-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, OZW/uZkR9zhg7Iph4w2MVfCFvE7u+plPEueQOGN/FFmLuXgBhiWbxXC0rW0XzJrR e49jdb7tiPdo4+SUD59epw== 0001019687-06-002596.txt : 20061103 0001019687-06-002596.hdr.sgml : 20061103 20061102192802 ACCESSION NUMBER: 0001019687-06-002596 CONFORMED SUBMISSION TYPE: 10-Q/A PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20060331 FILED AS OF DATE: 20061103 DATE AS OF CHANGE: 20061102 FILER: COMPANY DATA: COMPANY CONFORMED NAME: Integrated Healthcare Holdings Inc CENTRAL INDEX KEY: 0001051488 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-HOSPITALS [8060] IRS NUMBER: 870412182 STATE OF INCORPORATION: NV FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q/A SEC ACT: 1934 Act SEC FILE NUMBER: 000-23511 FILM NUMBER: 061184292 BUSINESS ADDRESS: STREET 1: 1301 N. TUSTIN AVENUE CITY: SANTA ANA STATE: CA ZIP: 92705 BUSINESS PHONE: 714-434-9191 MAIL ADDRESS: STREET 1: 1301 N. TUSTIN AVENUE CITY: SANTA ANA STATE: CA ZIP: 92705 FORMER COMPANY: FORMER CONFORMED NAME: Integrated Healthcare Holdings DATE OF NAME CHANGE: 20040816 FORMER COMPANY: FORMER CONFORMED NAME: FIRST DELTAVISION INC DATE OF NAME CHANGE: 19971216 10-Q/A 1 ihh_10qa1-033106.txt AMENDMENT NO. 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 - -------------------------------------------------------------------------------- Amendment No. 1 to FORM 10-Q (Mark One) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2006 OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number: 0-23511 - -------------------------------------------------------------------------------- Integrated Healthcare Holdings, Inc. (Exact name of small business issuer as specified in its charter) Nevada 87-0412182 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 1301 N. Tustin Ave. 92705 Santa Ana, California (Zip Code) (Address of principal executive offices) (714) 953-3503 (Registrant's telephone number, including area code) (Former name, former address and former fiscal year, if changed since last report) - -------------------------------------------------------------------------------- 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 past 90 days. Yes |_| No |X| Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. Large accelerated filer |_| Accelerated filer |_| Non-accelerated filer |X| Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). |_| Yes |X| No There were 84,351,189 shares outstanding of the issuer's Common Stock as of August 8, 2006. - -------------------------------------------------------------------------------- Explanatory Note On October 30, 2006, the Company's Audit Committee, acting on a recommendation from the Company's management determined that the Company's unaudited condensed consolidated quarterly financial statements for the periods ended March 31, 2006 and June 30, 2006, should be restated due to an error in the overstatement of net revenues and accounts receivable. More specifically, the Company determined that the restatements with respect to its financial statements for these periods were necessary to write off patient accounts receivable for services provided under capitated contracts. Please refer to Note 12 to our unaudited condensed consolidated quarterly financial statements included in this amendment on Form 10-Q/A for a further discussion of the restatement. Accordingly, the Company has restated its financial statements for the quarterly periods ended March 31, 2006 and June 30, 2006 with the filing of amended quarterly reports on Form 10-Q/A and is restating its financial statements for the quarterly period ended March 31, 2006 in this amended report. This amendment to the Company's Quarterly Report on Form 10-Q is being filed for the purpose of amending and restating Items 1, 2 and 4 of Part I and Item 6 of Part II of the Form 10-Q originally filed solely to the extent necessary (i) to reflect the restatement of the Company's unaudited condensed consolidated financial statements as of and for the period ended March 31, 2006, as described in Note 12 to the unaudited condensed consolidated financial statements and (ii) to make revisions to "Management's Discussion and Analysis of Financial Condition and Results of Operations" as warranted by the restatement, (iii) to make revisions to Item 4 of Part I to reflect our evaluation of controls and procedures as of the date of filing this amended Quarterly Report on Form 10-Q/A, (iv) to include the certifications required by the Sarbanes-Oxley Act of 2002 and (v) to update the exhibits. Except as previously discussed and included in Note 12 to our unaudited condensed consolidated quarterly financial statements included in this amendment on Form 10-Q/A, we have not modified or updated disclosures presented in the original quarterly report on Form 10-Q, except as required to reflect the effects of the restatement in this Form 10-Q/A. Accordingly, this Form 10-Q/A does not reflect events occurring after the filing of our original Form 10-Q or modify or update those disclosures affected by subsequent events. Information not affected by the restatement is unchanged and reflects the disclosures made at the time of the original filing of the Form 10-Q on August 11, 2006. This Form 10-Q/A should be read in conjunction with our filings made with the Securities and Exchange Commission subsequent to the filing of the original Form 10-Q, including any amendments to those filings. INTEGRATED HEALTHCARE HOLDINGS, INC. FORM 10-Q TABLE OF CONTENTS Page Number PART I FINANCIAL INFORMATION Item 1. Financial Statements: Condensed Consolidated Balance Sheets as of March 31, 2006 (unaudited) and December 31, 2005 2 Condensed Consolidated Statements of Operations for the three months ended March 31, 2006 and 2005 (unaudited) 3 Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2006 and 2005 (unaudited) 4 Notes to Condensed Consolidated Financial Statements (unaudited) 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 24 Item 3. Quantitative and Qualitative Disclosures About Market Risk 33 Item 4. Controls and Procedures 34 PART II OTHER INFORMATION Item 1. Legal Proceedings 34 Item 1A. Risk Factors 34 Item 6. Exhibits 34 SIGNATURES 35 - -------------------------------------------------------------------------------- 1 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS. INTEGRATED HEALTHCARE HOLDINGS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS MARCH 31, DECEMBER 31, 2006 2005 ------------- ------------- (unaudited) (as restated) (as restated) ASSETS Current assets: Cash and cash equivalents $ 7,129,693 $ 16,005,943 Restricted cash 4,971,636 4,971,636 Accounts receivable, net of allowance for doubtful accounts of $2,432,084 and $3,148,276, respectively 14,902,829 15,975,486 Security reserve funds 13,021,487 12,127,337 Deferred purchase price receivables 14,354,540 9,337,703 Inventories of supplies, at cost 5,786,274 5,719,717 Due from governmental payers 6,587,219 3,024,772 Prepaid expenses and other current assets 6,369,539 6,694,045 ------------- ------------- 73,123,217 73,856,639 ------------- ------------- Property and equipment, net of accumulated depreciation of $2,785,921 and $2,138,134, respectively 58,860,857 59,431,285 Debt issuance costs, net of accumulated amortization of $1,033,361 and $791,735, respectively 899,639 1,141,265 ------------- ------------- Total assets $ 132,883,713 $ 134,429,189 ============= ============= LIABILITIES AND STOCKHOLDERS' DEFICIENCY Current liabilities: Short term debt $ 70,330,734 $ - Accounts payable 28,999,871 26,835,606 Accrued compensation and benefits 11,561,638 12,533,499 Warrant liabilities, current 23,546,650 10,700,000 Due to governmental payers 1,045,126 - Other current liabilities 17,815,951 15,725,489 ------------- ------------- Total current liabilities 153,299,970 65,794,594 ------------- ------------- Long term debt - 70,330,734 Capital lease obligations, net of current portion of $87,880 and $85,296, respectively 4,938,295 4,961,257 Warrant liability - 21,064,669 Minority interest in variable interest entity 3,041,453 3,341,549 Commitments and contingencies Stockholders' deficiency: Common stock, $0.001 par value; 250,000,000 shares authorized; 84,351,189 and 83,932,316 shares issued and outstanding, respectively 84,351 83,932 Additional paid in capital 16,257,683 16,125,970 Accumulated deficit (44,738,039) (47,273,516) ------------- ------------- Total stockholders' deficiency (28,396,005) (31,063,614) ------------- ------------- Total liabilities and stockholders' deficiency $ 132,883,713 $ 134,429,189 ============= ============= THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS. 2 INTEGRATED HEALTHCARE HOLDINGS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited) THREE MONTHS ENDED MARCH 31, ------------------------------ 2006 2005 ------------- ------------- (as restated) Net operating revenues $ 86,163,974 $ 21,747,029 ------------- ------------- Operating expenses: Salaries and benefits 48,708,705 12,450,604 Supplies 12,031,608 3,033,815 Provision for doubtful accounts 8,298,928 3,141,406 Other operating expenses 16,757,363 3,900,220 Loss on sale of accounts receivable 2,807,805 - Depreciation and amortization 647,789 262,212 ------------- ------------- 89,252,198 22,788,257 ------------- ------------- Operating loss (3,088,224) (1,041,228) Other income (expense): Interest expense, net (2,694,414) (665,296) Common stock warrant expense - (17,215,000) Change in fair value of derivative 8,218,019 - ------------- ------------- 5,523,605 (17,880,296) ------------- ------------- Income (loss) before minority interest and provision for income taxes 2,435,381 (18,921,524) Income tax benefit (provision) - (944,000) Minority interest in variable interest entity 100,096 8,905 ------------- ------------- Net income (loss) $ 2,535,477 $ (19,856,619) ============= ============= Per Share Data: Earnings (loss) per common share-Basic $0.03 ($0.22) Earnings (loss) per common share-Fully Diluted $0.02 ($0.22) Weighted average shares outstanding-Basic 84,281,377 88,493,611 Weighted average shares-Fully Diluted 127,227,606 Note 10 THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS. 3 INTEGRATED HEALTHCARE HOLDINGS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) Three months ended March 31, ---------------------------- 2006 2005 ------------ ------------ (as restated) Cash flows from operating activities: Net income (loss) $ 2,535,477 $(19,856,619) Adjustments to reconcile net loss to cash used in operating activities: Depreciation and amortization of property and equipment 647,789 249,363 Amortization of debt issuance costs and intangible assets 241,626 75,203 Common stock warrant expense - 17,215,000 Change in fair value of derivative (8,218,019) - Minority interest in net loss of variable interest entity (100,096) (8,905) Changes in operating assets and liabilities: Accounts receivable, net 1,072,657 (16,968,328) Security reserve funds (894,150) - Deferred purchase price receivables (5,016,837) - Inventories of supplies (66,557) 71,868 Due from governmental payers (3,562,447) - Prepaids and other current assets 324,506 (1,375,081) Accounts payable 2,164,265 5,933,254 Accrued compensation and benefits (971,861) 7,073,364 Due to governmental payers 1,045,126 - Other current liabilities 2,090,462 1,439,151 ------------ ------------ Net cash used in operating activities (8,708,059) (6,151,730) ------------ ------------ Cash flows from investing activities: Acquisition of hospital assets - (63,171,676) Additions to property and equipment, net (77,361) - ------------ ------------ Net cash used in investing activities (77,361) (63,171,676) ------------ ------------ Cash flows from financing activities: Proceeds from long term debt - 50,000,000 Long term debt issuance costs - (1,933,000) Proceeds from minority investment in PCHI - 5,000,000 LLC distribution (200,000) - Drawdown on line of credit - 13,200,000 Issuance of common stock 132,132 10,699,501 Repayments of debt - (1,264,013) Payments on capital lease obligations (22,962) (34,414) ------------ ------------ Net cash (used in) provided by financing activities (90,830) 75,668,074 ------------ ------------ Net increase (decrease) in cash and cash equivalents (8,876,250) 6,344,668 Cash and cash equivalents, beginning of period 16,005,943 69,454 ------------ ------------ Cash and cash equivalents, end of period $ 7,129,693 $ 6,414,122 ============ ============ THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS. 4
INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) NOTE 1 - DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America ("U.S. GAAP") for interim consolidated financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, the accompanying unaudited consolidated financial statements for Integrated Healthcare Holdings, Inc. and its subsidiaries (the "Company") contain all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the Company's financial position as of March 31, 2006, and the Company's results of operations and cash flows for the three months ended March 31, 2006 and 2005. The consolidated balance sheet as of December 31, 2005 is derived from the December 31, 2005 audited consolidated financial statements. The results of operations for the three months ended March 31, 2006 are not necessarily indicative of the results to be expected for the full year. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2005 and notes thereto included in the Company's Form 10-K filed with the Securities and Exchange Commission (the "SEC") on July 28, 2006. The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. GAAP and prevailing practices for investor-owned entities within the healthcare industry. The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Management regularly evaluates the accounting policies and estimates that are used. In general, management bases the estimates on historical experience and on assumptions that it believes to be reasonable given the particular circumstances in which its hospitals operate. Although management believes that adjustments considered necessary for fair presentation have been included, actual results may vary from those estimates. DESCRIPTION OF BUSINESS - The Company was organized under the laws of the State of Utah on July 31, 1984 under the name of Aquachlor Marketing. Aquachlor Marketing never engaged in business activities and was suspended for failure to file annual reports and tax returns. In December 1988, all required reports and tax returns were filed and Aquachlor Marketing was reinstated by the State of Utah. In December 1988, Aquachlor Marketing merged with Aquachlor, Inc., a Nevada corporation incorporated on December 20, 1988. The Nevada corporation became the surviving entity and changed its name to Deltavision, Inc. In March 1997, Deltavision, Inc. received a Certificate of Revival from the State of Nevada using the name First Deltavision, Inc. In March 2004, First Deltavision, Inc. changed its name to Integrated Healthcare Holdings, Inc. On March 8, 2005, the Company completed its acquisition (the "Acquisition") of four Orange County, California hospitals and associated real estate, including: (i) 282-bed Western Medical Center--Santa Ana, CA; (ii) 188-bed Western Medical Center--Anaheim, CA; (iii) 178-bed Coastal Communities Hospital in Santa Ana, CA; and (iv) 114-bed Chapman Medical Center in Orange, CA (collectively, the "Hospitals") from Tenet Healthcare Corporation ("Tenet"). The Hospitals were assigned to four wholly-owned subsidiaries of the Company formed for the purpose of completing the Acquisition. The Company also acquired the following real estate, leases and assets associated with the Hospitals: (i) a fee interest in the Western Medical Center at 1001 North Tustin Avenue, Santa Ana, CA, a fee interest in the administration building at 1301 North Tustin Avenue, Santa Ana, CA, certain rights to acquire condominium suites located in the medical office building at 999 North Tustin Avenue, Santa Ana, CA, and the business known as the West Coast Breast Cancer Center; (ii) a fee interest in the Western Medical Center at 1025 South Anaheim Blvd., Anaheim, CA; (iii) a fee interest in the Coastal Communities Hospital at 2701 South Bristol Street, Santa Ana, CA, and a fee interest in the medical office building at 1901 North College Avenue, Santa Ana, CA; (iv) a lease for the Chapman Medical Center at 2601 East Chapman Avenue, Orange, CA, and a fee interest in the medical office building at 2617 East Chapman Avenue, Orange, CA; and (v) equipment and contract rights associated with the Hospitals. The results of operations of the acquired assets are included in the Company's consolidated statements of operations from the date of Acquisition (March 8, 2005). 5 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) BASIS OF PRESENTATION - The accompanying unaudited consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and settlement of obligations in the normal course of business. The Company generated income of $2,535,477 (primarily attributable to a gain from change in fair value of derivative of $8,218,019) during the three months ended March 31, 2006 and has a working capital deficit of $80,176,753 at March 31, 2006. For the three months ended March 31, 2006, cash used in operations was $8,708,059. On or around May 9, 2005, the Company received notice that it was in default of a credit agreement comprised of a $50 million acquisition loan (the "Acquisition Loan") and a $30 million working capital line of credit (the "Line of Credit"). Outstanding borrowings under the line of credit were $25,330,734 as of March 31, 2006 and December 31, 2005. On December 12, 2005, the Company entered into an additional credit agreement for $10,700,000, due December 12, 2006, which included an amendment that (i) declared cured the aforementioned default, (ii) required the Company to pay $5,000,000 against its Acquisition Loan, (iii) required the Company to obtain $10,700,000 in additional new capital contributions to pay in full and retire all amounts due and owing under the additional credit agreement and (iv) included certain indemnities and releases in favor of the lender. These factors, among others, indicate a need for the Company to take action to resolve its financing issues and operate its business as a going concern. In our Annual Report for the year ended December 31, 2005, our independent accountants expressed a substantial doubt about the Company's ability to continue as a going concern. Management is working on improvements in several areas that the Company believes will help to mitigate its financing issues, including (i) improved contracted reimbursements and governmental subsidies for indigent care, (ii) reduction in operating expenses, and (iii) reduction in the costs of borrowed capital. We believe that we can reduce our costs of borrowed capital by replacing debt with new equity. We are seeking new equity investments in the Company; however we have not yet secured alternative sources of capital or re-negotiated our commitments with our lenders. There can be no assurance that we will be able to raise additional funds on terms acceptable to us or at all. Such additional equity, if available, is likely to substantially dilute the interest of our current shareholders in the Company. In addition, changes in the level of investment are subject to the approval of the Company's Board of Directors, which is currently comprised of three representatives of the lead investor, two outside directors, and one officer of the Company and, accordingly, may not be assured. CONSOLIDATION - The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, the Hospitals and Mogel Management Group, Inc. ("MMG"). As discussed further in Note 8, the Company's management has determined that Pacific Coast Holdings Investment, LLC ("PCHI"), is a variable interest entity as defined in Financial Accounting Standards Board ("FASB") Interpretation Number 46R ("FIN 46R") "Consolidation of Variable Interest Entities (revised December 2003)--an interpretation of ARB No. 51" and, accordingly, the financial statements of PCHI are included in the accompanying consolidated financial statements. All significant intercompany accounts and transactions have been eliminated in consolidation. NET OPERATING REVENUES - Net operating revenues are recognized in the period in which services are performed and are recorded based on established billing rates (gross charges) less estimated discounts for contractual allowances, principally for patients covered by Medicare, Medicaid, managed care and other health plans. Gross charges are retail charges. They are not the same as actual pricing, and they generally do not reflect what a hospital is ultimately paid and therefore are not displayed in the consolidated statements of operations. Hospitals are typically paid amounts that are negotiated with insurance companies or are set by the government. Gross charges are used to calculate Medicare outlier payments and to determine certain elements of payment under managed care contracts (such as stop-loss payments). Because Medicare requires that a hospital's gross charges be the same for all patients (regardless of payer category), gross charges are also what hospitals charge all other patients prior to the application of discounts and allowances. 6 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) Revenues under the traditional fee-for-service Medicare and Medicaid programs are based primarily on prospective payment systems. Discounts for retrospectively cost based revenues and certain other payments, which are based on the Hospitals' cost reports, are estimated using historical trends and current factors. Cost report settlements for retrospectively cost-based revenues under these programs are subject to audit and administrative and judicial review, which can take several years until final settlement of such matters are determined and completely resolved. Since the laws, regulations, instructions and rule interpretations governing Medicare and Medicaid reimbursement are complex and change frequently, the estimates recorded by the Hospitals could change by material amounts. The Company has established a settlement receivable as of March 31, 2006 and December 31, 2005 of $1,845,511 and $2,273,248, respectively. Outlier payments, which were established by Congress as part of the diagnosis-related groups (DRG) prospective payment system, are additional payments made to hospitals for treating Medicare patients who are costlier to treat than the average patient in the same DRG. To qualify as a cost outlier, a hospital's billed (or gross) charges, adjusted to cost, must exceed the payment rate for the DRG by a fixed threshold established annually by the Centers for Medicare and Medicaid Services of the United State Department of Health and Human Services (CMS). Under Sections 1886(d) and 1886(g) of the Social Security Act, CMS must project aggregate annual outlier payments to all prospective payment system hospitals to be not less than 5% or more than 6% of total DRG payments (Outlier Percentage). The Outlier Percentage is determined by dividing total outlier payments by the sum of DRG and outlier payments. CMS annually adjusts the fixed threshold to bring expected outlier payments within the mandated limit. A change to the fixed threshold affects total outlier payments by changing (1) the number of cases that qualify for outlier payments, and (2) the dollar amount hospitals receive for those cases that still qualify. The most recent change to the cost outlier threshold that became effective on October 1, 2005 was a decrease from $25,800 to $23,600, which CMS projects will result in an Outlier Percentage of 5.1%. The Medicare fiscal intermediary calculates the cost of a claim by multiplying the billed charges by the cost-to-charge ratio from the hospital's most recent filed cost report. The Hospitals received new provider numbers in 2005 and, because there was no specific history, the Hospitals were reimbursed for outliers based on published statewide averages. If the computed cost exceeds the sum of the DRG payment plus the fixed threshold, the hospital receives 80% of the difference as an outlier payment. Medicare has reserved the option of adjusting outlier payments, through the cost report, to the hospital's actual cost-to-charge ratio. Upon receipt of the current payment cost-to-charge ratios from the fiscal intermediary, any variance between current payments and the estimated final outlier settlement will be reported. As of March 31, 2006 and December 31, 2005, the Company recorded reserves for excess outlier payments due to the difference between the Hospitals actual cost to charge rates and the statewide average in the amount of $2,890,637 and $2,196,626, respectively. These reserves offset against the third party settlement receivables and are included as a net payable of $1,045,126 in due to governmental payers as of March 31, 2006, and as a net receivable of $103,626 in due from governmental payers as of December 31, 2005. The Hospitals receive supplemental payments from the State of California to support indigent care (MediCal Disproportionate Share Hospital payments or "DSH"). During the three months ended March 31, 2006, the Hospitals received payments of $575,000. The Company estimates an additional $6,587,219 is receivable based on State correspondence, which is included in due from governmental payers in the consolidated balance sheet as of March 31, 2006 ($2,921,150 at December 31, 2005). In April 2006, $3,811,305 of the $6,587,219 was received. Revenues under managed care plans are based primarily on payment terms involving predetermined rates per diagnosis, per-diem rates, discounted fee-for-service rates and/or other similar contractual arrangements. These revenues are also subject to review and possible audit by the payers. The payers are billed for patient services on an individual patient basis. An individual patient's bill is subject to adjustment on a patient-by-patient basis in the ordinary course of business by the payers following their review and adjudication of each particular bill. The Hospitals estimate the discounts for contractual allowances utilizing billing data on an individual patient basis. At the end of each month, the Hospitals estimate expected reimbursement for patient of managed care plans based on the applicable contract terms. These estimates are continuously reviewed for accuracy by taking into consideration known contract terms as well as payment history. Although the Hospitals do not 7 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) separately accumulate and disclose the aggregate amount of adjustments to the estimated reimbursements for every patient bill, management believes the estimation and review process allows for timely identification of instances where such estimates need to be revised. Management does not believe there were any adjustments to estimates of individual patient bills that were material to its net operating revenues. Management is not aware of any material claims, disputes, or unsettled matters with any payers that would affect revenues that have not been adequately provided for in the accompanying consolidated financial statements. The Hospitals provide charity care to patients whose income level is below 200% of the Federal Poverty Level with only a co-payment charged to the patient. The Hospitals' policy is to not pursue collection of amounts determined to qualify as charity care; and accordingly, the Hospitals do not report the amounts in net operating revenues or in the provision for doubtful accounts. Patients whose income level is between 200% and 300% of the Federal Poverty Level may also be considered under a catastrophic provision of the charity care policy. Patients without insurance who do not meet the Federal Poverty Level guidelines are offered assistance in applying for Medicaid and other programs they may be eligible for, such as state disability, Victims of Crime, or county indigent programs. Patient advocates from the Hospitals' Medical Eligibility Program (MEP) screen patients in the hospital and determine potential linkage to financial assistance programs. They also expedite the process of applying for these government programs. Based on average revenue for comparable services from all other payers, revenues foregone under the charity policy, including indigent care accounts, for the three months ended March 31, 2006 were approximately $1.6 million. Receivables from patients who are potentially eligible for Medicaid are classified as Medicaid pending under the MEP, with appropriate contractual allowances recorded. If the patient does not quality for Medicaid, the receivables are reclassified to charity care and written off, or they are reclassified to self-pay and adjusted to their net realizable value through the provision for doubtful accounts. Reclassifications of Medicaid pending accounts to self-pay do not typically have a material impact on the results of operations as the estimated Medicaid contractual allowances initially recorded are not materially different than the estimated provision for doubtful accounts recorded when the accounts are reclassified. All accounts classified as pending Medicaid are fully reserved when they reach 180 days old. PROVISION FOR DOUBTFUL ACCOUNTS - The Company sells substantially all of its billed accounts receivable to a financing company (see Note 3). The Company provides for accounts receivable that could become uncollectible by establishing an allowance to reduce the carrying value of such receivables to their estimated net realizable value. The allowance for doubtful accounts for accounts not sold as of March 31, 2006 and December 31, 2005 was $2,432,084 and $3,148,276, respectively. The Hospitals estimate this allowance based on the aging of their accounts receivable, historical collections experience for each type of payer and other relevant factors. There are various factors that can impact the collection trends, such as changes in the economy, which in turn have an impact on unemployment rates and the number of uninsured and underinsured patients, volume of patients through the emergency department, the increased burden of co-payments to be made by patients with insurance and business practices related to collection efforts. These factors continuously change and can have an impact on collection trends and the estimation process. The Company's policy is to attempt to collect amounts due from patients, including co-payments and deductibles due from patients with insurance, at the time of service while complying with all federal and state laws and regulations, including, but not limited to, the Emergency Medical Treatment and Labor Act (EMTALA). Generally, as required by EMTALA, patients may not be denied emergency treatment due to inability to pay. Therefore, until the legally required medical screening examination is complete and stabilization of the patient has begun, services are performed prior to the verification of the patient's insurance, if any. In non-emergency circumstances or for elective procedures and services, it is the Hospitals' policy, when appropriate, to verify insurance prior to a patient being treated. During the three months ended March 31, 2006 and 2005, the Company recorded provisions for doubtful accounts of $8,298,928 and $3,141,406, respectively. CASH AND CASH EQUIVALENTS - The Company considers all highly liquid debt investments purchased with a maturity of three months or less to be cash equivalents. 8 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) RESTRICTED CASH - Restricted cash consists of amounts deposited in short term time deposits with a commercial bank to collateralize the Company's obligations pursuant to certain agreements. A certificate of deposit for $4,419,636 is pledged to a commercial bank that issued a standby letter of credit for $4,200,000 in favor of an insurance company that is the administrator of the Company's self-insured workers compensation plan. A certificate of deposit for $552,000 is pledged as a reserve under the Company's capitation agreement with CalOptima. PROPERTY AND EQUIPMENT - Property and equipment are stated at cost, less accumulated depreciation and any impairment write-downs related to assets held and used. Additions and improvements to property and equipment are capitalized at cost. Expenditures for maintenance and repairs are charged to expense as incurred. Capital leases are recorded at the beginning of the lease term as assets and liabilities. The value recorded is the lower of either the present value of the minimum lease payments or the fair value of the asset. Such assets, including improvements, are amortized over the shorter of either the lease term or their estimated useful life. The Company uses the straight-line method of depreciation for buildings and improvements, and equipment over their estimated useful lives of 25 years and 3 to 15 years, respectively. The Company evaluates its long-lived assets for possible impairment whenever circumstances indicate that the carrying amount of the asset, or related group of assets, may not be recoverable from estimated future cash flows. However, there is an evaluation performed at least annually. Fair value estimates are derived from independent appraisals, established market values of comparable assets or internal calculations of estimated future net cash flows. The estimates of future net cash flows are based on assumptions and projections believed by management to be reasonable and supportable. These assumptions take into account patient volumes, changes in payer mix, revenue, and expense growth rates and changes in legislation and other payer payment patterns. The Company believes there has been no impairment in the carrying value of its property and equipment at March 31, 2006. MEDICAL CLAIMS INCURRED BUT NOT REPORTED - The Company is contracted with CalOptima, which is a county sponsored entity that operates similarly to an HMO, to provide health care services to indigent patients at a fixed amount per enrolled member per month. The Company receives payments from CalOptima based on a fixed fee and the number of enrolled members at the Hospitals. The Company recognizes these capitation fees as revenues on a monthly basis for providing comprehensive health care services for the period. In certain circumstances, members will receive health care services from hospitals not owned by the Company. In these cases, the Company records estimates of patient member claims incurred but not reported (IBNR) for services provided by other health care institutions. Claims incurred but not reported are estimated using historical claims patterns, current enrollment trends, hospital pre-authorizations, member utilization patterns, timeliness of claims submissions, and other factors. There can be no assurance that the ultimate liability will not exceed our estimates. Adjustments to the estimated IBNR reserves are recorded in our results of operations in the periods when such amounts are determined. Per guidance under Statement of Financial Accounting Standards ("SFAS") No. 5, "Accounting for Contingencies," the Company accrues for IBNR reserves when it is probable that expected future health care costs and maintenance costs under an existing contract have been incurred and the amount can be reasonably estimable. The Company records these IBNR claim reserves against its net operating revenues. During the three months ended March 31, 2006, the Company recorded net revenues from CalOptima capitation of approximately $1,401,000, net of an increase in IBNR reserves of approximately $547,000, resulting in IBNR reserves of $5,520,000. The Company's direct cost of providing services to patient members in its facilities is recorded as an operating expense. STOCK-BASED COMPENSATION - SFAS No. 123, "Accounting for Stock-Based Compensation," encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has adopted SFAS 123. As of March 31, 2006, the Company had not granted any stock options to employees. 9 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) FAIR VALUE OF FINANCIAL INSTRUMENTS - The Company's financial instruments recorded in the consolidated balance sheets include cash and cash equivalents, restricted cash, receivables, accounts payable, and other liabilities including warrant liability and long term debt. Management believes that the recorded value of such financial instruments is a reasonable estimate of their fair value. To finance the Acquisition, the Company entered into agreements that contained warrants (see Notes 5 and 7), which are required to be accounted for as derivative liabilities in accordance with SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." A derivative is an instrument whose value is derived from an underlying instrument or index such as a future, forward, swap, or option contract, or other financial instrument with similar characteristics, including certain derivative instruments embedded in other contracts ("embedded derivatives") and for hedging activities. As a matter of policy, the Company does not invest in separable financial derivatives or engage in hedging transactions. However, the Company may engage in complex transactions in the future that also may contain embedded derivatives. Derivatives and embedded derivatives, if applicable, are measured at fair value and marked to market through earnings. WARRANTS - In connection with its Acquisition of the Hospitals, the Company entered into complex transactions that contained embedded derivatives in the form of warrants (see Notes 5 and 7). NET LOSS PER COMMON SHARE - Net loss per share is calculated in accordance with SFAS No. 128, "Earnings per Share." Basic net loss per share is based upon the weighted average number of common shares outstanding. Due to the loss from operations incurred by the Company for the three months ended March 31, 2005, the anti-dilutive effect of options and warrants has not been considered in the calculations of loss per share for that period. GOODWILL AND INTANGIBLE ASSETS - In accordance with SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Intangible Assets," acquisitions subsequent to June 30, 2001 must be accounted for using the purchase method of accounting. The cost of intangible assets with indefinite lives and goodwill are no longer amortized, but are subject to an annual impairment test based upon fair value. Goodwill and intangible assets principally result from business acquisitions. The Company accounts for business acquisitions by assigning the purchase price to tangible and intangible assets and liabilities. Assets acquired and liabilities assumed are recorded at their fair values; the excess of the purchase price over the net assets acquired is recorded as goodwill. As of March 31, 2006 no goodwill had been recorded on acquisitions. INCOME TAXES - The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes," which requires the liability approach for the effect of income taxes. Under SFAS 109, deferred income tax assets and liabilities are determined based on the differences between the book and tax basis of assets and liabilities and are measured using the currently enacted tax rates and laws The preparation of consolidated financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect the reported amount of tax-related assets and liabilities and income tax provisions. The Company assesses the recoverability of the deferred tax assets on an ongoing basis. In making this assessment the Company is required to consider all available positive and negative evidence to determine whether, based on such evidence, it is more likely than not that some portion or all of our net deferred assets will be realized in future periods. This assessment requires significant judgment. In addition, the Company has made significant estimates involving current and deferred income taxes, tax attributes relating to the interpretation of various tax laws, historical bases of tax attributes associated with certain tangible and intangible assets and limitations surrounding the realization of our deferred tax assets. As of March 31, 2006 and December 31, 2005, the Company has established a 100% valuation allowance against its deferred tax assets. 10 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) INSURANCE - The Company accrues for estimated general and professional liability claims, to the extent not covered by insurance, when they are probable and reasonably estimable. The Company has purchased as primary coverage a claims-made form insurance policy for general and professional liability risks. The policy limits are $1,000,000 per individual claim and $5,000,000 in the aggregate. For the policy year ended March 8, 2006, retentions by the Company were $500,000 per claim up to a maximum of $3,000,000 for claims covered during that policy year. As of March 8, 2006, those retentions changed to $2,000,000 per claim up to a maximum of $8,000,000 for the policy year. Estimated losses within general and professional liability retentions from claims incurred and reported, along with incurred but not reported (IBNR) claims, are accrued based upon actuarially determined projections and are discounted to their net present value using a weighted average risk-free discount rate of 5%. To the extent that subsequent claims information varies from our estimates, the liability is adjusted in the period such information becomes available. As of March 31, 2006 and December 31, 2005, the Company had accrued approximately $2.9 and $2.3 million, respectively, comprised of approximately $0.6 and $0.6 million, respectively, in incurred and reported claims, along with approximately $2.3 and $1.7 million, respectively, in IBNR and an allowance for potential increases in the costs of those claims incurred and reported. The Company has purchased as primary coverage occurrence form insurance policies to help fund its obligations under its workers' compensation program for which the Company is responsible to reimburse the insurance carrier for losses within a deductible of $500,000 per claim, to a maximum aggregate deductible of $9,000,000. The company accrues for estimated workers' compensation claims, to the extent not covered by insurance, when they are probable and reasonably estimable. The ultimate costs related to this program include expenses for deductible amounts associated with claims incurred and reported in addition to an accrual for the estimated expenses incurred in connection with IBNR claims. Claims are accrued based upon actuarially determined projections and are discounted to their net present value using a weighted average risk-free discount rate of 5%. To the extent that subsequent claims information varies from our estimates, the liability is adjusted in the period such information becomes available. As of March 31, 2006 and December 31, 2005, the Company had accrued approximately $1.7 and $1.3 million, respectively, comprised of approximately $0.4 and $0.3 million, respectively, in incurred and reported claims, along with $1.3 and $1.0 million, respectively, in IBNR. The Company has also purchased all risk umbrella liability policies with aggregate limits of $19,000,000. The umbrella policies provide coverage in excess of the of the primary layer and applicable retentions for all of its insured liability risks, including general and professional liability and the workers' compensation program. SEGMENT REPORTING - The Company operates in one line of business, the provision of health care services through the operation of general hospitals and related health care facilities. Our general hospitals generated substantially all of our net operating revenues during the three months ended March 31, 2006 and 2005. Our four general hospitals and our related health care facilities operate in one geographic region in Orange County, California. This region is our operating segment, as that term is defined by SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." The regions' economic characteristics, the nature of their operations, the regulatory environment in which they operate, and the manner in which they are managed are all similar. In addition, our general hospitals and related health care facilities share certain resources and they benefit from many common clinical and management practices. Accordingly, we aggregate the facilities into a single reportable operating segment. RECENTLY ENACTED ACCOUNTING STANDARDS - In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140." SFAS 155, among other things: permits the fair value re-measurement of any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation and establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. SFAS 155 is effective for all financial instruments acquired or issued in fiscal years beginning after September 15, 2006. The Company is currently evaluating the effect that adopting this statement will have on the Company's financial position and results of operations. 11 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of Financial Assets - an amendment of FASB Statement No. 140," with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS 156 permits the choice of the amortization method or the fair value measurement method, with changes in fair value recorded in income, for the subsequent measurement for each class of separately recognized servicing assets and servicing liabilities. The statement is effective for years beginning after September 15, 2006, with earlier adoption permitted. The Company is currently evaluating the effect that adopting this statement will have on the Company's financial position and results of operations. RECLASSIFICATIONS - Certain reclassifications have been made to the 2005 consolidated financial statements to conform to the 2006 presentation. NOTE 2 - ACQUISITION The purchase price, after all purchase price adjustments, of the Acquisition amounted to $66,246,821. The fair value of the assets acquired and related costs consisted of the following: Property and equipment $55,833,952 Inventories of supplies 6,018,995 Prepaid expenses and other current assets 2,460,874 ----------- 64,313,821 Debt issuance costs 1,933,000 ----------- $66,246,821 =========== The Company financed the Acquisition and related financing costs (see Note 5) by obtaining a $50 million Acquisition Loan, drawing $3 million on a working capital line of credit, selling shares of the Company's common stock for $10.1 Million, and receiving $5 million in proceeds from minority investments in PCHI. The amount of $64,313,821 above includes the Company's initial direct acquisition costs of $1,142,145, consisting primarily of legal fees, which were incurred prior to 2005. NOTE 3 - ACCOUNTS PURCHASE AGREEMENT In March 2005, the Company entered into a two year Accounts Purchase Agreement (the "APA") with Medical Provider Financial Corporation I, an unrelated party (the "Buyer"). The Buyer is an affiliate of the Lender (see Note 5). The APA provides for the sale of 100% of the Company's eligible accounts receivable, as defined, without recourse. After accounts receivable are sold, the APA requires the Company to provide billing and collection services, maintain the individual patient accounts, and resolve any disputes that arise between the Company and the patient or other third party payer. The Company accounts for its sale of accounts receivable in accordance with SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities - A Replacement of FASB Statement 125." The accounts receivable are sold weekly based on billings for each Hospital. The purchase price is comprised of two components, the advance rate amount and the deferred portion amount. The advance rate amount is based on the historical collection experience for accounts receivable similar to those included in a respective purchase. At the time of sale, the Buyer advances 95% of the advance rate amount (the "95% Advance"--note; increased from 85% effective January 1, 2006) to the Company and holds the remaining 5% as security reserve funds on sold accounts (the "Security Reserve Funds"), which is non-interest bearing. Except in the case of a continuing default, the Security Reserve Funds can not exceed 25% (the "25% Cap") of the aggregate advance rate amount, as defined, of the open purchases. The Company is charged a "purchase discount" (the "Transaction Fee") of 1.35% per month of the advance rate amount of each purchase until closed, at which time the Buyer deducts the Transaction Fee from the Security Reserve Funds. Collections are applied on a dollar value basis, not by specific identification, to the respective Hospital's most aged open purchase. The deferred portion amount represents amounts the Company expects to collect, based on regulations, contracts, and historical collection experience, in excess of the advance rate amount. 12 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) The following table reconciles accounts receivable as of March 31, 2006 and December 31, 2005, as reported, to the pro forma accounts receivable, as if the Company had deferred recognition of the sales. March 31, 2006 December 31, 2005 ---------------------------- ---------------------------- As reported Pro forma As reported Pro forma ------------ ------------ ------------ ------------ (as restated (as restated (as restated (as restated - Note 12) - Note 12) - Note 12) - Note 12) Accounts receivable: Governmental $ 5,732,795 $ 19,362,292 $ 10,394,875 $ 23,771,977 Non-governmental 11,602,118 51,808,270 8,728,887 45,564,554 ------------ ------------ ------------ ------------ 17,334,913 71,170,562 19,123,762 69,336,531 Less allowance for doubtful accounts (2,432,084) (15,140,247) (3,148,276) (17,723,163) ------------ ------------ ------------ ------------ Net patient accounts receivable 14,902,829 56,030,315 15,975,486 51,613,368 ------------ ------------ ------------ ------------ Security Reserve Funds 13,021,487 - 12,127,337 - Deferred purchase price receivables 14,354,540 - 9,337,703 - ------------ ------------ ------------ ------------ Receivable from Buyer of accounts 27,376,027 - 21,465,040 - ------------ ------------ ------------ ------------ Advance rate amount, net - (9,028,239) - (10,843,197) Transaction Fees deducted from Security Reserve Funds - (4,723,220) - (3,329,645) ------------ ------------ ------------ ------------ $ 42,278,856 $ 42,278,856 $ 37,440,526 $ 37,440,526 ============ ============ ============ ============
Although 100% of the Company's accounts receivable, as defined, is purchased by the Buyer, certain payments (generally payments that cannot be attributed to specific patient account, such as third party settlements, capitation payments and MediCal Disproportionate Share Hospital ("DSH") subsidies (collectively "Other Payments")) are retained by the Company and not applied to the purchases processed by the Buyer. In the opinion of our management, after consultation with the Buyer, DSH payments and CalOptima capitation premium payments of $0.6 and $5.1 million, respectively, for the three months ended March 31, 2006, are excludable from application to the Security Reserve Funds. However, if cash collections on purchases are not sufficient to recover the Buyer's advance rate amount and related transaction fees, the Buyer could be entitled to funds the Company has received in Other Payments or require transfer of substitute accounts to cover any such shortfall. Based on collection history under the APA to date, the Company's management believes the likelihood of the Buyer exercising this right is remote. Any other term of the APA notwithstanding, the parties agreed as follows: (a) all accounts derived from any government program payer including, without limitation, the Medicare, Medi-Cal, or CHAMPUS programs, shall be handled as set forth in a Deposit Account Security Agreement entered into by the parties, which provides for the segregation and control of governmental payments by the Company, (b) the parties agreed to take such further actions and execute such further agreements as are reasonably necessary to effectuate the purpose of the APA and to comply with the laws, rules, and regulations of the Medicare and other government programs regarding the reassignment of claims and payment of claims to parties other than the provider ("Reassignment Rules"), and (c) until such time as accounts are delivered by the Company to the Buyer controlled lockbox, the Company shall at all times have sole dominion and control over all payments due from any government program payer. The Company's management (i) believes that the foregoing method of segregating and controlling payments received from governmental program payers complies with all applicable Reassignment Rules, and (ii) the Company intends to request an opinion from the Federal Center for Medicare and Medicaid Services ("CMS") that such method is compliant with the Reassignment Rules in the view of CMS. As of March 31,2006 the Company has $13,629,497 in governmental accounts receivable that have been reported as sold subject to the foregoing limitation. The Company records estimated Transaction Fees and estimated servicing costs related to the sold accounts receivable at the time of sale. For the three months ended March 31, 2006, the Company incurred a loss on sale of accounts receivable of $2,807,805, which is reflected in operating expenses in the accompanying consolidated statement of operations, and is comprised of the following. 13 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) Transaction Fees deducted from Security Reserve Funds - closed purchases $ 1,393,575 Increase in accrued Transaction Fees - open purchases 108,208 ------------ Total Transaction Fees incurred 1,501,783 ------------ Servicing costs for sold accounts receivable - closed purchases 1,230,578 Increase in accrued servicing costs for sold accounts receivable - open purchases 75,444 ------------ Total servicing costs incurred 1,306,022 ------------ Loss on sale of accounts receivable for the three months ended March 31, 2006 $ 2,807,805 ============ No accounts receivable were sold as of March 31, 2005.
Effective March 31, 2006, an amendment to the APA reduced the required Security Reserve Funds amount as a percentage of the total advance rate amount outstanding from 25% to 15% (the "15% Cap"). At March 31, 2006, the Security Reserve Funds balance of $13,021,487 was in excess of the 15% Cap. As a result, $6,677,916 was released to the Company subsequent to March 31, 2006. NOTE 4 - PROPERTY AND EQUIPMENT Property and equipment consists of the following: March 31, December 31, 2006 2005 ------------ ------------ Buildings $ 33,696,897 $ 33,696,897 Land and improvements 13,522,591 13,522,591 Equipment 9,318,403 9,241,044 Buildings under lease 5,108,887 5,108,887 ------------ ------------ 61,646,778 61,569,419 Less accumulated depreciation (2,785,921) (2,138,134) ------------ ------------ Property and equipment, net $ 58,860,857 $ 59,431,285 ============ ============ The Hospitals are affected by State of California Senate Bill 1953 (SB 1953), which requires certain seismic safety building standards for acute care hospital facilities. The Company is currently reviewing the SB 1953 compliance requirements and developing multiple plans of action to achieve such compliance, the estimated time frame for complying with such requirements, and the cost of performing necessary remediation of certain of the properties. The Company cannot currently estimate with reasonable accuracy the remediation costs that will need to be incurred in order to make the Hospitals SB 1953-compliant, but such remediation costs could be significant. NOTE 5 - DEBT The Company's debt consists of the following: March 31, December 31, 2006 2005 ------------ ------------ Short term debt: ---------------- Secured note payable $ 10,700,000 $ 10,700,000 Less derivative - warrant liability, current (see Note 7) (10,700,000) (10,700,000) Secured acquisition loan 45,000,000 - Secured line of credit, outstanding borrowings 25,330,734 - ------------ ------------ Short term debt $ 70,330,734 $ - ============ ============ Long term debt: --------------- Secured acquisition loan $ - $ 45,000,000 Secured line of credit, outstanding borrowings - 25,330,734 ------------ ------------ Long term debt $ - $ 70,330,734 ============ ============
14 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) ACQUISITION LOAN AND LINE OF CREDIT - In connection with the Acquisition, the Company obtained borrowings from affiliates of Medical Capital Corporation. Effective March 3, 2005, the Company and its subsidiaries collectively entered into a credit agreement (the "Credit Agreement") with Medical Provider Financial Corporation II ("the Lender"), whereby the Company obtained initial financing in the form of a loan with interest at the rate of 14% per annum in the amount of $80,000,000 of which $30,000,000 is in the form of a non-revolving Line of Credit and a $50,000,000 Acquisition Loan (less $5,000,000 repayment on December 12, 2005) in the form of a real estate loan (collectively, the "Obligations"). The Company used the proceeds from the $50 million Acquisition Loan and $3 million from the Line of Credit to complete the Acquisition (see Note 1). The Line of Credit is to be used for the purpose of providing (a) working capital financing for the Company and its subsidiaries, (b) funds for other general corporate purposes of the Company and its subsidiaries, and (c) other permitted purposes. Effective January 1, 2006, the Company and the Lender agreed to an amendment to the Obligations that changed the interest rate from 14% to prime plus 5.75%. Interest payments are due on the Obligations on the first business day of each calendar month while any Obligation is outstanding. The Obligations mature at the first to occur of (i) the Commitment Termination Date for the Line of Credit; (ii) March 2, 2007; or (iii) the occurrence or existence of a continuing Event of Default under any of the Obligations. The Commitment Termination Date means the earliest of (a) thirty calendar days prior to March 2, 2007; (b) the date of termination of Lender's obligations to make Advances under the Line of Credit or permit existing Obligations to remain outstanding, (c) the date of prepayment in full by the Company and its subsidiaries of the Obligations and the permanent reduction of all commitments to zero dollars; or (d) March 2, 2007. Per the Credit Agreement, all future capital contributions to the Company by Orange County Physicians Investment Network, LLC ("OC-PIN") shall be used by the Company as mandatory prepayments of the Line of Credit. The Acquisition Loan and Line of Credit are secured by a lien on substantially all of the assets of the Company and its subsidiaries, including without limitation, a pledge of the capital stock by the Company in its wholly owned Hospitals. In addition, (i) PCHI has agreed to guaranty the payment and performance of the Obligations, (ii) West Coast and Ganesha have each agreed to pledge their membership interests in PCHI as security for repayment of the Obligations, (iii) the members of West Coast have agreed to pledge their membership interests in PCHI as security for repayment of the Obligations, and (iv) OC-PIN (see Note 8) has agreed to guaranty the payment and performance of all the Obligations. CREDIT AGREEMENT FEES - Concurrently with the execution and delivery of the Credit Agreement and as a condition to the funding of the Acquisition Loan, the Company and its subsidiaries agreed to pay to the Lender origination fees in amounts equal to 2% of the Credit Line, or $600,000, and 2% of the Acquisition Loan, or $1,000,000, Such fees were required to be paid out of the Company and its subsidiaries own funds were deemed earned in full upon receipt by the Lender. Upon the completion of the Acquisition on March 8, 2005, the Company paid the Lender a total of $1,600,000 in origination fees and paid the Lender's legal fees of approximately $333,000. The Company is amortizing the debt issuance costs of $1,933,000 over the two year term of the Obligations. During the three months ended March 31, 2006 and 2005, the Company recognized $241,626 and $62,355, respectively, of amortization expense and has unamortized debt issuance costs of $899,639 and $1,141,265 as of March 31, 2006 and December 31, 2005, respectively. DEFAULT NOTICE - On or about May 9, 2005, the Company received a notice of default from the Lender in connection with the Credit Agreement. In addition, each of OC-PIN, PCHI, Ganesha Realty, LLC, and West Coast Holdings, LLC, which are parties to the Credit Agreement, received a notice of default. The notice of default asserted that (i) the Company failed to provide satisfactory evidence that the Company received capital contributions of not less than $15,000,000, as required under the Credit Agreement, (ii) the Company failed to prepay $5,000,000 by the Mandatory Prepay Date as required under the Credit Agreement, and (iii) a Material Adverse Effect had occurred under the Credit Agreement for reasons relating primarily to OC-PIN's failure to fully fund its obligations under its Stock Purchase Agreement with the Company. 15 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) FORBEARANCE AGREEMENT - In connection with the First Amendment (see Note 6), the Company entered into an Agreement to Forbear as of June 1, 2005 by and among the Company, OC-PIN, West Coast Holdings, LLC and the Lender (the "Forbearance Agreement"). Without another default, the Lender agreed for 100 days to forbear from (i) recording Notices of Default, (ii) filing a judicial foreclosure lawsuit against the Company, OC-PIN and West Coast Holdings, LLC, and (iii) filing lawsuits against the Company, OC-PIN and West Coast Holdings, LLC. The interest rate on the notes was increased to the Default Rate of 19%, as defined in the Credit Agreement, and all Obligations (as defined in the Credit Agreement) were due and payable, as long as the events of default remain uncured. The Company's Line of Credit facility was suspended to additional advances. During the forbearance period of 100 days, OC-PIN and other investors agreed to invest not less than $15 million in new equity capital in the Company (see Note 6). SECURED SHORT TERM NOTE - On December 12, 2005, the Company entered into a credit agreement (the "December Credit Agreement") with the Credit Parties and the Lender. Under the December Credit Agreement, the Lender loaned $10,700,000 to the Company as evidenced by a promissory note (the "December Note"). Interest is payable monthly at the rate of 12% per annum and the December Note is due on December 12, 2006. The Company may not prepay the December Note in whole or in part. The December Note is secured by substantially all of the Company's assets. In addition, the Company issued a common stock warrant (the "December Note Warrant") to the Lender as collateral under the December Note. The December Note Warrant is exercisable by the Lender only in the event that a default has occurred and is continuing on the December Note. The December Note Warrant entitles the Lender to purchase the number of shares of the Company's common stock equal in value to the amount of the December Note not repaid at maturity, plus accrued interest and lender fees for an aggregate exercise price of $1.00, regardless of the number of shares acquired. The December Credit Agreement provides that "upon payment in full of the obligations, surplus net proceeds, if any, thereafter remaining shall be paid to the Borrower, subject to the rights of any holder of a Lien on the Collateral of which the Lender or Holder has actual notice." The December Note Warrant is exercisable from and after December 12, 2005 until the occurrence of either a termination of the December Credit Agreement by the Lender or the Company's payment in full of all obligations under the December Credit Agreement. The Company is obligated to register the estimated number of shares of common stock issuable upon exercise of the December Note Warrant by filing a registration statement under the Securities Act of 1933, as amended (the "Securities Act"), no later than ninety days prior to the maturity date of the December Note. If the Company proposes to file a registration statement under the Securities Act on or before the expiration date of the December Note Warrant, then the Company must offer to the holder of the December Note Warrant the opportunity to include the number of shares of common stock as the holder may request. In accordance with U.S. GAAP, the Company has classified the December Note as current warrant liability in the accompanying consolidated balance sheets as of March 31, 2006 and December 31, 2005 (see Note 7). CURE OF DEFAULT - On December 12, 2005, the Company entered into Amendment No. 1 to the December Credit Agreement (the "Amendment"), that amends the Credit Agreement with PCHI, OC-PIN, Ganesha Realty, LLC, West Coast Holdings, LLC (the "Credit Parties") and the Lender. The Amendment (i) declared cured those certain events of default set forth in the notices of default received on or about May 9, 2005, from the Lender, (ii) required the Company to pay $5,000,000 to Lender for mandatory prepayment required under the Credit Agreement, (iii) required the Company to obtain $10,700,000 in additional new capital contributions to pay in full and retire all amounts due and owing under the December Note evidenced by the December Credit Agreement and (iv) includes certain indemnities and releases in favor of the Lender. WAIVER OF DEFAULT - The Company is currently in default of its obligation under its loan and security agreements to timely file financial reports with the Securities and Exchange Commission. The lender has been notified of the condition of default and has conditionally waived its right to accelerate repayment of the debt subject to filing of Form 10-K for the year ended December 31, 2005 (which was filed with the SEC on July 28, 2006) and filing of this Form 10-Q for the quarter ended March 31, 2006 no later than August 10, 2006. 16 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) NOTE 6 - COMMON STOCK STOCK PURCHASE AGREEMENT - On January 28, 2005, the Company entered into a Stock Purchase Agreement (the "Stock Purchase Agreement") with OC-PIN, a company founded by Dr. Anil V. Shah, the Company's chairman, and owned by a number of physicians practicing at the acquired Hospitals, pursuant to which OC-PIN committed to invest $30,000,000 in the Company for an aggregate of 108,000,000 shares of the Company's common stock. In addition, a prior Purchase Option Agreement, dated November 16, 2004, between the Company and Dr. Shah, was terminated. In 2005, the Company issued a total of 61,973,316 shares of its common stock in consideration of $14.4 million from OC-PIN under the Stock Purchase Agreement. The Company used the proceeds from this stock sale as part of the consideration paid to Tenet for the Acquisition. Under the Stock Purchase Agreement, no later than nine calendar days before the closing of the Acquisition, OC-PIN was to deliver to the Company additional financing totaling $20,000,000. Upon receipt of the $20,000,000, the Company was to issue an additional 5.4 million shares of its common stock to OC-PIN. However, OC-PIN was unable to raise the additional financing in time for the closing of the Acquisition and OC-PIN indicated that it disagreed with the Company's interpretation of OC-PIN's obligations under the Stock Purchase Agreement. In order to avoid litigation, the Company agreed to extend OC-PIN's additional $20,000,000 financing commitment, and on June 16, 2005 the Company entered into the following new agreements with OC-PIN: First Amendment to the Stock Purchase Agreement, dated as of June 1, 2005 (the "First Amendment"); and Escrow Agreement, dated as of June 1, 2005, by and among the Company, OC-PIN and City National Bank (the "Escrow Agreement"). The following material terms were contained in the First Amendment and the Escrow Agreement: OC-PIN's total stock purchase commitment under the Stock Purchase Agreement was reduced from $30 million to $25 million; A total of 57,250,000 shares of the Company's common stock previously issued to OC-PIN were placed in an escrow account with City National Bank in July 2005. OC-PIN had until September 1, 2005 to make monthly installments into the escrow account up to an aggregate of approximately $15,000,000. Such portion of the escrowed shares which were fully paid was to be returned to OC-PIN and the balance was to be transferred back to the Company; OC-PIN agreed to reimburse the Company for $707,868 of its additional debt financing costs incurred since March 8, 2005. As of March 31, 2006, $340,000 of these costs had been recovered by the Company; The Company would work to complete a new borrowing transaction; and Upon receipt of at least $5,000,000 of new capital under the First Amendment, the Company would call a shareholders meeting to re-elect directors. Under the First Amendment and the Escrow Agreement, OC-PIN deposited a total of $12,500,000 into the escrow account. However, following receipt of such funds, a disagreement arose between OC-PIN and the third party which provided $11,000,000 of the $12,500,000 deposited into the escrow account. In order to resolve this matter and to avoid potential litigation involving the Company, the Company agreed to return $11,000,000 of these funds and provide OC-PIN with a limited opportunity to provide alternative financing. Therefore, effective October 31, 2005, the Company entered into a Second Amendment to the Stock Purchase Agreement (the "Second Amendment"), pursuant to which the Company and OC-PIN issued escrow instructions to release escrowed funds as of November 2, 2005, terminate the Escrow Agreement and distribute the assets in the escrow account as follows: 1. $1,500,000 of the escrowed cash, plus a pro rata portion of the accrued interest, was delivered to the Company for payment of stock. 2. $11,000,000 of the escrowed cash, plus a pro rata portion of the accrued interest was delivered to OC-PIN. 3. $5,798,831 of the escrowed shares of the Company's common stock were delivered to OC-PIN. 17 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) 4. 40,626,684 of the escrowed shares of the Company's common stock were delivered to the Company. 5. OC-PIN transferred $2,800,000 from another account to the Company for which OC-PIN received 10,824,485 of the escrowed shares. 6. The Company agreed to issue to OC-PIN 5,400,000 shares of its common stock multiplied by the percentage of OC-PIN's payment required to be made under the Stock Purchase Agreement, as amended, which had been made to date. As of March 31, 2006, 3,246,201 of these shares were not issued pending the Company's recovery of $367,868 in additional debt financing costs pursuant to the First Amendment. The Company resolved this matter with OC-PIN on July 25, 2006. 7. The Company granted OC-PIN the right to purchase up to $6,700,000 of common stock within 30 calendar days following the cure of the Company's default relating to the Credit Agreement at a price of $0.2586728 per share or a maximum of 25,901,447 shares of its common stock, plus interest on the purchase price at 14% per annum from September 12, 2005 through the date of closing on the funds from OC-PIN. Upon one or more closings on funds received under this section of the Second Amendment, the Company shall issue an additional portion of the 5,400,000 shares mentioned in item (6) above. As of March 31, 2006, the Company had issued 418,873 of these shares to OC-PIN. NOTE 7 - COMMON STOCK WARRANTS The Company entered into a Rescission, Restructuring and Assignment Agreement with Dr. Kali Chaudhuri and Mr. William Thomas on January 27, 2005 (the "Restructuring Agreement"). Previously, the Company had obtained financing from Dr. Chaudhuri and Mr. Thomas and had issued to them a $500,000 secured convertible promissory note that was convertible into approximately 88.8% of the Company's issued and outstanding common stock on a fully-diluted basis, a $10 million secured promissory note, and a Real Estate Purchase Option agreement originally dated September 28, 2004 to purchase 100% of substantially all of the real property in the Acquisition for $5 million (the "Real Estate Option"), all of which together with related accrued interest payable pursuant to the terms of the notes were rescinded and cancelled. Pursuant to the Restructuring Agreement, the Company released its initial deposit of $10 million plus accrued interest on the Acquisition back to Dr. Chaudhuri and issued non-convertible secured promissory notes totaling $1,264,014 and warrants to purchase up to 74,700,000 shares of the Company's common stock (the "Warrants") to Dr. Chaudhuri and Mr. Thomas (not to exceed 24.9% of the Company's fully diluted capital stock at the time of exercise). In addition, the Company amended the Real Estate Option to provide for Dr. Chaudhuri's purchase of 49% interest in PCHI for $2,450,000. Concurrent with the close of the Acquisition, the Company repaid the non-convertible secured promissory notes of $1,264,014 to Dr. Chaudhuri and Mr. Thomas. The Warrants are exercisable beginning January 27, 2007 and expire in 3.5 years from the date of issuance. The exercise price for the first 43 million shares purchased under the Warrants is $0.003125 per share, and the exercise or purchase price for the remaining 31.7 million shares is $0.078 per share if exercised between January 27, 2007 and July 26, 2007, $0.11 per share if exercised between July 27, 2007 and January 26, 2008, and $0.15 per share thereafter. As a result of the Company not being able to determine the maximum number of shares that could be required to be issued under the December Note Warrant issued on December 12, 2005 (see Note 5), the Company has determined that share settlement of the Warrants issued on January 27, 2005 is no longer within its control and reclassified the Warrants as a liability on December 12, 2005 in accordance with EITF No. 00-19 "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock" and SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities." 18 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) Based upon a valuation obtained by the Company from an independent valuation firm, the Company recorded an expense of $17,215,000 for the three months ended March 31, 2005 related to the issuance of the Warrants. For the three months ended March 31, 2006, the Company recognized a gain of $8,218,019 in change in fair value of derivative. The related warrant liability as of March 31, 2006 and December 31, 2005 is $12,846,650 and $21,064,669, respectively. The Company computed the expense of the Warrants based on the fair value of the underlying shares and the estimated maximum number of shares of 43,254,715 that could be issued under the Warrants. As of December 12, 2005, there was a substantial reduction in the shares outstanding to 83,932,316 shares as a result of the Company's settlement with OC-PIN. However, the requirement to repay the December Note for $10.7 million may obligate the Company to issue new shares of its common stock prior to the expected exercise of the Warrants and the estimated maximum number of shares exercisable of 43,254,715 accordingly remains unchanged. The Company computed the fair value of the Warrants based on the Black-Scholes option pricing model with the following assumptions: March 31, 2006 December 31, 2005 -------------- ----------------- Risk-free interest rate 4.8% 4.4% Expected volatility 27.9% 28.6% Dividend yield -- -- Expected life (years) 2.32 2.57 Fair value of Warrants $0.297 $0.487 Market value per share $0.30 $0.49 Management believes that the likelihood of the December Note Warrant being exercised is reasonably possible and, in accordance with EITF No. 00-19 and SFAS 133, has included the December Note value of $10.7 million in warrant liability, current, in the accompanying consolidated balance sheets as of March 31, 2006 and December 31, 2005. Under the terms of the December Credit Agreement, any proceeds from the sale of stock received under the December Note Warrant that are in excess of the December Note and related issuance costs are to be returned to the Company. Accordingly, the fair value of the December Note Warrant would contractually continue to be $10.7 million (plus any issuance and exercise costs, which are considered immaterial). The Company computed the fair value, and related number of shares, of the December Note Warrant based on the Black-Scholes option pricing model with the following assumptions: March 31, 2006 December 31, 2005 -------------- ----------------- Risk-free interest rate 4.4% 4.4% Expected volatility 23.8% 23.9% Dividend yield -- -- Expected life (years) .70 .95 Fair value of Warrants $0.300 $0.490 Number of shares 35,666,667 21,836,735 Due to the fact that the Company emerged from the development stage in 2005, the Company computed the volatility of its stock based on an average of the following public companies that own hospitals: Amsurg Inc (AMSG) Community Health Systems (CYH) HCA Healthcare Company (HCA) Health Management Associates Inc. (HMA) Lifepoint Hospitals Inc. (LPNT) Tenet Healthcare Corp. (THC) Triad Hospitals Inc. (TRI) Universal Health Services Inc., Class B (UHS) Although management believes this is the most reasonable and accurate methodology to determine the Company's volatility, the circumstances affecting volatility of the comparable companies selected may not be an accurate predictor of the Company's volatility. 19 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) NOTE 8 - VARIABLE INTEREST ENTITY Concurrent with the close on the Acquisition, and pursuant to an agreement dated September 28, 2004, as amended and restated on November 16, 2004, Dr. Chaudhuri and Dr. Shah exercised their option to purchase all of the equity interests in PCHI, which simultaneously acquired title to substantially all of the real property acquired by the Company in the Acquisition. The Company received $5 million and PCHI guaranteed the Company's Acquisition Loan. The Company remains primarily liable under the Acquisition Loan note notwithstanding its guarantee by PCHI, and this note is cross-collateralized by substantially all of the Company's assets and all of the real property of the Hospitals. All of the Company's operating activities are directly affected by the real property that was sold to PCHI. Given these factors, the Company has indirectly guaranteed the indebtedness of PCHI. The Company is standing ready to perform on the Acquisition Loan should PCHI not be able to perform and has undertaken a contingent obligation to make future payments if those triggering events or conditions occur. PCHI is a related party entity that is affiliated with the Company through common ownership and control. It is owned 51% by West Coast Holdings, LLC (Dr. Shah and investors) and 49% by Ganesha Realty, LLC (Dr. Chaudhuri and Mr. Thomas). Under FIN 46R (see Note 1) a company is required to consolidate the financial statements of any entity that cannot finance its activities without additional subordinated financial support, and for which one company provides the majority of that support through means other than ownership. Effective March 8, 2005, the Company determined that it provided the majority of financial support to PCHI through various sources including lease payments, remaining primarily liable under the Acquisition Loan, and cross-collateralization of the Company's non-real estate assets to secure the Acquisition Loan. Accordingly, the Company has included the net assets of PCHI, net of consolidation adjustments, in its consolidated financial statements. Consolidation adjustments to reflect the effects of the following matters are included in the accompanying consolidated financial statements as of March 31, 2006 and December 31, 2005, and for the three months ended March 31, 2006 and 2005: The Company's rental income and expense in the Hospitals has been eliminated, consolidating PCHI's ownership of the land and buildings in the accompanying financial statements. Additionally, a gain of $4,433,374 during the year ended December 31, 2005, arising from the Company's sale of the real property of the Hospitals to PCHI, has been eliminated to state the land and buildings at the Company's cost. PCHI's equity accounts have been classified as minority interest variable interest entity. The Company has a 25 year lease commitment to PCHI with rental payments equal to the following components: (1) Interest expense on the Acquisition Loan, or successor upon refinancing, and (2) Up to 2.5% spread if interest rate is below 12%, and (3) Amortization of principal on successor loan. Concurrent with the close of the Acquisition, the Company entered into a sale-leaseback transaction with PCHI involving substantially all of the real property acquired in the Acquisition, except for the fee interest in the medical office building at 2617 East Chapman Avenue, for an initial term of 25 years and option to renew for an additional 25 years. The rental payments are variable based primarily on the terms of financing. Based on the existing arrangements, aggregate payments are estimated to be approximately $226 million over the remainder of the initial term. Additionally, the tenant is responsible for seismic remediation (SB 1953) under the terms of the lease agreement. Subsequent to execution of the lease, the Company was required to pay down $5 million on the Acquisition Loan. The Company is evaluating the impact this has, if any, on the foregoing terms. 20 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) NOTE 9 - RELATED PARTY TRANSACTIONS PCHI - The Company leases substantially all of the real property of the acquired Tenet Hospitals from PCHI. PCHI is owned by two LLC's, which are owned and co-managed by Dr. Shah, Dr. Chaudhuri, and Mr. Thomas. Dr. Shah is the chairman of the Company and is also the co-manager and an investor in OC-PIN, which is the majority shareholder of the Company. Dr. Chaudhuri and Mr. Thomas are the holders of the Warrants to purchase up to 24.9% of the Company's fully diluted capital stock (see Note 7). The Company has consolidated the financial statements of PCHI in the accompanying financial statements in accordance with FIN 46R (see Note 8). During the three months ended March 31, 2006 and 2005, the Company incurred rent expense paid to PCHI of $1,545,156 and $523,000, respectively, which was eliminated upon consolidation. MANAGEMENT AGREEMENTS - In December 2004, February 2005, and March 2005, the Company entered into seven employment agreements with its executive officers. Four of these agreements were amended on August 5, 2006. Among other terms, the three year, amended employment agreements provide for annual salaries aggregating $2,790,000, total stock option grants to purchase 3,650,000 shares of the Company's common stock at an exercise price equal to the mean average per share for the ten days following the date of issuance with vesting at 33% per year, and an annual bonus to be determined by the Board of Directors. As of March 31, 2006, the Company has not issued any stock options pursuant to the employment agreements. NOTE 10 - EARNINGS (LOSS) PER SHARE Earnings (loss) per share have been calculated under SFAS No. 128, "Earnings per Share." SFAS 128 requires companies to compute earnings (loss) per share under two different methods, basic and diluted. Basic earnings (loss) per share is calculated by dividing the net earnings (loss) by the weighted average shares of common stock outstanding during the period. Diluted earnings (loss) per share is calculated by dividing the net earnings (loss) by the weighted average shares of common stock outstanding during the period and dilutive potential shares of common stock. Dilutive potential shares of common stock, as determined under the treasury stock method, consist of shares of common stock issuable upon exercise of stock warrants or options, net of shares of common stock assumed to be repurchased by the Company from the exercise proceeds. Since the Company incurred losses for the three months ended March 31, 2005, antidilutive potential shares of common stock, consisting of approximately 40 million shares, issuable under warrants, have been excluded from the calculation of diluted loss per share for that period in the following table. The following table sets forth the computation of basic and diluted earnings (loss) per share: Three months ended March 31, --------------------------- 2006 2005 ------------ ------------ (as restated) Numerator: Net income (loss) $ 2,535,477 $(19,856,619) ============ ============ Denominator: Weighted average common shares 84,281,377 88,493,611 Warrants 42,946,229 - ------------ ------------ Denominator for diluted calculation 127,227,606 88,493,611 ============ ============ Earnings (loss) per share - basic $ 0.03 $ (0.22) Earnings (loss) per share - diluted $ 0.02 $ (0.22) NOTE 11 - COMMITMENTS AND CONTINGENCIES OPERATING LEASES - Concurrent with the closing of the Acquisition as of March 8, 2005, the Company entered into a sale leaseback type agreement with a related party entity, PCHI. The Company leases substantially all of the real estate of the acquired Hospitals and medical office buildings from PCHI. The term of the lease for the Hospital is approximately 25 years, commencing March 8, 2005 and terminating on February 28, 2030. The Company has the option to extend the term of this triple net lease for an additional term of 25 years. 21 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) As noted in Note 8, PCHI is included in the Company's consolidated financial statements. Accordingly, the Company's liability related to its lease commitment with PCHI is eliminated in consolidation. Additionally, in connection with the Hospital Acquisition, the Company also assumed the leases for the Chapman facility, which include buildings, land, and other equipment with terms that were extended concurrently with the assignment of the leases to December 31, 2023. The following is a schedule of the Company's future minimum operating lease payments, excluding the triple net lease with PCHI, that have initial or remaining non-cancelable lease terms in excess of one year as of December 31, 2005: Year ending December 31, ------------------------ 2006 $ 2,114,106 2007 1,761,247 2008 1,233,130 2009 909,600 2010 909,600 Thereafter 16,589,772 ------------ $ 23,517,457 ============ Total rental expense was $454,724 and $130,509 for the three months ended March 31, 2006 and 2005, respectively. CAPITAL LEASES - The Company has a long-term lease obligation for the buildings at the Chapman facility. For financial reporting purposes, the lease has been classified as a capital lease; accordingly, assets with a net book value of $4,818,632 and $4,886,503 are included in property and equipment in the accompanying consolidated balance sheets as of March 31, 2006 and December 31, 2005, respectively. The following is a schedule of future minimum lease payments under the capitalized building lease together with the present value of the net minimum lease payments as of December 31, 2005: Year ending December 31, ------------------------ 2006 $ 686,292 2007 686,292 2008 686,292 2009 686,292 2010 686,292 Thereafter 8,921,796 ----------- Total minimum lease payments 12,353,256 Less amount representing interest 7,306,703 ----------- Present value of net minimum lease payments 5,046,553 Less current portion 85,296 ----------- Long-term portion $ 4,961,257 =========== AGREEMENT FOR COMPENSATION - In connection with the close of the Acquisition, the Company entered into an Agreement for Compensation Related to the 999 Medical Office Building (the "Compensation Agreement") with PCHI, a related party (see Note 9). In the amended Asset Sale Agreement with Tenet, certain medical office condominium units (the "Condo Units") were excluded from the Company's Hospital Acquisition due to the tenants of the Condo Units having the right of first refusal to purchase such real property. As a result, the Company's purchase price of the Hospitals from Tenet was reduced by $5 million. Pursuant to the amended Asset Sale Agreement, upon the expiration of the tenants' rights of first refusal, Tenet will transfer title to the Condo Units to the Company in exchange for consideration of $5 million, pro rated if less than all of the Condo Units are transferred. 22 INTEGRATED HEALTHCARE HOLDINGS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2006 (UNAUDITED) Pursuant to the Compensation Agreement, the Company shall acquire title to the Condo Units upon expiration of the tenants' rights of first refusal and then transfer such title to the Condo Units to PCHI. In the event of the Company's failure to obtain title to the Condo Units, the Company shall pay to PCHI a sum to be agreed upon between the Company, PCHI, and the owners of PCHI, but not less than the product of $2,500,000 multiplied by a fraction, the numerator of which shall be the number of Condo Units not acquired by the Company and transferred to PCHI, and the denominator equal to the total Condo Units of twenty-two. The tenants are currently in litigation with Tenet related to the purchase price of the Condo Units offered by Tenet to the tenants. As the financial statements of the related party entity, PCHI, a variable interest entity (see Note 8), are included in the Company's accompanying consolidated financial statements, management has determined that any future payment to PCHI under the Compensation Agreement would reduce the Company's gain on sale of assets to PCHI (see Note 8). CLAIMS AND LAWSUITS - The Company and the Hospitals are subject to various legal proceedings, most of which relate to routine matters incidental to our business. The results of these claims cannot be predicted, and it is possible that the ultimate resolution of these matters, individually or in the aggregate, may have a material adverse effect on the Company's business (both in the near and long term), financial position, results of operations, or cash flows. Although the Company defends itself vigorously against claims and lawsuits and cooperates with investigations, these matters (1) could require payment of substantial damages or amounts in judgments or settlements, which individually or in the aggregate could exceed amounts, if any, that may be recovered under insurance policies where coverage applies and is available, (2) cause substantial expenses to be incurred, (3) require significant time and attention from the Company's management, and (4) could cause the Company to close or sell the Hospitals or otherwise modify the way its business is conducted. The Company accrues for claims and lawsuits when an unfavorable outcome is probable and the amount is reasonably estimable. NOTE 12 - RESTATEMENT OF CONDENSED CONSOLIDATED FINANCIAL STATEMENTS During October 2006, the Company's management determined that the Company's unaudited condensed consolidated quarterly financial statements for the periods ended March 31, 2006 and June 30, 2006, should be restated due to an error in the overstatement of net revenues and accounts receivable. More specifically, the Company determined that the restatements with respect to its financial statements for these periods were necessary to write-off patient accounts receivable for services provided under capitated Cal Optima managed care contracts. The correction of errors resulted in a decrease in net operating revenues, income before minority interest and provision for income taxes and net income of $322,887 for the three months ended March 31, 2006 and a decrease in accounts receivable and an increase in accumulated deficit and stockholders' deficiency of $939,678 as of March 31, 2006. The following table sets for the amounts as originally reported in the Company's condensed consolidated balance sheet as of March 31, 2006, and the condensed consolidated statements of operations for the three months ended March 31, 2006 and the effects of the correction of the error as described above: As of March 31, 2006 ---------------------------- As previously reported As restated ------------ ------------ Balance Sheet: Accounts receivable $ 15,842,507 $ 14,902,829 Total assets 133,823,391 132,883,713 Accumulated deficit (43,798,361) (44,738,039) Total stockholders' deficiency (27,456,327) (28,396,005) Three months ended March 31, 2006 ---------------------------- As previously reported As restated ------------ ------------ Statement of Operations: Net operating revenues $ 86,486,861 $ 86,163,974 Operating loss (2,765,337) (3,088,224) Income (loss) before minority interest and provision for income taxes 2,758,268 2,435,381 Net income (loss) 2,858,364 2,535,477 23 The Company has determined that $616,791 of the $939,678 overstatement of accounts receivable and understatement of accumulated deficit and stockholders' deficiency as of March 31, 2006 related to errors that existed as of December 31, 2005. The overstatement of accounts receivable, net operating revenues, income before minority interest and provision for income taxes and net income and understatement of accumulated deficit and stockholders' deficiency by $616,791 was determined by management to be immaterial to the financial statements as of and for the year ended December 31, 2005 in accordance with Staff Accounting Bulletin No. 108 ("SAB 108"). However, in accordance with the dual approach outlined in SAB 108 management has determined that the impact of the $616,791 error is material to the unaudited condensed consolidated quarterly financial statements financial statements as of and for the three months ended March 31, 2006. Based on management's evaluation of the errors, SAB 108 requires the Company to correct the 2005 financial statements for the immaterial error and make such correction to the financial statements in the filing of the next annual report on Form 10-K. The following table sets forth the amounts as originally reported in the condensed consolidated balance sheet as of December 31, 2005 filed as part of Form 10-Q for the three months ended March 31, 2006, and the effects of the correction of the error as described above: As of December 31, 2005 ---------------------------- As previously reported As restated ------------ ------------ Balance Sheet: Accounts receivable $ 16,592,277 $ 15,975,486 Total assets 135,045,980 134,429,189 Accumulated deficit (46,656,725) (47,273,516) Total stockholders' deficiency (30,446,823) (31,063,614) 24 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. FORWARD-LOOKING INFORMATION This Quarterly Report on Form 10-Q contains forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "potential" or "continue" or the negative of these terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including the risks discussed under the caption "Risk Factors" in our Annual Report on Form 10-K filed on July 28, 2006 that may cause our Company's or our industry's actual results, levels of activity, performance or achievements to be materially different from those expressed or implied by these forward-looking statements. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Except as may be required by applicable law, we do not intend to update any of the forward-looking statements to conform these statements to actual results. As used in this report, the terms "we," "us," "our," "the Company," "Integrated Healthcare Holdings" or "IHHI" mean Integrated Healthcare Holdings, Inc., a Nevada corporation, unless otherwise indicated. OVERVIEW ACQUISITION - Prior to March 8, 2005, we were primarily a development stage company with no material operations and no revenues from operations. On September 29, 2004, the Company entered into a definitive agreement to acquire four hospitals from subsidiaries of Tenet Healthcare Corporation ("Tenet"), and completed the transaction on March 8, 2005 (the "Acquisition"). Effective March 8, 2005, we acquired and began operating the following four hospital facilities in Orange County, California (referred to in this report as our "Hospitals"): o 282-bed Western Medical Center in Santa Ana; o 188-bed Western Medical Center in Anaheim; o 178-bed Coastal Communities Hospital in Santa Ana; and o 114-bed Chapman Medical Center in Orange. We enter into agreements with third-party payers, including government programs and managed care health plans, under which rates are based upon established charges, the cost of providing services, predetermined rates per diagnosis, fixed per diem rates or discounts from established charges. During the 24 days ended March 31, 2005, substantially all of Tenet's negotiated rate agreements were assigned to our Hospitals. Our own Medicare provider numbers were received in April 2005. California State Medicaid Program provider numbers were received in June 2005. ACQUISITION DEBT - Effective March 3, 2005, in connection with the Acquisition, the Company and its subsidiaries collectively entered into a credit agreement (the "Credit Agreement") with Medical Provider Financial Corporation II ("the Lender"), whereby the Company obtained initial financing in the form of a loan with interest at the rate of 14% per annum in the amount of $80,000,000 of which $30,000,000 is in the form of a non-revolving Line of Credit and $50,000,000 (less $5,000,000 repayment on December 12, 2005) is in the form of an Acquisition Loan (collectively, the "Obligations"). The Company used the proceeds from the $50 million Acquisition Loan and $3 million from the Line of Credit to complete the Acquisition. The Acquisition Loan and Line of Credit are secured by a lien on substantially all of the assets of the Company and its subsidiaries, including without limitation, a pledge of the capital stock by the Company in its wholly owned Hospitals. LONG TERM LEASE COMMITMENT WITH VARIABLE INTEREST ENTITY - Concurrent with the close on the Acquisition, the Company sold substantially all of the real property acquired in the Acquisition to Pacific Coast Holdings Investment, LLC ("PCHI"). The Company sold $5 million in limited partnership interests to finance the Acquisition and PCHI guaranteed the Company's Acquisition Loan. PCHI is a related party entity that is affiliated with the Company through common ownership and control. Upon such sale, the Company entered into a 25 year lease agreement with PCHI involving substantially all of the real property acquired in the Acquisition. In accordance with Financial Accounting Standards Board Interpretation Number 46R, "Consolidation of Variable Interest Entities (revised December 2003)--an interpretation of ARB No. 51," PCHI is a variable interest entity and has been included in the accompanying consolidated financial statements as of March 31, 2006 and December 31, 2005, and for the three months ended March 31, 2006 and 2005. 25 The Company remains primarily liable under the Acquisition Loan note notwithstanding its guarantee by PCHI, and this note is cross-collateralized by substantially all of the Company's assets and all of the real property of the Hospitals. All of the Company's operating activities are directly affected by the real property that was sold to PCHI. Given these factors, the Company has indirectly guaranteed the indebtedness of PCHI. The Company is standing ready to perform on the Acquisition Loan should PCHI not be able to perform and has undertaken a contingent obligation to make future payments if those triggering events or conditions occur. ACCOUNTS PURCHASE AGREEMENT - In March 2005, the Company entered into a two year Accounts Purchase Agreement (the "APA") with Medical Provider Financial Corporation I, an unrelated party (the "Buyer"). The Buyer is an affiliate of the Lender (see Note 5). The APA provides for the sale of 100% of the Company's eligible accounts receivable, as defined, without recourse. After accounts receivable are sold, the APA requires the Company to provide billing and collection services, maintain the individual patient accounts, and resolve any disputes that arise between the Company and the patient or other third party payer. The Company accounts for its sale of accounts receivable in accordance with SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities - A Replacement of FASB Statement 125." The accounts receivable are sold weekly based on billings for each Hospital. The purchase price is comprised of two components, the advance rate amount and the deferred portion amount. The advance rate amount is based on the historical collection experience for accounts receivable similar to those included in a respective purchase. At the time of sale, the Buyer advances 95% of the advance rate amount (the "95% Advance"-note; increased from 85% effective January 1, 2006) to the Company and holds the remaining 5% as security reserve funds on sold accounts (the "Security Reserve Funds"), which is non-interest bearing. Except in the case of a continuing default, the Security Reserve Funds can not exceed 25% (the "25% Cap") of the aggregate advance rate amount, as defined, of the open purchases. The Company is charged a "purchase discount" (the "Transaction Fee") of 1.35% per month of the advance rate amount of each purchase until closed, at which time the Buyer deducts the Transaction Fee from the Security Reserve Funds. Collections are applied on a dollar value basis, not by specific identification, to the respective Hospital's most aged open purchase. The deferred portion amount represents amounts the Company expects to collect, based on regulations, contracts, and historical collection experience, in excess of the advance rate amount. The following table reflects the components of accounts receivable and receivable from Buyer of accounts as of March 31, 2006 and December 31, 2005. March 31, December 31, 2006 2005 ------------ ------------ (as restated) (as restated) Accounts receivable: Governmental $ 5,732,795 $10,394,875 Non-governmental 11,602,118 8,728,887 ------------ ------------ 17,334,913 19,123,762 Less allowance for doubtful accounts (2,432,084) (3,148,276) ------------ ------------ Net patient accounts receivable 14,902,829 15,975,486 ------------ ------------ Security Reserve Funds 13,021,487 12,127,337 Deferred purchase price receivables 14,354,540 9,337,703 ------------ ----------- Receivable from Buyer of accounts 27,376,027 21,465,040 ------------ ------------ $ 42,278,856 $ 37,440,526 ============ ============ Although 100% of the Company's accounts receivable, as defined, is purchased by the Buyer, certain payments (generally payments that cannot be attributed to specific patient account, such as third party settlements, capitation payments and MediCal Disproportionate Share Hospital ("DSH") subsidies (collectively "Other Payments") are retained by the Company and not applied to the purchases processed by the Buyer. In the opinion of our management, after consultation with the Buyer, DSH payments and CalOptima capitation premium payments of $0.6 and $5.1 million, respectively, for the three months ended March 31, 2006, are excludable from application to the Security Reserve Funds. However, if cash collections on purchases are not sufficient to recover the Buyer's advance rate amount and related transaction fees, the Buyer could be entitled to funds the Company has received in Other Payments or require transfer of substitute accounts to cover any such shortfall. Based on collection history under the APA to date, the Company's management believes the likelihood of the Buyer exercising this right is remote. 26 Any other term of the APA notwithstanding, the parties agreed as follows: (a) all accounts derived from any government program payer including, without limitation, the Medicare, Medi-Cal, or CHAMPUS programs, shall be handled as set forth in a Deposit Account Security Agreement entered into by the parties, which provides for the segregation and control of governmental payments by the Company, (b) the parties agreed to take such further actions and execute such further agreements as are reasonably necessary to effectuate the purpose of the APA and to comply with the laws, rules, and regulations of the Medicare and other government programs regarding the reassignment of claims and payment of claims to parties other than the provider ("Reassignment Rules"), and (c) until such time as accounts are delivered by the Company to the Buyer controlled lockbox, the Company shall at all times have sole dominion and control over all payments due from any government program payer. The Company's management (i) believes that the foregoing method of segregating and controlling payments received from governmental program payers complies with all applicable Reassignment Rules, and (ii) the Company intends to request an opinion from the Federal Center for Medicare and Medicaid Services ("CMS") that such method is compliant with the Reassignment Rules in the view of CMS. As of March 31,2006 the Company has $13,629,497 in governmental accounts receivable that have been reported as sold subject to the foregoing limitation. The Company records estimated Transaction Fees and estimated servicing costs related to the sold accounts receivable at the time of sale. For the three months ended March 31, 2006, the Company incurred a loss on sale of accounts receivable of $2,807,805. No accounts receivable were sold as of March 31, 2005. Effective March 31, 2006, an amendment to the APA reduced the required Security Reserve Funds amount as a percentage of the total advance rate amount outstanding from 25% to 15% (the "15% Cap"). At March 31, 2006, the Security Reserve Funds balance of $13,021,487 was in excess of the 15% Cap. As a result, $6,677,916 was released to the Company subsequent to March 31, 2006. COMMON STOCK WARRANTS - On January 27, 2005, the Company entered into a Rescission, Restructuring and Assignment Agreement with Dr. Kali Chaudhuri and Mr. William Thomas, both of whom have ownership interests in PCHI (the "Restructuring Agreement"). Previously, the Company had obtained financing from Dr. Chaudhuri and Mr. Thomas and had issued to them a $500,000 secured convertible promissory note that was convertible into approximately 88.8% of the Company's issued and outstanding common stock on a fully-diluted basis, a $10 million secured promissory note, and a Real Estate Purchase Option agreement originally dated September 28, 2004 to purchase 100% of substantially all of the real property in the Acquisition for $5 million (the "Real Estate Option"), all of which together with related accrued interest payable pursuant to the terms of the notes were rescinded and cancelled. Pursuant to the Restructuring Agreement, the company released its initial deposit of $10 million plus accrued interest on the Acquisition back to Dr. Chaudhuri and issued non-convertible secured promissory notes totaling $1,264,014 and warrants to purchase up to 74,700,000 shares of the Company's common stock (the "Warrants") to Dr. Chaudhuri and Mr. Thomas (not to exceed 24.9% of the Company's fully diluted capital stock at the time of exercise). Concurrent with the close of the Acquisition, the Company repaid the non-convertible secured promissory notes of $1,264,014 to Dr. Chaudhuri and Mr. Thomas. The Warrants are exercisable beginning January 27, 2007 and expire 3.5 years from the date of issuance. The exercise price for the first 43 million shares purchased under the Warrants is $0.003125 per share, and the exercise or purchase price for the remaining 31.7 million shares is $0.078 per share if exercised between January 27, 2007 and July 26, 2007, $0.11 per share if exercised between July 27, 2007 and January 26, 2008, and $0.15 per share thereafter until expiration of the warrants. Effective December 12, 2005, the Company entered into a credit agreement (the "December Credit Agreement") with the Credit Parties and the Lender. Under the December Credit Agreement, the Lender loaned $10,700,000 to the Company as evidenced by a promissory note (the "December Note"), of which $5 million was used to pay down the Acquisition Loan. Interest is payable monthly at the rate of 12% per annum and the December Note is due on December 12, 2006. The December Note is secured by substantially all of the Company's assets. In addition, the Company issued a common stock warrant (the "December Note Warrant") to the Lender as collateral under the December Note. The December Note Warrant is exercisable by the Lender only in the event that a default has occurred and is continuing on the December Note. The December Note Warrant entitles the Lender to purchase the number of shares of the Company's common stock equal in value to the amount of the December Note not repaid at maturity, plus accrued interest and lender fees for an aggregate exercise price of $1.00, regardless of the number of shares acquired. The December Note Warrant is exercisable from and after December 12, 2005 until the occurrence of either a 27 termination of the December Credit Agreement by the Lender or the Company's payment in full of all obligations under the December Credit Agreement. The Company is obligated to register the estimated number of shares of common stock issuable upon exercise of the December Note Warrant by filing a registration statement under the Securities Act of 1933, as amended (the "Securities Act"), no later than ninety days prior to the maturity date of the December Note. If the Company proposes to file a registration statement under the Securities Act on or before the expiration date of the December Note Warrant, then the Company must offer to the holder of the December Note Warrant the opportunity to include the number of shares of common stock as the holder may request. Based upon a valuation obtained by the Company from an independent valuation firm, the Company recorded a warrant expense of $17,215,000 for the three months ended March 31, 2005 related to the issuance of the Warrants. The Company computed the expense of the Warrants based on the fair value of the underlying shares at the date of grant and the estimated maximum number of shares of 43,254,715 that could be issued under the Warrants. The Company recognized a gain of $8,218,019 in change in fair value of derivative in the accompanying consolidated statement of operations for the three months ended March 31, 2006. As a result of the Company not being able to determine the maximum number of shares that could be required to be issued under the December Note Warrant issued on December 12, 2005, the Company has determined that share settlement of the Warrants issued on January 27, 2005 is no longer within its control and reclassified the Warrants as a liability on December 12, 2005 in accordance with EITF No. 00-19 "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock" and SFAS 133 "Accounting for Derivative Instruments and Hedging Activities." As of December 12, 2005, there was a substantial reduction in the shares outstanding to 83,932,316 shares as a result of the Company's settlement with OC-PIN. However, the requirement to repay the December Note for $10.7 million may obligate the Company to issue new shares of its common stock prior to the expected exercise of the Warrants and the estimated maximum number of shares exercisable of 43,254,715 accordingly remains unchanged. Management believes that the likelihood of the December Note Warrant being exercised is reasonably possible and, in accordance with EITF No. 00-19 and SFAS 133, has included the December Note value of $10.7 million in warrant liability, current, in its consolidated balance sheets as of March 31, 2006 and December 31, 2005. Under the terms of the December Credit Agreement, any proceeds from the sale of stock received under the December Note Warrant that are in excess of the December Note and related issuance costs are to be returned to the Company. Accordingly, the fair value of the December Note Warrant would contractually continue to be $10.7 million (plus any issuance and exercise costs, which are considered immaterial). The Company computed the fair value of the Warrants, and the fair value of the December Note Warrant and related number of shares, based on the Black-Scholes option pricing model. Due to the fact that the Company emerged from the development stage during 2005, the Company computed the volatility of its stock based on an average of public companies that own hospitals. Although management believes this is the most reasonable and accurate methodology to determine the Company's volatility, the circumstances affecting volatility of the comparable companies selected may not be an accurate predictor of the Company's volatility. SIGNIFICANT CHALLENGES COMPANY - Our acquisition of the Hospitals involves numerous potential risks, including: o potential loss of key employees and management of acquired companies; o difficulties integrating acquired personnel and distinct cultures; o difficulties integrating acquired companies into our proposed operating, financial planning and financial reporting systems; o diversion of management attention; and o assumption of liabilities and potentially unforeseen liabilities, including liabilities for past failure to comply with healthcare regulations. Our acquisition also involved significant cash expenditures, debt incurrence and integration expenses that could seriously strain our financial condition. If we are required to issue equity securities to raise additional capital, existing stockholders will likely be substantially diluted, which could affect the market price of our stock. 28 INDUSTRY - Our Hospitals receive a substantial portion of their revenues from Medicare and Medicaid. The healthcare industry is experiencing a strong trend toward cost containment, as the government seeks to impose lower reimbursement and resource utilization group rates, limit the scope of covered services and negotiate reduced payment schedules with providers. These cost containment measures generally have resulted in a reduced rate of growth in the reimbursement for the services that we provide relative to the increase in our cost to provide such services. Changes to Medicare and Medicaid reimbursement programs have limited, and are expected to continue to limit, payment increases under these programs. Also, the timing of payments made under the Medicare and Medicaid programs is subject to regulatory action and governmental budgetary constraints resulting in a risk that the time period between submission of claims and payment could increase. Further, within the statutory framework of the Medicare and Medicaid programs, a substantial number of areas are subject to administrative rulings and interpretations which may further affect payments. Our business is subject to extensive federal, state and, in some cases, local regulation with respect to, among other things, participation in the Medicare and Medicaid programs, licensure and certification of facilities, and reimbursement. These regulations relate, among other things, to the adequacy of physical property and equipment, qualifications of personnel, standards of care, government reimbursement and operational requirements. Compliance with these regulatory requirements, as interpreted and amended from time to time, can increase operating costs and thereby adversely affect the financial viability of our business. Because these regulations are amended from time to time and are subject to interpretation, we cannot predict when and to what extent liability may arise. Failure to comply with current or future regulatory requirements could also result in the imposition of various remedies including (with respect to inpatient care) fines, restrictions on admission, denial of payment for all or new admissions, the revocation of licensure, decertification, imposition of temporary management or the closure of a facility or site of service. We are subject to periodic audits by the Medicare and Medicaid programs, which have various rights and remedies against us if they assert that we have overcharged the programs or failed to comply with program requirements. Rights and remedies available to these programs include repayment of any amounts alleged to be overpayments or in violation of program requirements, or making deductions from future amounts due to us. These programs may also impose fines, criminal penalties or program exclusions. Other third-party payer sources also reserve rights to conduct audits and make monetary adjustments in connection with or exclusive of audit activities. The healthcare industry is highly competitive. We compete with a variety of other organizations in providing medical services, many of which have greater financial and other resources and may be more established in their respective communities than we are. Competing companies may offer newer or different centers or services than we do and may thereby attract patients or customers who are presently patients, customers or are otherwise receiving our services. An increasing trend in malpractice litigation claims, rising costs of malpractice litigation, losses associated with these malpractice lawsuits and a constriction of insurers have caused many insurance carriers to raise the cost of insurance premiums or refuse to write insurance policies for hospital facilities. Also, a tightening of the reinsurance market has affected property, auto and excess liability insurance carriers. Accordingly, the costs of all insurance premiums have increased. We receive all of our inpatient services revenue from operations in Orange County, California. The economic condition of this market could affect the ability of our patients and third-party payers to reimburse us for our services, through its effect on disposable household income and the tax base used to generate state funding for Medicaid programs. An economic downturn, or changes in the laws affecting our business in our market and in surrounding markets, could have a material adverse effect on our financial position, results of operations and cash flows. LIQUIDITY AND CAPITAL RESOURCES The Company's consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and settlement of obligations in the normal course of business. The Company generated income of $2,535,477 (primarily attributable to a gain from change in fair value of derivative of $8,218,019) during the three months ended March 31, 2006 and has a working capital deficit of $80,176,753 at March 31, 2006. For the three months ended March 31, 2006, cash used in operations was $8,708,059. 29 On or around May 9, 2005, the Company received notice that it was in default of its Acquisition Loan and Line of Credit. Effective December 12, 2005, the Company entered into a one year credit agreement for $10,700,000, which included an amendment that (i) declared cured the aforementioned default, (ii) required the Company to pay $5,000,000 against its Acquisition Loan, (iii) required the Company to obtain $10,700,000 in additional new capital contributions to pay in full and retire all amounts due and owing under the one year credit agreement and (iv) included certain indemnities and releases in favor of the Lender. Accordingly, on December 12, 2005, the Company paid $5,000,000 against the Acquisition Loan reducing its outstanding balance to $45 million. As of March 31, 2006, the Company had outstanding short term debt aggregating $81,030,734, of which $10,700,000 (included within Warrant Liability - - Current) was classified as warrant liability, current. See "Overview - Common Stock Warrants" above in this Item 2. Effective January 1, 2006, the Company and the Lender agreed to an amendment to the Acquisition Loan and Line of Credit that changed the interest rate from 14% to prime plus 5.75%. As a result, future increases in the prime rate would increase the Company's interest expense. Our working capital deficit as of March 31, 2006 was $80.2 million and, for the three months then ended, cash used by operations was $8.7 million. Management is working on improvements in several areas that the Company believes will mitigate these deficits: 1. Net operating revenues: The Hospitals serve a disproportionate number of indigent patients and receive governmental revenues and subsidies in support of care for these patients. We have received increases in Medicaid, Medicaid DSH, and Orange County, CA (CalOptima) payments. Increased reimbursement and support in these areas represent $0.7 million per month in committed improvement and an additional $0.1 to $0.2 million per month still under discussion. Commercial managed care rate improvements are approximately $0.2 million per month in 2006 vs. 2005. Adjusting for calendar days, revenues for the three months ended March 31, 2006 were $4.6 million higher than for the same period in the preceding year. 2. Operating expenses: Management is working aggressively to reduce cost without reduction in service levels. These efforts have in large part been offset by inflationary pressures. However, a net improvement of $0.2 to $0.3 million per month is a reasonable expectation for 2006. Adjusting for calendar days, operating expenses for the three months ended March 31, 2006 were $5.0 million higher than for the same period in the preceding year. 3. Financing costs: The Company completed the Acquisition of the Hospitals with a high level of debt financing. Additionally, the Company entered into an Accounts Purchase Agreement, and is incurring significant discounts on the sale of accounts receivable. As described in the notes to the consolidated financial statements, the largest investor was unable to meet all the commitments under the stock purchase agreement. As a result, the Company incurred additional interest costs from default rates and higher than planned borrowings. We are seeking new equity investments in the Company; however we have not yet secured alternative sources of capital or re-negotiated our commitments with our lenders. The Company intends to work with interested parties to place an additional $20 million in equity, of which $10.7 million will be applied toward the payment of the December Note and the remainder will reduce the level required when the term notes are refinanced. Management believes the reduction in leverage and refinancing, if successful, will yield reductions in the discount on sales of accounts receivable. The combined impact of these changes is expected to yield from $0.4 to $0.5 million in reduced capital costs per month. There can be no assurance that we will be able raise additional funds on terms acceptable to us or at all. Such additional equity, if available, is likely to substantially dilute the interest of our current shareholders in the Company. These steps are also subject to the approval of the Company's Board of Directors which currently is comprised of three representatives of the lead investor, two outside directors, and one officer of the Company and, accordingly, may not be assured. The foregoing analysis presumes that capital expenditures to replace equipment can be kept to an immaterial amount in the short term. It is the intent of management to fund future capital expenditures from operations. 30 As of March 31, 2006, the Company had approximately $4.7 million available under its $30 million Line of Credit. The Line of Credit is to be used for the purpose of providing (a) working capital financing for the Company and its subsidiaries, (b) funds for other general corporate purposes of the Company and its subsidiaries, and (c) other permitted purposes. Effective March 31, 2006, an amendment to the APA will accelerate the Company's cash receipts in connection with its sales of accounts receivable. The amendment reduced the required accumulated Security Reserve Funds amount as a percentage of the total advance rate amount outstanding from 25% to 15%. At March 31, 2006, the Security Reserve Funds balance of $13,021,487 was in excess of the 15% Cap. As result, $6,677,916 was released to the Company subsequent to March 31, 2006. RESULTS OF OPERATIONS The following table sets forth, for the three months ended March 31, 2006 and 2005, our consolidated statements of operations expressed as a percentage of net operating revenues. The three months ended March 31, 2005 reflects only 24 days of operations from the Acquisition date. Three months ended March 31, --------------------- 2006 2005 -------- -------- Net operating revenues 100.0% 100.0% Operating expenses 103.6 104.8 -------- -------- Operating loss (3.6) (4.8) -------- -------- Other income (expense): Interest expense, net (3.1) (3.0) Common stock warrant expense - (79.2) Change in fair value of derivative 9.5 - -------- -------- Other income (expense), net 6.4 (82.2) -------- -------- Income (loss) before provision for income taxes and minority interest 2.8 (87.0) Provision for income taxes - (4.3) Minority interest in variable interest entity 0.1 - -------- -------- Net income (loss) 2.9% (91.3)% ======== ======== CONSOLIDATED RESULTS OF OPERATIONS--THREE MONTHS ENDED MARCH 31, 2006 AND MARCH 31, 2005 NET OPERATING REVENUES Our consolidated net operating revenues, on a calendar day basis (using 24 days for the three months ended March 31, 2005- "Acquisition" days), increased 5.7% as a result of contract rate increases. Average daily census remained unchanged. OPERATING EXPENSES Operating expenses decreased as a percent of revenues by 1.2% which equates to inflationary increases (net of efficiencies) of 6.6%. The provision for doubtful accounts as a percentage of revenue decreased to 9.6% for the three months ended March 31, 2006 from 14.4% in the comparable period in 2005, more than offsetting the $2.8 loss on sale of accounts receivable incurred during the three months ended March 31, 2006. Salaries and benefits (adjusted for Acquisition days) increased $2.0 million or 4.3%, slightly under the average wage increase which ranged from 5-6%. Supplies increased $0.6 million or 5.8% due to inflationary pressures. Remaining operating expenses (adjusted for Acquisition days) increased approximately $1.8 million. The most significant of these were medical fees for emergency coverage, data processing fees for system conversions and medical equipment repairs. 31 OPERATING LOSS Loss from operations as a percent of revenue improved by 1.2% due to rate improvements in excess of cost increases. OTHER INCOME (EXPENSE), NET Other income (expense), net, changed primarily as a result of the changes in fair value of warrants. The initial valuation of warrants issued in the first quarter of 2005 (as described in Form 10-Q/A for the three months ended March 31 2005) was $17,215,000. As described more fully in our Annual Report on Form 10-K for the year ended December 31, 2005, this was revalued to $17,604,292 on December 12, 2005 and subsequently increased to $21,064,669 as of December 31, 2005. As of March 31, 2006, the fair value of these warrants had decreased to $12,846,650, resulting in a gain of $8,218,019. Interest costs were relatively consistent between the periods as a percentage of revenue. PROVISION FOR INCOME TAXES The estimated provision for income taxes for the first quarter of 2005 was reversed in the subsequent quarter as a result of the impact of the implementation of the Accounts Purchase Agreement. CRITICAL ACCOUNTING ESTIMATES REVENUE RECOGNITION - Net operating revenues are recognized in the period in which services are performed and are recorded based on established billing rates (gross charges) less estimated discounts for contractual allowances, principally for patients covered by Medicare, Medicaid, managed care and other health plans. Gross charges are retail charges. They are not the same as actual pricing, and they generally do not reflect what a hospital is ultimately paid and therefore are not displayed in the consolidated statements of operations. Hospitals are typically paid amounts that are negotiated with insurance companies or are set by the government. Gross charges are used to calculate Medicare outlier payments and to determine certain elements of payment under managed care contracts (such as stop-loss payments). Because Medicare requires that a hospital's gross charges be the same for all patients (regardless of payer category), gross charges are also what hospitals charge all other patients prior to the application of discounts and allowances. Revenues under the traditional fee-for-service Medicare and Medicaid programs are based primarily on prospective payment systems. Discounts for retrospectively cost-based revenues and certain other payments, which are based on the Hospitals' cost reports, are estimated using historical trends and current factors. Cost report settlements for retrospectively cost-based revenues under these programs are subject to audit and administrative and judicial review, which can take several years until final settlement of such matters are determined and completely resolved. Since the laws, regulations, instructions and rule interpretations governing Medicare and Medicaid reimbursement are complex and change frequently, the estimates recorded by the Hospitals could change by material amounts. The Company has established settlement receivables as of March 31, 2006 and December 31, 2005 of $1,845,511 and $2,273,248, respectively. Outlier payments, which were established by Congress as part of the diagnosis-related groups (DRG) prospective payment system, are additional payments made to hospitals for treating Medicare patients who are costlier to treat than the average patient in the same DRG. To qualify as a cost outlier, a hospital's billed (or gross) charges, adjusted to cost, must exceed the payment rate for the DRG by a fixed threshold established annually by the Centers for Medicare and Medicaid Services of the United State Department of Health and Human Services (CMS). Under Sections 1886(d) and 1886(g) of the Social Security Act, CMS must project aggregate annual outlier payments to all prospective payment system hospitals to be not less than 5% or more than 6% of total DRG payments (Outlier Percentage). The Outlier Percentage is determined by dividing total outlier payments by the sum of DRG and outlier payments. CMS annually adjusts the fixed threshold to bring expected outlier payments within the mandated limit. A change to the fixed threshold affects total outlier payments by changing (1) the number of cases that qualify for outlier payments, and (2) the dollar amount hospitals receive for those cases that still qualify. The most recent change to the cost outlier threshold that became effective on October 1, 2005 was a decrease from $25,800 to $23,600, which CMS projects will result in an Outlier Percentage of 5.1%. The Medicare fiscal intermediary calculates the cost of a claim by multiplying the billed charges by the cost-to-charge ratio from the hospital's most recent filed cost report. 32 The Hospitals received new provider numbers during the year ended December 31, 2005 and, because there was no specific history, the Hospitals were reimbursed for outliers based on published statewide averages. If the computed cost exceeds the sum of the DRG payment plus the fixed threshold, the hospital receives 80% of the difference as an outlier payment. Medicare has reserved the option of adjusting outlier payments, through the cost report, to the hospital's actual cost-to-charge ratio. Upon receipt of the current payment cost-to-charge ratios from the fiscal intermediary, any variance between current payments and the estimated final outlier settlement will be reported. As of March 31, 2006, the Company has recorded reserves for excess outlier payments due to the difference between the Hospitals' actual cost to charge rates and the statewide average in the amount of $2,890,637. These reserves offset against the third party settlement receivables and are included as a net payable of $1,045,126 in due to governmental payers in the Company's consolidated balance sheet as of March 31, 2006. The Hospitals receive supplemental payments from the State of California to support indigent care (MediCal Disproportionate Share Hospital payments or "DSH"). During the three months ended March 31, 2006, the Hospitals received payments of $575,000. The Company estimates an additional $6,587,219 is receivable based on State correspondence, which is included in due from governmental payers in the consolidated balance sheet as of March 31, 2006. In April 2006, $3,811,305 of the $6,587,219 was received. Revenues under managed care plans are based primarily on payment terms involving predetermined rates per diagnosis, per-diem rates, discounted fee-for-service rates and/or other similar contractual arrangements. These= revenues are also subject to review and possible audit by the payers. The payers are billed for patient services on an individual patient basis. An individual patient's bill is subject to adjustment on a patient-by-patient basis in the ordinary course of business by the payers following their review and adjudication of each particular bill. The Hospitals estimate the discounts for contractual allowances utilizing billing data on an individual patient basis. At the end of each month, the Hospitals estimate expected reimbursement for patient of managed care plans based on the applicable contract terms. These estimates are continuously reviewed for accuracy by taking into consideration known contract terms as well as payment history. Although the Hospitals do not separately accumulate and disclose the aggregate amount of adjustments to the estimated reimbursements for every patient bill, management believes the estimation and review process allows for timely identification of instances where such estimates need to be revised. Management does not believe there were any adjustments to estimates of individual patient bills that were material to its net operating revenues. Management is not aware of any material claims, disputes, or unsettled matters with any payers that would affect revenues that have not been adequately provided for in the Company's consolidated financial statements as of and for the three months ended March 31, 2006. The Hospitals provide charity care to patients whose income level is below 200% of the Federal Poverty Level with only a co-payment charged to the patient. The Hospitals' policy is to not pursue collection of amounts determined to qualify as charity care; and accordingly, the Hospitals do not report the amounts in net operating revenues or in the provision for doubtful accounts. Patients whose income level is between 200% and 300% of the Federal Poverty Level may also be considered under a catastrophic provision of the charity care policy. Patients without insurance who do not meet the Federal Poverty Level guidelines are offered assistance in applying for Medicaid and other programs they may be eligible for, such as state disability, Victims of Crime, or county indigent programs. Patient advocates from the Hospitals' Medical Eligibility Program (MEP) screen patients in the hospital and determine potential linkage to financial assistance programs. They also expedite the process of applying for these government programs. Based on average revenue for comparable services from all other payers, revenues foregone under the charity policy, including indigent care accounts, for the three months ended March 31, 2006 were approximately $1.6 million. Receivables from patients who are potentially eligible for Medicaid are classified as Medicaid pending under the MEP, with appropriate contractual allowances recorded. If the patient does not quality for Medicaid, the receivables are reclassified to charity care and written off, or they are reclassified to self-pay and adjusted to their net realizable value through the provision for doubtful accounts. Reclassifications of Medicaid pending accounts to self-pay do not typically have a material impact on the results of operations as the estimated Medicaid contractual allowances initially recorded are not materially different than the estimated provision for doubtful accounts recorded when the accounts are reclassified. All accounts classified as pending Medicaid are fully reserved when they reach 180 days old. 33 SALE OF ACCOUNTS RECEIVABLE - During the three months ended March 31, 2006, the Company incurred $2,807,805 in loss on sale of accounts receivable. See "Overview - Accounts Purchase Agreement" above in this Item 2. PROVISION FOR DOUBTFUL ACCOUNTS - The Company provides for accounts receivable that could become uncollectible by establishing an allowance to reduce the carrying value of such receivables to their estimated net realizable value. The Hospitals estimate this allowance based on the aging of their accounts receivable, historical collections experience for each type of payer and other relevant factors. There are various factors that can impact the collection trends, such as changes in the economy, which in turn have an impact on unemployment rates and the number of uninsured and underinsured patients, volume of patients through the emergency department, the increased burden of co-payments to be made by patients with insurance and business practices related to collection efforts. These factors continuously change and can have an impact on collection trends and the estimation process. The Company's policy is to attempt to collect amounts due from patients, including co-payments and deductibles due from patients with insurance, at the time of service while complying with all federal and state laws and regulations, including, but not limited to, the Emergency Medical Treatment and Labor Act (EMTALA). Generally, as required by EMTALA, patients may not be denied emergency treatment due to inability to pay. Therefore, until the legally required medical screening examination is complete and stabilization of the patient has begun, services are performed prior to the verification of the patient's insurance, if any. In non-emergency circumstances or for elective procedures and services, it is the Hospitals' policy, when appropriate, to verify insurance prior to a patient being treated. During the three months ended March 31, 2006, the Company recorded a provision for doubtful accounts of $8,298,928. COMMON STOCK WARRANTS - During the three months ended March 31, 2006 and 2005, the Company recorded a gain of $8,218,019 and a warrant expense of $17,215,000, respectively, related to warrants. See "Overview - Common Stock Warrants" above in this Item 2. RECENT ACCOUNTING STANDARDS In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140." SFAS 155, among other things: permits the fair value re-measurement of any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation and establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. SFAS 155 is effective for all financial instruments acquired or issued in fiscal years beginning after September 15, 2006. The Company is currently evaluating the effect that adopting this statement will have on the Company's financial position and results of operations. In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of Financial Assets - an amendment of FASB Statement No. 140," with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS 156 permits the choice of the amortization method or the fair value measurement method, with changes in fair value recorded in income, for the subsequent measurement for each class of separately recognized servicing assets and servicing liabilities. The statement is effective for years beginning after September 15, 2006, with earlier adoption permitted. The Company is currently evaluating the effect that adopting this statement will have on the Company's financial position and results of operations. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. At March 31, 2006, we did not have any investment in or outstanding liabilities under market rate sensitive instruments. We do not enter into hedging instrument arrangements. On December 12, 2005 we entered into a derivative financial instrument solely for the purpose of securing a related loan. This is discussed more fully in the notes 5 and 7 to the consolidated financial statements. We have no off-balance sheet arrangements. 34 ITEM 4. CONTROLS AND PROCEDURES. The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company's Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to the Company's management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure based closely on the definition of "disclosure controls and procedures" in Rule 15d-15(e). The Company's disclosure controls and procedures are designed to provide a reasonable level of assurance of reaching the Company's desired disclosure control objectives. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. We previously conducted an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of March 31, 2006 and June 30, 2006 and found them to be effective as of such dates. However, we have subsequently conducted a re-evaluation of the effectiveness of our disclosure controls and procedures as of March 31, 2006 and June 30, 2006 and identified certain material weaknesses, discussed further below. With the participation of the Company's Chief Executive Officer and Chief Financial Officer, management re-evaluated the effectiveness of our system of internal control over financial reporting as a result of the restatement of the financial statements for the quarterly periods ended March 31, 2006 and June 30, 2006, based on the framework in Internal Control-Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission. Based on these evaluations and re-evaluations, management determined that the Company's system of disclosure controls and procedures was not effective as of March 31, 2006 and June 30, 2006, and the Company's systems of internal control over financial reporting was not effective as of March 31, 2006 and June 30, 2006, due to the presence of certain material weaknesses. These weaknesses contributed to the need for restatements of our financial statements for the quarterly periods ending March 31, 2006 and June 30, 2006 as follows. As described in the notes to the accompanying restated financial statements, the Company's management determined that the Company's unaudited condensed consolidated quarterly financial statements for the periods ended March 31, 2006 and June 30, 2006, should be restated due to the an error in the overstatement of net revenues and accounts receivable. The Company determined that the restatements were necessary to write-off patient accounts receivable for services provided under capitated contracts. The correction of errors resulted in a decrease in net operating revenues, income before minority interest and provision for income taxes and net income of $322,887 for the three months ended March 31, 2006 and a decrease in accounts receivable and an increase in accumulated deficit and stockholders' deficiency of $939,678 as of March 31, 2006. Management has identified, as a material weakness contributing to these restatements, that the Company's controls over the timely preparation and review of account reconciliations was inadequate. Management has implemented new procedures to monitor the timely preparation and review of account reconciliations. In addition, management has implemented new procedures to ensure that material errors are prevented or detected on a timely basis. 35 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS We and our subsidiaries are involved in various legal proceedings most of which relate to routine matters incidental to our business. We do not believe that the outcome of these matters is likely to have a material adverse effect on the Company. ITEM 1A. RISK FACTORS There are no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005. ITEM 6. EXHIBITS. Exhibits required to be filed are listed below and except where incorporated by reference, immediately follow. References to the "Commission" mean the U.S. Securities and Exchange Commission. Exhibit Description Number - ----------------------------------------------------------------------- 10.1 Employment Severance Agreement and General Release of Claims and Waiver of the Right to Cancel or Revoke Employment Severance Agreement and General Release of Claims (incorporated herein by reference from Exhibit 99.1 to the Registrant's Current Report on Form 8-K filed with the Commission on January 26, 2006). * 31.1 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * Previously filed. 36 SIGNATURE In accordance with the requirements of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. INTEGRATED HEALTHCARE HOLDINGS, INC. Dated: November 2, 2006 By: /s/ Steven R. Blake ----------------------------------- Steven R. Blake Chief Financial Officer (Principal Financial Officer) 37 EX-31.1 2 ihh_10qa1ex31-1.txt EXHIBIT 31.1 CERTIFICATION PURSUANT TO RULE 13A-14 AND 15D-14 UNDER THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED I, Bruce Mogel, Chief Executive Officer of Integrated Healthcare Holdings, Inc., certify that: 1. I have reviewed this Quarterly Report on Form 10-Q/A of Integrated Healthcare Holdings, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated, or caused such disclosure controls and procedure to be designed under our supervision, subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls over financial reporting. Dated: November 2, 2006 By: /s/ Bruce Mogel --------------- Bruce Mogel Chief Executive Officer 38 EX-31.2 3 ihh_10qa1ex31-2.txt EXHIBIT 31.2 CERTIFICATION PURSUANT TO RULE 13A-14 AND 15D-14 UNDER THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED I, Steven R. Blake, Chief Financial Officer of Integrated Healthcare Holdings, Inc., certify that: 1. I have reviewed this Quarterly Report on Form 10-Q/A of Integrated Healthcare Holdings, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated, or caused such disclosure controls and procedure to be designed under our supervision, subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls over financial reporting. Dated: November 2, 2006 By: /s/ Steven R. Blake ------------------- Steven R. Blake Chief Financial Officer 39 EX-32.1 4 ihh_10qa1ex32-1.txt EXHIBIT 32.1 CERTIFICATE PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with this Quarterly Report on Form 10-Q/A of Integrated Healthcare Holdings, Inc. (the "Company") for the quarter ended March 31, 2006, as filed with the Securities and Exchange Commission (the "Report"), the undersigned, in the capacity and on the date indicated below, hereby certifies pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: 1. the Report fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934; and 2. the information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company at the dates and for the period indicated. This Certificate has not been, and shall not be deemed, "filed" with the Securities and Exchange Commission. Dated: November 2, 2006 By: /s/ Bruce Mogel --------------- Bruce Mogel Chief Executive Officer 40 EX-32.2 5 ihh_10qa1ex32-2.txt EXHIBIT 32.2 CERTIFICATE PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with this Quarterly Report on Form 10-Q/A of Integrated Healthcare Holdings, Inc. (the "Company") for the quarter ended March 31, 2006, as filed with the Securities and Exchange Commission (the "Report"), the undersigned, in the capacity and on the date indicated below, hereby certifies pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: 1. the Report fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934; and 2. the information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company at the dates and for the period indicated. This Certificate has not been, and shall not be deemed, "filed" with the Securities and Exchange Commission. Dated: November 2, 2006 By: /s/ Steven R. Blake ------------------- Steven R. Blake Chief Financial Officer 41 -----END PRIVACY-ENHANCED MESSAGE-----