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corresp

March 4, 2005

VIA OVERNIGHT MAIL

Ms. Michele M. Anderson

Legal Branch Chief

Securities and Exchange Commission

Division of Corporate Finance

Mail Stop 04-07

450 Fifth Street, N.W.

Washington, D.C. 20549

Facsimile: (202) 942-9594

    Re:
    Digital Recorders, Inc.

Registration Statement on Form S-1

Filed January 4, 2005

File No. 333-121834

    Form 8-K filed September 10, 2004 (the “Form 8-K”)

File No. 33-82870-A

Dear Ms. Anderson:

      On behalf of Digital Recorders, Inc. (the “Company”), we are responding to your letter dated
January 28, 2005 concerning the Company’s disclosures regarding internal control over financial
reporting and certain reportable conditions set forth in the Form 8-K. Your letter specifically
referenced the Company’s disclosures regarding its disclosure controls found in Item 9A of the
Company’s annual report on Form 10-K/A filed April 15, 2004, and Item 4 in the Company’s quarterly
reports on Form 10-Q filed on May 6, 2004, August 20, 2004, and November 15, 2004 (collectively,
the Company’s “2004 Periodic Reports”). We believe that once the Staff understands and considers
the context in which the comments of McGladrey & Pullen arose, the merits of the Company’s
position wherein a material weakness in internal controls over financial reporting does not
materially negatively impact its disclosure controls will become clear.

      The facts and circumstances described below represent the views of the Company’s executive
management. Such facts and circumstances, as well as this letter, were reviewed by the Audit
Committee of the Company’s Board of Directors, which unanimously concurred with its content.

      In light of our obligation to shareholders to file our Annual Report on Form 10-K shortly, we
have a strong sense of urgency to address this outstanding comment and we would appreciate your
timely consideration and response.

      For your convenience, we are first reciting the subject matter as copied from your letter then
presenting our response individually in each instance.

    1.
    COMMENT

    We note your statement in your response letter dated October 29, 2004, that despite the identification of a
material weakness in your internal controls over financial reporting by

Ms. Anderson

February 8, 2005

Page 2

    your former auditors, you still
believe that your disclosure controls and procedures are effective. However, in light of the documentation
that you submitted to us, it does not appear that your disclosure controls and procedures are effective.
In particular, we note the following deficiencies in your response letter and in the management report by
McGladrey and Pullen:

    1.A
    •
    lack of sufficient internal control policies and procedures over financial reporting to
ensure that financial statements and schedules are reliable and accurate, as reported on
page 12 of McGladrey & Pullen Management Report

RESPONSE

    Excerpted from McGladrey & Pullen Management Report (page 12):

    “During our audit, we noted that there were not sufficient internal controls policies and
procedures over financial reporting to ensure that financial statements and schedules are
reliable and accurate. To the extent that such internal controls do exist, they are more
geared to routine transactions rather than non-routine and complex transactions....”

    The Company has acknowledged the material weakness in internal controls over financial
reporting. Such was first disclosed in the Company’s Annual Report on Form 10-K/A for the
year ended December 31, 2003. The Company has taken steps to address such weakness and has
disclosed these steps in each of its subsequent periodic reports. However, while the
comment of McGladrey & Pullen is directed toward internal controls, policies, and
procedures over financial reporting, they made no comment that such circumstance negatively
impacted the Company’s disclosure controls.

    McGladrey & Pullen commented that the Company’s policies and procedures that do exist are
geared more toward routine transactions rather than non-routine complex transactions. The
Company acknowledges that its written policies and procedures are geared more toward
routine transactions. The fact is that routine transactions, simply because of their
routine nature, are more controllable by static, specific, and detailed written policies
and procedures.

    Having said the Company’s written policies and procedures are geared more toward routine
transactions is not saying the Company does not have adequate policies and procedures over
non-routine and complex transactions. The Company’s policy regarding non-routine and
complex transactions is to elevate such matters and invite the input and oversight of the
Corporate accounting staff including its Chief Financial Officer, Chief Accounting Officer,
and Corporate Controller so that a more considered analysis of the circumstances unique to
the situation might be performed by our senior management.

    We believe that our Company maintains a level of financial reporting and accounting
expertise among our financial executives that is adequate and appropriate for our
circumstances and size. We further believe that such is substantially above that
maintained by the vast majority of small businesses. In that regard, please consider the
following information.

    The then current Chief Financial Officer is a well-educated and experienced accounting
professional with more than 35 years of accounting experience, including approximately 12
years in the industry and seven years with us. Beginning with Arthur Young & Company in
1970, he maintained his license to practice as a Certified Public Accountant for more than
28

Ms. Anderson

February 8, 2005

Page 3

years. The Company hired a new Chief Financial Officer in October 2004. The former CFO
remains with the Company as Executive Vice President, Corporate Development.

The Chief Accounting Officer is a well-educated accounting professional with more than 20
years of accounting experience, a Masters Degree in Accounting, and a license to practice
as a Certified Public Accountant. The Chief Accounting Officer has been with us since
2002.

The Corporate Controller is a well-educated and experienced accounting professional with
more than 25 years of accounting experience and a license to practice as a Certified Public
Accountant. The Corporate Controller started his career with Arthur Andersen & Company and
has been with us since 2000.

Further reflecting our focus on maintaining effective disclosure controls, each supervisory
level person in the accounting department is an experienced and licensed professional (CPA
or comparable international designation) with more than 20 years of accounting experience.

Taken together, we believe that the level of experience and knowledge of our financial and
accounting personnel is adequate, appropriate, and in excess of that possessed by many
other small businesses of similar size.

While this expertise is considerable, it is obviously not to the depth that we are able to
absolutely ensure our ability, absent retaining outside assistance (which we do from
time-to-time), to address each and every complex accounting issue that may arise in the
course of our operations. However, this limitation does not per se mean that we do not
maintain effective disclosure controls.

We believe the Staff defines “disclosure controls and procedures” as controls and other
procedures of an issuer that are designed to ensure that information required to be
disclosed by the issuer in the reports filed or submitted by it under the Exchange Act is
recorded, processed, summarized and reported within the time periods specified in the
Commission’s rules and forms. “Disclosure controls and procedures” include, without
limitation, controls and procedures designed to ensure that information required to be
disclosed by an issuer in its Exchange Act reports is accumulated and communicated to the
issuer’s management, including its principal executive and financial officers, as
appropriate to allow timely decisions regarding required disclosure.

According to “Perspectives on Internal Control Reporting,” a resource published by the “Big
4” accounting firms in December 2004, internal control over financial reporting is a subset
of disclosure controls. That is, “disclosure controls and procedures typically include,
but are broader than, internal control over financial reporting.” The Company believes that
the existence of a material weakness in internal controls, particularly of the type
identified by McGladrey & Pullen, does not necessarily lead to the conclusion that the
broader area of disclosure controls are ineffective. A closer analysis of the underlying
rationale for McGladrey & Pullen’s statement must be made to determine if a material
weakness in internal controls in this instance necessarily makes our disclosure controls
ineffective.

We wish to note for the Staff
that the accumulation and communication of information to our
management was in no way questioned or raised as an issue by McGladrey & Pullen’s comments
concerning the identified material weakness in our internal controls. Rather, the steps
taken by our financial executives when faced with non-routine, complex transactions
demonstrate the effectiveness of our disclosure controls and procedures. This is true
because, as the Staff will see described herein, our highest level executives routinely
provide close

Ms. Anderson

February 8, 2005

Page 4

oversight of non-routine transactions – meaning that these executives are
made aware of, and get involved in, determining the proper accounting treatment for these
non-routine, complex transactions. This is indicative of effective disclosure controls and
procedures, rather than ineffective ones.

Relying on the escalation of non-routine and complex matters to the highest level financial
executives is not only typical, but in fact desirable in a small company. In fact, this
oversight acts to mitigate the absence of alternate, more highly structured, controls that
a larger issuer might have the resources to implement. If these transactions were not
identified or communicated to our highest level financial executives, our disclosure
controls would necessarily be called into question. However, that is not the situation.
Rather, McGladrey & Pullen noted that we experienced difficulty in accounting for
non-routine, complex transactions and that our accounting personnel would benefit from
additional training in one of those instances. We would ask the Staff to consider the
information presented herein concerning the experience and background of our accounting
executives and staff as contextual information for analysis of this issue.

Non-routine, complex transactions by definition involve unusual or non-recurring issues
that can confound even the most experienced financial officers and public accounting firms.
This proposition has been amply demonstrated by: (i) issues raised by the SEC’s Chief
Accountant in advisories to the accounting profession, such as the Letter to Robert J.
Kueppers, Chairman, Center for Public Company Audit Firms, from Donald T. Nicolaisen
(February 7, 2005 – accounting for operating and capital leases); and (ii) restatements
resulting from issuers improperly classifying short-term debt as long-term debt, an issue
that was apparently initially identified by the Public Company Accounting Oversight Board’s
inspection teams through their cursory inspections of the “Big 4” firms in 2004. The
difficulty of the question at hand in no means should be a litmus test for the “procedures”
in place to deal with such difficulties.

While additional training or adding more accounting personnel may help reduce the
difficulties highlighted by McGladrey & Pullen, it is apparent that non-routine, complex
transactions can lead to difficulties in determining the proper application of accounting
principles in spite of having the highest level of financial reporting and accounting
expertise.

The conclusion that McGladrey & Pullen reached concerning the difficulties encountered by
the Company in accounting for complex, non-routine transactions specifically originates
with the Series F Preferred Stock financing transaction concluded in 2003. We would ask the
Staff to take note of the fact that, as documented in e-mail included herewith, McGladrey &
Pullen itself (with its team of subject-matter experts and securities specialists, as well
as significant resources) had difficulty in confirming the accounting used by management
for that non-routine financial transaction. As such, no level of additional staff or
further education of our personnel could have reasonably ensured our ability to properly
account for the transaction in the context of McGladrey and Pullen’s comment.

The Company’s management has reviewed the effectiveness of the design and operation of the
Company’s disclosure controls and procedures in light of the issue raised by McGladrey &
Pullen’s comment about the single material weakness in internal controls over financial
reporting. Based on that review, we do not believe that a restatement relating to the
effectiveness of our disclosure controls is warranted due to the reasons outlined herein.

Ms. Anderson

February 8, 2005

Page 5

    1.B
    •
    Approximately 140 audit adjustments made to the original trial balance as well as the
nature of the adjustments as reported on page 6 McGladrey & Pullen Management Report.

RESPONSE

    Excerpted from McGladrey & Pullen Management Report (page 6):

    “There were approximately 140 audit adjustments made to the original trial balance
presented to us to begin our audit procedures. Of the adjustments that were recorded, the
following is a description of the adjustments that could, in our judgment, either
individually or in the aggregate, have a significant effect of the Company’s financial
reporting process.”

    The number of audit adjustments may appear to have been extraordinary, but we would ask the
Staff to, again, place this in context. Rather than reflecting a material weakness in
internal controls over financial reporting, the number of adjusting journal entries
substantially reflects a weather-induced lack of readiness for the audit due to the reasons
outlined below.

    We followed our usual annual closing procedures in early 2004, but such procedures were
interrupted when a snow storm closed our North Carolina offices for four full days just
prior to beginning the annual audit. Though headquartered in Dallas, Texas, our accounting
center is located in Durham, North Carolina. Had those offices not been closed for four
days due to the snow storm, the overwhelming majority of the 140 audit adjustments would
have been recorded prior to the start of the audit. In fact, of the 140 adjustments noted
by McGladrey & Pullen, 120, or 86%, were: (i) identified through our own internal processes
and internal controls, (ii) prepared by our own accounting staff, and (iii) given to
McGladrey & Pullen for review prior to being recorded in our financial books and records.
To call these “audit adjustments” is an unfortunate mischaracterization and overstatement
of the situation.

    Of the 120 entries identified though our own internal processes and controls, 17 were
routine consolidation entries, 24 entries were for less than $1,000 each, and 8 entries
were for tax accounting, that are always done at the end of the audit. Of the 140 journal
entries, only 20 entries arose by virtue of the audit and the efforts of McGladrey &
Pullen, and, in our view, that number would not be atypical for a company of our size and
complexity including multiple legal entities, multiple business units, multiple product
lines, and international operations in five countries. An analysis of the audit
adjustments is attached hereto as Exhibit A.

    Prior to the st