Overview

Our mission is to provide the emerging "voice interface" markets with state-of-the-art communications products that facilitate natural language, human/machine interfaces.

Examples of the applications and interfaces for which Andrea DSP Microphone and Audio Software Products and Andrea Anti-Noise Products provide benefits include:
Internet and other computer-based speech; telephony communications; multi-point conferencing; speech recognition; multimedia; multi-player Internet and CD ROM interactive games; and other applications and interfaces that incorporate natural language processing. We believe that end users of these applications and interfaces will require high quality microphone and earphone products that enhance voice transmission, particularly in noisy environments, for use with personal computers, mobile personal computing devices, cellular and other wireless communication devices and automotive communication systems. Our Andrea DSP Microphone and Audio Software Products use "far-field" digital signal processing technology to provide high quality transmission of voice where the user is at a distance from the microphone. High quality audio communication technologies will be required for emerging far-field voice applications, ranging from continuous speech dictation, to Internet telephony and multiparty video teleconferencing and collaboration, to natural language-driven interfaces for automobiles, home and office automation and other machines and devices into which voice-controlled microprocessors are expected to be introduced during the next several years.

We outsource to Asia high volume assembly for most of our products from purchased components. We assemble some low volume Andrea DSP Microphone and Audio Software Products from purchased components. As sales of any particular Andrea DSP Microphone and Audio Software Product increase, assembly operations are transferred to a subcontractor in Asia.

Our Critical Accounting Policies

Our consolidated financial statements and the notes to our consolidated financial statements contain information that is pertinent to management's discussion and analysis. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities and determination of revenues and expenses in the reporting period. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. On a continual basis, management reviews its estimates utilizing currently available information, changes in facts and circumstances, historical experience and reasonable assumptions. After such reviews, and if deemed appropriate, those estimates are adjusted accordingly. Actual results may vary from these estimates and assumptions under different and/or future circumstances. Management considers an accounting estimate to be critical if: 1) it requires assumptions to be made that were uncertain at the time the estimate was made; and 2) changes in the estimate, or the use of different estimating methods that could have been selected, could have a material impact on the Company's consolidated results of operations or financial condition.

The following critical accounting policies that affect the more significant judgments and estimates used in the preparation of the consolidated financial statements have been identified. In addition to the recording and presentation of our convertible preferred stock, we believe that the following are some of the more critical judgment areas in the application of our accounting policies that affect our financial condition and results of operations. We have discussed the application of these critical accounting policies with our Audit Committee. The following critical accounting policies are not intended to be a comprehensive list of all the Company's accounting policies or estimates.

Accounts Receivable - We are required to estimate the collectibility of our trade receivables. Judgment is required in assessing the realization of these receivables, including the current creditworthiness of each customer and related aging of the past due balances. We evaluate specific accounts when we become aware of a situation where a customer may not be able to meet its financial obligations due to a deterioration of its financial viability, credit ratings or bankruptcy. The reserve requirements are based on the best facts available to us and are reevaluated and adjusted as additional information is received. Our reserves are also determined by using percentages applied to certain aged receivable categories. At December 31, 2008 and 2007, our allowance for doubtful accounts were $7,815 and $21,705 respectively.

Inventory - We are required to state our inventories at the lower of cost or market. In assessing the ultimate realization of inventories, we are required to make considerable judgments as to future demand requirements and compare that with our current inventory levels. Our reserve requirements generally increase as our projected demand requirements decrease due to market conditions, technological and product life cycle changes as well as longer than previously expected usage periods. We have evaluated the current levels of inventories, considering historical net revenues and other factors and, based on this evaluation, recorded adjustments to cost of revenues to adjust inventories to net realizable value. Inventories of $868,213 and $714,864 at December 31, 2008 and 2007 are net of reserves of $701,821 and $566,941, respectively. It is possible that additional charges to inventory may occur in the future if there are further declines in market conditions, or if additional restructuring actions are taken.

Long Lived Assets - Statement of Financial Accounting Standards ("SFAS"), No.
144 "Accounting for the Impairment or Disposal of Long-Lived Assets" ("FAS 144") requires management judgments regarding the future operating and disposition plans for marginally performing assets, and estimates of expected realizable values for assets to be sold. Andrea accounts for its long-lived assets in accordance with FAS 144 for purposes of determining and measuring impairment of its other intangible assets. Andrea's policy is to periodically review the value assigned to its long lived assets to determine if they have been permanently impaired by adverse conditions which may affect Andrea. If required, an impairment charge would be recorded based on an estimate of future discounted cash flows. In order to test for recoverability, Andrea compared the sum of an undiscounted cash flow projections (gross margin dollars from product sales) of the Andrea DSP Microphone and Audio Software core technology to the carrying value of that technology. Considerable management judgment is necessary to estimate undiscounted future operating cash flows and fair values and, accordingly, actual results could vary significantly from such estimates. No impairment charges were recognized during the years ended December 31, 2008 and 2007, respectively.

Deferred Tax Assets - We currently have significant deferred tax assets. SFAS No. 109, "Accounting for Income Taxes"("FAS 109"), requires a valuation allowance be established when it is more likely than not that all or a portion of deferred tax assets will not be realized. Furthermore, FAS 109 provides that it is difficult to conclude that a valuation allowance is not needed when there is negative evidence such as cumulative losses in recent years. Therefore, cumulative losses weigh heavily in the overall assessment. Accordingly, and after considering changes in previously existing positive evidence, we recorded a full valuation allowance. In addition, we expect to provide a full valuation allowance on future tax benefits until we can sustain a level of profitability that demonstrates our ability to utilize the assets, or other significant positive evidence arises that suggests our ability to utilize such assets. The future realization of a portion of our reserved deferred tax assets related to tax benefits associated with the exercise of stock options, if and when realized, will not result in a tax benefit in the consolidated statement of operations, but rather will result in an increase in additional paid in capital. We will continue to re-assess our reserves on deferred income tax assets in future periods on a quarterly basis.

Contingencies - We are subject to proceedings, lawsuits and other claims, including proceedings under laws and government regulations related to securities, environmental, labor, product and other matters. We are required to assess the likelihood of any adverse judgments or outcomes to these matters, as well as potential ranges of probable losses. A determination of the amount of reserves required, if any, for these contingencies is based on an analysis of each individual issue with the assistance of legal counsel. The amount of any reserves may change in the future due to new developments in each matter.

The impact of changes in the estimates and judgments pertaining to revenue recognition, receivables and inventories is directly reflected in our segments' loss from operations. Although any charges related to our deferred tax provision are not reflected in our segment results, the long-term forecasts supporting the realization of those assets and changes in them are significantly affected by the actual and expected results of each segment.

Certain information contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 2008 and other items set forth in this Annual Report on Form 10-K are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The words "anticipates," "believes," "estimates," "expects," "intends," "plans," "seeks," variations of such words, and similar expressions are intended to identify forward-looking statements. We have based these forward-looking statements on our current expectations, estimates and projections about our business and industry, our beliefs and certain assumptions made by our management. Investors are cautioned that matters subject to forward-looking statements involve risks and uncertainties including economic, competitive, governmental, technological and other factors that may affect our business and prospects. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. These statements are based on current expectations and speak of as of the date of such statements. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of future events, new information or otherwise. In order to obtain the benefits of these "safe harbor" provisions for any such forward-looking statements, we wish to caution investors and prospective investors about the following significant factors, which, among others, have in some cases affected our actual results and are in the future likely to affect our actual results and could cause them to differ materially from those expressed in any such forward-looking statements. These factors include the risks noted in Item 1A.

Results Of Operations

Year Ended December 31, 2008 Compared to Year Ended December 31, 2007

Net Revenues

                                                          For the Year Ended December 31
                                                              2008                 2007          % Change
Andrea Anti-Noise Products net Product revenues
Sales of products to an OEM customer for use with
speech recognition software                             $        313,243       $    376,699            (20 ) (a)
Sales of gaming headset products to an OEM customer                    -            183,261           (100 ) (b)
All other Andrea Anti-Noise net product revenues               2,117,693          2,058,904              3   (c)
Total Andrea Anti-Noise Products net Product revenues          2,430,936          2,618,864             (8 )

Andrea DSP Microphone and Audio Software Products
revenues
Sales of array microphone products to an OEM customer            107,800            927,210           (760 ) (d)
All other Andrea DSP Microphone and Audio product
revenues                                                         641,210            804,916            (26 ) (e)
License revenues                                               1,531,148            695,223             55   (f)
Total Andrea DSP Microphone and Audio Software
Products revenues                                              2,280,158          2,427,349             (6 )

Total Revenues                                          $      4,711,094       $  5,046,213             (7 )

(a) The decrease of revenues of Andrea Anti-Noise Products is directly related to a speech recognition software OEM's decreased demand for our products. We believe this decreased demand is associated with the timing of the launches of this OEMs software updates during the year ended 2008 as compared to the same period in 2007.

(b) The difference of approximately $183,000 relates to the sale of product to one of our OEM customers for a one-time design and build of a particular product. These revenues represented one-time revenues that were only anticipated to be repeated if the OEM's product was successful in the marketplace, which it was not.

(c) The slight increase in Andrea Anti Noise Product revenues of 3% is primarily associated with increased sales of products to educational customers for use with their distance learning products.

(d) The significant decreases of revenues of microphone array products to an OEM customer for the year ending December 31, 2008, relates to the decreased demand from the OEM customer. We believe that this decrease is result of the OEM deciding not to continue including a microphone array with all applicable product models. The revenues in 2007 were a result of the OEM's introduction of the OEM's product and the OEM customers' need to supply all of its customers for the initial launch. We do not expect any revenues from the OEM for this product in 2009.

(e) The 26% decrease in all other Andrea DSP Microphone and Audio product revenues is primarily associated with decreased sales of our Andrea AutoArray Microphone products. We believe this decrease is related to the decreased federal funding to state and local police departments.

(f) The 55% increase in licensing revenues for the year ended December 31, 2008 is a result of one of our OEM licensing partner's initial launch of one of our licensed products in their product line.

Cost of revenues as a percentage of net revenues for the year ended December 31, 2008 decreased to 42% from 51% for the year ended December 31, 2007. The cost of revenues as a percentage of net revenues for the year ended December 31, 2008 for Andrea Anti-Noise Products was 64% as compared to 60% for the year ended December 31, 2007. The cost of revenues as a percentage of net revenues for the year ended December 31, 2008 for Andrea DSP Microphone and Audio Software Products is 20% compared to 42% for the year ended December 31, 2007. The changes are primarily the result of the changes in revenue as described under "Net Revenues" above. Specifically, the increase in cost of revenues as a percentage of revenues for the Andrea Anti-Noise Products is a result of increased overhead costs associated with this segment. The decrease in cost of revenues as a percentage of revenues for the Andrea DSP Microphone and Audio Software is the result of the increase in license revenues coupled with the decrease in the revenues of high volume low margin microphone array products to an OEM customer.

Research and Development

Research and development expenses for the year ended December 31, 2008 increased by 8% to $728,187 from $676,977 for the year ended December 31, 2007. This increase primarily relates to the increase in stock-based compensation expense, as well as employee compensation and related benefit costs related to the hire of an employee dedicated to engineering and product development. For the year ended December 31, 2008, research and development expenses in our Andrea DSP Microphone and Audio Software Technology efforts were approximately the same as 2007 at $480,994, or 66% of total research and development expenses and a 26% increase in our Andrea Anti-Noise Headset Product efforts to $247,193, or 34% of total research and development expenses. With respect to DSP Microphone and Audio Software technologies, research efforts are primarily focused on the pursuit of commercializing a natural language-driven human/machine interface by developing optimal far-field microphone solutions for various voice-driven interfaces, incorporating Andrea's digital super directional array microphone technology, and certain other related technologies such as noise suppression and stereo acoustic echo cancellation. We believe that continued research and development spending should provide Andrea with a competitive advantage.

General, Administrative and Selling Expenses

General, administrative and selling expenses increased approximately 8% to $2,316,723 for the year ended December 31, 2008 from $2,143,159 for the year ended December 31, 2007. This increase is principally related to the increase in stock-based compensation expense related to the employment agreement entered into with the Company's President and Chief Executive Officer in August 2008 as well as the hire of an employee dedicated to the Company's sales and marketing efforts. For the year ended December 31, 2008, the increase reflects a 3% increase in our Andrea DSP Microphone and Audio Software Technology efforts to $1,297,003, or 56% of total general, administrative and selling expenses and a 15% increase in our Andrea Anti-Noise Headset Product efforts to $1,019,720, or 44% of total general, administrative and selling expenses.

Interest Income, net

Interest income, net for the year ended December 31, 2008 was $8,992 compared to interest income, net of $8,623 for the year ended December 31, 2007.

Provision for Income Taxes

The provision for income taxes the year ended December 31, 2008 was $4,902 compared to a provision for income taxes of $29,410 for the year ended December 31, 2007. The decrease is a result of a decrease of certain licensing revenues that are subject to withholding of income tax as mandated by the foreign jurisdiction in which the revenues are earned.

Net loss

Net loss for the year ended December 31, 2008 was $326,738 compared to a net loss $390,124 for the year ended December 31, 2007. The net loss for the year ended December 31, 2008 principally reflects the factors described above.

Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on its financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.

Our principal sources of funds are and are expected to continue to be gross cash flows from operations. At December 31, 2008, we had cash of $1,006,951 compared with $811,403 at December 31, 2007. The balance of cash at December 31, 2008 is primarily a result of our cash provided from operations during the year ended December 31, 2008.

Our working capital balance at December 31, 2008 was $2,196,689 compared to a working capital of $1,837,521 at December 31, 2007. The increase in working capital reflects an increase in total current assets of $219,574 and a decrease in total current liabilities of $139,594. The increase in total current assets reflects an increase in cash of $195,548, a decrease in accounts receivable of $190,013, an increase in inventory of $153,349, and an increase in prepaid expenses of $60,690. The decrease in total current liabilities reflects a decrease in trade accounts payable of $201,907, a decrease in accrued interest of $1,672 partially offset by an increase of $63,984 in other current liabilities.

The increase in cash of $195,548 reflects $274,681 of net cash provided by operating activities and $79,133 of net cash used by investing activities.

The cash provided by operating activities of $274,681, excluding non-cash charges, is primarily attributable to the $326,738 net loss for the year ended December 31, 2008, a $190,013 decrease in accounts receivable, a $288,229 increase in inventory, a $60,690 increase in prepaid expenses and other current assets, a $201,907 decrease in accounts payable, and an increase of $63,985 in other current liabilities. The changes in receivables, inventory and accounts payable primarily reflect differences in the timing related to both the payments for and the acquisition of inventory as well as for other services in connection with ongoing efforts related to Andrea's various product lines.

The cash used by investing activities of $79,133 reflects an increase in property and equipment of $35,511 and an increase in patents and trademarks of $43,622. The increase in property and equipment reflects capital expenditures associated with molds for our Andrea Anti Noise Headset business line and computers and related equipment. The increase in patents and trademarks reflects capital expenditures associated with our intellectual property.

We plan to continue to improve our cash flows in 2009 by aggressively pursuing additional licensing opportunities related to our Andrea DSP Audio Software and increasing the sales of our Andrea Anti-Noise Headset Products through the introduction of refreshed product line introduced in the latter part of 2008 as well as the increased efforts we are putting into our sales and marketing efforts. However, there can be no assurance that we will be able to successfully execute the aforementioned plans. As of March 25, 2009, Andrea has approximately $1,600,000 of cash deposits. We believe that we have sufficient liquidity available to continue in operation through at least December 2009. To the extent that we do not generate sufficient cash flows from our operations in the next twelve months, additional financing might be required. Although we have improved cash flows by reducing overall expenses, if our revenues decline, these reductions may impede our ability to be cash flow positive and our net income or loss may be disproportionately affected. We have no commitment for additional financing and may experience difficulty in obtaining additional financing on favorable terms, if at all. Any financing we obtain may contain covenants that restrict our freedom to operate our business or may have rights, preferences or privileges senior to our common stock and may dilute our current shareholders' ownership interest in Andrea. We cannot assure that demand will continue for any of our products, including future products related to our Andrea DSP Microphone and Audio Software technologies, or, that if such demand does exist, that we will be able to obtain the necessary working capital to increase production and provide marketing resources to meet such demand on favorable terms, or at all.

Recently Issued Accounting Pronouncements

For a discussion of the impact of recent accounting pronouncements, see Note 2 of the accompanying financial statements.

Market Risk

Our principal source of financing activities is the issuance of convertible preferred stock with financial institutions. We are affected by market risk exposure primarily through any amounts payable in stock, or cash by us under convertible securities. We do not utilize derivative financial instruments to hedge against changes in interest rates or for any other purpose. In addition, substantially all transactions entered into by us are denominated in U.S. dollars. As such, we have shifted foreign currency exposure onto our foreign customers. As a result, if exchange rates move against foreign customers, we could experience difficulty collecting unsecured accounts receivable, the cancellation of existing orders or the loss of future orders. The foregoing could materially adversely affect our business, financial condition and results of operations.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

Not Applicable.