HORIZON HEALTH CORP /DE/ - 10-K Annual Report

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

FORM 10-K

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

For the Fiscal Year Ended August 31, 2003

or

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

For the transition period from ___________ to _______________

Commission File number 1-13626

HORIZON HEALTH CORPORATION
(Exact name of registrant as specified in its charter)

Delaware 75-2293354
--------- ----------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)

1500 Waters Ridge Drive
Lewisville, Texas 75057-6011
----------------------------
(Address of principal executive offices, including zip code)

(972) 420-8200
--------------
(Registrant's telephone number, including area code)

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

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

Title of each class
-------------------
Common Stock, $.01 par value

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 Rule 12b-2 of the Exchange Act).

Yes [ ] No [x]

The aggregate market value of the voting common stock held by non-affiliates of
the registrant (assuming for purposes of this calculation, but without
conceding, that all executive officers and directors are "affiliates" of the
registrant) at February 28, 2003 (the last business day of the most recently
completed second fiscal quarter) was $69,616,153, based on the market price at
the close of business on February 28, 2003.

The number of shares outstanding of the registrant's Common Stock, $.01 par
value per share, as of November 10, 2003 was 5,369,910.

DOCUMENTS INCORPORATED BY REFERENCE

There is incorporated by reference in Part III of this Annual Report on Form
10-K portions of the information contained in the registrant's proxy statement
for its annual meeting of stockholders to be held on January 29, 2004.

TABLE OF CONTENTS

HORIZON HEALTH CORPORATION

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PART II

Item 5. Market for the Company's Common Equity
and Related Stockholder Matters........................................... 22

Item 6. Selected Financial Data ............................................................... 22

Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations ............................................... 24
General Overview....................................................................... 24
Acquisitions........................................................................... 24
Segments............................................................................... 24
Revenues............................................................................... 25
Operating Expenses..................................................................... 26
Results of Operations ................................................................. 27
Fiscal Year Ended August 31, 2003 Compared to Fiscal Year
Ended August 31, 2002 Fiscal Year Ended August 31, 2002
Compared to Fiscal Year Ended August 31, 2001
Newly Issued Accounting Standards...................................................... 34
Liquidity and Capital Resources........................................................ 34
Inflation.............................................................................. 35
Critical Accounting Policies & Estimates............................................... 36
Disclosure Regarding Forward Looking Statements........................................ 37

Item 7A. Quantitative and Qualitative Disclosures About Market Risk............................. 38

Item 8. Financial Statements and Supplementary Data............................................ 38

Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure................................................ 38

Item 9A. Controls and Procedures................................................................ 38

PART III

Item 10. Directors and Executive Officers of the Registrant .................................... 40

Item 11. Executive Compensation................................................................. 41

Item 12. Security Ownership of Certain Beneficial Owners and Management ........................ 41

Item 13. Certain Relationships and Related Transactions ........................................ 42

Item 14. Principal Accounting Fees & Services................................................... 42

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PART IV

Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K ..................... 43
Index to Consolidated Financial Statements F-1
Note 1: Organization F-9
Note 2: Significant Accounting Policies F-9
Note 3: Earnings Per Share F-14
Note 4: Acquisitions F-15
Note 5: Property and Equipment F-17
Note 6: Accrued Expenses F-17
Note 7: Long-Term Debt F-17
Note 8: Shareholders' Equity F-18
Note 9: Stock Options F-19
Note 10:Goodwill and Other Intangible Assets F-21
Note 11:Retirement Plan F-22
Note 12:Income Taxes F-22
Note 13:Commitments and Contingencies F-23
Note 14:Segment Information F-24
Note 15:Quarterly Financial Information F-26
Index to Financial Statement Schedules........................................................... S-1

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PART I

ITEM 1. BUSINESS

Unless the context otherwise requires, whenever used herein the terms
"Company", "Horizon" and "Registrant" refer to Horizon Health Corporation and
its subsidiaries.

General Overview

The Company is a diversified health care services provider. The Company
has grown both internally and through acquisitions, increasing both the variety
of its treatment programs and services, and the number of its contracts. The
Company considers that it has four identifiable business segments as follows:
(1) mental health contract management services, including psychiatric outcomes
measurement services, (2) physical rehabilitation contract management services,
(3) specialized temporary nurse staffing services and (4) employee assistance
programs and managed care behavioral health services. For the year ended August
31, 2003, the revenues of such business segments constituted 46.1%, 10.4%,
13.3%, and 29.2%, respectively, of the total revenues of the Company. See Note
14 "Segment Information" to the Consolidated Financial Statements of the Company
included elsewhere herein for financial information regarding business segments
of the Company and the "General Overview" section of Management's Discussion and
Analysis included elsewhere herein for additional information regarding the
Company's businesses, including the respective number of contracts as of August
31, 2003.

The Company believes the hospital based clinical service delivery
system for the mental health and physical rehabilitation programs it manages, is
a cost efficient and effective model competitive with other forms of delivery
systems in the marketplace. While the Company is generally not experiencing
material adverse consequences as a result of recent changes in reimbursement
under federal health care programs, at this time, the Company cannot
meaningfully predict the ultimate impact that reimbursement changes may have on
the programs it currently manages or on its ability to obtain new management
contracts. See "Government Regulation" - "Medicare and Medicaid; Reimbursement
for Services" elsewhere herein regarding Medicare statutes, hospital
reimbursement systems and related recent changes.

The Company was incorporated in 1989 and is the successor to Horizon
Mental Health Management, Inc., incorporated in 1981 which began the development
and contract management of mental health treatment programs for general acute
care hospitals.

MENTAL HEALTH SERVICES

The Company believes that there continues to be a viable market for
mental health treatment program contract management services provided to general
acute care hospitals. General acute care hospitals are outsourcing key clinical
departments to independent contract management companies for several reasons,
including: (i) the expertise necessary for the development, management and
operation of specialized clinical programs differs from that necessary for
traditional medical/surgical services, (ii) hospitals often lack access to the
skilled professionals and support staff needed to operate specialized clinical
programs, (iii) hospitals often lack expertise in community education activities
required to support specialized clinical programs, and (iv) hospitals often lack
expertise necessary to design and operate specialized clinical programs that
satisfy regulatory, licensing, accreditation and reimbursement requirements.

A major focus on the delivery of mental health services continues as
payors are increasingly using managed care methods for pre-approval reviews of
mental health treatment services and to evaluate alternatives to inpatient
hospitalization in order to ensure that each patient's treatment regimen
utilizes clinical resources effectively. The Company believes that general acute
care hospitals need to be able to offer a broad array of mental health care
services in order to develop or participate in integrated delivery systems
responsive to the changing demands of governmental payors, managed care
companies and other third-party payors. General acute care hospitals are able to
provide their mental health patients with needed medical and surgical care
on-site and in a more cost-effective manner than freestanding psychiatric
hospitals. Furthermore, general acute care hospitals are eligible to receive

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reimbursement under the Medicaid program for mental health care provided to
Medicaid-eligible adults, unlike freestanding psychiatric hospitals, which are
not presently eligible.

The Company believes it is uniquely positioned to capitalize on an
increased demand for mental health contract management services as a result of
its demonstrated industry expertise to provide a continuum of mental health
services and its proprietary quality and outcomes measurement system. In
addition, the Company believes its position as the leading contract manager of
mental health programs provides the Company with a significant advantage in
attracting and retaining employees and yields several economies of scale such as
the ability to consolidate administrative functions.

The Company has the expertise to manage a broad range of clinical
mental health programs, including geropsychiatric, general adult, substance
abuse and child and adolescent programs. The programs use a treatment team
concept, with the admitting physician, team psychologist, social workers,
nurses, therapists and counselors coordinating each phase of therapy. The
programs include crisis intervention, individual therapy, group and family
therapy, recreational therapy, occupational therapy, lifestyle education, social
services and substance abuse counseling. Family involvement is encouraged. Each
treatment program is individually tailored as much as practicable to meet the
needs of the patients, the client hospital, physicians and payor groups.

The Company intends to continue to emphasize the area of mental health
programs for the elderly ("geropsychiatric programs"). At August 31, 2003,
approximately 61.1% of the mental health treatment programs managed by the
Company were geropsychiatric programs. Many elderly patients with short-term
mental illness also have physical problems that make the general acute care
hospital environment the most appropriate site for their care. Subject to
certain regulatory maximum limitations on reimbursement amounts, the Medicare
program currently reimburses general acute care hospitals for their cost of
providing these services, which includes the Company's management fee as well as
allocated overhead costs to the facility, and also allows reimbursement for
partial hospitalization on a specified fee for service basis that facilitates
the ability to treat patients in the most cost-effective environment. The
Company has developed particular expertise in developing specialized psychiatric
programs for the elderly, in operating such programs, and in assisting hospitals
in receiving approval for inpatient programs as distinct part units ("DPUs") to
qualify for reimbursement under Medicare. Approval of an inpatient program as a
DPU is significant to client hospitals because services provided in DPUs are
exempt from predetermined reimbursement rates and are reimbursed by Medicare on
an actual cost basis, subject to certain significant limitations described
below. As discussed below, a prospective payment system is under consideration,
however, for inpatient mental health services.

The contract management fees received by the Company for its services
are paid directly by its client hospitals. The client hospitals receive
reimbursement for the clinical services provided to patients of the programs
managed by the Company under either the Medicare or Medicaid programs or from
insurers, self-funded benefit plans or other third-party payors for the
services. As a result, the availability and amount of such reimbursements, which
are subject to change, impacts the decisions of general acute care hospitals
regarding whether to offer mental health services pursuant to management
contracts with the Company, as well as the decisions whether to renew such
contracts and the amount of fees to be paid thereunder. See "Government
Regulation" - "Medicare and Medicaid; Reimbursement for Services" elsewhere
herein for a further discussion of funding methods, and recent changes in them.

Elements of the Continuum of Care

The mental health treatment programs managed by the Company are
designed to be part of a continuum of mental health services, consisting of
inpatient, partial hospitalization (or day treatment) and outpatient services.

Inpatient Services. Inpatient services are generally provided to
patients needing the most intensive mental health treatment and who frequently
have accompanying medical care needs. The patient is admitted to the client
hospital and remains there on a 24-hour per day basis throughout the course of
the inpatient treatment, which is continued until the patient can be stabilized
and moved to another level in the continuum of mental health services.

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Partial Hospitalization. Partial hospitalization services are provided
for limited periods per day with the patient returning home at the conclusion of
each day's treatment. Partial hospitalization services are designed to be both
an alternative to inpatient hospitalization services and a key component of care
following inpatient hospitalization.

Outpatient Services. Outpatient services consist generally of
consultative and therapeutic sessions that can be rendered in a variety of
individual or group settings at various locations, including hospitals, clinics
or the offices of the service provider. Outpatient service providers can also
serve a "gatekeeper" function for persons being evaluated for treatment. Once an
individual is assessed for treatment in an outpatient environment, the
individual is provided the appropriate level of service in relation to the
diagnosis.

CQI+ Mental Health Outcomes Measurement

The Company began offering its proprietary CQI+ Outcomes Measurement
System in 1994. The CQI+ System provides a qualitative and quantitative tool for
mental health programs to evaluate the clinical effectiveness of treatment and
to make adjustments in the programs in order to improve quality and
appropriateness of care. The CQI+ Outcomes Measurement System provides outcome
information regarding the effectiveness of a hospital's mental health programs.
The availability of such information enables a hospital to demonstrate to
third-party payors whether patients are improving as a result of the treatment
provided, to refine its clinical treatment programs to improve the effectiveness
of care provided and to demonstrate the benefits of its programs to patients and
providers. The CQI+ System also provides the Company with a valuable tool for
demonstrating clinical results of the mental health programs managed by the
Company and for marketing its management services to other hospitals. The
Company provides outcome measurement services to acute care hospital-based
programs as well as freestanding psychiatric hospitals. The Company's CQI+
System has met the criteria for inclusion in the Joint Commission on
Accreditation of Healthcare Organizations ("JACHO") ORYX Initiative and is
included on JACHO's list of acceptable outcome measurement systems. The Company
is committed to meeting the requirements as established by JACHO. As of August
31, 2003, 45 of the Company's mental health management contracts included the
CQI+ System and there were an additional 68 stand-alone contracts. Since
offering the CQI+ System, the Company has compiled a proprietary database
containing de-identified patient outcome measurement data on approximately
127,000 patients. Sample data is typically collected from randomly selected
patients at admission, discharge and 90 to 180 days after discharge. Quarterly
outcome reports include a summary of patient characteristics and outcome
measures. The Company trains and supervises on-site personnel to ensure the
collection of accurate outcome measurement data. With the continued emphasis on
enhancing patient care, accountability and the JACHO accreditation requirement,
the Company believes that its CQI+ System is an important component of the
mental health services it provides.

PHYSICAL REHABILITATION SERVICES

The Company's acquisition of Specialty Healthcare Management, Inc. in
August 1997 expanded the Company's operations to include the contract management
of physical rehabilitation programs. The Company believes that many of the same
factors that drive demand for contract management of mental health programs are
also applicable to physical rehabilitation programs. The Company provides
contract management services for a full range of physical rehabilitation
services. In addition to acute physical therapy and rehabilitation services, the
Company also provides contract management for skilled nursing services and
outpatient rehabilitation programs.

Acute rehabilitation units are specialized programs that incorporate a
variety of treatments and services aimed at improving an individual's functional
level following a disabling illness or traumatic injury. The treatment program
is led by a physician and provided by an interdisciplinary team of health care
professionals including physical, speech, occupational and recreational
therapists, rehabilitation nurses and social workers. The Company tailors an
acute rehabilitation program for a health care facility to satisfy unmet
community and medical staff needs, while maximizing utilization of the facility.

Outpatient rehabilitation serves as an adjunct to inpatient physical
therapy and rehabilitation programs. Outpatient rehabilitation services are
dominated by the treatment of sports and work related injuries, but also provide
the continuum of rehabilitative care necessary to meet the medical needs of a
post-acute care patient following a

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disabling illness or traumatic injury. Pressure from payors to move inpatients
to the lowest-cost appropriate treatment setting has helped stimulate growth in
outpatient rehabilitation services.

SPECIALIZED TEMPORARY NURSE STAFFING SERVICES

The Company's acquisition of ProCare One Nurses in June 2002 expanded
the Company's operations to include temporary nurse staffing. The Company
focuses on providing specialized nurses (primarily labor & delivery, neo-natal,
emergency room and critical care) to general acute care hospitals. The Company
provides its specialized temporary nurse staffing services on an on-call,
twenty-four hour per day, seven days a week, basis. The Company provides a
solution to hospitals for short term staffing needs resulting from increases in
the number of patients, increases in patient acuity, or the unavailability of
their own staff. The specialized temporary nurse staffing industry is expected
to continue to grow due to a chronic staffing shortage. The staffing shortfall
is primarily caused by an aging workforce, a declining number of new entrants
into the profession, an increased demand for healthcare professionals and in
some locales, regulatory mandated nurse-staffing levels. A key driver for the
Company to be successful in this business segment is its ability to continue to
attract and retain a large supply of highly qualified and experienced nurses.
The staffing shortage and an increased demand by hospitals is causing the hourly
rates paid to nurses to rise and is increasing the costs of recruiting an
adequate supply of nurses. As an industry practice, when a hospital experiences
a staffing shortage, it may call on one of many staffing companies to fill the
position. Typically the first contacted staffing company to call the hospital
back with a qualified, available nurse will have the opportunity to fill the
open position. Although hospitals are sensitive to a nurse's hourly rate, often
this concern is secondary to availability.

EMPLOYEE ASSISTANCE PROGRAMS AND MANAGED BEHAVIORAL HEALTH CARE
SERVICES

The Company contracts with employers to provide Employee Assistance
Programs (EAPs) to their employees. An EAP is a worksite-based program that is
designed to assist in the early identification and resolution of productivity
problems associated with behavioral conditions or other personal concerns of
employees and their dependants. An EAP is usually provided by employers as a
benefit at no cost to employees. Under an EAP, staff or network providers
provide assessment and referral services to employee beneficiaries and their
dependants. These services consist of evaluating a beneficiary's needs and, if
indicated, providing limited counseling and/or identifying an appropriate
provider, treatment facility or other resource for more intensive treatment
services. For its EAP services, the Company is usually paid a specified fee per
month per employee based on the range and breadth of services provided to the
employer, which may include work life services, and the method(s) in which those
services are provided.

The Company frequently provides training to employer personnel for
identifying troubled employees. Often an employer will refer an employee for
consultation after observing a change in work performance. The Company believes
that such early identification and resolution of productivity problems can
frequently minimize the likelihood that the problem will develop into a serious
debilitating event requiring extensive treatment. The Company's EAP services can
include a comprehensive array of work life information and referral sources if
desired by the employer. Modes of access to services include traditional
face-to-face sessions as well as HorizOnline, an internet based EAP program, and
HorizonCareLink, a telephonic based EAP program, all of which focus on providing
consultation and resource services to assist employees and their families in
achieving personal and professional success and emotional well-being. Through
several acquisitions, as described in Note 4 "Acquisitions" in the Notes to
Financial Statements included elsewhere herein, the Company has expanded its
services offerings, including the ability to conduct EAP business in the State
of California, through the acquisition of a limited Knox-Keene license.

The Company also contracts with self-insured employers, insurance
companies and HMOs to provide the managed behavioral health care component of
the general health plans offered by such entities. The contracts are primarily
on a full risk, capitated basis under which the Company is paid a set fee per
month for each member of the respective health plan, however, a small portion of
the contracts are structured on a stipulated fee-for-service basis. The Company
provides its clients with quality, cost-effective programs for administration
and management of behavioral health, substance abuse and psychiatric disability
management services.

8

The EAP and managed behavioral health care services are provided
primarily through a network of approximately 28,000 independent providers that
have contracted with the Company to provide such services. In addition, the
Company provides such services through behavioral health care professionals
employed by the Company and it operates four clinics within the state of
Florida. The Company reimburses the independent professionals and institutions
on a negotiated fee-for-service basis. The clinical providers represent a broad
range of treatment and case management specialties and are qualified to respond
to the complete continuum of behavioral health concerns, pediatric to geriatric.
The clinical providers include psychiatrists, nurses, psychologists, social
workers, and other related mental health personnel. The Company believes that
its relationships with health care providers and its expertise in the provision
of behavioral health care services provide it with the capability to establish,
operate and manage the network of health care professionals necessary to
economically and adequately furnish such services.

In March 2002, the Company's Philadelphia service center received its
fourth successive full, two-year accreditation for utilization management from
the American Accreditation HealthCare/Commission (a/k/a URAC), a non-profit
charitable organization founded in 1990 to establish standards for the health
care industry. In October 2000, the Company's Orlando service center was awarded
a three year, Full Accreditation from the National Committee for Quality
Assurance ("NCQA") under its 2000 standards for managed behavioral health care
organizations. In July 2003, the Company was reaccredited by NCQA for an
additional three years beginning October 2003. NCQA is an independent,
not-for-profit organization dedicated to assessing and reporting on the quality
of managed behavioral health care organizations, physician organizations,
managed care organizations and credentials verification organizations. The NCQA
accreditation process is a voluntary review that evaluates how well a managed
behavioral health care organization manages all parts of its delivery system in
order to continuously improve health care for its members. The NCQA standards
for the accreditation are intended to help organizations achieve the highest
level of performance possible, reduce patient risk for untoward outcomes, and
create an environment of continuous improvement.

OPERATIONS

MANAGEMENT CONTRACTS

The Company operates its mental health management contract business
through a regional structure that includes management personnel officed in the
regional territory and in the Company's national support center ("NSC") in the
Dallas suburb of Lewisville, Texas. The structure is designed to maintain key
operating employees of the Company in direct contact with clients. Each region
is under the supervision of a vice president who in turn supervises regional
directors, each of whom has direct responsibility over eight to twelve mental
health management contract locations. Other regional personnel include clinical
and other specialists, who are available to provide assistance to the local
programs and client hospital personnel. The Company's physical rehabilitation
management contracts are also operated in a regional organizational manner.

The Company provides its management services under contracts with
client hospitals. Each contract is tailored to address the specific needs of the
client hospital and its community. The Company and the client hospital determine
the programs and services to be offered by the hospital and managed by the
Company. At any location, these may consist of one or more treatment programs
offering inpatient, partial hospitalization, outpatient services, and also other
specialized services. Under the management contracts, the hospital is the actual
provider of the mental health or physical rehabilitation services and utilizes
its own facilities (including beds for inpatient programs), its own support
services (such as billing, dietary and housekeeping), and frequently its own
nursing staff for the operation of the treatment programs with the Company
providing operating and clinical expertise through its onsite management staff.

While the treatment programs subject to each of the management
contracts is tailored to the specific needs of the client hospital,
substantially all of the management contracts contain certain non-compete and
confidentiality provisions. In addition, the management contracts typically
prohibit the client hospital from soliciting the employment of the Company's
employees during the contract term and for a specified period thereafter.

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The management contracts generally have a term of 3-5 years although
some contracts have shorter or longer terms. Contracts are frequently renewed or
amended prior to their stated expiration date. As of August 31, 2003, 2002 and
2001, the Company had successfully retained 82%, 83%, and 86%, respectively, of
the management contracts in existence at the beginning of the respective fiscal
year. Some contracts are terminated prior to their stated expiration date by
mutual agreement of the parties or pursuant to early termination provisions
included in the contract. The Company's experience is that the most frequent
reasons why the client hospitals do not renew a contract is that the hospital
desires to manage the program itself, the economic viability of the program has
changed resulting in the hospital closing the program, or a change in hospital
administration has occurred that results in a philosophical change regarding the
use of contract managers.

Under each contract, the Company receives a fee for its services paid
by the client hospital. The management fee may be a variable fee related in part
to patient volumes (census, admissions, or discharges) at the program, a fixed
fee with reimbursement for specified direct program costs, or a combination of
these structures. The management fee is frequently subject to periodic
adjustments as a result of changes in a relevant price index or other economic
factors. A significant number of the Company's management contracts require the
Company to refund some or all of its fee if either Medicare reimbursement for
services provided to patients of the programs is denied or the fee paid to the
Company is denied as a reimbursable cost. During the last three fiscal years the
Company has not refunded any significant amount of its fees in relation to such
denials.

Program Development

The Company assists in the development of each clinical program as
requested by the client hospital, including such matters as licensing,
accreditation, certificate of need approvals and Medicare certification. The
Company also develops and implements community education awareness plans and
development plans for the clinical programs to be offered by the hospital. Each
program is marketed locally in the name of the client hospital with an emphasis
on the hospital addressing the needs of the local community. The Company's name
is not used and its role is not publicly emphasized in the operation of the
clinical programs offered by its client hospitals. The medical staff of the
client hospital admits each patient. Charges for treatment services provided to
the patients of the programs accrue directly to and are billed by the client
hospital and/or treating physician.

The Company also develops and maintains standardized clinical,
operating, and administrative policy and procedure manuals, conducts initial and
ongoing staff training and education, and implements quality assurance and
ethical and regulatory compliance procedures. Each local program director
receives ongoing support from the regional support staff and the national
support center staff in areas including recruiting, finance, reimbursement,
referral development, marketing, quality assurance and regulatory compliance.

Each operating region is responsible for training new employees,
including formalized instruction and on-the-job training. Continuing education
programs are also provided to employees. In addition, the Company has a
centralized orientation program for new program directors and other program
management personnel, an annual leadership conference for all program directors
and other program personnel, and an on-going comprehensive ethics compliance
plan.

Program Staffing

Mental health programs managed by the Company generally have a program
director that is usually a psychologist, an advance degreed nurse or a social
worker and additional social workers or therapists as needed. Many programs also
include a nurse manager, a community education manager or a clinical assessment
coordinator. Physical rehabilitation programs managed by the Company generally
have a program director, and additional clinical staff tailored to meet the
needs of the specific hospital program, which may include physical and
occupational therapists, speech pathologists, social workers and other
appropriate supporting personnel.

In addition, for mental health and physical rehabilitation programs,
the Company contracts with a medical director on an independent contractor basis
under which on-site administrative services for medical oversight of the program
are provided. These contracts generally include nondisclosure, nonsolicitation
and noncompetition covenants pursuant to which the medical director agrees not
to solicit the Company employees for specified periods,

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disclose confidential information of the Company or render certain
administrative or management services within specified time periods and
geographic areas to any enterprise in competition with the Company or the
programs it manages.

Except for the nursing staff, which is typically provided and employed
by the hospital, the other program personnel are usually employees of the
Company. The Company's management contracts typically contain non-solicitation
covenants whereby the hospital agrees not to solicit or otherwise employ Company
employees for specified periods.

Program Education and Referral Development

The treatment programs managed by the Company are a service provided by
the general acute care hospital client. Most patients are referred by the client
hospital's medical staff or result from relationships that the client hospital
has in the community. Many contract locations have a community education manager
(CEM) employed by the company who works with a community awareness and referral
development committee consisting of the Company and hospital personnel to
educate physicians, other health professionals and nursing homes in the
community of the treatment programs that are available at the client hospital,
to which they can direct patients. The CEM also designs and offers community
educational programs regarding various health issues.

Internal Clinical Audits

The Company has established an internal audit process for its mental
health and physical rehabilitation programs. The Company's regional mental
health clinical specialists review, as a part of the ongoing operations, the
services and clinical documentation of the treatment programs for compliance
with client hospital, federal, state and Company standards. The Company also has
a corporate internal audit department that is independent from contract clinical
and operations staff. The corporate auditors periodically visit all contract
locations. The auditor typically reviews medical records, clinical and operating
procedures, staffing, marketing programs, etc. and conducts interviews with
physicians, referral sources and client hospital staff members and frequently
patients and/or their families. Results of the audits are reported directly to
the senior management of the Company, independent from the operating
organizations.

Contract Locations

At August 31, 2003, the Company had a total of 142 mental health and
physical rehabilitation management contracts with general acute care hospitals
located in 37 states as shown below:

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Client Hospitals

The Company's clients are primarily small to medium sized hospitals
often located in rural areas, but also include some large tertiary care
hospitals. At August 31, 2003, approximately 16.9% of the Company's management
contracts were with proprietary hospitals. The remaining contracts are with
community not-for-profit hospitals.

CQI+ Mental Health Outcomes Measurement

The Company develops and operates its outcomes measurement system
primarily out of its NSC. Program personnel are responsible for the completion
of the data input forms concerning the various treatment programs. The data is
input into the national database using automated technologies from which reports
are developed, reviewed and analyzed.

SPECIALIZED TEMPORARY NURSE STAFFING SERVICES

On average, the Company provides specialized temporary nurse staffing
services on a monthly basis to over 100 hospitals through per diem, short-term
and traveling nurse contracts with acute care hospitals. The per diem contracts
provide short-term staffing solutions to hospitals resulting from increases in
the number of patients or the patient acuity and the availability of their own
staff. Hospitals typically have contracts with multiple staffing agencies.
Usually, the first contacted staffing company with an available, qualified nurse
will have the opportunity to fill the position. The per diem contracts meet
incidental needs and are not exclusive agreements and do not guarantee the
number of health professionals that will be provided to the hospital. The
short-term and traveling nurse contracts normally assist the hospital in filling
an expected vacancy of four to thirteen weeks. Under some agreements the
hospital may charge the Company a fee (of approximately two hours at the hourly
rate contracted with the hospital) if the Company staff does not "show" for an
assigned shift. Contracts are usually renewed if the hospital is satisfied with
the quality and the availability of the Company's nurses.

The Company provides specialized temporary nurse staffing services from
two offices, with Santa Ana, California being the major location and the second
being West Bloomfield, Michigan, a Detroit suburb. ProCare has nurse "staffers",
sales personnel and administrative support personnel at both locations.

EMPLOYEE ASSISTANCE AND MANAGED CARE CONTRACTS

The Company's Horizon Behavioral Services ("HBS") subsidiary is
positioning itself as a nationally integrated organization to better service and
market to a growing regional and national customer base, for stronger market
identification, and to achieve operating efficiencies. The Company's service
centers are located in the Philadelphia, Nashville, Denver, San Diego and
Orlando metropolitan areas. Additionally, the Company has satellite sales
offices located in various smaller cities.

HBS has a total network of approximately 28,000 independent providers
located in all 50 states. HBS has employees working in clinical management and
administrative positions at its service centers and has licensed clinicians
providing services in its four clinic locations in Florida. HBS also has
employees performing sales and support services and administrative functions
based at the NSC and its various operating locations.

ADMINISTRATION

The Company's employees at its NSC provide company-wide support in
finance, human resources, information technology, physician and program director
recruitment, clinical compliance, risk management, auditing, and other
administrative and executive services.

12

SALES AND MARKETING

The Company conducts direct sales activities for its mental health and
physical rehabilitation contract management businesses. The Company compiles
information from numerous databases, as well as other sources and referrals, to
identify prospective clients. The Company has developed profiles of almost 5,000
hospitals in the United States, with numerous clinical, operating, and financial
characteristics for each hospital. Potential clients include hospitals without
existing mental health, physical rehabilitation or other programs as well as
hospitals with existing programs of which the Company could assume management. A
select list of candidates, which number approximately 2,500, is systematically
and regularly updated based on criteria indicating which hospitals are the most
likely potential clients. Once identified, an internal telemarketing system is
in place to contact and qualify the potential clients. A Vice President of Sales
Development, who typically acts as the point person on the sales team then
contacts the prospective clients and, where appropriate, presents a detailed
proposal to key decision-makers. The proposal often contains detailed operating
and financial projections of the proposed programs. The Company works with the
potential client to develop contract terms responsive to the client's specific
needs. The typical sales cycle for a management contract is approximately nine
months. Operations and clinical management also participate in and support the
sales process. The Company believes it has opportunity to cross-sell a range of
services to client hospitals and is pursuing such opportunities as a part of its
business strategy.

The Company's subsidiary Horizon Behavioral Services ("HBS") markets
employee assistance programs and managed behavioral health programs to employers
both directly and through qualified brokers, by assessing the individualized
behavioral health benefit needs of their employees and providing the appropriate
EAP or managed care model.

The company's subsidiary ProCare One Nurses ("ProCare") markets
specialized temporary nurse-staffing services to acute care hospitals primarily
in California and Michigan. The operating management and certain staff in each
office participate in marketing to hospitals in their area to obtain contracts.
The short-term and travel placements are marketed by staff who match each
opportunity with a qualified nurse from the Company's portfolio of nurses who
are available and meet the hospital's required qualifications.

COMPETITION

The health care industry is highly competitive and subject to continual
changes in the method in which services are provided and the types of companies
providing such services. The Company competes with several national competitors
and many regional and local competitors, some of which have greater resources
than the Company. In addition, hospitals could elect to manage their own mental
health or physical rehabilitation programs.

Competition among contract managers for hospital-based mental health
and physical rehabilitation programs is generally based upon reputation for
quality, price, the ability to provide financial and other benefits for the
hospital, and the management, operational and clinical expertise necessary to
enable the hospital to offer mental health and physical rehabilitation programs
that provide the full continuum of mental health and physical rehabilitation
services in a quality and cost-effective manner. The pressure to reduce health
care expenditures has strengthened the need to manage the appropriateness of
mental health and physical rehabilitation services provided to patients. As a
result, competitors without substantive management experience covering the
various levels of the continuum of mental health and physical rehabilitation
services may not be able to compete successfully. The Company believes that its
reputation and management expertise will enable it to compete successfully in
this rapidly changing market.

In addition, general acute care hospitals offering mental health and
physical rehabilitation programs managed by the Company compete for patients
with other providers of mental health care services, including other general
acute care hospitals, freestanding psychiatric hospitals, independent
psychiatrists and psychologists, and with other providers of physical
rehabilitation services, including other general acute care hospitals,
freestanding rehabilitation facilities and outpatient facilities.

13

The Company competes with hospitals, nursing homes, clinics,
physicians' offices and other staffing companies for the services of registered
and other nurses. Registered nurses, especially those with specialized skills,
are in limited supply and there can be no assurance that the Company will be
able to attract a sufficient number of registered nurses for its growing needs.
The Company has direct competition from local, regional and national staffing
companies when recruiting nurses. Nurses may have special training, or a
preference to work in a specific service area of the hospital that may narrow
their general availability to work assignments.

Competition among specialized temporary nurse staffing companies is
generally based on the quality of the nurses provided, availability to fill
shifts, responsiveness and price. Hospitals require qualified nurses to fill
staff vacancies and to allow for flexibility and efficiency due to change in the
number of patients being treated and their acuity. A hospital's success is
predicated, in part, on the ability to staff quality nurses.

The behavioral health care marketplace includes three large national
providers who control over half of the market. The balance of the market is
highly fragmented and for EAP business consists of organizations from medium
size and regional operations to small local providers. The primary factors
affecting competition in the EAP business are the range and quality of services
provided, the ease of access to the services and price. Price is the primary
factor in obtaining managed care customers. Companies involved in behavioral
health care must meet heightened requirements related to increased customer and
government scrutiny, particularly under the new Health Insurance Portability and
Accountability Act of 1996 ("HIPAA") regulations. Customers frequently require
sophisticated data that provides information regarding clinical utilization and
outcomes, patient and provider satisfaction, administrative performance, and
other performance related information.

CUSTOMERS

The Company has no individual customer comprising of 10% or more of its
consolidated revenue or on which its overall operations or financial results are
substantially dependent. See the "General Overview" section of MD&A included
elsewhere in for the number of customer contracts as of August 31, 2003 and
other related information.

EMPLOYEES

At September 30, 2003, the Company had approximately 1,371 employees.
By operating subsidiary and corporate headquarters, the employee allocation is
as follows:

Horizon Mental Health Management 695
Specialty Rehab Management 200
ProCare One Nurses 22*
Horizon Behavioral Services 346
National Support Center 108

*Excludes nurses who as temporary staffing employees work
various hours and frequencies.

ProCare One Nurses, on a monthly average for fiscal 2003 placed over
500 specialized nurses in temporary and travel nurse staffing positions with
client hospitals. At September 30, 2003, the Company had contracts with 163
physicians as independent contractors to serve as medical directors providing
administrative services for hospital clinical programs managed by the Company.
The Company has no collective bargaining agreements with unions and believes
that its overall relations with its employees are good.

14

GOVERNMENT REGULATION

The Company's business is affected by federal, state and local laws and
regulations concerning, among other matters, mental health and physical
rehabilitation facilities and reimbursement for such services. These regulations
impact the development and operation of mental health and physical
rehabilitation programs managed by the Company for its client hospitals.
Licensing, certification, reimbursement and other applicable state and local
government regulations vary by jurisdiction and are subject to periodic
revision. The Company is not able to predict the content or impact of future
changes in laws or regulations affecting the mental health or physical
rehabilitation sectors.

FACILITY USE AND QUALIFICATION

Licensing and Certification

Hospital facilities are subject to various federal, state and local
regulations, including facilities use, licensure and inspection requirements,
and licensing or certification requirements of federal, state and local health
agencies. Many states also have certificate of need laws intended to avoid the
proliferation of unnecessary or under-utilized health care services and
facilities. The mental health and physical rehabilitation programs which the
Company manages are also subject to licensure and certification requirements.
The Company assists its client hospitals in obtaining required approvals for new
programs. Some approval processes may lengthen the time required for programs to
commence operations. In granting and renewing a facility's licenses,
governmental agencies generally consider, among other factors, community needs,
the physical condition of the facility, the qualifications of administrative and
professional staff, the quality of professional and other services, and the
continuing compliance of such facility with the laws and regulations applicable
to its operations. The Company believes that the mental health and physical
rehabilitation programs it manages and the facilities of the client hospitals
used in the operation of such programs comply in all material respects with
applicable licensing and certification requirements.

Provider-Based Rules

In April 2000, the Centers for Medicare and Medicaid Services, or "CMS"
(formerly the Health Care Financing Administration or "HCFA") of the U.S.
Department of Health and Human Services ("HHS") adopted new rules requiring a
CMS determination that a facility has provider-based status before a provider
can bill Medicare for the services rendered at the facility. On August 1, 2002
CMS issued amendments to the provider based regulations, which in addition to
requirements applicable to all provider based facilities, provide specific
requirements for provider based status of "off-campus" locations and additional
specific requirements applicable to "off-campus" locations operational under a
management contract. The Company estimates that the revised regulations, while
still subject to additional clarification as to specific applicability, will
affect few of its management contracts. The Company believes that the
provider-based regulation will not have a significant impact on its current
operations of inpatient psychiatric units located within general hospitals. In
February 2002, it was clarified by CMS that inpatient rehabilitation units do
not have to meet provider-based status in order to bill Medicare for services
rendered to patients.

MEDICARE AND MEDICAID; REIMBURSEMENT FOR SERVICES

Overview and Background

Most of the Company's client hospitals receive reimbursement under one
or more of the Medicare or Medicaid programs for mental health and physical
rehabilitation services provided in programs managed by the Company. The Company
is paid a fee directly by the client hospitals for its management services.
While fees paid to the Company by client hospitals are not subject to or based
upon reimbursement under the Medicare or Medicaid programs or from any other
third-party payor, under many of its management contracts the Company is
obligated to refund a portion of its fee if Medicare denies reimbursement for an
individual patient treatment, or its fee if the fee paid to the Company is
denied by Medicare as a reimbursable cost. Historically, such reimbursement
amounts have been insignificant. However, since a substantial portion of the
patients of the programs managed by the Company

15

are covered by Medicare, changes which limit or reduce Medicare reimbursement
levels could have a material adverse effect on the Company's client hospitals
and, in turn, on the Company.

The Company is not a provider reimbursed by Medicare or Medicaid but
provides contract management services to such providers. As such, the Company
could be considered subject to applicable federal and state laws. While the
Company believes that its relationships with its client hospitals, medical
directors and other providers and the fee arrangements with its client hospitals
are consistent with Medicare and Medicaid criteria, those criteria are often
general and ambiguous in nature and subject to interpretation, sometimes
differently by different Medicare fiscal intermediaries who administer the
programs on behalf of the federal government. In addition, the federal
government has been actively investigating health care providers for potential
abuses. There can be no assurance that aggressive anti-fraud enforcement actions
will not adversely affect the business of the Company.

The Medicare program is a federally funded health insurance program for
the elderly. The program is divided into Part A and Part B, each of which has
separate rules and requirements. Part A pays for hospital, skilled nursing, home
health agency, hospice, and dialysis services determined to be medically
necessary for the individual patient. Part B is a voluntary medical benefits
plan in which eligible individuals can enroll to receive benefits in addition to
those available under Part A and for which they must pay a monthly premium. Part
B covers non-institutional services, including physician services, outpatient
hospital services, durable medical equipment, and laboratory services, among
others.

The Medicare program is administered by CMS, which adopts regulations
and issues interpretive memoranda and program manuals providing detailed
explanation of the Medicare program. The payment operations of the Medicare
program are handled by fiscal intermediaries (under Part A) and carriers (under
Part B) who are insurance companies and Blue Cross/ Blue Shield plans which
contract with the Secretary of HHS (the "Secretary") to make Medicare payments
to providers in a particular geographic region. Individual intermediaries and
carriers issue transmittals, bulletins, notices, and general instructions to
providers and suppliers in their respective areas to facilitate the
administration of the Medicare program, but are required to follow the Medicare
statute, CMS regulations, CMS transmittals, and the program manuals. Within
these requirements, intermediaries and carriers are granted broad discretion to
establish particular guidelines and procedures for making Medicare coverage
determinations and payments, including prior approval, utilization limits, and
specific documentation.

The Medicaid program is a joint federal-state cooperative arrangement
established for the purpose of enabling states to furnish medical assistance on
behalf of aged, blind, or disabled individuals, or members of families with
dependent children, whose income and resources are insufficient to meet the
costs of necessary medical services. The federal and state governments share the
costs. The Secretary has primary federal responsibility for administering the
Medicaid program that has been delegated to CMS. States are not required to
participate in the Medicaid program. States that choose to participate, however,
must administer their Medicaid programs in accordance with federal law, the
implementing regulations and policies of the Secretary, and their approved state
plans. The federal Medicaid statute establishes minimum standards for state
plans but states have significant latitude, within these standards, to determine
the mix of services and structure of their state Medicaid programs.

In order to receive reimbursement under the Medicare or Medicaid
programs, each client hospital or facility must meet applicable requirements
promulgated by HHS relating to the type of facility, personnel, standards of
patient care and compliance with all state and local laws, rules and
regulations. The Company has a comprehensive ethics and regulatory compliance
program and believes that the programs it manages comply in all material
respects with applicable Medicare and Medicaid requirements.

Federal law contains certain provisions designed to ensure that
services rendered by hospitals to Medicare and Medicaid patients are medically
necessary and meet professionally recognized standards. These provisions include
a requirement that admissions of Medicare and Medicaid patients to hospitals
must be reviewed in a timely manner to determine the medical necessity of the
admissions. In addition, these provisions state that a hospital may be required
by the federal government to reimburse the government for the cost of
Medicare-reimbursed services that are determined by a peer review organization
to have been medically unnecessary. As part of its on-going regulatory and
regulatory compliance program initiatives, the Company and its client hospitals
have developed and

16

implemented quality assurance programs and procedures for utilization review and
retrospective patient care evaluation intended to meet these requirements.

Mental Health Reimbursement Changes/Proposals

In the mid-1980's, changes in reimbursement rates and procedures
included the creation of the Prospective Payment System ("PPS") using
predetermined reimbursement rates for diagnosis related groups ("DRGs"). The DRG
system established fixed payment amounts per discharge for diagnoses generally
provided by acute care hospitals. Mental health services provided by acute care
hospitals may qualify for an exemption as Distinct Part Units ("DPUs"), which
currently are reimbursed under a cost-based system and are not included in the
DRG system. Psychiatric services provided by DPUs are reimbursed on an actual
cost basis, subject to certain limitations. The mental health programs managed
by the Company which are eligible for reimbursement by the Medicare program
currently meet the applicable requirements for exemption as DPUs, where desired.
In the future, however, it is possible that Medicare reimbursement for mental
health services, including those provided by programs managed by the Company,
could be under a proposed PPS (as discussed below) or otherwise altered as has
recently occurred for physical rehabilitation services as discussed below. A
substantial number of the mental health treatment programs managed by the
Company are geropsychiatric programs for which the majority of the patients are
covered by Medicare.

Amendments to the Medicare regulations established maximum
reimbursement amounts on a per case basis for inpatient mental health services.
Effective as of October 1, 1997, regulations promulgated pursuant to these
amendments established a ceiling on the rate of increase in operating costs per
case for mental health services furnished to Medicare beneficiaries. Prior to
these amendments, the reimbursement amounts were tied to each hospital's mental
health unit cost during such unit's first year of operations, subject to
subsequent annual adjustment. Per the regulations, a nationwide maximum cap,
adjusted for area wage indices, was established limiting the reimbursement
target amount on a per case basis for mental health services, for Medicare
fiscal years beginning on or after October 1, 1997, subject to annual
adjustment.

The Balanced Budget Act of 1997 also mandated the elimination of
cost-based reimbursement of mental health partial hospitalization services.
Implementation began August 1, 2000. The resulting reimbursement for partial
hospitalization services based on the Medicare outpatient PPS utilizes a fixed
reimbursement amount per patient day. This change adversely affected the ability
of the Company to maintain and/or obtain management contracts for partial
hospitalization services and the amount of fees paid to the Company under such
contracts. As of January 1, 2003 the base reimbursement rate is a wage-adjusted
rate of $240 per day, which lowered Medicare reimbursement levels to many
hospitals for partial hospitalization services.

The Balanced Budget Refinement Act of 1999 mandates that a PPS for
inpatient psychiatric services be developed. The system is to include an
adequate patient classification system that reflects the differences in patient
resource use and costs, i.e. acuity. In addition, the law states that the
payment system must be budget neutral and be a per diem system.

The law outlined that the Secretary shall submit to the appropriate
committees of Congress a report that includes a description of the system no
later than October 1, 2001, and that the system must be implemented by October
1, 2002. Not withstanding these deadlines, both dates have passed and no
description of the system has been presented as yet. In early 2002, Tom Scully,
Administrator for CMS, gave a speech in which he predicted that a proposed
prospective payment system for inpatient psychiatric services would be released
in March 2003, subjected to a comment period, and then implemented in January
2004. As of August 31, 2003 no system has been released. At this time the
Company does not know what effect, if any, such prospective payment system might
have on its operations if and when adopted.

17

Physical Rehabilitation Reimbursement Changes/Proposals

Acute rehabilitation units within acute-care hospitals were previously
eligible as exempt DPU's under a cost-based reimbursement system prior to
January 1, 2002. Beginning January 1, 2002, acute rehabilitation units began
transitioning to PPS. As of September 1, 2003 all physical rehabilitation
services have been transitioned to PPS.

CMS published proposed rules in the September 9, 2003 Federal Register
to modify exemption criteria for acute rehabilitation services. The proposed
rule reduces the required percentage of patients in a given program that must be
admitted with a specific qualifying medical condition from 75% to 65%. The
proposed rule also eliminates polyarthritis as a qualifying medical condition
and adds three other arthritis diagnoses that are more restrictive. As a result,
patients that previously met the polyarthritis conditions may no longer meet a
specific qualifying medical condition required to meet the new 65% threshold.
The proposed rules are subject to a public comment period and possible
subsequent modification. If passed in their current form, the proposed rules
could have an adverse effect on the programs managed by the Company.

POTENTIAL ADVERSE IMPACTS OF CHANGES IN REIMBURSEMENT

The Medicare and Medicaid programs are subject to statutory and
regulatory changes, retroactive and prospective rate adjustments, administrative
rulings and funding restrictions, any of which could have the effect of limiting
or reducing reimbursement levels to general acute care hospitals for mental
health and physical rehabilitation services provided by programs managed by the
Company. The Company cannot predict whether any changes to such government
programs will be adopted or, if adopted, the effect, if any, such changes will
have on the Company. Also, Medicare retrospectively audits cost reports of
client hospitals upon which Medicare reimbursement for services rendered in the
programs managed by the Company is based. Accordingly, the Company could be
contractually obligated to make refunds to client hospitals for prior year cost
reports that have not been audited and settled at the date hereof. The cost
reports are prepared by the client hospitals independent of the Company which
does not participate in, nor offer advice on, their preparation. Any significant
decrease in Medicare reimbursement levels, the imposition of significant
restrictions on participation in the Medicare program, or the disallowance by
Medicare of any significant portion of the client hospital's costs, including
the fee to the Company, where the Company has a reimbursement denial repayment
obligation, could adversely affect the Company. In addition, there can be no
assurance that hospitals which offer mental health or physical rehabilitation
programs now or hereafter managed by the Company will satisfy the requirements
for participation in Medicare or Medicaid programs.

Payors, including Medicare and Medicaid, are attempting to manage
costs, resulting in declining amounts paid or reimbursed to hospitals for the
services provided for inpatient services. As a result, the number of patients
served by general acute care hospitals on a per diem, episodic or capitated
basis may increase in the future. There can be no assurance that if amounts paid
or reimbursed to hospitals decline, it will not adversely affect the Company.

The target maximums and the PPS limitations have resulted, or may
result, in some cases, in decreased amounts reimbursed to the Company's client
hospitals. This decrease in reimbursement has led, or may lead, in some cases,
to the renegotiation of a lower contract management fee structure for the
Company and in other cases has resulted, or may result, in termination or
non-renewal of the management contract, or closure of the program.

Patient Referral Laws

Various state and federal laws regulate the relationships between
health care providers and referral sources, including federal and state fraud
and abuse laws prohibiting individuals and entities from knowingly and willfully
offering, paying, soliciting or receiving remuneration in order to induce
referrals for the furnishing of health care services or items. These federal
laws generally apply only to referrals for items or services reimbursed under
the Medicare or Medicaid programs or any state health care program. The
objective of these laws is generally to ensure that the purpose of a referral is
quality of needed care and not monetary gain by the referring party. Violations
of

18

such laws can result in felony criminal penalties, civil sanctions and exclusion
from participation in the Medicare and Medicaid programs.

The Medicare and Medicaid anti-kickback statute, 42 U.S.C. Section
1320a-7b, prohibits the knowing and willful solicitation or receipt of any
remuneration "in return for" referring an individual, or for recommending or
arranging for the purchase, lease, or ordering, of any item or service for which
payment may be made under Medicare or a state health care program. In addition,
the statute prohibits the offer or payment of remuneration "to induce" a person
to refer an individual, or to recommend or arrange for the purchase, lease, or
ordering of any item or service for which payment may be made under the Medicare
or state health care programs. The statute contains exceptions for certain
discounts, group purchasing organizations, employment relationships, waivers of
coinsurance by community health centers, health plans, and practices defined in
regulatory safe harbors.

On April 3, 2003 the Office of the Inspector General of the Department
of Health and Human Services ("OIG") issued an advisory opinion in which it
declined to provide prospective protection from the Medicare Anti-Kickback
Statue to a proposed contract to manage rehabilitation services under which the
compensation was based on a variable fee. The OIG opinion was only applicable to
the specific situation presented and did not advise that variable fees were
improper in and of themselves. Under a significant number of its management
contracts, the Company receives a variable fee related in part to average daily
patient census or number of admissions or discharges in a given period for the
mental health or physical rehabilitation program. In addition, the Company has
entered into agreements with physicians to serve as medical directors at the
mental health and physical rehabilitation programs and facilities managed by the
Company, which generally provide for payments to such persons by the Company as
compensation for their administrative services. These medical directors also
generally provide professional services at such programs and facilities. In
1991, regulations were issued under federal fraud and abuse laws creating
certain "safe harbors" for relationships between health care providers and
referral sources. Any relationship that satisfies the terms of the safe harbor
is considered permitted. Failure to satisfy a safe harbor, however, does not
mean that the relationship is prohibited. Although the contracts and
relationships between the Company and its client hospitals and medical directors
are not within the safe harbors, the Company believes that such contracts and
relationships comply with applicable laws. There can be no assurance, however,
that the Company's activities, while not challenged thus far, will not be
challenged by regulatory authorities in the future.

The Omnibus Budget Reconciliation Act of 1993 contains provisions
("Stark II") prohibiting physicians from referring Medicare and Medicaid
patients to an entity with which the physician has a "financial relationship"
for the furnishing of a list of "designated health services" including physical
therapy, occupational therapy, home health services, and others. If a financial
relationship exists, the entity is generally prohibited from claiming payment
for such services under the Medicare or Medicaid programs. Compensation
arrangements are generally exempted from the Stark provisions if, among other
things, the compensation to be paid is set in advance, does not exceed fair
market value and is not determined in a manner that takes into account the
volume or value of any referrals or other business generated between the
parties.

Other provisions in the Social Security Act authorize other penalties,
including exclusion from participation in Medicare and Medicaid, for various
billing-related offenses. HHS can also initiate permissive exclusion actions for
such improper billing practices as submitting claims "substantially in excess"
of the provider's usual costs or charges, failure to disclose ownership and
officers, or failure to disclose subcontractors and suppliers. Executive Order
12549 prohibits any corporation or facility from participating in federal
contracts if it or its principals have been disbarred, suspended or are
ineligible, or have been voluntarily excluded, from participating in federal
contracts. A principal has been defined as an officer, director, owner, partner,
key employee or other person with primary management or supervisory
responsibilities.

Additionally "HIPAA" granted expanded enforcement authority to HHS and
the U.S. Department of Justice ("DOJ"), and provided enhanced resources to
support the activities and responsibilities of the Office of Inspector General
("OIG") of HHS and DOJ by authorizing large increases in funding for
investigating fraud and abuse violations relating to health care delivery and
payment. On January 24, 1997, the OIG issued guidelines for the Fraud and Abuse
Control Program as mandated by the Act, and on February 19, 1997 issued an
interim final rule establishing procedures for seeking advisory opinions on the
application on the anti-kickback statute and certain other fraud and abuse laws.
The 1997 Balanced Budget Act also includes numerous health fraud provisions,

19

including: new exclusion authority for the transfer of ownership or control
interest in an entity to an immediate family or household member in anticipation
of, or following, a conviction, assessment, or exclusion; increased mandatory
exclusion periods for multiple health fraud convictions, including permanent
exclusion for those convicted of three health care-related crimes; authority of
the Secretary to refuse to enter into Medicare agreements with convicted felons;
new civil money penalties for contracting with an excluded provider or violating
the Medicare and Medicaid antikickback statute; new surety bond and information
disclosure requirements for certain providers and suppliers; and an expansion of
the mandatory and permissive exclusions added by HIPAA to any federal health
care program (other than the Federal Employees Health Benefits Program).

In addition, federal and some state laws impose restrictions on
referrals for certain designated health services by physicians and, in a few
states, psychologists and other mental health care professionals to entities
with which they have financial relationships. The Company believes that its
operations comply with these restrictions to the extent applicable, although no
assurance can be given regarding compliance in any particular factual situation.
Federal legislation has been considered to expand current law from its
application to Medicare and Medicaid business to all payors and to additional
health services. Certain states are considering adopting similar restrictions or
expanding the scope of existing restrictions. There can be no assurance that the
federal government or other states in which the Company operates will not enact
similar or more restrictive legislation or restrictions that could, under
certain circumstances, adversely impact the Company's operations.

Mental Health Care Patient Rights

Many states have adopted "patient bill of rights" regulations, which
set forth standards for least restrictive treatment, patient confidentiality,
patient access to mail and telephones, patient access to legal counsel and
requirements that patients be treated with dignity. There are also laws and
regulations relating to the civil commitment of patients to mental health
programs, disclosure of information concerning patient treatments and related
matters. The Company believes that its operations comply with the laws and
regulations, although no assurance can be given regarding compliance in any
particular factual situation.

Licensing Requirements, Managed Behavioral Health

Certain of the managed behavioral services provided by the Company may
be subject to certain licensing requirements in some states. The Company
currently holds various licenses in 19 states. If such business operations are
determined to require licenses in other states, the time and expense of
obtaining such licenses or the inability to obtain such licenses could adversely
affect such business operations. In addition, several states have laws that
prohibit business corporations from providing, or holding themselves out as
providers of, medical care. While the Company has no reason to believe that it
is in violation or has violated such statutes, these laws vary from state to
state and have seldom been interpreted by the courts or regulatory agencies.

ITEM 2. PROPERTIES

Effective July 31, 2003, the Company purchased its National Support
Center in the Dallas suburb of Lewisville, Texas, which it was previously
leasing. The NSC contains approximately 40,000 square feet of office and
training facility space.

For its contract management businesses, the Company leases an aggregate
of 1,650 square feet of space for a regional office in the Chicago metropolitan
area with a lease term expiring in December 2006. The space required for the
clinical programs managed by the Company is provided by the client hospitals
either within their existing facilities or at other locations owned or leased by
the hospitals.

For its employee assistance program and managed behavioral health care
businesses, the Company leases approximately 89,239 square feet of office space
primarily in the Orlando, Philadelphia, Nashville, Denver, and San Diego
metropolitan areas, with smaller offices in various parts of the country, under
lease terms expiring from September 2003 to June 2008. In addition, the Company
leases approximately 13,987 square feet in various

20

locations throughout central Florida with lease terms expiring from June 2004 to
May 2006 for its managed behavioral health care clinical operations.

For its specialized temporary nurse staffing service business, the
Company leases approximately 7,595 square feet of office space primarily in the
Los Angeles, Santa Ana and Detroit areas under lease terms expiring from
September 2003 to December 2005.

The Company considers that its properties are generally in good
condition, are well maintained, and are generally suitable and adequate to carry
on the Company's business. Also see Note 13 "Commitments and Contingencies -
Property Leases" to the Notes to the Consolidated Financial Statements included
elsewhere herein.

ITEM 3. LEGAL PROCEEDINGS

For a discussion of the Company's legal proceedings see the "Legal
Proceedings" caption in Note 13 "Commitments and Contingencies" in the Notes to
the Consolidated Financial Statements included elsewhere herein.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of the Company's stockholders in
the fourth fiscal quarter in fiscal 2003.

21

PART II

ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The Common Stock of the Company is traded on the Nasdaq National Market
under the symbol "HORC".

The following table sets forth the "intra-day" high and low sale prices
per share for the Common Stock of the Company as reported by the Nasdaq National
Market for the periods indicated:

As of October 28, 2003, there were 173 stockholders of record of the
Common Stock of the Company. As of October 28, 2003 (the most recent date that
data was available to the Company) there were approximately 587 beneficial
owners of 100 or more shares of Common Stock of the Company.

The Company has not paid or declared any cash dividends on its capital
stock since its inception. The Company currently intends to retain future
earnings for use in the expansion and operation of its business. The payment of
any future cash dividends will be determined by the Board of Directors based on
conditions then existing, including the Company's earnings, financial condition
and capital requirements, restrictions in financing agreements (which currently
prohibit any payment of dividends), business opportunities and conditions, and
other factors. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Liquidity and Capital Resources," included
elsewhere herein.

ITEM 6. SELECTED CONSOLIDATED FINANCIAL INFORMATION AND STATISTICAL DATA

The selected historical consolidated financial data presented below for
the fiscal years ended August 31, 2003, 2002 and 2001, and at August 31, 2003
and 2002, are derived from the audited Consolidated Financial Statements of the
Company included elsewhere in this Report. The selected historical consolidated
financial data presented below for the fiscal years ended August 31, 2000 and
1999, and at August 31, 2001, 2000 and 1999, are derived from the audited
consolidated financial statements of the Company not included herein. The
selected financial information presented below should be read in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and with the Consolidated Financial Statements of the Company and
Notes thereto included elsewhere in this Report, including Note 4,
"Acquisitions" describing the Company's various acquisitions in the periods
presented.

22

(1) Intangible assets consist of goodwill, as well as service contract
valuations, non-compete agreements and trademarks related to various
acquisitions of the Company.

(2) Includes only the Company's mental health and physical rehabilitation
management contracts.

(3) The company elected to adopt SFAS 141 and SFAS 142 on a prospective
basis as of September 1, 2001. As a result, the Company discontinued
the amortization of goodwill as of August 31, 2001.

23

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

GENERAL OVERVIEW

Horizon Health Corporation is a diversified health care services
provider. The Company has grown both internally and through acquisitions,
increasing both the variety of its contract services, and the number of its
contracts. The Company is (i) a contract manager of mental health and physical
rehabilitation clinical programs offered by general acute care hospitals in the
United States, (ii) a provider of specialized temporary nurse staffing services
for general hospitals, and (iii) a provider of employee assistance programs and
behavioral health care services to businesses and managed care organizations. At
August 31, 2003, Horizon had 107 mental health program management contracts and
35 physical rehabilitation program management contracts relating to hospitals
located in 37 states; 113 CQI+ mental health outcomes measurement contracts; and
1,160 contracts to provide employee assistance programs and managed care mental
health services covering in excess of 3.3 million lives. During the year ended
August 31, 2003, Horizon's ProCare One Nurses subsidiary provided, on a monthly
average, nurses to over 100 general acute care hospitals primarily located in
California and Michigan.

The Company plans to enhance its position as the leader (based on
market share) in the contract management of mental health programs and its
growing position in the contract management of physical rehabilitation programs
by further expanding the range of services that it offers to its client
hospitals and the continuum of care it provides. A significant challenge in
marketing mental health and physical rehabilitation clinical management
contracts is overcoming the initial reservations that many hospital
administrators have with outsourcing key clinical services. The Company believes
its expertise in working with hospital administrators, its reputation in the
industry and its existing hospital contractual relationships provide it with a
significant advantage in marketing new contracts. The Company also believes it
has opportunities to cross-sell management services of mental health and
physical rehabilitation programs to client hospitals. With the June 13, 2002
acquisition of ProCare One Nurses, the Company expanded it's hospital services
offerings. In addition, the Company capitalizes on its expertise in managing the
delivery of mental health services by directly offering employee assistance
programs and managed behavioral health care services to managed care
organizations and employers. The Company believes it is strategically sized to
deliver national programs, while providing local, individualized service to both
employers and health plans and to their respective employees or members.

ACQUISITIONS

See Note 4, "Acquisitions" to the Notes to Consolidated Financial
Statements included elsewhere herein for a discussion of the Company's
acquisition activity.

SEGMENTS

See Note 14, "Segment Information" to the Notes to the Consolidated
Financial Statements included elsewhere herein for a discussion of the Company's
current four reportable business segments. Previously the Company had a fifth
business segment, which during the fiscal periods of its existence, had
comprised less than five percent (5%) of its consolidated revenue and operating
profit. The Company had developed and began to market in fiscal 1999 its
proprietary PsychScope Research Services, which were based on de-identified
patient outcomes measurement data collected in the Company's CQI+ Outcomes
Measurement System since 1994. The PsychScope Research Services allowed
pharmaceutical product marketers and researches to access "real world"
information on the use of key drugs within behavioral healthcare. The market for
these PsychScope database, outcomes and Phase IV clinical research services is a
limited market that is highly competitive, therefore the Company has decided to
no longer pursue such business.

24

REVENUES

Contract Management Services (Horizon Mental Health Management and
Specialty Rehabilitation Management)

The fees received by the Company for its services under management
contracts are paid directly by its client hospitals. Generally, contract fees
are paid on a monthly basis. The client hospitals receive reimbursement under
Medicare or Medicaid programs or payments from insurers, self-funded benefit
plans or other third-party payors for the mental health and physical
rehabilitation services provided to patients of the programs managed by the
Company. As a result, the availability and amount of such reimbursement, which
are subject to change, impacts the decisions of general acute care hospitals
regarding whether to offer mental health and physical rehabilitation services
pursuant to management contracts with the Company, as well as whether to
continue such contracts (subject to contract termination provisions) and the
amount of fees to be paid thereunder. See "Government Regulation" - "Medicare
and Medicaid; Reimbursement for Services" contained elsewhere herein for a
discussion of funding factors and recent changes in regulations. Also see
"Operations" - "Management Contracts" elsewhere herein for a discussion of
factors affecting contract scope, operation, and renewal.

The primary factors affecting revenues in a period are the number of
management contracts with treatment programs in operation in the period and the
scope of services covered by each such management contract. The Company provides
its management services under contracts with terms generally ranging from three
to five years. Each contract is tailored to address the differing needs of each
client hospital and its community. The Company and the client hospital determine
the programs and services to be offered by the hospital and managed by the
Company, which may consist of one or more mental health or physical
rehabilitation treatment programs offering inpatient, partial hospitalization,
and/or outpatient services. Under the contracts, the hospital is the actual
provider of the mental health or physical rehabilitation services and utilizes
its own facilities (including beds for inpatient programs), nursing staff and
support services (such as medical ancillaries, billing, dietary and
housekeeping) in connection with the operation of its programs with the Company
providing clinical, operating and compliance management staff and expertise. As
the Company expanded the breadth of treatment programs it offers to hospitals,
it increased the number of contracts that included management of multiple
treatment programs.

The Company has increased revenues through acquisitions and through
internal growth, as well as by adding services, price escalators and increasing
volumes at existing contract locations. The increase in contract revenue has
primarily been due to the increased range of services offered per contract. For
the Company's mental health segment, additional contracts have resulted from the
increased demand for geropsychiatric services as general hospitals have sought
to enter this market. An additional factor favorably affecting revenues has been
the Company's pricing policy of establishing a minimum direct margin threshold
for its management contracts.

The Company through its mental health contract management segment also
provides mental health outcomes measurement services primarily to acute care
hospital-based programs and free standing psychiatric hospitals. The contracts
for outcomes measurement services are generally for one to two years with an
automatic renewal provision. The rates for the outcomes measurement services are
negotiated based on the range of services provided and the number of patients
and are generally paid on a monthly basis.

Specialized Temporary Nurse Staffing Services

The Company's acquisition of ProCare, in June 2002, expanded the
Company's operations in healthcare services by entering into the specialized
temporary nurse staffing industry. The Company provides an on-call, twenty-four
hour per day, seven days a week, specialized temporary nurse staffing service to
hospitals with a focus on the labor & delivery, neonatal, ICU, and emergency
room areas. The fees received by the Company for its services related to
specialized temporary nurse staffing services are paid directly by its client
hospitals. Generally, temporary nurse-staffing fees are determined by the number
of hours worked and are billed and paid on a weekly basis. Hourly rates vary
based on the specialty of nurse required, day of the week, and time of shift to
be filled. Fees are generally billed based on predetermined rates as specified
in a fee schedule with the client hospital. As of August 31, 2003, ProCare
provided, on a monthly average, in excess of 500 nurses to more than 100 client
hospitals. Revenues are recognized in the month in which services are rendered,
at the estimated net realizable amounts.

25

Employee Assistance Programs and Managed Behavioral Health Care
Services

Through its subsidiary Horizon Behavioral Services ("HBS"), the Company
offers an array of behavioral health care products to corporate clients,
self-funded employer groups, insurance companies, commercial HMO and PPO plans,
government agencies, and third-party administrators. Revenues are derived from
employee assistance program services ("EAP"), administrative services only
services, and at risk managed behavioral health services. Generally fees are
paid on a monthly basis.

Revenues from EAP contracts are typically based on a specified fee per
month per employee based on the range and breadth of services provided to the
employer, which may include work life services (including child and elder care
consultation), referral resource and critical incident debriefings and
intervention, and the method(s) in which those services are provided. Each plan
is specifically designed to fulfill the clients' needs.

Revenues for administrative services only contracts relate to the
administration of behavioral health benefits and are dependent upon the number
of contracts and the services provided. Fees are usually a case rate or a per
member per month fee applied to the number of eligible members. The client
remains financially liable for direct cost associated with providing the medical
services. The client is able to benefit from the Company's expertise in clinical
case management, the behavioral health professionals employed by the Company,
the independent health care providers contracted by the Company at favorably
discounted rates and the administrative efficiencies provided by the Company.

Revenues derived from at risk managed behavioral health care services
are primarily affected by the scope of behavioral health benefits provided and
the number and type of members covered. Fees are based on a per member per month
fee applied to the number of eligible members. The rate is dependent upon the
benefit designs and actuarially determined anticipated utilization of the
customer's covered members. The Company is responsible for the cost of the
medical services provided to the members under these contracts.

The Company-owned clinics operated in the state of Florida derive
income from counseling and therapy services rendered, including providing
services to patients who are employees of customers under various EAP or managed
care contracts.

OPERATING EXPENSES

In addition to the respective primary expense factors described below,
other operating expenses generally incurred by each of the Company's business
segments include items such as training, continuing professional education and
credentialing services, marketing costs and expenses, consulting, accounting and
legal fees and expenses, employee recruitment and relocation expenses, rent,
utilities, telecommunications costs, and property taxes, as well as bad debt
expense.

Contract Management Services (Horizon Mental Health Management and
Specialty Rehabilitation Management)

The primary factors affecting operating expenses for the Company's
contract management business in any period is the number of programs in
operation in the period and the volume of patients at those locations. Operating
expenses consist primarily of salaries and benefits paid to program management,
clinicians, therapists and supporting personnel. Mental health programs managed
by the Company generally have a program director that is usually a psychologist
or a social worker, a community education manager and additional social workers
or therapists as needed. Physical rehabilitation programs managed by the Company
generally have a program director and additional clinical staff tailored to meet
the needs of the program and the client hospital, which may include physical and
occupational therapists, a speech pathologist, a social worker and other
appropriate supporting personnel. In addition, for both types of programs the
Company contracts with a medical director on an independent contractor basis
under which on-site administrative and clinical oversight services needed to
administer the program are provided. The nursing staff is typically provided and
employed by the hospital.

26

Specialized Temporary Nurse Staffing Services

The primary factor affecting operating expenses for the Company's
specialized temporary nurse staffing business in any period is the number of
shifts filled in the period and the mix of wage rates, including overtime, for
the placed nurses. Operating expenses consist primarily of salaries and benefits
paid to the Company's nursing pool.

Employee Assistance Programs and Managed Behavioral Health Care

Operating expenses for the Company's employee assistance programs and
managed behavioral health care services are primarily comprised of medical
claims from clinical providers and salaries and benefits for its clinical,
operations and supporting personnel. Medical claims include payments to
independent health care professionals providing services to the covered
enrollees under the employee assistance programs and the managed behavioral
healthcare contracts offered by the Company.

RESULTS OF OPERATIONS

The following table sets forth for the fiscal years ended August 31,
2003, 2002 and 2001, the percentage relationship to total revenues of certain
costs, expenses and income, and the number of management contracts and covered
lives at the end of each fiscal year.

27

FISCAL YEAR ENDED AUGUST 31, 2003 COMPARED TO FISCAL YEAR ENDED AUGUST 31, 2002

REVENUE. Total revenue increased $22.6 million, or 15.7%, to $166.3
million for the year ended August 31, 2003, as compared to $143.7 million for
the year ended August 31, 2002. This increase is primarily attributable to: (1)
a full year of temporary nurse staffing service revenue as a result of the
acquisition of ProCare, effective June 13, 2002, (2) HBS' acquisitions of EAP
International, effective November 1, 2002, and Integrated Insights on July 1,
2003, and (3) a full year of revenue for a significant HBS' managed care
contract which commenced April 1, 2002. Specialty Rehab Management also
experienced an increase in revenue due to an increase in the number of average
locations in operation and in the average revenue per location. The increases
were partially offset by a decrease in Horizon Mental Health Management revenue
resulting from a decrease in the average number of locations in operation.

Horizon Mental Health Management

Revenue associated with the contract management of mental health
programs decreased by $4.5 million, or 5.5%, to $76.7 million for the year ended
August 31, 2003, as compared to $81.2 million for the year ended August 31,
2002. This decrease was primarily attributable to the decline in the average
number of psychiatric locations in operation from 112.9 for the fiscal year
ended August 31, 2002 to 105.7 for the fiscal year ended August 31, 2003, as
well as a decrease in psychiatric partial hospitalization programs in operation
from 31 for the fiscal year ended August 31, 2002 to 25 for the fiscal year
ended August 31, 2003.

Specialty Rehab Management

Revenue associated with the contract management of physical
rehabilitation services increased by $2.3 million, or 15.2%, to $17.4 million
for the year ended August 31, 2003, as compared to $15.1 million for the year
ended August 31, 2002. This increase was primarily attributable to the increase
in the average number of physical rehabilitation locations in operation from
20.7 for the year ended August 31, 2002 to 22.4 for the year ended August 31,
2003, as well as a 6.5% increase in average revenue per location.

ProCare One Nurses

Revenue associated with specialized temporary nurse staffing services
was $22.2 million for the year ended August 31, 2003, as compared to $5.3
million for the year ended August 31, 2002. The Company entered into this
business segment with the acquisition of ProCare effective June 13, 2002.

Horizon Behavioral Services

Revenue associated with the employee assistance program and managed
behavioral health care services increased by $7.8 million, or 19.2%, to $48.5
million for the year ended August 31, 2003, as compared to $40.7 million for the
year ended August 31, 2002. Increases of $4.7 million and $800,000,
respectively, were attributable to the acquisition of EAP International on
November 1, 2002 and Integrated Insights on July 1, 2003. A $5.5 million
increase resulted from the commencement of a significant managed care contract
on April 1, 2002. These increases were partially offset by a decrease of $3.3
million attributable to the termination of a significant managed care contract
on December 31, 2002.

Other Services

Revenue associated with other services increased by $300,000, or 19.0%,
to $1.9 million for the year ended August 31, 2003, as compared to $1.6 million
for the year ended August 31, 2002. This increase is primarily attributable to a
higher level of PsychScope Phase IV project activity.

28

COST OF SERVICES. Total costs of services provided increased $20.1
million, or 18.2%, to $130.4 million for the year ended August 31, 2003,
compared to $110.3 million for the year ended August 31, 2002. This increase is
primarily attributable to the increased operations resulting from the
acquisitions described above, i.e. EAP International and Integrated Insights,
and the first full year of operations for ProCare One Nurses. Specialty Rehab
Management also experienced a rise in costs as a result of its increase in the
average number of locations in operation. These increases were partially offset
by a decrease in cost of services in the Company's HMHM subsidiary resulting
from the decrease in the average number of locations in operation. As a net
result, and also due to change in the percentage of differing margins of the
business mix, as a percent of revenue, gross profits decreased to 21.6% for the
year ended August 31, 2003 from 23.3% for the year ended August 31, 2002.

Horizon Mental Health Management

Cost of services provided associated with contract management of mental
health programs decreased by $4.4 million, or 7.9%, to $51.2 million for the
year ended August 31, 2003, compared to $55.6 million for the year ended August
31, 2002. This decrease was primarily attributable to the decline in the average
number of psychiatric locations in operation. As a percent of revenue, gross
profits increased to 33.2% for the year ended August 31, 2003 from 31.5% for the
year ended August 31, 2002.

Specialty Rehab Management

Cost of services provided associated with contract management of
physical rehabilitation services increased by $1.8 million, or 16.1%, to $13.0
million for the year ended August 31, 2003, compared to $11.2 million for the
year ended August 31, 2002. The increase was primarily due to a rise in salary
and benefits costs per full time equivalent employee between the periods and an
increase in full time equivalent employees necessary to staff several newly
opened unit locations, as reflected in the increase in the average number of
locations in operation. As a percent of revenue, gross profits decreased to
25.0% for the year ended August 31, 2003 from 26.1% for the year ended August
31, 2002.

ProCare One Nurses

Cost of services provided associated with specialized temporary nurse
staffing services was $20.0 million for the year ended August 31, 2003, as
compared to $4.7 million for the year ended August 31, 2002, primarily due to
the year ended August 31, 2003 being the Company's first full year of operations
in this segment. As a percent of revenue, gross profits were 9.7% for the year
ended August 31, 2003 as compared to 11.0% for the 2.6 months included in the
year ended August 31, 2002.

Horizon Behavioral Services

Cost of services provided associated with employee assistance program
and managed behavioral health care services increased by $8.0 million, or 21.7%,
to $44.9 million for the year ended August 31, 2003, as compared to $36.9
million for the year ended August 31, 2002. A $3.5 million increase was
attributable to a net increase in medical claims expense associated with the
addition of the managed behavioral health care contract described above. An
additional $4.2 million increase was the result of the acquisitions of EAP
International and Integrated Insights. A $1.0 million increase in the medical
claims expense was the result of an increase in existing client utilization and
costs per unit of service. As a percent of revenue, gross profits decreased to
7.4% for the year ended August 31, 2003 from 9.2% for the year ended August 31,
2002.

Other Services

Costs of services provided associated with other services decreased by
$500,000, or 25.0%, to $1.5 million for the year ended August 31, 2003. This
compares to $2.0 million for the year ended August 31, 2002, which included
higher costs associated with Phase IV PsychScope projects.

SELLING, GENERAL AND ADMINISTRATIVE. Total selling, general, and
administrative expenses, on a net basis, increased $2.4 million, or 15.3%, to
$18.1 million for the year ended August 31, 2003, compared to $15.7 million for
the year ended August 31, 2002. Salaries, wages and benefits increased
approximately $700,000, or 7.5%, for the year ended August 31, 2003 as compared
to the year ended August 31, 2002. Commissions increased $320,000 over the same
period primarily due to an increase in new contract signings for Specialty Rehab
Management, as well as a significant new contract for HMHM. Legal fees and legal
settlements (net) increased approximately $770,000

29

when compared to the same period last year. Primary reasons for this increase
include compliance efforts related to HIPAA as well as an increase in estimates
for actual and projected legal claims and settlements and related expenses that
were and/or may be incurred related to the current fiscal year.

PROVISION FOR DOUBTFUL ACCOUNTS. The provision for doubtful accounts
expense for the year ended August 31, 2003 was a net recovery of $615,000
representing a decrease of $909,000 as compared to a net expense of $294,000 for
the year ended August 31, 2002. The net recovery is primarily the result of
receiving payments related to old receivables, net of legal costs, for amounts
expensed in prior periods. This includes the complete recovery of $720,324 in a
receivable from a hospital that declared bankruptcy in 1998 of which $600,727
was recorded as a bad debt recovery.

DEPRECIATION AND AMORTIZATION. Depreciation and amortization expenses
for the year ended August 31, 2003 were $2.6 million representing a decrease of
$200,000 or 7.1% as compared to depreciation and amortization expense of $2.8
million for the year ended August 31, 2002. As a result of the Company's limited
capital expenditure requirements, depreciation associated with the acquisition
of the NSC and other assets acquired during the period did not exceed a
reduction in depreciation associated with items becoming fully depreciated,
thereby resulting in the decrease.

INTEREST AND OTHER INCOME (EXPENSE), NET. Interest expense, interest
income and other income for the year ended August 31, 2003 was a net expense of
$296,000 as compared to $110,000 in net expense for the year ended August 31,
2002. This net change is primarily the result of an increase in interest expense
of $168,000 related to the increase in the weighted average principal balance
outstanding under the credit facility between the periods. The weighted average
outstanding credit facility balance for the twelve months ending August 31, 2003
was $10.3 million with an ending balance of $14.0 million. The weighed average
outstanding credit facility balance for the corresponding period in the prior
fiscal year was $5.1 million with an ending balance of $10.0 million.

INCOME TAX EXPENSE. Income tax expense for fiscal year 2003 was $6.0
million representing an increase of $400,000 or 7.1 %, as compared to income tax
expense of $5.6 million for the prior fiscal year. The increase in income tax
expense was largely due to a corresponding increase in pre-tax earnings. The
effective tax rate for fiscal years 2003 and 2002 was 38.7%.

30

FISCAL YEAR ENDED AUGUST 31, 2002 COMPARED TO FISCAL YEAR ENDED AUGUST 31, 2001

REVENUE. Total revenue increased $16.0 million, or 12.5%, to $143.7
million for the year ended August 31, 2002, as compared to $127.7 million for
the year ended August 31, 2001. This increase is primarily attributable to the
increase in Horizon Behavioral Services revenue due to the commencement of a
significant managed care contract on April 1, 2002, the acquisition of OHCA on
August 1, 2001, and a significant increase in the number of covered lives under
an existing managed care contract. In addition, revenue increased in the
temporary nurse-staffing segment as a result of the acquisition of ProCare,
effective June 13, 2002, and in Specialty Rehab Management due to an increase in
the number of average locations in operation.

Horizon Mental Health Management

Revenue associated with contract management of mental health programs
was essentially level, on a net basis, at $81.2 million for the year ended
August 31, 2002 and 2001. Included was an increase of $3.9 million for the year
ended August 31, 2002, as compared to the year ended August 31, 2001, primarily
due to the acquisition of the contracts of PHM effective October 1, 2001. This
increase was offset by a decrease in revenue primarily attributable to the
decline in the number of average inpatient psychiatric locations in operation
(exclusive of acquired PHM contracts) from 107 for the fiscal year ended August
31, 2001 to 103 for the fiscal year ended August 31, 2002, as well as a decrease
in psychiatric partial hospitalization programs in operation from 40 for the
fiscal year ended August 31, 2001 to 31 for the fiscal year ended August 31,
2002

Specialty Rehab Management

Revenue associated with the contract management of physical
rehabilitation services increased by $1.6 million, or 11.9%, to $15.1 million
for the year ended August 31, 2002, as compared to $13.5 million for the year
ended August 31, 2001. This increase was primarily attributable to the increase
in the average revenue per location from $681,000 for the year ended August 31,
2001, to $729,000 for the year ended August 31, 2002, as well as an increase in
the average locations in operation from 20 for the year ended August 31, 2001 to
21 for the year ended August 31, 2002.

ProCare One Nurses

Revenue associated with the specialized temporary nurse staffing
services was $5.3 million for the year ended August 31, 2002 representing 2.6
months of operation. The Company entered into this business segment with the
acquisition of ProCare One Nurses, LLC on June 13, 2002.

Horizon Behavioral Services

Revenue associated with employee assistance program and managed
behavioral health care services increased by $8.6 million, or 26.8%, to $40.7
million for the year ended August 31, 2002, as compared to $32.1 million for the
year ended August 31, 2001. Of this increase, $3.7 million was attributable to
the commencement of a significant managed care contract on April 1, 2002, $3.8
million was attributable to the acquisition of OHCA on August 1, 2001 and $1.1
million was attributable to an increase of 26,000 covered lives under an
existing managed care contract.

Other Services

Revenue associated with other services increased by $600,000, or 52.5%,
to $1.6 million for the year ended August 31, 2002, as compared to $1.0 million
for the year ended August 31, 2001. This increase is primarily attributable to
the commencement of two significant PsychScope Phase IV projects during the year
ended August 31, 2002, as well as a full year for a significant PsychScope Phase
IV project which commenced in August 2001.

31

COST OF SERVICES. Total costs of services provided increased $17.4
million, or 18.7%, to $110.3 million for the year ended August 31, 2002,
compared to $92.9 million for the year ended August 31, 2001. As a percent of
revenue, gross profits decreased to 23.3% for the year ended August 31, 2002
from 27.2% for the year ended August 31, 2001, primarily attributable to the mix
of revenues, i.e. a higher percentage of total revenues attributable to the
Company's lower margin HBS and ProCare subsidiaries.

Horizon Mental Health Management

Costs of services provided associated with the mental health contract
management business segment increased by $1.2 million, or 2.2%, to $55.6 million
for the year ended August 31, 2002, compared to $54.4 million for the year ended
August 31, 2001. This nominal increase was primarily attributable to normal
increases in salaries and benefits, purchased services and other operating
expenses. As a percent of revenue, the mental health contract management
business segment's gross profits decreased to 31.5% for the year ended August
31, 2002 from 33.0% for the year ended August 31, 2001 as a result of the slight
increase in cost of services mentioned above.

Specialty Rehab Management

Costs of services provided associated with contract management of
physical rehabilitation services increased by $1.5 million, or 15.5%, to $11.2
million for the year ended August 31, 2002, compared to $9.7 million for the
year ended August 31, 2001. Salaries and benefits for the fiscal year ended
August 31, 2002 were $8.2 million representing an increase of $1.0 million or
13.9%, as compared to salaries and benefits of $7.2 million for the fiscal year
ended August 31, 2001. This increase is primarily due to the contract openings
during fiscal year 2002 with higher staffing levels than previous contracts. In
addition, increased travel, meals and consulting contributed to the overall
increase in cost of services. As a percent of revenue, gross profits decreased
to 26.1% for the year ended August 31, 2002 from 27.7% for the year ended August
31, 2001.

ProCare One Nurses

Costs of services provided associated with the specialized temporary
nurse staffing services was $4.7 million for the year ended August 31, 2002. The
Company entered into this business segment with the acquisition of ProCare One
Nurses, LLC effective June 13, 2002. As a percent of revenue, gross profits were
11.0% for the 2.6 months included in the year ended August 31, 2002.

Horizon Behavioral Services

Costs of services provided associated with employee assistance program
and managed behavioral health care services increased by $8.8 million, or 31.3%,
to $36.9 million for the year ended August 31, 2002, compared to $28.1 million
for the year ended August 31, 2001. An increase of $3.3 million was primarily
attributable to the additional OHCA business acquired effective August 1, 2001
and $4.2 million from the commencement of a significant managed care contract,
which had greater than expected utilization. An additional $1.0 million increase
was the result of an increase in existing client claims due to a 16.6% increase
in the average cost per inpatient day and a 7.9% increase in inpatient days. As
a percent of revenue, gross profits decreased to 9.2% for the year ended August
31, 2002 from 12.5% for the year ended August 31, 2001.

Other Services

Costs of services provided associated with other services increased by
$1.2 million, or 146.5%, to $2.0 million for the year ended August 31, 2002,
compared to $819,000 for the year ended August 31, 2001. This increase was
primarily attributable to costs associated with three significant Phase IV
PsychScope projects.

SELLING, GENERAL AND ADMINISTRATIVE. Total selling, general, and
administrative expenses, on a net basis, decreased $1.1 million, or 6.5%, to
$15.7 million for the year ended August 31, 2002, compared to $16.8 million for
the year ended August 31, 2001, in spite of an approximate $500,000 or 5.3%
increase in salaries and benefits. A decrease of $1.7 million or 27.9% in other
expenses between fiscal years was primarily attributable to three components.
Legal settlement expenses decreased $760,000 due to a decrease in expenses
incurred and for estimates for actual and projected legal claims and settlements
and related expenses that were incurred or anticipated versus the prior fiscal
year. Other operating expenses decreased $450,000 primarily due to the
termination of a computer software development project that occurred in fiscal
year 2001. Printing decreased $330,000 for the fiscal year 2002, as compared to
fiscal year 2001, due to sourcing materials at lower costs as well as to lower
usage.

32

PROVISION FOR DOUBTFUL ACCOUNTS. The provision for doubtful accounts
expense for the fiscal year ended August 31, 2002 was $294,000, representing a
lower expense amount of $1.5 million as compared to $1.8 million for the prior
fiscal year. The higher expenses in fiscal year 2001 were primarily the result
of accruals recorded in the prior period for the outstanding balances related to
several contract management agreements in which the contract had terminated,
litigation was being pursued and/or the hospital had failed or was expected to
fail soon. In addition, recoveries totaling $373,000 related to balances
reserved in prior fiscal years for 4 terminated management contracts were
received during the year ended August 31, 2002.

DEPRECIATION AND AMORTIZATION. Depreciation and amortization expenses
for fiscal year 2002 were $2.8 million representing a decrease of $1.7 million
or 37.8% as compared to depreciation and amortization expense of $4.5 million
for fiscal year 2001. $1.4 million of this decrease is due to the Company's
adoption of SFAS 141 and SFAS 142 which addresses the initial recognition and
measurement and the subsequent accounting and reporting for goodwill and other
intangible assets. As a result of the implementation of these new standards, the
Company discontinued the amortization of goodwill as of September 1, 2001. A
decrease in amortization expense of $263,000 resulted from the completion of
contract valuation amortization for contracts that are now fully amortized. This
decrease was reduced by an increase of $134,000 due to contract valuation
amortization for contracts that were acquired late in fiscal year 2001 and
fiscal year 2002. The remaining decrease is due to the Company's limited capital
expenditure requirements, which resulted in depreciation generated from assets
acquired during the period being less than a reduction in depreciation
associated with items becoming fully depreciated.

INTEREST AND OTHER INCOME (EXPENSE), NET. Interest expense, interest
income and other income for fiscal year 2002 was a net expense of $110,000 as
compared to $372,000 in net expense for fiscal year 2001. This change is
primarily a result of a decrease in interest expense of $414,000 related to a
reduction in the weighted average outstanding credit facility balance between
periods, as well as to lower interest rates. The weighted average outstanding
credit facility balance for fiscal year 2002 was $5.1 million with an ending
balance of $10.0 million. The weighted average outstanding credit facility
balance for fiscal year 2001 was $8.2 million with an ending balance of $6.9
million. The decrease in interest expense is offset by a decrease in interest
income of approximately $91,000 due to lower interest rates.

INCOME TAX EXPENSE. Income tax expense for fiscal year 2002 was $5.6
million representing an increase of $1.1 million or 24.4%, as compared to income
tax expense of $4.5 million for the prior fiscal year. The increase in income
tax expense was largely due to a corresponding increase in pre-tax earnings. The
effective tax rates for fiscal years 2002 and 2001 were 38.7% and 40.0%
respectively.

33

NEWLY ISSUED ACCOUNTING STANDARDS

See Note 2, "Significant Accounting Policies and Estimates" to the
Notes to the Consolidated Financial Statements included elsewhere herein for a
discussion of newly issued accounting standards.

LIQUIDITY AND CAPITAL RESOURCES

The Company believes that its future cash flows from operations (which
was $13.5 million for the year ended August 31, 2003), along with cash of $2.0
million at August 31, 2003, and its $60 million revolving credit facility (of
which $40.4 million was available at August 31, 2003 after letter of credit
commitments), will be sufficient to cover operating cash requirements over the
next 12 months. The Company further believes that its ongoing cash flows from
operations (which were $13.5, $14.1, and $12.4 during fiscal yeas 2003, 2002 and
2001, respectively) combined with its relatively low capital expenditure
requirements and existing $60 million revolving credit facility, will enable the
Company to continue to cover operating cash requirements in future fiscal years.
The Company may require additional capital to fund acquisitions.

Cash used in investing activities was $12.4 million during fiscal year
2003. The expenditures included approximately $7.3 million used to acquire EAP
International and Integrated Insights as well as $4.9 million used for the
purchase of property and equipment. Of the $4.9 million related to property and
equipment, $4.4 million was attributable to the purchase of the Company's
National Support Center ("NSC") located in Lewisville, Texas, which occurred
effective July 31, 2003. Property and equipment expenditures exclusive of the
purchase of the NSC building were approximately $500,000. Property and equipment
expenditures for fiscal years 2002 and 2001 were approximately $727,000 and $1.5
million, respectively. The Company anticipates its normal property and equipment
expenditures to be approximately $700,000 annually.

The Company purchased $9.6 million of its common stock during fiscal
year 2003. Under the existing credit facility, the Company may repurchase up to
an additional $7.5 million of its common stock beginning, August 29, 2003
through the maturity of the revolving credit facility, which is May 31, 2005. On
October 7, 2002 the Board of Directors authorized the repurchase of up to
800,000 shares of its common stock. As of August 31, 2003, the company had
repurchased 656,659 shares in total of the 800,000 share authorization, which
remains in effect.

Effective May 23, 2002, the Company entered into a Second Amended and
Restated Credit Agreement. See Note 7, "Long-Term Debt" to the Notes to the
Consolidated Financial Statements included elsewhere herein for a general
discussion including a summary of certain material provisions of the Credit
Agreement which does not purport to be complete, and is subject to, and
qualified in its entirety by reference to, the Second Amended Credit Agreement,
a copy of which was previously filed as Exhibit 10.1 in the May 2002 Form 10-Q.

The Company has completed various acquisitions as described in Note 4
"Acquisitions" in Notes to Consolidated Financial Statements included elsewhere
herein.

34

The following table provides aggregate information about the Company's
material contractual payment obligations and the fiscal year in which these
payments are due:

(1) At August 31, 2003, the Company had outstanding borrowings of $14.0 million
related to its $60.0 million revolving credit facility. The Company will be
required to begin making principal payments on the revolving credit facility
beginning August 31, 2005, based on outstanding borrowings at June 1, 2005, as
described in Note 7 of the consolidated financial statements. The principal
payments will be made in eight installments consisting of (a) seven quarterly
installments (representing 10% of the outstanding balance at June 1, 2005)
beginning August 31, 2005 through February 28, 2007 and (b) the final
installment which will be made upon the credit facility termination date of May
31, 2007. This final payment will represent the aggregate amount equal to the
loans outstanding. The long-term debt principal payments reflected in the table
above assume that the $14.0 million in borrowings at August 31, 2003 remains
constant through June 1, 2005. However, the amounts reflected above could change
significantly, as the actual payments will ultimately be based on the
outstanding borrowings at June 1, 2005.

(2) Projected interest payments reported in the table above were calculated
based on outstanding debt of $14.0 million at an interest rate of 3.46% which
represents the weighted average interest rate of Company debt at August 31,
2003. Actual interest payments will differ, possibly significantly, as it cannot
be assumed that outstanding borrowings will remain at $14.0 million. In
addition, future interest payments will be affected by changes in interest rate
levels over time, as well as the Company's basis point spread over the base rate
as affected by its debt leverage.

(3) Projected commitment fee payments relate to a 0.5% fee paid on the unused
portion of the Company's $60.0 revolving credit facility. At August 31, 2003 the
Company had $14.0 million in borrowings outstanding under the revolving credit
facility. The unused portion is also reduced by approximately $6.9 million
relating to various letters of credit expected to be in place during the
periods. The revolving credit facility expires on May 31, 2003.

(4) The company leases various office facilities and equipment under operating
leases, as described in Note 13 in the notes to the consolidated financial
statements. The table above reflects payments through the end of the lease terms
currently in place. The significant leases (payments in excess of $100,000
annually) included in the table above have the following terms: (a) San Diego,
California, approximately $11,600 per month, will term on June 30, 2004 (b) Blue
Bell, Pennsylvania lease, approximately $32,000 per month, will term on October
31, 2004, (c) Lake Mary, Florida, approximately $51,000 per month, will term on
January 31, 2006 and (d) Denver, Colorado, approximately $11,700 per month, will
term on June 29, 2008. At this time, the Company anticipates the renewal of
these leases.

Contractual obligations represent future cash commitments and
liabilities under agreements with third parties, and exclude contingent
liabilities for which the Company cannot reasonably predict the amount(s) or
timing of future payments, if any. See Note 13 "Commitments and Contingencies"
to the Consolidated Financial Statements of the Company included elsewhere
herein.

INFLATION

The Company's multi-year contracts, which typically include its
management contracts and behavioral health contracts, generally provide for
annual adjustments in the Company's fees based upon various inflation indexes,
thus mitigating the effect of inflation. During the periods covered by this
annual report, inflation has had no significant effects on the Company's
business.

35

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

This discussion should be read in conjunction with Note 2 "Significant
Accounting Policies and Estimates" in Notes to Consolidated Financial Statements
included elsewhere herein which describes in more detail the Company's
significant accounting policies and estimates.

The Consolidated Financial Statements and accompanying Notes have been
prepared in accordance with generally accepted accounting principles applied on
a consistent basis, with the exception of the Company's adoption of FAS 141 and
FAS 142 effective September 1, 2001, as described in Note 10, "Goodwill and
Other Intangible Assets" included elsewhere herein. The preparation of these
financial statements requires the use of estimates, judgements and assumptions
that affect the reported amounts of assets and liabilities, and the disclosure
of contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the respective reporting
periods. The Company's senior management has discussed the critical accounting
estimates with the Company's audit committee.

The Company continually evaluates its accounting policies and the
estimates it uses to prepare the consolidated financial statements. In general,
the estimates are based on historical experience, on information from third
party professionals and on various other sources and assumptions that are
believed to be reasonable under the facts and circumstances. Management
considers an accounting estimate to be critical if:

o it requires assumptions to be made that were uncertain at the time the
estimate was made, and

o changes in the estimate, or the use of different estimating methods
that could have been selected, could have a material impact on the
Company's consolidated results of operations or financial condition.

The following presents information about the Company's most critical
accounting estimates.

ALLOWANCES FOR DOUBTFUL ACCOUNTS: The Company maintains allowances for
doubtful accounts for estimated losses that may result from the inability of its
customers to make required payments. Allowances are based on the likelihood of
recoverability of accounts receivable considering such factors as past
experience and taking into account current collection trends that are expected
to continue. Factors taken into consideration in estimating the allowance are
amounts past due, in dispute, or a client that the Company believes might be
having financial difficulties. If economic, industry, or specific customer
business trends worsen beyond earlier estimates, the Company increases the
allowances for doubtful accounts by recording additional expense. Legal fees
expended in the pursuit of the outstanding amounts are considered "recovered"
prior to the reversal of any previously written off bad debt.

MEDICAL CLAIMS: Medical claims payable represents the liability for
healthcare claims reported but not yet paid and claims incurred but not yet
reported ("IBNR") related to the Company's managed behavioral healthcare
business. The IBNR portion of medical claims payable is estimated based upon
authorized healthcare services, past claims payment experience for member
groups, enrollment data, utilization statistics and other factors using both
accounting and actuarial methodologies. Although variability is inherent in such
estimates, management believes the recorded liability for medical claims payable
is adequate. Medical claim payable balances are monitored and reviewed monthly
and actuarially certified, by an independent third party actuarial firm, on an
annual basis. Changes in assumptions for care costs caused by changes in actual
or expected experience could cause these estimates to change significantly.
Reserves for these liabilities at August 31, 2003 and 2002 were $2.8 million and
$3.3 million, respectively. A 10% increase in the assumed utilization of
healthcare services would reduce net income by $1.4 million after tax on an
annualized basis. This charge would impact the Company's HBS segment.

GOODWILL AND INTANGIBLE ASSETS: Goodwill represents the excess of
purchase price over the fair value of identifiable assets acquired, net of
liabilities assumed. Intangibles consist of the separately identifiable
intangibles, such as contract valuations, non-competes and trade names. At
August 31, 2003, goodwill and intangible assets represented 73% of total assets
and exceed in amount the Company's net worth. Contract valuations represent the
fair value of management contracts and service contracts purchased and are being
amortized using the straight-line method over seven years. Other intangibles are
being amortized over their expected useful lives. Per the provisions of SFAS No.
142, the Company performs an annual goodwill impairment review, for each
business segment as

36

defined in Note 10 "Goodwill and Other Intangible Assets" to the Consolidated
Financial Statements, in the third quarter of each fiscal year or when events or
changes in circumstances indicate the carrying value may not be recoverable.
Indicators the Company consider important which could trigger an impairment
review include, without limitation, (i) significant under-performance or loss of
key contracts acquired in an acquisition relative to expected historical or
projected future operating results; (ii) significant changes in the manner or
use of the acquired assets or the strategy of the Company's overall the manner
or use of the acquired assets or the strategy of the Company's overall business;
(iii) significant negative industry or economic trends; (iv) increased
competitive pressures; (v) a significant decline in the Company's stock price
for a sustained period; and (vi) regulatory changes. In assessing the
recoverability of the Company's goodwill and intangibles, the Company must make
assumptions regarding estimated future cash flows and other factors to determine
the fair value of the respective assets. The fair value of the asset could be
different using different estimating methods and assumptions in these valuation
techniques resulting in a possible impairment of the intangible assets and/or
goodwill, or alternatively an acceleration in amortization expense may result.
An impairment charge would reduce operating income in the period it was
determined that the charge was needed. As a result of the May 31, 2003
impairment testing, no impairment adjustments were deemed necessary.

RESERVES FOR EMPLOYEE HEALTH BENEFITS: This reserve represents an
accrual for estimated health benefit claims incurred, but unpaid or not
reported. The accrual is based on a number of factors including historical
experience, industry trends and recent claims history and are subject to ongoing
revision as conditions might change and as new data may be presented. In
estimating the liability for claims, the Company obtains an estimate from an
independent third party actuarial firm, which calculates an estimate using
historical experiences and estimates of claim costs as well as numerous
assumptions regarding factors relevant to the derivation of an estimate of
future claim costs. Reserves for these liabilities at August 31, 2003 and 2002
were $1,066,314 and $785,000 respectively. Reserve estimates are expected values
of the amounts required to pay claims reported or incurred through August 31,
2003 and includes a reasonable additional reserve to account for a possible
adverse deviation from the expected values estimated.

SELF INSURANCE RESERVES: This reserve represents an accrual for certain
general and professional liability claims filed and for claims incurred, but not
reported. Estimates of the aggregate or portions of claims pursuant to the
Company's self-insurance retentions, and liability for uninsured claims
incurred, are determined by using actuarial assumptions followed in the
insurance industry and historical experience. In estimating the liability for
claims, the Company obtains an estimate from an independent third party
actuarial firm, which calculates an estimate using historical experiences and
estimates of claim costs as well as numerous assumptions regarding factors
relevant to the derivation of an estimate of future claim costs. Reserves for
these liabilities at August 31, 2003 and 2002 were $1,086,000 and $727,320.
Reserve estimates are expected values of the amounts required to pay claims
reported or incurred through August 31, 2003 and include a reasonable additional
reserve to account for a possible adverse deviation from the expected values
estimated.

DISCLOSURE REGARDING FORWARD LOOKING STATEMENTS

Certain written and oral statements made or incorporated by reference
from time to time by the Company or its representatives in this report, other
reports, filings with the Commission, press releases, conferences, or otherwise,
are "forward looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. Such statements include, without limitation, any
statement that may predict, forecast, indicate, or imply future results,
performance or achievements, and may contain the words "believe," "anticipate,"
"expect," "estimate," "project," "will be," "will continue," "will likely
result," or words or phrases of similar meaning. Such statements involve risks,
uncertainties or other factors which may cause actual results to differ
materially from the future results, performance or achievements expressed or
implied by such forward looking statements. Certain risks, uncertainties and
other important factors are detailed in this report and will be detailed from
time to time in reports filed by the Company with the Commission, including
Forms 8-K, 10-Q, and 10-K, and include, among others, the following: general
economic and business conditions which are less favorable than expected;
unanticipated changes in industry trends; decreased demand by general hospitals
for the Company's services; the Company's inability to retain existing
management contracts or to obtain additional contracts or maintain customer
relationships; adverse changes in reimbursement to general hospitals by Medicare
or other third-party payers for costs of providing mental health or physical
rehabilitation or nursing; adverse changes to other regulatory requirements
relating to the provision of mental health or physical rehabilitation or nursing
services; adverse consequences of investigations by governmental

37

regulatory agencies; adverse judgements rendered in the qui tam lawsuits pending
against the Company; fluctuations and difficulty in forecasting operating
results; the ability of the Company to sustain, manage or forecast its growth;
the ability of the Company to successfully integrate acquired businesses on a
cost effective basis; heightened competition, including specifically the
intensification of price competition; the entry of new competitors and the
development of new products or services by new and existing competitors; changes
in business strategy or development plans; inability to carry out marketing and
sales plans; business disruptions; liability and other claims asserted against
the Company; loss of key executives; the ability to attract and retain qualified
personnel; adverse publicity; demographic changes; and other factors referenced
or incorporated by reference in this report and other reports or filings with
the Commission. Moreover, the Company operates in a very competitive and rapidly
changing environment. New risk factors emerge from time to time and it is not
possible for management to predict all such risk factors, nor can it assess the
impact of all such risk factors on the Company's business or the extent to which
any factor may cause actual results to differ materially from those contained in
any forward looking statements. These forward-looking statements represent the
estimates and assumptions of management only as of the date of this report. The
Company expressly disclaims any obligation or undertaking to disseminate any
updates or revisions to any forward looking statement contained herein to
reflect any change in its expectations with regard thereto or any change in
events, conditions or circumstances on which any statement is based. Given these
risks and uncertainties, investors should not place undue reliance on
forward-looking statements as a prediction of actual results.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

In its normal operations, the Company has market risk exposure to
interest rates due to its interest bearing debt obligations, which were entered
into for purposes other than trading purposes. To manage its exposure to changes
in interest rates, the Company uses both variable rate debt and fixed rate debt
of short duration with maturities ranging from 30 to 180 days. The Company has
estimated its market risk exposure using sensitivity analyses assuming a 10%
change in market rates.

At August 31, 2003, the Company had $14.0 million of debt obligations
outstanding with a weighted average interest rate of 3.46%. A hypothetical 10%
change in the effective interest rate for these borrowings, assuming debt levels
as of August 31, 2003, would change interest expense by approximately $48,000
annually. This change amount would be funded out of cash flows from operations,
which were approximately $13.5 million for the twelve months ended August 31,
2003.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Reference is made to the Consolidated Financial Statements of the
Company and the Notes thereto appearing at page F-1 to F-26 elsewhere herein,
which information is incorporated by reference into this Item 8.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

ITEM 9A. CONTROLS AND PROCEDURES

Disclosure controls and procedures are controls and other procedures
that are designed to ensure that information required to be disclosed in the
reports that are filed or submitted under the Exchange Act is recorded,
processed, summarized and reported, within the time periods specified in the
Securities and Exchange Commissions' rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed in the reports that are filed
under the Exchange Act is accumulated and communicated to management, including
the chief executive officer and chief financial officer, as appropriate to allow
timely decisions regarding required disclosure. Under the supervision of and
with the participation of

38

management, including the chief executive officer and chief financial officer,
the Company has evaluated the effectiveness of the design and operation of its
disclosure controls and procedures as of August 31, 2003, and based on its
evaluation, our chief executive officer and chief financial officer have
concluded that these controls and procedures are effective.

There have been no significant changes in internal controls or in other
factors that could significantly affect these controls subsequent to the date of
the evaluation described above, including any corrective actions with regard to
significant deficiencies and material weaknesses.

39

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The Company will file with the Commission a definitive proxy statement
with respect to the annual meeting of stockholders of the Company to be held on
January 29, 2004 (the "Proxy Statement"). The Company hereby incorporates into
this Item 10 by reference to the Proxy Statement the information required by
this Item 10 that will appear in the Proxy Statement under the caption "ELECTION
OF DIRECTORS".

Audit Committee Financial Experts

The Company has determined that the three members of the Audit
Committee of the Board of Directors, George E. Bello, James E. Buncher and
Donald A. Steen, each qualify as "audit committee financial expert" as defined
in Item 401(h) of Regulation S-K, and that each of those individuals is
"independent" as the term is used in Item 7(d)(3)(iv) of Schedule 14A under the
Securities Exchange Act.

Code Of Ethics

The Company has adopted a Code of Ethics applicable to all employees,
including the principal executive officer, principal financial officer and
principal accounting officer of the Company. A copy of the Code of Ethics is
available on the Company's Web site at www.horizonhealthcorp.com. The Company
intends to post on its Web site any amendments to, or waivers from, its Code of
Conduct applicable to such senior officers.

EXECUTIVE OFFICERS OF THE REGISTRANT

James K. Newman returned from semi-retirement to re-assume the position
of President and Chief Executive Officer of the Company on April 28, 2003, a
position he held from July 1989 through August 1997. Mr. Newman has served as
Chairman of the Board since February 1992. Mr. Newman served as a consultant to
the Company from September 1997 through April 2003. Mr. Newman currently serves
as a director of Telecare Corporation, a privately held mental health service
provider.

Ronald C. Drabik has been Senior Vice President - Finance and
Administration, Chief Financial Officer, Treasurer and Ethics Compliance Officer
since July 12, 1999. He was previously Senior Vice President, Chief Financial
Officer, Secretary and Treasurer of Cuno, Inc., a multinational manufacturer of
filtration products, from 1996 to 1999. He was previously Vice President -
Finance for Acme Cleveland, a multinational manufacturer of telecommunications
and electronic products, from 1995 to 1996. He also served as President and CEO
of Met-Coil Systems Corp., a machine tool manufacturer, from 1993 to 1995.

Frank J. Baumann has been Senior Vice President - Operations since
March 22, 1999. He was President - ProCare One Nurses from June 2002 to October
2003 and continues to have oversight responsibility for that subsidiary. He has
been President - Specialty Rehab Management since March 1999. He formerly served
as a Regional Vice President from March 1997 to March 1999. He was also a
Regional Director of Operations from November 1996 to March 1997. He was Chief
Executive Officer of Mountain Crest Behavioral Healthcare Systems, a
freestanding psychiatric hospital, from August 1994 to November 1996.

40

Jackie L. James has been Senior Vice President - Operations and
President - Horizon Behavioral Services since April 3, 2003. She was previously
President - Western Region for One Health Plan of California, a national HMO,
from January 1997 to June 2002. She also served in increasing levels of
responsibility with Health Net, a national HMO, as Regional Sales Manager (June
1990 to September 1992), as Executive Director - Central California (September
1992 to September 1994), as Director - Medicare Operations (September 1994 to
January 1996) and as Regional Vice President - Network Management (January 1996
to January 1997).

David K. White, Ph.D. has been Senior Vice President - Operations since
November 1, 1998. Effective September 28, 2002, he was appointed President -
Horizon Mental Health Management. He formerly served as Executive Vice President
- - Operations from February 1998 to October 1998. He was a Regional Vice
President from September 1996 to January 1998. He also served as a Regional
Director of Operations from April 1995 to August 1996. He was President and
Chief Executive Officer of Charles River Health Management, Inc., a contract
management company focusing on the public and private sector, from December 1990
to November 1994.

Donald W. Thayer has been Senior Vice President-Acquisitions and
Development since September 2003. He formerly served as the Managing
Director-Mergers and Acquisitions for B.C. Ziegler and Company from December
2001 to September 2003. From July 2000 to November 2001 he was an independent
consultant working under multiple consulting agreements to provide acquisition
and development services. Mr. Thayer served as Vice President-Acquisition and
Development from July 1978 through July 2000 for Tenet Healthcare Corporation.

Officers of the Company are elected by the Board of Directors of the
Company and serve at the pleasure of the Board of Directors until their
respective successors are elected and qualified.

ITEM 11. EXECUTIVE COMPENSATION

The Company hereby incorporates into this Item 11 by reference to the
Proxy Statement the information required by this Item 11 that will appear in the
Proxy Statement under the caption "EXECUTIVE COMPENSATION".

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT

The following table sets for the a summary of the equity compensation
plans offered by the Company:

EQUITY COMPENSATION PLAN INFORMATION AS OF OCTOBER 28, 2003

41

The Company hereby incorporates into this Item 12 by reference to the
Proxy Statement the other information required by this Item 12 that will appear
in the Proxy Statement under the caption SECURITY OWNERSHIP BY MANAGEMENT AND
PRINCIPAL STOCKHOLDERS.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

None.

ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES

The Company hereby incorporates into this Item 14 by reference to the
Proxy Statement the information required by this Item 14 that will appear in the
Proxy Statement under the caption APPOINTMENT OF INDEPENDENT AUDITORS.

42

PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a) (1) Financial Statements - Reference is made to the Index to
Consolidated Financial Statements appearing at page F-1 of
this report.

(2) Financial Statement Schedule - Reference is made to
the Index to Financial Statement Schedule appearing
at page S-1 of this report.

(3) Exhibits.

NUMBER EXHIBIT

3.1 - Certificate of Incorporation of the Company, as amended
(incorporated herein by reference to Exhibit 3.1 to the
Company's Current Report on Form 8-K dated August 11, 1997).

3.2 - Amended and Restated Bylaws of the Company, as amended
(incorporated herein by reference to Exhibit 3.2 to Amendment
No. 2 as filed with the Commission on February 16, 1995
("Amendment No. 2") to the Company's Registration Statement on
Form S-1 filed with the Commission on January 6, 1995
Registration No. 33-88314) (the "Form S-1").

4.1 - Specimen certificate for the Common Stock, $.01 par value of
the Company (incorporated herein by reference to Exhibit 4.1
to the Company's Current Report on Form 8-K dated August 11,
1997).

4.2 - Rights Agreement, dated February 6, 1997, between the
Company and American Stock Transfer & Trust Company, as Rights
Agent (incorporated by reference to Exhibit 4.1 to the
Company's Registration Statement on Form 8-A, Registration No.
000-22123, as filed with the Commission on February 7, 1997).

10.1 - Second Amended and Restated Credit Agreement dated May 23,
2002, between Horizon Health Corporation and Horizon Mental
Health Management, Inc., as Borrowers, and J.P. Morgan Chase
Bank, as Agent and the banks named therein (incorporated
herein by reference to Exhibit 10.1 to the Company's Quarterly
Report on Form 10-Q for the quarter ended May 31, 2002).

10.2 - First Amendment to Second Amended and Restated Credit
Agreement dated as of September 25, 2002 between Horizon
Health Corporation and Horizon Mental Health Management, Inc.,
J.P. Morgan Chase Bank as Agent, and the banks named therein
(incorporated herein by reference to Exhibit 10.2 to the
Company's Annual Report on Form 10-K for the fiscal year ended
August 31, 2002).

10.3 - Second Amendment to Second Amended and Restated Credit
Agreement, dated as of October 4, 2002 between Horizon Health
Corporation and Horizon Mental Health Management, Inc., J.P.
Morgan Chase Bank as Agent and the banks named therein
(incorporated herein by reference to Exhibit 10.3 to the
Company's Annual Report on Form 10-K for the fiscal year ended
August 31, 2002).

43

10.4 - Third Amendment to Second Amended and Restated Credit
Agreement, dated as of April 4, 2003 between Horizon Health
Corporation and Horizon Mental Health Management, Inc., as
Borrowers and J.P. Morgan Chase Bank as Agent, and the banks
named therein (incorporated herein by reference to Exhibit
10.2 to the Company's Quarterly Report on Form 10-Q for the
quarter ended May 31, 2003).

10.5 - Fourth Amendment to Second Amended and Restated Credit
Agreement, dated as of August 29, 2003 between Horizon Health
Corporation and Horizon Mental Health Management, Inc., as
Borrowers and J.P. Morgan Chase Bank as Agent, and the banks
named therein (filed herewith).

10.6 - Horizon Health Group, Inc. 1989 Stock Option Plan, as
amended (incorporated herein by reference to Exhibit 10.8 to
the Company's Annual Report on Form 10-K for the fiscal year
ended August 31, 2002).

10.7 - Horizon Mental Health Management, Inc. 1995 Stock Option
Plan as amended (incorporated herein by reference to Exhibit
10.9 to the Company's Annual Report on Form 10-K for the
fiscal year ended August 31, 2002).

10.8 - Horizon Mental Health Management, Inc. Amended and Restated
1995 Stock Option Plan for Eligible Outside Directors as
amended (incorporated herein by reference to Exhibit 10.10 to
the Company's Annual Report on Form 10-K for the fiscal year
ended August 31, 2002).

10.9 - Horizon Health Corporation 1998 Stock Option Plan as amended
(incorporated herein by reference to Exhibit 10.11 to the
Company's Annual Report on Form 10-K for the fiscal year ended
August 31, 2002).

10.10 - Horizon Health Corporation Employee Stock Purchase Plan
(incorporated herein by reference to Exhibit 4.3 to the
Company's Registration Statement on Form S-8 filed with the
Commission on November 30, 1999, Registration No. 333-91761).

10.11 - Horizon Health Corporation Bonus Plan Fiscal 2003
(incorporated herein by reference to Exhibit 10.14 to the
Company's Annual Report on Form 10-K for the fiscal year ended
August 31, 2002).

10.12 - Horizon Health Corporation Bonus Plan Fiscal 2004 (filed
herewith).

10.13 - Executive Retention Agreement effective May 1,2003 between
the Company and James Ken Newman (incorporated herein by
reference to Exhibit 10.1 to the Company's Quarterly Report on
Form 10-Q for the quarter ended May 31, 2003).

10.14 - Agreement dated August 31, 1999 between Horizon Health
Corporation, Inc. and Ronald C. Drabik regarding severance
arrangements (incorporated herein by reference to exhibit 10.1
to the Company's Annual Report on Form 10-K for the fiscal
year ended August 31, 1999).

10.15 - Member Interests Purchase Agreement, dated June 13, 2002,
between Horizon Health Corporation, as buyer, and Lara Mac,
Steve MacEachern, Vicki Lotz and Obstetrical Nurses, Inc. as
sellers (Incorporated by reference to Exhibit 10.1 to the
Company's Current Report on Form 8-K dated June 13, 2002).

11 - Statement Regarding Computation of Per Share Earnings (filed
herewith).

21 - List of Subsidiaries of the Company (filed herewith).

23 - Consent of PricewaterhouseCoopers LLP (filed herewith).

44

31.1 - Certification of Chief Executive Officer required by
Securities and Exchange Commission Rule 13a-14(a) or
15d-14(a).

31.2 - Certification of Chief Financial Officer required by
Securities and Exchange Commission Rule 13a-14(a) or
15d-14(a).

32 - Certification of Chief Executive Officer and Chief Financial
Officer pursuant to Section 906 of the Sarbanes-Oxley Act of
2002, 18 U.S.C. Section 1350.

(b) The Company filed the following reports on Form 8-K during the
last quarter of the period covered by this report.

Current report on Form 8-K filed with the Commission on
September 30, 2003. The item reported was Item 5, Other
Events, announcing a publicly available conference call
regarding the Company's 4th quarter and year end financial
results on October 21, 2003.

45

SIGNATURES

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

DATE: NOVEMBER 14, 2003
HORIZON HEALTH CORPORATION

BY: /S/ RONALD C. DRABIK
----------------------------------------
RONALD C. DRABIK
SENIOR VICE PRESIDENT - FINANCE AND
ADMINISTRATION AND TREASURER
(PRINCIPAL FINANCIAL OFFICER)

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
Company and in the capacities and on the dates indicated.

46

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Report of Independent Auditors ............................................ F-2

Consolidated Balance Sheets at August 31, 2003 and 2002 ................... F-3

Consolidated Statements of Operations
For the Years Ended August 31, 2003, 2002, and 2001 ....................... F-5

Consolidated Statements of Changes in Stockholders' Equity
For the Years Ended August 31, 2003, 2002, and 2001 ....................... F-6

Consolidated Statements of Cash Flows
For the Years Ended August 31, 2003, 2002, and 2001 ....................... F-7

Notes to Consolidated Financial Statements ................................ F-9

F-1

REPORT OF INDEPENDENT AUDITORS

To Board of Directors and Stockholders of Horizon Health Corporation:

In our opinion, the consolidated financial statements listed in the accompanying
index on page F-1 present fairly, in all material respects, the financial
position of Horizon Health Corporation and its subsidiaries at August 31, 2003
and August 31, 2002, and the results of their operations and their cash flows
for each of the three years in the period ended August 31, 2003 in conformity
with accounting principles generally accepted in the United States of America.
In addition, in our opinion, the financial statement schedules listed in the
accompanying index on page S1 present fairly, in all material respects, the
information set forth therein when read in conjunction with the related
consolidated financial statements. These financial statements and financial
statement schedules are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements and
financial statement schedules based on our audits. We conducted our audits of
these statements in accordance with auditing standards generally accepted in the
United States of America, which 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, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

/s/ PricewaterhouseCoopers LLP
- -------------------------------
PricewaterhouseCoopers LLP
Dallas, Texas
October 30, 2003

F-2

HORIZON HEALTH CORPORATION
CONSOLIDATED BALANCE SHEETS

See accompanying notes to consolidated financial statements.

F-3

HORIZON HEALTH CORPORATION
CONSOLIDATED BALANCE SHEETS

See accompanying notes to consolidated financial statements.

F-4

HORIZON HEALTH CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes to consolidated financial statements.

F-5

HORIZON HEALTH CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY

See accompanying notes to consolidated financial statements.

F-6

HORIZON HEALTH CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS

F-7

HORIZON HEALTH CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONT.)

(a) Consists of the purchase of EAP, International effective November 1,
2002 and the purchase of Integrated Insights effective June 30, 2003.
See Note 4.

(b) Consists of the purchase of management contracts of Perspectives Health
Management Corporation effective October 1, 2001, an adjustment to the
purchase price of Occupational Health Consultants of America and the
purchase of ProCare One Nurses effective June 13, 2002. See Note 4.

(c) Acquisition of Occupational Health Consultants of America effective
August 1, 2001. See Note 4.

See accompanying notes to the consolidated financial statements.

F-8

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AUGUST 31, 2003, 2002 AND 2001

1. ORGANIZATION

Horizon Health Corporation ("the Company") is a diversified health care
services provider. It is a leading contract manager of clinical and
related services, primarily of mental health and physical rehabilitation
programs, offered by general acute care hospitals in the United States.
The management contracts are generally for initial terms ranging from
three to five years, the majority of which have automatic renewal
provisions. Through its acquisition of ProCare One Nurses ("ProCare")
effective June 13, 2002, the Company also provides specialized temporary
nurse staffing services to hospitals. The Company also offers employee
assistance programs ("EAP") and behavioral health services under
contracts to businesses and managed care organizations. The Company
currently has offices in the Chicago, Illinois; Tampa, Florida; Orlando,
Florida; Denver, Colorado; Philadelphia, Pennsylvania; Nashville,
Tennessee; San Diego, California; Los Angeles, California; and Detroit,
Michigan metropolitan areas. The Company's National Support Center is in
the Dallas suburb of Lewisville, Texas.

The Company was formed in July 1989 for the purpose of acquiring all the
assets of two companies. One of these companies, known as Horizon Health
Management Company, had been formed in 1981 and since that time had been
engaged in the mental health contract management business. The other
company owned a freestanding psychiatric hospital in California.
Effective March 1, 1990, the assets constituting the contract management
business and the psychiatric hospital of the two companies were
transferred to the Company.

Since its formation, the Company has completed 14 acquisitions, including
the following five consummated in the last three fiscal years. Effective
August 1, 2001, the Company acquired all of the outstanding capital stock
of Occupational Health Consultants of America, Inc. ("OHCA"). OHCA has
been consolidated with the Company as of August 1, 2001. Effective
October 1, 2001, the Company purchased all the mental health management
contracts of Perspectives Health Management Corporation ("PHM"), a wholly
owned subsidiary of Legal Access Technologies, Inc. PHM has been
consolidated with the Company as of October 1, 2001. Effective June 13,
2002, the Company purchased all of the membership interests of ProCare
One Nurses, LLC ("ProCare"). ProCare has been consolidated with the
Company as of June 13, 2002. Effective November 1, 2002, the company
purchased all of the capital stock of Employee Assistance Programs
International, Inc. ("EAP International"). EAP International has been
consolidated with the Company as of November 1, 2002. Effective June 30,
2003, the Company purchased all of the capital stock of privately held
Health and Human Resource Center, Inc., d/b/a Integrated Insights.
Integrated Insights has been consolidated with the Company as of July 1,
2003 (see Note 4).

2. SIGNIFICANT ACCOUNTING POLICIES AND ESTIMATES

The consolidated financial statements and accompanying notes have been
prepared in accordance with generally accepted accounting principles
applied on a consistent basis. The preparation of these financial
statements requires the use of estimates, judgements and assumptions that
affect the reported amounts of assets and liabilities, and the disclosure
of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting periods.

The Company continually evaluates its accounting policies and the
estimates it uses to prepare the consolidated financial statements. In
general, the estimates are based on historical experience, on information
from third party professionals and on various other assumptions that are
believed to be reasonable under the facts and circumstances. In the
Company's opinion, the significant accounting policies most important to
aid in understanding its financial results are the following:

F-9

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

CONSOLIDATION: The consolidated financial statements include those of the
Company and it's wholly owned and majority owned subsidiaries.
Investments in unconsolidated affiliated companies are accounted for on
the equity method. All significant intercompany accounts and transactions
are eliminated in consolidation.

CASH AND CASH EQUIVALENTS: Cash and cash equivalents primarily include
highly liquid investments with original maturities of three months or
less when purchased. The carrying amount approximates fair value due to
the short maturity of these instruments.

ALLOWANCES FOR DOUBTFUL ACCOUNTS: The Company maintains allowances for
doubtful accounts for estimated losses which may result from the
inability of its customers to make required payments. Allowances are
based on the likelihood of recoverability of accounts receivable
considering such factors as past experience and taking into account
current collection trends that are expected to continue. Factors taken
into consideration in estimating the allowance are amounts past due, in
dispute, or a client which the Company believes might be having financial
difficulties. If economic, industry, or specific customer business trends
worsen beyond earlier estimates, the Company increases the allowances for
doubtful accounts by recording additional expense. Legal fees expended in
the pursuit of the outstanding amounts are considered "recovered" prior
to the reversal of any previously written off bad debt.

PROPERTY AND EQUIPMENT: Property and equipment are recorded at cost.
Depreciation expense is recorded on the straight-line basis over
estimated useful lives. The useful life of the building is estimated to
be thirty years. The useful lives of computer hardware and software are
estimated to be three years. The useful lives of furniture and fixtures,
and transportation equipment are estimated to be five years. The useful
life of office equipment is estimated to be three years. Building
improvements are recorded at cost and amortized over the estimated useful
lives of the improvements or the terms of the underlying lease whichever
is shorter. Routine maintenance, repair items, and customer facility and
site improvements are charged to current operations.

ACCOUNTING FOR INTANGIBLE ASSETS AND GOODWILL: The cost of acquired
companies is allocated first to their identifiable assets based on
estimated fair values, and then to goodwill. Costs allocated to
identifiable intangible assets are generally amortized on a straight-line
basis over the remaining estimated useful lives of the assets. The excess
of the purchase price over the fair value of identifiable assets
acquired, net of liabilities assumed, is recorded as goodwill. At August
31, 2003 and 2002, respectively, other identifiable intangible assets,
net, consist of contracts (approximately $3,622,210 and $3,145,605),
non-compete agreements (approximately $431,655 and $186,112) and trade
names (approximately ($58,597 and $93,055). In July 2001, the Financial
Accounting Standards Board ("FASB") issued Statement of Financial
Accounting Standards No. ("SFAS") 141 "Business Combinations" ("SFAS
141") and SFAS 142 "Goodwill and Other Intangible Assets" ("SFAS 142").
SFAS 141 addresses the initial recognition and measurement of goodwill
and other intangible assets acquired in a business combination. SFAS 142
addresses the initial recognition and measurement of intangible assets
acquired outside of a business combination, whether acquired individually
or with a group of other assets, and the accounting and reporting for
goodwill and other intangibles subsequent to their acquisitions. These
standards require all future business combinations be accounted for using
the purchase method of accounting and goodwill not to be amortized, but
instead to be subject to impairment tests at least annually. The Company
elected to adopt SFAS 141 and SFAS 142 on a prospective basis as of
September 1, 2001. As a result of implementing these new standards, the
Company discontinued the amortization of goodwill as of August 31, 2001.

Accounting for intangible assets and goodwill requires significant
estimates and judgement, especially as to: a) the valuation in connection
with the initial purchase price allocation and b) the ongoing evaluation
for impairment. For each acquisition, a valuation was completed to
determine a

F-10

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

reasonable purchase price allocation. Upon completion of the allocation
process an amount was assigned to various identified assets including
intangible assets and the remainder was assigned to goodwill. The
purchase price allocation process requires estimates and judgements as to
expectations for the various businesses and business strategies. For
example, certain growth rates were assumed for each business.
Additionally, different operating margins for each type of service
offering were included in the estimates. If actual growth rates or
operating margins, among other assumptions, differ significantly from the
estimate and judgements used in the purchase price allocation, a possible
impairment of the intangible assets and/or goodwill or an acceleration in
amortization expense may result.

In addition, SFAS 142, "Goodwill and Other Intangible Assets" ("SFAS
142"), adopted in 2001, discontinued the amortization of goodwill and
generally requires that goodwill impairment be tested annually using a
two-step process. The first step is to identify a potential impairment.
The second step measures the amount of the impairment loss, if any.
However, intangible assets with indefinite lives are to be tested for
impairment using a one-step process that compares the fair value to the
carrying amount of the asset. Because of the significance of the
identified intangible assets and goodwill to the Company's consolidated
balance sheet, annual or interim impairment analyses are important.
Changes in key assumptions about the business and its prospects, or
changes in market conditions or other external factors, could result in
an impairment charge and such a charge could have a material adverse
effect on the Company's financial condition and results of operations.

Contracts represent the fair value of management contracts and service
contracts purchased and are being amortized using the straight-line
method over seven years. Other intangibles primarily includes the fair
value of trade names and non-compete agreements, which are being
amortized over their expected useful lives. The Company elected to
conduct the annual impairment testing during its fiscal year third
quarter.

TREASURY STOCK: The Company accounts for the treasury stock using the
cost method. Gains on sales of treasury stock are credited to Additional
Paid in Capital ("APIC"), losses are charged to APIC to the extent that
previous net gains from sales are included therein, otherwise to retained
earnings.

MEDICAL CLAIMS: Medical claims payable represent the liability for
healthcare claims reported but not yet paid and claims incurred but not
yet reported ("IBNR") related to the Company's managed behavioral
healthcare business. The IBNR portion of medical claims payable is
estimated based upon authorized healthcare services, past claims payment
experience for member groups, enrollment data, utilization statistics and
other factors using both accounting and actuarial methodologies. Although
variability is inherent in such estimates, management believes the
recorded liability for medical claims payable is adequate. Medical claim
payable balances are continually monitored and reviewed. Changes in
assumptions for care costs caused by changes in actual or expected
utilization experience could cause these estimates to change
significantly.

RESERVES FOR EMPLOYEE HEALTH BENEFITS: The Company retains a significant
amount of self-insurance risk for its employee health benefits. The
Company maintains stop-loss insurance such that the Company's liability
for health insurance is subject to certain individual and aggregate
limits. Each month end the Company records an accrued expense for
estimated health benefit claims incurred but unpaid or not reported at
the end of such period. The Company estimates this accrual based on a
number of factors including historical experience, industry trends and
recent claims history. This accrual estimate is subject to ongoing
revision as conditions might change and as new data may be presented.
Adjustments to estimated liabilities are recorded in the accounting
period in which the change in estimate occurs. Changes in assumptions for
care costs caused by changes in actual or expected utilization experience
could cause these estimates to change significantly.

F-11

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

SELF-INSURANCE RESERVES: Pursuant to various deductibles and retentions,
the Company is self-insured for certain losses for general and
professional liability claims and up to certain individual and aggregate
stop losses relating to worker's compensation and malpractice liability
claims. Self-insurance claims filed and claims incurred but not reported
are accrued based upon management's estimates of the aggregate liability
for uninsured claims incurred using actuarial assumptions followed in the
insurance industry and historical experience. Although management
believes it has the ability to adequately estimate losses related to
claims, it is possible that actual results could differ from recorded
self-insurance liabilities.

REVENUE RECOGNITION: Service revenue is generated by the Company's four
business segments and recognized in the following three categories:

(1) Contract management revenue, generated by Horizon Mental Health
Management and Specialty Rehabilitation Management, is reported in
the period the services are provided at the estimated net
realizable amounts from contracted hospitals for contract
management services rendered. Adjustments are accrued on an
estimated basis in the period they become known and are adjusted
in future periods, as final settlement is determined.

The fees received by the Company for its services under management
contracts are paid directly by its client hospitals. Contract
management revenue is based on various criteria such as a fixed
fee and/or variable components and may include per diem
calculations based on patients per day or for defined periods, the
number of admissions or discharges, direct expenses, or any
combination of the preceding, depending on the specific contract.
Generally, contract fees are paid on a monthly basis.

Some management contracts include a clause, which states that the
Company will indemnify the hospital for any third-party payor
denials, including Medicare. At the time the charges are denied or
anticipated to be denied, the Company records an allowance for
100% of the potential amount. The Company believes it has
adequately provided for potential adjustments that may result from
final settlement of potential denials, which amounts have
historically not been significant.

Client hospitals receive reimbursement under Medicare or Medicaid
programs or payments from insurers, self-funded benefit plans or
other third-party payors for the mental health and physical
rehabilitation services provided to the patients of the programs
managed by the Company. As a result, the availability and amount
of such reimbursements, which are subject to change, may impact
the decision of general acute care hospitals regarding whether to
offer mental health and physical rehabilitation services pursuant
to management contract with the Company, as well as whether to
continue such contracts (subject to contract termination
provisions) and the amount of fees to be paid thereunder.

(2) Premium and fees revenue, generated by Horizon Behavioral
Services, is reported in the period services are provided at the
estimated net realizable amounts as defined by client contracts
for services rendered. Adjustments are accrued on an estimated
basis in the period they become known and are adjusted in future
periods if and when necessary.

Revenues are derived from EAP services, administrative service
only contracts, and at risk managed behavioral health services.
This revenue consists primarily of capitation

F-12

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

payments, which are calculated on the basis of a
per-member/per-month or a per-employee/per-month fee, but also
include fee for service payments. For certain capitated
managed care contracts the Company is 'at risk' and bears the
economic risk as to the adequacy of capitated revenue versus
the actual cost of behavioral health care services provided to
covered members by third parties. At August 31, 2003, overall
capitated revenue was sufficient to meet these costs.

(3) Service revenues, generated by ProCare One Nurses are
recognized in the month in which services are rendered, at the
estimated net realizable amounts. These revenues are generated
through the Company's specialized temporary nurse staffing
services.

EARNINGS PER SHARE: Earnings per share has been computed in accordance
with SFAS No. 128, "Earnings Per Share". Basic earnings per share are
computed by dividing income available to common stockholders by the
weighted-average number of common shares outstanding for the period.
Diluted earnings per share reflect the potential dilution that may occur
if the Company's in the money stock options were exercised. Such dilutive
potential common shares are calculated using the treasury stock method.

ACCOUNTING FOR INCOME TAXES: The Company accounts for income taxes in
accordance with SFAS No. 109, "Accounting for Income Taxes", which
requires that deferred tax assets and liabilities be recognized using
enacted tax rates for the effect of temporary differences between the
book and tax basis of recorded assets and liabilities. SFAS No. 109 also
requires that deferred tax assets be reduced by a valuation allowance if
it is more likely than not that some portion or all of the deferred tax
assets will not be realized. (See Note 12)

Based upon the Company's estimates of the sources, nature, and amount of
expected future taxable income it determined that it is more likely than
not that it's deferred tax assets will be realized, resulting in no
valuation allowance. At August 31, 2003, the Company had deferred tax
liabilities in excess of deferred tax assets of $1,047,118.

The Company evaluates quarterly the realizability of its deferred tax
assets and accordingly adjusts its valuation allowance, if any as
necessary. The factors used to assess the likelihood of realization
include the Company's estimates of future taxable income and available
tax initiatives that could be reasonably implemented to assure
realization of the net deferred tax assets. The Company has used various
appropriate tax initiatives and alternative tax treatments to realize or
to renew net deferred tax assets in order to avoid the potential loss of
tax benefits.

Failure to achieve forecasted taxable income amounts might affect the
ultimate realization of all or portions of net deferred tax assets.
Factors that may affect the Company's ability to achieve sufficient
forecasted taxable income include general business conditions, increased
competition, a change in Medicare or Medicare reimbursement, an increase
in medical services utilization, etc., resulting in a decline in sales or
margins.

USE OF ESTIMATES: The Company has made certain estimates and assumptions
relating to the reporting of assets and liabilities and the disclosure of
contingent assets and liabilities at the date of the financial statements
and the amounts of revenues and expenses recorded for the reporting
period in order to prepare the financial statements in conformity with
generally accepted accounting principles. Future actual results could
differ from those estimates.

RECLASSIFICATIONS: Certain prior year amounts have been reclassified to
conform to the current year presentation. See Note 8 "Shareholders'
Equity" to the consolidated financial statements included elsewhere
within this document.

F-13

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NEW ACCOUNTING STANDARDS: In December 2002, the Financial Accounting
Standards Board ("FASB") issued Statement of Financial Accounting
Standards No. ("SFAS") 148, "Accounting for Stock-Based Compensation
Transition and Disclosure." This statement amends SFAS 123, "Accounting
for Stock-Based Compensation," and establishes two alternative methods of
transition from the intrinsic value method to the fair value method of
accounting for stock-based employee compensation. In addition, SFAS 148
requires prominent disclosure about the effects of SFAS 123 on reported
net income and requires disclosure of these effects in interim financial
information. The provisions for the alternative transition methods are
effective for fiscal years ending after December 15, 2002, and the
amended disclosure requirements are effective for interim periods
beginning after December 15, 2002 and allow for early application. The
Company currently plans to continue accounting for stock-based
compensation under APB 25, an allowable method, with additional
disclosures as required. See note 9 "Stock Options" to the consolidated
financial statements included elsewhere within this document.

In January 2003, the FASB issued FASB Interpretation No.46,
"Consolidation of Variable Interest Entities" ("FIN 46") which changes
the criteria by which one company accounts for another entity in its
consolidated financial statements. FIN 46 requires a variable interest
entity to be consolidated by a company if that company is subject to a
majority of the risk of loss from the variable interest entity's
activities or entitled to receive a majority of the entity's residual
returns or both. The consolidation requirements of FIN 46 apply to
variable interest entities created after January 31, 2003, and apply in
the first fiscal period beginning after June 15, 2003, for variable
interest entities created prior to February 1, 2003. As of August 31,
2003, the Company does not have a relationship with a variable interest
entity. Effective July 31, 2003 with the acquisition of the National
Support Center building, the Company no longer has any variable interest
entities that fall within the scope of this interpretation.

In June 2002, the FASB issued SFAS 146, "Accounting for Costs Associated
with Exit or Disposal Activities." ("SFAS 146"). SFAS 146 requires that,
subsequent to December 31, 2002, all costs associated with exit or
disposal activities be recognized when they are incurred rather than at
the date of a commitment to an exit or disposal plan. The Company does
not expect this statement to materially impact its consolidated financial
statements.

3. EARNINGS PER SHARE

The Company has adopted the provisions of Statement of Financial
Accounting Standards No. 128, "Earnings Per Share", ("SFAS 128"). All
prior earnings per share data presented have been restated in accordance
with SFAS 128.

The following is a reconciliation of the numerators and the denominators
of the basic and diluted earnings per share computations for net income
for the years ended August 31:

F-14

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

During 2003, 2002, and 2001 certain options to acquire common stock were
not included in certain computations of EPS because the options exercise
price was greater than the average market price of the common shares. The
options excluded by quarter are as follows:

4. ACQUISITIONS

HEALTH AND HUMAN RESOURCE CENTER, INC., D/B/A INTEGRATED INSIGHTS

Effective June 30, 2003 the Company purchased all of the capital stock of
privately held Health and Human Resource Center, Inc., d/b/a Integrated
Insights for approximately $4.3 million. Integrated Insights,
headquartered in San Diego, California, provides employee assistance
programs under contracts directly with employers. It holds a limited
California Knox-Keene License to operate as a specialized health care
plan. The Company accounted for the acquisition of Integrated Insights by
the purchase method as required by generally accepted accounting
principles. As of August 31, 2003, the allocation of the purchase price
exceeded the fair value of Integrated Insights' tangible net assets by
$3,923,764, of which $2,610,595 is recorded as goodwill, which is fully
deductible for tax purposes, $1,213,169 as service contract valuation and
$100,000 as non-compete agreements. Tangible assets acquired and
liabilities assumed totaled $754,473 and $406,237, respectively. The cash
purchase price of approximately $4.3 million was funded by the Company's
revolving credit facility. Proforma financial data is not presented
because the impact of this acquisition is not material to the Company's
results of operations for the periods presented.

EMPLOYEE ASSISTANCE PROGRAMS INTERNATIONAL

The Company acquired all of the outstanding capital stock of Employee
Assistance Programs International, Inc. ("EAP International") of Denver,
Colorado, on November 4, 2002, with an effective date of November 1, 2002
for approximately $3.4 million. The Company accounted for the acquisition
of EAP International using the purchase method as required by generally
accepted accounting principles. EAP International provides employee
assistance programs and other related behavioral health care services to
employers. The purchase price of approximately $3.4 million exceeded the
fair value of EAP International's tangible net assets by $3,549,140 of
which $2,674,087 is recorded as goodwill, which is fully deductible for
tax purposes, and $628,898 as service contract valuation and $246,155 as
non-compete agreements. Tangible assets acquired and liabilities assumed
totaled $756,697 and $936,586, respectively. Pro forma financial data is
not presented because the impact of this acquisition is not material to
the Company's results of operation for any period presented.

F-15

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

PROCARE ONE NURSES

Effective June 13, 2002, the Company purchased all of the membership
interests of ProCare One Nurses, LLC ("ProCare"). ProCare, headquartered
in Santa Ana, California, provides specialized temporary nurse staffing
services to hospitals primarily in California and Michigan. The Company
accounted for the acquisition by the purchase method as required by
generally accepted accounting principles. Of the purchase price of
approximately $12.5 million, $11.5 million was funded by the Company's
revolving credit facility and $1.0 million from existing cash. Of the
$12.5 million purchase price, the amounts recorded as intangible assets
were $10.0 million as goodwill, which is fully deductible for tax
purposes, $225,000 as non-compete agreements and $109,000 as trade name
value. Proforma financial data is not presented because the impact of
this acquisition is not material to the Company's results of operations
for the periods presented.

CONTRACTS OF PERSPECTIVES HEALTH MANAGEMENT

Effective October 1, 2001, the Company acquired in an asset purchase the
mental health management contracts comprising the contract mental health
business of Perspectives Health Management Corporation ("PHM"), a wholly
owned subsidiary of Legal Access Technologies, Inc. ("LAT"). The Company
accounted for the acquisition by the purchase method as required by
generally accepted accounting principles. PHM had 12 mental health
management contract locations. The management contracts covered 12
inpatient mental health programs, one partial hospitalization mental
health program and three intensive outpatient mental health programs. The
management contracts constituted all of the business operations of PHM.
The purchased price of approximately $2.9 million in cash was funded by
the Company's revolving credit facility. Of the $2.9 million purchase
price, $2,234,449 is recorded as goodwill, which is fully deductible for
tax purposes, and $681,760 as contract valuation. Proforma financial data
is not presented because the impact of this acquisition is not material
to the Company's results of operations for the periods presented.

OCCUPATIONAL HEALTH CONSULTANTS OF AMERICA

Effective August 1, 2001, the Company acquired all of the outstanding
capital stock of Occupational Health Consultants of America, Inc.
("OHCA") of Nashville, Tennessee, and OHCA has been consolidated with the
Company as of August 1, 2001. The Company accounted for the acquisition
of OHCA by the purchase method. OHCA provides employee assistance
programs and other related behavioral health care services to employers.
As of August 31, 2002, the allocation of the purchase price exceeded the
fair value of OHCA's tangible net assets by $3,469,708, of which
$3,126,532 is recorded as goodwill, which is fully deductible for tax
purposes, and $343,176 as service contract valuation. Tangible assets
acquired and liabilities assumed totaled $917,244 and $848,906,
respectively. Pro forma financial data is not presented because the
impact of this acquisition is not material to the Company's results of
operations for the periods presented.

F-16

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

5. PROPERTY AND EQUIPMENT

Property and equipment consist of the following at August 31:

(a) Effective July 31, 2003, the Company purchased the land and
building comprising its National Support Center.

Depreciation expense was $1,046,715, $1,206,704, and $1,393,380
for the years ended August 31, 2003, 2002, and 2001, respectively.

6. ACCRUED EXPENSES AND UNEARNED REVENUE

Accrued expenses consisted of the following at August 31:

7. LONG-TERM DEBT

At August 31, 2003 and 2002, the Company had long-term debt comprised of
a revolving credit facility with outstanding balances of $14.0 million
and $10.0 million, respectively. On May 23, 2002, the Company entered
into a Second Amended and Restated Credit Agreement (the "Second Amended
Credit Agreement"), with JPMorgan Chase Bank, as Agent, and Bank of
America, NA which refinanced the loans then outstanding under the
existing credit agreement. The Second Amended Credit Agreement was
originally a five year facility which consisted of a $30 million, three
year revolving/two year term credit facility (which had provisions to
allow for its expansion to a $50

F-17

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

million facility) to fund ongoing working capital requirements, refinance
existing debt, finance future acquisitions by the Company, and for other
general corporate purposes. On August 29, 2003, the Company amended the
current agreement to allow for its expansion to a $60 million facility by
adding Wells Fargo Bank Texas as an equal bank participant in the
facility.

The revolving credit facility bears interest at (1) the Base Rate plus
the Base Rate Margin, as defined or (2) the Adjusted Eurodollar Rate,
plus the Eurodollar Margin, as defined. The weighted average interest
rate on outstanding indebtedness under the credit facility at August 31,
2003, 2002, and 2001 were 3.46%, 4.00%, and 6.65%, respectively. The
Eurodollar Margin varies depending on the debt coverage ratio of the
Company. The revolving credit facility matures on May 31, 2005, at which
time it converts to a two year amortizing term loan.

As of October 4, 2002, April 4, 2003 and August 29, 2003, the Credit
Agreement was amended to allow the Company to finance the redemption or
repurchase of its capital stock, subject to certain conditions. The
amendments currently allow the Company to expend, from August 29, 2003
through May 31, 2005, up to $7.5 million for the repurchase of shares.

The Company is subject to certain covenants which include prohibitions
against (i) incurring additional debt or liens, except specified
permitted debt or permitted liens, (ii) certain material acquisitions,
other than specified permitted acquisitions (including any single
acquisition not greater than $10.0 million or cumulative acquisitions not
in excess of $25.0 million during any twelve consecutive monthly
periods), without prior bank approval, (iii) certain mergers,
consolidations, dividend payments or asset dispositions by the Company or
changes of control of the Company, (iv) certain executive management
changes at the Company, and (v) material change in the nature of business
conducted. In addition, the terms of the revolving credit facility
require the Company to satisfy certain ongoing financial covenants. The
revolving credit facility is secured by a first lien on or first priority
security interest in and/or pledge of substantially all of the assets of
the Company and of all present and future material subsidiaries of the
Company. As of August 31, 2003, the Company was in compliance with the
covenants of the agreement.

8. SHAREHOLDERS' EQUITY

COMMON STOCK

The Board of Directors adopted in October 1999 the Horizon Health
Corporation Employee Stock Purchase Plan ("the Plan"). The purpose of the
Plan, which became effective January 1, 2000, is to provide employees of
the Company and its subsidiaries the opportunity to acquire an ownership
interest in the Company through the purchase of Common Stock at a price
below current market prices. The Plan offers eligible employees the
ability to purchase Company stock at a price 15% below the current market
price at designated periods.

Eligible employees are able to contribute 1 to 10% of their base salary
pursuant to two, six-month offering periods which are defined as January
1 - June 30 and July 1 - December 31. Pursuant to the Plan the Company
issued 10,774, 12,023, and 23,959 shares of Common Stock from treasury
for the fiscal years ended August 31, 2003, 2002, and 2001, respectively.

TREASURY STOCK

During the time period of September 1998 through February 2001 the Board
of Directors of the Company authorized the repurchase of up to 2,525,000
shares of its common stock. As of August

F-18

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

31, 2002 the Company had repurchased 2,292,863 shares of its common stock
pursuant to such authorizations, which had previously expired. On October
7, 2002 the Board of Directors authorized the repurchase of up to 800,000
shares of its common stock. As of August 31, 2003, the company had
repurchased 656,659 shares in total of the 800,000 share authorization,
which remains in effect. The stock repurchase plan, as approved by the
Board of Directors, authorized the Company to make purchases of its
outstanding common stock from time to time in the open market or through
privately negotiated transactions, depending on market conditions and
applicable securities regulations. The repurchased shares are added to
the treasury shares of the Company and may be used for employee stock
plans and for other corporate purposes. The shares were repurchased
utilizing available cash and borrowings under the Company's credit
facility. A total of 1,078,711 and 493,660 treasury shares had been
reissued pursuant to the exercise of certain stock options and in
connection with the Employee Stock Purchase Plan as of August 31, 2003
and August 31, 2002, respectively.

The Company accounts for the treasury stock using the cost method. Gains
on sales of treasury stock are credited to "APIC", losses are charged to
APIC to the extent that previous net gains from sales are included
therein, otherwise to retained earnings. Therefore, on the statement of
changes in stockholders' equity, for the year ending August 31, 2002 and
2001, the net difference between the cost price and the option price on
the issuance of treasury stock of $305,878 and $560,052, respectively,
has been reclassified from Additional Paid in Capital to Retained
Earnings. A cumulative net difference of $1,544,347 on the issuance of
treasury stock as of August 31, 2000, has been reclassified from
Additional Paid in Capital to Retained Earnings.

9. STOCK OPTIONS

The 1989, 1995 and 1998 Stock Option Plans for employees and the 1995
Stock Option Plan for Eligible Outside Directors are collectively
referred to as the "Plans." In accordance with the Plans, as amended,
2,981,843 shares of common stock have been reserved for grant to key
employees, directors and consultants.

The exercise prices of the options granted approximated or exceeded the
market value of the common stock at the date of the grant. The options
generally vest ratably over five years from the date of grant and
terminate ten years from the date of grant.

On April 28, 1995 the board of directors created the 1995 Stock Option
Plan for Eligible Outside Directors for outside directors owning less
than 7.15% of the stock of the Company. 250,000 shares of common stock
are reserved for issuance under this plan. This plan has been amended and
restated to provide for 15,000 option grants upon initial election as a
director. In addition, the Director plan provides for successive annual
grants, as of the day of each annual meeting of stockholders of the
Company, of options to purchase the number of shares of Common Stock
determined by dividing $50,000 by the fair market value per share of the
Common Stock on the date of grant. Fair market value is defined as the
closing price per share on the NASDAQ National Market. With respect to
each such successive annual grant, an Eligible Outside Director has the
right to elect to receive stock options for only 50% of such shares as so
determined and to also receive the receipt of a fee in the amount of
$2,500 for each of the first four meetings of the Board of Directors
actually attended by such Eligible Outside Director in the year following
the Annual Meeting. Options vest ratably over five years from the date of
grant.

F-19

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

The following table summarizes the status of the Plans:

The following table summarizes information about options outstanding
under the Plans at August 31, 2003:

The Company accounts for these plans under the recognition and
measurement principles of APB Opinion No. 25, "Accounting for Stock
Issued to Employees" and related interpretations. No stock-based employee
compensation cost is reflected in net income, as all options granted
under those plans had an exercise price equal to or greater than the
market value of the underlying common stock on the date of grant. The
following table illustrates the effect on net income and earnings per
share of the Company had the Company applied the fair value recognition
provisions of FASB Statement No. 123, "Accounting for Stock-Based
Compensation", relating to stock-based employee compensation.

F-20

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

In accordance with SFAS 123, the fair value of options at date of grant
was estimated using the Black-Scholes option-pricing model with the
following weighted average assumptions:

In accordance with SFAS 123, the weighted average fair value of options
granted during 2003, 2002, and 2001 was $9.76, $7.04, and $2.77
respectively.

10. GOODWILL AND OTHER INTANGIBLE ASSETS

The costs of certain management contracts and other intangible assets
acquired by the Company remain subject to amortization. Amortization of
recorded values for contracts, non-compete agreements, and trade names
for the twelve months ended August 31, 2003 was $1,534,530. During the
quarter ended November 30, 2002, there was a $93,000 acceleration of the
final portions of contract valuation amortization associated with a 1997
acquisition that has now been fully amortized. During the year ended
August 31, 2003, the Company retired five fully amortized contract
valuation balances totaling $7,055,026 from its books, which accounts for
the net decrease in accumulated amortization between the periods
presented on the face of accompanying the balance sheet. The following
table sets forth the estimated amortization expense for intangibles
subject to amortization for the four succeeding fiscal years.

For the year ended August 31: 2004 $ 1,428,739
2005 908,166
2006 492,910
2007 443,937
Thereafter 838,710
-------------
$ 4,112,462
=============

The following table sets forth by business segment of the Company, as
described in Note 14 elsewhere herein, the amount of goodwill as of
August 31, 2003 that is subject to impairment tests rather than
amortization and the adjustments, if any, to the amount of such goodwill
in the twelve months ended August 31, 2003. The Company elected to
conduct the annual impairment testing during its fiscal year third
quarter. As a result of the May 31, 2003 impairment testing, no
impairment adjustments were deemed necessary.

(A) Goodwill adjusted during the period related to a purchase price
adjustment of $243,704.

(B) $2,674,087 of goodwill acquired during the period relates to the purchase
of EAP International and $2,610,595 relates to the purchase of Integrated
Insights (see Note 4).

* See note 14 elsewhere herein, for a description of the Company's business
segments.

F-21

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

11. RETIREMENT PLAN

The Company sponsors a 401(k) plan that covers substantially all
employees, subject to certain eligibility requirements. The Company can
elect to make matching fund contributions at its discretion, but has
historically done so annually. For the years ended August 31, 2003, 2002
and 2001 the Company's contributions were approximately $653,000,
$604,000, and $550,000 respectively.

12. INCOME TAXES

Deferred taxes are provided for those items reported in different periods
for income tax and financial reporting purposes. Income tax expense for
the years ended August 31 is comprised of the following components:

The components of the net deferred tax (liability) asset at August 31
were obtained using the liability method in accordance with SFAS No. 109
and are as follows:

F-22

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

At August 31, 2003, the Company had available estimated, unused net
operating loss carryforwards for tax purposes of approximately
$646,186. These carryforwards, subject to annual utilization limits,
may be utilized to offset future years' taxable income and will expire
during 2011 if unused prior to that date.

The following is a reconciliation of income taxes at the U.S. federal
income tax rate to the Company's effective income tax rate:

13. COMMITMENTS AND CONTINGENCIES

Property Leases

The Company leases various office facilities and equipment under
operating leases. The following is a schedule of minimum rental
payments under these leases, which expire at various dates:

For the year ending August 31: 2004 $ 2,201,156
2005 1,631,923
2006 970,622
2007 358,754
2008 and thereafter 224,339
-----------
$ 5,386,794
===========

Rent expense for the years ended August 31, 2003, 2002, and 2001 was
$2,580,278, $2,507,278, and $2,282,279, respectively.

Insurance Risk Retention

The Company's liability and property risk management program involves a
cost-effective balance of insured risks and self-insured retentions.
The Company carries general and professional liability, malpractice and
liability, comprehensive property damage, workers' compensation,
directors and officers and other insurance coverages that management
considers cost-effective and reasonable and adequate for the protection
of the Company's assets, operations and employees. There can be no
assurance, however, that the coverage limits of such policies will be
adequate. A successful claim against the Company in excess of its
insurance coverage or several claims for which the Company's
self-insurance components are significant in the aggregate could have a
material adverse effect on the Company.

F-23

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

Legal Proceedings

The Company is, and may be in the future, party to litigation arising
in the ordinary course of its business. While the Company has no reason
to believe that any such pending claims are material, there can be no
assurance that the Company's insurance coverages will be adequate to
substantially cover liabilities arising out of such claims or that any
such claims will be covered by the Company's insurance. Any material
claim which is not covered by insurance may have an adverse effect on
the Company's business. Claims against the Company, regardless of their
merit or outcome, may also have an adverse effect on the Company's
reputation and business.

In late 1999, the Company became aware that a civil qui tam lawsuit
brought under the Federal False Claims Act had been filed under seal
naming the Company's psychiatric contract management subsidiary,
Horizon Mental Health Management (Horizon), as one of the defendants
therein. In March 2001, the relators served the complaint in the
lawsuit. The U.S. Department of Justice had previously declined to
intervene in the lawsuit. The complaint alleges that certain on-site
Company personnel acted in concert with other non-Company personnel to
improperly inflate certain Medicare reimbursable costs associated with
psychiatric services rendered at a Tennessee hospital prior to August
1997. The lawsuit names the hospital, the parent corporation of the
hospital and a home health agency as additional defendants. A motion to
dismiss filed by the Company has recently denied by the court and the
parties have initiated discovery proceedings. The Company does not
believe the claims asserted in the lawsuit, based on present
allegations, represent a material liability to the Company.

In early December 2000, the Company was served with a U.S. Department
of Justice subpoena issued by the U.S. Attorney's Office for the
Northern District of California. The subpoena requested the production
of documents related to certain matters such as patient admissions,
patient care, patient charting, and marketing materials, pertaining to
hospital gero-psychiatric programs managed by the Company. The Company
furnished documents relating to one facility in response to the
subpoena in January 2001 and there has been no further activity in
relation to the subpoena since that time. On October 30, 2002, the
Company received a letter from the Civil Division of the U.S.
Department of Justice proposing a preliminary meeting to discuss
possible False Claim Act violations alleged in a sealed qui tam suit
and also to discuss the findings of the U.S. Department of Justice
after its review of certain records. The Company met with the U.S.
Department of Justice in December 2002 and furnished additional
information regarding what appear to be the allegations. The qui tam
suit remains under seal and the U.S. Government is still considering
whether or not it will intervene in the suit. The Company has not been
served with the suit. The allegations and the records reviewed relate
to the same matters that were the subject of the 2000 U.S. Department
of Justice subpoena. At this time, the Company cannot predict the
ultimate scope or any particular future outcome of the qui tam suit or
the investigation. Eventually allegations could be asserted against the
Company involving claims anywhere from minor to significant in amount.

14. SEGMENT INFORMATION

The Company has determined that its reportable segments are
appropriately based on its method of internal reporting which
disaggregates its business by services category in a manner consistent
with the Company's consolidated statements of income format. The
Company's reportable segments are Horizon Mental Health Management,
Specialty Rehab Management, ProCare One Nurses and Horizon Behavioral
Services. During the fiscal year ended August 31, 2003, the Company
discontinued reporting its smallest segment Mental Health Outcomes as a
separate business segment due to its downsizing and integration into
Horizon Mental Health Management as a product line and accordingly has
restated all previous periods shown. See notes (A) through (D) below
for a description of the services provided by each of the identified
segments. The Company's business is conducted solely in the United
States.

F-24

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

The following schedule represents revenues and operating results for
the twelve months ended August 31 by operating division/segment:

(A) Horizon Mental Health Management provides mental health contract
management services to general acute care hospitals.

(B) Specialty Rehab Management provides physical rehabilitation contract
management services to general acute care hospitals.

(C) ProCare One Nurses provides specialized temporary nurse staffing
services to hospitals primarily in California and Michigan.

(D) Horizon Behavioral Services provides managed behavioral care and
employee assistance programs.

(E) "Other" represents revenue and expenses associated with residual Phase
IV PsychScope agreements and the Company's primary general and
administrative costs, i.e., expenses associated with the corporate
offices and National Support Center located in the Dallas suburb of
Lewisville, Texas which provides management, financial, human
resources, and information system support for the Company and its
subsidiaries.

(F) EBITDA is a presentation of "earnings before interest, taxes,
depreciation, and amortization." EBITDA is the unit of measure reviewed
by the chief operating decision makers in determining segment operating
performance. EBITDA may not be comparable to similarly titled measures
reported by other companies. In addition, EBITDA is a non-GAAP measure
and should not be considered an alternative to operating or net income
in measuring company results. For the year ended August 31, 2003, 2002
and 2001, consolidated EBITDA is derived by adding depreciation and
amortization of $2,581,245, $2,778,445, and $4,510,424, respectively,
to the Company's operating income for the same periods of $15,927,296,
$14,668,370, and $11,690,823, respectively. Consolidated cash flows
from operating, investing, and financing activities for the period
ended August 31, 2003 were $12,832,667, ($12,371,411) and ($2,524,167),
respectively, for the period ended August 31, 2002 were $13,954,316,
($15,810,351), and $3,910,960, respectively, and for the period ended
August 31, 2001 were $11,983,986, ($4,960,910), and ($13,559,310),
respectively, and are represented on the Statement of Cash Flows
elsewhere herein.

F-25

HORIZON HEALTH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

15. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

The following is a summary of unaudited quarterly financial data for
fiscal 2003 and 2002:

*Amounts may not add due to rounding or independent calculation.

F-26

INDEX TO FINANCIAL STATEMENT SCHEDULE

Schedule II Valuation and Qualifying Accounts.................S-2

S-1

HORIZON HEALTH CORPORATION

SCHEDULE II: VALUATION AND QUALIFYING ACCOUNTS

* Excludes additions charged (recoveries credited) of $74,626, $324,011
and $383,041 related to other receivables for the fiscal years ending
2003, 2002, and 2001.

S-2

INDEX TO EXHIBITS

10.7 - Horizon Mental Health Management, Inc. 1995 Stock Option
Plan as amended (incorporated herein by reference to
Exhibit 10.9 to the Company's Annual Report on Form 10-K
for the fiscal year ended August 31, 2002).

10.8 - Horizon Mental Health Management, Inc. Amended and
Restated 1995 Stock Option Plan for Eligible Outside
Directors as amended (incorporated herein by reference to
Exhibit 10.10 to the Company's Annual Report on Form 10-K
for the fiscal year ended August 31, 2002).

10.9 - Horizon Health Corporation 1998 Stock Option Plan as
amended (incorporated herein by reference to Exhibit 10.11
to the Company's Annual Report on Form 10-K for the fiscal
year ended August 31, 2002).

10.10 - Horizon Health Corporation Employee Stock Purchase Plan
(incorporated herein by reference to Exhibit 4.3 to the
Company's Registration Statement on Form S-8 filed with
the Commission on November 30, 1999, Registration No.
333-91761).

10.11 - Horizon Health Corporation Bonus Plan Fiscal 2003
(incorporated herein by reference to Exhibit 10.14 to the
Company's Annual Report on Form 10-K for the fiscal year
ended August 31, 2002).

10.12 - Horizon Health Corporation Bonus Plan Fiscal 2004 (filed
herewith).

10.13 - Executive Retention Agreement effective May 1,2003 between
the Company and James Ken Newman (incorporated herein by
reference to Exhibit 10.1 to the Company's Quarterly
Report on Form 10-Q for the quarter ended May 31, 2003).

10.14 - Agreement dated August 31, 1999 between Horizon Health
Corporation, Inc. and Ronald C. Drabik regarding severance
arrangements (incorporated herein by reference to exhibit
10.1 to the Company's Annual Report on Form 10-K for the
fiscal year ended August 31, 1999).

10.15 - Member Interests Purchase Agreement, dated June 13, 2002,
between Horizon Health Corporation, as buyer, and Lara
Mac, Steve MacEachern, Vicki Lotz and Obstetrical Nurses,
Inc. as sellers (Incorporated by reference to Exhibit 10.1
to the Company's Current Report on Form 8-K dated June 13,
2002).

11 - Statement Regarding Computation of Per Share Earnings
(filed herewith).

21 - List of Subsidiaries of the Company (filed herewith).

23 - Consent of PricewaterhouseCoopers LLP (filed herewith).

31.1 - Certification of Chief Executive Officer required by
Securities and Exchange Commission Rule 13a-14(a) or
15d-14(a).

31.2 - Certification of Chief Financial Officer required by
Securities and Exchange Commission Rule 13a-14(a) or
15d-14(a).

32 - Certification of Chief Executive Officer and Chief
Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.