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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended May 31, 2004

For the transition period from              to             

Commission File Number: 000-21574

DYNACQ HEALTHCARE, INC.

(Exact name of registrant as specified in its charter)

(713) 378-2000

(Registrant’s telephone number, including area code)

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  ¨    No  x

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

As of August 20, 2004, the number of shares outstanding of the registrant’s common stock, par value $.001 per share, was: 14,852,072.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Stockholders and Board of Directors

Dynacq Healthcare, Inc.

Houston, Texas

We have reviewed the consolidated balance sheet of Dynacq Healthcare Inc., as of May 31, 2004, and the related consolidated statements of operations for the three-month and nine-month periods ended May 31, 2004 and 2003 and cash flows for the nine-month periods ended May 31, 2004 and 2003. These interim financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the consolidated interim financial statements for them to be in conformity with United States generally accepted accounting principles.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Dynacq Healthcare Inc., as of August 31, 2003, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year then ended not presented herein, and in our report dated June 18, 2004, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of August 31, 2003, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ Killman, Murrell & Company, P.C.

Killman, Murrell & Company, P.C.

Houston, TX

August 27, 2004

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PART I - FINANCIAL INFORMATION

ITEM I - FINANCIAL STATEMENTS

Dynacq Healthcare, Inc.

Consolidated Balance Sheets

See accompanying notes.

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Dynacq Healthcare, Inc.

Consolidated Balance Sheets (continued)

See accompanying notes.

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Dynacq Healthcare, Inc.

Consolidated Statements of Operations

See Accompanying Notes.

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Dynacq Healthcare, Inc.

Consolidated Statements of Cash Flows

(Reviewed)

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Consolidated Statements of Cash Flows (continued)

See accompanying notes.

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Dynacq Healthcare, Inc.

Notes to Consolidated Financial Statements

May 31, 2004

Basis of Presentation

The accompanying reviewed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete consolidated financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included. All such adjustments are of a normal and recurring nature. The majority of the Company’s expenses are “cost of revenue” items. Costs that could be classified as general and administrative by the Company would include the corporate office costs, including advertising and marketing expenses, which were approximately $3.9 million and $3.6 million for the quarters ended May 31, 2004 and 2003, respectively, and $11.7 million and $10.0 million for the nine months ended May 31, 2004 and 2003, respectively. These reviewed financial statements should be read in conjunction with the audited financial statements at August 31, 2003. Operating results for the quarter and nine months ended May 31, 2004 are not necessarily indicative of the results that may be expected for the year ending August 31, 2004.

The Company operates in one line of business and its strategy is to develop and manage general acute care hospitals that provide specialized general surgeries. The Company’s strategy is to develop and operate general acute care hospitals designed to handle specialized general surgeries such as bariatric, orthopedic and neuro spine surgeries. The Company manages these hospitals on an individual basis. The hospitals’ economic characteristics, nature of their operations, regulatory environment in which they operate and the way in which they are managed are all similar. Accordingly, the Company aggregates its hospitals into a single reportable segment as that term is defined by SFAS No. 131 “Disclosures About Segments of an Enterprise and Related Information.”

General

As of May 31, 2004, the Company operated two facilities in the Houston metropolitan area (Pasadena and West Houston Facilities), and one each in the Dallas-Fort Worth area (Garland Facility) and in Baton Rouge (Baton Rouge Facility). The Garland Facility was acquired in August 2003, and surgical procedures started at this facility at the end of November 2003.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. The most significant of the Company’s estimates is the determination of revenue to recognize the services the Company provides and the determination of the contractual allowance. See “Revenue Recognition” below for further discussion. Actual results could differ materially from those estimates used in preparation of these financial statements.

Reclassifications

Certain accounts in the comparable period in the prior year have been reclassified to conform to the presentation in the current fiscal quarter. For the quarter and nine months ended May 31, 2003, income from operations, income before cumulative effect of a change in accounting principle and net income have been restated to reflect audit adjustments for depreciation expense of $(119,576) and $48,256, respectively. The cumulative effect of a change in accounting principle was increased by $460,564 for the nine months ended May 31, 2003 to reflect additional negative goodwill recorded by the Company in connection with the acquisition of minority interest of a subsidiary. Medical services and supplies expense was increased and other operating expenses decreased by $147,828 and $514,888, respectively, to reflect the cost of medical services which had been charged to other operating expenses.

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Stock Based Compensation

The Company applies Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations in accounting for its employee stock compensation. As required by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), the Company has determined pro forma net income and earnings per share, as if compensation cost for the employees stock options had been determined based upon fair values at the grant dates. These pro forma amounts are as follows:

The fair value of the stock-based awards was estimated using the Black-Scholes model with the following weighted average assumptions:

Revenue Recognition

Background

The Company’s revenue recognition policy is significant because net patient service revenue is the primary component of its results of operations. Revenue is recognized as services are delivered. The determination of the amount of revenue to be recognized in connection with the Company’s services is subject to significant judgments and estimates, which are discussed below.

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Revenue Recognition Policy

The Company is normally not a party to any managed care contracts. The Company records revenue pursuant to the following policy. The Company has established billing rates for its medical services that it bills as gross revenue as services are delivered. Gross billed revenues are then reduced by the Company’s estimate of the discount (contractual allowance) to arrive at net patient service revenues. Net patient service revenues represents the Company’s estimate of the amounts ultimately expected to be collected for the services it has delivered.

Contractual Allowance

The Company computes its contractual allowance based on the ratio of the Company’s historical cash collections during the trailing twelve months on a case by case basis to gross billed revenue on a case by case basis by operating facility. For operating facilities with less than twelve months historical collection period, all of its collections are used to calculate the contractual allowance. This ratio of cash collections to billed services is then applied to the gross billed services by operating facility. The following table shows gross revenues and contractual allowances for the three and nine months ended May 31, 2004 and 2003:

The contractual allowance for the three and nine months ended May 31, 2004 is 53% and 47%, respectively, of gross billed charges compared to 45% and 45% for the three and nine months ended May 31, 2003, respectively, primarily due to contractual allowance of 76% estimated on gross billed charges of $8.7 million at the Garland Facility, which has only been open since November 2003.

Accounts Receivable

Accounts receivable represent net receivables for services provided by the Company. The estimated accounts receivable not expected to be collected within twelve months of the balance sheet date have been shown as long-term receivables and represent receivables in the Medical Dispute Resolution (“MDR”) and legal third party financial class. The contractual allowance is provided as revenue is recognized. At each balance sheet date management reviews the accounts receivables for collectibility. If after the review management believes certain receivables would be uncollectible, the receivable would be written down to the expected collectable amount. Management has not written down any receivables during the quarters and nine months ended May 31, 2004 and 2003 as a result of the collectibility test.

The contractual allowance stated as a percentage of gross receivables at the balance sheet dates of May 31, 2004 and August 31, 2003 is 81% and 74%, respectively. This percentage is larger than the contractual allowance percentage used to reduce gross billed charges due to the application of partial cash collections to the outstanding gross receivable balances without any adjustment being made to the contractual allowance. The contractual allowance amounts netted against gross receivables are not adjusted until such time as the final collections on the receivables is recognized.

Collections for services provided are generally settled or written off as uncollectible against the contractual allowance within six months of the date of service except for services provided to injured workers in Texas. Collections for services provided to injured workers in Texas may take up to three years or longer to be completely adjudicated. Because the Company has in recent years focused on providing services to injured workers in Texas, accounts receivable in the workers compensation and MDR financial classes have increased.

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The MDR process is an established reimbursement resolution process available to providers of healthcare services under the regulations guiding reimbursement for services provided to injured workers in the State of Texas. Accounts generally do not become subject to the MDR process prior to being outstanding for at least 90 days subsequent to patient discharge. For medical services provided to injured workers’ in the state of Texas, the MDR process is specifically based upon the administrative and statutory regulations promulgated by the Texas Labor Code and Texas Administrative Code provisions.

Due to a number of factors outside the Company’s control, including a change in the Company’s reimbursement collection experience associated with potential changes in the reimbursement environment in which the Company operates, it is possible that management’s estimates of patient service revenues could change, which could have a material impact on the Company’s revenue and profitability in the future.

Allowance for Uncollectible Accounts

The Company has estimated uncollectible accounts expense as 1% of gross outpatient revenue. Through August 31, 2003, the Company made no charge offs against allowance for uncollectible accounts, as historically all charge offs have been against the contractual allowance. During the quarter and nine months ended May 31, 2004, the Company charged $ – and $222,518, respectively, against the allowance for uncollectible accounts.

Minority Interests

The equity of minority investors (generally physician groups and other healthcare providers that perform surgeries at the Company’s facilities) in certain subsidiaries of the Company is reported on the consolidated balance sheets as minority interests. Minority interests reported in the consolidated income statements reflect the respective interests in the income or loss of the limited partnerships or limited liability companies attributable to the minority investors (equity interest was at 2.14% at May 31, 2004 and ranged from 2.14% to 5% during the nine months ended May 31, 2004). During the quarter ended November 30, 2003, the Company purchased minority interest from certain minority interest holders at an amount that was $301,040 less than the net book value of the minority interest liability on the date of purchase. The $301,040 gain less applicable income taxes of $114,170 has been recorded as an extraordinary gain during the quarter ended November 30, 2003. The partnership agreement provided a means for the minority interest holders to be cashed out at the net book value. The amounts paid to the minority interest holders were less than the buy out amount that was called for in the partnership agreements. Legal counsel has advised the Company that the acquisitions were negotiated transactions occurring outside the partnership agreement.

Contingencies

The Company maintains various insurance policies that cover each of its facilities. Specifically, the Company maintains medical malpractice insurance coverage in Texas. The Company has claims-made malpractice coverage and has purchased tail coverage effective through August 12, 2004. In Louisiana, the Company is a member of the Louisiana Patient Compensation Fund and purchases insurance through the Louisiana Patient Compensation Fund for medical malpractice. In addition, all physicians granted privileges at the Company’s facilities are required to maintain medical malpractice insurance coverage. The Company also maintains general liability and property insurance coverage for each facility and flood coverage for the Baton Rouge Facility. The Company also maintains workers’ compensation coverage for the Baton Rouge Facility, but does not currently maintain worker’s compensation coverage in Texas. In regard to the Employee Health Insurance Plan, the Company is self insured with specific and aggregate re-insurance with stop loss levels management believes are appropriate for the Company’s group size. Coverages are maintained in amounts management deems adequate.

In January 2002, the Company, two of its officers, and the spouse of one of the officers were named as defendants in a shareholder class action lawsuit, Hamilton v. Dynacq International, et al., in the United States District Court for the Southern District of Texas alleging violations of federal securities laws and regulations. The suit was brought in early 2002 following a sharp high volume increase in short sales of our common stock. The plaintiffs alleged that the Company violated Sections 10(b) and 20(a) and Rule 10b-5 under the Exchange Act by making materially false or misleading statements or omissions regarding revenues and receivables and regarding whether our operations complied with various federal regulations. The district court consolidated these actions and appointed a lead plaintiff in the matter. The lead plaintiff filed a consolidated amended complaint on September 6,

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2002. The Company and its officers moved to dismiss the complaint on February 25, 2003. On August 26, 2003, the Court dismissed with prejudice and denied plaintiffs leave to amend further. The plaintiffs thereafter filed a notice of appeal. In May 2004, the third quarter for the Company, the plaintiffs dismissed their appeal, thereby concluding the case.

In March 2002, the Company accepted service of a shareholder derivative action, Brill v. Chan, et al., filed on or about February 26, 2002 in the 295th District Court of Harris County, Texas brought on behalf of the Company against its officers and directors, outside auditor, investment bank, and two analysts affiliated with that investment bank. The suit alleged breach of fiduciary duty, aiding and abetting breach of fiduciary duty, negligence and breach of contract. The final settlement, which was approved by the Court on November 10, 2003, provided, among other things, that (1) the claims were dismissed with prejudice and (2) defendants agreed to pay the legal fees and expenses of plaintiffs (shareholders), which the Court set at $500,000. Among the terms of the settlement, it was stipulated that, as a result of the prosecution of the lawsuit and/or the work of the Special Litigation Committee of the Board of Directors of Dynacq, Dynacq had implemented and/or had agreed to implement certain procedures relating to its Audit Committee and its accounting for uncollectible accounts and contractual allowances. The settlement does not require any change in previously reported financial statements. The Company had accrued for this settlement at August 31, 2003. The Company made the payment in December 2003 and the matter was concluded in the first quarter of 2004.

A separate shareholder derivative action alleging breach of fiduciary duty, abuse of control, gross mismanagement and unjust enrichment, Flory v. Chan, et al., H-02-3123, was brought in U.S. District Court for the Southern District of Texas in August 2002, but was stayed on November 12, 2002 by the district court pending the outcome of the shareholder class action described above. Given the plaintiff’s dismissal of the appeal in the Hamilton shareholder class action described above and given the state court’s dismissal of the same or similar claims in the Brill state derivative action described above, the Company moved in the fourth quarter of fiscal 2004 to dismiss this derivative action.

In the second quarter of 2004, eight lawsuits were filed in the United States District Court for the Southern District of Texas (Houston Division) between December 24, 2003 and January 26, 2004, alleging federal securities law causes of action against the Company and various current and former officers and directors. The cases were filed as class actions brought on behalf of persons who purchased shares of Company common stock in the open market generally during the period of January 14, 2003 through December 18, 2003. Under the procedures of the Private Securities Litigation Reform Act, certain plaintiffs have filed motions asking to consolidate these actions and be designated as lead plaintiff. The court consolidated the actions and appointed a lead plaintiff in the matter. An amended complaint was filed on June 30, 2004, asserting a class period of November 27, 2002 – December 19, 2003 and naming additional defendants, including Ernst & Young LLP, the Company’s prior auditors. The amended complaint seeks certification as a class action and alleges that the defendants violated Sections 10(b), 20(a), 20(A) and Rule 10b-5 under the Exchange Act by publishing materially misleading financial statements that did not comply with generally accepted accounting principles, making materially false or misleading statements or omissions regarding revenues and receivables, operations and financial results and engaging in an intentional fraudulent scheme aimed at inflating the value of Dynacq’s stock. After the Company filed its Form 10-K for fiscal 2003 on July 30, 2004, the procedural schedule was amended so that plaintiffs have until 30 days after this and the other outstanding 10-Q’s are filed to file an amended complaint. The Company is vigorously defending against the allegations and will file a motion to dismiss all or some of the claims. The Company cannot predict the ultimate outcome of the lawsuit or whether the lawsuit will have a material adverse effect on the Company’s financial condition.

The Company was named as a defendant in the lawsuit Leo Borrell v. Dynacq International, Inc., NeWeigh, Inc., and Diane Crumley, Vital Weight Control, Inc., d/b/a NeWeigh, and Vista Community Medical Center, L.L.C. (Cause No. 2002-13659) filed in March 2002 in the 281st Judicial District Court of Harris County, Texas. The Company has been nonsuited in the fourth quarter of 2004.

Late in fiscal year 2003, a dispute arose between one of the Company’s subsidiaries and Jane Capital, LLC and Sunbelt Medical Corp. related to the purchase of medical equipment for the Company’s Baton Rouge Facility. Because Jane Capital and Sunbelt each demanded identical full payment for the equipment without providing necessary supporting documents, the Company’s subsidiary filed suit in April 2003 in state district court in Harris

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County, Texas (165th District) to require Jane Capital, LLC and Sunbelt Medical Corp. to produce the documents, to determine the proper amount owed for the equipment and to whom such amounts were owed and to reimburse the Company for selling the Company certain defective products. The lawsuit was settled in May 2004, the third quarter of 2004.

In September 2003, a lawsuit, case number 598-564, was filed in the Twenty Fourth Judicial District Court for the Parish of Jefferson, State of Louisiana, by Liljeberg Enterprises International, L.L.C. alleging that the plaintiff is owed damages for costs of goods and services rendered for pharmacy operations at the Baton Rouge Facility. The plaintiff has asserted claims for breach of contract, fraud, negligence, fraudulent misrepresentation, negligent misrepresentation, civil conspiracy and gross negligence. On August 6, 2004, the plaintiff filed a Motion for Partial Summary Judgment, which is currently set for hearing on October 15, 2004, claiming damages in the amount of approximately $725,000 plus accounting fees. The Company believes the motion is premature and that the amount of alleged damages is without merit. The Company intends to oppose the motion and to continue to vigorously defend the lawsuit. However, we cannot predict the ultimate outcome of the lawsuit or whether the lawsuit will have a material adverse effect on the Company’s financial condition.

In December 2002, the Pasadena Facility was notified by the Centers for Medicare and Medicaid Services (“CMS”) that the Pasadena Facility had allegedly violated requirements of the Emergency Medical Treatment and Labor Act (“EMTALA”). The Texas Department of Health (“TDH”) conducted an investigation and reported to the CMS that appropriate corrective actions had been taken. As a result of TDH’s findings, the CMS notified the facility in January 2003 that its eligibility for Medicare participation remained in effect, but, as required by §1867(d) of the Social Security Act, the matter would be forwarded to the Quality Improvement Organization (“QIO”) to review the case and report its findings to the OIG for a possible assessment of a civil monetary penalty. Representatives of the facility met with the QIO on October 3, 2003. As of this date, there has been no report issued by the QIO or any response received from the OIG. The Company does not anticipate that it will incur any material liability that would have a material adverse effect on the Company’s operations, cash flows, or financial condition as a result of this proceeding.

In February 2004, the Company was notified by the Office of the Attorney General of Texas that it is the subject of an investigation of possible violations of the statutes governing the solicitation of patients. Based on the documents requested and communications with Company representatives, the Company believes that such investigation stems from the same allegations that were asserted in the private lawsuit with Dr. Borrell described above in which the Company has been nonsuited. The Company is cooperating with the AG’s Office on this matter, but believes the complaint received by the AG’s office to be without merit.

From time to time, the Company is involved in litigation and administrative proceedings that are incidental to its business. The Company cannot predict whether any litigation to which it is currently a party will have a material adverse effect on the Company’s results of operations, cash flows, or financial condition.

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

This quarterly report on Form 10-Q contains forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or the negative of these terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. Such forward-looking statements relate to future events or future financial performance and involve known and unknown risks, uncertainties and other factors that may cause the Company’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by the forward-looking statements, including the risks and uncertainties described in “Risk Factors” in our annual report on Form 10-K for the fiscal year ended August 31, 2003. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, or achievements. You must read the following discussion of the results of our business and our operations and financial condition in conjunction with our reviewed consolidated financial statements, including the notes, included in this quarterly report on Form 10-Q and our audited consolidated financial statements, including the notes, included in our annual report on Form 10-K for the fiscal year ended August 31, 2003.

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Executive Summary

Third Quarter of Fiscal 2004

During the quarter ended May 31, 2004, we experienced a sharp decline in our results of operations. We had previously begun the process of developing the business of our new hospitals in Baton Rouge and Garland and had planned for substantial increased expenses for personnel, depreciation and other operating expenses, as well as additions to the physician staff. However, the departure earlier in the year of several key physicians from our Pasadena facility caused a sharp drop in operating activity at that hospital. Since the reduction in operating expenses only partially offset the decline in revenue at Pasadena, Garland was still in the early stage when operating expenses were higher than revenue, our operating margin decreased. In addition, ongoing regulatory investigations and legal proceedings as well as negative publicity about the Company made it more difficult for us to recruit physicians in Pasadena and elsewhere and substantially increased our legal and auditing expenses.

Net Patient Service Revenues Down 49%

During the quarter ended May 31, 2004, net patient service revenues declined $12.7 million, or 49%, compared to the prior year period, to $12.9 million, as net patient service revenue from our Baton Rouge and Garland Facilities increased by $0.9 million and $1.2 million, respectively, partially offsetting a 67% decline of $14.2 million in net patient service revenue at the Pasadena Facility. During the nine months ended May 31, 2004, physicians who accounted for more than 52% of our gross revenues for 2003 were no longer performing surgeries at the Pasadena Facility.

Net Income Down 120%

Net income declined $7.7 million or 120%, resulting in a net loss of $1.3 million from a net income of $6.4 million in the comparable quarter of fiscal 2003, primarily because of the following:

Nine Months Ended May 31, 2004

The 26% decline in net patient service revenue from $64.7 million to $47.9 million and the 93% decline in net income from $15.7 million to $1.1 million in the nine months ended May 31, 2004 was mainly caused by the factors listed in the preceding paragraph, as well as a $1.1 million noncash pretax compensation expense incurred in the first two quarters of fiscal 2004 relating to options previously granted to a former employee.

For the first nine months of fiscal 2004, net patient service revenue declines of $29.6 million (51%), at the Pasadena facility was only partly offset by the increases of $11.3 million and $2.1 million, respectively, at the Baton Rouge and Garland Facilities.

Total costs and expenses increased $7.5 million, mainly because the expense of operating the new Baton Rouge and Garland Facilities.

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Outlook for the Fourth Quarter of Fiscal 2004

During the first half of the current quarter ending August 31, 2004 we have added physicians to the staff of each of our three hospital facilities. While we are continuing our efforts to recruit additional physicians, we do not expect that these additions will have a near-term impact on our financial results.

Update on Critical Accounting Policies and Estimates

There have been no changes to the critical accounting policies used in our reporting of results of operations and financial position for the quarter ended May 31, 2004. For a discussion of our critical accounting policies see Management’s Discussion and Analysis of Financial Condition and Results of Operations in our annual report on Form 10-K for the fiscal year ended August 31, 2003.

Results of Operations

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