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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2004

Commission File Number 0-23038

CORRECTIONAL SERVICES CORPORATION

(Exact name of Registrant as specified in its charter)

1819 Main Street, Suite 1000, Sarasota, Florida 34236

(Address of principal executive offices)

Registrant’s telephone number, including area code: (941) 953-9199

Not Applicable

(Former name, former address and former fiscal year if changed since last report)

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 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

Number of shares of common stock outstanding on August 16, 2004: 10,166,940

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CORRECTIONAL SERVICES CORPORATION

INDEX

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PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

CORRECTIONAL SERVICES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited)

(in thousands)

The accompanying notes are an integral part of these statements.

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CORRECTIONAL SERVICES CORPORATION

AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)

(in thousands, except per share data)

The accompanying notes are an integral part of these statements.

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CORRECTIONAL SERVICES CORPORATION

AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)

(in thousands, except per share data)

The accompanying notes are an integral part of these statements.

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CORRECTIONAL SERVICES CORPORATION

AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

(in thousands)

The accompanying notes are an integral part of these statements.

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CORRECTIONAL SERVICES CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 2004

NOTE 1 – BASIS OF PRESENTATION

The condensed consolidated financial statements include the accounts of Correctional Services Corporation and its wholly owned subsidiaries (the “Company”).

In the opinion of the Company’s management, the accompanying unaudited condensed consolidated financial statements as of June 30, 2004, and for the six and three months ended June 30, 2004 and 2003, include all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation. Certain reclassifications were made to 2003 amounts to conform to the 2004 presentations.

The statements herein are presented in accordance with the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in the financial statements on Form 10-K for the Company have been omitted from these statements, as permitted under the applicable rules and regulations. The statements should be read in conjunction with the consolidated financial statements and the related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

The results of operations for the six months ended June 30, 2004 are not necessarily indicative of the results to be expected for the full year.

NOTE 2 – NEW ACCOUNTING PRONOUNCEMENTS

On January 31, 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”). FIN 46 clarifies existing accounting for whether variable interest entities should be consolidated in financial statements based upon the investees’ ability to finance its activities without additional financial support and whether investors possess characteristics of a controlling financial interest. FIN 46 applies to years or interim periods beginning after June 15, 2003 with certain disclosure provisions required for financial statements issued after January 31, 2003. The Company currently does not have investments in any variable interest entities. In December 2003 the FASB issued FIN 46(R), which replaced FIN 46. FIN 46(R) is effective immediately for certain disclosure requirements and variable interest entities referred to as special-purpose entities for periods ended after December 15, 2003 and for all other types of entities for financial statements for periods ended after March 15, 2004. The application of FIN 46(R) in 2003 did not have a material effect on the Company’s financial position, results of operations and cash flows and is not expected to have material impact on the Company’s financial position, results of operations and cash flows during 2004.

NOTE 3 –LOAN PAYABLE AND LINE OF CREDIT

The Company’s credit facility, as amended, is subject to compliance with various financial covenants and borrowing base criteria. The Company is in compliance with or has obtained waivers for those covenants as of June 30, 2004. The credit facility consists of a $19 million revolving line of credit that matures on September 25, 2005 and accrues interest at the lesser of LIBOR plus 4.0%, or prime plus 2.0%. As of June 30, 2004, there are no outstanding borrowings under this revolving line of credit and the availability under the revolving line of credit is approximately $11.4 million taking into consideration $2.7 million in collateral limitations and $4.9 million in outstanding letters of credit. The revolving line of credit is secured by all assets of the Company, except for real property.

At June 30, 2004, the Company has a $309,000 loan payable that matures in 2006 and is secured by restricted cash in an amount that approximates the remaining total of payments.

NOTE 4 –RESTRICTED CASH AND NOTE PAYABLE

On June 30, 2003, CSC of Tacoma LLC, a wholly owned subsidiary of the Company issued a $57.2 million note payable, net of a $175,000 discount, to the Washington Economic Development Finance Authority, an instrumentality of the State of Washington, which issued revenue bonds and subsequently loaned the proceeds of the

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bond issuance to CSC of Tacoma LLC. The bonds are non-recourse to CSC of Tacoma LLC and the Company. The proceeds of the note were disbursed into escrow accounts held in trust to be used to pay the issuance costs for the revenue bonds, to construct a 500-bed detention facility in Tacoma, Washington, for the Department of Homeland Security, Immigration and Customs Enforcement and to establish debt service and other reserves. Construction of the facility is complete, and the facility is now in operation. As of June 30, 2004, the non-current restricted cash of $7.2 million are funds held in trust for debt service and other reserves.

NOTE 5 – CAPITALIZED INTEREST

During the six month period ended June 30, 2004, the Company incurred interest costs of approximately $2,353,000, of which the Company capitalized approximately $722,000, associated with the construction of the Tacoma, Washington facility, discussed above.

NOTE 6 – EARNINGS PER SHARE

The following table sets forth the computation of basic and diluted earnings (loss) per share (in thousands):

During the six and three-month periods ended June 30, 2004 and 2003, there were approximately 448,000 and 410,000 common stock equivalents, for both periods in the respective year, that were excluded from the calculation of earnings per share because their effect would have been anti-dilutive.

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NOTE 7 – STOCK - BASED COMPENSATION

The Company follows the disclosure provisions of SFAS No. 123, which establishes a fair value based method of accounting for stock-based employee compensation plans; however, the Company has elected to account for its employee stock compensation plans using the intrinsic value method under Accounting Principles Board Opinion No. 25 with pro forma disclosures of net earnings and earnings per share, as if the fair value based method of accounting defined in SFAS No. 123 had been applied. Had compensation cost for the Company’s stock option plan been determined on the fair value at the grant dates for stock-based employee compensation arrangements consistent with the method required by SFAS No. 123, the Company’s net income (loss) and net income (loss) per common share would have been the pro forma amounts indicated below:

NOTE 8 – START UP COSTS

The Company incurs costs as it relates to the start up of new facilities. Such costs are principally comprised of expenses associated with the recruitment, hiring and training of staff, travel of personnel, certain legal costs and other costs incurred after a contract has been awarded. The Company expenses start up costs as they are incurred. Start up costs are usually incurred through the population ramp up period, generally within the first three full months of operations. Also, to the extent that other operating expenses exceed revenue during the ramp up period, they are recognized as start up expenses. This is due to the need to incur a significant portion of the facility’s operating expenses while the facility is in the process of attaining full occupancy. The Company recorded start up costs of $2.8 million for the six months ended June 30, 2004. There were no start up costs for the six months ended June 30, 2003.

NOTE 9 – DISCONTINUED OPERATIONS

During June, 2004, the Company approved a plan to discontinue its operations at its Tarkio Academy, located in Missouri. The Company reported the results of operations of this facility as discontinued operations for the six months and three months ended June 30, 2004 and 2003. The Company also recognized an impairment of $1.5 million on the net assets associated with this facility. Following is the revenue and pre-tax loss included in discontinued operations for the Tarkio facility (in thousands):

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In addition to its Tarkio facility the company continues to incur costs related to it Keweenaw and Genesis facilities, discontinued in the previous year. Following is the revenue and pre-tax loss associated with these discontinued facilities (in thousands):

NOTE 10 – CONTINGENCIES

As described in the Company’s Annual Reports on Form 10-K (including the Company’s most recent Annual Report on Form 10-K) and in the accompanying Quarterly Report on Form 10-Q, the nature of the Company’s business results in numerous claims and litigation against the Company for damages allegedly arising from the conduct of its employees and others. The Company believes that most of these claims and suits lack legal merit and/or that the Company has meritorious defenses to the claims, and vigorously defends against these types of actions. The Company also has procured liability insurance to protect the Company against most of the types of claims that reasonably could be expected to be asserted against the Company, based upon the Company’s past experience, including worker’s compensation, employment-related, negligence and other types of tort and civil rights claims and suits. The Company believes that, except as noted below, the insurance coverage maintained by the Company for the claims and suits currently pending against the Company or which reasonably can be expected to be asserted against the Company, based upon the Company’s past experience, should be adequate to protect the Company from any material exposure in any given matter, even if the outcome of the matter is unfavorable to the Company. However, the dollar amount of certain of the claims currently pending against the Company exceed the amount of insurance coverage available to the Company, and, therefore, if the Company is unsuccessful in defending against such claims, the insurance coverage available to the Company would not be sufficient to satisfy the claims, and such a result could have a

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material adverse effect on the Company’s results of operations, financial condition and liquidity. In addition, if all, or a substantial number of the claims and suits currently pending against the Company are resolved unfavorably to the Company, the insurance coverage available to the Company would not be sufficient to satisfy all such claims, and such a result could have a material adverse effect on the Company’s results of operations, financial condition and liquidity. Nevertheless, the Company currently believes that the outcome of the claims and suits currently pending against the Company will not have a material adverse effect on its financial condition, liquidity or results of operations; however, there can be no assurance that the Company will be successful defending these claims and charges.

As described in the Company’s most recent Annual Report on Form 10-K, and as otherwise announced publicly by the Company, in September, 2003, following a trial related to the death of a trainee in the Tarrant County Community Correctional Center, which was being operated by the Company at the time of the trainee’s death, a Tarrant County, Texas trial court entered a judgment against the Company for a total of $37.5 million in compensatory damages and $750,000 in punitive damages, which the Company has appealed to the Second Court of Appeals of Texas. The Company had originally expected to file its initial brief in this appeal during the first half of 2004; however, due to the failure of the court reporter to file certified copies of the transcript from the trial with the appellate court, the Company has to date been unable to do so. The Company recently filed a motion with the appellate court to compel the court reporter to file the transcripts, and is hopeful that it will be able to prepare and file its initial brief before the end of the year.

In the meantime, as described in the Company’s most recent Annual Report on Form 10-K, and as otherwise announced publicly by the Company, on or about December 28, 2003, the Company’s general liability insurance carriers posted with the trial court unconditional and irrevocable bonds in the aggregate amount of $25 million in order to secure the judgment pending the outcome of the Company’s appeal. (Although the judgment in this case exceeds $25 million, Texas law required that only $25 million in bonds be posted in this case in order to secure the judgment.) Consequently, the plaintiffs are precluded by Texas law from executing upon the judgment pending the outcome of the appeal.

The Company also previously announced and described in most recent Annual Report on Form 10-K that Northland Insurance Company, the Company’s primary liability insurance carrier, had filed a declaratory judgment action in federal court against the Company seeking to disclaim any obligation to defend or indemnify the Company or its former employee with respect to this case, and had filed a motion for summary judgment with the court seeking an expedited ruling in its favor. However, on July 28, 2004, the federal district court in which this action had been filed denied Northland’s motion for summary judgment, and entered a memorandum order in the case which contained an affirmative finding by the court that the Company’s insurers were obligated to defend and indemnify the Company and its employees against the claims made in this case. Accordingly, the Company believes, based upon the advice of its counsel, that the entire amount of liability insurance provided by Northland and the Company’s excess liability insurance carrier will be available to the Company in order to satisfy the ultimate amount of the judgment in this case (if any) or to settle the case with the plaintiffs. The primary general and excess liability insurance policies of the Company in effect at the time of the trainees’s death provided $35 million of coverage, which, less amounts paid on other claims under the policies, should be available for these purposes.

However, because the amount of the judgment in this case exceeds the amount of insurance available to the Company by approximately $2.5 million and post-judgment interest has accrued on the judgment since the date the judgment was entered against the Company and will continue to accrue until this case is resolved on appeal or the judgment is satisfied, the Company has an uninsured exposure in this case of several million dollars. Nevertheless, based upon the fact that the federal court has made an affirmative finding that the Company’s insurance carriers are obligated to indemnify the Company with respect to this case and based upon the advice of counsel that a settlement or final judgment amount, if any, in this case is not reasonably likely to exceed $25 million, the Company believes that it is not probable or likely that the Company will incur any material loss in this case. Accordingly, no loss has been recognized in connection with this litigation. The Company will continue to assess this matter with its legal counsel in accordance with SFAS No. 5, Accounting for Contingencies, and, if and when deemed appropriate, will reflect the potential impact of the case on its financial statements.

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The Company also notes that, because it maintained the primary and excess liability policies that provide coverage for this case on an “occurrence” basis, to the extent that the Company’s insurers make any payments to the plaintiffs in this case under the policies, such payments will serve to reduce the amount of insurance coverage available to the Company for other claims made against the Company that are covered by the same policies. Currently, there are only two lawsuits pending against the Company that relate to “occurrences” that occurred during the policy period covered by these policies, which are described below:

The Plaintiff in this case is a former resident of the Summit View Youth Correctional Facility (which was formerly operated by the Company) who has brought civil rights, intentional infliction of emotional distress, assault and battery and negligence claims against the Company arising out of allegations that, between November, 2000 and January, 2001, the Plaintiff was “subjected to repeated sexual assaults” by co-Defendant Jennifer Burkley, a former employee of the Company. Plaintiff seeks compensatory damages in the amount of $2,000,000 and unspecified punitive damages. The Company has not disputed that co-Defendant Burkley engaged in sexual activities with the Plaintiff while he was incarcerated at the Summit View Correctional Facility, but has denied the Plaintiff was “sexually assaulted” and that the Company has any liability for these activities. The State of Nevada has been dismissed from this case on governmental immunity grounds. Discovery in this case has been completed, and the Company has filed motions to strike the Plaintiff’s expert on the issues of causation and damages and for summary judgment on the Plaintiff’s claims against the Company. These motions are currently pending. The Company is not providing a defense to co-Defendant Burkley and Burkley has not sought coverage or a defense from the Company or its insurance carrier. Based upon the advice of counsel, the Company does not believe that it is probable that the Company will incur any material loss in this case, and therefore, no loss has been recognized in connection with this litigation.

The Plaintiff in this case is a former inmate at the Tarrant County Community Correctional Facility that the Company formerly operated in Mansfield, Texas. Plaintiff alleges that, while he was incarcerated at the facility, the facility’s staff ordered him to shave despite his serious acne condition, failed to provide him with adequate medical attention for his condition, and that, as a result, he suffered severe facial scarring. Plaintiff has alleged negligence and intentional torts against the Company. Plaintiff seeks unspecified compensatory and punitive damages. This case is currently in discovery. The key issues in this case will be whether the Company’s employees breached any applicable standards of care towards the Plaintiff, and, if so, whether the acts or omissions of the Company’s employees were the proximate cause of Plaintiff’s alleged damages. Accordingly, this will necessitate the presentation of testimony from experts regarding the acts and omissions of the Company’s employees, including testimony from dermatologists as to the effect of the actions or inaction of the Company’s employees with regard to the Plaintiff’s acne condition. The Plaintiff has designated a dermatologist that will testify that the Company’s employees should have treated Plaintiff’s condition more aggressively than they did and that the requirement that Plaintiff shave exacerbated his condition. The Company will also retain a dermatologist to review deposition testimony and the Plaintiff’s medical records in order to form an opinion on these issues. The Company is currently awaiting this assessment. Accordingly, given that the Company does not yet have a basis to assess its potential liability in this case (if any), at this time, it is not possible to conclude whether the Company will incur any material loss in this case, and therefore, no loss has been recognized in connection with this litigation.

Since the Company filed its most recent Annual Report on Form 10-K on March 30, 2004, the Company has not been served with any new claims or litigation that reasonably could be expected to have a material adverse effect on its financial condition or results of operations.

The Company has ceased operation in its Canadian facility, located in Texas, due to the low utilization by the contracting agency. The Company is investigating other opportunities including both juvenile and adult to continue to operate this facility. There are approximately $1.4 million of assets associated with this facility. There can be no assurance that the Company will be successful in finding other opportunities for this operation.

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During 2003, the Company had initiated legal action against the Puerto Rican government to recover unpaid revenues and receive reimbursement for costs and damages. The Puerto Rican government had initiated a counter suit seeking a similar amount for alleged damages to the Bayamon, Puerto Rico facility. The Company had approximately $2.0 million in receivables and approximately $560,000 in deferred charges related to assets purchased by the Company for use at the facility as of December 31, 2003, pending resolution of the aforementioned lawsuit. During the three months ended June 30, 2004, the Company settled its dispute with the government whereby the Company received $1.4 million as the net payment for its settlement, including $2.0 million received for its accounts receivables and as settlement of all claims the Company had against the government, partially offset by $600,000 for settlement of alleged damages payable by the Company. The $600,000 amount was accrued as of December 31, 2003. As a result of this settlement the Company wrote off the $560,000 in deferred charges which is included in the accompanying financial statements as loss on disposal of assets.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

This document contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and 21E of the Securities Exchange Act of 1934, as amended, which are not historical facts and involve risks and uncertainties. These include statements regarding the expectations, beliefs, intentions or strategies regarding the future. The Company intends that all forward-looking statements be subject to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements reflect the Company’s views as of the date they are made with respect to future events and financial performance, but are subject to many uncertainties and risks which could cause the actual results of the Company to differ materially from any future results expressed or implied by such forward-looking statements. Examples of such uncertainties and risks include, but are not limited to: fluctuations in occupancy levels and labor costs; the ability to secure both new contracts and the renewal of existing contracts; the ability to meet financial covenants; the ability to reduce various operating costs; and public resistance to privatization. Additional risk factors include those contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. The Company does not undertake any obligation to update any forward-looking statements.

General

Correctional Services Corporation and its wholly owned subsidiaries (the “Company”) is one of the largest and most comprehensive providers of juvenile rehabilitative services. The Company has 18 facilities and approximately 2,000 juveniles in its care. In addition, the Company is a leading developer and operator of adult correctional facilities operating 15 facilities representing approximately 5,600 beds. On a combined basis, the Company provided services in 12 states, representing approximately 7,600 beds including aftercare services.

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Results of Operations

The following table sets forth certain operating data as a percentage of total revenues:

Six Months Ended June 30, 2004 compared to the Six Months Ended June 30, 2003

Revenues decreased by $1.0 million or 1.5% for six months ended June 30, 2004 to $66.1 million compared to the same period in 2003 due primarily to:

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As various state and local government agencies continue to face budgetary issues, the agencies have gradually decreased juvenile placements in privately operated, long-term residential facilities, such as those operated by the Company, in favor of government-operated facilities. Additionally, various agencies are opting for less costly non-residential programs, reserving residential placements for the most challenging at-risk youth who have demonstrated significant mental health or behavioral health needs. The Company has responded to this trend by developing specialized programming to provide needed specialized behavioral health services for sexually delinquent juveniles, fire starters and other specialized behavioral issues, substance abuse treatment services, and additional mental health services, as well as pursuing contracts in new markets. The Company can provide no assurance that it will be able to reverse this trend through these efforts. Additionally, the Company has terminated contracts at certain juvenile facilities, as discussed above, and continues to evaluate the future earning potential of other juvenile facilities, as needed.

Although the Company’s adult division was affected by the same budgetary issues discussed above, occupancy rates have remained relatively consistent after considering the ramp up of new facilities. The Company has also been successful seeking out-of-state inmates at certain locations.

Overall operating expenses decreased $1.4 million or 2.4% for the six months ended June 30, 2004 to $57.7 million compared to the same period in 2003. As a percentage of revenues (87.3%), operating expenses for the six months ended June 30, 2004 remained relatively consistent to that of the prior period. The decrease in the operating expense percentage is partially due to the closure of unprofitable facilities, offset by the increases in various operating expenses, such as medical/dental services and business insurance. The Company incurred approximately $2.8 million in start-up costs associated with the ten new facilities that opened during the first half of 2004 or that will open during the second half of 2004. Start-up costs are primarily comprised of expenses associated with the recruitment, hiring and training of staff, travel of personnel, certain legal cost and other costs incurred after a contract has been awarded. Approximately $1.1 million of the start-up costs were associated with the opening of the new Tacoma facility.

General and administrative expenses decreased $453,000 or 9.5% for the six months ended June 30, 2004 compared to the same period in 2003. As a percentage of revenues, general and administrative expenses was 6.6% for the six months ended June 30, 2004 and remained relatively consistent with the six months ended June 30, 2003. The decrease is due to position eliminations and vacancies at the corporate headquarters.

Loss on disposal of assets was $541,000 for the six months ended June 30, 2004 compared to a gain of $20,000 for the six months ended June 30, 2003. The current period loss is related to the Company’s settlement of its claim related to its Puerto Rico facility.

Interest expense, net of interest income, was $1.6 million for the six months ended June 30, 2004 compared to interest expense net of interest income, of $1.1 million for the six months ended June 30, 2003, a net increase in interest expense of $0.5 million. The increase is primarily interest on the $57.2 million note payable related to the construction of the Tacoma, Washington facility. Interest incurred on qualified expenditures during the construction phase of the facility is capitalized. In April, this facility moved from the construction phase to operations. As such, interest is now recognized as expense. During the six months ended June 30, 2004, the Company capitalized interest of approximately $722,000 on the $57.2 million loan related to the construction of its Tacoma, Washington facility. Interest of $80,000 was capitalized during the same period in 2003.

For the six months ended June 30, 2004, the overall tax benefit recognized was $1,246,000 vs. a tax provision of $655,000 in 2003. Of the 2004 amount, $307,000 and $939,000 were allocated to continuing operations and discontinued operations, respectively. Of the 2003 amount, $884,000 and $(229,000) were allocated to continuing operations and discontinued operations, respectively. To calculate the tax provision (benefit) the Company uses an estimated effective tax rate. This rate is based on the federal and state statutory rates as adjusted by various non-deductible items. For the six months ended June 30, 2004, the estimated effective rate used was approximately 37.1% vs. 43.23% for 2003. The decrease is attributable to the effect of adding back non-deductible items when there are negative operating results such as for the six months ended June 30, 2004 vs. positive operating results for 2003. The allocation to discontinued operations is based on an incremental tax rate of 39.0%.

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For the six months ended June 30, 2004 and 2003, the Company recognized losses on discontinued operations of $1.5 million and $358,000, after tax, respectively. During June 2004 the Company approved a plan to discontinue its operations at its Tarkio Academy, located in Missouri. The Company reported the results of operations of this facility under discontinued operations for the six months ended June 30, 2004 and 2003. The Company also reported a $1.5 million charge related to the net assets of the facility.

Three Months Ended June 30, 2004 Compared to the Three Months Ended June 30, 2003

Revenues increased by $1.3 million or 4.1% for the three months ended June 30, 2004 to $33.5 million compared to the same period in 2003 due primarily to:

As various state and local government agencies continue to face budgetary issues, the agencies have gradually decreased juvenile placements in privately operated, long-term residential facilities, such as those operated by the Company, in favor of government-operated facilities. Additionally, various agencies are opting for less costly non-residential programs, reserving residential placements for the most challenging at-risk youth who have demonstrated significant mental health or behavioral health needs. The Company has responded to this trend by developing specialized programming to provide needed specialized behavioral health services for sexually delinquent juveniles, fire starters and other specialized behavioral issues, substance abuse treatment services, and additional mental health services, as well as pursuing contracts in new markets. The Company can provide no assurance that it will be able to reverse this trend through these efforts. Additionally, the Company has terminated contracts at certain juvenile facilities, as discussed above, and continues to evaluate the future earning potential of other juvenile facilities, as needed.

Although the Company’s adult division was affected by the same budgetary issues discussed above, occupancy rates have remained relatively consistent after considering the ramp up of new facilities. The Company has also been successful seeking out-of-state inmates at certain locations.

Overall operating expenses increased $913,000 or 3.3% for the three months ended June 30, 2004 to $29.0 million compared to the same period in 2003. As a percentage of revenues (86.5%), operating expenses for the three months ended June 30, 2004 remained relatively consistent to that of the prior period. The decrease in the operating expense percentage is partially due to the closure of unprofitable facilities, offset by the increases in various operating expenses, such as medical/dental services and business insurance. The Company incurred approximately $1.1 million in start-up costs associated with the nine new facilities that opened during the second quarter of 2004 or that will open during the third quarter of 2004. Start-up costs are primarily comprised of expenses associated with the recruitment, hiring and training of staff, travel of personnel, certain legal costs and other costs incurred after a contract has been awarded.

General and administrative expenses decreased $294,000 or 12.0% for the three months ended June 30, 2004 compared to the same period in 2003. As a percentage of revenues, general and administrative expenses was 6.4% for the three months ended June 30, 2004 and remained relatively consistent with the three months ended June 30, 2003. The decrease is due to position eliminations and vacancies at the corporate headquarters.

Loss on disposal of assets was $561,000 for the three months ended June 30, 2004 compared to a gain of $20,000 for the three months ended June 30, 2003. The current period loss is related to the Company’s settlement of its claim related to its Puerto Rico facility.

Interest expense, net of interest income, was $1.1 million for the three months ended June 30, 2004 compared to interest expense, net of interest income, of $0.6 million for the three months ended June 30, 2003, a net increase in interest expense of $0.5 million. The increase is primarily interest on the $57.2 million note payable related to the construction of the Tacoma, Washington facility. Interest incurred on qualified expenditures during the construction phase of the facility is capitalized. In April, this facility moved from the construction phase to operations. As such, interest is now recognized

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as expense. During the three months ended June 30, 2004, the Company capitalized interest of approximately $92,000 on the $57.2 million loan related to the construction of its Tacoma, Washington facility. Interest of $80,000 was capitalized during the same period in 2003.

For the three months ended June 30, 2004, the overall tax benefit recognized was $756,000 vs. a tax provision of $323,000 in 2003. Of the 2004 amount, $47,000 and $709,000 were allocated to continuing operations and discontinued operations, respectively. Of the 2003 amount, $468,000 and $(145,000) were allocated to continuing operations and discontinued operations, respectively. To calculate the tax provision (benefit) the Company uses an estimated effective tax rate. This rate is based on the federal and state statutory rates as adjusted by various non-deductible items. For the three months ended June 30, 2004, the estimated effective rate used was approximately 34.19% vs. 42.95% for 2003. The decrease is attributable to the effect of adding back non-deductible items when there are negative operating results such as for the three months ended June 30, 2004 vs. positive operating results for 2003. The allocation to discontinued operations is based on an incremental tax rate of 39.0%.

For the three months ended June 30, 2004 and 2003, the Company recognized losses on discontinued operations of $1.1 million and $228,000, after tax, respectively. During June 2004 the Company approved a plan to discontinue its operations at its Tarkio Academy, located in Missouri. The Company reported the results of operations of this facility under discontinued operations for the three months ended June 30, 2004 and 2003. The Company also reported a $1.5 million charge related to the net assets of the facility.

Liquidity and Capital Resources

At June 30, 2004, the Company had $2.5 million in cash, $3.2 million in current restricted cash and working capital of $13.9 million compared to December 31, 2003 when the Company had $3.8 million in cash, $4.5 million in current restricted cash and working capital of $13.6 million. The current restricted cash is primarily related to the construction of the new Tacoma, Washington facility and will be used to service debt, pay certain invoices and other liabilities included in accounts payable and accrued liabilities.

Net cash used by operating activities was $1.3 million for the six months ended June 30, 2004 compared to net cash provided by operating activities of $6.5 million for the six months ended June 30, 2003. The change was attributable primarily to the increased expenses associated with the startup of the ten new facilities and to the timing of receipts on accounts receivables.

Net cash of $230,000 was provided in investing activities during the six months ended June 30, 2004 as compared to $58.8 million used in investing activities in the six months ended June 30, 2003. During the 2004 period, the Company’s uses included $9.2 million for the payment of construction costs at the Company’s Tacoma site and other new facilities. Included in these new facilities expenditures is $1.7 million associated with a contract the company was awarded during the first quarter of 2004, to operate a 1,000-bed detention center in Frio, Texas for the Department of Homeland Security, Immigration and Customs Enforcement. The construction budget for this facility is approximately $39 million. At June 30, 2004, the Company had not executed a construction contract for this facility, and is currently negotiating the structure of the financing arrangement. The company expects to finalize these contracts during the third quarter. The remaining use of funds was associated with the capitalization of interest in the amount of $722,000, and for the purchase of property and equipment at existing facilities. In the comparable period for 2003, approximately $58.8 million was used to purchase the land, payments for construction and design costs at the Company’s Tacoma, Washington facility and for investments of restricted cash. The remaining use was to purchase property and equipment at existing facilities. The funds available in long term restricted cash were used for the construction costs of the Tacoma facility.

Net cash of $233,000 was used by financing activities for the six months ended June 30, 2004 as compared to $52.3 million provided by financing activities for the six months ended June 30, 2003. During the 2003 period, funds were borrowed under the line of credit and from a note payable to provide capital necessary to cover the capital expenditures of the Tacoma facility mentioned above.

The Company’s credit facility, as amended, is subject to compliance with various financial covenants and borrowing base criteria. The Company is in compliance with or has obtained waivers for those covenants as of June 30, 2004. The credit facility consists of a $19.0 million revolving line of credit that matures on September 25, 2005 and accrues interest at the lesser of LIBOR plus 4.0%, or prime plus 2.0%. As of June 30, 2004, there are no outstanding borrowings under this revolving line of credit and the availability under the revolving line of credit is approximately $11.4 million taking into consideration $2.7 million in collateral limitations and $4.9 million in outstanding letters of credit. The revolving line of credit is secured by all assets of the Company, except for real property.

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The Company expects to continue to have cash needs as it relates to financing start-up costs in connection with new contracts that would improve the profitability of the Company. There can be no assurance that the Company’s operations together with amounts available under the revolving line of credit, which expires in 2005, will continue to be sufficient to finance its existing level of operations, fund start-up costs and meet its debt service obligations.

Critical Accounting Policies

The consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. As such, we are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. The Company routinely evaluates its estimates based on historical experience and on various other assumptions that management believes are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. A summary of our significant accounting policies is described in Note A to our financial statements included in the Company’s Annual Report filed on Form 10-K for the year ended December 31, 2003. The significant accounting policies and estimates, which we believe are the most critical to aid in fully understanding and evaluating our reported financial results, include the following:

Revenue Recognition and Accounts Receivable

Facility management revenues are recognized as services are provided based on a net rate per day per inmate or on a fixed monthly rate. Certain revenues are accrued, based on population levels or other pertinent available data. Subsequent adjustments to revenue are recorded when actual levels are known or can be reasonably estimated.

The Company extends credit to the government agencies with which it contracts and other parties in the normal course of business. Further, the Company regularly reviews outstanding receivables and provides estimated losses through an allowance for doubtful accounts. In evaluating the level of established reserves, the Company makes judgments regarding its customers’ ability to make required payments, economic events and other factors. As the financial condition of these parties change, circumstances develop or additional information becomes available, adjustments to the allowance for doubtful accounts may be required. For the six months ended June 30, 2004 and 2003, the Company made no significant adjustments to the carrying values of accounts receivables.

Asset Impairments

As of June 30, 2004, the Company had approximately $84.8 million in long-lived property and equipment and assets under capital leases, including assets held for sale, of approximately $6.8 million. The Company evaluates the recoverability of the carrying values of its long-lived assets when events suggest that impairment may have occurred. In these circumstances, the Company utilizes estimates of undiscounted cash flows or other measures of fair value, to determine if impairment exists. If impairment exists, it is measured as the amount by which the carrying amount of the asset exceeds the estimated fair value of the asset. For the six months ended June 30, 2004 the company recorded an impairment of approximately $1.5 million associated with the assets at its Tarkio Academy, Missouri facility. (See Note 9 – DISCONTINUED OPERATIONS)

Start up Costs

The Company incurs costs as it relates to the start up of new facilities. Such costs are principally comprised of expenses associated with the recruitment, hiring and training of staff, travel of personnel, certain legal costs and other costs incurred after a contract has been awarded. The Company expenses start up costs as they are incurred. Start up costs are usually incurred through the population ramp up period, generally with in the first three full month of operations. Also to the extent that other operating expenses exceed revenue during the ramp up period, they are recognized as start up expenses. This is due to the need to incur a significant portion of the facility’s operating expenses while the facility is in the process of attaining full occupancy. The Company recorded start up costs of $2.8 million for the six months ended June 30, 2004. There were no start up costs for the six months ended June 30, 2003.

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Income Taxes

Deferred tax assets and liabilities are recognized as the difference between the book basis and tax basis of assets and liabilities. In providing for allowances for deferred taxes, the Company considers current tax regulations, estimates of future taxable income and available tax planning strategies. If tax regulations, operating results or the ability to implement tax-planning strategies vary, adjustments to the carrying value of deferred tax assets and liabilities may be required. For the six months ended June 30, 2004 and 2003, the Company made no valuation adjustments to the carrying values of deferred tax assets or liabilities.

Loss Contracts

The Company evaluates the future profitability of its contracts when events suggest that the contract may not be profitable over its remaining term. The Company measures the estimated future losses as the present value of the estimated net cash flows over the remainder of the contract from the time of measurement, with consideration first given to asset impairments as discussed above. For the six months ended June 30, 2004 and 2003, the Company did not recognize any loss contract costs.

Discontinued Operations

In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company has recorded the results of operations of components that have either been disposed of or are classified as held for sale under discontinued operations on the income statement. The Company defines components that have been disposed of as facilities not operating under a management agreement where the Company has unilaterally terminated its various contracts with sending agencies or has otherwise ceased operations. In these disposal situations, the Company typically has a significant facility investment or lease obligations. In situations where management agreements with a principal agency are terminated in accordance with the contract provisions, whether or not subject to renewal or proposal, and without disposal of a significant facility investment or lease obligation, the results of operations of these facilities continue to be recorded in continuing operations. (See Note 9 – DISCONTINUED OPERATIONS)

New Accounting Pronouncements

On January 31, 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”). FIN 46 clarifies existing accounting for whether variable interest entities should be consolidated in financial statements based upon the investees’ ability to finance its activities without additional financial support and whether investors possess characteristics of a controlling financial interest. FIN 46 applies to years or interim periods beginning after June 15, 2003 with certain disclosure provisions required for financial statements issued after January 31, 2003. The Company currently does not have investments in any variable interest entities. In December 2003 the FASB issued FIN 46(R), which replaced FIN 46. FIN 46(R) is effective immediately for certain disclosure requirements and variable interest entities referred to as special-purpose entities for periods ended after December 15, 2003 and for all other types of entities for financial statements for periods ended after March 15, 2004. The application of FIN 46(R) in 2003 did not have a material effect on the Company’s financial position, results of operations and cash flows and is not expected to have material impact on the Company’s financial position, results of operations and cash flows during 2004.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The Company’s current financing is subject to variable rates of interest and is therefore exposed to fluctuations in interest rates. The Company’s subordinated debt and mortgage on property accrues interest at fixed rates of interest.

The table below presents the principal amounts, weighted average interest rates, and fair value by year of expected maturity, required to evaluate the expected cash flows and sensitivity to interest rate changes. Actual maturities may differ because of prepayment rights stated in the Credit Agreement.

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Item 4. Controls and Procedures

The Company’s Chief Executive Officer and Chief Financial Officer (collectively, the “Certifying Officers”) are responsible for establishing and maintaining disclosure controls and procedures for the Company. Such officers have concluded (based upon their evaluation of these controls and procedures as of a date within 90 days of the filing of this report) that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in this report is accumulated and communicated to the Company’s management, including its principal executive officers as appropriate, to allow timely decisions regarding required disclosure.

The Certifying Officers also have indicated that there were no significant changes in the Company’s internal controls or other factors that could significantly affect such controls subsequent to the date of their evaluation, and there were no corrective actions with regard to significant deficiencies and material weaknesses.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

As described in the Company’s Annual Reports on Form 10-K (including the Company’s most recent Annual Report on Form 10-K) and in the accompanying Quarterly Report on Form 10-Q, the nature of the Company’s business results in numerous claims and litigation against the Company for damages allegedly arising from the conduct of its employees and others. The Company believes that most of these claims and suits lack legal merit and/or that the Company has meritorious defenses to the claims, and vigorously defends against these types of actions. The Company also has procured liability insurance to protect the Company against most of the types of claims that reasonably could be expected to be asserted against the Company, based upon the Company’s past experience, including worker’s compensation, employment-related, negligence and other types of tort and civil rights claims and suits. The Company believes that, except as noted below, the insurance coverage maintained by the Company for the claims and suits currently pending against the Company or which reasonably can be expected to be asserted against the Company, based upon the Company’s past experience, should be adequate to protect the Company from any material exposure in any given matter, even if the outcome of the matter is unfavorable to the Company. However, the dollar amount of certain of the claims currently pending against the Company exceed the amount of insurance coverage available to the Company, and, therefore, if the Company is unsuccessful in defending against such claims, the insurance coverage available to the Company would not be sufficient to satisfy the claims, and such a result could have a material adverse effect on the Company’s results of operations, financial condition and liquidity. In addition,

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if all, or a substantial number of the claims and suits currently pending against the Company are resolved unfavorably to the Company, the insurance coverage available to the Company would not be sufficient to satisfy all such claims, and such a result could have a material adverse effect on the Company’s results of operations, financial condition and liquidity. Nevertheless, the Company currently believes that the outcome of the claims and suits currently pending against the Company will not have a material adverse effect on its financial condition, liquidity or results of operations; however, there can be no assurance that the Company will be successful defending these claims and charges.

As described in the Company’s most recent Annual Report on Form 10-K, and as otherwise announced publicly by the Company, in September, 2003, following a trial related to the death of a trainee in the Tarrant County Community Correctional Center, which was being operated by the Company at the time of the trainee’s death, a Tarrant County, Texas trial court entered a judgment against the Company for a total of $37.5 million in compensatory damages and $750,000 in punitive damages, which the Company has appealed to the Second Court of Appeals of Texas. The Company had originally expected to file its initial brief in this appeal during the first half of 2004; however, due to the failure of the court reporter to file certified copies of the transcript from the trial with the appellate court, the Company has to date been unable to do so. The Company recently filed a motion with the appellate court to compel the court reporter to file the transcripts, and is hopeful that it will be able to prepare and file its initial brief before the end of the year.

In the meantime, as described in the Company’s most recent Annual Report on Form 10-K, and as otherwise announced publicly by the Company, on or about December 28, 2003, the Company’s general liability insurance carriers posted with the trial court unconditional and irrevocable bonds in the aggregate amount of $25 million in order to secure the judgment pending the outcome of the Company’s appeal. (Although the judgment in this case exceeds $25 million, Texas law required that only $25 million in bonds be posted in this case in order to secure the judgment.) Consequently, the plaintiffs are precluded by Texas law from executing upon the judgment pending the outcome of the appeal.

The Company also previously announced and described in most recent Annual Report on Form 10-K that Northland Insurance Company, the Company’s primary liability insurance carrier, had filed a declaratory judgment action in federal court against the Company seeking to disclaim any obligation to defend or indemnify the Company or its former employee with respect to this case, and had filed a motion for summary judgment with the court seeking an expedited ruling in its favor. However, on July 28, 2004, the federal district court in which this action had been filed denied Northland’s motion for summary judgment, and entered a memorandum order in the case which contained an affirmative finding by the court that the Company’s insurers were obligated to defend and indemnify the Company and its employees against the claims made in this case. Accordingly, the Company believes, based upon the advice of its counsel, that entire amount of liability insurance provided by Northland and the Company’s excess liability insurance carrier will be available to the Company in order to satisfy the ultimate amount of the judgment in this case (if any) or to settle the case with the plaintiffs. The primary general and excess liability insurance policies of the Company in effect at the time of the trainees’s death provided $35 million of coverage, which, less amounts paid on other claims under the policies, should be available for these purposes.

However, because the amount of the judgment in this case exceeds the amount of insurance available to the Company by approximately $2.5 million and post-judgment interest has accrued on the judgment since the date the judgment was entered against the Company and will continue to accrue until this case is resolved on appeal or the judgment is satisfied, the Company has an uninsured exposure in this case of several million dollars. Nevertheless, based upon the fact that the federal court has made an affirmative finding that the Company’s insurance carriers are obligated to indemnify the Company with respect to this case and based upon the advice of counsel that a settlement or final judgment amount, if any, in this case is not reasonable likely to exceed $25 million, the Company believes that it is not probable or likely that the Company will incur any material loss in this case. Accordingly, no loss has been recognized in connection with this litigation. The Company will continue to assess this matter with its legal counsel in accordance with SFAS No. 5, Accounting for Contingencies, and, if and when deemed appropriate, will reflect the potential impact of the case on its financial statements.

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The Company also notes that, because it maintained the primary and excess liability policies that provide coverage for this case on an “occurrence” basis, to the extent that the Company’s insurers make any payments to the plaintiffs in this case under the policies, such payments will serve to reduce the amount of insurance coverage available to the Company for other claims made against the Company that are covered by the same policies. Currently, there are only two lawsuits pending against the Company that relate to “occurrences” that occurred during the policy period covered by these policies, which are described below:

The Plaintiff in this case is a former resident of the Summit View Youth Correctional Facility (which was formerly operated by the Company) who has brought civil rights, intentional infliction of emotional distress, assault and battery and negligence claims against the Company arising out of allegations that, between November, 2000 and January, 2001, the Plaintiff was “subjected to repeated sexual assaults” by co-Defendant Jennifer Burkley, a former employee of the Company. Plaintiff seeks compensatory damages in the amount of $2,000,000 and unspecified punitive damages. The Company has not disputed that co-Defendant Burkley engaged in sexual activities with the Plaintiff while he was incarcerated at the Summit View Correctional Facility, but has denied the Plaintiff was “sexually assaulted” and that the Company has any liability for these activities. The State of Nevada has been dismissed from this case on governmental immunity grounds. Discovery in this case has been completed, and the Company has filed motions to strike the Plaintiff’s expert on the issues of causation and damages and for summary judgment on the Plaintiff’s claims against the Company. These motions are currently pending. The Company is not providing a defense to co-Defendant Burkley and Burkley has not sought coverage or a defense from the Company or its insurance carrier. Based upon the advice of counsel, the Company does not believe that it is probable that the Company will incur any material loss in this case, and therefore, no loss has been recognized in connection with this litigation.

The Plaintiff in this case is a former inmate at the Tarrant County Community Correctional Facility that the Company formerly operated in Mansfield, Texas. Plaintiff alleges that, while he was incarcerated at the facility, the facility’s staff ordered him to shave despite his serious acne condition, failed to provide him with adequate medical attention for his condition, and that, as a result, he suffered severe facial scarring. Plaintiff has alleged negligence and intentional torts against the Company. Plaintiff seeks unspecified compensatory and punitive damages. This case is currently in discovery. The key issues in this case will be whether the Company’s employees breached any applicable standards of care towards the Plaintiff, and, if so, whether the acts or omissions of the Company’s employees were the proximate cause of Plaintiff’s alleged damages. Accordingly, this will necessitate the presentation of testimony from experts regarding the acts and omissions of the Company’s employees, including testimony from dermatologists as to the effect of the actions or inaction of the Company’s employees with regard to the Plaintiff’s acne condition. The Plaintiff has designated a dermatologist that will testify that the Company’s employees should have treated Plaintiff’s condition more aggressively than they did and that the requirement that Plaintiff shave exacerbated his condition. The Company will also retain a dermatologist to review deposition testimony and the Plaintiff’s medical records in order to form an opinion on these issues. The Company is currently awaiting this assessment. Accordingly, given that the Company does not yet have a basis to assess its potential liability in this case (if any), at this time, it is not possible to conclude whether the Company will incur any material loss in this case, and therefore, no loss has been recognized in connection with this litigation.

Since the Company filed its most recent Annual Report on Form 10-K on March 30, 2004, the Company has not been served with any new claims or litigation that reasonably could be expected to have a material adverse effect on its financial condition or results of operations.

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Item 6. Exhibits and Reports on Form 8-K

The Company filed a Form 8-K on May 13, 2004 to announce its earnings and results of operations for the three months ended March 31, 2004.

Items 2, 3, 4 and 5 have been omitted from disclosure, as these items are not applicable.

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SIGNATURES

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

Dated: August 16, 2004

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