UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the Quarterly Period Ended: September 30, 2004

OR

For the transition period from _________ to _________.

Commission file No.: 1-12996

Advocat Inc.

277 Mallory Station Road, Suite 130, Franklin, TN 37067

(615) 771-7575

None

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [   ]

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

5,695,287

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Table of Contents

Part I. FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

ADVOCAT INC.
INTERIM CONSOLIDATED BALANCE SHEETS
(in thousands)

(Continued)

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ADVOCAT INC.

INTERIM CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
(continued)

The accompanying notes are an integral part of these interim consolidated balance sheets.

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ADVOCAT INC.

INTERIM CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts, unaudited)

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

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ADVOCAT INC.

INTERIM CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts, unaudited)

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

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ADVOCAT INC.

INTERIM CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands and unaudited)

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

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ADVOCAT INC.

INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands and unaudited)

(Continued)

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ADVOCAT INC.

INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands and unaudited)
(continued)

During the nine month periods ended September 30, 2004 and 2003, the Company accrued, but did not pay, Preferred Stock dividends of $221,000 and $206,000, respectively.

During 2004, promissory notes totaling $3,331,000 were issued in connection with the settlement of certain professional liability claims and other disputes, with terms requiring monthly payments through February 2007.

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

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ADVOCAT INC.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2004 AND 2003

1. BUSINESS

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. 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.

On May 11, 2004, the Company sold 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 operated 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, and by regulatory authorities in Canada in April 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 September 30, 2004, the Company operates 62 facilities, consisting of 48 nursing homes with 5,108 licensed beds and 14 assisted living facilities with 987 units. As of September 30, 2004, the Company owns 10 nursing homes and leases 38 others. Additionally, the Company owns 12 assisted living facilities and leases 2 others.

The Company leases three nursing homes in Texas under a lease that expired in April 2004. Since the expiration of the lease, the Company has operated under the lease on a month to month basis. The owner of the properties has notified the Company that it intends to sell these properties. Following the sale, the Company will terminate its operations in these facilities and cooperate in an orderly transition to the new owner.

In October 2004, the Company sold an assisted living facility in North Carolina that had been closed in 2003. The net proceeds were approximately $60,000 and there was no material gain or loss resulting from the sale.

In November 2004, the Company sold certain assets of its medical supply business, Advocat Distribution Services. The initial purchase price was $225,000, with additional consideration based on the results of operations of the business over the two years following the sale. No material gain or loss is expected from the initial proceeds. Any additional consideration received in the future under the terms of the agreement will be recorded when determined.

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

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results of operations of these facilities are included in the Company’s results of operations beginning April 1, 2003.

Effective May 31, 2003, the Company terminated the lease of an assisted living facility. The lease termination agreement required aggregate payments of approximately $355,000, with $75,000 paid in June 2003 and the balance over the following twelve months. The Company made its final payment under this agreement in May 2004.

Since the implementation of the Balanced Budget Act of 1997, the long-term health care environment has undergone substantial change with regard to reimbursement and other payor sources, compliance regulations, competition among other health care providers and relevant patient liability issues. The Company continually monitors these industry developments as well as other factors that affect its business. See Item 2 for further discussion of recent changes in the long-term health care industry and the related impact on the operations of the Company.

2. BASIS OF PRESENTATION OF FINANCIAL STATEMENTS

The interim consolidated financial statements for the three and nine month periods ended September 30, 2004 and 2003, included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In the opinion of management of the Company, the accompanying interim consolidated financial statements reflect all adjustments necessary to present fairly the Company’s financial position at September 30, 2004 and the results of operations for the three and nine month periods ended September 30, 2004 and 2003, and the cash flows for the three and nine month periods ended September 30, 2004 and 2003.

The results of operations for the three and nine month periods ended September 30, 2004 and 2003 are not necessarily indicative of the operating results that may be expected for a full year. These interim consolidated financial statements should be read in connection with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003.

The accompanying consolidated financial statements have been prepared assuming that Advocat will continue as a going concern. Although the Company reported a profit for the nine month period ended September 30, 2004, the profit primarily resulted from non-cash expense reductions caused by downward adjustments in the Company’s accrual for self-insured risks associated with professional liability claims, as discussed in Note 3 below. The Company has recorded total liabilities for reported professional liability claims and estimates for incurred but unreported claims of $43.4 million as of September 30, 2004. The Company does not have cash or available resources to pay these accrued professional liability claims or any significant portion thereof. The Company incurred operating losses in 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 and beyond. The Company has a net working capital deficit of $46.0 million as of September 30, 2004. The Company has $38.2 million of scheduled debt maturities (including short term debt and current portions of long term debt) during the next twelve months.

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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 the policy years 2001 through 2004 and is less than the coverage required by certain of the Company’s debt and lease agreements. The ultimate payments on professional liability claims accrued as of September 30, 2004, or other claims that could be incurred during 2004 could require in the future cash resources 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. 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. If the Company’s lenders force immediate repayment, the Company would not be able to repay the related debt outstanding. Accordingly, the Company has classified the related debt principal amounts as current liabilities in the accompanying consolidated financial statements as of September 30, 2004. Of the total $38.2 million of matured or scheduled debt maturities (including short term debt and current portions of long term debt) during the next twelve months, the Company intends to repay approximately $3 million from cash generated from operations 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 September 30, 2004. 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.

At a minimum, the Company’s cash requirements during 2004 and 2005 include funding operations (including settlement payments related to professional liability and other 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. The independent accountants’ report on the Company’s financial statements at December 31, 2003, 2002 and 2001 includes an explanatory paragraph concerning the Company’s ability to continue as a going concern.

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 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 expenses, 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

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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.

3. INSURANCE MATTERS

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 arising from its operations.

Due to the Company’s past claims experience and the 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, 2001, 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 September 30, 2004, payments already made by the insurance carrier for this policy year have reduced the remaining aggregate coverage amount, and the Company has approximately $0.4 million of coverage remaining. 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

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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 September 30, 2004, 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 September 30, 2004, 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 September 30, 2004, payments already made by the insurance carriers have significantly reduced the remaining aggregate coverage, but coverage has not been exhausted.

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 $43.4 million as of September 30, 2004. 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.

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In the nine month period ended September 30, 2004, the Company reported income from continuing operations of $6.3 million, primarily as a result of non-cash expense reductions of $14.8 million, caused by downward adjustments in the Company’s accrual for self-insured risks associated with professional liability claims. These adjustments were primarily the result of the effects of settlements of certain claims for amounts less than previously estimated. 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. Any such judgment 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 out of pocket cost of $1.6 million, for the 12 month policy period. The Company has a letter of credit of $0.8 million securing its self insurance obligations under this program. The letter of credit is secured by a certificate of deposit of $0.8 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, and continuing for the policy year ending June 30, 2005, 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 these workers compensation policies for the years ending June 30, 2004 and 2005 may be increased or decreased from the level of initial premium payments by up to approximately $1.1 million and $2.0 million, respectively, depending upon the amount of claims incurred during the policy period. The Company has accounted for premium expense under these policies 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 $0.6 million as of September 30, 2004. 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 period 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

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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 $1.7 million at September 30, 2004. The differences between actual settlements and reserves are included in expense in the period finalized.

4. OTHER COMPREHENSIVE INCOME

The Company follows the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 130, “Reporting Comprehensive Income.” SFAS No. 130 requires the reporting of comprehensive income (loss) in addition to net income (loss) from operations. Comprehensive income is a more inclusive financial reporting methodology that includes disclosure of certain financial information that historically has not been recognized in the calculation of net income. Information with respect to the accumulated other comprehensive income (loss) balance is presented below:

Positive balances represent unrealized gains and negative balances represent unrealized losses.

5. STOCK-BASED COMPENSATION

SFAS No. 123, “Accounting for Stock-Based Compensation” encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock based compensation using the intrinsic value method as prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and the related Interpretations (all herein referred to as “APB No. 25”). Under APB No. 25, no compensation cost related to stock options has been recognized because all options are issued with exercise prices equal to the fair market value at the date of grant. Had compensation cost for the Company’s stock-based compensation plans been determined consistent with SFAS No. 123, the Company’s net income (loss) for common stock and net income (loss) per common share for the three and nine month periods ended September 30, 2004 and 2003 would not have differed materially from the amounts actually reported.

6. RECLASSIFICATIONS

Certain amounts in the 2003 interim financial statements have been reclassified to conform with the 2004 presentation.

7. OPERATING SEGMENT INFORMATION

The Company has two reportable segments: nursing homes and assisted living facilities. Management evaluates each of these segments independently due to the reimbursement, marketing, and regulatory differences between the segments. As discussed in Note 9, the Company sold its Canadian operations in May 2004, and reports these operations as a discontinued operation. The

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consolidated financial statements have been reclassified to reflect the discontinuation of these Canadian operations, which had previously been reported as a separate segment, for all periods presented.

Management evaluates performance based on income or loss from operations before income taxes not including asset impairments and other charges. The following information is derived from the Company’s segments’ internal financial statements and includes information related to the Company’s unallocated corporate revenues and expenses:

8. FINANCING TRANSACTIONS

In April 2004, the Company entered into an agreement to extend the maturities of certain borrowings from a commercial finance company with an outstanding balance of $3.3 million at March 31, 2004. The new agreement extended the maturities of these borrowings from March 31, 2004 to April 1, 2005.

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In July 2004, the Company entered into an agreement to extend the maturities of certain borrowings from a commercial finance company with an outstanding balance of $22.6 million at June 30, 2004. The new agreement extended the maturities of these borrowings from June 30, 2004 to January 1, 2005.

The Company believes that it has reached agreement on the terms of an extension of the maturities of certain borrowings from a bank lender, including the Company’s working capital line of credit, that have an aggregate outstanding balance of $8.5 million at September 30, 2004. The proposed terms extend the maturity date of this indebtedness to January 2005 and require monthly reductions in the maximum amount outstanding under the working capital line of credit of $33,333 until the limit is reduced from $2.5 million to $2.3 million. While the Company believes it has reached agreement with the bank, the extension has not been executed as of the date of this filing.

9. SALE OF CANADIAN OPERATIONS -

On May 11, 2004, the Company sold 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 operated 14 nursing homes and 24 assisted living facilities in the Canadian provinces of Ontario, British Columbia and Alberta.

The sales price was $16.5 million Canadian (approximately $11.8 million US at the May 11, 2004 exchange rate). Approximately $8.5 million Canadian ($6.1 million US) was received at closing, with the balance, $8.0 million Canadian ($5.7 million US), scheduled to be received in annual installments of $600,000 Canadian ($428,000 US) on the anniversary of the closing for the first four years and a final installment of $5.6 million Canadian ($4.0 million US) on the fifth anniversary of closing. The future payments may be accelerated upon the occurrences of certain events. The installment portion of the purchase price is evidenced by a promissory note that has been discounted to estimated fair value and was initially recorded in the accompanying balance sheet at $4.7 million US.

The Company recorded a gain before income taxes of approximately $583,000 US, including the effects of the recognition of cumulative foreign currency translation adjustments, and has recorded foreign and domestic taxes of $424,000 related to the gain.

Net proceeds from this transaction were used to repay outstanding bank debt and related transaction costs, including US and Canadian taxes. Payments received in the future under the promissory note will also be used to repay outstanding bank debt.

In accordance with SFAS 144, DCMS has been presented as a discontinued operation 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 results of discontinued operations do not reflect any allocation of corporate general and administrative expense or any allocation of corporate interest expense.

10. COMMITMENTS AND CONTINGENGIES

The Company was in a dispute with the owner of an assisted living facility in which the Company terminated the lease. This dispute was the subject of an arbitration hearing scheduled for June 2004. Prior to the arbitration hearing, the Company reached an agreement with the owner of the property

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for the settlement of all claims, and this settlement was executed in July 2004. In connection with this settlement, the Company agreed to make payments totaling $550,000 through February 2007, and to allow the property owner to draw on a $200,000 letter of credit that had been previously issued as security for the original lease. The Company recorded a charge of approximately $280,000 during the second quarter of 2004 in connection with the revised estimate of settlement charges and related legal costs.

During 2004, the Company recorded liabilities totaling $3.3 million for promissory notes issued in connection with the settlement of certain professional liability claims and the resolution of the dispute described above. These notes are payable in monthly installments through February 2007.

On September 8, 2004, the Company entered into a settlement agreement with the attorney General of the State of Arkansas setting forth the terms by which the Company resolved all civil claims and investigations commenced by the State of Arkansas prior to the entry of the agreement, including seven lawsuits then pending in the Circuit Court of Pulaski County, Arkansas alleging violations of the Arkansas Abuse of Adults Act and violation of the Arkansas Medicaid False Claims Act with respect to certain residents of facilities operated by the Company in Arkansas. Under the terms of the settlement, the Company is obligated (i) to pay $400,000 in equal monthly installments of $16,667 beginning on September 1, 2004 and ending on August 1, 2006, and (ii) to pay by no later than September 1, 2007 no less than $600,000 to install sprinkler systems in nursing homes within the State of Arkansas to be selected by the Company. The Company has incurred expenditures of approximately $134,000 to date toward this requirement.

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11. EARNINGS PER SHARE

Information with respect to basic and diluted net income (loss) per share is presented below:

12. ASSET IMPAIRMENT AND OTHER CHARGES

During 2004 and 2003, 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:

As a result of projected cash flows, impairment charges of $704,000 were recorded in 2004 for two owned nursing homes and two leased nursing homes. During the nine months ended September 30, 2003, the Company recorded charges of $20,000 to write down assets held for sale to estimated net realizable value.

The Company incurred lease termination charges relating to its assisted living facilities of approximately $280,000 in 2004 and $344,000 in 2003.

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ITEM 2. 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. 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.

On May 11, 2004, the Company sold 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 operated 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, and by regulatory authorities in Canada in April 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 of September 30, 2004, the Company operates 62 facilities, consisting of 48 nursing homes with 5,108 licensed beds and 14 assisted living facilities with 987 units. As of September 30, 2004, the Company owns 10 nursing homes and leases 38 others. Additionally, the Company owns 12 assisted living facilities and leases 2 others.

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.

Effective May 31, 2003, the Company terminated the lease of an assisted living facility. The lease termination agreement required aggregate payments of approximately $355,000, with $75,000 paid in June 2003 and the balance over the following twelve months. The Company made its final payment under this agreement in May 2004.

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.

Fluctuations in Earnings or Losses. In the nine month period ended September 30, 2004, the Company reported income from continuing operations of $6.3 million, primarily as a result of non-cash expense reductions of $14.8 million, caused by downward adjustments in the Company’s

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accrual for self-insured risks associated with professional liability claims. These adjustments were primarily the result of the effects of settlements of certain claims for amounts less than previously estimated. While these adjustments to the accrual resulted in reported income, they did not generate cash because the accrual is not funded by the Company. As of September 30, 2004, the Company has reported a liability of $43.4 million, including reported professional liability claims and estimates for incurred but unreported claims, compared to a liability of $47.2 million as of December 31, 2003. 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 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.

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:

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

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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 relates 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.

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 $43.4 million as of September 30, 2004. 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

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the judgment amounts would require cash resources that would be in excess of the Company’s available cash or other resources. Any such judgment 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 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 provided legislative relief in the form of increases in certain Medicare payment rates during 2000. 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.

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. While CMS announced two increases to skilled nursing facility rates effective October 2003, and will continue certain add-ons for high-acuity patients until CMS refines the Resource Utilization Group (“RUG”) system, there can be no assurances that payments from the Medicare program will remain at levels comparable to present levels or will, in the future, be sufficient to cover the costs allocable to Medicare patients. Any reduction in government spending for long-term health care would have an adverse effect on the operating results and cash flows of the Company.

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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, 2001, 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 September 30, 2004, payments already made by the insurance carrier for this policy year have reduced the remaining aggregate coverage amount, and the Company has approximately $0.4 million of coverage remaining. 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 September 30, 2004, 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 September 30, 2004, payments already made by the insurance carriers

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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 September 30, 2004, payments already made by the insurance carriers have significantly reduced the remaining aggregate coverage, but coverage has not been exhausted.

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 $43.4 million as of September 30, 2004. 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 of the judgment amounts would require cash resources that would be in excess of the Company’s available cash or other resources. Any such judgment could have a material adverse impact on the Company’s financial position and cash flows.

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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 out of pocket cost of $1.6 million, for the 12 month policy period. The Company has a letter of credit of $0.8 million securing its self insurance obligations under this program. The letter of credit is secured by a certificate of deposit of $0.8 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, and continuing for the policy year ending June 30, 2005, 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 policies for the years ending June 30, 2004 and 2005 may be increased or decreased from the level of initial premium payments by up to approximately $1.1 million and $2.0 million, respectively, depending upon the amount of claims incurred during the policy period. The Company has accounted for premium expense under these policies 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 $0.6 million as of September 30, 2004. 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 period 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 $1.7 million at September 30, 2004. The differences between actual settlements and reserves are included in expense in the period finalized.

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 Company’s financial

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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 comply with regulatory requirements.

A 2003 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. Some of the Company’s facilities do not have sprinkler systems, although the Company expects to install or upgrade sprinklers in seven facilities over the next three years. 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, state and federal government activity has increased with respect to investigations and allegations concerning possible violations by health care providers of fraud and abuse statutes and regulations, as well as of elder 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 claims and investigations, as described in Part II. Other Information – Item 1. Legal Proceedings. There can be no assurance that the Company will not be subject to other claims, investigations or allegations concerning possible violations by health care providers of fraud and abuse and elder abuse statutes and regulations. Any material fine, penalty or repayment obligation incurred as a result of a governmental investigation or claim or any limitation on the Company’s ability to participate in federal or state health care reimbursement programs imposed as a result of such an investigation or claim would have a material adverse impact upon the Company’s financial condition, cash flows or results of operations.

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Contractual Obligations and Commercial Commitments

The Company has certain contractual obligations of continuing operations as of September 30, 2004, 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 $1.0 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.

Results of Operations

The following tables present the unaudited interim statements of operations and related data for the three and nine months ended September 30, 2004 and 2003:

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Three Months Ended September 30, 2004 Compared With Three Months Ended September 30, 2003

As noted in the overview at the beginning of Management’s Discussion and Analysis of Financial Condition and Results of Operations, the Company sold DCMS, its Canadian subsidiary, on May 11, 2004, 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

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flows of DCMS have been reported separately, and the discussion below addresses principally the results of the Company’s continuing operations.

Revenues. Net revenues increased to $55.1 million in 2004 from $50.9 million in 2003, an increase of $4.2 million, or 8.1%. Patient revenues increased to $51.5 million in 2004 from $48.0 million in 2003, an increase of $3.5 million, or 7.3%. The increase in patient revenues is due to increased Medicare utilization, Medicare rate increases that were effective October 1, 2003 and increased Medicaid rates in certain states, partially offset by a 2.0% decline in census in 2004 as compared to 2003. As a percentage of total census, Medicare days increased to 12.6% in 2004 from 10.9% in 2003. Medicare revenues were 28.1% of patient revenue in 2004 and 24.6% in 2003, while Medicaid and similar programs were 59.7% in 2004 compared to 63.3% in 2003.

Resident revenues increased to $3.1 million in 2004 from $2.9 million in 2003, an increase of $0.2 million, or 7.5%. This increase is primarily attributable to increased rates in 2004 as compared to 2003.

Ancillary service revenues, prior to contractual allowances, increased to $9.3 million in 2004 from $8.8 million in 2003, an increase of $0.5 million, or 6.2%. The increase is primarily attributable to increased Medicare census. Certain per person annual Medicare reimbursement limits on therapy services were implemented for approximately three months in late 2003, but were subsequently suspended until December 31, 2005. The limits impose a $1,590 per patient annual ceiling on physical, speech and occupational therapy services. While the Company is unable to quantify the impact that these limitations 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 and cash flows.

Other income of $303,000 in 2004 consists of gains recognized from foreign currency translation of a note receivable from the sale of the Company’s Canadian operations.

Interest income increased to $111,000 in 2004 from $10,000 in 2003, an increase of $101,000. The increase in interest income is primarily due to non-cash interest income related to a note receivable recorded in connection with the sale of DCMS, the Company’s Canadian subsidiary.

Operating Expense. Operating expense increased to $43.2 million in 2004 from $41.7 million in 2003, an increase of $1.5 million, or 3.6%. As a percentage of patient and resident revenues, operating expense decreased to 79.1% in 2004 from 81.9% in 2003. The increase in operating expense is primarily attributable to cost increases related to wages and benefits. The decrease in operating expense as a percent of patient and resident revenues is primarily due to the effects of increases in Medicare and Medicaid rates and effects of increased Medicare utilization, as discussed above.

The largest component of operating expenses is wages, which increased to $24.9 million in 2004 from $23.6 million in 2003, an increase of $1.3 million, or 5.5%. This increase is primarily attributable to an increase in wages as a result of competitive labor markets in most of the areas in which the Company operates and increased Medicare census. Partially offsetting this increase, the Company experienced a decrease in wages as a result of reduced costs associated with reduced Medicaid census.

Lease Expense. Lease expense was approximately $3.9 million in 2004 and 2003.

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Professional Liability. Professional liability expense decreased to $2.9 million in 2004 from $3.7 million in 2003, a decrease of $0.8 million, or 21.7%. During the three months ended September 30, 2004, the Company increased its total recorded liabilities for self-insured professional liability risks associated with the settlement of certain professional liability claims to $43.4 million from $41.5 million at June 30, 2004. This increase resulted from the provision for anticipated future claims incurred during the third quarter of 2004, which provision was partially offset by a reduction in the accrual for claims incurred in earlier periods. 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.

General and Administrative Expense. General and administrative expense increased to $3.4 million in 2004 from $3.1 million in 2003, an increase of $0.3 million or 9.7%. The increase is primarily attributable to increased compensation costs. As a percentage of total net revenues, general and administrative expense was approximately 6.2% in 2004 and 6.1% and 2003.

Interest Expense. Interest expense was approximately $0.8 million in 2004 and 2003. Interest expense increased as a result of promissory notes issued in connection with the settlement of certain professional liability claims and other disputes, and interest rate increases on the Company’s variable rate debt. These increases were offset by reduction in interest as a result of the payment of debt with proceeds from the sale of the Company’s Canadian subsidiary.

Depreciation and Amortization. Depreciation and amortization expense was approximately $1.2 million in 2004 and 2003.

Loss from Continuing Operations before Income Taxes; Loss from Continuing Operations Per Common Share. As a result of the above, continuing operations reported a loss before income taxes of $259,000 in 2004 compared to a loss before income taxes of $3.4 million in 2003. The provision for income taxes was $32,000 in 2004, and no tax provision was required in the third quarter of 2003. The Company’s effective tax rate differs materially from the statutory rate mainly due to changes in the Company’s valuation allowance for net deferred tax assets. The basic and diluted loss per share from continuing operations were $0.06 each in 2004 as compared to $0.62 each in 2003.

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 sold its Canadian subsidiary on May 11, 2004, and this subsidiary has been presented as a discontinued operation 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. Income from discontinued operations, net of taxes, was approximately $572,000 in 2003. A gain from the sale of the Canadian operations of $77,000, net of related taxes, was recorded in the third quarter of 2004.

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Nine Months Ended September 30, 2004 Compared With Nine Months Ended September 30, 2003

The following discussion is significantly impacted by the termination of a lease for one assisted living facility during 2003 and the closure of another assisted living facility in 2003 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 sold DCMS, its Canadian subsidiary, on May 11, 2004, 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.

Revenues. Net revenues increased to $158.8 million in 2004 from $143.2 million in 2003, an increase of $15.6 million, or 10.9%. Patient revenues increased to $148.9 million in 2004 from $133.5 million in 2003, an increase of $15.4 million, or 11.5%. The increase in patient revenues is due to the new lease for four Florida nursing homes, increased Medicare utilization, Medicare rate increases that were effective October 1, 2003 and increased Medicaid rates in certain states, partially offset by a 1.4% decline in census in the United States in 2004 as compared to 2003. As a percentage of total census in the United States, Medicare days increased to 12.8% in 2004 from 11.2% in 2003. Medicare revenues were 28.9% of patient revenue in 2004 and 25.8% in 2003, while Medicaid and similar programs were 58.9 % in 2004 compared to 62.0 % in 2003.

Resident revenues decreased to $9.2 million in 2004 from $9.5 million in 2003, a decrease of $0.3 million, or 3.9%. This decline is primarily attributable to the termination of a lease for one assisted living facility and the closure of another assisted living facility in 2003, and a decline in census in 2004 as compared to 2003.

Ancillary service revenues, prior to contractual allowances, increased to $28.7 million in 2004 from $24.7 million in 2003, an increase of $4.0 million, or 16.5%. The increase is primarily attributable to increased Medicare census and the new lease for four Florida nursing homes. Certain per person annual Medicare reimbursement limits on therapy services were implemented for approximately three months in late 2003, but were subsequently suspended until December 31, 2005. The limits impose a $1,590 per patient annual ceiling on physical, speech and occupational therapy services. While the Company is unable to quantify the impact that these limitations 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 and cash flows.

Other income of $496,000 in 2004 consists of gains recognized from foreign currency translation of a note receivable from the sale of the Company’s Canadian operations. Other income of $82,000 in 2003 consists of management fees from a contract that was terminated effective April 2003.

Interest income increased to $155,000 in 2004 from $40,000 in 2003, an increase of $115,000. The increase in interest income is primarily due to non-cash interest income related to a note receivable recorded in connection with the sale of DCMS, the Company’s Canadian subsidiary.

Operating Expense. Operating expense increased to $125.5 million in 2004 from $115.6 million in 2003, an increase of $9.8 million, or 8.5%. As a percentage of patient and resident revenues, operating expense decreased to 79.4% in 2004 from 80.8% in 2003. The increase in operating expenses is primarily attributable to the operating costs of the four new leased Florida nursing homes and cost increases related to wages and benefits. The decrease in operating expense as a percent of

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patient and resident revenues is primarily due to the effects of increases in Medicare and Medicaid rates and increased Medicare utilization, as discussed above.

The largest component of operating expenses is wages, which increased to $72.3 million in 2004 from $66.1 million in 2003, an increase of $6.2 million, or 9.3%. This increase is primarily attributable to costs of the four new leased Florida nursing homes, an increase in wages as a result of competitive labor markets in most of the areas in which the Company operates and increased Medicare census. Partially offsetting this increase, the Company experienced a decrease in wages as a result of reduced costs associated with reduced Medicaid census, the termination of a lease for one assisted living facility during 2003 and the closure of another assisted living facility in 2003.

Lease Expense. Lease expense increased to $11.6 million in 2004 from $11.3 million in 2003, an increase of $0.3 million, or 3.0%. The increase in lease expense is primarily attributable to the additional rent for the new Florida leased facilities, partially offset by rent decreases resulting from the termination of a lease on an assisted living facility in 2003.

Professional Liability. Professional liability expense in 2004 resulted in a net benefit of $1.1 million, compared to an expense of $16.5 million in 2003, a decrease in expense of $17.6 million. During the nine months ended September 30, 2004, the Company reduced its total recorded liabilities for self-insured professional liability risks associated with the settlement of certain professional liability claims to $43.4 million, down from $47.2 million at December 31, 2003. Downward adjustments totaling $14.8 million in the liability primarily resulting from the quarterly actuarial valuations were partially offset by the provision for current liability claims recorded during the first nine months of 2004, resulting in a net benefit of $1.1 million in 2004. These reductions were primarily the result of the effects of settlements of certain claims for amounts less than previously estimated. 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.

General and Administrative Expense. General and administrative expense increased to $9.3 million in 2004 from $8.7 million in 2003, an increase of $0.6 million, or 7.4%. The increase is primarily due to increased compensation costs.

Interest Expense. Interest expense was approximately $2.3 million in 2004 and 2003. Interest expense increased as a result of promissory notes issued in connection with the settlement of certain professional liability claims and other disputes, and interest rate increases on the Company’s variable rate debt. These increases were offset by reduction in interest as a result of the payment of debt with proceeds from the sale of the Company’s Canadian subsidiary.

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Asset Impairment and Other Charges. During 2004 and 2003, 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:

As a result of projected cash flows, impairment charges of $704,000 were recorded in 2004 for two owned nursing homes and two leased nursing homes. During the nine months ended September 30, 2003, the Company recorded charges of $20,000 to write down assets held for sale to estimated net realizable value.

The Company incurred lease termination charges relating to its assisted living facilities of approximately $280,000 in 2004 and $344,000 in 2003.

Depreciation and Amortization. Depreciation and amortization expense was approximately $3.7 million in 2004 and 2003.

Income (loss) from Continuing Operations before Income Taxes; Income (loss) from Continuing Operations Per Common Share. As a result of the above, continuing operations reported income before income taxes of $6.5 million in 2004 compared to a loss before income taxes of $15.2 million in 2003. The provision for income taxes was $186,000 in 2004, compared to $15,000 in 2003. The Company’s effective tax rate differs materially from the statutory rate mainly due to changes in the Company’s valuation allowance for net deferred tax assets. The basic and diluted income per share from continuing operations were $1.08 and $0.98, respectively, in 2004, as compared to a basic and diluted loss per share from continuing operations of $2.80 each in 2003.

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 sold its Canadian subsidiary on May 11, 2004, and this subsidiary has been presented as a discontinued operation 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. Income from discontinued operations, net of taxes, was approximately $0.5 million in 2004 for the period through the date of sale, and $1.5 million for the first nine months in 2003. In addition, a gain from the sale of the Canadian operations of $159,000, net of related taxes, was recorded in 2004.

Liquidity and Capital Resources

At September 30, 2004, the Company had negative working capital of $46.0 million and a current ratio of 0.37, compared with negative working capital of $53.7 million and a current ratio of 0.37 at December 31, 2003. 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.

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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 September 30, 2004, 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. 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 September 30, 2004, the Company has $38.2 million of scheduled debt maturities 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 $47.0 million of debt as current liabilities as of September 30, 2004.

In April 2004, the Company entered into an agreement to extend the maturities of certain borrowings from a commercial finance company with an outstanding balance of $3.3 million at March 31, 2004. The new agreement extended the maturities of these borrowings from March 31, 2004 to April 1, 2005.

In July 2004, the Company entered into an agreement to extend the maturities of certain borrowings from a commercial finance company with an outstanding balance of $22.6 million at June 30, 2004. The new agreement extended the maturities of these borrowings from June 30, 2004 to January 1, 2005.

The Company believes that it has reached agreement on the terms of an extension of the maturities of certain borrowings from a bank lender, including the Company’s working capital line of credit, that have an aggregate outstanding balance of $8.5 million at September 30, 2004. The proposed terms extend the maturity date of this indebtedness to January 2005 and require monthly reductions in the maximum amount outstanding under the working capital line of credit of $33,333 until the limit is reduced from $2.5 million to $2.3 million. While the Company believes it has reached agreement with the bank, the extension has not been executed as of the date of this filing.

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 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 September 30, 2004. 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 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 expenses, in negotiating waivers, amendments, or refinancings of outstanding debt, or if the Company will be able to meet

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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 regard to the uncertainty of the Company’s ability to continue as a going concern.

As of September 30, 2004, the Company had no borrowings under its working capital line of credit. During the nine months ending September 30, 2004, average monthly borrowings under the working capital line of credit were as high as $0.8 million. The total maximum outstanding balance of the working capital line of credit, including letters of credit outstanding, is $2.5 million, and, under proposed terms agreed to in November 2004, decreases by $33,333 each month until it is reduced to $2.3 million. There are certain limitations based on borrowing base restrictions. As of September 30, 2004, the Company had total additional borrowing availability of $2.5 million under its working capital line of credit. The Company believes the working capital line of credit will be extended to January 2005, 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 and other legal actions), 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 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. As of September 30, 2004, future committed settlements total $2.3 million over the next twelve months, and $4.3 million in total. Certain of these commitments have been secured by promissory notes which have been included with debt in the accompanying balance sheet. Additionally, payments made or due in connection with settlement of disputed claims could have a material adverse impact on the Company’s ability to meet its obligations as they become due.

Net cash provided by operating activities of continuing operations totaled $4.8 million and $2.5 million in 2004 and 2003, 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 $0.5 million in 2004.

Investing activities provided cash of $3.1 million in 2004 and used cash of $2.7 million in 2003. These amounts primarily represent proceeds from the sale of the Company’s Canadian operations in

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2004 and purchases of property plant and equipment. 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 $4.5 million.

Net cash used in financing activities totaled $7.2 million and $2.0 million in 2004 and 2003, respectively. The net cash used in financing activities primarily represents net repayments of debt. Proceeds from the sale of the Company’s Canadian operations in 2004 were used to pay down 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 September 30, 2004 and December 31, 2003 totaled $16.5 million and $17.7 million, respectively, representing approximately 29 and 30 days in accounts receivable, respectively. The allowance for bad debt was $1.8 million at September 30, 2004 and December 31, 2003, respectively.

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.

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Recent Accounting Pronouncements

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 was adopted by the Company effective March 31, 2004. The Company does not have an interest in any variable interest entities and the adoption of this interpretation did not have a material 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 Annual Report on Form 10-K for the year ended December 31, 2003. 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 the Company’s Form 10-K for the year ended December 31, 2003 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 3. 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 September 30, 2004, the Company had outstanding borrowings of approximately $48.4 million, including $13.3 million in fixed-rate borrowings and $35.1 million in variable-rate borrowings. In the event that interest rates were to change 1%, the impact on future cash flows would be approximately $351,000 annually, representing the impact of increased interest expense on variable rate debt.

The Company has a note receivable denominated in Canadian dollars related to the sale of its Canadian operations. This note was initially recorded on the Company’s balance sheet at $4.7 million US based on the exchange rate as of the date of the note (May 11, 2004). The carrying value of the note in the Company’s financial statements will be increased or decreased each period based on fluctuations in the exchange rate between US and Canadian currencies, and the effect of such

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changes will be included as income or loss in the Company’s statement of operations in the period of change. In the three and nine month periods ended September 30, 2004, the Company reported income of $303,000 and $496,000, respectively, as a result of the effect of changes in the currency exchange rates on this note. A further change of 1% in the exchange rate between US and Canadian currencies would result in a corresponding increase or decrease to revenues of approximately $53,000.

ITEM 4. CONTROLS AND PROCEDURES

The Company, with the participation of its principal executive and financial officers has evaluated the effectiveness of the Company’s disclosure controls and procedures, as such term is defined under Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of September 30, 2004. Based on this evaluation, the principal executive and financial officers have determined that such disclosure controls and procedures are effective to ensure that information required to be disclosed in our filings under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

There has been no change (including corrective actions with regard to significant deficiencies or material weaknesses) in the Company’s internal control over financial reporting that has occurred during the Company’s fiscal quarter ended September 30, 2004 that has materially affected, or is reasonably likely to materially affect the Company’s internal control over financial reporting.

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PART II — OTHER INFORMATION

ITEM 1. 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 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 September 30, 2004, the Company is engaged in 21 professional liability lawsuits. Some of these matters are currently scheduled for trial within the next year and additional cases may be set for trial during this period. 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.

On September 8, 2004, the Company entered into a settlement agreement with the attorney General of the State of Arkansas setting forth the terms by which the Company resolved all civil claims and investigations commenced by the State of Arkansas prior to the entry of the agreement, including seven lawsuits then pending in the Circuit Court of Pulaski County, Arkansas alleging violations of the Arkansas Abuse of Adults Act and violation of the Arkansas Medicaid False Claims Act with respect to certain residents of facilities operated by the Company in Arkansas. Under the terms of the settlement, the Company is obligated (i) to pay $400,000 in equal monthly installments of $16,667 beginning on September 1, 2004 and ending on August 1, 2006, and (ii) to pay by no later than September 1, 2007 no less than $600,000 to install sprinkler systems in nursing homes within the State of Arkansas to be selected by the Company. The Company has incurred expenditures of approximately $134,000 to date toward this requirement.

The Company was in a dispute with the owner of an assisted living facility in which the Company terminated the lease. This dispute was the subject of an arbitration hearing scheduled for June 2004. Prior to the arbitration hearing, the Company reached an agreement with the owner of the property for the settlement of all claims, and this settlement was executed in July 2004. In connection with this settlement, the Company agreed to make payments totaling $550,000 through February 2007, and to allow the property owner to draw on a $200,000 letter of credit that had been previously issued as security for the original lease. The Company recorded a charge of approximately $280,000 during the second quarter of 2004 in connection with the revised estimate of settlement charges and related legal costs.

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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’s insurance carriers have paid the judgment amount and interest. 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 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.

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.

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The Commonwealth of Kentucky has notified the Company that it believes the Commonwealth has overpaid for certain ancillary services provided at facilities currently operated in Kentucky. The overpayments sought by the Commonwealth relate to operations during the period from June 30, 1991 to December 31, 1995. The Company began managing these facilities in December 1994 and became lessee in September 1995. Of the approximately $803,000 claimed overpayment, approximately $788,000 relates to periods prior to the time the Company managed such facilities. The Company is currently disputing its obligation to repay these amounts to the Commonwealth of Kentucky, but no assurances can be given that these efforts will be successful. A hearing before an Administrative Law Judge has been scheduled for November 30, 2004. If the Company’s efforts are unsuccessful, the Commonwealth may be entitled to recoup these sums from the Company.

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 fraud and abuse laws or of elderly abuse laws or any state or Federal False Claims Act case could have a material adverse impact on the Company’s financial condition, cash flows or results of operations and could also subject the Company to fines, penalties and damages. Moreover, the Company could be excluded from the Medicare, Medicaid or other state or federally-funded health care programs, which would also have a material adverse impact on the Company’s financial condition, cash flows or results of operations.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES.

The Company is not currently in compliance with certain covenants of its loan agreements and certain other indebtedness. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources.”

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.

(a)		The exhibits filed as part of this report on Form 10-Q are listed in the Exhibit Index immediately following the signature page.
(b)		Reports on Form 8-K:
		Form 8-K filed on July 1, 2004 for a press release announcing that the Company’s shares have been delisted from the Berlin Stock Exchange at the Company’s demand.
		Form 8-K filed on August 13, 2004 for a press release announcing that certain of the Company’s facilities received National Quality Awards from the American Healthcare Association.
		Form 8-K filed on August 13, 2004 for a press release reporting the Company’s results of operations for the fiscal quarter ended June 30, 2004.
		Form 8-K filed on September 13, 2004 for a press release announcing that the Company had reached an agreement with the Attorney General of the State of Arkansas to settle all civil claims the State had filed against the Company.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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