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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-K



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|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------------



For the fiscal year ended December 31, 2004



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from
 to



Commission File No.: 0-22073



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DAOU SYSTEMS, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|Delaware                                                       |  | 33-0284454                       
|(State or other jurisdiction of incorporation or organization) |  | (IRS Employer Identification No.)



|                                                 |  |           
|------------------------------------------------ |  | ----------
|412 Creamery Way, Suite 300, Exton, Pennsylvania |  | 19341     
|(Address of principal executive offices)         |  | (Zip Code)



Registrants
telephone number, including area code: (800) 578-3268



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Securities registered pursuant to Section 12(b) of the Act: None



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



Common Stock, $0.001 par value per share

(Title of Class)



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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 if
disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrants knowledge, in definitive proxy or information statements incorporated by reference in Part
III of this Form 10-K or any amendment to this Form 10-K. ̈



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



The aggregate market value of the voting stock held by non-affiliates of the
Registrant as of June 30, 2004 was $5,729,082.



Indicate by
check mark whether the registrant has filed all documents required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a
court.    YES ̈NO ̈



As of March 15, 2005, the number of issued and outstanding shares of the Registrants Common Stock was 21,815,378.



Portions of the registrants Proxy Statement for its 2005 Annual Meeting of Stockholders are incorporated herein by reference into Part III of this
Form 10-K. If the Proxy Statement is not filed with the Securities and Exchange Commission in definitive form prior to April 30, 2005, the registrant intends to amend this report to include information omitted from Part III hereof.



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PART I



CAUTIONARY STATEMENT



This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 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. (Daou). 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 words estimate, anticipate, hope, believe,
think, expect, intend, plan or similar expressions, and are subject to numerous known and unknown risks and uncertainties. In evaluating such statements, you should carefully review various risks and
uncertainties identified in this report, including the matters set forth under the captions Risk Factors and in Daous other SEC filings. These risks and uncertainties could cause Daous 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.



Item 1:Business.



General



Daou Systems, Inc. (Daou or the Company) 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 information technology (IT) offerings include data and voice networking, applications consulting and implementation, as well as operational and Internet solutions. The Company has provided
services to more than 1,600 health care organizations, including many of the nations top 100 integrated delivery systems and middle market payer organizations.



Daous operating principles are to meet or exceed our customers objectives and to pursue excellence in the
specific healthcare practices in which our professional staff works. We believe that our key competitive advantage is the extensive knowledge and experience of our people and their core understanding of our clients complex healthcare
environment. Daou is a trusted advisor to leading organizations in each of the markets we serve. We remarket certain third-party applications and solutions, such as portals, through business partners. We sell no proprietary hardware,
although our wireless and traditional network solutions may include the resale of certain third-party products, and we do not develop proprietary software applications.



Daou Systems, Inc. was originally incorporated in California on July 16, 1987 and was reincorporated in Delaware on November
15, 1996. Our principal executive offices are located at 412 Creamery Way, Suite 300, Exton, Pennsylvania 19341. You may contact us by telephone (800.578.3268), by facsimile (610.594.7683) or by e-mail (info@daou.com).



We maintain a website where information concerning our business can be found.
The address of our Internet website is http://www.daou.com. We provide a link on our website, under Investor Relations, to our filings with the SEC, including our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form
8-K, and all amendments to those reports. These documents are generally available on the same day they are electronically filed with or furnished to the Securities and Exchange Commission. The information available on or through our website is not a
part of this or any report we file with or furnish to the SEC.



In addition, Daous Board of Directors has adopted a Code of Business Conduct and Ethics for all Company directors, officers and employees. The Code of Business Conduct and Ethics is posted on Daous website. This document is also
available in print form to any stockholder who requests it. Requests should be sent to Investor Relations at Daou Systems, Inc., 412 Creamery Way, Suite 300, Exton, Pennsylvania 19341.



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Business



Daou provides professional services exclusively for healthcare organizations. Our employees and subcontractors possess diverse technical skills and are
highly experienced in the healthcare IT industry. 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. Our services include application implementation and support, management and technology related business consulting, wireless and wired infrastructure and network services, application
development and integration, and web-based portal solutions. We believe that our services offer our customers a combination of healthcare-familiar and practice-driven technology experts that determine how each individual project works within the
customers IT strategic plan. In addition, our healthcare engineers and technicians are experienced with many types of technology, such as integration, software application development, networking, interfacing, database management, data
security and help desk consulting. We work with clients to provide real-world solutions that work with their clinical and business processes.



Payers of healthcare services



Daous payer services business is focused on providing: application implementation and support, consulting in the areas of business process
assessments and re-engineering, management consulting, and design, development and implementation of web-based solutions addressing self-service requirements. Our implementation services address the primary challenges payers face as they plan for
and execute the transition from their legacy system to a new application. Our experience, methodology and approach provide the industry knowledge and execution to support payers as they navigate change across their enterprise.



Our vendor-certified application implementation and support teams have helped
many of the nations largest payer organizations successfully implement and support applications from the major application vendors. The drivers for health plan automation, self service and business process efficiencies, and new healthcare
financing options are leading the demand for implementation and change management support, business process support, IT strategic planning and management consulting  all core competencies of ours and services that we provide.



We have developed a rigorous, cost-effective methodology that drives on-time,
on-budget implementations. Our application implementation and support services include:



| |  |  | Transition Services. Migrating from one system to another is far more complex than simply turning one computer on and one off on a specified date. The process of change, or
transition, to a new methodology begins with the elemental recognition that a new system or process is needed. How well an organization navigates through the change of an implementation will determine the success of the project. For nearly two
decades, we have provided help to our customers as they transition their organizations through the myriad of changes that a system migration engenders. And, because transition involves nuances of organizational development and communication with
stakeholders at all levels, the nuances must be managed prudently.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Application Technical Support. The overlapping departmental and organizational responsibilities in healthcare require innovative technical solutions to manage and communicate
data effectively. Our technical application support specialists plan and implement solutions related to system and data conversions, custom interface development, integration engine support, data extracts, e-commerce services, report writing and
automated document production and distribution.
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| |  |  | Application and Operational Systems Support. Work doesnt stop at the end of the implementation. Changing operational environments, new business needs, additional
regulatory requirements and even changes in personnel create perpetual challenges. Our operational and application support specialists help our customers leverage their initial investment to create ongoing returns. We focus our efforts in areas
where technology and operations often meet, including system and personnel transition management, system evaluation and improvement, operational evaluation and improvement, application modification and support, interim business office management and
data consolidation and preparation.
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| |  |  | Application Procurement. We provide expert assistance in system selection, and we guide clients through the five critical stages of a successful procurement effort: 1)
Planning; 2) Requirements Definition; 3) Vendor Evaluation; 4) Contract Negotiations; and 5) Pre-Implementation Planning.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Application Implementation Services. A system implementation consists of more than just converting files, installing programs and plugging in equipment. Knowledge of the
process, including timelines, approach, resource selection and key project strategies, is critical to project success. Our implementation teams include project managers, configuration strategists, configuration analysts and other specialized support
personnel, all with broad implementation experience and deep knowledge of the methodology necessary to make the process go smoothly.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Knowledge Management/Reporting Services. From key management performance indicators to the detail data on a specific contract or business arrangement, it is critical to
optimize an organizations data to meet its strategic business needs. Timely, accurate, accessible data is indeed a universal business requirement, and yet many organizations are challenged to make this a reality. Daou has assisted many clients
in the last two decades through development of strategy, system selection, implementation and deployment, and report development.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Project Management. Implementation project management is the initiation, continued driving and persistent follow-up of all activities and tasks throughout the continuum of
the project lifecycle: Planning/Orient/Design, Load/Development, Test/Train, Go-live and Post-implementation. Three key areas of focus are: planning, people management and subject knowledge. We understand healthcare needs in all these areas, and
work closely with clients to deliver projects that consistently meet managements goals.
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Application implementation and support services are typically provided on a time and expense basis. The engagement period for these services typically
averages six months, but varies depending on the size and complexity of the project. Implementation projects have lasted as much as one to two years.



Our management consulting know-how helps organizations meet the many challenges surrounding increasing competition, growing member and patient service
demands, expanding regulatory requirements and the confusing horizon of emerging technologies. We provide solutions through key consulting services that include: strategic IT planning, system procurement, security and privacy consulting including
readiness assessment, planning and remediation related to the Health Insurance Portability and Accountability Act of 1996 (HIPAA) and transition management.



In the area of general consulting, our most senior consultants provide counsel on business process improvement, business
strategy and critical management problem solving, planning, and procurement of medical management care systems and management information systems. The engagement period for management consulting services typically averages three to six months, but
varies depending on the size and complexity of the project.



Business process improvement examines the activities of a particular process and determines, through analysis, a more efficient and effective manner to complete the process. It must fundamentally change workflows, roles and
responsibilities, measurements and incentives, career opportunities, organizational structure, information technology and shared values and skills. A structured business process redesign assists our customers to enhance revenue and growth
opportunities, position strategically in their marketplace, reduce administrative costs and increase efficiencies, and improve customer service.



Payer organizations continue to waiver between two core applications strategies: a strategy that leads to replacement or one that leads to life extension.
Key drivers in todays environment are for the payer to achieve the combination of personalized self-service for the consumer with administrative cost efficiencies through higher automation and integration of business processes, data and
functionality. Our self-service solutions for members and producers address the primary challenges payers are contending with today regardless of the core application strategy they have chosen.



Providers of healthcare services



Our provider services group is focused on two vital components of a
healthcare organizations infrastructure: the information technology itself and the experts who manage it. We assist the healthcare marketplace in the assessment, design, implementation, integration and support of legacy and emerging network
services and systems. We provide solutions in key areas, including wireless technology, local area networks



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including servers and active directories, security, and application services. We have developed a Mobile Health
Solutions initiative as our primary focus centered on creating a mobile workforce for our healthcare customers. Our Mobile Health Solutions approach includes: offering technology strategic planning; voice, alert, notification, and
communication technologies; business process alignment and workflow assessment and design; end-user device selection, design and management; and application presentation including the customization and development of web-based portals.



The advantage our Mobile Health Solution offers is based on our taking an
enterprise wide approach and is combined with our experience and knowledge of our clients complex healthcare environment. Our approach to the combined technical, clinical and business requirements across the enterprise supports advancements in
technology and patient safety, advancements that are not limited to a particular department, but rather advancements that can be made throughout the enterprise. By developing a mobile infrastructure, organizations can ensure that the needs of
end-users will be met and that multiple constituent needs and their specific requirements will not be in conflict with one another, thus saving organizations the additional costs of retrofitting or redoing their infrastructure each time a wireless
point solution is implemented. By integrating business process and workflow with technology, the Mobile Health Solution fosters end-user buy-in and, consequently, device adoption ensuring that the value of the investment is fully realized.



In addition, we evaluate hardware and software requirements
within our customer sites, interpret and research development results, update existing network designs and research specific products and technologies of interest to customers. We provide additional technical personnel to customers during periods of
peak network requirements to accommodate and assist in network upgrade implementation or to support the anticipated or unanticipated need for additional technical staff.



The engagement period for mobile and wireless infrastructure design and implementation services generally range from three
to nine months, although our approach to the market is to extend project scope when requirements involve enterprise wide strategies that encompass a continuum of services from planning to implementation to long-term management services.



Services are generally performed on a time and expense basis and billed
semi-monthly or monthly. Certain projects, generally those with significant hardware components, are performed on a fixed-fee basis, with revenue recognized as services are performed.



Government Healthcare



Our government and integration services business has extensive experience developing, implementing and/or supporting data
extractions, commercial off-the-shelf (COTS) product integration, and module support for government healthcare organizations including the Military Health System, the Indian Health Services, the Veterans Health Administration and the Department of
Health and Human Services. Our systems integration solutions enable government healthcare organizations to cost-effectively access information and communicate across the enterprise in spite of the fact that systems run on disparate platforms in
different environments.



In addition to offering those services
provided by our commercial healthcare practice, our government healthcare services include:



| |  |  | Custom Programming. We provide instrument interfaces, specialized reporting requirements, web-enabled, back-end systems allowing real-time results and support for legacy and
sunsetted systems.
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| |  |  | System Integration Engines. We are experience in optimizing leading system integration engines and opening up M/MUMPS-based systems to current or emerging technologies
through our proprietary integration engine.
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| |  |  | Conversions and Upgrades. Fulfilling reporting requirements through data extraction, cleansing and scrubbing data warehouses and relational databases.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------



By developing and implementing existing
interfaces, Web-enabling a system, or migrating data to more compatible systems, our government healthcare practice provides federal healthcare systems with low-cost methods of sharing data between legacy systems, on-line transaction processing
systems, and off-the-shelf applications, regardless of technology platform or location. In addition, our capabilities include



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building and supporting the M/MUMPS-based systems typically used by government-run healthcare organizations. The
groups consultants are experienced in healthcare information systems such as CHCS, VistA and RPMS.



The engagement period for these services generally ranges from nine to twelve months, but varies depending on the size and complexity of the project.
Services are typically invoiced semi-monthly or monthly on a time and expense basis.



Recruiting and Training of Professional Services Employees



We dedicate significant time and resources to recruit, train and retain qualified technical personnel. Our technical personnel include consultants, engineers and technicians providing healthcare IT consulting, managed
care systems implementation, application implementation and support, application development and integration, communications infrastructure, outsourcing, Internet and emerging technology services. We use both internal and external recruiters to
attract technical personnel.



We believe that our future
success will depend in large part on our ability to hire, train and retain qualified technical, clinical and business personnel who together have expertise in a wide array of sophisticated IT solutions and a broad understanding of the payer,
provider and government healthcare organizations that we serve. Competition for qualified personnel is intense and salaries, commissions, and bonuses are increasing across all healthcare markets we serve. Consequently, there can be no assurance that
we will be successful in attracting and retaining such personnel. If we are unable to hire, train and retain a sufficient number of qualified technical personnel, our ability to adequately manage and complete our existing projects or to obtain new
projects could be impaired. This could have a material adverse effect on our business, financial condition and results of operations. See Risk FactorsLoss of Key Personnel Could Adversely Affect Our Business; Our executive
management team is in transition; We do not have employment agreements with most of our key business managers.



Each employee is required to enter into a confidentiality and proprietary information agreement with the Company. This agreement is designed to protect
our trade secrets and other confidential information during and for a period subsequent to employment. Any significant loss of employees to a competitor, or our inability to enforce a confidentiality and proprietary information agreement could have
a material adverse effect on our business, financial condition and results of operations.



Sales and Marketing



We
seek to establish long-term relationships with our customers by providing a high level of service and by becoming a trusted advisor to information technology executives and their operational staffs. We focus our sales and marketing efforts on the
CIOs and other technology decision-makers of hospitals, IDNs, government healthcare organizations and their prime contractors, managed care and insurance companies and other healthcare provider organizations. To develop new business opportunities,
we rely on our reputation in the marketplace, the personal contacts and networking of our professionals, our promotional events including Daou CIO Forums and national, industry conferences such as Managed Care Executive Group, Medical Group
Management Association (MGMA), American Health Insurance Plans (AHIP), Health Information and Management Systems Society (HIMSS), our relationships with business partners and the various programs of our marketing department. We also receive sales
leads directly from consultants, value-added resellers, and product and service vendors.



The principal objectives of our marketing department are to increase Daous market presence, provide strategic direction and generate sales leads. We receive valuable feedback from our customers, Advisory Boards,
CIO Forums, and outside advisors. Based on this feedback, our marketing program positions Daou as a thought leader in healthcare information technology with mobile health, application, infrastructure, and integration expertise and the know-how to
make information technology work for healthcare organizations.



In May of 2004, the company launched the Know-How Exchange Program, a series of webinars and seminars focused on mobile health. The Program is targeted at IT directors and hospitals, IDNs and other healthcare provider organizations.
Approximately 115 IT professionals from 59 healthcare organizations participated in the Know-How Exchange Program in 2004, and Program events are scheduled throughout 2005.



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We have entered into marketing agreements with certain third party vendors to market our services to
their respective customer bases, and we intend to pursue additional marketing agreements and strategic alliances as part of our marketing plan and business development efforts.



Daou CIO Forums, Advisory Boards, and Public Relations



As a supplement to our direct selling efforts, the marketing department has developed tradeshow participation, public
relations programs, marketing research and communications and sales presentation materials to establish thought leadership in strategic areas such as business process alignment, mobile health and web services. We also continue to develop our
presence on the Internet through our corporate website and online advertising.



The Company continued to invest in the CIO Forum program (launched in 2002), holding Forums in major cities across the country which brought together key CIOs in one-day educational sessions addressing key issues,
trends, challenges and opportunities within the industry. The Forums consistently receive high quality ratings from participants, and generate new sales opportunities. CIO Forum participants are reimbursed for lodging and meal expenses incurred in
connection with attendance at a CIO Forum.



Daou maintains two
distinct Advisory Boards which are non-governing bodies comprised of CIOs from leading healthcare provider organizations (Daou Provider Advisory Board), and CIOs from organizations within the payer segment (Daou Payer Advisory Board). The Advisory
Boards meet semi-annually to provide advice on issues and trends in the healthcare industry and emerging technologies, as well as to provide strategic direction and feedback regarding our current and future services. Members of an Advisory Board are
reimbursed for travel, lodging and meal expenses incurred in connection with attendance at Advisory Board sessions.



Intellectual Property and Proprietary Information



Our ability to compete effectively depends in part on our intellectual property and proprietary information, including our proprietary methodologies, best
practices, research, tools, information systems, databases and other information and procedures. We rely on a combination of copyright laws, non-disclosure agreements and other confidentiality procedures to protect Daous intellectual property
and proprietary information. However, these protections may not be sufficient, and they do not prevent independent third-party development of competitive products or services. See Risk FactorsAny failure or inability to protect our
technology and confidential information could adversely affect our business.



Competition



The healthcare IT services
industry is comprised of a large number of participants and is subject to rapid change and intense competition. Further challenges, complexities and, occasionally, opportunities arise from the fact that healthcare IT vendors with specialty services
may find themselves collaborating on one customer mission and competing on another. We believe that the principal competitive factors in the markets in which Daou competes include reputation, price, healthcare industry expertise, timely delivery of
services, quality of service, responsiveness to customers, product knowledge and technological expertise, marketing and customer relationships.



Many of our competitors have significantly greater financial, technical and marketing resources and brand recognition than we do. Our competitors include:



| |  |  | consulting firms such as First Consulting Group, Inc., Capgemini, and Superior Consultant Company (now ACS Healthcare Solutions);
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| |  |  | the consulting divisions or former affiliates of the major accounting firms such as Deloitte Consulting and Accenture;
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| |  |  | healthcare information technology companies such as The TriZetto Group, QCSI, and Cerner Corporation;
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| |  |  | systems integrators such as Science Applications International Corporation, SeeBeyond, Northrop Grumman, Unisys, and Electronic Data Systems Corporation;
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| |  |  | health care portal companies and network equipment vendors such as Park City Solutions, Cisco, and Johnson Controls.
| | - |  | --------------------------------------------------------------------------------------------------------------------



In addition to these major companies, we also compete with smaller regional
IT systems firms, which have a niche in selected geographic areas of the country.



We have faced, and expect to continue to face, additional competition from new entrants into our markets. Barriers to entry are low for professional services firms in our industry, and competition from internal IT
resources is pervasive. We expect there will be new entrants in our markets that will threaten our ability to maintain on-going customer loyalties. We also anticipate that continued consolidations in the payer and provider markets will result in
greater competition from their internal resources as our customers evaluate the costs associated with maintaining certain fixed costs in their IT departments while attempting to reduce costs of third party consultants. Other healthcare information
technology companies not presently offering or emphasizing application and network systems services, and large network services companies not currently focusing on healthcare may enter the markets in which we compete. Increased competition could
result in price reductions, fewer customer projects, under-utilization of employees, reduced operating margins and loss of market share, any of which could materially and adversely affect our business, financial condition and results of operations.



There can be no assurance that we will be able to compete
successfully against current and future competitors. In addition, most of our customers have internal IT support and service capabilities and could choose to satisfy their needs through internal resources rather than through outside service
providers. As a result, any decision by our customers or potential customers to perform IT services internally or choose one of our competitors could have a material adverse effect on our business, financial condition and results of operations. See
Risk FactorsWe operate in highly competitive markets.



Employees



As of December 31, 2004, we
employed 133 technical, clinical and support professionals involved in application implementation and support, infrastructure and network services, application development and integration, management consulting, sales and marketing, business
development, information technology, finance and accounting, human resources, company leadership and administration. We also have an internal referral bonus program throughout the organization to encourage employees to refer or recommend qualified
professionals to join us. Referring employees are rewarded with a bonus for each referred candidate hired by us. Our employees are not represented by a labor union.



Risk Factors



An investment in Daous Common Stock involves a high degree of risk. You should carefully consider the following risk factors and warnings. The risks
described below are not the only ones facing us. Additional risks that we do not yet know of or that we currently think are immaterial may also impair our business operations. If any of the following risks actually occurs, our business, financial
condition or results of operations could be materially and adversely affected. In such case, the trading price of our common stock could decline, and you could lose all or part of your investment. You should also refer to the other information set
forth in this report, including our Financial Statements and the related notes.



Many factors may cause our revenues, operating income and cash flow results to fluctuate and possibly decline.



We have experienced significant quarterly fluctuations in our operating results and recent declines in revenue and profits due to shifts in demand for our
services, employing fewer billable personnel, the commencement and completion of large fixed-fee contracts, and the closure and wind down of operating units and difficulties related to the transition of our companys leadership. Fluctuations in
our revenues and operating results are expected to continue from time to time, due to various factors, including:



| |  |  | the ability of our people to effectively sell our services to existing and new customers;
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| |  |  | industry spending patterns and market conditions that may affect adversely the buying decisions of our current and prospective customers;
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| |  |  | consolidation of healthcare payer and provider organizations could decrease the number of our existing and potential customers;
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| |  |  | fluctuations in billing and utilization rates of our professional staff;
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| |  |  | the long sales cycle in obtaining new customers and larger contracts;
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| |  |  | the timing and extent of employee training or the loss of key employees or executive officers;
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| |  |  | increased competition and pricing pressure;
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| |  |  | government regulations;
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| |  |  | the reduction in size, delay in commencement, interruption or termination of one or more significant projects;
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| |  |  | the loss or termination of business relationships with software/hardware vendors, hospital groups, health plans or government agencies;
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| |  |  | the failure to estimate accurately the resources required to complete new or ongoing projects, including increased labor costs due to delays in project delivery schedules;
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| |  |  | the commencement or completion during a quarter of one or more significant projects;
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| |  |  | variations in the product or professional service content of our projects;
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| |  |  | the development and introduction of new services;
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| |  |  | the use and reductions in our available cash and other capital resources;
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| |  |  | the continued effect of our high costs associated with certain dividend rights of our preferred shareholders; and
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| |  |  | the effect of negative publicity relating to our litigation and operations.
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Accordingly, we believe that quarter-to-quarter comparisons of operating results for preceding quarters are not necessarily meaningful. You should not
rely on results of any single quarter as an indication of our future performance.



We have a history of losses and our future profitability is uncertain.



We have a history of operating losses and our accumulated deficit at December 31, 2004 is approximately $42 million. Our ability to become profitable is dependent on a number of factors, including our ability to
secure new and maintain existing customers, the development and introduction of new services, industry spending patterns and market conditions and our ability to manage project risks. The markets in which we compete are fragmented and highly
competitive, and we may not be successful in increasing our market presence, growing our business or achieving profitability. As a result, we are unable to predict accurately whether there will be, and the extent of, any future losses.



We depend on a small number of large customers to provide a significant portion of
our revenue.



We receive a significant portion of our
revenue from a relatively small number of large customers, some of whom operate under a single contract. From year to year our largest customers may not be the same organizations. A majority of our customers are able to reduce or cancel their use of
our services before the end of the contract term, subject to certain monetary penalties. If these customers terminate or modify existing



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contracts or experience business difficulties, it could materially and adversely affect our revenue and earnings. Delays
in reassigning staff and the resulting under-utilization of these employees would negatively impact our operating results and financial condition. As a percentage of total net revenue, our five largest customers accounted for approximately 32% for
the year ended December 31, 2004, 41% for the year ended December 31, 2003, and 32% for the year ended December 31, 2002.



The consolidation and changing economic environment of the healthcare industry may negatively impact revenue.



We receive substantially all of our revenue from customers in the healthcare
industry. Consequently, our business is vulnerable to changing conditions affecting this industry. Many healthcare provider and payer organizations are combining through affiliation and consolidation to create larger organizations with greater
regional market power and are forming affiliations for purchasing products and services. This consolidation could reduce our target market and result in the termination of customer contracts. In particular, some of our customers have scaled back or
terminated their relationship with us following their acquisition, and this trend may continue in the future. Moreover, consolidated enterprises or affiliated enterprises may try to use their greater bargaining power to negotiate reductions in the
amounts paid to us for services we perform. Any reduction in the size of our target market or failure to maintain adequate price levels could materially and adversely affect our revenue and financial condition.



A substantial majority of our operating expenses are fixed.



Though our revenue fluctuates from quarter to quarter, the substantial
majority of our operating expenses, particularly personnel and related costs, depreciation and rent, are relatively fixed.



Accordingly, a variation in the timing of the commencement or completion of customer projects or contracts may cause significant variations in operating
results from quarter to quarter and could result in losses for a particular quarter. In addition, an unanticipated delay or termination of a major project or contract, or a series of smaller projects or contracts, could require that we maintain or
terminate under-utilized employees, which could result in higher than expected expenses during a quarter.



We operate in highly competitive markets.



We operate in intensely competitive markets. We cannot assure you that we will be able to compete successfully against current and future competitors or that competitive pressures faced by us will not have a material
adverse effect on our business, financial condition and operating results.



Our long sales and project delivery cycles may adversely affect financial performance.



Our sales process is often subject to delays associated with the lengthy approval process that typically accompanies significant capital expenditures by a
customer. During this process, we expend substantial time, effort and resources marketing our services, preparing contract proposals and negotiating contracts. Any failure to procure a signed contract after expending significant time, effort and
resources could have a material adverse effect on our business, financial condition and results of operations.



The implementation cycles for our network implementation, software application implementation, and Web portal projects generally require a significant
commitment of resources by Daou and by the customer. The length of time required to complete a project may depend on many factors outside of our control. In some instances, projects have been prolonged substantially as a result of delays
attributable to customers. Any delay or failure to receive payment for our services after expending significant time, effort and resources could have a material adverse effect on our business, financial condition and results of operations. In
addition, if we fail to deliver services on a timely and cost-efficient basis, our business, financial condition and results of operations could be materially and adversely affected.



New technologies or industry standards could render our services obsolete or unmarketable.



We receive a significant portion of our revenue from projects based on
complex healthcare applications and computer networks. The markets for software applications and computer network products and services are continuing to develop and are characterized by rapid change, including emerging technologies. If we fail to
meet the changing demands of technology, we may not continue to be able to compete successfully with other providers of software applications and technology solutions.



Page 10 of 53



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Our success depends on our ability to offer services, products, and skilled and competent professionals
to keep pace with continuing changes in technology, evolving industry standards and the changing preferences of our healthcare customers. We cannot make assurances that products, systems, methodologies, or technologies developed by third parties
will not render one or more of our services noncompetitive or obsolete.



We could lose customers and revenue if we fail to manage project risks or performance standards.



Many of our service agreements contain performance standards or deliverables. Some of our contracts with customers permit termination in the event our
performance is not consistent with service levels specified in those contracts. Our failure to perform services that meet customers expectations may result in not getting paid for services rendered. Further, if customers are not satisfied with
our level of performance, our reputation could be damaged and our ability to attract new business may be materially and adversely affected.



Our insurance coverage may not be sufficient to cover potential claims.



Although we maintain errors and omissions insurance, there can be no assurance that such insurance coverage would adequately
cover any claims asserted against us. Consequently, these potential claims could have a material adverse effect on our business, financial condition and results of operations. For example, any failure by our computer network systems to provide
accurate, reliable and timely information could result in claims against us. We are also subject to claims by customers for actions of our employees which may have caused damages to customers businesses or otherwise.



Customers may defer, modify or cancel a project on short notice.



Many of our consulting contracts are cancelable by the customer upon 30 days
written notice. When a customer defers, modifies or cancels a project, we must rapidly deploy our technical and other personnel to other projects to minimize the under-utilization of employees and the resulting adverse impact on our operating
results. Furthermore, our operating expenses are relatively fixed and cannot be reduced on short notice to compensate for unanticipated variations in the number or size of projects in progress. As a result, any termination, significant reduction or
modification of our business relationships with any of our significant customers or with a number of smaller customers could have a material adverse effect on our business, financial condition and operating results.



Loss of key personnel could adversely affect our business.



Our business strategy depends in large part on the services of our key
management and highly skilled healthcare technology professionals. Our business also requires that our employees learn and implement the latest technical applications and innovations for our customers. Our continued ability to compete effectively in
our business depends on our ability to attract, retain and motivate these individuals. We experience turnover among our technical personnel due in part to the significant time and travel demands and increased competition for their services. Any
inability to hire, train and retain a sufficient number of qualified personnel could impair our ability to adequately manage and complete our existing projects or to obtain new customers and projects.



Transition of our executive management.



In July 2004, we named Vincent K. Roach as our Chief Executive Officer. Mr.
Roach succeeded our former Chief Executive Officer who held that position from December 2002 to July 2004. Prior to Mr. Roachs predecessor, our Chief Executive Officer held the position for approximately eighteen months. The transition of our
senior leadership may adversely affect our operating performance, given the impact of frequent executive turnover on personnel and the time required for new senior personnel to assimilate and manage our business operations effectively.



We do not have employment agreements with most of our key business
managers.



We do not have employment agreements
with most of our key personnel and some of the management team. The loss of services from one or more of our management or key personnel, or the inability to hire additional management or key personnel as needed, could have a material adverse effect
on our business, financial condition and operating results. We also may not be able to enforce non-compete agreements, thereby losing business to competitors.



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Our success depends on our key vendors and partners.



We depend on our software application and product vendor relationships. If
our software application or product vendors terminate or modify existing contracts or experience business difficulties, or if we are unable to establish new relationships with additional software application or product vendors, our business could be
harmed. We depend, and will continue to depend, on our business relationships with third-party software application and product vendors. Our success depends significantly on our ability to maintain our existing relationships with our vendors and to
build new relationships with other vendors in order to enhance our services and application offerings and remain competitive. We cannot assure you that we will be able to maintain relationships with our vendors or establish relationships with new
vendors. We cannot assure you that the software, products or services of our third-party vendors will achieve or maintain market acceptance or commercial success. Accordingly, we cannot assure you that our existing relationships will result in
sustained business partnerships, successful product or service offerings or the generation of significant revenue or profits for us.



We do not have exclusive arrangements with our software application and product vendors.



Our arrangements with third-party software application and product vendors are not exclusive. We cannot assure you that
these third-party vendors regard our relationships with them as important to their own respective businesses and operations. They may reassess their commitment to us at any time and may choose to develop or enhance their own competing distribution
channels and product support services. If we do not maintain our existing relationships or if the economic terms of our business relationships change, we may not be able to license and offer these services and products on commercially reasonable
terms, or at all. Our inability to obtain any of these licenses could delay service development or timely introduction of new services and divert our resources. Any such delays could materially and adversely affect our business, financial condition
and operating results.



Our relationships with key vendors or partners
may adversely impact our customer relationships.



As
we form an increasing number of relationships with software application and product vendors, our customers may perceive that we are not independent from those vendors. Our ability to obtain consulting and assessment engagements is due in part to our
ability to analyze and recommend solutions while remaining independent from the software and product vendors themselves. If customers believe we are not independent from software application and product vendors, our ability to obtain consulting or
assessment engagements from customers may be adversely impacted, resulting in reduced revenue and profits.



Market forces in the payer market are beyond our control.



Our services targeting healthcare payers have been trending down as a direct result of consolidations in the market and unique sales cycles inherent in
this market. Consolidation has led to fewer payers in an already small field of similar organizations. Additionally, the acquisition and installation of this software has historically been cyclical, and our business is dependant on this element of
the market. Any reduction, or continued decline, in the number of core administrative software system implementations could materially and adversely affect our revenue and financial condition.



We have restructured our business to be market focused and not service line focused.



In order to improve our focus, we have organized our
service lines by markets; including healthcare payers, providers, and government. In addition, we must improve our management, operational and financial systems and controls, including quality control and delivery and service capabilities. If we are
unable to establish growth or manage the restructuring effectively or are unsuccessful in recruiting or retaining personnel, it could have a material adverse effect on our business, financial condition and operating results.



Increasingly complex regulatory environments may increase our risk and our costs.



Increasingly complex regulatory environments affect a
number of our services. As an example, changes in healthcare information privacy laws and regulations may increase our risk of liability and increase the cost of some services we offer. In addition, HIPAA regulations governing the standardization
and security for healthcare information could impact the amount, timing and types of services requested by customers.



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The healthcare industry also is subject to changing political, economic and regulatory influences that
may affect the procurement practices and operations of participants in the healthcare industry. Reduced reimbursements may negatively impact the spending patterns and demand for our information technology services. We cannot predict with any
certainty what impact these developments could have on our business, financial condition and results of operations.



Our contracts contain pricing risks that affect our revenue and profit.



We offer a portion of our services on a fixed-price, fixed-time frame basis, rather than on a time-and-expense basis.
Consequently, we bear the risk of cost over-runs in connection with these projects. If we fail to estimate accurately the resources and time required for a project or fail to complete our contractual obligations within the committed fixed-time
frame, there could be a material adverse effect on our business, financial condition and results of operations.



Any failure or inability to protect our technology and confidential information could adversely affect our business.



Our ability to compete effectively depends in part on our intellectual
property and proprietary information, including our proprietary methodologies, best practices, research, tools, information systems, databases and other information and procedures. There can be no assurance that the steps we have taken to protect
our intellectual property will be adequate to prevent unauthorized use or misappropriation of our proprietary information. Any significant loss or unauthorized use of our intellectual property or proprietary information by a competitor could have a
material adverse effect on our business, financial condition or results of operations. We believe that our systems and procedures and other proprietary rights do not infringe upon the rights of third parties. There can be no assurance, however, that
third parties will not assert infringement claims against Daou or that such claims will not require protracted and costly litigation, regardless of the merits of such claims.



Our officers and directors have the power to influence the election of directors and the passage of stockholder proposals.



As of March 15, 2005, Daous executive officers,
directors and their affiliates beneficially owned approximately 37% of the outstanding shares of common stock and Series A convertible preferred stock (Preferred shareholders own certain restrictive, preferred and voting rights). As a result, these
stockholders can exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership also may delay or prevent a
change in control of Daou.



Our common stock price is
subject to wide fluctuations in value and significant volatility.



Based upon the historical performance of our common stock, we anticipate that the future price of our common stock may be subject to wide fluctuations because of announcements of:



| |  |  | impacts relating to our financing or capital structure;
| | - |  | -------------------------------------------------------



| |  |  | quarterly fluctuations in our operating results;
| | - |  | ------------------------------------------------



| |  |  | new customer contracts or services by Daou or our competitors, or the loss of a large customer;
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | negative publicity relating to litigation against Daou;
| | - |  | -------------------------------------------------------



| |  |  | changes in our pricing policies or those of our competitors;
| | - |  | ------------------------------------------------------------



| |  |  | strategic relationships, acquisitions or divestitures;
| | - |  | ------------------------------------------------------



| |  |  | general conditions in the market for healthcare IT services; and
| | - |  | ----------------------------------------------------------------



| |  |  | healthcare industry and general market conditions, including HIPAA developments.
| | - |  | --------------------------------------------------------------------------------



In addition, in recent years, the stock market in general and the shares of technology companies in particular have
experienced extreme price fluctuations. Fluctuations in the price of our common stock may be disproportionate or unrelated to our operating performance.



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Provisions of our certificate of incorporation, bylaws, and Delaware law could deter takeover attempts.



A number of provisions of Delaware law and our
certificate of incorporation and bylaws could delay, defer or prevent a change in control of Daou and could limit the price that some investors might be willing to pay in the future for shares of our common stock. These provisions:



| |  |  | prohibit us from engaging in any business combination with any interested stockholder for a period of three years from the date the person became an interested stockholder unless
specific conditions are met;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | permit our board of directors to issue shares of preferred stock without stockholder approval on the terms as our board may determine;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------



| |  |  | provide for a classified board of directors;
| | - |  | --------------------------------------------



| |  |  | eliminate the right of our stockholders to act by written consent without a meeting;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | require advanced stockholder notice to nominate directors and raise matters at the annual stockholders meeting;
| | - |  | ---------------------------------------------------------------------------------------------------------------



| |  |  | do not permit cumulative voting in the election of directors; and
| | - |  | -----------------------------------------------------------------



| |  |  | allow for the removal of directors only with cause, and only by a two-thirds vote of our outstanding shares.
| | - |  | ------------------------------------------------------------------------------------------------------------



Future sales of our common stock could adversely affect the price of our common stock
and our ability to raise additional equity capital.



The sale of substantial amounts of our common stock in the public market, the prospect of these sales or the sale or issuance of common stock or securities convertible into or exercisable for common stock could affect
adversely the market price of our common stock.



As of December
31, 2004, we had 13,438,087 shares of common stock reserved for future issuance, as follows: 2,750,000 shares upon conversion of the 2,181,818 outstanding shares of Series A convertible preferred stock plus accrued dividends, 3,540,000 shares upon
exercise of warrants, 6,243,939 shares upon exercise of stock options and 904,189 shares reserved for issuance under our Employee Stock Purchase Plan. See Item 7 Liquidation and Capital Resources and Note 8 of the notes to our audited
financial statements as of December 31, 2004 for more information relating to our preferred stock, common stock, warrants and stock options.



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Item 2: Description of Properties.



Daou leases the following office space for our principal administrative operating and support facilities:



|                 |  |                            |  |               |  |                                     
|---------------- |  | -------------------------- |  | ------------- |  | ------------------------------------
|Location         |  | Approximate Square Footage |  | Expiration    |  | Principal Use                       
|Chevy Chase, MD  |  | 12,000                     |  | April 2009    |  | Operating and support facilities    
|                 |  |                            | 
|Alexandria, VA   |  | 17,000                     |  | May 2005      |  | Operating and support facilities (1)
|                 |  |                            | 
|Exton, PA        |  | 13,000                     |  | March 2009    |  | Corporate Office Facility           
|                 |  |                            | 
|Indianapolis, IN |  | 6,000                      |  | June 2010     |  | Operating and support facilities    
|                 |  |                            | 
|Alexandria, VA   |  | 4,000                      |  | June 2005     |  | Operating and support facilities (1)
|                 |  |                            | 
|Indianapolis, IN |  | 4,000                      |  | December 2007 |  | Operating and support facilities    

---

|(1) | Portions of the property have been subleased, and the Company has no intentions to renew any of these leases. We continually evaluate the adequacy of our existing facilities and
believe that our current and planned facilities will be adequate for the next twelve months.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Item 3:Legal Proceedings.



IN RE DAOU SYSTEMS SECURITIES LITIGATION



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.



Page 15 of 53



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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 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 pending 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.



DICKSON V DAOU SYSTEMS, INC. ET AL



On February 27, 2002, a Complaint was filed against certain of the
Companys former officers and directors as well as DAOU On-Line, Inc. in the Superior Court of New Jersey located in Bergen County. A First Amended Complaint was filed on March 1, 2002, adding the Company and its former Chief Financial Officer
as parties-defendant. The Company filed a Motion to Dismiss the First Amended Complaint on April 24, 2002. The Court conducted a hearing on June 7, 2002 and granted the motion. On July 23, 2002, plaintiffs filed a Notice of Appeal, but later
abandoned their appeal in favor of refiling their lawsuit in San Diego County Superior Court. The parties stipulated to a stay of this lawsuit and submission of the matter to arbitration before the American Arbitration Association. The court
approved that stipulation and stayed all proceedings by order dated July 22, 2003. On October 6, 2003, plaintiffs filed a Statement of Claim with the American Arbitration Association, the gravaman of which is the same as the former complaint filed
in Bergen County, New Jersey and San Diego County Superior Court. The Statement of Claim alleges compensatory damages in the amount of $1,094,600 and also prays for punitive damages as well as attorneys fees and costs. On December 3, 2003, the
Company filed an answer to the Statement of Claim, generally denying the allegations and alleging certain affirmative defenses. All parties agreed to the appointment of Peter Shenas as the arbitrator. A preliminary hearing was conducted on February
3, 2004, during which the parties agreed to the scope of written and oral discovery and how the arbitration would proceed.



The Company and certain of the Companys former officers and directors entered into a Settlement Agreement And Mutual General Release Of All Claims with Steven C.
Dickson and Mary B. Dickson on October 29, 2004. The Parties voluntarily elected to settle the litigation entitled Steven C. Dickson v. Daou Systems, Inc., et al.; the arbitration entitled Steven C. Dickson v. Daou Systems, Inc, et al.; and a
certain judgment lien in favor of Daou Systems, Inc. against Steven C. Dickson and any and all other claims or disputes arising out of any other contract, agreement or business dealings of any kind between the Parties. The settlement did not have a
material impact to the 2004 financial results.



Item 4:Submission
of Matters to a Vote of Security Holders.



No
matters were submitted to a vote of stockholders during the fourth quarter of 2004.



Page 16 of 53



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PART II



Item 5:Market for Registrants Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities.



Daous shares of common stock have traded on the
Over the Counter Bulletin Board (OTCBB) since April 25, 2001 under the symbol DAOU. The following table sets forth the high and low closing bid information for the common stock. Bid quotations reflect inter-dealer prices without retail mark-up or
mark-down and may not necessarily represent actual transactions.



|            |  |              |       |     |   |      
|----------- |  | ------------ | ----- | --- | - | -----
|            |  | Common Stock
|            |  | HIGH         |       | LOW
|2003        |  |              |       |     |   |      
|1st Quarter |  | $            | 0.425 |     | $ | 0.280
|2nd Quarter |  |              | 0.810 |     |   | 0.330
|3rd Quarter |  |              | 0.930 |     |   | 0.720
|4th Quarter |  |              | 1.110 |     |   | 0.670
|2004        |  |              |       |     |   |      
|1st Quarter |  | $            | 1.010 |     | $ | 0.450
|2nd Quarter |  |              | 0.530 |     |   | 0.270
|3rd Quarter |  |              | 0.390 |     |   | 0.220
|4th Quarter |  |              | 0.270 |     |   | 0.110



On March 15, 2005, the
closing bid and ask prices of the common stock were $0.15 and $0.14, respectively. As of March 15, 2005, there were 21,815,378 holders of record of common stock.



Dividend Policy



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, to 8% on July 26, 2002, to 9% on July 26, 2003, to 10% on July 26, 2004, and will continue to increase an additional 1% on July 26 of each year up to a maximum of 12%. As of December 31, 2004, Daou has accrued but undeclared
preferred stock dividends of approximately $5.8 million. No cash 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. See Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations under the heading Liquidity and Capital Resources and Note 8 of the notes to our audited
financial statements as of December 31, 2004 for more information relating to our preferred stock.



Daou has never declared nor paid cash dividends on the common stock. We currently intend to retain any available earnings for future growth and,
therefore, do not intend to pay any cash dividends in the foreseeable future.



Recent Sales of Unregistered Securities



None.



Issuer Purchases



None



Item 6:Selected Financial Data.



The following table presents selected financial data and has been derived from our financial statements, which have been
audited by Ernst & Young LLP, Independent Registered Public Accounting Firm. The information set forth below is not necessarily indicative of the results of future operations and should be read



Page 17 of 53



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in conjunction with the other sections of Managements Discussion and Analysis of Financial Condition and
Results of Operations in Item 7 of this report and the financial statements and the related notes thereto included elsewhere herein (in thousands, except per share data):



|                                                                     |  |                          |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|-------------------------------------------------------------------- |  | ------------------------ | ------- | - | ---- | - | ------ | ---- |  | - | ------ | - |  | ---- | ------ | - |  | - | ------ | -
|                                                                     |  | Years ended December 31, |        
|                                                                     |  | 2000                     |         |   | 2001 |   |        | 2002 |  |   | 2003   |   |  | 2004 |       
|Revenue before reimbursements (net revenue)                          |  | $                        | 63,748  |   |      | $ | 41,082 |      |  | $ | 37,935 |   |  | $    | 42,161 |   |  | $ | 27,107 |  
|Cost of revenue before reimbursable expenses                         |  |                          | 58,700  |   |      |   | 30,964 |      |  |   | 26,128 |   |  |      | 28,760 |   |  |   | 20,479 |  
|                                                                     |  |                          |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Gross profit                                                         |  |                          | 5,048   |   |      |   | 10,118 |      |  |   | 11,807 |   |  |      | 13,401 |   |  |   | 6,628  |  
|Operating expenses:                                                  |  |                          |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Sales and marketing                                                  |  |                          | 5,715   |   |      |   | 3,309  |      |  |   | 4,807  |   |  |      | 4,550  |   |  |   | 3,208  |  
|General and administrative                                           |  |                          | 12,083  |   |      |   | 8,919  |      |  |   | 8,611  |   |  |      | 6,670  |   |  |   | 6,428  |  
|Restructuring (credits) charges                                      |  |                          | 2,133   |   |      |   | 1,263  |      |  |   | 1,598  |   |  |      | (252   | ) |  |   |       |  
|                                                                     |  |                          |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Total operating expenses                                             |  |                          | 19,931  |   |      |   | 13,491 |      |  |   | 15,016 |   |  |      | 10,968 |   |  |   | 9,636  |  
|                                                                     |  |                          |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Income (loss) from operations                                        |  |                          | (14,883 | ) |      |   | (3,373 | )    |  |   | (3,209 | ) |  |      | 2,433  |   |  |   | (3,008 | )
|Other income, net                                                    |  |                          | 699     |   |      |   | 421    |      |  |   | 270    |   |  |      | 207    |   |  |   | 209    |  
|                                                                     |  |                          |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Income (loss) before income taxes                                    |  |                          | (14,184 | ) |      |   | (2,952 | )    |  |   | (2,939 | ) |  |      | 2,640  |   |  |   | (2,799 | )
|Provision for income taxes                                           |  |                          |        |   |      |   |       |      |  |   |       |   |  |      | (52    | ) |  |   | (36    | )
|                                                                     |  |                          |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Net income (loss)                                                    |  |                          | (14,184 | ) |      |   | (2,952 | )    |  |   | (2,939 | ) |  |      | 2,588  |   |  |   | (2,835 | )
|Dividends on preferred stock                                         |  |                          | (4,837  | ) |      |   | (854   | )    |  |   | (1,054 | ) |  |      | (1,290 | ) |  |   | (1,571 | )
|                                                                     |  |                          |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Net income (loss) available to common stockholders                   |  | $                        | (19,021 | ) |      | $ | (3,806 | )    |  | $ | (3,993 | ) |  | $    | 1,298  |   |  | $ | (4,406 | )
|                                                                     |  |                          |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Net income (loss) available to common stockholders per common share: |  |                          |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Basic                                                                |  | $                        | (1.07   | ) |      | $ | (0.22  | )    |  | $ | (0.21  | ) |  | $    | 0.06   |   |  | $ | (0.20  | )
|                                                                     |  |                          |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Diluted                                                              |  | $                        | (1.07   | ) |      | $ | (0.22  | )    |  | $ | (0.21  | ) |  | $    | 0.05   |   |  | $ | (0.20  | )
|                                                                     |  |                          |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Shares used in computing net income (loss) per common share:         |  |                          |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Basic                                                                |  |                          | 17,712  |   |      |   | 17,682 |      |  |   | 19,075 |   |  |      | 20,821 |   |  |   | 21,656 |  
|                                                                     |  |                          |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Diluted                                                              |  |                          | 17,712  |   |      |   | 17,682 |      |  |   | 19,075 |   |  |      | 26,513 |   |  |   | 21,656 |  
|                                                                     |  |                          |         |   |      |   |        |      |  |   |        |   |  |      |        |   |  |   |        |  
|Cash, cash equivalents, restricted cash and short-term investments   |  | $                        | 10,586  |   |      | $ | 15,074 |      |  | $ | 12,394 |   |  | $    | 13,147 |   |  | $ | 11,069 |  
|Total assets                                                         |  |                          | 26,832  |   |      |   | 24,384 |      |  |   | 24,640 |   |  |      | 25,228 |   |  |   | 18,680 |  
|Total stockholders equity                                           |  | $                        | 20,360  |   |      | $ | 17,308 |      |  | $ | 14,469 |   |  | $    | 17,045 |   |  | $ | 14,275 |  



Item 7: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. In evaluating such statements, you should carefully review various risks and uncertainties identified in this report, including the
matters set forth under the captions Risk Factors and in Daous other SEC filings. These risks and uncertainties could cause Daous 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.



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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 IT industry and material trends impacting the Companys results of operations



The overall healthcare industry is impacted by events on both a national and regional level including attention on patient
safety, staffing shortages, privacy of personal information, and a divided political landscape. With these external challenges intersecting internal issues such as consolidation and demands on cost savings, the three sectors of the health care
market we serve (payers, providers and government) are under a great deal of pressure. The healthcare IT services industry continues to experience fiscal constraints imposed by federal, state and commercial payers, resulting in a reduced overall
industry demand for new IT service consulting projects. Some of these forces and others hampered demand for certain of our services in 2004. Furthermore, changes in federal, state and commercial payer reimbursement may continue to adversely affect
the financial stability of our clients and may impact their ability to contract for and pay for professional services such as those offered by Daou.



Acute financial pressures continue to plague the healthcare markets we serve. One-third of hospitals in the U.S. are losing money, another one-third are
just breaking even, according to the American Hospital Association. The outlook for non-profit hospitals (the primary market for our provider services business) is weak based on minimal volume growth, declines in reimbursement for commercial and
government payers, increasing expense pressures and un-funded capital needs. Payers encountered similar challenges in 2004. Executive decision-making regarding IT spending was driven by the impact of consolidation and constraints on capital spending
and demands to reduce overall administrative and medical costs.



Our revenue and profit declines in 2004 were a direct result of weaknesses in each of our three markets. In the provider services area, our hospital customers were constrained by capital budgets that precluded their ability to upgrade and
enhance IT infrastructures. We consequently were not able to sell new large upgrade or data center consolidation projects. Our largest project of this type was an approximate $4.5 million effort that ended in the first quarter of 2004. Revenue
declined immediately beginning in the second quarter, and did not rebound at any point throughout the remainder of 2004. Organizational consolidations and budget reductions have resulted in weak demand for our traditional IT infrastructure services
around local area networks and security.



In our payer market,
we continued to experience lower than expected demand for financial and administrative software solutions. Our revenue from new implementations and post implementation support declined $5.2 million in 2004, as compared to 2003. This decline in
revenue was the result of 1) fewer large regional payers in the market as the result of continued industry consolidations, and 2) the completion of most major core administrative systems implementations by mid-year 2004. As a result, we are evolving
our service offerings to extend our core capabilities derived from implementation services. As payers aggressively move to improve efficiency and reduce administrative costs, we are able to offer business process improvement consulting and member
and producer self-service solutions. Because these service offerings are new, there is no guarantee that it will produce enough new opportunities in the near term to create momentum in revenue growth as we proceed into 2005.



Our government and integration services business also experienced a decline
in revenue and profit margin overall in 2004 as compared to 2003. We believe the delays in congressional approval of the FY 2004 Consolidated Appropriations Bill (Omnibus) to January 2004 had a negative impact on our business in the first quarter of
2004. However, since the first quarter of 2004, our revenue from government and integration



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services has shown improvement in each of the subsequent quarters of the year. A positive shift in our government
business will be partly dependent upon the convergence of several market forces. There is strong political interest in cross-organization initiatives. For example, the Department of Defense Military Health Service and the Veterans Health
Administration have begun to collaborate on programs designed to share patient health data across the two entities. There is also interest in industry wide adoption of an electronic medical record driven by the Department of Health and Human
Services. While there is increasing governmental oversight of IT purchases, we are experiencing a growing interest by the Federal government in contracting with smaller organizations.



Elimination of the DTC



We discontinued providing support center management services to hospitals and IDNs, with the completion of the final contract in the first quarter of
2004. This decision included the closing of our Indianapolis-based Daou Technology Center (DTC), which provided Help Desk and Desktop support services on an outsourcing basis to two regional hospital providers: Indianapolis Community Health
Network (CHN) and St. Vincent Health.



The CHN contract ended
on December 31, 2003 and the St. Vincent contract ended on February 25, 2004. The two contracts represented approximately $4.5 million or 11 percent of Daous total net revenues for the year ended December 31, 2003, compared to $941,000 or 3%
for the year ended 2004.



Key indicators of our financial condition and
operating performance



Our financial performance is driven
principally by effective management of three key aspects of our business: utilization of billable personnel, sales to new and existing customers, and control of our overhead expenses.



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 one of our greatest challenges. We employed approximately 100 billable professionals on December 31, 2004. 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. While quarterly revenues declined during the year, we worked to balance maintaining
enough experienced professionals ready to be deployed when the business opportunities were presented, while striving to protect our gross margin. We target an overall utilization rate of 80% for our business. In 2004, we experienced an average
utilization rate of 63%, down from 83% in 2003.



Selling,
general and administrative (SG&A) overhead expenses in 2004 were 36% of net revenue, compared to 27% in 2003. We continue to reduce our general and administrative expenses by managing those costs that are mostly controllable such as facilities,
staffing, IT and operating systems. However, in 2004 we did not reduce these costs on pace with the declines in our 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 also provided support, management and help desk services in the first quarter of 2004, in which revenue was recognized ratably over the
period that these services were provided. Our help desk services as described above were billed on a price per call or price per node basis.



We continue to provide some of our professional services on a fixed-fee basis. Revenue on 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. 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.



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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) Issue 01-14, Income Statement Characterization of Reimbursements Received for Out-of-Pocket Expenses
Incurred, issued in November 2001. EITF Issue 01-14 states that reimbursements received for out-of-pocket expenses should be characterized as revenue on the income statement. 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 year ended December 31, 2004 to the year ended December 31, 2003 and the year ended
December 31, 2003 to the year ended December 31, 2002.



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. 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. 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 years indicated, certain statement of operations data as a percentage of net revenue.



|                                             |  |                          |    |  |      |   |  |      |   
|-------------------------------------------- |  | ------------------------ | -- |  | ---- | - |  | ---- | --
|                                             |  | Years Ended December 31, |   
|                                             |  | 2004                     |    |  | 2003 |   |  | 2002 |   
|Revenue before reimbursements (net revenue)  |  | 100                      | %  |  | 100  | % |  | 100  | % 
|Cost of revenue before reimbursable expenses |  | 76                       |    |  | 68   |   |  | 69   |   
|                                             |  |                          |    |  |      |   |  |      |   
|Gross profit                                 |  | 24                       |    |  | 32   |   |  | 31   |   
|Sales and marketing expense                  |  | 12                       |    |  | 11   |   |  | 13   |   
|General and administrative expense           |  | 23                       |    |  | 16   |   |  | 23   |   
|Restructuring charges (credit)               |  |                         |    |  | (1   | ) |  | 4    |   
|                                             |  |                          |    |  |      |   |  |      |   
|Income (loss) from operations                |  | (11                      | )  |  | 6    |   |  | (9   | ) 
|Other income, net                            |  | 1                        |    |  |     |   |  | 1    |   
|                                             |  |                          |    |  |      |   |  |      |   
|Income (loss) before income taxes            |  | (10                      | )  |  | 6    |   |  | (8   | ) 
|Provision for income taxes                   |  |                         |    |  |     |   |  |     |   
|                                             |  |                          |    |  |      |   |  |      |   
|Net income (loss)                            |  | (10                      | )% |  | 6    | % |  | (8   | )%
|                                             |  |                          |    |  |      |   |  |      |   



Years Ended December 31, 2004 and
2003



Our net revenue decreased 36%, or $15.1 million to
$27.1 million for the year ended December 31, 2004 from $42.1 million for the year ended December 31, 2003. In addition to our poor sales performance in 2004, the decrease was primarily due to 1) the closing of Daous IT outsourcing business
 resulting in a revenue decline of over $3.7 million in 2004 compared to 2003; 2) the completion of a large network upgrade project in the first quarter of 2004  resulting in an annualized revenue loss of over $1.2 million; 3) the
continued downward trend in revenue throughout the year as a result of competitive pricing pressure forcing hourly rates lower, and declining demand for application implementation services across the market  resulting in



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annualized revenue declines of approximately $5.2 million; and 4) the delay in certain government projects in the first
quarter of 2004  resulting in revenue declines of approximately $1.2 million.



Services to our five largest customers accounted for $8.8 million of net revenue for the year ended December 31, 2004, representing 32% of total net revenue, with no one customer accounting for more than 8% of net
revenue. This compares to net revenue from the five largest customers for the year ended December 31, 2003 totaling $17.4 million, or 41% of net revenue.



Cost of revenue before reimbursable expenses decreased 29%, or $8.3 million, to $20.5 million for the year ended December 31, 2004 from $28.8 million for
the year ended December 31, 2003. The decrease was the result of lower revenue and the associated direct costs related to billable personnel and subcontractors.



Gross margin decreased to 24% for the year ended December 31, 2004 as compared to 32% for the year ended December 31, 2003. This decrease was
attributable primarily to lower utilization and increased training and education costs of our professional staff.



Sales and marketing expenses decreased 29%, or $1.3 million, to $3.2 million for the year ended December 31, 2004 as compared to $4.6 million for the year
ended December 31, 2003, primarily due to a reduction in sales and business development staff, and the reduction of advertising and public relations programs.



General and administrative expenses decreased $242,000, or 4%, to $6.4 million for the year ended December 31, 2004 as compared to $6.7 million for the
year ended December 31, 2003, reflecting a reduction in administrative overhead.



Other income, net, remained constant at $200,000 for the year ended December 31, 2004 as compared to the year ended December 31, 2003. Other income is comprised primarily of interest income on cash and cash
equivalents, and investments.



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 million and approximately $10.9 million, respectively. The federal loss
carryforwards expire beginning 2018 through 2024, and the state loss carryforwards expire from 2004 through 2024, unless previously utilized. Additionally, the Company has federal alternative minimum tax credit carryforwards of approximately $36,000
which may be carried forward indefinitely. Pursuant to generally accepted accounting principles, we have 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 net operating loss carryforwards may be limited in the event of a cumulative change
in ownership of more that 50%. However, we currently do not believe such a limitation will have a material impact on the ultimate utilization of these carryforwards.



The income tax provision of $36,000 recorded in 2004 represents current state income taxes in those jurisdictions where we
do not have NOL carryforwards. Deferred income taxes are provided for temporary differences in recognizing certain income and expense items for financial and tax reporting purposes.



Years Ended December 31, 2003 and 2002



Our net revenue increased 11%, or $4.2 million, to $42.1 million for the year ended December 31, 2003 from $37.9 million for the year ended December 31,
2002. This increase was primarily due to a $3.5 million increase in revenue related to the hardware component of two large network upgrade projects delivered by our infrastructure services team in 2003. In addition, revenue from government
healthcare integration services



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increased $1.7 million from 2002 to 2003, as a result of enhanced relationships with government agencies and new prime
government contractors. The increase in revenue was offset by a decrease in revenue from application services, primarily due to a decrease in revenue from new implementations and post implementation support as mentioned above.



Services to our five largest customers accounted for $17.4 million of net
revenue for the year ended December 31, 2003, representing 41% of total net revenue, with no one customer accounting for more than 10% of net revenue. This compares to net revenue from the five largest customers for the year ended December 31, 2002
totaling $12.3 million, or 32% of net revenue.



Cost of revenue
before reimbursable expenses increased 10%, or $2.6 million, to $28.7 million for the year ended December 31, 2003 from $26.1 million for the year ended December 31, 2002. The increase was the result of the increase in revenue and the associated
direct costs related to the hardware component of network upgrade projects.



Gross margin increased to 32% for the year ended December 31, 2003 as compared to 31% for the year ended December 31, 2002. This increase was attributable primarily to better utilization and cost control throughout
our business, but primarily in our government and integration and infrastructure service lines.



Sales and marketing expenses decreased 5%, or $300,000, to $4.5 million for the year ended December 31, 2003 as compared to $4.8 million for the year
ended December 31, 2002, primarily due to effective budget management.



General and administrative expenses decreased $1.9 million, or 22%, to $6.7 million for the year ended December 31, 2003 as compared to $8.6 million for the year ended December 31, 2002, reflecting an improving management of administrative
overhead as well as savings in employee-related and facilities costs as a result of previously disclosed actions taken in December 2002.



In the third quarter of 2003, we were able to reduce our obligations relating to unused office space resulting in the reversal of $252,000 of previously
accrued restructuring charges. The amount has been recorded as a restructuring credit in the statement of operations as the original provision was recorded as a restructuring expense in the period in which the charge was recorded.



Other income, net, decreased 23%, or $100,000 to $200,000 for the year ended
December 31, 2003 as compared to $300,000 for the year ended December 31, 2002. Other income was comprised primarily of interest income on cash and cash equivalents, and investments.



The income tax provision of $52,000 recorded in 2003 was comprised of current federal alternative minimum taxes of $36,000
and current state income taxes of $16,000.



Liquidity and Capital Resources



On December 31, 2004, we had working capital of $13.0
million, a decrease of $2.8 million from $15.8 million on December 31, 2003. The decrease was primarily attributable to the reduction in 2004 of current assets, including cash and accounts receivable due to lower revenue in the period, and $1.3
million reduction in contract work in progress related to the hardware component of a large network upgrade project completed in the first quarter of 2004.



For the year ended December 31, 2004, net cash used in operating activities was $1.8 million, compared to net cash provided by operating activities of
$1.1 million for the year ended December 31, 2003. The change was primarily the result of a net loss of $2.8 million for 2004 compared to net income of $2.6 million for 2003 and a decrease in deferred revenue; offset by a reduction in accounts
receivable.



Net cash used in investing activities was $354,000
for the year ended December 31, 2004, compared to $371,000 in the comparable prior period. The decrease was primarily due to a reduction in spending relating to fixed assets in 2004.



Net cash received in financing activities was $39,000 for the year ended December 31, 2004, compared to cash used in
financing activities of $49,000 in the comparable prior year period.



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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 are 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, to 8% on July 26, 2002, to 9% on July 26, 2003, to 10% on July 26, 2004 and will continue to increase an additional 1% on July 26 of each year up to a maximum
of 12%. No cash 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. At the option of the holders, shares of the
Series A Preferred Stock can be converted into shares of common stock at any time, subject to certain antidilution adjustments. 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 described below.



As of December 31, 2004, Daou had accrued but undeclared preferred stock
dividends of approximately $5.8 million (payable in kind by the issuance of approximately 1.1 million shares of Series A Preferred Stock), thereby entitling the holders of the Series A Preferred Stock to a total liquidation preference of
approximately $17.8 million.



On November 9, 2000, as a
consequence of the resignation of Larry Grandia, Daous former President and Chief Executive Officer, holders of the Series A Preferred Stock had the right to cause the redemption of their Series A Preferred Stock for approximately $12.9
million. We entered into an agreement with the holders of the Series A Preferred Stock under which the holders of the Series A Preferred Stock permanently waived their redemption rights in return for $2.0 million in cash and warrants to purchase
3,540,000 shares of our common stock exercisable at $0.01 per share. The warrants expire on November 9, 2005, and the common stock for which the warrants may be exercised is subject to demand registration rights. The total consideration for this
transaction was valued at approximately $4.1 million and for financial reporting purposes was recorded as a one-time dividend in the fourth quarter of 2000.



As of December 31, 2004, Daous contractual obligations were as follows:



|                            |  |                        |           |                  |   |           |  |           |           |                  |   |         |  |   |       
|--------------------------- |  | ---------------------- | --------- | ---------------- | - | --------- |  | --------- | --------- | ---------------- | - | ------- |  | - | ------
|                            |  | Payments due by period
|Contractual Obligations     |  | Total                  |           | Less than 1 Year |   | 1-3 Years |  | 3-5 Years |           | More than5 Years
|Operating lease obligations |  | $                      | 3,422,000 |                  | $ | 947,000   |  | $         | 1,435,000 |                  | $ | 990,000 |  | $ | 50,000



We believe that our
available funds will be sufficient to meet our capital requirements for the foreseeable future. We may sell additional equity or debt securities or obtain credit facilities. The sale of additional equity securities or issuance of equity securities
in future acquisitions would 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. See Risk FactorsFuture sales of our common stock could adversely affect the price of the common stock and our ability to raise additional equity capital.



Critical Accounting Policies and Estimates



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



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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.



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:



| |  |  | persuasive evidence of an arrangement,
| | - |  | --------------------------------------



| |  |  | services have been delivered,
| | - |  | -----------------------------



| |  |  | price is fixed and determinable, and
| | - |  | ------------------------------------



| |  |  | collectibility is reasonably assured.
| | - |  | -------------------------------------



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 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 recognized is 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 customer payment history.



Litigation



We are currently involved in legal proceedings regarding shareholder litigation. As discussed in Note 11 of our financial statements, we believe that the
lawsuit is without merit and intend to defend against it vigorously. Although the ultimate outcome of this matter is not presently determinable, management believes that the resolution of the matter, net of amounts accrued, will not have a material
adverse effect in 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 this proceeding.



Recently Issued Accounting Standards



In June 2002, the FASB issued Statement of Financial
Accounting Standards (SFAS) No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 provides guidance related to accounting for costs associated with disposal activities covered by SFAS No. 144
or with exit or restructuring activities previously covered by EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring). SFAS No. 146 supercedes EITF Issue No. 94-3 in its entirety. SFAS No. 146 requires that costs related to exiting an activity or to a restructuring not be recognized until the liability is incurred. SFAS No. 146 will be applied
prospectively to exit or disposal activities that are initiated after December 31, 2002. The adoption of this method did not have a material impact on Daous results of operations or financial condition.



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Effective July 1, 2003, we adopted the FASBs consensus on EITF Issue No. 00-21, Accounting
for Revenue Arrangements with Multiple Deliverables. This issue addresses how to account for arrangements that may involve the delivery or performance of multiple products, services, and/or rights to use assets. The final consensus of this
issue is applicable to agreements entered into in fiscal periods beginning after June 15, 2003. Adoption of this issue had no material impact on Daous financial condition, results of operations, or liquidity.



In December 2003, the SEC issued SAB 104, which supercedes SAB No. 101,
Revenue Recognition in Financial Statements (SAB 101). The primary purpose of SAB 104 is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, superceded as a result of the
issuance of Emerging Issues Task Force (EITF) Issue No. 00-21. Additionally, SAB 104 rescinds the SECs Revenue Recognition in Financial Statements Frequently Asked Questions and Answers (the FAQ) issued with SAB 101
that had been codified in SEC Topic 13, Revenue Recognition. Selected portions of the FAQ have been incorporated into SAB 104. The adoption of SAB 104 did not have an impact on our financial condition or results of operations.



On December 16, 2004, the Financial Accounting Standards Board
(FASB) issued Statement 123 (revised 2004), Share Based Payment (FAS 123R). FAS123R supersedes APB 25, Accounting for Stock Issued to Employees, and is effective for public companies at the beginning of the first interim or
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.



Item 7A:Quantitative and Qualitative Disclosures about Market Risks.



We invest 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, 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 8:Financial Statements.



Index to Financial Statements and Financial Statement Schedules



|                                                                                         |  |   
|---------------------------------------------------------------------------------------- |  | --
|Financial Statements                                                                     |  |   
|Report of Ernst & Young LLP, Independent Registered Public Accounting Firm               |  | 27
|Balance Sheets at December 31, 2004 and 2003                                             |  | 28
|Statements of Operations for the years ended December 31, 2004, 2003, and 2002           |  | 29
|Statements of Stockholders Equity for the years ended December 31, 2004, 2003, and 2002 |  | 30
|Statements of Cash Flows for the years ended December 31, 2004, 2003, and 2002           |  | 31
|Notes to Financial Statements                                                            |  | 33
|                                                                                         | 
|Financial Statement Schedule                                                             |  |   
|Schedule II  Valuation and Qualifying Accounts                                         |  | 46



Other schedules are omitted for the
reason that they are not required or are not applicable, or the required information is included in the financial statements or notes thereto.



Page 26 of 53



---

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of Directors and Stockholders



Daou Systems, Inc.



We have audited the accompanying balance sheets of Daou
Systems, Inc. as of December 31, 2004 and 2003, and the related statements of operations, stockholders equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement
schedule listed in the index to the financial statements. These financial statements and schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements and schedule based
on our audits.



We conducted our audits in accordance with the
standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were
not engaged to perform an audit of the Companys internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Companys internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.



In our
opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Daou Systems, Inc. at December 31, 2004 and 2003 and the results of its operations and its cash flows for each of the three years
in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information set forth therein.



/s/ ERNST & YOUNG LLP



Philadelphia,
Pennsylvania



February 4, 2005



Page 27 of 53



---

Daou Systems, Inc.

Balance Sheets

(In thousands, except for per share data)



|                                                                                                                                                                                                                                            |  |              |         |   |      |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | - | ---- | - | ------- | -
|                                                                                                                                                                                                                                            |  | December 31, |        
|                                                                                                                                                                                                                                            |  | 2004         |         |   | 2003 |  
|ASSETS                                                                                                                                                                                                                                      |  |              |         |   |      |   |         |  
|Current assets:                                                                                                                                                                                                                             |  |              |         |   |      |   |         |  
|Cash and cash equivalents                                                                                                                                                                                                                   |  | $            | 10,941  |   |      | $ | 13,045  |  
|Investments, available-for-sale                                                                                                                                                                                                             |  |              | 128     |   |      |   | 102     |  
|Accounts receivable, net of allowance for doubtful accounts of $367 and $789 in 2004 and 2003, respectively                                                                                                                                 |  |              | 5,218   |   |      |   | 8,226   |  
|Contract work in progress                                                                                                                                                                                                                   |  |              | 190     |   |      |   | 1,457   |  
|Other current assets                                                                                                                                                                                                                        |  |              | 571     |   |      |   | 640     |  
|                                                                                                                                                                                                                                            |  |              |         |   |      |   |         |  
|Total current assets                                                                                                                                                                                                                        |  |              | 17,048  |   |      |   | 23,470  |  
|Due from officers/stockholders                                                                                                                                                                                                              |  |              | 119     |   |      |   | 83      |  
|Equipment, furniture and fixtures, net                                                                                                                                                                                                      |  |              | 885     |   |      |   | 1,144   |  
|Other assets                                                                                                                                                                                                                                |  |              | 628     |   |      |   | 531     |  
|                                                                                                                                                                                                                                            |  |              |         |   |      |   |         |  
|                                                                                                                                                                                                                                            |  | $            | 18,680  |   |      | $ | 25,228  |  
|                                                                                                                                                                                                                                            |  |              |         |   |      |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                                                                        |  |              |         |   |      |   |         |  
|Current liabilities:                                                                                                                                                                                                                        |  |              |         |   |      |   |         |  
|Trade accounts payable                                                                                                                                                                                                                      |  | $            | 765     |   |      | $ | 823     |  
|Accrued salaries and benefits                                                                                                                                                                                                               |  |              | 1,814   |   |      |   | 4,063   |  
|Accrued project costs                                                                                                                                                                                                                       |  |              | 44      |   |      |   | 68      |  
|Other accrued liabilities                                                                                                                                                                                                                   |  |              | 899     |   |      |   | 1,280   |  
|Deferred revenue                                                                                                                                                                                                                            |  |              | 489     |   |      |   | 1,426   |  
|                                                                                                                                                                                                                                            |  |              |         |   |      |   |         |  
|Total current liabilities                                                                                                                                                                                                                   |  |              | 4,011   |   |      |   | 7,660   |  
|Deferred rent, net of current portion                                                                                                                                                                                                       |  |              | 394     |   |      |   | 489     |  
|Other long-term liabilities                                                                                                                                                                                                                 |  |              |        |   |      |   | 34      |  
|Commitments and contingencies                                                                                                                                                                                                               |  |              |         |   |      |   |         |  
|Stockholders equity:                                                                                                                                                                                                                       |  |              |         |   |      |   |         |  
|Convertible preferred stock, $ .001 par value. Authorized 3,520 shares; issued and outstanding 2,182 shares, with a liquidation preference of
$17,827 and $16,256, respectively, at December 31, 2004 and 2003, including accrued dividends |  |              | 2       |   |      |   | 2       |  
|Common stock, $ .001 par value. Authorized 50,000 shares; issued and outstanding 21,815 and 21,583 at December 31, 2004 and 2003,
respectively, and 1,292 shares held in treasury at December 31, 2004 and 2003                             |  |              | 22      |   |      |   | 22      |  
|Additional paid-in capital                                                                                                                                                                                                                  |  |              | 57,546  |   |      |   | 55,936  |  
|Notes receivable from stockholders                                                                                                                                                                                                          |  |              | (1,160  | ) |      |   | (1,160  | )
|Accumulated other comprehensive loss                                                                                                                                                                                                        |  |              | (3      | ) |      |   | (29     | )
|Accumulated deficit                                                                                                                                                                                                                         |  |              | (42,132 | ) |      |   | (37,726 | )
|                                                                                                                                                                                                                                            |  |              |         |   |      |   |         |  
|Total stockholders equity                                                                                                                                                                                                                  |  |              | 14,275  |   |      |   | 17,045  |  
|                                                                                                                                                                                                                                            |  |              |         |   |      |   |         |  
|                                                                                                                                                                                                                                            |  | $            | 18,680  |   |      | $ | 25,228  |  
|                                                                                                                                                                                                                                            |  |              |         |   |      |   |         |  



See accompanying notes
to financial statements.



Page 28 of 53



---

Daou Systems, Inc.

Statements of Operations

(In thousands, except for per share data)



|                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|---------------------------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                           |  | 2004 |        |   | 2003 |   |        | 2002 | 
|Revenue before reimbursements (net revenue)                |  | $    | 27,107 |   |      | $ | 42,161 |      |  | $ | 37,935 |  
|Out-of-pocket reimbursements                               |  |      | 2,284  |   |      |   | 3,265  |      |  |   | 3,240  |  
|                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|Total revenue                                              |  |      | 29,391 |   |      |   | 45,426 |      |  |   | 41,175 |  
|                                                           |  |      |       
|Cost of revenue before reimbursable expenses               |  |      | 20,479 |   |      |   | 28,760 |      |  |   | 26,128 |  
|Out-of-pocket reimbursable expenses                        |  |      | 2,284  |   |      |   | 3,265  |      |  |   | 3,240  |  
|                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|Total cost of revenue                                      |  |      | 22,763 |   |      |   | 32,025 |      |  |   | 29,368 |  
|                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|Gross profit                                               |  |      | 6,628  |   |      |   | 13,401 |      |  |   | 11,807 |  
|Operating expenses:                                        |  |      |        |   |      |   |        |      |  |   |        |  
|Sales and marketing                                        |  |      | 3,208  |   |      |   | 4,550  |      |  |   | 4,807  |  
|General and administrative                                 |  |      | 6,428  |   |      |   | 6,670  |      |  |   | 8,611  |  
|Restructuring (credit) charges                             |  |      |       |   |      |   | (252   | )    |  |   | 1,598  |  
|                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|                                                           |  |      | 9,636  |   |      |   | 10,968 |      |  |   | 15,016 |  
|                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|Income (loss) from operations                              |  |      | (3,008 | ) |      |   | 2,433  |      |  |   | (3,209 | )
|Other income, net                                          |  |      | 209    |   |      |   | 207    |      |  |   | 270    |  
|                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|Income (loss) before income taxes                          |  |      | (2,799 | ) |      |   | 2,640  |      |  |   | (2,939 | )
|Provision for income taxes                                 |  |      | (36    | ) |      |   | (52    | )    |  |   |       |  
|                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|Net income (loss)                                          |  |      | (2,835 | ) |      |   | 2,588  |      |  |   | (2,939 | )
|Accrued dividends on preferred stock                       |  |      | (1,571 | ) |      |   | (1,290 | )    |  |   | (1,054 | )
|                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|Net income (loss) available to common stockholders         |  | $    | (4,406 | ) |      | $ | 1,298  |      |  | $ | (3,993 | )
|                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|Earnings (loss) per common share:                          |  |      |        |   |      |   |        |      |  |   |        |  
|Basic                                                      |  | $    | (0.20  | ) |      | $ | 0.06   |      |  | $ | (0.21  | )
|                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|Diluted                                                    |  | $    | (0.20  | ) |      | $ | 0.05   |      |  | $ | (0.21  | )
|                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|Shares used in computing earnings (loss) per common share: |  |      |        |   |      |   |        |      |  |   |        |  
|Basic                                                      |  |      | 21,656 |   |      |   | 20,821 |      |  |   | 19,075 |  
|                                                           |  |      |        |   |      |   |        |      |  |   |        |  
|Diluted                                                    |  |      | 21,656 |   |      |   | 26,513 |      |  |   | 19,075 |  
|                                                           |  |      |        |   |      |   |        |      |  |   |        |  



See accompanying notes
to financial statements.



Page 29 of 53



---

Daou Systems, Inc.

Statements of Stockholders Equity

For the Years Ended December 31, 2004, 2003, and 2002

(In thousands)



|                                                            |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   |        |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   |        |  
|----------------------------------------------------------- |  | -------------------------- |  | ------------ | - | ------------------------ | ------ | - | --------------------------------- | - | -- | ----------------------------------- | - | ------ | ------------------ |  | - | ------------------------ | - |  | - | --- | - |  | - | ------- | - |  | - | ------ | -
|                                                            |  | Convertiblepreferred stock |  | Common stock |   | Additionalpaid-incapital |        |   | Notesreceivable fromstock-holders |   |    | Accumulatedothercomprehensiveincome |   |        | Accumulateddeficit |  |   | Totalstockholdersequity |  
|                                                            |  | Shares                     |  | Amount       |   | Shares                   |        |   | Amount                            |   |    |                                     |   |       
|Balance at December 31, 2001                                |  | 2,182                      |  | $            | 2 |                          | 21,556 |   |                                   | $ | 22 |                                     | $ | 53,668 |                    |  | $ | (1,281                   | ) |  | $ | (72 | ) |  | $ | (35,031 | ) |  | $ | 17,308 |  
|                                                            |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   |        |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   |        |  
|Issuance of common stock under employee stock purchase plan |  |                           |  |              |  |                          | 160    |   |                                   |   |   |                                     |   | 81     |                    |  |   |                         |   |  |   |    |   |  |   |        |   |  |   | 81     |  
|Accrued dividends on preferred stock                        |  |                           |  |              |  |                          |       |   |                                   |   |   |                                     |   | 1,054  |                    |  |   |                         |   |  |   |    |   |  |   | (1,054  | ) |  |   |       |  
|Issuance of common stock upon exercise of stock options     |  |                           |  |              |  |                          | 21     |   |                                   |   |   |                                     |   | 3      |                    |  |   |                         |   |  |   |    |   |  |   |        |   |  |   | 3      |  
|Comprehensive loss:                                         |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   |        |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   |        |  
|Unrealized gain on investments                              |  |                           |  |              |  |                          |       |   |                                   |   |   |                                     |   |       |                    |  |   |                         |   |  |   | 16  |   |  |   |        |   |  |   | 16     |  
|Net loss                                                    |  |                           |  |              |  |                          |       |   |                                   |   |   |                                     |   |       |                    |  |   |                         |   |  |   |    |   |  |   | (2,939  | ) |  |   | (2,939 | )
|                                                            |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   |        |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   |        |  
|Comprehensive loss:                                         |  |                           |  |              |  |                          |       |   |                                   |   |   |                                     |   |       |                    |  |   |                         |   |  |   |    |   |  |   |        |   |  |   | (2,923 | )
|                                                            |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   |        |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   |        |  
|Balance at December 31, 2002                                |  | 2,182                      |  |              | 2 |                          | 21,737 |   |                                   |   | 22 |                                     |   | 54,806 |                    |  |   | (1,281                   | ) |  |   | (56 | ) |  |   | (39,024 | ) |  |   | 14,469 |  
|                                                            |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   |        |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   |        |  
|Accrued dividends on preferred Stock                        |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   | 1,290  |                    |  |   |                          |   |  |   |     |   |  |   | (1,290  | ) |  |   |       |  
|Issuance of stock options for Services                      |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   | 10     |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   | 10     |  
|Issuance of common stock upon exercise of stock options     |  |                            |  |              |   |                          | 146    |   |                                   |   |    |                                     |   | 26     |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   | 26     |  
|Purchase of restricted Stock                                |  |                            |  |              |   |                          | (300   | ) |                                   |   |   |                                     |   | (196   | )                  |  |   | 121                      |   |  |   |     |   |  |   |         |   |  |   | (75    | )
|Comprehensive income:                                       |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   |        |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   |        |  
|Unrealized gain on investments                              |  |                           |  |              |  |                          |       |   |                                   |   |   |                                     |   |       |                    |  |   |                         |   |  |   | 27  |   |  |   |        |   |  |   | 27     |  
|Net income                                                  |  |                           |  |              |  |                          |       |   |                                   |   |   |                                     |   |       |                    |  |   |                         |   |  |   |    |   |  |   | 2,588   |   |  |   | 2,588  |  
|                                                            |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   |        |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   |        |  
|Comprehensive income:                                       |  |                           |  |              |  |                          |       |   |                                   |   |   |                                     |   |       |                    |  |   |                         |   |  |   |    |   |  |   |        |   |  |   | 2,615  |  
|                                                            |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   |        |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   |        |  
|Balance at December 31, 2003                                |  | 2,182                      |  |              | 2 |                          | 21,583 |   |                                   |   | 22 |                                     |   | 55,936 |                    |  |   | (1,160                   | ) |  |   | 29  |   |  |   | (37,726 | ) |  |   | 17,045 |  
|                                                            |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   |        |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   |        |  
|Accrued dividends on preferred stock                        |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   | 1,571  |                    |  |   |                          |   |  |   |     |   |  |   | (1,571  | ) |  |   |       |  
|                                                            |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   |        |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   |        |  
|Issuance of common stock upon exercise of stock options     |  |                            |  |              |   |                          | 232    |   |                                   |   |    |                                     |   | 39     |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   | 39     |  
|Comprehensive loss:                                         |  |                            |  |              |   |                          |        |   |                                   |   |   |                                     |   |        |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   |        |  
|Unrealized gain on investments                              |  |                           |  |              |  |                          |       |   |                                   |   |   |                                     |   |       |                    |  |   |                         |   |  |   | 26  |   |  |   |        |   |  |   | 26     |  
|Net loss                                                    |  |                           |  |              |  |                          |       |   |                                   |   |   |                                     |   |       |                    |  |   |                         |   |  |   |    |   |  |   | (2,835  | ) |  |   | (2,835 | )
|                                                            |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   |        |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   |        |  
|Comprehensive loss:                                         |  |                           |  |              |  |                          |       |   |                                   |   |   |                                     |   |       |                    |  |   |                         |   |  |   | 26  |   |  |   | (2,835  | ) |  |   | (2,809 | )
|                                                            |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   |        |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   |        |  
|Balance at December 31, 2004                                |  | 2,182                      |  | $            | 2 |                          | 21,815 |   |                                   | $ | 22 |                                     | $ | 57,546 |                    |  | $ | (1,160                   | ) |  | $ | (3  | ) |  | $ | (42,132 | ) |  | $ | 14,275 |  
|                                                            |  |                            |  |              |   |                          |        |   |                                   |   |    |                                     |   |        |                    |  |   |                          |   |  |   |     |   |  |   |         |   |  |   |        |  



See accompanying notes
to financial statements.



Page 30 of 53



---

Daou Systems, Inc.

Statements of Cash Flows

(In thousands)



|                                                                                                   |  |                          |        |   |      |   |        |      |  |   |        |  
|-------------------------------------------------------------------------------------------------- |  | ------------------------ | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                                                                   |  | Years ended December 31, |       
|                                                                                                   |  | 2004                     |        |   | 2003 |   |        | 2002 | 
|Net income (loss)                                                                                  |  | $                        | (2,835 | ) |      | $ | 2,588  |      |  | $ | (2,939 | )
|Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |  |                          |        |   |      |   |        |      |  |   |        |  
|Depreciation and amortization                                                                      |  |                          | 577    |   |      |   | 665    |      |  |   | 959    |  
|Amortization of deferred compensation                                                              |  |                          | 40     |   |      |   | 113    |      |  |   | 108    |  
|Provision for uncollectible accounts                                                               |  |                          | (405   | ) |      |   | (57    | )    |  |   | 186    |  
|Issuance of common stock and options for services                                                  |  |                          |       |   |      |   | 10     |      |  |   |       |  
|(Gain) loss on retirement of fixed assets                                                          |  |                          |       |   |      |   |       |      |  |   | (10    | )
|Changes in operating assets and liabilities:                                                       |  |                          |        |   |      |   |        |      |  |   |        |  
|Accounts receivable                                                                                |  |                          | 3,413  |   |      |   | (247   | )    |  |   | (536   | )
|Contract work in progress                                                                          |  |                          | 1,267  |   |      |   | 690    |      |  |   | 131    |  
|Other current assets                                                                               |  |                          | 69     |   |      |   | (132   | )    |  |   | (79    | )
|Accounts payable and accrued liabilities                                                           |  |                          | (463   | ) |      |   | (3,267 | )    |  |   | 259    |  
|Accrued salaries and benefits                                                                      |  |                          | (2,249 | ) |      |   | (265   | )    |  |   | 753    |  
|Deferred revenue                                                                                   |  |                          | (937   | ) |      |   | 1,061  |      |  |   | (220   | )
|Other long-term liabilities                                                                        |  |                          | (266   | ) |      |   | (13    | )    |  |   | (11    | )
|                                                                                                   |  |                          |        |   |      |   |        |      |  |   |        |  
|Net cash provided by (used in) operating activities                                                |  |                          | (1,789 | ) |      |   | 1,146  |      |  |   | (1,399 | )
|                                                                                                   |  |                          |       
|Investing activities                                                                               |  |                          |        |   |      |   |        |      |  |   |        |  
|Purchase of equipment, furniture and fixtures                                                      |  |                          | (318   | ) |      |   | (342   | )    |  |   | (900   | )
|Increase in other assets                                                                           |  |                          | (36    | ) |      |   | (29    | )    |  |   | (334   | )
|                                                                                                   |  |                          |        |   |      |   |        |      |  |   |        |  
|Net cash used in investing activities                                                              |  |                          | (354   | ) |      |   | (371   | )    |  |   | (1,234 | )
|                                                                                                   |  |                          |       
|Financing Activities                                                                               |  |                          |        |   |      |   |        |      |  |   |        |  
|Proceeds from issuance of common stock                                                             |  |                          | 39     |   |      |   | 26     |      |  |   | 84     |  
|Repurchase of restricted stock, net of notes receivable                                            |  |                          |       |   |      |   | (75    | )    |  |   |       |  
|                                                                                                   |  |                          |        |   |      |   |        |      |  |   |        |  
|Net cash (used in) provided by financing activities                                                |  |                          | 39     |   |      |   | (49    | )    |  |   | 84     |  
|                                                                                                   |  |                          |        |   |      |   |        |      |  |   |        |  
|Increase (decrease) in cash and cash equivalents                                                   |  |                          | (2,104 | ) |      |   | 726    |      |  |   | (2,549 | )
|Cash and cash equivalents at beginning of year                                                     |  |                          | 13,045 |   |      |   | 12,319 |      |  |   | 14,868 |  
|                                                                                                   |  |                          |        |   |      |   |        |      |  |   |        |  
|Cash and cash equivalents at end of year                                                           |  | $                        | 10,941 |   |      | $ | 13,045 |      |  | $ | 12,319 |  
|                                                                                                   |  |                          |        |   |      |   |        |      |  |   |        |  



See accompanying notes
to financial statements.



Page 31 of 53



---

Daou Systems, Inc.

Statements of Cash Flows

(In thousands)



|                                                                       |  |                          |       |      |   |       |  |   |      
|---------------------------------------------------------------------- |  | ------------------------ | ----- | ---- | - | ----- |  | - | -----
|                                                                       |  | Years ended December 31,
|                                                                       |  | 2004                     |       | 2003 |   | 2002 
|Supplemental disclosure of noncash investing and financing activities: |  |                          |       |      |   |       |  |   |      
|Accrued preferred stock dividends to preferred stockholders            |  | $                        | 1,571 |      | $ | 1,290 |  | $ | 1,054
|                                                                       |  |                          |       |      |   |       |  |   |      
|Unrealized gain on investments                                         |  | $                        | 26    |      | $ | 27    |  | $ | 16   
|                                                                       |  |                          |       |      |   |       |  |   |      
|Property and equipment acquired through tenant allowance               |  | $                        |      |      | $ | 461   |  | $ |     
|                                                                       |  |                          |       |      |   |       |  |   |      
|Income taxes paid                                                      |  | $                        | 96    |      | $ | 17    |  | $ |     
|                                                                       |  |                          |       |      |   |       |  |   |      



See accompanying notes
to financial statements.



Page 32 of 53



---

Daou Systems, Inc.

Notes to Financial Statements



1. Organization and Summary of Significant Accounting Policies



Organization and Basis of Presentation



Daou Systems, Inc. (Daou or the Company), a Delaware company, was incorporated in California on July 16, 1987 under the name Daou
Systems, Inc., and reincorporated in Delaware on November 15, 1996. The Company provides expert consulting and management services to healthcare organizations in the design, deployment and support of IT infrastructure and application systems. Daou
offers a range of comprehensive services including infrastructure and mobile health solutions, application implementation and support, management consulting and business process improvement, integration and wed services. Daou has provided services
to more than 1,600 healthcare organizations, including leading private and public hospitals, managed care organizations on both the payer and provider sides of the market, as well as integrated healthcare delivery networks (IDNs) and some of the
nations largest government healthcare entities. Daou Systems, Inc. is a publicly traded company listed on the OTC Bulletin Board under the stock symbol DAOU.



In 2003, the Company announced its decision to reorganize Daous internal management structure, consolidate operations
and eliminate non-strategic services. As part of the reorganization, the Company consolidated Daous two operating divisionsTechnology Services and Application Services, and operates as one business with multiple service offerings. As
such, the Company currently has no reportable segments.



Revenue Recognition



The Company recognizes 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:



| |  |  | persuasive evidence of an arrangement,
| | - |  | --------------------------------------



| |  |  | services have been delivered,
| | - |  | -----------------------------



| |  |  | price is fixed and determinable, and
| | - |  | ------------------------------------



| |  |  | collectibility is reasonably assured.
| | - |  | -------------------------------------



The Company has the following types of revenue recognition: 1) services performed on an hourly basis, 2) services performed on a fixed-fee basis and 3)
sales of material and maintenance contracts. In general, the Company enters 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. Revenue for the development and implementation of network solutions under fixed-fee contracts is recognized based on the level of service performed (i.e. the amount of
actual labor cost incurred on the project) compared to 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.
Costs incurred on projects where revenue recognition milestones have not been reached are classified as Contract Work in Progress. Payments received in advance of services performed are recorded as Deferred Revenue and recognized as revenue as the
services are performed.



Concentration of Credit Risk and Major Customers



Financial instruments which subject the Company to
potential concentrations of credit risk consist principally of the Companys accounts receivable. Substantially all of the Companys accounts receivable are from managed care organizations, hospitals, government healthcare organizations
and other healthcare providers. The Company performs credit evaluations of its new customers and generally requires no collateral. The Company provides for losses from uncollectible accounts pursuant to a formal policy which is based on analyzing
historical data and trends and such losses have historically not exceeded managements expectations. Past due or delinquency status is based on contractual terms. Past due amounts are written off against the allowance for doubtful accounts when
collection is deemed unlikely and all collection efforts have ceased.



Page 33 of 53



---

Daou Systems, Inc.

Notes to Financial Statements(Continued)



Services to Daous five largest customers accounted for approximately $8.8 million of net revenue for the year ended December 31, 2004, representing approximately 32% of total net revenue, with no one customer accounting for more than
8% of net revenue. Net accounts receivable due from Daous five largest customers accounted for approximately $1.7 million at year ended December 31, 2004, representing approximately 32% of net accounts receivable.



Cash, Cash Equivalents, Restricted Cash and Investments



Cash and cash equivalents consist of cash and highly liquid investments with
maturities of three months or less when purchased. The Company has established guidelines relative to diversification and maturities that are periodically reviewed and modified to take advantage of trends in yields and interest rates. The Company
historically has not experienced any material losses on its cash equivalents or short-term investments.



The Company classifies its investments as Available-for-Sale and records such assets at the estimated fair value on the balance sheet with
unrealized gains and losses excluded from earnings and reported as a separate component of comprehensive income until realized. The basis for computing realized gains or losses is by specific identification.



At December 31, 2004, the Company has approximately $276,000 of cash related
to operating leases in an escrow account subject to certain withdrawal restrictions. This amount is classified in Other Assets on the balance sheet.



Equipment, Furniture and Fixtures



Equipment, furniture and fixtures are carried at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the
assets, ranging from two to five years. Leasehold improvements are amortized over the lesser of the estimated useful lives of the assets or the remaining lease term.



Advertising Expense



Advertising expenditures are charged to expense as incurred. The Company expensed $196,000, $260,000 and $222,000 for the years ended December 31, 2004,
2003 and 2002, respectively.



Recent Pronouncements



In June 2002, the FASB issued Statement of Financial Accounting Standards
(SFAS) No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 provides guidance related to accounting for costs associated with disposal activities covered by SFAS No. 144 or with exit or
restructuring activities previously covered by EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). SFAS No. 146
supercedes EITF Issue No. 94-3 in its entirety. SFAS No. 146 requires that costs related to exiting an activity or to a restructuring not be recognized until the liability is incurred. SFAS No. 146 will be applied prospectively to exit or disposal
activities that are initiated after December 31, 2002. The adoption of this method did not have a material impact on the Companys results of operations or financial condition.



On December 16, 2004, the Financial Accounting Standards Board (FASB) issued Statement 123 (revised 2004), Share Based
Payment (FAS 123R). FAS123R supersedes APB 25, Accounting for Stock Issued to Employees, and is effective for public companies at the beginning of the first interim or 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.



Effective July 1, 2003, the
company adopted the FASBs consensus on EITF Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. This issue addresses how to account for arrangements that may involve the delivery or performance of
multiple products, services, and/or rights to use



Page 34 of 53



---

Daou Systems, Inc.

Notes to Financial Statements(Continued)



assets. The
final consensus of this issue is applicable to agreements entered into in fiscal periods beginning after June 15, 2003. Adoption of this issue had no material impact on the Companys financial condition, results of operations, or liquidity.



In December 2003, the SEC issued SAB 104, which supercedes SAB No. 101,
Revenue Recognition in Financial Statements (SAB 101). The primary purpose of SAB 104 is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, superceded as a result of the
issuance of Emerging Issues Task Force (EITF) Issue No. 00-21. Additionally, SAB 104 rescinds the SECs Revenue Recognition in Financial Statements Frequently Asked Questions and Answers (the FAQ) issued with SAB 101
that had been codified in SEC Topic 13, Revenue Recognition. Selected portions of the FAQ have been incorporated into SAB 104. The adoption of SAB 104 did not have an impact on the Companys financial condition or results of
operations.



Use of Estimates



The preparation of financial statements in conformity with generally
accepted accounting principles 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 to the financial statements. The actual
results could differ from those estimates.



Stock-Based Compensation



The Company has stock-based employee compensation plans
which are described more fully in Note 8. 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 income and earnings per share if
the Company had applied the fair value recognition provisions of SFAS No. 123:



(In thousands, except per share information)



|                                                                                                                 |  |                          |        |   |      |   |       |      |  |   |        |  
|---------------------------------------------------------------------------------------------------------------- |  | ------------------------ | ------ | - | ---- | - | ----- | ---- |  | - | ------ | -
|                                                                                                                 |  | Years Ended December 31, |       
|                                                                                                                 |  | 2004                     |        |   | 2003 |   |       | 2002 | 
|Net income (loss) available to common stockholders as reported                                                   |  | $                        | (4,406 | ) |      | $ | 1,298 |      |  | $ | (3,993 | )
|Add total stock-based employee compensation determined under APB No. 25                                          |  |                          |       |   |      |   | 10    |      |  |   |       |  
|Deduct total stock-based employee compensation determined under the fair value method for all awards, net of tax |  |                          | (363   | ) |      |   | (953  | )    |  |   | (3,425 | )
|                                                                                                                 |  |                          |        |   |      |   |       |      |  |   |        |  
|Pro forma net income (loss)                                                                                      |  | $                        | (4,769 | ) |      | $ | 355   |      |  | $ | (7,418 | )
|                                                                                                                 |  |                          |        |   |      |   |       |      |  |   |        |  
|Earnings (loss) per share                                                                                        |  |                          |        |   |      |   |       |      |  |   |        |  
|Basic  as reported                                                                                              |  | $                        | (0.20  | ) |      | $ | 0.06  |      |  | $ | (0.21  | )
|                                                                                                                 |  |                          |        |   |      |   |       |      |  |   |        |  
|Diluted  as reported                                                                                            |  | $                        | (0.20  | ) |      | $ | 0.05  |      |  | $ | (0.21  | )
|                                                                                                                 |  |                          |        |   |      |   |       |      |  |   |        |  
|Basic  pro forma                                                                                                |  | $                        | (0.22  | ) |      | $ | 0.02  |      |  | $ | (0.39  | )
|                                                                                                                 |  |                          |        |   |      |   |       |      |  |   |        |  
|Diluted  pro forma                                                                                              |  | $                        | (0.22  | ) |      | $ | 0.01  |      |  | $ | (0.39  | )
|                                                                                                                 |  |                          |        |   |      |   |       |      |  |   |        |  



Page 35 of 53



---

Daou Systems, Inc.

Notes to Financial Statements(Continued)



2. Earnings
Per Share



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



(In thousands,
except per share information)



|                                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  
|---------------------------------------------------------------------------------------------------------- |  | ------------------------ | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                                                                           |  | Years Ended December 31, |       
|                                                                                                           |  | 2004                     |        |   | 2003 |   |        | 2002 | 
|Numerator:                                                                                                 |  |                          |        |   |      |   |        |      |  |   |        |  
|Net income (loss)                                                                                          |  | $                        | (2,835 | ) |      | $ | 2,588  |      |  | $ | (2,939 | )
|Preferred stock dividends                                                                                  |  |                          | 1,571  |   |      |   | 1,290  |      |  |   | 1,054  |  
|                                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  
|Numerator for basic and diluted earnings (loss) per share - income (loss) available to common stockholders |  |                          | (4,406 | ) |      |   | 1,298  |      |  |   | (3,993 | )
|                                                                                                           |  |                          |       
|Denominator:                                                                                               |  |                          |        |   |      |   |        |      |  |   |        |  
|Weighted-average common shares outstanding                                                                 |  |                          | 21,742 |   |      |   | 21,662 |      |  |   | 21,591 |  
|Weighted-average unvested common shares subject to repurchase agreements                                   |  |                          | (86    | ) |      |   | (841   | )    |  |   | (2,516 | )
|                                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  
|Denominator for basic earnings (loss) per share                                                            |  |                          | 21,656 |   |      |   | 20,821 |      |  |   | 19,075 |  
|                                                                                                           |  |                          |       
|Effect of dilutive securities:                                                                             |  |                          |        |   |      |   |        |      |  |   |        |  
|Unvested common shares subject to repurchase agreements                                                    |  |                          |       |   |      |   | 841    |      |  |   |       |  
|Stock options                                                                                              |  |                          |       |   |      |   | 1,368  |      |  |   |       |  
|Warrants                                                                                                   |  |                          |       |   |      |   | 3,483  |      |  |   |       |  
|                                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  
|Dilutive potential common shares                                                                           |  |                          |       |   |      |   | 5,692  |      |  |   |       |  
|                                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  
|Denominator for diluted earnings (loss) per share                                                          |  |                          | 21,656 |   |      |   | 26,513 |      |  |   | 19,075 |  
|                                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  
|Basic earnings (loss) per share                                                                            |  | $                        | (0.20  | ) |      | $ | 0.06   |      |  | $ | (0.21  | )
|                                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  
|Diluted earnings (loss) per share                                                                          |  | $                        | (0.20  | ) |      | $ | 0.05   |      |  | $ | (0.21  | )
|                                                                                                           |  |                          |        |   |      |   |        |      |  |   |        |  



Options to purchase an
additional 1,478,526 shares of common stock were outstanding during the year ended December 31, 2003, but were not included in the computation of diluted earnings per share because the options exercise prices were greater than the average
market price of the common shares and, therefore, the effect would be anti-dilutive. In addition, the Series A Convertible Preferred Stock and accrued dividends were excluded from diluted earnings per share for the year ended December 31, 2003 as
the assumed conversion would be anti-dilutive.



For the years
ended December 31, 2004 and 2002, diluted loss per share is unchanged from basic loss per share because the effects of the unvested common shares subject to repurchase agreements and the assumed conversions of Series A Convertible Preferred Stock,
stock options and warrants would be anti-dilutive.



3. Restructuring Charges



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 Costs 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.



Page 36 of 53



---

Daou Systems, Inc.

Notes to Financial Statements(Continued)



As of December 31, 2002, as part of its strategy to position itself for continued growth in the marketplace, the Company reorganized its management structure, consolidated operations and eliminated certain non-strategic services. In
addition, in the fourth quarter of 2002, the Company increased its estimate of costs and related sublease income related to previously announced closures of certain facilities. These combined actions resulted in a workforce reduction of
approximately 16 employees and a restructuring charge in the fourth quarter of 2002 of $1.6 million.



The following table summarizes the activity in the Companys accrued restructuring liability:



|                              |  |                                                    |       |   |                                                    |   |        |       |  |   |        |  
|----------------------------- |  | -------------------------------------------------- | ----- | - | -------------------------------------------------- | - | ------ | ----- |  | - | ------ | -
|                              |  | Severance costsfor involuntaryemployeeterminations |       |   | Costsrelated toclosure andcombinationof facilities |   |        | Total | 
|Balance at December 31, 2001  |  | $                                                  | 151   |   |                                                    | $ | 1,161  |       |  | $ | 1,312  |  
|Year Ended December 31, 2002: |  |                                                    |       |   |                                                    |   |        |       |  |   |        |  
|Reserve established           |  |                                                    | 1,065 |   |                                                    |   | 533    |       |  |   | 1,598  |  
|Reserve utilized              |  |                                                    | (222  | ) |                                                    |   | (1,064 | )     |  |   | (1,286 | )
|                              |  |                                                    |       |   |                                                    |   |        |       |  |   |        |  
|Balance at December 31, 2002  |  |                                                    | 994   |   |                                                    |   | 630    |       |  |   | 1,624  |  
|Year Ended December 31, 2003: |  |                                                    |       |   |                                                    |   |        |       |  |   |        |  
|Reserve established           |  |                                                    |      |   |                                                    |   |       |       |  |   |       |  
|Reserve utilized              |  |                                                    | (994  | ) |                                                    |   | (309   | )     |  |   | (1,303 | )
|Other adjustments (a)         |  |                                                    |       |   |                                                    |   | (252   | )     |  |   | (252   | )
|                              |  |                                                    |       |   |                                                    |   |        |       |  |   |        |  
|Balance at December 31, 2003  |  |                                                    |      |   |                                                    |   | 69     |       |  |   | 69     |  
|                              |  |                                                    |      
|Year Ended December 31, 2004: |  |                                                    |       |   |                                                    |   |        |       |  |   |        |  
|Reserve established           |  |                                                    |       |   |                                                    |   |        |       |  |   |        |  
|Reserve utilized              |  |                                                    |      |   |                                                    |   | (31    | )     |  |   | (31    | )
|                              |  |                                                    |       |   |                                                    |   |        |       |  |   |        |  
|Balance at December 31, 2004  |  | $                                                  |      |   |                                                    | $ | 38     |       |  | $ | 38     |  
|                              |  |                                                    |       |   |                                                    |   |        |       |  |   |        |  

---

|(a) | In the third quarter of 2003, the Company was able to reduce its obligations relating to unused office space. The amount has been recorded as a restructuring credit in the
statements of operations as the original provision was recorded as a restructuring expense in the period in which the charge was recorded.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Page 37 of 53



---

Daou Systems, Inc.

Notes to Financial Statements(Continued)



4.
Investments, Available-For-Sale



Short-term investments,
available-for-sale, consist of the following (in thousands):



|                           |  |               |     |                      |   |                       |  |                    |   |  |   |    
|-------------------------- |  | ------------- | --- | -------------------- | - | --------------------- |  | ------------------ | - |  | - | ---
|                           |  | AmortizedCost |     | GrossUnrealizedGains |   | GrossUnrealizedLosses |  | EstimatedFairValue
|December 31, 2004          |  |               |     |                      |   |                       |  |                    |   |  |   |    
|Government debt securities |  | $             | 102 |                      | $ | 26                    |  | $                  |  |  | $ | 128
|                           |  |               |     |                      |   |                       |  |                    |   |  |   |    
|December 31, 2003          |  |               |     |                      |   |                       |  |                    |   |  |   |    
|Government debt securities |  | $             | 75  |                      | $ | 27                    |  | $                  |  |  | $ | 102
|                           |  |               |     |                      |   |                       |  |                    |   |  |   |    



The government debt
securities mature in 2007 and 2008.



5. Selected Balance Sheet Details



Equipment, furniture and fixtures consist of the
following (in thousands):



|                                               |  |              |        |   |      |   |        |  
|---------------------------------------------- |  | ------------ | ------ | - | ---- | - | ------ | -
|                                               |  | December 31, |       
|                                               |  | 2004         |        |   | 2003 |  
|Equipment and furniture                        |  | $            | 5,084  |   |      | $ | 4,826  |  
|Leasehold improvements                         |  |              | 701    |   |      |   | 641    |  
|                                               |  |              |        |   |      |   |        |  
|                                               |  |              | 5,785  |   |      |   | 5,467  |  
|Less accumulated depreciation and amortization |  |              | (4,900 | ) |      |   | (4,323 | )
|                                               |  |              |        |   |      |   |        |  
|                                               |  | $            | 885    |   |      | $ | 1,144  |  
|                                               |  |              |        |   |      |   |        |  



Other accrued liabilities consist of
the following (in thousands):



|                      |  |              |     |      |   |      
|--------------------- |  | ------------ | --- | ---- | - | -----
|                      |  | December 31,
|                      |  | 2004         |     | 2003
|Customer prepayments  |  | $            | 82  |      | $ | 432  
|Accrued restructuring |  |              | 38  |      |   | 69   
|Other                 |  |              | 779 |      |   | 779  
|                      |  |              |     |      |   |      
|                      |  | $            | 899 |      | $ | 1,280
|                      |  |              |     |      |   |      



6. Commitments



The Company leases its facilities and certain equipment under operating
lease agreements. The facility leases provide for abatement of rent during certain periods, escalating rent payments, and tenant work allowances during the lease term. The Company records the total amount of rent payments (including abatement of
rent and escalating rent payments) on a straight-line basis over the term of the lease. Tenant work allowances are recorded as a deferred liability when received from the landlord and are recorded as a reduction of rental expense over the term of
the lease. Rent expense for 2004, 2003 and 2002 totaled $846,000, $678,000, and $760,000 respectively.



Page 38 of 53



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Daou Systems, Inc.

Notes to Financial Statements(Continued)



Annual future minimum lease payments under non-cancelable operating leases with initial terms of one year or more at December 31, 2004, consist of the following (in thousands):



|           |  |   |      
|---------- |  | - | -----
|2005       |  | $ | 947  
|2006       |  |   | 707  
|2007       |  |   | 728  
|2008       |  |   | 708  
|2009       |  |   | 282  
|Thereafter |  |   | 50   
|           |  |   |      
|           |  | $ | 3,422
|           |  |   |      



The Company also
subleases certain of its leased facilities under non-cancelable sublease agreements through 2005. Income related to these subleases is used to primarily offset restructuring liabilities. For the years ended December 31, 2004 and 2003, the full
amount received from subleases was applied to restructuring liabilities. Future amounts due to the Company under sublease agreements, aggregate $234,000 for the year ended December 31, 2005.



7. Related Party Transactions



During the year ended December 31, 2002, the Company received certain
personnel recruitment services from a Company owned by one of its Board members at the time. The Company believes the terms of its arrangement were at least as favorable, if not more, than those offered by competing recruitment firms. Payments for
these services during the year ended December 31, 2002 consisted of cash compensation totaling $141,000. There were no such services performed in 2004 or 2003.



8. Stockholders Equity



Convertible Preferred Stock



In July 1999, the Company 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, to 8% on July 26, 2002, to 9% on July 26, 2003, to 10% on July 26, 2004, and will continue to increase an additional 1% on July 26 of each year up to a maximum of 12%. No cash 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. At the option of the holders, shares of the Series A Preferred Stock can be converted into
shares of common stock at any time, subject to certain antidilution adjustments. The Company is 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 described below.



As of December 31, 2004, the Company had accrued but undeclared preferred stock dividends of
approximately $5.8 million (payable in kind by the issuance of approximately 1.1 million shares of Series A Preferred Stock), thereby entitling the holders of the Series A Preferred Stock to a total liquidation preference of approximately $17.8
million.



Page 39 of 53



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Daou Systems, Inc.

Notes to Financial Statements(Continued)



On November 9,
2000, as a consequence of the resignation of Larry Grandia, the Companys former President and Chief Executive Officer, holders of the Series A Preferred Stock had the right to cause the redemption of their Series A Preferred Stock for
approximately $12.9 million. The Company entered into an agreement with the holders of the Series A Preferred Stock under which the holders of the Series A Preferred Stock permanently waived their redemption rights in return for $2.0 million in cash
and warrants to purchase 3,540,000 shares of the Companys common stock exercisable at $0.01 per share. The warrants expire on November 9, 2005, and the common stock for which the warrants may be exercised is subject to demand registration
rights. The total consideration for this transaction was valued at approximately $4.1 million and for financial reporting purposes was recorded as a one-time dividend in the fourth quarter of 2000.



Restricted Stock Purchase Agreements and Deferred Compensation



On July 24, 2001, the Company agreed to sell 150,000 shares of restricted
common stock at the July 24, 2001 closing price of $.52 per share to an executive officer of the Company, in exchange for a full recourse note receivable that accrues interest at a rate of 6.75% and is due on July 24, 2006.



On June 1, 2001, the Company agreed to sell an aggregate of 4,150,000 shares
of restricted common stock at the June 1, 2001 closing price of $.29 per share to three executive officers of the Company, in exchange for full recourse notes receivable that accrue interest at a rate of 6.75% and which are due on May 31, 2006. As
part of this agreement, 1,710,000 options to purchase common stock previously granted to these executive officers were canceled.



In connection with two of the agreements, the Company agreed to reimburse the officers for the interest due in accordance with the terms of the notes
receivable. Accordingly, deferred compensation totaling $321,000 was recorded in connection with these agreements. This amount is included in other assets and is being amortized ratably over the five year term of the notes. Amortization totaled
$40,000, $113,000 and $108,000 for the years ended December 31, 2004, 2003 and 2002, respectively.



On July 9, 2003, the Company repurchased 300,000 shares of its restricted common stock in private transactions with its President and Chief Executive
Officer and its former Chief Financial Officer. The aggregate cost to the Company was $196,000. In connection with the repurchases, the Company received an aggregate amount of $139,000 for repayment of promissory notes, including principal and
interest, relating to the original purchase in 2001 of the shares from the Company. The related stock pledge and registration rights agreements between each person and the Company were terminated.



Employee Stock Purchase Plan



In May 2000, the Company adopted the Daou Systems, Inc. Employee Stock
Purchase Plan (ESPP), under which 1,500,000 shares of the Companys common stock are reserved for issuance. Under the ESPP, eligible employees are allowed to purchase common stock at six-month intervals at the lower of the fair
market value at the beginning of the measurement period or 85% of the fair market value at the end of the measurement period. On December 31, 2002 and June 30, 2002, the Company issued 105,571 shares of common stock at $.3485 per share and 54,237
shares of common stock at $.8415 per share, respectively. At December 31, 2002, 904,189 shares remained available for future issuance under the ESPP. The Company has placed the ESPP in suspended status since January 1, 2003.



Stock Option Plans



During 1996, the Company adopted the 1996 Stock Option Plan (the Plan), under which 5,000,000 shares, as
amended, of the Companys common stock are reserved for issuance upon exercise of options granted by the Company. The Plan provides for the grant of both incentive and nonstatutory stock options to officers, directors, employees and consultants
of the Company. Options granted by the Company generally vest over a three to five-year period and are exercisable for a period of ten years from the date of the grant.



Page 40 of 53



---

Daou Systems, Inc.

Notes to Financial Statements(Continued)



The following
summary of the Companys stock option activity and related information includes 225,000 non-qualified stock options at an exercise price ranging from $0.41 to $1.03 per share, 100,000 options at an exercise price of $0.28 per share, and 300,000
options at an exercise price ranging from $0.20 to $0.38 per share, granted outside of the plan and approved by the Companys Board of Directors in 2002, 2003 and 2004, respectively:



|                                                               |  |            |   |      |                                |      |         |           |   |                                |   |         |  |           |                                |  |   |     
|-------------------------------------------------------------- |  | ---------- | - | ---- | ------------------------------ | ---- | ------- | --------- | - | ------------------------------ | - | ------- |  | --------- | ------------------------------ |  | - | ----
|                                                               |  | 2004       |   | 2003 |                                | 2002
|                                                               |  | Options    |   |      | Weighted- AverageExercisePrice |      | Options |           |   | Weighted- AverageExercisePrice |   | Options |  |           | Weighted- AverageExercisePrice
|Outstandingbeginning of year                                  |  | 4,471,138  |   |      | $                              | 1.47 |         | 4,538,462 |   |                                | $ | 1.77    |  | 4,382,703 |                                |  | $ | 2.02
|Granted                                                        |  | 400,000    |   |      |                                | 0.29 |         | 475,750   |   |                                |   | 0.36    |  | 778,250   |                                |  |   | 0.92
|Exercised                                                      |  | (232,002   | ) |      |                                | 0.18 |         | (146,671  | ) |                                |   | 0.18    |  | (21,669   | )                              |  |   | 0.18
|Forfeited                                                      |  | (1,080,928 | ) |      |                                | 1.96 |         | (396,403  | ) |                                |   | 3.96    |  | (600,822  | )                              |  |   | 2.58
|                                                               |  |            |   |      |                                |      |         |           |   |                                |   |         |  |           |                                |  |   |     
|Outstandingend of year                                        |  | 3,558,208  |   |      | $                              | 1.28 |         | 4,471,138 |   |                                | $ | 1.47    |  | 4,538,462 |                                |  | $ | 1.77
|                                                               |  |            |   |      |                                |      |         |           |   |                                |   |         |  |           |                                |  |   |     
|Exercisable at end of year                                     |  | 2,341,756  |   |      | $                              | 1.62 |         | 2,294,990 |   |                                | $ | 2.22    |  | 1,550,701 |                                |  | $ | 3.57
|                                                               |  |            |   |      |                                |      |         |           |   |                                |   |         |  |           |                                |  |   |     
|Weighted-average fair value of options granted during the year |  |            |   |      | $                              | 0.24 |         |           |   |                                | $ | 0.24    |  |           |                                |  | $ | 0.61
|                                                               |  |            |   |      |                                |      |         |           |   |                                |   |         |  |           |                                |  |   |     



The following table
summarizes information about stock options outstanding at December 31, 2004:



|                         |  |                   |  |                                           |  |                               |       |                   |           |                                |   |      
|------------------------ |  | ----------------- |  | ----------------------------------------- |  | ----------------------------- | ----- | ----------------- | --------- | ------------------------------ | - | -----
|                         |  | Outstanding       |  | Exercisable                              
|Range of Exercise Prices |  | NumberOutstanding |  | Weighted-AverageRemainingContractual Life |  | Weighted-AverageExercisePrice |       | NumberExercisable |           | Weighted-AverageExercise Price
|$.00 - $.18              |  | 613,665           |  | 6.2                                       |  | $                             | 0.18  |                   | 613,665   |                                | $ | 0.18 
|$.19 - $.33              |  | 710,000           |  | 6.6                                       |  | $                             | 0.26  |                   | 467,778   |                                | $ | 0.29 
|$.34 - $.50              |  | 456,777           |  | 8.3                                       |  | $                             | 0.41  |                   | 177,212   |                                | $ | 0.41 
|$.51 - $.75              |  | 875,000           |  | 6.6                                       |  | $                             | 0.52  |                   | 625,000   |                                | $ | 0.52 
|$.76 - $1.00             |  | 405,500           |  | 7.0                                       |  | $                             | 1.00  |                   | 3,667     |                                | $ | 0.80 
|$1.01 - $2.00            |  | 177,667           |  | 7.2                                       |  | $                             | 1.14  |                   | 137,335   |                                | $ | 1.14 
|$2.01 - $3.00            |  | 2,500             |  | 5.3                                       |  | $                             | 2.19  |                   | 2,000     |                                | $ | 2.19 
|$3.01 - $4.00            |  | 32,234            |  | 4.3                                       |  | $                             | 3.75  |                   | 30,234    |                                | $ | 3.75 
|$4.01 - $5.00            |  | 79,034            |  | 2.2                                       |  | $                             | 4.34  |                   | 79,034    |                                | $ | 4.34 
|$5.01 - $25.00           |  | 205,831           |  | 3.2                                       |  | $                             | 12.29 |                   | 205,831   |                                | $ | 12.29
|                         |  |                   |  |                                           |  |                               |       |                   |           |                                |   |      
|                         |  | 3,558,208         |  | 6.5                                       |  | $                             | 1.28  |                   | 2,341,756 |                                | $ | 1.62 
|                         |  |                   |  |                                           |  |                               |       |                   |           |                                |   |      



At December 31, 2004,
options for 2,685,731 common shares were available for future grant.



Page 41 of 53



---

Daou Systems, Inc.

Notes to Financial Statements(Continued)



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:



|                                                                             |  |      |   |  |      |   |  |      |  
|---------------------------------------------------------------------------- |  | ---- | - |  | ---- | - |  | ---- | -
|                                                                             |  | 2004 |   |  | 2003 |   |  | 2002 |  
|Risk-free interest rate                                                      |  | 3.5  | % |  | 3.00 | % |  | 6.0  | %
|Dividend yield                                                               |  | 0    | % |  | 0    | % |  | 0    | %
|Volatility factor of the expected market price of the Companys common stock |  | 123  | % |  | 82   | % |  | 138  | %
|Weighted average expected life of options (years)                            |  | 5    |   |  | 5    |   |  | 5    |  



Common Stock Reserved



At December 31, 2004, the Company had the following
shares reserved for future issuance:



|                                     |  |           
|------------------------------------ |  | ----------
|Series A convertible preferred stock |  | 2,750,000 
|Warrants                             |  | 3,540,000 
|Stock options                        |  | 6,243,939 
|Employee stock purchase plan         |  | 904,189   
|                                     |  |           
|Total                                |  | 13,438,128
|                                     |  |           



9. Income Taxes



The income tax provision of $36,000 recorded in 2004 represents current
state income taxes and the income tax provision of $52,000 recorded in 2003 is comprised of current Federal alternative minimum taxes of $36,000 and current state income taxes of $16,000. Deferred income taxes are provided for temporary differences
in recognizing certain income and expense items for financial and tax reporting purposes.



Significant components of the Companys deferred tax assets and liabilities are shown below (in thousands):



|                                                  |  |              |         |   |      |   |         |  
|------------------------------------------------- |  | ------------ | ------- | - | ---- | - | ------- | -
|                                                  |  | December 31, |        
|                                                  |  | 2004         |         |   | 2003 |  
|Deferred tax liabilities:                         |  |              |         |   |      |   |         |  
|Depreciation and amortization                     |  | $            | 157     |   |      | $ | 60      |  
|                                                  |  |              |         |   |      |   |         |  
|                                                  |  |              | 157     |   |      |   | 60      |  
|Deferred tax assets:                              |  |              |         |   |      |   |         |  
|Reserves and allowances                           |  |              | 443     |   |      |   | 696     |  
|Tax credit carryforwards                          |  |              | 35      |   |      |   | 36      |  
|Net operating losses                              |  |              | 11,930  |   |      |   | 9,925   |  
|                                                  |  |              |         |   |      |   |         |  
|                                                  |  |              | 12,408  |   |      |   | 10,657  |  
|                                                  |  |              |         |   |      |   |         |  
|Net deferred tax asset before valuation allowance |  |              | 12,251  |   |      |   | 10,597  |  
|Valuation allowance for deferred tax assets       |  |              | (12,251 | ) |      |   | (10,597 | )
|                                                  |  |              |         |   |      |   |         |  
|Net deferred tax asset                            |  | $            |        |   |      | $ |        |  
|                                                  |  |              |         |   |      |   |         |  



At December 31, 2004, the Company has
federal and state net operating loss carryforwards of approximately $32.0 million and $10.9 million, respectively. The federal loss carryforwards expire beginning in 2018 through



Page 42 of 53



---

Daou Systems, Inc.

Notes to Financial Statements(Continued)



2024 and the
state loss carryforwards expire from 2004 through 2024, unless previously utilized. Additionally, the Company has federal alternative minimum tax credit carryforwards of approximately $36,000 which may be carried forward indefinitely. For financial
reporting purposes the Company has recorded a valuation allowance against the deferred tax assets (which have arisen primarily due to these net operating losses) as realization is not certain.



Under section 382 of the Internal Revenue Code, the annual use of the
Companys net operating loss carryforwards may be limited in the event of a cumulative change in ownership of more than 50%. However, the Company does not believe such a limitation will have a material impact on the ultimate utilization of
these carryforwards.



The reconciliation of income tax computed at the federal
statutory rate to the total provision for income taxes is as follows:



|                                        |  |                          |    |  |       |   |  |       |   
|--------------------------------------- |  | ------------------------ | -- |  | ----- | - |  | ----- | --
|                                        |  | Years Ended December 31, |   
|                                        |  | 2004                     |    |  | 2003  |   |  | 2002  |   
|Tax at federal statutory rate           |  | (35.0                    | )% |  | 35.0  | % |  | (35.0 | )%
|Nondeductible expenses                  |  | 0.4                      |    |  | 0.9   |   |  | 2.4   |   
|State taxes, net of federal benefit     |  | (2.2                     | )  |  | 5.6   |   |  | (5.5  | ) 
|                                        |  |                          |   
|Valuation allowance                     |  | 37.6                     |    |  |      |   |  | 38.1  |   
|Use of net operating loss carryforwards |  |                         |    |  | (39.5 | ) |  |      |   
|                                        |  |                          |    |  |       |   |  |       |   
|                                        |  | 0.8                      | %  |  | 2.0   | % |  | 0.0   | % 
|                                        |  |                          |    |  |       |   |  |       |   



10. Benefit Plans



The Company sponsors the Daou Systems, Inc. 401(k) Salary Savings Plan
(the 401(k) Plan) which covers employees who meet certain age and service requirements. Employees may contribute a portion of their earnings each plan year subject to certain Internal Revenue Service limitations. This Plan replaces the
former Daou Systems, Inc. 401(k) Salary Savings Plan. The Company also had various other defined contribution plans related to acquisitions under which employees also participated. During 2003, the Company terminated all of its former defined
contribution plans and as of December 31, 2003 the Company only maintains the 401(k) Plan. Contributions under the 401(k) Plan are made at the sole discretion of the Company and were $0, $370,000 and $344,000 for 2004, 2003 and 2002, respectively.



11. Contingencies



IN RE DAOU SYSTEMS SECURITIES LITIGATION



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.



Page 43 of 53



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Daou Systems, Inc.

Notes to Financial Statements(Continued)



A Motion to Dismiss the second amended consolidated class action complaint was filed on February 23, 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 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 pending 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.



DICKSON V DAOU SYSTEMS, INC. ET AL



On February 27, 2002, a Complaint was filed against certain of the Companys former officers and directors as well as DAOU On-Line, Inc. in the Superior Court of New Jersey located in Bergen County. A First
Amended Complaint was filed on March 1, 2002, adding the Company and its former Chief Financial Officer as parties-defendant. The Company filed a Motion to Dismiss the First Amended Complaint on April 24, 2002. The Court conducted a hearing on June
7, 2002 and granted the motion. On July 23, 2002, plaintiffs filed a Notice of Appeal, but later abandoned their appeal in favor of refiling their lawsuit in San Diego County Superior Court. The parties stipulated to a stay of this lawsuit and
submission of the matter to arbitration before the American Arbitration Association. The court approved that stipulation and stayed all proceedings by order dated July 22, 2003. On October 6, 2003, plaintiffs filed a Statement of Claim with the
American Arbitration Association, the gravaman of which is the same as the former complaint filed in Bergen County, New Jersey and San Diego County Superior Court. The Statement of Claim alleges compensatory damages in the amount of $1,094,600 and
also prays for punitive damages as well as attorneys fees and costs. On December 3, 2003, the Company filed an answer to the Statement of Claim, generally denying the allegations and alleging certain affirmative defenses. All parties agreed to
the appointment of Peter Shenas as the arbitrator. A preliminary hearing was conducted on February 3, 2004, during which the parties agreed to the scope of written and oral discovery and how the arbitration would proceed.



Page 44 of 53



---

Daou Systems, Inc.

Notes to Financial Statements(Continued)



The Company and
certain of the Companys former officers and directors entered into a Settlement Agreement And Mutual General Release Of All Claims with Steven C. Dickson and Mary B. Dickson on October 29, 2004. The Parties voluntarily elected to settle the
litigation entitled Steven C. Dickson v. Daou Systems, Inc., et al.; the arbitration entitled Steven C. Dickson v. Daou Systems, Inc, et al.; and a certain judgment lien in favor of Daou Systems, Inc. against Steven C. Dickson and any and all other
claims or disputes arising out of any other contract, agreement or business dealings of any kind between the Parties. The settlement did not have a material impact to the 2004 financial results.



12. Quarterly Financial Data (Unaudited)



The following is a summary of the unaudited quarterly results of operations
for the year ended December 31, 2004 and 2003, respectively. The unaudited financial information reflects all normal recurring adjustments, which in the opinion of management are necessary for the fair statement of the results of the interim periods
(in thousands, except per share amounts).



Page 45 of 53



---

|                                                              |  |               |        |   |          |   |        |               |  |   |              |   |  |   |       |    
|------------------------------------------------------------- |  | ------------- | ------ | - | -------- | - | ------ | ------------- |  | - | ------------ | - |  | - | ----- | ---
|                                                              |  | Quarter Ended |       
|                                                              |  | March 31,     |        |   | June 30, |   |        | September 30, |  |   | December 31, |  
|2004                                                          |  |               |        |   |          |   |        |               |  |   |              |   |  |   |       |    
|Net revenue                                                   |  | $             | 8,838  |   |          | $ | 6,643  |               |  | $ | 5,631        |   |  | $ | 5,995 |    
|Gross profit                                                  |  |               | 1,716  |   |          |   | 1,755  |               |  |   | 1,118        |   |  |   | 2,039 |    
|Net loss available to common stockholders                     |  |               | (1,275 | ) |          |   | (1,323 | )             |  |   | (1764        | ) |  |   | (44   | ) *
|Net loss available to common stockholders per common share:   |  |               |        |   |          |   |        |               |  |   |              |   |  |   |       |    
|Basic                                                         |  |               | (0.06  | ) |          |   | (0.06  | )             |  |   | (0.08        | ) |  |   |      |    
|Diluted                                                       |  |               | (0.06  | ) |          |   | (0.06  | )             |  |   | (0.08        | ) |  |   |      |    
|                                                              |  |               |        |  
|2003                                                          |  |               |        |   |          |   |        |               |  |   |              |   |  |   |       |    
|Net revenue                                                   |  | $             | 11,217 |   |          | $ | 11,202 |               |  | $ | 10,127       |   |  | $ | 9,615 |    
|Gross profit                                                  |  |               | 3,522  |   |          |   | 4,113  |               |  |   | 3,113        |   |  |   | 2,653 |    
|Net income available to common stockholders                   |  |               | 376    |   |          |   | 556    |               |  |   | 331          |   |  |   | 35    |    
|Net income available to common stockholders per common share: |  |               |        |   |          |   |        |               |  |   |              |   |  |   |       |    
|Basic                                                         |  |               | 0.02   |   |          |   | 0.03   |               |  |   | 0.02         |   |  |   |      |    
|Diluted                                                       |  |               | 0.02   |   |          |   | 0.02   |               |  |   | 0.01         |   |  |   |      |    



---

|* | The fourth quarter was favorably impacted by certain accrual adjustments made in the period. The Company reduced employee bonus and commission expenses by approximately $400,000 and
Company 401(k) discretionary match accruals by approximately $225,000 as a result of lower than expected revenue and gross margin performance, and made a $257,000 adjustment to the provision for bad debt as the result of collecting overdue accounts.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



SCHEDULE IIVALUATION AND QUALIFYING ACCOUNTS

(In thousands)



|                                |  |                              |     |                             |   |        |                                   |        |            |   |                        |   |     |  |   |    
|------------------------------- |  | ---------------------------- | --- | --------------------------- | - | ------ | --------------------------------- | ------ | ---------- | - | ---------------------- | - | --- |  | - | ---
|COL. A                          |  | COL. B                       |     | COL. C                      |   | COL. D |                                   | COL. E
|                                |  |                              |     | Additions                   |   |        |                                   |       
|Description                     |  | Balance atBeginningof Period |     | Charged toCosts andExpenses |   |        | Charged toOtherAccounts Describe |        | Write-offs |   | Balance atEnd ofPeriod
|Year Ended December 31,2004:    |  |                              |     |                             |   |        |                                   |        |            |   |                        |   |     |  |   |    
|Allowance for doubtful accounts |  | $                            | 789 |                             | $ | (405   | )                                 |        | $          |  |                        | $ | 17  |  | $ | 367
|Year Ended December 31, 2003:   |  |                              |     |                             |   |        |                                   |        |            |   |                        |   |     |  |   |    
|Allowance for doubtful accounts |  | $                            | 732 |                             | $ | 57     |                                   |        | $          |  |                        | $ |    |  | $ | 789
|Year Ended December 31, 2002:   |  |                              |     |                             |   |        |                                   |        |            |   |                        |   |     |  |   |    
|Allowance for doubtful accounts |  | $                            | 715 |                             | $ | 186    |                                   |        | $          |  |                        | $ | 169 |  | $ | 732



Page 46 of 53



---

Item 9:Changes in and Disagreements With Accountants on Accounting and Financial Disclosure.



None.



Item 9A: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 Rules 13a-15(a) and 15d-15(e). Based on that evaluation, the Companys Chief Executive Officer and Chief Financial Officer concluded that the Companys disclosure
controls and procedures were effective, as of December 31, 2004, 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 fourth quarter of 2004.



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 III



Item 10:Directors, Executive Officers, Promoters and Control Persons;
Compliance with Section 16(a) of the Exchange Act.



The information required by this item will be included under the captions entitled Elections of Directors and Information Concerning Directors and Executive Officers in the Companys Proxy Statement and is
incorporated herein by reference.



Item 11:Executive
Compensation.



The information required by this
item will be included under the caption entitled Executive Compensation in the Companys Proxy Statement and is incorporated herein by reference.



Item 12:Security Ownership of Certain Beneficial Owners and Management.



The information required by this item will be included under the caption
entitled Security Ownership of Certain Beneficial Owners and Management in the Companys Proxy Statement and is incorporated herein by reference.



Item 13:Certain Relationships and Related Transactions.



The information required by this item will be included under the caption
entitled Certain Relationships and Related Transactions in the Companys Proxy Statement and is incorporated herein by reference.



Page 47 of 53



---

Item 14:Principal Accountant Fees and Services.



The information required by this item will be included under the caption
entitled Principal Accountant Fees and Services in the Companys Proxy Statement and is incorporated herein by reference.



PART IV



Item 15:Exhibits, Financial Statement Schedules, and Reports on Form 8-K.



(a) The following are filed as part of, or included in, this Annual Report on Form 10-K:



| | (1) | The financial statements listed in the Index to Consolidated Financial Statements and Consolidated Financial Statement Schedule are filed as a part of this Annual Report on Form
10-K.
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (2) | The financial statement schedule listed in the Index to Consolidated Financial Statements and Consolidated Financial Statement Schedule is filed as a part of this Annual Report on
Form 10-K.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (3) | The exhibits listed in the Index to Exhibits hereof are attached hereto or incorporated herein by reference and filed as part of this Report.
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------



Page 48 of 53



---

SIGNATURES



Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.



Date: March
30, 2005



|                   |  |                                      
|------------------ |  | -------------------------------------
|DAOU SYSTEMS, INC.
|                   | 
|By:                |  | /s/ Vincent K. Roach                 
|                   |  | Vincent K. Roach                     
|                   |  | Chief Executive Officer              
|                   |  | (Principal Executive Officer)        
|                   | 
|By:                |  | /s/ John A. Roberts                  
|                   |  | John A. Roberts                      
|                   |  | Chief Financial Officer and Secretary
|                   |  | (Principal Financial Officer)        



Pursuant to the requirements of the
Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.



|                          |  |                                                 |  |               
|------------------------- |  | ----------------------------------------------- |  | --------------
|Signature                 |  | Title                                           |  | Date          
|/s/ Vincent K. Roach      |  | Director, President and Chief Executive Officer |  | March 30, 2005
|Vincent K. Roach          |  |                                                 |  |               
|                          |  |                                                
|/s/ Larry R. Ferguson     |  | Chairman of the Board                           |  | March 30, 2005
|Larry R. Ferguson         |  |                                                 |  |               
|                          |  |                                                
|/s/ Bruce R. Wesson       |  | Director                                        |  | March 30, 2005
|Bruce R. Wesson           |  |                                                 |  |               
|                          |  |                                                
|/s/ Douglas L. Cox        |  | Director                                        |  | March 30, 2005
|Douglas Cox               |  |                                                 |  |               
|                          |  |                                                
|/s/ Richard A. Blumenthal |  | Director                                        |  | March 30, 2005
|Richard Blumenthal        |  |                                                 |  |               
|                          |  |                                                
|/s/ Robert F. Radin       |  | Director                                        |  | March 30, 2005
|Robert F. Radin           |  |                                                 |  |               



Page 49 of 53



---

INDEX TO EXHIBITS



|              |  |             |  |                                                                                                                                                                                                                                                                                                                                                                                    
|------------- |  | ----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description
|3.1(1)        |  |            |  | Amended and Restated Certificate of Incorporation of the Registrant.                                                                                                                                                                                                                                                                                                               
|              |  |            
|3.2(1)        |  |            |  | Bylaws of the Registrant.                                                                                                                                                                                                                                                                                                                                                          
|              |  |            
|4.1           |  |            |  | Reference is made to Exhibits 3.1 and 3.2.                                                                                                                                                                                                                                                                                                                                         
|              |  |            
|4.2(1)        |  |            |  | Specimen stock certificate.                                                                                                                                                                                                                                                                                                                                                        
|              |  |            
|4.3(3)        |  |            |  | Certificate of Designations of the Registrant, as filed with the Secretary of State of the State of Delaware on July 23, 1999.                                                                                                                                                                                                                                                     
|              |  |            
|4.4(4)        |  |            |  | Amended and Restated Registration Rights Agreement, dated as of November 9, 2000, by and between the Registrant, Galen Partners III, L.P., a Delaware limited partnership (Galen
III), Galen Partners International III, L.P., a Delaware limited partnership (Galen International), and Galen Employee Fund III, L.P., a Delaware limited partnership (Galen Employee Fund).
|              |  |            
|4.5(6)        |  |            |  | Restricted Stock Purchase Agreement, dated June 1, 2001, by and between the Registrant and Vincent K. Roach.                                                                                                                                                                                                                                                                       
|              |  |            
|4.6(6)        |  |            |  | Registration Rights Agreement, dated June 1, 2001, by and between the Registrant and Vincent K. Roach.                                                                                                                                                                                                                                                                             
|              |  |            
|4.7(7)        |  |            |  | Registration Rights Agreement, dated June 1, 2001, by and between the Registrant and James T. Roberto.                                                                                                                                                                                                                                                                             
|              |  |            
|10.1(1)       |  |            |  | Form of Indemnification Agreement.                                                                                                                                                                                                                                                                                                                                                 



Page 50 of 53



---

|              |  |             |  |                                                                                                                                                                   
|------------- |  | ----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description
|10.2(2)       |  |            |  | Amendment No. 5 to Daou Systems, Inc. 1996 Stock Option Plan, as amended.                                                                                         
|              |  |            
|10.3(1)       |  |            |  | Form of Incentive Stock Option Agreement under the 1996 Stock Option Plan.                                                                                        
|              |  |            
|10.4(1)       |  |            |  | Form of Nonstatutory Stock Option Agreement under the 1996 Stock Option Plan.                                                                                     
|              |  |            
|10.5(*)       |  |            |  | Form of Master Services Agreement.                                                                                                                                
|              |  |            
|10.6(3)       |  |            |  | Voting Agreement, dated as of July 26, 1999, by and among the Registrant, Daniel J. Daou, Georges J. Daou, Galen III, Galen International and Galen Employee Fund.
|              |  |            
|10.7(3)       |  |            |  | Series A Preferred Stock Purchase Agreement, dated as of July 26, 1999, by and among the Registrant, Galen III, Galen International and Galen Employee Fund.      
|              |  |            
|10.8(6)       |  |            |  | Employment Agreement, dated June 1, 2001, by and between the Registrant and Vincent K. Roach.                                                                     
|              |  |            
|10.9(11)      |  |            |  | Amended and Restated Employment Agreement, dated August 13, 2004, by and between the Registrant and Vincent K. Roach.                                             
|              |  |            
|10.10(6)      |  |            |  | Secured Promissory Note, dated June 1, 2001, by and between the Registrant and Vincent K. Roach.                                                                  
|              |  |            
|10.11(6)      |  |            |  | Stock Pledge Agreement, dated June 1, 2001, by and between the Registrant and Vincent K. Roach.                                                                   
|              |  |            
|10.12(7)      |  |            |  | Secured Promissory Note, dated June 1, 2001, by and between the Registrant and James T. Roberto.                                                                  
|              |  |            
|10.13(7)      |  |            |  | Stock Pledge Agreement, dated June 1, 2001, by and between the Registrant and James T. Roberto.                                                                   



Page 51 of 53



---

|               |  |   |  |                                                                                                                                                                                                                                                                                    
|-------------- |  | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  |   |  | Description                                                                                                                                                                                                                                                                        
|               |  |  
|10.14(2)       |  |  |  | Executive Stock Option Agreement, dated December 13, 2001, between the Registrant and Neil R. Cassidy.                                                                                                                                                                             
|               |  |  
|10.15(2)       |  |  |  | Executive Stock Option Agreement, dated December 13, 2001, between the Registrant and James T. Roberto.                                                                                                                                                                            
|               |  |  
|10.16(2)       |  |  |  | Executive Stock Option Agreement, dated November 6, 2001, between the Registrant and Daniel J. Malcolm.                                                                                                                                                                            
|               |  |  
|10.17(8)       |  |  |  | Executive Stock Option Agreement, dated May 17, 2002, by and between Registrant and Neil R. Cassidy.                                                                                                                                                                               
|               |  |  
|10.18(8)       |  |  |  | Form of Board of Director Stock Option Agreement, dated November 5, 2002, by and between Registrant and Kevin. M. Fickenscher, David W. Jahns, and H. Lawrence Ross (25,000 options each), and
November 6, 2002, by and between Registrant and Larry R. Ferguson (100,000 options).
|               |  |  
|10.19(8)       |  |  |  | Separation Agreement and General Release, dated December 31, 2002, between the Registrant and Neil R. Cassidy.                                                                                                                                                                     
|               |  |  
|10.20(8)       |  |  |  | Separation Agreement and General Release, dated December 31, 2002, between the Registrant and James T. Roberto.                                                                                                                                                                    
|               |  |  
|10.21(8)       |  |  |  | Form of Indemnification Agreement.                                                                                                                                                                                                                                                 
|               |  |  
|10.22(9)       |  |  |  | Executive Stock Option Agreement, dated February 10, 2003, between Registrant and Daniel J. Malcolm.                                                                                                                                                                               
|               |  |  
|10.23(9)       |  |  |  | Amendment No. 1 to Separation Agreement and General Release, dated effective March 31, 2003, between Registrant and Neil R. Cassidy.                                                                                                                                               
|               |  |  
|10.24(10)      |  |  |  | General Release, dated July 19, 2004, between Registrant and Daniel J. Malcolm.                                                                                                                                                                                                    
|               |  |  
|10.25(12)      |  |  |  | Employment Agreement, dated March 9, 2005, between Registrant and John A. Roberts.                                                                                                                                                                                                 
|               |  |  
|23.1           |  |  |  | Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm.                                                                                                                                                                                                       
|               |  |  
|31.1(*)        |  |  |  | Certification of Vincent K. Roach                                                                                                                                                                                                                                                  
|               |  |  
|31.2(*)        |  |  |  | Certification of John A. Roberts                                                                                                                                                                                                                                                   



Page 52 of 53



---

|               |  |                                                                                                                                                   
|-------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                       
|32.1(*)        |  | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
|               | 
|32.2(*)        |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.



---

|(*) | Filed herewith.
|--- | ---------------

|(1) | Incorporated by reference to the similarly described exhibit included with the Registrants Registration Statement on Form SB2, File No. 333-18155, declared effective by the
Commission on February 12, 1997.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Incorporated by reference to the similarly described exhibit included with the Registrants Annual Report on Form 10-K for the year ended December 31, 2001, filed with the
Commission on April 1, 2002.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Incorporated by reference to the similarly described exhibit included with the Registrants Current Report on Form 8-K, filed with the Commission on July 29, 1999.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(4) | Incorporated by reference to the similarly described exhibit included with the Registrants Quarterly Report on Form 10-Q for the quarter ended September 30, 2000, filed with
the Commission on November 14, 2000.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(5) | Incorporated by reference to the similarly described exhibit included with the Registrants Quarterly Report on Form 10-Q for the quarter ended March 31, 2001, filed with the
Commission on May 14, 2001.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(6) | Incorporated by reference to the similarly described exhibit included with the Registrants Quarterly Report on Form 10-Q for the quarter ended June 30, 2001, filed with the
Commission on August 14, 2001.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(7) | Incorporated by reference to the similarly described exhibit included with the Registrants Quarterly Report on Form 10-Q for the quarter ended September 30, 2001, filed with
the Commission on November 14, 2001.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(8) | Incorporated by reference to the similarly described exhibit included with the Registrants Annual Report on Form 10-K for the year ended December 31, 2002, filed with the
Commission on March 31, 2003.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(9) | Incorporated by reference to the similarly described exhibit included with the Registrants Quarterly Report on Form 10-Q for the quarter ended June 30, 2003, filed with the
Commission on August 14, 2003.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(10) | Incorporated by reference to the similarly described exhibit included with the Registrants Quarterly Report on Form 10-Q for the quarter ended June 30, 2004, filed with the
Commission on August 11, 2004.
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(11) | Incorported by reference to the similarly described exhibit included with the Registrants Quarterly Report on Form 10-Q for the quarter ended September 30, 2004 filed with the
Commission on November 12, 2004.
|---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(12) | Incorporated by reference to the similarly described exhibit included with the Registrants Current Report on Form 8-K, filed with the Commission on March 11, 2005.
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------



Page 53 of 53