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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended March 31, 2005

OR

For the transition period from              to             

Commission File No.: 000-22073

Daou Systems, Inc.

(Exact name of registrant as specified in its charter)

(610) 594-2700

(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  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

The number of shares of Registrant’s Common Stock, par value $.001 per share, outstanding as of April 29, 2005: 21,815,378.

Table of Contents

Daou Systems, Inc.

Index to Form 10-Q

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PART I. FINANCIAL INFORMATION

ITEM 1. CONDENSED FINANCIAL STATEMENTS

Daou Systems, Inc.

Condensed Balance Sheets

(In thousands, except for per share data)

See accompanying notes to the condensed financial statements.

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Daou Systems, Inc.

Condensed Statements of Operations

(In thousands, except for per share data)

(unaudited)

See accompanying notes to the condensed financial statements.

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Daou Systems, Inc.

Condensed Statements of Cash Flows

(In thousands)

(unaudited)

See accompanying notes to the condensed financial statements.

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Daou Systems, Inc.

Notes to Condensed Financial Statements

(unaudited)

1. Basis of Presentation

The unaudited condensed financial statements of Daou Systems, Inc. (“Daou” or the “Company”) at March 31, 2005 and for the three-month period ended March 31, 2005 have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information. Accordingly, they do not include all information and footnotes required by GAAP for a complete set of financial statements. These financial statements reflect all adjustments, consisting of normal recurring adjustments, which in the opinion of management are necessary to present fairly the financial position of the Company at March 31, 2005 and the results of operations for the three-month periods ended March 31, 2005 and 2004. The results of operations for the three months ended March 31, 2005 are not necessarily indicative of the results to be expected for the year ending December 31, 2005. The Company has experienced significant quarterly fluctuations in operating results and it expects that these fluctuations will continue. The balance sheet at December 31, 2004 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. Certain balances in prior periods have been reclassified to conform with the current year’s presentation.

The financial statements and related disclosures have been prepared with the presumption that users of the interim financial information have read or have access to the audited financial statements for the preceding fiscal year. Accordingly, these financial statements should be read in conjunction with the audited financial statements and the related notes thereto contained in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”) on March 30, 2005.

2. Recent Pronouncements

On December 16, 2004, the Financial Accounting Standards Board (FASB) issued Statement 123 (revised 2004), “Share Based Payment” (FAS 123R). FAS 123R supersedes APB 25, “Accounting for Stock Issued to Employees,” and is effective for public companies at the beginning of the first annual period after June 15, 2005. FAS 123R requires that the fair value of equity based awards be recognized in the financial statements for new awards and previously granted awards that are not yet fully vested on the adoption date. The Company is currently evaluating the impact of adopting FAS 123R but does not expect a material impact.

3. 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 about the future that affect the amounts reported in the financial statements and disclosures made in the accompanying notes of the financial statements. The actual results could differ from those estimates.

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Daou Systems, Inc.

Notes to Condensed Financial Statements

(unaudited)

4. Earnings Per Share

The following table details the computation of basic and diluted earnings per share:

(In thousands, except per share information)

For the periods ending March 31, 2005 and 2004, diluted loss per share is unchanged from basic loss per share because the effects of the assumed conversions of Series A Preferred Stock and accrued dividends and the exercise of stock options and warrants would be anti-dilutive.

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Daou Systems, Inc.

Notes to Condensed Financial Statements

(unaudited)

5. Stock-Based Compensation

The Company has stock-based employee compensation plans. The Company applies the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for those plans. Pro forma information regarding net income and earnings per share is required by SFAS No. 123, “Accounting for Stock-Based Compensation,” and has been determined as if the Company had accounted for its stock plans under the fair value method of SFAS No. 123. For purposes of the pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting periods. The following table illustrates the effect on net loss available to common shareholders and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123:

The fair value of options granted was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions for option grants during the first quarter of 2004: risk-free interest rate of 3%; dividend yield of 0%; volatility factors of the expected market price of the Company’s common stock of 82%; and a weighted-average expected life of the options of five years. No options were granted during the first quarter of 2005.

6. Restructuring Plan

The Company recorded restructuring charges for years prior to 2003 in accordance with SEC SAB No. 100, Restructuring And Impairment Charges, and EITF No. 94-3, Liability Recognition For Certain Employee Termination Benefits And Other Costs To Exit An Activity (Including Certain Cost Incurred In A Restructuring). Effective January 1, 2003, the Company follows the provisions of SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities.”

As of March 31, 2005, the Company’s remaining restructuring liability was $29,000 related to the closure of certain facilities. The future lease obligations relating to the closure of these facilities are payable through June 2005.

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Daou Systems, Inc.

Notes to Condensed Financial Statements

(unaudited)

7. Contingencies

On August 24, 1998, August 31, 1998, September 14, 1998 and September 23, 1998, four separate complaints were filed against the Company and certain of its officers and directors in the United States District Court for the Southern District of California. A group of shareholders has been appointed the lead plaintiff in this federal litigation, and they filed a second amended consolidated class action complaint on January 21, 2000. This new complaint realleges that the Company improperly used the “percentage-of-completion” accounting method for revenue recognition. Claims are pleaded under both the 1933 Securities Act (relating to the Company’s initial public offering) and section 10b of the 1934 Securities Act. The complaint was brought on behalf of a purported class of investors who purchased the Company’s Common Stock between February 13, 1997 and October 28, 1998, but it does not allege specific damage amounts.

A Motion to Dismiss the second amended consolidated class action complaint was filed on February 22, 2000. On March 27, 2002, the Court granted the Motion but extended to plaintiffs the opportunity to file a Third Amended Complaint. The plaintiffs filed their third amended consolidated class action complaint on May 16, 2002, to which the Company responded with another Motion to Dismiss. The Motion was filed on June 24, 2002 and challenged the legal sufficiency of the allegations. On October 15, 2002, the Court granted that Motion, this time with prejudice.

Plaintiffs timely noticed an appeal and filed their Appellants’ Brief with the Ninth Circuit Court of Appeals on April 9, 2003. On July 2, 2003, the Company filed its Respondents’ Brief and Cross-Appeal. The Cross-Appeal challenges the trial court’s failure to assess whether the complaint complied with applicable pleadings standards. The matter was argued before the court on February 12, 2004. On February 2, 2005, the court reversed the dismissal and remanded the case back to the district court. Because it reversed the dismissal, it did not decide the Company’s cross-appeal. The Company appealed the reversal by way of petition for rehearing to the Ninth Circuit Court of Appeals filed February 23, 2005. Among other issues appealed was the court’s ruling on loss causation. On March 3, 2005, the Ninth Circuit deferred consideration on the petition for rehearing until the United States Supreme Court renders its opinion in another case involving the same loss causation issue. Given this deferral, the Company’s intended appeal to the Supreme Court by way of writ of certiorari is in abeyance until the Ninth Circuit decides the petition for rehearing.

On October 7, 1998 and October 15, 1998, two separate complaints were filed in the Superior Court of San Diego County, California. These state court complaints mirror the allegations set forth in the federal complaints. They also assert claims for common law fraud and the violation of certain California statutes. As with their federal counterparts, they do not allege specific damage amounts. On April 1, 1999, a Consolidated Amended Class Action was filed on behalf of the same state court plaintiffs, and this new complaint alleges the same factual basis as is asserted in the federal litigation. The state litigation pleads claims for fraud and violations of certain California Corporation Code provisions. By stipulation of the parties and order of the court, this state court litigation was stayed pending the outcome of the motion to dismiss the federal lawsuits, as well as the resulting Appeal and Cross-Appeal.

The Company believes that the allegations set forth in the federal and state complaints are without merit, and the Company intends to defend against these lawsuits vigorously. The Company is occasionally party to other various claims and legal actions arising in the normal course of business. Although the ultimate outcome of the matters is not presently determinable, management believes that the resolution of all such matters, net of amounts accrued, will not have a material adverse affect on the Company’s business, results of operations or financial condition; however, there can be no assurance that the ultimate resolution of these matters will not have a material impact on the Company’s results of operations in any period.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934. All forward-looking statements are inherently uncertain as they are based on current expectations and assumptions concerning future events or future performance of Daou Systems, Inc. You should not place undue reliance on these forward-looking statements, which are only predictions and speak only as of the date hereof. Forward-looking statements usually contain the word “estimate,” “anticipate,” “hope”, “believe,” “think”, “expect,” “intend”, “plan” or similar expressions, and are subject to numerous known and unknown risks and uncertainties. The forward-looking statements included herein are based on current expectations and certain assumptions and entail various risks and uncertainties, including risks and uncertainties relating to: the Company’s ability to sell its services to existing and new customers; the long sales cycle in obtaining new customers and larger contracts; the timing and extent of employee training or the loss of key employees; industry spending patterns and market conditions; the reduction in size, delay in commencement or loss or termination of one or more significant projects; increased competition and the resulting pricing pressure; the Company’s ability to continually offer services and products that meet its customers’ demands, as new technologies or industry standards could render its services obsolete or unmarketable; the ability of the company to successfully execute strategies for realizing shareholder value; the effects of healthcare industry consolidation and changes in the healthcare regulatory environment on existing customer contracts; and the continued effect of our high costs associated with certain dividend rights of our preferred shareholders. In evaluating such statements, you should carefully review various risks and uncertainties identified in this report, including our Financial Statements and the related notes and in our other SEC filings, including those more fully set forth in the “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other sections of our Form 10-K for the year ended December 31, 2004 on file with the SEC. These risks and uncertainties could cause our actual results to differ materially from those indicated in the forward-looking statements. We do not undertake any obligation to update or publicly announce revisions to any forward-looking statements to reflect future events or developments.

Overview of the Company

Daou performs applications consulting and implementation, wireless and traditional network services, enterprise application integration, software engineering and database migration and conversions and integration of legacy systems with emerging technologies, such as wireless and other portable computing solutions for the U.S. healthcare industry. Our IT offerings include data and voice networking, applications consulting and implementation, as well as operational and Internet solutions. We organize our business by markets, with specific focus areas in 1) payers of health care services in the commercial markets including health plans, insurance companies, managed care organizations, and third party administrators; 2) providers of clinical services such as community and urban hospitals and hospital systems, and 3) government healthcare organizations including Veterans Health Administration, Department of Defense Military Health Service, and the Department of Health and Human Services.

Overview of the healthcare IT industry and material trends impacting the Company’s results of operations

The overall healthcare industry has been slow to adopt new information technologies. Much of the hesitation for providers has been due to reimbursement pressures, which limit the amount of capital available to fund broad IT initiatives. Payers have faced the demands of consolidation and constant pressure to reduce administrative expenditures. However, notwithstanding the financial pressures of the past, we believe demand for clinical and financial healthcare IT systems is poised to accelerate as providers look to reduce errors, cut costs, and boost efficiency and payers offer new products intended to empower their members through greater involvement in their individual care.

The federal government is an active participant in progressing the potential for information technology to improve healthcare quality while reducing costs. A new sub-cabinet level position, National Coordinator for Health Information Technology, has been created to move forward an initiative for every U.S. citizen to have an electronic medical record within 10 years. However, funding challenges will likely persist for providers, as hospitals cope with declining patient admissions and revenues and physician reimbursements remain under pressure. At the same time, operating costs are increasing for all sectors of the healthcare market, negatively impacting financial results in the IT sector where revenue and earnings have been volatile.

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The three sectors of the health care market we serve (payers, providers and government) remain under a great deal of pressure due to issues such as consolidation and demands on cost savings and reduced IT budgets, and an ongoing increase in outsourcing of IT services. However, our revenue challenges in the first quarter 2005 were more directly attributed to our difficulty in establishing sustainable sales results. While the downward pressure on prices for professional IT services has eased somewhat, we have not reengineered our services fast enough to meet the current demands of the healthcare IT industry.

Key indicators of our financial condition and operating performance

Utilization of our professional staff, which is the ratio of total billable hours to available hours in a given period, and our ability to manage fixed price contracts, are among our top challenges. We employed 93 billable professionals on March 31, 2005. The salaries and benefits of this staff are recognized in our cost of revenue before reimbursable expenses. Most non-billable employee salaries and benefits are recognized as a component of either selling or general and administrative expenses.

Quarterly net revenues declined by 29% in the first quarter 2005 as compared to the first quarter 2004; however, first quarter 2005 revenue increased by $278,000, or 5%, compared to fourth quarter 2004. The revenue decline was partially impacted by the discontinued support center management services to hospitals and Integrated Delivery Networks on February 25, 2004 (revenue from this business was approximately $851,000 in the first quarter 2004), and partially impacted by the completion of a large network upgrade project at the end of the first quarter 2004 (revenue from this project was approximately $1,664,000 in the first quarter 2004).

Selling, general and administrative (SG&A) overhead expenses of $1,940,000 in the first quarter 2005 were $730,000 lower than the first quarter 2004 as a result of: reduced sales and administrative staff, travel and related expenses, and general overhead expenses. We continue to strive to reduce our general and administrative expenses by managing those costs that are mostly controllable such as staffing, facilities, IT and operating systems in order to more closely align these costs with net revenue.

Characteristics of our revenue and expenses

We generate substantially all of our revenue from professional services, primarily on a “time and expense” project basis, under which revenue is recognized as the services are performed. Billings for these services occur on a semi-monthly or monthly basis as specified by the contract with a particular customer. Our billing rates are commensurate with the healthcare-domain IT expertise, know-how and skills of our people. Our time and expense projects generally range from three to six months, although certain projects have been for periods in excess of a year. Our network system and payer application system implementation engagements typically average six months, but may vary depending on the size and complexity of the project.

We continue to provide some of our professional services on a fixed-fee basis. Revenue on fixed-fee contracts is recognized relative to the level of service performed based upon the amount of labor cost incurred on the project versus the total labor costs to complete the project. Our gross margin with respect to fixed fee contracts varies significantly depending on the percentage of such services consisting of the resale of third-party products (with respect to which we obtain a lower margin) versus professional services.

We bill our customers for out-of-pocket expenses, primarily travel and related expenses incurred with respect to services provided to customers, and have adopted the provisions of the Emerging Issues Task Force (“EITF”) Topic D-103, Income Statement Characterization of Reimbursements for “Out-of-Pocket” Expenses Incurred, issued in November 2001. EITF Topic D-103 states that reimbursements received for out of pocket expenses should be characterized as revenue on the income statement. The application of EITF Topic D-103 does not have an impact on current or previously reported net income (loss) or net income (loss) per share. We will continue to use net revenue (revenue before reimbursements) and cost of revenue before reimbursable expenses to compute percentage and margin calculations, as well as for purposes of comparing the results of operations for the three months ended March 31, 2005 to the three months ended March 31, 2004.

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Payments received in advance of services performed are recorded as deferred revenue. Certain contract payment terms may result in customer billing occurring at a pace slower than revenue recognition. The resulting revenue recognized in excess of amounts billed and project cost is included in contract work in progress on our balance sheet.

Cost of revenue primarily consists of all expenses that are directly attributable to our service lines and include the salaries, bonuses and related benefits of our consultants as well as non-billable managers and support staff, subcontractor expenses, training costs and unit-specific office space costs. Our consultant-related costs are relatively fixed; therefore, fluctuations in our gross margin may occur due to changes in project margins and utilization rates of our professional staff. We often continue to employ non-engaged employees in anticipation of commencement of a project. We invest in training these key billable employees not engaged in contract work in order to improve our ability to diversify our service offerings to include business process improvement consulting, wireless and mobile computing, and other related IT consulting services. If delays in contract signing occur or projects do not materialize, our gross margin could vary due to the associated loss of revenue to cover fixed labor costs.

Sales and marketing expenses primarily consist of the salaries, benefits, travel and other costs of our sales and marketing teams, as well as marketing initiatives and business development expenses. In the first quarter 2005, while we have reduced our overall direct sales expenses, we are making on-going investments in our sales development and marketing plans in the provider market.

General and administrative expenses primarily consist of the costs attributable to the support of our consultants, such as: investments in information systems, salaries, expenses and office space costs for executive management, financial accounting, purchasing, administrative and human resources personnel, recruiting fees, legal and other professional services.

Results of Operations

The following table sets forth, for the periods indicated, certain statement of operations data as a percentage of net revenues.

Three Months Ended March 31, 2005 and 2004

Our net revenue decreased 29% or $2.6 million to $6.3 million for the three months ended March 31, 2005 from $8.8 million for the three months ended March 31, 2004. However, first quarter 2005 revenue increased by $278,000, or 5%, compared to fourth quarter 2004. While our current revenue trend is relatively flat, the decrease in the first quarter 2005 compared to first quarter 2004 was primarily due to our overall lack of sales to new and existing customers, the discontinuation of our support center management services in the first quarter 2004, the completion of a large network upgrade project in the first quarter 2004, and our slow transformation of our services to meet the current demands of our customers.

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Services to our five largest customers accounted for $2.4 million of net revenue for the three months ended March 31, 2005, representing 38% of total net revenue, with one customer accounting for 9% of total net revenue. This compares to net revenue from the five largest customers for the three months ended March 31, 2004 totaling $4.1 million, or 47% of total net revenue, with one customer accounting for 21% of total net revenue. With the discontinuation of our support center management services and the completion of large network upgrade projects, revenues are becoming less concentrated among a small group of customers.

Cost of revenue before reimbursable expenses decreased 35% or $2.5 million to $4.6 million for the three months ended March 31, 2005 from $7.1 million for the three months ended March 31, 2004. This was attributable primarily to a decrease in our billable workforce to 93 professionals in the first quarter 2005 from 105 in the first quarter of 2004, and a decrease in direct material costs by $1,127,000 in the first quarter 2005 compared to the first quarter of 2004 as a result of the completion of a large network upgrade project at the end of the first quarter 2004.

Gross margin was 27% in the first quarter of 2005, compared to 19% in the first quarter of 2004. We experienced higher margins on professional services as a result of improved utilization of our billable consultants in our payer and government healthcare units.

First quarter 2005 operating results reflected a reduced level of marketing and business development expenses as we continue to lower our costs as a result of declining revenue. For the three months ended March 31, 2005, sales and marketing expenses decreased by $543,000, or 47%, to $614,000 from $1.2 million for the three months ended March 31, 2004.

General and administrative expenses decreased 12%, or $187,000, to $1.3 million for the three months ended March 31, 2005 from $1.5 million for the three months ended March 31, 2004, partially due to the reduced number of administrative staff, and reduced general overhead costs. We continue to manage those costs that are mostly controllable such as staffing, facilities and operational overhead.

Income Taxes

We have a history of losses, which, for income tax purposes, generated sizeable federal and state tax net operating loss (“NOL”) carryforwards, at December 31, 2004, of approximately $32.0 million and approximately $10.9 million, respectively. The federal loss carryforwards will expire beginning 2018 through 2024, and the state loss carryforwards expire from 2004 through 2024, unless previously utilized. Pursuant to generally accepted accounting principles, we previously recorded a valuation allowance against the deferred tax asset associated with these NOL carryforwards as it is more likely than not that we will not be able to utilize the NOL carryforwards to offset future taxes. Due to the size of the NOL carryforwards in relation to our history of unprofitable operations, we have not recognized any of this net deferred tax asset. It is possible that we could be profitable in the future at levels which would cause us to conclude that it is more likely than not that we will be able to realize all or a portion of the NOL carryforwards. Upon reaching such a conclusion, we would record the estimated net realizable value of the deferred tax asset at that time and would then begin to provide for income taxes at a rate equal to our combined federal and state effective rates, which we believe would approximate 40%. Subsequent revisions to the estimated net realizable value of the deferred tax asset could cause our provision for income taxes to vary significantly from period to period.

Under Section 382 of the Internal Revenue Code, the annual use of our NOL carryforwards may be limited in the event of a cumulative change in ownership of more that 50%.

Liquidity and Capital Resources

At March 31, 2005, we had working capital of approximately $13.0 million.

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For the three months ended March 31, 2005, net cash used by operating activities of $1.6 million was attributable to two large infrastructure services contracts, resulting in an increase in accounts receivable and contract work in process, and the decrease in accrued salaries and benefits as a result of the payment of various compensation commitments accrued in 2004. These were partially offset by an increase in deferred revenue related to the same infrastructure contracts. This compares to net cash used by operating activities of $955,000 for the three months ended March 31, 2004 which was primarily the result of net operating losses experienced in that period.

Net cash used in investing activities was $152,000 for the three months ended March 31, 2005, compared to net cash used in investing activities of $156,000 in the comparable prior period. The use of these funds in both periods was primarily due to the purchase of fixed assets.

Net cash provided by financing activities for the three months ended March 31, 2004 was $8,000 which was attributable to proceeds from the issuance of common stock.

As previously disclosed, in July 1999 we issued 2,181,818 shares of Series A Convertible Preferred Stock to Galen Partners and their affiliates for an aggregate amount of $12 million; or $5.50 per share. Holders were initially entitled to receive cumulative dividends at the rate of six percent per annum, generally payable in the form of shares of Series A Preferred Stock until July 26, 2001. The dividend rate increased to 7% on July 26, 2001, and increases an additional 1% on July 26 of each year up to a maximum of 12%. The current dividend rate is 10%. No dividends may be paid on the common stock unless full dividends on the Series A Preferred Stock for the then current dividend period have been either paid or declared with a sum sufficient for the payment set apart.

The holders of the Series A Convertible Preferred Stock vote on an as converted to common stock basis with the holders of common stock. The Series A Preferred stockholders also have a liquidation preference of $5.50 per Series A share, plus any accrued but unpaid dividends. We are required to make a best efforts attempt to secure one Board of Director seat for a representative of the holders of Series A Preferred Stock. The holders of Series A Preferred Stock also obtained certain redemption rights as part of the original financing transaction in July 1999. They have since permanently waived those rights.

As of March 31, 2005, we have accrued but undeclared preferred stock dividends of $6.3 million (payable in kind by the issuance of approximately 1,139,538 shares of Series A Preferred Stock), thereby entitling the holders of the Series A Preferred Stock to a total liquidation preference of $18.3 million.

We are continuing to evaluate ways to improve our financial structure. Although we have an accumulated deficit as of March 31, 2005, we believe that our available funds are sufficient to meet our current operating needs. However, there can be no assurances that our available cash and investments will be adequate to sustain cash requirements in the future. We have no bank debt or outstanding lines of credit. We may sell additional equity or debt securities or obtain credit facilities. The sale of equity securities could result in dilution to our stockholders and the incurrence of debt could result in interest expense. However, there can be no assurance that we will be able to sell additional equity or debt securities, or be able to obtain financing on acceptable terms, if at all. Our management and Board of Directors continue to explore alternatives to address the Preferred Stock to maximize common shareholder value. In connection with such opportunities, we may decide to incur debt or sell additional equity securities. There can be no assurances that we will be successful in modifying our capital structure.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosures. On an on-going basis, we evaluate these estimates, including those related to revenue recognition, long-lived assets, accrued liabilities, stock-based compensation, and income taxes. Estimates are based on historical experience, information received from third parties and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

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We believe the following critical accounting policies affect the significant judgments and estimates used in the preparation of our financial statements.

Revenue Recognition

We recognize revenue in accordance with Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition. SAB 104 requires that the following criteria be met in determining whether revenue has been earned:

We have the following types of revenue recognition: i) services performed on an hourly basis, ii) services performed on a fixed fee basis and iii) sales of software, material and maintenance contracts. In general, we enter into contracts with customers to provide services at a specified fee or rate per hour. Revenue from professional services is recognized primarily on an hourly basis. Revenue from technical support, network management and help desk services is recognized as the services are performed. Contract revenue for the development and implementation of network solutions under fixed-fee contracts is recognized related to the level of service performed based upon the amount of labor cost incurred on the project versus the total labor costs to complete the project. Provisions for estimated losses on contracts, if any, are made during the period when the loss becomes probable and can be reasonably estimated. Revenue recognized in excess of amounts billed and project costs are classified as contract work in progress. Payments received in advance of services performed are recorded as deferred revenue and amortized as the services are performed.

Bad Debt

We are required to estimate the collectibility of our trade accounts receivable. We perform this analysis on a specific customer identification basis. A considerable amount of judgment is required in assessing the ultimate realization of these receivables, including the credit worthiness of each customer and the age of the customer balances. We estimate the amount to reserve for a specific customer by taking into account the age of the receivables and the payment history of the customer. Significant changes in required reserves have been recorded in recent periods and may occur in the future due to the current market environment and changes in client payment history.

Litigation

We are currently involved in legal proceedings regarding shareholder litigation and other general legal proceedings. As discussed in Note 7 of our financial statements, we believe that the lawsuits are without merit and intend to defend against them vigorously. Although the ultimate outcome of these matters is not presently determinable, management believes that the resolution of all such pending matters, net of amounts accrued, will not have a material adverse effect on our financial position. It is possible, however, that future results of operations for any particular quarterly or annual period could be materially affected by changes in our assumptions, or the effectiveness of our strategies, related to these proceedings.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Daou invests excess cash primarily in U.S. government securities and marketable debt securities of financial institutions and corporations with strong credit ratings. These instruments have maturities of three months or less when acquired. We do not utilize derivative financial instruments, derivative commodity instruments or other market risk sensitive instruments, positions or transactions in any material fashion. Accordingly, we believe that,

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while the instruments held are subject to changes in the financial standing of the issuer of such securities, we are not subject to any material risks arising from changes in interest rates, foreign currency exchanges rates, commodity prices, equity prices or other market changes that affect market risk sensitive instruments.

ITEM 4. CONTROLS AND PROCEDURES

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer (Principal Executive Officer) and Chief Financial Officer (Principal Financial Officer), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective, as of March 31, 2005, in alerting them in a timely manner to material information relating to the Company required to be included in the Company’s periodic SEC filings. There were no significant changes in the Company’s disclosure controls or internal controls over financial reporting during the first quarter of 2005.

Disclosure controls and procedures are designed to ensure information required to be disclosed in reports filed with the Securities Exchange Act of 1934 (Exchange Act) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to the Company’s management, including the Chief Executive Officer and the Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Disclosure controls include internal controls that are designed to provide reasonable assurance that transactions are safeguarded against unauthorized or improper use and that transactions are properly recorded and reported.

Any control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. The design of the control system inherently has limitations, and the benefits of controls must be weighed against their costs. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. Therefore, no evaluation of a cost-effective system of controls can provide absolute assurance that all control issues and instances of fraud, if any, will be detected.

PART II OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On August 24, 1998, August 31, 1998, September 14, 1998 and September 23, 1998, four separate complaints were filed against the Company and certain of its officers and directors in the United States District Court for the Southern District of California. A group of shareholders has been appointed the lead plaintiff in this federal litigation, and they filed a second amended consolidated class action complaint on January 21, 2000. This new complaint realleges that the Company improperly used the “percentage-of-completion” accounting method for revenue recognition. Claims are pleaded under both the 1933 Securities Act (relating to the Company’s initial public offering) and section 10b of the 1934 Securities Act. The complaint was brought on behalf of a purported class of investors who purchased the Company’s Common Stock between February 13, 1997 and October 28, 1998, but it does not allege specific damage amounts.

A Motion to Dismiss the second amended consolidated class action complaint was filed on February 22, 2000. On March 27, 2002, the Court granted the Motion but extended to plaintiffs the opportunity to file a Third Amended Complaint. The plaintiffs filed their third amended consolidated class action complaint on May 16, 2002, to which the Company responded with another Motion to Dismiss. The Motion was filed on June 24, 2002 and challenged the legal sufficiency of the allegations. On October 15, 2002, the Court granted that Motion, this time with prejudice.

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Plaintiffs timely noticed an appeal and filed their Appellants’ Brief with the Ninth Circuit Court of Appeals on April 9, 2003. On July, 2003, the Company filed its Respondents’ Brief and Cross-Appeal. The Cross-Appeal challenges the trial court’s failure to assess whether the complaint complied with applicable pleadings standards. The matter was argued before the court on February 12, 2004. On February 2, 2005, the court reversed the dismissal and remanded the case back to the district court. Because it reversed the dismissal, it did not decide the Company’s cross-appeal. The Company appealed the reversal by way of petition for rehearing to the Ninth Circuit Court of Appeals filed February 23, 2005. Among other issues appealed was the court’s ruling on loss causation. On March 3, 2005, the Ninth Circuit deferred consideration on the petition for rehearing until the United States Supreme Court renders its opinion in another case involving the same loss causation issue. Given this deferral, the Company’s intended appeal to the Supreme Court by way of writ of certiorari is in abeyance until the Ninth Circuit decides the petition for rehearing.

On October 7, 1998 and October 15, 1998, two separate complaints were filed in the Superior Court of San Diego County, California. These state court complaints mirror the allegations set forth in the federal complaints. They also assert claims for common law fraud and the violation of certain California statutes. As with their federal counterparts, they do not allege specific damage amounts. On April 1, 1999, a Consolidated Amended Class Action was filed on behalf of the same state court plaintiffs, and this new complaint alleges the same factual basis as is asserted in the federal litigation. The state litigation pleads claims for fraud and violations of certain California Corporation Code provisions. By stipulation of the parties and order of the court, this state court litigation was stayed pending the outcome of the motion to dismiss the federal lawsuits, as well as the resulting Appeal and Cross-Appeal.

The Company believes that the allegations set forth in the federal and state complaints are without merit, and the Company intends to defend against these lawsuits vigorously. The Company is occasionally party to other various claims and legal actions arising in the normal course of business. Although the ultimate outcome of the matters is not presently determinable, management believes that the resolution of such matters, net of amounts accrued, will not have a material adverse affect on the Company’s business, results of operations or financial condition; however, there can be no assurance that the ultimate resolution of these matters will not have a material impact on the Company’s results of operations in any period.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

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

None.

ITEM 5. OTHER INFORMATION

None.

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ITEM 6. EXHIBITS

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SIGNATURES

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

Date: May 13, 2005

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