Although children with language impairments, including those associated with reading, usually demonstrate deficits in phonological processing, there is minimal agreement as to the source of those deficits. This study examined two problems hypothesized to be possible sources: either poor auditory sensitivity to speech-relevant acoustic properties, mainly formant transitions, or enhanced masking of those properties. Adults and 8-year-olds with and without phonological processing deficits (PPD) participated. Children with PPD demonstrated weaker abilities than children with typical language development (TLD) in reading, sentence recall, and phonological awareness. Dependent measures were word recognition, discrimination of spectral glides, and phonetic judgments based on spectral and temporal cues. All tasks were conducted in quiet and in noise. Children with PPD showed neither poorer auditory sensitivity nor greater masking than adults and children with TLD, but they did demonstrate an unanticipated deficit in category formation for nonspeech sounds. These results suggest that these children may have an underlying deficit in perceptually organizing sensory information to form coherent categories. (Contains 8 tables and 3 figures.)