporated by reference to the exhibits filed with Form 10-Q for the
quarter ended September 28, 1997

(10) Incorporated by reference to the exhibits filed with Form 8-K dated March
16, 1998

<PAGE> 1

EXHIBIT 23.1

CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS

As independent public accountants, we hereby consent to the
incorporation of our report included in this Form 10-K/A into the Company's
previously filed Registration Statements (File Nos. 33-55006, 33-55008 and
33-36086 and 33-90798) filed on Form S-8.

/s/ ARTHUR ANDERSEN LLP
----------------------------------------
ARTHUR ANDERSEN LLP

San Jose, California
May 29, 1998