FORM 10-K

(Mark One)

Commission file number 1-12996

Registrant’s telephone number, including area code: (615) 771-7575

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

None.

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

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 the 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. [X]

Indicate by check mark whether the registrant is an accelerated filer as defined in Exchange Act Rule 12b-2. Yes [   ] No [X].

The aggregate market value of Common Stock held by non-affiliates on June 30, 2003 (based on the closing price of such shares on the NASD OTC Market) was $355,829. For purposes of the foregoing calculation only, all directors, named executive officers and persons known to the Registrant to be holders of 5% or more of the Registrant’s Common Stock have been deemed affiliates of the Registrant.

On March 15, 2004, 5,608,287 shares of the registrant’s $0.01 par value Common Stock were outstanding.

Documents Incorporated by Reference:

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The following documents are incorporated by reference into Part I, Item 5 and Part III, Items 10, 11, 12, 13 and 14 of this Form 10-K: The Registrant’s definitive proxy materials for its 2004 annual meeting of stockholders.

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Table of Contents

PART I

ITEM 1. BUSINESS

Introductory Summary.

Advocat Inc. (together with its subsidiaries, “Advocat” or the “Company”) provides long-term care services to nursing home patients and residents of assisted living facilities in nine states, primarily in the Southeast, and three Canadian provinces.

The Company’s objective is to become the provider of choice of health care and related services to the elderly in the communities in which it operates. Advocat will continue to implement its operating strategy of (i) providing a broad range of cost-effective elder care services; (ii) increasing occupancy in its nursing homes and assisted living facilities through an increased emphasis on attracting and retaining patients and residents; and (iii) clustering its operations on a regional basis. Key elements of the Company’s growth strategy are to increase revenue and profitability at existing facilities and pursue additional management contract opportunities. The Company’s financial position significantly limits its strategic opportunities to non-capital intensive opportunities.

The Company’s principal executive offices are located at 277 Mallory Station Road, Suite 130, Franklin, Tennessee 37067. The Company’s telephone number at that address is (615) 771-7575, and its facsimile number is (615) 771-7409. The Company’s web-site is located at www.irinfo.com/AVC. The information on the Company’s web-site does not constitute part of this Annual Report on Form 10-K.

Material Corporate Developments and Risk Factors.

There have been a number of material developments both within the Company and the long-term care industry. These developments have had and are likely to continue to have a material impact on the Company. This section summarizes these developments, as well as other risks, that should be considered by stockholders and prospective investors in the Company.

Self-Insured Professional Liability Exposure

The entire long-term care profession in the United States has experienced a dramatic increase in claims related to alleged negligence and malpractice in providing care to its patients and the Company is no exception in this regard. The Company has numerous pending liability claims, disputes and legal actions for professional liability and other related issues. The Company has limited, and sometimes no, professional liability insurance with respect to many of these claims. In the event a significant judgment is entered against the Company in one or more of these legal actions in which there is no or insufficient professional liability insurance, the Company does not anticipate that it will have the ability to pay such a judgment or judgments. See “Item 1. Business – Insurance.” for a more detailed discussion of the Company’s professional liability insurance. See “Item 3. Legal Proceedings.” for further descriptions of pending claims, and see

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“Item 7. Management’s Discussion and Analysis of Financial Condition – Liquidity and Capital Resources.” for discussion of the Company’s ability to meet its anticipated cash needs.

In addition, due to the Company’s past claims experience and increasing cost of claims throughout the long-term care industry, the premiums paid by the Company for professional liability and other liability insurance exceeds the coverage purchased so that it costs more than $1 to purchase $1 of insurance coverage. For this reason, effective March 9, 2002, the Company has purchased professional liability insurance coverage for its United States nursing homes and assisted living facilities that, based on historical claims experience, is likely to be substantially less than the claims that are expected to be incurred. As a result, the Company is effectively self-insured and expects to remain so for the foreseeable future. See “Item 1. Business – Insurance.”

Operating Losses

The Company has incurred operating losses during each of the three years in the period ended December 31, 2003 and has limited resources available to meet its operating, capital expenditure and debt service requirements during 2004. The Company has a working capital deficit of $53.3 million as of December 31, 2003. No assurance can be given that the Company will achieve profitable operations during 2004.

The Company cannot assure that existing cash or cash flows generated from operations or other sources will be sufficient to fund existing debt obligations, any judgments that may be entered against the Company in litigation or future capital and working capital requirements through fiscal year 2004. At a minimum, the Company’s cash requirements during 2004 include funding operations (including potential payments related to professional liability claims), capital expenditures, scheduled debt service, and working capital requirements. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Financial Resources.”

Fluctuations in Earnings or Losses

In the fourth quarter of 2003, the Company reported income from continuing operations of $1.9 million, primarily as a result of a non-cash expense reduction of $5.8 million resulting from a downward adjustment in the Company’s accrual for self-insured risks associated with the settlement of certain professional liability claims. While this adjustment to the accrual resulted in reported income, it did not generate cash because the accrual is not funded by the Company. As of December 31, 2003, the Company has reported a liability of $47.2 million, including reported professional liability claims and estimates for incurred but unreported claims. The Company does not have cash or available resources to pay these accrued professional liability claims or any significant portion thereof. These self-insurance reserves are assessed on a quarterly basis, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified. Any increase in the accrual decreases income in the period, and any reduction in the accrual increases income during the period. Although the Company retains a third-party actuarial firm to assist management in estimating the appropriate accrual for these claims, professional liability claims are inherently uncertain, and the liability associated with anticipated claims is very difficult to estimate. As a result, the Company’s actual liabilities may

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vary significantly from the accrual, and the amount of the accrual may fluctuate by a material amount in any given quarter. Each change in the amount of this accrual will directly affect the Company’s reported earnings for the period in which the change in accrual is made.

Current Debt Maturities and Financial Covenant Non-Compliance

The Company has $42.5 million of scheduled debt maturities in 2004. In addition, certain of the Company’s debt agreements contain various financial covenants, the most restrictive of which relate to current ratio requirements, tangible net worth, cash flow, net income (loss), required insurance coverage and limits on the payment of dividends to shareholders. As of December 31, 2003, the Company was not in compliance with certain of these financial covenants. The Company has not obtained waivers of the non-compliance. Cross-default or material adverse change provisions contained in the debt agreements allow the holders of substantially all of the Company’s debt to demand immediate repayment. The Company would not be able to repay this indebtedness if the applicable lenders demanded repayment. Although the Company does not anticipate that such demands will be made, the continued forbearance on the part of the Company’s lenders cannot be assured at this time. Given that events of default exist under the Company’s working capital line of credit, there can be no assurance that the lender will continue to provide working capital advances. Any demands for repayment by lenders or the inability to obtain waivers or refinance the related debt would have a material adverse impact on the financial position, results of operations and cash flows of the Company. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Financial Resources.”

Cross-Defaults Under Debt, Leases and Management Agreements.

As noted above, as of December 31, 2003, the Company was not in compliance with certain of its debt covenants. An event of default under the Company’s debt agreements could lead to actions by the lenders that could result in an event of default under the Company’s lease agreements covering a majority of its United States nursing facilities. In addition, the Company has obtained professional liability insurance coverage for its United States nursing homes that is less than amounts required in the Omega Master Lease. The Company has not obtained waivers of the non-compliance. The Master Lease provides that a default with respect to one facility is a default with respect to the entire Master Lease. The Company also leases eight facilities and manages nine facilities owned by Counsel Corporation or its affiliates. A default under any one of these agreements constitutes a default under all of the leases and management agreements with Counsel Corporation. Finally, three management contracts that cover two, four and seven nursing homes, respectively, provide that a default with respect to any facility under any one of the management contracts is a default with respect to all facilities under such management contracts. In addition, certain of the Company’s debt agreements provide that a default under any of the Company’s leases or management agreements constitutes a default under the debt agreements. Should such a default occur in the related lease agreements, the lessor would have the right to terminate the lease agreements.

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Health Care Industry

The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse (collectively the “Health Care Laws”). Changes in these laws and regulations, such as reimbursement policies of Medicare and Medicaid programs as a result of budget cuts by federal and state governments or other legislative and regulatory actions, have had a material adverse effect on the profession and the Company’s consolidated financial position, results of operations, and cash flows. Future federal budget legislation and federal and state regulatory changes may negatively impact the Company. See “Item 1. Business – Government Regulation and Reimbursement.”

Dependence on Reimbursement by Third-Party Payors.

Substantially all of the Company’s nursing home revenues are directly or indirectly dependent upon reimbursement from third-party payors, including the Medicare and Medicaid programs, and private insurers. For the year ended December 31, 2003, the Company’s patient and resident revenues from continuing operations derived from Medicaid, Medicare and private pay sources were approximately 63.0%, 24.6%, and 12.4%, respectively.. Changes in the mix of the Company’s patients among Medicare, Medicaid and private pay categories and among different types of private pay sources may affect the Company’s net revenues and profitability. The net revenues and profitability of the Company are also affected by the continuing efforts of all payors to contain or reduce the costs of health care. Efforts to impose reduced payments, greater discounts and more stringent cost controls by government and other payors are expected to continue.

Under the current law, Medicare reimbursements for nursing facilities were reduced following the October 1, 2002 expiration of two temporary payment increases enacted as part of earlier Medicare enhancement bills. There are two additional payment increases that were originally scheduled to expire October 1, 2002. In August 2003, the Centers for Medicare & Medicaid Services (“CMS”) announced that the expiration of these payment increases has been postponed until at least October 1, 2004. However, President Bush’s proposed fiscal year 2005 budget indicates that the refinements will not be implemented before September 30, 2005. The August 2003 CMS rule also included an inflation update and a correction of past forecast errors that together increase the fiscal year 2004 skilled nursing facility PPS base rates by a total of 6.26%.

A number of state governments, including several of the Company’s operating states, have announced projected budget shortfalls and/or deficit spending situations. Possible actions by these states include reductions of Medicaid reimbursement to providers such as the Company or the failure to increase Medicaid reimbursements to cover increased operating costs.

Any changes in reimbursement levels or in the timing of payments under Medicare, Medicaid or private pay programs and any changes in applicable government regulations could have a material adverse effect on the Company’s net revenues and net income. The Company is unable

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to predict what reform proposals or reimbursement limitations will be adopted in the future or the effect such changes will have on its operations. No assurance can be given that such reforms will not have a material adverse effect on the Company. See “Item 1. Business – Government Regulation and Reimbursement.”

Government Regulation.

The United States government, the Canadian government, and all states and provinces in which the Company operates regulate various aspects of its business. Various federal, state and provincial laws regulate relationships among providers of services, including employment or service contracts and investment relationships. The operation of long-term care facilities and the provision of services are also subject to extensive federal, state, provincial and local laws relating to, among other things, the adequacy of medical care, distribution of pharmaceuticals, equipment, personnel, operating policies, environmental compliance, compliance with the Americans with Disabilities Act, fire prevention and compliance with building codes. A recent fire at a skilled nursing facility in Tennessee with which the Company had no connection has caused legislators and others to focus on existing fire codes. In some instances these codes do not require that sprinklers be installed in all nursing facilities. Certain of the Company’s facilities do not have sprinkler systems. The Company believes that these facilities comply with existing fire codes. While the Company works to comply with all applicable codes and to ensure that all mechanical systems are working properly, a fire or a failure of such systems at one or more of the Company’s facilities, or changes in applicable safety codes or in the requirements for such systems, could have a material adverse impact on the Company.

Long-term care facilities are also subject to periodic inspection to assure continued compliance with various standards and licensing requirements under state law, as well as with Medicare and Medicaid conditions of participation. The failure to obtain or renew any required regulatory approvals or licenses could adversely affect the Company’s growth and could prevent it from offering its existing or additional services. In addition, health care is an area of extensive and frequent regulatory change. Changes in the laws or new interpretations of existing laws can have a significant effect on methods and costs of doing business and amounts of payments received from governmental and other payors. The Company’s operations could be adversely affected by, among other things, regulatory developments such as mandatory increases in the scope and quality of care to be afforded patients and revisions in licensing and certification standards. The Company at all times attempts to comply with all applicable laws; however, there can be no assurance that new legislation or administrative or judicial interpretation of existing laws or regulations will not have a material adverse effect on the Company’s operations or financial condition. See “Item 1. Business – Government Regulation and Reimbursement.”

Increased Regulatory Scrutiny.

The Office of Inspector General (“OIG”), the enforcement arm of the Medicare program, announced in its work plan for 2002 that it intended to increase scrutiny of nursing homes. Compliance review has focused on quality of care, medical necessity of mental health services, and documentation of therapy services, among other concerns. The OIG’s 2004 work plan indicates that quality and survey deficiencies will continue to be an investigative focus in 2004.

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The Company cannot predict the likelihood, scope or outcome of any such investigations on its facilities.

On August 5, 2002, the Company was served in a lawsuit filed by the State of Arkansas styled Arkansas v. Diversicare Leasing Corp. d/b/a Eureka Springs Nursing & Rehabilitation Center, et. al., case number 02-6822 in the Circuit Court of Pulaski County, Arkansas. The allegations against the Company include violations of the Arkansas Abuse of Adults Act and violation of the Arkansas Medicaid False Claims Act with respect to a resident of the Eureka Springs facility. This action is scheduled for trial on September 13, 2004. On February 18, 2004, the Company was served in six additional lawsuits filed by the State of Arkansas in the Circuit Court of Pulaski County, Arkansas. The six lawsuits involve fifteen patients at five nursing homes operated by the Company in Arkansas and also allege violations of the Arkansas Abuse of Adults Act and the Arkansas Medicaid False Claims Act. The six complaints, in the aggregate, seek actual damages totaling approximately $250,000 and fines and penalties in excess of $45 million. No trial date has been set in these six actions. However, the Company cannot currently predict with certainty the ultimate impact of the above cases on the Company’s financial condition, cash flows or results of operations. The Company intends to vigorously defend itself against the allegations in all of these lawsuits.

Self-Referral and Anti-Kickback Legislation.

The health care industry is highly regulated at the state, provincial and federal levels. In the United States, various state and federal laws regulate the relationships between providers of health care services, physicians, and other clinicians. These self-referral laws impose restrictions on physician referrals for designated health services to entities with which they have financial relationships. These laws also prohibit the offering, payment, solicitation or receipt of any form of remuneration in return for the referral of Medicare or state health care program patients or patient care opportunities for the purchase, lease or order of any item or service that is covered by the Medicare and Medicaid programs. To the extent that the Company, any facility with which it does business, or any of their owners or directors have a financial relationship with each other or with other health care entities providing services to long-term care patients, such relationships could be subject to increased scrutiny. There can be no assurance the Company’s operations will not be subject to review, scrutiny, penalties or enforcement actions under these laws, or that these laws will not change in the future. Violations of these laws may result in substantial civil or criminal penalties for individuals or entities, including large civil monetary penalties and exclusion from participation in the Medicare or Medicaid programs. Such exclusion or penalties, if applied to the Company, could have a material adverse effect on the profitability of the Company.

Liquidity.

During 1999, the New York Stock Exchange de-listed the Company’s Common Stock. Trading of the Company’s Common Stock is currently conducted on the over-the-counter market (“OTC”) or, on application by broker-dealers, in the NASD’s Electronic Bulletin Board using the Company’s current trading symbol, AVCA. As a result of the de-listing, the liquidity of the

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Company’s Common Stock and its price have been adversely affected, which may limit the Company’s ability to raise additional capital.

Competition.

The long-term care industry generally, and the nursing home and assisted living center businesses particularly, are highly competitive. The Company faces direct competition for the acquisition or management of facilities. In turn, its facilities face competition for employees, patients and residents. Some of the Company’s present and potential competitors are significantly larger and have or may obtain greater financial and marketing resources than those of the Company. Some hospitals that provide long-term care services are also a potential source of competition to the Company. In addition, the Company may encounter substantial competition from new market entrants. Consequently, there can be no assurance that the Company will not encounter increased competition in the future, which could limit its ability to attract patients or residents or expand its business, and could materially and adversely affect its business or decrease its market share.

Anti-takeover Considerations.

The Company is authorized to issue up to 400,000 shares of preferred stock, the rights of which may be fixed by the Board of Directors without shareholder approval. In November 2000, the Company issued 393,658 shares of the Company’s Series B Redeemable Convertible Preferred Stock to Omega Healthcare Investors, Inc. in connection with the Settlement and Restructuring Agreement. In March 1995, the Board of Directors approved the adoption of a Shareholder Rights Plan (the “Plan”). The Plan is intended to encourage potential acquirors to negotiate with the Company’s Board of Directors and to discourage coercive, discriminatory and unfair proposals. The Company’s stock incentive plans provide for the acceleration of the vesting of options in the event of certain changes in control (as defined in such plans). The Company’s Certificate of Incorporation (the “Certificate”) provides for the classification of its Board of Directors into three classes, with each class of directors serving staggered terms of three years. The Company’s Certificate requires the approval of two-thirds of the outstanding shares to amend certain provisions of the Certificate. Section 203 of the Delaware General Corporate Law restricts the ability of a Delaware corporation to engage in any business combination with an interested stockholder. Provisions in the executive officers’ employment agreements provide for post-termination compensation, including payment of amounts up to 2.5 times their annual salary, following certain changes in control. Certain changes in control of the Company also constitute an event of default under the Company’s bank credit facility. The foregoing matters may, together or separately, have the effect of discouraging or making more difficult an acquisition or change of control of the Company.

Business.

Advocat provides a broad range of long-term care services to the elderly including assisted living, skilled nursing and ancillary health care services. As of December 31, 2003, Advocat’s portfolio includes 100 facilities composed of 62 nursing homes containing 7,080 licensed beds and 38 assisted living facilities containing 3,965 units. In comparison, at December 31, 2002,

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the Company operated 98 facilities composed of 62 nursing homes containing 7,138 licensed beds and 36 assisted living facilities containing 3,499 units. Within the current portfolio, 28 facilities are managed on behalf of other owners, 22 of which are on behalf of unrelated owners and six in which the Company holds a minority equity interest. The remaining facilities, consisting of 45 leased and 27 owned facilities, are operated for the Company’s own account. In the United States, the Company operates 48 nursing homes and 14 assisted living facilities, and in Canada, the Company operates 14 nursing homes and 24 assisted living facilities. As discussed below under “Discontinued Operations,” the Company has entered into an agreement to sell its Canadian operations.

The Company’s facilities provide a range of health care services to its residents. In addition to the nursing and social services usually provided in long-term care facilities, the Company offers a variety of rehabilitative, nutritional, respiratory, and other specialized ancillary services. As of December 31, 2003, the Company operates facilities in Alabama, Arkansas, Florida, Kentucky, North Carolina, Ohio, Tennessee, Texas, West Virginia, and the Canadian provinces of Ontario, British Columbia and Alberta.

The Company, in its role as owner, lessee, or manager, is responsible for the day-to-day operations of all operated facilities. These responsibilities include recruiting, hiring, and training all nursing and other personnel, and providing resident care, nutrition services, marketing, quality improvement, accounting, and data processing services for each facility. The lease agreements pertaining to the Company’s 45 leased facilities are “triple net” leases, requiring the Company to maintain the premises, pay taxes and pay for all utilities. The leases typically provide for an initial term of 2 1/2 to 15 years with renewal options up to 10 years. The average remaining term of the Company’s lease agreements, including renewal options, is approximately 12.5 years.

As compensation for providing management services, the Company earns a management fee, which in 2003 averaged approximately 3.9% of the facilities’ net patient revenues. Of the Company’s 28 management agreements, none have more than five years remaining on their current terms, 9 have from one to four years remaining on their current terms and 19 have a current term expiring within one year, with an average remaining life of approximately 1.1 years for all contracts. Currently, all of the Company’s management contracts are part of its Canadian operations, and are presented in the Company’s consolidated financial statements as discontinued operations.

Discontinued Operations.

In August 2003, the Company entered into a definitive agreement to sell the stock of its wholly owned subsidiary, Diversicare Canada Management Services Co., Inc. (“DCMS”), the Company’s Canadian operations, to DCMS Holding, Inc. (“Holding”), a privately-owned Ontario corporation. The transaction was approved by the Company’s shareholders on November 21, 2003, but as of March 26, 2004, remains subject to approval by regulatory authorities in Canada. Management expects to receive regulatory approval and close the transaction during the second quarter of 2004. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the consolidated financial statements of the Company have been reclassified to reflect DCMS as a discontinued operation.

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Industry Background.

The long-term care profession encompasses a broad range of non-institutional and institutional services. For those among the elderly requiring temporary or limited special services, a variety of home care options exist. As needs for assistance in activities of daily living develop, assisted living facilities become the most viable and cost effective option. For those among the elderly requiring much more intensive care, skilled nursing facility care becomes the only viable option. The Company, through its assisted living facilities and nursing homes, is actively involved in the continuum of care and believes that it has, through its history of operating such facilities, developed the expertise required to serve the varied needs of its elderly residents.

Since the enactment of the Balanced Budget Act (“BBA”) in 1997, numerous changes affecting government funding levels of the nursing home industry have resulted. See “Item 1. Business – Government Regulation and Reimbursement – Medicare and Medicaid.” While the ultimate impact of the BBA on nursing homes is presently unknown, management believes there are a number of significant trends that will support the continued growth of the assisted living and nursing home segments of the long-term care industry, including:

     Demographic Trends. The primary market for the Company’s long-term health care services is comprised of persons aged 75 and older. This age group is one of the fastest growing segments of the United States population. As the number of persons aged 75 and over continues to grow, the Company believes that there will be corresponding increases in the number of persons who need skilled nursing care or who want to reside in an assisted living facility for assistance with activities of daily living.

     Cost Containment Pressures. In response to rapidly rising health care costs, governmental and other third-party payors have adopted cost-containment measures to reduce admissions and encourage reduced lengths of stays in hospitals and other acute care settings. The federal government had previously acted to curtail increases in health care costs under Medicare by limiting acute care hospital reimbursement for specific services to pre-established fixed amounts. Other third-party payors have begun to limit reimbursement for medical services in general to predetermined reasonable charges, and managed care organizations (such as health maintenance organizations) are attempting to limit hospitalization costs by negotiating for discounted rates for hospital and acute care services and by monitoring and reducing hospital use. In response, hospitals are discharging patients earlier and referring elderly patients, who may be too sick or frail to manage their lives without assistance, to nursing homes and assisted living facilities where the cost of providing care is typically lower than hospital care. In addition, third-party payors are increasingly becoming involved in determining the appropriate health care settings for their insureds or clients based primarily on cost and quality of care.

     Limited Supply of Facilities. As the nation’s elderly population continues to grow, life expectancy continues to expand, and there continue to be limitations on granting Certificates of Need (“CON’s”) for new skilled nursing facilities, management believes that there will be continued demand for skilled nursing beds in the markets in which the

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Company operates. The majority of states have adopted CON, or similar statutes, requiring that prior to the addition of new skilled beds, any new services, or making certain capital expenditures, a state agency must determine that a need exists for the new beds or proposed activities. The Company believes that this CON process tends to restrict the supply and availability of licensed skilled nursing facility beds. High construction costs, limitations on state and federal government reimbursement for the full costs of construction, and start-up expenses also act to restrict growth in the supply for such facilities. At the same time, skilled nursing facility operators are continuing to focus on improving occupancy and expanding services to include high acuity subacute patients, who require significantly higher levels of skilled nursing personnel and care. Although many states do not require CON’s for assisted living facilities, some states impose additional limitations on the supply of these facilities. For example, North Carolina has imposed a moratorium on any addition of new beds unless there is a demonstrated need based on several criteria, such as those items noted in the original language of the law stating that county vacancy rates are less than 15%, as well as other specific factors.

     Reduced Reliance on Family Care. Historically, the family has been the primary provider of care for seniors. Management of the Company believes that the increase in the percentage of women in the work force, the reduction of average family size, and the increased mobility in society will reduce the role of the family as the traditional care-giver for aging parents. Management believes that this trend will make it necessary for many seniors to look outside the family for assistance as they age.

Nursing Home and Assisted Living Facility Services.

Operations. As of December 31, 2003, the Company operates 62 nursing homes with 7,080 licensed beds and 38 assisted living facilities with 3,965 units as set forth below:

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For the year ended December 31, 2003, the Company’s net patient and resident revenues related to continuing operations were $195.6 million, or 99.9% of total net revenue of continuing operations. For the year ended December 31, 2003, the Company’s net revenues from the provision of management services related to continuing operations were $0.1 million. See Notes 10 and 16 of the Company’s Consolidated Financial Statements for more information on the Company’s operating segments and the proposed sale of the Company’s Canadian operations.

Nursing Home Services. The nursing homes operated by the Company provide skilled nursing health care services, including room and board, nutrition services, recreational therapy, social services, and housekeeping and laundry services. The Company’s nursing homes in its continuing operations range in size from 48 to 180 licensed beds. The nursing homes dispense medications prescribed by the patients’ physicians. In addition, a plan of care is developed by professional nursing staff for each resident. In an effort to increase revenues by attracting patients with more complex health care needs, the Company also provides for the delivery of ancillary medical services at the nursing homes it operates. These specialty services include rehabilitation therapy services, such as speech therapy, audiology, and occupational, physical therapies, which are provided through licensed therapists and registered nurses, and the provision of medical supplies, nutritional support, infusion therapies, and related clinical services. On October 1, 2001 the Company entered into an agreement with a regional rehabilitation company to provide financial and clinical management of the Company’s therapists. The Company believes that the rehabilitation company provides better management of the therapy function, including an emphasis on better utilization of available therapists, while containing the total cost. The Company has historically contracted with third parties for a fee to assist in the provision of various ancillary services to the Company’s patients. The Company owns an ancillary service supply business through which it provides medical supplies and enteral nutritional support services directly to patients.

Assisted Living Facility Services. Services and accommodations at assisted living facilities include central dining facilities, recreational areas, social programs, housekeeping, laundry and maintenance service, emergency call systems, special features for handicapped persons and transportation to shopping and special events. The Company’s assisted living facilities in its continuing operations range in size from 12 to 142 units. The Company believes that assisted living services will continue to increase as an attractive alternative to nursing home care because a variety of supportive services and supervision can be obtained in a more independent and less institutional setting. Generally, basic care and support services can be offered more economically in an assisted living facility than either in a nursing home or through home health care assistance.

Operating and Growth Strategy.

The Company’s objective is to be the provider of choice of health care and related services to the elderly in the communities in which it operates. The Company achieves this objective by:

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Provide a Broad Range of Cost-Effective Services. The Company’s objective is to provide a variety of services in a broad continuum of care which will meet the ever changing needs of the elderly. The Company’s expanded service offering currently includes assisted living, skilled nursing (including Alzheimer and Dementia Care), comprehensive rehabilitation services and medical supply and nutritional support services. By addressing varying levels of acuity, the Company is able to meet the needs of the elderly population it serves for a longer period of time and can establish a reputation as the provider of choice in a particular market. Furthermore, the Company believes it is able to deliver quality services cost-effectively, thereby expanding the elderly population base that can benefit from the Company’s services, including those not otherwise able to afford private-pay assisted living services.

Increase occupancy through emphasis on marketing efforts. The Company believes it can increase occupancy in its nursing homes and assisted living facilities through an increased emphasis on attracting and retaining patients and residents. The Company emphasizes strong corporate and regional support for local facility based marketing efforts.

Cluster Operations on a Regional Basis. The Company has developed regional concentrations of operations in order to achieve operating efficiencies, generate economies of scale and capitalize on marketing opportunities created by having multiple operations in a regional market area.

Key elements of the Company’s growth strategy are to:

Increase Revenues and Profitability at Existing Facilities. The Company’s strategy includes increasing facility revenues and profitability levels through increasing occupancy levels, maximizing reimbursement rates and containing costs. In 2002, the Company added more intensive corporate support for local facility based marketing efforts and in 2003 the Company hired a marketing vice president. In addition, regional marketing coordinators have been added to support the overall marketing program in each local facility, in order to promote higher occupancy levels and improved payor and case mixes at its nursing homes and assisted living facilities.

Consider Divestiture of Selected Facilities. Management has from time to time evaluated certain facilities for possible divestiture. As noted above, the Company has entered into an agreement to sell DCMS, its Canadian subsidiary. Other than the sale of DCMS, there are no agreements in place, nor can there be any assurance that any divestitures will occur, though the Company will evaluate any options that could improve liquidity and/or operating results. The Company terminated the leases on two Florida nursing homes during 2001 and sold another owned Florida nursing home during 2002. In 2002, the Company terminated leases on 16 assisted living facilities, and in 2003 the Company terminated the lease on one assisted living facility and closed another assisted living facility. The Company continues to evaluate the other leased and owned facilities for possible divestiture.

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Marketing.

At a local level, the Company’s sales and marketing efforts are designed to promote higher occupancy levels and optimal payor mix. Management believes that the long-term care industry is fundamentally a local industry in which both patients and residents and the referral sources for them are based in the immediate geographic area in which the facility is located. The Company’s marketing plan and support activities emphasize the role and performance of administrators, admissions coordinators and social services directors of each nursing home and the administrator of each assisted living facility, all of whom are responsible for contacting various referral sources such as doctors, hospitals, hospital discharge planners, churches, and various community organizations. Administrators are evaluated based on their ability to meet specific goals and performance standards that are tied to compensation incentives. The Company’s regional managers and marketing coordinators assist local marketing personnel and administrators in establishing relationships and follow-up procedures with such referral sources. In addition to soliciting admissions from these sources, management emphasizes involvement in community affairs in order to promote a public awareness of the Company’s nursing homes and assisted living facilities and their services. The Company also promotes effective customer relations and seeks feedback through family and employee surveys. Also, the Company has ongoing family councils and community based “family night” functions where organizations come to the facility to educate the public on various topics such as Medicare benefits, powers of attorney, and other matters of interest. In 2002, the Company added more intensive corporate support for local facility based marketing efforts and in 2003 the Company hired a marketing vice president. In addition, regional marketing coordinators have been added to support the overall marketing program in each local facility, in order to promote higher occupancy levels and improved payor and case mixes at its nursing homes and assisted living facilities.

The Company has an internally-developed marketing program that focuses on the identification and provision of services needed by the community. The program assists each facility administrator in analysis of local demographics and competition with a view toward complementary service development. The Company believes that the primary referral area in the long-term care industry generally lies within a five-to-fifteen-mile radius of each facility depending on population density; consequently, local marketing efforts are more beneficial than broad-based advertising techniques.

Description of Management Services and Agreements.

Prior to April 2003, the Company had four management contracts in the United States, but terminated these agreements and entered into leases for the facilities with the owner. All the Company’s current management agreements are related to the Canadian operations. As discussed above, the Company has entered into an agreement to sell DCMS, its Canadian subsidiary, and has presented DCMS as a discontinued operation in its consolidated financial statements. Accordingly, the majority of the discussion below with regard to these management services and agreements relates to the Company’s discontinued operations.

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Included in the Company’s discontinued operations are 28 facilities operated by the Company under management contracts, where the Company’s responsibilities include recruiting, hiring and training all nursing and other personnel, and providing quality assurance, resident care, nutrition services, marketing, accounting and data processing services. Services performed at the corporate level include group contract purchasing, employee training and development, quality assurance oversight, human resource management, assistance in obtaining third-party reimbursement, financial and accounting functions, policy and procedure development, system design and development and marketing support. The Company’s financial reporting system monitors certain key data for each managed facility, such as payroll, admissions and discharges, cash collections, net patient care revenues, rental revenues, staffing trend analysis and measurement of operational data on a per patient basis.

The Company’s management fee is subordinated to debt payments at 7 facilities. The Company has the potential to earn incentive management fees over its base management fees at 26 facilities and is obligated to provide cash flow support at two facilities. The Company receives a base management fee for the management of long-term care facilities ranging generally from 3.5% to 6.0% of the net revenues of each facility. Total management fees as a percentage of the managed facilities’ patient and resident revenues were 3.9% in 2003. Management fees with respect to four United States facilities were reduced in 2002 and 2001 because of the failure to meet defined operational thresholds. Other than certain corporate and regional overhead costs, the services provided at the facility are the facility owner’s expense. The facility owner also is obligated to pay for all required capital expenditures. The Company generally is not required to advance funds to the owner. However, with respect to one management agreement covering two facilities in Canada, the Company advanced $190,000 as of December 31, 2002; this advance carried 7.5% interest, and was repaid in 2003.

Based upon the initial term and any renewal terms over which the Company holds the option, the Company’s remaining management contracts expire in the following years:

The Company currently anticipates that all of the Canadian management agreements coming due for renewal in 2004 will be renewed. However, there can be no assurance that any of these agreements will be renewed.

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The following table summarizes the Company’s net revenues derived from management services and the net revenues of the managed facilities during the years indicated (in thousands):

Description of Lease Agreements.

The Company’s continuing operations include 40 long-term care facilities subject to operating leases, including 31 owned by Omega Healthcare Investors, Inc. (“Omega”), three owned by Counsel Corporation (together with its affiliates, “Counsel”), and six owned by other parties. In addition, five properties leased from Counsel are operated by DCMS and included in the Company’s discontinued operations. The Company’s operating leases generally require the Company to pay stated rent, subject to increases based on changes in the Consumer Price Index, a minimum percentage increase, or increases in the net revenues of the leased properties. Certain of the leases require the Company to pay certain scheduled rent increases. The Company’s leases are “triple-net,” requiring the Company to maintain the premises, pay taxes, and pay for all utilities. The Company generally grants its lessor a security interest in the Company’s personal property located at the leased facility. The leases generally require the Company to maintain a minimum tangible net worth and prohibit the Company from operating any additional facilities within a certain radius of each leased facility. The Company is generally required to maintain comprehensive insurance covering the facilities it leases as well as personal and real property damage insurance and professional liability insurance. The failure to pay rentals within a specified period or to comply with the required operating and financial covenants, including insurance coverage, generally constitutes a default, which default, if uncured, permits the lessor to terminate the lease and assume the property and the contents within the facilities. In all cases where mortgage indebtedness exists with respect to a leased facility, the Company’s interest in the premises is subordinated to that of the lessors’ mortgage lenders.

Omega Leases. On November 8, 2000, the Company entered into a 10-year restructured lease agreement (the “Settlement and Restructuring Agreement”) with Omega. The Settlement and Restructuring Agreement, effective as of October 1, 2000, provides for reduced future lease costs under an amended lease agreement covering all nursing homes leased from Omega (the “Omega Master Lease”). All of the accounts receivable, equipment, inventory and other assets of the facilities leased pursuant to the Omega Master Lease have been pledged as security under the Omega Master Lease. The initial term of the Omega Master Lease is ten years, expiring September 30, 2010, with an additional ten-year renewal term at the option of the Company, assuming no defaults. As discussed below, the Company is not currently in compliance with

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certain covenants of the Omega Master Lease. Lease payments of $10,875,000 were required during the first two years of the Omega Master Lease. During subsequent years, increases in the lease payments are equal to the lesser of two times the consumer price index or 3.0%. The Company is recording all scheduled rent increases, including the 3.0% rent increases, as additional lease expense on a straight-line basis over the initial lease term.

The Omega Master Lease also required the Company to fund capital expenditures related to the leased facilities totaling $1,000,000 during the first two years of the initial lease term. The Company is also required to fund annual capital expenditures equal to $325 per licensed bed over the initial lease term (annual required capital expenditures of $994,000), subject to adjustment for increases in the Consumer Price Index. Total required capital expenditures over the initial lease term are $10,940,000. These required capital expenditures are depreciated on a straight-line basis over the remaining initial lease term.

Upon expiration of the Omega Master Lease or in the event of a default under the Omega Master Lease, the Company is required to transfer all of the leasehold improvements, equipment, furniture and fixtures of the leased facilities to Omega. In the event that the Company does not transfer all of the facility assets to Omega, the Company will be required to pay Omega $5,000,000 plus accrued interest at 11.00% from the effective date of the Settlement and Restructuring Agreement. The Company’s management intends to transfer the facility assets to Omega at the end of the lease term.

As of December 31, 2003, the Company is not in compliance with certain debt covenants. Such events of default under the Company’s debt agreements could lead to actions by the lenders that could result in an event of default under the Omega Master Lease. In addition, effective March 9, 2002, the Company obtained professional liability insurance coverage that is less than the coverage required by the Omega Master Lease. The Company has not obtained a waiver. Upon a default in the Omega Master Lease, the lessor has the right to terminate the lease agreements and assume operating rights with respect to the leased properties. The net book value of property and equipment, including leasehold improvements, related to these facilities total approximately $4.0 million as of December 31, 2003.

Florida Leases. Effective April 1, 2003, the Company entered into leases for four nursing home facilities in Florida that had previously been managed by the Company under management contracts. Accordingly, the results of operations of these facilities are included in the Company’s results of operations beginning April 1, 2003. The leases expire December 31, 2005. Lease payments of $1,498,000 are required each year. Additional rent may be imposed based on the profitability of the facilities. There was no additional rent incurred in 2003.

Under the terms of the previous management contracts, the Company was required to obtain professional liability insurance coverage for the four facilities and received reimbursement for the facilities’ pro rata share of premiums paid as well as any claims paid on behalf of the owner. Due to the deteriorated financial condition of the owner and the terms of the owner’s mortgage on the facilities, the Company does not believe that the owner of the four facilities will in the future be able to reimburse the Company for costs incurred in connection with professional liability claims arising out of events occurring at the four facilities prior to the entry of the lease.

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As a result, the Company recorded a liability of approximately $4.3 million in the second quarter of 2003 to record obligations for estimated professional liability claims relating to these facilities for which the Company does not anticipate receiving reimbursement from the owner of the facilities.

Counsel Leases. The Company’s continuing operations lease three facilities from Counsel with an initial term of ten years through April 2004 and one ten-year renewal option. The Company’s discontinued operations lease five additional facilities in Canada from Counsel with a remaining term expiring in April 2004. With respect to all of these facilities, the Company has a right of first refusal and a purchase option at the end of the lease term. As discussed above, the Company has entered into an agreement to sell its Canadian operations, and at the request of the purchaser of the Canadian operations, the Company has notified Counsel of its intent to exercise the purchase option for the Canadian leased facilities. The Company is attempting to negotiate an extension of its leases with Counsel for United States facilities, but no assurances can be given that these efforts will be successful.

Prior to September 2001, the Company leased three additional facilities from Counsel. Omega was Counsel’s mortgage lender on the three facilities. Pursuant to the Settlement and Restructuring Agreement with Omega, Counsel was required to transfer one of the facilities to Omega in exchange for the outstanding mortgage balance, at which time the facility would be leased by the Company from Omega in accordance with the terms of the Omega Master Lease. The transfer of this facility occurred during 2001. Also pursuant to the Settlement and Restructuring Agreement, the Company had the right to require Counsel to transfer the remaining two facilities to Omega in exchange for the related outstanding mortgage balances, at which time the facilities were expected to be sold or leased by Omega to a third party. Effective September 30, 2001, both facilities were transferred to Omega. Effective October 1, 2001, Omega leased these two facilities to a third party. Pursuant to the Settlement and Restructuring Agreement with Omega, the Company will receive 20% of the lease proceeds (net of costs associated with the leasing transaction) throughout the term of the lease and 20% of any sales proceeds. The Company is recording these proceeds as a reduction of lease expense as they are received.

Assisted Living Leases. Effective April 30, 2002, the Company entered into a Lease Termination and Operations Transfer Agreement (the “Pierce Agreement”) with Pierce Management Group and related persons (collectively, “Pierce”), pursuant to which the 13 leases for United States assisted living facilities with the former principal owners or affiliates of Pierce were terminated. Effective May 31, 2002, the leases on two additional United States assisted living facilities were assumed by Pierce. As a result, the Company was relieved of its future obligations with respect to these 15 leases. Effective June 30, 2002, the Company terminated the lease on one additional United States assisted living facility. The Company is in a dispute with the owner of this property which will be the subject of an arbitration hearing currently scheduled in April 2004. The Company asserts that it was entitled to terminate the lease as a result of the landlord’s failure to correct construction defects at the facility and for the landlord’s other breaches of the lease agreement. The Company seeks return of its $285,000 security deposit, cancellation of a $200,000 letter of credit as well as payment for personal property and equipment and accounts receivable collected and retained by the landlord. The landlord has asserted claims against the

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Company for unpaid rents, taxes and operating losses in excess of $1.3 million. The Company has accrued for the estimated costs associated with this matter. However, the results of this matter cannot be predicted, and an adverse result could have a material adverse impact on the Company’s financial condition, cash flows or results of operations.

Effective May 31, 2003, the Company terminated the lease of its only remaining leased assisted living facility in the United States. The lease termination agreement requires aggregate payments of approximately $355,000, with $75,000 paid in June 2003 and the balance over the following twelve months.

The Company incurred lease termination charges of approximately $389,000 and $750,000 in 2003 and 2002, respectively, consisting of the remaining net book value of these 17 facilities and costs of completing the transactions.

Facilities.

The following table summarizes certain information with respect to the nursing homes and assisted living facilities owned, leased and managed by the Company as of December 31, 2003:

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(1)		Facilities that provide both nursing care and assisted living services are counted as nursing homes. The Company operates two such facilities in Alabama and one in Kentucky.
(2)		The Company has entered into an agreement to sell its Canadian subsidiary, and has presented its Canadian operations as a discontinued operation in the consolidated financial statements.

Organization.

The Company’s long-term care facilities are currently organized into nine regions, seven in the United States and two in Canada, each of which is supervised by a regional vice president or manager. The regional vice president or manager is generally supported by nursing, human resource personnel, marketing and clerical personnel, all of whom are employed by the Company. The day-to-day operations of each owned, leased or managed nursing home are supervised by an on-site, licensed administrator. The administrator of each nursing home is supported by other professional personnel, including a medical director, who assists in the medical management of the facility, and a director of nursing, who supervises a staff of registered nurses, licensed practical nurses, and nurses aides. Other personnel include dietary staff, activities and social service staff, housekeeping, laundry and maintenance staff, and a business office staff. Each assisted living facility owned, leased or managed by the Company is supervised by an on-site administrator, who is supported by a director of resident care, a director of food services, a director of maintenance, an activities coordinator, dietary staff and housekeeping, laundry and maintenance staff. With respect to the managed facilities, the majority of the administrators are employed by the Company, and the Company is reimbursed for their salaries and benefits by the respective facilities. All other personnel at managed facilities are employed and paid by the owner of the nursing home or assisted living facility, not by the Company. All personnel at the leased or owned facilities, including the administrators, are employed by the Company.

The Company has in place a Continuous Quality Improvement (“CQI”) program, which is focused on identifying opportunities for improvement, as well as overseeing the initiation and effectiveness of interventions. The Company conducts monthly audits to monitor adherence to

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the standards of care established by the CQI program at each facility which it owns, leases or manages. The facility administrator, with assistance from regional nursing personnel, is primarily responsible for adherence to the Company’s quality improvement standards. In that regard, the annual operational objectives established by each facility administrator include specific objectives with respect to quality of care. Performance of these objectives is evaluated quarterly by the regional vice president or manager, and each facility administrator’s incentive compensation is based, in part, on the achievement of the specified quality objectives. Issues regarding quality of care and resident care outcomes are addressed routinely by senior management. The Company also has established a quality improvement committee consisting of nursing representatives from each region. This committee periodically reviews the Company’s quality improvement programs and conducts facility audits.

The Company and its predecessor have operated a medical advisory committee in Ontario for more than 14 years and has developed similar committees in some of the other jurisdictions in which it operates. It is the Company’s view that these committees provide a vehicle for ensuring greater physician involvement in the operations of each facility with resulting improved focus on CQI and resident care plans. In addition, the Company has provided membership for all of its United States medical directors in the American Medical Directors Association. All of the nursing homes operated by the Company in Ontario have been accredited by the Canadian Council on Health Facilities Accreditation. The CQI program used at all locations was designed to meet accreditation standards and to exceed state and federal government regulations.

Competition.

The long-term care business is highly competitive. The Company faces direct competition for additional facilities and management agreements, and the facilities operated by the Company face competition for employees, patients and residents. Some of the Company’s present and potential competitors for acquisitions and management agreements are significantly larger and have or may obtain greater financial and marketing resources. Competing companies may offer new or more modern facilities or new or different services that may be more attractive to patients, residents or facility owners than some of the services offered by the Company.

The nursing homes and assisted living facilities operated by the Company compete with other facilities in their respective markets, including rehabilitation hospitals, other “skilled” and personal care residential facilities. In the few urban markets in which the Company operates, some of the long-term care providers with which the Company’s operated facilities compete are significantly larger and have or may obtain greater financial and marketing resources than the Company’s operated facilities. Some of these providers are not-for-profit organizations with access to sources of funds not available to the facilities operated by the Company. Construction of new long-term care facilities near the Company’s existing operated facilities could adversely affect the Company’s business. Management believes that the most important competitive factors in the long-term care business are: a facility’s local reputation with referral sources, such as acute care hospitals, physicians, religious groups, other community organizations, managed care organizations, and a patient’s family and friends; physical plant condition; the ability to identify and meet particular care needs in the community; the availability of qualified personnel to provide the requisite care; and the rates charged for services. There is limited, if any, price

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competition with respect to Medicaid and Medicare patients, since revenues for services to such patients are strictly controlled and are based on fixed rates and cost reimbursement principles. Although the degree of success with which the Company’s operated facilities compete varies from location to location, management believes that its operated facilities generally compete effectively with respect to these factors.

Government Regulation and Reimbursement.

The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse (collectively the “Health Care Laws”). Changes in these laws and regulations, such as reimbursement policies of Medicare and Medicaid programs as a result of budget cuts by federal and state governments or other legislative and regulatory actions, have had a material adverse effect on the industry and the Company’s consolidated financial position, results of operations, and cash flows. Future federal budget legislation and federal and state regulatory changes may further negatively impact the Company.

All of the Company’s facilities are required to obtain annual licensure renewal and are subject to annual surveys and inspections in order to be certified for participation in the Medicare and Medicaid programs. In order to maintain their state operating license and their certification for participation in Medicare and Medicaid programs, the nursing facilities must meet certain statutory and administrative requirements at both the state and Federal level. These requirements relate to the condition of the facilities, the adequacy and condition of the equipment used therein, the quality and adequacy of personnel, and the quality of resident care. Such requirements are both subjective and subject to change. There can be no assurance that, in the future, the Company will be able to maintain such licenses and certifications for its facilities or that the Company will not be required to expend significant sums in order to comply with regulatory requirements.

The Company’s assisted living facilities in the United States are also subject to state and local licensing requirements.

Reimbursement. A significant portion of the Company’s revenues is derived from government-sponsored health insurance programs. The nursing homes operated by the Company derive revenues under Medicaid, Medicare, the Ontario Government Operating Subsidy program, and private pay sources. The United States assisted living facilities derive revenues from Medicaid and similar programs as well as from private pay sources. The Company’s assisted living facilities in Canada derive virtually all of their revenues from private pay sources. The Company employs specialists in reimbursement at the corporate level to monitor regulatory developments, to comply with reporting requirements, and to maximize payments to its operated nursing homes. It is generally recognized that all government-funded programs have been and will continue to be under cost containment pressures, but the extent to which these pressures will affect the Company’s future reimbursement is unknown.

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Under the current law, Medicare reimbursements for nursing facilities were reduced following the October 1, 2002 expiration of two temporary payment increases enacted as part of earlier Medicare enhancement bills. There are two additional payment increases that were originally scheduled to expire October 1, 2002. CMS has announced that the expiration of these payment increases has been postponed until at least October 1, 2004. However, President Bush’s proposed fiscal year 2005 budget indicates that the refinements will not be implemented before September 30, 2005.

Medicare and Medicaid. Medicare is a federally-funded and administered health insurance program for the aged and for certain chronically disabled individuals. Part A of the Medicare program covers inpatient hospital services and certain services furnished by other institutional providers such as skilled nursing facilities. Part B covers the services of doctors, suppliers of medical items, various types of outpatient services, and certain ancillary services of the type provided by long term and acute care facilities. Medicare payments under Part A and Part B are subject to certain caps and limitations, as provided in Medicare regulations. Medicare benefits are not available for intermediate and custodial levels of nursing home care, nor for assisted living facility arrangements.

Medicaid is a medical assistance program for the indigent, operated by individual states with financial participation by the federal government. Criteria for medical indigence and available Medicaid benefits and rates of payment vary somewhat from state to state, subject to certain federal requirements. Basic long-term care services are provided to Medicaid beneficiaries, including nursing, dietary, housekeeping and laundry and restorative health care services, room and board, and medications. Previously, under legislation known as the Boren Amendment, federal law required that Medicaid programs pay to nursing home providers amounts adequate to enable them to meet government quality and safety standards. However, the Balanced Budget Act enacted during 1997 (the “BBA”) repealed the Boren Amendment, and the BBA requires only that a state Medicaid program must provide for a public process for determination of Medicaid rates of payment for nursing facility services. Under this process, proposed rates, the methodologies underlying the establishment of such rates, and the justification for the proposed rates are published. This public process gives providers, beneficiaries and concerned state residents a reasonable opportunity for review and comment. Certain of the states in which the Company now operates are actively seeking ways to reduce Medicaid spending for nursing home care by such methods as capitated payments and substantial reductions in reimbursement rates.

The BBA contains numerous Medicare and Medicaid cost-saving measures. The BBA required that nursing homes transition to a prospective payment system (“PPS”) under the Medicare program during a three-year “transition period,” commencing with the first cost reporting period beginning on or after July 1, 1998. The BBA also contained certain measures that have and could lead to further future reductions in Medicare therapy reimbursement and Medicaid payment rates. Revenues and expenses have both been reduced significantly from the levels prior to PPS. The BBA has negatively impacted the entire long-term care industry.

During 1999 and 2000, certain amendments to the BBA were enacted, including the Balanced Budget Reform Act of 1999 (“BBRA”) and the Benefits Improvement and Protection Act of 2000 (“BIPA”). The BBRA included a four percent across-the-board increase in payments to

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skilled nursing facilities for Fiscal Years 2001 and 2002 and a temporary 20 percent increase to 15 Resource Utilization Groups (RUGs) for patients considered medically complex. These changes became effective on October 1, 2000. The BIPA increased the inflation update to the full market basket in Fiscal Year 2001 and raised the nursing component of the RUGs by 16.6 percent in an effort to improve PPS nursing staff ratios. Additionally, the BIPA spread the BBRA 20 percent increase to the three rehabilitation RUGs across all 14 special rehabilitation RUGs as a 6.7 percent increase. The other RUGs changed in the BBRA maintained the 20 percent increase. These changes went into effect on April 1, 2001.

Under the current law, Medicare reimbursements for nursing facilities were reduced following the October 1, 2002 expiration of two temporary payment increases enacted as part of earlier Medicare enhancement bills. There are two additional payment increases that were originally scheduled to expire October 1, 2002. CMS has announced that the expiration of these payment increases has been postponed until at least October 1, 2004. However, President Bush’s proposed fiscal year 2005 budget indicates that the refinements will not be implemented before September 30, 2005. The August 4, 2003 rule also includes an inflation update and a correction of past forecast errors that together increase the fiscal year 2004 skilled nursing facility PPS base rates by a total of 6.26%.

Although refinements resulting from the BBRA and the BIPA have been well received by the United States nursing home industry, it is the Company’s belief that the resulting revenue enhancements are still significantly less than the losses sustained by the industry due to the BBA. Current levels of or further reductions in government spending for long-term health care would continue to have an adverse effect on the operating results and cash flows of the Company. The Company will attempt to maximize the revenues available from governmental sources within the changes that have occurred and will continue to occur under the BBA. In addition, the Company will attempt to increase revenues from non-governmental sources, including expansion of its assisted living operations, to the extent capital is available to do so, if at all.

Reduction in health care spending has become a national priority in the United States, and the field of health care regulation and reimbursement is a rapidly evolving one. For the fiscal year ended December 31, 2003, the Company derived 24.6% and 63.0% of its total patient and resident revenues related to continuing operations from the Medicare and Medicaid programs, respectively. Any health care reforms that significantly limit rates of reimbursement under these programs could, therefore, have a material adverse effect on the Company’s profitability. The Company is unable to predict which reform proposals or reimbursement limitations will be adopted in the future, or the effect such changes would have on its operations. In addition, private payors, including managed care payors, are increasingly demanding that providers accept discounted fees or assume all or a portion of the financial risk for the delivery of health care services. Such measures may include capitated payments, which can result in significant losses to health care providers if patients require expensive treatment not adequately covered by the capitated rate.

HIPAA Compliance. The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) has mandated an extensive set of regulations to standardize electronic patient health, administrative and financial data transactions, and to protect the privacy of individually

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identifiable health information. In October 2002, the Company filed for an extension of the deadline for compliance with the electronic patient health information requirements, and had until October 2003 to be in compliance with these requirements. In October 2003, CMS implemented a contingency plan to accept non-compliant electronic transactions after the October 16, 2003 compliance deadlines for those states that were not ready. The company is submitting HIPAA compliant claims in the states of Florida, Alabama, Texas, Arkansas, Kentucky and North Carolina. The company is working with Ohio, West Virginia and Tennessee to be compliant, where the individual state processing systems are not yet completely in compliance.

The Company has an active HIPAA Compliance Committee and designated privacy and security officers. The privacy regulation of HIPAA was presented to every employee and is presented to new hires during the orientation process. Privacy notices are posted in each facility, and provided to every new admission. The company is working on finalizing Business Associate Agreements with current vendors and providers.

The Company is in the process of identifying information inflow and outflow throughout the organization in order to determine the appropriate security safeguards the Company will need to put in place to be HIPAA-compliant. The Company is unable to definitively assess the full cost of compliance with HIPAA’s electronic transactions, privacy, and security standards at this time. Expenditures for any substantial changes to the Company’s information management systems required for HIPAA compliance could have a material financial impact on the Company.

Ontario Government Operating Subsidy Program. The Ontario Government Operating Subsidy program (“OGOS”) regulates both the total charges allowed to be levied by a licensed nursing home and the maximum amount that the OGOS program will pay on behalf of nursing home residents. The maximum amounts that can be charged to residents for ward, semi-private and private accommodation are established each year by the Ontario Ministry of Health. Regardless of actual accommodation, at least 40% of the beds in each home must be filled at the ward rate. Generally, amounts received from residents should be sufficient to cover the accommodation costs of a nursing home, including food, laundry, housekeeping, property costs and administration. In addition, the Ontario government partially subsidizes each individual, and funds each nursing home for the approximate care requirements of its residents. This funding is based upon an annual assessment of the levels of care required in each home, from which “caps” are determined and funding provided on a retrospective basis. The Ontario government funds from 35.0% to 70.0% of a resident’s charges, depending on the individual resident’s income and type of accommodation. The Company receives payment directly from OGOS by virtue of its ownership of two nursing homes in Canada. Additionally, the Company earns management fees from Canadian nursing homes, which derive significant portions of their revenues from OGOS. As described above in “Business,” the Company has entered into an agreement to sell its Canadian operations.

Self-Referral and Anti-Kickback Legislation. The health care industry is subject to state and federal laws which regulate the relationships of providers of health care services, physicians, and other clinicians. These self-referral laws impose restrictions on physician referrals to any entity with which they have a financial relationship, which is a broadly defined term. The Company

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believes its relationships with physicians are in compliance with the self-referral laws. Failure to comply with self-referral laws could subject the Company to a range of sanctions, including civil monetary penalties and possible exclusion from government reimbursement programs. There are also federal and state laws making it illegal to offer anyone anything of value in return for referral of patients. These laws, generally known as “anti-kickback” laws, are broad and subject to interpretations that are highly fact dependent. Given the lack of clarity of these laws, there can be no absolute assurance that any health care provider, including the Company, will not be found in violation of the anti-kickback laws in any given factual situation. Strict sanctions, including fines and penalties, exclusion from the Medicare and Medicaid programs and criminal penalties, may be imposed for violation of the anti-kickback laws.

Licensure and Certification. All the Company’s nursing homes must be licensed by the state in which they are located in order to accept patients, regardless of payor source. In most states, nursing homes are subject to certificate of need laws, which require the Company to obtain government approval for the construction of new nursing homes or the addition of new licensed beds to existing homes. The Company’s nursing homes must comply with detailed statutory and regulatory requirements on an ongoing basis in order to qualify for licensure, as well as for certification as a provider eligible to receive payments from the Medicare and Medicaid programs. Generally, the requirements for licensure and Medicare/Medicaid certification are similar and relate to quality and adequacy of personnel, quality of medical care, record keeping, dietary services, resident rights, and the physical condition of the facility and the adequacy of the equipment used therein. Each facility is subject to periodic inspections, known as “surveys” by health care regulators, to determine compliance with all applicable licensure and certification standards. If the survey concludes that there are deficiencies in compliance, the facility is subject to various sanctions, including but not limited to monetary fines and penalties, suspension of new admissions, non-payment for new admissions and loss of licensure or certification. Generally, however, once a facility receives written notice of any compliance deficiencies, it may submit a written plan of correction and is given a reasonable opportunity to correct the deficiencies.

Recently, government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of fraud and abuse statutes and regulations and quality of care issues in the skilled nursing profession in general. Violations of these laws and regulations could result in exclusion from government health care programs together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Compliance with such laws and regulations is subject to ongoing government review and interpretation, as well as regulatory actions which may be unknown or unasserted at this time. The Company has been a defendant in one such false claims action, and is currently a defendant is seven suits brought by the State of Arkansas involving alleged false claims actions, as described under “Item 3. Legal Proceedings.”

Privately owned nursing homes in Ontario are licensed by the Ministry of Health under the Ontario Nursing Homes Act. The legislation, together with program manuals, establishes the minimum standards that are required to be provided to the patients of the home, including staffing, space, nutrition and activities. Patients can only be admitted and subsidized if they require at least 1.5 hours per day of care, as determined by a physician. Retirement centers in

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Canada are generally regulated at the municipal government level in the areas of fire safety and public health and at the provincial level in the areas of employee safety, pay equity, and, in Ontario, rent control.

Licensure and regulation of assisted living facilities varies considerably from state to state, although the trend is toward increased regulation in the United States. In North Carolina, the Company’s facilities must pass annual surveys and the state has established base-level requirements that must be maintained. Such requirements include or relate to staffing ratios, space, food service, activities, sanitation, proper medical oversight, fire safety, resident assessments and employee training programs. In Canada, assisted living facilities are generally not required to be licensed and are subject to only minor regulations. However, assisted living facilities in Canada undergo a voluntary certification process through the Ontario Residential Care Association. This certification validates proper care and services through an on-site review process of two to three years.

Payor Sources.

The Company classifies its revenues from patients and residents into three major categories: Medicaid, Medicare and private pay. In addition to traditional Medicaid revenues, the Company includes within the Medicaid classification revenues from other programs established to provide benefits to those in need of financial assistance in the securing of medical services. Examples include the OGOS and North Carolina state and county special assistance programs. Medicare revenues include revenues received under both Part A and Part B of the Medicare program. The Company classifies payments from individuals who pay directly for services without government assistance as private pay revenue. The private pay classification also includes revenues from commercial insurers, HMOs, and other charge-based payment sources. Veterans Administration payments are included in private pay and are made pursuant to renewable contracts negotiated with these payors.

The following table sets forth net patient and resident revenues related to continuing operations by payor source for the Company for the years presented:

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Patient and residential service is generally provided and charged in daily service units, commonly referred to as patient and resident days. The following table sets forth patient and resident days related to continuing operations by payor source for the Company for the years presented:

The above tables include net patient revenues and the patient days of the six facilities comprising Texas Diversicare Limited Partnership (“TDLP”). See Note 5 of the Company’s Consolidated Financial Statements.

Consistent with the nursing home industry in general, changes in the mix of a facility’s patient population among Medicaid, Medicare, and private pay can significantly affect the profitability of the facility’s operations.

Supplies and Equipment.

The Company purchases drugs, solutions and other materials and leases certain equipment required in connection with the Company’s business from many suppliers. The Company has not experienced, and management does not anticipate that the Company will experience, any significant difficulty in purchasing supplies or leasing equipment from current suppliers. In the event that such suppliers are unable or fail to sell supplies or lease equipment to the Company, management believes that other suppliers are available to adequately meet the Company’s needs at comparable prices. National purchasing contracts are in place for all major supplies, such as food, linens, and medical supplies. These contracts assist in maintaining quality, consistency and efficient pricing.

Professional Liability and Other Liability Insurance.

The entire long-term care profession in the United States has experienced a dramatic increase in claims related to alleged negligence and malpractice in providing care to its patients and the Company is no exception in this regard. The Company has numerous pending liability claims, disputes and legal actions for professional liability and other related issues. The Company has limited, and sometimes no, professional liability insurance with respect to many of these claims or with respect to any other claims normally covered by liability insurance. In the event a significant judgment is entered against the Company in one or more of these legal actions in

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which there is no or insufficient professional liability insurance, the Company anticipates that it will not have the ability to pay such a judgment or judgments. Also, because professional liability and other liability insurance are covered under the same policies, the Company does not anticipate that it would have insurance in the event of any material general liability loss to any of its properties.

Due to the Company’s past claims experience and increasing cost of claims throughout the long-term care industry, the premiums paid by the Company for professional liability and other liability insurance exceeds the coverage purchased so that it costs more than $1 to purchase $1 of insurance coverage. For this reason, effective March 9, 2002, the Company has purchased professional liability insurance coverage for its United States nursing homes and assisted living facilities that, based on historical claims experience, is likely to be substantially less than the claims that are expected to be incurred. As a result, the Company is effectively self-insured and expects to remain so for the foreseeable future.

The Company has essentially exhausted all general and professional liability insurance available for claims first made during the period from March 9, 2001 through March 9, 2003. For claims made during the period from March 10, 2003 through March 9, 2004, the Company maintains insurance with coverage limits of $250,000 per medical incident and total aggregate policy coverage limits of $1,000,000. The Company is self-insured for the first $25,000 per occurrence with no aggregate limit. As of December 31, 2003, payments already made by the insurance carrier for this policy year have significantly reduced the remaining aggregate coverage amount. For claims made during the period from March 10, 2004 through March 9, 2005, the Company maintains insurance with coverage limits of $250,000 per medical incident and total aggregate policy coverage limits of $500,000. The Company is self-insured for the first $25,000 per occurrence with no aggregate limit.

For claims made during the period March 9, 2000 through March 9, 2001, the Company is self-insured for the first $500,000 per occurrence with no aggregate limit for the Company’s United States nursing homes. The policy has coverage limits of $1,000,000 per occurrence, $3,000,000 per location and $12,000,000 in the aggregate. The Company also maintains umbrella coverage of $15,000,000 in the aggregate for claims made during this period. As of December 31, 2003, payments already made by the insurance carrier for this policy year have reduced the remaining aggregate coverage amount.

Prior to March 9, 2000, the Company was insured on an occurrence basis. For the policy period January 1, 1998 through February 1, 1999 and for the policy period February 1, 1999 through March 9, 2000, the Company had insurance, including excess liability coverage, in the total amount of $50,000,000 per policy. As of December 31, 2003, payments already made by the insurance carriers for these policy years have significantly reduced the remaining aggregate coverage amount in each of the policy periods, but coverage has not been exhausted in either policy period.

Effective October 1, 2001, the Company’s United States assisted living properties were added to the Company’s insurance program for United States nursing home properties and are covered under the same policies as the Company’s nursing facilities. Prior to October 1, 2001, the

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Company’s United States assisted living facilities maintained occurrence based insurance and a $15,000,000 aggregate umbrella liability policy. As of December 31, 2003, payments already made by the insurance carriers have significantly reduced the remaining aggregate coverage, but coverage has not been exhausted.

In Canada, the Company’s professional liability claims experience and associated costs have been dramatically less than that in the United States. The Canadian facilities owned or leased by the Company are self-insured for the first $4,000 ($5,000 Canadian) per occurrence. The Company’s aggregate primary coverage limit with respect to Canadian operations is $1,545,000 ($2,000,000 Canadian). The Company also maintains a $3,863,000 ($5,000,000 Canadian) aggregate umbrella policy for claims in excess of the foregoing limits for these facilities.

Even for insured claims, the payment of professional liability claims by the Company’s insurance carriers is dependent upon the financial solvency of the individual carriers. The Company is aware that two of its insurance carriers providing coverage for prior years’ claims have either been declared insolvent or are currently under rehabilitation proceedings.

Reserve for Estimated Self-Insured Professional Liability Claims.

Because the Company anticipates that its actual liability for existing and anticipated claims will exceed the Company’s limited professional liability insurance coverage, the Company has recorded total liabilities for reported professional liability claims and estimates for incurred but unreported claims of $47.2 million as of December 31, 2003. Such liabilities include estimates of legal costs. The Company does not have cash or available resources to pay these accrued professional liability claims or any significant portion thereof.

The Company records its estimated liability for these professional liability claims based on the results of an actuarial analysis. These self-insurance reserves are assessed on a quarterly basis, and the amounts recorded for professional and general liability claims are adjusted for revisions in estimates and differences between actual settlements and reserves as determined each period, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified. Any increase in the accrual decreases income in the period, and any reduction in the accrual increases income during the period. Although the Company retains a third-party actuarial firm to assist management in estimating the appropriate accrual for these claims, professional liability claims are inherently uncertain, and the liability associated with anticipated claims is very difficult to estimate. As a result, the Company’s actual liabilities may vary significantly from the accrual, and the amount of the accrual may fluctuate by a material amount in any given quarter. Each change in the amount of this accrual will directly affect the Company’s reported earnings for the period in which the change in accrual is made.

While each quarterly adjustment to the recorded liability for professional liability claims affects reported income, these changes do not directly affect the Company’s cash position because the accrual for these liabilities is not funded. The Company does not have cash or available resources to pay these accrued professional liability claims or any significant portion thereof. In the event a significant judgment is entered against the Company in one or more legal actions in which there is no or insufficient professional liability insurance, the Company anticipates that payment

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of the judgment amounts would require cash resources that would be in excess of the Company’s available cash or other resources. These potential future payments, whether of a judgment or in settlement of a disputed claim, could have a material adverse impact on the Company’s financial position and cash flows.

Other Insurance.

With respect to workers’ compensation insurance, substantially all of the Company’s employees became covered under either an indemnity insurance plan or state-sponsored programs in May 1997. Prior to that time, the Company was self-insured for the first $250,000, on a per claim basis, for workers’ compensation claims in a majority of its United States nursing facilities. However, the insurance carrier providing coverage above the Company’s self insured retention has been declared insolvent by the applicable state insurance agency. As a result, the Company is completely self-insured for workers compensation exposures prior to May 1997. The Company has been and remains a non-subscriber to the Texas workers’ compensation system and is, therefore, completely self-insured for employee injuries with respect to its Texas operations. For the policy period July 1, 2002 through June 30, 2003, the Company entered into a “high deductible” workers compensation insurance program covering the majority of the Company’s United States employees. Under the high deductible policy, the Company is self insured for the first $25,000 per claim, subject to an aggregate maximum of out of pocket cost of $1.6 million, for the 12 month policy period. The Company has a letter of credit of $1.252 million securing its self insurance obligations under this program. The letter of credit is secured by a certificate of deposit of $1.252 million, which is reflected as “restricted cash” in the accompanying balance sheet. The reserve for the high deductible policy is based on known claims incurred and an estimate of incurred but not reported claims determined by an analysis of historical claims incurred. Effective June 30, 2003, the Company entered into a new workers compensation insurance program that provides coverage for claims incurred with premium adjustments depending on incurred losses. Policy expense under this workers compensation policy may be increased or decreased from the level of initial premium payments by up to approximately $1.2 million depending upon the amount of claims incurred during the policy period. The Company has accounted for premium expense under this policy based on its estimate of the level of claims expected to be incurred, and has provided reserves for the settlement of outstanding self-insured claims at amounts believed to be adequate. The liability recorded by the Company for the self-insured obligations under these plans is $1.2 million as of December 31, 2003. Any adjustments of future premiums for workers compensation policies and differences between actual settlements and reserves for self-insured obligations are included in expense in the year finalized.

The Company is self-insured for health insurance benefits for certain employees and dependents for amounts up to $150,000 per individual annually. The Company provides reserves for the settlement of outstanding self-insured health claims at amounts believed to be adequate. The liability for reported claims and estimates for incurred but unreported claims is $1.1 million at December 31, 2003. The differences between actual settlements and reserves are included in expense in the year finalized.

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Employees.

As of March 1, 2004, the Company employed a total of approximately 5,579 individuals in the United States. Management believes that the Company’s employee relations are good. Approximately 160 of the Company’s United States employees are represented by a labor union.

As of March 1, 2004, the Company employed a total of approximately 531 individuals in Canada. As described in “Discontinued Operations” in Part I, the Company has entered into an agreement to sell its Canadian subsidiary. Management believes that the Company’s employee relations with these Canadian employees are good. Approximately 414 of the Company’s Canadian employees are represented by a labor union. With the exception of some administrators of managed facilities (whose salaries are reimbursed by the owners), the staff of the managed nursing homes and assisted living facilities are not employees of the Company. The Company’s managed Canadian facilities employ approximately 2,644 individuals, approximately 2,152 of whom are represented by various unions.

A major component of the Company’s CQI program is employee empowerment initiatives, with particular emphasis placed on selection, recruitment, retention and recognition programs. Administrators and managers of the Company include employee retention and turnover goals in the annual facility, regional and personal objectives.

Although the Company believes it is able to employ sufficient nurses and therapists to provide its services, a shortage of health care professional personnel in any of the geographic areas in which the Company operates could affect the ability of the Company to recruit and retain qualified employees and could increase its operating costs. The Company competes with other health care providers for both professional and non-professional employees and with non-health care providers for non-professional employees. During 2003, the Company faced increased competition for workers due to tight labor markets in most of the areas in which the Company operates in the United States and the nursing shortage that is affecting the United States and Canada.

Available Information

The Company files reports with the Securities and Exchange Commission (“SEC”), including annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K. Copies of the Company’s reports filed with the SEC may be obtained by the public at the SEC’s Public Reference Room by calling the SEC at 1-800-SEC-0330. The Company files such reports with the SEC electronically, and the SEC maintains an Internet site at www.sec.gov that contains the Company’s reports, proxy and information statements, and other information filed electronically. The Company’s website address is www.irinfo.com/AVC. The Company also makes available, free of charge through the Company’s website, its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and other materials filed with the SEC as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. The information provided on the Company’s website is not part of this

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report, and is therefore not incorporated by reference unless such information is otherwise specifically referenced elsewhere in this report.

ITEM 2. PROPERTIES

The Company owns 27 and leases 45 long-term care facilities. See “Item 1. Business – Description of Lease Agreements” and “– Facilities.” The Company leases approximately 19,000 square feet of office space in Franklin, Tennessee, that houses the executive offices of the Company, centralized management support functions, and the ancillary services supply operations. In addition, the Company leases its regional office for Canadian operations with approximately 10,800 square feet of office space in Mississauga, Ontario, its regional office with approximately 3,400 square feet of office space in Kernersville, North Carolina, and its regional office with approximately 3,000 square feet of office space in Ashland, Kentucky. Lease periods on these facilities generally range up to seven years. Regional executives for Alabama, Arkansas, Florida, Tennessee and Texas work from offices of up to 1,000 square feet each. Management believes that the Company’s leased properties are adequate for its present needs and that suitable additional or replacement space will be available as required.

ITEM 3. LEGAL PROCEEDINGS

The provision of health care services entails an inherent risk of liability. In recent years, participants in the health care industry have become subject to an increasing number of lawsuits alleging malpractice, product liability, or related legal theories, many of which involve large claims and significant defense costs. The entire long-term care profession in the United States has experienced a dramatic increase in claims related to alleged negligence in providing care to its patients and the Company is no exception in this regard. The Company, as with the rest of the industry, has numerous pending liability claims, disputes and legal actions for professional liability and other related issues. It is expected that the Company will continue to be subject to such suits as a result of the nature of its business. Further, as with all health care providers, the Company is potentially subject to the increased scrutiny of regulators for issues related to compliance with health care fraud and abuse laws.

As of December 31, 2003, the Company is engaged in 47 professional liability lawsuits, including 14, 13, and 8 in the states of Florida, Arkansas and Texas, respectively. Several of these matters are scheduled for trial in 2004. The ultimate results of these or any other of the Company’s professional liability claims and disputes cannot be predicted. The Company has limited, and sometimes no, professional liability insurance with regard to most of these claims. In the event a significant judgment is entered against the Company in one or more of these legal actions in which there is no or insufficient professional liability insurance, the Company would not have available cash resources to satisfy the judgment. Further, settlement of these and other cases may require cash resources that would be in excess of the Company’s available cash or other resources. These potential future payments, whether of a judgment or in settlement of a disputed claim, could have a material adverse impact on the Company’s financial position and cash flows.

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On August 5, 2002, the Company was served in a lawsuit filed by the State of Arkansas styled Arkansas v. Diversicare Leasing Corp. d/b/a Eureka Springs Nursing & Rehabilitation Center, et. al., case number 02-6822 in the Circuit Court of Pulaski County, Arkansas. The allegations against the Company include violations of the Arkansas Abuse of Adults Act and violation of the Arkansas Medicaid False Claims Act with respect to a resident of the Eureka Springs facility. This action is scheduled for trial on September 13, 2004. On February 18, 2004, the Company was served in six additional lawsuits filed by the State of Arkansas in the Circuit Court of Pulaski County, Arkansas. The six lawsuits involve fifteen patients at five nursing homes operated by the Company in Arkansas and also allege violations of the Arkansas Abuse of Adults Act and the Arkansas Medicaid False Claims Act. The six complaints, in the aggregate, seek actual damages totaling approximately $250,000 and fines and penalties in excess of $45 million. No trial date has been set in these six actions. However, the Company cannot currently predict with certainty the ultimate impact of the above cases on the Company’s financial condition, cash flows or results of operations. The Company intends to vigorously defend itself against the allegations in all of these lawsuits.

The Company is in a dispute with the owner of an assisted living facility in which the Company terminated the lease. This dispute is the subject of an arbitration hearing scheduled for April 2004. The Company asserts that it was entitled to terminate the lease as a result of the landlord’s failure to correct construction defects at the facility and for the landlord’s other breaches of the lease agreement. The Company seeks return of its $285,000 security deposit, cancellation of a $200,000 letter of credit as well as payment for personal property and equipment and accounts receivable collected and retained by the landlord. The landlord has asserted claims against the Company for unpaid rents, taxes and operating losses in excess of $1.3 million. The Company has accrued for the estimated costs associated with this matter. However, the results of this matter cannot be predicted, and an adverse result could have a material adverse impact on the Company’s financial condition, cash flows or results of operations.

On June 22, 2001, a jury in Mena, Arkansas, issued a verdict in a professional liability lawsuit against the Company totaling $78.425 million. On May 1, 2003, the Arkansas Supreme Court reduced the damage award to $26.425 million, plus interest from the date of the original verdict. On November 10, 2003, the U.S. Supreme Court denied the Company’s request for a review, and the amended judgment became final. The trial court has ordered that the Company’s insurance carriers for its 1997 and 1998 policy years each pay one-half of the total judgment and interest. The Company has been advised that at least one of its insurance carriers is disputing the methodology used for calculation of interest. The Company’s insurance carriers have paid the judgment amount and interest, or have bonded the portion in dispute. The Company’s 1997 policy included primary coverage of up to $1 million through one carrier that has been declared insolvent. The umbrella carrier has demanded that the Company pay this $1 million portion of the judgment. The Company has denied responsibility for this liability, and the carrier has not filed any action seeking to recover this amount.

On October 17, 2000, the Company was served with a civil complaint by the Florida Attorney General’s office, in the case of State of Florida ex rel. Mindy Myers v. R. Brent Maggio, et al. In this case, the State of Florida accused multiple defendants of violating Florida’s False Claims Act. The Company, in its capacity as the manager of four nursing homes owned by Emerald

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Healthcare, Inc. (“Emerald”), was named in the complaint, as amended, which accused the Company of making illegal kickback payments to R. Brent Maggio, Emerald’s sole shareholder, and fraudulently concealing such payments in the Florida Medicaid cost reports filed by the nursing homes. During the first quarter of 2003, the State of Florida executed a voluntary dismissal, with prejudice, of all claims related to this incident against the Company. In addition, a settlement agreement was executed between the State of Florida, Maggio and Emerald, pursuant to which the State of Florida has dropped its prosecution of this matter. In response to this settlement, the whistle blower in this action filed a written objection opposing the State of Florida’s settlement with Maggio, and asked the court to reject the settlement agreement on the grounds that the settlement was not fair, adequate or reasonable under the circumstances. Under Florida’s False Claims Act, a whistle blower may ask a court to reject a settlement between the State of Florida and any defendant named in the suit, but has the burden of demonstrating that the settlement is not fair, adequate or reasonable.

Following a hearing on the State of Florida’s motion, the Leon County Circuit Court approved the State of Florida’s settlement agreement. Upon entry of an order approving the settlement agreement, the whistle blower appealed the circuit court’s ruling to Florida’s First District Court of Appeal, arguing that the circuit court judge failed to apply the proper standards in determining whether the settlement was appropriate. On January 29, 2004, the Florida First District Court of Appeal reversed and remanded the circuit court judge’s ruling, holding that the circuit judge should have applied different legal criteria in evaluating whether the State of Florida’s settlement was fair, adequate and reasonable, and this case remains pending in the Florida appellate courts. Notwithstanding the ruling of the Florida First District Court of Appeal, the Company believes that it is no longer a party to this lawsuit since it was not a party to the State of Florida’s settlement agreement. Moreover, the State of Florida filed a voluntary dismissal, with prejudice, of all claims identified in this lawsuit, after obtaining a general release from the Company in which the Company agreed not to sue the State of Florida for any and all claims that the Company had, or might have, against the State of Florida’s Department of Legal Affairs stemming from that agency’s participation in this lawsuit. In the event, however, that the Company is required to litigate any remaining matters involving this lawsuit, the Company believes it has meritorious defenses in this matter and intends to vigorously pursue these defenses in litigation.

The Company cannot currently predict with certainty the ultimate impact of any of the above cases on the Company’s financial condition, cash flows or results of operations. An unfavorable outcome in any of the lawsuits, any investigation or lawsuit alleging violations of elderly abuse laws or any state or Federal False Claims Act case could subject the Company to fines, penalties and damages. Moreover, the Company could be excluded from the Medicare, Medicaid or other federally-funded health care programs, which could have a material adverse impact on the Company’s financial condition, cash flows or results of operations.

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

On November 21, 2003 the Company held a special meeting of its shareholders to approve the sale of DCMS. A total of 2,814,037 shares, or 51.2% of the total outstanding shares, voted in

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favor of the DCMS transaction. A total of 1,434,784 shares, or 26.1% of the total outstanding shares, voted against the transaction, and 43,010 shares abstained from voting. The proposal required approval by a majority of the Company’s shareholders in order to pass, and was approved as a result of this vote.

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PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS

The Common Stock of the Company was listed on the New York Stock Exchange under the symbol “AVC” through November 9, 1999. Since that time, the Company’s Common Stock has been traded on NASD’s OTC Bulletin Board under the symbol “AVCA.” The following table sets forth the high and low bid prices of the common stock for each quarter in 2002 and 2003:

The Company’s Common Stock has been traded since May 10, 1994. On March 15, 2004, the closing price for the Common Stock was $0.60, as reported by PCQuote.com.

On March 15, 2004, there were approximately 332 holders of record of the Common Stock. Most of the Company’s shareholders have their holdings in the street name of their broker/dealer.

The Company has not paid cash dividends on its Common Stock and anticipates that, for the foreseeable future, any earnings will be retained for use in its business and no cash dividends will be paid. The Company is currently prohibited from issuing dividends under certain of its debt instruments.

The Company’s equity compensation plan information is incorporated by reference to the Company’s definitive proxy materials for the Company’s 2004 Annual Meeting of Shareholders.

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ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

The selected financial data of Advocat as of December 31, 2003, 2002, 2001, 2000 and 1999 and for the years ended December 31, 2003, 2002, 2001, 2000 and 1999 have been derived from the financial statements of the Company, and should be read in conjunction with the annual financial statements and related Notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations.

This selected financial data for all periods shown have been reclassified to present the Company’s Canadian subsidiary as a discontinued operation.

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

Overview

Advocat Inc. (together with its subsidiaries, “Advocat” or the “Company”) provides long-term care services to nursing home patients and residents of assisted living facilities in nine states, primarily in the Southeast, and three Canadian provinces. The Company’s facilities provide a range of health care services to their patients and residents. In addition to the nursing, personal care and social services usually provided in long-term care facilities, the Company offers a variety of comprehensive rehabilitation services as well as medical supply and nutritional support services.

In August 2003, the Company entered into a definitive agreement to sell the stock of its wholly owned subsidiary, Diversicare Canada Management Services Co., Inc. (“DCMS”) to DCMS Holding, Inc. (“Holding”), a privately-owned Ontario corporation. DCMS operates 14 nursing homes and 24 assisted living facilities in the Canadian provinces of Ontario, British Columbia and Alberta. The transaction was approved by the Company’s shareholders on November 21, 2003, but, as of March 26, 2004, remains subject to approval by regulatory authorities in Canada. Management expects to receive regulatory approval and close the transaction during the second quarter of 2004. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the consolidated financial statements of the Company have been reclassified to reflect DCMS as a discontinued operation.

As part of continuing operations at December 31, 2003, the Company operates 62 facilities, consisting of 48 nursing homes with 5,108 licensed beds and 14 assisted living facilities with 987 units. In comparison, as part of continuing operations at December 31, 2002, the Company operated 64 facilities composed of 48 nursing homes containing 5,138 licensed beds and 16 assisted living facilities containing 1,127 units. As of December 31, 2003, the Company owns 10 nursing homes and leases 38 others. Additionally, the Company owns 12 assisted living facilities and leases 2 others.

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Effective April 1, 2003, the Company entered into leases for four nursing home facilities in Florida that had previously been managed by the Company under management contracts. Accordingly, the results of operations of these facilities are included in the Company’s results of operations beginning April 1, 2003. Under the terms of the previous management contracts, the Company was required to obtain professional liability insurance coverage for the four facilities and received reimbursement for the facilities’ pro rata share of premiums paid as well as any claims paid on behalf of the owner. Due to the deteriorated financial condition of the owner and the terms of the owner’s mortgage on the facilities, the Company does not believe that the owner of the four facilities will in the future be able to reimburse the Company for costs incurred in connection with professional liability claims arising out of events occurring at the four facilities prior to the entry of the lease. As a result, the Company recorded a liability of approximately $4.3 million in the second quarter of 2003 to record obligations for estimated professional liability claims relating to these facilities for which the Company does not anticipate receiving reimbursement from the owner of the facilities.

Effective April 30, 2002, the Company entered into a Lease Termination and Operations Transfer Agreement (the “Pierce Agreement”) with Pierce Management Group and related persons (collectively, “Pierce”), pursuant to which the 13 leases with the former principal owners or affiliates of Pierce were terminated. Effective May 31, 2002, the leases on two additional assisted living facilities were assumed by Pierce. As a result, the Company was relieved of its future obligations with respect to these 15 leases.

Effective June 30, 2002, the Company terminated the lease on one additional assisted living facility. The Company is in a dispute with the owner of this property which will be the subject of an arbitration hearing in April 2004. The Company asserts that it was entitled to terminate the lease as a result of the landlord’s failure to correct construction defects at the facility and for the landlord’s other breaches of the lease agreement. The Company seeks return of its $285,000 security deposit, cancellation of a $200,000 letter of credit and payment for personal property and equipment and accounts receivable collected and retained by the landlord. The landlord has asserted claims against the Company for unpaid rents, taxes and operating losses in excess of $1.3 million. The Company has accrued for the estimated costs associated with this matter. However, the results of this matter cannot be predicted, and an adverse result could have a material adverse impact on the Company’s financial condition, cash flows or results of operations.

Effective May 31, 2003, the Company terminated the lease of its only remaining leased assisted living facility in the United States. The lease termination agreement requires aggregate payments of approximately $355,000, with $75,000 paid in June 2003 and the balance over the following twelve months.

The Company incurred lease termination charges of approximately $389,000 and $750,000 in 2003 and 2002, respectively, consisting of the remaining net book value of these 17 facilities and costs of completing the transactions.

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During the fourth quarter of 2001, the Company terminated the leases on two Florida nursing homes, and sold another owned Florida nursing home during the fourth quarter of 2002. The Company recorded impairment provisions of approximately $95,000 and $482,000 in 2002 and 2001, respectively, to write-off the remaining net book value of these properties in connection with these transactions.

Basis of Financial Statements. The Company’s patient and resident revenues consist of the fees charged for the care of patients in the nursing homes and residents of the assisted living facilities owned and leased by the Company. The Company’s operating expenses include the costs, other than lease, depreciation and amortization expenses, incurred in the operation of the nursing homes and assisted living facilities owned and leased by the Company. The Company’s general and administrative expenses consist of the costs of the corporate office and regional support functions, including the costs incurred in providing management services to other owners. The Company’s depreciation, amortization and interest expenses include all such expenses across the range of the Company’s operations.

Operating Data

The following table summarizes the Advocat statements of operations for the years ended December 31, 2003, 2002 and 2001, and sets forth this data as a percentage of revenues for the same years.

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The Company has incurred significant operating losses during 2003, 2002 and 2001. The Company has a working capital deficit of $53.3 million as of December 31, 2003. Also, the Company has limited resources available to meet its operating, capital expenditure and debt service requirements during 2004. Given that events of default exist under the Company’s working capital line of credit, there can be no assurances that the respective lender will continue to provide working capital advances.

The following table presents data about the facilities operated by the Company as of the dates or for the years indicated:

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Critical Accounting Policies and Judgments

A “critical accounting policy” is one which is both important to the understanding of the financial condition and results of operations of the Company and requires management’s most difficult, subjective or complex judgments often of the need to make estimates about the effect of matters that are inherently uncertain. The Company’s accounting policies that fit this definition include the following:

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Revenues

Patient and Resident Revenues

The fees charged by the Company to patients in its nursing homes and residents in its assisted living facilities include fees with respect to individuals receiving benefits under federal and state-funded cost reimbursement programs. These revenues are based on approved rates for each facility that are either based on current costs with retroactive settlements or prospective rates with no cost settlement. Amounts earned under federal and state programs with respect to nursing home patients are subject to review by the third-party payors. In the opinion of management, adequate provision has been made for any adjustments that may result from such reviews. Final cost settlements, if any, are recorded when objectively determinable, generally within three years of the close of a reimbursement year depending upon the timing of appeals and third-party settlement reviews or audits.

Allowance for Doubtful Accounts

The Company’s allowance for doubtful accounts is estimated utilizing current agings of accounts receivable, historical collections data and other factors. Management monitors these factors and determines the estimated provision for doubtful accounts. Historical bad debts have generally resulted from uncollectible private balances, some uncollectible coinsurance and deductibles and other factors. Receivables that are deemed to be uncollectible are written off. The allowance for doubtful accounts balance is assessed on a quarterly basis, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified.

Self-Insurance Reserves

Self-insurance reserves primarily represent the accrual for self insured risks associated with general and professional liability claims, employee health insurance and workers compensation. The self insurance reserves include a liability for reported claims and estimates for incurred but unreported claims. The Company’s policy with respect to a significant portion of the general and professional liability claims is to use an actuary to support the estimates recorded for the development of known claims and incurred but unreported claims. The Company’s health insurance reserve is based on known claims incurred and an estimate of incurred but unreported claims determined by an analysis of historical claims paid. The Company’s workers compensation reserve related to periods of self insurance prior to May 1997 and a high deductible policy issued July 1, 2002 through June 30, 2003 covering most of the Company’s employees in the United States. The reserve for workers compensation self insurance prior to May 1997 consists only of known claims incurred and the reserve is based on an estimate of the future costs to be incurred for the known claims. The reserve for the high deductible policy issued July 1, 2002 is based on known claims incurred and an estimate of incurred but not reported claims determined by an analysis of historical claims incurred. Expected insurance coverages are reflected as a reduction of the reserves.

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The self insurance reserves are assessed on a quarterly basis, with changes in estimated losses and effects of settlements being recorded in the consolidated statements of operations in the period identified. The amounts recorded for professional and general liability claims are adjusted for revisions in estimates and differences between actual settlements and reserves as determined each period with changes in estimated losses being recorded in the consolidated statements of operations in the period identified. Any increase in the accrual decreases income in the period, and any reduction in the accrual increases income during the period.

Because the Company anticipates that its actual liability for existing and anticipated claims will exceed the Company’s limited professional liability insurance coverage, the Company has recorded total liabilities for reported professional liability claims and estimates for incurred but unreported claims of $47.2 million as of December 31, 2003. Such liabilities include estimates of legal costs. The Company does not have cash or available resources to pay these accrued professional liability claims or any significant portion thereof.

Although the Company retains a third-party actuarial firm to assist management in estimating the appropriate accrual for these claims, professional liability claims are inherently uncertain, and the liability associated with anticipated claims is very difficult to estimate. As a result, the Company’s actual liabilities may vary significantly from the accrual, and the amount of the accrual may fluctuate by a material amount in any given quarter. Each change in the amount of this accrual will directly affect the Company’s reported earnings for the period in which the change in accrual is made.

While each quarterly adjustment to the recorded liability for professional liability claims affects reported income, these changes do not directly affect the Company’s cash position because the accrual for these liabilities is not funded. The Company does not have cash or available resources to pay these accrued professional liability claims or any significant portion thereof. In the event a significant judgment is entered against the Company in one or more of these legal actions in which there is no or insufficient professional liability insurance, the Company anticipates that payment of the judgment amounts would require cash resources that would be in excess of the Company’s available cash or other resources. These potential future payments, whether of a judgment or in settlement of a disputed claim, could have a material adverse impact on the Company’s financial position and cash flows.

Asset Impairment

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company evaluates the recoverability of the carrying values of its properties on a property by property basis. On a quarterly basis, the Company reviews its properties for recoverability when events or circumstances, including significant physical changes in the property, significant adverse changes in general economic conditions, and significant deteriorations of the underlying cash flows of the property, indicate that the carrying amount of the property may not be recoverable. The need to recognize an impairment is based on estimated future cash flows from a property compared to the carrying value of that property. If recognition of an impairment is necessary, it

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is measured as the amount by which the carrying amount of the property exceeds the fair value of the property.

Medicare Reimbursement

During 1997, the federal government enacted the Balanced Budget Act of 1997 (“BBA”), which contained numerous Medicare and Medicaid cost-saving measures. The BBA required that nursing homes transition to a prospective payment system (“PPS”) under the Medicare program during a three-year “transition period,” commencing with the first cost reporting period beginning on or after July 1, 1998. The BBA also contained certain measures that have and could lead to further future reductions in Medicare therapy reimbursement and Medicaid payment rates. Revenues and expenses have both been reduced significantly from the levels prior to PPS. The BBA has negatively impacted the entire long-term care industry.

During 1999 and 2000, certain amendments to the BBA were enacted, including the Balanced Budget Reform Act of 1999 (“BBRA”) and the Benefits Improvement and Protection Act of 2000 (“BIPA”). The BBRA has provided legislative relief in the form of increases in certain Medicare payment rates during 2000. The BIPA has continued to provide additional increases in certain Medicare payment rates during 2001. In July 2001 CMS published a final rule updating payment rates for skilled nursing facilities under PPS. The new rules increased payments to skilled nursing facilities by an average of 10.3% beginning on October 1, 2001.

Although refinements resulting from the BBRA and the BIPA have been well received by the United States nursing home industry, it is the Company’s belief that the resulting revenue enhancements are still significantly less than the losses sustained by the industry due to the BBA. Current levels of or further reductions in government spending for long-term health care would continue to have an adverse effect on the operating results and cash flows of the Company. The Company will attempt to maximize the revenues available from governmental sources within the changes that have occurred and will continue to occur under the BBA. In addition, the Company will attempt to increase revenues from non-governmental sources, including expansion of its assisted living operations, to the extent capital is available to do so, if at all.

Under the current law, Medicare reimbursements for nursing facilities were reduced following the October 1, 2002 expiration of two temporary payment increases enacted as part of earlier Medicare enhancement bills. There are two additional payment increases that were originally scheduled to expire October 1, 2002. CMS has announced that the expiration of these payments increases have been postponed until at least October 1, 2004. However, President Bush’s proposed fiscal year 2005 budget indicates that the refinements will not be implemented before September 30, 2005. The August 4, 2003 rule also includes an inflation update and a correction of past forecast errors that together increase the fiscal year 2004 skilled nursing facility PPS base rates by a total of 6.26%.

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Insurance

Professional Liability and Other Liability Insurance.

The entire long-term care profession in the United States has experienced a dramatic increase in claims related to alleged negligence and malpractice in providing care to its patients and the Company is no exception in this regard. The Company has numerous pending liability claims, disputes and legal actions for professional liability and other related issues. The Company has limited, and sometimes no, professional liability insurance with respect to many of these claims or with respect to any other claims normally covered by liability insurance. In the event a significant judgment is entered against the Company in one or more of these legal actions in which there is no or insufficient professional liability insurance, the Company does not anticipate that it will have the ability to pay such a judgment or judgments. Also, because professional liability and other liability insurance are covered under the same policies, the Company does not anticipate that it would have insurance in the event of any material general liability loss for any of its properties.

Due to the Company’s past claims experience and increasing cost of claims throughout the long-term care industry, the premiums paid by the Company for professional liability and other liability insurance to cover future periods exceeds the coverage purchased so that it costs more than $1 to purchase $1 of insurance coverage. For this reason, effective March 9, 2002, the Company has purchased professional liability insurance coverage for its United States nursing homes and assisted living facilities that, based on historical claims experience, is likely to be substantially less than the claims that are expected to be incurred. As a result, the Company is effectively self-insured and expects to remain so for the foreseeable future.

The Company has essentially exhausted all general and professional liability insurance available for claims first made during the period from March 9, 2001 through March 9, 2003. For claims made during the period from March 10, 2003 through March 9, 2004, the Company maintains insurance with coverage limits of $250,000 per medical incident and total aggregate policy coverage limits of $1,000,000. The Company is self-insured for the first $25,000 per occurrence with no aggregate limit. As of December 31, 2003, payments already made by the insurance carrier for this policy year have significantly reduced the remaining aggregate coverage amount. For claims made during the period from March 10, 2004 through March 9, 2005, the Company maintains insurance with coverage limits of $250,000 per medical incident and total aggregate policy coverage limits of $1,000,000. The Company is self-insured for the first $25,000 per occurrence with no aggregate limit.

For claims made during the period March 9, 2000 through March 9, 2001, the Company is self-insured for the first $500,000 per occurrence with no aggregate limit for the Company’s United States nursing homes. The policy has coverage limits of $1,000,000 per occurrence, $3,000,000 per location and $12,000,000 in the aggregate. The Company also maintains umbrella coverage of $15,000,000 in the aggregate for claims made during this period. As of December 31, 2003, payments already made by the insurance carrier for this policy year have reduced the remaining aggregate coverage amount.

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Prior to March 9, 2000, the Company was insured on an occurrence basis. For the policy period January 1, 1998 through February 1, 1999 and for the policy period February 1, 1999 through March 9, 2000, the Company had insurance, including excess liability coverage, in the total amount of $50,000,000 per policy. As of December 31, 2003, payments already made by the insurance carriers for these policy years have significantly reduced the remaining aggregate coverage amount in each of the policy periods, but coverage has not been exhausted in either policy period.

Effective October 1, 2001, the Company’s United States assisted living properties were added to the Company’s insurance program for United States nursing home properties and are covered under the same policies as the Company’s nursing facilities. Prior to October 1, 2001, the Company’s United States assisted living facilities maintained occurrence based insurance and a $15,000,000 aggregate umbrella liability policy. As of December 31, 2003, payments already made by the insurance carriers have significantly reduced the remaining aggregate coverage, but coverage has not been exhausted.

In Canada, the Company’s professional liability claims experience and associated costs have been dramatically less than that in the United States. The Canadian facilities owned or leased by the Company are self-insured for the first $4,000 ($5,000 Canadian) per occurrence. The Company’s aggregate primary coverage limit with respect to Canadian operations is $1,545,000 ($2,000,000 Canadian). The Company also maintains a $3,863,000 ($5,000,000 Canadian) aggregate umbrella policy for claims in excess of the foregoing limits for these facilities.

Even for insured claims, the payment of professional liability claims by the Company’s insurance carriers is dependent upon the financial solvency of the individual carriers. The Company is aware that two of its insurance carriers providing coverage for prior years’ claims have either been declared insolvent or are currently under rehabilitation proceedings.

Reserve for Estimated Self-Insured Professional Liability Claims.

Because the Company anticipates that its actual liability for existing and anticipated claims will exceed the Company’s limited professional liability insurance coverage, the Company has recorded total liabilities for reported professional liability claims and estimates for incurred but unreported claims of $47.2 million as of December 31, 2003. Such liabilities include estimates of legal costs. The Company does not have cash or available resources to pay these accrued professional liability claims or any significant portion thereof.

The Company records its estimated liability for these professional liability claims based on the results of an actuarial analysis. These self-insurance reserves are assessed on a quarterly basis, and the amounts recorded for professional and general liability claims are adjusted for revisions in estimates and differences between actual settlements and reserves as determined each period, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified. Any increase in the accrual decreases income in the period, and any reduction in the accrual increases income during the period. Although the Company retains a third-party actuarial firm to assist management in estimating the appropriate accrual for these

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claims, professional liability claims are inherently uncertain, and the liability associated with anticipated claims is very difficult to estimate. As a result, the Company’s actual liabilities may vary significantly from the accrual, and the amount of the accrual may fluctuate by a material amount in any given quarter. Each change in the amount of this accrual will directly affect the Company’s reported earnings for the period in which the change in accrual is made.

While each quarterly adjustment to the recorded liability for professional liability claims affects reported income, these changes do not directly affect the Company’s cash position because the accrual for these liabilities is not funded. The Company does not have cash or available resources to pay these accrued professional liability claims or any significant portion thereof. In the event a significant judgment is entered against the Company in one or more legal actions in which there is no or insufficient professional liability insurance, the Company anticipates that payment of the judgment amounts would require cash resources that would be in excess of the Company’s available cash or other resources. These potential future payments, whether of a judgment or in settlement of a disputed claim, could have a material adverse impact on the Company’s financial position and cash flows.

Other Insurance.

With respect to workers’ compensation insurance, substantially all of the Company’s employees became covered under either an indemnity insurance plan or state-sponsored programs in May 1997. Prior to that time, the Company was self-insured for the first $250,000, on a per claim basis, for workers’ compensation claims in a majority of its United States nursing facilities. However, the insurance carrier providing coverage above the Company’s self insured retention has been declared insolvent by the applicable state insurance agency. As a result, the Company is completely self-insured for workers compensation exposures prior to May 1997. The Company has been and remains a non-subscriber to the Texas workers’ compensation system and is, therefore, completely self-insured for employee injuries with respect to its Texas operations. For the policy period July 1, 2002 through June 30, 2003, the Company entered into a “high deductible” workers compensation insurance program covering the majority of the Company’s United States employees. Under the high deductible policy, the Company is self insured for the first $25,000 per claim, subject to an aggregate maximum of out of pocket cost of $1.6 million, for the 12 month policy period. The Company has a letter of credit of $1.252 million securing its self insurance obligations under this program. The letter of credit is secured by a certificate of deposit of $1.252 million, which is reflected as “restricted cash” in the accompanying balance sheet. The reserve for the high deductible policy is based on known claims incurred and an estimate of incurred but not reported claims determined by an analysis of historical claims incurred. Effective June 30, 2003, the Company entered into a new workers compensation insurance program that provides coverage for claims incurred with premium adjustments depending on incurred losses. Policy expense under this workers compensation policy may be increased or decreased from the level of initial premium payments by up to approximately $1.2 million depending upon the amount of claims incurred during the policy period. The Company has accounted for premium expense under this policy based on its estimate of the level of claims expected to be incurred, and has provided reserves for the settlement of outstanding self-insured claims at amounts believed to be adequate. The liability recorded by the Company for the self-insured obligations under these plans is $1.2 million as of

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December 31, 2003. Any adjustments of future premiums for workers compensation policies and differences between actual settlements and reserves for self-insured obligations are included in expense in the year finalized.

The Company is self-insured for health insurance benefits for certain employees and dependents for amounts up to $150,000 per individual annually. The Company provides reserves for the settlement of outstanding self-insured health claims at amounts believed to be adequate. The liability for reported claims and estimates for incurred but unreported claims is $1.1 million at December 31, 2003. The differences between actual settlements and reserves are included in expense in the year finalized.

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Asset Impairments and Other Charges

In 2003, 2002 and 2001, the Company recorded asset impairment and other charges of $2,092,000, $3,370,000 and $4,847,000, respectively, as shown below.

During 2002, the Company retained the services of an investment banker consultant to seek alternatives to the Company’s capital structure, and paid this consultant approximately $181,000.

During the third quarter of 2002, the Company entered into a letter of intent to enter into a merger agreement with another company. Effective October 7, 2002, the Company terminated the letter of intent. During the fourth quarter of 2002, the Company entered into a letter of intent

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to enter into a merger agreement with another company. Effective March 3, 2003, the Company terminated the letter of intent. The Company incurred expenses of $408,000 in connection with these letters of intent.

During 2003, 2002 and 2001, the Company terminated facility leases, including one assisted living facility in 2003, 16 assisted living facilities in 2002, and two nursing homes in 2001. The Company incurred lease termination charges of approximately $389,000, $750,000 and $360,000 in 2003, 2002 and 2001, respectively, consisting of the remaining net book value of these facilities and costs of completing the transactions.

The other charges of $505,000 in 2001 consist of an accrual for the future operating costs of a leased facility that is no longer operating, including projected rent, maintenance, taxes and insurance.

Company Liquidity and Continuing Operating Losses

The Company has incurred operating losses in the years ended December 31, 2003, 2002 and 2001 and has limited resources available to meet its operating, capital expenditure and debt service requirements during 2004. The Company has a net working capital deficit of $53.3 million as of December 31, 2003. The Company has $42.5 million of scheduled debt maturities (including short term debt and current portions of long term debt) during 2004, and is in default of certain debt covenants contained in debt agreements.

In addition, effective March 9, 2001, the Company obtained professional liability insurance coverage that, based on historical claims experience, is estimated to be substantially less than the claims that could be incurred during 2001, 2002 and 2003 and is less than the coverage required by certain of the Company’s debt and lease agreements. As of December 31, 2003, the Company is engaged in 47 professional liability lawsuits, including 14, 13 and 8 in the states of Florida, Arkansas and Texas, respectively. Several of these cases are scheduled for trial in 2004. The Company is also in a dispute with the landlord of a terminated lease that is subject to an arbitration hearing in April 2004. The Company is the subject of 7 lawsuits filed by the Arkansas Attorney General for which the Company has no insurance. The first of these suits is scheduled for trial in September 2004. The ultimate payments on professional liability claims accrued as of December 31, 2003, arbitration awards, the Arkansas Attorney General lawsuits or claims that could be incurred during 2004 could require cash resources during 2004 that would be in excess of the Company’s available cash or other resources.

The Company is also not in compliance with certain lease and debt agreements, including financial covenants, insurance requirements and other obligations, that allow the Company’s primary lessor certain rights as discussed below and allows the holders of substantially all of the Company’s debt to demand immediate repayment. The majority of the Company’s lenders have the right to force immediate repayment of outstanding debt. If the Company’s lenders force immediate repayment, the Company would not be able to repay the related debt outstanding. Although the Company does not anticipate that such demands will be made, the continued forbearance on the part of the Company’s lenders cannot be assured at this time. Accordingly, the Company has classified the related debt principal amounts as current liabilities in the accompanying consolidated financial statements as of December 31, 2003. Of the total $42.5

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million of matured or scheduled debt maturities (including short term debt and current portions of long term debt) during 2004, the Company intends to repay approximately $3 million from cash generated from operations, approximately $5 million with proceeds from the sale of DCMS and will attempt to refinance the remaining balance. Given that events of default exist under the Company’s working capital line of credit, there can be no assurance that the lender will continue to provide working capital advances. Events of default under the Company’s debt agreements could lead to additional events of default under the Company’s lease agreements covering a majority of its United States nursing facilities. A default in the related lease agreements allows the lessor the right to terminate the lease agreements and assume operating rights with respect to the leased properties. The net book value of property and equipment, including leasehold improvements, related to these facilities total approximately $4.0 million as of December 31, 2003. A default in these lease agreements also allows the holder of the Series B Redeemable Convertible Preferred Stock the right to require the Company to redeem such stock, as described in Note 4. At a minimum, the Company’s cash requirements during 2004 include funding operations (including potential payments related to professional liability claims, arbitration awards and the Arkansas Attorney General’s lawsuits), capital expenditures, scheduled debt service, and working capital requirements. No assurance can be given that the Company will have sufficient cash to meet these requirements.

The Company’s management has implemented a plan to enhance revenues related to the operations of the Company’s nursing homes and assisted living facilities, but the results of these efforts are uncertain. Management is focused on increasing the occupancy in its nursing homes and assisted living facilities through an increased emphasis on attracting and retaining patients and residents. Management is also focused on minimizing future expense increases through the elimination of excess operating costs. Management is also attempting to minimize professional liability claims in future periods by vigorously defending itself against all such claims and through the additional supervision and training of staff employees. The Company is unable to predict if it will be successful in enhancing revenues, reducing operating losses, in negotiating waivers, amendments, or refinancings of outstanding debt, or if the Company will be able to meet any amended financial covenants in the future. Regardless of the effectiveness of management’s efforts, any demands for repayment by lenders, the inability to obtain waivers or refinance the related debt, the termination of lease agreements or entry of a final judgment in a material amount for a professional or general liability claim would have a material adverse impact on the financial position, results of operations and cash flows of the Company. If the Company is unable to generate sufficient cash flow from its operations, is unable to successfully negotiate debt or lease amendments, or is subject to a significant judgment not covered by insurance, the Company may have to explore a variety of other options, including but not limited to other sources of equity or debt financings, asset dispositions, or relief under the United States Bankruptcy Code. The accompanying consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset carrying amounts or the amounts and classification of liabilities that might result should the Company be unable to continue as a going concern.

See additional discussion in “Liquidity and Capital Resources.”

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Health Care Industry

The health care industry is subject to numerous laws and regulations of federal, state and local governments. These laws and regulations include, but are not necessarily limited to, matters such as licensure, accreditation, government health care program participation requirements, reimbursement for patient services, quality of resident care and Medicare and Medicaid fraud and abuse (collectively, the “Health Care Laws”). Changes in these laws and regulations, such as reimbursement policies of Medicare and Medicaid programs as a result of budget cuts by federal and state governments or other legislative and regulatory actions, could have a material adverse effect on the Company’s financial position, results of operations, and cash flows. Future federal budget legislation and federal and state regulatory changes may negatively impact the Company.

All of the Company’s facilities are required to obtain annual licensure renewal and are subject to annual surveys and inspections in order to be certified for participation in the Medicare and Medicaid programs. In order to maintain their state operating license and their certification for participation in Medicare and Medicaid programs, the nursing facilities must meet certain statutory and administrative requirements. These requirements relate to the condition of the facilities, the adequacy and condition of the equipment used therein, the quality and adequacy of personnel, and the quality of resident care. Such requirements are subjective and subject to change. There can be no assurance that, in the future, the Company will be able to maintain such licenses and certifications for its facilities or that the Company will not be required to expend significant sums in order to maintain compliance with regulatory requirements.

A recent fire at a skilled nursing facility in Tennessee with which the Company had no connection has caused legislators and others to focus on existing fire codes. In some instances these codes do not require that sprinklers be installed in all nursing facilities. Certain of the Company’s facilities do not have sprinkler systems. The Company believes that these facilities comply with existing fire codes. While the Company works to comply with all applicable codes and to ensure that all mechanical systems are working properly, a fire or a failure of such systems at one or more of the Company’s facilities, or changes in applicable safety codes or in the requirements for such systems, could have a material adverse impact on the Company.

Recently, government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of fraud and abuse statutes and regulations. Violations of these laws and regulations could result in exclusion from government health care programs together with the imposition of significant fines and penalties, as well as significant repayments for patient services previously billed. Compliance with such laws and regulations can be subject to future government review and interpretation as well as regulatory actions unknown or unasserted at this time. The Company is currently subject to certain ongoing investigations, as described in Part 1. – Item 3. – Legal Proceedings.

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Contractual Obligations and Commercial Commitments

The Company has certain contractual obligations of continuing operations as of December 31, 2003, summarized by the period in which payment is due, as follows (dollar amounts in thousands):

The Company has employment agreements with certain members of management that provide for the payment to these members of amounts up to 2.5 times their annual salary in the event of a termination without cause, a constructive discharge (as defined), or upon a change of control of the Company (as defined). The maximum contingent liability under these agreements is approximately $1.9 million. In addition, upon the occurrence of any triggering event, certain executives may elect to require the Company to purchase options granted to them for a purchase price equal to the difference in the fair market value of the Company’s common stock at the date of termination versus the stated option exercise price. The terms of such agreements are from one to three years and automatically renew for one year if not terminated by the employee or the Company.

The Company’s Canadian subsidiary has provided guarantees of certain cash flow deficiencies and quarterly return obligations of Diversicare VI Limited Partnership (“Diversicare VI”), which may obligate the subsidiary to make interest-free loans to Diversicare VI. Such cash flow obligations have never been called upon. There is no assurance that all or any portion of the loans made to Diversicare VI, if any, will be repaid. These guarantees are not included in the table above due to uncertainty about the amount and timing of obligations under the guarantees. The Company has entered into an agreement to sell its Canadian subsidiary.

Year Ended December 31, 2003 Compared With Year Ended December 31, 2002

The following discussion is significantly impacted by the termination of leases on 16 assisted living properties during 2002, one assisted living facility during 2003 and the closure of another assisted living facility in 2003 (the “Assisted Living Eliminated Operations”), the sale of one Florida nursing home in the fourth quarter of 2002, and the initiation of leases for four Florida nursing homes in 2003, as discussed in the overview at the beginning of Management’s Discussion and Analysis of Financial Condition and Results of Operations. As also noted in the overview, the Company has entered into an agreement to sell DCMS, its Canadian subsidiary, and the consolidated financial statements of the Company have been reclassified to present DCMS as a discontinued operation. Accordingly, the revenue, expenses, assets, liabilities and cash flows of DCMS have been reported separately, and the discussion below addresses principally the results of the Company’s continuing operations.

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Revenues. Net revenues increased to $195.8 million in 2003 from $182.0 million in 2002, an increase of $13.8 million, or 7.6%. Patient revenues increased to $183.1 million in 2003 from $161.8 million in 2002, an increase of $21.3 million, or 13.1%. The increase in patient revenues is due to the new lease for four Florida nursing homes, increased Medicare utilization and increased Medicaid rates in certain states, partially offset by a 1.4% decline in census in the United States in 2003 as compared to 2002, the Florida nursing home sold in the fourth quarter in 2002 and the expiration of Medicare temporary payment increases effective October 1, 2002. As a percentage of total census in the United States, Medicare days increased to 11.4% in 2003 from 10.3% in 2002. Medicare revenues were 26.3% of patient revenue in 2003 and 25.9% in 2002, while Medicaid and similar programs were 61.6% in 2003 compared to 62.2% in 2002.

Resident revenues decreased to $12.5 million in 2003 from $20.1 million in 2002, a decrease of $7.6 million, or 38.1%. This decline is primarily attributable to the Assisted Living Eliminated Operations, which resulted in reduced revenue of approximately $7.4 million.

Ancillary service revenues, prior to contractual allowances, increased to $33.8 million in 2003 from $28.0 million in 2002, an increase of $5.8 million, or 20.4%. The increase is primarily attributable to increased Medicare census and the new lease for four Florida nursing homes, partially offset by the Florida nursing home sold in the fourth quarter of 2002 and reductions in revenue availability under Medicare. Certain per person annual Medicare reimbursement limits on therapy services, which had been temporarily suspended, became effective on September 1, 2003. The limits imposed a $1,590 per patient annual ceiling on physical, speech and occupational therapy services. In December 2003, these limits were again temporarily suspended until December 31, 2005. While the Company is unable to quantify the impact that these new rules will have, it is expected that the reimbursement limitations, if not suspended further, will significantly reduce therapy revenues, and negatively impact the Company’s operating results.

Management fee revenue was $82,000 in 2003. No management fee revenue was recorded in 2002. The management contract under which these revenues were earned included a defined calculation of the “priority of distribution,” which determined the amount of management fees that could be earned by the Company. The management fees at these facilities were reduced by the priority of distribution calculation in 2002 as a result of increased operating costs, primarily salaries and wages. Increases in occupancy led to the management fees earned in 2003. In April 2003, the management contract was terminated and the Company began leasing these facilities, as described above.

Operating Expense. Operating expense increased to $172.6 million in 2003 from $156.7 million in 2002, an increase of $15.9 million, or 10.1%. As a percentage of patient and resident revenues, operating expense increased to 88.3% in 2003 from 86.1% in 2002. The increase in operating expenses is primarily attributable to the operating costs of the four new leased Florida nursing homes, including costs of professional liability claims, and cost increases related to wages and benefits. Partially offsetting these increases are reductions in expense resulting from decreases in the accrual for professional liability claims, the Assisted Living Eliminated Operations and the sale of a Florida nursing home.

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The largest component of operating expenses is wages, which increased to $89.7 million in 2003 from $81.0 million in 2002, an increase of $8.7 million, or 10.8%. This increase is primarily attributable to costs of the four new leased Florida nursing homes and an increase in wages as a result of competitive labor markets in most of the areas in which the Company operates. Partially offsetting this increase, the Company experienced a decrease in wages as a result of reduced costs associated with reduced Medicaid census, the sale of a Florida nursing home and the Assisted Living Eliminated Operations.

The Company’s professional liability costs for United States nursing homes and assisted living facilities, including insurance premiums and reserves for self-insured claims, increased to $16.5 million in 2003 from $16.3 million in 2002, an increase of 0.2 million, or 1.1%. There were increases in expense of approximately $6.6 million related to the four new leased Florida nursing homes. Under the terms of the previous management contracts, the Company was required to obtain professional liability insurance coverage for the four facilities and received reimbursement for the facilities’ pro rata share of premiums paid as well as any claims paid on behalf of the owner. Due to the deteriorated financial condition of the owner and the terms of the owner’s mortgage on the facilities, the Company does not believe that the owner of the four facilities will in the future be able to reimburse the Company for costs incurred in connection with professional liability claims arising out of events occurring at the four facilities prior to the entry of the lease. As a result, the Company recorded a liability of approximately $4.3 million in the second quarter of 2003 to record obligations for estimated professional liability claims relating to these four facilities for which the Company does not anticipate receiving reimbursement from the owner of the facilities.

Offsetting the increases from the new leased homes, there was a non-cash expense reduction of $5.8 million resulting from a downward adjustment in the Company’s accrual for self-insured professional liability risks associated with the settlement of certain professional liability claims. These self-insurance reserves are assessed on a quarterly basis, with changes in estimated losses being recorded in the consolidated statements of operations in the period identified. Professional liability costs include cash and non-cash charges recorded based on current actuarial reviews. The actuarial reviews include estimates of known claims and an estimate of claims that may have occurred, but have not yet been reported to the Company.

Lease Expense. Lease expense decreased to $15.2 million in 2003 from $16.1 million in 2002, a decrease of $0.9 million, or 6.0%. The decrease in lease expense is primarily attributable to the Assisted Living Eliminated Operations, partially offset by additional rent for the new Florida leased facilities.

General and Administrative Expense. General and administrative expense decreased to $11.2 million in 2003 from $12.1 million in 2002, a decrease of $0.9 million, or 8.0%. The decrease is primarily due to severance costs of $735,000 incurred in 2002 following the retirement of the Company’s Chairman and Chief Executive Officer and the resignation of its Chief Operating Officer and resulting reductions in executive compensation costs.

Interest Expense. Interest expense decreased to $3.1 million in 2003 from $3.7 million in 2002, a decrease of $0.6 million, or 16.8%. The decrease is primarily attributable to interest rate

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reductions on the Company’s variable rate debt and reduced interest rates on bank debt refinanced in December 2002.

Asset Impairment and Other Charges. During 2003 and 2002, the Company recorded impairment charges in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” and certain other charges, as follows:

Depreciation and Amortization. Depreciation and amortization expenses decreased to $4.9 million in 2003 from $5.0 million in 2002, a decrease of $88,000 or 1.8%.

Loss from Continuing Operations before Income Taxes; Loss from Continuing Operations Per Common Share. As a result of the above, the loss from continuing operations before income taxes was $13.3 million in 2003 compared to $15.1 million in 2002. No provision or benefit from income taxes was required in 2003. The income tax benefit in 2002 consists of a benefit of $447,000 for a refund of US Federal income taxes received in 2002, offset by a provision of $60,000 for US state income taxes. The Company’s effective tax rate differs materially from the statutory rate mainly due to increases in the Company’s valuation allowance for net deferred tax assets. The basic and diluted loss per share from continuing operations were $2.47 each in 2003 as compared to $2.73 each in 2002.

Income from Discontinued Operations. As discussed in the overview at the start of Management’s Discussion and Analysis of Financial Condition and Results of Operations, the Company has entered into an agreement to sell its Canadian subsidiary, and this subsidiary has been presented as discontinued operations for all periods presented in the Company’s consolidated financial statements. Accordingly, the revenue, expenses, assets, liabilities and cash flows of DCMS have been reported separately. The income from discontinued operations in 2003 was $2.1 million, compared to $1.7 million in 2002, an increase of $353,000, or 20.6%. The increase is primarily due to changes in currency exchange rates.

Year Ended December 31, 2002 Compared With Year Ended December 31, 2001

The following discussion is significantly impacted by termination of leases on 16 assisted living properties during 2002, the termination of leases on two Florida nursing homes in the fourth quarter of 2001 and the sale of one Florida nursing home in the fourth quarter of 2002 (together, the three Florida facilities are referred to as “Nursing Home Eliminated Operations”) as discussed in the overview at the start of Management’s Discussion and Analysis of Financial Condition and Results of Operations. As also noted in the overview, the Company has entered into an agreement to sell DCMS, its Canadian subsidiary, and the consolidated financial statements of the Company have been reclassified to present DCMS as a discontinued operation.

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Accordingly, the revenue, expenses, assets, liabilities and cash flows of DCMS have been reported separately, and the discussion below addresses principally the results of the Company’s continuing operations.

Revenues. Net revenues decreased to $182.0 million in 2002 from $190.4 million in 2001, a decrease of $8.4 million, or 4.4%. Patient revenues increased to $161.8 million in 2002 from $158.4 million in 2001, an increase of $3.4 million, or 2.2%. The increase in patient revenues is due to increased Medicare utilization, Medicare rate increases at several facilities which became effective in October 2001 and increased Medicaid rates in certain states, partially offset by a 1.9% decline in census in 2002 as compared to 2001, the Nursing Home Eliminated Operations and the expiration of Medicare temporary payment increases effective October 1, 2002. As a percent of total census in the United States, Medicare days increased to 10.3% in 2002 from 8.7% in 2001. As a percent of patient revenues, Medicare increased to 25.9% in 2002 from 24.0% in 2001 while Medicaid and similar programs decreased to 62.2% from 64.1% in 2001.

Resident revenues decreased to $20.1 million in 2002 from $31.9 million in 2001, a decrease of $11.8 million, or 36.8%. This decline is primarily attributable to the assisted living facility lease terminations, which resulted in reduced revenue of approximately $11.7 million.

Ancillary service revenues, prior to contractual allowances, increased to $28.0 million in 2002 from $23.0 million in 2001, an increase of $5.0 million or 22.1%. The increase is primarily attributable to increased Medicare census, partially offset by the Nursing Home Eliminated Operations and reductions in revenue availability under Medicare and is consistent with the Company’s expectations.

No management fee revenue was recorded in 2002, compared to $93,000 in 2001. The management contract under which these revenues were earned includes a defined calculation of the “priority of distribution”, which determines the amount of management fees which may be earned by the Company. The Company’s management fee is the lesser of 6% of facility revenues or the amount determined by the priority of distribution calculation. The reduction in management fee revenue is as a result of increased operating costs of these facilities, including primarily salaries and wages.

Operating Expense. Operating expense decreased to $156.7 million in 2002 from $167.7 million in 2001, a decrease of 11.0 million, or 6.5%. As a percent of patient and resident revenues, operating expense decreased to 86.1% in 2002 from 88.1% in 2001. The decrease in operating expense is primarily attributable to a reduction in bad debt and professional liability expenses, the assisted living lease terminations and the Nursing Home Eliminated Operations. Partially offsetting these decreases are cost increases related to nursing and ancillary expenses to support the increased Medicare utilization.

The largest component of operating expenses is wages, which decreased to $81.0 million in 2002 from $82.9 million in 2001, a decrease of $1.9 million, or 2.3%. The decrease in wages is due to reduced costs associated with reduced Medicaid census, the assisted living facility terminations and the Nursing Home Eliminated Operations, partially offset by wage increases due to competitive labor markets in most of the areas in which the Company operates.

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The Company’s professional liability costs for United States nursing homes and assisted living facilities, including insurance premiums and reserves for self-insured claims, decreased to $16.3 million in 2002 from $21.2 million in 2001, a decrease of $4.8 million, or 22.6%. The 2001 professional liability expense included a one-time charge of $8.7 million, recorded based on an actuarial review and reflecting the effects of additional claims and higher settlements per claim. The 2002 professional liability cost includes cash and non-cash charges recorded based on current actuarial reviews, including the recent effects of additional claims and higher settlements per claim. The actuarial reviews include estimates of known claims and a prediction of claims that may have occurred, but have not yet been reported to the Company.

Lease Expense. Lease expense decreased to $16.1 million in 2002 from $19.7 million in 2001, a decrease of $3.6 million, or 18.2%. The decrease in lease expense is primarily attributable to the assisted living lease terminations.

General and Administrative Expense. General and administrative expense increased to $12.1 million in 2002 from $11.6 million in 2001, an increase of $0.5 million, or 4.2%. The increase is primarily attributable to charges of $735,000 recorded for severance following the retirement of the Company’s and Chief Executive Officer and the resignation of its Chief Operating Officer in 2002, together with increases in salaries and wages. These increases were partially offset by lower workers compensation audit premiums and a reduction in travel and entertainment in 2002.

Interest Expense. Interest expense decreased to $3.7 million in 2002 from $4.7 million in 2001, a decrease of $1.0 million or 21.5%. The decrease is primarily due to interest rate reductions on the Company’s variable rate debt and a decrease in 2002 in the Company’s average outstanding debt balance.

Depreciation and Amortization. Depreciation and amortization expenses decreased to $5.0 million in 2002 from $5.3 million in 2001, a decrease of $0.3 million, or 4.4%

Asset Impairment and Other Charges. During 2002, the Company recorded impairment charges in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” and certain other charges, as follows:

During 2001, the Company recorded asset impairment charges of $4.3 million for the estimated impairment of certain assets and other charges of $505,000 for an accrual of the future operating costs of a non-operating facility, including projected rent, maintenance, taxes and insurance.

Loss from Continuing Operations before Income Taxes; Loss from Continuing Operations Per Common Share. As a result of the above, the loss from continuing operations before income

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taxes was $15.1 million in 2002 compared to $23.5 million in 2001. The income tax benefit in 2002 consists of a benefit of $447,000 for a refund of US Federal income taxes received in 2002, offset by a provision of $60,000 for US state income taxes. No provision or benefit from income taxes was required in 2001. The Company’s effective tax rate differs materially from the statutory rate mainly due to increases in the Company’s valuation allowance for net deferred tax assets. The basic and diluted loss per share from continuing operations were $2.73 each in 2002 as compared to $4.32 each in 2001.

Income from Discontinued Operations. As discussed in the overview at the start of Management’s Discussion and Analysis of Financial Condition and Results of Operations, the Company has entered into an agreement to sell its Canadian subsidiary, and this subsidiary has been presented as discontinued operations for all periods presented in the Company’s consolidated financial statements. Accordingly, the revenue, expenses, assets, liabilities and cash flows of DCMS have been reported separately. The income from discontinued operations in 2002 was $1.7 million, compared to $1.4 million in 2001, an increase of $262,000, or 18.1%.

Liquidity and Capital Resources

At December 31, 2003, the Company had negative working capital of $53.3 million and a current ratio of 0.37, compared with negative working capital of $58.8 million and a current ratio of 0.29 at December 31, 2002. The Company has incurred losses during 2003, 2002, and 2001 and has limited resources available to meet its operating, capital expenditure and debt service requirements during 2004.

Certain of the Company’s debt agreements contain various financial covenants, the most restrictive of which relate to current ratio requirements, tangible net worth, cash flow, net income (loss), required insurance coverages, and limits on the payment of dividends to shareholders. As of December 31, 2003, the Company was not in compliance with certain of the financial covenants contained in the Company’s debt and lease agreements. The Company has not obtained waivers of the non-compliance. Cross-default or material adverse change provisions contained in the debt agreements allow the holders of substantially all of the Company’s debt to demand immediate repayment. The Company would not be able to repay this indebtedness if the applicable lenders demanded repayment. Although the Company does not anticipate that such demand will be made, the continued forbearance on the part of the Company’s lenders cannot be assured at this time. Given that events of default exist under the Company’s working capital line of credit, there can be no assurance that the lender will continue to provide working capital advances.

As of December 31, 2003, the Company has $42.5 million of scheduled debt maturities in 2004 that must be repaid or refinanced during the next twelve months. As a result of these maturities, covenant non-compliance and other cross-default provisions, the Company has classified a total of $52.5 million of debt as current liabilities as of December 31, 2003.

The existing events of default under the Company’s debt agreements could lead to actions by the lenders that could result in an event of default under the Company’s lease agreements covering a majority of its United States nursing facilities. Should such a default occur in the related lease

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agreements, the lessor would have the right to terminate the lease agreements and assume operating rights with respect to the leased properties. The net book value of property and equipment, including leasehold improvements, related to these facilities total approximately $4.0 million as of December 31, 2003. A default in these lease agreements would also give the holder of the Series B Redeemable Convertible Preferred Stock the right to require the Company to redeem those shares.

Management continues to focus on efforts to increase revenues and to minimize future expense increases through the elimination of excess operating costs. Management is also attempting to minimize professional liability claims in the future periods by vigorously defending the Company against all such claims and through the additional supervision and training of staff employees. The Company is unable to predict if it will be successful in reducing operating losses, in negotiating waivers, amendments, or refinancings of outstanding debt, or if the Company will be able to meet any amended financial covenants in the future. Any demands for repayment by lenders, the inability to obtain waivers or refinance the related debt, the termination of the lease agreements or entry of a final judgment in a material amount for a professional or general liability claim would have a material adverse impact on the financial position, results of operations and cash flows of the Company. If the Company is unable to generate sufficient cash flow from its operations or successfully negotiate debt or lease amendments, or is subject to a significant judgment not covered by insurance, the Company may have to explore a variety of other options, including but not limited to other sources of equity or debt financings, asset dispositions, or relief under the United States Bankruptcy Code. The accompanying consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset carrying amounts or the amounts and classification of liabilities that might result should the Company be unable to continue as a going concern. The independent public accountant’s report on the Company’s financial statements at December 31, 2003, 2002 and 2001 includes a paragraph with regards to the uncertainty of the Company’s ability to continue as a going concern.

As of December 31, 2003, the Company had no borrowings under its working capital line of credit, and during 2003, average monthly borrowings under the working capital line of credit were as high as $824,000. The total maximum outstanding balance of the working capital line of credit, including letters of credit outstanding, is $2.5 million. There are certain restrictions based on certain borrowing base restrictions. As of December 31, 2003 the Company had $200,000 of letters of credit outstanding with the same bank lender, which further reduce the maximum available amount outstanding under the working capital line of credit. As of December 31, 2003, the Company had total additional borrowing availability of $2.3 million under its working capital line of credit. The working capital line of credit matures in April 2004 with interest at either LIBOR plus 2.50% or the bank’s prime rate plus .50% (up to a maximum of 9.50%). Given the Company’s default under its credit facility, no assurance can be given that the bank will allow the Company to draw under its working capital line of credit. At a minimum, the Company’s cash requirements during 2004 include funding operations (including potential payments related to professional liability claims), capital expenditures, scheduled debt service, and working capital requirements. No assurance can be given that the Company will have sufficient cash to meet these requirements.

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The Company has numerous pending liability claims, disputes and legal actions for professional liability and other related issues. The Company has limited, and sometimes no, professional liability insurance with respect to many of these claims. In the event a significant judgment is entered against the Company in one or more of these legal actions in which there is no or insufficient professional liability insurance, the Company does not anticipate that it will have the ability to pay such a judgment or judgments.

Net cash provided by operating activities of continuing operations totaled $3.3 million, $10.8 million and $5.0 million in 2003, 2002 and 2001, respectively. These amounts primarily represent the cash flows from net operations plus changes in non-cash components of operations and by working capital changes. Discontinued operations provided cash of $2.6 million in 2003 and $1.0 million in 2001. The increased amount of cash provided by operating activities during 2002 was due primarily to improved management of its accounts receivable collections.

Net cash used in investing activities totaled $3.6 million, $3.8 million and $2.9 million in 2003, 2002 and 2001, respectively. These amounts primarily represent purchases of property plant and equipment and investments in and advances to joint ventures. The Company has used between $2.7 million and $3.5 million for capital expenditures in the three calendar years ending December 31, 2003. Substantially all such expenditures were for facility improvements and equipment, which were financed principally through working capital. For the year ending December 31, 2004, the Company anticipates that capital expenditures for improvements and equipment for its existing facility operations will be approximately $4.0 million.

Net cash used in financing activities totaled $1.4 million, $5.0 million and $3.7 million in 2003, 2002 and 2001, respectively. The net cash used in financing activities primarily represents net repayments of debt.

Receivables

The Company’s operations could be adversely affected if it experiences significant delays in reimbursement of its labor and other costs from Medicare, Medicaid and other third-party revenue sources. The Company’s future liquidity will continue to be dependent upon the relative amounts of current assets (principally cash, accounts receivable and inventories) and current liabilities (principally accounts payable and accrued expenses). In that regard, accounts receivable can have a significant impact on the Company’s liquidity. Continued efforts by governmental and third-party payors to contain or reduce the acceleration of costs by monitoring reimbursement rates, by increasing medical review of bills for services, or by negotiating reduced contract rates, as well as any delay by the Company in the processing of its invoices, could adversely affect the Company’s liquidity and results of operations.

Accounts receivable of continuing operations attributable to the provision of patient and resident services at December 31, 2003 and 2002, totaled $17.7 million and $14.1 million, respectively, representing approximately 30 and 26 days in accounts receivable, respectively. The allowance for bad debt was $1.8 million and $2.2 million at December 31, 2003 and 2002, respectively.

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The Company continually evaluates the adequacy of its bad debt reserves based on patient mix trends, aging of older balances, payment terms and delays with regard to third-party payors, collateral and deposit resources, as well as other factors. The Company continues to evaluate and implement additional procedures to strengthen its collection efforts and reduce the incidence of uncollectible accounts.

Stock Exchange

The Company’s stock is quoted on the NASD’s OTC Bulletin Board under the symbol AVCA.

Inflation

Management does not believe that the Company’s operations have been materially affected by inflation. The Company expects salary and wage increases for its skilled staff to continue to be higher than average salary and wage increases, as is common in the health care industry.

Recent Accounting Pronouncements

In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The statement nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring).” The Statement changes the measurement and timing of recognition for exit costs, including restructuring charges. The Statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. A fundamental conclusion reached by the Board in this Statement is that an entity’s commitment to a plan, by itself, does not create a present obligation to others that meets the definition of a liability. The Statement is effective for any such activities initiated after December 31, 2002. It has no effect on charges recorded for exit activities begun prior to this date. The adoption of this statement did not have a material effect on the Company’s financial position or results of operations.

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities (“FIN 46”). FIN 46 clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is generally applicable to the Company effective March 21, 2004, with disclosure required currently if the Company expects to consolidate any variable interest entities. The Company does not have an interest in any variable interest entities and the adoption of this interpretation is not expected to have a material effect on the Company’s financial position or results of operations.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” that amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133. With certain exceptions, SFAS 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designed

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after June 30, 2003. The adoption of this statement did not have any effect on the Company’s financial position or results of operations.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity,” that improves the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity. SFAS 150 requires that these instruments be classified as liabilities in the statement of financial position. This statement is effective for financial instruments entered into or modified after May 31, 2003 and otherwise will be effective for the Company’s quarter beginning July 1, 2003. The adoption of this statement did not have any effect on the Company’s financial position or results of operations.

Forward-Looking Statements

The foregoing discussion and analysis provides information deemed by Management to be relevant to an assessment and understanding of the Company’s consolidated results of operations and its financial condition. This discussion and analysis should be read in conjunction with the Company’s consolidated financial statements included herein. Certain statements made by or on behalf of the Company, including those contained in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere, are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements involve risks and uncertainties including, but not limited to, changes in governmental reimbursement, government regulation and health care reforms, the increased cost of borrowing under the Company’s credit agreements, covenant waivers from the Company’s lenders, possible amendments to the Company’s credit agreements, ability to control ultimate professional liability costs, the impact of future licensing surveys, changing economic conditions as well as others. Investors also should refer to the risks identified in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as well as risks identified in “Part 1. Item 1. Business – Material Corporate Developments and Risk Factors” for a discussion of various risk factors of the Company and that are inherent in the health care industry. Given these risks and uncertainties, the Company can give no assurances that these forward-looking statements will, in fact, transpire and, therefore, cautions investors not to place undue reliance on them. Actual results may differ materially from those described in such forward-looking statements. Such cautionary statements identify important factors that could cause the Company’s actual results to materially differ from those projected in forward-looking statements. In addition, the Company disclaims any intent or obligation to update these forward-looking statements.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The chief market risk factor affecting the financial condition and operating results of the Company is interest rate risk. As of December 31, 2003, the Company’s continuing operations had outstanding borrowings of approximately $52.5 million including $16.8 million in fixed-rate borrowings and $35.7 million in variable-rate borrowings. In the event that interest rates were to change 1%, the impact on future cash flows would be approximately $357,000 for 2004, representing the impact of increased interest expense on variable rate debt.

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The Company receives revenues and incurs expenses in Canadian dollars with respect to Canadian management activities and operations of the Company’s eight Canadian retirement facilities (three of which are owned) and two owned Canadian nursing homes. The Company believes that its exposure to market risk related to changes in foreign currency exchange rates and trade accounts receivable and accounts payable is not material. As discussed in the overview at the start of Management’s Discussion and Analysis of Financial Condition and Results of Operations, the Company has entered into an agreement to sell its Canadian subsidiary.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Audited financial statements are contained on pages F-1 through F-41 of this Annual Report on Form 10-K and are incorporated herein by reference. Audited supplemental schedule data is contained on pages S-1 and S-2 of this Annual Report on Form 10-K and is incorporated herein by reference.

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

None.

ITEM 9A. CONTROLS AND PROCEDURES.

In an effort to ensure that the information the Company must disclose in its filings with the Securities and Exchange Commission is recorded, processed, summarized, and reported on a timely basis, the Company’s principal executive officer and principal financial officer have evaluated the effectiveness of the Company’s disclosure controls and procedures, as defined in Exchange Act Rules 13a-15(e) and 15d-15(e), as of December 31, 2003. Based on such evaluation, such officers have concluded that, as of December 31, 2003, the Company’s disclosure controls and procedures were effective in timely alerting them to information relating to the Company required to be disclosed in the Company’s periodic reports filed with the SEC. There has been no change in the Company’s internal control over financial reporting during the quarter ended December 31, 2003 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Information concerning Directors and Executive Officers of the Company is incorporated herein by reference to the Company’s definitive proxy materials for the Company’s 2004 Annual Meeting of Shareholders.

ITEM 11. EXECUTIVE COMPENSATION

Information concerning Executive Compensation is incorporated herein by reference to the Company’s definitive proxy materials for the Company’s 2004 Annual Meeting of Shareholders.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

Information concerning Security Ownership of Certain Beneficial Owners and Management is incorporated herein by reference to the Company’s definitive proxy materials for the Company’s 2004 Annual Meeting of Shareholders.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Information concerning Certain Relationships and Related Transactions is incorporated herein by reference to the Company’s definitive proxy materials for the Company’s 2004 Annual Meeting of Shareholders.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

Information concerning the fees and services provided by the Company’s principal accountant is incorporated herein by reference to the Company’s definitive proxy materials for the Company’s 2004 Annual Meeting of Shareholders.

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PART IV

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

Financial statements and schedules of the Company and its subsidiaries required to be included in Part II, Item 8 are listed below.

Exhibits

The exhibits filed as part of this Report on Form 10-K are listed in the Exhibit Index immediately following the financial statement pages.

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Reports on Form 8-K

Form 8-K filed on November 3, 2003, to announce that the deadline for shareholders to vote on the transaction to sell the Company’s wholly-owned subsidiary, Diversicare Canada Management Services Co., Inc. (DCMS), had been extended to November 21, 2003.

Form 8-K filed on November 10, 2003, to announce that the Company’s petition for certiorari was denied by the United States Supreme Court in the Mena Arkansas case of Advocat v. Sauer.

Form 8-K filed on November 14, 2003, to file the press release issued to report results of operations for the quarter ending September 30, 2003.

Form 8-K filed on November 21, 2003, to announce that the Company’s shareholders have approved the sale of its Canadian subsidiary for $16.5 million Canadian. The transaction remains subject to certain regulatory approval.

Form 8-K filed on December 12, 2003, to announce the appointment of Raymond L. Tyler to Executive Vice President and Chief Operating Officer.

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