American Technology Corporation
STATEMENTS OF CASH FLOWS
(Unaudited)

	For the nine months ended June 30,
	2004			2003
Increase (Decrease) in Cash
Operating Activities:
Net loss	$	(3,692,034	)	$	(5,968,603	)
Adjustments to reconcile net loss to net cash
used in operations:
Depreciation and amortization		164,920			497,880
Allowance for doubtful accounts		—			(1,140	)
Warranty reserve		83,233			63,568
Common stock issued for services and compensation		—			410,816
Options and warrants issued for services		—			179,995
Provision for litigation costs		150,000			950,000
Amortization of debt discount		—			405,000
Changes in assets and liabilities:
Trade accounts receivable		(1,202,762	)		97,013
Inventories		(488,864	)		(219,443	)
Prepaid expenses and other		(221,109	)		(15,106	)
Accounts payable		430,086			(333,033	)
Change in warranty reserve		(37,588	)		—
Accrued liabilities		(95,414	)		124,587
Net cash used in operating activities		(4,909,532	)		(3,808,466	)
Investing Activities:
Purchase of equipment		(299,623	)		(9,700	)
Patent costs paid		(254,096	)		(30,777	)
Net cash used in investing activities		(553,719	)		(40,477	)
Financing Activities:
Payments on capital lease		(7,341	)		(7,252	)
Proceeds from issuance of convertible promissory notes		—			500,000
Proceeds from issuance of preferred stock		—			2,432,500
Cash paid for offering costs		—			(176,222	)
Proceeds from exercise of stock options and warrants		1,106,367			401,490
Net cash provided by financing activities		1,099,026			3,150,516
Net increase (decrease) in cash		(4,364,225	)		(698,427	)
Cash, beginning of period		9,850,358			1,807,720
Cash, end of period	$	5,486,133		$	1,109,293
Supplemental Disclosure of Cash Flow Information
Cash paid for interest	$	2,263		$	72,521
Cash paid for taxes		—			—
Non-cash financing activities:
Sale of equipment for accounts payable		—		$	117,000
Secured notes converted to Series E preferred stock		—		$	1,000,000
Common stock issued on repayment of 8% promissory note				$	681,845
Common stock issued on conversion of preferred stock	$	320,414		$	2,169,396
Common stock issued for legal settlement accrual	$	248,000			—
Subordinated notes and accrued interest paid in common stock		—		$	2,435,032

The following table summarizes information about warrant activity during the ninethree months ended June 30,December 31, 2004:

At June 30,December 31, 2004, the following stock purchase warrants were outstanding arising from offerings and other transactions, each exercisable into one common share:

Subsequent to December 31, 2004, the Company received proceeds of $356,930 from the exercise of 74,360 warrants.

11.12.  BUSINESS SEGMENT DATA

The Company is engaged in design, development and commercialization of sound, acoustic and other technologies. In the fourth quarter of fiscal 2003 the CompanyThe Company’s operations are organized operations into two segments by the end-user markets they serve. The Company’s reportable segments are strategic business units that sell the Company’s products to distinct distribution channels. The Business Products and Licensing Group (Business Group) markets and licenses HSS and markets HSS, NeoPlanar and PureBasssound products to companies that employ audio in consumer, commercial and professional applications. The Government and Force Protection Systems Group (Government Group) markets LRAD, NeoPlanar, Sound Cluster and HSS sound products to government and military customers and to the expanding force protection market.and commercial security markets. The segments are managed separately because each segment requires different selling and marketing strategies as the class of customers within each segment is different.

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The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company does not allocate operating expenses or assets between its two reportable segments. Accordingly the measure of profit for each reportable segment is based on gross profit. Although the segments became separately managed only in the last quarter of fiscal 2003, the Company has segmented historical operations for comparable customers for comparison.

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			Three Months Ended December 31,
			2004			2003
Revenues:
Business Group			$	187,349		$	81,939
Government Group				4,221,564			692,839
			$	4,408,913		$	774,778

			Three Months Ended December 31,
			2004			2003
Gross Profit (Loss):
Business Group			$	(204,296	)	$	(3,612	)
Government Group				3,085,506			369,912
			$	2,881,210		$	366,300

AMERICAN TECHNOLOGY CORPORATION
NOTES TO INTERIM FINANCIAL STATEMENTS
(Unaudited)

12.13.  LEGAL PROCEEDINGS

In September 2003, the Company filed a complaint against eSOUNDideas, Inc., in the Superior Court of California, County of San Diego, alleging breach of contract and seeking a declaratory judgment to the effect that a License, Purchase and Marketing Agreement dated September 28, 2000 (the “ESI License Agreement”) with eSOUNDideas, a California partnership, was properly terminated in May 2003. The principals of eSOUNDideas are Greg O. Endsley and Douglas J. Paschall. The principals also founded a corporation, eSOUNDideas, Inc., which purported to assume the contractual obligations of eSOUNDideas. The Company amended the complaint in November 2003 to include eSOUNDideas (the general partnership), Mr. Endsley and Mr. Paschall as defendants. For convenience, the following discussion refers to eSOUNDideas and eSOUNDideas, Inc. collectively as “ESI.” In November 2003, the Company filed complaints in the Superior Court of California, County of San Diego, against Mr. Endsley and Paschall seeking declaratory judgments that options granted to each of Mr. Endsley and Mr. Paschall in April 2001 were terminated in October 2002.

The ESI License Agreement formerly appointed ESI as an exclusive distributor of HSS products specifically targeted to the point of sale/purchase, kiosk and display, and the event, trade show and exhibit markets in North America for five years. In June 2002, the Company and ESI purported to enter into an amendment to the ESI License Agreement, extending the term to ten years commencing on the first delivery of a commercial HSS product to an end user, and eliminating minimum purchase requirements for the first three years. The Company believes the amendment was invalid as it was given in consideration for a large order from ESI, which was later withdrawn by ESI due to a dispute over the payment and delivery terms of such order. In May 2003, the Company gave notice to ESI of termination of the ESI License Agreement. The Company based its termination on its belief that ESI had failed to fulfill certain covenants contained in the ESI License Agreement related to efforts and resources required to maximize the distribution and sales of HSS products in its product categories. Under the terms of the ESI License Agreement, the termination was effective immediately, but ESI had sixty days to cure conditions giving rise to termination and reinstate the agreement. ESI did not tender a cure within such sixty daysixty-day period.

The three cases were consolidated upon motion by the defendants and order of the court. The defendants filed a first amended cross-complaint againstcross-action in the Companyconsolidated action alleging fraud, breach of contract in connection with the ESI License Agreement and the options, breach of the implied covenant of good faith and fair dealing, intentional interference with contract, negligent interference with contract, intentional interference with prospective economic advantage, negligent interference with prospective economic advantage, defamation, and violation of California Business and Professions Code §17200. The defendants seek actual and punitive damages in unstated amounts and other relief. The Company filed a demurrer and motion to strike as to the first amended cross-complaint, which was granted, in part, in May 2004. In June 2004, ESI filed a second amended cross-complaint containing allegations similar to the first amended cross-complaint and seeking the same relief. The Company has filed a demurrer and motion to strike asits answer to the second amended cross-complaint which will be heard by the court onin August 13, 2004. Discovery has commenced. No trial dateis ongoing. Trial has been set.set for May 2005.

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The Company intends to vigorously pursue its complaint against the Company’s April 2000 purchase of the NeoPlanar speaker technology, the Company wasdefendants in dispute with a predecessor owner of the technology regarding a minimum film royalty for 2002 of approximately $228,000. In March 2004 the Company settled this matter for a payment of $25,000 and the issuance of 50,000 shares of common stock, which included a buyout of all future royalties.

In February 2004, the Company gave notice of termination of two licensing and sales agreements with General Dynamics Armament and Technical Products, Inc. (GD-ATP), originally entered into in February 2003. GD-ATP was the original licensee under one agreement, and took assignment of the rights of Bath Iron Works Corporation, another subsidiary of General Dynamics Corporation, under the other agreement. The agreements gave GD-ATP the right to purchase, market and resell NeoPlanar and HIDA (High Intensity Directional Acoustics) products and components with exclusive rights for specified applications to certain government customers, including the Department of Defense, Department of Homeland Security and certain Federal, State and local agencies. GD-ATP disputed the Company’s right to terminate the agreements and demanded arbitration. In April 2004 the Company announced that it and GD-ATP had mutually agreed to resolve their disputes in an amicable manner,case and to dismissvigorously challenge the arbitration proceedings. GD-ATP and the Company agreed that neither was liable to the other and that no party engaged in any wrongdoing. The resolution resulted in the termination of the two agreements, and in the Company assuming GD-ATP’s role in servicing certain LRAD customers previously serviced by GD-ATP.

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AMERICAN TECHNOLOGY CORPORATION
NOTES TO INTERIM FINANCIAL STATEMENTS
(Unaudited)

The Company may at times be involved in litigation in the ordinary course of business. The Company will also, from time to time, when appropriate in management’s estimation, record adequate reserves in the Company’s financial statements for pending litigation. Except as set forth above, there are no pending material legal proceedings to which the Company is a party or to which any of its property is subject.

13.14.  INCOME TAXES

At June 30,December 31, 2004, a valuation allowance has been provided to offset the net deferred tax asset as management has determined that it is more likely than not that the deferred tax asset will not be realized. At September 30, 20032004 the Company had for federal income tax purposes net operating loss carryforwards of approximately $28,500,000$37,400,000, which expire through 20242025 of which certain amounts are subject to significant limitations under the Internal Revenue Code of 1986, as amended.

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

The following discussion should be read in conjunction with the accompanying unaudited interim financial statements and the related notes included under Item 1 of this Quarterly Report on Form 10-Q, together with Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2004.

The following discussion provides an overview of our results of operations for the three months ended December 31, 2004 and 2003. Significant period-to-period variances in the statements of operations are discussed under the caption “Results of Operations.” Our financial condition and cash flows are discussed under the caption “Liquidity and Capital Resources.”

Forward Looking Statements

This Report contains certain statements of a forward-looking nature relating to future events or the future performance.  Words such as “expects,”“anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the only means of identifying forward-looking statements.  Prospective investors are cautioned that such statements are only predictions and that actual events or results may differ materially.  In evaluating such statements, prospective investors should specifically consider various factors identified in this Report, including the matters set forth below under the caption “Business Risks”, which could cause actual results to differ materially from those indicated by such forward-looking statements.

Overview

We are an innovator of proprietary sound reproduction technologies and products.

Our HyperSonic Sound, (HSS)or HSS, technology is a new method of sound reproduction that uses parametric acoustics to createcreates sound “in the air.”  Sound is generated along an air column using ultrasonic frequencies, which are those above the normal range of hearing. The HSS sound beam is highly directional and maintains sound volume over longer distances than traditional loudspeakers. We believe HyperSonic Sound’s unique features are useful in new sound applications. We believe we are the leader in developing and commercializing parametric loudspeakers.

Our Long Range Acoustic Device, (LRAD)or LRAD, technology produces variable intensity acoustical sound intended for use in long-range delivery of directional and highly intelligible sound information, which is effectively a supercharged megaphone. LRAD products are used as directed long-range hailing and warning systems.

Our NeoPlanar technology is a thin film magnetic speaker that produces sound of high quality, low distortion and high volume. NeoPlanar applications include high-end sound, systemspublic address and public address.mass notification systems. Our SoundCluster technology is a new militarymulti-transducer, speaker cluster optimized for even sound system (5MC) offers improved intelligibilitycoverage over large and highly ambient noise areas such as aircraft carrier flight decks.  We have other proprietary sound technologies and products in various stages of development.

Our primary products sold to date have been LRAD and HSS products. These products are currently manufactured for us by Pemstar, Inc., an established contract manufacturer with multiple locations worldwide. Our sales have been highly dependent on flight deckslarge orders from a few customers.  We target our products for sale worldwide, but expect the largest markets to be the U.S., Europe and Asia. To date, our sales have been made in other applications. Our PureBass extended range woofer employs unique cabinet construction, novel vent configurationsU.S. dollars and multiple acoustic filterswe do not expect currency fluctuations to minimize distortion and provide high output. It provideshave a high frequency interface withmaterial impact on our NeoPlanar panels and other upper range satellite speaker systems.operations.

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We are focusing our marketing efforts on providing sound reproduction products and components to customers and licensing our technologies for customer applications. When we supply systems or components used in other products to customers, distributors or OEMs, we include our intellectual property fees in the selling prices of the systems or components. We currently produce HSS systems and NeoPlanar panels as components of a sound system. When we license a sound technology, we typically receive a flat fee up-front, with the balance of payments based upon a percentage of net revenues of the products in which our technology is incorporated. Revenues from up-front license fees are recognized ratably over the specified term of the particular license. Contract fees are recorded as services are performed.

The following is a summary description of our operating results for the three and nine months ended June 30, 2004. A more detailed discussion of our operating results is included below under the heading “Results of Operations.”

Our third quarter of fiscal 2004 represented a continuation of business and strategic initiatives implemented inbelieve the first quarter of fiscalended December 31, 2004 including:

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	-       Sales:

	•	We are focusing greater effort on pursuing sales opportunities internally with marketing teams in the Business Group and Government Group experienced in the target markets. In the past, we relied primarily on outside licensees for sales and marketing of our key products.

	•      We are focusing on maintaining acceptable margins for the substantial majority of our sales.

	•	Our marketing teams are focused on sales growth and we expect continued revenue growth in the fourth quarter of fiscal 2004.

	-       Business Relationships:

	•	We are establishing relationships with established national or global partners for sales, manufacturing and distribution to accelerate the worldwide adoption of our products. We are generally pursuing relationships on a non-exclusive basis to maximize the performance incentives for our partners and market penetration of our products.
	•	Relationships are being chosen and structured carefully for complimentary fit with our strategy and achievement of desired objectives.

We believe our third quarter shows positive results deriving from these initiatives.improvements in operating results. Our revenues for the quarterthree months ended June 30,December 31, 2004 were $2.1 million,$4,408,913, compared to $1.5 million$774,778 for the immediately preceding second quarter of fiscal 2004, and $313,600 for the quarterthree months ended June 30,December 31, 2003. Our gross profit for the three and nine months ended June 30,December 31, 2004 was 52% and 46%65% of revenues, compared to 40% and 12% gross profit47% of revenues for the comparable prior year three and nine months of the prior fiscal year.month period. We accomplished these significant improvements in sales and margins, while increasing only modestly our totalwith gross profit of $2,881,210 in the three months ended December 31, 2004 which was $2,514,910 or 687% higher than the gross profit of $366,300 in the three months ended December 31, 2003. This was partially offset by increases in operating expenses. Overall,expenses of $1,935,245 or 127% from $1,521,285 in the three months ending December 31, 2003 to $3,456,530 in the three month period ending December 31, 2004. However, due to the $950,141 derivative revaluation expense associated with the increase in value of the warrant we reducedissued to Kingsbridge Capital, our net loss increased from $6.0 million in$1,136,427 for the first ninethree months of fiscalended December 31, 2003 to $3.7 million$1,526,850 for the first ninethree months of fiscal 2004, and from $2.4 million in the third quarter of fiscal 2003 to $1.4 million in the third quarter of fiscalended December 31, 2004.

Management is continuing to focus efforts upon near-term revenue and gross margin improvement from our existing, marketable products. We have filled key management and operations positions and increased the number of personnel to further in-housein our sales and marketing grow our Advanced Development Departmentand engineering departments. While new hires have necessarily resulted in increased expenses, we believe these new hires, and others planned, are important to develop new productsnear-term revenue and product applications, and to fill key management and operational positions. Personnel cost increases reflect our objective to assemble the right teams to accelerate quality product development, build market momentum, and generate sales. We believe our new generation HSS and LRAD products, plus quarter-over-quarter sales increases, are direct results of building the proper staff.gross margin improvements. We are currently focusing our resources primarily on sales, marketing, engineering and production of existing products, and we willproducts. We are closely monitor research andmonitoring expenses for our Advanced Development department, charged with development activities in future periods with a view toward establishingof new products. Our policy is to establish a compelling business case for each Advanced Development initiative.

Our various technologies are high risk in nature. Our future is largely dependent upon the success of our sound technologies. We invest significant funds in research and development and on patent applications related to our proprietary technologies. Unanticipated technical or manufacturing obstacles can arise at any time and disrupt sales or licensing activities and result in lengthy and costly delays. Our technologies may not achieve market acceptance sufficient to sustain operations or achieve future profits. See “Business Risks” below.

Recent Developments

In April 2004, Kalani Jones was appointed PresidentOn January 18, 2005, we gave notice to all holders of Series D and Chief Operating Officer. He formerly served as Chief Operating Officer. InSeries E Preferred Stock that we had elected to convert the new position, he has assumed greater responsibilities for all aspectsshares of Series D and Series E Preferred Stock to common stock. The designations, rights and preferences of the Series D and Series E Preferred Stock permitted us to exercise this conversion option if the market price of our business operations. He is also managing Salescommon stock exceeded $9.50 per share for ten consecutive trading days and Marketingcertain other conditions were satisfied. The price condition was satisfied on January 6, 2005. The notice of conversion was effective immediately for our Business Group pending the hiringSeries D Preferred Stock, and resulted in all 50,000 issued and outstanding shares of a Vice PresidentSeries D Preferred Stock converting into an aggregate of Sales129,259 shares of common stock. The notice of conversion for the Series E Preferred Stock was effective on February 1, 2005, and Marketing.

In June 2004 we announcedall 233,250 issued and outstanding shares of Series E Preferred Stock converted into an aggregate of 801,306 shares of common stock. As all the hiring of Michael A. RussellSeries D and Series E Preferred Stock was called for conversion as our Chief Financial Officer. Carl Gruenler, who was acting as Interim Chief Financial Officer, is now focused full-time on his duties as Vice President of our Government Group.

In May 2004 we announced a manufacturing partnership with Pemstar, Inc. to build volume HSS® and LRAD(TM) orders. Pemstar is a leading provider of manufacturing services with over 1,000,000 square feet in 15 manufacturing facilities locateddescribed above, $1,504,711 will be accreted in the United States, Asia, Europe, South America and Mexico.

Also in May 2004 we announced that we have been developing a new flight deck voice communications system designated as the 5MC system by the U.S. Navy. This new product was supported in part by a $436,000 contract by the U.S. Navy via a contract with Signal Solutions, Inc., a subsidiary of General Dynamics Network Systems. Our 5MC military sound system complements our LRAD and NeoPlanar product offerings to government customers.

In June 2004 we received our first shipments of Generation III HSS units from our contract manufacturer (Pemstar, Inc.) and commenced testing with selected customers in anticipation of growing production and sales starting in the fourthsecond fiscal quarter of 2004. Generation III HSS features higher SPL (loudness), lower distortion (cleaner sound) and attractive packaging resulting from internal and external industrial design. Withwill increase the known performance of our Generation III HSS product we are focusing our Business Group marketing efforts on the digital signage, kiosk/display and trade show markets where we believe HSS speakers offer customers compelling advantages by directing soundnet loss available to target users and reducing noise clutter. Existing Business Group sales and marketing personnel and those we seek to hire will be focused on end-user customers and technology integrators and others specializing in these market segments. In addition to direct sales to end-users, we expect to develop relationships with established national or global partners for sales, distribution and installation of HSS products to accelerate the worldwide adoption of HSS sound solutions. We are also in the early stages of developing opportunities and relationships to employ HSS technology in home theater and related applications.common stockholders.

Critical Accounting Policies

We have identified the policies below as critical to our business operations and the understandings of our results of operations. The impact and any associated risks related to theseOur accounting policies on our business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations when such policies affect our reported and expected financial results.

In the ordinary course of business, we have made a number of estimates and assumptions relating to the reporting of results of operations and financial conditionare more fully described in the preparation of our financial statements located in accordanceItem 8 of Part II, “Financial Statements and Supplementary Data.”

The methods, estimates and judgments we use in applying our accounting policies, in conformity with generally accepted accounting principles generally accepted in the United States, have a significant impact on the results we report in our financial statements. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. The estimates affect the carrying values of America for interim financial information.assets and liabilities. Actual results could materiallymay differ from thosethese estimates under different assumptions and conditions and operating results for the three and nine month periods presented are not necessarily indicative of the results that may be expected for the year.or conditions. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require our most difficult, subjective, and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

Revenue Recognition.We currently derive our revenue primarily from two sources: (i) component and product sale revenues and associated engineering and installation, (“product sales”)which we refer to collectively as Product Sales and (ii) contract and license fee revenue.  Component and product saleProduct Sales revenues are recognized in the periods that products are shipped to customers, FOB shipping point or destination, per contract, ifwhen a signed contract exists, the fee is fixed and determinable, collection of resulting receivables is probable and there are no remaining obligations. Revenues from engineering contracts are recognized based on milestones or completion of the contracted services. Revenues from ongoing per unit license fees are earned based on units shipped incorporating our patented proprietary technologies and are recognized in the period when the ultimate customer accepts the product and collectibility is reasonably assured. Revenues from up-front license and other fees and annual license fees are generally recognized ratably over the specified term of the particular license or agreement.

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