DAOU SYSTEMS INC - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

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FORM 10-K

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[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934

For the fiscal year ended December 31, 2002

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from to

Commission File No.: 0-22073

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DAOU SYSTEMS, INC.
(Exact name of registrant as specified in its charter)

Delaware 33-0284454
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)

412 Creamery Way,
Suite 300,
Exton, Pennsylvania 19341
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: (800) 578-3268

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of share the Act:

Common Stock, $0.001 par value per share
(Title of Class)

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 [X] NO [_]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). YES [_] NO [X]

The aggregate market value of the voting stock held by non-affiliates of the
Registrant as of June 28, 2002 was $16,033,700.

As of March 20, 2003, the number of issued and outstanding shares of the
Registrant's Common Stock was 21,782,707.

Portions of the registrant's Proxy Statement for its 2003 Annual Meeting of
Stockholders are incorporated herein by reference into Part III of this Form
10-K. If the Proxy Statement is not filed with the Securities and Exchange
Commission in definitive form prior to April 30, 2003, the registrant intends
to amend this report to include information omitted from Part III hereof.

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PART I

CAUTIONARY STATEMENT

This report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. All forward-looking statements are inherently uncertain
as they are based on current expectations and assumptions concerning future
events or future performance of Daou Systems, Inc. You should not place undue
reliance on these forward-looking statements, which are only predictions and
speak only as of the date hereof. Forward-looking statements usually contain
the words "estimate," "anticipate," "hope", "believe," "think", "expect,"
"intend", "plan" or similar expressions, and are subject to numerous known and
unknown risks and uncertainties. In evaluating such statements, you should
carefully review various risks and uncertainties identified in this report,
including the matters set forth under the captions "Risk Factors" and in Daou's
other SEC filings. These risks and uncertainties could cause Daou's actual
results to differ materially from those indicated in the forward-looking
statements. We do not undertake any obligation to update or publicly announce
revisions to any forward-looking statements to reflect future events or
developments.

Item 1: Business.

General

Daou provides integrated information technology ("IT") solutions and
services to the U.S. healthcare industry. Since 1987, we have provided IT
services to approximately 1,500 customers, including many of the nation's
hospitals, top 100 integrated delivery networks ("IDNs"), government healthcare
organizations, health plans, insurance companies and managed care
organizations. Our services include (1) management consulting, (2) traditional
network services, (3) application implementation and support, (4) application
development and integration, and (5) strategic outsourcing, including remote
help desk and related technology support services. Daou currently has
approximately 218 employees.

Daou is principally focused on providing IT services and solutions to
healthcare providers, payors and health plans and government healthcare
organizations. We design and implement solutions to help healthcare
organizations navigate the intersection of legacy systems with emerging
technologies, such as web portals, wireless and other portable computing
solutions. As a "trusted advisor" to leading organizations in the payor/insurer
segment of the market, we provide consultative services to health maintenance
organizations ("HMOs"), health insurers, blues plans and independent practice
associations. Our provider customers include hospitals, IDNs, medical groups,
academic medical centers, physician groups and ancillaries. In addition, we
provide IT services to government healthcare organizations, third-party
administrators, medical services organizations, service vendors, software
vendors and hardware vendors. We believe that our key competitive advantage is
our core understanding of our client's complex healthcare environment based on
our extensive knowledge and experience in the healthcare industry.

We remarket certain third-party applications and solutions, such as
emPOWERnet (TM) portals, through our Strategic Partner Program. We sell no
proprietary hardware, although our network solutions may include the resale of
certain third-party products. Through extensive research and our payor and
provider Advisory Boards and Chief Information Officer (CIO) Forums, we have
the opportunity to fine-tune our strategic plans and service offerings with
influential healthcare executives. Daou's operating philosophy is to meet or
exceed the customer's objectives and to pursue excellence in every area in
which our professional staff works.

Daou Systems, Inc. was originally incorporated in California on July 16,
1987 and reincorporated in Delaware on November 15, 1996. Our principal
executive offices are located at 412 Creamery Way, Suite 300, Exton,
Pennsylvania 19341. You may contact us by telephone (800.578.3268), by
facsimile (610.594.7683) or by e-mail (info@daou.com).

We maintain a website where information concerning our business can be
found. The address of our Internet website is http://www.daou.com. We provide a
link on our website, under Investor Relations, to our filings with the SEC,
including our annual report on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K, and all amendments to those reports.

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Reorganization

On January 9, 2003, we announced our decision to reorganize Daou's internal
management structure, consolidate operations and eliminate non-strategic
services. This reorganization, which was approved by our Board of Directors in
December 2002, is part of our strategy to position Daou for continued growth in
the marketplace. We recorded a one-time restructuring charge of approximately
$1.6 million in the fourth quarter of 2002 related to severance costs, expenses
associated with a slight workforce reduction, elimination of non-strategic
services and the consolidation of office space in connection with this
reorganization.

As part of the reorganization, we consolidated Daou's two operating
divisions--Technology Services and Application Services, and plan to operate as
one business unit. For purposes of improving overall sales and operations
effectiveness, and to offer our customers an integrated solutions approach
through multi-disciplinary teams, we now provide our services through two
primary practice groups: commercial healthcare and government healthcare. We
believe the consolidation was necessary due to changing market forces in the
healthcare industry. We expect that operating under our new structure will
allow us to focus on our core competencies and pursue a seamless approach to
applications and technology.

Effective January 1, 2002, certain overhead expenses directly attributable
to the business units and formerly recorded as general and administrative
expenses are now recorded as cost of revenue before reimbursable expenses. The
prior period amounts have been reclassified to conform to their current period
presentation.

Services

Daou provides integrated information technology solutions and services to
the U.S. healthcare industry. We principally focus on (1) healthcare providers,
(2) payors and health plans and (3) government healthcare organizations. We
focus exclusively on healthcare IT and have diverse technical resources. We
believe that this offers our customers a combination of healthcare-familiar and
practice-driven technology experts that factor in how each individual project
works within the customer's IT strategic plan. Many of our technology
consultants have extensive healthcare experience. In addition, our healthcare
engineers and technicians are experienced with many types of technology, such
as application development, networking, interfacing, database management, data
security and help desk management. We work with clients to provide real-world
solutions that work with their clinical and business processes. We provide
services through two practice groups: commercial healthcare and government
healthcare.

Commercial Healthcare

Daou's commercial healthcare practice serves both the health delivery and
the payor/insurer segments of the industry. We believe that the healthcare
industry faces a variety of challenges, including lower reimbursements, rising
premiums, increased physician demand for clinical transformation and
integration, and the need to improve quality of care and information management
processes without harming financial performance.

We seek to position Daou as a company with the know-how to help our
customers out of the dilemma that faces so many healthcare organizations
today--organizations that can't afford to replace their legacy systems, and
can't afford not to. Many organizations are unable to afford multi-million
dollar system replacements/upgrades proposed by large software application
vendors. Our focus is on providing healthcare organizations with cost effective
solutions to extend the useful life of legacy systems through the integration
of emerging technologies and applications. By unlocking the potential of their
existing systems to support the emerging technologies to stay competitive, and
then implementing those technologies in a rapid, affordable way that delivers
results, we are helping healthcare organizations solve their biggest IT
challenge.

We believe that our healthcare domain expertise, vision, applications and
technology expertise, and customer service position Daou to better serve the
commercial healthcare IT field in the following areas:

. Management Consulting

. Infrastructure--Assessment, Design and Implementation

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. Application Implementation and Support

. Application Development and Integration

. Strategic Outsourcing

Daou's management consulting know-how helps organizations meet the many
challenges surrounding increasing competition, growing member and patient
service demands, expanding regulatory requirements and the confusing horizon of
emerging technologies. We provide solutions through key consulting services
that include: strategic IT planning, security and privacy consulting, including
readiness assessment, planning and remediation related to the Health Insurance
Portability and Accountability Act of 1996 ("HIPAA"), eHealth and mHealth
strategic planning, system procurement and transition management.

To build teams tailored to meet unique requirements of each client
engagement, our consulting practice draws upon the most experienced management
personnel. HIPAA consultants offer an approach methodology--including
assessment tools, educational programs, and consultative assistance--to help
organizations establish a HIPAA project office, understand the regulations,
plan an approach, and achieve compliance. Senior consultants offer clients the
benefit of overall project management vision as well as application and
technical skills appropriate for specific assignments. The unit works with its
clients in a goal-directed, strategic partnership to achieve results in a
timely and cost-effective manner.

In the area of general consulting, our most senior consultants provide
counsel on business process improvement, business strategy and critical
management problem solving, planning, and procurement of managed care systems,
hospital systems and physician practice management systems. The engagement
period for management consulting services typically averages three to six
months, but varies depending on the size and complexity of the project.

Daou's infrastructure services are focused on two vital components of a
healthcare organization's infrastructure: the information technology itself and
the experts who manage it. We assist the healthcare marketplace in the
assessment, design, implementation, integration and support of legacy and
emerging network services and systems. We provide solutions in key areas,
including servers/directories, security, wireless and desktop. The success of
our infrastructure services emanates from our core understanding of the
client's complex healthcare environment. Our primary focus is in helping
clients extend the value of legacy systems and enabling them to work with
emerging technologies, such as web portals, wireless and other portable
computing devices. We support healthcare organizations in all stages of
infrastructure design and implementations, from the requisition and purchase of
hardware to the installation and support of turn-key data networks.

Our infrastructure consultants evaluate the customer's computer network
system and provide recommendations for new network capabilities and capacity on
an ongoing basis consistent with the evolving needs and strategy of the
customer. In addition, we evaluate hardware and software options, interpret
research and development results, update existing network designs and research
specific products and technologies of interest to customers. We provide these
services subject to predetermined schedules. We provide additional technical
personnel to customers during periods of peak network requirements to
accommodate and assist in network upgrade implementation or to accommodate the
anticipated or unanticipated need for additional technical staff.

The engagement period for infrastructure design and implementation services
generally ranges from three to nine months, although certain projects have
required a year or more for completion, and varies depending on the size and
complexity of the implementation project. Services are generally performed on a
time and expense basis and billed semi-monthly or monthly. Certain projects,
generally those with significant hardware content, are performed on a fixed-fee
basis, with revenue recognized as services are performed.

In the area of long-term infrastructure solutions, we offer on-site
management services that are designed to maintain the effective performance of
a customer's computer network system. As healthcare IT systems become more
complex, organizations are experiencing difficulties in hiring,

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training and retaining information technology professionals who can maintain
the performance and functionality of their advanced systems. Accordingly,
healthcare organizations have begun to outsource certain functions of their
information systems departments. We will work with the customer to assess the
appropriate staffing needs to maintain and support its computer network system.
We will place our employees on-site on a full-time basis to provide network
support services and ongoing training of the customer's internal staff. We
generally provide these services in multi-year engagements on a fixed-price
basis, with revenue recognized over the term of the agreement.

Daou's vendor-certified application implementation and support teams have
helped many of the nation's largest payor and provider organizations
successfully implement and support applications from The TriZetto(R) Group,
Epic Systems, McKesson Corporation, QCSI, Siemens Medical Solutions Health
Services, CSC and many others. We are proficient in many of the most frequently
used healthcare applications for both the payor and provider markets. Daou
entered the application implementation and support business with the 1998
acquisition of TMI, a company that has been the leader in implementing payor
sector systems for 20 years. Together with our provider sector experts, we have
assisted over 750 payor and provider organizations to implement applications
solutions.

We have developed a rigorous, cost-effective methodology that drives
on-time, on-budget implementations. Our application implementation and support
services include:

. Application Procurement. We provide expert assistance in system
selection, and we guide clients through the five critical stages of a
successful procurement effort: 1) Planning; 2) Requirements Definition;
3) Vendor Evaluation; 4) Contract Negotiations; and 5) Pre-Implementation
Planning.

. Application Implementation Services. A system implementation consists of
more than just converting files, installing programs and plugging in
equipment. Knowledge of the process, including timelines, approach,
resource selection and key project strategies, is critical to project
success. Our implementation teams include project managers, configuration
strategists, configuration analysts and other specialized support
personnel, all with broad implementation experience and deep knowledge of
the methodology necessary to make the process go smoothly.

. Application and Operational Systems Support. Work doesn't stop at the
end of the implementation. Changing operational environments, new
business needs, additional regulatory requirements and even changes in
personnel create perpetual challenges. Our operational and application
support specialists help our customers leverage their initial investment
to create ongoing returns. We focus our efforts in areas where technology
and operations often meet, including system and personnel transition
management, system evaluation and improvement, operational evaluation and
improvement, application modification and support, interim business
office management/model office and data consolidation and preparation.

. Application Technical Support. The overlapping departmental and
organizational responsibilities in healthcare require innovative
technical solutions to manage and communicate data effectively. Our
technical application support specialists plan and implement solutions
related to system and data conversions, custom interface development,
integration engine support, data extracts and e-commerce services, report
writing and automated document production and distribution.

. Knowledge Management/Reporting Services. From key management performance
indicators to the detail data on a specific contract or business
arrangement, it is critical to optimize an organization's data to meet
its strategic business needs. Timely, accurate, accessible data is indeed
a universal business requirement, and yet many organizations are
challenged to make this a reality. Daou has assisted many clients in the
last 20 years through development of strategy, system selection,
implementation and deployment, and report development.

. Transition Services. Migrating from one system to another is far more
complex than simply turning one computer on and one off on a specified
date. The process of change, or transition, to a new methodology begins
with the elemental recognition that a new system or

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process is needed. How well an organization navigates through the change
of an implementation will determine the success of the project. For two
decades, we have helped clients transition their organizations through
the myriad changes system migration engenders. And, because transition
involves nuances of organizational development and communication with
stakeholders at all levels, the nuances must be managed prudently.

. Project Management. Implementation project management is the initiation,
continued driving and persistent follow-up of all activities and tasks
throughout the continuum of the project lifecycle:
Planning/Orient/Design, Load/Development, Test/Train, Go Live and
Post-implementation. Three key areas of focus are: planning, people
management and subject knowledge. We understand healthcare needs in all
these areas, and work closely with clients to deliver projects that
consistently meet management's goals.

Application implementation and support services are typically provided on a
time and expense basis. The engagement period for these services typically
averages six months, but varies depending on the size and complexity of the
project. Implementation projects can last one to two years.

Preserving, optimizing and extending the life cycle of existing systems is
one of the key challenges facing the healthcare industry today. We help
healthcare organizations maximize the value of their current and planned
systems. Our application development and integration solutions are designed to
enable organizations to cost-effectively access information and communicate
across the enterprise despite systems running on disparate platforms in
different environments. By developing interfaces, implementing existing
interfaces, web-enabling a system or migrating to new, more compatible systems,
we can help organizations streamline their technology to avoid information
roadblock. Our custom integration skills can get clinical, lab and financial
systems working in unison, while extending the value of legacy products and
infrastructure. Our system integration and data extraction capabilities have
helped commercial and government clients for over 20 years. Our application
development and integration solutions include: custom programming, system
integration engines, conversions and upgrades.

The engagement period for application development and integration services
generally ranges from six to nine months, but varies depending on the size and
complexity of the project. Services are typically invoiced monthly on a time
and expense basis.

Daou's strategic outsourcing services are focused on maximizing the
effectiveness of an organization's support center through our best practices
methodology or by serving as an outsourcing partner in select managed services.
Outsourcing service areas may include: security, network and server monitoring,
help desk and desktop management. We seek to provide timely, professional
resources to complement our client's existing staff and to provide proactive
support for their systems. Our customer relationship and IT management team
uses a proactive approach to minimize risk in these key areas:

. Support Center Management. Our SCP-certified Technology Center supports
the objectives of user service level agreements ("SLAs") for healthcare
providers, primarily hospitals and IDNs, within a predictable financial
model for world-class help desk management services. It is designed to be
the first point of contact for all help desk calls. The Technology Center
handles ID and password problems, printer problems, network connectivity
issues, telecom requests and Microsoft Office application questions.

. Desktop Management. Poorly designed or deployed desktop images
frequently create an intense and unnecessary demand on a customer's
support center and break/fix operation. Daou's desktop management
services provide reliable and centrally managed desktop environments.
From standard image content definition and creation, library management,
automated distribution technologies, remote control tools, asset
inventory tracking to central desktop engineering expertise, Daou works
to standardize and automate desktop management.

. Server/Network Management. Daou implements tools to proactively monitor
server and network performance to anticipate upcoming problems, and
resolve situations before they lead to costly downtime. Our remote
network management services are designed to reduce the need for onsite
staffing for all but emergencies or routine onsite support.

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We provide our IT functional outsourcing services in accordance with
pre-determined, detailed schedules and plans established with the customer. We
typically provide help desk services and these other services in multi-year
engagements on a fixed-price fee per node or fee per call basis. The engagement
period for help desk and desktop computing assessments generally averages one
to two months, but varies depending on the size and complexity of the project.
The assessment services are normally provided to customers on a time and
expense basis, with billing occurring semi-monthly or monthly.

Government Healthcare

Daou has extensive experience developing, implementing and/or supporting
data extractions, commercial off-the-shelf (COTS) product integration, and
module support for government healthcare organizations including the Military
Health System, the Indian Health Services and Veterans Health Administration.
Our systems integration solutions enable government healthcare organizations to
cost-effectively access information and communicate across the enterprise in
spite of the fact that systems run on disparate platforms in different
environments. Daou entered the government healthcare market through the 1998
acquisition of Sentient. Sentient had developed an expertise in government
healthcare, with a track record of implementing solutions that ultimately
reduce the cost and improve the quality of healthcare.

In addition to offering those services provided by our commercial healthcare
practice, our government healthcare services include:

. Custom Programming. We provide instrument interfaces, specialized
reporting requirements, web-enabled, back-end systems allowing real-time
results and support for legacy and "sunsetted" systems.

. System Integration Engines. We are experienced in optimizing leading
system integration engines and opening up MUMPS-based systems to current
or emerging technologies through our proprietary integration engine.

. Conversions and Upgrades. Fulfilling reporting requirements through data
extraction, cleansing and scrubbing for warehouses and relational
databases.

By developing interfaces, implementing existing interfaces, Web-enabling a
system, or migrating data to more compatible systems, our government healthcare
practice provides federal healthcare systems with low-cost methods of sharing
data between legacy systems, on-line transaction processing systems, and
off-the-shelf applications, regardless of technology platform or location. In
addition, our capabilities include building and supporting the M/MUMPS-based
systems typically used by government-run healthcare organizations. The group's
consultants are experienced in healthcare information systems such as CHCS,
VistA and RPMS.

The engagement period for these services generally ranges from nine to
twelve months, but varies depending on the size and complexity of the project.
Services are typically invoiced semi-monthly or monthly on a time and expense
basis.

Recruiting and Training of Technical Employees

We dedicate significant time and resources to recruit, train and retain
qualified technical personnel. Our technical personnel include consultants,
engineers and technicians providing healthcare IT consulting, managed care
systems implementation, application implementation and support, application
development and integration, communications infrastructure, help desk,
outsourcing, Internet and emerging technology services. We use both internal
and external recruiters to attract technical personnel.

Our technical personnel undergo extensive training and certification
attainment from leading healthcare, technology and integration vendors such as:
Siemens Medical Solutions, McKesson Corporation, Eclipsys, Cerner, Epic, IDX,
TriZetto, PerSe, QCSI, Microsoft, Cisco, Marconi, Nortel, Novell, Checkpoint,
Citrix, Sun Microsystems, HP, Compaq and See Beyond. In addition, we are a
member of leading technological forums and organizations, including HIMSS and
CHIME.

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We believe that our future success will depend in large part on our ability
to hire, train and retain qualified technical personnel who together have
expertise in a wide array of sophisticated IT solutions and a broad
understanding of the healthcare payor and provider organizations that we serve.
Competition for qualified technical personnel is intense and is expected to
increase. Consequently, there can be no assurance that we will be successful in
attracting and retaining such personnel. If we are unable to hire, train and
retain a sufficient number of qualified technical personnel, our ability to
adequately manage and complete our existing projects or to obtain new projects
could be impaired. This could have a material adverse effect on our business,
financial condition and results of operations. See "--Risk Factors--Loss of Key
Personnel Could Adversely Affect Our Business;--Our executive management team
is in transition;--We do not have employment agreements with most of our key
business managers."

Each technical employee is required to enter into a confidentiality and
proprietary information agreement with Daou. This agreement is designed to
protect our trade secrets and other confidential information during and
subsequent to employment. Any significant loss of employees to a competitor, or
our inability to enforce a confidentiality and proprietary information
agreement could have a material adverse effect on our business, financial
condition and results of operations.

Sales and Marketing

During 2002, we increased our spending in marketing and sales in an effort
to re-establish Daou's position as a leading independent resource for the
assessment, design, implementation, and management of the information
technology infrastructure of hospitals and IDNs. We are also seeking to enhance
our position as a management consultant and application implementation and
support expert in the health insurer and managed care market, and application
development and integration solutions provider in the government healthcare
market.

We seek to establish long-term relationships with our customers by providing
a high level of service and by becoming an integral part of their IT
operations. We focus our sales and marketing efforts on the CIOs and other
technology decision-makers of hospitals, IDNs, government healthcare
organizations and their prime contractors, managed care and insurance companies
and other healthcare provider organizations. We rely on our reputation in the
marketplace, the personal contacts and networking of our professionals, our
Strategic Partner Program and the various programs of our marketing department
to develop new business opportunities. We also receive sales leads directly
from consultants, value added resellers, and product and service vendors.

The principal objectives of our marketing department are to increase Daou's
market presence, provide strategic direction and generate sales leads. We
receive valuable feedback from customers, the Advisory Boards, CIO Forums, the
Strategic Partner Program and other trusted advisors. Based on this feedback,
our marketing program positions Daou as healthcare information technology
application and infrastructure experts, with the know-how to make information
technology work for healthcare organizations. We believe that Daou is well
positioned to serve the growing demand for application and technology solutions
that extend the useful life of legacy systems and integrate them with emerging
technologies.

As a supplement to our direct selling efforts, the marketing department has
developed advertising campaigns, tradeshow participation, direct mail
campaigns, public relations programs, marketing research and communications and
sales presentation materials. Public speaking engagements and the publication
of technical articles and reports directed to the healthcare information
technology industry also enhance our marketing efforts. We also continue to
develop our presence on the Internet as a new marketing channel.

We have entered into marketing agreements with certain third party vendors
to market our services to their respective customer bases. We intend to pursue
additional marketing agreements, joint ventures and alliances as part of our
marketing plan and business development efforts.

Strategic Partner Program

In 2002, we established our Strategic Partner Program as part of our
evolving business and product development strategy designed to meet the
clinical transformation needs of the healthcare

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marketplace. The program provides customers with an expanded product offering
from top vendors. We believe these vendors add even greater value to Daou's
core consulting and management services in applications, infrastructure,
systems integration and customer support.

As a solutions provider, we pursue a seamless approach to applications and
technology by extending the useful life of legacy systems and integrating them
with emerging technology. The charter member of the program is Park City
Solutions, Inc. of Midway, Utah, selected for its emPOWERnet (TM) portal
solution which enables organizations to unify and extend their applications,
information, and business processes to patients, clinicians, employers, payors,
and their surrounding communities. We intend to pursue additional strategic
partners, joint ventures and alliances as part of our marketing plan and
business development efforts.

Daou Advisory Boards and CIO Forums

We maintain two Advisory Boards which are non-governing bodies comprised
primarily of CIOs of (1) various healthcare provider organizations, and (2)
organizations within the payor/insurer segment. The Advisory Boards meet
bi-annually and the members confer separately with us periodically to provide
advice on issues and trends in the healthcare industry and emerging
technologies, as well as to provide strategic direction and feedback regarding
our current and future services. Members of an Advisory Board are reimbursed
for travel, lodging and meal expenses incurred in connection with attendance at
an Advisory Board's sessions.

In 2002, we established our CIO Forums that provide an opportunity for
regional healthcare IT professionals to learn from their peers. The CIO Forums
are conducted in a one-day session and address issues, challenges, and
opportunities within the industry. We conduct the CIO Forums several times per
year in various cities throughout the United States. CIO Forum participants are
reimbursed for lodging and meal expenses incurred in connection with attendance
at a CIO Forum, and we may make a cash contribution to their organization's
non-profit foundation or other charitable organization.

Intellectual Property and Proprietary Information

Our ability to compete effectively depends in part on our intellectual
property and proprietary information, including our proprietary methodologies,
best practices, research, tools, information systems, databases and other
information and procedures. We rely on a combination of copyright laws,
non-disclosure agreements and other confidentiality procedures to protect
Daou's intellectual property and proprietary information. However, these
protections may not be sufficient, and they do not prevent independent
third-party development of competitive products or services. See "--Risk
Factors--Any failure or inability to protect our technology and confidential
information could adversely affect our business."

Competition

The healthcare IT services industry is comprised of a large number of
participants and is subject to rapid change and intense competition. Further
challenges, complexities and occasionally, opportunities, arise from the fact
that healthcare IT vendors with specialty services may find themselves
collaborating on one customer mission and competing on another. We believe that
the principal competitive factors in the markets in which Daou competes include
reputation, healthcare industry expertise, system performance and reliability,
timely delivery of services, quality of service, responsiveness to customers,
product knowledge and technological expertise, marketing, customer
relationships and price.

Many of our competitors have significantly greater financial, technical and
marketing resources and greater name recognition than we do. Our competitors
include:

. consulting firms such as First Consulting Group, Inc., and Superior
Consultant Holdings Corporation;

. the consulting divisions or former affiliates of the major accounting
firms;

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. healthcare information technology companies such as The TriZetto Group,
McKesson Corporation and Siemens Medical Solutions;

. systems integrators such as Science Applications International
Corporation, Electronic Data Systems Corporation and Perot Systems
Corporation;

. customers' internal information management departments; and

. healthcare portal companies and network equipment vendors.

In addition to these major companies, we also compete with smaller regional
IT systems firms, which have a niche in selected geographic areas of the
country.

We have faced, and will continue to face, additional competition from new
entrants into our markets. Other healthcare information technology companies
not presently offering or emphasizing application and network systems services,
and large network services companies not currently focusing on healthcare may
enter the markets in which we compete. Increased competition could result in
price reductions, fewer customer projects, under-utilization of employees,
reduced operating margins and loss of market share, any of which could
materially and adversely affect our business, financial condition and results
of operations.

There can be no assurance that we will be able to compete successfully
against current and future competitors. In addition, most of our customers have
internal IT support and service capabilities and could choose to satisfy their
needs through internal resources rather than through outside service providers.
As a result, any decision by our customers or potential customers to perform IT
services internally or choose one of our competitors could have a material
adverse effect on our business, financial condition and results of operations.
See "--Risk Factors--We operate in highly competitive markets."

Customers

Since 1987, we have provided IT services to approximately 1,500 customers,
including many of the nation's hospitals, top 100 integrated delivery networks,
government healthcare organizations, health plans, insurance companies and
managed care organizations. In addition, selected services are provided on a
business-to-business basis to other healthcare IT vendors, including emerging
technology companies needing a partner to integrate these new technologies with
existing, legacy systems.

We derive a significant portion of our revenue from a relatively limited
number of large customers. For the year ended December 31, 2002, our five
largest customers accounted for approximately 32% of net revenue, with one help
desk outsourcing customer accounting for 9.2% of total net revenue.

Employees

As of December 31, 2002, after the effects of reorganization, we employed
217 technology and support professionals involved in management consulting,
infrastructure services, application installation and support, application
development and integration, strategic outsourcing, sales and marketing,
business development, information technology, finance and accounting, human
resources, company leadership and administration. We use internal and external
recruiters for the hiring of our technical and support professionals. We also
have an internal referral bonus program throughout the organization to
encourage employees to refer or recommend qualified professionals to join us.
Referring employees are rewarded with a bonus for each candidate hired by us.
Our employees are not represented by a labor union and we believe that our
relationship with our employees is good.

Risk Factors

An investment in Daou's Common Stock involves a high degree of risk. You
should carefully consider the following risk factors and warnings. The risks
described below are not the only ones facing us. Additional risks that we do
not yet know of or that we currently think are immaterial may

9

also impair our business operations. If any of the following risks actually
occurs, our business, financial condition or results of operations could be
materially and adversely affected. In such case, the trading price of our
common stock could decline, and you could lose all or part of your investment.
You should also refer to the other information set forth in this report,
including our Consolidated Financial Statements and the related notes.

Many factors cause our financial results to fluctuate.

Historically, we have experienced significant quarterly fluctuations in our
operating results due to shifts in demand for our services, the commencement
and completion of large fixed-fee contracts, and the closure and wind down of
operating units and difficulties in successfully integrating our acquired
companies. Variations in our revenues and operating results are expected to
continue from time to time, due to various factors, including:

. the failure to achieve a successful sales program and to secure and
deliver new customer contracts at the budgeted rate;

. industry spending patterns and market conditions that may affect
adversely the buying decisions of our current and prospective customers;

. the relatively longer sales cycle in obtaining new customers and larger
contracts;

. the timing and extent of employee training or the loss of key employees
or executive officers;

. increased competition;

. government regulations;

. the reduction in size, delay in commencement, interruption or termination
of one or more significant projects;

. the loss or termination of preferred partnership relationships with
software/hardware vendors, hospital groups, health plans or government
agencies;

. the failure to estimate accurately the resources required to complete new
or ongoing projects, including increased labor costs due to delays in
project delivery schedules;

. the commencement or completion during a quarter of one or more
significant projects;

. variations in the product or professional service content of our projects;

. the development and introduction of new services;

. the continued effect of acquisitions, including additional administrative
staffing and other increased infrastructure requirements to integrate the
newly acquired companies; and

. the effect of negative publicity relating to our litigation and
operations.

Accordingly, we believe that quarter-to-quarter comparisons of operating
results for preceding quarters are not necessarily meaningful. You should not
rely on results of any one quarter as an indication of our future performance.

We have a history of losses and our future profitability is uncertain.

We have incurred losses in each year since 1997. As of December 31, 2002, we
had an accumulated deficit of approximately $39.0 million. Our ability to
achieve profitability is dependent on a number of factors, including our
ability to secure new and maintain existing customers, the development and
introduction of new services, industry spending patterns and market conditions
and our ability to manage project risks. The markets in which we compete are
highly competitive, and we may not be successful in increasing our market
presence, growing our business or achieving profitability. As a result, we are
unable to accurately predict the extent of any future losses or the time
required to regain profitability, if at all.

10

We depend on a small number of large customers to provide a significant portion
of our revenue.

We receive a significant portion of our revenue from a relatively small
number of large customers, some of which operate under a single contract, and
we expect this pattern to continue in the future. A majority of our customers
are able to reduce or cancel their use of our services before the end of the
contract term, subject to certain monetary penalties. If these customers
terminate or modify existing contracts or experience business difficulties, it
could adversely affect our revenue and earnings. Certain of our outsourcing
contracts are set to expire in the next twelve months. Failure to renew these
contracts could adversely affect our revenue or earnings. As a percentage of
net revenue, our five largest customers accounted for approximately 32% for the
year ended December 31, 2002, 33% for the year ended December 31, 2001, and 33%
for the year ended December 31, 2000.

If we lose one of these large customers, or a large customer does not renew
its existing contract, we will face significant challenges in finding other
engagements on which to staff these employees. Delays in reassigning and the
resulting under-utilization of these employees would negatively impact our
operating results and financial condition.

A substantial majority of our operating expenses are fixed.

Though our revenue fluctuates from quarter to quarter, the substantial
majority of our operating expenses, particularly personnel and related costs,
depreciation and rent, are relatively fixed. We expect these costs to increase
in the future as we grow our business and expand our resources. Accordingly, a
variation in the timing of the commencement or completion of customer projects
or contracts, particularly at or near the end of any quarter, may cause
significant variations in operating results from quarter to quarter and could
result in losses for a particular quarter. In addition, an unanticipated delay
or termination of a major project or contract, or a series of smaller projects
or contracts, could require Daou to maintain or terminate under-utilized
employees, which could result in higher than expected expenses during a quarter.

We operate in highly competitive markets.

We operate in intensely competitive markets. We cannot assure you that we
will be able to compete successfully against current and future competitors or
that competitive pressures faced by us will not have a material adverse effect
on our business, financial condition and operating results. See "Competition"
above for a discussion of some of the risks associated with our markets.

Our long sales and project delivery cycles may adversely affect financial
performance.

Our sales process is often subject to delays associated with the lengthy
approval process that typically accompanies significant capital expenditures by
a customer. During this process, we expend substantial time, effort and
resources marketing our services, preparing contract proposals and negotiating
contracts. Any failure to procure a signed contract after expending significant
time, effort and resources could have a material adverse effect on our
business, financial condition and results of operations.

The implementation cycles for our network implementation, managed care
implementation, Web portal and outsourcing projects generally requires a
significant commitment of resources by Daou and by the customer. The length of
time required to complete a project may depend on many factors outside of our
control. In some instances, projects have been prolonged substantially as a
result of delays attributable to customers. Any delay or failure to receive
payment for our services after expending significant time, effort and resources
could have a material adverse effect on our business, financial condition and
results of operations. In addition, if we fail to deliver services on a timely
and cost-efficient basis, our business, financial condition and results of
operations could be materially and adversely affected. See "Sales and
Marketing" and "Item 7: Management's Discussion and Analysis of Financial
Condition and Results of Operations."

11

New technologies or industry standards could render our services obsolete or
unmarketable.

We receive a significant portion of our revenue from projects based on
complex healthcare applications and computer networks. The markets for software
applications and computer network products and services are continuing to
develop and are characterized by rapid change, including emerging Internet
based solutions. If we fail to meet the changing demands of technology, we may
not continue to be able to compete successfully with other providers of
software applications and technology solutions.

Our success depends on our ability to offer services and products that keep
pace with continuing changes in technology, evolving industry standards and the
changing preferences of our healthcare customers.

We cannot make assurances that products, systems or technologies developed
by third parties will not render one or more of our services noncompetitive or
obsolete.

We could lose customers and revenue if we fail to manage project risks or
performance standards.

Many of our service agreements contain performance standards or
deliverables. Some of our contracts with customers permit termination in the
event our performance is not consistent with service levels specified in those
contracts. Our failure to perform services that meet a customer's expectations
may result in not getting paid for services rendered. Further, if customers are
not satisfied with our level of performance, our reputation could be damaged
and our ability to attract new business may be materially and adversely
affected.

Our insurance coverage may not be sufficient to cover potential claims.

Any failure by our computer network systems to provide accurate, reliable
and timely information could result in claims against us. For example, where
the unavailability of such information to a provider of healthcare services is
alleged to have resulted in any physical or emotional injury to a patient, we
may become subject to claims by the provider. We are also subject to claims by
customers for actions of our employees which may have caused damages to
customers' businesses or otherwise. Although we maintain errors and omissions
insurance, there can be no assurance that such insurance coverage would
adequately cover any claims asserted against us. Consequently, these potential
claims could have a material adverse effect on our business, financial
condition and results of operations.

Customers may defer, modify or cancel a project on short notice.

Many of our consulting contracts are cancelable by the customer upon 30 days
written notice. When a customer defers, modifies or cancels a project, we must
rapidly redeploy our technical and other personnel to other projects to
minimize the under-utilization of employees and the resulting adverse impact on
our operating results. Furthermore, our operating expenses are relatively fixed
and cannot be reduced on short notice to compensate for unanticipated
variations in the number or size of projects in progress. As a result, any
termination, significant reduction or modification of our business
relationships with any of our significant customers or with a number of smaller
customers could have a material adverse effect on our business, financial
condition and operating results.

Loss of key personnel could adversely affect our business.

Our business strategy depends in large part on the services of our key
management and highly skilled healthcare technology professionals. Our business
also requires that our employees learn and implement the latest technical
applications and innovations for our customers. Our continued ability to
compete effectively in our business depends on our ability to attract, retain
and motivate these individuals. We have experienced significant turnover among
our technical personnel due in part to the significant time and travel demands,
increased competition for their services and recent reorganization. Any
inability to hire, train and retain a sufficient number of qualified technical
professionals could impair our ability to adequately manage and complete our
existing projects or to obtain new customers and projects.

12

Our executive management team is in transition.

In December 2002, we named Daniel J. Malcolm as our Chief Executive Officer.
In January 2003, we named Vincent K. Roach as our Executive Vice President,
Commercial Operations and announced the resignation of Neil R. Cassidy, Chief
Financial Officer (effective the second quarter of 2003.) This transition of
management personnel may adversely affect our operating performance, given the
time required for new senior personnel to assimilate and manage effectively our
business operations.

We do not have employment agreements with most of our key business managers.

We do not have employment agreements with most of our business management
team. The loss of services from one or more of our management or key personnel,
or the inability to hire additional management or key personnel as needed,
could have a material adverse effect on our business, financial condition and
operating results. In addition, we expect to further grow our operations and
our needs for additional management and key personnel will increase.

Our success depends on our key vendors and partners.

We depend on our software application and product vendor relationships. If
our software application or product vendors terminate or modify existing
contracts or experience business difficulties, or if we are unable to establish
new relationships with additional software application or product vendors, our
business could be harmed. We depend, and will continue to depend, on our
licensing and business relationships with third-party software application and
product vendors. Our success depends significantly on our ability to maintain
our existing relationships with our vendors and to build new relationships with
other vendors in order to enhance our services and application offerings and
remain competitive. Although most of our licensing agreements are perpetual or
automatically renewable, they are subject to termination in the event that we
materially breach such agreements. We cannot assure you that we will be able to
maintain relationships with our vendors or establish relationships with new
vendors. We cannot assure you that the software, products or services of our
third-party vendors will achieve or maintain market acceptance or commercial
success. Accordingly, we cannot assure you that our existing relationships will
result in sustained business partnerships, successful product or service
offerings or the generation of significant revenue for us.

We do not have exclusive arrangements with our software application and product
vendors.

Our arrangements with third-party software application and product vendors
are not exclusive. We cannot assure you that these third-party vendors regard
our relationships with them as important to their own respective businesses and
operations. They may reassess their commitment to us at any time and may choose
to develop or enhance their own competing distribution channels and product
support services. If we do not maintain our existing relationships or if the
economic terms of our business relationships change, we may not be able to
license and offer these services and products on commercially reasonable terms
or at all. Our inability to obtain any of these licenses could delay service
development or timely introduction of new services and divert our resources.
Any such delays could materially adversely affect our business, financial
condition and operating results.

Our relationships with key vendors or partners may adversely impact our
customer relationships.

As we form an increasing number of relationships with software application
and product vendors, our customers may perceive that we are not independent
from those vendors. Our ability to obtain consulting and assessment engagements
is due in part to our ability to analyze and recommend solutions while
remaining independent from the software and product vendors themselves. If
customers believe we are not independent from software application and product
vendors, our ability to obtain consulting or assessment engagements from
customers may be adversely impacted, resulting in reduced revenue and profits.

13

We may be unable to manage our restructured business units and future growth.

Some of our lines of business have experienced periods of rapid growth, and
we have restructured our business units in recent years. This growth and
restructuring have placed, and may continue to place, significant demands on
our managerial, operational and financial resources. In addition, in order to
manage any future growth, we must continue to improve and expand our
management, operational and financial systems and controls, including quality
control and delivery and service capabilities. If we are unable to manage our
growth or restructuring effectively or are unsuccessful in recruiting or
retaining personnel, it could have a material adverse effect on our business,
financial condition and operating results.

The consolidation and changing economic environment of the healthcare industry
may negatively impact revenue.

We receive substantially all of our revenue from customers involved in the
healthcare industry. Consequently, our business is vulnerable to changing
conditions affecting this industry. Many healthcare provider organizations are
combining through affiliation and consolidation to create larger organizations
with greater regional market power and are forming affiliations for purchasing
products and services. This consolidation could reduce our target market and
result in the termination of customer contracts. In particular, some of our
customers have scaled back or terminated their relationship following their
acquisition, and this trend may continue in the future. Moreover, consolidated
enterprises or affiliated enterprises may try to use their greater bargaining
power to negotiate reductions in the amounts paid to us for services we
perform. Any reduction in the size of our target market or failure to maintain
adequate price levels could materially and adversely affect our revenue and
financial condition.

Increasingly complex regulatory environments may increase our risk and our
costs.

Increasingly complex regulatory environments affect a number of our
services. As an example, changes in healthcare information privacy laws and
regulations may increase our risk of liability and increase the cost of some
services we offer. In addition, new regulations governing the standardization
and security for healthcare information under HIPAA could significantly impact
the amount, timing and types of services requested by customers.

The healthcare industry also is subject to changing political, economic and
regulatory influences that may affect the procurement practices and operations
of participants in the healthcare industry. For example, recent federal
legislation may reduce the reimbursements available for hospitals. Reduced
reimbursements may negatively impact the spending patterns and demand for our
information technology services. We cannot predict with any certainty what
impact these developments could have on our business, financial condition and
results of operations.

Our contracts contain pricing risks that affect our revenue and profit.

We offer a portion of our computer network system, consulting services and
outsourcing services on a fixed-price, fixed-time frame basis, rather than on a
time-and-expense basis. Consequently, we bear the risk of cost over-runs in
connection with these projects. If we fail to estimate accurately the resources
and time required for a project or fail to complete our contractual obligations
within the committed fixed-time frame, it could have a material adverse effect
on our business, financial condition and results of operations.

Any failure or inability to protect our technology and confidential information
could adversely affect our business.

There can be no assurance that the steps we have taken to protect our
intellectual property will be adequate to prevent unauthorized use or
misappropriation of our proprietary information. Any significant loss or
unauthorized use of our intellectual property or proprietary information by a
competitor could have a material adverse effect on our business, financial
condition or results of operations. We believe that our systems and procedures
and other proprietary rights do not infringe upon the rights of third parties.
There can be no assurance, however, that third parties will not assert
infringement claims against Daou or that such claims will not require
protracted and costly litigation, regardless of the merits of such claims.

14

Our officers and directors have the power to influence the election of
directors and the passage of stockholder proposals.

As of March 20, 2003, Daou's executive officers, directors and affiliated
persons beneficially owned approximately 42.9% of the outstanding shares of
common stock. As a result, these stockholders can exercise significant
influence over all matters requiring stockholder approval, including the
election of directors and approval of significant corporate transactions. This
concentration of ownership also may delay or prevent a change in control of
Daou.

Our common stock price is subject to wide fluctuations in value and significant
volatility.

Based upon the historical performance of our common stock, we anticipate
that the future price of our common stock may be subject to wide fluctuations
because of announcements of:

. quarterly fluctuations in our operating results

. changes in earnings estimates by analysts;

. negative publicity relating to our litigation and operations;

. strategic relationships or acquisitions;

. new customer contracts or services by Daou or our competitors, or the
loss of a large customer;

. general conditions in the market for healthcare IT applications and
computer network services;

. healthcare industry and general market conditions, including HIPAA
developments; and

. changes in our pricing policies or those of our competitors.

In addition, in recent years, the stock market in general and the shares of
technology companies in particular have experienced extreme price fluctuations.
Fluctuations in the price of our common stock may be disproportionate or
unrelated to our operating performance and may affect adversely the market
price of our common stock.

Provisions of our certificate of incorporation, bylaws, and Delaware law could
deter takeover attempts.

A number of provisions of Delaware law and our certificate of incorporation
and bylaws could delay, defer or prevent a change in control of Daou and could
limit the price that some investors might be willing to pay in the future for
shares of our common stock. These provisions:

. prohibit us from engaging in any business combination with any interested
stockholder for a period of three years from the date the person became
an interested stockholder unless specific conditions are met;

. permit our board of directors to issue shares of preferred stock without
stockholder approval on the terms as our board may determine;

. provide for a classified board of directors;

. eliminate the right of our stockholders to act by written consent without
a meeting;

. require advanced stockholder notice to nominate directors and raise
matters at the annual stockholders meeting;

. eliminate cumulative voting in the election of directors; and

. allow for the removal of directors only for cause and with a two-thirds
vote of our outstanding shares.

Future sales of our common stock could adversely affect the price of our common
stock and our ability to raise additional equity capital.

The sale of substantial amounts of our common stock in the public market,
the prospect of these sales or the sale or issuance of convertible securities
or warrants could affect adversely the market

15

price of our common stock. Of the 21,782,707 shares outstanding as of March 20,
2003, 16,783,180 shares of common stock are freely tradable without restriction
in the public market. The remaining 4,999,527 shares are "restricted
securities" as defined in Rule 144.

In September 1999, we registered 2,750,000 shares of common stock that will
be freely tradable upon conversion of the 2,181,818 outstanding shares of
Series A convertible preferred stock. In addition, we registered on a Form S-8
Registration Statement an aggregate of 5,000,000 shares of common stock under
the Daou Systems, Inc. 1996 Stock Option Plan. An additional 1,475,000 shares
of common stock were subject to options issued outside of our 1996 Stock Option
Plan. In December 2000, we registered an aggregate of 1,500,000 shares of
common stock under the Daou Systems, Inc. Employee Stock Purchase Plan. We have
also issued warrants exercisable for 3,540,000 shares of common stock
exercisable at $.01 per share and have the obligation to register the shares of
common stock deliverable upon exercise of the warrants. During 2001, we sold
4,300,000 shares of restricted common stock to four of our officers and
directors in return for full-recourse promissory notes. We are obligated to
register such shares of common stock.

Item 2: Description of Properties.

Daou leases the following office space for our principal administrative,
operating, support and training facilities:

Approximate
Location Square Footage Expiration Principal Use
-------- -------------- ------------- --------------------------------

Kensington, MD.. 21,000 February 2004 Operating and support facilities
Alexandria, VA.. 21,000 May 2005 Operating and support facilities(1)
Exton, PA....... 13,000 March 2009 Corporate office facility
Indianapolis, IN 6,000 April 2002 Operating and support facilities
Alexandria, VA.. 4,000 June 2005 Operating and support facilities
Indianapolis, IN 4,000 May 2003 Operating and support facilities

- --------
(1) Portions of the property have been subleased.

We continually evaluate the adequacy of our existing facilities and believe
that our current and planned facilities will be adequate for the next twelve
months.

Item 3: Legal Proceedings.

IN RE DAOU SYSTEMS SECURITIES LITIGATION

On August 24, 1998, August 31, 1998, September 14, 1998 and September 23,
1998, four separate complaints were filed against the Company and certain of
its officers and directors in the United States District Court for the Southern
District of California. On October 15, 2002, the Court granted the Company's
Motion to Dismiss the class action complaint, with prejudice. The plaintiffs
noticed appeal to the Ninth Circuit Court of Appeal on November 13, 2002.

As background, a group of shareholders were appointed the lead plaintiff in
this federal litigation, and they filed a second amended consolidated class
action complaint on January 21, 2000. Their second amended complaint realleges
that the Company improperly used the "percentage-of-completion" accounting
method for revenue recognition. Claims are pleaded under both the 1933
Securities Act (relating to the Company's initial public offering) and section
10b of the 1934 Securities Act. The complaint was brought on behalf of a
purported class of investors who purchased the Company's Common Stock between
February 13, 1997 and October 28, 1998, but it does not allege specific damage
amounts. A Motion to Dismiss the second amended consolidated class action
complaint was filed on February 22, 2000. On March 27, 2002, the Court granted
the Motion but extended to plaintiffs the opportunity to file a Third Amended
Complaint. The plaintiffs filed their Third Amended Complaint on May 16, 2002,
to which the Company responded with another Motion to Dismiss. The Motion was
filed on June 24, 2002 and challenged the legal sufficiency of the allegations.
On October 16, 2002, the Court granted that Motion, this time with prejudice.
The plaintiffs noticed appeal to the Ninth Circuit Court of Appeal on November
13, 2002. The Company filed a Notice of Cross-Appeal on November 26, 2002
challenging the failure of the trial court to assess whether the complaints
were filed in violation of Rule 11 of the Federal Rules of Civil Procedure.
Plaintiffs must file their Opening Brief by April 9, 2003. The Company is
currently

16

scheduled to file its Brief no later than May 19, 2003. On October 7, 1998 and
October 15, 1998, two separate complaints were filed in the Superior Court of
San Diego County, California. These state court complaints mirror the
allegations set forth in the federal complaints. They also assert claims for
common law fraud and the violation of certain California statutes. As with
their federal counterparts, they do not allege specific damage amounts. On
April 1, 1999, a Consolidated Amended Class Action was filed on behalf of the
same state court plaintiffs, and this new complaint alleges the same factual
basis as is asserted in the federal litigation. The state litigation pleads
claims for fraud and violations of certain California Corporation Code
provisions. By stipulation of the parties and order of the court, this state
court litigation was stayed pending the outcome of the motion to dismiss the
federal lawsuits. The Company believes that the allegations set forth in the
federal and state complaints are without merit, and the Company intends to
defend against these lawsuits vigorously. No assurance as to the outcome of
this matter can be given, however, and an unfavorable resolution of this matter
could have a material adverse effect on the Company's business, results of
operations, and financial condition.

DICKSON V DAOU SYSTEMS, INC. ET AL

On February 27, 2002, a complaint was filed against certain of the Company's
former officers and directors, as well as Daou On-Line, Inc., in the Superior
Court of New Jersey located in Bergen County. The Court conducted a hearing on
June 7, 2002 and granted the Company's Motion to Dismiss. The plaintiffs
abandoned their appeal which the Appellate Court dismissed on January 3, 2003.
The plaintiffs filed a Complaint against the Company, as well as certain of its
former officers in San Diego County Superior Court on December 5, 2002. An
answer or other responsive pleading to the Complaint must be filed on April 4,
2003 absent agreement to stay the case and proceed to arbitration.

As background, a First Amended Complaint was filed on March 1, 2002, adding
the Company and its former Chief Financial Officer as parties/defendant. The
gravamen of the First Amended Complaint is twofold. First, it alleges Daou's
financial statements were misleading and fraudulently induced the plaintiff to
merge his company with Daou. Second, the First Amended Complaint alleges breach
of an indemnification and severance agreement obligating the Company to defend
the plaintiff in a lawsuit filed by Traci Melia, a former employee. Neither the
Complaint nor the First Amended Complaint alleges specific damage amounts. The
Company filed A Motion to Dismiss the First Amended Complaint on April 24,
2002. The Court conducted a hearing on June 7, 2002 and granted our motion. On
July 23, 2002, plaintiffs filed a Notice of Appeal but later abandoned their
appeal which the Appellate Court dismissed on January 3, 2003. The Plaintiffs
filed a Complaint against the Company, as well as certain of its former
officers in San Diego County Superior Court on December 5, 2002. The Summons
and Complaint was served by way of Notice and Acknowledgment of Receipt. While
not identical to the Complaints filed in New Jersey, the gravaman of the San
Diego action is the same. The Complaint prays for compensatory damages of at
least $1,450,000. An answer or other responsive pleading to the Complaint must
be filed on April 4, 2003 absent agreement to stay the case and proceed to
arbitration. Counsel for Mr. Dickson has advanced that proposal given a
controlling arbitration provision set forth in one of the contracts giving rise
to the lawsuit. The Company believes that the allegations set forth in the
Complaint are without merit, and the Company intends to defend against the
lawsuit or arbitration vigorously. No assurance as to the outcome of this
matter can be given, however, and an unfavorable resolution of this matter
could have a material adverse effect on the Company's business, results of
operations and financial condition.

The Company is party to other various claims and legal actions arising in
the normal course of business. Although the ultimate outcome of the matters is
not presently determinable, management believes that the resolution of all such
pending matters, net of amounts accrued, will not have a material adverse
affect on the Company's business, results of operations or financial condition;
however, there can be no assurance that the ultimate resolution of these
matters will not have a material impact on the Company's results of operations
in any period.

Item 4: Submission of Matters to a Vote of Security Holders.

No matters were submitted to a vote of stockholders during the fourth
quarter of 2002.

17

PART II

Item 5: Market for Common Equity and Related Stockholder Matters.

Daou's shares of Common Stock have traded on the Over the Counter Bulletin
Board (OTCBB) since April 25, 2001 under the symbol DAOU. Daou's shares of
common stock traded on the NASDAQ National Market System under the symbol DAOU
from February 12, 1997 through April 24, 2001. The following table sets forth
the high and low closing bid information for the common stock. Bid quotations
reflect inter-dealer prices without retail mark-up or mark-down and may not
necessarily represent actual transactions.

Common Stock
-------------
HIGH LOW
------ ------

2002
1st Quarter. $1.500 $0.650
2nd Quarter. 1.560 0.910
3rd Quarter. 0.930 0.410
4th Quarter. 0.525 0.260
2001
1st Quarter. $0.789 $0.289
2nd Quarter. 0.500 0.140
3rd Quarter. 0.710 0.310
4th Quarter. 1.280 0.410

On March 20, 2003, the closing bid and ask prices of the common stock were
$0.34 and $0.36, respectively. As of March 20, 2003, there were 148 holders of
record of common stock.

Dividend Policy

Daou has never declared nor paid cash dividends on the capital stock. We
currently intend to retain any earnings for future growth and, therefore, do
not intend to pay any cash dividends in the foreseeable future.

Daou issued Series A Preferred Stock on July 26, 1999. Holders of the Series
A Preferred Stock were initially entitled to receive cumulative dividends at
the rate of six percent per annum, generally payable in the form of shares of
Series A Preferred Stock until July 26, 2001. The dividend rate increased to 7%
on July 26, 2001, to 8% on July 26, 2002 and will continue to increase an
additional 1% on July 26 of each year. As of December 31, 2002, Daou has
accrued but undeclared preferred stock dividends of $3.0 million payable in
shares of Series A Preferred Stock. No dividends may be paid on the common
stock unless full dividends on the Series A Preferred Stock for the then
current dividend period have been either paid or declared with a sum sufficient
for the payment set apart.

Recent Sales of Unregistered Securities

On July 24, 2001, we sold 150,000 shares of restricted common stock in a
private placement pursuant to Section 4(2) of the Securities Act, at the July
24, 2001 closing price of $.52 per share to one of our executive officers, in
exchange for a full recourse note receivable that accrues interest at a rate of
6.75% and is due on July 24, 2006.

On June 1, 2001, we sold an aggregate of 4,150,000 shares of restricted
common stock in a private placement pursuant to Section 4(2) of the Securities
Act, at the June 1, 2001 closing price of $.29 per share to three of our
executive officers, in exchange for full recourse notes receivable that accrue
interest at a rate of 6.75% and which are due on May 31, 2006.

Although none of these officers has indicated a present intention to sell,
Daou is contractually obligated to register these 4,300,000 shares of common
stock for resale.

On November 9, 2000, as a consequence of the resignation of Larry Grandia,
Daou's former Chief Executive Officer, holders of the Series A Preferred Stock
had the right to cause the redemption of their Series A Preferred Stock for
approximately $12.9 million. We entered into an agreement with the holders of
the Series A Preferred Stock under which the holders of the Series A Preferred
Stock permanently waived their redemption rights in return for $2.0 million in
cash and warrants to purchase 3,540,000 shares of our common stock exercisable
at $0.01 per share. The total consideration of this transaction was valued at
approximately $4.1 million and for financial reporting purposes was recorded as
a one-time dividend in the fourth quarter of 2000.

18

Item 6: Selected Consolidated Financial Data.

The following table presents selected consolidated financial data and has
been derived from our consolidated financial statements, which have been
audited by Ernst & Young LLP, independent auditors. The information set forth
below is not necessarily indicative of the results of future operations and
should be read in conjunction with the other sections of "Management's
Discussion and Analysis of Financial Condition and Results of Operations" in
Item 7 of this report and the consolidated financial statements and the related
notes thereto included elsewhere herein (in thousands, except per share data):

Years ended December 31,
----------------------------------------------
1998 1999 2000 2001 2002
-------- -------- -------- ------- -------

Revenue before reimbursements (net
revenue)................................. $104,784 $103,400 $ 63,748 $41,082 $37,935
Cost of revenue before reimbursable
expenses................................. 85,834 82,030 59,923 32,424 27,668
-------- -------- -------- ------- -------
Gross profit............................... 18,950 21,370 3,825 8,658 10,267
Operating expenses:
Sales and marketing..................... 12,203 10,398 5,744 3,360 5,040
General and administrative.............. 10,643 18,968 10,831 7,408 6,838
Restructuring charges................... -- -- 2,133 1,263 1,598
Merger and related expenses............. 2,825 -- -- -- --
-------- -------- -------- ------- -------
Total operating expenses............ 25,671 29,366 18,708 12,031 13,476
-------- -------- -------- ------- -------
Income (loss) from operations.............. (6,721) (7,996) (14,883) (3,373) (3,209)
Other income, net.......................... 163 779 699 421 270
-------- -------- -------- ------- -------
Income (loss) before income taxes.......... (6,558) (7,217) (14,184) (2,952) (2,939)
Provision (benefit) for income taxes....... (802) (1,761) -- -- --
-------- -------- -------- ------- -------
Net income (loss).......................... (5,756) (8,978) (14,184) (2,952) (2,939)
Dividends on preferred stock............... -- (308) (4,837) (854) (1,054)
-------- -------- -------- ------- -------
Net income (loss) available to common
stockholders............................. $ (5,756) $ (9,286) $(19,021) $(3,806) $(3,993)
======== ======== ======== ======= =======
Net income (loss) available to common
stockholders per common share:
Basic................................... $ (0.33) $ (0.52) $ (1.07) $ (0.22) $ (0.21)
======== ======== ======== ======= =======
Diluted................................. $ (0.33) $ (0.52) $ (1.07) $ (0.22) $ (0.21)
======== ======== ======== ======= =======
Shares used in computing net income (loss)
per common share:
Basic................................... 17,657 17,697 17,712 17,682 19,075
======== ======== ======== ======= =======
Diluted................................. 17,657 17,697 17,712 17,682 19,075
======== ======== ======== ======= =======
Cash, cash equivalents, restricted cash and
short-term investments................... $ 7,780 $ 15,548 $ 10,586 $15,074 $12,394
Total assets............................... 54,517 46,060 26,832 24,384 24,640
Long-term debt, less current portion....... 26 -- -- -- --
Redeemable convertible preferred stock..... -- 11,382 -- -- --
Total stockholders' equity................. $ 34,775 $ 24,974 $ 20,360 $17,308 $14,469

Item 7: Management's Discussion and Analysis of Financial Condition and Results
of Operations.

This discussion contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and section 21E of the
Securities Exchange Act of 1934. All forward-looking statements are inherently
uncertain as they are based on current expectations and assumptions concerning
future events or future performance of Daou Systems, Inc. You should not place
undue reliance on these forward-looking statements, which are only predictions
and speak only as of the date hereof. Forward-looking statements usually
contain the word "estimate," "anticipate,"

19

"hope", "believe," "think", "expect," "intend", "plan" or similar expressions,
and are subject to numerous known and unknown risks and uncertainties. In
evaluating such statements, you should carefully review various risks and
uncertainties identified in this report, including the matters set forth under
the captions "Risk Factors" and in Daou's other SEC filings. These risks and
uncertainties could cause Daou's actual results to differ materially from those
indicated in the forward-looking statements. We do not undertake any obligation
to update or publicly announce revisions to any forward-looking statements to
reflect future events or developments.

Recent Developments

On January 9, 2003, we announced our decision to reorganize Daou's internal
management structure, consolidate operations and eliminate non-strategic
services. This reorganization, which was approved by our Board of Directors in
December 2002, is part of our strategy to position Daou for continued growth in
the marketplace and ultimately achieve profitability. We recorded a one-time
restructuring charge of approximately $1.6 million in the fourth quarter of
2002 related to severance costs, expenses associated with a slight workforce
reduction, elimination of non-strategic services and the consolidation of
office space in connection with this reorganization. We have consolidated
operations and incurred restructure charges in each of the last three years. As
a consequence of the consolidations and elimination of non-strategic and
unprofitable lines of business, our revenue has declined. In addition,
competition has intensified and we have incurred operating losses.

As part of the reorganization, we consolidated Daou's two operating
divisions--Technology Services and Application Services, and plan to operate as
one business unit. We currently have no reportable segments. (In 2001, Daou had
five reportable segments: Technology Management ("TMI"), Resources in
Healthcare Innovation ("RHI"), Sentient, Infrastructure Services Group ("ISG")
and RTC). Today, Daou has no reportable segments and operates as one business
unit. For purposes of improving overall sales and operations effectiveness, and
to offer our customers an integrated solutions approach through
multi-disciplinary teams, we now provide our services through two primary
practice groups: commercial healthcare and government healthcare. We believe
the consolidation was necessary due to changing market forces in the healthcare
industry. We expect that operating under our new structure will allow us to
focus on our core competencies and pursue a seamless approach to applications
and technology.

Effective January 1, 2002, certain overhead expenses directly attributable
to the business units and formerly recorded as general and administrative
expenses are now recorded as cost of revenue before reimbursable expenses. The
prior period amounts have been reclassified to conform to their current period
presentation.

Overview

Daou provides integrated IT solutions and services to the U.S. healthcare
industry. Since 1987, we have provided IT services to approximately 1,500
customers, including many of the nation's hospitals, top 100 IDNs, government
healthcare organizations, health plans, insurance companies and managed care
organizations. Our services include (1) management consulting, (2) traditional
network services, (3) application implementation and support, (4) application
development and integration, and (5) strategic outsourcing, including remote
help desk and related technology support services. Daou currently has
approximately 218 employees.

Daou is principally focused on providing IT services and solutions to
healthcare providers, payors and health plans and government healthcare
organizations. We design and implement solutions to help healthcare
organizations navigate the intersection of legacy systems with emerging
technologies such as web portals, wireless and other portable computing
solutions. As a "trusted advisor" to leading organizations in the payor/insurer
segment of the market, we provide consultative services to HMO, health
insurers, blues plans and independent practice associations. Our provider
customers include hospitals, IDNs, medical groups, academic medical centers,
physician groups and ancillaries. In addition, we provide IT services to
government healthcare organizations, third-party administrators, medical
services organizations, service vendors, software vendors and hardware vendors.
We believe that our key competitive advantage is our core understanding of our
client's complex healthcare environment based on our extensive knowledge and
experience in the healthcare industry.

20

We remarket certain third-party applications and solutions, such as
emPOWERnet(TM) portals, through our Strategic Partner Program. We sell no
proprietary hardware, although our network solutions may include the resale of
certain third-party products. Through extensive research and our payor and
provider Advisory Boards and CIO Forums, we have the opportunity to fine-tune
our strategic plans and service offerings with influential healthcare
executives. Daou's operating philosophy is to meet or exceed the customer's
objectives and to pursue excellence in every area in which our professional
staff works.

In 2002, Daou provided integrated information technology solutions and
services to the U.S. healthcare industry. We principally focused on (1)
healthcare providers, (2) payors and health plans and (3) government healthcare
organizations. We focus exclusively on healthcare IT and have diverse technical
resources. We believe that this offers our customers a combination of
healthcare-familiar and practice-driven technology experts that factor in how
each individual project works within the customer's IT strategic plan. Many of
our technology consultants have extensive healthcare experience. In addition,
our healthcare engineers and technicians are experienced with many types of
technology, such as application development, networking, interfacing, database
management, data security and help desk management. We work with clients to
provide real-world solutions that work with their clinical and business
processes. We provide services through two practice groups: commercial
healthcare and government healthcare.

Our service offerings represent aggregated end-to-end healthcare IT
solutions. Depending on the specific needs of our customers, our relationships
may begin anywhere along the IT solution process, growing within one of the
service lines or developing cohesively across the complete end-to-end IT
solution process from conceptualization to operation.

We generate substantially all of our revenue from professional services,
primarily on a "time and expense" project basis, under which revenue is
recognized as the services are performed. Billings for these services occur on
a semi-monthly or monthly basis as specified by the contract with a particular
customer. Our billing rates are commensurate with the healthcare-domain IT
expertise, know-how and skills of our consultants. Our time and expense
projects generally range from three to six months, although certain projects
have been for periods in excess of a year. Our network system and payor
application system implementation engagements typically average six months but
may vary depending on the size and complexity of the project. We also provide
support, management and help desk services, under multi-year engagements, in
which revenue is recognized ratably over the period that these services are
provided. Our help desk services are generally provided in multi-year
engagements on a price per call or price per node basis.

Prior to 1999, the majority of our contract services were generally provided
on a fixed-fee basis. Revenue on fixed-fee contracts is recognized related to
the level of service performed based upon the amount of labor cost incurred on
the project versus the total labor costs to complete the project. Our gross
margin with respect to fixed fee contracts varies significantly depending on
the percentage of such services consisting of third-party products (with
respect to which we obtain a lower margin) versus professional services.

We bill our customers for out-of-pocket expenses, primarily travel and
related expenses incurred with respect to services provided to customers, and
have adopted the provisions of the Emerging Issues Task Force ("EITF") Topic
D-103, Income Statement Characterization of Reimbursements for "Out-of-Pocket"
Expenses Incurred.

Payments received in advance of services performed are recorded as deferred
revenue. Certain contract payment terms may result in customer billing
occurring at a pace slower than revenue recognition. The resulting revenue
recognized in excess of amounts billed and project costs is included in
contract work in progress on our balance sheet.

Cost of revenue primarily consists of all expenses that are directly
attributable to our service lines and include the salaries, bonuses and related
benefits of our consultants as well as non-billable managers and support staff,
subcontractor expenses, training costs and unit-specific office space costs.
Our consultant-related costs are relatively fixed therefore, fluctuations in
our gross margin may occur due to changes in project margins and utilization
rates of our professional staff. We often hire employees in anticipation of
commencement of a project. If delays in contract signing occur, our gross
margin could vary due to the associated loss of revenue to cover fixed labor
costs.

21

Sales and marketing expenses primarily consist of the salaries, benefits,
travel and other costs of our sales and marketing teams, as well as marketing
initiatives and business development expenses. General and administrative
expenses primarily consist of the costs attributable to the support of our
consultants, such as: investments in information systems, salaries, expenses
and office space costs for executive management, financial accounting,
purchasing, administrative and human resources personnel, recruiting fees,
legal and other professional services.

Results of Operations

The following table sets forth, for the years indicated, certain statement
of operations data as a percentage of net revenue.

Years Ended December 31,
----------------------
2002 2001 2000
---- ---- ----

Revenue before reimbursements (net revenue). 100% 100% 100%
Cost of revenue before reimbursable expenses 73 79 94
--- --- ---
Gross profit................................ 27 21 6
Sales and marketing expense................. 13 8 9
General and administrative expense.......... 18 18 17
Restructuring charges....................... 4 3 3
--- --- ---
Loss from operations........................ (8) (8) (23)
Other income, net........................... 1 1 1
--- --- ---
Loss before income taxes.................... (7) (7) (22)
Provision for income taxes.................. -- -- --
--- --- ---
Net loss.................................... (7)% (7)% (22)%
--- --- ---

Years Ended December 31, 2002 and 2001

Our net revenue decreased 8%, or $3.2 million, to $37.9 million for the year
ended December 31, 2002 from $41.1 million for the year ended December 31,
2001. This decrease is a combination of a $5.0 million increase in managed care
implementation revenue, offset by a $4.0 million decrease in revenue associated
with the termination of a large outsourcing contract and the elimination of
unprofitable lines of business in 2001, a $2.2 million decrease in revenue due
to the downsizing of our temporary staffing business, a $2.0 million decrease
in revenue associated with long-term contracts expiring in 2001 that were not
renewed and a reduction in infrastructure services revenue. Revenue from
third-party equipment sales remained relatively flat at $1.0 million in 2002
and 2001.

Services to our five largest customers accounted for $12.3 million of net
revenue for the year ended December 31, 2002, representing 32% of total net
revenue, with one help desk outsourcing customer accounting for 9.2% of net
revenue. This compares to net revenue from the five largest customers for the
year ended December 31, 2001 totaling $13.5 million, or 33% of net revenue.

Cost of revenue before reimbursable expenses decreased 15%, or $4.7 million,
to $27.7 million for the year ended December 31, 2002 from $32.4 million for
the year ended December 31, 2001 primarily due to the 8% decrease in net
revenue as well as our efforts to eliminate under-performing lines of
businesses and a reduction of costs and more effective management of our
workforce, offset by higher costs in our managed care implementation business
associated with the higher revenue attainment in that business.

Gross margin increased to 27% for the year ended December 31, 2002 as
compared to 21% for the year ended December 31, 2001. This increase is
attributable primarily to the above-referenced exit from certain lines of
business that were not profitable or had low margins as well as disciplined
management procedures and controls resulting in increased operating
efficiencies and billable utilization of our workforce.

22

Sales and marketing expenses increased 50%, or $1.6 million, to $5.0 million
for the year ended December 31, 2002 as compared to $3.4 million for the year
ended December 31, 2001, primarily due to our efforts to re-establish market
presence in 2002 following a period of limited activity as we focused
internally to restructure and gain operating efficiencies. Sales and marketing
expenses were 13% and 8% of net revenue for the years ended December 31, 2002
and 2001, respectively. We expect sales and marketing expenses to increase in
2003 as we continue to invest in strategic business development initiatives in
an effort to increase revenue.

General and administrative expenses decreased $600,000, or 8%, to $6.8
million for the year ended December 31, 2002 as compared to $7.4 million for
the year ended December 31, 2001, reflecting our efforts in improving
administrative operating performance and the centralization of accounting,
human resources, and IT functions at the corporate level. General and
administrative expenses were 18% of net revenue for each of the years ended
December 31, 2002 and 2001.

We recorded a restructuring charge for the year ended December 31, 2002
totaling $1.6 million primarily related to our decision to reorganize our
internal management structure, consolidate operations and eliminate
non-strategic services as part of our strategy to position Daou for continued
growth in the marketplace. The restructuring charge includes $1.1 million in
severance costs and $500,000 related to the closure and combination of certain
facilities.

Other income, net, decreased 36%, or $100,000 to $300,000 for the year ended
December 31, 2002 as compared to $400,000 for the year ended December 31, 2001.
Other income is comprised primarily of interest income on cash and cash
equivalents, and investments.

The effective income tax rate for the year ended December 31, 2002 and 2001
was 0%. We did not record an income tax benefit on the operating loss as
realization is not certain.

Years Ended December 31, 2001 and 2000

Our net revenue decreased 35%, or $22.6 million, to $41.1 million for the
year ended December 31, 2001 from $63.7 million for the year ended December 31,
2000. This decrease is primarily due to our previously announced termination of
large outsourcing contracts, our decision to exit certain unprofitable lines of
businesses and continued softened demand for services in our core health care
IT business. Revenue from third-party material sales decreased to $1.0 million
in 2001 from $4.7 million in 2000.

Services to our five largest customers accounted for $13.5 million of net
revenue for the year ended December 31, 2001, representing 33% of total net
revenue, with one customer in the Sentient business group accounting for 9.7%
of total net revenue. This compares to net revenue from the five largest
customers for the year ended December 31, 2000 totaling $21.0 million, or 33%
of total net revenue. One customer, included in the five largest customers for
each of the years, exercised its right to terminate its outsourcing contract as
of March 31, 2001. This customer accounted for $3.0 million in net revenue for
the year ended December 31, 2001, or 7.3% of total net revenue, and accounted
for $10.1 million in net revenue, representing 16% of total net revenue, for
the year ended December 31, 2000.

Cost of revenue before reimbursable expenses decreased 46%, or $27.5
million, to $32.4 million for the year ended December 31, 2001 from $59.9
million for the year ended December 31, 2000 primarily due to the 35% decrease
in net revenue and our efforts to reduce headcount and other costs of revenue
to maximize productivity at the current revenue levels.

Gross margin increased to 21% for the year ended December 31, 2001 as
compared to 6% for the year ended December 31, 2000. This increase is primarily
attributable to our efforts to eliminate unprofitable lines of businesses,
reduce costs and more effectively manage our workforce resulting in higher
utilization. Also, in February 2000, we formed the Enosus subsidiary division
to provide Internet and eCommerce services. Start up investments in Enosus
further reduced gross margin during 2000. We previously announced that Enosus
was merged into the ISG business unit in December 2000.

23

Sales and marketing expenses decreased 41%, or $2.3 million, to $3.4 million
for the year ended December 31, 2001 as compared to $5.7 million for the year
ended December 31, 2000, primarily due to the reduction in sales staff and
related expenditures as a result of consolidation, integration of the sales and
marketing functions and our withdrawal from certain unprofitable lines of
businesses. Sales and marketing expenses were 8% and 9% of net revenue for the
years ended December 31, 2001 and 2000, respectively. We expect sales and
marketing expenses to increase by approximately $3 million in 2002 and
subsequent periods as we reinvest in marketing and sales programs to generate
renewed interest in our offerings, as well as opportunities related to emerging
healthcare information technologies.

General and administrative expenses decreased $3.4 million, or 32%, to $7.4
million for the year ended December 31, 2001 as compared to $10.8 million for
the year ended December 31, 2000, primarily due to efficiencies realized with
the consolidation and integration of certain general and administrative
functions of the divisions. During 2000, we completed the implementation of our
ERP system and have been able to centralize certain functions into the
corporate office and reduce overhead costs as a result. General and
administrative expenses were 18% and 17% of net revenue for the years ended
December 31, 2001 and 2000, respectively.

We recorded a restructuring charge for the year ended December 31, 2001
totaling $1.3 million primarily related to the consolidation and relocation of
our corporate offices with existing facilities in Exton, Pennsylvania. The
restructure charge consisted of approximately $1.0 million related to the
closure and combination of certain facilities and approximately $300,000
related to severance costs. We recorded a restructuring charge for the year
ended December 31, 2000 totaling $2.1 million. This charge resulted primarily
from severance costs related to a workforce reduction and the costs related to
the closure and combination of certain facilities. We implemented the
restructuring plan in order to improve our overhead cost structure and to
refocus operations into areas in which we believe we have a core competency. We
believe the restructuring was necessary due to the significant decline in
revenue and gross margin in 2000 as compared to 1999. The restructuring charge
recorded in 2000 includes the estimated costs of workforce reductions of $1.1
million and the closure and combination of certain facilities in periods
subsequent to December 31, 2000 of $1.0 million. We believe these estimates
reflect the anticipated costs to complete the restructuring plans. At December
31, 2001, approximately $1.9 million of the total $2.1 million restructuring
charge recorded during 2000 had been paid out. As of December 31, 2001, we had
incurred approximately $200,000 of the restructuring charge recorded in the
fourth quarter of 2001.

Other income (expense), net, decreased 40%, or $300,000 to $400,000 for the
year ended December 31, 2001 as compared to $700,000 for the year ended
December 31, 2000. This other income is comprised primarily of interest income
on cash and cash equivalents, and investments. This decrease in other income
(expense), net, was primarily due to a decrease in interest rates during 2001.

The effective income tax rate for the year ended December 31, 2001 and 2000
was 0%. We did not record an income tax benefit on the operating loss as
realization is not certain.

Liquidity and Capital Resources

On December 31, 2002, we had working capital of $12.9 million, a decrease of
$3.1 million from $16.0 million on December 31, 2001. The decrease is primarily
attributable to cash used to fund operations as well as to purchase equipment,
furniture and fixtures.

For the year ended December 31, 2002, cash used in operating activities was
$1.4 million, compared to net cash provided by operating activities of $4.7
million for the year ended December 31, 2001. Cash provided by operations for
the year ended December 31, 2001 resulted primarily from the net loss for 2001
and a $4.1 million decrease in trade receivables in 2001 due to our increased
collection efforts. Cash used in operations for the year ended December 31,
2002 was primarily the result of our net loss for that year.

24

Net cash used in investing activities was $1.2 million for the year ended
December 31, 2002, compared to $226,000 in the comparable prior period. The
increase in cash used by investing activities was primarily due to increased
purchases of equipment, furniture and fixtures associated with the relocation
of our corporate headquarters from San Diego, California to Exton, Pennsylvania
as well as investments in equipment used in our help desk service line.

Net cash provided by financing activities was $84,000 for the year ended
December 31, 2002, compared to cash used in financing activities of $113,000 in
the comparable prior year period. This increase was primarily the result of the
$198,000 cash purchase of treasury stock in 2001.

On July 27, 1999 we issued 2,181,818 shares of Series A Preferred Stock. The
Series A Preferred Stock agreement contained a redemption feature that was
outside of our control. On November 9, 2000, the holders of the Series A
Preferred Stock permanently waived their redemption rights arising from the
resignation of our Chief Executive Officer, in return for $2.0 million in cash
and warrants to purchase 3,540,000 shares of common stock exercisable at $0.01
per share. Even though the holders of the Series A Preferred Stock have waived
their redemption rights, we still have our right to redeem the Series A
Preferred Stock anytime after July 26, 2003 for the issue price plus accrued
dividends.

We have contractual obligations, principally under operating lease
agreements, as follows: due within one year--$1,528,000; due in one to three
years--$1,669,000; due in four to five years--$558,000; and due after five
years--$347,000.

Although we have an accumulated deficit as of December 31, 2002, we believe
that our available funds will be sufficient to meet our capital requirements
for the foreseeable future. We may sell additional equity or debt securities or
obtain additional credit facilities. The sale of additional equity securities
or issuance of equity securities in future acquisitions would result in
dilution to our stockholders and the incurrence of additional debt could result
in additional interest expense. However, there can be no assurance that we will
be able to sell additional equity or debt securities, or be able to obtain
additional financing on acceptable terms, if at all. See "Risk Factors--Future
sales of our common stock could adversely affect the price of the common stock
and our ability to raise additional equity capital."

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of
operations are based upon our financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States.
The preparation of these financial statements requires management to make
estimates and judgments that affect the reported amounts of assets,
liabilities, revenue and expenses, and related disclosures. On an on-going
basis, we evaluate these estimates, including those related to revenue
recognition, long-lived assets, accrued liabilities, stock-based compensation,
and income taxes. Estimates are based on historical experience, information
received from third parties and on various other assumptions that are believed
to be reasonable under the circumstances, the results of which form the basis
for making judgments about the carrying values of assets and liabilities that
are not readily apparent from other sources. Actual results may differ from
these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect the significant
judgments and estimates used in the preparation of our financial statements.

Revenue Recognition

We recognize revenue in accordance with Staff Accounting Bulletin ("SAB")
No. 101, Revenue Recognition in Financial Statements. SAB 101 requires that the
following criteria be met in determining whether revenue has been earned:

. persuasive evidence of an arrangement,

. services have been delivered,

25

. price is fixed and determinable, and

. collectibility is reasonably assured.

We have the following types of revenue recognition: i) services performed on
an hourly basis, ii) services performed on a fixed fee basis and iii) sales of
material and maintenance contracts. In general, we enter into contracts with
customers to provide services at a specified fee or rate per hour. Revenue from
professional services is recognized primarily on an hourly basis. Revenue from
technical support, network management and help desk services is recognized as
the services are performed. Contract revenue for the development and
implementation of network solutions under fixed-fee contracts is recognized
related to the level of service performed based upon the amount of labor cost
incurred on the project versus the total labor costs to complete the project.
Provisions for estimated losses on contracts, if any, are made during the
period when the loss becomes probable and can be reasonably estimated. Revenue
recognized in excess of amounts billed and project costs are classified as
contract work in progress. Payments received in advance of services performed
are recorded as deferred revenue and amortized as the services are performed.

Bad Debt

We are required to estimate the collectibility of our trade accounts
receivable. We perform this analysis on a specific customer identification
basis. A considerable amount of judgment is required in assessing the ultimate
realization of these receivables, including the credit worthiness of each
customer and the age of the customer balances. We estimate the amount to
reserve for a specific customer by taking into account the age of the
receivables and the payment history of the customer. Significant changes in
required reserves have been recorded in recent periods and may occur in the
future due to the current market environment and changes in client payment
history.

Restructuring Charges

During the years ended December 2002, 2001 and 2000, we recorded reserves in
connection with our restructuring program. These reserves include estimates
pertaining to the reduction in employee headcount and the costs of exiting
facilities and unused equipment. Although we do not anticipate significant
changes, the actual costs may differ from the estimates recorded.

Litigation

We are currently involved in legal proceedings regarding shareholder
litigation and other general legal proceedings. As discussed in Note 11 of our
consolidated financial statements, we have not accrued an amount, as we believe
that the lawsuits are without merit and intend to defend against them
vigorously. We do not believe these proceedings will have a material adverse
effect in our consolidated financial position. It is possible, however, that
future results of operations for any particular quarterly or annual period
could be materially affected by changes in our assumptions, or the
effectiveness of our strategies, related to these proceedings.

Recently Issued Accounting Standards

On January 1, 2002, we adopted the provisions of the Emerging Issues Task
Force ("EITF") Topic D-103, Income Statement Characterization of Reimbursements
for "Out-of-Pocket" Expenses Incurred. In accordance with the provisions of
EITF Topic D-103, we adjusted revenue and cost of revenue for all periods
reported to include out-of-pocket expenses. We have reclassified our prior
period financial statements in accordance with this accounting pronouncement.
Adoption of the provisions of EITF Topic D-103 had no impact on reported net
loss, net loss available to common stockholders or net loss per share for the
periods presented.

26

In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities." SFAS No. 146 provides guidance related to
accounting for costs associated with disposal activities covered by SFAS No.
144 or with exit or restructuring activities previously covered by Emerging
Issues Task Force ("EITF") Issue No. 94-3, "Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred in a Restructuring)." SFAS No. 146 supercedes EITF Issue
No. 94-3 in its entirety. SFAS No. 146 requires that costs related to exiting
an activity or to a restructuring not be recognized until the liability is
incurred. SFAS No. 146 will be applied prospectively to exit or disposal
activities that are initiated after December 31, 2002. The adoption of this
method is not expected to have a material impact on our operations or financial
condition.

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation, Transition and Disclosure." SFAS No. 148 provides alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. SFAS No. 148 also requires
that disclosures of the pro forma effect of using the fair value method of
accounting for stock-based employee compensation be displayed more prominently
and in a tabular format. Additionally, SFAS No. 148 requires disclosure of the
pro forma effect in interim financial statements. The transition and annual
disclosure requirements of SFAS No. 148 are effective for Daou for the year
ended December 31, 2002.

Item 7A: Quantitative and Qualitative Disclosures about Market Risks.

We invest excess cash primarily in U.S. government securities and marketable
debt securities of financial institutions and corporations with strong credit
ratings. These instruments have maturities of three months or less when
acquired. We do not utilize derivative financial instruments, derivative
commodity instruments or other market risk sensitive instruments, positions or
transactions in any material fashion. Accordingly, we believe that, while the
instruments held are subject to changes in the financial standing of the issuer
of such securities, we are not subject to any material risks arising from
changes in interest rates, foreign currency exchanges rates, commodity prices,
equity prices or other market changes that affect market risk sensitive
instruments.

Item 8: Financial Statements.

Index to Consolidated Financial Statements and Financial Statement Schedule

Page
----

Consolidated Financial Statements
Report of Ernst & Young LLP, Independent Auditors...................................... 28
Consolidated Balance Sheets at December 31, 2002 and 2001.............................. 29
Consolidated Statements of Operations for the years ended December 31, 2002, 2001, and
2000................................................................................. 30
Consolidated Statements of Stockholders' Equity for the years ended December 31, 2002,
2001, and 2000....................................................................... 31
Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2001,
and 2000............................................................................. 32
Notes to Consolidated Financial Statements............................................. 34
Consolidated Financial Statement Schedule
Schedule II--Valuation and Qualifying Accounts............................................ 48

Other schedules are omitted for the reason that they are not required or are
not applicable, or the required information is included in the consolidated
financial statements or notes thereto.

27

REPORT OF INDEPENDENT AUDITORS

The Board of Directors and Stockholders
Daou Systems, Inc.

We have audited the accompanying consolidated balance sheets of Daou
Systems, Inc. as of December 31, 2002 and 2001, and the related consolidated
statements of operations, stockholders' equity, and cash flows for each of the
three years in the period ended December 31, 2002. Our audits also included the
financial statement schedule listed in Item 15(a). These financial statements
and schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and
schedule based on our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Daou Systems,
Inc. at December 31, 2002 and 2001 and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
December 31, 2002, in conformity with accounting principles generally accepted
in the United States. Also, in our opinion, the related financial statement
schedule, when considered in relation to the basic financial statements taken
as a whole, presents fairly in all material respects the information set forth
therein.

/s/ ERNST & YOUNG LLP

Philadelphia, Pennsylvania
February 13, 2003

28

Daou Systems, Inc.
Consolidated Balance Sheets
(In thousands, except for per share data)

December 31,
------------------
2002 2001
-------- --------

ASSETS
Current assets:
Cash and cash equivalents............................................... $ 12,319 $ 14,868
Restricted cash......................................................... -- 147
Investments, available-for-sale......................................... 75 59
Accounts receivable, net of allowance for doubtful accounts of $732 and
$715 in 2002 and 2001, respectively................................... 7,922 7,572
Contract work in progress............................................... 2,147 310
Other current assets.................................................... 554 328
-------- --------
Total current assets....................................................... 23,017 23,284
Due from officers/stockholders............................................. 54 19
Equipment, furniture and fixtures, net..................................... 1,006 970
Other assets............................................................... 563 372
-------- --------
$ 24,640 $ 24,645
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable.................................................. $ 705 $ 1,004
Accrued salaries and benefits........................................... 4,328 3,575
Accrued project costs................................................... 1,968 45
Other accrued liabilities............................................... 2,765 2,077
Deferred revenue........................................................ 365 585
-------- --------
Total current liabilities.................................................. 10,131 7,286
Other long-term liabilities................................................ 40 51
Commitments and contingencies
Stockholders' equity:
Convertible preferred stock, $ .001 par value. Authorized 3,520 shares;
issued and outstanding 2,182 shares at December 31, 2002 and 2001,
with a liquidation preference of $14,966 and $13,912 at December 31,
2002 and 2001, including accrued dividends............................ 2 2
Common stock, $ .001 par value. Authorized 50,000 shares; issued and
outstanding 21,737 and 21,556 at December 31, 2002 and 2001,
respectively and 992 shares held in treasury at December 31, 2002 and
2001.................................................................. 22 22
Additional paid-in capital.............................................. 54,806 53,668
Notes receivable from stockholders...................................... (1,281) (1,281)
Accumulated other comprehensive loss.................................... (56) (72)
Accumulated deficit..................................................... (39,024) (35,031)
-------- --------
Total stockholders' equity................................................. 14,469 17,308
-------- --------
$ 24,640 $ 24,645
======== ========

See accompanying notes to consolidated financial statements.

29

Daou Systems, Inc.
Consolidated Statements of Operations
(In thousands, except for per share data)

Years Ended December 31,
---------------------------
2002 2001 2000
------- ------- ---------

Revenue before reimbursements (net revenue)..................... $37,935 $41,082 $ 63,748
Out-of-pocket reimbursements.................................... 3,240 3,161 3,460
------- ------- ---------
Total revenue.................................................. 41,175 44,243 67,208
Cost of revenue before reimbursable expenses.................... 27,668 32,424 59,923
Out-of-pocket reimbursable expenses............................. 3,240 3,161 3,460
------- ------- ---------
Total cost of revenue.......................................... 30,908 35,585 63,383
Gross profit.................................................... 10,267 8,658 3,825
Operating expenses:
Sales and marketing.......................................... 5,040 3,360 5,744
General and administrative................................... 6,838 7,408 10,831
Restructuring charges........................................ 1,598 1,263 2,133
------- ------- ---------
13,476 12,031 18,708
------- ------- ---------
Loss from operations............................................ (3,209) (3,373) (14,883)
Other income, net............................................... 270 421 699
------- ------- ---------
Loss before income taxes........................................ (2,939) (2,952) (14,184)
Provision for income taxes...................................... -- -- --
------- ------- ---------
Net loss........................................................ (2,939) (2,952) (14,184)
Accrued dividends on preferred stock............................ (1,054) (854) (4,837)
------- ------- ---------
Net loss available to common stockholders....................... $(3,993) $(3,806) $ (19,021)
------- ------- ---------
Basic and diluted net loss available to common stockholders per
common share.................................................. $ (0.21) $ (0.22) $ (1.07)
------- ------- ---------
Shares used in computing basic and diluted net loss available to
common stockholders per common share.......................... 19,075 17,682 17,712
======= ======= =========

See accompanying notes to consolidated financial statements.

30

Daou Systems, Inc.
Consolidated Statements of Stockholders' Equity
For the Years Ended December 31, 2002, 2001, and 2000
(In thousands)

Notes
Convertible receivable
preferred stock Common stock Additional from
--------------- -------------- paid-in stock- Deferred
Shares Amount Shares Amount capital holders compensation
------ ------ ------ ------ ---------- ---------- ------------

Balance at December 31, 1999............................... -- $-- 17,712 $18 $37,395 $ -- $(192)
----- --- ------ --- ------- ------- -----
Issuance of common stock upon exercise of stock options.... -- -- 1 -- 1 -- --
Issuance of common stock under employee stock purchase plan -- -- 118 -- 54 -- --
Amortization of deferred compensation...................... -- -- -- -- -- -- 139
Reversal of deferred compensation for separated employees.. -- -- -- -- (53) -- 53
Removal of redemption feature on preferred stock........... 2,182 2 -- -- 11,380 -- --
Warrants issued to preferred stockholders.................. -- -- -- -- 2,088 -- --
Accrued dividends on preferred stock....................... -- -- -- -- 749 -- --
Comprehensive loss:
Unrealized loss on investments.......................... -- -- -- -- -- -- --
Net loss................................................ -- -- -- -- -- -- --

Comprehensive loss......................................... -- -- -- -- -- -- --
----- --- ------ --- ------- ------- -----
Balance at December 31, 2000............................... 2,182 2 17,831 18 51,614 -- --
----- --- ------ --- ------- ------- -----
Issuance of common stock under employee stock purchase plan -- -- 318 -- 85 -- --
Accrued dividends on preferred stock....................... -- -- -- -- 854 -- --
Issuance of common stock and options for services.......... -- -- 99 -- 36 -- --
Purchase of treasury stock................................. -- -- (992) -- (198) -- --
Issuance of restricted stock in exchange for notes......... -- -- 4,300 4 1,277 (1,281) --
Comprehensive loss:
Unrealized loss on investments............................. -- -- -- -- -- -- --
Net loss................................................ -- -- -- -- -- -- --

Comprehensive loss...................................... -- -- -- -- -- -- --
----- --- ------ --- ------- ------- -----
Balance at December 31, 2001............................... 2,182 2 21,556 22 53,668 (1,281) --
----- --- ------ --- ------- ------- -----
Issuance of common stock under employee stock purchase plan -- -- 160 -- 81 -- --
Accrued dividends on preferred stock....................... -- -- -- -- 1,054 -- --
Issuance of common stock upon exercise of stock options.... -- -- 21 -- 3 -- --
Comprehensive loss:
Unrealized gain on investments............................. -- -- -- -- -- -- --
Net loss................................................ -- -- -- -- -- -- --

Comprehensive loss:..................................... -- -- -- -- -- -- --
----- --- ------ --- ------- ------- -----
Balance at December 31, 2002............................... 2,182 $ 2 21,737 $22 $54,806 $(1,281) $ --
----- --- ------ --- ------- ------- -----

Accumulated
other Total
comprehensive Accumulated stockholders'
income (loss) deficit equity
------------- ----------- -------------

Balance at December 31, 1999............................... $(43) $(12,204) $ 24,974
---- -------- --------
Issuance of common stock upon exercise of stock options.... -- -- 1
Issuance of common stock under employee stock purchase plan -- -- 54
Amortization of deferred compensation...................... -- -- 139
Reversal of deferred compensation for separated employees.. -- -- --
Removal of redemption feature on preferred stock........... -- (2,000) 9,382
Warrants issued to preferred stockholders.................. -- (2,088) --
Accrued dividends on preferred stock....................... -- (749) --
Comprehensive loss:
Unrealized loss on investments.......................... (6) -- (6)
Net loss................................................ -- (14,184) (14,184)
--------
Comprehensive loss......................................... -- -- (14,190)
---- -------- --------
Balance at December 31, 2000............................... (49) (31,225) 20,360
---- -------- --------
Issuance of common stock under employee stock purchase plan -- -- 85
Accrued dividends on preferred stock....................... -- (854) --
Issuance of common stock and options for services.......... -- -- 36
Purchase of treasury stock................................. -- -- (198)
Issuance of restricted stock in exchange for notes......... -- -- --
Comprehensive loss:
Unrealized loss on investments............................. (23) -- (23)
Net loss................................................ -- (2,952) (2,952)
--------
Comprehensive loss...................................... -- -- (2,975)
---- -------- --------
Balance at December 31, 2001............................... (72) (35,031) 17,308
---- -------- --------
Issuance of common stock under employee stock purchase plan -- -- 81
Accrued dividends on preferred stock....................... -- (1,054) --
Issuance of common stock upon exercise of stock options.... -- -- 3
Comprehensive loss:
Unrealized gain on investments............................. 16 -- 16
Net loss................................................ -- (2,939) (2,939)
--------
Comprehensive loss:..................................... -- -- (2,923)
---- -------- --------
Balance at December 31, 2002............................... $(56) $(39,024) $ 14,469
---- -------- --------

See accompanying notes to consolidated financial statements

31

Daou Systems, Inc.
Consolidated Statements of Cash Flows
(In thousands)

Years ended December 31,
--------------------------
2002 2001 2000
------- ------- --------

Net loss........................................................... $(2,939) $(2,952) $(14,184)
Adjustments to reconcile net loss to net cash (used in) provided by
operating activities:
Depreciation and amortization................................... 959 1,334 2,388
Amortization of deferred compensation........................... 108 60 139
Provision for uncollectible accounts............................ 186 232 402
Issuance of common stock and options for services............... -- 36 --
(Gain) loss on retirement of fixed assets....................... (10) 362 273
Changes in operating assets and liabilities:
Restricted cash............................................. 147 (147) --
Accounts receivable......................................... (536) 4,096 9,610
Contract work in progress................................... 131 750 1,756
Other current assets........................................ (226) 230 490
Accounts payable and accrued liabilities.................... 259 (405) (1,443)
Accrued salaries and benefits............................... 753 981 (1,975)
Deferred revenue............................................ (220) 188 218
Other long-term liabilities................................. (11) 51 --
Deferred rent............................................... -- (113) (32)
------- ------- --------
Net cash (used in) provided by operating activities................ (1,399) 4,703 (2,358)

Investing activities
Purchase of equipment, furniture and fixtures...................... (900) (259) (907)
(Increase) decrease in other assets................................ (334) 33 156
Purchases of investments........................................... -- -- (20)
Payments from officers/stockholders................................ -- -- 98
------- ------- --------
Net cash used in investing activities.............................. (1,234) (226) (673)

Financing Activities
Proceeds from issuance of common stock............................. 84 85 55
Payment and issuance costs to remove redemption feature of
preferred stock.................................................. -- -- (2,000)
Purchase of treasury stock......................................... -- (198) --
------- ------- --------
Net cash provided by (used in) financing activities................ 84 (113) (1,945)
------- ------- --------
(Decrease) increase in cash and cash equivalents................... (2,549) 4,364 (4,976)
Cash and cash equivalents at beginning of year..................... 14,868 10,504 15,480
------- ------- --------
Cash and cash equivalents at end of year........................... $12,319 $14,868 $ 10,504
======= ======= ========

Cash paid during the year for:
Interest........................................................ -- -- $ 11
======= ======= ========

See accompanying notes to consolidated financial statements.

32

Daou Systems, Inc.
Consolidated Statements Of Cash Flows
(In thousands)

Years ended December 31,
----------------------
2002 2001 2000
------ ------ -------

Supplemental disclosure of noncash investing and financing activities:
Issuance of common stock and options for services.................. $ -- $ 36 $ --
====== ====== =======
Issuance of restricted common stock in exchange for notes
receivable....................................................... -- 1,281 --
====== ====== =======
Accrued preferred stock dividends to preferred stockholders........ 1,054 854 749
====== ====== =======
Issuance of warrants to remove redemption feature of preferred
stock............................................................ -- -- (2,088)
====== ====== =======
Unrealized gain (loss) on investments.............................. $ 16 $ (23) $ (6)
====== ====== =======

See accompanying notes to consolidated financial statements.

33

Daou Systems, Inc.
Notes to Consolidated Financial Statements

1. Organization and Summary of Significant Accounting Policies

Organization and Basis of Presentation

Daou Systems, Inc. ("Daou" or the "Company"), a Delaware company, was
incorporated in California on July 16, 1987 under the name Daou Systems, Inc.,
and reincorporated in Delaware on November 15, 1996. Daou is principally
focused on providing IT services and solutions to the U.S. healthcare industry
including providers, payors and health plans and government healthcare
organizations. The Company designs and implements solutions to help healthcare
organizations navigate the intersection of legacy systems with emerging
technologies, such as web portals, wireless and other portable computing
solutions. The Company's services include (1) management consulting, (2)
traditional network services, (3) application implementation and support, (4)
application development and integration, and (5) strategic outsourcing,
including remote help desk and related technology support services. On December
31, 2000, the Company merged all of its subsidiaries into the parent company,
Daou Systems, Inc.

During December 2002, the Company reorganized its internal management
structure, consolidated operations and eliminated non-strategic services. This
reorganization, which was approved by the Company's Board of Directors, is part
of Daou's strategy to position itself for continued growth in the marketplace.
The Company recorded a one-time restructuring charge of approximately $1.6
million in the fourth quarter of 2002 related to severance costs, expenses
associated with a slight workforce reduction, elimination of non-strategic
services and the consolidation of office space in connection with this
reorganization.

As part of the reorganization, the Company consolidated its two operating
divisions--Technology Services and Application Services. For purposes of
improving overall sales and operations effectiveness, and to offer its
customers an integrated solutions approach through multi-disciplinary teams,
the Company now provides its services through two primary practice groups:
commercial healthcare and government healthcare. The Company believes the
consolidation was necessary due to changing market forces in the healthcare
industry. Daou expects that operating as one business unit will allow the
Company to focus on its core competencies and pursue a seamless approach to
applications and technology.

The consolidated financial statements reflect the consolidated financial
position and operating results for the Company. All significant intercompany
transactions and accounts have been eliminated.

Revenue Recognition

The Company recognizes revenue in accordance with the provisions of Staff
Accounting Bulletin ("SAB") No. 101, Revenue Recognition in Financial
Statements. SAB 101 requires that the following criteria be met in determining
whether revenue has been earned:

. persuasive evidence of an arrangement,

. services have been delivered,

. price is fixed and determinable, and

. collectibility is reasonably assured.

The Company has the following types of revenue recognition: 1) services
performed on an hourly basis, 2) services performed on a fixed fee basis and 3)
sales of material and maintenance contracts. In general, the Company enters
into contracts with customers to provide services at a specified fee or rate
per hour.

34

Daou Systems, Inc.
Notes to Consolidated Financial Statements--(Continued)

1. Organization and Summary of Significant Accounting Policies--(Continued)

Revenue from professional services is recognized primarily on an hourly
basis. Revenue from technical support, network management and help desk
services is recognized as the services are performed. Contract revenue for the
development and implementation of network solutions under fixed-fee contracts
is recognized related to the level of service performed based upon the amount
of labor cost incurred on the project versus the total labor costs to complete
the project. Provisions for estimated losses on contracts, if any, are made
during the period when the loss becomes probable and can be reasonably
estimated. Revenue recognized in excess of amounts billed and project costs is
classified as contract work in progress. Payments received in advance of
services performed are recorded as deferred revenue and recognized as the
services are performed.

Concentration of Credit Risk and Major Customers

Financial instruments which subject the Company to potential concentrations
of credit risk consist principally of the Company's accounts receivable.
Substantially all of the Company's accounts receivable are from managed care
organizations, hospitals, government healthcare organizations and other
healthcare providers. The Company performs credit evaluations of its new
customers and generally requires no collateral. The Company provides for losses
from uncollectible accounts pursuant to a formal policy which is based on
analyzing historical data and trends and such losses have historically not
exceeded management's expectations. Past due or delinquency status is based on
contractual terms. Past due amounts are written off against the allowance for
doubtful accounts when collection is deemed unlikely and all collection efforts
have ceased.

Services to Daou's five largest customers accounted for approximately $12.3
million of net revenue for the year ended December 31, 2002, representing
approximately 32% of total net revenue, with one customer accounting for 9.2%
of net revenue.

Cash, Cash Equivalents, Restricted Cash and Investments

Cash and cash equivalents consist of cash and highly liquid investments with
maturities of three months or less when purchased. The Company has established
guidelines relative to diversification and maturities that are periodically
reviewed and modified to take advantage of trends in yields and interest rates.
The Company historically has not experienced any material losses on its cash
equivalents or short-term investments.

The Company classifies its investments as "Available-for-Sale" and records
such assets at the estimated fair value on the balance sheet with unrealized
gains and losses excluded from earnings and reported as a separate component of
comprehensive income until realized. The basis for computing realized gains or
losses is by specific identification.

At December 31, 2002, the Company has approximately $300,000 of cash related
to an operating lease in an escrow account subject to certain withdrawal
restrictions. This amount is classified in other assets on the balance sheet.

Equipment, Furniture and Fixtures

Equipment, furniture and fixtures are carried at cost. Depreciation is
computed using the straight-line method over the estimated useful lives of the
assets, ranging from two to five years. Leasehold improvements are amortized
over the lesser of the estimated useful lives of the assets or the remaining
lease term.

35

Daou Systems, Inc.
Notes to Consolidated Financial Statements--(Continued)

1. Organization and Summary of Significant Accounting Policies--(Continued)

Software development costs, consisting of internally developed software, are
accounted for using Statement of Position ("SOP") 98-1, Accounting for the
Costs of Computer Software Developed or Obtained for Internal use. In
accordance with SOP 98-1, internal and external costs incurred to develop
internal use computer software during the application development stage are
capitalized. Application development stage costs generally include software
configuration, coding, installation to hardware, and testing. Capitalized
internal-use software development costs are included in equipment, furniture
and fixtures and are amortized on a straight-line basis over the estimated
useful lives of the related software applications of up to three years.

Advertising Expense

Advertising expenditures are charged to expense as incurred. The Company
expensed $222,000, $14,000 and $145,000 for the years ended December 31, 2002,
2001 and 2000.

Recent Pronouncements

On January 1, 2002, the Company adopted the provisions of the Emerging
Issues Task Force ("EITF") Topic D-103, Income Statement Characterization of
Reimbursements for "Out-of-Pocket" Expenses Incurred. In accordance with the
provisions of EITF Topic D-103, the Company adjusted revenue and cost of
revenue for all periods reported to include out-of-pocket expenses. The Company
has reclassified its prior period financial statements in accordance with this
accounting pronouncement. Adoption of the provisions of EITF Topic D-103 had no
impact on reported net loss, net loss available to common stockholders or net
loss per share for the periods presented.

In June 2002, the FASB issued Statement of Financial Accounting Standards
("SFAS") No. 146, "Accounting for Costs Associated with Exit or Disposal
Activities." SFAS No. 146 provides guidance related to accounting for costs
associated with disposal activities covered by SFAS No. 144 or with exit or
restructuring activities previously covered by EITF Issue No. 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit
an Activity (including Certain Costs Incurred in a Restructuring)." SFAS No.
146 supercedes EITF Issue No. 94-3 in its entirety. SFAS No. 146 requires that
costs related to exiting an activity or to a restructuring not be recognized
until the liability is incurred. SFAS No. 146 will be applied prospectively to
exit or disposal activities that are initiated after December 31, 2002. The
adoption of this method is not expected to have a material impact on the
Company's operations or financial condition.

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation, Transition and Disclosure." SFAS No. 148 provides alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. SFAS No. 148 also requires
that disclosures of the pro forma effect of using the fair value method of
accounting for stock-based employee compensation be displayed more prominently
and in a tabular format. Additionally, SFAS No. 148 requires disclosure of the
pro forma effect in interim financial statements. The transition and annual
disclosure requirements of SFAS No. 148 are effective for Daou for the year
ended December 31, 2002.

Use of Estimates

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions about the future that affect the amounts reported in the financial
statements and disclosures made in the accompanying notes of the financial
statements. The actual results could differ from those estimates.

36

Daou Systems, Inc.
Notes to Consolidated Financial Statements--(Continued)

1. Organization and Summary of Significant Accounting Policies--(Continued)

Reclassifications

Effective January 1, 2002, certain overhead expenses directly attributable
to the business units and formerly recorded as general and administrative
expenses are now recorded as cost of revenue before reimbursable expenses. The
prior period amounts have been reclassified to conform to their current period
presentation. Certain other prior year amounts have been reclassified to
conform to the current year's presentation.

Stock-Based Compensation

The Company has stock-based employee compensation plans, which are described
more fully in Note 8. The Company applies the recognition and measurement
principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees,"
and related interpretations in accounting for those plans. For stock options,
no compensation expense is reflected in net income as all stock options granted
had an exercise price equal to or greater than the market value of the
underlying common stock on the date of grant. In addition, no compensation
expense is recognized for common stock purchases under the Employee Stock
Purchase Plan. Pro forma information regarding net income and earnings per
share is required by SFAS No. 123, "Accounting for Stock-Based Compensation,"
and has been determined as if the Company had accounted for its stock plans
under the fair value method of SFAS No. 123. For purposes of the pro forma
disclosures, the estimated fair value of the options is amortized to expense
over the options' vesting periods. The following table illustrates the effect
on net income and earnings per share if the Company had applied the fair value
recognition provisions of SFAS No. 123:

Years Ended December 31,
--------------------------
2002 2001 2000
------- ------- --------

Net loss as reported............................ $(3,993) $(3,806) $(19,021)
Deduct total stock-based employee compensation
determined under the fair value method for all
awards, net of tax............................ (3,425) (5,788) (8,763)
------- ------- --------
Pro forma net loss.............................. $(7,418) $(9,594) $(27,784)
------- ------- --------

Loss per share
Basic and diluted--as reported............... $ (0.21) $ (0.22) $ (1.07)
======= ======= ========
Basic and diluted--pro forma................. $ (0.39) $ (0.54) $ (1.57)
======= ======= ========

2. Net Loss Per Share

Net loss per share is computed in accordance with SFAS No. 128, Earnings Per
Share. Basic net loss per share is computed using the weighted average number
of common shares outstanding during each period. Diluted net loss per share
includes the dilutive effect of common shares potentially issuable upon the
exercise of stock options and warrants. For the years ended December 31, 2002,
2001 and 2000, diluted loss per share is unchanged from basic loss per share
because the effects of the assumed conversion of Series A Preferred Stock,
stock options and warrants would be anti-dilutive.

37

Daou Systems, Inc.
Notes to Consolidated Financial Statements--(Continued)

2. Net Loss Per Share--(Continued)

The following table details the computation of basic and diluted net loss
per share:

(In thousands, except per share information)

Years Ended December 31,
--------------------------
2002 2001 2000
------- ------- --------

Numerator:
Net loss available to common
stockholders............................ $(3,993) $(3,806) $(19,021)
Denominator:
Weighted average common shares
outstanding............................. 21,591 19,233 17,712
Weighted average unvested common shares
subject to repurchase agreements........ (2,516) (1,551) --
------- ------- --------
Denominator for basic and diluted calculation 19,075 17,682 17,712
------- ------- --------
Basic and diluted net loss per share...... $ (0.21) $ (0.22) $ (1.07)
======= ======= ========

3. Restructuring Charges

The Company accounts for restructuring charges in accordance with SEC SAB
No. 100, Restructuring And Impairment Charges, and EITF No. 94-3, Liability
Recognition For Certain Employee Termination Benefits And Other Costs To Exit
An Activity (Including Certain Cost Incurred In A Restructuring). As part of
its strategy to position itself for continued growth in the marketplace, the
Company reorganized its management structure, consolidated operations and
eliminated certain non-strategic services as of December 31, 2002. In addition,
in the fourth quarter of 2002 the Company increased its estimate of costs and
related sublease income related to previously announced closures of certain
facilities. These combined actions resulted in a workforce reduction of
approximately 16 employees and a restructuring charge in the fourth quarter of
2002 of $1.6 million.

During the year ended December 31, 2001, the Company recorded restructuring
charges totaling $1.3 million in connection with its decision to close and
combine certain facilities. These charges included severance costs related to a
reduction in workforce of approximately 28 employees and the costs estimated to
be incurred in connection with the closure of certain facilities.

During the year ended December 31, 2000, the Company recorded restructuring
charges totaling approximately $2.1 million in connection with the various
actions to reduce the cost structure of the Company. These charges included
severance costs related to a reduction in workforce of approximately 50
employees and the closure of certain facilities.

38

Daou Systems, Inc.
Notes to Consolidated Financial Statements--(Continued)

3. Restructuring Charges--(Continued)

The following table summarizes the restructuring and other related charges
recorded, and the related activity to such charges, in the years ended December
31, 2002, 2001 and 2000 (in thousands).

Severance costs for Costs related to
involuntary closure and
employee combination of
terminations facilities Total
------------------- ---------------- -------

Year Ended December 31, 2000:
Reserve established....... $1,140 $ 993 $ 2,133
Reserve utilized.......... (747) (80) (827)
------ ------- -------
Balance at December 31, 2000. 393 913 1,306
Year Ended December 31, 2001:
Reserve established....... 310 953 1,263
Reserve utilized.......... (552) (705) (1,257)
------ ------- -------
Balance at December 31, 2001. 151 1,161 1,312
Year Ended December 31, 2002:
Reserve established....... 1,065 533 1,598
Reserve utilized.......... (222) (1,064) (1,286)
------ ------- -------
Balance at December 31, 2002. $ 994 $ 630 $ 1,624
====== ======= =======

4. Investments, Available-For-Sale

Short-term investments, available-for-sale, consist of the following (in
thousands):

Gross Gross Estimated
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------- ---------- ---------- ---------

December 31, 2002
Government debt securities. $59 $16 $ -- $75
--- --- ---- ---
December 31, 2001
Government debt securities. $82 $-- $(23) $59
=== === ==== ===

The government debt securities mature in 2008.

5. Selected Balance Sheet Details

Contract work in progress consists of the following (in thousands):

December 31,
---------------
2002 2001
------- -------

Unbilled project costs....................... $ 1,726 $ --
Other........................................ 421 310
------- -------
$ 2,147 $ 310
======= =======

Unbilled project costs include the costs of equipment that was not billed as
of December 31, 2002.

39

Daou Systems, Inc.
Notes to Consolidated Financial Statements--(Continued)

5. Selected Balance Sheet Details--(Continued)

Equipment, furniture and fixtures consist of the following (in thousands):

December 31,
----------------
2002 2001
------- -------

Equipment and furniture.......... $ 4,492 $ 4,519
Leasehold improvements........... 178 68
------- -------
4,670 4,587
Less accumulated depreciation and
amortization................... (3,664) (3,617)
------- -------
$ 1,006 $ 970
======= =======

Other accrued liabilities consist of the following (in thousands):

December 31,
---------------
2002 2001
------- -------

Restructure costs $ 1,624 $ 1,312
Other............ 1,141 765
------- -------
$ 2,765 $ 2,077
======= =======

6. Commitments

The Company leases its facilities and certain equipment under operating
lease agreements. The facility leases provide for abatement of rent during
certain periods and escalating rent payments during the lease term. Rent
expense for 2002, 2001 and 2000 totaled $760,000, $1,312,000 and $2,144,000,
respectively.

Annual future minimum lease payments under non-cancelable operating leases
with initial terms of one year or more at December 31, 2002, consist of the
following (in thousands):

2003...... $1,528
2004...... 1,097
2005...... 572
2006...... 273
2007...... 285
Thereafter 347
------
$4,102
======

The Company also subleases certain of its leased facilities under
non-cancelable sublease agreements through 2005. Income related to these
subleases is used to primarily offset restructuring liabilities. The amount
received from subleases that was not applied to restructuring liabilities
totaled $0 and $133,000 for the years ended December 31, 2002 and 2001,
respectively, and was recorded as rental income. Future amounts due to the
Company under sublease agreements, aggregating $1,049,000, are as follows for
the year ended December 31; 2003--$478,000; 2004--$492,000; and, 2005--$79,000.

7. Related Party Transactions

During the years ended December 31, 2002 and 2001, the Company received
certain personnel recruitment services from a Company owned by one of its Board
members. The Company believes the terms of its arrangement were at least as
favorable, if not more, than those offered by competing

40

Daou Systems, Inc.
Notes to Consolidated Financial Statements--(Continued)

7. Related Party Transactions--(Continued)

recruitment firms. Payments for these services during the year ended December
31, 2002 consisted of cash compensation totaling $141,000. Payments for these
services during the year ended December 31, 2001, consisted of cash
compensation totaling $87,500 and the issuance of 88,968 shares of the
Company's common stock valued at $25,000.

8. Stockholders' Equity

Convertible Preferred Stock

On July 26, 1999, 2,181,818 shares of Series A Preferred Stock were issued
at $5.50 per share to a related party. Holders of the Series A Preferred Stock
were initially entitled to receive cumulative dividends at the rate of six
percent per annum, generally payable in the form of shares of Series A
Preferred Stock until July 26, 2001. The dividend rate increased to 7% on July
26, 2001, to 8% on July 26, 2002 and will continue to increase an additional 1%
on July 26 of each year. The Series A Preferred Stock has a liquidation
preference of $5.50 per share plus any accrued (whether or not declared) but
unpaid dividends and is convertible, at the option of the holder, into
2,720,965 shares of common stock, which includes accrued but unpaid dividends
as of December 31, 2002, subject to certain antidilution adjustments. The
Series A Preferred Stock is redeemable at the option of the Company four years
after the date of issuance.

The Series A Preferred Stock is subject to mandatory conversion in the event
the Company's common stock price reaches certain predetermined price targets.
The offering resulted in net proceeds of approximately $11.1 million after
expenses incurred by the Company in connection with the Offering of
approximately $926,000 (which include commissions and other expenses including
registration and filing fees, printing, accounting and legal expenses). In
addition, during 1999, the Company registered 2,750,000 shares of common stock
for issuance upon the conversion of the 2,181,818 outstanding shares of Series
A Preferred Stock.

On November 9, 2000, as a consequence of the resignation of Larry Grandia,
the Company's former President and Chief Executive Officer, holders of the
Series A Preferred Stock had the right to cause the Company to redeem their
Series A Preferred Stock for approximately $12.9 million. The holders of the
Series A Preferred Stock and the Company entered into an agreement whereby the
holders of the Series A Preferred Stock permanently waived their redemption
rights in return for $2.0 million in cash and warrants to purchase 3,540,000
shares of the Company's common stock exercisable at $0.01 per share. The
warrants expire on November 9, 2005. The total consideration of this
transaction was valued at approximately $4.1 million and for financial
reporting purposes was recorded as a one-time dividend in the fourth quarter of
2000.

Restricted Stock Purchase Agreements and Deferred Compensation

On July 24, 2001, the Company agreed to sell 150,000 shares of restricted
common stock at the July 24, 2001 closing price of $.52 per share to an
executive officer of the Company, in exchange for a full recourse note
receivable that accrues interest at a rate of 6.75% and is due on July 24, 2006.

On June 1, 2001, the Company agreed to sell an aggregate of 4,150,000 shares
of restricted common stock at the June 1, 2001 closing price of $.29 per share
to three executive officers of the Company, in exchange for full recourse notes
receivable that accrue interest at a rate of 6.75% and which are due on May 31,
2006. As part of this agreement, 1,710,000 options to purchase common stock
previously granted to these executive officers were canceled.

In connection with two of the agreements, the Company agreed to reimburse
the officers for the interest due in accordance with the terms of the notes
receivable. Accordingly, deferred compensation totaling $321,000 was recorded
in connection with these agreements. This amount is

41

Daou Systems, Inc.
Notes to Consolidated Financial Statements--(Continued)

8. Stockholders' Equity--(Continued)

included in other assets and is being amortized ratably over the five year term
of the notes. Amortization totaled $108,000 and $60,000 for the years ended
December 31, 2002 and 2001, respectively.

Common Stock Repurchase

On April 25, 2001, the Company repurchased 992,111 shares of the Company's
common stock from the former Chairman of the Board of the Company at a fair
market value price equal to $.20 per share for a total purchase price of
$198,000.

Employee Stock Purchase Plan

In May 2000, the Company adopted the Daou Systems, Inc. Employee Stock
Purchase Plan ("ESPP"), under which 1,500,000 shares of the Company's common
stock are reserved for issuance. Under the ESPP, eligible employees are allowed
to purchase common stock at six-month intervals at the lower of the fair market
value at the beginning of the measurement period or 85% of the fair market
value at the end of the measurement period. On December 31, 2002 and June 30,
2002, the Company issued 105,571 shares of common stock at $.3485 per share and
54,237 shares of common stock at $.8415 per share, respectively. At December
31, 2002, 904,148 shares remained available for future issuance under the ESPP.
On January 1, 2003, the Company suspended the ESPP.

Stock Option Plans

During 1996, the Company adopted the 1996 Stock Option Plan (the "Plan"),
under which 5,000,000, as amended, shares of the Company's common stock are
reserved for issuance upon exercise of options granted by the Company. The Plan
provides for the grant of both incentive and nonstatutory stock options to
officers, directors, employees and consultants of the Company. Options granted
by the Company generally vest over a three to five-year period and are
exercisable for a period of ten years from the date of the grant.

The following summary of the Company's stock option activity and related
information includes 1,550,000 non-qualified stock options at an exercise price
ranging from $0.29 to $1.00 per share and 225,000 options at an exercise price
ranging from $0.41 to $1.03 per share, granted outside of the plan and approved
by the Company's Board of Directors in 2001 and 2002, respectively:

2002 2001 2000
-------------------- --------------------- ----------------------
Weighted- Weighted- Weighted-
Average Average Average
Exercise Exercise Exercise
Options Price Options Price Options Price
--------- --------- ---------- --------- ----------- ---------

Outstanding--beginning
of year................. 4,298,199 $1.75 3,542,731 $4.10 $ 3,363,152 $7.80
Granted................... 778,250 0.92 3,472,000 0.40 2,083,700 1.21
Exercised................. (21,669) 0.18 -- -- (400) 3.25
Forfeited................. (600,822) 2.58 (2,716,532) 3.09 (1,903,721) 7.47
--------- ----- ---------- ----- ----------- -----
Outstanding--end of
year.................... 4,453,958 $1.50 4,298,199 $1.75 $ 3,542,731 $4.10
--------- ----- ---------- ----- ----------- -----
Exercisable at end of
year.................... 2,144,697 $2.24 633,326 $5.95 $ 863,312 $8.03
========= ===== ========== ===== =========== =====
Weighted-average fair
value of options granted
during the year......... $0.82 $0.54 $0.50
===== ===== =====

42

DAOU SYSTEMS, INC.
Notes to Consolidated Financial Statements--(Continued)

8. Stockholders' Equity--(Continued)

The following table summarizes information about stock options outstanding
at December 31, 2002:

Outstanding Exercisable
------------------------------------------- ----------------------------
Weighted-Average
Range of Number Remaining Number Weighted-Average
Exercise Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price
- --------------- ----------- ---------------- -------------- ----------- ----------------

$ 0.18-$ 2.74 3,791,785 8.3 $ 0.53 1,610,576 $ 0.54
$ 2.75-$ 5.49 460,516 5.3 $ 4.71 348,284 $ 4.73
$ 5.50-$ 8.24 54,189 4.1 $ 6.00 54,189 $ 6.00
$ 8.25-$10.99 3,368 3.9 $10.69 3,368 $10.69
$11.00-$13.74 120,000 3.3 $13.63 105,600 $13.63
$13.75-$16.49 0 0 $ 0 0 $ 0
$16.50-$19.24 7,000 4.5 $16.63 7,000 $16.63
$19.25-$21.99 7,100 5.1 $21.75 5,680 $21.75
$22.00-$24.74 5,000 5.0 $24.25 5,000 $24.25
$24.75-$27.50 5,000 4.8 $25.00 5,000 $25.00
--------- --- ------ --------- ------
4,453,958 7.8 $ 1.50 2,144,697 $ 2.24
========= === ====== ========= ======

At December 31, 2002, options for 1,896,609 common shares were available for
future grant.

The fair value of options granted was estimated at the date of grant using
the Black-Scholes option pricing model with the following weighted-average
assumptions for 2002, 2001 and 2000: risk-free interest rate of 6% for all
years; dividend yield of 0% for all years; volatility factors of the expected
market price of the Company's common stock of 138% for all years; and a
weighted-average expected life of the options of five years for all years.

Common Stock Reserved

At December 31, 2002, the Company had the following shares reserved for
future issuance:

Redeemable convertible preferred stock 2,750,000
Warrants.............................. 3,540,000
Stock options......................... 6,350,567
Employee stock purchase plan.......... 904,148
----------
Total.............................. 13,544,715
==========

43

Daou Systems, Inc.
Notes to Consolidated Financial Statements--(Continued)

9. Income Taxes

Deferred income taxes are provided for temporary differences in recognizing
certain income and expenses items for financial and tax reporting purposes.

Significant components of the Company's deferred tax assets and liabilities
are shown below (in thousands):

December 31,
------------------
2002 2001
-------- --------

Deferred tax liabilities:
Depreciation and amortization................. $ -- $ 61
-------- --------
-- 61
Deferred tax assets:
Reserves and allowances....................... 1,620 670
Net operating losses.......................... 10,020 9,927
-------- --------
11,640 10,597
-------- --------
Net deferred tax asset before valuation allowance 11,640 10,536
Valuation allowance for deferred tax assets...... (11,640) (10,536)
-------- --------
Net deferred tax asset........................... $ -- $ --
-------- --------

The Company has recorded a full valuation allowance against the deferred tax
asset as realization of the asset is not certain. At December 31, 2002, the
Company has federal and state net operating loss carryforwards of approximately
$27.3 million and $8.4 million, respectively. The federal loss carryforwards
will begin to expire in 2018 and the state loss carryforwards began to expire
in 2002, unless previously utilized.

Under section 382 of the Internal Revenue Code, the annual use of the
Company's net operating loss carryforwards may be limited in the event of a
cumulative change in ownership of more than 50%. However, the Company does not
believe such a limitation will have a material impact on the ultimate
utilization of these carryforwards.

The reconciliation of income tax computed at the federal statutory rate to
the total provision for income taxes is as follows:

Years Ended December 31,
---------------------
2002 2001 2000
----- ----- -----

Tax at federal statutory rate...... (35.0)% (35.0)% (35.0)%
Nondeductible expenses............. 2.4 0.8 0.4
State taxes, net of federal benefit (5.5) (2.4) (2.6)
Valuation allowance................ 38.1 36.6 30.0
Other.............................. -- -- 7.2
----- ----- -----
0.0% 0.0% 0.0%
===== ===== =====

10. Benefit Plans

Effective November 1, 1999, the Company initiated a new Daou Systems, Inc.
401(k) Salary Savings Plan (New Plan) which covers employees who meet certain
age and service requirements. Employees may contribute a portion of their
earnings each plan year subject to certain Internal Revenue Service
limitations. This New Plan replaces the former Daou Systems, Inc. 401(k) Salary
Savings Plan. The Company has various other defined contribution plans related
to acquisitions under which employees also participated. Contributions under
these plans are made at the sole discretion of the Company and were $344,000,
$426,000 and $832,000 for 2002, 2001 and 2000, respectively. The Company is
currently in the process of terminating all of its other defined contribution
plans and will only maintain the New Plan.

44

Daou Systems, Inc.
Notes to Consolidated Financial Statements--(Continued)

11. Contingencies

On August 24, 1998, August 31, 1998, September 14, 1998 and September 23,
1998, four separate complaints were filed against the Company and certain of
its officers and directors in the United States District Court for the Southern
District of California. On October 15, 2002, the Court granted the Company's
Motion to Dismiss the class action complaint, with prejudice. The plaintiffs
noticed appeal to the Ninth Circuit Court of Appeal on November 13, 2002.

As background, a group of shareholders were appointed the lead plaintiff in
this federal litigation, and they filed a second amended consolidated class
action complaint on January 21, 2000. Their second amended complaint realleges
that the Company improperly used the "percentage-of-completion" accounting
method for revenue recognition. Claims are pleaded under both the 1933
Securities Act (relating to the Company's initial public offering) and section
10b of the 1934 Securities Act. The complaint was brought on behalf of a
purported class of investors who purchased the Company's Common Stock between
February 13, 1997 and October 28, 1998, but it does not allege specific damage
amounts. A Motion to Dismiss the second amended consolidated class action
complaint was filed on February 22, 2000. On March 27, 2002, the Court granted
the Motion but extended to plaintiffs the opportunity to file a Third Amended
Complaint. The plaintiffs filed their Third Amended Complaint on May 16, 2002,
to which the Company responded with another Motion to Dismiss. The Motion was
filed on June 24, 2002 and challenged the legal sufficiency of the allegations.
On October 16, 2002, the Court granted that Motion, this time with prejudice.
The plaintiffs noticed appeal to the Ninth Circuit Court of Appeal on November
13, 2002. The Company filed a Notice of Cross-Appeal on November 26, 2002
challenging the failure of the trial court to assess whether the complaints
were filed in violation of Rule 11 of the Federal Rules of Civil Procedure.
Plaintiffs must file their Opening Brief by April 9, 2003. The Company is
currently scheduled to file its Brief no later than May 19, 2003. On October 7,
1998 and October 15, 1998, two separate complaints were filed in the Superior
Court of San Diego County, California. These state court complaints mirror the
allegations set forth in the federal complaints. They also assert claims for
common law fraud and the violation of certain California statutes. As with
their federal counterparts, they do not allege specific damage amounts. On
April 1, 1999, a Consolidated Amended Class Action was filed on behalf of the
same state court plaintiffs, and this new complaint alleges the same factual
basis as is asserted in the federal litigation. The state litigation pleads
claims for fraud and violations of certain California Corporation Code
provisions. By stipulation of the parties and order of the court, this state
court litigation was stayed pending the outcome of the motion to dismiss the
federal lawsuits. The Company believes that the allegations set forth in the
federal and state complaints are without merit, and the Company intends to
defend against these lawsuits vigorously. No assurance as to the outcome of
this matter can be given, however, and an unfavorable resolution of this matter
could have a material adverse effect on the Company's business, results of
operations, and financial condition.

On February 27, 2002, a complaint was filed against certain of the Company's
former officers and directors, as well as Daou On-Line, Inc, in the Superior
Court of New Jersey located in Bergen County. The Court conducted a hearing on
June 7, 2002 and granted the Company's Motion to Dismiss. The plaintiffs
abandoned their appeal which the Appellate Court dismissed on January 3, 2003.
The plaintiffs filed a Complaint against the Company, as well as certain of its
former officers in San Diego County Superior Court on December 5, 2002. An
answer or other responsive pleading to the Complaint must be filed on April 4,
2003 absent agreement to stay the case and proceed to arbitration.

As background, a First Amended Complaint was filed on March 1, 2002, adding
the Company and its former Chief Financial Officer as parties/defendant. The
gravamen of the First Amended Complaint is twofold. First, it alleges Daou's
financial statements were misleading and fraudulently induced the plaintiff to
merge his company with Daou. Second, the First Amended Complaint alleges

45

Daou Systems, Inc.
Notes to Consolidated Financial Statements--(Continued)

11. Contingencies--(Continued)

breach of an indemnification and severance agreement obligating the Company to
defend the plaintiff in a lawsuit filed by Traci Melia, a former employee.
Neither the Complaint nor the First Amended Complaint alleges specific damage
amounts. The Company filed A Motion to Dismiss the First Amended Complaint on
April 24, 2002. The Court conducted a hearing on June 7, 2002 and granted our
motion. On July 23, 2002, plaintiffs filed a Notice of Appeal but later
abandoned their appeal which the Appellate Court dismissed on January 3, 2003.
The Plaintiffs filed a Complaint against the Company, as well as certain of its
former officers in San Diego County Superior Court on December 5, 2002. The
Summons and Complaint was served by way of Notice and Acknowledgment of
Receipt. While not identical to the Complaints filed in New Jersey, the
gravaman of the San Diego action is the same. The Complaint prays for
compensatory damages of at least $1,450,000. An answer or other responsive
pleading to the Complaint must be filed on April 4, 2003 absent agreement to
stay the case and proceed to arbitration. Counsel for Mr. Dickson has advanced
that proposal given a controlling arbitration provision set forth in one of the
contracts giving rise to the lawsuit. The Company believes that the allegations
set forth in the Complaint are without merit, and the Company intends to defend
against the lawsuit or arbitration vigorously. No assurance as to the outcome
of this matter can be given, however, and an unfavorable resolution of this
matter could have a material adverse effect on the Company's business, results
of operations and financial condition.

The Company is party to other various claims and legal actions arising in
the normal course of business. Although the ultimate outcome of the matters is
not presently determinable, management believes that the resolution of all such
pending matters, net of amounts accrued, will not have a material adverse
affect on the Company's business, results of operations or financial condition;
however, there can be no assurance that the ultimate resolution of these
matters will not have a material impact on the Company's results of operations
in any period.

12. Disclosure of Segment Information

Daou provides integrated information technology solutions and services to
the U.S. healthcare industry. The Company principally focuses on healthcare
providers, payors and health plans and government healthcare organizations.
Daou's services include (1) management consulting, (2) traditional network
services, (3) application implementation and support, (4) application
development and integration, and (5) strategic outsourcing, including remote
help desk and related technology support services.

As part of the reorganization discussed in Note 1, the Company consolidated
its two operating divisions--Technology Services and Application Services and
plans to operate as one business unit. The Company currently has no reportable
segments. (In 2001, Daou had five reportable segments: Technology Management
("TMI"), Resources in Healthcare Innovation ("RHI"), Sentient, Infrastructure
Services Group ("ISG") and RTC). For purposes of improving overall sales and
operations effectiveness, and to offer its customers an integrated solutions
approach through multi- disciplinary teams, the Company now provides its
services through two primary practice groups: commercial healthcare and
government healthcare. The Company believes the consolidation was necessary due
to changing market forces in the healthcare industry. Daou expects that
operating under its new structure will allow the Company to focus on its core
competencies and pursue a seamless approach to applications and technology.

46

Daou Systems, Inc.
Notes to Consolidated Financial Statements--(Continued)

13. Quarterly Financial Data (Unaudited)

The following is a summary of the unaudited quarterly results of operations
for the year ended December 31, 2002 and 2001, respectively. The unaudited
financial information reflects all normal recurring adjustments, which are in
the opinion of management, necessary for the fair statement of the results of
the interim periods (in thousands, except per share amounts).

Quarter Ended
--------------------------------------------
March 31, June 30, September 30, December 31,
--------- -------- ------------- ------------

2002
Net revenue..................................... $ 9,104 $ 9,734 $9,493 $ 9,604
Gross profit.................................... 2,575 2,398 2,364 2,930
Net loss available to common stockholders....... (709) (858) (871) (1,555)
Basic and diluted net loss available to
common stockholders per common
share..................................... (0.04) (0.05) (0.05) (0.07)
2001
Net revenue..................................... $12,760 $10,121 $9,129 $ 9,072
Gross profit.................................... 2,428 1,690 1,727 2,813
Net loss available to common stockholders....... (622) (1,062) (965) (1,157)
Basic and diluted net loss available to
common stockholders per common
share..................................... (0.03) (0.06) (0.06) (0.07)

47

SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS

COL. A COL. B COL. C COL. D COL. E
- ----------------------------- ------------ ------------------------- ---------- ----------
Additions
-------------------------
Balance at Charged to Balance at
Beginning of Costs and Charged to Other End of
Description Period Expenses Accounts--Describe Write-offs Period
----------- ------------ ---------- ------------------ ---------- ----------

Year Ended December 31, 2002:
Allowance for doubtful
accounts................ $ 715 $186 $ -- $ 169 $ 732
Year Ended December 31, 2001:
Allowance for doubtful
accounts................ $1,138 $232 $(381)(A) $ 274 $ 715
Year Ended December 31, 2000:
Allowance for doubtful
accounts................ $1,868 $402 $ -- $1,132 $1,138

- --------
(A) Amounts reclassified to Contract work in progress.

Item 9: Changes in and Disagreements With Accountants on Accounting and
Financial Disclosure.

None.

PART III

Item 10: Directors, Executive Officers, Promoters and Control Persons;
Compliance with Section 16(a) of the Exchange Act.

The information required by this item will be included under the captions
entitled "Elections of Directors" and "Information Concerning Directors and
Executive Officers" in the Company's Proxy Statement and is incorporated herein
by reference.

Item 11: Executive Compensation.

The information required by this item will be included under the caption
entitled "Executive Compensation" in the Company's Proxy Statement and is
incorporated herein by reference.

Item 12: Security Ownership of Certain Beneficial Owners and Management and
Related Stockholders Matters.

The information required by this item will be included under the captions
entitled "Security Ownership of Certain Beneficial Owners and Management" and
"Equity Compensation Plan Information" in the Company's Proxy Statement and is
incorporated herein by reference.

Item 13: Certain Relationships and Related Transactions.

The information required by this item will be included under the caption
entitled "Certain Relationships and Related Transactions "in the Company's
Proxy Statement and is incorporated herein by reference.

Item 14: Controls and Procedures.

(a) Under the supervision and with the participation of our management,
including our principal executive officer and principal financial officer, we
conducted an evaluation of our disclosure controls and procedures, as such term
is defined under Rule 13a-14(c) promulgated under the Securities Exchange Act
of 1934, as amended (the "Exchange Act"), within 90 days of the filing date of
this report. Based on their evaluation, our principal executive officer and
principal accounting officer concluded that Daou's disclosure controls and
procedures are effective.

(b) There have been no significant changes (including corrective actions
with regard to significant deficiencies or material weaknesses) in our internal
controls or in other factors that could significantly affect these controls
subsequent to the date of the evaluation referenced in paragraph (a) above.

48

PART IV

Item 15: Exhibits, Financial Statement Schedules, and Reports on Form 8-K.

(a) The following are filed as part of, or included in, this Annual Report
on Form 10-K:

(1) The financial statements listed in the Index to Consolidated
Financial Statements and Consolidated Financial Statement Schedule, filed as
a part of this Annual Report on Form 10-K.

(2) The financial statement schedule listed in the Index to Consolidated
Financial Statements and Consolidated Financial Statement Schedule, filed as
a part of this Annual Report on Form 10-K.

(3) The exhibits listed in the Index to Exhibits hereof are attached
hereto or incorporated herein by reference and filed as part of this Report.

(b) Reports on Form 8-K:

(1) No reports on Form 8-K were filed by the Company during the fourth
quarter of the year ended December 31, 2002.

49

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.

Date: March 31, 2003

DAOU SYSTEMS, INC.

By: /s/ Daniel J. Malcolm
-----------------------------
Daniel J. Malcolm
Chief Executive Officer

POWER OF ATTORNEY

KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Daniel J. Malcolm and Neil R. Cassidy, jointly
and severally, as his attorney-in-fact, each with the power of substitution,
for him in any and all capacities, to sign any amendments to this report and to
file the same, with exhibits thereto and other documents in connection
therewith, with the Commission, hereby ratifying and confirming all that each
of said attorneys-in-fact, or his substitute or substitutes, may do or cause to
be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

Signature Title Date
- ----------------------------- ------------------------------------------------------------ --------------

/s/ DANIEL J. MALCOLM March 31, 2003
- --------------------------- Director, President and Chief
Daniel J. Malcolm Executive Officer
/s/ NEIL R. CASSIDY Executive Vice President, March 31, 2003
- --------------------------- Chief Financial Officer and
Neil R. Cassidy Secretary (Principal
Financial and Accounting
Officer)
/s/ JAMES T. ROBERTO Chairman of the Board March 31, 2003
- ---------------------------
James T. Roberto
/s/ DAVID W. JAHNS Director March 31, 2003
- ---------------------------
David W. Jahns
/s/ LARRY R. FERGUSON Director March 31, 2003
- ---------------------------
Larry R. Ferguson
/s/ H. LAWRENCE ROSS Director March 31, 2003
- ---------------------------
H. Lawrence Ross
/s/ VINCENT K. ROACH Director and Executive Vice President, Commercial Operations March 31, 2003
- ---------------------------
Vincent K. Roach

50

CERTIFICATION

I, Daniel J. Malcolm, certify that:

1. I have reviewed this annual report on Form 10-K of Daou Systems, Inc.;

2. Based on my knowledge, this annual 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 annual report;

3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
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 as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and

c) presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified
for the registrant's auditors any material weaknesses in internal
controls; 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; and

6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or
in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.

Date: March 31, 2003

/s/ DANIEL J. MALCOLM
By: -----------------------------
Daniel J. Malcolm
Principal Executive Officer

51

CERTIFICATION

I, Neil R. Cassidy, certify that:

1. I have reviewed this annual report on Form 10-K of Daou Systems, Inc.;

2. Based on my knowledge, this annual 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 annual report;

3. Based on my knowledge, the financial statements, and other financial
information included in this annual 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 annual report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
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 as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and

c) presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified
for the registrant's auditors any material weaknesses in internal
controls; 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; and

6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or
in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.

Date: March 31, 2003

/s/ NEIL R. CASSIDY
By: -----------------------------
Neil R. Cassidy
Principal Financial Officer

52

EXHIBIT INDEX

Exhibit
Number Description
------- -----------------------------------------------------------------------------------------------------

3.1(1) --Amended and Restated Certificate of Incorporation of the Registrant.

3.2(1) --Bylaws of the Registrant.

4.1 --Reference is made to Exhibits 3.1 and 3.2.

4.2(1) --Specimen stock certificate.

4.3(2) --Certificate of Designations of the Registrant, as filed with the Secretary of State of the State of
Delaware on July 23, 1999.

4.4(4) --Amended and Restated Registration Rights Agreement, dated as of November 9, 2000, by and
between the Registrant, Galen Partners III, L.P., a Delaware limited partnership ("Galen III"),
Galen Partners International III, L.P., a Delaware limited partnership ("Galen International"),
and Galen Employee Fund III, L.P., a Delaware limited partnership ("Galen Employee Fund").

4.5(6) --Restricted Stock Purchase Agreement, dated June 1, 2001, by and between the Registrant and
Vincent K. Roach.

4.6(6) --Registration Rights Agreement, dated June 1, 2001, by and between the Registrant and Vincent
K. Roach.

4.7(6) --Stock Purchase Agreement, dated April 25, 2001, by and between the Registrant and Georges J.
Daou.

4.8(7) --Restricted Stock Purchase Agreement, dated June 1, 2001, by and between the Registrant and
Neil R. Cassidy.

4.9(7) --Registration Rights Agreement, dated June 1, 2001, by and between the Registrant and Neil R.
Cassidy.

4.10(7) --Restricted Stock Purchase Agreement, dated June 1, 2001, by and between the Registrant and
James T. Roberto.

4.11(7) --Registration Rights Agreement, dated June 1, 2001, by and between the Registrant and James
T. Roberto.

4.12(8) --Restricted Stock Purchase Agreement, dated November 6, 2001, by and between the Registrant
and Daniel J. Malcolm.

4.13(8) --Registration Rights Agreement, dated November 6, 2001, by and between the Registrant and
Daniel J. Malcolm.

10.1(1) --Form of Indemnification Agreement.

10.2(8) --DAOU Systems, Inc. 1996 Stock Option Plan, as amended.

10.3(1) --Form of Incentive Stock Option Agreement under the 1996 Stock Option Plan.

10.4(1) --Form of Nonstatutory Stock Option Agreement under the 1996 Stock Option Plan.

10.5(+ )(1) --Principal Agreement, dated as of June 18, 1996, by and between the Registrant and Catholic
Medical Center of Brooklyn & Queens, Inc.

10.6(+ )(1) --Master Agreement, dated as of June 4, 1996, by and between the Registrant and Atlantic Health
System.

10.7(1) --Form of Master Services Agreement.

10.8(3) --Voting Agreement, dated as of July 26, 1999, by and among the Registrant, Daniel J. Daou,
Georges J. Daou, Galen III, Galen International and Galen Employee Fund.

10.9(3) --Series A Preferred Stock Purchase Agreement, dated as of July 26, 1999, by and among the
Registrant, Galen III, Galen International and Galen Employee Fund.

1

Exhibit
Number Description
- ------- -------------------------------------------------------------------------------------------------

10.10(5) --Employment Agreement, dated October 2, 2000, by and between the Registrant and Neil R.
Cassidy.

10.11(6) --Employment Agreement, dated June 1, 2001, by and between the Registrant and Vincent K.
Roach.

10.12(6) --Secured Promissory Note, dated June 1, 2001, by and between the Registrant and Vincent K.
Roach.

10.13(6) --Stock Pledge Agreement, dated June 1, 2001, by and between the Registrant and Vincent K.
Roach.

10.14(7) --Amendment No. 1 to Employment Agreement, dated June 1, 2001, by and between the Registrant
and Neil R. Cassidy.

10.15(7) --Secured Promissory Note, dated June 1, 2001, by and between the Registrant and Neil R. Cassidy.

10.16(7) --Stock Pledge Agreement, dated June 1, 2001, by and between the Registrant and Neil R. Cassidy.

10.17(7) --Amendment to Employment Agreement, dated June 1, 2001, by and between the Registrant and
James T. Roberto.

10.18(7) --Secured Promissory Note, dated June 1, 2001, by and between the Registrant and James T.
Roberto.

10.19(7) --Stock Pledge Agreement, dated June 1, 2001, by and between the Registrant and James T.
Roberto.

10.20(8) --Employment Agreement, dated November 6, 2001, by and between the Registrant and Daniel J.
Malcolm.

10.21(8) --Secured Promissory Note, dated November 6, 2001, by and between the Registrant and Daniel J.
Malcolm.

10.22(8) --Stock Pledge Agreement, dated November 6, 2001, by and between the Registrant and Daniel J.
Malcolm.

10.23(8) --Executive Stock Option Agreement, dated December 13, 2001, between the Registrant and Neil R.
Cassidy.

10.24(8) --Executive Stock Option Agreement, dated December 13, 2001, between the Registrant and James
T. Roberto.

10.25(8) --Executive Stock Option Agreement, dated November 6, 2001, between the Registrant and Daniel
J. Malcolm.

10.26(*) --Executive Stock Option Agreement, dated May 17, 2002, by and between Registrant and Neil R.
Cassidy.

10.27(*) --Amendment No. 2 to Employment Agreement, dated July 1, 2002, by and between the Registrant
and Neil R. Cassidy.

10.28(*) --Form of Board of Director Stock Option Agreement, dated November 5, 2002, by and between
Registrant and Kevin. M. Fickenscher, David W. Jahns, and H. Lawrence Ross (25,000 options
each), and November 6, 2002, by and between Registrant and Larry R. Ferguson (100,000
options).

10.29(*) --Separation Agreement and General Release, dated December 31, 2002, between the Registrant and
Neil R. Cassidy.

10.30(*) --Separation Agreement and General Release, dated December 31, 2002, between the Registrant and
James T. Roberto.

10.31(*) --Form of Indemnification Agreement.

2

Exhibit
Number Description
- ------- -----------------------------------------------------------------------------------------------------

23.1 --Consent of Ernst & Young LLP, independent auditors.

24 --Power of Attorney (included on the signature page to this report).

99.1(*) --Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.

99.2(*) --Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.

- --------
(*) Filed herewith.
(+) Confidential treatment has been granted with respect to certain portions of
this exhibit.
(1) Incorporated by reference to the similarly described exhibit included with
the Registrant's Registration Statement on Form SB-2, File No. 333-18155,
declared effective by the Commission on February 12, 1997.
(2) Incorporated by reference to the similarly described exhibit included with
the Registrant's Current Report on Form 8-K, filed with the Commission on
April 14, 1998.
(3) Incorporated by reference to the similarly described exhibit included with
the Registrant's Current Report on Form 8-K, filed with the Commission on
July 29, 1999.
(4) Incorporated by reference to the similarly described exhibit included with
the Registrant's Quarterly Report on Form 10-Q for the quarter ended
September 30, 2000, filed with the Commission on November 14, 2000.
(5) Incorporated by reference to the similarly described exhibit included with
the Registrant's Quarterly Report on Form 10-Q for the quarter ended March
31, 2001, filed with the Commission on May 14, 2001.
(6) Incorporated by reference to the similarly described exhibit included with
the Registrant's Quarterly Report on Form 10-Q for the quarter ended June
30, 2001, filed with the Commission on August 14, 2001.
(7) Incorporated by reference to the similarly described exhibit included with
the Registrant's Quarterly Report on Form 10-Q for the quarter ended
September 30, 2001, filed with the Commission on November 14, 2001.
(8) Incorporated by reference to the similarly described exhibit included with
the Registrant's Annual Report on Form 10-K for the year ended December 31,
2001, filed with the Commission on April 1, 2002.

3