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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission File Number: 0-20135

AMERICA SERVICE GROUP INC.

(615) 373-3100
(Registrant’s telephone number, including area code)

      Indicate by check mark whether the registrant (1) has filed all reports required to be filed under 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 þ No o

      Indicate by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Act. Yes o No þ

      There were 6,692,840 shares of Common Stock outstanding as of November 12, 2003.

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AMERICA SERVICE GROUP INC.

QUARTERLY REPORT ON FORM 10-Q
INDEX

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PART I:

FINANCIAL INFORMATION

ITEM 1. — FINANCIAL STATEMENTS

AMERICA SERVICE GROUP INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

The accompanying notes to condensed consolidated financial statements
are an integral part of these balance sheets. The condensed consolidated balance sheet at
December 31, 2002 is taken from the audited financial statements at that date.

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AMERICA SERVICE GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

The accompanying notes to condensed consolidated financial statements are an
integral part of these statements.

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AMERICA SERVICE GROUP INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

The accompanying notes to condensed consolidated financial statements are an
integral part of these statements.

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AMERICA SERVICE GROUP INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2003
(dollar amounts shown in 000’s except per share amounts)
(unaudited)

1. Basis of Presentation

      The interim condensed consolidated financial statements of America Service Group Inc. and its consolidated subsidiaries (the “Company”) as of September 30, 2003 and for the quarters and nine month periods ended September 30, 2003 and 2002 are unaudited, but in the opinion of management, have been prepared in conformity with accounting principles generally accepted in the United States applied on a basis consistent with those of the annual audited consolidated financial statements. Such interim condensed consolidated financial statements reflect all adjustments (consisting of normal recurring accruals) necessary for a fair presentation of the financial position and the results of operations for the quarters and nine month periods presented. The results of operations for the quarters and nine month periods presented are not necessarily indicative of the results to be expected for the year ending December 31, 2003. The interim condensed consolidated financial statements should be read in connection with the audited consolidated financial statements for the year ended December 31, 2002.

2. Description of Business

      The Company provides managed healthcare services to correctional facilities under capitated contracts (with certain adjustments) with state and local governments and certain private entities. The health status of inmates may impact results of operations under such contractual arrangements.

3. Recently Issued Accounting Pronouncements

      In August 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 supercedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of and resolves significant implementation issues that had evolved since the issuance of SFAS No. 121. SFAS No. 144 established a single accounting model for long-lived assets to be disposed of by sale or abandonment. Additionally, SFAS No. 144 expanded the scope of financial accounting and reporting of discontinued operations to require that all components of an entity that have either been disposed of (by sale, by abandonment, or in a distribution to owners) or are held for sale and whose operations and cash flows can be clearly distinguished, operationally and for financial reporting purposes from the rest of the entity, should be presented as discontinued operations. SFAS No. 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001. The provisions for presenting the components of an entity as discontinued operations are effective only for disposal activities after the effective date of SFAS No. 144. The Company adopted the provisions of SFAS No. 144 effective January 1, 2002. Pursuant to SFAS No. 144, each of the Company’s contracts is a component of the entity, whose operations can be distinguished from the rest of the Company. Therefore, when a contract terminates, by expiration or otherwise, the contract’s operations generally will be eliminated from the continuing operations of the Company. Accordingly, the operations of such contracts, net of applicable income taxes, have been presented as discontinued operations and prior period Consolidated Statements of Operations have been reclassified. See Note 5 for a further discussion of discontinued operations.

      In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”), which requires the consolidation of certain variable interest entities, as defined by FIN 46. FIN 46 requires an assessment of contractual arrangements to determine if they represent interests in variable interest entities. Variable interest entities created prior to February 1, 2003, will be subject to the consolidation provisions of FIN 46 in fiscal periods ending after December 15, 2003. Variable interest entities created subsequent to February 1, 2003 are subject to the consolidation provisions currently. Additionally, disclosures are required currently if the Company expects to consolidate any variable interest entities in the future. The Company continues to evaluate the consolidation requirements of FIN 46 with respect to variable interest entities created prior to February 1, 2003.

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4. Stock Options

      The Company has elected to follow Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees and related Interpretations in accounting for its employee stock options. Under APB No. 25, compensation expense is generally recognized as the difference between the exercise price of the Company’s employee stock options and the market price of the underlying stock on the date of grant.

      Pro forma information regarding net income and earnings per share is required by SFAS No. 123, Accounting for Stock-Based Compensation, which also requires that the information be determined as if the Company has accounted for its employee stock options granted subsequent to December 31, 1994 under the fair value method of that Statement. The fair value of options issued during 2003 and 2002 was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions:

      The following table illustrates the effect on net income per common share as if the Company had applied the fair value recognition provisions of SFAS 123 for each of the quarters and nine month periods ended September 30, 2003 and 2002:

      The resulting pro forma disclosures may not be representative of that to be expected in future years. The weighted average fair value of options granted during the nine month periods ended September 30, 2003 and 2002 as determined under the fair value provisions of SFAS No. 123, is $9.33 and $6.10, respectively. No options were issued during the quarters ended September 30, 2003 and 2002. The above pro forma adjustments do not include any offsetting income tax benefits due to the Company’s use of a tax valuation allowance during the periods presented.

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5. Discontinued Operations

      Pursuant to the provisions of SFAS No. 144 and as previously described in Note 3, the Company has classified contracts that expired subsequent to January 1, 2002, the effective date of SFAS No. 144, as discontinued operations. The components of income (loss) from discontinued operations, net of taxes, are as follows:

6. Prepaid Expenses and Other Current Assets

      Prepaid expenses and other current assets are comprised of the following:

7. Property and Equipment

      Property and equipment are stated at cost and comprised of the following:

      Depreciation expense for the quarters ended September 30, 2003 and 2002 was $589 and $682, respectively. Depreciation expense for the nine months ended September 30, 2003 and 2002 was $1,851 and $2,067, respectively.

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8. Contracts and Other Intangible Assets

      The gross and net values of contracts and other intangible assets consist of the following:

      Estimated aggregate amortization expense related to the above intangibles for the remainder of 2003 is $456 and for each of the next four years is $1,827.

9. Accounts Payable and Accrued Expenses

      Accounts payable consist of the following:

      The noncurrent portion of accounts payable consists of $2,381 payable to Health Cost Solutions, Inc., (see Note 10) and $16 of other noncurrent trade payables.

      Accrued expenses consist of the following:

10. Reserve for Loss Contracts

      On a quarterly basis, the Company performs a review of its portfolio of contracts for the purpose of identifying loss contracts and developing a contract loss reserve for succeeding periods. As a result of its 2001 review, the Company identified five non-cancelable contracts that, based upon management’s projections, were expected to continue to incur negative gross margins over their remaining terms. In December 2001, the Company recorded a charge of $18.3 million to establish a reserve for future losses under these non-cancelable contracts. The five contracts covered by the charge had expiration dates ranging from June 30, 2002 through June 30, 2005. Ninety percent of the charge related to the State of Kansas Department of Corrections (the “Kansas DOC”) contract, which was to expire on June 30, 2005, and the City of Philadelphia contract, which was renewable annually, at the client’s option, through June 30, 2004.

      In June 2002, the Company and the City of Philadelphia reached a mutual agreement that the contract between the Company’s subsidiary and the City of Philadelphia would expire effective June 30, 2002. As a result of the

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earlier than anticipated expiration of this loss contract, the Company recorded a gain of $3,320, in the second quarter of 2002, to reduce its reserve for loss contracts. From July 1, 2002 to September 30, 2002, the Company provided services to the City of Philadelphia under a transition arrangement. On September 30, 2002, the Company and the City of Philadelphia entered into a new contract amendment under which the Company is continuing to provide healthcare services to the City of Philadelphia under modified contract terms.

      During the second quarter of 2003, the Company experienced a significant increase in healthcare expenses associated with its contract to provide healthcare service to the Kansas DOC. As a result of this negative trend, in June 2003, the Company recorded a charge of $4,500 to increase its reserve for future losses under its contract with the Kansas DOC which was to expire June 30, 2005.

      On August 22, 2003, the Company entered into an assignment and novation agreement with the Kansas DOC to assign the Kansas DOC contract to HCS effective October 1, 2003. The Company also entered into a general assignment, novation and assumption agreement with Health Cost Solutions, Inc. (“HCS”) to transfer the Kansas DOC contract to HCS, effective October 1, 2003. Beginning October 1, 2003, HCS became solely responsible for the performance of the Kansas DOC contract, and the Company has no obligation to the Kansas DOC or to HCS related to HCS’ performance of the contract. Under the terms of the Company’s agreement with HCS, the Company will pay HCS net consideration of $5,632 in 21 monthly installments, commencing October 31, 2003, and continuing through June 30, 2005. The net consideration of $5,632 is comprised of payments of $6,500 to assume the Company’s obligations under the Kansas DOC contract, less $868 related to fixed assets and inventory purchased from the Company by HCS.

      As a result of the financial terms of the Company’s agreement with HCS, the Company has reclassified $6,500 of its reserve for loss contracts to accounts payable on the Company’s consolidated balance sheet. The Company has also recorded a gain of $1,714, in the third quarter of 2003, to reduce its reserve for loss contracts. This reduction in the reserve, as well as the second quarter increase in the reserve of $4,500, are reflected as components of income (loss) from discontinued operations, net of tax, in the Company’s statements of operations.

      As of September 30, 2003, the Company had a loss contract reserve totaling $876, which relates to a county contract which expires on June 30, 2005. Negative gross margin and overhead costs charged against the loss contract reserve related to loss contracts, including contracts classified as discontinued operations, totaled $1,485 and $1,204 for the quarters ended September 30, 2003 and 2002, respectively. Negative gross margin and overhead costs charged against the loss contract reserve related to loss contracts, including contracts classified as discontinued operations, totaled $4,397 and $5,189 for the nine month period ended September 30, 2003 and 2002, respectively. The amounts charged against the loss contract reserve during 2002 represented losses associated with all five of the contracts that were identified during 2001. The amounts charged against the loss contract reserve during 2003 relate only to the Kansas DOC contract discussed above and the remaining loss contract, a county contract, which expires on June 30, 2005.

      There is a potential that in the course of performing its quarterly review in future periods, the Company might identify additional contracts which have become loss contracts due to a change in circumstances. Circumstances that might change and result in the identification of a contract as a loss contract in a future period include unanticipated adverse changes in the healthcare cost structure or the utilization of outside medical services in a contract where such changes are not offset by increased revenue. Should a contract be identified as a loss contract in a future period, the Company would record, in the period in which such identification is made, a reserve for the estimated future losses that would be incurred under the contract. Such a reserve could have a material adverse effect on the Company’s results of operations in the period in which it is recorded.

11. Banking Arrangements

      On October 31, 2002, the Company entered into a new credit facility with CapitalSource Finance LLC (the “CapitalSource Credit Facility”). The CapitalSource Credit Facility matures on October 31, 2005 and includes both a $55,000 revolving credit facility (the “Revolver”) and a $5,000 term loan (the “Term Loan”). Proceeds from the CapitalSource Credit Facility were used to repay the borrowings outstanding pursuant to the Company’s previously existing revolving credit facility (the “Prior Credit Facility”), at which time the Company wrote off approximately $726 of deferred loan costs related to the Prior Credit Facility.

      The CapitalSource Credit Facility is secured by substantially all assets of the Company and its operating subsidiaries. At September 30, 2003, the Company had borrowings outstanding under the CapitalSource Credit Facility totaling $24,191 and $19,145 available for additional borrowing, based on the Company’s collateral base on that date and outstanding standby letters of credit.

      In June 2003, the Company and CapitalSource Finance LLC entered into an amendment to the CapitalSource Credit Facility. Under the terms of the amendment, the Company may have standby letters of credit issued under the loan agreement in amounts up to $10,000. The amount available to the Company for borrowings under the

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CapitalSource Credit Facility is reduced by the amount of each outstanding standby letter of credit. At September 30, 2003, the Company had outstanding standby letters of credit totaling $4,000, which were used to collateralize performance bonds. Prior to this amendment, the performance bonds were collateralized by restricted cash. As a result of this amendment, the Company is no longer required to maintain the restricted cash balances that were previously used as collateral for the performance bonds.

      Borrowings under the Revolver are limited to the lesser of (1) 85% of eligible receivables (as defined) or (2) $55,000 (the “Revolver Capacity”). Interest under the Revolver is payable monthly at the greater of 5.75% or the Citibank N.A. prime rate plus 1.0%. The Company is also required to pay a monthly collateral management fee, equal to an annual rate of 1.38%, on average borrowings outstanding under the Revolver. Additionally, the Company is required to pay a monthly letter of credit fee equal to an annual rate of 3.5% on the outstanding balance of letters of credit issued pursuant to the Revolver.

      Under the terms of the CapitalSource Credit Facility, the Company is required to pay a monthly unused line fee equal to an annual rate of 0.6% on the Revolver Capacity less the actual average borrowings outstanding under the Revolver for the month and the balance of any outstanding letters of credit.

      All amounts outstanding under the Revolver will be due and payable on October 31, 2005. If the Revolver is extinguished prior to July 1, 2005, the Company will be required to pay an early termination fee equal to 1.0% of the Revolver Capacity. In connection with the Revolver, the CapitalSource Credit Facility requires a lockbox agreement, which provides for all cash receipts to be swept daily to reduce borrowings outstanding. This agreement, combined with the existence of a Material Adverse Effect (“MAE”) clause in the Capital Source Credit Facility, requires the Revolver to be classified as a current liability, in accordance with the Financial Accounting Standards Board’s Emerging Issues Task Force Issue No. 95-22, Balance Sheet Classification of Borrowings Outstanding under Revolving Credit Agreements that Include Both a Subjective Acceleration Clause and a Lock-Box Arrangement. The MAE clause, which is a typical requirement in commercial credit agreements, allows the lender to require the loan to become due if the lender determines there has been a material adverse effect on the Company’s operations, business, properties, assets, liabilities, condition or prospects. The classification of the Revolver as a current liability is a result only of the combination of the two aforementioned factors: the lockbox agreements and the MAE clause. The Revolver does not expire or have a maturity date within one year. As discussed above, the Revolver has a final expiration date of October 31, 2005.

      The Term Loan requires monthly principal payments of $139 through its maturity on October 31, 2005. Interest under the Term Loan is payable monthly at the greater of 8.5% or the Citibank, N.A. prime rate plus 3.5%. Upon expiration of the Term Loan, the Company will be required to pay a fee of $100.

      The CapitalSource Credit Facility requires the Company to meet certain financial covenants related to minimum levels of earnings. At September 30, 2003, the Company was in compliance with the covenants. The CapitalSource Credit Facility also contains restrictions on the Company with respect to certain types of transactions including acquisition of the Company’s own stock, payment of dividends, indebtedness and sales or transfers of assets.

      The Company is dependent on the availability of borrowings pursuant to the CapitalSource Credit Facility to meet its working capital needs, capital expenditure requirements and other cash flow requirements during 2003 and 2004. Management believes that the Company can comply with the terms of the CapitalSource Credit Facility and meet its expected obligations throughout 2003 and 2004. However, should the Company fail to meet its projected results, it may be forced to seek additional sources of financing in order to fund its working capital needs.

12. Professional and General Liability Insurance

      The Company records a liability for reported and unreported professional and general liability claims based upon an actuarial estimate of the cost of settling losses and loss adjustment expenses. Amounts accrued were $7,782 and $8,924 at September 30, 2003 and December 31, 2002, respectively, and are included in accrued expenses and non-current portion of accrued expenses. Changes in estimates of losses resulting from the continuous review process and differences between estimates and actual loss payments are recognized in the period in which the estimates are changed or payments are made. Reserves for professional liability exposures are subject to fluctuations in frequency

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and severity. Given the inherent degree of variability in any such estimates, the reserves reported at September 30, 2003 represent management’s best estimate of the amounts necessary to discharge the Company’s obligations.

13. Commitments and Contingencies

Catastrophic Limits

      Many of the Company’s contracts require the Company’s customers to reimburse the Company for all treatment costs or, in some cases, only out-of-pocket treatment costs related to certain catastrophic events, and/or for AIDS or AIDS-related illnesses. Certain contracts do not contain such limits. The Company attempts to compensate for the increased financial risk when pricing contracts that do not contain individual, catastrophic or specific disease diagnosis-related limits. However, the occurrence of severe individual cases, AIDS-related illnesses or a catastrophic event in a facility governed by a contract without such limitations could render the contract unprofitable and could have a material adverse effect on the Company’s operations. For contracts that do not contain catastrophic protection, the Company maintains insurance from an unaffiliated insurer for annual hospitalization amounts in excess of $500 per inmate up to an annual per inmate cap of $2,000. The Company believes this insurance significantly mitigates its exposure to unanticipated expenses of catastrophic hospitalization. Catastrophic insurance premiums and recoveries, neither of which is significant, are included in healthcare expenses. Receivables for insurance recoveries, which are not significant, are included in accounts receivable.

Litigation and Claims

      The Company was successful on its appeal of a summary judgment granted against it on an indemnification claim by the insurer of a client. The case has been remanded to the lower court in accordance with the appelate opinion as discussed below. In December 1995, the Florida Association of Counties Trust (“FACT”), as the insurer for the Polk County Sheriff’s Office, and the Sheriff of Polk County, Florida, brought an action against Prison Health Services, Inc. (a wholly owned subsidiary of the Company and “PHS”) in the Circuit Court, 10th Judicial Circuit, Polk County, Florida seeking indemnification for $1,000 paid on behalf of the plaintiffs for settlement of a lawsuit brought against the Sheriff’s Office. The recovery is sought for amounts paid in settlement of a wrongful death claim brought by the estate of an inmate who died as a result of injuries sustained from a beating from several corrections officers employed by the Sheriff’s Office. The plaintiffs contend that an indemnification provision in the contract between PHS and the Sheriff’s Office obligates the Company to indemnify the Sheriff’s Office against losses caused by its own wrongful acts. The Company was represented by counsel provided by Reliance Insurance Company (“Reliance”), the Company’s insurer. In April 2001, FACT’s motion for summary judgment on the question of liability for indemnity was denied, but on rehearing in July 2001 the prior denial was reversed and summary judgment was granted. In October 2001, Reliance filed for receivership. In January 2002, the court entered final judgment in favor of FACT for approximately $1,700 at a hearing at which the Company was not represented, as counsel provided by Reliance had simultaneously filed a motion to withdraw. The Company retained new counsel in February 2002 and obtained a reversal of the summary judgment motion on October 31, 2003. The Company expects to be able to apply for release of its appeal bond in the amount of $2,035, which has been classified as a deposit and included in prepaid expenses and other current assets on its Consolidated Balance Sheets. As of September 30, 2003, the Company has reserved $461 related to costs associated with this proceeding. The case has been remanded to the trial court to determine if the actions of the officers, for which some of them were indicted and convicted, were intentional and whether the claims for which indemnity was sought arose out of the provision of medical services and not the actions of the officers. In addition, the Sheriff’s Office released the Company from liability for this claim subsequent to filing the lawsuit. The Company believes it will be successful at the trial court level. In the event that the Company is not successful at the trial court level, an adverse judgment could have a material adverse effect on the Company’s financial position and its quarterly or annual results of operations.

      In addition to the matter discussed above, the Company is a party to various legal proceedings incidental to its business. Certain claims, suits and complaints arising in the ordinary course of business have been filed or are pending against the Company. An estimate of the amounts payable on existing claims for which the liability of the Company is probable is included in accrued expenses at September 30, 2003 and December 31, 2002. The Company is not aware of any material unasserted claims and, based on its past experience, would not anticipate that potential future claims would have a material adverse effect on its consolidated financial position or results of operations.

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Performance Bonds

      The Company is required under certain contracts to provide performance bonds. At September 30, 2003, the Company has outstanding performance bonds totaling approximately $33,475. These performance bonds are collateralized by standby letters of credit totaling $4,000 (see Note 11).

14. Net Income Per Share

      Net income per share is measured at two levels: basic income per share and diluted income per share. Basic income per share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted income per share is computed by dividing net income by the weighted average number of common shares outstanding after considering the additional dilution related to other dilutive securities. The Company’s other dilutive securities outstanding consist of warrants and options to purchase shares of the Company’s common stock. The table below sets forth the computation of basic and diluted earnings per share as required by SFAS No. 128, Earnings Per Share, for the quarters and nine month periods ended September 30, 2003 and 2002.